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INTERNATIONAL MONETARY SYSTEM
IMS has evolved over the course of centuries and
defines the overall financial environment in which
MNCs operate.
IMS plays a crucial role in the financialmanagement of a MNC business and economic
and financial policies of a country.
IMS will continue to evolve in the future as theinternational business and political environment
of the global economy continues to change.
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Specie Commodity Standard
In earlier days trade payments were settledthrough barter arrangement.
On account of inconsistency and inconvenience,traders began using metals like gold and silver to
settle the payments. Subsequently metals took the form of coins that
had the stamp of sovereignty on the basis ofweight and fineness of the metal and that wasthe beginning of the Specie Commodity Standard.
The coins were called full-bodied coins meaningthat their value was equal to the value of themetal contained in it.
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Specie Commodity Standard
Over a period of time other metals with a lower valuewas mixed with gold coins, as a result value of themetal came to be lower than the face value of the coin.
These coins were known as debased coins.
Full-bodied coins were primarily used for store of
value. To act as a store of value, coins must be reliably saved,
stored, and retrieved and also be usable as a mediumof exchange when it is retrieved.
The value of the money must also remain stable overtime.
The full-bodied coins were driven out of circulation bythe year 1560 by the debased coins.
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Specie Commodity Standard
The Coinage Act or the Mint Act of 1792 of the USA
established dollar as the monetary unit of the country,declared it as a lawful tender and also fixed its value interms of gold and silver.
The mint ratio between gold and silver was 1:15 in theUnited States and 1:15.5 in France.
The difference in the bimetallic standard between the USand the France led to the export of gold from US to Francefor the purchase of silver.
This led to diminution of gold stock in the US and thecountry was forced to adopt a monometallic silver
standard. Therefore in 1834, the 15:1 ratio of silver to gold was
changed to a 16:1 ratio by reducing the weight of thenation's gold coinage.
Now what is the impact on Dollar???
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Specie Commodity Standard
This created a new U.S. dollar that was backedby 1.50 g (23.22 grains) of gold.
However, the previous dollar had been
represented by 1.60 g (24.75 grains) of gold. The result of this revaluation, which was the
first ever devaluation of the U.S. dollar, was
that the value in gold of the dollar wasreduced by 6%.
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Specie Commodity Standard
In 1853, the weight of US silver coin was reduced.This led to placing the nation effectively on thegold standard.
With the enactment of the National Banking Act
in 1863 by the US Government, the dollarbecame the sole currency of the United Statesand remains so today.
The Bland Allison Act of 1878 required thegovernment to purchase between USD 2 millionand USD 4 million worth of silver bullion eachmonth at market prices and to coin it into Silverdollars as a subsidy for the politically influentialsilver producers.
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Specie Commodity Standard
The discovery of large silver deposits in thewestern regions of the United States in the late19th century created a political controversy.
Due to the large influx of silver, the value of silver
in the nation's coinage dropped considerably. The Eastern banking and commercial interests
advocated a sound money policy and a switch tothe gold standard.
The status of silver was slowly diminishedthrough a series of legislative changes from 1873to 1900, when a gold standard was formallyadopted.
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Gold Standard
From 1876 to 1913, the exchange rates were dictated bythe gold standard.
The gold standard lasted for nearly 40 years and the centreof the international financial system during this period wasLondon, indicating the preeminence position it enjoyed
during the hey days of British rule across the globe. Every country adopting the gold standard had its own
traditional and customary norms.
The fundamental rule of the gold standard was that eachcountry should set a par value for its currency in terms of
gold and enforce its value in commerce and trade. Thus each and every country has to establish the rate, at
which its currency should be converted into the weight ofgold.
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Gold Standard
A true gold standard came in 1900 with thepassage of the Gold Standard Act.
Thus US made gold the sole legal-tendercoinage of the United States, and set the valueof the dollar at $ 20.67 per ounce (66.46 /g)of gold.
This made the dollar convertible to 1.5 g
(23.22 grains), the same convertibility intogold that was possible on the bimetallicstandard.
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Features of Gold Standard
1. Country adopting the gold standard shall fix thevalue of currency in terms of specific weight andfineness of gold and guarantees a two wayconvertibility
2. Export and import of gold shall be allowed sothat it can flow freely among the countriesadopting the gold standard
3. Apex monetary institution shall hold goldreserves in relationship to the currency it hasissued and
4. Government shall allow unrestricted minting ofgold and melting of gold coins at the option ofthe holder
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Features of Gold Standard
Since fixed weight of gold formed the basis for aunit of currency and as free flow of gold waspermitted among the countries adopting the goldstandard, the gold standard carried an automaticmechanism for domestic price stability, fixedexchange rates and adjustment in balance ofpayment.
The exchange rate mechanism depended uponthe content of gold in different countries.
Let us say that the pound sterling contained a halfounce of gold and one dollar bill contained onefourth ounce of gold, the exchange rate was fixedat 1 = $ 2.
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Features of Gold Standard
The United States set the value of the dollar at $20.67 per ounce of gold and the British pound
was pegged at 4.2474 per ounce of gold.
Thus the dollar to pound ( $ / ) exchange rate
was determined as follows:
$ 20.67 per ounce of gold
--------------------------------- = $ 4.8665 per
4.2474 per ounce of gold
Todays Rate: GBP 1= USD 1.67
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Features of Gold Standard
The rate was known as the mint rate or themint exchange rate.
The actual exchange rate remained close to
mint rate and the free flow of gold betweenthe two countries ensured not much deviation
in the exchange rate.
This led to fixed parity between the currenciesand helped to preserve the value of each
individual currency in terms of gold.
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Features of Gold Standard
In the event of occurrence of a transportation cost ortransaction cost, the dollar pound exchange rate wouldfluctuate above or below the fixed rate.
Let us assume hypothetically that the value of thedollar had depreciated to $ 5 per .
This will give an opportunity for the arbitrageurs tomove in.
The arbitrageurs would buy one ounce of gold in theUS for $ 20.67and sell it in Great Britain for 4.24 and
then exchange the pound for the dollar in the forexmarket for $ 5 x $ 4.24 = $ 21.20, thus making a profitof $ 21.20 -$ 20.67 =$ 0.53 per ounce.
This process would continue till the original parity wasestablished.
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Features of Gold Standard
Definition of 'Arbitrageur' A type of investor who attempts to profit from
price inefficiencies in the market by makingsimultaneous trades that offset each other and
capturing risk-free profits. An arbitrageur would, for example, seek out price
discrepancies between currencies listed on morethan one exchange, and buy the undervaluedcurrency on one exchange while short selling thesame number of overvalued currency on anotherexchange, thus capturing risk-free profits as theprices on the two exchanges converge.
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Features of Gold Standard
The gold standard maintained a reasonable equilibrium
through the principles of price-specie flow mechanism. This arrangement restored automatic adjustment in
the balance of payments.
Eg: in the event Great Britain faced a deficit on its tradeaccount leading to outflow of gold for trade settlementand reducing the money supply with in the country, theemerging deflation would make the British exportscompetitive and the resultant rise in exports wouldeventually wipe out any deficit on this account.
On the other side, reduced money supply pushes upthe interest rate and the credit restrictions imposed bythe apex banks will push up the bank interest rate,resulting in the foreign investment moving into theeconomy and off-setting any deficit on the capital
account.
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Decline of the Gold Standard
The gold standard as an international monetary
system was accepted by most of the countries
until the First World War broke out in 1914.
The warring nations required huge money supply
for financing the activities borne out of war. This was not possible under the gold standard.
The strained relations among the warring nations
further impeded the free flow of gold from onenation to another.
The exchange rate parity hither to followed by
the various nations went hay wire.
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Decline of the Gold Standard
During WW I, US corporations had large debts payable to
European entities and they began liquidating their debts ingold.
USD to GBP exchange rate reached as high as $ 6.75, farabove the parity of $ 4.8665.
This caused large outflow of gold. In July 1914, the New
York Stock Exchange was closed and the gold standard wastemporarily suspended.
In order to defend the exchange value of the dollar, the USTreasury issued emergency currency under the Aldrich-Vreeland Act, and the newly-created Federal Reserve
organized a fund to clear the debts to foreign creditors. These efforts were largely successful, and the Aldrich-
Vreeland notes were retired starting in November 1914 andthe gold standard was restored and the NYSE re-opened inDecember 1914.
How did the US emerge stronger in WWI????
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Decline of the Gold Standard
From 1915-17, US remained neutral in the war
US banned gold export, thereby suspending the goldstandard for foreign exchange.
US demanded repayment of war debts from Franceand France asked compensation from Germany tomeet the war debt.
The United States finally joined the war in 1917.
Now it enjoyed a huge trade surplus with the EuropeanNations.
Hence the USD became stronger and the Europeancurrencies became weaker and the US began toassume the role of the leading creditor nation.
For the above reasons, the gold standard wassuspended during WW I
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Decline of the Gold Standard
After the end of the WW I, the nations on Gold
Standard re-entered.
The US returned to gold in 1919, Great Britain in
1925, France in 1926 and Switzerland in 1928.
All other European countries followed soon after.
The pound sterling returned at the old mint
exchange rate of $ 4.8665 per .
As Great Britain had liquidated most of its foreigninvestment in financing the war and the pound
stood overvalued and completely exposed.
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Decline of the Gold Standard
A great depression swept the world in 1929 and lasted
for nearly ten years. The depression originated in the US, starting with the
stock market crash of Oct 1929, known as the BlackTuesdaybut quickly spread to almost every country inthe world.
During the period of great depression, almost everymajor currency abandoned the gold standard.
The Bank of England abandoned the gold standard in1931 as speculators demanded gold in exchange for
currency. This pattern was repeated throughout Europeand North America.
In the US, the Federal Reserve was forced to raiseinterest rates to protect the gold standard for the USdollar.
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Decline of the Gold Standard
The production of gold during 1915-22 was
much lower and this resulted in a scramble for
gold.
In early 1933, in order to fight the deflation,
the US suspended the gold standard except
for foreign exchange, revoked gold as
universal legal tender for debts, and banned
private ownership of significant amounts ofgold coin.
After the US abandoned the gold standard,
other nations followed suit.
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Gold Exchange Standard
In the year 1934, the US returned to a modified gold
standard. For foreign exchange purposes, the set $ 20.67 per
ounce value of the dollar was lifted, allowing the dollarto float freely in foreign exchange markets with no setvalue in gold.
This was however terminated after one year.
The US finally devalued its dollar from the previous rateof $ 20.67 per ounce to $ 35.00 per ounce, making thedollar more attractive for foreign buyers.
The higher price increased the conversion of gold intodollars, allowing the US to effectively corner the worldgold market.
The modified gold standard was known as the GoldExchange Standard.
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Bretton Wood System Established in 1944 and named after the New Hampshire
town where the agreements were drawn up, the BrettonWoods system created an international basis forexchanging one currency for another.
It also led to the creation of the International MonetaryFund (IMF) and the International Bank for Reconstruction
and Development, now known as the World Bank. IMF was designed to monitor exchange rates and lend
reserve currencies to nations with trade deficits, the IBRDto provide underdeveloped nations with needed capital
although each institution's role has changed over time. Each of the 44 nations who joined the discussions at
Bretton Woods contributed a membership fee to fundthese institutions; the amount of each contributiondesignated a country's economic ability and dictated its
number of votes.
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Bretton Wood System The Bretton Woods system was history's first
example of a fully negotiated monetary order
intended to govern currency relations among
sovereign states.
In principle, it was designed to combine legalobligations with multilateral decision conducted
through an international organization the IMF.
In practice, the initial scheme, as well as itssubsequent development and ultimate demise,
were directly dependent on the preferences and
policies of its most powerful member, the US.
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Bretton Wood System Here a compromise was sought between the polar
alternatives of either freely floating or irrevocablyfixed rates.
What emerged was the 'pegged rate' or 'adjustablepeg' currency regime, also known as the par value
system. Countries were obligated to declare a par value (a
'peg') for their national money and to intervene incurrency markets to limit exchange rate fluctuations
within maximum margins (a 'band') one per centabove or below the parity
Countries also retained the right to alter their parvalue to correct a 'fundamental disequilibrium' in
their balance of payments.
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Bretton Wood System What emerged largely reflected US preferences: a system
of subscriptions and quotas embedded in the IMF, whichitself was to be no more than a fixed pool of nationalcurrencies and gold subscribed by each country.
Countries were assigned quotas, roughly reflecting their
relative economic importance. The subscription was to be paid 25 % in gold or currency
convertible into gold (effectively the dollar, which was theonly currency then still directly gold convertible for
central banks) and 75 % in the countrys own money. Each country was then entitled, when short of reserves,
to borrow needed foreign currency in amountsdetermined by the size of its quota
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Bretton Wood System Nations were in principle forbidden to engage in discriminatory
currency practices or exchange regulation, with only twopractical exceptions.
First, convertibility obligations were extended to currentinternational transactions only. Governments were to refrainfrom regulating purchase and sale of currency for trade in
goods or services. They were formally encouraged to make useof capital controls to maintain external balance in the face ofpotentially destabilizing 'hot money' flows.
Second, convertibility obligations could be deferred if amember so chose during a postwar 'transitional period.'
Members deferring their convertibility obligations were knownas Article XIV countries and members accepting them wereknown as Article VIII countries.
One of the responsibilities assigned to the IMF was to overseethis legal code governing currency convertibility.
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Chronology of Bretton Wood System The chronology of the Bretton Woods system can be divided into
two periods: the period of 'dollar shortage," lasting roughly until1958; and the period of 'dollar glut,' covering the remainingdecade and a half
The period of the dollar shortage was the heyday of America'smonetary hegemony.
The term 'dollar shortage,' universally used at the time, wassimply a shorthand expression for the fact that only the US wasthen capable of assuring some degree of global monetary stability;only the US could help other governments avoid a mutuallydestructive scramble for gold by promoting an outflow of dollarsinstead.
Dollar deficits began in 1950, following a round of devaluations ofEuropean currencies and shortfalls in the US balance of payments.
The period upto 1958 was rightly called one of 'beneficialdisequilibrium.'
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Chronology of Bretton Wood System The US balance of payments plunged to a $ 3.5 billion gap
in 1958 and to even larger deficits in 1959 and 1960. In 1958 Europe's currencies returned to convertibility.
Subsequently, the eagerness of European governments toobtain dollar reserves was transformed into what seemed
an equally fervent desire to avoid excess dollaraccumulations.
Before 1958, less than 10 % of America's deficits had beenfinanced by calls on the US gold stock and the balance
being financed with dollars. During the next decade, almost two thirds of America's
cumulative deficit was transferred in the form of gold,mostly to Europe. Bretton Woods was clearly coming under
strain.
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Chronology of Bretton Wood System By Mid 60s, negotiations began to create the Special Drawing
Rights (SDR), an entirely new type of international reserve asset. Governments hoped that with SDRs in place, any future threat of
world liquidity shortage would be averted. On the other hand,
they were totally unprepared for the opposite threat - a reserve
surfeit - which is in fact eventually emerged in the late 1960s. Earlier in the decade a variety of defensive measures were
initiated in an effort to contain mounting speculative pressures
against the dollar.
These included a network of reciprocal short term credit facilitiescalledswaps among the central banks as well as enlarged lending
authority for the IMF.
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Chronology of Bretton Wood System By Mid 60s, negotiations began to create the Special Drawing
Rights (SDR), an entirely new type of international reserveasset.
Governments hoped that with SDRs in place, any future threat
of world liquidity shortage would be averted. On the other
hand, they were totally unprepared for the opposite threat - areserve surfeit - which is in fact eventually emerged in the late
1960s.
Earlier in the decade a variety of defensive measures were
initiated in an effort to contain mounting speculative pressuresagainst the dollar.
These included a network of reciprocal short term credit
facilities calledswaps among the central banks as well as
enlarged lending authority for the IMF.
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Chronology of Bretton Wood System A second source of strain was inherent in the structure of the par
value system: How could governments be expected to changetheir exchange rates if they can not even tell when a fundamental
disequilibrium existed?
And if they were inhibited from re-pegging the rates, then how
would international payments equilibrium be maintained? The Bretton Woods system rested on one simple assumption - that
economic policy in the US would stabilize.
During the first half of the 1960s, America's foreign deficit actually
shrank as a result of a variety of corrective measures adopted athome. After 1965, however, US became increasingly destabilized,
as a result of increased government spending on social programs
at home and an escalating war in Vietnam. America's economy
began to overheat and inflation began to gain momentum, causing
deficits to widen once again.
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Chronology of Bretton Wood System Inflation everywhere began to accelerate, exposing all
the latent problems of Bretton Woods.
The pegged rate system was incapable of coping with
widening payments imbalances, and the confidence
problem was worsening as speculators were encouragedto bet on devaluation of the dollar or revaluations of the
currencies of Europe or Japan.
On 15 August 1971, the Richard Nixon administration
suspended the convertibility of the dollar into gold,freeing the greenback to find its own level in currency
markets.
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Smithsonian Arrangement
From Aug to Dec 1971, most of the major currencies
were allowed to fluctuate.
The US dollar dropped in value against a number of
major currencies.
Several nations imposed trade and exchange controlsand it was feared that such protective measures might
endanger the institution on international commerce and
trade.
To mitigate these problems, the worlds leading tradingcountries called Group of Ten met at the Smithsonian
Institute in Washington DC and formed the Smithsonian
arrangement to restore stability of the system.
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Smithsonian Arrangement
Smithsonian arrangement called for realignment of the
par value of major currencies to conform to theirrealistic values.
Gold parity of the US dollar was changed from $ 35 to $
38.02 per troy ounce of gold resulting in devaluation of8.57%.
Currencies of surplus countries were revalued upwards
by percentages ranging from 7.4% in respect of the
Canadian dollar to 16.9% in respect of the Japanese yen. Currencies were permitted to fluctuate over a wider
band than in the past.
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Smithsonian Arrangement
Although a currency was allowed to fluctuate with in a
margin of 2.25% from the central rates without thegovernment intervention, it could fluctuate by as much
as 9% against any currency except the dollar.
Since a currency was permitted to fluctuate up to 2.25%on either side of the central rat,, its total fluctuation
against the dollar could be as high as 4.5%.
Purpose of Smithsonian arrangement was to infuse
greater flexibility into the par value system.
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Case Study 4 :Greece Economy
In the beginning of 2009, the Greece economy collapsed
and the country was bailed out to the tune of over $100billion.
Unions and the socialists are upset that the Greek
government has to cut their pay and benefits to justkeep them employed.
Greece already has a VAT of 21 % which has been
increased to 23% after the collapse.
Imagine 23% being added to the cost of everything youbuy.
Greece has announced a 20% pay cut to public
employees and a hiring freeze for the next 3-5 years.
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Case Study 4 :Greece Economy
Today Greece roughly has a debt of 150 % of GDP.
Q
i) Analyse the real issue of the collapse of the Greece
economy.
ii) What is happening in Europe can and may very well
happen in India. Discuss
iii) A bloated broke government that cant pay for its
own survival is a recipe for new taxes and one otherthing, a disaster. Comment in Detail.
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