Mandates: promote stability of the international
financial system (IMF); promote economic
development (WB).
International monetary system:
the gold standard
 A system under which the value of a nation’s monetary
unit was backed by gold
 Gold 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 flows
 This would result in exchange rates that are fixed
 Domestic macro adjustments
 The gold standard implies changes in the domestic
money supply of nations, which affects prices,
real output and employment
 Advantages of gold standard
 Stable exchange rates resulting from the gold
standard reduces uncertainty and risk
 The 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 standard
 Nations must accept domestic adjustments in
the form of higher unemployment or inflation
 Countries must have sufficient reserves of gold
 Demise of the gold standard
 During the Depression years of the 1930s
Bretton Woods monetary system
 Bretton Woods conference 1944
 Adjustable 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 rates
 Stabilisation 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 credit
 Provided 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 system
 Fundamental 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 Wood
 Dilemma: dollars and the deficits
 Emergence of floating rates
Managed float
 An 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 rights
 Special 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-IMF
 IMF
 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 functions
 Surveillance: (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 Created
 Avoid 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 stability
Exchange rate stability (balanced growth of trade)
Forum for international monetary cooperation
Temporary financial assistance to members experiencing
balance of payments difficulties
World Bank
 Reconstruction and economic development after WWII
 Long-term economic development
 Project 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 System
 The 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 States
 The 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 problem
 The 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 asset
 SDRs 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 Power
 IMF 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 countries
 Quotas 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 GDP
 regular 5-yearly reviews
Distribution of quotas
 US %17
 Europe % 41
 Americas %10
 Asia and Pacific % 20
 Africa % 5
 Middle East % 7
Global financial crisis
 Financial 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 sharply
 Role of Fund
 Early warning signs
 risks 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.
Summary
 In 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.