Unit - 3

International Monetary System (IMS): An

Overview
International monetary system is defined as a set of procedures,
mechanisms, processes, institutions to establish that rate at which exchange
rate is determined in respect to other currency. To understand the complex
procedure of international trading practices, it is pertinent to have a look at
the historical perspective of the financial and monetary system.

The whole story of monetary and financial system revolves around 'Exchange
Rate' i.e. the rate at which currency is exchanged among different countries for
settlement of payments arising from trading of goods and services. To have an
understanding of historical perspectives of international monetary system,
firstly one must have a knowledge of exchange rate regimes. Various exchange
rate regimes found from 1880 to till date at the international level are
described briefly as follows:

Monetary System Before First World War: (1880-1914 Era of Gold Standard)

The oldest system of exchange rate was known as "Gold Species Standard" in
which actual currency contained a fixed content of gold. The other version
called "Gold Bullion Standard", where the basis of money remained fixed gold
but the authorities were ready to convert, at a fixed rate, the paper currency
issued by them into paper currency of another country which is operating in
Gold. The exchange rate between pair of two currencies was determined by
respective exchange rates against 'Gold' which was called 'Mint Parity'. Three
rules were followed with respect to this conversion:

In India, 10 gram gold = Rs 50000

In USA, 10 gram gold = $700

So Rs/$ Exchange Rate = 50000/700 = Rs 71.42/$

• The authorities must fix some once-for-all conversion rate of paper money
issued by them into gold.
• There must be free flow of Gold between countries on Gold Standard.

• The money supply should be tied with the amount of Gold reserves kept by
authorities. The gold standard was very rigid and during 'great
depression' (1929-32) it vanished completely. In modern times some
economists and policy makers advocate this standard to continue
because of its ability to control excessive money supply.
Merits:
1. Public Confidence:
Since the standard coin is made of gold, it is universally acceptable. Thus, gold
coin Standard enjoys full confidence of the public.
2. Automatic Working:
It is automatic in working and needs no government intervention. Money
supply depends upon the volume of gold reserves and money supply can be
changed in accordance with the changes in the volume of gold reserves.
3. Price Stability:
Since there are no frequent changes in the supply of gold, this system ensures
reasonable degree of internal price stability.
4. Exchange Stability:
Free and unrestricted import and export of gold under gold coin standard
ensures stability in foreign exchange rates. This promotes international trade.
5. Simplicity:
This is the simplest form of gold standard which can be easily understood by
the common people.
Demerits:
1. Fair-Weather Standard:
It is fair-weather standard; it operates smoothly during peace times but fails to
work properly and to inspire public confidence at the time of economic crisis.
2. Wastage of Gold:
There is great deal of wastage of gold under this standard. Circulation of gold
coins suffers depreciation. Moreover, since paper currency is fully backed by
gold, gold remains idle while in reserves.
3. Not Automatic:
Gold coin standard operates automatically with the cooperation of the
participating countries. After World War I, in the absence of international
cooperation, this standard ceased to be automatic in its functioning.
4. Price Stability Unreal:
Under this system, internal price stability is unreal. Various factors like
discoveries of new gold mines, changes in the techniques of production of
gold, changes in imports and exports of gold, lead to changes in the price of
gold, and hence cause fluctuations in the internal prices.

The Gold Exchange Standard (1925-1931)

With the failure of gold standard during first world war, a much-refined form
of exchange regime was initiated in 1925 in which US and England could hold
gold reserve and other nations could hold both gold and dollars/sterling as
reserves. In 1931, England took its foot back which resulted in abolition of this
regime.

Also to maintain trade competitiveness, the countries started devaluing their

currencies in order to increase exports and demotivate imports. This was
termed as "beggar-thy-neighbour" policy. This practice led to great depression
which was a threat to war ravaged world after the second world war. Allied
nations held a conference in New Hampshire, the outcome of which gave birth
to two new institutions namely the International Monetary Fund (IMF) and the
World Bank, (WB) and the system was known as Bretton Woods System which
prevailed during (1946-1971). (Bretton Woods, the place in New Hampshire,
where more than 40 nations met to hold a conference).
Features:
(i) The domestic currency is made of token coins and paper money. Gold coins
are not in circulation.
(ii) The domestic currency is not convertible into gold but is convertible at the
fixed rate into the currency of the other country based on the gold standard.
(v) The gold market is regulated and controlled by the government. There is no
free import and export of gold.
(vi) Gold is used neither as a medium of exchange nor as a measure of value.
But prices of all goods and services are indirectly determined by the price of
gold.
(vii) Foreign payments are made either in gold or in currency based on gold.
Merits:
The gold exchange standard enjoys the following advantages:
1. Economical:
Gold exchange standard is cheaper and economical.
It economies the use of gold in two ways:
(a) It avoids the wastage of gold because of non-circulation of gold coins,
(b) The government need not keep gold reserves for converting domestic
currency into gold.
2. Elastic Money Supply:
Since the domestic currency is not backed by gold reserves, the monetary
authority can easily, expand money supply to meet the increasing needs of
trade and industry.

3. Exchange Stability:
Under gold exchange standard, it is the responsibility of the government to
maintain the stability of exchange rate. Exchange stability is essential for the
promotion of foreign trade.
4. Gains of Gold Standard:
All the advantages of the gold standard become available under this standard
without putting gold coins in circulation.
5. Suitable for Poor Countries:
This standard is particularly suited to the less developed countries with gold
scarcity.
Demerits:
The gold exchange standard has the following drawbacks:
1. Complex:
This standard is complex in its working and is not easily understandable by the
common people.
2. Less Public Confidence:
Under this standard, domestic currency is not directly linked with gold and the
currency is not convertible into gold. Therefore, it does not inspire much public
confidence.
3. Not Automatic:
This standard does not work automatically and needs active government
intervention. It may be more appropriately called a managed standard.
4. Inflation-Oriented:
Under this system, money supply can be increased easily but it is very difficult
to reduce money supply. Hence it is prone to inflation.
5. Expensive:
This system is not economical. To make it work, the government has to keep
many reserves which involve lot of expenditure. It is due to its expensive
nature that India abandoned this system on the recommendations of Hilton
Young Commission.
Why Gold? (Gold is also known as Yellow Metal)
Most commodity-money advocates choose gold as a medium of
exchange because of its intrinsic properties. Gold has non-monetary uses,
especially in jewellery, electronics and dentistry, so it should always retain a
minimum level of real demand. It is perfectly and evenly divisible without
losing value, unlike diamonds, and does not spoil over time. It is impossible to
perfectly counterfeit and has a fixed stock — there is only so much gold on
Earth, and inflation is limited to the speed of mining.

2.2.3 The Bretton Woods Era (1946 to 1971)

To streamline and revamp the war ravaged world economy & monetary
system, allied powers held a conference in 'Bretton Woods', which gave birth
to two super institutions - IMF and the WB. In Bretton Woods modified form of
Gold Exchange Standard was set up with the following characteristics :

• One US dollar conversion rate was fixed by the USA as one dollar = 35 ounce
of Gold

• Other members agreed to fix the parities of their currencies vis-à-vis dollar
with respect to permissible central parity with one per cent (± 1%)
fluctuation on either side. In case of crossing the limits, the authorities were
free hand to intervene to bring back the exchange rate within limits.

The mechanism of Bretton Woods can be understood with the help of the
following illustration:

Suppose there is a supply curve SS and demand curve DD for Dollars. On Y-axis,
let us draw price of Dollar with respect to Rupees
Suppose Indian residents start demanding American goods & services.
Naturally demand of US Dollar will rise. And suppose US residents develop an
interest in buying goods and services from India, it will increase supply of
dollars from America.

Assume a parity rate of exchange is Rs. 10.00 per dollar. The ± 1% limits are
therefore Rs. 10.10 (Upper support and Rs. 9.90 lower support).

As long as the demand and supply curve intersect within the permissible range;
Indian authorities will not intervene.

Suppose demand curve shifts towards right due to a shift in preference of

Indians towards buying American goods and the market determined exchange
rate would fall outside the band, in this situation, Indian authorities will
intervene and buy rupees and supply dollars to bring back the demand curve
within permissible band. The vice-versa can also happen.

There can be two consequences of this intervention. Firstly, the domestic

money supply, price and G.N.P. etc. can be effected. Secondly, excessive supply
of dollars from reserves may lead to exhaustion or depletion of forex reserves,
there by preventing all possibilities to borrow dollars from other countries or
IMF.

During Bretton Woods regime American dollar became international money

while other countries needed to hold dollar reserves. US could buy goods and
services from her own money. The confidence of countries in US dollars
started shaking in 1960s with chronological events which were political and
economic and on August 15, 1971 American abandoned their commitment to
convert dollars into gold at fixed price of $35 per ounce, the currencies went
on float rather than fixed. Though "Smithsonian Agreement" also failed to
resolve the crisis yet by 1973, the world moved to a system of floating rates.
(Note : Smithsonian Agreement made an attempt to resurrect the system by
increasing the price of gold and widening the band of permissible variations
around the central parity).

Post Bretton Woods Period (1971-1991)

Two major events took place in 1973-74 when oil prices were quadrupled by
the Organisational of Petroleum Exporting Countries (OPEC). The result was
seen in expended oils bills, inflation and economic dislocation, thereby the
monetary policies of the countries were being overhauled. From 1977 to 1985,
US dollar observed fluctuations in the oil prices which imposed on the
countries to adopt a much flexible regime i.e. a hybrid between fixed and
floating regimes. A group of European Nations entered into European
Monetary System (EMS) which was an arrangement of pegging their currencies
within themselves.

An exchange rate regime is the way a monetary authority of a country

or currency union manages the currency in relation to other currencies and
the foreign exchange market. It is closely related to monetary policy and the
two are generally dependent on many of the same factors, such as economic
scale and openness, inflation rate, elasticity of the labour market, financial
market development, capital mobility etc.

The Gold Standard: A History

10 gram gold in USA =$ 500

10 gram gold in India = Rs 40,000

$500 = Rs 40000

$1 = Rs 80 (40000/500)

"We have gold because we cannot trust governments," President Herbert

Hoover famously said in 1933 in his statement to Franklin D. Roosevelt. The
gold standard is a monetary system where a country's currency or paper
money has a value directly linked to gold. With the gold standard, countries
agreed to convert paper money into a fixed amount of gold. A country that
uses the gold standard sets a fixed price for gold and buys and sells gold at that
price. That fixed price is used to determine the value of the currency. For
example, if the U.S. sets the price of gold at $500 an ounce, the value of the
dollar would be 1/500th of an ounce of gold.

The gold standard is not currently used by any government. Britain stopped
using the gold standard in 1931 and the U.S. followed suit in 1933 and
abandoned the remnants of the system in 1973. The gold standard was
completely replaced by fiat money, a term to describe currency that is used
because of a government's order, or fiat, that the currency must be accepted
as a means of payment.

What Is Fiat Money?

Fiat money is government-issued currency that is not backed by a physical
commodity, such as gold or silver, but rather by the government that issued it.
The value of fiat money is derived from the relationship between supply and
demand and the stability of the issuing government, rather than the worth of a
commodity backing it as is the case for commodity money. Most
modern paper currencies are fiat currencies, including the U.S. dollar, the euro,
and other major global currencies.

Advantages and Disadvantages of Fiat Money

Advantages
Fiat money serves as a good currency if it can handle the roles that a nation's
economy needs of its monetary unit—storing value, providing a numerical
account, and facilitating exchange. It also has excellent seigniorage.

Fiat currencies gained prominence in the 20th century in part because

governments and central banks sought to insulate their economies from the
worst effects of the natural booms and busts of the business cycle. Since fiat
money is not a scarce or fixed resource like gold, central banks have much
greater control over its supply, which gives them the power to manage
economic variables such as credit supply, liquidity, interest rates, and money
velocity. For instance, the U.S. Federal Reserve has the dual mandate to keep
unemployment and inflation low.

Disadvantages
The mortgage crisis of 2007 and subsequent financial meltdown, however,
tempered the belief that central banks could necessarily prevent depressions
or serious recessions by regulating the money supply. A currency tied to gold,
for example, is generally more stable than fiat money because of the limited
supply of gold. There are more opportunities for the creation of bubbles with
fiat money due to its unlimited supply.

Example of Fiat Money

The African nation of Zimbabwe provided an example of the worst-case
scenario in the early 2000s. In response to serious economic problems, the
country's central bank began to print money at a staggering pace. That
resulted in hyperinflation, which ran between 230 and 500 billion percent in
2008. Prices rose rapidly and consumers were forced to carry bags of money
just to purchase basic staples. At the height of the crisis, a 100-trillion
Zimbabwean dollar was worth about 40 cents in U.S. currency.

Sources of demand of foreign exchange:

The demand (or outflow) of foreign exchange comes from the people who
need it to make payments in foreign currencies. It is demanded by the
domestic residents for the following reasons:
(a) Imports of Goods and Services: When India imports goods and services,
foreign exchange is demanded to make the payment for imports of goods and
services.
(b) Tourism: Foreign exchange is demanded to meet expenditure incurred in
foreign tours.
(c) Unilateral Transfers Sent Abroad: Foreign exchange is required for making
unilateral transfers like sending gifts to other countries.
(d) Purchase of Assets in Foreign Countries: It is demanded to make payment
for purchase of assets, like land, shares, bonds, etc. in foreign countries.
(e) Repayment of loans to Foreigners: As and when we have to pay interest
and repay the loans to foreign lenders, we require foreign exchange.
(d) Speculation: Demand for foreign exchange arises when people want to
make gains from appreciation of currency

Sources of supply of foreign exchange:

The supply (inflow) of foreign exchange comes from the people who receive it
due to the following reasons.

(a) Exports of Goods and Services: Supply of foreign exchange comes through
exports of goods and services.
(b) Tourism: The amount, which foreigners spend in the home country,
increases the supply of foreign exchange.
(c) Remittances (unilateral transfers) from Abroad: Supply of foreign exchange
increases in the form of gifts and other remittances from abroad.
(d) Loan from Rest of the world: It refers to borrowing from abroad. A loan
from U.S. means flow of U.S. $ from U.S. to India, which will increase supply of
Foreign exchange.
(e) Foreign Investment: The amount, which foreigners invest in our home
country, increases the supply of foreign exchange.
(f) Speculation: Supply of foreign exchange comes from those who want to
speculate on the value of foreign exchange.

Exchange Rates
The equilibrium exchange rate is the rate which equates demand and supply
for a particular currency against another currency.