International_Monetary_System

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International Monetary System:

International Monetary System

Definition :

Definition International monetary systems are sets of internationally agreed rules, conventions and supporting institutions that facilitate international trade, cross border investment, and generally the reallocation of capital between nation states.

Types of International Monetary System:

Types of International Monetary System Bimetallism: Before 1875 Classical Gold Standard: 1875 – 1914 Interwar Period: 1915 – 1944 Bretton Woods System: 1945 – 1972 Flexible Exchange Rate Regime: From 1973 onwards

Bimetallism:

Bimetallism A “Double Standard” in the sense that both gold and silver were used as money. Some countries were on the gold standard, some on silver standard, some on both. It is a monetary standard in which the value of the monetary unit can be expressed either with a certain amount of gold or with a certain amount of silver.

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i.e Both gold and silver were used as international means of payments and the exchange rates among currencies were determined by either their gold or silver contents.

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The bimetallic standard was first used in the United States in 1792 as a means of controlling the value of money. For example, during the 18th century in the United States, one ounce of gold was equal to 15 ounces of silver. Therefore, there would be 15 times more Silver (by weight) in $10 worth of silver coins than $10 worth of gold coins. Adequate gold and silver was kept in reserves to back the paper currency. This bimetallic standard was used until the civil war, when the Resumption Act of 1875 stated that paper money could be converted to gold.

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Gresham’s law states that “Bad money drives good money out of circulation”.

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What is good money ? What is bad money ? What is circulation ? How bad money drives out good money from the market ?

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Good Money – Which shows little difference between its nominal value and its commodity value. People prefer trading in coins rather than in anonymous hunks of precious metals, so they attribute more value to the coins of equal weight. The price spread between face value and commodity value is called seigniorage .

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Bad Money – It is money that has a commodity value considerably lower than its face value and is in circulation along with good money, where both forms are required to be accepted at equal value as legal tender. To make it more clear bad money includes any coin that had been debased. Debasement was often done by the issuing body, where less than the officially specified amount of precious metal usually by allowing it with a base metal.

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Public can also debase coins by scrapping of the portions of precious metal. Counterfeit coins are also example of bad money.

Reasons for Collapse :

Reasons for Collapse It was the political conflict which was the main reason of collapse of bimetallism there were some new silver mines discovered in the end of nineteenth century which led to the decrease in the value of money. These created a conflict between those that favoured inflationary policies caused by ther bimetallic standard and those that favoured sound money produced by gold standard.

Advantages of Gold Standard :

Advantages of Gold Standard Because of it’s fixed supply gold standard creates price level stability Provides cushion against hyperinflation Automatic adjustment in balance of payments is ensured under this system.

Disadvantages of Gold Standard :

Disadvantages of Gold Standard It may lead to possible deflationary pressure. With a fixed supply of gold or fixed money supply, output growth would lead to deflation. There is no commitment on part of countries or enforcement mechanism, to keep countries on the gold standard if they decide to abandon gold.

Interwar Period: 1915 – 1944 :

Interwar Period: 1915 – 1944 Every country had to meet the requirement of military during the World War. They printed currencies in large volumes. It caused inflation.

Sterilization:

Sterilization Most banks engaged in the process called “sterilization” where they would counteract neutralize the price-specie-flow adjustment mechanism. Central banks would match inflows of gold with reduction in the domestic money supply and vice versa, so that domestic price level would not change

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Sterilization basically doesn’t allows adjustment mechanism to work. 1. Great Britain returned to gold standard by pegging the pound to gold at £ 4.25 per ounce. Britain had substantial inflation between 1914 - 1925

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It lead to the rise in the prices of B ritish products. Which made them out of the foreign market. Which led Britain into depression. Foreign holders of £ lost confidence in £ and started converting their holdings of pound into gold. British Govt. feeling the scarcity of gold and shortening of reserves suspended convertibility to gold in 1931.

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2. After the war, hyperinflation followed in many countries like Austria, Hungry, Poland, Germany etc. Price level increased in Germany by 1 trillion times. 3. United States gave up gold standard in 1933 Raised the dollar price of gold from $ 20.67/Ounce to $ 35/Ounce More $ were required to buy an ounce of gold, making $ worthless.

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The united states started devaluing the $ relative to other currencies. Reducing the price of exports and increasing the price of imports. Believing that this will generate more employment in the country. Other nations also started following the same thing. Leading to the cycle of competitive de-valuations. No country could win the race.

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4. Countries started loosing confidence in gold standard Many devalued their currencies at will leading to unknowingness that how much gold a currency could buy. People started converting their currency holdings into gold. Which put pressure on the gold reserves of countries. Forcing countries to suspend gold convertibility.

The Bretton Woods System:

The Bretton Woods System The world war II was at its height in 1944 Gold standard was collapsed World went through the great depression of 1930’s Countries were devaluing there currencies Lack of multinational institution to control the world economic events

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It led to the search of new International Monetary System to build an enduring economic order Intention was to help countries facilitating post-war economic growth They came to a conclusion that fixed exchange rates were desirable at that time The main agendum was to avoid senseless competitive devaluations

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Representatives of 44 countries met at Bretton Woods, New Hampshire. After the proceedings of the conference, participants succeeded in drafting and signing the Articles of Agreement of the IMF. The agreement was later ratified by majority of the countries to launch IMF in 1945. The agreement established two multinational institutions: (i) International Monetary Fund & (ii) World Bank

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The task of the IMS is to maintain order in the IMS The world bank would be to promote general economic development

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The Bretton Woods agreement is also called a system of fixed exchange rate system. The IMF was empowered to monitor it. The main contents of the agreement were: All the countries were to fix the value of their currency in terms of gold However they were not required to exchange their currencies for gold

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The dollar alone remained convertible into gold at a price of $ 35 per ounce . Each country decided what it wanted its exchange rate to be against the dollar exchange rate.

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All participant countries accepted to maintain the value of their currencies within 1 % of the par value by buying or selling currencies or gold as needed. For example, if foreign exchange dealers were selling more of a country’s currency than the demand the Govt. of that country will intervene in the foreign exchange markets, buying in currency in an attempt to increase demand and maintain the value.

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Another aspect of the Bretton woods was a commitment not to use devaluation as a weapon of competitive trade policy “But if currency becomes too weak to defend a devaluation of 10% is allowed without any formal approval of IMF”. “Larger devaluations require IMF approval”.

The Role of the IMF:

The Role of the IMF The IMF has articles of agreement. The contents of Articles are made by keeping the following pre-IMF events: The worldwide financial breakdown. Competitive devaluations of currencies Trade war among countries High unemployment rate Hyperinflation rate in Europe and elsewhere and:

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The general economic disintegration occurred between the two world wars. The aim of the Bretton Woods agreement, of which the IMF was the main custodian, was to try to avoid a repetition of all above mentioned events with the help of discipline and flexibility.

Discipline :

Discipline Fixed exchange rate regime imposes discipline in two ways: There should be no more devaluation of currencies. This ensures the stability to the world trade environment. A fixed exchange rate, secondly, imposes monetary discipline on countries it prevents inflation.

Flexibility :

Flexibility Rigidity of the gold standard was one of the main reason of its failure as Bretton woods also imposed monetary discipline. It would also break down as gold standard had. A country’s attempts to reduce it’s money supply growth and correct a persistent balance of payment’s deficit could force the country into recession.

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Two major features of the IMF Articles of Agreement which fostered flexibility was: IMF lending facilities Adjustable Parities The following arrangements were made based on the above points:

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Tightening of monetary or fiscal policy will negatively affect domestic unemployment. The IMF was ready to lend foreign currencies to its members to tide them over during the short period of balance of payments deficit. For lending operations members contributed a pool of gold and currencies.

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A prolonged deficit in balance of payments account depletes a country’s reserves of foreign currency. It forces the countries to devalue their currencies. IMF comes to their rescue by lending short-term foreign currency loans. This would bring down the inflation and reduce the balance of payments deficit. The belief was that such loans would reduce pressures for devaluation and for more orderly and less painful adjustment.

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Countries were to be allowed to borrow a limited amount from IMF without adhering to any specific agreements. However, extensive drawings from IMF funds would require a country to agree to increasingly stringent IMF supervision of its macroeconomic policies Heavy borrowers from the IMF must agree to monetary and fiscal conditions set down by the IMF, which typically included IMF – mandated targets on domestic money supply growth, exchange rate policy, tax policy, government spending and so on.

Fundamental Disequilibrium:

Fundamental Disequilibrium A country was allowed to devalue its currency to manage deficit of BOP of account up to 10%. The system of adjustable parities allows for this devaluation. This provision was made specially for those countries whose BOP is in “Fundamental Disequilibrium”. The IMF’s article of agreement did not define “Fundamental Disequilibrium”. This provision was specially made to countries permanently

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suffered by adverse shifts in demand of their products. Such countries would experience high unemployment and a persistent trade deficit until the domestic price level had fallen far enough to restore a balance of payment equilibrium. The belief was that devaluation could help sidestep a painful adjustment process in such circumstances.

The Role of the World Bank :

The Role of the World Bank The World Bank is officially known as IBRD European countries were not in good shape and their economies were in shamble due to World War II. Participants of Bretton Woods kept this condition of Europe in mind while establishing the World Bank. The aim of the World Bank was to help financially building of Europe’s economy.

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For this purpose World Bank gave loans to Europe at low rate of interest. The World Bank was overshadowed in this role by the Marshall Plan, under which the United States lent money directly to European nations to help them rebuild. Therefore the World Bank started lending soft loans to the third world countries. The bank concentrated on public – sector projects in the third world countries. Power station projects, road building and other transportation investments were much in favour .

The Schemes of the World Bank:

The Schemes of the World Bank The World Bank lends money under two schemes: Under the IBRD scheme, money is raised through bonds sale in the international capital market. Borrower’s pay what the bank calls a market rate of interest - the banks cost of funds and a margin for expenses.

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This market rate is lower than commercial banks market rate. Under the IBRD scheme, the bank offers low-interest loans to risky customers whose credit rating is often poor. A second scheme is overseen by the International Development Agency (IDA), an arm of the bank created in 1960. Resources to fund IDA loans are raised through subscription from wealthy members such as United States, Japan and Germany.

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IDA loans go only to the poorest countries. Poorest countries defined in 1991 with annual income per capita of less than US$ 580. Borrowers have 50 years to repay at an interest rate of 1% per year.

Special Drawing Rights:

Special Drawing Rights The world experienced a substantial growth in 1960s The warring nations of world war II grew very fast It weakened the position of USA Which forced US Govt. to devalue us $ The reserves were not enough to back the trade expansion

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Which slowed down economic development IMF reacted by issuing Special Drawing Rights Which member countries could add to their holdings of foreign currencies and gold SDRs were assigned with a value based on the average worth of world major currencies Which were the US $, the French Franc, the Pound Sterling, the Japanese Yen and the German M ark

Features of Special Drawing Rights:

Features of Special Drawing Rights An SDR, is like gold, an internationally acceptable reserve asset that is not simultaneously in use with national currency In addition the growth rate of the asset can be can be kept relatively low , and the value of the asset is more stable than the value of any single national currency The SDR does not have a fixed official price and the SDR is not a physical asset with intrinsic value

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SDRs can be used in settlement of payments imbalances between countries and can provide International liquidity to SDR holders Critical to the success of SDRs is that they have relative stability in value and most willingly the surplus countries are willing to accept SDRs in payment of imbalances However SDRs continue to be a very small fraction of international reserve assets held by central bank

The Collapse of the Fixed Exchange Rate System:

The Collapse of the Fixed Exchange Rate System The system went well till the late 1960s, then it began to show signs of strain and ultimately collapsed in 1973 As US $ has the main role in this system any pressure on the US $ to devalue could play havoc and that is what occurred Economist believed that US macroeconomic package of 1965 – 1968 caused the collapse of fixed exchange system

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American President Mr. Lyndon B. Johnson increased the US Govt. spending to finance both the Vietnam War and his welfare programs with the help of increasing money supply, it increased inflation from 4% in 1966 to 9% in 1968, with more money in pocket people spend more on imports and US trade balance deteriorate.

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Increasing inflation and worsening foreign trade position created an impression that $ would be devalued The US $ weakened against Germany Mark reacting to this Germany allowed it’s currency to float. Things went more worst when it was declared that for the first time in 1971 since 1945, US was importing more then it was exporting.

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The $ could be devalued only if all countries agreed to revalue against $ In 1971 President Mr. Richard Nixon that dollar was no longer convertible to gold. He also announced that 10% duty on imports will remain in effect until the trading partners of US agrees to revalue their currencies against the dollar. In December 1971 the trading partners agreed, $ was devalued by about 8% and then import tax was removed

After the Collapse of Fixed Exchange Rate System:

After the Collapse of Fixed Exchange Rate System US BOP position continue to deteriorate throughout 1972 while the money supply was increasing at inflationary rate. Speculation continued that the dollar is still overvalued and the second devaluation is necessary. In anticipation US $ got converted into other currencies

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European banks spent $ 3.6 billion on March 1 to try to prevent their currencies from appreciating against the dollar. The forex market was closed When the market got reopened on March 19, the currency of Japan and most European countries were floating against the dollar.

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At that time, the switch to a floating system was viewed as a temporary response to unmanageable speculation in the foreign exchange market. But it is now almost more than 40 years since the Bretton W oods system of fixed exchange rates collapsed, and now the temporary solution looks permanent

Weaknesses of the Bretton Woods:

Weaknesses of the Bretton Woods The system could not work if its key currency US $, was under speculative attack . The Bretton Woods system could work only as long as the US inflation rate remained low and the united states did not run a BOP deficit Once these things occurred, the system soon became strained to the break even point.

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There were capital movements restrictions throughout the Bretton Woods years as well as the fact that parities were only adjusted after speculative and financial crisis Bretton Woods put enormous pressure on the US, which was not willing to supply the amount of gold the rest of the world demanded.

Benefits of the Bretton Woods System:

Benefits of the Bretton Woods System There was a significant expansion of international trade and investment as well as a notable macroeconomic policy. The rate of inflation was lower on average for every industrialised country except Japan, than during the period of floating exchange rates that followed.

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The real per capita growth was higher than in any monetary regime since 1879 The interest rates were low and stable It has to be noted that leading economists nowadays argue “whether macroeconomic stability was responsible for the successes of Bretton Woods or the controversy”.

Tiffin's Dilemma:

Tiffin's Dilemma Prof. Robert Triffin came out with an explanation that why Bretton Woods system had to collapse inevitably.

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He noted that there was a fundamental liquidity dilemma when some countries national currency was used as a international currency.

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World economy grows Growing economy requires more money ( = US $) To supply that US has to run a BOP deficit If US continues to run BOP deficit, it would lose credibility as sound currency country.

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The amount of gold that US had would soon be much less than the amount of $ held by other countries. This means US could not guarantee conversion of international $ into gold if all the foreign central banks tried to cash in.

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“ To supply global liquidity, the US must run a deficit. But to maintain credibility, the US must not run a deficit” That was the fundamental dilemma. In the end the US opted to run a BOP deficit, which ultimately led to the loss of credibility and collapse of Bretton Woods system. As per Triffin the US should not be blamed for the collapse of the Bretton Woods, because there was no way to get out of this impossible situation.

The Floating Exchange Rate Regime:

The Floating Exchange Rate Regime The Jamaica Agreement The floating exchange rate came into operation immediately after the downfall of the fixed system. It was formalised in Jan – 1976. The IMF members met in Jamaica. They framed rules for IMS that are being practiced today.

Elements of Jamaican Agreement:

Elements of Jamaican Agreement Floating rates were declared acceptable. IMF members were permitted to enter the foreign exchange markets to even out “unwarranted” speculative fluctuations. Gold was abandoned as a reserve asset. The IMF returned it’s gold reserves to member countries at the current market price, placing the proceeds in a trust fund to help poor nations. Members were permitted to sell their gold reserves at the market price

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Total amount IMF quotas: the contribution of the IMF members to IMF was increased to $ 41 billion. Since then they have been increased to $ 195 billion and the membership has been increased to 182 countries.

What is Floating?:

What is Floating? It is the rate decided by the market forces i.e demand and supply. It is also termed as self correcting In a floating regime, the central bank may also intervene when it is necessary to ensure stability and to avoid inflation.

Exchange Rates since 1973:

Exchange Rates since 1973 Since March 1973, exchange rates have become much more volatile and less predictable than they were between 1945 – 1973. The volatility has been partly due to a number of unexpected shocks to the world monetary system, including:

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The oil crisis in 1971 when the OPEC quadrupled the price of oil. It resulted in decline of value of US $ due to high inflation and trade deficit. The loss of confidence in US $ that followed the rise of US inflation in 1977 and 1978 The oil crisis in 1979 when the OPEC doubled the price of oil. Unexpected rise in the $ between 1980 – 85

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Rapid fall of US $ against the Mark and Yen in 1985 – 87 and between 1993 – 1995 respectively The partial collapse of the E uropean monetary system in 1992 The 1997 Asian currency crisis when the Asian currencies of several countries lost between 50% t0 80% of their value against US $ in few months.

Rise in the Value of $ from 1980 - 1985:

Rise in the Value of $ from 1980 - 1985 The $ value rose between 1980 and 1985. This was a very peculiar situation $ appreciation occurred though there was growing trade deficit in US BOP a/c. Wisdom suggests that the increased supply of dollar in the foreign exchange market as a result of the deficit should lead to a reduction in the value of the $, but it increased in value.

Reasons for Rise in the Value of $:

Reasons for Rise in t he Value of $ A number of favourable factors temporarily overcame the unfavourable effect of a trade deficit: Strong economic growth in the US attracted heavy inflows of capital from foreign investors. Foreign investors invested their money in the US because real interest rates was high then.

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Moreover, political instability prevailed in Europe and US looked as a safer investment to other countries.

The Plaza Accord:

The Plaza Accord The fall in the value of US $ between 1985 – 1988 was caused by the combination of govt. intervention and market forces. US reported a record high trade deficit of $ 160 billion. This led to the growth in demand for protectionism in the US. In September 1985, the top leaders of so called group of five major industrial countries (Great Britain, France, Japan, Germany and US)

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met at the Plaza Hotel in New York and reached what was later referred to as the Plaza Accord. They announced that it would be desirable for most major currencies to appreciate the US $ and pledged to intervene in the foreign exchange markets, selling $, to encourage this objective, this announcement further accelerated the decline.

The Louvre Accord :

The Louvre Accord The $ continues to decline until early 1987. The Govt. of the G5 even began to worry that $ may decline too far so they met in Feb 1987 in Paris and reached a new agreement known as Louvre accord. They agrees that exchange rates had been realigned sufficiently and pledged to support the stability of exchange rates around their current levels by intervening in the foreign markets when necessary to buy and sell currency.

Intervention and the Dirty Float:

Intervention and the Dirty Float The market forces and Govt. interventions caused changes in the v alue of $ over years as noticed earlier. Under floating system market forces have produced a volatile $ exchange rate. Govt. have responded by either selling or buying in the market to limit the volatility. The frequency of Govt. entering the foreign exchange market explains why this system is referred as managed – float system or a dirty float system

Fixed Vs. Floating Exchange Rates:

Fixed Vs. Floating Exchange Rates The floating exchange rate regime recently is criticized by many economists. Dissatisfaction over floating rate is mounting today. Many prefer the fixed exchange rate in place of floating exchange rate. The debate is going on right now in the world.

Arguments in Favour of Floating Exchange Rate System:

Arguments in Favour of Floating Exchange Rate System Monetary policy autonomy and Automatic trade balance adjustments

Monetary Policy Autonomy:

Monetary Policy Autonomy Floating exchange rate removes the obligation to maintain the exchange rate. This helps them to maintain exchange rates parity. Ultimately it gives power to the Govt. to control the exchange rates. If a Govt. faced with unemployment wanted to increase its money supply to stimulate domestic demand and reduce unemployment it can do so.

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While monetary expansion might lead to inflation, this would lead to depreciation in the country’s currency. If PPP theory holds true, the resulting currency depreciation on the foreign exchange markets s hould offset the effect of inflation The rise in domestic cost should be exactly offset by the fall in the value of the country’s currency of the foreign exchange markets Similarly a Govt. could use monetary policy to contract the economy without worrying about the need to maintain parity.

Automatic Trade Balance Adjustments:

Automatic Trade Balance Adjustments Under fixed exchange system, if the balance of a trade account of a country shows a permanent deficit that could not be corrected by country’s domestic policy, this demands the IMF intervention by agreeing the currency devaluation. The adjustment mechanism under floating exchange system takes such shocks easily.

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A country may face a trade deficit. When your imports exceeds your exports this is known as trade deficit, it will lead to the increase in the supply of a country’s currency exceeds demand of a country’s currency in forex market. Such a situation demands currency depreciation. In turn by making it’s exports cheaper and its imports more expensive, exchange rate

Arguments in Favour of Fixed Exchange Rates:

Arguments in Favour of Fixed Exchange Rates The arguments in favour of fixed exchange system rest on the following points: Monetary Discipline Speculation Uncertainty and The lack of connection between trade balance and exchange rates.

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Monetary Discipline: The power to expand or contract money supply is not with the governments. A nod is to be obtained from the higher ups to do so. The following are the arguments supporting the fixed exchange regime The nature of monetary discipline is inherent in the fixed exchange rate system. Some one must be there to say whether you are alright or not.

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To maintain the fixed exchange rate parity, the governments do not expand their money supplies at inflationary rates The economists also said that Govt. generally gives in to political pressures and expand the monetary supply too rapidly, which would cause unacceptably high price inflation. The fixed exchange rate regimes will not yield to such pressures.

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Speculation It does not prevail in fixed exchange rate system They said that the volatility in $ rates during 1980 was a result of speculation only It can damage a country’s economy by distorting exports and imports prices. Thus advocates of a fixed exchange rate regime argue that such a system will limit the destabilising effects of speculation

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Uncertainty Uncertainties are more or less non existent under fixed exchange rate regime It makes planning, exporting, importing and foreign investment risky activities It dampens the growth of international trade and investment Fixed exchange rate system helps us in eliminating this uncertainty promotes the growth of international trade and investment.

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Trade Balance Adjustments The economists in favour of floating rate regime say that floating rates help adjust trade balances. Lets see how this was countered by the pro – fixed exchange rate economists: Critics question the closeness of the link between the exchange rates and trade balance.

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They determine that the trade balances are determined by the balance between savings and investment in a country and not by the external value of its currency. They argue that depreciation in a currency will lead to inflation. This inflation will wipe out any apparent gains in cost competitiveness that comes from currency depreciation. In other words, a depreciating

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exchange rate will not boost exports and reduce imports, as advocates of floating rates claim it will simply boost price inflation. In support of this argument those who favour fixed rates point out that the 40% fall in the value of the dollar between 1985 – 1988 did not did not correct the US trade deficit.

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