Which International Monetary System Is Better? - dummies

Which International Monetary System Is Better?

By Ayse Evrensel

Economics is all about tradeoffs, and there’s no such thing as a flawless international monetary system. All systems have their benefits and costs. Any variety of a metallic standard, such as the gold standard of pre–World War II years and the reserve currency standard of the Bretton Woods era (1944–1971), avoids volatility in exchange rates.

But the stability in exchange rates comes at a high cost. Evidence suggests that, when trying to keep the fixed exchange rate, achieving internal balance (growth and full employment) and external balance (no large current account surplus or deficit), and allowing free flow of funds between countries, the internal and external balance was sacrificed for the fixed exchange rate.

This situation led to persistent current account deficits, lower growth, and higher unemployment in many countries. Especially during the early 1930s, retaliatory trade restrictions were introduced as a desperate attempt to promote growth and employment, which only worsened the overall economic outlook.

The floating exchange rate regime that developed countries have adopted since the early 1970s has the benefit of requiring no internal or external balance. It’s virtually maintenance free. But because currency trading in foreign exchange markets determines the exchange rates, countries’ monetary and fiscal policies or expectations regarding these policies have an effect on exchange rates.

The problem is that short-run fluctuations in floating exchange rates don’t reflect the changes in macroeconomic fundamentals. In fact, the short-run volatility seems to be excessive compared to the changes in macroeconomic fundamentals.

Many developing countries have adopted pegged exchange rates, and they have their benefits and costs as well. A pegged currency can signal stability and encourage much-needed hard currency flowing to the country.

If the country has a well-developed financial system that can distribute these funds efficiently among borrowers, hot money can stimulate growth. If the financial system of the country is weak or the government’s policies aren’t consistent with the peg, investors will expect that the peg will be broken. If they wait until the peg is actually broken, they suffer losses because, when the peg is broken, the currency substantially depreciates.

Therefore, investors convert their investment into hard currency right away. Clearly, a large amount of hard currency leaves the country in this case. The peg is broken, the currency is let to float (and depreciate), and the country has lost most of its international reserves.