FINM8007 Chap.2 The International Monetary System
The International Monetary System
How rates have been fixed, and freed
This chapter follows the international monetary system through five stages: bimetallism and Gresham’s law, the classical gold standard with its mint parities and self-correcting trade, the unstable interwar years, the dollar-centred Bretton Woods system and its collapse in 1971, and the mix of regimes since 1973.
The choice every country still faces
It then compares free floats, managed floats, hard pegs such as currency boards and soft pegs, and explains why no regime can deliver a stable exchange rate, open capital markets and independent monetary policy together.
The eurozone shows one answer to that trilemma and its cost.
Where marks are won and lost
Tutorial questions on this topic are mostly written answers, and the solutions link each regime to its trade-off rather than simply describing it. For the trilemma, name the two goals a country keeps and the one it gives up, and give the mechanism, usually a capital flow chasing an interest gap.
For the gold standard, show the arbitrage loop with numbers and add what shipping costs do to it.
For pegged regimes, use devaluation and revaluation rather than depreciation and appreciation, a distinction the Quiz 1 review tested directly.
How it connects
The regime a country chooses decides which tools of Chapter 4 it can use: a floating currency is moved by interest rates and expectations, while a pegged one is defended with reserves until they run out.
The balance of payments in Chapter 3 shows that drain in the official reserves account, and the trilemma returns in the group assignment, where Part A asks how a central bank’s policy moves its currency.
What this chapter covers
- 01
Bimetallism and Gresham’s law
- 02
Mint parity under the gold standard
- 03
Price-specie-flow mechanism
- 04
Bretton Woods and the IMF
- 05
Special drawing rights
- 06
Free and managed floats
- 07
Currency boards and soft pegs
- 08
The impossible trinity
Worked example · free
Find the gold parity and run the arbitrage loop
- 1Mint parity: 35.00 ÷ 7.00 = $5.00/£, so the market overvalues the pound.
- 1Sell the pounds in the FX market: 1,000 × 5.25 = $5,250.
- 1Buy gold in New York: 5,250 ÷ 35.00 = 150 ounces.
- 1Sell the gold in London: 150 × 7.00 = £1,050, a gain of £50 before shipping costs.
Key terms
- Gresham’s Law
- The tendency for undervalued coins to be hoarded so that only cheaper coins circulate.
- Mint Parity
- The exchange rate implied by two currencies’ fixed gold prices.
- Special Drawing Right
- An IMF reserve asset valued against a basket of major currencies.
- Currency Board
- A hard peg that backs domestic money fully with foreign reserves.
- Devaluation
- An official reduction in the value of a pegged or managed currency.
- Price-Specie-Flow Mechanism
- Hume’s account of how gold flows corrected trade imbalances under the gold standard.
The International Monetary System FAQ
Why did the Bretton Woods system break down?
Growing world trade needed more dollars, which the United States supplied through persistent deficits. Foreign dollar holdings came to exceed US gold, confidence fell, the costs of the Vietnam War added pressure, and in August 1971 the dollar’s convertibility into gold was ended.
Is a free float always better than a peg?
No. A float insulates a country from its partners’ inflation and unemployment, but it can let a troubled country’s own inflation or unemployment persist. Pegs shelter trade and investment from currency risk but expose the currency to speculative attack when a reset looks likely.
Which goal does a eurozone member give up?
Monetary independence. Members share a currency, so the exchange rate is fixed among them and capital moves freely, but interest rates and money issuance are set by the European Central Bank rather than by each country.
What is the difference between devaluation and depreciation?
Devaluation is a government decision to lower the official value of a controlled currency, while depreciation is a fall in value driven by the market. Questions on pegged regimes expect the first word, questions on floating rates the second.
Why do many emerging economies choose a fixed exchange rate?
Shallow capital markets make a flexible rate hard to accommodate, and the IMF notes that most emerging economies use some form of fixed regime, from soft pegs to currency boards. The cost is greater exposure to speculative attack when a reset looks likely, as several past currency crises showed.
Exam move
Learn the five stages as answers to three questions: what fixes the rate, what disciplines money, what happens to a rule-breaker. Then place six real countries on the sides of the trilemma triangle. Finish by writing a short paragraph on the eurozone that names its two kept goals, its lost one and the cost of that loss during a local recession.
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