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Exchange rate management and control

Rohit Oberoi

MBA 4thsemWFTM

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Topics Covered

1. IMS(international monetary system)

2. types of exchange rates

3. FERA/FEMA

4. Determination of foreign exchange

rate-exchange control regulations andprocedures in india.

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The international monetary system refers tothe institutional arrangements that countries

adopt to govern exchange rates.

Also called International monetary and FinancialSystem.

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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

Objective of IMSTo contribute to stable and high global growth

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Evolution of the

International Monetary System

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Bimetallism: Before 1875

A double standard in the sense that both gold

and silver were used as money.

Both gold and silver were used as international

means of payment and the exchange ratesamong currencies were determined by eithertheir gold or silver contents.

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Great Britain: Until 1816 (law passed for free coinage on gold only)

US: From 1792 (Coinage Act of 1792) till 1873

France: Since French Revolution till 1878

India, China, Germany, Holland were on silver standard

Due to wars and political unstability, US, Russia and Austria-Hungry had irredeemablecurrencies :1848-79

Not systematic IMS until 1870s

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Greshams Law

Phenomenon experienced by the countriesthat were on the bimettalic standard.

Since exchange rate between two currency

was fixed officially, only the abundant metalwas used as money, driving more scarce metalout of circulation.

Greshams Law: Bad (abundant) moneydrives out Good(scarce) money

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Classical Gold Standard:

1875-1914

Strong interest of every

country to implement the

same international

monetary system as their

most important economic

and financial partners have

implemented

Country Year

Great Britain 1816

Germany 1871

Sweden, Norway and Denmark 1873

France, Belgium, Switzerland, Italy and

Greece

1874

Netherlands 1875

Uruguay 1876

USA 1879

Austria 1892

Chile 1895

Japan 1897Russia 1898

Dominican Republic 1901

Panama 1904

Mexico 1905

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1875-1914

During this period in most major countries:

Gold alone was assured of unrestricted coinage

There was two-way convertibility between gold and nationalcurrencies at a stable ratio.

Gold could be freely exported or imported.

The exchange rate between two countrys currencies

would be determined by their relative gold contents.

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For example, if the dollar is pegged to gold at

U.S.$30 = 1 ounce of gold, and the British

pound is pegged to gold at 6 = 1 ounce of gold,

it must be the case that the exchange rate is

determined by the relative gold contents:


1875-1914

$30 = 6

$5 = 1

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1875-1914

Highly stable exchange rates under the classical

gold standard provided an environment that

was favorable to international trade and

investment.

Misalignment of exchange rates and

international imbalances of payment were

automatically corrected by theprice-specie-flow

mechanism.

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Price-Specie-Flow Mechanism

Suppose Great Britain exported more to France than

France imported from Great Britain.

Net export of goods from Great Britain to France will be

accompanied by a net flow of gold from France to Great Britain. This flow of gold will lead to a lower price level in France and, at

the same time, a higher price level in Britain.

The resultant change in relative price levels will slow

exports from Great Britain and encourage exports fromFrance.

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1875-1914

There are shortcomings:

The supply of newly minted gold is so restricted that

the growth of world trade and investment can be

hampered for the lack of sufficient monetary

reserves.

Even if the world returned to a gold standard, any

national government could abandon the standard.

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The Interwar Experience

With the outbreak of World War I, the classicalgold standard came to an end: exchange rate depended completely on the supply

of and demand for foreign currency

extremely negative effects of the lack ofagreement on the functioning of theinternational monetary system

three trials of establishment: Conference in Genoa (1922) negotiations in 1933 three-party agreement between the USA, Great

Britain and France (1936)

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1919 1926: Experience With

Flexible Exchange Rates entirely different economic and political

circumstances at the end of World War I

made quick return to stable economic

circumstances realistically impossible

flexible exchange rates were perceived as

an exclusively temporary solution that

needed to be replaced by a morepermanent solution (going back to the pre-

war classical gold standard) as soon as

possible

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1919 1926: Experience With

Flexible Exchange Rates

high rate of inflation caused by printing ofmoney, that was used for financing high

budget deficits an ingredient of stabilization programs was

establishment of the mint parity ofnational currencies, or return to gold

standard

countries with hyperinflation and their returnto the gold standard:

which mint parity should be used?

return of other countries to the gold standard:

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1926 1931: Functioning of the

Renewed Gold Standard Period

mint parity was established at the wrong

level, resulting in continued problems in

the balance-of-payments adjustments not a real gold standard, rather, a gold

exchange standard:

assumption of high confidence intocountries with a reserve currency to

guarantee unconditional conversion oftheir currencies into gold

differencesin gold

standard inthe interwarperiod and

beforeWorld War I:

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Renewed Gold Standard Period not following the rules of the game or differentpriorities of national economic policies :

countries started to systematically give priority to

internal economic goals and relatively lowerimportance to balance-of-payments equilibrium

changed significance of the short-run capital

flows:

flows under the strong influence of lowered

confidence into mint parities, which was reflected

mostly in escape of capital from weak currencies

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Renewed Gold Standard Period

End of the gold standard:

convergence of different causes that pressuredthe already weak international monetary

system of renewed gold standard at the end of

1920s

deflation and unemployment; New York StockExchange crisis (1929)

decreased confidence

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1931 1944: Period of Economic

Nationalism cannot talk about the existence of an

international monetary system

economic nationalism: competitive devaluations

protectionism

trade wars, international trade cut almost in half

less international provision of credit and investment

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