03 history of ims

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HISTORY OF MONETARY SYSTEM

• GOLD STANDARD (1870-1914)

• GOLD-EXCHANGE STANDARD (1914-1944)

• BRETTON WOODS SYSTEM (1944-1973)

• POST BRETTON WOODS SYSTEM (the current system)

• EUROPEAN MONETARY SYSTEM

Ankur Srivastava [email protected]

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GOLD STANDARD• Oldest standard (1870-1914)

• UK since 1821• US since 1834

• Most of the countries had joined the system by 1870

• It was in use till the beginning of World War I (After this again for

few years)• The essential feature of this system was:Governments gave an unconditional guarantee to convert theirpaper money into gold at a pre-fixed rate at any point of time, ondemand.

• Continued commitment of governments and readiness of people tobelieve it, were the reasons for the sustenance of such system for along period of time

• The exchange rate between two currencies was determined on the

basis of the rates at which respective currencies could be convertedinto gold Ankur Srivastava [email protected] 9212803190



• Example: if in US 1 ounce gold = US $400and in UK 1 ounce gold = UK £200,

then the exchange rate (called Mint parity) between $ and £would be $2/ £

The exchange rate would stay at this equilibrium level because of arbitragepossibility involved

• Assume prevailing rate be $2/ £

so a person wanting to convert $ into £ would have to pay $2.5 forevery £

He could instead buy an ounce of gold for $400-------Transport it to UK--------Sell it for £200

Therefore he would be able to get pounds at the exchange rate of $2/ £

As everyone would follow this route, there would be no demand for poundsin the foreign exchange market. Yet the supply would remain unaffected.

This demand-supply imbalance would cause the exchange rate to comedown and this would keep happening till the exchange rate reaches theequilibrium level i.e. $2/ £

An exactly opposite process would correct the exchange rate if it falls belowthe equilibrium level. Thus, the exchange rate would be maintained at

equilibrium. Ankur Srivastava [email protected] 9212803190



• Note: Above discussion assumes

1. no transaction cost for buying and selling goods

2. no shifting/transportation cost

• In reality, the above said costs are involved, so the exchange ratewould be able to fluctuate between the bands on either side of theequilibrium exchange rate, the bands being determined by the size of

these costs.• the end points of the range fixed by these bands is referred to as“ Gold points”

• there was an inbuilt mechanism in the Gold standard to help correct

any imbalance in international trade (i.e. international receipts andpayments) is known as “ price-specie-flow-mechanism”


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Example: France Germany

Exporting more

than importing

Result Trade surplus Trade deficit

Excess supply of DM

DM-₣ exchange rate wouldcome down below mint-paritylevelSuppliers of DM would prefer to ∆their holdings via “Sell DM forGold-ship it to France-sell

Gold for ₣” route

So, there will be a transfer of Goldfrom Germany to France

Gold reserves would go up & its would come down

money supply & will be forced to reduce

will increase money supply According to Quantum Price of goods produced Price of German goodstheory of Money in France also increases decreases

Attractiveness of goods Decreases Increasesto both German & Exports comes down & French consumers import from Germany increases

This process continues till the trade balance between the two countries isachieved Ankur Srivastava [email protected] 9212803190



Note:

Fixed parity theory in Gold Standard

1. from 1821-1914, Great Britain has value £3,17s,101/2 d perounce

2. from 1834-1933, United States has value $20.67 per ounce

(with the exception of Greenback period 1861-1878)

Thus, over the period 1834-1914 (with the exception ofGreenback period), the exchange rate between £ and $ was$4.867 per £ (referred to as Par exchange rate)


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GOLD-EXCHANGE STANDARD


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• 1914-1944

• The Gold standard broke down during World War I and was brieflyreinstated from 1925-1931 as the Gold-exchange Standard

• Under this standard, the US and England could hold only Gold reserves,but the other countries could hold both Gold as well as US$ or UK£ asreserves.

• So, instead of holding Gold as a reserve asset, they started holdingreserves of that currency which is on Gold Standard i.e. US$ or UK£

(for most of the countries, it was UK£)• During World War I and early 1920s, currencies were allowed to

fluctuate over fairly wide ranges in terms of Gold, however, flexibleexchange rates did not work in an equilibrating manner. On thecontrary, international speculators sold the weak currencies short,

causing them to fall further in value than warranted by the real economicfactors. The reverse happened with strong currencies.

• The net result was that the volume of world trade did not grow in 1920s inproportion to the world GNP and declined to a very low level with theadvent of depression in 1930s


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• Although Britain was acting as the banker to the world, even itsgold reserves were not enough to back financial obligations it wascreating on itself.

• Further, unlike a normal bank, it did not have any lender of lastresort

Germany defaulted on its payment obligation

France started converting its £ holding into gold in order to

shore up its gold reserves As a result, Britain gold reserves started depleting rapidly

A major Australian bank “Credit Anstalt” collapsed

All these together spread a financial panic around the world as

Britain‟s ability to honour its commitment becomes doubtful Soon everyone started trying to convert their pound holdingsinto gold

Britain being unable to fulfill its commitment abandoned thesystem in 1931, in order to save its economy from disaster

Ankur Srivastava [email protected] 9212803190



• With Britain‟s departure from the system, the pressure shifted to US $(the only remaining currency convertible into gold). This pressureeventually resulted in the US suspending the convertibility in 1933.

• With this, the Gold exchange standard effectively came to an end.

• As most of the countries were facing an economic downturn and neededexternal demand to boost domestic economy, a series of competitivedevaluations (where every country tries to devalue its currency morethan the other countries, in order to boost its exports-also calledbeggar- thy-neighbor policy) started taking place.

• US returned to modified gold standard in 1934 when $ was devalued toUS$35 per ounce of gold. Although US returned to standard, gold wastraded only with foreign central banks, not private citizens.

• From 1934 to end of World War II, exchange rates were theoreticallydetermined by each currency‟s value in terms of Gold

• During World War II and its immediate aftermath, many of the maintrading currencies lost their convertibility into other currencies. The dollarwas the only major trading currency that continued to be convertible.

• Due to extreme volatility of the exchange rates and the restrictionsimposed on trade and capital flows, international trade came down to

very low levels and international capital flows almost stopped. Ankur Srivastava [email protected] 9212803190



BRETTON WOODS SYSTEM


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• 1944-1973

• With the world at war, representatives of 44 countries met inBretton Woods, New Hampshire, USA to create a new

international monetary system (on July 1, 1944)]• Such system should address the following issues:

Stoppage of all international economic activity;

Steep fall in global economic growth;

Hyper inflation; Co-operation on economic front impossible because of war;

A system of stable exchange rate was required;

Ensure that the countries do not get incentive by following

inflationary policies; Also, some arrangement is required to tide over ST BOP

problem and help them remain within the system withoutcausing undue turmoil in their economies


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• The agreement was made in 1944 but implemented in 1946

• The breakdown of the inter war gold standard and themutually destructive policies that followed, convinced leaders

that a new set of o-operative monetary and tradearrangements was a pre- requisite for the world peace andprosperity

• The new international monetary system agreed upon by all

44 nations held at Brettons Woods, came to be known as theBRETTON WOODS SYSTEM


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The main terms of the agreement arrived at were as follows:

1) A system (which came to be known as the adjustable peg

system) was established which fixed the exchange rates, with

the provision of changing them if necessity arose. Under thenew system, all the members of the newly set up IMF (see point2) were to fix the par value of their currency either in terms ofgold or in terms of US$. The par value of the US$ ,in turn, wasfixed at $35 per ounce. All these values were fixed the approval

of IMF and reflected the changed economic and financialscenario in each of the countries and their new position ininternational trade. Further, member countries agreed tomaintain exchange rates for their currency within a band of onepercent on either side of fixed par value. The extreme points of

these bands were to be referred to as UPPER and LOWERSUPPORT POINT. If rates moves beyond these points, themonetary authorities were to stand ready to buy or sell theircurrencies in exchange for US$ and thereby support theexchange rates.

Ankur Srivastava [email protected] 9212803190



2) Two new institutions were to be established namely, INTERNATIONALMOENETARY FUND (IMF) and THE INTERNATIONAL BANK FORRECONSTRUCTION AND DEVELPOMENT (IBRD) also known asWORLD BANK

IMF was supposed to be more important and powerful than theWorld Bank. It was decided that the member countries would meetunder the aegis of this institution and together take a decision on anyimportant matter which might affect the world trade or world monetarysystem. Hence, co-operation and mutual consultation was built into the

system in order to avoid the universally harming policies beingfollowed by most of the countries before the World War II.

The second most important function of these institution wasto provide funds to member countries to help them tide over temporaryBOP deficit.

3) Currencies were required to be convertible for trade related and othercurrent account transactions and the government were given thepower to regulate capital flows. This was done in the belief that capitalflows destabilize economies. For the purpose of such conversion, goldreserves needed to be maintained by US and US$ reserves by other

countries. Ankur Srivastava [email protected] 9212803190



4) Since there was a possibility of such exchange rate being determined asmay not be compatible with a country‟s BOP position, the countrieswere allowed to revise the exchange rate up to 10% of the initiallydetermined rate, within 1 year of the rates being determined.

After that period, a member country could change the original parvalue up to 5% on either side without referring the matter to IMF, thattoo if its financial and economic conditions made it essential. Abigger change could be brought only with the consent of IMF‟sexecutive board, which allow it in case of a fundamental disequilibrium

in its BOP. Continuous reduction in reserves was supposed to serve asan indication of a fundamental disequilibrium.

5) All the member countries were required to subscribe to IMF capital. Thesubscription was to be in the form of the gold (one-fourth ofsubscription) and its own currency (the balance).

Each country quota in IMF capital was to be decided in accordancewith its position in the world economy. This capital was needed toenable IMF to help countries in need of reserves for defending theircurrency.


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• DEMAND DM Importer of German goodsneed to pay in DM (GermanExports)

Investors who invests inGermany

Demand curve for DMfollows the normal shape ofa commodity demand curve

As the price for DM goesup, its demand goes down

Price ↑ Demand ↓

• SUPPLY DMExporter of German goodsuse DM to buy othercurrencies

German investors whoinvests outside Germany

Supply curve for DM alsoconfirms to the normal shapeof a commodity supply curve

As the price of DM goes up,its supply increases

Price ↑ Supply ↑

Market demand DM – D1(DM)

Market supply DM – S (DM)

Intersection – Parity

$0.6667/DM or DM1.5/$


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PRICE ADJUSTMENT MECHANISM



PRICE ADJUSTMENT MECHANISM

Demand increases D2(DM), rate above S‟, Central Bankdemand $.

As $ have to be paid in DM – Supply of DM increases. According to the Quantum theory, increase in money supplyincreases the price of the German goods and hence makethem less competitive

Demand of imported goods increase in GermanyDemand of German exports decreases – Demand of DM alsodecreases – Demand curve shifts to D3(DM)

At the same time,Increased demand of imported goods in Germany increasesthe supply of DM – Supply curve shifts to S2(DM)

The new equilibrium rate now will again falls under the

permitted range. Ankur Srivastava [email protected]

9212803190



During Bretton Woods System

IMF (International Monetary Fund)

IBRD (International Bank for Reconstruction and Developmentalso called as World Bank)

IFC (International Finance Corporation) 1956

IDA (International Development Corporation) 1960


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International Monetary Fund (IMF)



International Monetary Fund (IMF)

4) To assist in the establishment of multilateral system of payments inrespect of current transactions between the members and in theelimination of foreign exchange restrictions which hamper the growth of

the world trade.

5) To give confidence to the members by making the general resources ofthe fund temporary available to them under adequate safeguards, thusproviding them with opportunity to correct maladjustments in their BOPwithout resorting to measures destructive of national or international

prosperity.

6) In accordance with the above, to shorten the duration and lessen thedegree of disequilibrium in the international BOP of members.


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One of the most important function was to provide reserve credit to member



One of the most important function was to provide reserve credit to membercountries facing temporary BOP problems. For the purpose, a currencypool was maintained. Each member country contribute (partly ininternational reserve currency and partly in its domestic currency) as per itsquota (which determines a country‟s access to the pool and its voting power

at IMF) Acountry could draw from IMF in tranches. A tranche is equal to 25% of acountry quota. Drawing of first tranche – automatically approved by IMF. Afurther 100% of its quota can be borrowed in four steps, with each step,stricter conditions are imposed. In order to draw from IMF, a member

country has to buy reserve asset and other currencies by paying its owncurrency to IMF. At the time of repayment, borrowing country reverses thedeal.

IMF‟ management is vested in its executive board out of its 22 directors, sixare appointed by government holding largest quota and the rest are elected

by remaining countries. MD (also, Chairman of the executive board) isappointed by the executive board for 5 years. The board of governors,which is the highest governing body of IMF meet once in a year to takemajor policy decisions. Its members are generally the Finance Ministers orthe Central Bank governors of the member countries. All member countries

are represented on this board. Ankur Srivastava [email protected] 9212803190



POST-BRETTON WOODS SYSTEM


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As the Bretton Woods System was abandoned in 1973 most countries



As the Bretton Woods System was abandoned in 1973, most countriesshifted to floating exchange rates.

This fact was finally recognized by IMF and amendments were carried outin the articles in Jamaica in 1976 and became effective on April 1, 1978

Now, countries were given much more flexibility in choosing the exchangerate system they wanted to follow and in managing the resultant exchangerates. They could either float or peg their currencies.

The peg could be with a currency, with a basket of currencies or with SDRbut not with gold.

This was done to reduce the role of gold and to make SDR more popularwith reserve assets.

For the same, value of SDR was redefined in terms of a basket of currencyrather than in $ terms.

Also, members were not required to deposit a part of their quota in gold andIMF sold off its existing gold reserves.

In order to make SDR more attractive as a reserve asset they were madeinterest bearing.


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It was allowed to be used for different types of international transactions



It was allowed to be used for different types of international transactions.

The member countries were also left free to decide upon the degree ofintervention required in foreign exchange markets and hence make itcompatible with their economic policies.

IMF was given increased responsibility for supervising the monetary system - identify countries causing changes in exchange rates whichproved disruptive to international trade and investment.

- then suggest alternative economic policies to such countries- also identify any country trying to defend its exchange rates

(which is inconsistent with the underlying economic fundamentals)- a constant monitoring of the reserves position of various countries

Now, access to IMF‟ assistance become easier for the countries facing theST imbalances in their BOP.


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Countries were free to determine their exchange rate policies however



Countries were free to determine their exchange rate policies, however,they were required to ensure that economic and financial policiesfollowed by them were such as to foster „orderly economic growth andreasonable price stability‟. They also had to follow principles ofexchange management adopted by IMF in 1977, which are :

1. A member country neither should manipulate the exchange rates (toprevent a correction in BOP) nor use exchange rates to gaincompetitive advantage in international markets.

2. A member country was required to prevent short term movements in

exchange rate which could prove disruptive to international transactionsby intervening in the exchange markets.

3. While intervening in foreign exchange markets, a member countryshould keep others interest in mind, especially whose currency itchooses to intervene in.


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These principles attempted to bring some stability in the foreign exchange



These principles attempted to bring some stability in the foreign exchangemarkets and to prevent another of competitive devaluations.

Given the freedom, different countries chose different exchangerate mechanism.

Some kept their currencies floating, some pegged them either to a

single currency/a basket of currencies. A peg was maintained by intervention in foreign exchange markets

and by regulating foreign exchange transactions.Instead a lot of volatility has been since experienced. To remove suchvolatility to an extent, sometimes a group of nations come together to form

closer economic ties. One such group is European Monetary System.


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03 history of ims

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