EXCHANGE RATE SYSTEM

GROUP MEMBERS
Ronak Shah Shreyas Mehta Shaily Mehta Libin Moni 115 116 117 118

Introduction
International Transactions have to effect payment from one party to other party Payments may be gifts or remittances Trade of merchandise as well as services is to be considered Capital Purchases have a different modes of payment such as forfeiting

What is Money???
Store Value

Medium of Exchange
Unit of account

Barter System works when two individuals each possessing a commodity the other wanted or needed would enter into an agreement to trade their goods

Limitations:

Lack of Transferability Lack of Divisibility Problem of Stocking Fair Pricing

To solve the problem of barter system came commodity money It is a kind of currency based on the value of underlying commodity They are widely desired , valuable, durable, portable and easily storable In past salt, tea, tobacco, cattle and seeds were commodities & therefore were once used as money

Metal objects were introduced as money around 5000 B.C Metal was used because it was readily available, easy to work with & could be recycled Earliest Paper Money became common from about AD 960 onwards in China With the introduction of Paper Currency, Commodity Money evolved into representative money

Representative money has now been replaced by Fiat Money Fiat Money is paper or low value metal coins) money authenticated by the government Fiat is the Latin word for let it be done Money is now given value by a government fiat or decree, in other words enforceable legal tender laws were made

Years
Some time unknown 9000 BC to 6000 BC 1200 BC 1000 BC 500 BC 118 BC 806 AD 1816 AD Barter Cattle

Form of money

Cowries shells First metal money and coins Modern coin age Leather money Paper currency Gold standard

There are three known kinds of gold standard that have been adopted since the early 1700s gold specie, gold exchange, gold bullion standards

In this gold standard, the unit of currency is linked to the gold coins that are in circulation More specifically, the monetary unit is associated with the unit of value of a specific gold coin in circulation along with that of any secondary coinage (coins made of metal that is valued less than gold)

The

central bank of the country concerned had to back the currency, promising to buy or sell the metal in unrestricted amount at the price fixed
Extending

this reasoning, a person who possessed gold could approach the State mint and have the right to have coin struck from gold, whatever the amount
By

the same reasoning, he could also melt the gold as and when he wished to do so; Gold could be freely imported and exported

Money in circulation is a paper note

On these notes is the written promise of monetary authorities that if you demand, on submission of this note, they would give you specified quantity of gold This means currency is pegged with gold

Unconditional conversion
We can say in this gold standard , gold bullion is sold on demand at a fixed cost. The currency-to-bullion ratio i.e. sold on demand at a fixed cost

In this mechanism, money in circulation is a paper note or coins of lesser valuable metals
On these notes/low-value-metal-coins was the promise by monetary authorities to give specified number of notes/gold coins of other specified countrys currency ,on demand

This means currency is pegged with the other currency

The other specified currency was either in the form of gold coin itself or paper notes with the promise to give gold on submission by monetary

Mechanism of Exchange of Two Currencies

It imposes discipline on policy makers regarding expansion of money supply as it is limited by reserve of gold with them Control on money supply, so it has in-built anti-inflationary system Exchange rates are more stable Exchange rates are more predictable

They should never change the ratio of conversion of paper money to gold
They should be ready to convert unlimited amount of paper currency to gold at any time whatsoever There should not be any restriction on transfer of gold from one country to another. It should be free flow in all respects They should issue notes exactly proportionate to the quantity of gold they have in reserve

It

imposes very rigid discipline on the policy makers and monetary authority
In

order to adhere to success elements, often many economic compromises and sacrifices are required. For instance , full employment may not be targeted
Political
It

cost of such compromises is very high

is not possible to maintain gold parity ratio) in critical times such as war, earthquake
Free

trade of gold with all countries all the time is not practical in order to prevent permanent loss of

The USA undertook to convert the US Dollar freely into gold at a fixed parity of $ 35 per ounce. (1 ounce = 28.35 grams) Other countries agreed to maintain their currencies at specific parties with US Dollar. 1% variation in this parity was allowed

If the exchange rate of these member countries tended to exceed this 1% limit, then their monetary authorities shall take the necessary measures to restore it
This was supposed to be done by buying or selling dollars. For example, if their market is

In order to follow this parity-maintaining obligation, if required, member countries may borrow from IMF If there is a genuine problem in maintaining parity to a particular member country, then it can change its parity itself by 10% (+ or -), without consulting IMF If it desired to exceed 10% limit, it has to inform IMF and seek its consent. Because of this feature, this system was often referred as

An adjustable peg exchange rate is a system where a currency is fixed to a certain level against another strong currency such as the Dollar or Euro
Usually the peg involves a degree of flexibility of 2% against a certain level However, if the exchange rate fluctuates by more than the agreed level, the central bank needs to intervene to maintain the target exchange rate peg

Dollar was the universally accepted exchange currency US did not have freedom to change gold parity of its currency All other countries were willing to accumulate dollars by selling goods and services to US US can buy these goods from other countries by simple printing dollars

Reason for collapse of BRETTON WOOD SYSTEM

The system was dependent on dollar as the key currency

United States free from external economic pressures Member countries were not willing to accept the high inflation rates
Another fundamental problem was the delayed adjustment of the parties to changes in the economic environment of the countries

IMF members have been free to choose any form of exchange arrangement they wish By 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 monetary union

Exchange Arrangements with No Separate Legal Tender Currency Board Arrangements Other Conventional Fixed Peg Arrangements Pegged Bands Exchange Rates within Horizontal

Crawling Pegs Exchange Rates within Crawling Bands Managed floating with no Predetermined Path for the Exchange Rate

Independently Floating

I.

Fixed (pegged) with one currency (Hard peg or Conventional peg)

Features Central banks buy and sell currencies at fixed price

Defending of Currency Rate Central Bank hold foreign currency

Central Bank ultimately devalues its currency

ADVANTAGES

Certainty of Exchange Rate Less inflationary Smooth working Prevents monetary shock

DISADVANTAGES

Heavy burden Need sufficient reserves Fails to solve balance of payments Does not prevent real shocks No long term solution

ll. Free Float and Independent Float (Flexible Exchange Rate System) ADVANTAGES Simple operation, smoother, more fluid adjustment Brings realism in forest transactions Disequilibrium in balance of payment auto stabilize No need to manage exchange rate Prevents real shocks Reinforces monetary policy effectiveness

DISADVANTAGES

Exchange rate risk to exporters and importers which need to be hedged Adverse effect of speculation Encourages inflation

Crawling peg system is that there exists an exchange rate which equilibrates the international supply and demand for particular currency

Possibilities The peg he allowed to crawl not more than one sixth of 1 % in any one month, with the timing of such changes subject to the discretion of govt. officials Adopt a plan such that the pegs crawl is automatic. the rate would be allowed to move freely within a band around the crawling peg

Snake in tunnel
The concept was accepted by the European Economic Community since 1972,though was called differently as Joint Float Snake The graph of the currency moving against each other would look like snake in tunnel In 1978 snake turn into a worm

Liberalized Exchange Rate Management System Under the LERMS, 40 percent of foreign exchange earnings had to be surrendered at an official rate determined by the reserve bank The balance 60 percent of exchange earnings were to be converted at rates determined by the market