Mandates: promote stability of the international financial system (IMF); promote economic development (WB).

International monetary system: the gold standardA system under which the value of a nation’s

monetary unit was backed by goldGold standard conditions

Define the monetary unit in terms of a certain quantity of gold

Fixed relationship between stock of gold and the domestic currency

Allow gold to be freely exported and imported

Gold flowsThis would result in exchange rates that are fixed

Domestic macro adjustmentsThe gold standard implies changes in the domestic

money supply of nations, which affects prices, real output and employment

Advantages of gold standardStable exchange rates resulting from the gold

standard reduces uncertainty and riskThe flow of gold between countries caused shifts

in the supply and demand curves and automatically corrects balance of payments deficits or surpluses

Disadvantages of gold standardNations must accept domestic adjustments in

the form of higher unemployment or inflationCountries must have sufficient reserves of gold

Demise of the gold standardDuring the Depression years of the 1930s

Bretton Woods monetary systemBretton Woods conference 1944Adjustable peg system of exchange rate emerged

A system by which members of the IMF were obligated to define their monetary units in terms of gold (or US dollars), establishing par rates of exchange between the currencies of all other members, and to keep their exchange rates within 1 per cent of these par values

IMF and pegged exchange ratesStabilisation funds

Suppliers of both foreign and domestic moneys and gold held with the central bank or treasury for the purpose of intervention in the foreign exchange market to maintain the par value of the exchange rate

IMF creditProvided short-term loans to nations with temporary

or short-term balance of payments deficits out of currencies and gold contributed by member nations

Bretton Woods monetary systemFundamental imbalances: adjusting the peg

Countries running persistent balance of payments deficits ran out of reserves and were unable to maintain its fixed exchange rate

Demise of the Bretton WoodDilemma: dollars and the deficitsEmergence of floating rates

Managed floatAn exchange rate system where central banks

buy and sell foreign exchange to smooth out short-run or day-to-day fluctuations in rates

Encourages international trade and finance, while allowing for trend or long-term exchange rate flexibility to correct fundamental payments disequilibria

Liquidity and special drawing rightsSpecial drawing rights are bookkeeping entries

at the IMF, available to IMF members in proportion to their IMF quotas, that may be used to settle payments deficits or satisfy reserve needs in place of foreign exchange or gold

The Bretton Woods System and the International Monetary Fund-IMFIMF

In July 1944, 44 representing countries met in Bretton Woods, New Hampshire to set up a system of fixed exchange rates.

All currencies had fixed exchange rates against the U.S. dollar and an unvarying dollar price of gold ($35 an ounce).

It intended to provide lending to countries with current account deficits.

It called for currency convertibility.

Goals and Structure of the IMF

The IMF agreement tried to incorporate sufficient flexibility to allow countries to attain external balance without sacrificing internal objectives or fixed exchange rates.

Two major features of the IMF Articles of Agreement helped promote this flexibility in external adjustment: IMF lending facilities

IMF conditionality is the name for the surveillance over the policies of member counties who are heavy borrowers of Fund resources.

Adjustable parities

Convertibility

Convertible currency A currency that may be freely exchanged for foreign

currencies. Example: The U.S. and Canadian dollars became convertible

in 1945. A Canadian resident who acquired U.S. dollars could use them to make purchases in the U.S. or could sell them to the Bank of Canada.

The IMF articles called for convertibility on current account transactions only.

IMF: 3 main functionsSurveillance: (economic analysis/advice): appraise

each member’s exchange rate policies within overall analysis of general economic situation.Multilateral: World/Regional Economic Outlooks; Global

Financial Stability Report;Bilateral: Annual assessment (Article IV consultation);

financial sector (FSAP); standards and codes.Financial assistance: loans to support countries with

BoP problems and low income countries (concessional loans, Policy Support Instrument, external shocks facility (ESF)).

Technical assistance: advice/support on technical issues related to macroeconomic policy.

Why the Bretton Woods System Was CreatedAvoid Past Mistakes -Disastrous economic policies

that contributed to Great Depression of the 1930s and WW II- Protectionism - Tariff wars- Competitive Devaluations

Rebuild confidence in international cooperation and international financial system

Such "beggar-thy-neighbor" policies devastated the international economy; world trade declined sharply, as did employment and living standards in many countries.

Roles of IMF and World Bank IMF

Promote global financial stabilityExchange rate stability (balanced growth of trade)Forum for international monetary cooperationTemporary financial assistance to members experiencing

balance of payments difficulties

World BankReconstruction and economic development after WWIILong-term economic developmentProject financing, including infrastructure, energy,

education, health

Both IMF and WB share the common objective of raising living standards of their member countries with distinct mandates: WB promotes long-term economic development while IMF promotes international financial stability (stable exchange rates) and facilitates the growth of trade.

Internal and External Balance Under the Bretton Woods SystemThe Changing Meaning of External Balance

The “Dollar shortage” period (first decade of the Bretton Woods system) The main external problem was to acquire enough dollars to

finance necessary purchases from the U.S.Marshall Plan (1948)

A program of dollar grants from the U.S. to European countries. It helped limit the severity of dollar shortage.

Speculative Capital Flows and Crises

Current account deficits and surpluses took on added significance under the new conditions of increased private capital mobility. Countries with a large current account deficit might be

suspected of being in “fundamental disequilibrium”under the IMF Articles of Agreement.

Countries with large current account surpluses might be viewed by the market as candidates for revaluation.

The External Balance Problem of the United StatesThe U.S. was responsible to hold the dollar price of

gold at $35 an ounce and guarantee that foreign central banks could convert their dollar holdings into gold at that price.Foreign central banks were willing to hold on to the

dollars they accumulated, since these paid interest and represented an international money par excellence.

The Confidence problemThe foreign holdings of dollars increased until they

exceeded U.S. gold reserves and the U.S. could not redeem them.

Special Drawing Right (SDR)An artificial reserve assetSDRs are used in transactions between central banks

but had little impact on the functioning of the international monetary system.

Worldwide Inflation and the Transition to Floating Rates

The acceleration of American inflation in the late 1960’s was a worldwide phenomenon.It had also speeded up in European economies.

When the reserve currency country speeds up its monetary growth, one effect is an automatic increase in monetary growth rates and inflation abroad.

U.S. macroeconomic policies in the late 1960s helped cause the breakdown of the Bretton Woods system by early 1973.

Who Governs the IMF?IMF governed by member countries, through Board

of Governors(1 governor per country). Meets annually.

Subset of governors--International Monetary and Financial Committee (IMFC)--advises Board of Governors. Meets 2 x year.

Funding, Quotas, Voting PowerIMF capital base consists of membership quotas: the

financial contributions made by member countries. Total quotas nearly $300 billion.

Quotas broadly determined by their economic position relative to other countries, and reviewed regularly.

A country’s quota determines its voting power and access to financing.

When you become a member you must pay in a certain sum of money; we call it a quota.

The bigger your economy, the bigger your quota. The United States is the biggest economy in the world and

its quota is the largest in the Fund; it represents about 17% of total quotas or about $40 billion.

Think of IMF as a credit union. All members put money in the bank, and when a member needs money, the other members lend it money under certain conditions. The quotas members pay in are the main source of funding of IMF.

Note that just like when you put money in a bank the money still belongs to you, the money countries put in the Fund is still theirs; they merely transfer some of their monetary assets to the Fund, but it is still part of their reserves.

Reforms to increase share of developing countriesQuotas raised for China, Turkey, Korea, Mexico in

2006. April 2008 approved:

further increase in quota/votes for mainly developing countries (including China)

formula more closely based on GDPregular 5-yearly reviews

Distribution of quotasUS %17Europe % 41Americas %10Asia and Pacific % 20Africa % 5Middle East % 7

Global financial crisisFinancial turmoil: loose monetary policy and

regulation led to excessive leverage and risk.“Sub-prime”problem sparked off financial turmoil,

leading to world recession.

World economy slowing sharplyRole of Fund

Early warning signsrisks in sub-prime

Financial assistance

Policy advice

Multilateral assessments, distillinginternational experience

Actions and issues

Moving quickly to help affected emerging countries. Stand ready to lend over $200 billion. Offering policy advice.

New short-term liquidity facility: help countries with sound fundamentals that face acute liquidity pressures. Fast/flexible, no conditionality.

Questions of resources and new roles in global financial architecture.

SummaryIn an open economy, policymakers try to maintain

internal and external balance.The architects of the IMF hoped to design a fixed

exchange rate system that would encourage growth in international trade.

To reach internal and external balance at the same time, expenditure-switching as well as expenditure-changing policies were needed.

The United States faced a unique external balance problem, the confidence problem.

U.S. macroeconomic policies in the late 1960s helped cause the breakdown of the Bretton Woods system by early 1973.