HISTORY OF MONETARY SYSTEM

GOLD STANDARD (1870-1914)

GOLD-EXCHANGE STANDARD (1914-1944)

BRETTON WOODS SYSTEM (1944-1973)

POST BRETTON WOODS SYSTEM (the current system) EUROPEAN MONETARY SYSTEM

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GOLD STANDARD
Oldest standard (1870-1914) UK since 1821 US since 1834 Most of the countries had joined the system by 1870 It was in use till the beginning of World War I (After this again for few years) The essential feature of this system was: Governments gave an unconditional guarantee to convert their paper money into gold at a pre-fixed rate at any point of time, on demand. Continued commitment of governments and readiness of people to believe it, were the reasons for the sustenance of such system for a long period of time The exchange rate between two currencies was determined on the basis of the rates at which respective currencies could be converted into gold Ankur Srivastava srivankur@rediffmail.com 9212803190

 Example: if in US 1 ounce gold = US $400 and in UK 1 ounce gold = UK 200, then the exchange rate (called Mint parity) between $ and would be $2/ The exchange rate would stay at this equilibrium level because of arbitrage possibility involved Assume prevailing rate be $2/ so a person wanting to convert $ into would have to pay $2.5 for every He could instead buy an ounce of gold for $400-------Transport it to UK-------Sell it for 200 Therefore he would be able to get pounds at the exchange rate of $2/ As everyone would follow this route, there would be no demand for pounds in the foreign exchange market. Yet the supply would remain unaffected. This demand-supply imbalance would cause the exchange rate to come down and this would keep happening till the exchange rate reaches the equilibrium level i.e. $2/ An exactly opposite process would correct the exchange rate if it falls below the equilibrium level. Thus, the exchange rate would be maintained at equilibrium. Ankur Srivastava srivankur@rediffmail.com 9212803190

 Note: Above discussion assumes 1. no transaction cost for buying and selling goods 2. no shifting/transportation cost In reality, the above said costs are involved, so the exchange rate would be able to fluctuate between the bands on either side of the equilibrium exchange rate, the bands being determined by the size of these costs. the end points of the range fixed by these bands is referred to as Gold points there was an inbuilt mechanism in the Gold standard to help correct any imbalance in international trade (i.e. international receipts and payments) is known as price-specie-flow-mechanism

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Example:

Result

France Exporting more than importing Trade surplus

Germany

Gold reserves

According to Quantum theory of Money Attractiveness of goods to both German & French consumers

would go up & its money supply will increase Price of goods produced in France also increases Decreases Exports comes down & import from Germany increases

Trade deficit Excess supply of DM DM- exchange rate would come down below mint-parity level Suppliers of DM would prefer to their holdings via Sell DM for Gold-ship it to France-sell Gold for route So, there will be a transfer of Gold from Germany to France would come down & will be forced to reduce money supply Price of German goods decreases Increases

This process continues till the trade balance between the two countries is Ankur Srivastava srivankur@rediffmail.com 9212803190 achieved

Advantages: 1.Price stability of Gold enforced discipline 2.Predictability of exchange rate movements

According to Quantum theory of Money:

in price level is directly proportional to in money supply With an increase in money supply, the same amount of goods are being chased by more money, hence price of those goods increases

The Gold Standard was abandoned with the advent of World War I in 1914.

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Note: Fixed parity theory in Gold Standard 1. from 1821-1914, Great Britain has value 3,17s,101/2 d per ounce 2. from 1834-1933, United States has value $20.67 per ounce (with the exception of Greenback period 1861-1878)

Thus, over the period 1834-1914 (with the exception of Greenback period), the exchange rate between and $ was $4.867 per (referred to as Par exchange rate)

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GOLD-EXCHANGE STANDARD

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 1914-1944
The Gold standard broke down during World War I and was briefly reinstated from 1925-1931 as the Gold-exchange Standard Under this standard, the US and England could hold only Gold reserves, but the other countries could hold both Gold as well as US$ or UK as reserves. So, instead of holding Gold as a reserve asset, they started holding reserves of that currency which is on Gold Standard i.e. US$ or UK (for most of the countries, it was UK) During World War I and early 1920s, currencies were allowed to fluctuate over fairly wide ranges in terms of Gold, however, flexible exchange rates did not work in an equilibrating manner. On the contrary, international speculators sold the weak currencies short, causing them to fall further in value than warranted by the real economic factors. The reverse happened with strong currencies. The net result was that the volume of world trade did not grow in 1920s in proportion to the world GNP and declined to a very low level with the advent of depression in 1930s
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 US returned to Gold standard in 1919, UK in 1925 and France in 1928 UK returned to a modified version of the Gold standard at the prewar parity (over-valued) (Increase in unemployment + economic stagnation) The final blow came in the form of the Great Depression of late 1920s and early 1930s that started in US and soon spread to the other parts of the world. The effect of America increasing its interest rates and trying to deflate its economy was devastating for other countries. While capital started flowing from Britain to America (instead of towards Britain), other economies dependent on exports to America found their income falling drastically due to reduced American demand and trade barriers put up by America. Such economies then faced low employment, low earnings, low demand and all this was happening when the employment levels were worrying the countries more than worsening account balance.
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 Although Britain was acting as the banker to the world, even its gold reserves were not enough to back financial obligations it was creating on itself. Further, unlike a normal bank, it did not have any lender of last resort Germany defaulted on its payment obligation France started converting its holding into gold in order to shore up its gold reserves As a result, Britain gold reserves started depleting rapidly A major Australian bank Credit Anstalt collapsed All these together spread a financial panic around the world as Britains ability to honour its commitment becomes doubtful Soon everyone started trying to convert their pound holdings into gold Britain being unable to fulfill its commitment abandoned the system in 1931, in order to save its economy from disaster
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 With Britains departure from the system, the pressure shifted to US $ (the only remaining currency convertible into gold). This pressure eventually resulted in the US suspending the convertibility in 1933. With this, the Gold exchange standard effectively came to an end. As most of the countries were facing an economic downturn and needed external demand to boost domestic economy, a series of competitive devaluations (where every country tries to devalue its currency more than the other countries, in order to boost its exports-also called beggar- thy-neighbor policy) started taking place. US returned to modified gold standard in 1934 when $ was devalued to US$35 per ounce of gold. Although US returned to standard, gold was traded only with foreign central banks, not private citizens. From 1934 to end of World War II, exchange rates were theoretically determined by each currencys value in terms of Gold During World War II and its immediate aftermath, many of the main trading currencies lost their convertibility into other currencies. The dollar was the only major trading currency that continued to be convertible. Due to extreme volatility of the exchange rates and the restrictions imposed on trade and capital flows, international trade came down to very low levels and international capital flows almost stopped.
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BRETTON WOODS SYSTEM

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 1944-1973 With the world at war, representatives of 44 countries met in Bretton Woods, New Hampshire, USA to create a new international monetary system (on July 1, 1944)] Such system should address the following issues: Stoppage of all international economic activity; Steep fall in global economic growth; Hyper inflation; Co-operation on economic front impossible because of war; A system of stable exchange rate was required; Ensure that the countries do not get incentive by following inflationary policies; Also, some arrangement is required to tide over ST BOP problem and help them remain within the system without causing undue turmoil in their economies
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 The agreement was made in 1944 but implemented in 1946 The breakdown of the inter war gold standard and the mutually destructive policies that followed, convinced leaders that a new set of o-operative monetary and trade arrangements was a pre- requisite for the world peace and prosperity The new international monetary system agreed upon by all 44 nations held at Brettons Woods, came to be known as the BRETTON WOODS SYSTEM

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The main terms of the agreement arrived at were as follows: 1) A system (which came to be known as the adjustable peg system) was established which fixed the exchange rates, with the provision of changing them if necessity arose. Under the new system, all the members of the newly set up IMF (see point 2) were to fix the par value of their currency either in terms of gold or in terms of US$. The par value of the US$ ,in turn, was fixed at $35 per ounce. All these values were fixed the approval of IMF and reflected the changed economic and financial scenario in each of the countries and their new position in international trade. Further, member countries agreed to maintain exchange rates for their currency within a band of one percent on either side of fixed par value. The extreme points of these bands were to be referred to as UPPER and LOWER SUPPORT POINT. If rates moves beyond these points, the monetary authorities were to stand ready to buy or sell their currencies in exchange for US$ and thereby support the exchange rates.
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2) Two new institutions were to be established namely, INTERNATIONAL MOENETARY FUND (IMF) and THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELPOMENT (IBRD) also known as WORLD BANK IMF was supposed to be more important and powerful than the World Bank. It was decided that the member countries would meet under the aegis of this institution and together take a decision on any important matter which might affect the world trade or world monetary system. Hence, co-operation and mutual consultation was built into the system in order to avoid the universally harming policies being followed by most of the countries before the World War II. The second most important function of these institution was to provide funds to member countries to help them tide over temporary BOP deficit. 3) Currencies were required to be convertible for trade related and other current account transactions and the government were given the power to regulate capital flows. This was done in the belief that capital flows destabilize economies. For the purpose of such conversion, gold reserves needed to be maintained by US and US$ reserves by other countries. Ankur Srivastava srivankur@rediffmail.com 9212803190

4) Since there was a possibility of such exchange rate being determined as may not be compatible with a countrys BOP position, the countries were allowed to revise the exchange rate up to 10% of the initially determined rate, within 1 year of the rates being determined. After that period, a member country could change the original par value up to 5% on either side without referring the matter to IMF, that too if its financial and economic conditions made it essential. A bigger change could be brought only with the consent of IMFs executive board, which allow it in case of a fundamental disequilibrium in its BOP. Continuous reduction in reserves was supposed to serve as an indication of a fundamental disequilibrium. 5) All the member countries were required to subscribe to IMF capital. The subscription was to be in the form of the gold (one-fourth of subscription) and its own currency (the balance). Each country quota in IMF capital was to be decided in accordance with its position in the world economy. This capital was needed to enable IMF to help countries in need of reserves for defending their currency.
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THE MECHANISM Process of maintenance of exchange rate under Bretton Woods: Example: DM and US$. Parity exchange rate = 1.5 DM/$ or $0.6667/DM 1.5 DM/$ DM 1.485/$ DM 1.515/$ $0.6667/DM $ 0.6600/DM $ 0.6734/DM The demand and supply curve for DM under Bretton Woods System D2(DM) S(DM)

$/DM
0.6734 0.6667 0.6600 0

D1(DM)
A B

S Upper Support Point

D3(DM) D Lower Support Point

Quantity of DM per period of time

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Market demand DM D1(DM) Market supply DM S (DM)

Intersection Parity $0.6667/DM or DM1.5/$

DEMAND DM
Importer of German goods need to pay in DM (German Exports) Investors who invests in Germany

SUPPLY DM
Exporter of German goods use DM to buy other currencies German investors who invests outside Germany Supply curve for DM also confirms to the normal shape of a commodity supply curve As the price of DM goes up, its supply increases

Demand curve for DM follows the normal shape of a commodity demand curve
As the price for DM goes up, its demand goes down

Price Demand

Price

Supply

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NOTE: A reduction in the price of a currency in terms of another currency is termed as depreciation in exchange rate and an increase in the price of a currency in terms of another currency is termed as appreciation in exchange rates.

Demand for a currency goes up when it depreciates

Supply of a currency goes up when it appreciates Suppose, sudden increase in demand of German goods, increase in demand DM and the demand curve shifts to right D2(DM). New equilibrium rate lies above S. So, Central Bank of Germany has to intervene and supply adequate amount of DM (by buying $). Hence, accretion of $ reserves in case of an appreciation of the domestic currency. If, demand decreases D3(DM) Sell $ for DM Supply adequate amount of $. Hence, depletion of reserves in case of depreciation of domestic currency.Ankur Srivastava srivankur@rediffmail.com
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PRICE ADJUSTMENT MECHANISM Demand increases D2(DM), rate above S, Central Bank demand $. As $ have to be paid in DM Supply of DM increases. According to the Quantum theory, increase in money supply increases the price of the German goods and hence make them less competitive Demand of imported goods increase in Germany Demand of German exports decreases Demand of DM also decreases Demand curve shifts to D3(DM) At the same time, Increased demand of imported goods in Germany increases the supply of DM Supply curve shifts to S2(DM) The new equilibrium rate now will again falls under the Ankur Srivastava srivankur@rediffmail.com permitted range. 9212803190

S1(DM) D2(DM) $/DM 0.6734 0.6667 0.6600 0 D3(DM) D Lower Support Point D1(DM)
A B

S2(DM) S Upper Support Point

Quantity of DM per period of time

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During Bretton Woods System

IMF (International Monetary Fund) IBRD (International Bank for Reconstruction and Development also called as World Bank) IFC IDA (International Finance Corporation) (International Development Corporation)

1956 1960

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International Monetary Fund (IMF)

Established in 1944, operative in 1947 The IMF was the key institution in the new international monetary system and it has remained so to the present. OBJECTIVE: To ensure proper working of the international monetary system PURPOSE: 1) To promote international monetary cooperation through a permanent institution which provides the machinery for consultation and collaboration on international monetary problems. 2) To facilitate the expansion and balanced growth of international trade and to contribute there by to the promotion and maintenance of high level of employment and real income and to the development of the productive resources of all members as the primary objective of economic policy. 3) To promote exchange stability, to maintain orderly exchange arrangement among members, and to avoid competitive exchange depreciation Ankur Srivastava srivankur@rediffmail.com
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International Monetary Fund (IMF)

4) To assist in the establishment of multilateral system of payments in respect of current transactions between the members and in the elimination of foreign exchange restrictions which hamper the growth of the world trade. 5) To give confidence to the members by making the general resources of the fund temporary available to them under adequate safeguards, thus providing them with opportunity to correct maladjustments in their BOP without resorting to measures destructive of national or international prosperity.

6) In accordance with the above, to shorten the duration and lessen the degree of disequilibrium in the international BOP of members.

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One of the most important function was to provide reserve credit to member countries facing temporary BOP problems. For the purpose, a currency pool was maintained. Each member country contribute (partly in international reserve currency and partly in its domestic currency) as per its quota (which determines a countrys access to the pool and its voting power at IMF) A country could draw from IMF in tranches. A tranche is equal to 25% of a country quota. Drawing of first tranche automatically approved by IMF. A further 100% of its quota can be borrowed in four steps, with each step, stricter conditions are imposed. In order to draw from IMF, a member country has to buy reserve asset and other currencies by paying its own currency to IMF. At the time of repayment, borrowing country reverses the deal. IMF management is vested in its executive board out of its 22 directors, six are appointed by government holding largest quota and the rest are elected by remaining countries. MD (also, Chairman of the executive board) is appointed by the executive board for 5 years. The board of governors, which is the highest governing body of IMF meet once in a year to take major policy decisions. Its members are generally the Finance Ministers or the Central Bank governors of the member countries. All member countries are represented on this board.
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POST-BRETTON WOODS SYSTEM

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As the Bretton Woods System was abandoned in 1973, most countries shifted to floating exchange rates.

This fact was finally recognized by IMF and amendments were carried out in the articles in Jamaica in 1976 and became effective on April 1, 1978
Now, countries were given much more flexibility in choosing the exchange rate system they wanted to follow and in managing the resultant exchange rates. They could either float or peg their currencies. The peg could be with a currency, with a basket of currencies or with SDR but not with gold. This was done to reduce the role of gold and to make SDR more popular with reserve assets. For the same, value of SDR was redefined in terms of a basket of currency rather than in $ terms. Also, members were not required to deposit a part of their quota in gold and IMF sold off its existing gold reserves. In order to make SDR more attractive as a reserve asset they were made interest bearing. Ankur Srivastava srivankur@rediffmail.com
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It was allowed to be used for different types of international transactions. The member countries were also left free to decide upon the degree of intervention required in foreign exchange markets and hence make it compatible with their economic policies. IMF was given increased responsibility for supervising the monetary system - identify countries causing changes in exchange rates which proved disruptive to international trade and investment. - then suggest alternative economic policies to such countries - also identify any country trying to defend its exchange rates (which is inconsistent with the underlying economic fundamentals) - a constant monitoring of the reserves position of various countries Now, access to IMF assistance become easier for the countries facing the ST imbalances in their BOP.

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Countries were free to determine their exchange rate policies, however, they were required to ensure that economic and financial policies followed by them were such as to foster orderly economic growth and reasonable price stability. They also had to follow principles of exchange management adopted by IMF in 1977, which are : 1. A member country neither should manipulate the exchange rates (to prevent a correction in BOP) nor use exchange rates to gain competitive advantage in international markets. 2. A member country was required to prevent short term movements in exchange rate which could prove disruptive to international transactions by intervening in the exchange markets. 3. While intervening in foreign exchange markets, a member country should keep others interest in mind, especially whose currency it chooses to intervene in.

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These principles attempted to bring some stability in the foreign exchange markets and to prevent another of competitive devaluations. Given the freedom, different countries chose different exchange rate mechanism. Some kept their currencies floating, some pegged them either to a single currency/a basket of currencies. A peg was maintained by intervention in foreign exchange markets and by regulating foreign exchange transactions. Instead a lot of volatility has been since experienced. To remove such volatility to an extent, sometimes a group of nations come together to form closer economic ties. One such group is European Monetary System.

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