The international financial system
Global finance is shaped by exchange rate regimes, international institutions, capital flows, and periodic crises.
Exchange rate regimes
Countries choose floating exchange rates (set by markets, as for the US dollar, euro, and yen), fixed or pegged rates (maintained by central banks, as for the Hong Kong dollar since 1983), managed floats, or currency unions such as the euro. Each choice trades off stability against monetary policy independence.
History: gold standard to Bretton Woods
Under the classical gold standard (about 1870-1914), currencies were tied to gold. The 1944 Bretton Woods agreement pegged currencies to the US dollar, which was convertible to gold at 35 dollars an ounce. The system ended when President Nixon suspended dollar convertibility in 1971, leading to floating rates by 1973.
The IMF and World Bank
The International Monetary Fund (IMF), created at Bretton Woods, monitors economies, advises governments, and lends to countries facing balance-of-payments crises, often with conditions attached. The World Bank provides loans and grants for development projects. Both have been criticised for the conditions attached to their loans and praised for stabilising crises.
Capital flows
Capital flows between countries through foreign direct investment (building or buying businesses abroad), portfolio investment (buying foreign stocks and bonds), and bank lending. Emerging markets attract capital for growth but can suffer 'sudden stops' when investors pull money out, often when US interest rates rise.
Currency and debt crises
Financial crises often involve currency collapses and debt problems: the 1997 Asian financial crisis began in Thailand; Argentina defaulted on its debt in 2001 and several times since; the euro area debt crisis of 2010-2012 affected Greece, Portugal, Ireland, Spain, and others. Countries with large foreign-currency debts are especially vulnerable to depreciation.
The dollar's global role
The US dollar is the world's main reserve currency, held by central banks, used in much of global trade, and dominant in international debt. This 'exorbitant privilege' lowers US borrowing costs. Shares of other currencies, including the euro and Chinese renminbi, have grown modestly, and debates continue about whether the dollar's dominance will last.
Sovereign wealth funds and new technology
Sovereign wealth funds invest countries' surplus wealth globally; Norway's fund, built from oil revenues, is among the world's largest, holding over 1.5 trillion dollars. Central bank digital currencies and faster cross-border payment systems are being developed and could change how international payments work.
Worked example
A small country pegs its currency to the dollar and has free capital flows. When the US Federal Reserve raises interest rates, capital starts flowing toward the US. To defend the peg, the country must raise its own rates even if its economy is weak, or spend foreign reserves buying its currency, illustrating the 'impossible trinity': a country cannot have a fixed exchange rate, free capital movement, and independent monetary policy all at once.
Key takeaways
Exchange rate regimes include floating, pegged, managed, and currency unions. The gold standard gave way to Bretton Woods (1944), which ended in 1971-1973. The IMF lends to countries in crisis; the World Bank funds development. Capital flows can reverse suddenly. Crises such as Asia 1997, Argentina 2001, and the euro area 2010-2012 often involve currencies and debt. The dollar dominates global finance. The impossible trinity limits policy choices.
Flashcard
Set by markets
Check your understanding
What ended the Bretton Woods system of fixed exchange rates?