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International monetary system


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International monetary system

  1. 1. The International Monetary System
  2. 2. Introduction  The international monetary system refers to the institutional arrangements that countries adopt to govern exchange rates
  3. 3. Introduction 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
  4. 4. Introduction  It addresses to solve the problems relating to international trade: a. b. c. Liquidity Adjustment Stability
  5. 5. 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
  6. 6. The Gold Standard The first modern international monetary system was the gold standard Put in effect in 1850 Participants – UK, France, Germany & USA
  7. 7. Gold Standard- I ( 1876-1913) ●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.
  8. 8. 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 to maintain adequate reserves of gold in order to back its currency
  9. 9. 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 gold or currencies of these developed countries
  10. 10. The System of Bretton Woods ( 1944-71)  In July, 1944, 44 countries met in Bretton Woods, New Hampshire, USA – a new International Monetary System was created  John Maynard Keynes of Britain and Harry Dexter White of USA were the key movers
  11. 11. 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
  12. 12. 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 and Development (IBRD) was created to rehabilitate war-torn countries and help developing countries
  13. 13. 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 was permitted by IMF  Thus each currency was tied to dollar directly or indirectly 
  14. 14. Collapse of the Fixed 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 US dollars was held outside the USA ; it was more than the total gold holdings of the USA
  15. 15. Collapse of the Fixed 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 of gold and dollar and decided for floating exchange rate system
  16. 16. The end of the Bretton Woods System (1972– 81)  The system dissolved between 1968 and 1973  By March 1973, the major currencies began to float against each other
  17. 17. The end of the Bretton Woods System (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  Forming part of a monetary union
  18. 18. Exchange Systems after 1973 Exchange 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)
  19. 19. Exchange Systems after 1973 But as usual, between these two extreme positions there exists also an intermediate range of different systems with limited flexibility, usually referred to as “soft pegs”
  20. 20. A fixed peg regime 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 Countries do not have a separate national currency, either when they have formally dollarized, or when the country is a member of a currency union, for example Euro
  21. 21. Floating Exchange Rate System ● The collapse of Bretton Woods and Smithsonian Agreements coupled with oil crisis of 1970, the floating exchange rate system was adopted by leading industrialised countries ● Officially approved in April 1978 ● Under the system, the exchange rate would be determined by market forces without the intervention of government
  22. 22. Floating Exchange Rate System ●No country in the world has adopted freely floating exchange rate system ●Floating exchange rate regimes consist of independent floating and managed floating systems
  23. 23. Independent Floating systems In Independent Floating systems the exchange rate is market determined and monetary policy usually functions without exchange rate considerations Foreign exchange interventions are rare and meant to prevent undue fluctuations But no attempt is undertaken to achieve/maintain a particular rate
  24. 24. Managed Floating systems  Managed Floating systems usually let the market take its own course but the monetary authorities intervene in the market to “manage” the exchange rate, if needed, to prevent high volatilities and to stimulate growth, without committing 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 Exchange Rate”
  25. 25. Intermediate Regimes ( Soft Pegs) Intermediate exchange rate regimes consist of an array of differing systems allowing a varying degree of flexibility, such as conventional fixed exchange rate pegs, crawling pegs and exchange rate bands
  26. 26. Conventional fixed exchange rate pegs In a Conventional Fixed Peg arrangement a currency is pegged at a fixed rate to a major currency or a basket of currencies, allowing the exchange rate to fluctuate within a narrow margin of ±1 percent around a formal central rate The monetary authority intervenes in the market, if the fluctuation is outside these limits
  27. 27. Crawling Peg ( The Dirty Float) ●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
  28. 28. Crawling Peg ( The Dirty Float) 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
  29. 29. Crawling Peg ( The Dirty Float) ● 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
  30. 30. Exchange Rates Since 1973 ● The merits of each continue to be debated ● There is no agreement as to which system is better ● Many countries today are disappointed with the floating exchange rate system
  31. 31. Implications For Managers For managers, understanding the international monetary system is important for:  Currency management  Business strategy  Corporate-government relations
  32. 32. 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, speculative buying and selling of currencies can create volatile movements in exchange rates
  33. 33. Business Strategy Managers need to recognize that while exchange rate movements are difficult to predict, their movement can have a major impact on the competitive position of businesses To contend with this situation, managers need strategic flexibility e.g. dispersing production to different locations
  34. 34. Corporate-Government Relations Managers need to recognize that businesses can influence government policy towards the international monetary system Companies should promote an international monetary system that facilitates international growth and development