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Success or failure of an international monetary system depends upon the extent to which it can fulfill these goals without allowing conflicting goals of national governments to undermine the system. While many international arrangements have tried to fulfill these goals over the past century, three systems deserve special mention.

One type was the gold standard (1879–1913). More by convention than through an international agreement, most countries had based their monetary system on gold in the 19th century. Value of a currency was fixed in terms of gold and the supply of a currency depended upon the gold reserves held by a country. Payments between countries were achieved easily through shipments of gold, and exchange rates were effectively fixed as a result of each currency’s rigid link to gold. Trade imbalances between countries were paid for in gold that could be shipped between countries without restrictions. An outflow of gold for a deficit country would reduce gold reserves and hence the money supply (automatically). This would put downward pressure on domestic prices, while foreign prices would be rising due to consequences of increased gold reserves in that country. These changes in relative prices set in motion the corrective forces that eliminated the trade imbalances. Free flow of gold also ensured that capital was free to move from one country to another. Indeed, the global economy had reached very high levels of integration under this regime.

The downfall of the gold standard lay in its reliance on gold supplies. It left very little room for governments to play an active role in their economies. With the start of World War I, that objective became more important than maintenance of fixed exchange rates.

Another type was the Bretton Woods system (1945–1972). Experience with the Depression in the 1930s convinced world leaders that self-serving economic policies that attempt to transfer costs of economic hardships to others do not necessarily work. The financial turmoil of the Depression era was replaced by a fixed exchange rate system in 1945 in which the dollar was to acquire a central role. Signatories to the Bretton Woods agreement gave up their currencies’ links with gold and established fixed exchange rates against the U.S. dollar. In turn, the U.S. dollar was to have a fixed price in terms of gold and would be freely convertible into gold.

The international monetary system in effect became a dollar standard. The role of the dollar as a reserve and as a vehicle currency increased significantly over the next three decades. The fixed exchange rates could only be changed infrequently with international consultations and only when fundamental economic situations warranted such changes. The International Monetary Fund (IMF) was established to guide countries and to ensure stability in the international financial markets.

The IMF also became a source of funds for countries that were facing balance of payments imbalances.

The Bretton Woods system provided an unprecedented stability in the financial markets for war-ravaged countries to rebuild their economies after World War II. The IMF was successful in persuading more and more countries to gradually open their financial markets and get rid of exchange controls. By the late 1960s, however, flaws of this system became increasingly apparent. First, there was a bias in the system against allowing exchange rates to change quickly and by small amounts when economic conditions warranted. This bias had led to a number of speculative runs against a number of currencies as speculators could spot under or overvalued currencies and could lay bets against those currencies. Second, the resources of the IMF became inadequate as the industrialized countries grew in size and their financial requirements grew far more rapidly than the funds available to the IMF. Third, and most important, the system had left no room for the U.S. economy to adjust should it have balance of payments difficulties. While all other countries could use a change in their exchange rate as a policy tool, the U.S. economy was denied this possibility because it had become the anchor for the international monetary system.

A third system type is the floating rate system (1973–). In 1968, the U.S. government withdrew the promise to freely convert U.S. dollars into gold for nonofficial purposes. A slight adjustment was made to the price of gold in terms of dollars in 1971, and the gold window was completely closed. By early 1973, the fixed exchange rate system was abandoned and most currencies were allowed to float freely. Market participants would determine the values of currencies.

With the exception of the developments in the European Monetary System, most major currencies of the world continue to float. Central banks of some emerging economies “manage” the values of their currencies by intervening in the foreign exchange markets. Some other countries link their currencies to that of a country on which their economies depend heavily. Most industrialized countries today allow unrestricted flow of capital between their economies and the rest of the world.

Bibliography:

Benjamin J. Cohen, Global Monetary Governance (Routledge, 2008);
Benjamin Cohen, “The International Monetary System: Diffusion and Ambiguity,” International Affairs (v.84/3, 2008);
Barry J. Eichengreen, Globalizing Capital: A History of the International Monetary System (Princeton University Press, 2008);
Barry Eichengreen and Raul Razo-Garcia, “The International Monetary System in the Last and Next 20 Years,” Economic Policy (v.21/47, 2006);
Roland I. McKinnon, The Rules of the Game: International Money and Exchange Rates (MIT Press, 1996);
Robert A. Mundell, “The Significance of the Euro in the International Monetary System,” American Economist (v.47, 2003);
Richard Samans, Marc Uzan, and Augusto Lopez-Claros, The International Monetary System, the IMF and the G20 (World Economic Forum, 2007).

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