International monetary system

A set of rules, regulations, institutions,

procedures, practices and mechanisms
which determine the rate at which the
conversion takes place ( called the
exchange rate) and the movements in the
exchange rate over a period is called
international monetary system.
 Exchange rate
• Exchange rate is formally defined as the
value of one currency in terms of another.
There are different ways in which
exchange rates can be determined.
• IMF currently classifies exchange rate
arrangements into eight separate regimes:
 They are
• Exchange arrangements with no separate legal
tender
• Currency board arrangements
• Conventional fixed peg arrangements
• Pegged exchange rates with horizontal bands
• Crawling pegs
• Exchange rates with crawling bands
• Managed float system
• Independent float system
 Exchange arrangements with no
separate legal tender
• The currency of another country circulates
as the sole legal tender or the country
belongs to a monetary or currency union
in which the same legal tender is shared
by the members of the union. E.g.
Ecuador, El Salvador and Panama uses
US dollar. 12 euro zone members use
Euro, common currency
 Currency board system
• Under currency board system, the country
fixes the rate of its domestic currency in
terms of a foreign currency and its
exchange rates in terms of other
currencies depends on the exchange
rates between the other currencies and
the currency to which the domestic
currency is pegged. Eg. Hong Kong,
Argentina and Estonia
 Conventional fixed peg
arrangement
• The country pegs its currency( formally or
de facto) at a fixed rate to a major
currency or a basket of currencies, where
the exchange rate fluctuates within a
narrow margin of less than 1%, plus or
minus, around a central rate. Eg. Malaysia
and Saudi Arabia
 Pegged exchange rates within
horizontal bands
• The value of the currency is maintained
within margins of fluctuation around a
formal or de facto fixed peg that are wider
than at least 1 percent, plus or minus,
around a central rate. Eg. Denmark, Egypt
and Hungary
 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. Eg. Bolivia and
Costa Rica.
 Exchange rates within crawling
bands
• The currency is maintained within certain
fluctuation margins around a central rate
that is adjusted periodically at a fixed pre
announced rate or in response to changes
in selective quantitative indicators. Eg:
Israel, Romania and Venezuela.
 Independent float
• The exchange rate is said to be freely
floating when its movements are totally
determined by the market. There is no
intervention by the government or by the
central bank. It is also known as clean
float. Eg: US, UK, Japan, Australia,
Canada, Korea, Switzerland, etc.
 Managed float

• It is a system wherein, the central bank

generally intervenes in the currency
market to smoothen the fluctuations, in
order to reduce the inefficiencies. Eg:
India, Algeria, Singapore, Thailand,
Russia, etc.
 History of monetary systems

• Bi metallic standard
• Gold standard
• Inter war period
• Bretton woods system
• Flexible exchange rate regime
• European monetary system
 Gold standard ( 1875 – 1914)
• During this regime, governments gave an
unconditional guarantee to convert their
paper money or fiat money into gold at a
pre fixed rate at any point of time on
demand.
• The exchange rate between two
currencies was determined on the basis of
the rates at which the respective
currencies could be converted into gold.
 Example
• Suppose one ounce of gold is $400 in US
and £200 in UK, then exchange rate
between $ and £ would be $2 / £.
• The exchange rate will stay at this level
because of arbitrage possibility.
- Quantity theory of money
- Price specie flow mechanism
 Inter war period (1915 – 1944)
• World war I ended the classical gold
standard in Aug 1914 major countries
moved out of this system and imposed
embargoes on gold exports.
• The concept of sterilization was followed
by many countries.
• Beggar-thy-neighbor policy followed.
 Bretton woods system
• In 1944, representatives of 44 countries
met in Bretton woods, USA to sign an
agreement to establish a new monetary
system.
• Two new institutions IMF and IBRD set up.
• All members were required to subscribe to
IMF capital. One fourth in the form of gold
and the balance in its own currency.
 Bretton woods system
• Under this system, each country
established a par value in relation to US
dollar, which was pegged to gold at $35
per ounce.
• Countries held US dollars as well as gold
as reserves.
• This led to seigniorage gain.
• This created a paradox in the system
called Triffin paradox.
 Bretton woods system
• A new reserve asset called SDR was
created by IMF.
• In 1963, US imposed Interest Equalization
Tax on US purchases of foreign securities
in order to stem the outflow of dollars.
• To save the Bretton Woods system, ten
major countries reached a Smithsonian
Agreement in 1971.
 Smithsonian agreement
• The price of gold was raised to $38 per ounce.
• Each of the other countries revalued its currency
against USD by 10%.
• The band was set at 2.25% in either direction.
• This lasted for little more than one year.
• The price of gold was further raised to $42 per
ounce.
• Bretton woods system collapsed by 1973.
 Flexible exchange rate system
(1973 - )
• In Jan 1976, IMF members met in jamaica
and agreed to a new set of rules.
• Most countries shifted to floating
exchange rates.
• Members no longer need to deposit gold.
• Peg could be with a currency or basket of
currencies or SDRs.
 European monetary system
• EMS was formally launched in March
1979
• The objectives were
3. To establish a zone of monetary stability
in Europe.
4. To coordinate exchange rate policies
with non EMS currencies.
5. To pave way for EMU.
 EURO
• On Jan 1, 1999 eleven out of 15 EU countries
adopted a common currency called Euro.
• Greece joined in 2001.
• Denmark, Sweden and UK didn’t join.
• The benefits include reduced transaction costs
and elimination of exchange rate uncertainty.
• If euro proves successful, it will pave way for
political integration of Europe, eventually making
“United states of Europe”.