Monetary Systems

 International monetary systems are sets of
internationally agreed rules, conventions and
supporting institutions, that facilitate international
trade, cross border investment and generally there
allocation of capital between nation states.
 International monetary system refers to the system
prevailing in world foreign exchange markets through
which international trade and capital movement are
financed and exchange rates are determined.
MEANING:-

 The International Monetary System is part of the
institutional framework that binds national
economies, such a system permits producers to
specialize in those goods for which they have a
comparative advantage, and serves to seek
profitable investment opportunities on a global
basis.
MEANING CONTD…..

 Flow of international trade and investment according
to comparative advantage.
 Stability in foreign exchange and should be stable.
 Promoting Balance of Payments adjustments to
prevent disruptions associated with temporary or
chronic imbalances.
FEATURES THAT IMS SHOULD POSSESS:-

 Providing countries with sufficient liquidity to
finance temporary balance of payments deficits.
 Should at least try avoid adding further uncertainty.
 Allowing member countries to pursue independent
monetary and fiscal policies.
FEATURES CONTD…..

 Bimetallism:
 Classical Gold Standard
 Interwar Period
 Bretton Woods System
 The Flexible Exchange Rate Regime:Present
EVOLUTION OF THE
INTERNATIONAL MONETARY SYSTEM

 A “double standard” in the sense that both gold and silver
were used as money, rather than one (monometallism)
 19th-century bimetallic system defined a nation’s monetary
unit by law in terms of fixed quantities of gold and silver
(thus automatically establishing a rate of exchange
between the two metals).
 Major problem in the international use of bimetallism was
with each nation independently setting its own rate of
exchange between the two metals, the resulting rates often
differed widely from country to country.
BIMETALLISM: BEFORE 1875

• To establish the Bimetallic system on an international scale,
France, Belgium, Italy, and Switzerland formed the Latin
Monetary Union in 1865.
• Established a mint ratio between the two metals and provided
for use of the same standard units and issuance of coins.
• The system was undermined by the monetary manipulations of
Italy and Greece came to a speedy end with the Franco-German
War (1870–71).
• Bimetallic standard was sealed at international monetary
conference held in Paris
BIMETALLISM CONTD…

(1) The combination of two metals can provide greater
monetary reserves;
(2) Greater price stability will result from the larger monetary
base; and
(3) Greater ease in the determination and stabilization of
exchange rates among countries using gold, silver, or bimetallic
standards will result.
SUPPORTERS OF BIMETALLISM

(1) It is practically impossible for a single nation to use such a
standard without having international cooperation.
(2) Such a system is wasteful in that the mining, handling, and
coinage of two metals is more costly;
(3) Because price stability is dependent on more than the type of
monetary base, bimetallism does not provide greater stability of
prices
(4)Bimetallism in effect freezes the ratio of the prices of the two
metals without regard to changes in their demand and supply
conditions.
ARGUMENTS AGAINST BIMETALLISM

 Some countries were on the gold standard, some on the silver
standard, some on both.
 Both gold and silver were used as international means of
payment and the exchange rates among currencies were
determined by either their gold or silver contents.
 Gresham’s Law implied that it would be the least valuable metal
that would tend to circulate.
 (“bad money drives out good.” More exactly, if coins containing metal of
different value have the same value as legal tender, the coins composed of the
cheaper metal will be used for payment, while those made of more expensive
metal will be hoarded or exported and thus tend to disappear from
circulation.)
BIMETALLISM CONTD…

 Of the two metals, gold is considered to be more valuable. In a
bimetallic system, the value of gold and silver is tied to each
other.
 For example, the value of one ounce of gold might be worth
15 ounces of silver. The value ratio of the two would be 1 to
15.
 Governments would then use gold and silver to mint coins to
use as money.
 If the government decided to print paper money, that paper
money could be traded in for the equivalent value of silver or
gold.
HOW THE SYSTEM WORKS

Classic Gold Standard (1879– 1914)
Interwar Period (1918 – 1939)
Bretton Woods System (1944 – 1971)
Present International Monetary System (1971
STAGES IN INTERNATIONAL MONETARY
SYSTEM:-

 Foreign Currency Exchange Rate – the price of one
country’s currency in units of another currency of
commodity.
Can be fixed or floating
 Spot Exchange Rate – the quoted price for foreign
exchange to be delivered at once, or in two days for
interbank transactions.
 Forward Rate – the quoted price for foreign exchange
to be delivered at a specified date in the future.
Can be guaranteed with a forward exchange contract
CURRENCY TERMINOLOGY

Forward Premium or Discount – the
percentage difference between the spot and
forward exchange rate.
Devaluation of a Currency – refers to a drop in
foreign exchange value of a currency that is
pegged to gold or another currency.
The opposite is revaluation
Weakening, deterioration, or depreciation of a
Currency – refers to a drop in the foreign
exchange value of a floating currency.
CURRENCY TERMINOLOGY CONTD…

Soft or Weak – describes a currency that is
expected to devalue or depreciate relative to
major currencies.
Also refers to currencies being artificially sustained
by their governments
Hard or Strong – describes a currency that is
expected to revalue or appreciate relative to
major trading currencies.
Eurocurrencies – are domestic currencies of
one country on deposit in a bank in a second
country.
CURRENCY TERMINOLOGY CONTD…

Classical Gold
Standard (1879–
1914)

 The gold standard is a monetary system in which paper money
is freely convertible into a fixed amount of gold.
 In other words, in such a monetary system gold backs the
value of money.
 Between 1696 and 1812, the development and formalization
of the gold standard began as the introduction of paper
money posed some problems.
 A gold standard was needed to instill the necessary controls
on money.
CLASSIC GOLD STANDARDS

 22nd June 1816, Great Britain declared the gold currency as
official national currency (Lord Liverpool’s Act). On 1st May
1821 the convertibility of Pound Sterling into gold was
legally guaranteed.
 Other countries pegged (Pegging is a method of stabilizing a
country's currency by fixing its exchange rate to that of
another country) their currencies to the British Pound, which
made it a reserve currency. This happened while the British
more and more dominated international finance and trade
relations.
 At the end of the 19th century, the Pound was used for two
thirds of world trade and most foreign exchange reserves
were held in this currency.
CLASSIC GOLD STANDARDS:-

 Between 1810 and 1833 the United States had de
facto the silver standard. In 1834 (Coinage Act of
1834), the government set the gold-silver exchange
rate to 16:1 which implemented a de facto (exercising
power, in fact, whether by right or not) gold standard.
 In 1879 the United States set the gold price to US$
20,67 and returned to the gold standard. With the
“Gold Standard Act” of 1900, gold became an official
instrument of payment.

 From 1879 to 1914, the gold standard was at its
pinnacle.
 During this period near-ideal political conditions
existed in the world.
 Governments worked very well together to make the
system work, but this all changed forever with the
outbreak of the Great War in 1914.
 From the 1870s to the outbreak of World War I in
1914, the world benefited from a well integrated
financial order, sometimes known as the First age of
Globalization. ( An Economic History of Real Wages and Market
Integration, era of unprecedented global interconnectedness)
CLASSIC GOLD STANDARDS CONTD…

 In the absence of shared membership of a union,
transactions were facilitated by widespread
participation in the gold standard, by both
independent nations and their colonies.
 Money unions were operating which effectively
allowed members to accept each other's currency as
legal tender including the Latin Monetary
Union and Scandinavian monetary union (was a monetary
union formed by Denmark and Sweden Norway too joined later)
CLASSIC GOLD STANDARDS CONTD…

Goods market integration under free trade:
 International price linkage was strong, and the world
experienced common price movements and business cycles.
 The law of one price (the same products bear the same price
in different locations)
 Absence of the Nominal Anchor (a mechanism to prevent inflation or
deflation)
 This means that no country, organization or mechanism
played the role of stabilizing the global price level.
 As a result, there was globally common price fluctuations
FEATURES OF CLASSIC GOLD STANDARD

Financial integration under free capital mobility
 The private sector could issue, sell or buy foreign stocks
and bonds freely.
 Free capital movement resulted in strong interest rate
linkage.
 Short-term interest rates were volatile while long-term
interest rates were extremely stable, and these interest
movements were internationally synchronized.
 British interest rates always provided the floor (i.e., they
were lowest) for the rates of other countries.
 British securities had highest liquidity and lowest risk
premium, and because London was the financial center
of the world.
CONTD..

Fixed Exchange Rates
• In those days, the exchange rate was called the "gold
parity" which was the conversion ratio between the
home currency and an ounce (31.10 grams) of gold.
• The cross rates between two currencies could be
calculated as the ratio of two gold parities.
CONTD..

Macroeconomic Fundamentals Were Not Stable
 Although integrated in trade and finance, the world
economy was far from stable, from the viewpoint of
macro economy.
 There were booms and busts, and severe recessions
were experienced. Financial crises and bank runs
were common.
CONTD..

 Provides long-term economic stability and growth.
 Prevents inflation, and would reduce the size of
government.
 Gold standard would restrict the ability of
government to print money at will, run up large
deficits, and increase the national debt.
 Economy has historically performed best under a
gold standard.
ADVANTAGES

 Price Stability:-
 By tying the money supply to the supply of gold,
central banks are unable to expand the money
supply.
 Facilitates BOP adjustment automatically:-
 The basic idea is that a country that runs a current
account deficit needs to import money (gold) to
the countries that run a surplus. The surplus of
gold reduces the deficit country’s money supply
and reduces the surplus country’s money supply.
ARGUMENTS IN FAVOR OF A GOLD STANDARD

 A gold standard would create economic instability.
 Spur (encourage) periodic economic deflation and contraction.
 Hamper government's ability to stimulate the economy and
reduce unemployment during recessions and financial crises.
 Returning to a gold standard would be extremely difficult
given the scarcity of gold and could severely harm the already
fragile US economy
DISADVANTAGES

 The growth of output and the growth of gold supplies
needs to be closely linked. For example, if the supply
of gold increased faster than the supply of goods did
there would be inflationary pressure. Conversely, if
output increased faster than supplies of gold did
there would be deflationary pressure.
 Volatility in the supply of gold could cause adverse
shocks to the economy, rapid changes in the supply
of gold would cause rapid changes in the supply of
money and cause wild fluctuations in prices that
could prove quite disruptive
ARGUMENTS AGAINST GOLD STANDARD

 In practice monetary authorities may not be forced
to strictly tie their hands in limiting the creation of
money.
 Countries with respectable monetary policy makers
cannot use monetary policy to fight domestic
issues like unemployment.
ARGUMENTS AGAINST GOLD STANDARD

 A nominal anchor is a mechanism to stabilize nominal
variables, especially the general price level.
 Mechanism to prevent inflation or deflation. This can be
an informal policy rule adopted by the central bank.
 It can be a legally binding commitment such as inflation
targeting.
 The nominal anchor can be domestic or global. Here, we
are discussing the nominal anchor for the entire world.
 The point is that no one ensured the price stability of the
gold standard world--neither the UK government, the
Bank of England, the City, nor the supply and demand of
gold.
THE NOMINAL ANCHOR

The rules of the game means a set of rules of conduct that are
expected of the participating members.
 Gold parity. Each country must declare a fixed value ratio
between gold and domestic currency. For example, 1 ounce of
gold = 20.69 US dollars, 1 ounce of gold = 4.24 British
pounds, and so on. This establishes the cross ratio of 1 British
pound = 4.87 US dollars.
 Convertibility to gold (domestic convertibility). All paper
money must be exchanged freely to gold at the declared gold
parity, if the bearer brings it to the central bank. Usually this
promise was clearly printed on bank notes. In those
days, convertibility meant convertibility to gold (today, it
means convertibility to international currencies such as dollar,
euro and yen).
THE RULES OF THE GAME

 Free International Gold Movement (International
Convertibility): There should be no restriction on the
exportation or importation of gold as a commodity as well as
a payment method. This guaranteed free monetary mobility
based on demand and supply conditions.
 Interest Rate Policy: if a country began to lose gold through a
balance-of-payments deficit, it was expected to raise short-
term interest rates to attract back the monetary metal.
 If it is gaining gold, short-term interest rates must be lowered
to repel the gold inflow. By this symmetrical operation, it was
thought that the monetary authority could assist international
adjustment
THE RULES OF THE GAME

 Here, price means inflation or deflation.
 Species (true money) means gold.
 Term really means a "mechanism linking
inflation/deflation with gold flows."
 Through this mechanism, it was thought that the
gold standard had a wonderful built-in adjustment
mechanism.
 Even if governments did nothing, international
macroeconomic adjustment would occur
automatically.
THE PRICE-SPECIES FLOW MECHANISM

THE PRICE-SPECIES FLOW MECHANISM CONTD…

 The biggest problem with this explanation is its total
neglect of capital mobility
 it is focused on the current account and price
competitiveness only.
 But in a financially integrated world with firmly fixed
exchange rates, a tiny difference in interest rates will
prompt a huge and immediate private capital flow.
 Moreover, the current account is just a mirror image of
the capital account (with the opposite sign). Therefore,
as long as the country continues to lend or borrow, there
is no need for the current account to "balance."
THE PRICE-SPECIES FLOW MECHANISM CONTD…

INTERWAR PERIOD (1918 – 1939)

 The Classical Gold Standard was shattered by the outbreak of
WW1.
 The system collapsed not because of an internal dilemma but
because of an external violence.
 As soon as the fighting began in Europe, private trade and
financial transactions were suspended. Gold exports were
banned.
 As international linkage disappeared, each country started to
issue bonds and print money to finance the war effort. They
began to have different inflation rates.
 World War I marks the beginning of the end of the Gold
Standard .
 During the war, countries suspended the convertibility of their
currencies into gold.
INTERWAR PERIOD

 1919
 – U.S. returned to gold
 1922
 – Group of countries (Britain, France, Italy, and Japan) agreed
on a program
 calling for:
 A general return to the gold standard
 Cooperation among central banks in attaining external and
 Internal objectives.
 1925
 Britain returned to the gold standard by pegging Pound to gold
at pre war parity price
 Severe unemployment and deflation before, after.
THE FLEETING RETURN TO GOLD

 Great Depression
 Initial collapse in 1929 (stock market crash)
 Followed by bank failures throughout the world.
 1931
 Britain forced off gold when foreign holders of pounds
lost confidence in Britain’s commitment to maintain its
currency’s value. (Keynes: Gold a “barbarous relic.”)
 Japan left too and had a rapid recovery (unlike today).
 United States devalued in 1933.
 “Gold bloc” countries (e.g., France, Belgium,
Switzerland, Poland) stayed with gold until 1936.
THE FLEETING RETURN TO GOLD CONTD..

 Many countries suffered during the Great Depression.
 Major economic harm was done by restrictions on
international trade and payments.
 Protectionist policies. Smoot-Hawley tariff in US (1930)
(is a U.S. law which caused an increase in import duties
by as much as 50%. Goal was to increase U.S. farmer
protection against agricultural imports.
Beggar-thy-neighbor policies(an economic policy through
which one country attempts to remedy its economic
problems by means that tend to worsen the economic
problems of other countries.)
INTERNATIONAL ECONOMIC DISINTEGRATION

 Foreign retaliation and disintegration of the world
economy.
 All countries’ situations could have been bettered
through international cooperation.
 It was this realization that inspired the blueprint of
the post war international monetary system, the
Bretton Woods System.
 Bretton Woods Agreement
INTERNATIONAL ECONOMIC DISINTEGRATION
CONTD…

 The years between the world wars have been
described as a period of de-globalization, as both
international trade and capital flows shrank
compared to the period before World War I.
 During World War I countries had abandoned the gold
standard and, except for the United States.
 The onset of the World Wars saw the end of the gold
standard as countries, other than the U.S., stopped
making their currencies convertible and started
printing money to pay for war related expenses.
INTERWAR PERIOD CONTD…

 After the war, with high rates of inflation and a large
stock of outstanding money, a return to the old gold
standard was only possible through a deep recession
inducing monetary contraction as practiced by the
British after WW I.
 The focus shifted from external cooperation to
internal reconstruction and events like the Great
Depression further illustrated the breakdown of the
international monetary system, bringing such bad
policy moves such as a deep monetary contraction in
the face of a recession.
INTERWAR PERIOD CONTD…

 First, the 1920s and 30s saw frequent recessions and
banking.
 It was thought that governments had first and foremost
the responsibility to solve the domestic problems of
bankruptcy and unemployment, rather than keeping
international commitments.
 Second, there was a leadership vacuum in the
international regime. The UK, the old leader, was losing
power and incapable of handling the situation.
 The US, the new leader, would not assume the
responsibility yet.
REASONS FOR THE FALIURE TO RESTORE THE GOLD
STANDARD IN THE INTERWAR PERIOD

 Third, as a result of this and in the absence of policy
cooperation, each country became selfish.
 Protectionism and competitive devaluation escalated.
 During this period, the famous British economist John
Maynard Keynes argued against returning to gold.
 He argued that the gold standard was a "barbaric relic"
(i.e., crude and outdated system) and should be
abandoned.
 The value of money should not be subjected to the
demand and supply of gold which was uncontrollable.
 The world should move to paper currency managed
scientifically and responsibly by central banks.
REASONS FOR THE FALIURE TO RESTORE THE GOLD
STANDARD IN THE INTERWAR PERIOD CONTD..

CONDITIONS PRIOR TO BRETTON WOODS:-
 Prior to WW I major national currencies were on a
system of fixed exchange rates under the international
gold standards. This system had been abandoned
during WW I.
 There were fluctuating exchange rates from the end of
the War to 1925. But it collapsed with the happening of
the Great Depression.
 After the First World War there was complete lack of
monetary cooperation among countries of the world.
There was acute commercial rivalry

CONDITIONS PRIOR TO BRETTON WOODS CONTD…
 Every country was trying to maximize export and to minimize its
import, to do so they resolved to competitive currency
devaluation.
 The Second World War broke down primarily on account of these
economic causes.
 Many countries resorted to protectionism and competitive
devaluation. But depression disappeared during WW II
 After closing of the war countries got worried over the possibility
of repetition.
 They started thinking of way to establish peace after the war.
 An International Monetary conference was held at “Bretton
Woods” USA

 British and American policy makers began to plan
the post war international monetary system in the
early 1940s.
 The objective was to create an order that combined
the benefits of an integrated and relatively liberal
international system with the freedom for
governments to pursue domestic policies aimed at
promoting full employment and social wellbeing.
 The principal architects of the new system, John
Maynard Keynes and Harry Dexter White
BRETTON WOODS (1945-1971):-

 Bretton Woods is a little town in New Hampshire,
famous mostly for good skiing. In July 1944, the
International Monetary and Financial Conference
organized by the U.N attempted to put together an
international financial system that eliminated the chaos
of the inter-war years.
 The terms of the agreement were negotiated by 44
nations, led by the U.S and Britain. The main hope of
creating a new financial system was to
 stabilize exchange rates,
 provide capital for reconstruction from the war
 foment (develop) international cooperation.
BRETTON WOODS CONTD..

 The features of the Bretton Woods system can be
described as a “gold-exchange” standard rather than
a “gold-standard”. The key difference was that the
dollar was the only currency that was backed by and
convertible into gold. (The rate initially was $35 an
ounce of gold)
 Other countries would have an “adjustable peg”
basically, they were exchangeable at a fixed rate
against the dollar, although the rate could be
readjusted at certain times under certain conditions.
(To correct disequilibrium in their BOP)
FEATURES OF BRETTON WOODS SYSTEM:-

• Each country was allowed to have a 1% band around
which their currency was allowed to fluctuate around
the fixed rate.
• Except on the rare occasions when the par value was
allowed to be readjusted, countries would have to
intervene to ensure that the currency stayed in the
required band.
• The IMF was created with the specific goal of being
the multilateral body that monitored the
implementation of the Bretton Woods agreement.
BRETTON WOODS CONTD…

 Since exchange rates were not to float freely all
governments required assurance of an adequate
supply of monetary reserves.
 A system of subscriptions and quotas embedded in
IMF
 A fixed pool of national currencies and gold
subscribed by each country.
 Members were assigned quotas, roughly reflecting
their relative economic importance.

 To pay into the Fund a subscription of equal amount.
 Subscription to be paid 25% in gold or currency
convertible into gold ( Dollar was the only currency
directly convertible) and 75% in the members own
money.
 Countries could borrow needed foreign currency
determined by the size of its quota during short of
reserves.

 IMFs role was to hold gold reserves and currency reserves
that were contributed by the member countries and then
lend this money out to other nations that had difficulty
meeting their obligations under the agreement.
 The borrowing was classified into tranches, each with
attached conditions that became progressively stricter.
 This enabled the IMF to force countries to adjust excess
fiscal deficits, tighten monetary policy etc, and force
them to be more consistent with their obligations under
the agreement.

Currencies had to be convertible: central banks
had to exchange domestic currency for dollars
upon request.
Although the adjustable exchange rate system
meant that countries that could no longer
sustain the fixed exchange rate vis-a-vis the
dollar would be allowed to devalue their
currencies,
They could only do so with the consent of the
other countries and the auspices (protection and
support) of the IMF.

 Inconvertibility hampers international trade.
 The IMF articles called for convertibility on current
account transactions only. (fear of speculative
capitalflows: “hot money”)
 Bretton Woods System in Conclusion:
 A monetary regime with IMF at its centre , unchanged
gold exchange standard, supplemented by
 Centralized pool of gold and national currencies with new
exchange rate system of adjustable pegs.

 IMF performing 3 major functions:
 Regulatory: Administering the rules governing
currency values and convertibility.
 Financial: Supplying supplementary liquidity.
 Consultative: Providing a forum for cooperation
among Governments

 US dollar-based system. Officially, the Bretton Woods
system was a gold-based system which treated all
countries symmetrically, and the IMF was charged with
the responsibility to manage this system. In reality,
however, it was a US-dominated system with the US
dollar playing the role of the key currency.
 Adjustable Peg System. This means that exchange
rates were normally fixed but permitted to be adjusted
infrequently under certain conditions.
BRETTON WOODS FEATURES

 Capital Control Was Tight. This was a big difference from
the Classical Gold Standard of 1879-1914, when there
was free capital mobility. Although the US and Germany
had relatively less capital-account regulations, other
countries imposed severe exchange controls.
 Macroeconomic Performance Was Good. Global price
stability and high growth were simultaneously achieved
under deepening trade liberalization. Stability in tradable
prices from the mid 1950s to the late 1960s was almost
perfect and globally common. This macroeconomic
achievement was historically unprecedented.
BRETTON WOODS FEATURES CONTD..

 Negotiators at Bretton Woods betrayed a remarkable
optimism regarding prospects for monetary stability after
the war's end.
 They Underlined their choice for exchange rate system.
 The pegged rate regime was manifestly biased against
frequent changes of currency values.
 Negotiators evidently felt future threats to stability were
likely to come from private speculation than from basic
price or income developments.
 They also believed that IMF's centralized pool of liquidity,
though limited, would suffice to cope with any financing
problems that might emerge.
THE IMPLICIT BARGAIN

 Their optimism proved utterly Panglossian.
 Monetary relations after the war were but stable,
 The transitional period was brief.
 Fund's initial resources were sufficient to cope with
emerging payments difficulties.
 After a short burst of activity during its first two years
 IMF lending shrank to an extremely small scale for over a
decade.
 the burden was shifted to the one actor at the time
namely, the United States
 Shoulder responsibility for global monetary stabilization -
THE IMPLICIT BARGAIN CONTD…

 US willingly took that responsibility, in effect assuming the
role of global monetary hegemon (supreme leader): money
manager of the world.
 American hegemony was exercised principally in three ways:
 First, a relatively open market was maintained for imports of
foreign goods.
 Second, a generous flow of long-term loans and grants was
initiated.
 Third, a liberal lending policy was eventually established for
provision of shorter term funds in ti
 Reserves of countries were near exhaustion
 Fund's pool of liquidity was inadequate, the rest of the world
willing to accumulate dollars .

 Scarcity of central bank gold outside the United States
 Limited prospects for new gold production.
 America became the residual source of global liquidity
growth.
 Other governments with payments surpluses stabilized their
exchange rate.
 Bretton Woods system in practice quickly became
synonymous with a hegemonic monetary regime centered
on the dollar.
 Being money manager of the world fit in well with America's
newfound leadership role.
 Uspolicy-makers perceived a need to promote the economic
recovery of important allies in Europe and Japan.

 The United States could issue the world's principal reserve
currency in amounts presumed to be consistent with its own
priorities .
 Foreign dollar holders, also conced
 America accepted the necessity, preferential trade and payments
arrangements in Europe.
 Accepted the necessity of granting Japanese exporters access to
the U.S. market while countries remained closed to goods labeled
'Made in Japan
 In effect, an implicit bargain was struck.
 America's allies acquiesced (accept something reluctantly) in a
hegemonic system that accorded the United States special
privileges to act abroad unilaterally to promote U.S.

 The term 'dollar shortage,' universally was simply a shorthand
expression for the fact that only the United States was then
capable of assuring some degree of global monetary stability.
 After 1958, however, America's persistent deficits began to take
on a different coloration.
 U.S. balance of payments plunged to a $3.5 billion gap in 1958
and to even larger deficits in 1959 and 1960.
 Instead of talking about a dollar shortage, observers began to
speak of a dollar glut.
 In 1958 Europe's currencies returned to convertibility.
 Eagerness of European governments to obtain dollar reserves
was transformed into equally fervent desire to avoid excess
dollar accumulations
FROM DOLLAR SHORTAGE TO DOLLAR GLUT

 Robert Triffin in his book Gold and the Dollar Crisis illuminated
the source of strain, in the structure of the postwar gold
exchange standard.
 He argued that gold exchange standard, is flawed by its reliance
on the pledge of convertibility of some national currency, such as
the dollar, into gold.
 Reserve currency status gave US to run large deficits, the deficits
were paid by issuing dollars.
 When excess dollars began showing up in global central banks,
countries began converting their dollars into gold.
 America’s “dollar overhand” was growing larger than its gold
stock.
 Erosion of America’s net reserve position reduced confidence in
the dollar’s continued convertibility.
THE TRIFFIN DILEMMA

 States found themselves caught on the horns of a dilemma -
what came to be known as the *Triffin dilemma.
 To forestall (stop) speculation against the dollar, U.S deficits
would had to cease.
 But this would confront the system with a liquidity problem.
 To forestall the liquidity problem US deficits had to continue.
 But this would confront the system with a confidence problem.
 By the mid-1960s, to establish a substitute source of liquidity
growth to reduce systemic reliance on dollar deficits, culminated
in agreement to create the *Special Drawing Right (SDR)
 An entirely new type of international reserve (Currency) asset.
THE TRIFFIN DILEMMA CONTD…

 Source of strain was inherent in the structure of the par value
system.
 The key notion of fundamental disequilibrium.
 How could governments be expected to change their exchange
rates if they could not even tell when a fundamental
disequilibrium existed.
 And if they were inhibited from repeating rates, how would
international payments equilibrium be maintained.
 Governments tried to avoid the "defeat" of an altered par
value.
EXCHANGE-RATE RIGIDITY

 The rigidity of exchange rates aggravated fears of a potential
world liquidity shortage.
 It also created irresistible incentives for speculative currency
shifts, greatly adding to the global confidence problem.
 The heaviest weight on exchange rates was the dollar glut
(excess supply)
 Persisted payment imbalance between US and the surplus
countries of Europe and Japan
 Each side blamed the other for the disequilibrium.
EXCHANGE-RATE RIGIDITY CONTD…

 The debate over asymmetries masked a deeper political
conflict. The postwar bargain was coming unstuck.
 U.S was concerned about the competitive commercial threat
from Europe and Japan.
 Concern was growing in Europe and Japan about America’s
use of its privilege of liability financing- ‘ the exorbitant
privilege’
 Europeans and Japanese had one major weapon to curb
America’s policy autonomy.
 Right to demand conversion of accumulated dollar balances
into gold.
THE BARGAIN COMES UNSTUCK

 The dollar overhang continued to grow. it was a weapon most
governments became increasingly reluctant to deploy.
 America’s foreign deficit shrank as a result of a variety of
corrective measures adopted at home.
 As a result of increased government spending on social
programs at home and an escalating war in Vietnam
 America’s economy began to overheat and inflation began to
gain momentum, causing deficits to widen once again.
 Inflation everywhere began to accelerate, exposing all the
latent problems of Bretton Woods
THE BARGAIN COMES UNSTUCK CONTD...

 The pegged rate system was incapable of coping with widening
payments imbalances, and the confidence problem was
worsening.
 U.S leading member of the system, brought the drama to its
denouement (end to Story).
 Richard Nixon was determined to force the Europeans and
Japanese to accept a mutual adjustment of exchange rates.
 on 15 August 1971, the convertibility of the dollar into gold was
suspended.
 Monies of all the industrial countries were set free to float
independently.
 Par value system and the gold exchange standard were
terminated.
 The Bretton Woods system passed into history.
THE BARGAIN COMES UNSTUCK CONTD...

 Built-in instability: It was an adjustable peg system within + or
– 1 % of the par value of $ 35. In case of disequilibrium,
Countries could devalue its currency with IMF approval.
But were reluctant to do so since they had to export more
goods to pay for dealer imports.
 The Triffin Dilemma: Since dollar was the medium of
exchange, each country wanted to increase its reserve in
dollars holding to greater extent than it needed.
Reserve currency status gave US to run large deficits, the
deficits were paid by issuing dollars.
Erosion of America’s net reserve position reduced confidence
in the dollar’s continued convertibility.
THE DEMISE OF THE BRETTON WOODS
SYSTEM

Since dollar was convertible into gold the supply of dollar was
inadequate in relation to the liquidity needs of countries,
which forced US to abandon its commitment to convert dollars
into gold, this led to the collapse.
 Lack of international Liquidity: Growing lack of international
liquidity due to increasing demand for dollar in world
monetary market.
Expansion of trade BOP deficits (and surpluses) increased.
Necessitated the supply of gold and dollar.
Supply of dollar was inadequate.
US printed more notes.
SYSTEM CONTD…

 Mistake in US Policies: BOP deficits of US became worse.
To overcome policies adopted by US Govt let to world crises.
Rising US Govt expenditure in Vietnam War
Financing of US space programme
‘Greater Society’ Social welfare programme.
 Destabilizing Speculation: Countries with “Fundamental
disequilibrium” in BOP
 Reluctant to devalue currencies, took time to get approval IMF
 Speculators had opportunity to speculate in dollars.
 When devaluations were made, More doses than anticipated.
 Which was due to destabilizing speculation.
SYSTEM CONTD…

 Crisis of confidence and collapse: Eruption of a crisis of
confidence in the US dollar.
No control over the world gold market
Rumor in March 1971 US would devalue the dollar
US suspended the conversion of dollar into gold when
European central banks wanted to convert their dollar reserve
into gold.
 In 1971, the U.S. government “closed the gold window” by
decree of President Nixon.
SYSTEM CONTD…

 In the early post-war period, the U.S. government had to
provide dollar reserves to all countries who wanted to
intervene in their currency markets. Lead to problem of lack
of international liquidity.
 The increasing supply of dollars worldwide, made available
through programs like the Marshall Plan, meant that the
credibility of
 the gold backing of the dollar was in question. U.S. dollars
held abroad grew rapidly and this represented a claim on U.S.
gold stocks and cast some doubt on the U.S.’s ability to
convert dollars into gold upon request.
THE DEMISE OF THE BRETTON
WOODS SYSTEM

 A floating exchange rate or fluctuating exchange is a type
of exchange rate regime in which a currency's value is
allowed to fluctuate in response to foreign-exchange
market mechanisms.
 A currency that uses a floating exchange rate is known as a
floating currency.
 A floating currency is contrasted with a fixed currency whose
value is tied to that of another currency.
 The exchange the rate in which the value of the currency is
determined by the free market.
THE FLEXIBLE EXCHANGE RATE

• A currency has a floating exchange rate.
• When its value changes constantly depending on the supply and
demand for that currency,aswell as the amount of the currency
held in foreign reserves.
• Advantage to a floating exchange rate is that it tends
to be more economically efficient.
• Floating exchange rates tend to be more volatile depending on
the particular currency.
• A currency with a floating exchange rate may undergo currency
appreciation or depreciation, depending on market fluctuations.
• A floating exchange rate is also called a flexible exchange rate
THE FLEXIBLE EXCHANGE RATE CONTD..

 Countries interact with each other through trade and
investment.
 Trade - export and import of goods and services.
 Investment involves the borrowing and lending of money.
 Important international macroeconomic variables are:
 Trade balance: which measures the difference between the
total value of exports and the total value of imports
 Exchange rate, which measures the number of units of one
currency that exchanges for one unit of another currency.

 Flexible rate is opposite to fixed exchange rate regime and is
a flexible or floating exchange rate.
 The value of the currency fluctuates according to market
forces and can change from day to day.

 Countries use different national currencies, international trade
and investment requires an exchange of currency.
 For international purchases one must first exchange one’s
national currency for another.
 Governments must decide not only how to issue its currency
but how international transactions will be conducted.
 Today’s currencies are not backed by gold.
 Most countries have a central bank that issues an amount of
currency that will be adequate to maintain a vibrant growing
economy with low inflation and low unemployment.
EXCHANGE RATE REGIMES

 One of the decisions a country must make with respect to its
currency
 To fix its exchange value and try to maintain it for an
extended period.
 To allow its value to float or fluctuate according to market
conditions.
 Throughout history, fixed exchange rates have been the norm,
long period countries maintained a gold standard and Bretton
Woods system.
 Bretton Woods system collapsed, countries have pursued a
variety of different exchange rate mechanisms.
EXCHANGE RATE REGIMES CONTD….

 IMF created to monitor and assist countries with international
payments problems, maintains a list of country currency
regimes.
 The list displays a wide variety of systems currently being
used.
 “Which is the most suitable currency system?” remains largely
unanswered.
 Different countries have chosen differently.

Country/Region Regime
Euro Area Single currency within: floating externally
United States Float
China Crawling peg
Japan Float
India Managed float
Russia Fixed to composite
Brazil Float
South Korea Float
Indonesia Managed float
Spain Euro zone; fixed in the European Union; float externally
South Africa Float
Estonia Currency board
EXCHANGE RATE REGIMES TABLE

 Many currencies independently floating,
 Their exchange values are determined in the private market
on the basis of supply and demand.
 Because supply and demand for currencies fluctuate over
time, so do the exchange values.
 India and Indonesia are classified as “managed floating.”
 The countries’ central banks will sometimes allow the
currency to float freely, but at other times will nudge (Push)
the exchange rate in one direction or another.
 China - Crawling peg, the currency is essentially fixed except
that the central bank is allowing its currency to appreciate
slowly with respect to the U.S. dollar

 Currency Board: maintaining a fixed exchange rate by
essentially eliminating the central bank in favor of a currency
board that is mandated by law to follow procedures that will
automatically keep its currency fixed in value.
 Russia-Composite Currency - Instead of fixing to one other
currency, such as the U.S. dollar or the euro, Russia fixes to a
basket of currencies, also called a composite currency.
 16 countries in the European Union are currently members of
the euro area. Within this area, the countries have retired
their own national currencies in favor of using a single
currency, the euro.

 One of the most widely monitored international statistics is a
country’s trade balance.
 The terminology is unfortunate because it conveys:
 A negative connotation to trade deficits
 A positive connotation to trade surpluses, and perhaps an ideal
connotation to trade balance.
 “Decry”large deficits as being a sign of danger for an economy.
 “Hail” large surpluses as a sign of strength and dominance.
 To long for the fairness and justice that would arise if only the
country could achieve balanced trade. This is not appropriate.
 It is appropriate to know how large the countries’ trade deficits
and surpluses are.
TRADE BALANCES AND INTERNATIONAL
INVESTMENT POSITIONS

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