Seminar on International Monetary System

AISWARYA V V

4th Sem M.com

DCMS

Meaning:- • International monetary systems are sets of

internationally agreed rules, conventions and supporting institutions, that facilitate international trade, cross border investment and generally the reallocation of capital between nation states.

• International monetary system refers to the system prevailing in world foreign exchange markets through which international trade and capital movement are financed and exchange rates are determined.

• The International Monetary System is part of the institutional framework that binds national economies, such a system permits producers to specialize in those goods for which they have a comparative advantage, and serves to seek profitable investment opportunities on a global basis.

Features that IMS should possess:-

• Flow of international trade and investment

according to comparative advantage.

• Stability in foreign exchange and should is

stable.

• Promoting Balance of Payments adjustments to

prevent disruptions associated with temporary or

chronic imbalances..

• Should at least try avoid adding further uncertainty.

• Allowing member countries to pursue independent monetary and fiscal policies.

• Providing countries with sufficient liquidity to finance temporary balance of payments deficits

Stages in International Monetary System:-

• Classic Gold Standard (1816 – 1914)

• Interwar Period (1918 – 1939)

• Bretton Woods System (1944 – 1971)

• Flexible exchange rate regime since 1973

Classical Gold Standard (1816 – 1914)

The Gold Standard

The first modern international monetary system was the gold standard

Put in effect in 1850Participants – UK,

France, Germany & USA

USAJapan

Gold

Trade

In this system gold was used as a storage of wealth and as a

medium of exchange.

In this system, each currency was linked to a weight of gold

The fundamental principle of the classical gold standard was

that each country should set a par value for its currency in terms

of gold and then try to maintain this value. Thus, each country

had to establish the rate at which its currency could be

converted to the weight of gold.

The three important features of gold standard are:

1. The government of each country defines its national

monetary unit in terms of gold.

2. Free import or export of gold.

3. Two way convertibility between gold and national

currencies at a stable price .

The gold standard, the exchange rate between any two currencies

was determined by their gold content.

Example for exchange rate determination: the USA declared the dollar to be convertible to gold at a rate of $20.67/ounce of gold. The British pound was pegged at £4.247/ounce of gold. Thus the dollar pound exchange rate would be determined as follow

$20.67/ounce of gold

£4.247/ounce of gold

The problem was every country needed to maintain adequate reserves of gold in order to back its currency.

After World War I, the exchange rates were allowed to fluctuate.

= $ 4.86656/£

Since gold was convertible into currencies of the major developed countries, central banks of different countries either held gold or currencies of these developed countries.

Advantages of the gold standard

1. The gold standard dramatically reduced the risk in exchange rate because it established fixed exchange rate between currencies.

2. The countries were forced to observe strict monetary policies.

3. Gold standard would help a country correct its trade imbalance.

Decline Of Gold Standard• Money supply for financing the war activities is not easy.• The strained political relations impeded free flow of gold from

one country to another.• Exchange rate parity was greatly disturbed.• Gold volume could not grow fast enough.• To allow adequate amount of money to be created (printed) to

finance the growth of world trade.• The problem was further aggravated when gold was taken out of

reserve for art or industrial purpose.• It was not practical for a country to subordinate their national

currencies to gold.

INTERWAR PERIOD (1918 – 1939)

Interwar Period:-• The gold standards as an international monetary system worked

well until the beginning of World War I.• War interrupted the trade flow and disturbed the stability of

exchange rate for currencies of major countries. There was wide spread fluctuation in currencies in terms of gold during World War 1.

• The role of Great Britain as the major creditor nation also came to an end after World War 1.

• The United States began to assume the role of the leading creditor nation.

• The depression of 1930s followed by World War II had vastly diminished:– commercial trade– International exchange of currencies– Cross border lending and borrowing

• Revival of the system was necessary.

THE BRETTON WOODS SYSTEM (1945-1971)

BRETTON WOODS (1945-1971):- The depression of the 1930s, followed by another war, had vastly

diminished commercial trade the international exchange of currencies and cross border lending and borrowing.

Revival of the system was necessary and the reconstruction of the post war ,financial system began with the Bretton woods agreement that emerged from the international monetary and financial conference of the United and associated nations in July 1944 at Bretton woods, New Hampshire.

The principal architects of the new system, John Maynard Keynes and Harry Dexter White.

The terms of the agreement were negotiated by 44 nations, led by the U.S and Britain. The main hope of creating a new financial system was to stabilize exchange rates, provide capital for reconstruction from the war and foment international cooperation.

The main characteristics of the international monetary system developed at Bretton Woods can be summarized as follows:

1.Fixed rates in terms of gold.

2.A procedure for mutual international credits.

3.Creation of International Monetary Fund(IMF) to supervise and ensure smooth functioning of the system.

4.Devaluation of more than 5% had to be done with the permission of the IMF.

Features of Bretton Woods System:-• The features of the Bretton Woods system can be described

as a “gold-exchange” standard rather than a “gold-standard”. The key difference was that the dollar was the only currency that was backed by and convertible into gold. (The rate initially was $35 an ounce of gold)

• Other countries would have an “adjustable peg” basically, they were exchangeable at a fixed rate against the dollar, although the rate could be readjusted at certain times under certain conditions.

• Each country was allowed to have a 1% band around which their currency was allowed to fluctuate around the fixed rate. Except on the rare occasions when the par value was allowed to be readjusted, countries would have to intervene to ensure that the currency stayed in the required band.

• The IMF was created with the specific goal of being the multilateral body that monitored the implementation of the Bretton Woods agreement.

• Its role was to hold gold reserves and currency reserves that were contributed by the member countries and then lend this money out to other nations that had difficulty meeting their obligations under the agreement.

• Currencies had to be convertible: central banks had to exchange domestic currency for dollars upon request.

• Although the adjustable exchange rate system meant that countries that could no longer sustain the fixed exchange rate vis-a-vis the dollar would be allowed to devalue their currencies, they could only do so with the consent of the other countries and the auspices of the IMF.

The Breakdown of the Bretton Woods System

The system of fixed exchange rates established at Bretton

Woods worked well until the late 1960’s.

Any pressure to devalue the dollar would cause problems

throughout the world.

The trade balance of the USA became highly negative and a

very large amount of US dollars was held outside the USA ; it

was more than the total gold holdings of the USA.

During end of sixties, European governments wanted gold in

return for the dollar reserves they held.

On 15th Aug. 1971, President Nixon suspended the system of

convertibility of gold and dollar and decided for floating

exchange rate system.

The system dissolved between 1968 and 1973.

By March 1973, the major currencies began to float against

each other.

EXCHANGE RATE SYSTEM AFTER 1973

The collapse of the Bretton Woods system of exchange rate, the Board of Governors of the IMF appointed committee to suggest guidelines for evolving an exchange rate system that could be acceptable to the member countries.

Rate systems are classified on the basis of the flexibility that the monetary authorities show towards fluctuations in the exchange rates and are divided into two categories:1. Systems with a fixed exchange rate

( “fixed peg” or “hard peg”) and2. Systems with a flexible exchange rate ( “Floating” systems)

FLEXIBLE EXCHANGE RATE SYSTEM AFTER 1973

Fixed Exchange Rate System In this system, a currency is pegged to a foreign currency, with

fixed parity. The rates are maintained constant or they may fluctuate within a narrow range. When a currency trends towards crossing over the limits, government intervene to keep it within the band.

A fixed peg regime exists when the exchange rate of the home currency is fixed to an anchor currency.

This is the case with economies having currency boards or with no separate national currency of their own.

Flexible Exchange Rate System

Floating exchange rate system involves market forces

determining the exchange rate. Its merits are:

1.Exchange rates are automatically adjusted to changes in macro- economic variables.

2. Exchange rate is almost stable around the equilibrium in the long run.

3. Currency remains insulated from the shocks emanating abroad.

No country in the world has adopted freely floating exchange

rate system.• Within the flexible exchange rate regime there are categories:

1.Floating

2.Pegging

3.Target Zone ArrangementsFloating exchange rate regimes consist:

1.Independent floating system

2.Managed floating systems

1.Independent floating system Independent floating system does not involve intervention. This is

why independent floating is often termed as ‘clean floating’.

In practice, intervention is found also in the case of independent

floating.

In independent floating, the purpose of intervention is simply to

moderate the exchange rate and to prevent any undue fluctuation.

But no attempt is undertaken to achieve/maintain a particular rate.

2.Managed floating systems Floating is generally managed in the sense that the system of

managed floating involves direct or indirect intervention by the monetary authorities of the country to stabilize the exchange rate.

When the monetary authorities stabilize the exchange rate through changing the interest rates, it is indirect intervention.

In the case of direct intervention, on the other hand, the monetary authorities purchase and sell foreign currency in the domestic market.

Managed floating is also known as ‘dirty floating’. The IMF calls this practice a “Managed Floating With No

Predetermined Path for the Exchange Rate”

• Pegging of Currencies means its fixed value in terms of

1.A single currency

2.A basket of currencies

3.SDRs

Special Drawing Rights are international reserves asset created by the IMF.– A semi fixed system adjusts the exchange rate slowly by

small amounts– On a continuous basis to correct for any overvaluation and

undervaluation– Designed to discourage speculation by setting an upper limit

Pegging of Currencies

Crawling Peg● Crawling peg involves periodic adjustment of fixed exchange

rate to catch up with market determined rates.

● In this system an attempt is made to combine the advantages of fixed exchange rate with flexibility of floating exchange rate

● It fixes the exchange rate at a given level which is responsive to changes in market conditions i.e. it is allowed to crawl.

● In a Crawling Peg arrangement the currency is adjusted periodically “in small amounts at a fixed rate or in response to changes in selective quantitative indicators (past inflation differentials vis-à-vis major trading partners…)

A Crawling Band allows a periodic adjustment of the exchange rate band itself.

● The upper and lower limits are decided for exchange rate depending demand and supply of foreign exchange

● As the exchange rate crosses these limits, fiscal and monetary policies come into play to push the exchange rate within the target zone

● But in this case, these limits are sustained for some time and if it is felt that economic indicators are being disturbed, the monetary authorities let the exchange rate depreciate or appreciate as the case may be.

Target – Zone Arrangements• Target zone arrangement involves member countries having

fixed exchange rate among their currencies. Alternatively, they may use a common currency.

References: P K Jain, Josette Peyrard, Surendra S Yadav, “International

Financial Management”, Macmillan India Ltd, New Delhi, 2005.

Madhu Vij, “ International Financial Management”, Excel books publications, New Delhi, 2001.

Vyuptakesh Sharan, “ International Financial Management”, Prentice Hall of India Pvt Ltd, New Delhi, 2006.

Thank You………