International Monetary System (IMS)

 is also known as “International Monetary and Financial System” and also “International Financial
Architecture.”
 is a well-designed system that regulates the valuations and exchange of money across countries.
 It is a well-governed system looking after the cross-border payments, exchange rates, and mobility of
capital.
 This system has rules and regulations which help in computing the exchange rate and terms of
international payments.
 mobilizes the capital from one nation to another by felicitating trade.
 Participants: MNCs (Multinational Corporations), Investors, Financial Institutions, etc.
 The main purpose is to enhance high growth in the world with stable price levels.
 Earlier the scope was only up to exchange rates. Now the system has a broader scope by taking
financial stability into consideration.
 has established International Monetary Fund (IMF) and the World Bank in the year 1944.

International Money Market

 Another name for this market is the foreign exchange or forex.
 is a money market but on a massive scale.
 This market enables investors, usually central banks of different countries, to lend and borrow money.
 Participants: Central banks and major commercial banks
 This market deals in short-term instruments, mainly those that mature within the year.

Characteristics of International Money Market

1. Global Market
 It is likely the biggest financial market globally as it handles trillions of dollars of transactions on a daily
basis. Also, it is the most liquid market.

2. Participants
 Central banks and major commercial banks are the main participants in this market. Individuals also
participate in this market, but they typically transact small amounts.

3. Having an international network of dealers

 most of these dealers are commercial banks and investment banks.
 These dealers are usually in different countries with branches around the globe.

4. Exchange Rate Pairs

 The international money market usually works with pairs to determine the exchange rate between
currencies.
 For instance, GBP/USD tells about the exchange rate between British pounds and U.S. dollars.
Similarly, EUR/USD measures the rate between euros and U.S. dollars. Since the U.S. dollar is the
most active or popular currency, most pairs measure the value of one currency against the U.S. dollar.
Some currencies, however, do use currencies other than the USD as well.
 Even though the U.S. dollar is the most active currency, the United Kingdom accounts for the highest
amount of foreign exchange trading

5. Number of Transactions
 It is a very big market that trades almost 24 hours a day.
 this market trades every second, giving rise to constant small fluctuations.
 These small movements could be as tiny as up to eight decimals. Such movements may appear small,
but when you are dealing with millions of dollars, it could result in thousands in profit or losses.

6. Trading In/Out of the Country

 The short-term instruments, such as bank deposits, are usually issued and traded outside of the nation
issuing the currency.

7. Pricing of Instruments
 The pricing of many instruments in this market depends on the benchmark, such as LIBOR.

8. Price Transparency
 is the highest in the international money market.
 transparency continues to improve with advancements in technology.
 In this market, a trader is able to directly trade with the market maker, ensuring higher transparency.
Trading directly with the market maker also means that traders get a fair price on all trades.
 9. Rules of Market
 Though it is an international market, each country has its rules for the transactions in the market. These
rules are for accounting, tax, payment and settlement, and banking laws.

10. Physical Offices

 has no physical offices. Rather, the dealers in this market are connected online and share information
with each other.

Advantages of Current International Monetary System

 IMS enhances financial stability and maintains the price level on a global scale. It also boosts global
growth.
 International Monetary System mobilizes money across countries and determines the exchange rate.
 This system encourages the governments of respective countries to manage their Balance of Payment
by reducing the trade deficit.
 IMS is a well-regulated system that makes the whole process of international trading smooth.
 This system relocates the capital from one country to another by enhancing cross-border investments.
 International Financial Architecture provides liquidity to the countries of the world.
 This system tries and avoids any short or long-run disruptions in the world economy.
 These advantages are non-exhaustive in nature.

Criticisms of Current International Monetary System

 Incompetent in avoiding global financial crises
 Unable to avoid financial breakdowns
 Sometimes, exchange rate remains misaligned

Central Banks' Control of Foreign Exchange Rates

Role of the Central Bank
 Since the exchange rate is directly linked to the economic stability, the central banks of all the countries
closely monitor the forex market and take adequate actions, whenever needed, to protect the vested
interests of the country they represent.
 The central banks play a major role in setting the currency exchange rates by altering the interest rates.
 By increasing interest rates the central banks indirectly stimulate traders to buy the respective country’s
currency. This process drives the value of the corresponding central bank’s currency higher in
comparison to other currencies.

Impact of Foreign Exchange Rate on Economy

1. International trade

 Industrial sector can grow only when a country has adequate foreign exchange. When the exchange rate
is poor, the value of goods which can be purchased for every dollar equivalent of currency will largely
decrease. This would deplete the foreign exchange resources quickly.
 a lack or shortage of foreign exchange would create difficulty in importing essential goods, raw materials,
and much needed machinery.
 When vital goods fall short of requirement there won’t be any surplus good available for export. This
would cause a spiraling effect on a country’s economic growth.

2. Service sector
 The local economy benefits when the currency exchange rate of a country is stronger. The reason is that
overseas clients need to spend more to purchase one dollar equivalent of service (tourism, banking etc.).

3. Technology transfer
 A country with a strong exchange rate will have better bargaining power. Additionally, it becomes easier
to purchase high end technologies without draining the foreign exchange reserves.

4. International remittance & capital inflows

 A country with a strong currency will not default from its debt obligations. Thus, investors will have no
issues in getting dividend / profit remittances. This would encourage capital inflow thereby strengthening
the local economy further.

Balance of payment theory or demand and supply theory

 As per this modern theory of exchange, which is currently accepted as the standard, the rate of
exchange equates to the demand and supply of foreign exchange.
 The rate of exchange is the price point where there is equilibrium between the forces of demand and
supply.
 When there is a surplus in the balance of payments the demand and consecutively the rate of
exchange will decrease due to unhindered flow of foreign exchange. On the other hand, a country with
a negative balance of payment will struggle to manage the foreign exchange reserve needs.
Correspondingly, the demand and rate of exchange will increase.
 The theory is comprehensive, practical and realistic. Even though the theory is widely accepted, still it
suffers drawbacks from assumptions related to balance of payments.

Why exchange rate changes often?

1. Gradual or abrupt change in the foreign exchange demand and supply scenario.
2. Changes in the volume of imports and exports.
3. Amendments in the monetary policy of a country.
4. Capital inflow and outflow from industries, stock market etc.,
5. Changes in the economic conditions (inflation, deflation)
6. Geo-political changes.
7. Changes in the banking sector.
8. Rise or fall in the average household income will contribute indirectly to a change in the exchange
rates.
9. Overall sentiment.
10. Activities of speculators.
11. Huge technological advancements will gradually affect the exchange rate in a positive manner.

Need for foreign exchange control

 Theoretically there is no limit for the rise or fall of a paper currency. Thus, adverse changes in the
exchange rates will create unmanageable economic instability.
 When the currency of a country strengthens (rise in the exchange rate) there will be positive effects
(rising productivity, lower unemployment, high economic growth, incentives to cut cots etc.,) overall.
 However, if a currency becomes stronger because of speculative activities then it would lead to a
recession.
 Swiss Franc is a classic example for a speculation driven currency. Problems in the USA and the Euro
zone naturally lure investors to Switzerland, which is considered as a safe haven for investments. Thus,
Swiss Franc often sees fundamental overvaluation and the central bank should intervene to prevent the
country from falling into recession.
 A weak currency will have undesirable effects on the economy. It will adversely affect imports and
capital inflows, which form the nerve center of any healthy economy. Thus, no responsible central bank
will allow its currency to fall freely. With a weak currency in place, no country in history has successfully
come out of debt or recession.
 Considering the facts mentioned above, it becomes very important to closely monitor the exchange rate
and intervene, if necessary, to keep the economy healthy and growth oriented.

Strategies adopted by central banks to control exchange rates

1. Direct and indirect methods

 If the exchange control strategy affects the conversion rate straight away then it is called as the direct
method. If the tactic affects some other sector but finally influences a change in the exchange rate then
it is called as the indirect method.

2. Unilateral, bilateral and multilateral methods

 Unilateral methods are strategies implemented by the central bank of a country without taking into
consideration the opinion of other countries. Bilateral and multilateral methods are those exchange rate
control mechanisms applied with mutual consent of two or more countries.

Unilateral Method
A. Exchange intervention or pegging
 It is a soft form of intervention in the market. As per this strategy, the central bank of a country will
intervene in the market to bring the exchange rate to a desired level, if there is a concern about
speculators driving the price too high or low.
 If the central bank buys the currency with an intention to increase the exchange rate then the currency
is said to be pegged up. Similarly, the currency is stated to be pegged down when the central bank
intervenes in the market to decrease the exchange rate. It should be noted that the intervention will not
cause permanent trend change.

B. Foreign currency exchange restrictions

 By controlling the demand and supply of currency, the central bank of a country can influence the
exchange rate. The following are the widely adopted measures to keep the exchange rate under check:

i. Blocked account
 The bank accounts of foreigners are blocked under this system. If there is a dire necessity the central
bank will even transfer funds from all the blocked accounts into one single account. However, it will
create bad impression about the country thereby leading to lasting negative effects on the economy as
a whole.
 ii. Multiple exchange rates
 Under this system, a central bank will have total control over the foreign currency and offer different
rates for purchase and sale by the importers and exporters respectively. This is done to control the
capital outflow from the country. It can be construed as rationing of foreign currency by price instead of
volume. The system is complex and only creates additional headaches to the central bank.

iii. Rationing of foreign exchange

 In this method, the control over foreign exchange will solely lie in the hands of the central bank, which
will decide the quantum of foreign exchange to be distributed for every incoming request. No individual
or corporate can hold foreign currency. Only urgent needs would be considered.

iv. Exchange Equalization Account (EEA)

 To control short-term volatility in the exchange rate, the central bank of UK, following the exit from the
Gold Standard, created a fund named Exchange Equalization Account in 1932 to prevent unwanted
volatility in the exchange rate of Pound Sterling. The strategy was later adopted by USA (Exchange
Stabilization Fund) and other European countries including Switzerland and France.

Advantages of foreign exchange control

 Results in exchange rate stability.
 Enables correcting adverse balance of payment scenario.
 Prevents depletion of gold reserves and foreign exchange reserves.
 Preserves capital flight.
 Fuels economic growth and stability.

Disadvantages of foreign exchange control

 Indirectly increases the level of administrative corruption.
 A large number of competent officials are required to manage the smooth functioning of the economy.
 Creates misunderstanding with major economic powers.
 Multinational companies are discouraged from making large commitments.
 By and large, fundamental disequilibrium is created.
 Volume of international trade declines as a whole.

 Exchange control measures can be considered as a double-edged sword. There may be situations
where exchange control measures would be temporarily necessary. However,

Manage floating system

- based on market demand and supply conditions
- has been in place since 1976 with the Jamaica Agreement. Later in 1980, the International Financial
Architecture was regulated by G-5 countries. This G-5 group has currently turned into G-20, with a group of 20
countries managing the exchange rate on managed float system.

Does government intervene?

- Yes, when the currency needs to be stabilize