International Monetary system:

International monetary system, rules and procedures by which different national

currencies are exchanged for each other in world trade. Such a system is necessary
to define a common standard of value for the world's currencies.

International Monetary Fund: (IMF)

The International Monetary Fund is an international organization that oversees the

global financial system by following the macroeconomic policies of its member countries,
in particular those with an impact on exchange rates and the balance of payments. It also
offers financial and technical assistance to its members, making it an international
lender of last resort. Its headquarters are located in Washington, D.C., USA.

Gold standard:

In 1816, England made gold a benchmark of value. This meant that the value of
currency was pegged to a certain number of ounces of gold. This would help to
prevent inflation of currency. The U.S. went on the gold standard in 1900.

Gold standard

The gold standard is a monetary system in which a region's common media of

exchange are paper notes which receive substantial premia because they are
normally freely convertible into fixed quantities of gold. Under a gold standard,
money issuers normally stand willing to redeem their notes, upon demand, for pre-
set, intertemporally constant, fixed amounts of gold. The gold standard is not
currently used by any government, having been replaced completely by fiat currency,
and private currencies backed by gold are rare.

Gold standards should not be confused with their historical predecessor, "gold-coin
standards," wherein taxes are payable in either gold coins or overvalued,
government-minted, less expensive, coins.

Gold standard from peak to crisis (1901–1932)

Suspending gold payments to fund the war:

As in previous major wars under its gold standard, the British government
suspended the convertibility of Bank of England notes to gold in 1914 to fund
military operations during World War I. By the end of the war Britain was on a series
of fiat currency regulations, which monetized Postal Money Orders and Treasury
Notes. The government later called these notes banknotes, which are different from
US Treasury notes. The United States government took similar measures. After the
war, Germany, having lost much of its gold in reparations, could no longer coin gold
"Reichsmarks" and moved to paper currency, although the Weimar Republic later

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introduced the "rentenmark" and later the gold-backed reichsmark in an effort to
control hyperinflation.

Also as in previous major wars under the gold standard, the UK was returned to the
gold standard in 1925, by a somewhat reluctant Winston Churchill. Although a
higher gold price and significant inflation had followed the wartime suspension,
Churchill similarly followed tradition by resuming conversion payments at the pre-
war gold price. For five years prior to 1925 the gold price was managed downward
to the pre-war level, causing deflation throughout those countries of the British
Empire and Commonwealth using the Pound Sterling. But the rise in demand for
gold for conversion payments that followed the similar European resumptions from
1925 to 1928 meant a further rise in demand for gold relative to goods and
therefore the need for a lower price of goods because of the fixed rate of conversion
from money to goods. Because of these price declines and predicatable
depressionary effects, the British government finally abandoned the standard
September 20, 1931. Sweden abandoned the gold standard in October 1931; and
other European nations soon followed. Even the U.S. government, which possessed
most of the world's gold, moved to cushion the effects of the Great Depression by
raising the official price of gold (from about $20 to $35 per ounce) and thereby
substantially raising the equilibrium price level in 1933-4.

Advantages

1.The history of money consists of three phases: commodity money, in which actual
valuable objects are bartered; then representative money, in which paper notes
(often called 'certificates') are used to represent real commodities stored
elsewhere; and finally fiat money, in which paper notes are backed only by use of'
"lawful force and legal tender laws" of the government, in particular by its
acceptability for payments of debts to the government (usually taxes).

2. Commodity money is inconvenient to store and transport and is subject to

hoarding. It also does not allow the government to control or regulate the flow of
commerce within their dominion with the same ease that a standardized currency
does. As such, commodity money gave way to representative money, and gold and
other specie were retained as its backing.

3. Gold was a common form of representative money due to its rarity, durability,
divisibility, fungibility, and ease of identification,[4] often in conjunction with silver.
Silver was typically the main circulating medium, with gold as the metal of
monetary reserve. The primary advantage of gold or silver backed currency is it self
regulates. Therefore there is no government tinkering with the boom and bust
cycles that accompany fiat-based currency.

4. The Gold Standard variously specified how the gold backing would be
implemented, including the amount of specie per currency unit. The currency itself
is just paper and so has no innate value, but is accepted by traders because it can

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be redeemed any time for the equivalent specie. A US silver certificate, for
example, could be redeemed for an actual piece of silver.

5. Representative money and the Gold Standard protect citizens from hyperinflation
and other abuses of monetary policy, as were seen in some countries during the
Great Depression.[citation needed] However, they were not without their problems and
critics, and so were partially abandoned via the international adoption of the
Bretton Woods System. That system eventually collapsed in 1971, at which time all
nations had switched to full fiat money.

Disadvantages and Rebuttals

The total amount of gold that has ever been mined has been estimated at around
142,000 tons. Assuming a gold price of US$1,000 per ounce, or $32,500 per
kilogram, the total value of all the gold ever mined would be around $4 trillion. This
is less than the value of circulating money in the U.S. alone, where more than $7.6
trillion is in circulation or in deposit (although international banking currently
practices fractional reserves). Therefore, a return to the gold standard would result
in a significant increase in the current value of gold, which may limit its use in
current applications. Fluctuations in the amount of gold that is mined could cause
inflation, if there is an increase, or deflation if there is a decrease. Some hold the
view that this contributed to the Great Depression, although the US was already off
the gold standard at that time.

It is difficult to manipulate a gold standard to tailor to an economy’s demand for

money, giving central banks fewer options to respond to economic crises.[11] Some
have contended that the gold standard may be susceptible to speculative attacks
when a government’s financial position appears weak. For example, some believe
the United States was forced to raise its interest rates in the middle of the Great
Depression to defend the credibility of its currency.

EXCHANGE RATE

Significance:

The exchange rate expresses the national currency's quotation in respect to foreign
ones. For example, if one US dollar is worth 10 000 Japanese Yen, then the
exchange rate of dollar is 10 000 Yen. If something costs 30 000 Yen, it
automatically costs 3 US dollars as a matter of accountancy. Going on with fictious
numbers, a Japan GDP of 8 million Yen would then be worth 800 Dollars.

Thus, the exchange rate is a conversion factor, a multiplier or a ratio, depending on

the direction of conversion.

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In a slightly different perspective, the exchange rate is a price. If the exchange rate
can freely move, the exchange rate may turn out to be the fastest moving price in
the economy, bringing together all the foreign goods with it.

Types of exchange rate:

nominal exchange rates

real exchange rates

It is customary to distinguish nominal exchange rates from real exchange rates.

Nominal exchange rates are established on currency financial markets called "forex
markets", which are similar to stock exchange markets. Rates are usually
established in continuous quotation, with newspaper reporting daily quotation (as
average or finishing quotation in the trade day on a specific market). Central bank
may also fix the nominal exchange rate.

Real exchange rates are nominal rate corrected somehow by inflation measures. For
instance, if a country A has an inflation rate of 10%, country B an inflation of 5%,
and no changes in the nominal exchange rate took place, then country A has now a
currency whose real value is 10%-5%=5% higher than before. In fact, higher prices
mean an appreciation of the real exchange rate, other things equal.

For instance, having a basket made up of 40% US dollars and 60% German marks, a
currency that suffered from a value loss of 10% in respect to dollar and 40% to
mark will be said having faced an "effective" loss of 10%x0.6 + 40%x0.4 = 22%.

Some countries impose the existence of more than one exchange rate, depending
on the type and the subjects of the transaction. Multiple exchange rates then exist,
usually referring to commercial vs. public transactions or consumption and
investment imports. This situation requires always some degree of capital controls.

In many countries, beside the official exchange rate, the black market offers foreign
currency at another, usually much higher, rate.

Exchange rate regime:

When the exchange rate can freely move, assuming any value that private demand
and supply jointly establish, "freely floating exchange rate" will be the name of
currency institutional regime. Equivalently, it is called "flexible" exchange rate as
well.

If the central bank timely and significantly intervenes on the currency market, a
"managed floating exchange rate regime" takes place. The central bank

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intervention can have an explicit target, for example in term of a band of currency
acceptable values.

In "freely" and "managed" floating regimes, a loss in currency value is

conventionally called” depreciation", whereas an increase of currency's
international value will be called "appreciation". If the dollar rise from 10 000 yen to
12 000 yen, then it has shown an appreciation of 20%. Symmetrically, the yen has
undergone a 8.3% depreciation.

But central banks can also declare a fixed exchange rate, offering to supply or buy
any quantity of domestic or foreign currencies at that rate. In this case, one talks of
a "fixed exchange rate".

Under this regime, a loss of value, usually forced by market or a purposeful policy
action, is called” devaluation", whereas an increase of international value is a
"revaluation".

The most stabile fixed exchange regimes are backed by an international agreement
on respective currency values, often with a formal obligation of loans among central
banks in case of necessity.

A "currency crisis" is a rupture of fixed exchange rates with an unwilling devaluation

or even the end of that regime in favor of a floating exchange rate.

An extreme national engagement to fixed exchange rates is the transformation of

the central bank in a mere "currency board" with no autonomous influence on
monetary stock. The bank will automatically print or lend money depending on
corresponding foreign currency reserves. Thus, exports, imports and capital inflows
(e.g. FDI) will largely determine the monetary policy.

Bretton Woods system

The Bretton Woods system of monetary management established the rules for
commercial and financial relations among the world's major industrial states. The
Bretton Woods system was the first example of a fully negotiated monetary order
intended to govern monetary relations among independent nation-states.

Preparing to rebuild the international economic system as World War II was still
raging, 730 delegates from all 44 Allied nations gathered at the Mount Washington
Hotel in Bretton Woods, New Hampshire for the United Nations Monetary and Financial
Conference. The delegates deliberated upon and signed the Bretton Woods
Agreements during the first three weeks of July 1944.

Setting up a system of rules, institutions, and procedures to regulate the

international monetary system, the planners at Bretton Woods established the
International Bank for Reconstruction and Development (IBRD) (now one of five institutions

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in the World Bank Group) and the International Monetary Fund (IMF). These
organizations became operational in 1946 after a sufficient number of countries had
ratified the agreement.

The chief features of the Bretton Woods system were an obligation for each country
to adopt a monetary policy that maintained the exchange rate of its currency within a
fixed value—plus or minus one percent—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.

Until the early 1970s, the Bretton Woods system was effective in controlling conflict
and in achieving the common goals of the leading states that had created it,
especially the United States

The political basis for the Bretton Woods system are in the confluence of several
key conditions: the shared experiences of the Great Depression, the concentration
of power in a small number of states (further enhanced by the exclusion of a
number of important nations because of the war), and the presence of a dominant
power willing and able to assume a leadership role in global monetary affairs.

The Bretton Woods system sought to secure the advantages of the gold standard
without its disadvantages. Thus, a compromise was sought between the polar
alternatives of either freely floating or irrevocably fixed rates—an arrangement that
might gain the advantages of both without suffering the disadvantages of either
while retaining the right to revise currency values on occasion as circumstances
warranted.

The rules of Bretton Woods, set forth in the articles of agreement of the
International Monetary Fund (IMF) and the International Bank for Reconstruction and
Development (IBRD), provided for a system of fixed exchange rates. The rules
further sought to encourage an open system by committing members to the
convertibility of their respective currencies into other currencies and to free trade.

What emerged was the "pegged rate" currency regime. Members were required to
establish a parity of their national currencies in terms of gold (a "peg") and to
maintain exchange rates within plus or minus 1% of parity (a "band") by intervening
in their foreign exchange markets (that is, buying or selling foreign money).

In practice, however, since the principal "Reserve currency" would be the U.S.
dollar, this meant that other countries would peg their currencies to the U.S. dollar,
and—once convertibility was restored—would buy and sell U.S. dollars to keep
market exchange rates within plus or minus 1% of parity. Thus, the U.S. dollar took
over the role that gold had played under the gold standard in the international
financial system.

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Meanwhile, in order to bolster faith in the dollar, the U.S. agreed separately to link
the dollar to gold at the rate of $35 per ounce of gold. At this rate, foreign
governments and central banks were able to exchange dollars for gold. Bretton
Woods established a system of payments based on the dollar, in which all
currencies were defined in relation to the dollar, itself convertible into gold, and
above all, "as good as gold." The U.S. currency was now effectively the world
currency, the standard to which every other currency was pegged. As the world's
key currency, most international transactions were denominated in dollars.

The U.S. dollar was the currency with the most purchasing power and it was the
only currency that was backed by gold. Additionally, all European nations that had
been involved in World War II were highly in debt and transferred large amounts of
gold into the United States, a fact that contributed to the supremacy of the United
States. Thus, the U.S. dollar was strongly appreciated in the rest of the world and
therefore became the key currency of the Bretton Woods system.

Member countries could only change their par value with IMF approval, which was
contingent on IMF determination that its balance of payments was in a
"fundamental disequilibrium."

Fixed exchange rate:

A fixed exchange rate, sometimes called a pegged exchange rate, is a type of

exchange rate regime wherein a currency's value is matched to the value of
another single currency or to a basket of other currencies, or to another measure of
value, such as gold. As the reference value rises and falls, so does the currency
pegged to it. In addition, fixed exchange rates deprive governments of the use of an
independent domestic monetary policy to achieve internal stability. A former
president of the Federal Reserve Bank of New York described fixed currencies as
follows:

"Fixing the value of the domestic currency relative to that of a low-inflation country
is one approach central banks have used to pursue price stability. The advantage of
an exchange rate target is its clarity, which makes it easily understood by the
public. In practice, it obliges the central bank to limit money creation to levels
comparable to those of the country to whose currency it is pegged. When credibly
maintained, an exchange rate target can lower inflation expectations to the level
prevailing in the anchor country. Experiences with fixed exchange rates, however,
point to a number of drawbacks. A country that fixes its exchange rate surrenders
control of its domestic monetary policy."

In certain situations, fixed exchange rates may be preferable for their greater
stability. For example, the Asian financial crisis was improved by the fixed exchange
rate of the Chinese renminbi, and the IMF and the World Bank now acknowledge
that Malaysia's adoption of a peg to the US dollar in the aftermath of the same crisis
was highly successful. Following the devastation of World War II, the Bretton Woods

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system allowed Western Europe to have fixed exchange rates until 1970 with the
US dollar.

Yet others argue that the fixed exchange rates (implemented well before the crisis)
had become so immovable that it had masked valuable information needed for a
market to function properly. That is, the currencies did not represent their true
market value. This masking of information created volatility which encouraged
speculators to "attack" the pegged currencies and as a response these countries
attempt to defend their currency rather than allow it to devalue. These economists
also believe that had these countries instituted floating exchange rates, as opposed
to fixed exchange rates, they may very well have avoided the volatility that caused
the Asian financial crisis. Countries like Malaysia adopted increased capital controls
believing that the volatility of capital was the result of technology and globalization,
rather than fallacious macroeconomic policies which resulted not in better stability
and growth in the aftermath of the crisis but sustained pain and stagnation.

Countries adopting a fixed exchange rate must exercise careful and strict
adherence to policy imperatives, and keep a degree of confidence of the capital
markets in the management of such a regime, or otherwise the peg can fail. Such
was the case of Argentina, where unchecked state spending and international
economic shocks disbalanced the system

Floating exchange rate:

A floating exchange rate or a flexible exchange rate is a type of exchange rate
regime wherein a currency's value is allowed to fluctuate according to the foreign
exchange market. A currency that uses a floating exchange rate is known as a floating
currency. The opposite of a floating exchange rate is a fixed exchange rate.

Many economists think that, in most circumstances, floating exchange rates are
preferable to fixed exchange rates. They allow the dampening of shocks and foreign
business cycles. However, in certain situations, fixed exchange rates may be
preferable for their greater stability and certainty. This may not necessarily be true,
considering the results of countries that attempt to keep the prices of their currency
"strong" or "high" relative to others, such as the UK or the Southeast Asia countries
before the Asian currency crisis.

Canada is the only country whose currency's value is determined absolutely and
entirely by the foreign exchange market; [1] in cases of extreme appreciation or
depreciation, a central bank will normally intervene to stabilize the currency. Thus,
the exchange rate regimes of floating currencies may more technically be known as
a managed float. A central bank might, for instance, allow a currency price to float
freely between an upper and lower bound, a price "ceiling" and "floor". Management
by the central bank may take the form of buying or selling large lots in order to
provide price support or resistance, or, in the case of some national currencies,
there may be legal penalties for trading outside these bounds.

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Fear of floating:

A free floating exchange rate increases foreign exchange volatility. This may cause
serious problems, especially in emerging economies. These economies have a
financial sector with one or more of following conditions:

1. High liability dollarization

2. Financial fragility

3. Strong balance sheet effects

When liabilities are denominated in foreign currencies while assets are in the local
currency, unexpected depreciations of the exchange rate deteriorate bank and
corporate balance sheets and threaten the stability of the domestic financial
system.

For this reason emerging countries appear to face greater fear of floating, as they
have much smaller variations of the nominal exchange rate, yet face bigger shocks
and interest rate and reserve movements (Calvo and Reinhart, 2002). This is the
consequence of frequent free floating countries' reaction to exchange rate
movements with monetary policy and/or intervention in the foreign exchange
market.

According to data the number of countries that present fear of floating increased
significantly during the nineties.

Real Effective Exchange Rate

An important refinement of the NEER is the Real Effective Exchange Rate (REER).
This is particularly useful in considering comparative changes in a country's real
economic circumstances. If the spot market rate for a country or its NEER shows a
downward trend this could be because other countries are becoming relatively more
productive. But it could arise from a difference in inflation rates between that
country and others in the World. The REER is a NEER with price or labour cost
inflation removed. It is thus a better measure of comparative economic activity
between countries than simple market rates.

Nominal Effective Exchange Rate

In simplest index form, the trade weighted exchange rate can be found as a set of
Nominal Effective Exchange Rates (NEER) in several databanks in the ESDS
International macro-data collection. A country's NEER is a weighted average of its
currency exchange rates with its major trading partners' currencies. The weightings
will be based on the level of trade with each trading partner. Thus a NEER gives a
much better view of changes in a country's terms of trade with the rest of the World
than bilateral or SDR rates.

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