EXCHANGE RATE SYSTEMS
Syllabus:- Alternative exchange rate systems; International Monetary System.
Introduction: International Monetary System is a set of rules, conventions and institutions that govern the international business, trade and investment. It defines the framework within which the exchange rates are determined. A foreign exchange rate is the price of one currency expressed in terms of the other currencies. The existence of an efficient International Monetary System is essential for smooth conduct of international business. Its main purpose is to facilitate transactions between different countries.
Evolution of Exchange Rate Systems: The IMS has evolved through various stages, starting from Gold Standard in 1870's, it gradually moved on to the Bretton Woods System, and then finally to Flexible Exchange Rate regime in 1973.
(1) Gold Standard: Under this system, each country allowed its currency to be converted into gold on demand and there were no restriction on movement of gold from one nation to another. Under this system:-
a) Each country maintained gold reserves in order to back the value of its currency. The payments between countries were mainly settled by the exchange of gold.
b) If a country imported more than it exported, gold flowed out and vice- versa.
c) The gold standard facilitated automatic correction in Balance Of Payment disequilibrium of a country.
For example; If India had a trade deficit which implies (Export < Import) then gold flowed out of india for settlement of trade, leading to contraction in india's money supply. This will push down the prices in india making its goods cheaper and competitive, this in turn will lead to increased demand for India's exports. Thus, wiping out the deficit.
# Suspension of Gold Standard: The gold standard was abandoned in 1914 with the outbreak of first world war.
(1) During the war, the countries started printing money to finance the war activities. The countries restricted the free movement of gold from one nation to another, and also suspended the convertibility of currency into gold.
(2) After the end of world war, countries started returning to gold standard, US became the first nation to adopt the gold standard back in 1919, followed by Britain in 1925.
(3) With the onset of the great depression in 1929, Britain started experiencing recurring BOP deficits. So in September 1931, the British government suspended the convertibility and let the pound float.
(4) Many countries like Japan, Austria and Sweden followed suit by the end of 1931.
(5) Investors started preferring gold to foreign currency dominated securities.This affected the US gold reserves adversely and eventually lead the US government to abandon the Gold Standard in April,1933.
(2) Bretton Woods System: After the collapse of gold standard, came in the Bretton woods system or Pegged exchange rate system. In july 1944, the representatives of 44 nations met at Bretton Woods, New Hampshire to design a new international monetary system. Agreement was reached to establish two multilateral institutions namely;
(!) International Monetary Fund {IMF}
(!!) International Bank for Reconstruction and Development {IBRD}
Under this system:-
a) Each country agreed to fix the par value of its currency in relation to the US dollar. This par value determined the exchange rate between different currencies.
b) The US dollar was in turn pegged to gold at $35 per ounce. Us dollar was the main reserve currency held by central banks and the only currency that was directly convertible into gold.
c) Each country was required to maintain the market value of its currency within ±1% of its adopted par value. However, the member countries were allowed to alter the par values if it faced "Fundamental Disequilibrium" in the Balance Of Payment.
d) For changes upto 10%, IMF approval was not required but, for changes beyond 10%, IMF approval was necessary.
#Collapse of Bretton woods System:
(1) During 1960's various expansionary programs were undertaken, due to which US Balance of payment swung into persistent deficit.
(2) The member countries lost confidence in US dollar and started converting their dollar reserves into gold. It lead to a dilemma known as Triffin's dilemma.
(3) The gold reserves with US treasury began to fall drastically. Due to recurring BOP deficits, In August, 1971 US suspended the convertibility of dollars into gold and also levied a surcharge of 10% on imports untill the re-evaluation of other currencies against US dollar.
(4) In order to save and restore Bretton Woods System, in December 1971, a conference was held at Smithsonian Institute in Washington DC.
(5) An agreement was reached to devalue US dollar to $38 per ounce of gold, from $35 per ounce. Currencies of surplus countries were revalued upward and fluctuation band was widened to ±2.25% from ±1%.
(6) The Smithsonian Agreement did not work for long as the devaluation of dollar wasn't enough to bring stability. In February,1973 the parity value of US dollar was again revised to $42 per ounce of gold.
(7) By March, 1973 the major currencies were allowed to float and Bretton Woods System came to an end.
Stay tuned for next post. We will continue our discussion with Exchange Rate System Since 1973 , and finally the European Monetary System.
Thank you.
Syllabus:- Alternative exchange rate systems; International Monetary System.
Introduction: International Monetary System is a set of rules, conventions and institutions that govern the international business, trade and investment. It defines the framework within which the exchange rates are determined. A foreign exchange rate is the price of one currency expressed in terms of the other currencies. The existence of an efficient International Monetary System is essential for smooth conduct of international business. Its main purpose is to facilitate transactions between different countries.
Evolution of Exchange Rate Systems: The IMS has evolved through various stages, starting from Gold Standard in 1870's, it gradually moved on to the Bretton Woods System, and then finally to Flexible Exchange Rate regime in 1973.
(1) Gold Standard: Under this system, each country allowed its currency to be converted into gold on demand and there were no restriction on movement of gold from one nation to another. Under this system:-
a) Each country maintained gold reserves in order to back the value of its currency. The payments between countries were mainly settled by the exchange of gold.
b) If a country imported more than it exported, gold flowed out and vice- versa.
c) The gold standard facilitated automatic correction in Balance Of Payment disequilibrium of a country.
For example; If India had a trade deficit which implies (Export < Import) then gold flowed out of india for settlement of trade, leading to contraction in india's money supply. This will push down the prices in india making its goods cheaper and competitive, this in turn will lead to increased demand for India's exports. Thus, wiping out the deficit.
# Suspension of Gold Standard: The gold standard was abandoned in 1914 with the outbreak of first world war.
(1) During the war, the countries started printing money to finance the war activities. The countries restricted the free movement of gold from one nation to another, and also suspended the convertibility of currency into gold.
(2) After the end of world war, countries started returning to gold standard, US became the first nation to adopt the gold standard back in 1919, followed by Britain in 1925.
(3) With the onset of the great depression in 1929, Britain started experiencing recurring BOP deficits. So in September 1931, the British government suspended the convertibility and let the pound float.
(4) Many countries like Japan, Austria and Sweden followed suit by the end of 1931.
(5) Investors started preferring gold to foreign currency dominated securities.This affected the US gold reserves adversely and eventually lead the US government to abandon the Gold Standard in April,1933.
(2) Bretton Woods System: After the collapse of gold standard, came in the Bretton woods system or Pegged exchange rate system. In july 1944, the representatives of 44 nations met at Bretton Woods, New Hampshire to design a new international monetary system. Agreement was reached to establish two multilateral institutions namely;
(!) International Monetary Fund {IMF}
(!!) International Bank for Reconstruction and Development {IBRD}
Under this system:-
a) Each country agreed to fix the par value of its currency in relation to the US dollar. This par value determined the exchange rate between different currencies.
b) The US dollar was in turn pegged to gold at $35 per ounce. Us dollar was the main reserve currency held by central banks and the only currency that was directly convertible into gold.
c) Each country was required to maintain the market value of its currency within ±1% of its adopted par value. However, the member countries were allowed to alter the par values if it faced "Fundamental Disequilibrium" in the Balance Of Payment.
d) For changes upto 10%, IMF approval was not required but, for changes beyond 10%, IMF approval was necessary.
#Collapse of Bretton woods System:
(1) During 1960's various expansionary programs were undertaken, due to which US Balance of payment swung into persistent deficit.
(2) The member countries lost confidence in US dollar and started converting their dollar reserves into gold. It lead to a dilemma known as Triffin's dilemma.
(3) The gold reserves with US treasury began to fall drastically. Due to recurring BOP deficits, In August, 1971 US suspended the convertibility of dollars into gold and also levied a surcharge of 10% on imports untill the re-evaluation of other currencies against US dollar.
(4) In order to save and restore Bretton Woods System, in December 1971, a conference was held at Smithsonian Institute in Washington DC.
(5) An agreement was reached to devalue US dollar to $38 per ounce of gold, from $35 per ounce. Currencies of surplus countries were revalued upward and fluctuation band was widened to ±2.25% from ±1%.
(6) The Smithsonian Agreement did not work for long as the devaluation of dollar wasn't enough to bring stability. In February,1973 the parity value of US dollar was again revised to $42 per ounce of gold.
(7) By March, 1973 the major currencies were allowed to float and Bretton Woods System came to an end.
Stay tuned for next post. We will continue our discussion with Exchange Rate System Since 1973 , and finally the European Monetary System.
Thank you.
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