UNIT 8 INTERNATIONAL MONETARY SYSTEM AND EXCHANGE RATE REGIME Strueture 8.0 Objectives 8.1 Introduction 8.2 Fixed Exchange Rates under Gold Standard (1880-1914) 8.2.1 Salient Features of the Gold Standard 8.2.2 Experiences with the Gold Standard Regime (1880-1914) 8.3 Fixed Exchange Rates under the Dollar based Gold Exchange Standard (1947-1973) 8.3.1 The Background 8.3.2 The Rise of Bretton Woods System 8.3.3. Salient Features of the Bretton Woods System 8.3.4 The Demise of the Bretton Woods System 84 Principles of Adjustments 84.1 Income Adjustment (Foreign Trade Multiplier with and without Foreign Repercussions and Determination of National Income and Output) 8.4.2 Price Adjustment (Marshall-Lemer Condition) 8.5 Floating Rates and Managed Floating 8.6 Monetary Theory of Balance of Payments 8.7 ACritical Review of Monetary Theory of Balance of Payments Adjustment 8.8 Relative Merits and Demerits of Fixed and Flexible Exchange Rates 8.9 Let Us Sum Up 8.10 Key Words 8.11 Some Useful References 8.12 Answers/Hints to Check Your Progress Exercises 8.0 OBJECTIVES After reading this Unit, you will be able to © describe the history of international monetary system; discuss the fixed exchange rate regime under Gold Standard; © explain the dollar based Gold Exchange Standard System; © justify the Price and Income Adjustment; © give reasons for the floating rates and managed floating regime; and © critically examine the Monetary Approach to Balance of Payments. 8.1 INTRODUCTION Economic transactions between residents of different countries require some sort of arrangement to effectuate payments and settle the trade or exchange involved. In modern times, these transactions have been effectuated by a wide array of monetary arrahgements. In this Unit, we will discuss different International Monetary Systems (henceforth, IMS), which have been evolved through time since 1873. We will begin with the fixed exchange rate regime as evolved under the Gold Standard and then proceed to discuss the Bretton Woods System, which came into existence immediately after the Second World War. It was a different version of the earlier Gold Standard regime in which dollar served as the reserve currency to settle any BoP disequilibrium. The GoldBalance of Payments, BOP Adjustments, Exchange Rates Exchange Standard regime ceased to exist after 1973 and floating or flexible tate system came into vogue. The era of IMS since 1973 is better described as managed float or no system. Along with tracing the evolution of different IMS since 1873 we will also focus our attention to BoP or external adjustment in an open economy. In this regard, we will’ discuss the price and income adjustments under fixed rate and monetary approach to BoP under floating rate. We will sum up our discussion by noting relative strengths and weakness of fixed and flexible exchange rate regimes. 8.2 FIXED EXCHANGE RATES UNDER GOLD STANDARD (1880-1914) From antiquity to modem times, countries operated on a specie commodity standard, implying the predominance of metals like gold and silver as the circulating media of the economy. Because of some particular attributes gold and also silver have been considered as the most suitable commodity money. ‘These attributes include scarcity, durability, divisibility, homogeneity, and consistency of quality. The acceptability of these metals as money was also aided by the fact that they were widely recognised to have value in non- monetary uses (e.g. jewellery, industrial), they enjoyed relatively stable value in terms of other commodities, and their quality could be verified or certified by experts. In their purest form, specie commodity standards operated on the basis of full-bodied coins, the monetary value of which equalled the value of the metals they contained, Sovereigns themselves frequently reduced the gold (or silver) content of the coins they minted, a practice called debasement. Coin debasement is the predecessor of the modem devaluation of currency, usually led to a loss of coin’s value. Both full-bodied and debased coins were in circulation. People generally tend to hoard fuller bodied coins for their own accumulation and used debased coins for transaction purposes. Fuller bodied coins could also be melted to be sold as metal, exported, or even sent to the coinage to be exchanged or coined into new, debased coins. Same face values were assigned to fuller bodied and debased coins. Debased coins were overvalued since they were assigned a higher face value than their metal contents justified, Going by this logic, fuller bodied coins were overvalued relative to the debased coins. The end product was that debased money — over- valued as a medium of exchange ~ would remain in circulation, while full bodied coins - undervalued as a medium of exchange ~ would disappear. In the above backdrop, we have to understand the fixed exchanged rate regime as evolved through the Gold Standard. Britain operated under a gold standard for most of the nineteenth century . It was not until 1870s it achieved widespread adoption. Most European countries, ted by Germany in 1871, moved toward the Gold Standard during this decade and the United States followed suit in 1879. By 1880 the Gold Standard became a full-fledged intemational ‘monetary system with the adherence of major countries. For the next three decades, until its abandonment after the outbreak of World War I in 1914, the international gold standard reigned supreme and came to incorporate the major trading countries and colonial territories of the time. 8.2.1 Salient Features of the Gold Standard The Goid Standard can be characterised in terms of three basic “rules of thegame”. They are as follows: i) A country fixed the value of its currency in terms of gold. It was done by the government setting a fixed price of the gold in terms of its own. currency and intervening in the gold market (through p maintain that price. This establishes a two-way convert domestic currency or coin and gold. For instance, the US set the gold price at $20.67 per ounce and the US government was ready to buy or sell gold at this price to maintain the price of gold at that level. Gold values of any two currencies operating under the Gold Standard, specified their relative value. This relative value was referred to as mint parity ot mint exchange rate. For example, the gold value in Britain was set at £4.24 per ounce. Given the US price of gold $20.67 per ounce, the implicit relative value of the dollar in.terms of the pound or the mint parity exchange rate of dollar in terms of pound was approximately $4.87 (=$20.67/£4.24) per pound, which remained so during 1880-1914, Note that the mint parity exchange rate of dollar in terms of pound was an implicit exchange rate. The direct market exchange rate between dollar and pounds was decided by the interaction of demand for and supply of dollar in the British foreign exchange market. The direct rate did not deviate much from the mint parity rate due to the free flow of gold among the countries. We will now learn why this was the case. ii) Under pure gold standard, free trade in gold was assured. Both imports and exports of gold were free and unrestricted. This free trade in gold ensured that market exchange rates would not deviate much from the mint parity. Let us consider an example here. Suppose the US dollar-pound exchange rate is $5.00/£, which is significantly different from the mint parity of $4.87/ £. In this case, one would purchase say an ounce of gold in the US at a cost, of $20.67 and sell it in Britain to get £4.24, and then exchange this pound in the British foreign exchange market to obtain $21.20 (=£4.24 X $5.00/ £). Thereby, he would make a profit of $0.53 per ounce of gold (=$21.20 - $20.67) by freely buying and selling gold across countries. This process of buying and selling to take advantage of different prices in different markets is known as arbitrage, and those who engage in these transactions are known as arbitrageurs. Returning to the above example, market exchange rate would fall, a arbitrageurs tend to sell more pounds to acquire dollar in the British market. In the absence of transaction costs, market exchange rate of dollar in terms of pound would match with the dollar-pound mint parity rate. However, the transaction costs in the form of shipments of gold, prevented the market exchange rates to equate with the mint parity rate. But the mar- ket rates confined within narrow limits around mint parity rates. These limits were known as gold points. iii) The Central Bank or the monetary authority has to hold gold reserves in a direct relationship to the money notes it issues. With this provision the monetary authorities could engage smoothly in their purchases and sales of gold and would not land up in situations of not being able to fulfil sudden demand for gold on the part of the public. The gold backing provides for a certain amount of gold behind the currency issued, thereby assuring the convertibility of the currency into gold. This gold provisioning imposed some discipline on monetary expansion in the economy. The Central Bank can issue new currency only by acquiring gold from the public. The main International Monetary System and Exchange Rate Regime