Ppt 8 International Monetary System.pdf

8/13/2019 Ppt 8 International Monetary System.pdf

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This terms denotes the institutions under which payments aremade for transactions that cross national boundaries

In particular, it determines how foreign exchange rates areset and how governments can affect exchange rates

A well-functioning monetary system facilitates international

trade and investment & smooth adaptation to change

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The central element of international monetary systeminvolves the arrangements by which exchange rates are set

In recent years, nations have used one of the following threemajor exchange-rate systems:

A system of fixed exchange rates

A system of flexible or floating exchange rates, whereexchange rates are determined by market forces

Managed exchange rates, in which nations intervene tosmooth exchange rate fluctuations or to move their currencytoward a target zone

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Historically the most important fixed exchange rate systemwas the Gold Standard, which was used off & on from 1717until 1936.

In this system, each country defined the value of its currencyin terms of fixed amount of gold, thereby establishing fixed

exchange rates among countries

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Once gold became the medium of exchange or money,foreign trade was no different than domestic trade aseverything could be paid for in gold.

The only difference being, countries could choose differentunits for their gold coins. Example, if Britain chose to make

its coins = ounce of gold (the pounds) and US chose tomake its coins = 0ounce of gold (the dollar. In that case,British pound being 5 times as heavy as dollar, had anexchange rate of $5/1

In practice, countries tended to use their own coins. But

anyone was free to melt them and sell them at going price ofgold. Thus, exchange rates were fixed for all countries on thegold standard. The exchange rates (also called par value) fordifferent currencies were determined by the gold content oftheir monetary units

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To promote international trade To promote international finance

To facilitate adjustment to shocks

The first two functions have already been understood in thecourse of our discussion earlier. The third needs to beexplained.

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Let there be only two countries A & B. Let country As wages &prices rise.

Implications for A: As domestic goods becoming uncompetitive inworld marketX falls & M rises X-M. To pay for its deficit, Awould have to ship gold to B A would run out of goldmoneysupply in A P in A would fall proportinately (the quantity theory ofmoney) cost would also fall proportionatelyincome too wouldfall in same proportioneconomy experiences deflation

Further, A lowers imports from B & is able to increase its exports asits domestic prices fall

Implications for B: Bs exports rise rapidly and receives gold for the

same its money supply Prices & costs rise in B (the quantitytheory of money) Bs exports to A fall but Bs import from A risesas As prices are less

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A has BoP deficit

A loses gold & Bgains gold

As moneysupply decrease

Prices decline in A

Step 3: rise inBs import

Prices rise in B

Bs money supplyincrease

Step 2: rise inin As export

Step 4: declinein Bs export

Bs BoP equilibriumrestored

Step 1: declinein As import

As BoP equilibriumrestored

Figure showing Humes four-pronged International adjustment mechanism8


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This is an improvement in BoPs of the country losing gold andworsening in that of the country gaining gold.

Eventually, an equilibrium of international trade and finance isreestablished at new relative prices, which keep trade andinternational lending in balance with no net gold flow. This

equilibrium is a stable one and requires no tariffs orgovernment intervention

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The essence of Humes argument is to explain the adjustmentmechanism for imbalances between countries under fixedexchange rate. The fixed exchange rate might be a goldstandard (as existed before 1936), a dollar standard (as underthe Bretton Woods system from 1945 to 1971) or a Euro

standard (among European Union countries toady) Under fixed exchange rate system, when the prices or income

of different countries get out of line, them domestic output &prices must adjust to restore equilibrium. If under fixedexchange rate, domestic prices become too high relative to

import prices, full adjustment can come only when domesticprices fall. This in turn happens when domestic output falls tothe extent that the countrys price level will decline relative toworld pricesthe countrys BoP return to equilibrium

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Under fixed exchange rate, a countrys domestic real outputand employment must adjust to ensure that the countrysrelative prices are aligned with those of its trading partners

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After World war II, international institutions were developed tofoster economic cooperation among nations. Theseinstitutions continue to be the means by which nationscoordinate their economic policies and seek solutions tocommon problems.

The major international economic institutions of the post warperiod were:

General agreement on Tariffs & Trade (re-chartered as WTOin 1995)

The Bretton Woods exchange rate system

The International Monetary Fund (IMF)

The World Bank

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This system replaced the gold standard after World War II This was a system of fixed exchange rates with the rates

being fixed but adjustable- it was more flexible than the goldstandard

Functioned effectively for quarter of a century after World War

II Broke down when dollar became overvalued with USA

abandoning the system in 1973

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Gold standard collapsed during the Great Depression of 1930s

Leading nations met at Bretton Woods, New Hampshire, in 1944 tocreate a new international monetary system. As the US at the timeaccounted for over half of the world's manufacturing capacity and

held most of the world's gold, it was decided that world currencieswould be tied to the dollar, which, in turn, was convertible into goldat $35 per ounce.

Central banks of other countries were to maintain fixed exchangerates between their currencies and the dollar by intervening in

foreign exchange markets. If a country's currency was too highrelative to the dollar, its central bank would sell its currency inexchange for dollars, driving down the value of its currency.Conversely, if the value of a country's money was too low, thecountry would buy its own currency, thereby driving up the price.

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The Bretton Woods system lasted until 1971. By that time, inflationin the United States and a growing American trade deficit wereundermining the value of the dollar. Americans urged Germany and

Japan, both of which had favorable BoP to appreciate theircurrencies. But those nations were reluctant to do this, as it wouldincreases prices for their goods and hurt their exports.

Finally, the United States abandoned the fixed value of the dollarand allowed it to "float" -- that is, to fluctuate against othercurrencies. The dollar promptly fell. World leaders sought to revivethe Bretton Woods system with the so-called Smithsonian

Agreement in 1971, but the effort failed. By 1973, the United Statesand other nations agreed to allow exchange rates to float.

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An integral part of the Bretton Woods system was theestablishment of the International Monetary Fund

The IMF's fundamental mission is to help ensure stability inthe international system. It does so in three ways:

keeping track of the global economy and the economies of

member countries; lending to countries with balance of payments difficulties;

and

giving practical help to members

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During the Great Depression 1930s, countries attempted to shore uptheir failing economies by raising trade barriers, devaluing theircurrencies to compete for export markets, and curtailing theircitizens' freedom to hold foreign exchange. These attempts provedto be self-defeating. Volume of trade, employment and income fellsharply across the World.

This necessitated the formation of an institution charged withoverseeing the international monetary and ensuring exchange ratestability and encourage its member countries to eliminate exchangerestrictions that hindered trade.

The IMF was conceived in July 1944, at Bretton Woods, NewHampshire and came into formal existence in December 1945, when

its first 29 member countries signed its Articles of Agreement. Itbegan operations on March 1, 1947. Later that year, France becamethe first country to borrow from the IMF.

The IMF's membership began to expand in the late 1950s andduring the 1960s as many African countries became independent

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Surveillance: When a country joins the IMF, it agrees to subject itseconomic and financial policies to the scrutiny of the internationalcommunity. It also makes a commitment to pursue policies that areconducive to orderly economic growth and reasonable price stability,to avoid manipulating exchange rates for unfair competitiveadvantage, and to provide the IMF with data about its economy. The

IMF's regular monitoring of economies and associated provision ofpolicy advice is intended to identify weaknesses that are causing orcould lead to financial or economic instability. This process is knownas surveillance.

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Technical assistance: The IMF shares its expertise with membercountries by providing technical assistance and training in a widerange of areas, such as central banking, monetary and exchangerate policy, tax policy and administration, and official statistics Theobjective is to help improve the design and implementation ofmembers' economic policies, including by strengthening skills in

institutions such as finance ministries, central banks, and statisticalagencies. The IMF has also given advice to countries that have hadto reestablish government institutions following severe civil unrestor war.

In 2008, the IMF embarked on an ambitious reform effort to enhancethe impact of its technical assistance. The reforms emphasize betterprioritization, enhanced performance measurement, moretransparent costing and stronger partnerships with donors.

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Lending: Any member country, whether rich, middle-income, orpoor, can turn to the IMF for financing if it has a balance ofpayments

IMF loans are meant to help member countries tackle balance ofpayments problems, stabilize their economies, and restoresustainable economic growth. This crisis resolution role is at the

core of IMF lending. At the same time, the global financial crisishas highlighted the need for effective global financial safety netsto help countries cope with adverse shocks. A key objective ofrecent lending reforms has therefore been to complement thetraditional crisis resolution role of the IMF with more effectivetools for crisis prevention.

The IMF's lending resources come mainly from the money thatcountries pay as quota subscriptions (countries pay 25 % of theirquota subscriptions in SDRs &remaining 75 % in their owncurrencies )when they become members

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The World Bank is another financial institution created in 1944 It is capitalized by high-income nations that subscribe in proportion

to their economic importance in terms of GDP and other factors

It is a vital source of financial and technical assistance to developingcountries around the world. It makes long-term low-interest loansto countries for projects which are economically sound but cannotget private sector financing

It comprises of two institutions managed by 187 member countries:the International Bank for Reconstruction and Development (IBRD)and the International Development Association (IDA). The IBRD aimsto reduce poverty in middle-income and creditworthy poorer

countries, while IDA focuses exclusively on the worlds poorestcountries. These institutions are part of a larger body known as theWorld Bank Group.

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Ppt 8 International Monetary System.pdf