International monetary system

 International monetary system refers to the system prevailing in world

foreign exchange markets through which international trade and
capital movement are financed and exchange rates are determined.

 International Monetary System is part of the institutional framework

that binds national economies, such a system permits producers to
specialize in those goods for which they have a comparative
advantage, and serves to seek profitable investment opportunities on a
global basis’’
Historical Background

 Classic Gold Standard (1875 – 1914)

 Interwar Period (1915 – 1944)
 Bretton Woods Agreement (1945 – 1972)
 Smithsonian Agreement (1971)
 Managed Float(1973 to present)
Gold standard

 Gold Specie Standard

 Gold Bullion Standard : Mint par parity theory

 Requisite:
 1. Fix conversion rate
 2. Free flow of gold between countries
 3. Money tied in reserve
Pros and Cons of Gold standard

 Pros  Cons
 Stable exchange rate  Limitation of production of gold thus
limiting the creation of money
 Automatic correction of
misalignment  Unequal geographic distribution of
gold
 Rigid discipline on policy makers
World War periods

 Currencies failed
 US saw trade surplus
 Suspension of gold standard
Bretton woods

 Establishment of International monetary fund

Member U.S Gold

Currency Dollar
Bretton wood

 Establishment of IMF
 All member countries were to fix the value of currency for gold but
were not allowed to convert currencies for gold. The currencies were
linked to dollar via their par value. The dollar war convertible into gold
at 35 $ per ounce
 Exchangeable rates could be readjusted at certain times under certain
conditions.
 Each country was allowed to have a 1% band around which their
currency was allowed to fluctuate around the fixed rate.
SMITHSONIAN AGREEMENT (1971)

 • Attempt to save Bretton Woods system

 .• Conditions - Price of gold was raised to $38 per ounce - Countries revalued its
currency against US dollars up to 10%

 Snake in the tunnel and worm in the snake

• Exchange rate band was expanded to+/- 2.25 % ( European currencies were permitted
to fluctuate against dollars)
• European countries allowed to fluctuate against each other by +/-1.25%
• Belgian and Dutch were allowed to fluctuate +/- 1% against each other

 Devaluation of dollar did not stabilize the situation. • Existed less than 2 years.
Bretton Wood

•  Lead to problem of lack of international liquidity.

• Countries began holding less in dollars and more keen on holding gold.
• Any pressure to devalue the dollar would cause problems throughout
the world.
• The trade balance of the USA became highly negative.
• Large amount of US dollars was held outside the USA that 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.
Special Drawing rights

 Special Drawing Rights (SDR) are the monetary unit of the reserve
assets of the International Monetary Fund (IMF). The unit was created
in 1969 in support of the Bretton Woods system of fixed exchange
rates to alleviate the shortage of U.S. dollar and gold reserves in the
expansion of international trade.
Special drawing rights

 The special drawing rights were created by opening an account in the

name of each member countries and crediting it with assigned quota
 The total volume created has to be Ratified by governing board and its
allocation among members is proportional to their quotas
 In 1976 – 16 currencies
 In 1981- 5 currencies
 Now there are four currencies $, Pound, Euro and Japanes Yen
Special drawing rights

• Special Drawing Rights are allocated to member states as a low cost

alternative to debt financing for building reserves.

• Special Drawing Rights carry an interest rate that is computed weekly

by the IMF. It is paid or received quarterly by the members for
deviations of their SDR holdings from their SDR allocations.
• Special Drawing Rights are denoted with ‘XDR’.
• SDRs are equal to a basket of 4 currencies with FIXED amounts,
however due to changing FX rates the relative weightings change with
time
Valuation of SDR
The exchange rates for the Japanese yen and the Chinese Yuan are expressed in terms of currency units per U.S. dollar; other
rate are expressed as U.S. dollars per currency unit . 

Currency amount U.S. dollar Percent change in exchange rate against U.S. dollar from previous
Currency Unit Exchange rate 1
under Rule O-1 equivalent calculation

1.0174 6.97110 0.145945 -0.120

Chinese yuan

Euro 0.38671 1.11305 0.430428 -0.492

11.900 108.02500 0.110160 0.694

Japanese yen

U.K. pound 0.085946 1.30570 0.112220 -1.072

0.58252 1.00000 0.582520

U.S. dollar
1.381273
U.S.$1.00 = SDR 0.723970 2 0.200 3

SDR1 = US$ 1.381270 4

European union

 In 1991 the Maastricht European council union reached an agreement

on draft treaty of European union which called for introduction of a
single European currency
 I stage- removing of controls
 II stage- institutional development
 III stage- meeting of certain criterian by member countries
 Towards single currency
PROS and CONS

 Advantages:
 No hedging
 Price transparency
 Promotion of trade and cross border investment
 Political cooperation
 No transaction cost

Disadvantages
• Loss of national monetary and exchange rate policy independence
Fixed Rate system

 Advantages
 Eliminates source of uncertainty , it fosters trade and investment
 Poorer nation get foreign exchange at cheap price
 Disadvantage
 It does not respond to changes in economy
 Requires rigorous control by monetary authorities
Advantages of floating exchange rate

• Automatically may correct international trade imbalance

• Eliminates opportunity cost of reserve
• Does not require regular monitoring by monetary authorities
• Market determined

 Disadvantage
• Greater exchange rate volatility discourage trade
Current exchange rate regime

 Floating- Independent or managed

 Pegging of currency
 To a single currency
 To a basket of currency
 To SDR
 To crawling peg
 To currency board arrangement
Target zone arrangement
Forex regimes
No separate legal tender

 As stated by the IMF, under an exchange arrangement with no

separate legal tender, “the currency of another country circulates as
the sole legal tender
 Eg: formal dollarization. In this case, the country adopts the dollar as
its currency. the US Dollar has legally circulated in Panama. In other
words, in practice, the currency used day-to-day in Panama is the US
dollar, which is also legal tender. The official currency of Panama is the
Balboa,.One Balboa is divided into 100 cents. Since 1904 one Balboa
equals one US Dollar and since then,
Currency board and Fixed rate
system

 As defined by the IMF, a currency board agreement is “a monetary regime

based on an explicit legislative commitment to exchange domestic
currency for a specific foreign currency at a fixed exchange rate,
combined with restrictions on the issuing authority”.
 It should have 100 percent coverage of monetary supply backed up with
foreign currency
 They are the extreme examples of fixed rate system. Here Central bank is
does not have any other capability except of converting domestic
currency to foreign currency
 Though In fixed rate system there are limited ways to pursue other goals
without disrupting the exchange rate
Target zone

 An agreement between two countries to keep exchange rate of their

currencies within a certain range of fixed rate
 Target zone arrangement requires that countries coordinate their
monetory policy
Pegging

 When pegged exchange rate agreements are set up, an initial target exchange rate
is agreed upon by the participating countries.
 A fluctuation range is also set in place to outline acceptable deviations from the
target exchange rate.
 Pegged exchange rate agreements usually have to be reviewed several times over
their lifetimes in order to adapt the target rate and fluctuations to the changing
economic climate.
 places pressure on governments to be more disciplined with monetary policy choices
 Two types
 adjustable peg system is closer to fixed exchange rate policy,
 the crawling peg system is closer to the flexible exchange rate policy.
Pegging (contd)

 Smaller economies that are particularly susceptible to currency

fluctuations will “peg” their currency to a single major currency or a
basket of currencies.
 These currencies are chosen based on which country the smaller
economy experiences a lot of trade activity with or on which currency
the nation’s debt is denominated in.