International Monetary System Term Paper

7/28/2019 International Monetary System Term Paper

1/18

A TERM PAPER ON

"International Monetary System"

Submitted By

DARSHANKUMAR GARAG

(1PI11MBA46)

Under the Guidance of

Prof Srinivas

PES Institute of Technology100 Feet Ring Road, BSK III Stage,

Bangalore-560085.

Page 1


2/18

INTERNATIONAL MONETARY SYSTEM

Financial markets are getting more and more integrated in recent years due toglobalization and people and corporates are entering into more and more cross-boarderfinancial deals and international trade. In order to make these transactions feasible, a

system for determination of the amount and method of payment of underlying financialflows 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 theexchange rate between currencies and the movements in exchange rate over a period iscalled the international monetary system. Thus, it is the institutional framework withinwhich international payments are made, exchange rates among currencies are determined,international trade and capital flows are accommodated, and balance-of-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-functioningmonetary system will facilitate international trade and investment and smooth adaptationto change.

Alternative Exchange Rate Systems (Exchange Rate Regimes)

An exchange rate is the price of one currency in terms of another currency. As in the caseof any other goods, the price of a currency is affected by supply and demand. As demandfor a currency increases (or supply decreases) its price will rise. This is referred as anappreciation. Conversely, as demand for a currency decreases, or supply increases, itsvalue will depreciate. The prospect of large and rapid swings in exchange rates introduces

uncertainty into the business environment. A well-functioning international monetarysystem ensures stability in the exchange rates. The central element of the internationalmonetary system involves the arrangements by which exchange rates are set. The purposeof an exchange-rate system is to facilitate and promote international trade and finance.There have been three major exchange rate regimes from a historical perspective fixed,floating, and managed exchange rates.

Fixed Exchange Rate System

A fixed (or pegged) exchange rate system is one where governments or central banks setofficial exchange rates and defend the set rates through foreign exchange market

intervention and monetary polices. Under this system, the currency is pegged to anothercurrency (or basket of currencies) and the central bank promises to exchange currency ata specified rate against the other currency. Each central bank actively buys or sells itscurrency in foreign exchange market whenever its exchange rate threatens to deviatefrom its stated par value by more than an agreed-upon percentage.

Page 2


3/18

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, therecould be excess supply of or demand for dinar, and its value would depreciate or appreciateto restore equilibrium. For example, if there were excess demand for dinar, the dinar wouldbecome more valuable relative to the dollar, and the number of dinar to buy a dollar woulddecrease, implying an appreciation of the dinar. In order to prevent such a move in theexchange rate, the Bahrain central bank intervenes in foreign exchange markets to meetthe excess demand by increasing the supply of dinar through buying dollars. Thus, whilethe 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 choicebut 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 forcurrency, 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 EuropeanMonetary System. Under this system, countries' exchange rates were fixed but allowed tofluctuate up or down by as much as 6% (widened to 15% in 1993) relative to an assignedpar value. The bands allowed countries some latitude with choosing monetary policiesand also were intended to reduce the risks of speculative attacks. In 2004, only one largeeconomy-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 inspecific aspects.

The key features of the fixed exchange rate system are:

Domestic currency is pegged to an anchor currency.

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.

Central bank has to maintain adequate international reserves to intervene in the

foreign exchange market.

Page 3


4/18

The various forms of fixed exchange rate system are as follows:

1. Conventional Fixed Peg Arrangement: In this system, a country pegs itscurrency at a fixed rate to a major currency or a basket of currencies with a band

of variation not exceeding plus or minus 1% around the central rate.

2. Currency Board System: Under the currency board system a country pegs itscurrency with another major currency and fixes the rate of its domestic currencyin terms of that foreign currency. Its exchange rate in terms of othercurrencies depends on the exchange rates between the domestic currency andthe currency to which it is pegged. . The monetary policies and the economicvariables are kept in line with that of the reference country by the centralmonetary authority, called the currency board. The currency board maintainsreserves of the anchor currency up to 100% or more of the domestic currencyin circulation. This means that a unit of domestic currency cannot be

introduced into the economy without an additional unit of foreign exchangereserves being obtained first. Currency board commits to convert its domesticcurrency on demand into the anchor foreign currency to an unlimited extent,at the fixed exchange rate. Thus, a currency board has three importantcomponents: the establishment of a fixed exchange rate, the requirement that centralbank reserves cover 100% of the monetary base at that exchange rate, and theobligation that the central bank meets all demand for anchor currency. As such, acurrency board imposes discipline on governments by prohibiting increases in moneysupply beyond the level of reserves. It also prohibits the central bank from extendingcredit to commercial banks and rules out a role as lender of last resort. Clearly, acurrency board does not make a country immune to speculative attack. But itprovides a more credible guarantee of a country 's commitment to a fixedexchange rate by limiting the ability of traders to launch speculative attacks againstthe local currency.

3. Crawling Pegs: Another variation on a fixed exchange rate regime is thecrawling peg or crawling band. Under a crawling peg, the central bank adjusts thevalue of its currency periodically in small amounts at a fixed, preannounced rateor in response to changes in specific indicators.

4. Target Zone Arrangement: A group of countries agree to maintain theexchange rate between the currencies within the certain band around fixedcentral exchange rates. The system is called the target zone arrangement inwhich convergence of economic policies of the participating countries are aprerequisite for this system.

Page 4


5/18

5. Monetary Union: Under this system the member nations of monetary unionsagree to use a common currency, instead of their individual currencies. Thiswipes out the fluctuations of exchange rates and the attendant inefficienciescompletely. A common central bank of member countries is set up, which hasthe 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 economicvariables of member nations to maintain the same inflation rate in all the membernations. European monetary union is an example of a monetary union. It hasits 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 islimited by its stock of foreign exchange reserves and by its ability to raise interest rates. Ifthere is persistent excess demand for anchor currency, the central bank must sell anchorcurrency, and its reserves therefore fall. If the central bank's reserves run low and it isunable to secure financing from private markets, it may have to devalue theexchange rate. Likewise, countries may be unable to increase interest rates to the

levels necessary to defend their national currency, maybe because unemployment is too highalready or the public debt is becoming unsustainable.

Advantages of a fixed exchange rate regime

It leads to orderly foreign exchange market.

Fixed exchange rates require countries to adopt restrictive monetary and fiscal

policies that foster an anti-inflationary environment. Thus it ensures monetary andfiscal discipline on the domestic economy.

Fixed exchange rate regimes promote institutional credibility by signaling monetarydiscipline.

It promotes international trade by providing stability in international prices and

reducing the cost of trading.

Disadvantages of fixed exchange rate regime

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 tounemployment through lowering the interest rate to stimulate investment because of

concerns about the effect on the exchange rate.

Burden to keep adequate reserves.

It is subject to destabilizing speculative attacks. Example, speculative attacks on

British pound in 1992, on east Asian currencies in 1997 and Argentinean peso in2001.

Page 5


6/18

Danger of sudden collapse of system and financial and economic instability.

Fixed rates may be maintained at rates that are inconsistent with economic

fundamentals, thereby exacerbating periods of recession.

Floating or Flexible Exchange Rate System

A floating or flexible exchange rate system is one in which the exchange rate betweencurrencies is determined purely by supply and demand of the currencies without anygovernment invention. The rates depend on the flow of money between the countries,which may either result due to international trade in goods or services, or due to purelyfinancial flows. Hence in case of a deficit or surplus in the balance of payment, theexchange rates get automatically adjusted and this leads to a correction of theimbalance.

In a floating exchange rate system, economic parameters like price level changes,

interest differentials, economic growth and government policies have an impact onthe exchange rate as these factors influence the supply and demand of currencies.

A purely floating exchange rate system is more of a theoretical benchmark rather thanreality in practice. Most economies fall in between the two extremes a rigidly fixedsystem and a purely floating system. The United States, the EU, and Japan are close tothe flexible exchange rate system, although central banks of these countries intervene inthe foreign exchange market from time to time.

Key features of a floating exchange rate system are:

No government intervention required.

Exchange rate determined by market forces.

Frequent fluctuations.

Balance of payments adjusts simultaneously with the exchange rate.

Floating exchange rates can be of two types:

Free float and

Managed float

Page 6


7/18

Free float: Under the free float, market exchange rates are determined by the interactionof currencies' supply and demand. The supply and demand schedules, in turn, areinfluenced by price level changes, interest differentials and economic growth. Asthese economic parameters change, market participants will adjust their current and

expected future currency needs. There is no intervention either by the government or bythe central bank.

Managed float: In the free float, there is always an uncertainty in exchange ratemovements that reduce economic efficiency by acting as a tax on trade andforeign investments. In order to reduce the volatility associated with the free float, thecentral 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 themarket 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-termcurrency appreciation or depreciation.

2. Leaning against wind: This approach is an intermediate policy designed tomoderate an abrupt short and medium-term fluctuations brought about by randomevents whose effects are expected to be only temporary. Intervention may takeplace to prevent these short and medium-term effects, while letting the marketsfind their own equilibrium rates in the long-term, in accordance with thefundamentals.

3. Unofficial pegging: In the third variation, though officially the exchange ratemay be floating, in reality the central bank may intervene regularly in thecurrency 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 domesticmacroeconomic policies to deal with domestic issues such as inflation orunemployment.

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.

Page 7


8/18

Disadvantages of Floating Exchange Rate System

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 smallemerging 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 hedgedunder 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 foreigncurrency.

Managed Exchange Rate System

A managed-exchange-rate system is a hybrid of fixed and flexible rates in whichgovernments attempt to affect their exchange rates directly by buying or selling foreigncurrencies or indirectly, through monetary policy, by raising or lowering interest rates.

Other Exchange Rate Regimes

There have been other arrangements that are variations of the one of the three regimes.Each of these exchange rate regimes has its own characteristics which may be classifiedin the following dimensions: the role of the government, how the exchange rate is

determined, and how a balance of payments imbalance is adjusted. For example, under apurely floating exchange rate system, the central bank does not intervene in the foreignexchange market; the exchange rate is determined purely by market forces; the balance ofpayments and the exchange rates adjust simultaneously to equilibrium.

Convertibility of currency

In addition to exchange rate policy (what type of exchange rate regime to adopt), acountry also has to decides whether to allow free convertibility of its currency to othercurrencies. Based on the two major parts of the balance of payments, convertibility canbe applied to either account alone or both. Current account convertibility means that

foreign exchange can be freely bought and sold provided its use is associated withinternational trade in goods and services. But there are still restrictions when the intendeduse of the foreign exchange is to purchase foreign financial assets or to make equityinvestments. Free trade in currencies for the latter purpose is called capital accountconvertibility. If convertibility is allowed for transactions in both the current and thecapital accounts, we say there isfull convertibility. Full convertibility is equivalent tofree capital mobility. Restrictions on convertibility are referred to as foreign exchangecontrol.

Page 8


9/18

A Brief History of the International Monetary System

The international monetary system went through several distinct stages of evolution inthe past. These stages can be summarized as follows:

1. The Bimetallism: Before 18752. Classical Gold Standard: 1875-19143. The Gold-Exchange Standard: Inter-war period 1915-19444. Bretton Woods System: 1945-19725. Flexible Exchange Rate Regime: Since 1973.

These five stages are briefly examined in the following sections.

Bimetallism

Prior to 1870 many countries had bimetallism, that is, a double standard in that freecoinage was maintained for both gold and silver. The international monetary systembefore 1870s can be characterized as bimetallism in the sense that both gold and silverwere used as international means of payment and that the exchange rates amongcurrencies were determined by either their gold or silver contents.

Gold Standard

The gold standard, which is a fixed exchange rate system, in its classical form, wasfollowed from 1875 to 1914. Under the gold standard, all major countries set values for theircurrencies in terms of gold and agreed to buy and sell gold on demand with any othercountry at that rate. As such, all exchange rates were fixed against one another. Forexample, the United States agreed to buy and sell gold for $20.67 per ounce, whileBritain set the rate at 4.2474 pounds per ounce. The dollar-pound exchange rate wastherefore fixed at 4.8665 dollars per pound. If the exchange rate veered from this value to,say, 5 dollars per pound, gold traders could buy gold in the United States for $20.67 andsell it in London for $21.237. With excess demand for U.S. gold, the exchange rate wouldquickly be pushed back to 4.8665 dollars per pound.

In order to fix their exchange rates in this way, countries had to maintain adequate goldreserves.

Some of the characteristics of the gold standard include the gold contents of currencies,money supply being determined by a countrys gold stock, and automatic adjustment ofthe balance of payments and prices (and the entire economy) or no requirement ofgovernment intervention.

Page 9


10/18

The main advantages of the gold standard were its monetary discipline and symmetricmonetary adjustment. There was monetary disciplinebecause central banks throughoutthe 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 monetarygrowth eventually raises the money prices of all goods and services, including gold.Symmetric monetary adjustment refers to the fact that no country in the systemoccupied a privileged position by being relieved of the commitment to intervene (or todefend the value of its currency). Countries shared equally in the cost or burden (relativeprices changes, unemployment or recession) of balance of payments adjustment.

The gold standard had a number of drawbacks as well. Since the money supply was tiedup to the stock of gold in a country, there were constraints on the use of monetary policyto fight unemployment. In a worldwide recession, it might be desirable for all countries toexpand 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. Asecond drawback was a reserve shortage. As the economy grew, more money would beneeded to facilitate the increasing economic transactions. But limits in gold supply mightnot keep up with economic growth and therefore would hinder economic growth.Another drawback of the gold standard was the asymmetric distribution of goldproduction and stock. The gold standard could give countries with potentially large goldproduction considerable ability to influence macroeconomic conditions throughout theworld through market sales of gold.

Failure of Gold Standard

The gold standard was suspended with the outbreak of World War I, which interruptedtrade flows, restricted the free movement of gold, and resulted in high inflation for manycountries.

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 theirmassive military expenditures by printing money without the backing of gold. Further,labor forces and productive capacity had been reduced sharply through war losses. As aresult, price levels were higher everywhere at the war's conclusion in 1918. The loss ofconfidence in the British pound as a reserve currency was another reason. A reservecurrency is one that the central banks hold in their international reserves, and under afixed exchange regime, each nations central bank fixes its currencys exchange rateagainst the reserve currency by standing ready to trade domestic money for reserve assetsat that rate. Under gold standard, the British pound was the reserve currency and wasregarded as good as gold. The U.K. deficits in its balance of payments made othercountries worry about the U.K.s inability to convert s into gold.

Page 10


11/18

During the inter-war years (1918-1939), several countries returned briefly to goldstandard. But as the great depression continued, many countries renounced their goldstandard 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 thehyperinflation 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 from1925 to 1931 as the Gold exchange Standard. Under this standard, the United States andEngland could only hold gold reserves, but other nations could hold both gold and dollars orpounds as reserves. In 1931, England departed from gold in the face of massive gold andcapital 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 thebasis for the post-World War II payments and trading system. In addition to designingthe framework for a new international monetary system, they created twointernational institutions - the International Bank for Reconstruction and Development (theWorld Bank) and the International Monetary Fund. Since the participating officials believedthat the inter-war Great Depression had been aggravated by the instability of exchange ratesand restrictions on currency convertibility, representatives to the Bretton Woods meetingsconcluded 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 wasto include a link to gold. However, in 1944 about 70 percent of the world's monetary goldwas 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 itselfto buy gold from, or sell gold to, any participating country's official monetary institutionfor $35 per ounce. But - in contrast to the classical gold standard - the United Statesundertook 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 thevalue of their currencies within plus or minus one percent of an announced "par rate" with theU.S. dollar. A country was only allowed to change this par rate (devalue or revalue) inresponse to a "fundamental disequilibrium" in its balance of payments. The system was tobe overseen by the International Monetary Fund, which had the capacity to lend, in limitedamounts, currencies to countries in temporary need, and which was supposed tobe consulted about any proposed changes in par values.

Page 11


12/18

Under the Bretton Woods arrangements, a country was obligated to intervene in the foreignexchange market if its exchange rate began to move outside the one percent bandaround its announced par value with the dollar. If, for example, the German mark began to fallin value and approach its one percent limit from the par value, the German central bank wouldbuy marks in the foreign exchange markets. It would generally use dollars for such an

intervention, although it was free to use any currency. If it needed dollars to sell formarks, it could sell gold from its reserves to the United States, which was obligated to buythem for dollars. It could then use those dollars to support the mark. On the other hand,if the mark were to rise in value, the German central bank would be expected to sell marks inthe market; generally, it would acquire dollars in exchange, which it could hold inreserve (and earn interest, if it invested them, in US Treasury securities, forexample) for future intervention, or it could sell them to the United States in exchange forgold.

Since a major goal of the participants in the Bretton Woods meetings was expansion ofinternational trade, member countries were encouraged to make their currencies freely

convertible for trade-related (or current account) transactions. Most WesternEuropean countries achieved this goal in 1958, and Japan followed in the early 1960s.Most countries maintained some kind of controls over capital account transactions for anumber of years. Until October 1979, for example, a British citizen could not use hisor her pounds to buy dollars for capital transactions (say to buy foreign stocks)without the permission of the British government. The United States, however, did notimpose foreign exchange controls, with the exception of a period in the late 1960's when itlimited foreign direct investment by U.S. firms and imposed a tax on the purchases byAmericans of bonds and equities from foreign countries.

Key features of Bretton Woods System are:

Reserves:

Gold, U.S. $ and SDR (added in 1960s)The U.S. dollar replaced the British pound as the reserve currency and was treated asgood as gold.

Fixed parities

Under the original provisions of the Bretton Woods agreement, all countries fixed thevalue of their currencies in terms of gold but were not required to exchange theircurrencies for gold. Only the dollar remained convertible into gold (at $35 per ounce).Therefore each country established its exchange rate vis--vis the dollar. This is oftencalled the two-tier system: (1) US $ pegged to gold: $35/ounce of gold dollar-goldparity, and (2) other currencies pegged to dollar. For example, the British pound wasfixed to the dollar at $2.80/, and Japanese yen was pegged to the dollar at 360/$.

Page 12


13/18

Adjustable parities

Although each country's exchange rate was fixed, it could be changed devalued orrevalued against the dollar if the IMF agreed that the country's balance of payments wasin 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. Othercountries would buy and sell U.S. dollars to keep market exchange rates within the 1percent band around par value foreign exchange market intervention (as required by thesystem).

An integral part of the Bretton Woods system was the establishment of the IMF, whichstill administers the international monetary system and operates as a central bank forcentral 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 mainfunction of the IMF is to make temporary loans to countries to help them tide overdifficulties with current account deficits and financial crises. Member countries areentitled 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 countrysaccepting 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 membercountry to adjust the values of its currency, the exchange rate, when there was afundamental 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 positionin the Bretton Woods system. Its money supply, unlike other countries, was not tied upto defend the exchange rate system. The expansionary policy in the United States in the1960s 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 WestGermany became increasingly competitive in the world market and their currencies wereunder pressure to revalue. While the United States called on Japan and West Germany torevalue their currencies, Japan and West Germany called upon the United States tocontrol its government spending and inflation.

From purchasing power parity, we know that when the exchange rates are fixed, inflationrates 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 isoften difficult due to issues of sovereignty.

Page 13


14/18

The coordination failures among the large economies led to the collapse of the BrettonWoods system. In August 1971, the United States suspended total convertibility of thedollar to gold. This resulted in no parity between currencies. Most major currenciesbegan to float against the dollar. Attempts to re-adopt the fixed rate system failed by 1973(coupled with first oil shock). . By early 1973, the Bretton Woods system of fixed

exchange rates was abandoned altogether. Countries eventually accepted what is now thecurrent exchange rate system a hybrid of different exchange rate regimes.

The biggest advantage of the Bretton Woods regime was that it provided a stableexchange rate environment that nurtured the reconstruction of the world economy and thegrowth of international trade and finance. The main disadvantage was that it requiredcoordination of policies among member countries.

European Monetary System

After the break down of the Bretton Woods system in 1973, several European countries

attempted various mechanisms to fix their exchange rates to each other. While allowingtheir currencies to float against the dollar, these European countries tried progressively tonarrow the extent to which they let their currencies fluctuate against each other. Sixmembers of the European Economic Community (EEC), including France and Germany,jointly floated their currencies against the dollar. The currencies of the participatingcountries were allowed to fluctuate in a narrow band with respect to each other (1.125%on either side of the parity exchange rate), and the permissible joint float against othercurrencies was also limited (to 2.5% on either side of the parity). This fixed exchangerate system that arose concurrently with the fall of the Bretton Wood System was calledthe snake as this gave the currency movement the look of a snake.

In 1979, eight European countries created a formal system of mutually fixed exchangerates, called the European Monetary system (EMS). They fixed their exchangerates relative to each other, floating jointly against the dollar. The system was quitesimilar to the Bretton Wood System, with the exception that instead of the currenciesbeing pegged to the currency of one of the participating nations, a new currency wascreated for the purpose. It was named the European Currency Unit (ECU) and wasdefined as a weighted average of the various European currencies. Each member had tofix the value of its currency in terms of the ECU. This had the effect of pegging thesecurrencies with each other. Each currency could vary against the ECU and against othercurrencies within a certain band on either side of the parity rate thereby forming a paritygrid. When EMS was first set up, a currency was allowed to deviate from parities withother currencies by a maximum of plus or minus 2.25%, with the exception of Italian lira,for which a maximum deviation of plus or minus 6% was allowed. In September 1993,however the band was widened to a maximum of plus or minus 15%. When a currency isat the lower or upper bound, the central bank of both countries are required to intervenein the foreign exchange markets to keep the market exchange rate within the band. Tointervene in the exchange markets, the central bank can borrow from a credit fund towhich member countries contribute gold and foreign reserves.

Page 14


15/18

For example, if the French franc depreciates to its lower limit relative to the DM, it isobligated to sell DM reserves to make Franc appreciate. German central bank is obligatedto 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 theireconomic policies, the EMS went through a series of realignments. Despite the recurrentturbulence in the EMS, European Union members met at Maastricht (Netherlands) inDecember 1991 and signed the Maastricht Treaty. According to the treaty, theEuropean Union will irrevocably fix exchange rates among the member currencies byJanuary 1, 1999, and subsequently introduce a common European currency, replacingindividual 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 MonetaryUnion (EMU), the member countries of the European Union agreed to closelycoordinate their fiscal, monetary, and exchange rate policies and a achieve aconvergence of their economies.

European Monetary Union

On January 1 2002, 12 European countries finalized their monetary union. This meantthat they had a common central bank in Frankfurt in Germany, at which all 12countries had to agree on a common monetary policy. Eleven European countriesadopted a common currency called the euro, voluntarily giving up

their monetary sovereignty. With the launching of the euro on January1, 1999, the European Monetary Union (EMU) was created. The EMU isa logical extension of the EMS, and the European Currency Unit (ECU)was the precursor of the euro. As the euro was introduced, eachnational currency of the euro-11 countries was irrevocablyfixed to theeuro at a conversion rate as of January 1, 1999. National currenciessuch as the French franc, German mark, and Italian lira are no longerindependent currencies. Rather, they are just different denominationsof 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 tenderin the euro countries. Monetary policy for the euro countries will be conducted by the

European Central Bank (ECB) headquartered in Frankfurt, Germany, whose primaryobjective is to maintain price stability. The independence of the ECB is legallyguaranteed so that in conducting its monetary policy, it will not be unduly subjectedto political pressure from any member countries or institutions. The national centralbanks of the euro countries will not disappear. Together with the European CentralBank, they form the European System of Central Banks (ESCB). The tasks of theESCB 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

Page 15


16/18

reserves of the euro member states. Although national central banks will have to followthe policies of the ECB, they will continue to perform important functions in theirjurisdiction such as distributing credit, collecting resources, and managing paymentsystems.

Current Exchange Rate Regimes

The current exchange rate system is a hybrid of many different arrangements. TheInternational Monetary Fund classifies these exchange rate regimes into eight specificcategories. The eight categories span the spectrum of exchange rate regimes from rigidlyfixed to independently floating:

1. Exchange Arrangements with No Separate Legal Tender: The currency ofanother country circulates as the sole legal tender or the member belongs to amonetary or currency union in which the same legal tender is shared by the membersof the union.

2. Currency Board Arrangements: A monetary regime based on an implicitlegislative commitment to exchange domestic currency for a specified foreigncurrency at a fixed exchange rate, combined with restrictions on the issuingauthority to ensure the fulfillment of its legal obligation.

3. Other Conventional Fixed Peg Arrangements: The country pegs its currency ata fixed rate to a major currency or a basket of currencies, where the exchange ratefluctuates 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 widerthan 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 certainfluctuation margins around a central rate that is adjusted periodically at a fixed pre-announced 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 ratethrough active intervention in the foreign exchange market without specifying orpre-committing to a pre-announced path for the exchange rate.

8. Independent Floating: The exchange rate is market determined, with central bankintervening only to moderate the speed of change and to prevent excessivefluctuations, but not attempting to maintain it at or drive it to any particular level.

Page 16


17/18

The United States, the EU, Japan, the United Kingdom, Switzerland, and Canada areamong the major countries that follow an independent floating policy. At the other end ofthe exchange rate regime spectrum (from floating to fixed) is the currency board, whichis a monetary regime based on an explicit legislative commitment to exchange domesticcurrency 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 anexample before the system failed in 2002. Currently, Hong Kong is a well knownexample of such an arrangement.

Page 17


18/18

Conclusion

The International monetary system has evolved from the days of the gold standardto 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 secondcountry

If the ideal currency existed in todays world, it would have three attributes: afixed value, convertibility, and independent monetary policy

Emerging market countries must often choose between two extreme exchange rateregimes, either free-floating or fixed regime such as a currency board ordollarization

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

Page 18

Documents

International Monetary System Term Paper