CONCEPTS QUESTIONS: 1) Gold Bullion Standard:

The basis of money remains a fixed weight of gold but the currency in circulation consist of paper notes with the authorities standing ready to convert unlimited amounts of paper currency in to gold and vice-versa, on demand at a fixed conversion ratio. Thus a pound sterling note can be exchanged for say x ounces of gold while a dollar note can be converted into say y ounces of gold on demand. 2) Gold Exchange Standard: Gold Exchange Standard was established in order to create additional liquidity in the international markets. Hence the some of the countries committed themselves to convert their currencies into the currency of some other country on the gold standard rather than into gold. The authorities were ready to convert at a fixed rate, the paper currency issued by them into the paper currency of another country, which is operating a gold specie or gold bullion standard. Thus, if rupees are freely convertible into dollars and dollars in turn into gold, rupee can be said to be on a gold exchange standard. 3) The Gold Standard: This is the oldest system which was in operation till the beginning of the First World War and a for few years thereafter ie it was basically from 1870 - 1914. The essential feature of this system was that the gouvernment gave an unconditional guarentee to convert their paper money to gold at a prefixed rate at any point of time or demand. 4) Triffins Paradox: The Bretton Woods System had some contradictions which were pointed out by Prof. R Tryffin which were :- The system depended on the dollar performing and its role as a key currency. Countries other than the U.S had to accumulate dollar balances as the dollar was the means of International payment. This meant that the US had to run BOP deficits so that other countries could build up a stock of claims on the US. When the US deficits started mounting, other countries started losing faith in the ability of the US to convert their dollar asset into gold. 5) Fixed exchange rate As the name suggests, under fixed exchange rate system, the value of a currency in terms of another is fixed. These rates are determined by governments or central banks of the respective countries. The fixed exchange rates result from pegging their currencies to either some common commodity or to some particular currency. The rates remain constant or they may fluctuate within a narrow range. When a currency tends crossing over the limits, governments intervene to keep within the band. Normally countries pegs its currency to the currency in which the major transactions are carried out or some countries even peg their currencies to SDR. For example

: - US dollar has 24 currencies pegged to itself whereas French franc has 14 currencies and 4 currencies are pegged to SDRs. The major advantage of this system is that it provides stability to international trade and exchange rate risk is reduced to some extent. Because of the fixed exchange rate system, exporters and importers are clear how much they have to pay each other on the due date. The disadvantage is that it is prone to speculation i.e. a speculator anticipating devaluation of pound sterling will buy US dollars at a forward rate so as to sell them when devaluation of the pound takes place. 6) Floating Exchange Rates: When the relative price of currencies are determined purely by force of demand and supply and when the authorities make no attempt to hold the exchange rate at any particular level within a specific band or move it in a certain direction by intervening in the exchange markets, it is referred to as Floating Exchange Rate. 7) Crawling Peg: A crawling peg rate is a hybrid of fixed and flexible exchange rate systems. Under this system, while the value of a currency is fixed in terms of a reference currency, this peg keeps on changing itself in accordance with the underlying economic fundamentals, thus letting the market forces play a role in the determination of the change in exchange rate. There are several bases which could be used to determine the direction of change in the exchange rate for example the actual exchange rate ruling the market, t there is gradual modifications with permissable variations around the parity restricted to a narrow band. The change in parity per unit period is subject to a ceiling with an additional short term constraint, e.g. parity change in a month cannot be more than 1/12th of the yearly ceiling. Parity changes are carried out , based on a set of indicators. They may be discretionary, automatic or presumptive. The indicators are : current account deficits, changes in reserves, relative inflation rates and moving average of past spot rates. Countries such as Portugal and Brazil have in the part adopted variants of Crawling Peg. 8) Adjustable Peg: Adjustable Peg system was established which fixed the exchange rates, with the provision of changing them if the necessity rose. Under the new system, all the members of the newly set up IMF were to fix the par value of their currency either in terms of gold, or in terms of US dollar. The par value of the US dollar was fixed at $ 35 per ounce. All these values were fixed with the approval of the IMF, and were reflected in the change economic and financial scenario in the countries engaged in international trade. The member countries agreed to maintain the exchange rates for their currency within a band of one percent on either sides of the fixed par value. The extreme points were to be referred to as upper and lower support point, due to which requirement that the countries do not allow the exchange rate to go beyond these points. The monetary authorities were to stand ready to buy or sell the US dollar and thereby support the exchange rates. For this purpose, a country which would freely buy and sell gold at the aforementioned par value for the settlement of international transactions was deemed to be maintaining its exchange rate within the one percent band.

9) Special Drawing Rights(SDRs): The IMF created an asset called Special Drawing Rights by simply opening an account in the name of each member country and crediting it with a certain amount of SDRs. The total volume created has to be ratified by the gouverning board and its allocation among the members is propotional to their quotas. The members can use it for settling payments among themselves as well as for transactions with the fund. E.g. paying the reserve tranch contribution of an increase in their quotas. 10) Devaluation : The lowering of a countrys official exchange rate in relation to a foreign currency (or to gold) so that exports compete more favourably in the overseas markets. Devaluation is the opposite to revaluation. 11) Lerms: An acronym for liberalization Exchange Management System that was introduced from March 1, 1992 under which the rupee was made partially convertible. The objective was to encourage exporters and induce a greater inflow of remittances through proper channels as well as bring about greater efficiency in import substitution. Under the system, percent of eligible foreign exchange receipts such as exports earnings or remittances was to be converted at the market rate and the balance 40% at the official rate of exchange. Importers could obtain their requirements of foreign exchange from authorized dealers at the market rate. Because of certain weaknesses, this system was replaced by a unified exchange rate in March 1993. This unification was recommended as an important step towards full convertibility by the committee on balance of payments under the chairmanship of C Ragranajan. Under the unified rate system all foreign exchange transactions through authorized dealers out at market determined rate exchange.

12) Custom Union: Custom Union is a form of economic integration in which two or more nations agree to free all internal trade amongst themselves while levying a common external tariff on all non-member countries. The theory of custom unions and economic integration is associated primarily with the work of Prof. Jacob Viner in the 1940s. This theory mainly focuses on optimum utilization of resources present in the member countries. Integration provides the opportunity of industries that have not yet been established as well as for those that have to take advantage of economies of large scale production made possible by expanded markets. 13) Dirty float:

The authorities are intervened more or less intensely in the foreign exchange market in which there are no officially declared parties, but there is official intervention that has come to be known as managed or dirty float. 14) Gold Tranche: Member countries have an absolute claim on the IMF upto the amountof gold subscriptions they have made. In operational terms, they can draw this amount (= 25% of their quota) from IMF any time. This is called reserve tranche or gold tranche and is treated as the reserve of the country concerned. However, this sum is reimbursed to the IMF within a specified period varying from 3 months to 5 years. 15) Credit Tranches : Any member can unconditionally borrow the part of its quota which it has contributed in the form of SDRs or foreign currency. When it can borrow upto 100% of its quota in four futher tranches it is called credit tranches. (Tranche means a slice) 16)International Liquidity : It refers to the stock of means of international payment

17) Extended Fund Facility (EFF): This facility was established in 1974 by the IMF to help countries address more protracted balance-of-payments problems with roots in the structure of the economy. Arrangements under the EFF are thus longer (3 years) and the repayment period can extend to 10 years, although repayment is expected within 4 -7 years. .

DESCRIPTIVE QUESTIONS
Q1.

How far SDRs have been able to solve the problem of international liquidity?

Ans: - As the Bretton Woods system started facing problems, and the pressure on the dollar increased, a new reserve asset named SDRs was created by IMF in 1967. This international currency was allocated to the IMF member countries in proportion of their quotas. The biggest benefit of SDRs was that there was a provision for international money to be created without any country needing to run a BoP deficit or to mine gold. Its value lay not in any backing by a currency or a real asset (like gold), but in the readiness of the IMF countries to accept it as a new form of international money. Any member country, when facing payment imbalances arising out of BoP deficits, could draw on these SDRs as long as it maintained an average balance of 30% of its total allocations. It could sell these SDRs to a surplus country in exchange for that countrys currency and use it for settlement of international payments. Every member country was obliged to accept up to 3 times its total allocations as a settlement of international payments. It was an interest bearing source of finance, i.e. countries holding their SDRs receive interest and the one drawing them pay interest. These rates were determined on the basis of the average money market interest rates prevailing in France, Germany, Japan, UK and US. Only the member countries of IMF and specific official institutions are eligible to hold SDRs. It is also an account of all IMF transactions. The value of a SDR was initially determined as equal to that of a dollar, i.e., one ounce of gold was equalized to 35 SDRs. Later, its value was revised and put equal to the weighted average value of 16 major currencies US dollar, yen, pound sterling, DM, and French Franc. Both the times the weights were based on the importance of the respective countries in world trade. An important advantage of SDRs was that its value was more stable than that of individual currencies. This happened because it derived its value from a number of currencies, whose values were unlikely to vary in the same direction and to the same extent thus making it a better unit than a single currency. However, despite the introduction of SDRs, the problem of international liquidity crisis was not solved. US gold holdings had reduced considerably and by 1979, its reserve turned negative as the BoP deficit increased drastically. There was great pressure on the US in the early 1971, because a number of countries had to buy a lot of dollars to defend their exchange rates. The condition of US worsened because it suffered from a trade deficit causing great unemployment. This problem continued for some period of time thus reducing the validity of SDRs to resolve the international liquidity crisis.

Q.2) Ans.

Bretton Woods System was valid as along as it lasted Discuss. Conference was held at Bretton Woods in USA in July, 1944, in order to put in place a new international monetary system. The main characteristics of the International Monetary System developed at Bretton Woods are summarized below:

a) Fixed Rates in terms of gold, but only the US $ was convertible into gold as the US ensured convertibility of the dollars into gold at international level. b) A procedure for mutual international credits. c) Creation of International Monetary Fund to supervise and ensure smooth functioning of the system. Countries were expected to pursue the economic and monetary policies in a manner so that currency fluctuations remained within a permitted margin 11%. This cause meant the Central Bank of every country has to intervene to buy or sell foreign exchange, depending on the need. d) Devaluation or Revaluation of more than 5% had to be done with the permission of IMF. The Bretton Woods System lasted from 1944 to 1971. The Bretton Woods planners expected that after a brief transition (5 years) the international economy would recover and the system would enter into operation. From 1945 to 1947, the US actively pressed for implementation of the Bretton Woods system as originally conceived (US provided resources to the IMF and the World Bank and urged other countries to do likewise) By 1947, the US conclude that the Bretton Woods system was not working and that the Western system was on the verge of collapse (WWII had destroyed the European economic system, and the IMFs modest credit facilities were insufficient to deal with Europes huge needs). In 1960s the US balance of payment deficits started mounting. In 1968, convertibility of privately held Dollar into Gold was abandoned and in 1971 convertibility was completely abandoned. The US managed the international monetary system by providing liquidity: gold production was insufficient; the dollar was the only strong currency to meet the rising demands for international liquidity. The strength of the US economy, the fixed relationship of the dollar to gold ($35 an ounce), and the commitment of the US government to convert dollars into gold at that price made the dollar as good as gold. But there was a huge dollar shortage (the US was running trade surpluses); and in order for the system to work, it would be necessary for the US to reverse this flow and to run a payment deficit, which of course happened The primary factor for the collapse of the system was currency convertibility into Gold. This idea can be explained with the Triffins Paradox. It is said that the entire monetary system depended on the Dollar performing its role as the key currency. Countries other than the US had to accumulate dollar balances as the dollar was the means of international payments. This meant that the US had to run balance of payment deficits (Foreign Exchange Deficits) so that the other countries could build up a stock of claims on the US. As long as US deficits

were moderate, this worked fine, but when they started mounting it lead to crisis of confidence viz. Other countries started losing faith in the ability of US to convert dollar into gold. Gold demands for such conversion began to be made in the early 60s by the French followed by other countries in suit. Soon it was obvious that US did not possess enough gold to honour its convertibility commitment if all holders of dollar assets decided to demand gold. Thus, a series of events finally led to the US abdicating its role as an anchor of the World Monetary System. Several attempts to revise the system trough a series of parity realignments, Dollar revaluation (in terms of gold) and widening the brands of permissible variations around central parties, failed thus making the Bretton Woods System totally invalid in 1978.

Q.3) What are the objectives of IMF ? How far has it achieved it ? Ans. The IMF is an international organisation consisting of 183 member countries. It was created : To promote international monetary corporation; To facilitate expansion and balanced growth of international trade; To promote exchange stability; To assist in the establishment of multilateral system of payments; To make its general resources temporarily available to its members experiencing balance of payment difficulties under adequate safeguard. To shorten the duration and lessen the degree of disequilibrium in the intenational balance of payments of members. According to the Articles of Agreement of IMF Article I, the main objectives of IMF are : To promote international monetary corporation through a permanent institution which provides machinery for consultation and collaboration on International Monetary Problems. To facilitate the expansion and balanced growth of international trade and contribute thereby to the promotion and maintenance of high levels of employment and real income to the development of the productive resources of all members as primary objectives of economic policy; To promote exchange stability to maintain orderly exchange agreement among the members and to avoid competitive exchange depreciation. To assist in the establishment of multilateral system of payments in respect of current transactions between members in the elimination of foreign exchange restrictions, which hamper the growth of world trade. To give confidence to the members by making the general resources of the fund temporarily available to them under adequate safeguard, thus providing them with opportunities to

correct mal-adjustments in their balance of payment without resorting to measures destructive of national and international prosperity. In accordance with the above, to shorten the duration and lessen the degree of disequilibrium in the international balance of payment of members. The capital of IMF is contributed by totality of the subscription of member states known as Quotas. These Quotas are determined as per the economic importance of each country reflected / measured in terms of national income, exports etc. Since 1970 a new instrument of reserve has been created viz. SDR (Special Drawing Rights). The value of SDRs represent a weighted average of five currencies i.e. US $ - 40%, German Deutsche Mark 21%, U.K. pound 11%, French Francs 11% and Japanese Yen 17%. The weights reflect the relative strength of these countries. The Quotas of different countries are paid to the IMF in the ration of 25% as SDRs and 75% as in the national currency. The member countries can withdral equal amount of gold subscriptions (on 25% of the Quota) under the Gold Tranch System. Beyond 25% a country can draw upon its Credit Tranch. Approval from the IMF is necessary for a country to draw on its Credit Tranch . Temporary increase of Credit Tranch to 400% of the Quota has been allowed against the statutory 200% of the Quota. The approval becomes strict as the drawings on the credit rise. This tentional credit is used by the borrowing countries to finance their temporary disequilibrium in balance of payments. Besides these Tranches, the IMF has three permanent credit facilities : 1. Compensatory Financing : Compensatory Financing facility established in 1963 was available when temporary export shortfall existed for reasons beyong members control. 2. Buffer Stock Financing Facility : This facility was established in 1969 which was available when an International Buffer Stock of funds excepted as suitable fund exists. 3. Extended Facility : It was established in 1974 and was available to overcome structural balance of payment maladjustments. There are other temporary facilities created in response to specific needs such as oil price increase and special emergency funds credited under General Agreement to Borow (GAB). The IMF has increasingly become the lender of last resort for countries, especially in Africa, with desperate difficulties of external insolvency, extreme poverty, and adjustment. The IMF's role has as a consequence increasingly overlapped with the World Bank's International Development Association (IDA). It is to the credit of the IMF that it has managed to transform itself from an intimidating ogre to a welcome source of concessional assistance. The Fund has a valuable role in financing developing countries, a role that has been strengthened by the Enhanced Structural Adjustment Facility (ESAF), which lends on highly concessional terms to low-income countries. However it was not able to provide

oversight of the international monetary system as a whole, but only to its most indigent members.

Q4). Examine the transformation of the European Union from a political and economic union to a monetary union. Ans: - The basis of the European Monetary Union was to build a united Europe after the World War II. This was initiated by when the European nations created the European Coal and Steel community, with a view to freeing trade in these two sectors. The pricing policies and commercial practices of the member nations of this community were regulated by a supranational agency. In 1957, the Treaty of Rome was signed by Belgium, France, Germany, Italy, Luxemburg and the Netherlands to form the European Economic Community (EEC), whereby they agreed to make Europe a common market. While they agreed to lift restrictions on movements of all factors of production and to harmonize domestic policies, the ultimate aim was economic integration. The EEC achieved the status of a customs union by 1968. In the same year, it adopted a Common Agricultural Policy (CAP), under which uniform prices were set for farm products in the member countries, and levies were imposed on imports from non- member countries to protect the regional industry from lower external prices. In the European unification, power was given to all member countries that they could veto any decision taken by other members. This hindrance was removed when the members approved of the Single European Act, in 1986, making it possible for a lot of proposals to be passed by weighted majority voting. This paved way for the unifications of the markets for capital and labour, which converted EEC practically into a market on January 1, 1993. The Heads of State and governments of the countries of the EU decided at Maastricht on 9 th and 10th December 1991 to put in place the European Monetary Union (EMU). Adhering to the EMU meant irrevocable fixed exchange rates between different countries of the Union. The setting up of the EMU had been a step forward towards the introduction of a common currency in the member states of EU, as per the Maastricht Treaty. It had been ratified by all 12 countries which constituted the union at that point of time. The EMU completed the mechanism that started with the Customs Union of the Treaty of Rome and the big Common Market of the Single Act. The objectives of the EMU are: Adoption of an economic policy, based on a close coordination between economic policies of the member states. Fixing of irrevocable exchange rates leading to a single currency. Development of a single monetary policy having objective of price stability and the support to the economic policies of the member states in general.

The primary advantage of EMU was that it helped in stabilizing exchange rates in the currencies of member states. It also helped in elimination of transaction costs, greater transparency in prices and greater credibility with respect to the world outside. Also, EMU signified giving up a independent national monetary policy. There seemed to be an agreement among the member

states that the effect of the EMS would be beneficial for the economic growth of Europe. However it was anticipated there would be some problems in short and medium term. For instance, the programmes of structural adjustment carried out by the countries like Italy, Spain, Germany to reduce public deficits and inflation by a restrictive policy had negative effects on internal demand and growth. This policy also had negative effects on neighboring countries in terms of reduction of their international business. The countries which had not attained a required level of economic convergence found it difficult for maintaining the currency within the EMS. Thus the transformation of the European Union from a political and economic union to a monetary union has explained above along with the features of the EMU.