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The International
Monetary SystemPart I
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Introduction
The international monetary system refers tothe institutional arrangements that countries
adopt to govern exchange rates
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Introduction
International monetary systems are sets of
internationally agreed rules, conventionsand supporting institutions that facilitateinternational trade, cross border investmentand generally the reallocation of capital
between nation states
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Introduction
It addresses to solve the problems relating to
international trade:
a. Liquidity
b. Adjustment
c. Stability
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The problem of Liquidity
The problem of liquidity existed even in the
domestic transactions through barter
system Barter system was replaced by precious
metals as a medium of exchange and store
of value
Gold standard system of international
payments came into existence
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The Gold Standard
The first moderninternationalmonetary systemwas the goldstandard
Put in effect in 1850
Participants – UK,France, Germany &USA
USAJapan
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Gold Standard- I ( 1876-1913)
● In this system, each currency was linkedto a weight of gold
●Under gold standard, each country had toestablish the rate at which its currencycould be converted to a weight of gold
E.g. $ 20.67/ ounce ; Pound 4.247/ once
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Gold Standard- I ( 1876-1913)
●Most of the countries used to declare par
value of their currency in terms of gold
●The problem was every country needed tomaintain adequate reserves of gold in
order to back its currency
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The Gold Standard
● After World War I, the exchange rates were
allowed to fluctuate
● Since gold was convertible into currencies
of the major developed countries, central
banks of different countries either held goldor currencies of these developed countries
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The System of Bretton Woods( 1944-71)
In July, 1944, 44 countries met in Bretton
Woods, New Hampshire, USA – a newInternational Monetary System was created
John Maynard Keynes of Britain and Harry
Dexter White of USA were the key movers
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The Bretton Woods Agreement
Creation of International Monetary Fund (IMF)
to promote consultations and collaboration
on international monetary problems and
countries with deficit balance of payments
Establish a par value of currency with
approval of IMF Maintain exchange rate for its currency
within one percent of declared par value
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The Bretton Woods Agreement
Each member to pay a quota into IMF pool –
one quarter in gold and the rest in their own
currency
The pool to be used for lending Dollar was to be convertible to gold till
international instrument was introduced
International Bank for Reconstruction andDevelopment (IBRD) was created to
rehabilitate war-torn countries and help
developing countries
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The System of Bretton Woods( 1944-71)
So in effect this was a gold – dollar exchange
standard ( $35/ounce)- known as fixed
exchange rate system or adjustable peg Devaluation could not be resorted arbitrarily
When BOP problem became structural i.e.
repetitive, devaluation upto ten percent waspermitted by IMF
Thus each currency was tied to dollar directly
or indirectly
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Collapse of theFixed Exchange 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 USdollars was held outside the USA ; it was
more than the total gold holdings of the USA
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Collapse of theFixed Exchange System
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 ofgold and dollar and decided for floating
exchange rate system
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The end of the Bretton WoodsSystem (1972 –81)
The system dissolved between 1968 and
1973
By March 1973, the major currencies began
to float against each other
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The end of the Bretton WoodsSystem (1972 –81)
IMF members have been free to choose any
form of exchange arrangement they wish
(except pegging their currency to gold): Allowing the currency to float freely
Pegging it to another currency or a basket
of currencies Adopting the currency of another country,
participating in a currency bloc, or
Forming part of a monetary union
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Exchange Systems after 1973
• Exchange Rate systems are classified onthe basis of the flexibility that themonetary authorities show towardsfluctuations in the exchange rates and aredivided into two categories:
1. Systems with a fixed exchange rate( “f ixed peg” or “hard peg”) and
2. Systems with a flexible exchange rate( “Floating” systems)
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Exchange Systems after 1973
• But as usual, between these two extremepositions there exists also an intermediaterange of different systems with limitedflexibility, usually referred to as “soft
pegs”
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A fixed peg regime
A fixed peg regime exists when theexchange rate of the home currency is fixedto an anchor currency
This is the case with economies havingcurrency boards or with no separatenational currency of their own
Countries do not have a separate nationalcurrency, either when they have formallydollarized, or when the country is a memberof a currency union, for example Euro
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Floating Exchange Rate System
● The collapse of Bretton Woods andSmithsonian Agreements coupled with oil
crisis of 1970, the floating exchange ratesystem was adopted by leadingindustrialised countries
● Officially approved in April 1978
● Under the system, the exchange ratewould be determined by market forceswithout the intervention of government
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Floating Exchange Rate System
●No country in the world has adopted freelyfloating exchange rate system
●Floating exchange rate regimes consist ofindependent floating and managed floating
systems
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Independent Floating systems
In Independent Floating systems theexchange rate is market determined andmonetary policy usually functions withoutexchange rate considerations
Foreign exchange interventions are rare
and meant to prevent undue fluctuations
But no attempt is undertaken toachieve/maintain a particular rate
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Managed Floating systems
Managed Floating systems usually let themarket take its own course but the monetaryauthorities intervene in the market to “manage”
the exchange rate, if needed, to prevent highvolatilities and to stimulate growth, withoutcommitting to a particular exchange rate level
The monetary authorities do not specify their
opinion on “suitable” exchange rate level The IMF calls this practice a “Managed Floating
With No Predetermined Path for the ExchangeRate”
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Intermediate Regimes ( Soft Pegs)
• Intermediate exchange rate regimes consist
of an array of differing systems allowing avarying degree of flexibility, such asconventional fixed exchange rate pegs,crawling pegs and exchange rate bands
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Conventional fixed exchange ratepegs
In a Conventional Fixed Peg arrangement acurrency is pegged at a fixed rate to a majorcurrency or a basket of currencies, allowingthe exchange rate to fluctuate within anarrow margin of ±1 percent around a formal(or de facto ) central rate
The monetary authority intervenes in themarket, if the fluctuation is outside theselimits
(post-crisis Malaysia, fixing Ringgit againstUS dollar for a rate of RM 3,8 per $1)
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Crawling Peg ( The Dirty Float)
● In this system an attempt is made tocombine the advantages of fixed exchange
rate with flexibility of floating exchange rate
● It fixes the exchange rate at a given levelwhich is responsive to changes in market
conditions i.e. it is allowed to crawl
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Crawling Peg ( The Dirty Float)
In a Crawling Peg arrangement the currencyis adjusted periodically “in small amounts ata fixed rate or in response to changes inselective quantitative indicators (pastinflation differentials vis-à-vis major tradingpartners…)
A Crawling Band allows a periodicadjustment of the exchange rate band itself
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Crawling Peg ( The Dirty Float)
● The upper and lower limits are decided forexchange rate depending demand and supplyof foreign exchange
● As the exchange rate crosses these limits,fiscal and monetary policies come into play topush the exchange rate within the target zone
● But in this case, these limits are sustained forsome time and if it is felt that economicindicators are being disturbed, the monetaryauthorities let the exchange rate depreciate or
appreciate as the case may be
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Trends in Global Exchange Rate Regimes
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Exchange Rate Regimes IMF Members, 2006
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Exchange Rates Since 1973
• Since 1973, exchange rates have become morevolatile and less predictable than they werebetween 1945 and 1973, due to:
Oil crisis -1971 Loss of confidence in the dollar - 1977-78
Oil crisis – 1979, OPEC increases price of oil
Unexpected rise in the dollar - 1980-85
Rapid fall of the dollar - 1985-87 and 1993-95
Partial collapse of European Monetary System –
1992
Asian currency crisis - 1997
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Exchange Rates Since 1973
● The merits of each continue to be debated
● There is no agreement as to which systemis better
● Many countries today are disappointedwith the floating exchange rate system
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Implications For Managers
For managers, understanding theinternational monetary system is important
for:
Currency management
Business strategy
Corporate-government relations
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Currency Management
Managers must recognize that the current
international monetary system is a managed
float system in which government
intervention can help drive the foreign
exchange market
Under the present system, speculativebuying and selling of currencies can create
volatile movements in exchange rates
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Business Strategy
Managers need to recognize that while
exchange rate movements are difficult to
predict, their movement can have a majorimpact on the competitive position of
businesses
To contend with this situation, managers
need strategic flexibility e.g. dispersing
production to different locations
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Corporate-Government Relations
Managers need to recognize that
businesses can influence government
policy towards the international monetarysystem
Companies should promote aninternational monetary system that
facilitates international growth and
development
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Evolution of Indian Exchange Ratesystem
• 1931 – Rupee pegged to Pound Sterling – parity Rs. 1= shilling 1 and 6 pence
• 1944 – IMF asked nations to peg currencyto dollar or gold – chose gold – parity again with sterling –
BP 1 = Rs. 13.33
• 1949 – Pound was devalued 30.5% so was
Rupee but 36.5% in dollar terms
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Evolution of Indian Exchange Ratesystem
• 1967 – Pound again devalued by 14.3% butIndia did not – it delinked rupee from
pound and linked it to dollar• 1971 – Smithsonian Agreement – theinternational currencies wererealigned – India returned to sterling
peg – parity BP = Rs. 18.9677
The fluctuation of (+)/(-) 2.25% wasallowed
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Evolution of Indian Exchange Ratesystem
• Sept. 1975 – the sterling peg was replacedby a basket peg - The
fluctuation band widened to(+)/(-) 5%
• July 1991 – the rupee was devalued twice by18-20%
• 1991-92 Budget - partial convertibility oncurrent account
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Evolution of Indian Exchange Ratesystem
• 1992-93 Budget – the rupee was made fullyconvertible on current account and a
liberalized exchange rate managementsystem ( LERMS) was introduced
• Presently, FEDAI announces indicativerates on every business day . RBI hasdiscretion to enter the market to stabilisethe exchange rate
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GOOD LUCK TO YOU
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