Chapter 11 – The International Monetary System
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The International Monetary System
Learning objectives
• Describe the historical
development of the modern
global monetary system.
• Explain the role played by the
World Bank and the IMF in the
international monetary system.
• Compare and contrast the
differences between a fixed and
a floating exchange rate system.
• Identify exchange rate systems
that are used in the world today
and why countries adopt
different exchange rate regimes.
• Understand the debate
surrounding the role of the IMF
in the management of financial
crises.
• Explain the implications of the
global monetary system for
currency management and
business strategy.
This chapter discusses the evolution of the international
monetary system and the implications of this system for
international business, focusing on the institutional context
within which exchange rates move.
The history of monetary systems includes a period with
the gold standard, a fixed exchange rates system, and the
current managed float system. Since WWII, the IMF and
the World Bank have played an important role in the
world economy
The role of the IMF is to maintain order in the
international monetary system to avoid a repetition of the
competitive devaluations of the 1930s, and to control price
inflation by imposing monetary discipline on countries.
IMF-mandated macro economic policies are under serious
debate, with critics charging that at times the IMF imposes
inappropriate conditions on developing nations.
The opening case explores the recent debt crisis in Ireland
that threatened the value of the euro. In order to prevent
the crisis from spreading to other countries and to stabilize
the euro, the IMF and the EU provided the troubled
country with bailout assistance. The closing case
examines explores the effect of the 2008 financial crisis on
Latvia, and the IMF aid package the country was forced to
accept.
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Chapter 11 – The International Monetary System
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OUTLINE OF CHAPTER 11: THE INTERNATIONAL MONETARY
SYSTEM
Opening Case: Ireland’s Debt Crisis
Introduction
The Gold Standard
Mechanics of the Gold Standard
Strength of the Gold Standard
The Period between the Wars, 1918-1939
The Bretton Woods System
The Role of the IMF
The Role of the World Bank
The Collapse of the Fixed Exchange Rate System
The Floating Exchange Rate System.
The Jamaica Agreement
Exchange Rates Since 1973
Country Focus: The U.S. Dollar, Oil Prices, and Recycling Petrodollars
Fixed versus Floating Exchange Rates
The Case for Floating Exchange Rates
The Case for Fixed Exchange Rates
Who is Right?
Exchange Rate Regimes in Practice
Pegged Exchange Rates
Currency Boards
Crisis Management by the IMF
Financial Crises in the Post-Bretton Woods Era
Mexican Currency Crisis of 1995
The Asian Crisis
Evaluating the IMF’s Policy Prescriptions
Country Focus: Turkey and the IMF
Implications for Managers
Currency Management
Business Strategy
Corporate-Government Relations
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Management Focus: Airbus and the Euro
Chapter Summary
Critical Thinking and Discussion Questions
Closing Case: Economic Turmoil in Latvia
CLASSROOM DISCUSSION POINT
Ask students how much their currency is worth. Try to get them to identify its value in
terms of another currency. Then ask students how they might know the value of the
currency. Students will probably indicate options like the posting at the currency kiosk at
the airport, or the rates that are printed in the newspaper or are available online.
Dig a little deeper, and try to get students to identify some of the factors that could
influence the value of a currency.
Next, ask students what happens to currency values each day, and why. Try to get
students to recognize the idea of a floating exchange rate system.
Finally, link this discussion to the evolution of the current international monetary system.
OPENING CASE: Ireland’s Debt Crisis
The opening case explores the debt crisis in Ireland. After more than a decade of
prosperity, Ireland was caught off guard by the 2008-2009 global recession which caused
demand for the country’s exports to drop significantly. Unemployment surged and
banks, burdened with high levels of bad debt teetered on the verge of collapse. A bailout
from the Irish government helped avert disaster, but also pushed the country’s budget
deficit to over 30 percent of its GDP and public debt to about 180 percent of GDP. The
International Monetary Fund (IMF) and European Union (EU) were ultimately forced to
step to prevent the crisis from spreading and to shore up the value of the euro.
Discussion of the case can revolve around the following questions.
1. Why was it so important for the IMF and EU to step in to help Ireland in 2010? What
were the potential implications of Ireland’s debt crisis for other EU countries? How
might the crisis have impacted the entire international monetary system?
2. How did the bailout package help Ireland? What impact did it have the country’s
economy and prospects for future growth?
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3. Discuss the costs and benefits of doing business in Ireland today. Would you invest in
the country?
Another Perspective: To extend this case discussion, consider several iGLOBE segments
including After Bailout For Irish, Questions Linger Over Portugal, Spain, Ireland’s New
Leader Wrestles With Lingering Debt Problems, EU Bailout, and Global Economic
Downturn Slams Ireland, Spares Poland.
LECTURE OUTLINE FOR CHAPTER
This lecture outline follows the Power Point Presentation (PPT) provided along with this
instructor’s manual. The PPT slides include additional notes that can be viewed by
clicking on “view”, then on “notes”. The following provides a brief overview of each
Power Point slide along with teaching tips, and additional perspectives.
Slides 11-3-11-4 What is the International Monetary System?
The international monetary system refers to the institutional arrangements that countries
adopt to govern exchange rates. Governments adopt various types of exchange rate
systems including the pegged rate, the dirty float and the fixed rate.
Slides 11-6-11-7 The Gold Standard
The system of exchange rates known as the gold standard dates back to ancient times
when gold coins were a medium of exchange, unit of account, and store of value.
Pegging currencies to gold and guaranteeing convertibility is central to the gold standard.
In the 1880s, most of the world’s trading nations followed this exchange rate system.
Slides 11-8-11-9 Strength of the Gold Standard
The gold standard provides a powerful mechanism to pull trade imbalances between
countries back into balance of trade equilibrium.
Another Perspective: The Advantages Of The Gold Standard was the topic of a 1961
paper by former Federal Reserve Board Chairman, Alan Greenspan. The paper is
available at {http://www.usagold.com/gildedopinion/Greenspan.html}.
The gold standard worked fairly well from the 1870s until the start of World War I in
1914, but by 1939, the gold standard had collapsed.
Slides 11-10-11-11 The Bretton Woods System
The Bretton Woods system established a fixed exchange rate system where all currencies
were fixed to gold, but only the U.S. dollar was directly convertible to gold.
Devaluations could not to be used for competitive purposes and a country could not
devalue its currency by more than 10% without IMF approval.
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The Bretton Woods system also provided for two multinational institutions – the
International Monetary Fund (IMF) and the World Bank (IBRD).
Slides 11-12-11-13 The IMF and the World Bank
The IMF was charged with executing the main goal of the Bretton Woods agreement –
avoiding a repetition of the chaos that occurred between the wars through a combination
of discipline and flexibility.
Another Perspective: The homepage of the IMF is available at {http://www.imf.org}.
Students can click on either “For First Time Visitors” or on “For Students” to get a good
overview of the IMF and its activities.
The World Bank is also known as the International Bank for Reconstruction and
Development (IBRD).
Slide 11-14 The Collapse of the Fixed Exchange System
The Bretton Woods worked well until the late 1960s, before collapsing.
Slide 11-15 The Floating Exchange Rate Regime
The Jamaica Agreement was signed in 1976 following the collapse of Bretton Woods.
The rules that were agreed on then are still in place today.
Under the Jamaica agreement:
Slides 11-16-11-17 Exchange Rates since 1973
Exchange rates have become more volatile and less predictable than they were between
1945 and 1973.
Slide 11-18-11-19 Fixed Versus Floating Exchange Rates
The merit of a fixed exchange rate versus a floating exchange rate system continues to be
debated.
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The case for floating exchange rates has two main elements:
1. monetary policy autonomy
2. automatic trade balance adjustments
Supporters of fixed exchange rates focus on monetary discipline, uncertainty, and the
lack of connection between the trade balance and exchange rates.
Slide 11-20 Who is Right?
There is no real agreement as to which system is better.
Slides 11-21-11-22 Exchange Rate Regimes in Practice
Currently:
• 14% of IMF members follow a free float policy
Slide 11-23 Pegged Exchange Rates
A country following a pegged exchange rate system, pegs the value of its currency to
that of another major currency.
Slides 11-25-11-27 Crisis Management by the IMF
Today, the IMF focuses on lending money to countries experiencing financial crises.
A currency crisis occurs when a speculative attack on the exchange value of a currency
A banking crisis refers to a situation in which a loss of confidence in the banking system
leads to a run on the banks, as individuals and companies withdraw their deposits.
A foreign debt crisis is a situation in which a country cannot service its foreign debt
obligations, whether private sector or government debt.
Slide 11-28 Mexican Currency Crisis of 1995
The Mexican currency crisis of 1995 was a result of:
• high Mexican debts
• a pegged exchange rate that did not allow for a natural adjustment of prices
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Slides 11-29-11-32 The Asian Crisis
The 1997 Southeast Asian financial crisis was caused by a series of events that took place
in the previous decade.
Slides 11-33-11-34 Evaluating the IMF Policy Prescriptions
Critics of the IMF worry:
• the “one-size-fits-all” approach to macroeconomic policy is inappropriate for
many countries
Slides 11-35-11-36 Implications for Managers
The present floating rate system mandates that firms carefully manage their foreign
exchange transactions and exposures.
Managers must recognize that the current international monetary system is a managed
float system in which government intervention can help drive the foreign exchange
market.
Managers need strategic flexibility.
Companies should promote an international monetary system that facilitates international
growth and development.
CRITICAL THINKING AND DISCUSSION QUESTIONS
QUESTION 1: Why did the gold standard collapse? Is there a case for returning to some
type of gold standard? What is it?
ANSWER 1: The gold standard worked reasonably well from the 1870s until the start of
World War I in 1914, when it was abandoned. During the war several governments
financed their massive military expenditures by printing money. This resulted in
inflation, and by the war’s end in 1918, price levels were higher everywhere. Several
countries returned to the gold standard after World War I. However, the period that
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QUESTION 2: What opportunities might current IMF lending policies to Third World
nations create for international businesses? What threats might they create?
ANSWER 2: The IMF lending policies require the recipient countries to implement
governmental reforms to stabilize monetary policy and encourage economic growth. One
QUESTION 3: Do you think the standard IMF policy prescriptions of tight monetary
policy and reduced government spending are always appropriate for developing nations
experiencing a currency crisis? How might the IMF change its approach? What would
the implications be for international business?
ANSWER 3: Critics argue that the tight macroeconomic policies imposed by the IMF in
the recent Asian crisis are not well suited to countries that are suffering not from
QUESTION 4: Debate the relative merits of fixed and floating exchange rate regimes.
From the perspective of an international business, what are the most important criteria for
choosing between the systems? Which system is the more desirable for an international
business?
ANSWER 4: The case for fixed exchange rates rests on arguments about monetary
discipline, speculation, uncertainty, and the lack of connection between the trade balance
and exchange rates. In terms of monetary discipline, the need to maintain fixed exchange
rate parity ensures that governments do not expand their money supplies at inflationary
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mechanism works much more smoothly under a floating exchange rate regime. They
argue that if a country is running a trade deficit, the imbalance between the supply and
demand of that country’s currency in the foreign exchange markets will lead to
QUESTION 5: Imagine that Canada, the US, and Mexico decide to adopt a fixed
exchange rate system. What would be the likely consequences of such a system for (a)
international businesses, and (b) the flow of trade and investment between all three
countries?
ANSWER 5: Were North America to adopt a common currency, it would become
increasingly attractive for foreign investment and would increase trade and investment
QUESTION 6: Reread the Country Focus on the U.S. dollar, oil prices and recycling
petrodollars, then answer the following questions:
a) What will happen to the value of the U.S. dollar if oil producers decide to invest most
of their earnings from oil sales in domestic infrastructure projects?
b) What factors determine the relative attractiveness of the dollar, euro, and yen
denominated assets to oil producers flush with petrodollars? What might lead them to
direct more funds towards non-dollar denominated assets?
c) What will happen to the value of the dollar if OPEC members decide to invest more of
their petrodollars towards non-dollar assets, such as euro denominated stocks and bonds?
d) In addition to oil producers, China is also accumulating a large stock of dollars,
currently estimated to total $1.4 trillion. What would happen to the value of the dollar if
China and oil producing nations all shifted out of dollar denominated assets at the same
time? What would be the consequences for the United States economy?
ANSWER 6: a) If oil producers decide to invest their earnings in domestic infrastructure
projects, it would be expected that the countries involved would see a boost in economic
b) The relative attractiveness of an investment whether it is denominated in dollars, euro,
or yen depends on expected returns and the degree of risk associated with the investment.
When considering different currencies, it would be important to consider expected shifts
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c) Oil producers have significantly increased their holdings of dollars as a result of higher
oil prices. Should OPEC members decide to sell their dollars to invest in non-dollar
d) If China and the oil producers simultaneously decide to sell off their dollars, there
would be significant downward pressure on the dollar. This downward pressure would
CLOSING CASE: Economic Turmoil in Latvia
The closing case explores how Latvia’s economic fortunes have changed since 2004. At
the time, the country was enjoying an economic boom, but critics worried that the
economy was becoming overheated. By 2008, financial institutions were in trouble, and
at least one major company was nationalized. Eventually, Latvia was pushed into
accepting assistance from the IMF. Discussion of the case can revolve around the
following questions:
QUESTION 1: What kind of crisis was Latvia experiencing in 2008, a currency crisis, a
banking crisis, or a debt crisis?
ANSWER 1: In 2008, Latvia’s largest private bank, Parex, requested government
assistance. The bank which, like many others, had aggressively extended loans during
the country’s economic boom years, suddenly found itself on the brink of collapse.
QUESTION 2: If the IMF had not stepped in with support, what do you think might have
occurred?
ANSWER 2: Most students will probably suggest that had the IMF not stepped in to help
Latvia in 2008 the country would have gone into an economic tailspin. In addition, both
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QUESTION 3: Could the Latvian government have headed off the 2008 crisis? What
actions could I have taken to do this? What might the economic and political
consequences of those actions have been?
ANSWER 3: Aggressive lending practices by Latvian banks put the institutions as risk
for the situation that Parex found itself in when the economic crisis that had begun in the
QUESTION 4: What do you think the short-term consequences of the IMF policies will
be for Latvia? What might the long term consequences be?
ANSWER 4: Latvia’s bailout package arranged by the IMF requires the country to
implement many austerity measures including wage cuts and reductions in government
INTEGRATING iGLOBES
There are several iGLOBE video clips that can be integrated with the material presented
in this chapter. In particular, you might consider the following:
Title: IMF, World Bank Members Mull Third World Aid
Run Time: 6:25
Abstract: This video explores efforts by the International Monetary Fund and the World
Bank to get commitments of money from developed countries, and then disperse the
funds to developing economies in need of assistance during the current economic
downturn.
Key Concepts: global capital markets, the International Monetary Fund, the World
Bank, global economy, political economy
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Notes: The World Bank and International Monetary Fund (IMF) together with finance
ministers from around the world met recently in Washington, D.C. to discuss how to fix
the floundering global economy. Usually the annual meetings of the two institutions are
relatively routine, but this year, the meetings held a certain level of urgency. The global
economy is in a tailspin –suffering from the worst recession since the Great Depression.
Finance ministers in Washington had two main objectives: getting promised funds from
some countries, and dispersing the funds to other countries.
Several developing countries have applied to the IMF for aid, but before the IMF can
disperse any funds, it needs to raise some money. At a meeting of the G-20 earlier in the
month, world leaders agreed to give an additional $1 trillion in aid to the IMF. However,
so far, the money has not been forthcoming. The IMF is still waiting for several
countries including the United States, Japan, and some European countries to proceed
with their pledges. Meanwhile, the developing economies that were affected early on in
The United States is ready to lead the way toward an economic recovery. U.S. Treasury
Secretary Timothy Geithner has asked the industrialized countries to make good on their
commitments to the IMF, and start the reform of the global financial system. Geithner
noted that the recovery in the United States was dependent on recovery in other markets.
Leaders from other nations suggested that the United States also take action. They want
the country to fix its banking industry, and in particular remove toxic assets from their
balance sheets. One bright spot at the meeting was the news that conditions in the
markets may be stabilizing, and in some areas even improving.
Discussion Questions:
1. What is the International Monetary Fund (IMF)? What is its role in the global
economy? How is the IMF different from the World Bank?
2. Why is the IMF slow to respond to countries that have asked for assistance? What
guarantees are there that IMF funds will actually help the global economy?
3. Some Eastern European countries have put in a particularly urgent request for funds
from the IMF. Why are these countries in such dire straits? What does your response tell
you about the interdependency of the global economy?
4. How does the United States see its role in the move to economic recovery? Why is the
United States pushing for IMF funds to be quickly deployed to countries in need?
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INTEGRATING VIDEOS
There are also several longer video clips that can be integrated with the material
presented in this chapter. In particular, you might consider the following from
International Business DVD Volume 6:
Title: Bank Launches Partnership for ‘Green Accounting’
Learning Objectives
The purpose of this video is to help you:
❖ Understand the nature of natural capital and environmental sustainability.
❖ Examine the concept of ‘green accounting’.
❖ Explore how multinational companies have and are destroying valuable ecosystems
in developing countries.
❖ Recognize the importance of managing resources to promote economic growth.
Key Words
❖ Globalization
❖ Environmental sustainability
❖ Social responsibility
❖ Levels of economic development
❖ Impact of multinational companies on host countries
❖ Ethics
❖ World Bank
Synopsis
The World Bank is launching a new program designed to help developing countries
better manage their natural capital. The World Bank is concerned that without the proper
knowledge of how to value natural resources, these countries could lose their ecosystems,
and with them potential economic benefits. In many developing countries, valuable
forests, wetlands, coral reefs, and other ecosystems have been damaged irreversibly by
multinational companies that invested in the countries hoping to make a quick profit.
Now, however, the World Bank wants to ensure that developing countries recognize the
true economic potential of their biodiversity and what the possible loss could be if their
ecosystems are destroyed.
The World Bank’s new program, which is being offered in partnership with the United
Nation’s Environmental Program, involves providing developing countries with the tools
for ‘green accounting.’ The goal is to ensure that a country’s finance minister has a full
understanding of the economic implications of decisions that involve the nation’s natural
resources. It is hoped that this will help avoid the type of exploitation by multinational
companies that can limit future economic growth in a country, and degrade the
environment. India and Columbia are the first countries to participate in the new
program. If it is successful it will be expanded to include additional countries.
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Identifying exactly how to value natural capital is a difficult task. While mechanisms to
assess the cost of air pollution and other types of environmental degradation have been
developed, valuing natural capital is a new challenge requiring new tools. Since it is not
always easy to understand the ecosystems themselves, this task becomes even more
complicated. Moreover, because there is not a market price for most ecosystems, it can
be difficult to understand and determine the economic impact of different investment
decisions on the natural resources. Countries that can successfully protect their assets and
plan into the longer term have a greater chance for economic development.
Discussion Questions
1. Explain the concept of natural capital. Why is the World Bank concerned about
protecting the natural capital of developing countries?
2. What is “green accounting’? How is the World Bank working to identify the necessary
tools for the task? Why is it so difficult to value natural capital?
3. What role do multinational companies play in the environmental degradation taking
place in many developing countries? Why do developing countries permit investments
by the companies? What responsibilities do these companies have to the host countries?
4. Discuss how companies can use ‘green accounting’ methods and tools to incorporate
social and environmental goals with their business strategies. How might promoting a
greener approach to strategy help companies be more profitable in the long run?
INCORPORATING globalEDGE™ EXERCISES
Use the globalEDGE™ site {http://globalEDGE.msu.edu/} to complete the following
exercises:
Exercise 1
The quality of life in specific markets sometimes is impacted by the country’s financial
and fiscal policies. As such, the Global Financial Stability Report is a semi-annual report
published by the International Capital Markets division of the International Monetary
Fund (IMF). The report aims to provide a regular assessment of global financial markets.
Locate and download the latest information to prepare a summary of the top 3 countries
that export and import capital.
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Exercise 2
An important element to understanding the international monetary system is keeping
updated on current growth trends worldwide. A German colleague told you yesterday that
Deutsche Bank Research’s Megatopics are an effective way to stay informed on
important topics in international finance. Find a Megatopics report for analysis. Is the
report on an established or emerging economy? What are the key takeaways from your
chosen report?
Answers to the Exercises
Exercise 1
The reports are accessible by searching for the phrase “Global Financial Stability Report”
at http://globaledge.msu.edu/ResourceDesk/. This resource is located under the
Exercise 2
The Megatopics reports are accessible by searching for the phrase “Deutsche Bank
Research” at http://globaledge.msu.edu/ResourceDesk/. This resource is located under
the globalEDGE category “Money: Finance”. After clicking the English button at the top