International Monetary System

Dr.C S ShylajanFaculty, IBS Hyderabad

Exchange Rate Determination-Different ways

Foreign trade involves the use of different national currencies

Foreign exchange rate is the price of domestic currency in relation to another currency

Foreign exchange rate is determined in the foreign exchange market by DD and SS

By Govt or Central Bank Mix of both

Exchange Rate Regimes

Main exchange rate regimes are three:

Fixed exchange rate system (gold standard or Bretton Woods system)

Flexible/Floating exchange rate system

Managed float exchange rate system

Policy Issue

Choice of exchange rate system is one of the key policy questions.

Whether to have fixed or floating exchange rates

Three main features that affect the choice of system are volatility and risk, inflationary consequences and monetary autonomy.

Fixed Exchange Rate System

The central bank fixes the price of the domestic currency in relation to the foreign currency and agrees to maintain the value at that level

Fixed Exchange Rate System

It has 4 major variants: Adjustable Peg: Exchange rate is

fixed but adjustable if there is unwithstandable pressure

Crawling Peg: Central bank allows a gradual adjustment of the exchange rate by intervening in the currency market in small measure to achieve the desired objective

Fixed exchange rate system

Currency Board: Under this the exchange rate is irrevocably fixed by the board (or the central bank)

Fixed exchange rate system

Unified Currency system:

Independent currency is abandoned and some other currency is adopted

Eg: Adoption of Euro by the European countries, Adoption of dollar by Argentina

The exchange rates are permanently set against such foreign currencies

Fixed exchange rate system

Advantages:

No uncertainty about the exchange rate which provides businesses with sure basis for planning an pricing

Imposes monetary policy discipline (no excessive borrowings and spending)

Fixed exchange rate system

Disadvantages:

Rigidity in the economy

Requirement of adequate foreign exchange reserves

Monetary policy is dictated by exchange rate concerns

Flexible Exchange Rate System

Exchange rate is determined on the basis of demand for and supply of foreign exchange in the market

Flexible Exchange Rate System

Advantages:

It reflects the true value of the exchange rate if the markets are perfect. Based on fundamentals of the economy

No scope for speculation The central bank can follow

independent monetary policy

Flexible Exchange Rate System

Disadvantages:

If markets are not perfect, exchange rates may not reflect the true value

Then, it may show high volatility, and thus affect business planning

Uncertainty and risk for business

Managed Float System

A compromise between a fixed exchange rate system and a flexible exchange rate system

The central bank allows the exchange rate to be market determine, but intervenes from time to time to orderly conditions in the market

Managed Float System

From 1971 until 1987 the US followed a policy of managed floating (market based exchange rate with periodic “re-alignments”).

India followed till 1996, then onwards a market determined rate

Managed Float System

Advantages: The fluctuations in the exchange rates are

smoothened and brings stability in ER Reduce speculative attack on ER

Disadvantages: Uncertainty is not completely eliminated The macroeconomic implications of Central

Bank intervention Uncertainty about Central Bank’s tactics

Exchange Rate Regimes: History

The Gold Standard (1870-1914)

Gold as a medium of exchange –

The exchange rate between any pair of currencies will be determined by their respective exchange rates against gold

The Gold Standard (1870-1914)

Major Features:

Long-run price stability because of monetary discipline

Rapid expansion of free international trade – not many tariff, quota restrictions

Stable exchange rate and prices Rapid economic growth Britain as the leader of world’s financial

system

Exchange Rate Regimes: History

The Gold Standard had some basic rules:

No restrictions on imports/exports of gold

• Disadvantages:

• The gold standard regime imposes very rigid discipline on the policy makers :

• The money supply in the country must be tied to the amount of gold the monetary authorities have in reserve.

• When a country loses (gains) gold, money supply must contract (expand) and vice versa.

Exchange Rate Regimes: History

The Bretton Woods System (1944-1976) Under the Breton Woods Agreement each govt.

pledges to maintain a fixed/pegged exchange rate for its currency vis-à-vis the dollar

The US government undertook to convert the US dollar freely into gold at a fixed parity of $35 per ounce

Other member countries of the IMF agreed to fix the parities of their currencies with the dollar with variation within 1% on either side of the central parity being permissibleIt was an Adjustable Peg system. Central parity could be changed in the face of “fundamental disequilibrium”.

Exchange Rate Regimes: History

This system could work as long as other countries had confidence in the stability of the US dollar

The system came under pressure and ultimately broke down when this confidence was shaken starting mid 1960’s.

US BoP deficit Increased speculative activities Major currencies started floating in early

1973.

Post-Bretton Woods System

Most countries shifted to floating exchange rate system

Change in the role of IMF The European Monetary System

Treaty of Rome (1957) was signed by 6 European countries to form European Economic Community (EEC)

Ultimate aim economic integration Agreed to lift up restrictions on factor

movements and harmonize domestic policies Adopted a Common Agricultural Policy where

uniform prices for farm products Single European Act of 1986 converted EEC into a

common market on January 1, 1993 Accepted Euro as their common currency 1999

Is there an ideal Exchange Rate Regime?

• Fixed rates provide a policy anchor & discipline.

• Freely floating rates provide monetary policy freedom.

• There is no such thing as "the ideal" exchange rate regime for all countries or even for a given country at all times

• Crawling pegs, crawling bands, managed float etc. attempts to get the best of both the worlds

The International Monetary Fund (IMF)

The Role of IMF Framework of the Articles of Agreement adopted at

Bretton Woods in1944 Establishment of 2 new institutions – IMF and

IBRD (World Bank) Increasing international monetary cooperation Promoting the growth of trade Promoting exchange rate stability Establishing a system of multilateral payments,

eliminating exchange restrictions which hamper the growth of world trade and encouraging progress towards convertibility of member currencies