1. International Monetary System
Dr.C S Shylajan
Faculty, IBS Hyderabad

2. Exchange Rate Determination-Different ways
Foreign trade involves the use of different national currencies
Foreign exchange rate is the price of domestic currency in relation to another currency
Foreign exchange rate is determined in the foreign exchange market by DD and SS
By Govt or Central Bank
Mix of both

3. Exchange Rate Regimes Main exchange rate regimes are three:
Fixed exchange rate system (gold standard or Bretton Woods system)
Flexible/Floating exchange rate system
Managed float exchange rate system

4. Policy Issue
Choice of exchange rate system is one of the key policy questions.
Whether to have fixed or floating exchange rates
Three main features that affect the choice of system are
volatility and risk,
inflationary consequences and
monetary autonomy.

5. Fixed Exchange Rate System
The central bank fixes the price of the domestic currency in relation to the foreign currency and agrees to maintain the value at that level

6. Fixed Exchange Rate System
It has 4 major variants:
Adjustable Peg: Exchange rate is fixed but adjustable if there is unwithstandable pressure
Crawling Peg: Central bank allows a gradual adjustment of the exchange rate by intervening in the currency market in small measure to achieve the desired objective

7. Fixed exchange rate system
Currency Board: Under this the exchange rate is irrevocably fixed by the board (or the central bank)

8. Fixed exchange rate system
Unified Currency system:
Independent currency is abandoned and some other currency is adopted
Eg: Adoption of Euro by the European countries, Adoption of dollar by Argentina
The exchange rates are permanently set against such foreign currencies

9. Fixed exchange rate system
Advantages:
No uncertainty about the exchange rate which provides businesses with sure basis for planning an pricing
Imposes monetary policy discipline (no excessive borrowings and spending)

10. Fixed exchange rate system
Disadvantages:
Rigidity in the economy
Requirement of adequate foreign exchange reserves
Monetary policy is dictated by exchange rate concerns

11. Flexible Exchange Rate System
Exchange rate is determined on the basis of demand for and supply of foreign exchange in the market

12. Flexible Exchange Rate System
Advantages:
It reflects the true value of the exchange rate if the markets are perfect. Based on fundamentals of the economy
No scope for speculation
The central bank can follow independent monetary policy

13. Flexible Exchange Rate System
Disadvantages:
If markets are not perfect, exchange rates may not reflect the true value
Then, it may show high volatility, and thus affect business planning
Uncertainty and risk for business

14. Managed Float System
A compromise between a fixed exchange rate system and a flexible exchange rate system
The central bank allows the exchange rate to be market determine, but intervenes from time to time to orderly conditions in the market

15. Managed Float System
From 1971 until 1987 the US followed a policy of managed floating (market based exchange rate with periodic “re-alignments”).
India followed till 1996, then onwards a market determined rate

16. Managed Float System Advantages: Disadvantages:
The fluctuations in the exchange rates are smoothened and brings stability in ER
Reduce speculative attack on ER
Disadvantages:
Uncertainty is not completely eliminated
The macroeconomic implications of Central Bank intervention
Uncertainty about Central Bank’s tactics

17. Exchange Rate Regimes: History
The Gold Standard ( )
Gold as a medium of exchange –
The exchange rate between any pair of currencies will be determined by their respective exchange rates against gold

18. The Gold Standard (1870-1914) Major Features:
Long-run price stability because of monetary discipline
Rapid expansion of free international trade – not many tariff, quota restrictions
Stable exchange rate and prices
Rapid economic growth
Britain as the leader of world’s financial system

19. Exchange Rate Regimes: History
The Gold Standard had some basic rules:
No restrictions on imports/exports of gold
Disadvantages:
The gold standard regime imposes very rigid discipline on the policy makers :
The money supply in the country must be tied to the amount of gold the monetary authorities have in reserve.
When a country loses (gains) gold, money supply must contract (expand) and vice versa.

20. Exchange Rate Regimes: History
The Bretton Woods System ( )
Under the Breton Woods Agreement each govt. pledges to maintain a fixed/pegged exchange rate for its currency vis-à-vis the dollar
The US government undertook to convert the US dollar freely into gold at a fixed parity of $35 per ounce
Other member countries of the IMF agreed to fix the parities of their currencies with the dollar with variation within 1% on either side of the central parity being permissible
It was an Adjustable Peg system. Central parity could be changed in the face of “fundamental disequilibrium”.

21. Exchange Rate Regimes: History
This system could work as long as other countries had confidence in the stability of the US dollar
The system came under pressure and ultimately broke down when this confidence was shaken starting mid 1960’s.
US BoP deficit
Increased speculative activities
Major currencies started floating in early 1973.

22. Post-Bretton Woods System
Most countries shifted to floating exchange rate system
Change in the role of IMF
The European Monetary System
Treaty of Rome (1957) was signed by 6 European countries to form European Economic Community (EEC)
Ultimate aim economic integration
Agreed to lift up restrictions on factor movements and harmonize domestic policies
Adopted a Common Agricultural Policy where uniform prices for farm products
Single European Act of 1986 converted EEC into a common market on January 1, 1993
Accepted Euro as their common currency 1999

23. Is there an ideal Exchange Rate Regime?
Fixed rates provide a policy anchor & discipline.
Freely floating rates provide monetary policy freedom.
There is no such thing as "the ideal" exchange rate regime for all countries or even for a given country at all times
Crawling pegs, crawling bands, managed float etc. attempts to get the best of both the worlds

24. The International Monetary Fund (IMF)
The Role of IMF
Framework of the Articles of Agreement adopted at Bretton Woods in1944
Establishment of 2 new institutions – IMF and IBRD (World Bank)
Increasing international monetary cooperation
Promoting the growth of trade
Promoting exchange rate stability
Establishing a system of multilateral payments, eliminating exchange restrictions which hamper the growth of world trade and encouraging progress towards convertibility of member currencies