The International

Monetary System
Part I
 Introduction

 The international monetary system refers to

the institutional arrangements that countries
adopt to govern exchange rates
Introduction

International monetary systems are sets of

internationally agreed rules, conventions
and supporting institutions that facilitate
international trade, cross border investment
and generally the reallocation of capital
between nation states
 Introduction

 It addresses to solve the problems relating to

international trade:

a. Liquidity
b. Adjustment
c. Stability
 The problem of Liquidity

 The problem of liquidity existed even in the

domestic transactions through barter
system
 Barter system was replaced by precious
metals as a medium of exchange and store
of value
 Gold standard system of international
payments came into existence
 The Gold Standard

 The first modern

international
monetary system
was the gold Japan USA
standard
 Put in effect in 1850
 Participants – UK,
France, Germany &
USA
 Gold Standard- I ( 1876-1913)

● In this system, each currency was linked

to a weight of gold

● Under gold standard, each country had to

establish the rate at which its currency
could be converted to a weight of gold
E.g. $ 20.67/ ounce ; Pound 4.247/ once
 Gold Standard- I ( 1876-1913)

● Most of the countries used to declare par

value of their currency in terms of gold

● The problem was every country needed to

maintain adequate reserves of gold in
order to back its currency
 The Gold Standard

● After World War I, the exchange rates were

allowed to fluctuate

● Since gold was convertible into currencies

of the major developed countries, central
banks of different countries either held gold
or currencies of these developed countries
 The System of Bretton Woods
( 1944-71)

 In July, 1944, 44 countries met in Bretton

Woods, New Hampshire, USA – a new
International Monetary System was created

 John Maynard Keynes of Britain and Harry

Dexter White of USA were the key movers
 The Bretton Woods Agreement

 Creation of International Monetary Fund (IMF)

to promote consultations and collaboration
on international monetary problems and
countries with deficit balance of payments
 Establish a par value of currency with
approval of IMF
 Maintain exchange rate for its currency
within one percent of declared par value
 The Bretton Woods Agreement
 Each member to pay a quota into IMF pool –
one quarter in gold and the rest in their own
currency
 The pool to be used for lending
 Dollar was to be convertible to gold till
international instrument was introduced
 International Bank for Reconstruction and
Development (IBRD) was created to
rehabilitate war-torn countries and help
developing countries
 The System of Bretton Woods
( 1944-71)

 So in effect this was a gold – dollar exchange

standard ( $35/ounce)- known as fixed
exchange rate system or adjustable peg
 Devaluation could not be resorted arbitrarily
 When BOP problem became structural i.e.
repetitive, devaluation upto ten percent was
permitted by IMF
 Thus each currency was tied to dollar directly
or indirectly
 Collapse of the
Fixed Exchange System

 The system of fixed exchange rates

established at Bretton Woods worked well
until the late 1960’s
 Any pressure to devalue the dollar would
cause problems throughout the world
 The trade balance of the USA became highly
negative and a very large amount of US
dollars was held outside the USA ; it was
more than the total gold holdings of the USA
 Collapse of the
Fixed Exchange System

 During end of sixties, European

governments wanted gold in return for the
dollar reserves they held

 On 15th Aug. 1971, President Nixon

suspended the system of convertibility of
gold and dollar and decided for floating
exchange rate system
 The end of the Bretton Woods
System (1972–81)

 The system dissolved between 1968 and

1973

 By March 1973, the major currencies began

to float against each other
 The end of the Bretton Woods
System (1972–81)

IMF members have been free to choose any

form of exchange arrangement they wish
(except pegging their currency to gold):
 Allowing the currency to float freely
 Pegging it to another currency or a basket
of currencies
 Adopting the currency of another country,
participating in a currency bloc, or
 Forming part of a monetary union
 Exchange Systems after 1973

• Exchange Rate systems are classified on

the basis of the flexibility that the
monetary authorities show towards
fluctuations in the exchange rates and are
divided into two categories:

1. Systems with a fixed exchange rate

( “fixed peg” or “hard peg”) and
2. Systems with a flexible exchange rate
( “Floating” systems)
 Exchange Systems after 1973

• But as usual, between these two extreme

positions there exists also an intermediate
range of different systems with limited
flexibility, usually referred to as “soft
pegs”
 A fixed peg regime

 A fixed peg regime exists when the

exchange rate of the home currency is fixed
to an anchor currency
 This is the case with economies having
currency boards or with no separate
national currency of their own
 Countries do not have a separate national
currency, either when they have formally
dollarized, or when the country is a member
of a currency union, for example Euro
 Floating Exchange Rate System

● The collapse of Bretton Woods and

Smithsonian Agreements coupled with oil
crisis of 1970, the floating exchange rate
system was adopted by leading
industrialised countries
● Officially approved in April 1978
● Under the system, the exchange rate
would be determined by market forces
without the intervention of government
 Floating Exchange Rate System

● No country in the world has adopted freely

floating exchange rate system

● Floating exchange rate regimes consist of

independent floating and managed floating
systems
 Independent Floating systems

 In Independent Floating systems the

exchange rate is market determined and
monetary policy usually functions without
exchange rate considerations

 Foreign exchange interventions are rare

and meant to prevent undue fluctuations

 But no attempt is undertaken to

achieve/maintain a particular rate
 Managed Floating systems

 Managed Floating systems usually let the

market take its own course but the monetary
authorities intervene in the market to “manage”
the exchange rate, if needed, to prevent high
volatilities and to stimulate growth, without
committing to a particular exchange rate level
 The monetary authorities do not specify their
opinion on “suitable” exchange rate level
 The IMF calls this practice a “Managed Floating
With No Predetermined Path for the Exchange
Rate”
Intermediate Regimes ( Soft Pegs)

• Intermediate exchange rate regimes consist

of an array of differing systems allowing a
varying degree of flexibility, such as
conventional fixed exchange rate pegs,
crawling pegs and exchange rate bands
Conventional fixed exchange rate
pegs

 In a Conventional Fixed Peg arrangement a

currency is pegged at a fixed rate to a major
currency or a basket of currencies, allowing
the exchange rate to fluctuate within a
narrow margin of ±1 percent around a formal
(or de facto) central rate
 The monetary authority intervenes in the
market, if the fluctuation is outside these
limits
 (post-crisis Malaysia, fixing Ringgit against
US dollar for a rate of RM 3,8 per $1)
 Crawling Peg ( The Dirty Float)

● In this system an attempt is made to

combine the advantages of fixed exchange
rate with flexibility of floating exchange rate

● It fixes the exchange rate at a given level

which is responsive to changes in market
conditions i.e. it is allowed to crawl
 Crawling Peg ( The Dirty Float)

 In a Crawling Peg arrangement the currency

is adjusted periodically “in small amounts at
a fixed rate or in response to changes in
selective quantitative indicators (past
inflation differentials vis-à-vis major trading
partners…)

 A Crawling Band allows a periodic

adjustment of the exchange rate band itself
 Crawling Peg ( The Dirty Float)

● The upper and lower limits are decided for

exchange rate depending demand and supply
of foreign exchange
● As the exchange rate crosses these limits,
fiscal and monetary policies come into play to
push the exchange rate within the target zone
● But in this case, these limits are sustained for
some time and if it is felt that economic
indicators are being disturbed, the monetary
authorities let the exchange rate depreciate or
appreciate as the case may be
Trends in Global Exchange Rate Regimes
Exchange Rate Regimes
IMF Members, 2006
 Exchange Rates Since 1973

• Since 1973, exchange rates have become more

volatile and less predictable than they were
between 1945 and 1973, due to:
 Oil crisis -1971
 Loss of confidence in the dollar - 1977-78
 Oil crisis – 1979, OPEC increases price of oil
 Unexpected rise in the dollar - 1980-85
 Rapid fall of the dollar - 1985-87 and 1993-95
 Partial collapse of European Monetary System –
1992
 Asian currency crisis - 1997
 Exchange Rates Since 1973

● The merits of each continue to be debated

● There is no agreement as to which system

is better

● Many countries today are disappointed

with the floating exchange rate system
 Implications For Managers

For managers, understanding the

international monetary system is important
for:

 Currency management
 Business strategy
 Corporate-government relations
 Currency Management

Managers must recognize that the current

international monetary system is a managed
float system in which government
intervention can help drive the foreign
exchange market

Under the present system, speculative

buying and selling of currencies can create
volatile movements in exchange rates
 Business Strategy

Managers need to recognize that while

exchange rate movements are difficult to
predict, their movement can have a major
impact on the competitive position of
businesses

To contend with this situation, managers

need strategic flexibility e.g. dispersing
production to different locations
 Corporate-Government Relations

Managers need to recognize that

businesses can influence government
policy towards the international monetary
system

Companies should promote an

international monetary system that
facilitates international growth and
development
Evolution of Indian Exchange Rate
system

• 1931 – Rupee pegged to Pound Sterling –

parity Rs. 1= shilling 1 and 6 pence
• 1944 – IMF asked nations to peg currency
to dollar or gold – chose gold –
parity again with sterling –
BP 1 = Rs. 13.33
• 1949 – Pound was devalued 30.5% so was
Rupee but 36.5% in dollar terms
Evolution of Indian Exchange Rate
system

• 1967 – Pound again devalued by 14.3% but

India did not – it delinked rupee from
pound and linked it to dollar
• 1971 – Smithsonian Agreement – the
international currencies were
realigned– India returned to sterling
peg – parity BP = Rs. 18.9677
The fluctuation of (+)/(-) 2.25% was
allowed
Evolution of Indian Exchange Rate
system

• Sept. 1975 – the sterling peg was replaced

by a basket peg - The
fluctuation band widened to
(+)/(-) 5%
• July 1991 – the rupee was devalued twice by
18-20%
• 1991-92 Budget - partial convertibility on
current account
Evolution of Indian Exchange Rate
system

• 1992-93 Budget – the rupee was made fully

convertible on current account and a
liberalized exchange rate management
system ( LERMS) was introduced

• Presently, FEDAI announces indicative

rates on every business day . RBI has
discretion to enter the market to stabilise
the exchange rate
GOOD LUCK TO YOU