The International Monetary System

By Author: STEPHANIE
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We start with an analysis of the international monetary system. This term denotes the institutions under which payments are made for transactions that reach across national boundaries. In particular, the international monetary system determines how foreign exchange rates are set and how governments can affect exchange rates.

The importance of the international monetary system was well described by economist Robert Solomon:

Like the traffic lights in a city, the international monetary system is taken for granted until it begins to malfunction and to disrupt people's Links Of London Bracelets lives. A well-functioning monetary system will facilitate international trade and investment and smooth adaptation to change. A monetary system that functions poorly may not only discourage the development of trade and investment among nations but subject their economies to disruptive shocks when necessary adjustments to change are prevented or delayed.

The central element of the international monetary system involves the arrangements by which exchange ...
... rates are set. In recent years, nations have used one of three major exchange-rate systems:

a system of flexible or floating exchange rates, where exchange rates are entirely determined by market forces;
a system of fixed exchange rates;
a hybrid system of "managed" exchange rates, which involves some currencies whose values float freely, some currencies whose values are determined by a combination of government intervention and the market, and some that are pegged or fixed to one currency or a group of currencies

At one extreme is an international monetary system in which exchange rates are completely flexible and move purely under the influence of supply and demand. This system, known as flexible exchange rates, is one where governments neither announce an exchange rate nor take steps to enforce one. (Another term often used is "floating" exchange rates, which means the same thing.) In a flexible exchange-rate system, the relative prices of currencies are determined by buying and selling among households and businesses.

Let us see how exchange rates are determined under flexible rates. In 1994, the peso was under attack in foreign exchange markets, and the Mexicans allowed the peso to float. At the original exchange rate of approximately 4 pesos per U. S. dollar, there was an excess supply of pesos. This meant that at that Links Of London Charms exchange rate, the supply of pesos by Mexicans to buy American and other foreign goods and assets outweighed the demand for pesos by Americans and others who wanted to purchase Mexican goods and assets.What was the outcome? As a result of the excess supply, the peso depreciated relative to the dollar. How far did the exchange rates move? Just far enough so that the quantities supplied and demanded were balanced.

What lies behind the equilibration of supply and demand? Two main forces are involved: (1) with the dollar more expensive, it costs more for Mexicans to buy American goods, services, and investments, causing the supply of pesos to fall off in the usual fashion. (2) With the depreciation of the peso, Mexican goods and assets become less expensive for foreigners. This increases the demand for pesos in the marketplace. (Note that this simplified discussion assumes that all transactions occur only between the two countries; a more complete discussion would involve the demands and supplies of currencies from all countries.)

Where is the government? In a freely flexible exchange-rate system, the government is on the sidelines. It allows the foreign exchange market to determine the value of the dollar, just as it allows markets to determine the value of Links Of London Earrings lettuce, machinery, GM stock, or copper. Consequently, it is possible to get enormous swings in flexible exchange rates over relatively short periods.