The International Monetary System

Every nation has a monetary system with a monetary authority. In the United States the Federal Reserve is our monetary authority and its task is to hold down inflation while promoting economic growth and raising our national standard of living Moreover if countries are to trade with one another. We must have some sort of system designed to facilitate payments between nations.

From the end of World War II until August 1971 the world was on a fixed exchange rate system administered by the International Monetary fund (IMF). Under this system the U.S. dollar was liked to gold ($35 per ounce) and other currencies were then tied to the dollar. Exchange rates between other currencies and the dollar were controlled within narrow limits but then adjusted periodically. For example. in1964 the British pound was adjusted to $2.80 for ₤1 with a 1 percent permissible fluctuation about this rate.

Fluctuations in exchange rates occur because of changes in the supply of and demand for dollars. Pounds and other currencies. These supply and demand changes have two primary sources. First changes in the demand for currencies depend on changes in imports and exports of goods and services. For example U.S. importers must buy British pounds to pay for British goods whereas British importers must buy U.S. dollars to pay for U.S. goods. if U.S. imports from Great Britain exceeded U.S. exports to Great Britain. There would be a greater demand for pounds than for dollars and this would drive up the price of the pound relative to that of the dollar. In terms of table 18-1 the dollar cost of a pound might rise from $1.6650 to $2.0000. The U.S. dollar would be said to be depreciating because a dollar would now be worth fewer pounds whereas the pound would be appreciating. In this example the root cause of the change would be the U.S. trade deficit with Great Britain. Of cause. If U.S. exports to Great Britain were greater than U.S. imports from Great Britain. Great Britain would have a trade deficit with the United States².

Changes in the demand for a currency hence exchange rate fluctuations also depend on capital movements. For example. suppose interest rates in Great Britain were higher than those in the United States. To take advantage of the high British interest rates U.S. banks corporations and even sophisticated individuals would buy pounds with dollars and then use those pounds to purchase high yielding British securities. These purchases would tend to drive up the price of pounds².