The history of international monetary system

The history of international monetary system

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  The international monetarysystem refers to the institutional arrangements that countries adopt to govern exchange rates. It consist of sets of internationally agreed rules, conventions, supporting institutions, instruments, and procedures, all of which are involved in the international transfers of money that facilitate international trade, cross border investment, the reallocation of capital between nation states and all other international business matters. Different international monetary systems posses different features including flow of international trade and investment according to comparative advantage, Stability in foreign exchange and should be stable, Promoting Balance of Payments adjustments to prevent disruptions associated with temporary or chronic imbalances, Providing countries with sufficient liquidity to finance temporary balance of payments deficits, and Allowing member countries to pursue independent monetary and fiscal policies. The international monetary system establishes the rules by which countries value and exchange their currencies. It is the basis and system of international flow of money. HISTORY/ STAGES ON INTERNATIONAL MONETARY SYSTEM The internationary monetary system that exist today has evolved over a period of more than 150 years. In the evolution process, several monetary system came into existance that either collapsed due to their weakness or were modified to cope with the changing international economic order. These stages consist of the following 1.THE GOLD STANDARD (1816- 1914) The gold standard involved Buying and selling of paper currency in exchange for gold on the request of any individual of firm. In this system Gold is freely transferable between countries. Participants in this system included UK, France, Germany & USA This is the first modern international monetary system, in this system each currency was linked to a weight of gold. Under gold standard, each country had to establish the rate at which its currency could be converted to a weight of gold.
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  This system createda fixed exchange rate system because each country defined the value of its currency in terms of gold. Suppose the US announces a willingness to buy gold for $200/oz and Great Britain announces a willingness to buy gold for £100. Then £1=$2 ADVANTAGES OF THE GOLD STANDARD SYSTEM 1. Highly stable exchange rates under the classical gold standard provided an environment that was conducive to international trade and investment. 2. Misalignment of exchange rates and international imbalances of payment were automatically corrected by the price-specie-flow mechanism DIFFICULTIES IN THE SYSTEM 1. The problem was every country needed to maintain adequate reserves of gold in order to back its currency. 2.Also transacting in gold was expensive, the costs of loading the gold into the cargo hold of a ship, guarding it against theft, transporting it, and insuring it against possible disasters, and Moreover, because of the slowness of sailing ships contibuted to the failure of this system. DEMISE OF THE GOLD SYSTEM In 1914 when the outbreak of the first world war crushed the first economic world order. With the outbreak of war, normal commercial transactions between the Allies (France, Russia, and the United Kingdom) and the Central Powers (Austria-Hungary, Germany, and the Ottoman Empire) ceased. The economic pressures of war caused country after country to suspend their pledges to buy or sell gold at their currencies' par values. 2. THE BRETTON WOODS SYSTEM (1945-1971) On brettons woods system. There was an agreement conference which was held in New hamisphere that created a post-war international monetary system which consisted of 44 country represantatives. It created IMF( international monetary finance) and World bank to promote international financial stability. IMF had agenda to foster global growth and economic stability while the world bank had a primary function of lending to nations devastated by the world war.
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  Brettons woods systemarised due to world war II impacts that created inflation, unemployment and an instable political situation. Every country was struggling to rebuild their war-torn economy. The Bretton Woods system was a dollar-based gold exchange standard. USD become the key currency, the U.S. dollar was pegged to gold at $35 per ounce and other currencies were pegged to the U.S. dollar.. Exachange rate were arrowed to fluctuate by 1% above or below intial base price. The fixed exchange rate were maintained by official intervation by central banks in the form of sales and purchase of dollars with the IMF providing the foreign exchange rate. ADVANTAGES 1.Stabililty of exchange rates removed a great deal of uncertainity from international trade and investment transactions 2.It also imposed a great deal of discipline on the participating nations economic policies. 3.Technical aspects of the system had practical implications on the participating countries THE KEY DIFFERENCE BETWEEN GOLD STANDARD AND BRETTON WOODS The key difference was that the dollar was the only currency that was backed by and convertible into gold on breeton Woods system while on gold standard other currencies were also allowed to be convertible into gold THE DEMISE OF BRETTONS WOODS STANDARD The system Bretton Woods worked well until the late 1960’s. 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. On 15th Aug. 1971, President Nixon suspended the system of convertibility of gold and dollar and decided for floating exchange rate system and By March 1973, the major currencies began to float against each other in which values being determined by supply and demand in the foreign-exchange market.
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  3. EXCHANGE RATEREGIMES (FIXED AND FLEXIBLE) Exchange rate regime is the way an authority manages its currency in relation to other currencies and the foreign exchange market. Exchange rates are affected by inflation differences and interest rates. An exchange rate change is simply the price of one currency expressed in terms of another There various types of exchange rate regimes but the two major exchange rate regimes are fixed exchange rate system and floating/flexible exchange rate system FIXED EXCHANGE RATE SYSTEM A fixed, or pegged,rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen, or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchangemarket in return for the currency to which it is pegged. If, for example, it is determined that the value of a single unit of local currency is equal to USD3.00, the central bank will have to ensure that it can supply the market with those dollars. In order to maintain the rate, the central bank must keep a high level of foreign reserves. This is a reserved amount of foreign currency held by the central bank which it can use to release (or absorb) extra funds into (or out of) the market. This ensures an appropriate money supply, appropriate fluctuations in the market (inflation/deflation), and ultimately, the exchange rate. The central bankcan also adjust the official exchange rate when necessary The purpose of a fixed rate system is to maintain a country’s currency value within a very narrow band. ADVANTAGES OF FIXED EXCHANGE RATE SYSTEM 1. Avoid Currency Fluctuations. If the value of currencies fluctuate significantly this can cause problems for firms engaged in trade. Example : If a firm relied on imported raw materials a devaluation would increase the costs of imports and would reduce profitability
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  2. Stability encouragesinvestment. The uncertainty of exchange rate fluctuations can reduce the incentive for firms to invest in export capacity. Some Japanese firms have said that the UK’s reluctance to join the Euro and provide a stable exchange rates maker the UK a less desirable place to invest. 3. Keep inflation Low. Governments who allow their exchange rate to devalue may cause inflationary pressures to occur. This is because AD increases, import prices increase and firms have less incentive to cut costs. 4. A rapid appreciation in the exchange rate will badly effect manufacturing firms who export, this may also cause a worsening of the current account. 5. Joining a fixed exchange rate may cause inflationary expectations to be lower 6.Helpful for Small Nations 7. It promote international trade DISADVANTAGES OF FIXED EXCHANGE RATE SYSTEM 1. Conflict with other objectives. To maintain a fixed level of the exchange rate may conflict with other macroeconomic objectives. · If a currency is falling below its band the government will have to intervene. It can do this by buying sterling but this is only a short term measure. · The most effective way to increase the value of a currency is to raise interest rates. This will increase hot money flows and also reduce inflationary pressures. · However higher interest rates will cause lower AD and economic growth, if the economy is growing slowly this may cause a recession and rising unemployment 2. Less Flexibility. It is difficult to respond to temporary shocks. For example an oil importer may face a balance of payments deficit if oil price increases, but in a fixed exchange rate there is little chance to devalue. 3. Join at the Wrong Rate. It is difficult to know the right rate to join at. If the rate is too high, it will make exports uncompetitive. If it is too low, it could cause inflation.
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  4. Current AccountImbalances. Fixed exchange rates can lead to current account imbalances. For example, an overvalued exchange rate could cause a current account deficit. 5. It does not reflect the true value of the currency 6. It may lead to the Black markets emerge 7. It can be expensive or even impossible to hold FLEXIBLE EXCHANGE RATE SYSTEM A flexible exchange rate is determined by the foreign exchange market through supply and demand. A flexible rate is often termed "self-correcting", as any differences in supply and demand will automatically be corrected in the market. For example if demand for a currency is low, its value will decrease, thus making imported goods more expensive and thus stimulating demand for local goods and services. This in turn will generate more jobs, andhence an auto-correction would occur in the market. A floating exchange rate is constantly changing. ADVANTAGES OF FLEXIBLE EXCHANGE RATE SYSTEM 1. Independent Monetary Policy. Under flexible exchange rate system, a country is free to adopt an independent policy to conduct properly the domestic economic affairs. The monetary policy of a country is not limited or affected by the economic conditions of other countries 2. Shock Absorber. A fluctuating exchange rate system protects the domestic economy from the shocks produced by the disturbances generated in other countries. Thus, it acts as a shock absorber and saves the internal economy from the disturbing effects from abroad 3. Promotes Economic Development. The flexible exchange rate system promotes economic development and helps to achieve full employment in the country. The exchange rates can be changed in accordance with the requirements of the monetary policy of the country to achieve the planned national objectives 4. Solutions to Balance of Payment Problems. The system of flexible exchange rates automatically removes the disequilibrium in the balance of payments. When, there is deficit in the balance of payments, the external value of a country's currency falls. As a result, exports
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  are encouraged, andimports are discouraged thereby, establishing equilibrium in the balance of payment 5. Promotes International Trade. The system of flexible exchange rates does not permit exchange control and promotes free trade. Restrictions on international trade are removed and there is free movement of capital and money between countries 6. Increase in International Liquidity. The system of flexible exchange rates eliminates the need for official foreign exchange reserves, if the individual governments do not employ stabilization funds to influence the rate. Thus, the problem of international liquidity is automatically solved. In fact, the present shortage of international liquidity is due to pegging the exchange rates and the intervention of the IMF authorities to prevent fluctuations in the rates beyond a narrow limit DISADVANTAGES OF FLEXIBLE EXCHANGE RATES 1. Unstable conditions. Flexible exchange rates create conditions of instability and uncertainty which, in turn, tend to reduce the volume of international trade and foreign investment. Long- term foreign investments arc greatly reduced because of higher risks involved 2. Adverse Effect on Economic Structure. The system of flexible exchange rates has serious repercussion on the economic structure of the economy. Fluctuating exchange rates cause changes in the price of imported and exported goods which, in turn, destabilise the economy of the country 3. Inflationary Effect. Flexible exchange rate system involves greater possibility of inflationary effect of exchange depreciation on domestic price level of a country. Inflationary rise in prices leads to further depreciation of the external value of the currency. 4. Low Elasticities. The elasticities in the international markets are too low for exchange rate, variations to operate successfully in bringing about automatic equilibrating adjustments. When import and export elasticities are very low, the exchange market becomes unstable. Hence, the depreciation of the weak currency would simply tend to worsen the balance of payments deficit further
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  HOW DO COUNTRIESCHOOSE EXCHANGE RATE REGIMES The following are the Socio – Economic Variables that Affecting choice of exchange rate regimes 1. Financial depth indicators. Deeper the financial markets prone to adopting Floating Exchange rates 2. Openness, size, trade concentration and economic volatility indicators. A country is less likely to adopt a fixed exchange rate if it is relatively large and closed, if its external trade is concentrated, and if the business cycle is more volatile. This suggests that what matters for the choice of the exchange rate regime is the exposure to external shocks. 3. Political variables. Fragmented policymaking calls for a Float probably because greater discretion makes it easier to settle conflicts among agents involved in the decision-making process. The use of monetary policy to raise consensus in the elections 4. Inflation IMPORTANCE OF EXCHANGE RATE REGIMES 1. Stock market trading 2. Symbolizes growth 3. Indicates Demand of currency 5. Position of currency in world CONCLUSION In reality, no currency is wholly fixed or flexible. In a fixed regime, market pressures can also influence changes in the exchange rate. Sometimes, when a local currency does reflect its true value against its pegged currency, a "black market" which is more reflective of actual supply and demand may develop. A central bank will often then be forced to revalue or devalue the official rate so that the rate is in line with the unofficialone, there by halting the activity of the black market. In a floating regime, the central bank may also intervene when it is necessary to ensure stability and to avoid inflation; however, it is less often that the central bank of a floating regime will interfere.
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  REFERENCES http://catalog.flatworldknowledge.com/bookhub/26?e=suranfin-ch11_s0 (Accessed 17th march2015) http://www.economicshelp.org/macroeconomics/exchangerate/advantages-disadvantages- fixed/( Accessed 17th march 2015) http://www.preservearticles.com/201012291898/advantages-disadvantages-flexible- exchange-rates.html (Accessed 17th march 2015). Drummond, The Gold Standard and the International Monetary System 1900-1939 (London: McMillan Education Group, 1987) Madura, j(2008); international corporate finance. Mcgraw-hill
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  REFERENCES http://catalog.flatworldknowledge.com/bookhub/26?e=suranfin-ch11_s0 (Accessed 17th march2015) http://www.economicshelp.org/macroeconomics/exchangerate/advantages-disadvantages- fixed/( Accessed 17th march 2015) http://www.preservearticles.com/201012291898/advantages-disadvantages-flexible- exchange-rates.html (Accessed 17th march 2015). Drummond, The Gold Standard and the International Monetary System 1900-1939 (London: McMillan Education Group, 1987) Madura, j(2008); international corporate finance. Mcgraw-hill