TOPIC 2: THE INTERNATIONAL MONETARY SYSTEM (IMS)

2.1: AN OVERVIEW OF THE EVOLUTION OF MODERN

INTERNATIONAL MONETARY SYSTEM
MNCs operate in a global market, buying/selling/producing in many different countries. For
example, GM sells cars in 150 countries, produces cars in 50 countries, so it has to deal with
hundreds of currencies. What are the mechanics of how currency and capital flows
internationally?
International Monetary System - Institutional framework within which:
1. International payments are made
2. Movements of capital are accommodated
3. Ex-rates are determined
An international monetary system is required to facilitate international trade, business, travel,
investment, foreign aid, etc. For domestic economy, we would study Money and Banking to
understand the domestic institutional framework of money, monetary policy, central banking,
commercial banking, check-clearing, etc. To understand the flow of international
capital/currency we study the IMS. IMS - complex system of international arrangements, rules,
institutions, policies in regard to ex-rates, international payments, capital flows. IMS has
evolved over time as international trade, finance, and business have changed, as technology has
improved, as political dynamics change, etc. Example: evolution of the European Union and the
Euro currency impacts the IMS. "Spontaneous Order."
Simply, the international monetary system refers primarily to the set of policies, institutions,
practices, regulations and mechanisms that determine the rate at which one currency is
exchanged for another.

2.1.1: BIMETALLISM (pre-1875)

Commodity money system using both silver and gold (precious metals) for int'l payments (and
for domestic currency). Why silver and gold? (Intrinsic Value, Portable, Recognizable,
Homogenous/Divisible, Durable/Non-perishable). Why two metals and not one (silver standard
or gold standard vs. bimetallism)? Some countries' currencies in certain periods were on either
the gold standard (British pound) or the silver standard (German DM) and some on a bimetallic
(French franc). Pound/Franc exchange rate was determined by the gold content of the two
currencies. Franc/DM was determined by the silver content of the two currencies. Pound (gold) /
DM (silver) rate was determined by their exchange rates against the Franc.
Under a bimetallic standard (or any time when more than one type of currency is acceptable for
payment), countries would experience "Gresham's Law" which is when "bad" money drives
out "good" money.
The more desirable, superior form of money is hoarded and withdrawn from circulation, and
people use the inferior or bad money to make payments. The bad money circulates, the good
money is hoarded. Under a bimetallic standard the silver/gold ratio was fixed at a legal rate.
When the market rate for silver/gold differed substantially from the legal rate, one metal would
be overvalued and one would be undervalued. People would circulate the undervalued (bad)
money and hoard the overvalued (good) money.
Examples: a) From 1837-1860 the legal silver/gold ratio was 16/1 and the market ratio was
15.5/1. One oz of gold would trade for 15.5 oz. of silver in the market, but one oz of gold would
trade for 16 oz of silver at the legal/official rate. Gold was overvalued at the legal rate, silver
was undervalued. Gold circulated and silver was hoarded (or not minted into coins), putting the
US on what was effectively a gold standard.
b) Later on, France went from a bimetallic standard to effectively a gold standard after the
discovery of gold in US and Australia in the 1800s. The fixed legal ratio was out of line with
the true market rate. Gold became more abundant, lowering its scarcity/value, silver became
more valuable. Only gold circulated as a medium of exchange.

2.1.2: THE CLASSICAL GOLD STANDARD (1875-WWI).

For about 40 years most of the world was on an international gold standard, ended with First
World War (WWI) when most countries went off gold standard. London was the financial
center of the world, most advanced economy with the most international trade.
Classical Gold Standard is a monetary system in which a country's government allows
its currency unit to be freely converted into fixed amounts of gold and vice versa. The exchange
rate under the gold standard monetary system is determined by the economic difference for an
ounce of gold between two currencies. The gold standard was mainly used from 1875 to 1914
and also during the interwar years.
Gold Standard exists when most countries:
1. Use gold coins as the primary medium of exchange.
2. Have a fixed ex-rate between ounce of gold and currency.
3. Allow unrestricted gold flows - gold can be exported/imported freely.
4. Banknotes had to be backed with gold to assure full convertibility to gold.
5. Domestic money stock had to rise and fall with gold flows
The creation of the gold standard monetary system in 1875 marks one of the most important
events in the history of the foreign exchange market. Before the gold standard was implemented,
countries would commonly use gold and silver as means of international payment as explained
earlier. The main issue with using gold and silver for payment is that their value is affected by
external supply and demand. For example, the discovery of a new gold mine would drive gold
prices down.
The underlying idea behind the gold standard was that governments guaranteed the conversion
of currency into a specific amount of gold, and vice versa. In other words, a currency would be
backed by gold. Obviously, governments needed a fairly substantial gold reserve in order to
meet the demand for exchanges. During the late nineteenth century, all of the major economic
countries had defined an amount of currency to an ounce of gold. Over time, the difference in
price of an ounce of gold between two currencies became the exchange rate for those two
currencies. The use of the gold standard would mark the first use of formalized exchange rates
in history. However, the system was flawed because countries needed to hold large gold reserves
in order to keep up with the volatile nature of supply and demand for currency.
Under a gold standard, exchange rates would be kept in line by cross-country gold flows. Any
mis-alignment of ex-rates would be corrected by gold flows. Payments could in effect be made
by either gold or banknotes. If market exchange rates ever deviated from the official ex-rate, it
would be cheaper to pay in gold than in banknotes.
Example: Suppose that the U.K. Pound is pegged to gold at: £6/oz., and the French franc is
pegged to gold at FF12/oz., then the ex-rate should be FF2/Pound. If the market rate was
FF1.80/£, then the pound is undervalued in the market (one pound should buy 2 FF, it only buys
1.8 FF). Arbitrage would re-align the ex-rate:
1. Take £500 and buy 83.33 oz of gold (£500 / 6) in U.K.
2. Sell the gold for FF1000 in France (83.33 oz. x 12)
3. Sell 1000 FF for £555.56 (FF1000 / 1.8FF/£), for an arbitrage profit of £55.56
Arbitrage would appreciate the £, depreciate the FF, and the ex-rate would be restored at 2FF/£.
The gold standard eventually broke down during the beginning of World War I. Due to the
political tension with Germany; the major European powers felt a need to complete large
military projects. The financial burden of these projects was so substantial that there was not
enough gold at the time to exchange for all the excess currency that the governments were
printing-off.
Although the gold standard would make a small comeback during the inter-war years, most
countries had dropped it again by the onset of World War II. However, gold never ceased being
the ultimate form of monetary value.

Advantages of Gold Standard

1. Ultimate hedge against inflation. Because of its fixed supply, gold standard creates price level
stability, eliminates abuse by central bank/hyperinflation.
2. Automatic adjustment in Balance of Payments due to price-specie-flow mechanism

Disadvantages of Gold Standard

1. Possible deflationary pressure. With a fixed supply of gold (fixed money supply), output
growth would lead to deflation.
2. An international gold standard has no commitment mechanism, or enforcement mechanism,
to keep countries on the gold standard if they decide to abandon gold.

INTERWAR PERIOD: 1915-1944

When WWI started, countries abandoned the gold standard, suspended redemption of banknotes
for gold, and imposed embargoes on gold exports (no gold could leave the country).After the
war, hyperinflationary finance followed in many countries such as Germany, Austria, Hungary,
Poland, etc. Price level increased in Germany by 1 trillion times!! Why hyperinflation then?
What are the costs of inflation??
US (1919), UK(1925), Switzerland, France returned to the gold standard during the 1920s.
However, most central banks engaged in a process called "sterilization" where they would
counteract and neutralize the price-specie-flow adjustment mechanism. Central banks would
match inflows of gold with reductions in the domestic MS, and outflows of gold with increases
in MS, so that the domestic price level wouldn't change. Adjustment mechanism would not be
allowed to work. If the US had a trade surplus, there would be a gold inflow which should have
increased US prices, making US less competitive. Sterilization would involve contractionary
monetary policy to offset the gold inflow.
In the 1930s, what was left of the gold standard faded - countries started abandoning the gold
standard, mostly because of the Great Depression, bank failures, stock market crashes. Started in
US, spread to the rest of the world. Also, escalating protectionism (trade wars) brought int'l
trade to a standstill. (Smoot-Hawley Act in 1930), slowing int'l gold flows. US went off gold in
1933, France lasted until 1936.
Between WWI and WWII, the gold standard never really worked, it never received the full
commitment of countries. Also, it was period of political instability, the Great Depressions, etc.
So there really was no stable, coherent IMS, with adverse effects on int'l trade, finance and
investment.
2.1.3: The Bretton Woods System 1944 – 1971
After World War II, a modified version of the gold standard monetary system, the Bretton
Woods monetary system, was created as its successor. This successor system was initially
successful, but because it also depended heavily on gold reserves, it was abandoned in 1971
when U.S president Nixon "closed the gold window.
Before the end of World War II, the Allied nations believed that there would be a need to set up
a monetary system in order to fill the void that was left behind when the gold standard system
was abandoned. In July 1944, more than 700 representatives from the Allies convened at Bretton
Woods, New Hampshire, to deliberate over what would be called the Bretton Woods System of
international monetary management. . The International Monetary Fund (IMF) and the World
Bank were created as part of a comprehensive plan to start a new IMS. The IMF was to
supervise the rules and policies of a new fixed exchange rate regime, promote foreign trade and
to maintain the monetary stability of countries and therefore that of the global economy; the
World Bank was responsible for financing development projects for developing countries
(power plants, roads, infrastructure investments).
It was agreed that currencies would once again be fixed, or pegged, but this time to the U.S.
dollar, which in turn was pegged to gold at USD 35/ounce. What this meant was that the value
of a currency was directly linked with the value of the U.S. dollar. So if you needed to buy
Japanese yen, the value of the yen would be expressed in U.S. dollars, whose value in turn was
determined in the value of gold. If a country needed to readjust the value of its currency, it could
approach the IMF to adjust the pegged value of its currency. The peg was maintained until 1971,
when the U.S. dollar could no longer hold the value of the pegged rate of USD 35/ounce of gold.
From then on, major governments adopted a floating system, and all attempts to move back to a
global peg were eventually abandoned in 1985. Since then, no major economies have gone back
to a peg, and the use of gold as a peg has been completely abandoned.
To simplify, Bretton Woods led to the formation of the following:
• A method of fixed exchange rates;
• The U.S. dollar replacing the gold standard to become a primary reserve currency; and
• The creation of three international agencies to oversee economic activity: the
International Monetary Fund (IMF), International Bank for Reconstruction and
Development, and the General Agreement on Tariffs and Trade (GATT)
The main features of the system were: -
One of the main features of Bretton Woods is that the U.S. dollar replaced gold as the main
standard of convertibility for the world’s currencies; and furthermore, the U.S. dollar became the
only currency that would be backed by gold. (This turned out to be the primary reason that
Bretton Woods eventually failed.)
(i) A system of fixed exchange rates on the adjustable peg system was established. Exchange
rates were fixed against gold but since there were fixed dollars of gold (35 per ounce) the fixed
rates were expressed relative to the dollar. Between 1949 and 1967 sterling was pegged at 2.80.
Governments were obliged to intervene in foreign exchange markets to keep the actual rate
within 1% of the pegged rate.
(ii) Governments were permitted by IMF rules to alter the pegged rate – in effect to devalue or
revalue the currency but only if the country was experiencing a balance of payments
deficit/surplus of a fundamental nature.
(iii) The dollar became the principal international reserve asset. Only the USA undertook to
convert their currency into gold if required. In the 1950’s the held the largest gold stocks in the
world. Thus the dollar became “as good as gold” and countries were willing to use the dollar as
their principal. Initially the Bretton Woods system appeared to work well. World trade grew at
record rates in the 1950’s and the world experienced what has since been described as the
“golden age of capitalism”. However in 1971 the system collapsed, clearly there were problems
that had developed over the previous two decades.
Why Peg?
The reasons to peg a currency are linked to stability. Especially in today's developing nations, a
country may decide to peg its currency to create a stable atmosphere for foreign investment.
With a peg the investor will always know what his/her investment value is, and therefore will
not have to worry about daily fluctuations. A pegged currency can also help to lower inflation
rates and generate demand, which results from greater confidence in the stability of the
currency.
Fixed regimes, however, can often lead to severe financial crises since a peg is difficult to
maintain in the long run. This was seen in the Mexican (1995), Asian and Russian (1997)
financial crises: an attempt to maintain a high value of the local currency to the peg resulted in
the currencies eventually becoming overvalued. This meant that the governments could no
longer meet the demands to convert the local currency into the foreign currency at the pegged
rate. With speculation and panic, investors scrambled to get out their money and convert it into
foreign currency before the local currency was devalued against the peg; foreign reserve
supplies eventually became depleted. In Mexico's case, the government was forced to devalue
the peso by 30%. In Thailand, the government eventually had to allow the currency to float, and
by the end of 1997, the bhat had lost its value by 50% as the market's demand and supply
readjusted the value of the local currency.
Countries with pegs are often associated with having unsophisticated capital markets and weak
regulating institutions. The peg is therefore there to help create stability in such an environment.
It takes a stronger system as well as a mature market to maintain a float. When a country is
forced to devalue its currency, it is also required to proceed with some form of economic reform,
like implementing greater transparency, in an effort to strengthen its financial institutions.
Some governments may choose to have a "floating," or "crawling" peg, whereby the government
reassesses the value of the peg periodically and then changes the peg rate accordingly. Usually
the change is devaluation, but one that is controlled so that market panic is avoided. This method
is often used in the transition from a peg to a floating regime, and it allows the government to
"save face" by not being forced to devalue in an uncontrollable crisis
Although the peg has worked in creating global trade and monetary stability, it was used only at
a time when all the major economies were a part of it. And while a floating regime is not
without its flaws, it has proven to be a more efficient means of determining the long-term value
of a currency and creating equilibrium in the international market
The collapse of the Bretton woods system:
Over the next 25 or so years, the U.S. had to run a series of balance of payment deficits in order
to be the world’s reserved currency. By the early 1970s, U.S. gold reserves were so depleted that
the U.S. treasury did not have enough gold to cover all the U.S. dollars that foreign central
banks had in reserve.
Finally, on August 15, 1971, U.S. President Richard Nixon closed the gold window, and the
U.S. announced to the world that it would no longer exchange gold for the U.S. dollars that were
held in foreign reserves. This event marked the end of Bretton Woods and most countries moved
to some system of floating exchange rates.
What caused the collapse of the system?
(a) The system relied on period revaluations/devaluations to ensure that exchange rates did not
move too far out of line with underlining competitive. However countries were reluctant to alter
their pegged exchange rates.
• Surplus countries were under no pressure to revalue since the accumulation of foreign
exchange reserves posed no real economic problems.
• Deficit countries regarded devaluation as an indicator of the failure of economic policy.
The UK resisted devaluation until 1967 – long after it had become dearly necessary.
Thus the deficit countries were forced into deflationary policy to protect overvalued exchange
rates. As Inflation rates accelerated and diverged the problem became more serious and
countries became less willing to accept the deflationary price of a fixed exchange rate system.
(b) The system became vulnerable to speculation since speculation was a “one way bet”. A
deficit country might devalue or not. Thus pressure grew on deficit countries especially as
capital flows in creased with the development of the Eurocurrency markets.
( c) The system had an inherent flaw. The system had adopted the dollar as the principal reserve
currency. As world trade expanded more dollars would be needed to provide sufficient
internationally liquid assets to finance that trade. A steady supply of dollars to the world
required that the USA ran a balance of payment deficit and financed it by exporting dollars. But
eventually the world held move dollars than the value of the USA’s holdings of gold. The ability
to convert dollars into gold was called in doubt. Thus confidence in the dollar declined.
With the collapse of Bretton woods, most countries moved to floating exchange rates of one sort
or another. This was not so much a positive choice by governments as recognition of the
inability to maintain the previous system. Attempts were made to restore a fixed rate system but
these failed.
It was soon recognized that a return to fixed exchange rates not likely in the immediate future
and steps were taken to formalize the new system, the most important outcome of which was an
agreement that:-
Countries could fix currencies against any measure except gold.
• Floating exchange rates were accepted and IMF members were only required to maintain
“orderly exchange arrangements and” stable systems of exchange rates.

G – 7 Council
The governments of the five major industrial economies met in the USA in 1985 to consider the
implications of what was considered to be the serious over valuation of the US. It was
considered that such major misalignments of currencies were damaging to the growth of
International trade. The result was an exercise in international policy Co – Ordination.
All five countries agreed to undertake policies to engineer a steady fall in the exchange value of
the dollar. This was broadly successful. Following the apparent success of this co – operation
the G – 7 groups of countries (USA, German, Japan, France, UK, Canada and Italy) attempted to
go further. Having considered that exchange rates were now “about right: the G 7 group agreed
to maintain management of their exchange rates in order to generate stability in exchange rates.
This involved: -
a. Intervention in the foreign exchange markets to prevent serious short-term fluctuations in
the exchange rate. This was to be done on a large scale and in a co – ordinate fashion.
b. Co – ordination overall fiscal and monetary policy in order to produce long-term
stability in exchange rates. The level of interest rates and the control of inflation would be
central to this and to short-term management of the exchange rate.
The European Monetary System
After the collapse of the Bretton woods systems, several European countries started to move
towards a system in which there was increasing stability between their national currencies, even
though there might still be volatility in their exchange rates with currencies of non – member
states. This objective was eventually incorporated into the European monetary system (EMS) of
the European Union.
The EMS was established in 1979. As part of this system, there was an exchange rate
mechanism for achieving stability in the exchange rates of member currencies, by restricting
exchange rate movements within certain limits or “bands”

The objectives of the EMS were: -

• Exchange rate stability:- Members agreed to stabilize exchange rates within the narrow
bands of the exchange Rate Mechanism (ERM).

The main features of the ERM were: -

1. Each country had a central rate in the system expressed in terms of a composite
currency, the European currency unit (ECU)
2. Currencies were only allowed to fluctuate within specified bands
3. Within these there were narrower limits, measured in ECU and acting as trigged for policy
action
by governments to limit further exchange rate movement.
• To promote convergence – in economic performance in member states especially in terms
of inflation rates, interest rates and public borrowing. This is seen as necessary step in the
move to a single currency.
• A long-term aim of achieving a single European currency as part of a wider economic and
monetary Union.
The first stage was to establish the ECU. This was the central currency of the EMS and was a
composite currency whose value was determined by a weighted basket of European currencies.
Use of the ECU was largely restricted to official transactions.
The central feature of the EMS the operation of the exchange rate mechanism and the
experience of the UK illustrates the difficulties of achieving exchange rate stability within
Europe.
THE EURO
The EU’s new single currency, the euro, was duly launched on 1st January 1999. 11 of the 15
EU countries agreed to participate and Greece subsequently joined as a 12th member. Three
countries (Denmark, Sweden and the UK) decided not to join. The euro and the national
currencies existed side-by-side for all countries in the euro-zone. Exchange rates for each
national currency were irrevocably locked in terms of euros.
The existing national currencies (such as the French franc and Dutch mark) continued in
circulation until 1st January 2002, when they were replaced by euro notes and coins. The euro
zone is comparable in size to the US and the euro has become one of the world’s major
currencies.
Main Advantages of Euro (€):
1. Significant reduction in transaction costs for consumers, businesses, governments, etc.
(estimated to be .4% of European GDP, about $50B!)
European Saying: If you travel through all 15 countries and exchange money in each country but
don't spend it, you end up with 1/2 of the original amount!
2. Elimination of currency risk, which will save companies hedging costs.
3. Promote corporate restructuring via M&A activity (mergers and acquisitions), encourage
optimal business location decisions.
Main Disadvantage of Euro:
Loss of control over domestic monetary policy and exchange rate determination.
Suppose that the Finnish economy is not well-diversified, and is dependent on exports of
paper/pulp products, it might be prone to "asymmetric shocks" to its economy. If there is a
sudden drop in world paper/pulp prices, the Finnish economy could go into recession,
unemployment could increase. If independent, Finland could use monetary stimulus to lower
interest rates and lower the value of its currency, to stimulate the domestic economy and
increase exports. As part of EU, Finland no longer has those options, it is under the EU Central
Bank, which will probably not adjust policy for the Eurozone to accommodate Finland's
recession. Finland may have a prolonged recession. There are also limits to the degree of fiscal
stimulus through tax cuts, since budget deficits cannot exceed 3% of GDP, a requirement to
maintain membership in EMU (to discourage irresponsible fiscal behavior).
The European Central bank (ECB)
The ECB began operations in May 1998 as the single body with the power to issue currency,
draft monetary policy and set interest rates in the euro-zone. It is based in Frankfurt and it is a
sole issuer of the euro.
Strategic implications of Economic and Monetary Union and the euro
For the member countries, Economic and Monetary Union (EMU) has created a single currency,
the euro, with a single interest rate and single monetary policy.
The benefits of EMU membership have included:-
• The elimination of foreign exchange risk from dealings in the form national currencies of
the euro-zone countries
• Larger and more competitive capital markets
• Greater transparency of competition within the euro-zone.

2.1.4: EXCHANGE RATE REGIME

It is generally accepted that in the larger term, exchange rates are affected by differences in rates
of inflation and rates of interest.
In addition, exchange rates can be subject to management by the central government or central
Bank. Certainly, a government should have a policy towards its exchange rate, even if it is just a
policy of begging neglect “(which means letting the currency find its value through market
forces of supply and demand in the foreign exchange markets)”
There are various exchange rate systems that countries might adopt. The two broad alternatives
are: -
1. Fixed exchange rate system
2. Floating exchange systems.

Fixed Exchange Rate Systems:

Under a fixed exchange rate system the government and the monetary authorities would have to
operate in the foreign exchange market to ensure that the market rate of exchange is kept at its
fixed (par) rate.
However, under this system, there are distinctions as to the form in which reserves are held and
the degree of fixity in the exchange rate: -
_ A government (through central banks) would have to maintain official reserves.

The reserves are required for: -

• Financing any current account deficit (fall in reserve) or surplus (rise in reserves) that occur.
• Intervening in the foreign exchange market to maintain the par value of the currency. The
currency would be bought with reserves if the exchange rate fell and sold in exchange for
reserves when the exchange rate rose
The reserves may take different forms: -
1. Gold, as under the gold standard system that operated prior to 1914.
2. Dollars, as under the Breton woods system 1945 – 1971
3. A basket of major currencies.
No exchange rate system is truly fixed for all time. The issue is the degree of fixity: -
• Under the gold standard system it was held that, for all practical purposes, the rates of exchange
were fixed. Under the Breton woods system, exchange rates were fixed within narrow limits but
with the possibility of occasional changes of the par value (an adjustment peg system).
A fixed exchange rate system has a variety of advantages and disadvantages.
(i) Because the system has eliminates fluctuation in the exchange rate, it reduces currency risk
faced by companies and hence encourages a higher level of International business that would
otherwise take place.
(ii) The absence of flexibility in exchange rates means that balance of Payments (BOP) deficits
on current account will not be automatically corrected; smile deficits cannot be financed forever
(because reserves are limited). Governments would have to use deflationary policies to depress
the demand for imports. This is likely to cause unemployment and slow down the growth of
output in the country.
(iii) Fixed exchange rates place, constraints of government policy. They must not allow the
country’s inflation rate to exceed that of its trading partner’s smile this would cause current
account deficits on the pressure on the balance of payments and lead to down ward pressure on
the exchange rate. This constraint is known as policy discipline.
Floating Exchange Rate Systems
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. Take a look at this simplified model:
if demand for a currency is low, its value will decrease, thus making imported goods more
expensive and thus stimulating demand for local goods and services. This in turn will
generate more jobs, and hence an auto-correction would occur in the market. A floating
exchange rate is constantly changing.
Under a system of floating exchange rate the government has no obligation to maintain the rate
of exchange at some declared level and leaves its determination to market forces (demand &
supply). However there degree to which governments will allow market forces to determine the
rate of exchange for their currency

(i) Free Floating Exchange Rate.

Under this system, governments leave the deterring of the exchange rate entirely to the market
forces.
No official intervention in the foreign exchange markets and hence no need of keeping any
fficial reserves. In practice it is unlikely that governments would have no interest in the rate of
exchange, for large changes in the rate have important domestic Implications especially for
economies with large trade ratios, e.g. USA, UK etc.

Currency appreciation reduces international competitiveness and has employment and output
implications.
2. Currency depreciation raises import prices and has Implication for the rate of inflation
Thus a system of managed floating is more likely to be adopted by the government than one of
genuine free floating.

(ii) Managed Floating

Not surprisingly, few countries have been able to resist for long the temptation to actively
intervene the foreign exchange in order to reduce the economic uncertainty associated with a
clean float. Too abrupt change in the value of its currency, it is feared, could imperil a nation’s
export industries (if the currency appreciate) or lead to higher rate of inflation (if the currency
depreciates). Exchange rate uncertainty reduces economic efficiency by acting as a tax on trade
and foreign investment. Therefore, most countries with floating currencies attempt, via central
banks intervention, to smooth out exchange rate fluctuations.
Under managed floating, governments allow markets to determine day to day movements in the
exchange rates but may intervene to prevent very large changes. This system of managed float is
also known as a dirty float.

Two approaches to managed floating are possible.

• Governments may allow the rate of exchange to fluctuate between very large bands (which are
often not publicly stated) but intervene if the currency looks like moving outside of these bounds.
• Governments may allow the market to determine the trend, in the exchange rate but intervene
to limit fluctuation around the trend.
The adoption of a floating exchange rate system has important implications: -
(a) Since there is greater movement of the exchange rate, there is the possibility of currency risk.
This might lead to a lower volume of international trade either because of the risk itself or
because of the cost of minimizing its consequences. The lower volume of trade implies a reduced
level of economic welfare.
(b) Under floating exchange rate systems balance of payments deficits/surpluses are, in principle,
automatically corrected by movements in the exchange rate. For example, a deficit leads to fall
in the exchange rate; this improves completeness and corrects the deficit. Thus, there is no need
for government to hold foreign reserves to finance payment disequilibrium
(c) Since the balance of payments is self-correcting, this removes constraints on government
policy making. Governments can choose any combination of employment/Inflation they choose
because the balance of payments Implication of their choice is atomically corrected. In effect,
floating exchange rates remove the policy discipline imposed by fixed rates.
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 does reflect 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.
2.1.5: Current Exchange System
After the Bretton Woods system broke down, the world finally accepted the use of floating
foreign exchange rates during the Jamaica agreement of 1976. This meant that the use of the gold
standard would be permanently abolished. However, this is not to say that governments adopted
a pure free-floating exchange rate system. Most governments employ one of the following three
exchange rate systems that are still used today:
1. Dollarization;
2. Pegged rate; and
3. Managed floating rate

Dollarization
This event occurs when a country decides not to issue its own currency and adopts a foreign
currency as its national currency. Although dollarization usually enables a country to be seen as a
more stable place for investment, the drawback is that the country’s central bank can no longer
print money or make any sort of monetary policy. An example of dollarization is El Salvador's
use of the U.S. dollar.

Pegged Rates
Pegging occurs when one country directly fixes its exchange rate to a foreign currency so that the
country will have somewhat more stability than a normal float. More specifically, pegging
allows a country’s currency to be exchanged at a fixed rate with a single or a specific basket of
foreign currencies. The currency will only fluctuate when the pegged currencies change.
For example, China pegged its Yuan to the U.S. dollar at a rate of 8.28 Yuan to US$1, between
1997 and July 21, 2005. The downside to pegging would be that a currency’s value is at the
mercy of the pegged currency’s economic situation. For example, if the U.S. dollar appreciates
substantially against all other currencies, the Yuan would also appreciate, which may not be what
the Chinese central bank wants.
Managed Floating Rates
This type of system is created when a currency’s exchange rate is allowed to freely change in
value subject to the market forces of supply and demand. However, the government or central
bank may intervene to stabilize extreme fluctuations in exchange rates. For example, if a
country’s currency is depreciating far beyond an acceptable level, the government can raise
short-term interest rates. Raising rates should cause the currency to appreciate slightly; but
understand that this is a very simplified example. Central banks typically employ a number of
tools to manage currency as it has already been explained previously under floating systems.