Question

1. History of the international financial system. 2. 2. Economics of the float and fixed exchange rate systems.

3. aspects of Bretton Woods Agreement.

4.Explain why and when the redemption of dollars in gold by the United States ended.

5. The functions (both from a critical and mainstream perspectives) of the international financial institutions

Answer 1

1.

International Financial System : It refers to financial institutions and financial markets / facilitators of international trade, financial instruments (to minimize risk exposure), rules regulations, principles and procedures of international trade.

International Monetary System : It is defined as a set of procedures, mechanisms, processes, institutions to establish that rate at which exchange rate is determined in respect to other currency. The whole story of monetary and financial system revolves around Exchange Rate i.e. the rate at which currency is exchanged among different countries for settlement of payments arising from trading of goods and services.

Monetary System Before First World War:(1880-1914 Era of Gold Standard)

• The oldest system of exchange rate was known as "Gold Species Standard“

• The other version called "Gold Bullion Standard", where the basis of money remained fixed gold but the authorities were ready to convert, at a fixed rate, the paper currency issued by them into paper currency of another country which is operating in Gold. The exchange rate between pair of two currencies was determined by respective exchange rates against Gold which was called Mint Parity.

Monetary System Before First World War:(1880-1914 Era of Gold Standard)

Three rules of Mint Parity

• The authorities must fix some once-for-all conversion rate of paper money issued by the minto gold.

• There must be free flow of Gold between countries on Gold Standard.

• The money supply should be tied with the amount of Gold reserves kept by authorities. The gold standard was very rigid and during great depression (1929-32) it vanished completely.

The Gold Exchange Standard (1925-1931)

• In 1925, US and England could hold gold reserve and other nations could hold both gold and dollars/sterling as reserves. The countries started devaluing their currencies in order to increase exports and de-motivate imports. This was termed as "beggar-thy-neighbor "policy

Bretton Woods System : Allied nations held a conference in New Hampshire, the outcome of which gave birth to two new institutions namely the International Monetary Fund (IMF) and the World Bank, (WB ) and the system was known as Bretton Woods System which prevailed during (1946-1971).

Post Bretton Woods Period (1971-1991)

• Two major events took place in 1973-74 when oil prices were quadrupled by the Organisational of Petroleum Exporting Countries (OPEC).

• From 1977 to 1985, US dollar observed fluctuations in the oil prices which imposed on the countries to adopt a much flexible regime i.e. a hybrid between fixed and floating regimes.

Current Scenario of Exchange Regimes

• Exchange arrangement with no separate legal tender

• The members of a currency union share a common currency.

• Currency Board Agreement: There is a legislative commitment to exchange domestic currency against a specified currency ata fixed rate.

• Conventional fixed peg arrangement : Country pegs its currency to another, or to a basket of currencies not exceeding +/- 1. Up to 1999, thirty countries had pegged their currencies to a single currency

Current Scenario of Exchange Regimes

• Managed float: In this regime, central bank interferes in the foreign exchange market by buying and selling foreign currencies against home currencies without any commitment or pronouncement.

• Independently floating: Here exchange rate is determined by market forces and central bank only act as a catalyst to prevent excessive supply of foreign exchange and not to drive it to a particular level.

The Era of Euro and European Monetary Union

• As a failure of the Smithsonian agreement in1973, some countries of Europe met together to form a union which was basically an attempt to keep the member countries exchange rate. This was known as Snake in the Tunnel and in1979 the snake became the European Monetary System (EMS) with all EEC countries joining the club except Britain.

The ECU was the sponsor of EURO commonly shared by eleven member countries. This was mainly an attempt to create a single economic zone in Europe with complete freedom of resource mobility within the zone. In November, 1999, central banks of EEC finalized the draft statute for a future European Central Bank. The Era of Euro and European Monetary Union

The concept of European economic and monetary union received shake when in 1992referendum, Denmark people (Danish) rejected the "Maastricht Theory" and Italy and Britain faced political anger against it. Debates were going on to resolve the conflicts and ultimately in Dec. 1996 "Growth & Stability Pact" was agreed upon in Dublin. As a consequence of this agreement, EURO came into existence on January 1, 1999 and trading began on January 4, 1999.The Era of Euro and European Monetary Union

2.

Fixed Exchange Rates

There are two ways the price of a currency can be determined against another. A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged. If, for example, it is determined that the value of a single unit of local currency is equal to US$3, the central bank will have to ensure that it can supply the market with those dollars. In order to maintain the rate, the central bank must keep a high level of foreign reserves. This is a reserved amount of foreign currency held by the central bank that it can use to release (or absorb) extra funds into (or out of) the market. This ensures an appropriate money supply, appropriate fluctuations in the market (inflation/deflation) and ultimately, the exchange rate. The central bank can also adjust the official exchange rate when necessary.

Floating Exchange Rates

Unlike the fixed rate, a floating exchange rate is determined by the private market through supply and demand. A floating rate is often termed "self-correcting," as any differences in supply and demand will automatically be corrected in the market. Look at this simplified model: if demand for a currency is low, its value will decrease, thus making imported goods more expensive and stimulating demand for local goods and services. This in turn will generate more jobs, causing an auto-correction in the market. A floating exchange rate is constantly changing. In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures can also influence changes in the exchange rate. Sometimes, when a local currency reflects its true value against its pegged currency, a "black market" (which is more reflective of actual supply and demand) may develop. A central bank will often then be forced to revalue or devalue the official rate so that the rate is in line with the unofficial one, thereby halting the activity of the black market. In a floating regime, the central bank may also intervene when it is necessary to ensure stability and to avoid inflation. However, it is less often that the central bank of a floating regime will interfere.

3.

The Bretton Woods system as a monetary management system was set as the rules for commercial and financial relations among the world’s major industrial nations. The planners at Bretton Woods established the International Bank for Reconstruction and Development (IBRD) (now known as one of the five institutions in the World Bank Group) and the International Monetary Fund (IMF). The reason behind setting up such a system of rules, institutions, and procedures was to manipulate the international monetary system. After satisfactory number of countries had ratified the agreement, this system became operational in the year 1946. Under main features of the Bretton Woods system, it was an obligation for each country to adopt a monetary policy that maintained the exchange rate of its currency within a fixed value. This value was expressed in terms of gold and the ability of the IMF to bridge temporary imbalances of payments. In the face of increasing strain, the system collapsed in 1971, following the United States’ suspension of convertibility from dollars to gold. By this time, due to inflation in the United States and a growing short fall in American trade were depressing the value of the dollar. Americans advocated Germany and Japan to appreciate their currencies. But both of the countries already had favorable payments balances. And both of the nations were disinclined to this decision. Because of the reason that raising their currency value might result in increased prices for there goods and which can further affect their exports. Lastly, the United States neglected the fixed rate of the dollar and allowed it at “float” rate. This meant to change the value of dollar against other currencies. The value of dollar swiftly started falling down. World leaders wanted to stimulate the Bretton Woods system in 1971, but the effort failed. By 1973, the float rate system was adopted by United States and other nations. Thus the delayed adjustment of the parties to change in the economic environment of the countries was the weakest point of Bretton Woods Agreement. This led to a lack of trust and strike at the foundations of guesswork. Another considerable problem was that one national currency had to be an International reserve currency at that time. This made the national monetary and economic policy of the United States liberated from external fiscal pressures, while greatly influencing those external economies. To guarantee international liquidity; USA was enforced to run shortage in their balance of payments, to avoid world inflation. However, in the 1960s they ran a policy that restricted the convertibility of the U.S. dollar to compete the insufficient reserves to meet the currency supply and demand. But other member nations were not ready to accept the high inflation rates and the value of dollar ended up being weak. Hence, the system of Bretton Woods collapsed. Set of multilateral agreements on International economic relations, negotiated at the UN Monetary and Financial conference held in July 1944 (in the aftermath of second world war) attended by the finance ministers of the U.K. N U.S. and other Allied countries. Its distinctive features are:

(i) Financing the re-construction of the Post war Europe.

(ii) Avoiding unstable exchange rates and competitive devaluations of pre Second World War Western economies by instituting fixed exchange rates.

(iii)World Bank (then called International Bank for Reconstruction & Development or IBRD, was established to serve the first objective, and international Monetary fund (IMF) for the second.