International Monetary system

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International Monetary system Harshad Bajpai : 

International Monetary system Harshad Bajpai

IMF: 

IMF >> International monetary systems are sets of internationally agreed rules , conventions and supporting institutions that >Facilitate international trade, cross border investment and movement of capital between nation states. >They provide means of payment acceptable between buyers and sellers of different nationality. >The IMS, to operate successfully, they need to inspire confidence, to provide sufficient liquidity for fluctuating levels of trade and to provide means by which global imbalances can be corrected. The systems can grow organically as the collective result of numerous individual agreements between international economic actors spread over several decades.

Why do we need IMS: 

Why do we need IMS International monetary system is -A world monetary and financial organization that facilitates the transfer of funds between parties, conversion of national currencies into one another, acquisition and liquidation of financial assets, and international credit creation.

IMS: 

IMS The most important feature of IMS is the exchange rate regimes.

Exchange rate regime : 

Exchange rate regime for determining the exchange rate at a point in time and changes overtime. It refers to the mechanism, procedure, and institutional framework

THE GOLD EXCHANGE STANDARD : 

THE GOLD EXCHANGE STANDARD The oldest exchange rate system. It has different models - The earliest was – Gold Specie standard , in which the actual currency circulated was gold coins. The gold standard is a monetary system in which the standard economic unit of account is a fixed weight of gold. Gold specie standard is a system in which the monetary unit is associated with circulating gold coins, in conjunction with subsidiary coinage made from a lesser valuable metal (ex-silver).

PowerPoint Presentation: 

Chronology of Exchange Rate regimes 1880-2000 1880-1914 -1918 Specie : Gold Standard/bullion (bimetallism, silver ) 1919-1945 Gold Exchange Standard 1946-1971 Bretton Woods (adjustable peg) 1973-2000 Free float; managed float, adjustable pegs, crawling pegs, basket pegs, target zones or bands; fixed exchange rates, currency unions, currency boards.

Gold bullion standard: 

Gold bullion standard Currency notes correspond to a fixed weight of gold were issued by the monetary authority. This means that if the gold reserve of the country increase only then it can print more paper money. By importing more if the gold reserves deplete then money in circulation should shrink correspondingly.

Gold exchange standard: 

Gold exchange standard Gold-exchange standard,  monetary system under which a nation’s currency may be converted for another currency which is convertible into gold at a stable rate of exchange. The gold-exchange standard came into prominence after World War I because of an inadequate supply of gold for reserve purposes. British sterling and the U.S. dollar have been the most widely recognized reserve currencies. Gold bullion + dealing with other currencies. Rupee can be converted into $, which then can be converted into gold. >The requirement of a fixed rate of exchange for the reserve currency has the effect of limiting the freedom of the other country’s monetary policy to solve domestic economic problems. >>A nation on the gold-exchange standard is thus able to keep its currency at parity with gold without having to maintain as large a gold reserve as is required under the gold standard.

Gold exchange standard: 

Gold exchange standard After the world war-I, US & UK became prominent, the world believed in their power, and hence in the power of their currency. As gold became scarce, it lost its potential to facilitate international trade. So the role was now assumed by the USD, and sterling. The focus shifted to maintaining the parity with USD and sterling. And hence the definition of reserve now included the USD and sterling. Now the monetary policy had a restricted role.

The diffrernce: 

The diffrernce The Gold bullion was essentially limited to the domestic economy, which gold exchange was a system created to facilitate world trade. That is why the world had to integrate and agree upon certain things, one of them was currency parity, it had to be fixed so one currency could be exchange for another.

PowerPoint Presentation: 

Chronology of Exchange Rate regimes 1880-2000 1880-1914 Specie : Gold Standard/bullion (bimetallism, silver ) 1919-1945 Gold Exchange Standard 1946-1971 Bretton Woods adjustable peg 1973-2000 Free float; managed float, adjustable pegs, crawling pegs, basket pegs, target zones or bands; fixed exchange rates, currency unions, currency boards.

Why the changs in the regimes ?: 

Why the changs in the regimes ? From gold specie to gold exchange standard, and then to Bretton woods and further. The change has been driven essentially by the need for liquidity, as the complexity increased and trade flourished the present system could not supply the needed liquidity for huge capital flows and had to be replaced by new more flexible regime.

Gold exchange standard: 

Gold exchange standard The countries following gold exchange standard had to stick to – 1) The conversion rate of paper money into gold must be fixed. 2) There must be free flow of gold between the countries in Gold exchange standard. 3) The money supply must correspond to the amount of gold the monetary authorities have. If the gold decreases the money supply should decrease. (cont.)

3rd point cont: 

3 rd point cont This poses rigid discipline on policy makers . The standard in short paralyzed the policy makers, restricting their activity, ex – inability to combat unemployment, deflation etc. After the great depression this system was abandoned.

PowerPoint Presentation: 

Advantages Long-term price stability has been described as the great virtue of the gold standard. The gold standard makes it difficult for governments to inflate prices through issuance of paper currency. Under the gold standard, high levels of inflation are rare, and hyperinflation is nearly impossible as the money supply can only grow at the rate that the gold supply increases. Economy-wide price increases caused by ever-increasing amounts of currency chasing a constant supply of goods are rare, as gold supply for monetary use is limited by the available gold that can be minted into coin. High levels of inflation under a gold standard are usually seen only when warfare destroys a large part of the economy, reducing the production of goods, or when a major new source of gold becomes available. In the U.S. one of those periods of warfare was the Civil War, which destroyed the economy of the South, while the California Gold Rush made large amounts of gold available for minting. Proponents of the gold standard claim that its stability fosters economic prosperity. The gold standard provides fixed international exchange rates between those countries that have adopted it, and thus reduces uncertainty in international trade. Historically, imbalances between price levels in different countries would be partly or wholly offset by an automatic balance-of-payment adjustment mechanism called the "price specie flow mechanism." Gold used to pay for imports reduces the money supply of importing nations, causing deflation and a reduction in the general price level for goods and services, making them more competitive, while the importation of gold by net exporters serves to increase the money supply, causes inflation and an increase in the general price level, making them less competitive.

PowerPoint Presentation: 

Advantages The gold standard acts as a check on government deficit spending as it limits the amount of debt that can be issued. It also prevents governments from inflating away the real value of their already existing debt through currency devaluation.  A central bank cannot be an unlimited buyer of last resort of government debt. A central bank could not create unlimited quantities of money at will, as there is a limited supply of gold. A gold standard cannot be used for what some economists call, financial repression. Newly printed money can be used to purchase goods and services, and to discharge debts, at no cost to the printer. This acts as a mechanism to transfer the wealth of society to those that can print money, from everyone else. Financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation, and it can be considered a form of taxation. In 1966 Alan Greenspan wrote "Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard." Per John Maynard Keynes "By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens“. Financial repression negatively affects economic growth. The gold standard benefits savers by preventing their savings from being devalued or destroyed through inflation, and by rewarding them with higher real (inflation adjusted) interest rates. In the US and United Kingdom, from 1945 to 1980 negative real interest rates have cost lenders an estimated 3-4% of GDP per year on average. The gold standard tends to limit credit booms and the resulting boom bust cycle because of the inelastic supply of money.

PowerPoint Presentation: 

Disadvantages The unequal distribution of gold as a natural resource makes the gold standard much more advantageous in terms of cost and international economic empowerment for those countries that produce gold. In 2010 the largest producers of gold, in order, are China, followed by Australia, the US, South Africa and Russia. The country with the largest reserves is Australia. The gold standard acts as a limit on economic growth. “As an economy’s productive capacity grows, then so should its money supply. Because a gold standard requires that money be backed in the metal, then the scarcity of the metal constrains the ability of the economy to produce more capital and grow.” Mainstream economists believe that economic recessions can be largely mitigated by increasing money supply during economic downturns. Following a gold standard would mean that the amount of money would be determined by the supply of gold, and hence monetary policy could no longer be used to stabilize the economy in times of economic recession. Such reason is often employed to partially blame the gold standard for the Great Depression, citing that the Federal Reserve couldn't expand credit enough to offset the deflationary forces at work in the market.

Gold prices (US$ per ounce) from 1968 to 2010, in nominal US$ and inflation adjusted US$.: 

Gold prices (US$ per ounce) from 1968 to 2010, in nominal US$ and inflation adjusted US $.

PowerPoint Presentation: 

Disadvantages Although the gold standard has brought long-run price stability, it has also historically been associated with high short-run price volatility. It has been argued that this kind of instability in short-term price levels can lead to financial instability as lenders and borrowers become uncertain about the value of debt. The total amount of gold that has ever been mined has been estimated at around 142,000 metric tons and arguments have been made that this amount is too small to serve as a monetary base. The value of this amount of gold is over 6 trillion dollars while the monetary base of the US, with a roughly 20% share of the world economy, stands at $2.7 trillion at the end of 2011. Murray Rothbard argues that the amount of gold available is not a bar to a gold standard since the free market will determine the purchasing power of gold money based on its supply. Deflation punishes debtors. Real debt burdens therefore rise, causing borrowers to cut spending to service their debts or to default. Lenders become wealthier, but may choose to save some of their additional wealth rather than spending it all. The overall amount of expenditure is therefore likely to fall. Monetary policy would essentially be determined by the rate of gold production. Fluctuations in the amount of gold that is mined could cause inflation if there is an increase, or deflation if there is a decrease. Some hold the view that this contributed to the severity and length of the Great Depression as the gold standard forced the central banks to keep monetary policy too tight, creating deflation.

PowerPoint Presentation: 

The gold standard may be susceptible to speculative attacks when a government's financial position appears weak, although others contend that this very threat discourages governments' engaging in risky policy,  For example, some believe that the United States was forced to contract the money supply and raise interest rates in September 1931 to defend the dollar after speculators forced Great Britain off the gold standard If a country wanted to devalue its currency, a gold standard would generally produce sharper changes than the smooth declines seen in fiat currencies, depending on the method of devaluation. Most economists favor a low, positive rate of inflation. Partly this reflects fear of deflationary shocks, but primarily because they believe that central banks still have some role to play in dampening fluctuations in output and unemployment. Central banks can more safely play that role when a positive rate of inflation gives them room to tighten money growth without inducing price declines. It is difficult to manipulate a gold standard to tailor to an economy’s demand for money, providing practical constraints against the measures that central banks might otherwise use to respond to economic crises. The demand for money always equals the supply of money. Creation of new money reduces interest rates and thereby increases demand for new lower cost debt, raising the demand for money.

The BRETTON WOODS SYSTEM: 

The BRETTON WOODS SYSTEM After the second world war the US took the task of revamping the IMS. Hence the birth of Bretton Woods. A) US government undertook to convert $ freely into gold at fixed parity of $35 per ounce. B) other countries agreed to fix their currency parity to $, with grace of 1% on either side(cont.)

B. cont: 

B. cont B) if the currency parity hit any extremes they were obliged to correct it by selling of purchasing dollar. BW was not a fixed exchange system as it had the flexibility of changing the parity by up to 10%, when faced with fundamental disequilibrium without the consent of IMF, and above with consent.

fundamental disequilibrium: 

fundamental disequilibrium The BOP crisis, mostly deficit is referred to fundamental disequilibrium, requires a repeated intervention of the monetary authority.

The sanctity of Bretton Woods : 

The sanctity of Bretton Woods As long as the world believed in the stability of USD, and its potential to convert it into gold, the BW shall stay. 1960s, witnessed several macro-economic shocks, which made US abandon $ convertibility to gold on 15 th August 1973. A Failed attempts were made to save the system by increasing the price of the gold, and increasing the rage of variation In currency parity. This was the – S mithsonian agreement.

Post Bretton Woods: 

Post Bretton Woods Many countries started to experiment between various regimes –From fixed to Free float. They also tried hybrids –managed floats.

Floating/Flexible Exchange Rate Systems: 

Floating/Flexible Exchange Rate Systems In a flexible exchange rate system, the value of the currency is determined by the market, i.e. by the interactions of thousands of banks, firms and other institutions seeking to buy and sell currency for purposes of transactions clearing, hedging, arbitrage and speculation. So higher demand for a currency, ceteris paribus, would lead to an appreciation of the currency. Lower demand, all else equal, would lead to a depreciation of the currency. An increase in the supply of a currency, all else equal, will lead to a depreciation of that currency while a decrease in supply, all else equal, will lead to an appreciation .

Floating/Flexible Exchange Rate Systems: 

Floating/Flexible Exchange Rate Systems Essentially, we can characterize the equilibrium exchange rate under a flexible exchange rate system as the value that is consistent with covered and uncovered interest rate parity given values for the expected future spot rate and the forward exchange rate. Since 1971, economies have been moving towards flexible exchange rate systems although only relatively few currencies are classifiable as truly floating exchange rates. Most OECD countries have floating exchange rate systems: the U.S., Canada, Australia, Britain, and the European Monetary Union.

Exchange rate regime with no separate legal tender: 

Exchange rate regime with no separate legal tender Under this a country either adopts the currency of another country or a group of country share a common currency. EU (12 countries is the biggest union using euro) Obviously a country adopting such policy can not have an independent monetary policy, since its money supply is tied to the country whose currency it has adopted or controlled by a common central bank which regulates the money supply of all the member nations.

Currency board agreements (CBU): 

Currency board agreements (CBU) A regime under which there is a legislative agreement to exchange the domestic currency with the specified foreign currency at a fixed rate. This implies constraint on the ability of the monetary authority to manipulate domestic money supply. In short if inflation becomes a concern the MP can not combat it for it main focus is on honoring he CBA, ensuring the parity remains fixed..

Conventional fixed peg arrangement: 

Conventional fixed peg arrangement This is similar to Bretton woods where in the country pledges its currency to another or to the basket of currencies with variation not to exceed 1%, and adjustment to the discretion of the domestic authority. 49 countries had this regime as of 2006, of which 40 had pegged it to single currency and the rest to the basket.

Intermediate pegs – Horizontal bands: 

Intermediate pegs – Horizontal bands It is more like a fixed exchange regime but has more flexibility. 2% variation is allowed. This give more power to MP.

Intermediate pegs – crawling peg: 

Intermediate pegs – crawling peg This is a variant of limited flexibility regime. The currency is pegged against foreign currency but peg is periodically adjusted. The adjustments may be due to adverse macro-economic movements like inflation, BoP , or pre-planned increments. The country might keep the currency parity on pre-announced trajectory.

Intermediate pegs – crawling bands: 

Intermediate pegs – crawling bands In Crawling band the rate is allowed to fluctuate in a band around a central value, which is adjusted periodically. This is done at a preannounced rate or in a controlled way following economic indicators. Band of fluctuation is the range within which the market value of a national currency is permitted to fluctuate by international agreements, or by unilateral decision by the central bank

Floats – Managed floats : 

Floats – Managed floats The central bank intervenes in the forex market actively to keep the volatility low, without any commitment t keep the exchange rate at a specific level. 53 countries adopted for such regime as of 2006.

Independent float: 

Independent float There is passive intervention of the central bank, which just intends to moderate the speed of change.26 countries went for such regime as of 2006.

Ideal policy: 

Ideal policy There is no such thing. Impossible trinity