INTERNATIONAL FINANCIAL

SYSTEM
 GLOBAL FINANCIAL SYSTEM: Drawing departure points from the
course literature

O’Brien & Williams (Chap. 4, 8) Schenke (Chap. 1, 6)

• International financial system (IMS & ICS) • Integration of production, trade and
• Gold Standard and Bretton Woods System finance
• Capital mobility & exchange rate system • Capital mobility & portfolio investments
(fixed vs floating) • Technology
• Technology •Mundell-Fleming Model
• Deregulation • Financial crises
• Mundell-Fleming Model • Ideational convergence
• Financial crises
TODAY’S LECTURE

• Monetary & fiscal policies

• What is the role of IMS?
• Classical Gold Standard
• Bretton Woods System
• Political economy of monetization
• Post – Bretton Woods financial system
• Capital / Equity markets
• Factors driving exchange rates
• GPE and international financial system:
critical reflections
 CHRONOLOGY OF THE INTERNATIONAL MONETARY SYSTEM

• MODERN POLITICAL MONEY (1700s – 1900s)

• CLASSICAL GOLD STANDARD (1870-1914)
• TRANSITION FROM PAX BRITANNICA (£)TO
PAX AMERICANA $ (1914 – 1944)
• BRETTON WOODS SYSTEM (1944 – 1976)
 POLITICAL ECONOMY: MONETARY POLICY AND FISCAL POLICY
MONETARY POLICY
• Monetary authority (territorial)
• Control over supply of money
CENTRAL BANK
• Establish growth and stability
• Interest rate management
• Managing prices, inflation and employment
via expansionary or contractionary policy

FISCAL POLICY – managing:

• Government expenditure (resource allocation, demand management)
• Government income (revenue, distribution of income) GOVT.
via government expenditure and taxation policies BUDGET

MACROECONOMICS
• Deals with structure, behavior, decision-making of entire economy (national, regional or global)
• Deals with aggretated information on GDP, unemployment rates, price indicies, national income,
output, inflation, savings, investment, trade, finance (national, regional or global)
MICROECONOMICS
• Deals with individual economic behavior (firms and consumers/ individuals) and the impact on prices,
demand and markets.
 INTERNATIONAL FINANCE AND IPE
International Finance is understood to
encompass:

1. All the main features of monetary relations

between states
2. The pocesses and institutions of financial
intermediation (savings, credit, repayment
etc.) itself – eg. printing of money,
exchange and interest rates management,
banking system, macroeconomic and fiscal
policies
 THE INTERNATIONAL MONETARY SYSTEM (IMS)
• IMS is understood as a system of norms and conventions that govern
international finance.
• IMS has important distributive effects on the power and welfare of
states in the international system.
• IMS is not economically or politically neutral

i.e. is a function of political economy (national and international)

WHY DO WE NEED AN IMS?

IMS addresses 3 technical problems:

1. Liquidity
Supply (availability) of currency to finance trade and financial reserves
2. Adjustment
Correct short-term balance of payment problems
3. Confidence
Restore confidence in a country’s currency and prevent destabilizing shifts in
national currency
 EARLY BANKING SYSTEM

Understanding monetary policy and monetary system requires

knowledge of how banking and credit systems work

Goldsmith shop bank (1300s) – a forerunner of today’s banknotes and

banking system:

”Receipts” on gold deposits

Receipts as medium of exchange
Loans based on the gold stocks
Receipts exceeding their gold stocks
Bankruptcy

Banks today are like the goldsmith banks. They loan most of the money
deposited with them to earn a return.

Banking system
Banking Explained – Money and Credit
 THE POLITICAL ECONOMY OF MONETIZATION IN EUROPE (ca 1100-
1500s)

Main features:
1. Expansion of trade (continent wide)
2. Problem of exchange rate (currency)
3. The money minting industry and feudalsim
4. Tension between monetary stability and inflation
5. The state and money supply (stability vs currency
manipulation)
What was the main form of early currency/money?
What problems can you think of with this form of
currency?

How Our Monetary System Works And Fails

PROBLEMS WITH METALLIC MONETARY ARRANGEMENTS IN EUROPE (1100 – 1870)

1. Seignorage (printing/ minting of money)

2. Liquidity (circulation of money – supply)

3. Tendency towards debasement (devaluation)

4. Inflation (rise in prices)

5. Several currencies in circulation (exchange rate problems)

6. Unregulated monetary system (weak economy)

7. Volatility of currency values caused by political conflicts

 WHY THE PRESSING NEED FOR A MONETARY SYSTEM (1500s-1800s)?
IPE - FINANCIAL DEVELOPMENTS
IPE AND TRADE
• Monetization of European economies
• Expansion of inter-European trade Financial innovations:
• Colonial expansion • Development of banking and new
• Spain (Americas), Portugal (Americas monetary instruments
1494; Africa 1500-1750) • Private-owned Central Banks to mint and
• Mercantilism (1500-1750) / bullionism manage public debt
• Inflow of silver and gold from the • Private banks lend to goverments and
Americas Popes
• Price revolution and prolonged • Bill of exchange – convertible to gold or
inflation silver
• Westphalian system (1648) • Printing of paper money backed by
• Industrial Revolution (ca 1760-1850) fractional reserves
• Free trade era • Wars resulted in inconvertibility and
peace to convertibility
• Monetization – issue of inconvertible
money
• Episodes of increasing inflation and
depreciation
 THE GOLD STANDARD (1870-1914)

Features of the Classical Gold Standard

1. Paper money (domestic and trade)

2. Liquidity and money supply
3. Gold reserve and currency value / Fixed exchange rate
4. Convertibility
5. Disciplinary control on money supply
6. Stability of currency
7. Central Bank

Gold Standard: the amount of money a country could issue was dependent on
the amount of gold it accumulated (gold bullion reserves) – i.e. money supply
tied to gold reserves

Nationalization of the monetary system after World War-I – i.e. State take over of
monetary matters (1914-1944) and the Great Depression led to collapse of the Gold
Standard
 Bretton Woods System (1947 – 1971)

1. US dollar as ”key currency” / ”reserve currency”

2. US $ and gold reserve
3. Fixed exchange rate (35 $/ounce of gold)
4. Convertibility
5. Stability and flexibility
6. Liquidity (global)
7. Accumulation of $ reserves outside US economy
8. European reconstruction & Marshall Plan
9. IMF and IBRD/ World Bank

Gold Exchange Standard (convertibility) and the accumulation of gold reserves and
claims on key currencies (USD and GBP) were the main problems of the BW system
 MONETARY SYSTEMS COMPARED
Gold Standard (1870- Bretton Woods (1947- Post-Bretton Woods
1914) 1971) (1971 -)
1. Liquidity • Limited / low • High • High
• Fixed to gold • Fixed to US$ • Multiple
• Convertibility • Convertibility currencies
2. Adjustment • Limited • Flexible • Flexible
• Central Bank • Central Bank • Exchange rate
fluctuations
• IMF
3. Confidence • Stability • Stability • Volatility

Strengths • Stability • Stability • High liquidity

• Limited liquidity • High liquidity • Forex markets
• Key currency (£) • Key currency ($) • Portfolio capital
• Capital mobility

Weaknesses • Rigid (gold supply) • Convertibility • Volatility in forex

• Fate tied to US • Financial instability
policy • Governance
• Financial crises
 The GPE Toolkit
INTERNATIONAL MONETARY
SYSTEMS

ACTORS PROCESSES INSTITUTIONS RULES NORMS

State Money supply Metallic system Fixed rates Embedded

Banks Exchange (fixed) Gold Standard Monetary Neo-
Central Monetization Bretton Woods policy liberalism
banks Inflation (poleco) system Fiscal policy
Paper money Central banks Macro
Financial innovation IMF economic
IBRD / World policy
Bank Convertibility
 Post-Bretton Woods International
Financial System
• Floating Exchange Rate System

• Capital / Equity Markets

• Factors Driving a Currency value

• International Finance and IPE:

Reflections
 POST-BRETTON WOODS: FLOATING EXCHANGE RATE SYSTEM

Collapse of Gold Standard and BW (fixed exchange rate system)

Main features of Post-Bretton Woods financial system:

• Centrality of foreign exchange in the international financial system.

• Currency values.
• Global capital/equity markets and capital mobility
• Interlocked global structures (trade, production, labor, forex and stock
markets)

Floating exchange rate: demand and supply of currency determine the exchange
rate without government intervention
Managed float: Central Banks are allowed to intervene and stabilize exchange
rates

Emergence of strong currencies in international financial markets - Japanese Yen

and German Deutschmark
Euro replaces the ECU to become the second most commonly used currency after
the dollar in the primary international bond markets
Many large companies now use Euro rather than dollar in bond trading with the
goal of receiving better exchange rate
 Two scenarios in foreign exchange

SCENARIO 1 - investing in local currency

• You are an investor with kr100,000 to invest
• You purchase today a one-month (30 days) Swedish government bonds @ fixed 5% interest
rate
• After 30 days you will have 100,000 + 5,000 = kr 105,000
• You make a net profit of kr 5,000 on your investment

SCENARIO 2 - investing in foreign currency

• You take the kr 100,000 to your bank and buy 10,000 one-month (30 days) Euro treasury
bills @ 10% interest rate (€1 = kr 10)
• After 30 days (maturity date) your € bills should be worth 10% more (or 1,000 bills more):
i.e. € bills 11,000 (or 11,000 x 10 = kr 110,000)
• On maturity date you go smiling to the bank to cash in your 11,000 € bills
• The bank tells you that current exchange rate due to global inflation, Ukraine war and
increased tariffs is €1 = kr 8.5 (i.e. 15% devaluation / lower)
• So you get € bills 11,000 x 8.5 = kr 93,500
• Your net loss is: 100,000 - 93,500 = kr 6,500!

How exchange rate works

 WHY AND HOW EXCHANGE RATES FLUCTUATE?

Import goods Make investments Speculation

USA & services (borrow & lend) (profits) EURO ZONE
(US$) (€)
Trading in currencies – i.e. forex

1. If more American investors want to invest in Euro zone, the demand for € increases, which in
turn increases the exchange rate of the €
2. If Euro countries invest more in Euro zone, the supply of € increases, which in turn decreases
the exchange rate of the € making it attractive for American investors to buy €
3. This demand and supply in € stabilizes its exchange rate – i.e. Market Equilibrium

V€

5
D2
S
4 D1
S1
V2 3 E2

E3
V1 2 E1

70
D€
10 20 30 40 50 60

Million €
 What are the factors influencing the exchange rate?

• Exports and imports (balance of payments)

• Foreign borrowing and lending (deficit and surplus)
• Expectations (future expectations influence exchange
rates)
• Inflation and monetary policy
• Political stability, economic stability, strong Central Banks

DOMESTIC AND INTERNATIONAL

POLITICAL ECONOMY
 POST-BRETTON WOODS POLICY TRILEMMA (Mundell-
Fleming Model)
Free capital mobility

If country adopts fixed If a country opens up to capital

exchange rate but wants to mobility, then it affects its
open up to capital mobility, A B currency value and seriously
then it cannot have undermine monetary autonomy
monetary autonomy (Eg. €)

Monetary autonomy
Exchange rate management
C
Independence to fix currency
value and manage interest
rates free from outside
influence. This restricts free
capital mobility

The model highlights the impact of capital mobility on interest rates, exchange rate
policy and on trade and stability
 CAPTIAL / EQUITY MARKETS

PRIMARY MARKET SECONDARY MARKET

• General public • Exchange or trading of

subscription previously issued securities
FTSE • Market determined prices
(shares) NASDAQ
• Price set by the • Global stock exchanges
DAX • Large capitalization
company DOW JONES
• Stocks / shares required for listing in stock
OMX exchanges
listed in local stock
exchanges

OVER-THE-COUNTER TRADING
MONEY MARKET (OTC)

• Short-term borrowing • Virtual market places

and lending • Computer & telephone trading
• Short-term liquid funding • Stocks traded do not meet
(i.e. trading in ’paper’) stock exchange requirements
• Institutional lenders and • Consist of companies with
dealers in money and smaller capitalization
credit • Securities not listed in stock
• Sector of capital market exchanges
How the stock exchange works
 WHAT ARE THE FUNDAMENTAL
FACTORS THAT DRIVE A
CURRENCY?

• Interest rates
DOMESTIC AND INTERNATIONAL
• Economic growth POLITICAL ECONOMY
• Inflation
• Balance of payments
• Market speculation
 INEREST RATES
• Has large impact when financial capital moves
freely between countries
• High interest rates attract investors seeking to
make profits
• Brings inflow of money into a country
• This ”interest differential” boosts the demand for
the currency and causes its value to rise
• Can have stabilizing and destabilizing effects on
economy and economic growth

When and why does a country / Central Bank

increase or decrease the interest rate?
 ECONOMIC GROWTH

• Economic recession weakens the exchange rate of a

currency
• Traders in currency markets and investors take slow
growth as economic weakness
• The currency gets ”marked down” in value in the
currency markets
• In extreme cases traders may stop trading in the
currency and quickly sell the currency (”run on
currency”)
• Financial markets are always sensitive to economic
growth trends
What happened to Sweden in 1990?
 INFLATION

• Increase in the general level of prices of goods

• Lot of money chasing few goods (excess money supply)
• Can lead to ”inflationary spiral” leading the complete
collapse of the economic system
• Creditors who lent money find the value of the money has
fallen - creating losses
• Borrowing and lending become very risky under inflation
• Inflation often reflects bad economic policy (fiscal and/or
monetary policies) – eg. public spending exceeding
revenue, or excessive provision of credit
• Increase in oil prices can trigger off a global inflationary
spiral

What happens to exports, imports, business and wages during

inflation?
 BALANCE OF PAYMENTS

BOP includes:
• All payments between a country and it’s trading partners and is
made up of the balance of trade (known as current account)
• Private foreign loans and their interest
• Loans and grants by governments or international
organizations
• Movements of gold (capital account)
Trade deficits:
• When a country imports more than it exports
• Trade deficits cause foreign exchange shortage
• Without foreign exchange governments and businesses can’t
pay outstanding bills, debts or import goods and services
• BOP problems hurt both country and trade deficit

What can you say about the US – China BOP situation?

 MARKET SPECULATORS & PORTFOLIO INVESTORS

• They have huge amounts reserve foreign currencies to

buy and sell
• They trade in billions and make profits in billions (but
also bleed in billions!)
• Speculators can decide to ”mark down” currencies –
speculative attacks on currencies
• They can cause overnight crises in countries and regions
• They can flood the financial market with marked down
currencies causing serious financial and economic
problems to the countries (excessive money supply)
• Herd mentality of speculators (rational or irrational?)
• Governments have difficulty in offsetting the power of
speculators
What happend to the currencies in Asia in 1997?
 PORTFOLIO INVESTMENTS
• Short-term investments or movement of money
characteristic of current international financial
market
• Generates quick profits without actually producing
anything
• Also called ”hot money” because it moves across
global financial markets in seconds (real time)
• Extremely sensitive to exchange rate fluctuations
and stock markets
• Can destabilize economies and trigger off financial
crises
• ’Over-the-counter’ (OTC) trading also play an
important role in portfolio investments
 THE STRUCTURE OF THE CURRENT GLOBAL ECONOMY

PRODUCTION TRADE LABOR CONSUMPTION

(goods & services) (goods & services) (skilled & unskilled) (goods & services)

FINANCE

LIQUIDITY IS KEY TO FDI INVESTMENTS PORTFOLIO

THE
INTERNATIONAL
FINANCIAL
EQUITY / CAPITAL MARKETS
SYSTEM AND
(national, regional, global)
TO THE GLOBAL
POLITICAL
ECONOMY PRIMARY MARKETS MONEY MARKET SECONDARY MARKETS

FOREX MARKETS
 INTERNATIONAL FINANCE AND GPE
FINANCIAL GLOBALIZATION: ITS CAUSES

SYSTEMIC LEVEL NATIONAL LEVEL COGNITIVE LEVEL

• Financial innovations • Competitive • Normative shift from

and IT revolution deregulation by govts. to Keynesianism to
• Capital mobility attract investments neoliberalism
independent of state • Pressure to open up • Loss of faith in efficacy
regulation economy of capital controls as
• Emerging economies • Competition between instrument of public
• IFIs organized interests within policy (liberalization of
national political economy financial markets)
• Integration of global
financial markets • Liberalization • Shared normative
(currency, stocks, • Role of large financial commitments to new
securities, bonds etc.) intermediaries, coporate financial orthodoxy -
borrowers and investors IMF, Washington
• Neoliberal system Consensus, WTO

NATIONAL AND INTERNATIONAL FINANCIAL SYSTEMS EXPOSED

TO FINANCIAL VOLATILITY AND RISKS THAT TRANSLATE FROM
ONE LEVEL TO ANOTHER
 The IPE Analytical Toolkit
FINANCIAL STRUCTURE

ACTORS PROCESSES INSTITUTIONS RULES NORMS

Liquidity/ mobility Central banks Floating rates Embedded

States Forex trading IMF Monetary
Banks Neo-
Inflation Stock policy
CBs liberalism
Interset rates exchanges Macro
Markets Economic growth economic
Investors Speculation policy
BOP
Crises

”Monetary and financial systems at both domestic and international

levels do not just serve economic functions. They also have
implications … relating to the pursuit of power, interests and ideas.”
(Helleiner 2014:195)