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Unit 2: International Monetary System

the face of the current turmoil. Many EMCs now have current account surpluses, and have Notes
built up substantial international reserves. Fiscal and monetary policy frameworks have
also improved in many of these countries. Price stability has become the cornerstone of
monetary policy, and a number of countries have adopted, or are moving to adopt, inflation
targeting. Many also have flexible exchange rate regimes, which can act as a shock absorber
to rapid changes in external circumstances. And their direct exposure to the U.S. subprime
market remains quite small. As a result of these positive factors, EMCs have been relatively
less affected by the recent turbulence.
Questions

1. Discuss the challenges to the international monetary system.
2. Do you think recent events in financial markets point to a rebalancing of the
assessment and pricing of risk, which will likely lead to a rebalancing of currencies
and growth in the foreseeable future. Elucidate.
Source: International Financial Management, Madhu Vij, Excel Books.

2.4 Summary

Changes in the International Monetary System have been driven largely by the rapid
growth of private international capital flows, which first overwhelmed the Bretton Woods
fixed exchange rate system, and, since the 1980s, have had especially strong effects on the
emerging market countries.
Increasingly the discretion of national policymakers is constrained by international capital
markets, which magnify the rewards for good policies and the penalties for bad policies.
But markets may, on occasion, overreact by responding late and excessively to change in
underlying conditions.
The International Monetary System has had to adapt to the increasing role of private
capital flows. That process was evident in the shift towards flexible exchange rates among
the major currencies three decades ago, and it continues today, as we absorb and react to
the lessons of the emerging market crises of the last decade.

The gold standard worked well until World War I interrupted trade flows and disturbed
the stability of exchange rate for currencies. The inter-war years from 1914-1944 were
characterised by political instabilities and financial crisis.
The Bretton Woods System, which played a major emphasis on the stability of exchange
rates, worked from 1945–1972. However it came under mounting pressure as the post-war
growth of international trade was complemented by an even more dramatic expansion of
cross-border capital flows. These starkly revealed the difficulty of fixed exchange rate, an
open capital account, and a monetary policy dedicated to domestic economic goals. With
the leading countries unwilling to subordinate domestic policies to maintenance of the
exchange rate, the fixed exchange rate regime among the major economies gave way.

Today, the flexible (floating) exchange rate is prevalent, wherein the market force, based
on demand and supply, determines a currency’s value.
Both fixed and floating exchange rates have their own advantages and disadvantage.

The main objective of the EMS was to coordinate the exchange rate policies vis-à-vis the
non EMS currencies and to form a zone of monetary stability in Europe. It has three
components – the ERM, the ECU and the EMCF.

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