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Ims lect 1

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International monetary System and types of exchange rate systems.

International monetary System and types of exchange rate systems.

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  • 1. WORKSHOP ON FOREIGN TRADE DOCUMENTATION AND TRADE FINANCE Course Instructor : Sneha Sharma
  • 2. INTERNATIONAL MONETARY SYSTEM
  • 3. INTERNATIONAL MONETARY SYSTEM It is a system that sets rules and procedures by which different national currencies are exchanged for each other in world trade.
  • 4. INTERNATIONAL MONETARY SYSTEM  It is often used interchangeably with terms such as ―international monetary and financial system‖ and ―international financial architecture.  The objective of the IMS is  to contribute to stable and high global growth,  while fostering price and financial stability.
  • 5. INTERNATIONAL MONETARY SYSTEM  The IMS regulates key dimensions of the balance of payments (IMF, 2009c; 2010a).  It consists of four elements: exchange arrangements and exchange rates;  international payments and transfers relating to current international transactions;  international capital movements; and  international reserves.  The essential purpose of the IMS is to facilitate the exchange of goods, services and capital among countries.
  • 6. INTERNATIONAL MONETARY SYSTEM WAS DIVIDED INTO MANY PHASES
  • 7. TIMELINE OF IMS The Gold Standard The Collapse of Gold Standard The Bretton Woods Era The End of the Bretton Woods System Post Bretton Woods System & the Floating Rate Era
  • 8. THE GOLD STANDARD Buying and selling of paper currency in exchange for gold • Adopted by UK in 1821 • Upshot • It created a fixed exchange rate system because each country tied the value of its currency. • Difficulty: Transacting in gold was expensive.
  • 9. STERLING BASED GOLD STANDARD  From  the 1821 until the end of 1918, most important currency in international commerce was the British pound sterling  because of the United Kingdom‘s large territory due to dominant economic and military power.
  • 10. THE COLLAPSE OF GOLD STANDARD  During World War 1, the sterling-based gold standard unraveled  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.
  • 11. POST-WAR CONFERENCES & READAPTATION OF GOLD STANDARD  After the war  Conferences at Brussels (1920) and Genoa (1922) yielded general agreements among the major economic powers to return to the prewar gold standard.  Most countries, including the United States, the United Kingdom, and France, readopted the gold standard in the 1920s
  • 12. IMPLEMENTATION OF FLOATING RATE SYSTEM BY BANK OF ENGLAND  The standard of gold standard was doomed by economic stresses triggered by the worldwide Great Depression.  The Bank of England, the United Kingdom's central bank, was unable to maintain its new pledges under the gold standard.
  • 13. IMPLEMENTATION OF FLOATING RATE SYSTEM BY BANK OF ENGLAND  On September 21, 1931 The Bank of England allowed the pound to float, meaning that the pound's value would be determined by the forces of supply and demand and the Bank of England would no longer guarantee to redeem British paper currency for gold at par value.
  • 14. COMPETITIVE DEVALUATION OF CURRENCIES & INCREASED TARIFF RATE  After the United Kingdom abandoned the gold standard,  a "sterling area‖ emerged as some countries, primarily members of the British Commonwealth, pegged their currencies to the pound and relied on sterling balances held in London as their international reserves.
  • 15. COMPETITIVE DEVALUATION OF CURRENCIES & INCREASED TARIFF RATE  Other countries tied the value of their currencies to the U.S. dollar or the French franc.  Some countries Kingdom, (United Belgium, States, France, Latvia, United the Netherlands, Switzerland & Italy) were deliberately & artificially devaluating their official value of currencies to make their goods cheaper in the international markets, which is stimulating its exports and reducing its imports.
  • 16. COMPETITIVE DEVALUATION OF CURRENCIES & INCREASED TARIFF RATE  But, none were getting the benefit due to competitive devaluation at almost same percentage that is each currency's value relative to the other remains the same.  Most countries also raised the tariffs they imposed on imported goods in the hope of protecting domestic jobs in import-competing industries.  Nations adversely affected by trade barriers of any kind are quite likely to impose retaliatory or reciprocal tariffs.
  • 17. BEGGAR-THY-NEIGHBOR POLICIES  An international trading policy that utilizes currency devaluations and protective barriers to alleviate a nation's economic difficulties at the expense of other countries.
  • 18. BEGGAR-THY-NEIGHBOR POLICIES  The policy name is derived from its resulting impact, making a beggar out of neighboring nations.  The goal of a Beggar-Thy-Neighbor strategy is to increase the demand for your nation's exports, while reducing your reliance on imports.  This is often executed by devaluing the nation's currency, which will make exports to other nations cheaper.
  • 19. EFFECT OF BEGGAR-THY-NEIGHBOR POLICIES (WORLD WAR II)  As more and more countries adopted beggar-thy-neighbor policies like  devaluation of currencies and increasing the tariff rate on imported goods,  international trade contracted that hurt employment in each country's export industries.  More ominously, this international economic conflict was soon replaced by international military conflict that was the outbreak of World War II in 1939.
  • 20. THE BRETTON WOODS ERA Lecture 2nd
  • 21. POST-WAR SITUATION  World War II created  inflation, unemployment and an instable political situation.  Every country was struggling to rebuild their wartorn economy.
  • 22. BRETTON WOODS CONFERENCE  To construct the postwar international monetary system  representatives of 44 countries met at a resort in Bretton Woods, New Hampshire in 1944.
  • 23. DECISIONS & OUTCOME OF THE BRETTON WOODS CONFERENCE  The Bretton Woods Conference has presented the world two historic agreements. These are as follows: Agreement of conferees to renew the gold standard on a modified basis.  Agreement to create two new international organizations to assist the rebuilding of the world economy and the international monetary system. These were:  International Bank for Reconstruction and Development (IBRD)  International Monetary Fund (IMF) 
  • 24. A DOLLAR-BASED GOLD STANDARD  IMF and the World Bank provided the institutional framework for the postwar international monetary system.  All countries agreed to peg the value of their currencies to gold.  However, only the United States pledged to redeem its currency for gold at the request of a foreign central bank.  Thus the U.S. dollar became the key-stone of the Bretton Woods system.
  • 25. A DOLLAR-BASED GOLD STANDARD  Countries had faith in the U.S. economy and so were willing to accept U.S. dollars to settle their transactions. As the British pound sterling had been in the nineteenth century, the U.S. dollar became the preferred vehicle for settling most international transactions.
  • 26. THE EFFECT OF THE BRETTON WOODS CONFERENCE  Under the Bretton Woods Agreement each country pledged to maintain the value of its currency within ±1% of its par value.  If the market value of its currency fell outside that range, a country was obligated to intervene in the foreign-exchange market to bring the value back within ±1% of par value.
  • 27. THE EFFECT OF THE BRETTON WOODS CONFERENCE  This stability in exchange international businesses. rates benefited
  • 28. BRETTON WOODS SYSTEM AS ADJUSTABLE PEG  The Bretton Woods system is often described as using an adjustable peg  because currencies were pegged to gold but the pegs themselves could be altered under certain conditions.
  • 29. BRETTON WOODS SYSTEM AS ADJUSTABLE PEG  The arrangement of Bretton Woods System worked well as long as pessimism about a country‘s economy was temporary.  But, if a country suffered from structural macroeconomic problems, major difficulties could arise.
  • 30. THE END OF THE BRETTON WOODS SYSTEM
  • 31. SHORTCOMING OF DOLLAR-BASED GOLD STANDARD UNDER BRETTON WOODS SYSTEM & TRIFFIN PARADOX  Ironically, the reliance of the Bretton Woods system on the dollar ultimately led to the system‗s undoing.  Because the supply of gold did not expand in the short run,  the only source of the liquidity needed to expand international trade was the U.S. dollar.
  • 32. SHORTCOMING OF DOLLAR-BASED GOLD STANDARD UNDER BRETTON WOODS SYSTEM & TRIFFIN PARADOX  Under the Bretton Woods system, the expansion of international liquidity depended on foreigners‗ willingness to continually increase their holdings of dollars.  Foreigners were perfectly happy to hold dollars as long as they trusted the integrity of the U.S. currency, and during the 1950s and 1960s the number of dollars held by foreigners rose steadily.
  • 33. SHORTCOMING OF DOLLAR-BASED GOLD STANDARD UNDER BRETTON WOODS SYSTEM & TRIFFIN PARADOX  As foreign dollar holdings increased, however,  people began to question the ability of the United States to live up to its Bretton Woods obligation.  This led to the Triffin paradox, named after Robert Triffin,who first identified the problem.
  • 34. SHORTCOMING OF DOLLAR-BASED GOLD STANDARD UNDER BRETTON WOODS SYSTEM & TRIFFIN PARADOX  The paradox arose because foreigners needed to increase their holdings of dollars to finance expansion of international trade.  But the more dollars they owned, the less faith they had in the ability of the United States to redeem those dollars for gold.
  • 35. SHORTCOMING OF DOLLAR-BASED GOLD STANDARD UNDER BRETTON WOODS SYSTEM & TRIFFIN PARADOX  The less faith foreigners had in the United States, the more they wanted to rid themselves of dollars and get gold in return  But if they did this, international trade and the international monetary system might collapse because the United States didn't have enough gold to redeem all the dollars held by foreigners.
  • 36. SHORTCOMING OF DOLLAR-BASED GOLD STANDARD UNDER BRETTON WOODS SYSTEM & TRIFFIN PARADOX  The shortcomings are listed below in brief    Limited gold. Liquidity problem. Foreigners‘ behavior of continuous increasing in dollar holding. Foreigners‘ less faith on United States.
  • 37. AGREEMENT TO CREATE SPECIAL DRAWING RIGHTS (SDRS)  To inject more liquidity into the international monetary system while reducing the demands placed on the dollar as a reserve currency,  IMF members created the special drawing rights in 1967.  SDR is a credit granted by the IMF that can be used to settle official transactions among central banks.  Thus SDRs are sometimes called "paper gold―.
  • 38. AGREEMENT TO CREATE SPECIAL DRAWING RIGHTS (SDRS)  As of 1993, approximately 21.4 billion SDRs, representing about 2% of the world‗s total reserves, had been distributed to IMF members in proportion to their IMF quotas.  The value of an SDR is a function of the current value of five different currencies from which it is comprised.  They include the U.S. dollar, the Japanese yen, the United Kingdom pound sterling, and the respective euro values of Germany and France.
  • 39. AGREEMENT TO CREATE SPECIAL DRAWING RIGHTS (SDRS)  An SDR's value is currently calculated daily as a weighted average of the market value of five major currencies  U.S. dollar,  German  French mark, franc,  Japanese  pound  with yen, sterling the weights revised every five years.
  • 40. OUTCOME OF CREATING SDRS  SDRs solved the liquidity problem for the international monetary system, but it failed to solve the problem related to the glut of dollars held by foreigners & faith.  By mid 1971, the Bretton Woods system was tottering, the victim of fears about the dollar's instability.  In the first seven months of 1971, the United States sold one third of its gold reserves.
  • 41. OUTCOME OF CREATING SDRS  It became clear to the marketplace that the United States did not have sufficient gold on hand to meet the demands of those who still wanted to exchange their dollars for gold.  The Bretton Woods system officially ended when in a dramatic address on August 15, 1971, President Richard M. Nixon announced that the United States would no longer redeem gold at $35 per ounce.
  • 42. POST BRETTON WOODS SYSTEM & THE FLOATING RATE ERA  After President Nixon's speech, most foreign currencies began to float, their values being determined by supply and demand in the foreignexchange market.  The value of the U.S. dollar fell relative to most of the world's major currencies.
  • 43. POST BRETTON WOODS SYSTEM & THE FLOATING RATE ERA  At the Smithsonian Conference, held in Washington, D.C. in December 1971, central bank representatives from the Group of Ten countries agreed to restore the fixed exchange-rate system but with restructured rates of exchange between the major trading currencies.
  • 44. FLOATING EXCHANGE RATE
  • 45. FLOATING EXCHANGE RATES  After abandoning gold convertibility IMF had to agree on a system of floating exchange rates.  According to which the gold standard became obsolete and the values of various currencies were to be determined by the market.  In the late 20th cent., the Japanese yen and the German Deutschmark strengthened and became important in international financial markets increasingly
  • 46. FLOATING EXCHANGE RATES  The U.S. dollar although still the most important national currency weakened with respect to them and diminished in importance.  The euro was introduced in financial markets in 1999 as replacement for the currencies (including the Deutschmark) of 11 countries belonging to the European Union (EU); it began circulating in 2002 in 12 EU nations.
  • 47. TYPES OF EXCHANGE RATES
  • 48. CLASSIFYING ER REGIMES HARD PEGS INTERMEDIATE FLOATING • Currency union • Basket peg • Managed float • Dollarization • Crawling peg • Free float • Currency board • Band
  • 49. HARD PEGS Dollarization Currency union • Use another country‘s currency as sole legal tender • E.g. Ecuador, El Salvador, Panama • Share same currency with other union members • E.g. Euro area Currency board • Legally commit to exchange domestic currency for specified foreign currency at fixed rate • E.g. Hong Kong(1983), Estonia(1992), Lithuania (1994), Bulgaria(1997), Bosnia and Herzegovina, Argentina (until 2001)
  • 50. DOLLARIZATION Dollarization: Country gives up completely its monetary autonomy by adopting another country‘s currency. - Mostly small and very open economies - Countries recently adopted: e.g. Ecuador (2000), El Salvador (2001), Guatemala (2001)  Advantages   Credibility in the regime is maximized Disadvantages  Limited flexibility for economic policy when facing adverse external shocks
  • 51. CURRENCY UNION (CU) Substitute a single currency for several national currencies - Efficiency gains: reduces transaction costs of trade within CU countries - Boost the volume of trade - More synchronization of business cycles inside the CU - A gradual loss of monetary policy autonomy  Fiscal policy is constrained by the convergence criteria
  • 52. CURRENCY BOARD  Strict fixed ER   Advantages   e.g. Hong Kong(1983), Estonia(1992), Lithuania (1994), Bulgaria(1997) High credibility because the institutional constraints are difficult to change Disadvantages  Limited flexibility for economic policy when facing adverse external shocks
  • 53. INTERMEDIATE REGIMES Conventional (soft) peg Band • Single currency peg (e.g. Malaysia, Nepal, Namibia) • Pegged exchange rate within horizontal bands (>±1%) • E.g. Denmark ( 2.25%), Tonga ( 5%), Hungary ( 15%) Crawling peg Crawling band • Backward or forward looking • E.g. Bolivia • Symmetric or asymmetric • E.g. Belarus ( 5%), Israel ( 22%)
  • 54. CONVENTIONAL (FIXED) PEG Soft fixed Exchange Rate, Central Bank not obliged to maintain the parity indefinitely  Advantages  Provides macroeconomic discipline by maintaining tradable goods prices in line with foreign prices  Built-in escape clause ―devaluation‖ provides some flexibility   Disadvantages If weak institutional constraints, the system is subject to speculative attacks  Realignments can be disruptive especially when dollarized debts are high 
  • 55. CRAWLING PEG  Nominal ER is adjusted periodically according to a set of indicators, and it is not allowed to fluctuate beyond a narrow range   – backward-looking or forward-looking adjustments Adjustment can be pre-announced. Advantages For high inflation countries, crawling helps avoid RER overvaluation  Pre-announcement helps guide public expectations   Disadvantages  If backward-looking adjustment, there is a risk of creating inflationary inertia
  • 56. CRAWLING BAND  A band system where the ER central parity crawls over time—asymmetric or symmetric band  Choice of ER bands Central rate: single currency or basket?  Whether the central rate is fixed , crawling, or realigned irregular depends on the inflation differential and permanent shocks to RER  Width of band  Rules governing the CB‘s FOREX intervention inside the bands 
  • 57. FLOATING Managed floating • No preannounced path for the exchange rate • Management by sterilized intervention or interest rate (monetary) policy • E.g. Thailand, Indonesia, Mongolia, Singapore, Brazil Independently floating • E.g. U.S., Japan,
  • 58. MANAGED FLOATING  with a feedback rule—   indirect intervention using interest rates and liquidity positions, dirty floating—sporadic CB interventions in the FOREX market Advantages Adjustments in NER absorb foreign and domestic shocks, but high international reserves required  Dampens excessive fluctuations of ER   Disadvantages Lack of transparency on CB intervention may create too much uncertainty  Effects of intervention are typically short-lived and may be destabilizing 
  • 59. INDEPENDENT /FREE FLOAT  No need for reserves but higher nominal ER volatility may distort resource allocation

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