Page 23 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management

Notes The International Monetary System plays a crucial role in the financial management of a
multinational business and economic and financial policies of each country.

2.1 Evolution of the International Monetary System

Evolution of the International Monetary System can be analysed in four stages as follows:

1. The Gold standard, 1876–1913
2. The Inter-war Years, 1914–1944
3. The Bretton Woods System, 1945–1973
4. Flexible Exchange Rate Regime since 1973

2.1.1 The Gold Standard, 1876–1913

In the early days, gold was used as storage of wealth and as a medium of exchange. The gold
standard, as an International Monetary System, gained acceptance in Western Europe in the
1870s and existed as a historical reality during the period 1875–1914. The majority of countries
got off gold in 1914 when World War I broke out. The classical gold standard thus lasted for
approximately 40 years. The centre of the international financial system during this period was
London reflecting its important position in international business and trade.
The fundamental principle of the classical gold standard was that each country should set a par
value for its currency in terms of gold and then try to maintain this value. Thus, each country had
to establish the rate at which its currency could be converted to the weight of gold. Also, under
the gold standard, the exchange rate between any two currencies was determined by their gold
content.
Thus, the three important features of the gold standard were, First, the government of each
country defines its national monetary unit in terms of gold. Second, free import or export of
gold and third, two-way convertibility between gold and national currencies at a stable ratio.
The above three conditions were met during the period 1875 to 1914.
The United States, for example, declared the dollar to be convertible to gold at a rate of $20.67/
ounce of old. The British pound was pegged at £ 4.2474/ounce of gold. Thus, the dollar-pound
exchange rate would be determined as follows:
$20.67/ounce of gold
= $4.86656/£2
£4.2474/ounce of gold

Each country’s government then agreed to buy or sell gold at its own fixed parity rate on
demand. This helped to preserve the value of each individual currency in terms of gold and
hence, the fixed parities between currencies. Under this system, it was extremely important for
a country to back its currency value by maintaining adequate reserves of gold.
Consider, by way of example, the US dollar in relation to the British pound and assume that the
par value of the pound as defined by the dollar when the gold standard was in effect was $4.86.
If the cost of moving gold between the two countries was 2 cents per British pound, the fluctuation
limit would then be 2 cents either above or below that par value. That is, the value of the pound
sterling could move either up to $4.88 or down to $4.84. The upper limit was known as the ‘gold
export point’. The pound could not rise above the gold export point because the rate would then
be greater than the actual cost of shipping gold. If the value of the gold export point was greater,
a US importer would find it more economical simply to buy gold with dollars and ship the gold
as a payment to the British creditor instead of paying a higher price unnecessarily to buy

18 LOVELY PROFESSIONAL UNIVERSITY