INTERNATIONAL MONETARY SYSTEMSpecie commodity standard:In early days prior to evolution of international monetary system, trade payments were settled through barter, but there were many inconveniences and so to overcome those difficulties, traders began using metal, especially gold or silver for settling payments. Metal took the form of coin which had the stamp of sovereign on the basis of weight and fineness giving birth to the specie commodity standard. Coins were full bodied coins meaning that their value was equal to the value of metal contained therein. With lapse of time lower value metal was mixed with the coin with the result the value of metal came to be lower than the face value of coin. Debased coins were largely used as medium of exchange. Full bodied coins mainly used for store of value and for melting and selling them as gold and silver. The debased coin had led to bimetallic standard.Gold standard 1876-1913:It is originated in England in 17th century. The form of gold standard was not the same in all the countries adopting it. In UK and USA gold coins were minted and ban k notes were also exchanged for gold on demand. The price of gold was fixed under law. It was the price at which gold could be bought and sold. It is the purest form of gold standard and was known as gold specie standard.A modified version of gold standard was known as gold bullion standard. It had all advantages of gold standard without any compulsion to maintain gold coinage. Individual bank notes were not convertible to gold directly and for conversion, gold bars were purchased at fixed rates.Gold exchange standard was more economical form of gold standard where neither gold coinage was required nor purchase of gold bars exists. A county on gold exchange standard linked its currency to the currency of a country on the gold specie standards. If a country on the gold exchange standard held pound as its reserves, its currency was convertible into pounds and the pound was convertible into gold.Essential features of gold standard:The government adopting it fixed the value of currency in terms of specific weight and fineness of gold and guaranteed a two way convertibilityExport and import of gold were allowed so that it could flow freely among the gold standard countriesThe central bank acting as the apex monetary institution held gold reserves in direct relationship with the currency it had issuedThe government allowed unrestricted minting of gold and melting of gold coins at the option of the holderSince fixed weight of gold had formed the basis for a unit of the currency and since free flow of gold was allowed among the countries gold standard possess automatic mechanism for domestic price stability, fixed exchange rates and adjustment in balance of payments.Decline of gold standard:One of the problems is price specie (gold) mechanism which requires the nations to keep above the balance of payments and foreign exchange considerations above domestic policy goals which is not realistic.Gold is scarce commodity and gold volume could not grow fast enough to allow adequate amounts of money to be created to finance the growth of world trade.Inter war years 1914-1944:Gold standard as IMS worked well until world war I. War had interrupted trade flows and disturbed the stability of exchange rates for currencies of major countries. There was a widespread fluctuation in currencies in terms of gold during war. The role of Great Britain as world major creditor nation also came to end and US began to assume the role of leading creditor nation.Countries had made attempts to recover from war and stabilize their economies to return to gold standard. The key currency involved in the attempt to restore the international gold standard was the pound sterling which returned to gold in 1925. This was a great mistake since UK had experienced considerably more inflation than US because UK had liquidated most of its foreign investment in financing the war. The result was increased unemployment and economic stagnation in Britain.Pounds overvaluation was not only the major problem of restored gold standard. Other problems included the failure of US to act responsibly, the undervaluation of French franc and general decrease in the willingness and ability of nations to rely on the gold standard adjustment mechanism.In 1934 US returned to modified gold standard and US$ was devalued. The modified gold standard was known as gold exchange standard. Under this standard the US traded gold only with foreign central banks not with private citizens. From 1934 till the end of world war II, exchange rates were theoretically determined by each currencys value in terms of gold. World war II also resulted in many of worlds major currencies losing their convertibility. The only major currency that continued to remain convertible was the dollar.Thus inter war period was characterized by half hearted attempts and failure to restore the gold standard, economic and political instabilities, widely fluctuating exchange rates, bank failures and financial crisis. The great depression in 1929 and stock market crash also resulted in the collapse of many banks.The Bretton woods system 1945-1972:The depression of 1930s followed by another war had vastly diminished commercial trade, the international exchange of currencies and cross border lending and borrowing. Revival of the system was necessary and the reconstruction of the post war financial system began with the Bretton woods agreement from the international monetary and financial conference of the united and associated nations in July 1944 at Bretton woods, New Hampshire.There was a general agreement that restoring gold standard was out of question. Governments needed access to credits in convertible currencies if they were to stabilize exchange rates and governments should make major adjustments in exchange rates only after consultation with other countries. But opinions were divided. British wanted a reduced role for the gold, more exchange rate flexibility than that had existed with gold standard, large pool of lendable resources at the disposal of a proposed international monetary organization and acceptance of principle that the burden of correcting payment disequilibria should be shared by both surplus countries and deficit countries. Americans favored a major role of gold, highly stable exchange rates, a small pool of lendable resources and principle that the burden of adjustment of payment imbalances should fall primarily on deficit countries.Recommendations in Bretton wood:1. Each nation should be at liberty to use macro- economic policies for full employment.2. Free floating exchange rates could not work. Their ineffectiveness had been demonstrated during the 1920s and 1930s. But the extremes of both permanently fixed and floating rates should be avoided.3. A monetary system was needed that would recognize that exchange rates were both a national and an international concern.The agreement established a dollar based IMS and created two new institutions The International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (World Bank). The basic role of IMF would be help countries with BOP and exchange rate problems while the World Bank would help countries with post war reconstruction and general economic development.Propositions of Bretton wood system:1. The stable exchange rates under the gold standard before world war I were desirable but there were certain conditions to make adjustments in exchange rates necessary2. Performance of fluctuating exchange rates had been unsatisfactory and3. The complex network of government controls during 1931-1945 deterred the expansion of world trade and investment.The Bretton wood agreement placed major emphasis on the stability of exchange rates by adopting the concept of fixed but adjustable rates. The keystones of the system were:1. No provision was made for the US to change the value of gold at $35 per ounce2. Each country was obligated to define its monetary unit in terms of gold or dollars. While other currencies were required to exchange their currencies for gold, US % remained convertible into gold at $35 per ounce.3. Each country established par rates of exchange between its currency and the currencies of all other countries.4. Each currency was permitted to fluctuate within plus or minus 1% of par value by buying or selling foreign exchange and gold as needed.5. If a currency became too weak to maintain its par value, it was allowed to devalue up to 10% without formal approval by IMF6. Countries would have to make payment of gold and currency to IMF in order to become a member. Subscription quotas were assigned according to a members size and resources. Payment of quota normally was 25% in gold and 75% in members own currency.Break down of Bretton wood system:The system has worked without major changes till 1971. During the period the fixed exchange rates were maintained by official intervention in foreign exchange markets. International trade expanded at a faster rate than world output and currencies of many nations particularly those of developed countries become convertible.The system suffered from a number of inherent structural problems. There was much imbalance in the roles and responsibilities of the surplus and deficits nations. Countries with persistent deficits in their BOP had under-go tight and stringent economic policy measures if they wanted to take help of IMF and stop the drain on their reserves. However countries with surplus positions in their BOP were not bound by such immediate compulsions. The basic problem here was the rigid approach adopted by IMF to BOP disequilibria situation. The controversy mainly centers around the conditionality issue which refers to a set of rules and policies that a member country is required to pursue as a prerequisite to using IMFs resources. These policies mainly try and ensure that the use of resources by concerned members is appropriate and temporary. The IMF distinguishes between two levels of conditionality low conditionality where a member needs funds only for a short period and high conditionality where a member country wants a large access to the funds resources. This involves formulation of a formal financial program containing specific measures designed to eliminate the countrys BOP disequilibrium. Use of IMFs resources requires IMFs willingness that the stabilization programmed is adequate for the achievement of its objectives and an understanding by the member to implement it.The Smithsonian Agreement:From August to December 1971 most of the major currencies were permitted to fluctuate. The US$ fell in value against a number of major currencies. Several countries imposed some trade and exchange controls causing major concern. It was felt that such measures would limit international commerce. In order to solve the problem the worlds leading trading countries called the Group of ten produced Smithsonian Agreement on December 18 1971. The agreement established a new set of parity rates.Although US$ was not convertible into gold, it was till defined in terms of gold. The other nine currencies were defined in terms of either gold or dollar. The US agreed to devalue the dollar from $35 per ounce of gold to $38 in return for promises from other members to up value their currencies relative to the dollar by specific amounts.In order to maintain market exchange rates relatively close to central rtes without constant government intervention currencies permitted to fluctuate over a wider band of margin of 2.25% and it could fluctuate by as much as 9% against any currency except the dollar.Proponents of Smithsonian Agreement argued that a wider band would allow countries to retain (i) discipline that they would expect from the fixed exchange rate system and (ii) greater freedom and a smoother adjustment process of flexible exchange rates.Flexible exchange rates Regime 1973- present:The flexible exchange rate regime that followed the demise of the Bretton Woods system was ratified after the fact in January 1976 when the IMF members met in Jamaica and agreed to a new set of rules for the international monetary system. The key elements of the Jamaica Agreement include:1. Flexible exchange rates were declared acceptable to the IMP members, and central banks were allowed to intervene in the exchange markets to iron out unwarranted volatilities.2. Gold was officially abandoned (i.e., demonetized) as an international reserve asset. Half of the IMF's gold holdings were returned to the members and the other half were sold, with the proceeds to be used to help poor nations.3. Non-oil-exporting countries and less-developed countries were given greater access to IMF funds.The IMF continued to provide assistance to countries facing balance-of-payments and exchange rate difficulties. The IMF, however, extended assistance and loans to the member countries on the condition that those countries follow the IMP's macroeconomic policy prescriptions. This "conditionality," which often involves deflationary macroeconomic policies and elimination of various subsidy programs, provoked resentment among the people of developing countries receiving the IMP's balance-of-payments loans.As can be expected, exchange rates have become substantially more volatile since March 1973 than they were under the Bretton Woods system.In September 1985, the so-called G-5 countries (France, Japan, Germany, the U.K., and the United States) met at the Plaza Hotel in New York and reached what became known as the Plaza Accord. They agreed that it would be desirable for the dollar to depreciate against most major currencies to solve the U.S. trade deficit problem and expressed their willingness to intervene in the exchange market to realize this objective.As the dollar continued its decline, the governments of the major industrial countries began to worry that the dollar may fall too far. To address the problem of exchange rate volatility and other related issues, the G-7 economic summit meeting was convened in Paris in 1987.6 The meeting produced the Louvre Accord, according to which:1. The G-7 countries would cooperate to achieve greater exchange rate stability.2. The G-7 countries agreed to more closely consult and coordinate their macroeconomic policies.The Louvre Accord marked the inception of the managed-float system under which the G-7 countries would jointly intervene in the exchange market to correct over- or undervaluation of currencies.