Why is an international monetary system necessary?
In Chapter 7, we discussed why money is important for economies – without it, all trade is based on barter and is limited due to the need for coincidence of wants. The same is true on an international scale. Normally, countries do not share currencies (although the euro, which we will return to below, is an important exception to this rule). Nevertheless, they must be able to convert their currencies if trade is not to be restricted to barter. Hence the need for an international monetary system.
In fact, without an international monetary system, trade will normally be restricted to balanced bilateral trade. Suppose for example that Denmark wishes to import 10 billion kroner worth of goods from Norway. It is important that the countries are able to barter, i.e. that Norway actually desires goods from Denmark in return. Even if this is the case, it might be that Norway only desires 5 billion kroner worth of goods from Denmark. In the absence of an international monetary system it is impossible for Norway to lend the difference to Denmark, i.e. there are no channels for international credit, and Denmark's imports are thus restricted to just 5 billion kroner. Trade is thus restricted, and countries are disadvantaged, since they cannot realize fully the gains from trade and specialization discussed in the previous chapter.
There are additional advantages to an international monetary system. In particular, as explained in Box 9.1, without a well-functioning international monetary system, domestic saving must equal domestic investment and thus foreign investment is impossible. Foreign investment is desirable, either by domestic investors abroad, or by foreign investors at home, if the return to investments differs at home and abroad.
History provides plenty of evidence for the disadvantages of the restrictions placed on the world economy by poorly functioning international monetary systems: at these times trade volumes and foreign investment have suffered.