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Financial markets are getting more and more integrated in recent years due to
globalization and people and corporates are entering into more and more cross-boarder
financial deals and international trade. In order to make these transactions feasible, a
system for determination of the amount and method of payment of underlying financial
flows is needed. Since the domestic currencies of the parties involved will be different,
the flows will take place in some mutually acceptable currencies. The set of rules,
regulations, institutions, procedures, practices, and mechanisms which determine the
exchange rate between currencies and the movements in exchange rate over a period is
called the international monetary system. Thus, it is the institutional framework within
which international payments are made, exchange rates among currencies are determined,
international trade and capital flows are accommodated, and balanceof-payments adjustments made.
International monetary system forms the backbone of all cross-border transactions
because it makes the settlement of international payments possible. A well-functioning
monetary system will facilitate international trade and investment and smooth adaptation
to change.
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For example, Bahrain pegs its dinar to the U.S. dollar at a rate of 0.40 dinar per dollar.
The Bahrain central bank must always be willing to buy dinar with dollars or to buy
dollars with dinar in any amount at the fixed rate of 0.40 dinar per dollar. Otherwise, there
could be excess supply of or demand for dinar, and its value would depreciate or appreciate to
restore equilibrium. For example, if there were excess demand for dinar, the dinar would
become more valuable relative to the dollar, and the number of dinar to buy a dollar would
decrease, implying an appreciation of the dinar. In order to prevent such a move in the
exchange rate, the Bahrain central bank intervenes in foreign exchange markets to meet
the excess demand by increasing the supply of dinar through buying dollars. Thus, while
the exchange rate does not move, the dollar reserves of the central bank do change.
Were these reserves to run out, the Bahrain central bank would indeed have little choice
but to float the dinar (or, more precisely, watch the dinar float).
In order to avoid the need to respond to all movements in the supply and demand for
currency, a country may fix its currency within a band to allow some fluctuation in value.
For example, from 1979 to 1998, a number of countries participated in the European
Monetary System. Under this system, countries' exchange rates were fixed but allowed to
fluctuate up or down by as much as 6% (widened to 15% in 1993) relative to an assigned
par value. The bands allowed countries some latitude with choosing monetary policies
and also were intended to reduce the risks of speculative attacks. In 2004, only one large
economy-Denmark-used this type of exchange rate regime.
The gold standard, the Bretton Woods system, and the European Monetary System
(EMS) are historical examples of fixed exchange rate regimes, although they differ in
specific aspects.
The key features of the fixed exchange rate system are:
Prices and interest rates have to be in line with the anchor currency, which ensures
monetary discipline.
Central bank has responsibility to defend exchange rate by foreign exchange market
intervention.
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5. Monetary Union: Under this system the member nations of monetary unions
agree to use a common currency, instead of their individual currencies. This
wipes out the fluctuations of exchange rates and the attendant inefficiencies
completely. A common central bank of member countries is set up, which has
the sole authority to issue currency and to determine the monetary policy of
the group as a whole. The central bank has the power to alter economic
variables of member nations to maintain the same inflation rate in all the member
nations. European monetary union is an example of a monetary union. It has
its own common currency (Euro) and has a common central bank.
The ability of the central bank to defend its currency under a fixed exchange rate regime is
limited by its stock of foreign exchange reserves and by its ability to raise interest rates. If
there is persistent excess demand for anchor currency, the central bank must sell anchor
currency, and its reserves therefore fall. If the central bank's reserves run low and it is
unable to secure financing from private markets, it may have to devalue the
exchange rate. Likewise, countries may be unable to increase interest rates to the
levels necessary to defend their national currency, maybe because unemployment is too high
already or the public debt is becoming unsustainable.
Advantages of a fixed exchange rate regime
Fixed exchange rates require countries to adopt restrictive monetary and fiscal
policies that foster an anti-inflationary environment. Thus it ensures monetary and
fiscal discipline on the domestic economy.
Loss of monetary independence: Central bank cannot use money supply as a tool to
stimulate the economy. The central bank would also be unable to respond to
unemployment through lowering the interest rate to stimulate investment because of
concerns about the effect on the exchange rate.
Fixed rates may be maintained at rates that are inconsistent with economic
fundamentals, thereby exacerbating periods of recession.
Frequent fluctuations.
Managed float
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Free float: Under the free float, market exchange rates are determined by the interaction
of currencies' supply and demand. The supply and demand schedules, in turn, are
influenced by price level changes, interest differentials and economic growth. As
these economic parameters change, market participants will adjust their current and
expected future currency needs. There is no intervention either by the government or by
the central bank.
Managed float: In the free float, there is always an uncertainty in exchange rate
movements that reduce economic efficiency by acting as a tax on trade and
foreign investments. In order to reduce the volatility associated with the free float, the
central bank generally intervenes in the currency markets to smoothen the fluctuations.
Such a system of managed exchange rates is referred to as a managed float or a dirty float.
There are three approaches to manage the float:
1. Smoothing out daily fluctuations: The central bank may occasionally enter the
market on the buy or sell side to ease the transition from one rate to another,
rather than resist fundamental market forces, tending to bring about long-term
currency appreciation or depreciation.
2. Leaning against wind: This approach is an intermediate policy designed to
moderate an abrupt short and medium-term fluctuations brought about by random
events whose effects are expected to be only temporary. Intervention may take
place to prevent these short and medium-term effects, while letting the markets
find their own equilibrium rates in the long-term, in accordance with the
fundamentals.
3. Unofficial pegging: In the third variation, though officially the exchange rate
may be floating, in reality the central bank may intervene regularly in the
currency market, thus unofficially keeping it fixed.
Advantages of Floating Exchange Rate System
Since the country is not required to defend the exchange rate at a certain level, the
government and central bank are free to choose independent domestic
macroeconomic policies to deal with domestic issues such as inflation or
unemployment.
Under floating exchange rate regime, market intervention by the central bank is not
required to defend the exchange rate.
Since there is no need for market intervention, there is only very low requirement for
international reserves.
For countries that lack monetary and fiscal disciplines, a floating exchange rate sets
no pressure for a country to observe these disciplines.
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Floating exchange rate system is susceptible to large swings in the exchange rate
causing substantial swings in the real economy, especially in the case of small
emerging market economies where exports, imports, and international capital flows
make up a relatively large share of the economy.
Floating exchange rate system provides uncertainty and exchange rate risk in
international trade and investment. Although exchange rate risk could be hedged
under a floating exchange rate regime, such hedges could be expensive.
Since the volatility in exchange rate is higher under floating exchange rate system,
any depreciation of the domestic currency may disrupt the financial system,
especially in the case of a country where banks make significant loans in foreign
currency.
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The main advantages of the gold standard were its monetary discipline and symmetric
monetary adjustment. There was monetary discipline because central banks throughout
the world were obliged to fix the money price of gold. They could not allow their money
supplies to grow more rapidly than real money demand, since such rapid monetary
growth eventually raises the money prices of all goods and services, including gold.
Symmetric monetary adjustment refers to the fact that no country in the system
occupied a privileged position by being relieved of the commitment to intervene (or to
defend the value of its currency). Countries shared equally in the cost or burden (relative
prices changes, unemployment or recession) of balance of payments adjustment.
The gold standard had a number of drawbacks as well. Since the money supply was tied
up to the stock of gold in a country, there were constraints on the use of monetary policy
to fight unemployment. In a worldwide recession, it might be desirable for all countries to
expand their money supplies jointly even if this were to raise the price of gold in terms of
national currencies. But they could not do that if they were to keep the gold standard. A
second drawback was a reserve shortage. As the economy grew, more money would be
needed to facilitate the increasing economic transactions. But limits in gold supply might
not keep up with economic growth and therefore would hinder economic growth. Another
drawback of the gold standard was the asymmetric distribution of gold production and
stock. The gold standard could give countries with potentially large gold production
considerable ability to influence macroeconomic conditions throughout the world through
market sales of gold.
Failure of Gold Standard
The gold standard was suspended with the outbreak of World War I, which interrupted
trade flows, restricted the free movement of gold, and resulted in high inflation for many
countries.
The outbreak of World War I was a direct cause for the collapse of the gold standard.
Governments abandoned the gold standard during the war and financed part of their
massive military expenditures by printing money without the backing of gold. Further,
labor forces and productive capacity had been reduced sharply through war losses. As a
result, price levels were higher everywhere at the war's conclusion in 1918. The loss of
confidence in the British pound as a reserve currency was another reason. A reserve
currency is one that the central banks hold in their international reserves, and under a
fixed exchange regime, each nations central bank fixes its currencys exchange rate
against the reserve currency by standing ready to trade domestic money for reserve assets
at that rate. Under gold standard, the British pound was the reserve currency and was
regarded as good as gold. The U.K. deficits in its balance of payments made other
countries worry about the U.K.s inability to convert s into gold.
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During the inter-war years (1918-1939), several countries returned briefly to gold
standard. But as the great depression continued, many countries renounced their gold
standard obligations and allowed their currencies to float in the foreign exchange market.
Inflation was rampant in some economies at the end of WWI. The loss of confidence in
the U.K., the existence of multiple reserve currencies (, $, French franc) and the
hyperinflation in Germany all contributed to the failure to restore the gold standard.
Multiple attempts in the following years to revive the gold standard failed.
The Gold-Exchange Standard
After the gold standard broke down during the World War I, it was briefly reinstated from
1925 to 1931 as the Gold exchange Standard. Under this standard, the United States and
England could only hold gold reserves, but other nations could hold both gold and dollars or
pounds as reserves. In 1931, England departed from gold in the face of massive gold and
capital flows, owing to an unrealistic exchange rate, leading to the failure of the gold
exchange standard.
The Bretton Woods System of Exchange Rates
In 1944 the major Allied trading nations met in Bretton Woods, New Hampshire, to lay the basis
for the post-World War II payments and trading system. In addition to designing the
framework for a new international monetary system, they created two international
institutions - the International Bank for Reconstruction and Development (the World Bank)
and the International Monetary Fund. Since the participating officials believed that the interwar Great Depression had been aggravated by the instability of exchange rates and restrictions
on currency convertibility, representatives to the Bretton Woods meetings concluded that
the post-War system should be governed by fixed exchange rates.
Following the perceived success of the classical gold standard prior to 1914, the new system was
to include a link to gold. However, in 1944 about 70 percent of the world's monetary gold
was in the hands of the United States. Thus, there emerged a system that has been called the
"gold exchange standard."
Under the Bretton Woods gold exchange standard, the United States committed itself
to buy gold from, or sell gold to, any participating country's official monetary institution
for $35 per ounce. But - in contrast to the classical gold standard - the United States
undertook no commitment to transact in gold with private parties, whether they were U.S.
citizens or foreign citizens. The other participating countries agreed to constrain the
value of their currencies within plus or minus one percent of an announced "par rate" with the
U.S. dollar. A country was only allowed to change this par rate (devalue or revalue) in
response to a "fundamental disequilibrium" in its balance of payments. The system was to
be overseen by the International Monetary Fund, which had the capacity to lend, in limited
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Adjustable parities
Although each country's exchange rate was fixed, it could be changed devalued or
revalued against the dollar if the IMF agreed that the country's balance of payments was
in a situation of "fundamental disequilibrium."
Narrow band (1% on either side of parity)
The exchange rates were allowed to fluctuate within 1% of its stated par value. Other
countries would buy and sell U.S. dollars to keep market exchange rates within the 1
percent band around par value foreign exchange market intervention (as required by the
system).
An integral part of the Bretton Woods system was the establishment of the IMF, which
still administers the international monetary system and operates as a central bank for
central banks. Member nations subscribe by lending their currencies to the IMF; the IMF
then re-lends these funds to help countries in balance-of-payments difficulties. The main
function of the IMF is to make temporary loans to countries to help them tide over
difficulties with current account deficits and financial crises. Member countries are
entitled to borrowing from the IMF up to a certain limit its contribution to the IMF.
Beyond that limit, the IMF lending is conditional upon the borrowing countrys
accepting the IMF surveillance over its policies.
One of the differences between the gold standard and the Bretton Woods system is that,
while both are fixed exchange rate systems, the Bretton Woods system allowed a member
country to adjust the values of its currency, the exchange rate, when there was a
fundamental problem with the countrys balance of payments.
Failure of Bretton Wood System
With its currency as the sole reserve currency, the United States was in a unique position
in the Bretton Woods system. Its money supply, unlike other countries, was not tied up
to defend the exchange rate system. The expansionary policy in the United States in the
1960s led to higher inflation in the U.S. than in Japan and West Germany. The U.S.
balance of payments suffered increasing deficits. In the meantime, Japan and West
Germany became increasingly competitive in the world market and their currencies were
under pressure to revalue. While the United States called on Japan and West Germany to
revalue their currencies, Japan and West Germany called upon the United States to
control its government spending and inflation.
From purchasing power parity, we know that when the exchange rates are fixed, inflation
rates for countries under the fixed exchange rate system have to be the same. That is,
countries have to coordinate their macroeconomic policies. But policy coordination is
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intervene in the exchange markets, the central bank can borrow from a credit fund to
which member countries contribute gold and foreign reserves.
For example, if the French franc depreciates to its lower limit relative to the DM, it is
obligated to sell DM reserves to make Franc appreciate. German central bank is obligated
to loan DM to France.
Initially there had been capital controls that limited the ability of private citizens to trade
in foreign currencies. This was to prevent speculators from starting a currency crisis.
These restrictions were later relaxed in 1987.
Since the EMS members were less than fully committed to coordinating their
economic policies, the EMS went through a series of realignments. Despite the recurrent
turbulence in the EMS, European Union members met at Maastricht (Netherlands) in
December 1991 and signed the Maastricht Treaty. According to the treaty, the European
Union will irrevocably fix exchange rates among the member currencies by January 1,
1999, and subsequently introduce a common European currency, replacing individual
national currencies. The European Central Bank, to be located in Frankfurt, Germany,
will be solely responsible for the issuance of common currency and conducting monetary
policy in the European Union. To pave the way for the European Monetary Union
(EMU), the member countries of the European Union agreed to closely coordinate their
fiscal, monetary, and exchange rate policies and a achieve a convergence of their
economies.
European Monetary Union
On January 1 2002, 12 European countries finalized their monetary union. This meant
that they had a common central bank in Frankfurt in Germany, at which all 12
countries had to agree on a common monetary policy. Eleven European countries
adopted a common currency called the euro, voluntarily giving up
their monetary sovereignty. With the launching of the euro on
January 1, 1999, the European Monetary Union (EMU) was created.
The EMU is a logical extension of the EMS, and the European
Currency Unit (ECU) was the precursor of the euro. As the euro was
introduced, each national currency of the euro-11 countries was
irrevocably fixed to the euro at a conversion rate as of January 1, 1999.
National currencies such as the French franc, German mark, and
Italian lira are no longer independent currencies. Rather, they are just
different denominations of the same currency, the euro. Once the
changeover is completed the legal-tender status of national currencies will be canceled,
leaving the euro as the sole legal tender in the euro countries. Monetary policy for the
euro countries will be conducted by the European Central Bank (ECB) headquartered
in Frankfurt, Germany, whose primary objective is to maintain price stability. The
independence of the ECB is legally guaranteed so that in conducting its monetary
policy, it will not be unduly subjected to political pressure from any member
countries or institutions. The national central banks of the euro countries will not
disappear. Together with the European Central Bank, they form the European System
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of Central Banks (ESCB). The tasks of the ESCB are threefold: (1) to define and
implement the common monetary policy of the Union; (2) to conduct foreign exchange
operations; and (3) to hold and manage the official foreign reserves of the euro member
states. Although national central banks will have to follow the policies of the ECB,
they will continue to perform important functions in their jurisdiction such as
distributing credit, collecting resources, and managing payment systems.
Current Exchange Rate Regimes
The current exchange rate system is a hybrid of many different arrangements. The
International Monetary Fund classifies these exchange rate regimes into eight specific
categories. The eight categories span the spectrum of exchange rate regimes from rigidly
fixed to independently floating:
1. Exchange Arrangements with No Separate Legal Tender: The currency of
another country circulates as the sole legal tender or the member belongs to a
monetary or currency union in which the same legal tender is shared by the members
of the union.
2. Currency Board Arrangements: A monetary regime based on an implicit
legislative commitment to exchange domestic currency for a specified foreign
currency at a fixed exchange rate, combined with restrictions on the issuing
authority to ensure the fulfillment of its legal obligation.
3. Other Conventional Fixed Peg Arrangements: The country pegs its currency at a
fixed rate to a major currency or a basket of currencies , where the exchange rate
fluctuates within a narrow margin or at most 1% around a central rate.
4. Pegged Exchange Rates within Horizontal Bands: The value of the currency is
maintained within margins of fluctuation around a formal fixed peg that are wider
than 1% around a central rate.
5. Crawling Pegs: The currency is adjusted periodically in small amounts at a fixed,
pre-announced rate or in response to changes in selective quantitative indicators.
6. Exchange Rates within Crawling Pegs: The currency is maintained within certain
fluctuation margins around a central rate that is adjusted periodically at a fixed preannounced rate or in response to change in selective quantitative indicators.
7. Managed Floating with No Pre-Announced Path for the Exchange
Rate: The monetary authority influences the movements of the exchange rate
through active intervention in the foreign exchange market without specifying or
pre-committing to a pre-announced path for the exchange rate.
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8. Independent Floating: The exchange rate is market determined, with central bank
intervening only to moderate the speed of change and to prevent excessive
fluctuations, but not attempting to maintain it at or drive it to any particular level.
The United States, the EU, Japan, the United Kingdom, Switzerland, and Canada are
among the major countries that follow an independent floating policy. At the other end of
the exchange rate regime spectrum (from floating to fixed) is the currency board, which
is a monetary regime based on an explicit legislative commitment to exchange domestic
currency for a specified foreign currency at a fixed rate, combined with restrictions on the
issuing authority to ensure the fulfillment of its legal obligation. Argentina was an
example before the system failed in 2002. Currently, Hong Kong is a well known
example of such an arrangement.
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Conclusion
The International monetary system has evolved from the days of the gold standard
to todays eclectic currency arrangement
Gold Standard (1876 1913)
Inter-war period (1914 1944)
Bretton Woods (1944)
Elimination of dollar convertibility into gold (1971)
Exchange rates began to float
Eurocurrencies are domestic currencies of one country on deposit in a second
country
If the ideal currency existed in todays world, it would have three attributes: a
fixed value, convertibility, and independent monetary policy
Emerging market countries must often choose between two extreme exchange rate
regimes, either free-floating or fixed regime such as a currency board or
dollarization
The 15 members of the EU are also members of the EMS.
Twelve members of this group have formed an island of fixed exchange
rates amongst themselves in a sea of floating currencies
They rely heavily on trade among themselves, so day-to-day benefits are
great
May 1, 2004 the European Union admitted 10 more countries
The euro affects markets in three ways
Countries within the zone enjoy cheaper transaction costs
Currency risks and costs related to exchange rate uncertainty are reduced,
All consumers and businesses, both inside and outside of the euro zone
enjoy price transparency and increased price-based competition
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