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AOF Business in the Global Economy

Lesson 8The International Monetary

System

Student Resources

Resource Description

Student Resource 8.1 Reading: The Development of the International Monetary System

Student Resource 8.2 Timeline: The International Monetary System

Student Resource 8.3 Venn Diagram: The IMF and the World Bank

Student Resource 8.4 Reading: The IMF and the World Bank

Student Resource 8.5 Partner Activity: Balance of Trade

Student Resource 8.6 Case Study: International Financial Management

Student Resource 8.7 Organizer: Economic Policy Recommendation Letter

Copyright © 20092016 NAF. All rights reserved.

AOF Business in a Global EconomyLesson 8 The International Monetary System

Student Resource 8.1

Reading: The Development of the International Monetary System

Directions: Make sure you understand the terms below before you begin reading. When you encounter the terms in your reading, underline them.

Terms:Fixed exchange rate: An exchange rate for a currency that government policy determines should be fixed (pegged) to the market value of another currency, a group of currencies, or another measure of value (such as the price of gold). Recall that fixed exchange rates tend to help keep inflation in check but also tend to hide a currency’s true market value.

Floating exchange rate: An exchange rate that is determined by supply and demand in the foreign exchange (FX) market, mostly without government intervention, and is therefore free to rise or fall.

Gold standard: An exchange rate policy that pegs the value of a currency to the price of gold and guarantees that all issued currency can be converted to gold on demand at a gold par value.

Gold par value: The amount of currency that is needed to purchase one ounce of gold.

1870s–1914: IndustrialismFrom ancient times until the Industrial Revolution, goods were usually bought with gold or silver. Or, they were bought with currency whose value in gold or silver was trusted and well established. The rise of industrialism caused an explosion in trade. By the 1880s, shipping heavy gold and silver as payment was seen to be impractical, especially for international trade. Major trading countries came up with a more efficient means of paying for goods: paper currency. The values of these countries’ different currencies were defined and protected by the gold standard. This meant that the value of the currency was pegged to the value of gold. The issuing governments or central banks promised that they would support the paper currency by exchanging it for a fixed amount of gold on demand. They would always keep as much gold stored as there was paper currency in circulation. This built confidence in the paper currency, since people knew they could exchange their paper currency for gold. Major trading countries continued with the gold standard until 1914. That was the year World War I broke out. These countries needed money to fill their war chests, so they began printing a lot more paper money, often without having gold to back it.

1918–1939: Economic TurbulenceAfter World War I ended in 1918, the major trading economies slowly returned to the gold standard. But, when a country’s government decided to return to the gold standard, it had to determine the gold par value for its currencyand this became a problem. For instance, the British pound suffered high inflation during World War I because too much money was in circulation, pushing up prices. In 1925, the British government decided to return to the gold standard. It did so at the prewar gold par value, making the value of the pound artificially high. This proved to be a huge economic policy mistake. It made the price of British goods to buyers in other countries skyrocket, pricing them out of foreign markets. This harmed British exports, production, and employment long before the 1929 world stock market crash inflicted further harm. The cumulative effect of all this, and the associated disruption of world trade, led to a very severe economic depression by 1931.

The United States was facing economic problems of its own at this time. The US government looked for a policy that would avoid the kind of trouble that had happened with the pound. It decided to devalue the dollar, which made the prices of American exports more competitive in other countries. The goal of the



policy was to increase US exports, and hence production and employment in the United States. Unfortunately, governments of other trading countries realized they could do the same. They soon followed suit and devalued their own currencies. Thus a cycle of competitive devaluations began. Each country would devalue its currency to match (or even exceed) the devaluation of the others. This caused severe international economic instability. The situation placed severe pressure on the gold reserves held by central banks. By 1939, when World War II began, the gold standard was dead. Governments and central banks could not afford to honor their promise to exchange gold for the paper money they had issued.

1944–1973: Bretton Woods and the Gold StandardBy 1945, when World War II ended, the international economy was in serious trouble. The gold standard had collapsed. Almost all of Europe was suffering from colossal war damage and economic depression, and the economies of Germany and Japan had been largely destroyed. Much of world trade had disappeared. Its disappearance was a result of the 1929–1934 depression, followed by extreme protectionism, competitive devaluations, and war. The US economy was thriving at home, but there were concerns that unless international trade was revived, the United States would have difficulty as well.

This is why representatives of 44 countries met at Bretton Woods, New Hampshire, to design a new international monetary system. Two important international financial institutions were formed at Bretton Woods. The International Monetary Fund (IMF) would work to maintain order and stability in the global financial and currency exchange system. The second was the World Bank, which would promote postwar reconstruction and longer-term economic development.

One major problem with the old system was the gold standard. The gold standard could not be sustained. Nevertheless, the participants at Bretton Woods did think it was best to stay with a fixed exchange rate regime to help keep the world’s economy stable. However, the participants also felt that the new exchange rate regime must be more flexible than the gold standard had been. A cycle of competitive devaluations of the kind that created huge disruption in the 1930s had to be avoided. That is why they required the exchange rate of each currency to be fixed to the US dollar (and thus indirectly to the value of gold) at levels agreed between the member countries. They also decided that exchange rates could occasionally be changed, after international consultations. Though the Bretton Woods agreement restored a link between the value of each currency and the price of gold, it did not require convertibility into gold.

The IMF was mandated to monitor exchange rates and help member countries’ governments keep their exchange rates within 1% of the value established at Bretton Woods.

There was a major weakness with this exchange rate regime. It arose from the way that each currency’s value was tied to the value of gold indirectly via the US dollar. Dollars were used for vast numbers of international transactions. Most countries’ central banks kept (and still keep) a large part of their currency reserves in US dollars. Linking currencies to gold via the US dollar worked well in the 1950s, but its success was dependent of the stability of the dollar in relation to gold. That is, it was dependent in terms of the amount of gold that one US dollar could buy. That meant that if the United States experienced high inflation or had a large trade deficit, there might then be too many dollars in circulation for the US central bank, the Federal Reserve, to be able to back with gold. That is what began happening in the mid-1960s, when American government spending and money supply increased dramatically. In 1971, the United States abandoned the gold standard, and by 1973 it had disappeared worldwide.

1973–Present: Regional and Global Financial CrisesIn 1976, the IMF’s member countries agreed that floating exchange rates were now acceptable. Since then, the world has operated a mixed exchange rate system, which is also called a managed float. This means that some currencies are allowed to float freely, but other currencies are actively managed by central banks. These currencies and often pegged in value to another currency or to a basket of currencies. This managed float exchange rate regime has generally led to more volatile exchange rates than before the world abandoned the gold standard in 1973. There have been long periods when the



floating exchange rates were fairly stable and distinctly less volatile than many had originally feared. (Volatile means that something can change quickly and unpredictably.) On the other hand, there have also been periods of extreme instability. Volatile exchange rates contributed to currency crises such as the Asian Financial Crisis of 1997. During that crisis, Asian countries, such as Indonesia, saw the exchange rates of their currencies decrease by more than 80% in only a few months.

The IMF often intervenes when such currency crises occur. It provides financial assistance (loans) and expert advice for countries attempting to keep the value of their currency sufficiently stable in the face of the crisis and to minimize disruption to their economy. In February 2009, the IMF began working with the governments of the United States and other major countries. Its goal has been to moderate the global financial crisis, limit the economic damage, and help create favorable conditions for recovery.




Timeline: The International Monetary SystemStudent Name:_______________________________________________________ Date:___________

Directions: Fill out the important events that happened during the years described in Student Resource 8.1, Reading: The Development of the International Monetary System. Be ready to share your answers.




Venn Diagram: The IMF and the World BankStudent Names:_______________________________________________________ Date:___________

Directions: Find at least three differences between the IMF and the World Bank and write them in the appropriate spaces on the Venn diagram. Then find at least two similarities and record them in the shared


IMF

World Bank


space.




Reading: The IMF and the World Bank

In 1944, as World War II was coming to a close, governments of more than 40 countries met in Bretton Woods, New Hampshire, at the United Nations Monetary and Financial Conference. There they formed two organizations. One was the International Monetary Fund (the IMF) and the other was the World Bank. The countries involved wanted to prevent worldwide economic troubles that could lead to instability throughout the world and possibly even war.

The purpose of these two international financial institutions (IFIs)was to help prevent a new meltdown in the worldwide economy and also to help countries that needed to rebuild after the war. Though the two IFIs have many similarities, each serves a distinct purpose in dealing with the member nations and the global economy.

During their creation, the IFIs were controversial. Governments of participating countries argued about how much influence each would have over the IFIs and how much money they would each need to invest. The IMF and World Bank were intended to foster peace and prosperity throughout the world, and many people feel that they have generally done so, even if imperfectly. However, many other people view IFIs as oppressive tools that prosperous countries use to impose their will on developing countries and not to the advantage of the developing countries.



When the founding member countries came together to create the IMF, they did so in order to deal with international monetary difficulties, to ensure free convertibility of currencies (which would help international trade grow), to ensure that international currency exchange rates remained stable, to ensure that instability in exchange rates and interest rates did not hurt trade, and to ensure that debts owed by one country to another could be repaid in an orderly way.

The IMF does its job by performing three functions: financial assistance, surveillance, and technical assistance.

Providing financial assistance when major international crises happen is the IMF’s primary function. But in order to get the money, the country seeking an IMF loan must usually agree to make changes to its economic policies. These changes are based on the IMF’s analysis of what got the country into economic trouble in the first place. The loans are at a variety of interest rates and for various lengths of time. The rate and duration of the loan depend on the state of the borrowing country’s economy and the intended use of the money.



A second function of the IMF is surveillance. The IMF staff visits each member country and examines many aspects of its economy. These include its exchange rate, monetary policies, and fiscal policies. (Monetary policies involve changing the interest rate; fiscal policy involves changing tax rates and government spending levels.)The IMF also does research on regional communities of countries, such as the European Union, and on the global economy.

The IMF provides technical assistance in such areas as monetary and tax policy and in the collection of economic data. It helps governments and central banks collect data and make policies on exchange rates and balance of payment issues.



In 2008, the world entered the worst financial crisis since the Great Depression. The IMF was supposed to head such a disaster off at the pass; that’s why one of its jobs is to monitor the financial health of countries around the globe.

But the IMF failed to see the signs of the Great Recession, as it has come to be known. Upon self-scrutiny, they realized that the macroeconomists at the IMF thought that the financial systems of advanced countries like the United States were sound, resilient, and able to redistribute risks. They also saw that the way the IMF is structured prevented different parts of the organization from sharing key information and getting a full picture of what was happening. Most importantly, the IMF staff did not pay enough attention to analysts outside of their organization. In 2011, the IMF created a set of reforms to their organization to make such an oversight much less likely in the future.

Even though the IMF didn’t see the recession coming, it has played an important role in mitigating, or lessening, the crisis. It has provided financial support to countries that have been deeply affected. It has channeled its surveillance into the recovery effort. Finally, it has coordinated global and regional responses to the recession.



The International Monetary Fund is based in Washington, DC. Two bodies control it. The board of governors meet once a year to deal with big issues and to vote on what’s to be done. There is also an executive board that makes daily decisions.

The members of the executive board run different departments within the IMF. For instance, there are groups for various regions of the world as well as for a variety of issues, such as fiscal planning and research and statistics.

Finally, the International Finance and Monetary Committee meets twice a year. Its purpose is to provide the IMF staff with suggestions and advice.

For all three bodies, a country’s voting power is based on a complex set of rules that give by far the most votes to the countries with the largest economies and that have provided the largest amount of funding to the IMF over time.

The World Bank has a similar structure. It also has a governing board. Voting power here is unequal, as it is in the IMF: it generally corresponds to how much money each country contributes to the World Bank.



The World Bank Group deals with money in both the public and private sectors. It offers governments advice and provides research to help governments manage their economic policies. In developing countries, the World Bank strengthens governments. It creates legal and political systems that encourage business. It provides research, consulting, and training as well. The World Bank also works with private business projects that benefit the economy. It offers low-interest loans, grants, and free-interest credit. It develops financial systems and combats corruption.

The overall goal of the World Bank is to reduce poverty. It also tries to increase access to education and medical care and to protect the environment, all while promoting economic development. Projects to improve an area’s economy have included building roads to connect communities in rural Peru, giving microcredit (less than $1,000) loans to small-business owners in developing countries, and helping poor mothers and children get access to medical care.

How is the World Bank funded to do this work? The 184 countries that are members of the IMF pay a subscription fee for their membership. This money is then used to fund the World Bank.



Though these two IFIs are different, they do have many similarities. They were created at the same time by a large group of countries. Their creation was part of a UN effort to help the global economy run in a smooth and stable way. Both of the IFIs have similar structures, with governing bodies made up of representatives from the member countries.

Both organizations have come under criticism. Some say their policies put poor people at a disadvantage and help rich corporations, and some feel that they threaten national sovereignty.

Though the IMF and World Bank are alike in many ways, they have distinct purposes. The IMF’s main goal is to make sure that the system of payments between countries runs smoothly. It lends money to governments when they need it. But it also monitors the policies and actions that determine countries’ currency exchange rates. It deals with large economic issues that are occurring between countries.

The World Bank, on the other hand, helps developing countries pay for economic development projects and needed services. It lends money to the governments of these poor countries to help pay for such projects. Unlike the IMF, which is focused on monetary issues, currency, banking, and macroeconomics, the World Bank is focused on microeconomic policies and structures for particular sectors of the economy (such as electricity or transportation), and on the funding of specific projects in those sectors.




Partner Activity: Balance of TradeStudent Name:_______________________________________________________ Date:___________

Directions: Answer the questions based on the Balance of Trade Rules of Thumb below and the data from the chart on the following page. Be ready to share how you arrived at your answers.

Balance of Trade Rules of Thumb A country’s balance of payments is the difference between the total of all payments into a

country from other countries (including incoming payments for exported goods and services and incoming investments) and the total of all payments out from the country (including payments for imported goods and services and outgoing investments) in a specific time period.

The total balance of payments can be broken down into various parts. One of these is the current account balance of payments (current account for short). The current account shows the flows of money into and out of a country other than flows of money for the purpose of making investments.

Economists look to the current account, which measures imports and exports, to determine the country’s trade balance. A positive number in the current account signifies a trade surplus; a negative number signifies a trade deficit.

Trade deficits decrease the demand for a country’s currency compared with what it would be if the country’s imports and exports balanced. Those buying a country’s exports first have to buy its currency in order to do so. This represents demand for the country’s currency in the FX market. Those who sell imports into that country are generally paid in its currency; this represents supply of the currency in the FX market. It follows that if the country has a trade deficit (its imports exceed its exports), the supply of the currency will exceed the demand and therefore the currency will tend to decrease in value. Trade surpluses have the opposite effect: they increase demand for a currency and tend to increase its value.

Inflation is a general increase in prices, reducing the purchasing power of a country’s currency.

Exports help maintain high employment levels; slow economic growth raises unemployment rates.

GDP changes can cause currency rate fluctuations.



2012 Balance of Trade Figures for (M)BRICS(K) Countries in US Dollars

GDP (PPP adjusted) ($trillion)

Real GDP Growth Rate (%)

Exchange Rate Yearly Change (%)

Inflation Rate

(%)

Current Account Balance ($billion)

Unemployment Rate (%)

MEXICO 1.8 3.9 -5.8 4.1 -14.1 4.9

BRAZIL 2.3 0.9 -16.8 5.5 -54.2 5.4

RUSSIA 2.5 3.4 -5.8 5.3 71.4 5.2

INDIA 4.7 6.5 -13.8 6.0 -91.5 9.9

CHINA 12.3 7.8 2.4 3.1 193.1 4.1

S. KOREA 1.6 2.0 -1.9 2.2 43.3 2.9

SOUTH AFRICA

0.6 2.5 -13.1 5.2 -24.1 25.5

Balance of Trade Questions:

1. Which countries have trade deficits?

2. Which countries have trade surpluses?

3. GDP reflects (in part) the purchasing power of consumers. If a country’s GDP falls, consumers are usually less able to purchase foreign goods, so the country’s imports decline. If GDP grows, consumers will probably buy more imports, decreasing any trade surplus or increasing a trade deficit. Which countries are most likely to see a change in the value of their currency for this reason? Why?



4. Compare the GDP growth rates of China and Brazil in 2012. How will their respective GDP growth rates likely impact their balance of payments?

5. Which countries might expect to see a change in employment numbers? Why?




Case Study: International Financial ManagementStudent Name:_______________________________________________________ Date:___________

Directions: Read the policy and effect statements for each of the three policies that China implemented, and in the effect statement circle your best guess about what the effect was. Then read the explanatory text that follows about the policy China implemented, and correct your answers, if necessary.

Balance of trade is a key indicator of what is happening in a country’s economy, and that is why governments implement policies to manage it. Many countries seek trade balance (when the income a country earns from its exports is equal to the money paid to other countries for imports), but others seek to maximize exports. The Chinese government has managed its economy and its currency so that it will have a large trade surplus.

Trade PolicyPolicy: The Chinese government makes its trade policies as export-friendly as possible.

Effect: China enjoys a trade surplus/deficit.

China is one of the trade leaders in the world. In 2012, the United States imported $426 billion worth of goods from China while exporting only $110 billion there. The world imported $2.0 trillion worth of Chinese goods, while China imported only $1.7 trillion.

Currency ManagementPolicy: The Chinese government keeps the value of its currency, known as the renminbi, artificially low.

Effect: This will affect China’s balance of trade by increasing/decreasing exports.

The Chinese government uses a pegged rate for its currency, the renminbi (the major unit of Chinese currency is called the yuan). China uses a pegged exchange rate regime, meaning that the exchange rate only fluctuates within a limited range decided upon by the Chinese government. To maintain its controlled exchange rate, the Chinese government buys or sells its currency to offset market fluctuations. Buying or selling the renminbi is controlled by law.

In 1997, in order to make Chinese goods more competitive in the United States, the Chinese government devalued the renminbi against the dollar and pegged the exchange rate at 8.27 yuan to the dollar. This made imports of Chinese goods artificially cheap for Americans, which contributed to the ever-increasing US trade deficit. (In 2015, the US trade deficit was $531 billion, or 2.8% of the nation’s GDP.) In addition, the Chinese manufacturing base grew at the expense of the American one. This is why the American government applied pressure on the Chinese government to revalue the yuan; it did so by pegging the rate to a basket of currencies. As of December 2013, one dollar buys slightly more than 6 renminbi. Nonetheless, economists see this rate as still undervaluing the yuan. Some estimates suggest that on a purchasing-power parity basis, the true exchange rate between the yuan and dollar should be 4:1.



Inflation RatesPolicy: The Chinese government has raised interest rates.

Effect: Chinese exports will be cheaper, increasing/decreasing trade.

For the past decade or so, inflation has been one of the biggest concerns the government of China has had about the performance of the Chinese economy. In February 2008, China’s general inflation rate was 8.7% and the inflation rate on food was 23.3%. High rates of inflation can seriously destabilize economies. The Chinese government had previously raised interest rates several times, making it more costly to borrow, presumably because this restrains business, which seemed to be overheating, creating scarcities of goods and services and thus bidding up prices. It seems the Chinese government was trying to combat inflation, but to limited effect. However, the contraction of the US economy in 2008–2009 impacted China’s economy by lowering the demand in the United States for goods imported from China. In 2009, consumer prices in China dropped 1.6%. In other words, in 2009 China was undergoing deflation, or negative inflation rate growth.

While inflation can cause problems for a country’s economy, so can deflation. For example, persistent deflation can result in a fall in the demand for goods and services, in part because consumers hold off on buying goods in the hope that prices fall further. This can lead to a downturn in the economy that is difficult to reverse: this has happened repeatedly in the Japanese economy since the 1990s.




Organizer: Economic Policy Recommendation LetterStudent Name:_______________________________________________________ Date:___________

Directions: Use Student Resource 8.6, Case Study: International Financial Management, to answer the questions below. Work on questions 1–6 with a partner. These answers will become the three examples in your letter. Then write down your own ideas for question 7. This information will also be added to the letter.

1. What is one trade policy change China could make?

2. What would be the result of this change?

3. What is one way China could change the way it manages its currency?

4. What would be the result of this change?

5. What is one way China could alter its interest rates?

6. How might a change in interest rates affect its trade balance?

7. Of the different economic policy changes China could make, which would you recommend and why?


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