international monetary system

international monetary system,

rules and procedures by which different national currencies are exchanged for each other in world trade. Such a system is necessary to define a common standard of value for the world's currencies.

The Gold and Gold Bullion Standards

The first modern international monetary system was the gold standard. Operating during the late 19th and early 20th cents., the gold standard provided for the free circulation between nations of gold coins of standard specification. Under the system, gold was the only standard of value.

The advantages of the system lay in its stabilizing influence. A nation that exported more than it imported would receive gold in payment of the balance; such an influx of gold raised prices, and thus lowered the value of the domestic currency. Higher prices resulted in decreasing the demand for exports, an outflow of gold to pay for the now relatively cheap imports, and a return to the original price level (see balance of trade and balance of payments).

A major defect in such a system was its inherent lack of liquidity; the world's supply of money would necessarily be limited by the world's supply of gold. Moreover, any unusual increase in the supply of gold, such as the discovery of a rich lode, would cause prices to rise abruptly. For these reasons and others, the international gold standard broke down in 1914.

During the 1920s the gold standard was replaced by the gold bullion standard, under which nations no longer minted gold coins but backed their currencies with gold bullion and agreed to buy and sell the bullion at a fixed price. This system, too, was abandoned in the 1930s.

The Gold-Exchange System

In the decades following World War II, international trade was conducted according to the gold-exchange standard. Under such a system, nations fix the value of their currencies not with respect to gold, but to some foreign currency, which is in turn fixed to and redeemable in gold. Most nations fixed their currencies to the U.S. dollar and retained dollar reserves in the United States, which was known as the "key currency" country. At the Bretton Woods international conference in 1944, a system of fixed exchange rates was adopted, and the International Monetary Fund (IMF) was created with the task of maintaining stable exchange rates on a global level.

The Two-Tier System

During the 1960s, as U.S. commitments abroad drew gold reserves from the nation, confidence in the dollar weakened, leading some dollar-holding countries and speculators to seek exchange of their dollars for gold. A severe drain on U.S. gold reserves developed and, in order to correct the situation, the so-called two-tier system was created in 1968. In the official tier, consisting of central bank gold traders, the value of gold was set at $35 an ounce, and gold payments to noncentral bankers were prohibited. In the free-market tier, consisting of all nongovernmental gold traders, gold was completely demonetized, with its price set by supply and demand. Gold and the U.S. dollar remained the major reserve assets for the world's central banks, although Special Drawing Rights were created in the late 1960s as a new reserve currency. Despite such measures, the drain on U.S. gold reserves continued into the 1970s, and in 1971 the United States was forced to abandon gold convertibility, leaving the world without a single, unified international monetary system.

Floating Exchange Rates and Recent Developments

Widespread inflation after the United States abandoned gold convertibility forced the IMF to agree (1976) on a system of floating exchange rates, by which the gold standard became obsolete and the values of various currencies were to be determined by the market. In the late 20th cent., the Japanese yen and the German Deutschmark strengthened and became increasingly important in international financial markets, while the U.S. dollar—although still the most important national currency—weakened with respect to them and diminished in importance. The euro was introduced in financial markets in 1999 as replacement for the currencies (including the Deutschmark) of 11 countries belonging to the European Union (EU); it began circulating in 2002 in 12 EU nations (see European Monetary System), and additional EU members have since adopted it. The euro replaced the European Currency Unit, which had become the second most commonly used currency after the dollar in the primary international bond market. Many large companies use the euro rather than the dollar in bond trading, with the goal of receiving a better exchange rate. The record deficits incurred by the United States in the wake of the financial crisis that began in 2007 and the resulting weaker dollar led many central banks to diversify their foreign reserves and greatly increase the percentage held in yen and euros. The growing economic importance of China in the 21st century led, by 2013, to its currency (the renminbi, whose main unit is the yuan) displacing the euro as the second most commonly used currency in world trade.

Bibliography

See T. Agmon et al., ed., The Future of the International Monetary System (1984); R. D. Horman, Reforming the International Monetary System: From Roosevelt to Reagan (1987).