International Monetary System

The term international monetary system refers to the formal and informal arrangements between national governments and financial institutions—private, public, and international—that govern the flow of money and capital between countries. Some aspects of these flows are strictly regulated by domestic and international laws; others are subject to whims and fancies of the market forces often governed by informal agreements and market conventions. Throughout history, there have been epochs when some countries were able to strongly influence the terms under which these flows would take place, and there have been epochs when chaos seemed to reign. The basic purpose of an international monetary system is to facilitate international flows of money and capital in an orderly fashion.

The system must provide a mechanism for payments across countries. Just as the domestic financial system provides very efficient mechanisms (checks, cash, electronic transfers) for transferring purchasing power across entities within the same currency area, an international system must facilitate transfer of purchasing power across countries. This is the easy part—banks have developed very sophisticated mechanisms for converting and transferring value across national boundaries. The foreign exchange market, the largest financial market in the world in terms of daily turnover, allows for efficient conversion of value from one currency to another. Many specialized instruments, for example, acceptance bills, provide liquidity to the market. Governments regulate such transactions merely to prevent payments for illegal and undesirable activities. There is international supervision and regulation of these activities to prevent some forms of systemic risks from spreading from one institution to another. Currencies of many countries have been used over time as international vehicles or reserve currencies to make this task easy and efficient. The challenge for the international monetary system is to ensure that real economic activities take place with minimum resistance arising from the financial transfer that must accompany every real transaction.

Participants in the international monetary system must agree upon a system that determines the values of various currencies in terms of each other—that is, the exchange rates between national currencies. The broad choices for exchange rate regimes are between fixed rates, managed rates, or floating rates. Since changes in exchange rates can have serious impacts upon domestic economies, governments have strong incentives to manipulate their exchange rates to extract some unfair advantages from the global economy. Since such a gain will probably come at someone else's cost, there is a need either for clear international agreements or an international “supervisor” that will ensure that exchange rates are not manipulated and remain with ranges that are justified by economic fundamentals. The challenge for the international monetary system is to ensure that the rules that determine values of currencies are clearly spelled out and there are few incentives for countries to break the rules.

Since countries are often likely to have imbalances in their economic transactions with the rest of the world, the international monetary system must ensure that there are mechanisms to finance such imbalances. While providing temporary relief to finance these imbalances, the system must ensure that incentives exist for countries to take corrective actions, that is, to “adjust” their economies when these balances have not resulted from temporary and reversible shocks. The international monetary system has to ensure that the pool of resources available for financing global imbalances is sufficiently large to meet the needs of countries under normal circumstances.

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