THE INTERNATIONAL MONETARY SYSTEM: The International Monetary Fund
The International Monetary Fund
The Depression, economic isolation, and trade wars of the 1930s were followed by the global conflict of World War II. Toward the close of World War II in 1944, the major Western governments met to determine what international institutions were needed to bring relative economic stability and growth to the free world. As a result of the meetings, the International Monetary Fund (IMF) and World Bank were organized.
The IMF was signed into existence in the United States in 1945 by 29 nations; the agreement now includes 151 countries. The IMF's major objectives are to promote exchange stability, maintain orderly exchange arrangements, avoid competitive currency devaluation, establish a multilateral system of payments, eliminate exchange restrictions, and create standby reserves.
The Bretton Woods system, named after the location of the 1944 conference, operated under a principle of fixed exchange rates by which each member country established a par value for its currency based on gold and the U.S. dollar. This par value became a benchmark by which the country related its currency to the currencies of the rest of the world. Currencies were allowed to vary within 1 percent of par value (extended to 2.25 percent in December 1971), depending on supply and demand conditions. Further moves from par value and formal changes in par value (through devaluation or revaluation) were made with the IMF's approval.
Because of the strength of the U.S. dollar during the 1940s and 1950s,
member currencies were denominated in terms of gold and dollars. By 1947 the United States held 70 percent of the international official gold reserves. Because of this, governments bought and sold dollars rather than gold. It was understood, although nof formalized, that the United States would redeem gold for dollars, and the two became fixed with respect to each other. The dollar thus became the benchmark of the world trading currency.
The Board of Governors is the highest authority of the fund, and it is comprised of a representative of each member country. The number of votes that a country gets depends on the size of its quota. Although the Board of Governors is the ultimate authority in key matters, it delegates day-to-day authority to a 22-person Board of Executive Directors. This Board tends to operate by consensus, even though the strength of each vote is based on the size of the quota.
When a country is selected by the Board of Governors to join the IMF, it is assigned a quota related to its national income, monetary reserves, trade balance, and other economic indicators. The quota, which determines a country's voting power and other issues, can be paid in Special Drawing Rights and the country's currency.
Problems with Liquidity
The problem with the system as envisioned by the IMF was that, in practice, rigidity replaced stability. Countries did not allow an exchange-rate alteration to occur until a crisis developed. It became more and more evident that, as the world's reserve currency, the dollar was in a difficult position. As other countries' economies began to strengthen, it appeared that gold and internationally acceptable currencies (initially known as the official reserves) could not handle the reserve requirements of a country. The freer flow of goods and capital put increasing pressure on a country's reserve assets. Also, the growing accumulation of dollars outside of the United States during the 1960s threatened to wreck the stability of the system of fixed exchange rates. The problem was that governments became increasingly uneasy about the currency (i.e., the dollar) component of their reserves. Thus they tended to want to replace these currencies with gold. As trade increased, the ratio of reserves to trade decreased sharply.2
To help increase international reserves during the period when the United States was expected to be able to reduce its balance-of-payments deficit, the IMF created the Special Drawing Right (SDR). The SDR is a unit of account that was created by the IMF and distributed to nations to expand their official reserves base. Brazil, for example, could trade some of its SDRs to the United States for dollars. The first SDR allocation was made in 1970. Initially, the SDR was denominated in gold, then by a basket of 16 currencies. On January 1, 1981, the IMF began to use a simplified basket of 5 currencies for determining valuation: the U.S. dollar (40 percent); the German mark (19 percent); and the Japanese yen, French franc, and British pound sterling (13 percent each). These specific weights were chosen because they broadly reflected the relative importance of the currencies in international trade and payments, which in turn are based on the value of the export of goods and services by the countries issuing these currencies.
The SDR has not taken over the role of gold or the dollar as a primary reserve asset, but it has become a unit of account. This means simply that the SDR has become a benchmark, or reference point, for a variety of transactions. The IMF uses the SDR rather than a specific national currency in most of its official reports. In addition, several countries base their currency on the value of the SDR or a combination of the SDR and another currency.
Evolution to Floating Exchange Rates
As just mentioned, the IMF's initial system was a system of fixed exchange rates. Because the U.S. dollar was the cornerstone of the international monetary system, its value remained constant with respect to gold. Other countries could change the value of their currencies against gold and the dollar, but the value of the dollar remained fixed.
Partly because of the inflationary pressures that began to build in the United States in the mid-1960s, the traditional U.S. trade surplus began to shrink. Continued outflow of private and governmental long-term capital, coupled with the diminishing trade surplus, caused an increasing deficit in the balance of trade and capital. As it became apparent that 1971 would see the first U.S. balance-of-trade deficit in the twentieth century, it was clear that something had to be done.
On August 15, 1971, President Nixon announced a new economic policy that included the suspension of exchanging gold for dollars and the institution of an import surcharge. These moves were an attempt to force the other industrial countries to the bargaining table in hopes of restructuring the world monetary order. The Smithsonian Agreement of December 1971 resulted in an 8 percent devaluation of the dollar, a revaluation of some other world currencies, a widening of exchange-rate flexibility (from 1 to 2.25 percent on either side of par value), and a commitment on the part of all countries to
reduce trade restrictions, thus allowing goods and services to flow according to supply and demand.
This restructuring of the international monetary system did not last. World currency markets remained unsteady during 1972, and the dollar was devalued again by 10 percent in early 1973. Major currencies began to float against each other instead of relying on the Smithsonian Agreement.
Because the Bretton Woods Agreement was based on the system of fixed exchange rates and par values, the IMF had to change its Article of Agreement in order to permit floating exchange rates. The Jamaica Agreement of 1976 provided the amendment to the original Articles of Agreement that permitted greater flexibility in exchange rates. There was some concern that the world monetary system would collapse under the freedom of flexible exchange rates, so the agreement reiterated the importance of pursuing exchange stability.
The Depression, economic isolation, and trade wars of the 1930s were followed by the global conflict of World War II. Toward the close of World War II in 1944, the major Western governments met to determine what international institutions were needed to bring relative economic stability and growth to the free world. As a result of the meetings, the International Monetary Fund (IMF) and World Bank were organized.
The IMF was signed into existence in the United States in 1945 by 29 nations; the agreement now includes 151 countries. The IMF's major objectives are to promote exchange stability, maintain orderly exchange arrangements, avoid competitive currency devaluation, establish a multilateral system of payments, eliminate exchange restrictions, and create standby reserves.
The Bretton Woods system, named after the location of the 1944 conference, operated under a principle of fixed exchange rates by which each member country established a par value for its currency based on gold and the U.S. dollar. This par value became a benchmark by which the country related its currency to the currencies of the rest of the world. Currencies were allowed to vary within 1 percent of par value (extended to 2.25 percent in December 1971), depending on supply and demand conditions. Further moves from par value and formal changes in par value (through devaluation or revaluation) were made with the IMF's approval.
Because of the strength of the U.S. dollar during the 1940s and 1950s,
member currencies were denominated in terms of gold and dollars. By 1947 the United States held 70 percent of the international official gold reserves. Because of this, governments bought and sold dollars rather than gold. It was understood, although nof formalized, that the United States would redeem gold for dollars, and the two became fixed with respect to each other. The dollar thus became the benchmark of the world trading currency.
The Board of Governors is the highest authority of the fund, and it is comprised of a representative of each member country. The number of votes that a country gets depends on the size of its quota. Although the Board of Governors is the ultimate authority in key matters, it delegates day-to-day authority to a 22-person Board of Executive Directors. This Board tends to operate by consensus, even though the strength of each vote is based on the size of the quota.
When a country is selected by the Board of Governors to join the IMF, it is assigned a quota related to its national income, monetary reserves, trade balance, and other economic indicators. The quota, which determines a country's voting power and other issues, can be paid in Special Drawing Rights and the country's currency.
Problems with Liquidity
The problem with the system as envisioned by the IMF was that, in practice, rigidity replaced stability. Countries did not allow an exchange-rate alteration to occur until a crisis developed. It became more and more evident that, as the world's reserve currency, the dollar was in a difficult position. As other countries' economies began to strengthen, it appeared that gold and internationally acceptable currencies (initially known as the official reserves) could not handle the reserve requirements of a country. The freer flow of goods and capital put increasing pressure on a country's reserve assets. Also, the growing accumulation of dollars outside of the United States during the 1960s threatened to wreck the stability of the system of fixed exchange rates. The problem was that governments became increasingly uneasy about the currency (i.e., the dollar) component of their reserves. Thus they tended to want to replace these currencies with gold. As trade increased, the ratio of reserves to trade decreased sharply.2
To help increase international reserves during the period when the United States was expected to be able to reduce its balance-of-payments deficit, the IMF created the Special Drawing Right (SDR). The SDR is a unit of account that was created by the IMF and distributed to nations to expand their official reserves base. Brazil, for example, could trade some of its SDRs to the United States for dollars. The first SDR allocation was made in 1970. Initially, the SDR was denominated in gold, then by a basket of 16 currencies. On January 1, 1981, the IMF began to use a simplified basket of 5 currencies for determining valuation: the U.S. dollar (40 percent); the German mark (19 percent); and the Japanese yen, French franc, and British pound sterling (13 percent each). These specific weights were chosen because they broadly reflected the relative importance of the currencies in international trade and payments, which in turn are based on the value of the export of goods and services by the countries issuing these currencies.
The SDR has not taken over the role of gold or the dollar as a primary reserve asset, but it has become a unit of account. This means simply that the SDR has become a benchmark, or reference point, for a variety of transactions. The IMF uses the SDR rather than a specific national currency in most of its official reports. In addition, several countries base their currency on the value of the SDR or a combination of the SDR and another currency.
Evolution to Floating Exchange Rates
As just mentioned, the IMF's initial system was a system of fixed exchange rates. Because the U.S. dollar was the cornerstone of the international monetary system, its value remained constant with respect to gold. Other countries could change the value of their currencies against gold and the dollar, but the value of the dollar remained fixed.
Partly because of the inflationary pressures that began to build in the United States in the mid-1960s, the traditional U.S. trade surplus began to shrink. Continued outflow of private and governmental long-term capital, coupled with the diminishing trade surplus, caused an increasing deficit in the balance of trade and capital. As it became apparent that 1971 would see the first U.S. balance-of-trade deficit in the twentieth century, it was clear that something had to be done.
On August 15, 1971, President Nixon announced a new economic policy that included the suspension of exchanging gold for dollars and the institution of an import surcharge. These moves were an attempt to force the other industrial countries to the bargaining table in hopes of restructuring the world monetary order. The Smithsonian Agreement of December 1971 resulted in an 8 percent devaluation of the dollar, a revaluation of some other world currencies, a widening of exchange-rate flexibility (from 1 to 2.25 percent on either side of par value), and a commitment on the part of all countries to
reduce trade restrictions, thus allowing goods and services to flow according to supply and demand.
This restructuring of the international monetary system did not last. World currency markets remained unsteady during 1972, and the dollar was devalued again by 10 percent in early 1973. Major currencies began to float against each other instead of relying on the Smithsonian Agreement.
Because the Bretton Woods Agreement was based on the system of fixed exchange rates and par values, the IMF had to change its Article of Agreement in order to permit floating exchange rates. The Jamaica Agreement of 1976 provided the amendment to the original Articles of Agreement that permitted greater flexibility in exchange rates. There was some concern that the world monetary system would collapse under the freedom of flexible exchange rates, so the agreement reiterated the importance of pursuing exchange stability.
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