The International Monetary System

International Monetary System: An Overview

International monetary system is defined as a set of procedures, mechanisms,

processes, institutions to establish that rate at which exchange rate is
determined in respect to other currency.
The whole story of monetary and financial system revolves around 'Exchange
Rate'
i.e. the rate at which currency is exchanged among different countries for
settlement of payments arising from trading of goods and services.

Various exchange rate regimes found from 1880 to till date at the
international level are described briefly as follows:
1 Monetary System Before First World War: (Era of Gold Standard) The
exchange rate between pair of two currencies was determined by respective
exchange rates against 'Gold' which was called 'Mint Parity’ system.
E.g.1 pound = .005 ounce of gold, 1$ = .00125 ounce of gold. Then 1pound = 4$. This is the
mint parity between dollar & pound.

Thus if the dollar pound exchange rate for some reason takes the value of $3.50 per pound,
any one will acquire a pound by spending $3.50, convert the pound into 0.005 ounce of gold
in U.K., ship the gold back to the U.S. & then convert the gold into $4.00 realizing a profit
of 0.50$. Thus, large demand will drive the price of pound down.
( buy .005 ounce of gold in US for 4 dollar, shift gold to UK….)
2 The Bretton Woods Era :
In Bretton Woods modified form of Gold Exchange Standard was set up with
the following characteristics :
• One US dollar conversion rate was fixed by the USA as 35 dollar per
ounce of Gold
• one per cent (± 1%) fluctuation on either side.
• In case of Fundamental Disequilibrium, changes upto 10% in either
direction could be made.
Suppose in India, 10 gm gold cost 350 rs, and 1 ounce =28 grams ( for
example), and in US 28 grams gold is equal to 35 dollar.

1 ounce will cost 980 rs. Now 980rs = 1ounce= 35 dollar. It means 1 dollar=
980/35= 28 rs
 Rs/$ D2 S
D1

12.12 Upper Support

12.00 Parity

11.88 S Lower Support

D2
D1
QUANTITY OF DOLLARS

8 Dr. Amitabh Joshi

LIMITATIONS OR TRIFFIN PARADOX

This system depend 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 means that the US had to run BOP deficit so that other countries could build
up a stock of claims on the US. When the US deficit started mounting, there was a crisis of
confidence. Soon it was obvious that the US did not possess enough gold to honour its
convertibility commitment if all holders of dollar assets decided to demand gold.
3 Floating Exchange Rate System: the relative prices of currencies are determined purely
by forces of demand & supply.

The system in which there are no officially declared parities but there is official intervention
is called as Dirty Float.
 The Current Scenario of Exchange Rate Regimes
The IMF classifies member countries into eight categories according to the
Exchange rate regime they have adopted. A brief summary of IMF’s
classification is given below:
1. No Separate Legal Tender Arrangement (coins or banknotes that must
be accepted if offered in payment of a debt.)

This group includes:

a) Countries which are members of a currency union and share a common
currency like the twelve members of the European Currency Union (ECU),
who have adopted Euro as their common currency or

b) Countries which have adopted the currency of another country as their

currency. IMF’s 1999 Annual Report on Exchange Arrangements and
Exchange Restrictions indicates that 37 countries belong to this category.
2. Currency Board Arrangement
A regime under which there is a legislative commitment to exchange the
domestic currency against a specific foreign currency at a fixed exchange rate
coupled with restrictions on the monetary authority to ensure that this
commitment will be honored. Ex: 1$= 40 Rs

Hong Kong's currency board has a 100% reserve requirement, so all

Hong Kong dollars are fully backed with U.S. dollars.
With a 100% reserve requirement, a currency board operates similarly to a
strong version of the gold standard.
3. Conventional Fixed Pegs Arrangement
This is identical to the Bretton Woods system where a country pegs its
currency to another or to a basket of currencies with a band of variation not
exceeding +1% around the central parity. The peg is adjustable at the
discretion of the domestic authorities.

4. Pegged Exchange Rates within Horizontal Bands

Here there is a peg but variation is permitted within wider bands.
5. Crawling Peg
This is another variant of limited flexibility regime. The currency is pegged to
another currency or a basket, but the peg is periodically adjusted to a well
specified criterion or is discretionary in response to changes in inflation rate
differentials.

6. Crawling Bands
The currency here is maintained within certain margins around a central parity
which ‘crawls’ in a pre-announced fashion or in response to certain indicators.
7. Managed Floating with no Pre-announced Path for the Exchange Rate
Here, the central bank influences the exchange rate by means of active
intervention in the foreign exchange market through buying and selling
foreign currency against home currency without any commitment to maintain
the rate at any particular level.

8. Independently Floating
Here, the exchange rate is market determined, where the central bank
intervening is only to moderate the speed of change and to prevent excessive
fluctuations but not attempting to maintain the rate at any particular level.
India is in this group.
International Monetary Fund
The IMF became operational on 27th December 1945 with 29 member
countries that agreed to be bound to this treaty. It began its financial
operations on 1st March 1947. Currently, the IMF consists of 189 member
countries.

The purposes of the International Monetary Fund are as follows:

• To promote international monetary cooperation i.e. for consultation and
collaboration on international monetary problems.

• To facilitate the expansion and balanced growth of international trade, and

to contribute thereby to the promotion and maintenance of high levels of
employment .
 To promote exchange stability, maintain orderly exchange arrangements
among members, and avoid competitive exchange depreciation.

 To assist in the establishment of a multilateral system of payments in respect

of current transactions between members and in the elimination of foreign
exchange restrictions that hamper the growth of world trade.

 To give confidence to members by making the general resources of the

Fund temporarily available to them
The IMF employs three main functions – surveillance, financial
assistance, and technical assistance
to promote the stability of the international monetary and financial system.

Surveillance: The IMF closely monitors each member country's economic

and financial developments (usually meet once each year, to assess its
economic conditions with a view to providing policy recommendations).
Financial Assistance: The IMF lends to its member countries facing balance
of payments problems in order to facilitate the adjustment process and restore
member countries' economic growth and stability through various loan
instruments or "facilities".
New Arrangements to Borrow (NAB) The NAB is a set of credit arrangements
between the IMF and 38 member countries and Institutions, including several
emerging market countries. The NAB is used in circumstances in which the
IMF needs to supplement its quota resources for lending purposes. The NAB
is subject to periodic renewal.

General Agreements to Borrow (GAB) The GAB enables the IMF to borrow
specified amounts of currencies from 11 advanced countries (or their central
banks), under certain circumstances. The GAB may only be activated when a
proposal to activate NAB is rejected by NAB participants.
What Are Special Drawing Rights (SDRs)?

Special drawing rights (SDR) refer to an international type of monetary

reserve currency created by the International Monetary Fund (IMF) in 1969
that operates as a supplement to the existing money reserves of member
countries.

Created in response to concerns about the limitations of gold and dollars as the
sole means of settling international accounts,

SDRs augment international liquidity by supplementing the standard reserve

currencies.
• Special drawing rights (SDRs) are an artificial currency instrument created
by the International Monetary Fund, which uses them for internal
accounting purposes.

• The value of the SDR is calculated from a weighted basket of major

currencies, including the U.S. dollar, the euro, Japanese yen, Chinese yuan,
and the British pound.
•The SDR interest rate (SDRi) provides the basis for calculating the interest
rate charged to member countries when they borrow from the IMF

•SDRs are allocated based on the quota amounts of each member country.

•SDRs can be used to exchange for other currencies, the repayment of loans,
the payments of obligations, etc.
Technical Assistance: The IMF provides technical assistance to help member
countries strengthen their capacity to design and implement effective policies
in four areas, namely,
1) monetary and financial policies

2) fiscal policy and management,

3) statistics and

4) economic and financial legislation.

World Bank
The World Bank is an international organization dedicated to providing
financing, advice, and research to developing nations to aid their economic
advancement. The bank predominantly acts as an organization that attempts to
fight poverty by offering developmental assistance to middle- and low-income
countries.

The World Bank is an international development organization owned by 187

countries. Its role is to reduce poverty by lending money to the governments
of its poorer members to improve their economies and to improve the standard
of living of their people.
Functions of the World Bank
 It helps the war-devasted countries by granting them loans for reconstruction.

 Thus, they provide extensive experience and the financial resources of the bank help
poor countries increase their economic growth, reducing poverty and a better standard
of living.

 It helps underdeveloped countries by granting development loans.

• It also provides loans to various governments for irrigation, agriculture, water supply,
health, education, etc.

 It promotes foreign investments to other organizations by guaranteeing the loans.

 the world bank provides economic, monetary, and technical advice to the member
countries for any of their projects.

 It encourages the development of of-industries in underdeveloped countries by

introducing various economic reforms.
Objectives of the World Bank
 This includes providing long-term capital to its member nations for economic
development and reconstruction.

 it helps in inducing long-term capital for improving the balance of payments and
thereby balancing international trade.

 it helps by providing guarantees against loans granted to large and small units and other
projects for the member nations.
Objectives of the World Bank
 it ensures that the development projects are implemented. Thus, it brings a sense of
transparency to a nation from wartime to a peaceful economy.

 it promotes capital investment for member nations by providing a guarantee for capital
investment and loans.

 if the capital investment is not available then it provides the guarantee, and then IBRD
provides loans for promotional activities on specific conditions.
Purposes of the World Bank
 It wants to create an environment that is pro-investment.

 It wants to improve economic stability by reducing poverty.

 It is working towards achieving sustainable growth.

 Increasing the opportunities for jobs and business in member nations that are
underdeveloped.
 Through investment, it plans to promote the socio-economic status of society.

 It wants to ensure that the judicial and legal systems are developed and individual
rights are protected.

 Strengthening the government of its member nations by promoting education.

 Combating corruption and ensuring that there are adequate training opportunities and
research facilities.

 It wants to provide loans with low-interest rates and interest-free credits.

The World Bank has created new organizations within itself that specialize in
different activities. All these organizations together are called the World Bank
Group. It consists of:

• IBRD lends to low- and middle-income countries

• International Development Association (IDA) lends to low-income countries;

• International Finance Corporation (IFC) lends to the private sector;

• Multilateral Investment Guarantee Agency (MIGA) encourages private companies to

invest in foreign countries; and

• International Centre for Settlement of Investment Disputes (ICSID) helps private

investors and foreign countries work out differences when they don't agree.