Unit 1: GLOBAL FINANCIAL ENVIRONMENT

Evolution of International Monetary System, Bimetallism, Classical Gold Standard, Interwar Period,
Bretton Woods System, Flexible Exchange Rate Regime, the current Exchange Rate Agreements,
European Monetary System, Fixed vs. Flexible Exchange Rate Regime.

INTERNATIONAL MONETARY SYSTEM

International Monetary System refers to set of rules, regulations, conventions and institutions
that govern the international business and trade. It is a framework within which foreign
exchange rates are determined.

Evolution/stages in international monetary system

 Phase 1: Bimetallism before 1875: Before 1875 Gold and silver coins were used as
international means of payment and that the exchange rates among currencies were
determined either by gold or silver content.

Downfall of bimetallism

 Gresham’s Law- Abundant metal was used as money driving away scarce metal out
of circulation. It brought huge variations in supply of money and was viewed as
unstable and the availability of gold was scare and silver was abundant.
 All the resources got drained.

 Phase 2: Gold standard: 1875-1914:

 Under this system countries allowed two way conversion of its currency to gold and
vice versa on demand.
 Only gold was used for international payments.
 Each country maintained gold reserves to back the value of its currency.
 There were no restrictions in the movement of gold and payment between two
currencies was mainly settled through exchange of gold.
 This led to the automatic correction in BOP situation of the country.

Gold
 Phase 3: Inter war period: 1915-1944:

 Outbreak of World War 1 ended the gold standard in the major parts of the world on 1914 as
many countries restricted free movement of gold.
  During this period, countries widely used ‘predatory’ depreciation of their currencies as
a means of gaining advantage in the world export market.
 Major countries were again on gold std. by 1928. But by the end of World War II Gold
Standard completely collapsed due to competitive devaluation and restriction of free
moment to gold.

Downfall of Gold Standard

 Outbreak of 1st World War.

 Restriction in the free movement of gold.
 Great depression 1929 followed by World War II.

 Phase 4: Bretton wood agreement/system1945-1972:

 Monetary and Financial Conference held in Bretton Woods, New Hampshire, from
July 1 to July 22, 1944. 730 delegates from the 44 Allied nations attended the
conference.
 The purpose was to design a post-war international monetary system and to set up
permanent institutional framework to manage international monetary co-operation.
 Under this system each country agreed to fix the par value of its currency in relation
to US dollar and US dollars were in turn pegged to gold at $35 per ounce.
 Major outcomes of the Bretton Woods conference included the formation of the
International Monetary Fund to maintain order in monetary system and the
International Bank for Reconstruction and Development to promote general
economic development post war.

Downfall of Bretton wood System

 Over valuation of Dollar. Member countries lost confidence in $ and started converting $
reserves into gold.
 Gold reserve in the US treasury began to fall.
 Due to recurring deficit in US BOP it suspended the convertibility of $ into gold.

 Phase 5: Flexible/floating exchange rate system.:1972-present:

 Flexible exchange rates were declared acceptable to the IMF members.
 Under this system exchange rates of the currency in the forex market based
on market forces i.e., Demand and supply.
 Central banks were allowed to intervene in the exchange rate markets to
avoid unwarranted volatilities.
 Gold was abandoned as an international reserve asset.
 The currencies are no longer backed by gold

Current Exchange Rate Arrangements:

Free Float: A floating exchange rate is a regime where the currency price is set by the forex market
based on market forces i.e., supply and demand compared with other currencies. The largest number
of countries, about 48, allows market forces to determine their currency’s value. E.g.: US, UK and
Japan

Managed Float: Central banks attempt to influence their countries' exchange rates by buying and
selling currencies to maintain a certain range. About 25 countries combine government intervention
with market forces to set exchange rates. E.g.: India, Russia Etc.

No national currency: Some countries do not printing their own, they just use the U.S. dollar. For
example, Ecuador and Palau have dollarized.

European Monetary System (EMS) (1979-1998)

The European Monetary System was created in response to the collapse of the Bretton Woods
Agreement.

European Monetary System was an adjustable exchange rate agreement set up in 1979 to foster
closer monetary policy cooperation between members of the European Community (EC). The EMS's
primary objective was to stabilize inflation and stop large exchange rate fluctuations between
European countries which later fostered economic and political unity in Europe. The system collapsed
because real exchange rates were more important than nominal exchange rates for investments, import
and exports.

European Monetary Union- After the collapse of EMS 18 European countries formed European
Monetary Union.

European Central Bank (ECB) was established. Through ECB, European Currency Unit (ECU) was
introduced- currency based on a basket of 12 EU member currencies, weighted according to each
country’s share of EU output.

All the member countries of European Community had to convent their currency to ECU for import
and export of goods and services within European Community.

This system worked till 1992 and the difference in political and economic conditions of member
countries like Exit of Britain from European Community and Reunification of Germany lead to the
downfall of EMU.

European Union – The number of members of European Community increased from 18 to 27. In
1999 27 members united politically, economically and monetarily with uniform currency called Euro
which is called as European Union which is operational till date.
Difference between fixed and floating exchange rates

Fixed Exchange Rates Floating Exchange Rates

Exchange rates fixed by government and Exchange rates determined by market forces-
monetary authority of the country. demand and supply.
Stability and day to day fluctuations are Instability as Forex Markets is volatile.
avoided.
Less risky and certain. More risk and certain.
No scope for speculation. There is scope for speculation.
Supported by international reserves of gold. Not supported by international gold reserves.
Examples – United Arab Emirates, Bahrain, Examples – UK, Japan, USA etc.
Oman etc.