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CHAPTER 2 INTERNATIONAL MONETARY SYSTEM
ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS
QUESTIONS
1. Explain Gresham’s Law.
2. Explain the mechanism which restores the balance of payments equilibrium when it is
disturbed under the gold standard.
Answer: The adjustment mechanism under the gold standard is referred to as the price-specie-
3. Suppose that the pound is pegged to gold at 6 pounds per ounce, whereas the franc is
pegged to gold at 12 francs per ounce. This, of course, implies that the equilibrium exchange
rate should be two francs per pound. If the current market exchange rate is 2.2 francs per
pound, how would you take advantage of this situation? What would be the effect of shipping
costs?
Answer: Suppose that you need to buy 6 pounds using French francs. If you buy 6 pounds
directly in the foreign exchange market, it will cost you 13.2 francs. Alternatively, you can first
4. Discuss the advantages and disadvantages of the gold standard.
Answer: The advantages of the gold standard include: (I) since the supply of gold is restricted,
5. What were the main objectives of the Bretton Woods system?
6. Comment on the proposition that the Bretton Woods system was programmed to an eventual
demise.
7. Explain how special drawing rights (SDR) are constructed. Also, discuss the circumstances
under which the SDR was created.
Answer: SDR was created by the IMF in 1970 as a new reserve asset, partially to alleviate the
8. Explain the arrangements and workings of the European Monetary System (EMS).
Answer: EMS was launched in 1979 in order to (i) establish a zone of monetary stability in
Europe, (ii) coordinate exchange rate policies against the non-EMS currencies, and (iii) pave the
9. There are arguments for and against the alternative exchange rate regimes.
a. List the advantages of the flexible exchange rate regime.
b. Criticize the flexible exchange rate regime from the viewpoint of the proponents of the fixed
exchange rate regime.
c. Rebut the above criticism from the viewpoint of the proponents of the flexible exchange rate
regime.
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
Answer: a. The advantages of the flexible exchange rate system include: (I) automatic
achievement of balance of payments equilibrium and (ii) maintenance of national policy
autonomy.
b. If exchange rates are fluctuating randomly, that may discourage international trade and
encourage market segmentation. This, in turn, may lead to suboptimal allocation of resources.
c. Economic agents can hedge exchange risk by means of forward contracts and other
techniques. They don’t have to bear it if they choose not to. In addition, under a fixed exchange
rate regime, governments often restrict international trade in order to maintain the exchange
rate. This is a self-defeating measure. What’s good about having the fixed exchange rate if
international trade need to be restricted?
10. In an integrated world financial market, a financial crisis in a country can be quickly
transmitted to other countries, causing a global crisis. What kind of measures would you
propose to prevent the recurrence of an Asia-type crisis.
11. Discuss the criteria for a ‘good’ international monetary system.
12. Once capital markets are integrated, it is difficult for a country to maintain a fixed exchange
rate. Explain why this may be so.
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
maintain a fixed exchange rate.
13. Assess the possibility for the euro to become another global currency rivaling the U.S.
dollar. If the euro really becomes a global currency, what impact will it have on the U.S. dollar
and the world economy?
Answer: In light of the large transactions domain of the euro, which is comparable to that of the
U.S. dollar, and the mandate for the European Central Bank (ECB) to guarantee the monetary
MINI CASE: Grexit or Not?
When the euro was introduced in 1999, Greece was conspicuously absent from the list of
the European Union member countries adopting the common currency. The country
was not ready. In a few short years, however, European leaders, probably motivated by
their political agenda, allowed Greece to join the euro club in 2001 although it was not
entirely clear if the country satisfied the entry conditions. In any case, joining the euro
club allowed the Greek government, households, and firms to gain easy access to
plentiful funds at historically low interest rates, ushering in a period of robust credit
growth. For a while, Greeks enjoyed what seemed to be the fruits of becoming a full-
fledged member of Europe. In December 2009, however, the new Greek government
revealed that the government budget deficit would be 12.7% for 2009, not 3.7% as
previously announced by the outgoing government, far exceeding the EU’s convergence
guideline of keeping the budget deficit below 3.0% of the GDP. As the true picture of the
government finance became known, the prices of Greek government bonds began to fall
sharply, prompting panic selling among international investors, threatening the
sovereign defaults.
Several years into the crisis, the Greek government debt stands at around 180% of GDP
and the jobless rate among youth is above 50%. The country’s GDP declined by about
25%. Severe austerity measures, such as sharply raised taxes and much reduced pension
benefits, were imposed on Greece as conditions for the bailouts arranged by the EU,
IMF, and the European Central Bank. In addition, people were allowed to have only
restricted access to their bank deposits, to prevent bank runs. Opinion polls indicate
that the majority of people in Germany, the main creditor nation for Greece, prefer the
Greek exit from the euro-zone, popularly called Grexit, while some people in Greece are
demanding Grexit themselves and restoration of the national currency, the drachma.
Suggested Solution to Grexit or Not?
As is often the case with many sovereign debt crises in history, the Greek sovereign debt
crisis, which raises the possibility of Grexit from the euro-zone, is attributable to the
excessive borrowing and spending on the part of the government which cannot be
