CHAPTER 3

THE INTERNATIONAL MONETARY SYSTEM

The purpose of this chapter is to help students understand what the international monetary system is and how the choice of system affects currency values. It also provides a historical background of the international monetary system. This enables students to gain perspective when trying to interpret the likely consequences of new policies in the area of international finance.

This chapter describes how exchange rates are determined under four different mechanisms--free float, managed float, fixed-rate system, and target-zone system. Under the latter three systems, governments intervene in the currency markets in one form or another to affect the exchange rate.

Key Points

1. Under the latter three systems, which involve varying degrees of central bank intervention, the real exchange rate is liable to change, with important implications for exchange risk management (as discussed in Chapters 9 through 11).

2. Regardless of the form of intervention, fixed rates don't remain fixed for long. Neither do floating rates. The basic reason that exchange rates don't stay fixed for long in either a fixed- or floating-rate system is that governments subordinate exchange rate considerations to domestic political considerations.

3. The gold standard is a specific type of fixed exchange rate system, one that required participating countries to maintain the value of their currencies in terms of gold. Calls for a new gold standard remind us of the fundamental lack of trust in fiat money due to the historical unwillingness of the monetary authorities to desist from tampering with the money supply.

4. Intervention to maintain a disequilibrium rate is usually either ineffective or injurious when pursued over lengthy periods of time. Seldom, if ever, have policy makers been able to outsmart for any extended period