The structure within which foreign exchange rates are determined, international trade and capital flows are accommodated and balance of payments adjustments are made.
The institutional arrangements that countries adopt to govern exchange rates of currencies used as money and monitor values to insure stability in currency value.
All of the institutions, instruments and agreements which link together the money markets, world currencies, real estate, commodity and futures markets, etc. are a part of the International Monetary System.
Fixed exchange rate system : value of the currency is fixed by the government and related to another currency or range of currencies. It remains the same and is changed only under specific circumstances by the government.
Role of Central Bank :
Must keep reserves of both foreign and domestic currency on hand to buy or sell to the foreign exchange market in order to preserve fixed exchange rate. If the domestic currency drops below the established fixed value, the central bank will increase the price of the domestic currency by trading in foreign currency reserves to buy domestic currency.
If the domestic currency rises above the established fixed value, the central bank will decrease the price of domestic currency by trading it in for foreign currency.
Has a monetary policy that centers around managing the money supply.
Floating rate system : value of currency in relation to another currency is not determined by the government, but by the free market where it “floats”. Exchange rates between two currencies are thus influenced by market factors, such as inflation, interest rates, etc. and equilibrium is reached through market forces. Foreign exchange market determines the relative value of a currency.
Dollar, Euro, Yen and Pound “float” against each other.
Role of the Central Bank :
Allows the mechanism of supply and demand in the foreign exchange market to equalize the exchange rate;
Has an independent monetary policy that is not guided solely by exchange rate concerns.
Early civilizations : exchange between societies of whatever was needed/wanted.
Major Empires through early feudalism : local forms of money (salt, grains, silver, cattle, etc); money is a vehicle through which goods are exchanged. Exchange is for survival.
Late feudal through City-States (14 th -16 th centuries): rise of mercantilism and trade; profit is made in spices, silks, quest for gold and metals; gold and silver are media of exchange; balance of trade is favorable
Industrialism (17 th -19 th centuries): paper money as currency is created; profit is made on production; trade deficits are acceptable.
Modern and post-modern (20-21 st centuries): profit is made on capital; fictitious wealth, rise of paramoney (credit cards, checks, etc.); trade deficits are acceptable. Value of money is no longer a face value reflection of use + worth. The globalized world is fueled by multiple currencies, of which many determine their value in the foreign exchange market.
In1800’s, major trading nations adopt the gold standard. The development of free trade led to need for a more formalized system for settling international balances.
The gold standard is a monetary standard that pegs currencies to gold; currencies are guaranteed by being convertible to gold.
This was a fixed rate, based on a determination made by each government about how much one ounce of gold would be worth in local currency. Each country had its own value. The value of two currencies could be determined by comparing the value of each individual currency in terms of gold.
The amount of currency needed to purchase one ounce of gold is the gold par value. e.g.
One ounce of gold was worth: US$20.67; £4.25.
How do you determine the exchange rate between U.S. dollars and English pounds?
$20.67/ounce of gold = $4.87 per GBP (English pound sterling)
During WWI, gold standard abandoned because of world war.
Post WWI, war heavy expenditures affected the value of dollars against gold.
1919-1929: many countries back on the gold standard.
1929-1933: no fixed standards because of the Depression era.
1934:US raised dollars to gold from $20.67 to $35 per ounce, causing devaluation of dollar to other currencies (more dollars needed to buy gold). Other countries followed suit and devalued their currencies.
1939: Gold Standard suspended due to start of WWII.
The International Monetary Fund (IMF) Articles of Agreement were heavily influenced by the worldwide financial collapse, competitive devaluations, trade wars, high unemployment, hyperinflation in Germany and elsewhere, and general economic disintegration that occurred between the two world wars
Created to police monetary system by ensuring maintenance of the fixed-exchange rate
Promote int’l monetary cooperation and facilitate growth of int’l trade The aim of the IMF was to try to avoid a repetition of that chaos through a combination of discipline and flexibility.
Many forms of money Main World Trading Partners Adopt the Gold Standard IMF countries Adopt fixed rate Tied to the U.S. $ (which is backed by gold Mixed system with Major currencies being floated; Other currencies- various systems 1973 - NOW On and off The Gold Standard
Since 1973, the world economy has suffered through numerous financial crises in various countries.
The post 1973 period is characterized by more volatility.
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
FINANCIAL CRISES in the POST-BRETTON WOODS ERA
A number of financial crisis have occurred in the past twenty five years, causing major shocks to the global economy and often needing help from the IMF. These three types of financial crises impacting the world monetary system are:
when a speculative attack on a currency’s exchange value results in a sharp depreciation of the currency’s value or forces authorities to defend the currency
Loss of confidence in the banking system leading to a run on the banks, capital flight occurs.
Foreign debt crisis
When a country cannot service its foreign debt obligations
Government action: example of too little, too late--
Governments defend home currency that is devaluating by using the foreign currency held in their reserves to buy back its home currency in order to strengthen it.
This can cause drain foreign reserves to dangerously low levels so that foreign debts cannot be serviced.
This causes other problems, especially a loss of confidence, which prompts investors to sell their holdings of the home currency; capital flight and panic can follow.
WHAT HAPPENS WHEN THERE IS FINANCIAL CRISIS IN A COUNTRY?
In a globalized world, countries are highly interdependent and therefore are impacted by financial crisis in a specific country.
When there is crisis in one country and that country’s money loses its value (devaluates), financial panic can occur that lead to similar devaluations at about the same time by other, often nearby countries. This is known as CONTAGION.
If countries cannot stop the devaluation themselves
Economic forecasts based on expansion are unrealistic.
Excess capacity in factories is created (e.g. semi-conductors in Korea).
Residential and commercial property stands idle but developers must continue to service debt secured to build projects (e.g. Thailand).
Demand for imports increases dramatically because of increase in individual disposable income and because of increase in capital equipment and materials needed for construction of factories and residential and commercial property. Result is outflow of foreign currency and trade deficit.
complications of the international monetary system
Faced with uncertainty about the future value of currencies, firms should utilize the forward exchange market to insure against exchange rate risk
Firms should pursue strategies that will increase the company’s strategic flexibility in the face of unpredictable exchange rate movements — that is, to pursue strategies that reduce the economic exposure of the firm
Governments have tremendous power and influence which they can wield in the international monetary system.