IFM

Q1. Evolution of international monetary system.

International monetary system:

• The international monetary system is a set of conventions and rules that support cross-border investments, trades,
and the reallocation of capital between different countries.
• These rules define how exchange rates, macroeconomic management, and balance of payments are addressed
between nations.
• The international monetary system structure was reformed after the North Atlantic financial crisis of 2008-2009.
Evolution of international monetary system:
• The international monetary system has undergone significant evolution over the past centuries, shaped by various
economic, political, and technological developments. Here's a brief overview of its evolution:
1.Gold Standard (1880-1914):
• Back in the late 1800s to early 1900s, many countries used gold as the basis for their currencies.
• The Gold Standard was established in the 19th century, where currencies were directly pegged to gold. It meant
one could exchange money for a certain amount of gold. Example: Each dollar or pound being worth a set amount
of gold.
• This system provided stability and facilitated international trade, but it also constrained monetary policy flexibility.
• The classical gold standard era lasted until the outbreak of World War I.
2. Interwar Period and Great Depression (1914 - 1944):

• The interwar period saw the breakdown of the gold standard due to the economic turmoil caused by World War I
and the Great Depression(1929-1939).
• Countries abandoned the gold standard and adopted flexible exchange rates, capital controls, and competitive
devaluations to manage their economies.
• The instability of this period led to calls for a new international monetary system.

3. Bretton Woods System (1944 - 1971):

• In 1944, representatives from 44 Allied nations gathered at Bretton Woods, New Hampshire, to design a new
international monetary system.
• Countries agreed on a new system where the US dollar was tied to gold, and other currencies were tied to the US
dollar. So indirectly, these other currencies were still linked to gold. It was like a hierarchy with the US dollar at
the top.
• The International Monetary Fund (IMF) and the World Bank were created to promote exchange rate stability and
provide financial assistance for reconstruction and development.
• The Bretton Woods system collapsed in 1971 when the United States abandoned the gold standard, leading to
the adoption of flexible exchange rates.

4. Jamaica system (1971 - present):

• This is what we have now. It's more flexible. Countries' currencies aren't tied to gold anymore. Instead, their
values are determined by supply and demand in the foreign exchange market.
• Following the collapse of the Bretton Woods system, most major currencies adopted floating exchange rates,
where market forces determine currency values.
• This system provides countries with greater flexibility in conducting monetary policy and responding to economic
shocks.
5. Recent Developments:

• The rise of digital currencies and blockchain technology has sparked discussions about the potential future of
money and the international monetary system.
• Central bank digital currencies (CBDCs) and privately issued cryptocurrencies have raised questions about how
they might fit into the existing system or potentially reshape it.
• There have also been ongoing debates about reforming international financial institutions like the IMF to better
address contemporary global economic challenges, such as financial crises, development issues, and income
inequality.

SQ

Q1. Meaning of monetary system and financial system.

Monetary system Financial system

A monetary system is a set of institutions, laws, and A financial system is a collection of institutions and
procedures that govern the creation, distribution, use, practices that allow the exchange of funds between
and regulation of money in an economy. investors, lenders, and borrowers.

Modern monetary systems usually consist of the national This includes banks, credit unions, stock exchanges, bond
treasury, the mint, the central banks and commercial markets, insurance companies, mutual funds, and
banks. various other intermediaries and financial instruments.

The monetary system plays a crucial role in influencing The financial system provides the infrastructure for
economic activity, controlling inflation, and stabilizing allocating capital efficiently, managing risk, and
financial markets. facilitating investment and consumption decisions.

There are three common types of monetary systems- The four main components of a financial system are:
▪ commodity money ▪ Financial institutions
▪ commodity-based money ▪ Financial assets
▪ fiat money ▪ Financial services
(Currently fiat money is the most common type of ▪ Financial markets
monetary system in the world. For example, the US
Dollar is fiat money.)

Q2. Types of exchange rate risk

• Exchange rate risk refers to the potential for losses arising from fluctuations in exchange rates. Here are some
common types of exchange rate risk:
Transaction risk:
• This type of risk arises from the effect of exchange rate fluctuations on transactions denominated in foreign
currencies. For example, a company that exports goods and invoices its customers in foreign currency faces
transaction risk if the value of that currency falls against its own currency before the payment is received.
Translation risk:
• It impacts financial statements of multinational corporations. It Results from converting financial results of foreign
subsidiaries into the reporting currency.
Economic risk:
• Economic risk refers to the impact of exchange rate fluctuations on a company's overall competitiveness, market
position, and future cash flows due to changes in macroeconomic factors like inflation, interest rates, and economic
growth.
Q3. Types of exchange rate regimes
• Exchange rate regimes refer to the way a country manages its currency in relation to other currencies. Here are
some common types:
Fixed exchange rate regime:
• Under this regime, the value of the currency is pegged or fixed relative to a reference currency or a basket of
currencies.
• Examples- The Chinese Yuan (CNY) has been fixed, or pegged, to the US dollar to a certain extent since 1994. This
has kept the Yuan low in comparison to the US dollar, which makes Chinese goods appear cheaper. Currently, it is
at about 6.50 CNY to one USD. This has allowed China to maintain a trade surplus with the United States and grow
its GDP by about 10% annually.
Floating Exchange Rate Regime:
• It allows currency values to be determined by market forces of supply and demand, with minimal intervention
from central banks. This system is flexible and market-driven.
Managed Float (Dirty Float):
• A mixed of fixed and floating where the currency is primarily allowed to float but with occasional intervention by
the government or central bank to stabilize its value.
Q4. Direct quote and indirect quote
Direct Quote Indirect Quote
This is a method of quoting exchange rates where the Indirect quote expresses the foreign currency in terms of
domestic currency is expressed in terms of a certain a certain amount of domestic currency.
amount of foreign currency.

The direct form of quotation is also called European An indirect form of quotation is also known as American
currency quotation. currency quotation.

A direct quote is the numbers of units of a local currency An indirect quote is the number of units of a foreign
exchangeable for one unit of a foreign currency. currency exchangeable for one unit of a local currency.
 Example: If you're in the United States and you want to Example: If the indirect quote is 1 INR = 0.012 USD, it
know how many US dollars it takes to buy one Indian means that one Indian Rupee is equivalent to 0.012 US
rupee, the direct quote would be expressed as the Dollars.
amount of USD per INR (e.g., 1 USD = 83 INR).

Q5. Nominal and real exchange rate

Nominal exchange rate Real exchange rate
The nominal exchange rate is the rate at which one The real exchange rate is the rate at which one country's
country's currency can be traded for another country's goods and services can be traded for another country's
currency. goods and services.

Nominal exchange rate is determined by macro factors Real exchange rate is determined using the nominal
and demand & supply of currency. exchange rate.
The nominal exchange rate is simply the rate of exchange The real exchange rate reflects the relative purchasing
between two currencies. power of two currencies after accounting for differences
in price levels.
For example, if 1 US dollar can be exchanged for 110 Formula:
Japanese yen, the nominal exchange rate between the Real exchange rate= Nominal exchange rate x (domestic
US dollar and the Japanese yen is 110. price index/ foreign price index)

Q6. Depreciation
• Depreciation is when a currency's value decreases relative to other currencies.
• For example, if the exchange rate of the EUR-USD moves from 1.15 to 1.00, the euro has depreciated by 13%
against the U.S. dollar.
• Currency depreciation can cause inflation because imports become more expensive.
• When a currency loses value, people's purchasing power declines as well because products — especially imported
ones — cost more money.
• However, currency depreciation creates the impact of making exports cheaper to foreign markets.
• An increase in export demand can lead to more productivity in the country and the creation of employment
opportunities in an effort to meet export demand.
Q7. Appreciation
• Appreciation refers to an increase in the value of one currency in relation to another currency.
• It means that one unit is capable of buying more foreign currency than before.
• It occurs when the exchange rate for a currency rises over time.
• Currency appreciation benefits importers as they have to pay less in domestic currency for imported goods.
• Some reasons for currency appreciation include:
 ▪ Demand for domestic currency: A global market's demand for domestic currency
▪ Inflation: A rise in inflation
▪ Interest rates: Interest rates due to government borrowings or fiscal policy flexibility
▪ Government spending: An increase in government spending

Q8. Devaluation

• Devaluation is the deliberate downward adjustment of the value of a country's money relative to another currency
or standard.
• It is a monetary policy tool used by countries with a fixed exchange rate or semi-fixed exchange rate.
• This can be done by the country's central bank or monetary authority through various policy measures, such as
reducing interest rates, selling foreign currency reserves, or implementing quantitative easing.
• Devaluation can have several purposes, including
▪ improving trade competitiveness
▪ increasing exports
▪ correcting trade imbalances
• Devaluation can affect finances by making imports more expensive, potentially leading to inflation, but it can also
boost exports and overall economic growth.
Q9. Revaluation

• Revaluation is the upward adjustment of a currency's value relative to a chosen baseline. The baseline can be wage
rates, the price of gold, or a foreign currency.
• Revaluation can occur naturally in response to market forces or be intentionally implemented by the government
or central bank.
• A currency revaluation, although less common than devaluation, can be a response to a couple of things-
▪ interest rate
▪ changes in the foreign market affect how competitive a nation is in international trade
▪ change in leadership can cause political shifts that affect a market and its perceived stability
• Revaluation can help reduce inflationary pressures by making imports cheaper and can also improve the
purchasing power of citizens.
• The effect of revaluation is to increase imports and decrease exports, which helps close the inflationary gap by
reducing aggregate demand.