International monetary systems

 International monetary systems are sets of internationally agreed rules,

conventions and supporting institutions, that facilitate international trade,
cross border investment and generally the reallocation of capital between
nation states.

 The IMS refers to the framework of institutions and rules within which
international; financial transactions are conducted and balance of payment
imbalances are settled.
 They provide means of payment acceptable between buyers and sellers of
different nationality, including deferred payment. To operate successfully,
they need to inspire confidence, to provide sufficient liquidity for fluctuating
levels of trade and to provide means by which global imbalances can be
corrected.
Exchange rate Mechanism
 To facilitate international transactions, currencies of different countries have to
be exchanged for each other.
 For this purpose, the value of one currency in terms of the other currencies
has to be determined. The rate of exchange between two currencies is
designated as the exchange rate.
 An exchange rate is the value of one currency in terms of another .
 The term exchange rate regime refers to the mechanism, procedures and
institutional framework for determining exchange rates at a point in time and
changes in them over time, including the factors which induce the changes.
 The exchange rate regime may prescribe a perfectly rigid or fixed exchange
rate between currencies or a perfectly flexible or floating exchange rate
between currencies
Fixed exchange rate system
 A country's exchange rate regime, under which the government or central
bank ties the official exchange rate to another country's currency (or the price
of gold). The purpose of a fixed exchange rate system is to maintain a
country's currency value within a very narrow band. Also known as pegged
exchange rate.
 Fixed rates provide greater certainty for exporters and importers. This also
helps the government maintain low inflation, which in the long run should keep
interest rates down and stimulate increased trade and investment.
Advantages
 1. It simplifies exchange transaction.
 2- It encourages long term investment by various investors across the globe.
 3- There is no fear of currency fluctuations.
 4- It is the best for small countries. It provides stability to international trade
 5- It is less inflationary.
 6- It imposes a discipline on monitory authorities to follow responsible financial
policies with countries.
 7- It promotes international trade.
 8- It contribute in raising productivity through increased international division of
labor and specialization.
 9- It promotes economic integration.
 10- It stimulates the growth of money and capital market.
Disadvantages
 1.It scarifies the objective of full employment and stable prices
 2- There is a fear of speculation
 3- A country has to bear a share of burden of the disturbances and policy
mistakes
 4- The exchange rate with a country cannot remain fixed for a long period
 5- It fails to solve the problem of BOP disequilibrium
 6- There is a need to undertake pegging operations. For this purpose it is
necessary to maintain sufficient reserves of foreign currencies
 7- It requires complicated exchange control mechanism
 Floating exchange rate
 system
System in which a currency's value is determined solely by the interplay of the
market forces of demand and supply, instead of by government intervention.
However, all central banks do try to defend these rates within a certain range by
buying or selling their country's currency as the situation warrants.
 Advantages
 1- The system is simple to operate. This system does not result in deficit or surplus
of foreign exchange. The exchange rate moves automatically and freely
 2- It helps in the promotion of foreign trade
 3- The adjustment of exchange rate is a continues process
 4- The possibility of speculation is reduced
 5- It removes the problem of international liquidity
 6- It is very economical. There is no idle holding of foreign currency reserves
 7- There is no need of international institutional arrangements
Disadvantages
 1 It is difficult to define a freely flexible exchange rate.
 2 Higher volatility: Floating exchange rates are highly volatile.
Additionally, macroeconomic fundamentals can’t explain especially
short-run volatility in floating exchange rates.
 3 Use of scarce resources to predict exchange rates: Higher volatility in
exchange rates increases the exchange rate risk that financial market
participants face. Therefore, they allocate substantial resources to
predict the changes in the exchange rate, in an effort to manage their
exposure to exchange rate risk.
 4 Tendency to worsen existing problems: Floating exchange rates may
aggravate existing problems in the economy. If the country is already
experiencing economic problems such as higher inflation or
unemployment, floating exchange rates may make the situation worse.
 5 It breaks up the world market.
 6- It is not suited for the less developed countries.
 Fixed Rate  Flexible Exchange Rate
1)Fixed rate is the system where 1) Flexible exchange rate is the
the government decides the system which is dependent on
exchange rate. the demand and supply of the
2) Fixed rate is determined by the currency in the market.
central government.
2) Flexible rate is determined by
3) Currency is devalued (official demand and supply forces.
lowering of the value of a country's
currency under a fixed exchange 3) Currency appreciates and
rate ) and if any changes take place depreciates in a flexible
in the currency, it is revalued. exchange rate.
4) Government bank determines the 4) No involvement of
rate of exchange. government bank.
5) Foreign reserves need to be 5) No need for maintaining
maintained foreign reserve.
6) Can cause deficit in BOP that 6) Deficit or surplus in BOP is
cannot be adjusted automatically corrected
Evolution of International Monetary
system
 1.Bimetallism-before( 1875)
 2. Classical gold standard(1875-1914)
 3. Interwar period(1915-1944)
 4 Bretton woods system (1945-1972)
 5. Flexible exchange rate regime(1973)
 In the first phase, namely, the commodity money phase, valuable objects
were used as the medium of exchange. It was also known as the barter
system.
 In the second phase, viz., the representative money phase, coins or notes,
backed by valuable metals such gold or silver were used as money. These
coins or notes were representing the metals stored for providing value to the
money.
 In the third phase, namely, the fiat money phase, paper currencies are used
as money. These currencies are not backed by any valuable commodities but
only by the ‘faith and credit’ in the government issuing these currencies. Fiat
money is the money that is intrinsically useless and is used only as a
medium of exchange.
 Bimetallism: Before 1875
 Before 1870 can be characterised as bimetallism means both gold and silver
were used as international means of payment and exchange rate can be either
determined by gold or silver.
 Double standard in free coinage was maintained both gold and silver.
 Example in Britain metallisation was maintained till 1816
 In USA this was adopted by the coinage act of 1792 and remained a legal
standard until 1873.
 France –after French revolution
THE GOLD STANDARD (1875-
1914)
The oldest exchange rate regime which prevailed from the later half of the
19th Century till the First World War was the gold standard.
 In the beginning, gold coins were used to be exchanged for goods and
services. The value of the coin was determined on the basis of the weight of
gold in the coin. Later on, the exact correspondence between the value of the
coin and its weight was relaxed and gold coins became representative money.
 Further modifications were made in the monetary system in tune with the
times, but gold still continued to be the base for the monetary system.
 The monetary system, which used gold as the base for determining the value
of money, was known as the gold standard.
 The phrase ‘gold standard’ is defined as the use of gold for determining the value
of money of a country. The gold standard was adopted by the Western European
countries and the United States during the later half of the 19th Century and
continued to be used till the outbreak of the First World War.
 There were different versions of the gold standard such as the gold specie
standard( Purest form of gold), the gold bullion standard, and the gold exchange
standard.
 Under the gold standard, the value of the domestic currency of a country is
stated in terms of weight of gold. The exchange rate between two currencies
depends on the relative weight of gold specified for each currency. The exchange
rate is the ratio of weight of gold of the currencies. This rate was known as the
mint parity or the mint exchange rate.
 The exchange rate remained constant as it was based on the weight of gold in
currencies. Thus the gold standard resulted in a fixed exchange rate system.
Features of Gold standard
 The Government adopting it fixed the value of currency in terms of specific
weight and fineness of gold, and guaranteed a two-way convertibility.
 Export and import of gold were allowed so that it could flow freely among the
gold standard countries.
 The Central Bank, acting as the apex monetary institution, held gold reserves in
direct relationship with the currency it had issued.
 The Government allowed unrestricted minting of gold and melting of gold coins at
the option of the holder.
Interwar period(1915-1944)
 War ended classic gold exchange standard in 1914
 After war many European country face hyperinflation.
 During World War I (1914–19), the warring nations which were following the gold
standard regime began to deviate from the system in order to expand money supply
beyond the gold reserves in possession. The countries engaged in the war required
expansion in money supply for financing the war activities. But this was not easy
under the gold standard regime.
 Gradually the system became non-functional. After the War, many countries tried to
return to the gold standard regime, but the attempt was not successful. The Great
Depression of the 1930s worsened the situation and led to the collapse of the gold
standard regime. Exchange rates between currencies became volatile, leading to a
system of floating exchange rates.
 This situation continued till the end of the World War II (1939–45). Thus, during the
inter-war years, there was instability in the global monetary system. A floating
exchange rate system replaced the fixed exchange rate system that prevailed under
the gold standard regime.
 THE BRETTON WOODS SYSTEM OF EXCHANGE RATES(1945-1972)

 At a major conference at Bretton Woods, New Hampshire, USA in July 1944,

two international financial institutions, namely, the International Monetary
Fund (IMF) and the World Bank (WB), were established.
 A new exchange rate regime was negotiated and approved. It was to be
monitored and implemented by the IMF.
 This new exchange rate system came to be known as the Bretton Woods
system of exchange rates.
 At the Bretton Woods Conference, an attempt was made to establish a fully
negotiated monetary order intended to govern currency relations among
sovereign states.
 A compromise was sought between the polar alternatives of freely floating
rates or irrevocably fixed rates so that some arrangement that could reap the
advantages of both without having the disadvantages of either could be
made. The Bretton Woods system was a negotiated global monetary system
that provided for a fixed parity between currencies with adjustable pegs.
 It was the ‘pegged rate’ or ‘adjustable peg’ currency regime, also known as
the par value system.
 The Bretton Woods system was expected to stabilize exchange rates. Under
this system, the US dollar became the international money and the
intervention currency. Hence, the success of the system depended on the
confidence in the stability of the US dollar.
 The system worked fairly well till the beginning of the 1960s. Slowly pressure
began to build on the US dollar from mid-1960s, and the confidence in the US
dollar was eroded due to a mixture of political and economic factors.
 On August 15, 1971, the US Government suspended the convertibility of the US
dollar into gold, thus virtually ending the Bretton Woods exchange rate regime.
The major currencies once again shifted to the floating exchange rate regime.
 Another attempt was made in December 1971 to resurrect the par value system
underlying the Bretton Woods system by a realignment of the par values of
major currencies and by widening the bands of permissible variation around the
central parity. This attempt was formalised so called Smithsonian Agreement.
 By early 1973, the world monetary system shifted to the floating exchange rate
regime.
 A committee was constituted to suggest guidelines for evolving an acceptable
exchange rate system. The recommendations of the committee resulted in
the Jamaica agreement of 1976.
The salient features of the Bretton Woods system
 Each country was required to set a fixed value for its currency in terms of gold
or the US dollar. This value would be known as the par value of the currency.
 The exchange rates between currencies would be determined on the basis of
their par values.
 Minor fluctuations in exchange rates within a narrow band of 1% above or
below the central parity were permissible.
 Fluctuations beyond 1% had to be corrected by the monetary authorities of
the country through market intervention.
 In the event of any ‘fundamental disequilibrium’ in balance of payments, a
country was free to readjust the par value of its currency. However, changes
beyond 1% of the existing par value in either direction required the consent
and approval of IMF.
 The US Government fixed the par value of US dollar in terms of gold as US $
35 per ounce of gold. Further, the US Government agreed to convert the US
dollar freely into gold at the fixed parity of US $ 35 per ounce of gold.

 The major options under the new exchange rate regime were
 Floating
 Independent or managed( Also called dirty float, currency is valued is allowed to
fluctuate in foreign exchange market mechanism but the central bank or monetary
authority of country intervenes)
 Pegging of currency( trying to nations currency exchange rate to other
currency)to
 a single currency
 a basket of currencies
 SDRs (Special Drawing Rights)
 Crawling peg(Controlling the value of currency in terms of other currency)
 Target zone arrangement. ( Monetary system where countries agree to keep their
exchange rates within a set range around a chosen central rate)
The flexible exchange rate regime :1973 to
present
 The flexible exchange rate regime that followed the demise of Bretton
wood system was ratified after the fact in January 1976 when IMF
members meet in Jamaica.
The key elements in Jamaican agreement include:
 Flexible exchange rates were declared by IMF
 Gold was officially abandoned as international reserve asset. Half of
the gold holdings were returned to the members and other half were
sold.
 Non oil exporting countries and less developed countries were given
greater access to IMF funds.
PRESENT EXCHANGE RATE
REGIME
Phase period Situation
1st period 1870- Adopted the gold standards for their domestic current,
1914 resulting in fixed exchange rate among the currencies.
Period ended with outbreak of First world war, when
most countries abandoned gold standard regime.

2nd period 1914- Period of instability in the international monetary

1946 system
3rd period 1946- The exchange rate policy was dominated by the
1973 Bretton woods agreement of 1944.
4th period 1973 Floating exchange regime , but it is not uniform
system(different variant).
Exchange rate regime in India
 1950- mid December 1973 exchange rate with rupee linked to the pound
sterling(Except for the devaluations in 1966 and 1971.
 When pound sterling floated on June 23 1972 the rupee links to the British currency
was maintained  a de facto devaluation to reflect the pounds depreciation.
 Sept 24 1975 rupee ties to the pound sterling were removed and India shifted to
managed floating exchange regime.
 In 1990s the above exchange rate regime came under severe pressure from the
increase in trade deficit and net visible deficit which led the RBI to undertake
downward adjustment of rupee in two stages on July 1 and July 3 1991.
 The adjustment was followed by the introduction of LERMS(Liberalised exchange rate
management system) march 1992 and adoption of dual (Dual and market
determined)
 In March 1993 LERMS replaced by unified exchange rate system and hence the system
of market determined exchange rate was adopted.
 In addition foreign exchange of India was characterised by the existence of both
official and black market rate with medium premium.
Currency CONVERTABILITY
Current Account Convertibility

 This refers to the freedom to convert domestic currency into

foreign currency for transactions related to goods, services, and
income. It facilitates international trade and is essential for
economies engaging in global commerce. For example, India
achieved current account convertibility in 1994, allowing free
conversion for most trade-related purposes.
 Currency convertibility refers to the ease with which a country's
currency can be converted into another currency or gold. It plays
a significant role in facilitating international trade and investment
by allowing businesses and individuals to exchange currencies
without significant restrictions. There are two main types of
currency convertibility:
Capital Account Convertibility

 This allows residents to freely convert local currency into foreign

currency for financial transactions, such as investments in foreign
assets or securities. Capital account convertibility is more
complex and is often controlled by governments to prevent
excessive capital flight or currency instability. India, for instance,
has partial capital account convertibility, with restrictions on the
amount and type of foreign exchange transactions individuals
and businesses can engage in.
Advantages of Currency
Convertibility:
 Facilitates International Trade: Simplifies the process of
buying and selling goods across borders.
 Attracts Foreign Investment: Easier conversion boosts
investor confidence.
 Encourages Economic Growth: Allows capital to flow freely
into productive sectors.
 Promotes Global Integration: Enhances a country’s
participation in the global economy.
Disadvantages

 Currency Volatility: Freely convertible currencies may

experience sharp fluctuations in value.
 Speculative Attacks: Open capital accounts can lead to
speculative trading that destabilizes the economy.
 Loss of Monetary Policy Control: Excessive external influence
on domestic financial systems.