International

Finance
 Unit 3: International
Monetary System

Part A -
Exchange Rate Regime

Dr SUDHEESH K
M. Com, MBA, MPhil, PhD, NET JRF(Commerce), NET
(Management), SET
Assistant Professor
DEPARTMENT OF COMMERCE
Introduction
 Money
D.H. Robertson, “anything which is widely accepted in payment for goods or in
discharge of other kinds of business obligation, is called money.” Seligman defines
money as “one thing that possesses general acceptability.”

Prof. Crowther’s definition of money is considered better as it takes into account all the
important functions of money. He defines money as “anything that is generally
acceptable as a means of exchange (i.e., as a means of setting debts) and at the
same lime, acts as a measure and a store of value.”
 Functions of Money
Money serves several key functions in an economy:

Medium of exchange: Money serves as a common medium of exchange for goods and
services, allowing transactions to occur without the need for barter or other forms of
direct exchange.

Unit of account: Money provides a common unit of measurement for pricing goods and
services, allowing for easy comparison and assessment of value.

Store of value: Money can be saved and held for future use, serving as a store of value
for individuals and businesses.
 IMS
International monetary systems are sets of internationally agreed rules,
conventions and supporting institutions that facilitate international trade, cross
border investment and generally the allocation of capital between nation states.

International monetary system refers to the system prevailing in world foreign

exchange markets through which international trade and capital movement are
financed and exchange rates are determined.
 Features of IMS
● Efficient and unrestricted flow of international trade and investment.
● Stability in foreign exchange aspects.
● Promoting Balance of Payments adjustments to prevent disruptions
associated
● Providing countries with sufficient liquidity to finance temporary balance
of payments deficits
● Should at least try avoid adding further uncertainty.
● Allowing member countries to pursue independent monetary and fiscal
policies
Requirements of A Good Monetary System
Adjustment - a good system must be able to adjust imbalances in BoP quickly and
at a relatively lower cost

Stability and Confidence - the system must be able to keep exchange rates
relatively fixed and people must have confidence in the stability of the system

Liquidity - the system must be able to provide enough reserve assets for a
nation to correct its BoP deficits without making the nation run into deflation or
inflation
 An exchange rate regime is a way a
Exchange Rate monetary authority of a country or
currency union manages the currency

Regime about other currencies and the foreign

exchange market.

It is closely related to monetary policy

and the two are generally dependent on
many of the same factors, such as
An exchange rate regime is the
economic scale and openness, inflation
system that a country’s monetary
rate, the elasticity of the labor market,
authority, -generally the central
financial market development, capital
bank-, adopts to establish the
mobility, etc.
exchange rate of its own currency
against other currencies.
 Types of Exchange Rate Regimes
There are three major regime types:
1. Free-Floating Exchange Rate System - In a free-floating exchange rate system,
governments and central banks do not participate in the market for foreign
exchange. The concept of a completely free-floating exchange rate system is a
theoretical one. In practice, all governments or central banks intervene in currency
markets in an effort to influence exchange rates.
2. Managed Float Systems - Exchange rates are still free to float, but governments
try to influence their values. Government or central bank participation in a floating
exchange rate system is called a managed float.
3. Fixed Exchange Rate System - In a fixed exchange rate system, the exchange
rate between two currencies is set by government policy. There are several
mechanisms through which fixed exchange rates may be maintained.
 Fixed Regime - Pros and Cons

Fixed Pros Fixed Cons

Enable the currency's value to remain stable Central bank must intervene often

Can help lower inflation which encourages Country loses monetary independence
investment

The Central Bank has the power to maintain Can be expensive to maintain
rate
Floating Rate Regime - Pros and Cons

Floating Pros Floating Cons

Allows greater change of internal policy Day to day uncertainty

Less power on central banks as changes occur Highly volatile

automatically

No need for large reserves More exchange rate risk

 Evolution of IMS
Evolution stages
1. Bimetallism: Before 1875
2. Classical Gold Standard: 1875-1914
3. Interwar Period: 1915-1944
4. Bretton Woods System: 1945-1972
5. The Flexible Exchange Rate Regime: 1973-Present
 Bimetallism
A "double standard" in the sense that both gold and silver were used is money. Some
countries were on the gold standard, some on the silver standard, some on both
Both gold and silver were used as international means of payment and the exchange
rates among currencies were determined by either their gold or silver contents.
Bimetallism was widely used in the 19th century, but was replaced by a gold standard
system in many countries due to the difficulty in maintaining a stable ratio between the
value of gold and silver.
Proponents of bimetallism saw it as a way to increase the money supply and promote
economic growth, while opponents argued that it would lead to inflation and devaluation
of the currency.
Gresham's Law implied that it would be the least valuable metal that would tend to
circulate.
 Gresham’s Law
Gresham's law is an economic principle that states: "if coins containing metal of
different value have the same value as legal tender, the coins composed of the cheaper
metal will be used for payment, while those made of more expensive metal will be
hoarded or exported and thus tend to disappear from circulation."
It is commonly stated as: ""Bad" (abundant) money drives out "Good" (scarce) money”
The law was named in 1860 by Henry Dunning Macleod, after Sir Thomas Gresham
(1519-1579), who was an English financier during the Tudor dynasty. However, there are
numerous predecessors.
The law had been stated earlier by Nicolaus Copernicus; for this reason, it is
occasionally known as the Copernicus Law
 Implications of Gresham's Law
In a bimetallic system, if the market value of one metal (e.g. silver) exceeds its
official value as determined by the government, individuals and businesses will
tend to spend the overvalued metal and hoard the undervalued one.
This can result in a shortage of the undervalued metal and disrupt the functioning
of the monetary system.
To counteract this effect, some governments set strict regulations on the use of
the metals, such as limiting the use of silver to small transactions, while reserving
gold for larger transactions.
However, this approach can be difficult to enforce and can lead to further
complications in the monetary system.
Gold Standard
 Introduction
● Gold standard is a monetary system in which the standard unit of currency is a
fixed quantity of gold or is kept at the value of a fixed quantity of gold. The
currency is freely convertible at home or abroad into a fixed amount of gold per
unit of currency.

● In an international gold-standard system, gold or a currency that is convertible

into gold at a fixed price is used as a medium of international payments. Under
such a system, exchange rates between countries are fixed; if exchange rates
rise above or fall below the fixed mint rate by more than the cost of shipping gold
from one country to another, large gold inflows or outflows occur until the rates
return to the official level.
 Principles
● There should be free movement of gold between countries;
● There should be automatic expansion or contraction of currency and credit with
the inflow and outflow of gold;
● The governments in different countries should help facilitate the gold movements
by keeping their internal price system flexible in their respective economies.
 History
The gold standard was first put into operation in Great Britain in 1821. Prior to this time
silver had been the principal world monetary metal; gold had long been used
intermittently for coinage in one or another country, but never as the single reference
metal, or standard, to which all other forms of money were coordinated or adjusted.
For the next 50 years a bimetallic regime of gold and silver was used outside Great
Britain, but in the 1870s a monometallic gold standard was adopted by Germany,France,
and the United States, with many other countries following suit.
This shift occurred because recent gold discoveries in western North America had
made gold more plentiful. In the full gold standard that thus prevailed until 1914, gold
could be bought or sold in unlimited quantities at a fixed price in convertible paper
money per unit weight of the metal.
 Advantages
● It was an easy system to introduce and operate.
● It provided for a very high level of stability in exchange rates which promoted
both international investments and trade.
● The Price Specie Adjustment Mechanism provided an in-built system for
achieving trade equilibrium.
● It provided a fully secured system for settlement of international
transactions.
 Disadvantages
● The cost of manufacturing gold gradually increased to levels beyond the official
prices. This would result in stoppage of gold production which had an adverse
effect on international liquidity.
● Countries with persistent trade deficit suffered from recessions resulting in
reduced investments and unemployment.
● The system had no flexibility to adjust money supply in times of economic crisis
such as natural disasters, war, recession etc. In such situations the system had
to be repeatedly discontinued.
● To avoid the negative effects of reduced money supply, countries would break the
equality between gold reserves and money supply, thereby diluting the system.
 Failure
Before World War I, gold standard worked efficiently and remained widely accepted. It
succeeded in ensuring exchange stability among the countries.
But with the starting of the war in 1914, gold standard was abandoned everywhere
mainly because of two reasons:
● to avoid adverse balance of payments and
● to prevent gold exports falling into the hands of the enemy.
After the war in 1918, efforts were made to revive gold standard and, by 1925, it was
widely established again. But, the great depression of 1929-33 ultimately led to the
breakdown of the gold standard which disappeared completely from the world by 1937.
 Reasons for Failure
● Violation of Rules of Gold Standard
● Restrictions on Free Trade
● Inelastic Internal Price System
○ During the inter-war period, the monetary authorities sought to maintain both
exchange stability as well as price stability.
○ This was impossible because exchange stability is generally accompanied by
internal price fluctuations.
● Unbalanced Distribution of Gold
● External Indebtedness
 Reasons for Failure
● Excessive Use of Gold Exchange Standard
● Absence of International Monetary Centre
● Lack of Co-operation
● Political Instability
● Great Depression
○ Falling prices and wide-spread unemployment were the fundamental features of
depression which forced the countries to impose high tariffs to restrict imports
and thus international trade.
● Rise of Economic Nationalism
Price-Specie- Flow-Mechanism
Definition: The Price-Specie-Flow Mechanism refers to the flow of gold and silver
between countries in response to changes in the prices of goods and services.
Link between money supply and gold reserves: Under the gold standard, the money
supply was directly linked to the gold reserves of a country, and central banks had to
maintain a certain level of gold reserves in order to issue currency.
Price changes trigger specie flows: If prices in one country increased faster than prices
in another country, this would make exports from the first country more expensive, and
imports cheaper. This would trigger a flow of gold and silver from the country with the
lower prices to the country with the higher prices, in order to balance the trade.
Balancing of trade: The Price-Specie-Flow Mechanism helped to balance trade
between countries by ensuring that the value of money remained stable, even as prices
fluctuated.
Price stability: The Price-Specie-Flow Mechanism helped to maintain price stability by
ensuring that there was always enough gold and silver in circulation to support the
volume of trade.
Limitations: The Price-Specie-Flow Mechanism was not without its limitations, as
changes in the volume of trade could cause fluctuations in the value of money and
disrupt the flow of gold and silver.
Monetary policy: The Price-Specie-Flow Mechanism placed limits on the ability of
central banks to implement monetary policy, as they had to maintain a certain level of
gold reserves in order to issue currency.
Capital flows: The Price-Specie-Flow Mechanism also encouraged capital flows
between countries, as investors sought to take advantage of changes in prices and
interest rates.
Wars and other shocks: Wars and other shocks to the system, such as natural
disasters or financial crises, could disrupt the flow of gold and silver and lead to
monetary instability.
Transition to floating exchange rates: The collapse of the gold standard in the early
20th century marked a transition to floating exchange rates, where the value of a
currency is determined by supply and demand in the market, rather than being fixed to
gold.
 Inter war period: 1914-1944
Exchange rates fluctuated as countries widely used "predatory" depreciations of
their currencies as a means of gaining advantage in the world export market.
Attempts were made to restore the gold standard, but participants lacked the
political will to "follow the rules of the game”
The world economy characterized by tremendous instability and eventually
economic breakdown, what is known as the Great Depression (1929-39)
 International Economic Disintegration
Many countries suffered during the Great Depression. Major economic harm was done
by restrictions on international trade and payments.
These beggar-thy neighbor policies provoked foreign retaliation and led to the
disintegration of the world economy
All countries situations could have been bettered through international cooperation

This led to evolution of the Bretton Woods agreement

 03
Bretton Woods
System
 Transition from Gold Standard
● The gold standard was the world's monetary system from the late 19th century to the
early 20th century, where currencies were defined in terms of gold and central banks
were required to convert their currency into a fixed amount of gold on demand.
● The gold standard was disrupted by World War I and the subsequent economic
instability and inflation, leading to the suspension of the convertibility of currencies into
gold.
● In the aftermath of World War II, the Bretton Woods system was established to promote
international economic cooperation and stability and to rebuild the world economy. The
US dollar became the world's reserve currency, with other currencies pegged to the
dollar at a fixed exchange rate.
● Under the Bretton Woods system, the US agreed to maintain the value of the dollar by
converting it into gold at a fixed rate of $35 per ounce, providing a new form of stability
and predictability in international exchange rates.
● The Bretton Woods system lasted until the early 1970s when the US suspended the
convertibility of the dollar into gold due to the high demand for gold and the increasing
cost of the Vietnam War (1954-75). The collapse of the Bretton Woods system marked
the transition from the gold standard to a system of floating exchange rates.
 History
● The Bretton Woods system was established at the United Nations Monetary and
Financial Conference in Bretton Woods, New Hampshire, USA, in July 1944.
● The conference was attended by representatives from 44 Allied nations and was
held to establish a new international monetary system after the end of World War
II.
● The goal of the Bretton Woods system was to promote international economic
cooperation and stability, and to rebuild the world economy.
● The conference resulted in the creation of two international organizations: the
International Monetary Fund (IMF) and the International Bank for Reconstruction
and Development (IBRD), now known as the World Bank.
● The Bretton Woods system established the US dollar as the world's reserve
currency, with all other currencies pegged to the dollar at a fixed exchange rate.
The US agreed to maintain the value of the dollar by converting it into gold at a
fixed rate of $35 per ounce.
 History
● The IMF was established to oversee the Bretton Woods system and to provide
loans to countries facing balance of payment difficulties. The IMF was also tasked
with promoting international monetary cooperation and exchange rate stability.
● The World Bank was established to provide loans for the reconstruction and
development of war-torn economies.
● The Bretton Woods system was in operation from the late 1940s to the early
1970s, but its collapse was brought on by a number of factors, including the high
demand for gold, the increasing cost of the Vietnam War, and growing inflation in
the US.
● In 1971, the US suspended the convertibility of the dollar into gold, effectively
ending the Bretton Woods system and leading to a shift towards floating
exchange rates.
Elements of the Bretton Woods System
1. International Monetary Fund
2. World Bank
3. Fixed Exchange Rate
4. Adjustable Peg
5. Gold Standard
6. Anchor Currency
7. IMF Quotas
8. Trade Liberalization
9. Surveillance and Cooperation
Fixed exchange rates

Fixed exchange rates: The Bretton Woods system was a monetary agreement
established in 1944 that established fixed exchange rates between currencies.
Centralized Authority: Under the Bretton Woods system, the exchange rates between
currencies were fixed and maintained by a centralized authority, the International
Monetary Fund (IMF).
Adjustment Mechanism: If a country's balance of payments was in deficit, its currency
could be devalued to correct the imbalance. Conversely, if the balance of payments
was in surplus, the currency could be revalued.
Anchor Currency: The U.S. dollar was established as the anchor currency under the
Bretton Woods system, with other currencies pegged to it at fixed exchange rates.
This ensured stability and predictability in international trade and investment.
Adjustable Peg
Adjustable Peg: The Adjustable Peg was a feature of the Bretton Woods System that
allowed participating countries to adjust their exchange rates with each other to
maintain stability and prevent imbalances in their balance of payments.
IMF Approval: The Adjustable Peg system required approval from the International
Monetary Fund (IMF) in order for a country to make changes to its exchange rate.
Limited Flexibility: While the Adjustable Peg allowed for some flexibility in exchange
rates, the system was still relatively rigid, with only limited changes allowed.
Abandonment: The Bretton Woods System eventually broke down in the 1970s, due in
part to the limited flexibility of the Adjustable Peg, which was unable to accommodate
the changing economic conditions of the time. The system was replaced by floating
exchange rates, where currency values are determined by market forces rather than by
a central authority.
Trade Liberalization

Encouragement of Open Markets: The Bretton Woods System encouraged member

countries to adopt policies promoting open markets and free trade. This was seen as a
way to promote economic growth and stability by increasing cross-border trade and
investment.
Removal of Barriers: The Bretton Woods System helped to remove trade barriers
between participating countries, such as tariffs, quotas, and exchange controls.
Predictability and Stability: By establishing fixed exchange rates, the Bretton Woods
System created a predictable and stable environment for international trade and
investment, reducing the risks associated with currency fluctuations.
Growth and Development: The increased trade and investment flows resulting from the
Bretton Woods System helped to promote economic growth and development in many
countries, particularly in Europe and Japan, which were recovering from the aftermath
of World War II. However, some countries, particularly developing nations, did not
experience the same level of economic benefits from the system.
 Failure of the
Bretton Woods
System
The failure of the Bretton Woods System was caused
by a combination of several factors, including
persistent inflation, trade imbalances, limited
flexibility, capital flows, monetary policy, and changes
in the global economic environment.
 Reasons for failure
Persistent Inflation: The U.S. experienced persistent inflationary pressures during the
1960s and 1970s, fueled by increased government spending and the costs of the
Vietnam War. This inflation led to a devaluation of the U.S. dollar and a loss of
confidence in the currency. Statistical evidence of this can be seen in the rising
Consumer Price Index (CPI) in the U.S., which rose from an average of 1.3% in the 1950s
to 5.5% in the 1970s.

Trade Imbalances: The Bretton Woods System also created imbalances in the global
economy, with some countries experiencing persistent trade deficits while others had
persistent surpluses. These imbalances put pressure on the system and contributed to
its eventual collapse. Statistical evidence of this can be seen in the persistent trade
deficits experienced by countries like the U.S. and the persistent surpluses of countries
like Germany during this period.
Limited Flexibility: The adjustable peg system was limited in its ability to accommodate
changing economic conditions, leading to persistent trade imbalances and the eventual
collapse of the Bretton Woods System. This can be seen in the inability of the system
to respond effectively to the changing economic conditions of the late 1960s and early
1970s.
Capital Flows: The increasing flow of capital between countries also contributed to the
failure of the Bretton Woods System. The large movements of capital between
countries made it difficult for central banks to maintain their exchange rate targets and
led to increased currency volatility.
Monetary Policy: Monetary policy also played a role in the failure of the Bretton Woods
System. The Federal Reserve's monetary policy, which was focused on controlling
inflation, led to a tightening of monetary policy in the U.S., which put pressure on the
system.
Changes in the Global Economic Environment: The global economic environment also
changed during the 1960s and 1970s, with the emergence of new economic powers and
a shift in the balance of power in the world economy. These changes put additional
pressure on the Bretton Woods System and contributed to its eventual collapse.
 Consequences of Failure
Rise of Inflation: One of the most significant consequences of the Bretton Woods
system failure was a rise in inflation. For example, in the United States, the average
annual inflation rate was 4.9% between 1965 and 1970, but rose to 9.1% between 1975
and 1980.
Currency Fluctuations: The end of the Bretton Woods system resulted in significant
currency fluctuations, as exchange rates became more flexible. For example, between
1970 and 1973, the value of the US dollar fell by 20% against the German Deutsche Mark.
Increased Volatility in Financial Markets: The failure of the Bretton Woods system
contributed to increased volatility in financial markets, as investors became more
cautious and uncertain about the future. For example, the stock market crash of 1987
was partly caused by the uncertainty and instability resulting from the end of the
Bretton Woods system.
Decreased International Trade: The end of the Bretton Woods system led to
decreased international trade, as countries became more protectionist and erected
trade barriers to protect their domestic industries.
Devaluation of Developing Countries' Currencies: The failure of the Bretton Woods
system also contributed to the devaluation of the currencies of developing countries,
making it more difficult for them to compete in international markets.
Decline in the US Dollar's Dominance: The end of the Bretton Woods system marked the
decline in the US dollar's dominance as the world's leading reserve currency.
 Notable Topics of Further Study
● The Great Depression
● Vietnam War
● Economic Impact of World War 2
● Rise of US Hegemony
● The Atlantic Charter
● Marshall Plan

Reading will provide historical context

https://www.cs.mcgill.ca/~rwest/wikispeedia/wpcd/wp/b/Bretton_Woods_system.htm
 BWS to Smithsonian Agreement
The world moved from a gold standard to a dollar standard from Bretton Woods to the
Smithsonian Agreement.
Growing increase in the amount of dollars printed further eroded faith in the system and
the dollars role as a reserve currency.
By 1973, the world had moved to search for a new financial system: one that no longer
relied on a worldwide system of pegged exchange rates.
An agreement was reached by a group of 10 countries (G10) in 1971 that effectively
ended the fixed exchange rate system established under the Bretton Woods
Agreement.
The Smithsonian Agreement re-established an international system of fixed exchange
rates without the backing of silver or gold, and allowed for the devaluation of the U.S.
dollar. This agreement was the first time in which currency exchange rates were
negotiated.The Smithsonian Agreement only lasted 15 months, as speculators drove
the dollar lower and countries abandoned the peg in favor of floating exchange rates.
 Post - Bretton Woods
End of the gold standard: The Bretton Woods system, which pegged the value of the
US dollar to gold, broke down in the early 1970s. This marked the end of the gold
standard and the beginning of a new era in foreign exchange.
Floating exchange rates: After the end of the Bretton Woods system, the major
currencies of the world began to float freely against each other, without any official peg
or target rate.
Increased currency volatility: With floating exchange rates, the value of currencies
became more volatile, leading to fluctuations in the exchange rate between countries.
Expansion of international trade: The post-Bretton Woods era saw a significant
expansion of international trade and investment, leading to increased demand for
foreign exchange.
 Post - Bretton Woods
Development of financial markets: As a result of increased currency volatility, financial
markets such as the foreign exchange market (FOREX) grew in size and importance.
Growth of currency trading: The rise of currency trading as a result of floating
exchange rates led to the development of new financial instruments, such as currency
futures and options.
Increased importance of central banks: The role of central banks became increasingly
important in the post-Bretton Woods era, as they sought to manage currency volatility
and maintain financial stability.
Emergence of the Euro: The post-Bretton Woods era also saw the emergence of the
Euro as a major global currency, further challenging the dominant role of the US dollar in
the international monetary system.
 International Forex Market
Participants: The international foreign exchange market (FOREX) is a decentralized and global
market that includes a wide range of participants, including central banks, commercial banks,
investment banks, hedge funds, multinational corporations, and retail traders.
Currencies traded: The FOREX market allows for the exchange of over 180 different
currencies, including major currencies such as the US dollar, Euro, Japanese yen, British
pound, and Swiss franc.
24-hour trading: The FOREX market operates 24 hours a day, five days a week, with trading
taking place across the world, from Sydney to New York.
Electronic trading: The FOREX market is primarily an electronic market, with most trading
taking place through electronic platforms. This allows for near-instant execution of trades
and reduces the need for physical market places.
Leverage: The FOREX market allows traders to use leverage to trade larger amounts of
currency with a relatively small amount of capital. This can amplify gains, but also increases
the risk of losses.
 International Forex Market
Volatility: The FOREX market is known for its high volatility, with currency exchange rates
fluctuating in response to economic, political, and geopolitical events.
Interbank market: The FOREX market is primarily made up of banks and financial institutions
that trade currencies between each other in the interbank market. This market is responsible
for the majority of FOREX trading volume.
Regulated market: The FOREX market is regulated by financial authorities in various countries,
including the US Commodity Futures Trading Commission (CFTC) and the European
Securities and Markets Authority (ESMA).
Impact of technology: The FOREX market has been greatly impacted by technology in recent
years, with the rise of algorithmic trading, high-frequency trading, and other forms of
automated trading.
Interconnectivity: The FOREX market is highly interconnected, with events in one part of the
world having the potential to impact exchange rates and financial markets around the globe.