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

The Gold Standard
The first modern
international monetary
system was the gold
standard
Put in effect in 1850
Participants – UK,
France, Germany &
USA
USAJapan

 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:-
• 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.

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.

 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”) and
2. 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 Arrangements
Floating 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.

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