208 gwes unit 4

Unit 4. International Monetary System
4. International Monetary System:
The International Financial System
- Reform of International Monetary Affairs
- The Bretton Wood System and the International
Monetary Fund, Controversy over Regulation of
International Finance, Developing Countries'
Concerns, Exchange Rate Policy of Developing
Economies.

International Financial System
The international financial system (IFS)
constitutes the full range of interest‐ and
return‐bearing assets, bank and nonbank
financial institutions, financial markets that
trade and determine the prices of these
assets, and the nonmarket activities (e.g.,
private equity transactions, private
equity/hedge fund joint ventures, leverage
buyouts whether bank financed or not, etc.)
through which the exchange of financial assets
can take place.
The IFS lies at the heart of the global credit
creation and allocation process.

To be sure, the IFS depends on the effective
functioning and prudent management of the
IMS and the ready availability of currencies to
support the payment system.
Nevertheless, the IFS extends far beyond IMS’s
common payments and currency pricing role
to encompass the full range of financial
assets, including derivatives, credit classes
and the institutions that engage in the
exchange of these assets as well as their
regulatory and governing bodies.
The IFS encompasses the IMS — but extends
in function and complexity well beyond the
IMS.

Government debt links the two systems, as
government debt can function as “near
money” in a zero interest rate environment.
Many financial transactions pass through a
stage of payment in money (i.e., a demand
deposit) — quickly —to a “riskless”
interest‐bearing asset, like government
bonds.
When “riskless” assets become more “risky”
and less liquid, the payment system slows
down and may even be upended.

Three features of the international financial
system in the 21 st century:
―the currency system,
―capital flows,
―the responsibilities of authorities in
the major economies.

(1) The international monetary system (how
exchange rates, balance of payments and
macroeconomic management are
managed and adjusted globally) is part of
a broader international regime. As such, it
is influenced strongly by the way power is
distributed and exercised in the world, as
well as the presence or absence of a
powerful and reliable leader country.

(2) Over time, international monetary
systems exhibit oscillation between two
opposites: for example, (i) general floating
versus general fixity, (ii) stability versus
instability, and (iii) free capital mobility
versus no such mobility. It is hard to say
which situation is normal and which is
abnormal. People often believe that the
prevailing system is normal and
permanent, but it usually isn't. Whether
capital mobility has become irreversible in
the 21st century is an interesting and
open question.

(3) "The triangle of impossibility": Consider (i)
exchange rate stability (i.e., fixed exchange
rates), (ii) monetary policy independence,
and (iii) free capital mobility. These three
things are regarded as desirable, but only
two can be realized at any time. Different
international monetary systems emerge
depending on which one we give up. For
example, if we abandon the first, we have a
floating rate system; and if the second is
removed, monetary union like EU will
emerge, and so on.

(4) Since the 19th century, there has been a
gradual movement away from commodity
money (typically gold) toward paper money
(managed currency).
The problem with gold is its quantity is too
constraining, which is also a merit if the
central bank is irresponsible. In the 21st
century, maybe we will have e-money which
has completely new characteristics (and
risks).

The Currency System
The safest judgment is that the currency
system will continue to evolve along with
the evolution of the international financial
system.
Article IV of the IMF Articles of Agreement
calls upon members to assure orderly
exchange rate arrangements and to
promote a stable system of exchange rates
not a stable exchange rate system.

The Currency System
In a rapidly changing international financial system,
the search for comprehensive approaches to
global exchange rate systems is likely to be
unrewarding.
When it comes to exchange rate regimes, there are
no panaceas.
It is easy to demonstrate that there is no single
regime that is best for any national economy
under all economic and financial circumstances;
the disturbances with which regimes must cope
change over time.

The Currency System
National authorities have to make choices about
which regime on balance will best serve their
economies; because changes in regimes are not
costless. Eclecticism also is not a realistic option.
Similarly no global currency system promises to
serve best the interests of the global financial
system under all conditions.

The economic case for a trade bloc rests on
the observation that ex ante trade barriers
are high; the establishment of the trade
bloc serves on balance to reduce trade
distortions, creating more trade than is
diverted.
Currency blocs, on the other hand, run the
risk of increasing distortions through the
erection of barriers to the free flows of
finance where few exist today, at least
among the major currencies and financial
markets.

Capital Flows
Consider a regime with a common global
currency.
Under such a regime, as with national
monetary systems, capital flows would not
be immune from irrational exuberance or
despondence, and crises would continue
to be possible.

At a pragmatic level, responding to potential
problems associated with international
capital flows by the imposition of controls
on those flows is likely over time to prove
to be inefficient (and, therefore, costly),
ineffective, or both, unless the national
financial market itself is tightly controlled or
highly underdeveloped.
Moreover, as countries develop and grow,
controls are relaxed and financial systems
are opened up.

Better response to the potential problems
associated with international capital flows
lies in the promotion of sound
macroeconomic policies, flexible markets,
robust financial systems supported by
appropriate regulations and supervision,
transparency about regimes and
institutions, and adherence to agreed
global standards.

Responsibilities of Authorities in the Major
Economies
In order to provide support for the appropriate evolution
of the international financial system in the 21 st
century, the authorities in the major economies should
implement sound macroeconomic and structural
policies, demonstrate their respect for market forces,
and endeavor to follow a policy of inclusion when it
comes to establishing the rules and principles that will
guide and govern the financial system. All this may
sound like very little, but it is remarkable how taxing it
is to accomplish these tasks effectively and
successfully.

The United Nations Monetary and Financial
Conference, commonly known as Bretton Woods
conference, was held in Bretton Woods, New
Hampshire, USA to regulate the international
monetary and financial order after the conclusion
of World War II.
The aim was to help rebuild the shattered
post-war economy ( WW2 had just finished
in 1945) and to promote international
economic cooperation.

The conference resulted in the agreements
to set up the International Bank for
Reconstruction and Development
(IBRD)- popularly known as World Bank
and the International Monetary Fund
(IMF).
The IMF was set up to foster monetary
stability at global level. The IBRD was
created to speed up post-war
reconstruction. The two institutions are
known as the Bretton Woods twins.

Origins of Bretton Woods
Political origin lies in 2 key conditions –
Shared experiences of 2 World Wars, with the
sense that failure to deal with economic
problems after the first war had led to the
second <Treaty of Versailles demanding
massive reparation amount from
Germany being the cause of collapse of
German economy and Hitler’s rise to power>
The concentration of power in a small number
of states (US and Western Europe)

Members of Bretton Woods Family aka Bretton Woods
Twins
1. International Monetary Fund(IMF) – To maintain
global financial stability through technical assistance,
training, and loans to member states to tide over short
term balance of payment crisis
2. World Bank (WB) Group – Consisting of 5 agencies
which provides vital financial and technical assistance to
developing countries around the world to reduce global
poverty
Remember that WTO has nothing to so with Bretton Woods.
It officially commenced only in 1995 under the Marrakesh
agreement and replace General Agreement on Tariff and
trade (GATT)

The Bretton Woods System is a set of unified rules and
policies that provided the framework necessary to
create fixed international currency exchange rates.
Essentially, the agreement called for the newly
created IMF to determine the fixed rate of exchange
for currencies around the world. Every represented
country assumed the responsibility of upholding the
exchange rate, with incredibly narrow margins above
and below. Countries struggling to stay within the
window of the fixed exchange rate could petition the
IMF for a rate adjustment, which all allied countries
would then be responsible for following.
The system was depended on and was used heavily
until the beginning of the 1970s.

The Collapse of the Bretton Woods System
Backing currency by the gold standard started to become a
serious problem throughout the late 1960s. By 1971, the
issue was so bad that US President Richard Nixon gave
notification that the ability to convert the dollar to gold was
being suspended “temporarily.” The move was inevitably
the final straw for the system and the agreement that
outlined it.
Still, there were several attempts by representatives,
financial leaders, and governmental bodies to revive the
system and keep the currency exchange rate fixed.
However, by 1973, nearly all major currencies had begun
to float relatively toward one another, and the entire
system eventually collapsed.

A brief World War II Timeline
Adolf Hitler demanded that Gdansk be given to
Germany, claiming that Gdansk residents were
predominantly German. Backed by France and
Britain, Poland refused. With this excuse, Germany
invaded Poland on September 1, 1939.
Recall that the representatives of the US and its
Allies worked out three post-war arrangements
(i) ITO (still-born), replaced by GATT and WTO.
(ii) IBRD (which became the World Bank), and
(iii) IMF, immediately after the Normandy invasion
in June 1944.

Stable and adjustable exchange rates
For 25 years after WWII, the international monetary
system known as the Bretton Woods system, was
based on stable and adjustable exchange rates.
Exchange rates were not permanently fixed, but
occasional devaluations of individual currencies
were allowed to correct fundamental disequilibria
in the balance of payments (BP). Ever-increasing
attack on the dollar in the 1960s culminated in the
collapse of the Bretton Woods system in 1971,
and it was reluctantly replaced with a regime of
floating exchange rates.

loss of national sovereignty
• By signing the agreement, nations were
submitting their exchange rates to
international disciplines.
• This amounted to a significant surrender of
national sovereignty to an international
organization.
• Territorial waters = 12 nautical miles. US
navy ships patrolled near Spratly
archipelago on international waters (outside
12 nm).

Advantages over the gold exchange standard
Deflationary policy: Under the gold exchange
standard, a country has to resort to the classical
medicine of deflating the domestic economy when
faced with chronic BP deficits.
Before World War II, European nations often used
this policy, in particular the Great Britain. Even
though few currencies were convertible into gold,
policy makers thought that currencies should be
backed by gold and willingly adopted deflationary
policies after WWI.

Advantages over the gold exchange standard
Deflationary policy is not the only option when faced
with BP deficits. Devaluation is accepted in
Bretton Woods.
The adjustable peg was viewed as a vast
improvement over the gold exchange standard
with fixed parity.
Currencies were convertible into gold, but unlike the gold
exchange standard, countries had the ability to change par
values of their currencies . For this reason, Keynes
described the Bretton Woods system as "the exact
opposite of the gold standard." The world economy tripled
in size during the two decades, but gold supply did not
change much.

Unanticipated Problems
Structural problems: (i) Over time the world
economy grew and needed more liquidity or
reserve assets. ⇒ Marshall Plan Aid.
Gate of Honor, Versaille Palace
"Wir wollen Kohle, Wir wollen Brot" (We want
coal, We want bread). (former) President Herbert
Hoover (1947): The whole economy of Europe is
interlinked with German economy through the
exchange of raw materials and manufactured
goods.)
(ii)

(ii) Given the fixed quantity of gold (192,000 tons or
6.2 billion ounces, annual production of gold = 80
million ounces = $100 billion), other countries had
to hold US dollar and gold as reserve. Keynes
had proposed that a world reserve currency be
created and managed by a central bank. (Today
IMF manages SDR.)
(iii) As the world economy grew, the increased world
demand for dollar as reserve assets meant that
US had to incur increasing trade deficits.

The dollar was the numéraire of the system, i.e., it was
the standard to which every other currency was
pegged. Accordingly, the U.S. did not have the power
to set the exchange rate between the dollar and any
other currency.
Changing the value of dollar in terms of gold has no real
effect, because the parities of other currencies were
pegged to the dollar. This is the n-th currency
problem. This problem would not have existed if most
of other currencies were pegged to gold. However,
none of these currencies were pegged to gold
because they were not convertible into gold. (limited
supply of gold)

Invasion of Normandy (June 6, 1944)
International Monetary Fund and World Bank
meeting was held in July 1944 in Bretton Woods,
New Hampshire, one month after the invasion of
Normandy.
This meeting to establish United Nations was held in
San Francisco and the charter was signed in June
1945 (after Germany's surrender).
UN came into existence in October 1945. The
Articles of Agreement of the IMF was signed in
December 1945. The next year, the By-laws were
adopted at a meeting in Savanna, Georgia (March
8-18, 1946).

Contents of the Articles of Agreement
• IMF was established to provide member
countries with the necessary funds to cover
short term balance of payments problems.
The Fund in turn received resources from
members who were allotted quotas.
• Initial quota: $8 billion (worth about $80
billion today)
(Total Quota = 238 billion SDR as of 2010,
doubled, reaching 476 billion SDR in 2011).

Par value and 1% band
Upon entering the Fund, a country submitted
a par value of its currency expressed in
terms of gold or in terms of the US dollar
using the weight of gold in effect on July 1,
1944 ($35 per troy oz).
All exchange transactions between member
countries were to be effected at a rate that
fluctuated within 1% band (which
approximates gold import/export points)
around the par values of the respective
currencies.

Article IV : Changing par value
Article IV: A member could change the par value of its
currency only to correct a fundamental disequilibrium in
its balance of payments, and only after consulting with the
Fund.
(However, speculators correctly anticipate such weak
currencies, making it more difficult for the monetary
authorities to defend them.)
In case the Fund objects a change, but the member devalues
its currency, then that member is ineligible to use Fund's
resources.
The Fund cannot formally propose a change of the par value
of a currency.
No objection to a change if the cumulative change is less
than 10% of the par value.

Article VI: allows members to control capital
movements.
Article VII: The Fund may declare a currency to be
scarce. If so, member countries are authorized to
impose exchange control over the scarce
currency.
Remark: A problem that appeared during the interwar period was that
unlike deficit countries, surplus countries were not under any pressure
to adjust their BP. A deficit country was compelled to take some kind of
action to restore equilibrium, but a surplus country can accumulate
reserves indefinitely. (This is still true even today. IMF monitors
currency practices of deficit countries that receive loans.)
Britain adopted deflationary policy in the 1920s, but the surplus countries
(US + France) did not participate in the adjustment process.

Article VIII forbids restrictions on current account
balances. Members are obligated to maintain the
convertibility of foreign held current account
balances (to facilitate trade).
Exceptions: Article VII + XIV
Article XIV allows a member country to retain
exchange control restrictions in effect when that
country entered the Fund. Once a member
country abolishes its exchange control over the
current payments and accepted the obligations of
Article VIII, then it cannot reimpose exchange
control without the approval of the Fund.

Remark: Most major countries in Europe accepted
the obligations of Article VIII by 1961. Japan came
under this article in 1964.
The remaining Article XIV countries are obligated to
consult annually with the Fund on exchange
controls, but the Fund has no power to abolish the
exchange control unilaterally. No scarce currency
declaration has been made.
Most nations outside the Communist bloc became
members of the IMF.

Borrowing under Bretton Woods
During the Bretton Woods era (1948-73),
world trade volume increased six-fold while
GWP tripled (from $7 trillion in 1950 to $21
trillion) . ⇒ Transctions demand for foreign
currencies increased 6 times but the gold
supply did not increase much. Per capita
US GDP doubled ($2,700 in 1950 to $5,400
in 1973 at the end of the Bretton Woods.)

• But the total international reserve increased
only by 3% during the same period. So
there developed an acute shortage of
international reserve assets. The US had
acquired the bulk of the world's gold. In
1946, the US held $26 billion worth of gold
(740 million ounces, world total = 6 billion
oz). Today, Treasury owns 260 million
ounces of gold (mostly in Fort Knox,
Denver, and West Point and a little bit at
FRB NY).

If the U.S. had exported Treasury bills, it
would have provided additional reserves for
the US. However, nations became
increasingly reluctant to hold $. Gradually,
the US stock of gold was depleted.
The Fund was the source of financing for a
member country experiencing a temporary
disequilibrium in its balance of payments.
These resources come from gold and
currency subscriptions of its members.

Reserve/Gold tranche / Credit tranche
Upon entering the Fund, each country was
allotted a quota in accordance with its
relative economic size.
Reserve (gold) tranche: 25% of quota was
paid to the Fund in gold (1944 US dollar).
Today, this must be paid in SDR or major
currencies ($, £, € and yen).
Credit tranche: 75% of quota was paid in the
currency's own currency.

Quota
In 1946, the Fund started with aggregate quotas of
$8 billion, 20% of world reserves. (Today, this
amount is worth roughly $100 billion) The quota
was raised in 1971. The largest quota was US:
$6.7 billion (21.9%): U.K. $2.8 billion (9.2%),
Germany, France 5%, Japan 4%. The quota was
increased several times.
In 1990 the quota was increased to $135 billion, still
equal to about 20% of world reserves.
In 2011, quota increased to SDR 477 billion
(about $677 billion). There have been no
increases thereafter.

Quota
The quota determines the voting power of a
member's executive director. (250 votes + 1 vote
for SDR100,000)
e.g., US = 17.75% ($65 billion), total = $366 billion
(as of 2009)
Total: 2.5 million votes (and growing).
US holding of gold: currently, about 8,000 tons
($160 billion at $40 per oz), or about 5% of the
world's total gold stock. (the world has about
190,000 tons in 2019, World Gold Council)
Jewelry: 90,000 tons, Investors: 40,000 tons,
governments: 33,000 tons

Borrowing
The size of a country's quota determines the
borrowing limit of that country.
(i) Basic Facility: gold tranche + 4 credit tranche =
125%
(ii) Extended Facility: 140%
(iii) Standby Agreements: Short term borrowing
member countries negotiate to receive the Fund's
guarantee. usually borrowing is for 3-5 years.
.

Borrowing
(iv) General Agreements to Borrow (GAB): was negotiated
in 1962 by the Group of Ten: France, Italy, Germany,
Belgium, Netherlands, Sweden, Japan, UK, US, Canada.
Switzerland joined in 1964. The fund could borrow up to
$5.9 billion from the Group of Ten to provide more short
term assistance.
(v) Currency Swap Arrangements : made in 1962. bilateral
arrangements between central banks. Purpose: to avoid
exchange control. At maturity, both parties re-exchange
the original amounts.
The total quota is small, not sufficient to deal with the
European crisis.
In 2008, Japan lent $100 billion to the IMF. US also extended
$100 billion line of credit.

SPECIAL DRAWING RIGHTS
Benefits of Reserve Currency
(i) avoid exchange rate risk: (a) Exchange rates
between two currencies can be volatile, dramatically
changing the prices of the goods. (b) Traders are
reluctant to use the currencies of small countries.
(ii) Other countries hold dollar balances for
transactions purposes ⇒They are lending money to
the US (interest-free loans, much like the commercial
banks paying no interest to checking account
balances). US firms have easier access to the
financial market. US has unlimited financing (Douglas
North, 1993 Nobel lecture)

Benefits of Reserve Currency
In particular, President of France, De Gaulle,
complained in 1965 that the US enjoys the
hegemony, using "worthless paper to plunder
other nation's resources and factories." (unlimited
financing)
Vladimir Putin: "US is a parasite on the world
economy." (Reuters, Aug 1, 2011). The Russia-
China currency swap has been ineffective due to
low demand for the Ruble.

Costs
US did not coerce any country to hold USD. USD has
been simply more reliable, and trading countries were
willing to hold USD. As the demand for the reserve
currency increases, and USD appreciates. ⇒ US
trade deficit increases.
In a certain sense, SDR allocations were like the credit
limits on a person's credit card or line of credit. SDRs
can be used to make payments to settle debts
between central banks.
In addition, each member country agreed to accept
three times its own SDR quota from other central
banks.

An agreement was reached at the IMF annual
meeting in Rio de Janeiro in 1967 to issue
SDRs to be allocated to 104 participants.
The first allocation was made in 1970 (3.4
billion), then 1971 (2.95 billion), 1972 (2.95
billion)

value of SDR
Originally, the value of an SDR was set at one US dollar,
both having the same weight in gold in 1970.
However, dollar was devalued a couple of times, and
there was a general move to end the key role of $ in
the international monetary system.
After July 1, 1974, the value of SDR was determined in
terms of "basket" of 16 main currencies. Weights:
USD = 33%, mark = 12.5%, pound = 9%, FF = 7.5%,
yen = 7.5%, CND = 6%, lira = 6%. From April 1980,
only 5 major currencies.
$ = 42%, DM = 19%, yen = 13%, FF = 13%, pound =
13% The value of SDR is calculated daily by IMF.

SDR included $, euro, pound and yen. 1 SDR =
$1.50 as of 2013
From October 1, 2016, five currencies are
included: USD, €, Renminbi, yen, £ (GBP).
Renminbi is not "freely convertible" in
international transactions.
Codes: USD, EUR, GBP, CNY, JPY, XDR
SDRs are merely bookkeeping entries. It
becomes a reserve asset because of the
commitment of participating countries to
accept SDRs up to an amount equal to 3 times
their own SDR allocations.

creation of SDR
A decision to create SDRs require the approval of a
majority of member countries holding 85% of the
weighted voting power of the Fund.
Once created, SDRs are distributed to participants
in proportion to Fund quotas. As of 2009, the total
allocation reached SDR 204 billion.
Between central banks
Unlike dollar and other currencies, SDRs are not
usable for private international transactions.

SDRs represent a net addition to international
reserve that are as useful as gold or dollars,
unlike international borrowing (which does
not change reserves). Since it costs nothing
to create SDRs, the world saves resources
that would otherwise be wasted to mine and
refine gold. For this reasons, SDRs are
sometimes called paper gold. However,
they should be called "e-Gold" (electronic
gold) since no paper notes are issued.

Importance
SDR plays a limited role as an international reserve
asset due to its small quantity relative to the daily
transactions volume (about $5 trillion dollars) in
the foreign exchange market. Its main function is
the unit of account of transactions of international
organizations and central banks.
SDR is not tied to any single currency., and hence
there is no need for the US to have large trade
deficits in order to provide more reserves to the
ROW.

SDRs can be created as needed to insure
stable growth of international reserves. If
SDRs replace $ as reserve assets in central
banks, the US does not have to be a world
banker. SDR makes the IMF an
international central bank.

interest rate
Once every year, the IMF charges every
country interest on allotment, and credits
every country with interest on the average
SDR holdings during the past year. The
interest rate was 1.5% per year originally,
but raised to 5% in 1975. Now it is
calculated weekly based on a weighted
average of short term interest rates in the
basket currencies (Euro, Yen, Pound
Sterling, USD). 1 SDR is about $1.5 in April
2014.

The Role of the US Dollar
The international monetary system evolved in a way
that was not foreseen in the Articles of Agreement
of IMF.
During the 1950s the USD increasingly took over
the function of gold as the major international
reserve asset.
Why hold dollar, not gold?
No one planned this development. The US was the
dominant world power. (US share of output: 50%
in 1950, 40% in 1960, but has been stable at 25%
since the 1980s

Well over half of all international money transactions
were financed in terms of dollar
The US also owned about two thirds of the official gold
reserve in the world in 1940.
The dollar became the dominant invoice currency. (The
US profits as the banker.) Most exporters invoiced the
importers in dollars. When the European countries
had reserve surpluses in the 1950s and early 1960s,
they converted the surpluses into dollar reserves
rather than gold because.
(i) interest could be earned on dollar assets, and
(ii) dollar reserves can always be converted into gold at
$35 per ounce whenever it became necessary.

All of the non-Communist countries maintained a stable
relationship between their currencies and the dollar
either directly or indirectly through the British pound.
The US dollar was at the center of this system. Since
the Great Britain had halted the gold convertibility of
its currency, US dollar was the only currency directly
convertible into gold for official purposes. Before
WWI, the pound sterling performed a similar function,
but the sterling area had shrunken to a small number
of countries.
As the Bretton Woods system evolved, the reserves of
most countries became a mixture of gold and dollars.
Over time, US dollar became increasingly more
important.

dollar as principal reserve asset
The US balance of payments was more important
than those of other countries, because other
countries were holding US dollar as the principal
reserve asset. Moreover, the US was unable to
eliminate ever-increasing trade deficits, which
undermined the Bretton Woods system.
External debts:
US: $18 trillion
EU: $14
UK: $7
Japan: $3

Five Ways to Correct BP
Deficits
(1) deflate the
economy
use contractionary Monetary policy
(raise interest rate) or Fiscal policy (cut
federal spending) to reduce aggregate
demand. This is a painful option
because the government will become
less popular. (e.g., Great Britain after
WWI)
A permanent but painful solution.
(2) devalue
As the price of the foreign currency (e)
rises, net exports = X(e) - M(e)
declines, which reduces trade deficit.

Five Ways to Correct BP Deficits
(3) impose exchange
control on current
account
An exchange control limits imports. A
temporary stopgap solution.
(4) deplete gold stock
A temporary remedy.
Since the stock of gold is limited, it
will soon run out.

Five Ways to Correct BP Deficits
(5) increase
liabilities to
foreign central
banks.
(6)The surplus
country (e.g.,
China) holds
more dollar
assets.
This means the US is unwilling to devalue $, or the
surplus country (e.g., China) is unwilling to let RMB
appreciate. A temporary solution, and eventually
the latter country gives up.
Instead of importing American goods, China buys
dollar assets. As China holds more dollar assets,
their value in RMB declines when RMB appreciates
(Chinese investors lose money: buy high, sell low)
China buys properties in the middle east, and
central Asia (Kazakhstan) (Silkroad Economic Belt,
2013)
China's trade/GDP ratio = 41% in 2015
US = 30%)

US Payments Deficit in the 1960s
Persistent US BP deficits in the 60s
In the 1960s the international monetary
system was shaken by a series of
disturbances in the foreign exchange and
gold markets.
Since the US dollar was used as the principal
reserve asset by our trading partners, the
weakness of dollar raised doubts about the
viability of the entire system.

Persistent US BP deficits in the 60s
During the period 1958-1971, the US experienced a
persistent deficit in its balance of payments. At
first, economists viewed these annual deficits as
temporary. However, it gradually dawned to policy
makers that the US deficits were not
disappearing. The causes of these chronic deficits
are:
(a) a higher rate of return r* > r, which results in
capital outflows.
(b) military commitments in Europe and Asia.
(c) The Vietnam war also caused inflation in the US.

International reserve assets of the US
During the years 1958-1971, the US experienced a
cumulative reserve deficit of $56 billion. International
reserve in other countries mainly consisted of US dollar
and gold, although the currencies of other major countries
were reserve assets but they played a minor role.
US reserve assets included foreign currencies such as Yen,
DM and British pound at first. However, by the end of the
1960s, the US international reserve consisted mainly of
gold.
Some of the fundamentals are wrong (p, w, r, Y, e). The first
best policy is a devaluation of USD. All other policies such
as lowering interest rates are second best.

Increasing liabilities to foreign central
banks
During this period (from 1958 to 1971), the
US not only witnessed a gradual depletion
of its international reserve assets but also a
dramatic increase in liabilities to foreign
central banks.
Gold Coverage of a currency
= Gold held by the Fed/Liabilities to Foreign
Central Banks

Gold coverage in 1963 Gold coverage in 1971
(a few months after Nixon’s
declaration of dollar’s
gold inconvertibility)

By 1963, the US gold reserve at FRB New
York (Manhattan) barely covered liabilities
to foreign central banks, and by 1970 the
gold coverage had fallen to 55%, by 1971
22%. Thus, from 1963, had the foreign
central banks tried to convert their dollar
reserves into gold, the US would have been
forced to abandon dollar's gold
convertibility.

Collapse of the Bretton Woods
Temporary measures
To lesson the outflow of private capital, the
US imposed an interest equalization tax
in 1963. This was effective to curb
temporarily the outflow of portfolio
investment. However, because r* > r, it was
more than offset by a big jump in US bank
loans to foreign borrowers and a further
growth in US direct investment.

(a) Voluntary Foreign Credit Restraint program was adopted
in 1965 (Canada and developing countries were
exempted). This was replaced by Mandatory Investment
Controls in 1968, lifted in 1975.
(b)Federal Reserve System entered into a series of
currency swap agreements with central banks of
Western Europe, Canada, and Japan. Under these
bilateral agreements, a foreign central bank provided
standby credit (in foreign currency) to the Federal Reserve
System in return for an equal amount of standby credit (in
dollar).
None of these measures reduced US basic deficit but
lessened the gold drain and dampened the speculative
capital outflows. President Nixon once raised the value of
dollar, to penalize the speculators. (It did not work).

Collapse of Bretton Woods
President Richard Nixon
The crisis of 1971 was caused by a gradual loss of
confidence in dollar. In 1970, funds began to
move at an enormous rate from the US dollar to
financial centers in Europe and Japan.
In May 1971, West Germany left the Bretton woods
system. Switzerland redeemed $50 million for
gold. In early August 1971, France sent a
battleship to New York harbor and took delivery of
$191 million in gold (Huffington Post).

Collapse of Bretton Woods
Then on August 11, the British ambassador
requested to redeem $3 billion for gold (1/3 of US
gold reserve, Tyler Durden) President Nixon
announced on August 15, 1971:
(i) a 90-day freeze on wages and prices
(ii)10% import surcharge on dutiable imports
(iii) suspension of dollar's convertibility into gold.

"Dollars for Oil" replaces "Dollars for
gold”
After the Yom Kippur war (October 6-25,
1973), in July 1974, Kissinger sent his
deputy William Simon to the Middle East.
Kissinger and Saudi royal family agreed:
(i) All of oil sales will be prices in USD
(Saudi's will not accept other currencies),
and invest surplus oil revenues in US
securities,
(ii) in return, US will protect Saudi's oil fields
and guarantee protection from Israel.

SMITHSONIAN AGREEMENT
International monetary negotiations were
undertaken within the framework of the Group of
Ten. Details were worked out by the Group of Ten
in a meeting at the Smithsonian Institution in
Washington DC in December 1971. The
agreement was then formalized by the IMF.
It was a temporary regime. The agreement
allowed member countries to vary their exchange
rates within margins of 2 ¼% on either side of the
central rates after currency realignment.

Currency realignment: Yen appreciated 17%, Mark
13.5 %, pound 9%, FF 9%. Par value of other
minor currencies were also changed. In return for
the revaluation of other currencies, the U.S.
agreed to raise the price of gold from $35 to $38
an ounce. This was equivalent to a dollar
devaluation of 8.57%.
This devaluation of dollar has no significance
because the dollar remains inconvertible. 10%
import surcharge was suppressed.
The collapse of the Bretton Woods system did not
generate a chaos as did the collapse of the
international gold standard in the 1930s.

The Smithsonian Agreement was a useless attempt
to perpetuate the adjustable peg system with a
new currency alignment.
Par Value Modification Act, 1973 (amended) With
the second devaluation of the dollar in March
1973 by 11% (the price of gold rose from $38.00
to $42.22 per ounce), the Smithsonian agreement
fell apart and other currencies were left to float
against the dollar. Bank of Japan absorbed a few
billion dollars in one week, but eventually quit.

The International Monetary Fund (IMF) is an
organization of 189 member countries, each of which
has representation on the IMF's executive board in
proportion to its financial importance, so that the
most powerful countries in the global economy have
the most voting power.
Objective
―Foster global monetary cooperation
―Secure financial stability
―Facilitate international trade
―Promote high employment and sustainable economic
growth
―And reduce poverty around the world

History
The IMF, also known as the Fund, was conceived at a
UN conference in Bretton Woods, New
Hampshire, United States, in July 1944.
The 44 countries at that conference sought to build a
framework for economic cooperation to avoid a
repetition of the competitive devaluations that had
contributed to the Great Depression of the 1930s.
Countries were not eligible for membership in the
International Bank for Reconstruction and
Development (IBRD) unless they were members of
the IMF.

IMF, as per Bretton Woods agreement to
encourage international financial cooperation,
introduced a system of convertible currencies at
fixed exchange rates, and replaced gold with the
U.S. dollar (gold at $35 per ounce) for official
reserve.
After the Bretton Woods system (system of fixed
exchange rates) collapsed in the 1971, the IMF
has promoted the system of floating exchange
rates. Countries are free to choose their
exchange arrangement, meaning that market
forces determine the value of currencies relative
to one another. This system continues to be in
place today.

During 1973 oil crisis, IMF estimated that
the foreign debts of 100 oil-importing
developing countries increased by 150%
between 1973 and 1977, complicated
further by a worldwide shift to floating
exchange rates. IMF administered a new
lending program during 1974–1976 called
the Oil Facility. Funded by oil-exporting
nations and other lenders, it was available
to nations suffering from acute problems
with their balance of trade due to the rise in
oil prices.

IMF was one of the key organisations of the
international economic system; its design
allowed the system to balance the rebuilding of
international capitalism with the maximisation of
national economic sovereignty and human
welfare, also known as embedded liberalism.
The IMF played a central role in helping the
countries of the former Soviet bloc transition from
central planning to market-driven economies.

In 1997, a wave of financial crises swept over
East Asia, from Thailand to Indonesia to Korea
and beyond. The International Monetary Fund
created a series of bailouts (rescue packages)
for the most-affected economies to enable them
to avoid default, tying the packages to currency,
banking and financial system reforms.

Global Economic Crisis (2008): IMF
undertook major initiatives to strengthen
surveillance to respond to a more
globalized and interconnected world.
These initiatives included revamping the
legal framework for surveillance to cover
spill-overs (when economic policies in one
country can affect others), deepening
analysis of risks and financial systems,
stepping up assessments of members’
external positions, and responding more
promptly to concerns of the members.

Functions
Provides Financial Assistance: To provide
financial assistance to member
countries with balance of payments
problems, the IMF lends money to
replenish international reserves,
stabilize currencies and strengthen
conditions for economic growth. Countries
must embark on structural adjustment
policies monitored by the IMF.

Functions
IMF Surveillance: It oversees the
international monetary system and
monitors the economic and financial
policies of its 189 member countries. As
part of this process, which takes place both
at the global level and in individual
countries, the IMF highlights possible risks
to stability and advises on needed policy
adjustments.

Functions
Capacity Development: It provides technical
assistance and training to central banks,
finance ministries, tax authorities, and other
economic institutions. This helps countries
raise public revenues, modernize banking
systems, develop strong legal frameworks,
improve governance, and enhance the
reporting of macroeconomic and financial
data. It also helps countries to make progress
towards the Sustainable Development
Goals (SDGs).

IMF Reforms
IMF Quota: a member can borrow up to 200
percent of its quota annually and 600 percent
cumulatively. However, access may be higher in
exceptional circumstances.
IMF quota simply means more voting rights and
borrowing permissions under IMF. But it is
unfortunate that IMF Quota’s formula is designed
in such a way that USA itself has 17.7% quota
which is higher than cumulative of several
countries. The G7 group contains more than 40%
quota where as countries like India & Russia
have only 2.5% quota in IMF.

Due to discontent with IMF, BRICS countries
established a new organization called BRICS bank
to reduce the dominance of IMF or World Bank and
to consolidate their position in the world as BRICS
countries accounts for 1/5th of WORLD GDP and
2/5th of world population.
It is almost impossible to make any reform in the
current quota system as more than 85% of total
votes are required to make it happen. The 85% votes
does not cover 85% countries but countries which
have 85% of voting power and only USA has voting
share of around 17% which makes it impossible to
reform quota without consent of developed countries.

2010 Quota Reforms approved by Board of
Governors were implemented in 2016 with
delay because of reluctance from US
Congress as it was affecting its share.
Combined quotas (or the capital that the
countries contribute) of the IMF increased to a
combined SDR 477 billion (about $659 billion)
from about SDR 238.5 billion (about $329
billion). It increased 6% quota share for
developing countries and reduced same
share of developed or over represented
countries.

More representative Executive Board:
2010 reforms also included an
amendment to the Articles of Agreement
established an all-elected Executive
Board, which facilitates a move to a more
representative Executive Board.
The 15th General Quota Review provides
an opportunity to assess the appropriate
size and composition of the Fund’s
resources and to continue the process of
governance reforms.

• One proposed reform is a movement towards
close partnership with other specialist agencies
such as UNICEF, the Food and Agriculture
Organization (FAO), and the United Nations
Development Program (UNDP).
• IMF loan conditions should be paired with other
reforms—e.g., trade reform in developed
nations, debt cancellation, and increased
financial assistance for investments in basic
infrastructure.

• COVID-19 Financial Assistance and Debt
Service Relief
• The IMF is providing financial assistance and
debt service relief to member countries facing
the economic impact of the COVID-19 pandemic.
overview of assistance approved by the IMF’s
Executive Board since late March 2020 under its
various lending facilities and debt service relief
financed by the Catastrophe Containment and
Relief Trust (CCRT). Overall, the IMF is currently
making about $250 billion, a quarter of its $1
trillion lending capacity, available to member
countries.

As part of the COVID19-related rapid arrangements,
borrowing countries have committed to undertake
governance measures to promote accountable and
transparent use of these resources.
Total Debt Relief for 29 Countries:
1st Tranche: SDR 183.13 million / US$ 251.24 million
2nd Tranche: SDR 168.40 million / US$ 237.46 million
3rd Tranche: SDR 168.07 million / US$ 238.05 million
Debt service relief total: SDR 519.60 million / US$ 726.75
million
https://www.imf.org/en/Topics/imf-and-
covid19/COVID-Lending-Tracker#APD
Total Financial Assistance for 85 Countries:
SDR 81,715.40 million / US$ 113,067.08 million

The Executive Board of the International Monetary
Fund (IMF) today approved a disbursement to
the Central Bank of Solomon Islands for an
amount of SDR 20.8 million (about US$28.5
million, 100 percent of quota), comprising SDR
6.93 million (about US$ 9.5 million, 33.3 percent
of quota) under the Rapid Credit Facility (RCF)
and SDR 13.87 million (about US$ 19 million,
66.7 percent of quota) under the Rapid
Financing Instrument (RFI) to help cover urgent
balance of payments needs stemming from the
COVID-19 pandemic.

The Rapid Financing Instrument (RFI) provides
rapid financial assistance, which is available to
all member countries facing an urgent balance of
payments need.
The RFI was created as part of a broader reform to
make the IMF’s financial support more flexible to
address the diverse needs of member countries.
The RFI replaced the IMF’s previous emergency
assistance policy and can be used in a wide
range of circumstances.

The Rapid Credit Facility (RCF) provides rapid
concessional financial assistance with limited
conditionality to low-income countries (LICs) facing
an urgent balance of payments need.
The RCF was created under the Poverty Reduction
and Growth Trust (PRGT) as part of a broader
reform to make the Fund’s financial support more
flexible and better tailored to the diverse needs of
LICs, including in times of crisis.
The RCF places emphasis on the country’s poverty
reduction and growth objectives.
Financing under the RCF carries a zero interest rate,
has a grace period of 5½ years, and a final maturity
of 10 years.

IMF and India
International regulation by IMF in the field of
money has certainly contributed towards
expansion of international trade. India has,
to that extent, benefitted from these fruitful
results.
Post-partition period, India had serious
balance of payments deficits, particularly
with the dollar and other hard currency
countries. It was the IMF that came to her
rescue.

The Fund granted India loans to meet the financial
difficulties arising out of the Indo–Pak conflict of
1965 and 1971.
From the inception of IMF up to March 31, 1971,
India purchased foreign currencies of the value
of Rs. 817.5 crores from the IMF, and the same
have been fully repaid.
Since 1970, the assistance that India, as other
member countries of the IMF, can obtain from it
has been increased through the setting up of the
Special Drawing Rights (SDRs created in
1969).

India had to borrow from the Fund in the wake of the steep
rise in the prices of its imports, food, fuel and fertilizers.
In 1981, India was given a massive loan of about Rs. 5,000
crores to overcome foreign exchange crisis resulting from
persistent deficit in balance of payments on current
account.
India has availed of the services of specialists of the IMF
for the purpose of assessing the state of the Indian
economy. In this way India has had the benefit of
independent scrutiny and advice.
The balance of payments position of India having gone
utterly out of gear on account of the oil price escalation
since October 1973, the IMF has started making
available oil facility by setting up a special fund for the
purpose.

India wanted large foreign capital for her
various river projects, land reclamation
schemes and for the development of
communications. Since private foreign
capital was not forthcoming, the only
practicable method of obtaining the
necessary capital was to borrow from the
International Bank for Reconstruction
and Development (i.e. World Bank).

Early 1990s when foreign exchange reserves – for two
weeks’ imports as against the generally accepted 'safe
minimum reserves' of three month equivalent —
position were terribly unsatisfactory. Government of
India's immediate response was to secure an emergency
loan of $2.2 billion from the International Monetary Fund
by pledging 67 tons of India's gold reserves as collateral
security. India promised IMF to launch several structural
reforms (like devaluation of Indian currency, reduction in
budgetary and fiscal deficit, cut in government expenditure and
subsidy, import liberalisation, industrial policy reforms, trade
policy reforms, banking reforms, financial sector reforms,
privatization of public sector enterprises, etc.) in the coming
years.

• The foreign reserves started picking up
with the onset of the liberalisation policies.
• India has occupied a special place in the
Board of Directors of the Fund. Thus,
India had played a creditable role in
determining the policies of the Fund.
This has increased the India’s prestige in
the international circles.

Evaluations of International Monetary System
Gold Standard:
Gold has historically been used as a medium of
exchange primarily due to its scarce availability and
desirable properties. Besides its durability, portability,
and ease of standardization, the high production
costs of the yellow metal make it costly for
governments to manipulate short-run changes in its
stock.
As gold is commodity money, it tends to promote price
stability in the long run. Thus, the purchase power of
an ounce of gold will tend toward equality with its
long-run cost of production.

The various versions of gold standards used
were:
Gold specie standard:
The actual currency in circulation consists of gold
coins with fixed gold content.
Gold bullion standard:
The currency in circulation consists of paper notes
but a fixed weight of gold remains the basis of
money. Any amount of paper currency can be
converted into gold and vice versa by the
country’s monitory authority at a fixed conversion
ratio.

Gold exchange standard:
Paper currency can be converted at a fixed rate into
the paper currency of the other country, if it is
operating a gold specie or gold bullion standard.
Such an exchange regime was followed in the post-
Bretton Woods era.
Exchange rates from 1876 to 1913 were generally
dictated by gold standards. Each country backed up
its currency with gold, and currencies were
convertible into gold at specified rates. Relative
convertibility rates of the currencies per ounce of
gold determined the exchange rates between the
two currencies.

Gold standard was suspended following World War I in 1914 and
governments financed massive military expenditure by printing
money. This led to a sharp rise both in the supply of money
and market prices. Hyperinflation in Germany presents a
classic example where the price index rapidly shot from 262 in
1919 to 12,61,60,00,00,00,000 (a factor of 481.5 billion) in
December 1923.
The US and some other countries returned to gold standards so
as to achieve financial stability, but following the Great
Depression in 1930, gold standards were finally abandoned.
Some countries attempted to peg their currencies to the US
dollar or British pound in the 1930s but there were frequent
revisions.
This followed severe restrictions on international transactions and
instability in the foreign exchange market, leading to a decline
in the volume of international trade during this period.

Fixed Exchange Rates:
In July 1944, representatives of 44 allied nations
agreed to a fixed rate monetary system and setting
up of the International Monetary Fund in a
conference held in Bretton Woods, New Hampshire.
Each member country pledged to maintain a fixed or
pegged exchange rate for its currency vis-a-vis gold
or the US dollar.
Since the price of each currency was fixed in terms of
gold, their values with respect to each other were
also fixed. For instance, price of one ounce of gold
was fixed equal to US$35. This exchange regime,
following the Bretton Woods Conference, was
characterized as the Gold Exchange Standard.

In the Bretton Woods era, which lasted from 1944
to 1971, fixed exchange rates were maintained
by government intervention in the foreign
exchange markets so that the exchange rates
did not drift beyond 1 per cent of their initially
established levels.
Under the Bretton Woods system, the US dollar
effectively became the international currency.
Other countries accumulated and held US dollars
for making international payments whereas the
US could pay internationally in its own currency.

By 1971, the foreign demand for the US
dollar was substantially less than the
supply and it appeared to be overvalued.
On 15 August 1971 the US government
abandoned its commitment to convert the
US dollar into gold at the fixed price of
US$35 per ounce and the major currencies
went on a float.

In an attempt to revamp the monetary
system, consequent to a conference of
various countries’ representatives, the
Smithsonian Agreement was concluded in
December 1971, which called for a
devaluation of US dollar by 8 per cent
against other currencies and pegging the
official price of gold to US$38 per ounce.
Besides, 2.25 per cent fluctuations in either
direction were also allowed in the newly
set exchange rates.

Pros and cons of fixed exchange rate
system:
Under the fixed exchange rate system,
international managers can operate their
international trade and business activities
without worrying about future rates.
However, companies do face
repercussions of currency devaluation both
by their home and the host countries.
Further, the currency of each country
becomes more vulnerable to economic
upheavals in other countries.

Floating Exchange Rate System:
Even after the Smithsonian Agreement,
governments still faced difficulty in maintaining
their exchange rates within the newly
established exchange rates regime. By March
1973, the fixed exchange rate system was
abandoned and the world officially moved to a
system of floating exchange rates.
Under the freely floating exchange rate system,
currency prices are determined by market
demand and supply conditions without the
intervention of the governments.

Pros and cons of floating exchange rates:
A country under the floating exchange rate system
is more insulated from inflation, unemployment,
and economic upheavals prevalent in other
countries. Thus, the problems faced in one
country need not be contagious to another.
The adjustment of exchange rates serves as a form
of protection against exporting economic
problems to other countries. Besides, the central
bank of a country is not required to constantly
maintain the exchange rates within the specified
limits and to make frequent interventions.

Although other countries are reasonably
insulated from the problems faced by one
country under the freely floating exchange
rates, the exchange rates themselves can
further aggravate the economic woes of a
country plagued by economic problems
and unemployment.
This possibility makes it essential for
international managers to devote
substantial resources to measure and
manage the exposure to exchange rate
fluctuations.

Special Drawing Rights (SDR)
Special drawing rights (SDRs) are supplementary foreign
exchange reserve assets defined and maintained by
the International Monetary Fund (IMF)
SDR is not a currency, instead represents a claim to
currency held by IMF member countries for which they
may be exchanged.
The value of an SDR is defined by a weighted currency
basket of four major currencies: the US dollar, the euro,
the British pound, the Chinese Yuan and the Japanese
yen
Central bank of member countries held SDR with IMF which
can be used by them to access funds from IMF in case of
financial crises in their domestic market

Controversy over Regulation of International
Finance
As the global market expands, the need for
international regulation becomes urgent. Since
World War II, financial crises have been the
result of macroeconomic instability until the
fatidic week end of September 15 2008, when
Lehman Brothers filed for bankruptcy. The
financial system had become the source of its
own instability through a combination of greed,
lousy underwriting, fake ratings and
regulatory negligence.

Controversy over Regulation of International
Finance
From that date, governments tried to put together a
new regulatory framework that would avoid using
taxpayer money for bailout of banks.
In an uncoordinated effort, they produced a series
of vertical regulations that are disconnected from
one another. That will not be sufficient to stop
finance from being instable and the need for
international and horizontal regulation is urgent.

Developing Countries' Concerns,
in three areas where further change is certainly
needed:
-First, the international financial architecture, where
important reforms have been made, but where
the hard work of implementation still lies ahead;
-Second, in international financial regulation, where
there is more work to do to ensure that the right
incentives are in place for financial institutions in
developed and developing markets to manage
their risks more effectively in future; and
-

Developing Countries' Concerns,
Third, in emerging market countries
themselves, where there is a need for
more practical efforts to upgrade
accounting and legal standards, and
systems of financial regulation, and of
course to clean up the balance sheets of
banking systems which, in many cases,
remain very fragile.

The main elements of that quiet
revolution are:
- much more outreach for banking
supervisors, above all to supervisors in
emerging markets;
- increasing acceptance by all supervisors
that core principles of supervision,
rigorously applied in all countries of the
world, are essential;
- increasing acceptance of the need for
external monitoring to ensure compliance
with those core principles;

- a willingness by supervisors to work much
more closely than before with the financial
institutions as the leaders of that
monitoring exercise;
- greater willingness by supervisors to work
more closely with each other across
borders and across traditional sectors of
banking, securities and insurance;

-a willingness by the Fund and the Bank to take on
the rôle of monitoring and to integrate financial
sector surveillance and reconstruction much
more closely into their work; and
-a desire by the international financial community to
consider more carefully the threats to financial
stability, to put in place better incentives for
avoiding such crises, and to bring together the
key government officials, supervisors, central
banks and the financial institutions, through the
new Financial Stability Forum.

Exchange Rate Policy of Developing
Economies.
An exchange rate, as a price of one country's
money in terms of another's, is among the most
important prices in an open economy. It
influences the flow of goods, services, and
capital in a country, and exerts strong pressure
on the balance of payments, inflation and other
macroeconomic variables. Therefore, the choice
and management of an exchange rate regime is
a critical aspect of economic management to
safeguard competitiveness, macro economic
stability, and growth

Exchange Rate Policy of Developing Economies.
The choice of an appropriate exchange rate regime
for developing countries has been at the center
of the debate in international finance for a long
time.
―What are the costs and benefits of various
exchange rate regimes?
―What are the determinants of the choice of an
exchange rate regime and how would country
circumstances affect the choice?
― Does macroeconomic performance differ under
alternative regimes?
―How would an exchange rate adjustment affect
trade flows?

The steady increase in magnitude and variability of
international capital flows has intensified the
debate in the past few years as each of the
major currency crises in the 1990s has in some
way involved a fixed exchange rate and sudden
reversal of capital inflows.
New questions include:
―Are pegged regimes inherently crisis-prone?
― Which regimes would be better suited to deal
with increasingly global and unstable capital
markets?

While today almost every advanced nation has a
flexible exchange rate regime similar to that
advocated by Milton Friedman, most emerging
countries continue to have ‘conventional peg’.
Historical work of Milton Friedman examined the
conditions under which he thought that flexible
rates were the right system for developing
countries, and when he thought that it was
appropriate to have an alternative regime.

The currency crises in Lebanon, Turkey, and
Argentina have once again brought to the fore
the question of the optimal exchange rate regime
in an emerging country.
Almost 70 years ago, Milton Friedman published
“The case for flexible exchange rates”
(Friedman 1953).
In it he argued that a system of ‘pegged but
adjustable’ parities was highly unstable and
made a strong pitch for flexible exchange rates
regimes.

While today almost every advanced nation has a
flexible exchange rate regime similar to the one
advocated by Friedman, most emerging
countries continue to have ‘conventional peg’
(IMF 2019).
What Friedman’s views on currency and monetary
regimes in developing countries were. In a 1973
Congressional testimony, Friedman said:
“[w]hile I have long been in favor of a system
of floating exchange rates for the major
countries, I have never argued that that is
necessarily also the best system for the
developing countries.”

Milton Friedman in India: 1955 and 1963
In 1955, Milton Friedman traveled to India to advise
the Nehru government. He prepared a short
memorandum that covered, among other things,
the exchange rate issue. At the time, foreign
exchange was rationed and allocated in a
discretionary fashion.
Friedman wrote that there were only two ways to
deal with external imbalances: “First, to inflate or
deflate internally in response to a putative
surplus or deficit in the balance of payments;

Milton Friedman in India: 1955 and 1963
second, to permit the exchange rate to fluctuate…
[a method] that has been adopted by Canada
with such conspicuous success” (Friedman
1955).
He added that if a completely free float was ruled
out (for political reasons), an auction system was
a solid second-best solution. This would allow
“purchasers to use it for anything they wish and
in any currency area they wish.”

Friedman returned to India in 1965. This time he
was particularly critical of the Bretton Woods’
pegged-but-adjustable regime. A mere
devaluation, he stated, was not a solution in a
country with chronic inflation. In a lecture
delivered in Mumbai he said: “The temptation will
be to change its [the rupee’s] value from its
present level… and then try to hold it at the new
fixed level. That would be another mistake. Even
if the new exchange rates are correct when
established, once you pegged them, there is no
assurance that they will indefinitely remain
correct” (Friedman 1968).

The ten regimes are arranged under the following four
relatively homogeneous groups
(a) Floating regimes (independent floating, lightly
managed float);
(b) Intermediate regimes (managed float, crawling
broad band);
(c) Soft peg reglmes (crawling narrow band, crawling
peg, pegged within bands, fixed peg); and
(d) Hard peg regimes (currency board, currency
union/dollarization).

The floating regimes would be an appropriate choice for medium and
large industrialized countries and some emerging market economies
that have import and export sectors that are relatively small
compared to GDP, but are fully integrated in the global capital
markets and have diversified production and trade, a deep and broad
financial sector, and strong prudential standards. The hard peg
regimes are more appropriate for countries satisfying the optimum
currency area criteria (countries in the European Economic and
Monetary Union), small countries already integrated in a larger
neighboring country (dollarization in Panama), or countries with a
history of monetary disorder, high inflation, and low credibility of
policymakers to maintain stability that need a strong anchor for
monetary stabilization (currency board in Argentina and Bulgaria).

The soft peg regimes would be best for countries with
limited links to international capital markets, less
diversified production and exports, and shallow financial
markets, as well as countries stabilizing from high and
protracted inflation under an exchange rate-based
stabilization program (Turkey). These are largely but not
exclusively non emerging market developing countries .
The intermediate regimes, a middle road between
floating rates and soft pegs, aim to incorporate the
benefits of floating and pegged regimes while avoiding
their shortcomings.

The macroeconomic authorities of developing and transition
countries are faced with a difficult task.
On the one hand, the global economy is unstable with
frequent shocks, crises and volatilities. It is also a place
with fierce competition with multinational corporations of
EU, US, Japan and Korea, the emergence of China as
the factory of the world, dumping and unfair trade
practices by some exporters, etc.
On the other hand, the domestic capability of most
developing and transition countries is still weak. The
market economy is not well developed, and domestic
enterprises lack competitiveness. The government is
often saddled with inefficiency, corruption, lack of
expertise, and political pressure.

The question for the central bank governor and the
finance minister is: how do you manage monetary
policy, and especially the exchange rate, in order to avoid
unnecessary shocks and provide stable environment for
economic development? More specifically, in this age of
accelerated globalization, what is the appropriate
exchange rate system for developing or transition
countries?
The question is difficult enough, but to make the
matter even more complicated, there are many
policy goals but only one exchange rate.

If a country has the multiple exchange rate
system, the IMF will not seriously deal with
you and FDI will probably not come. It is a
good idea to unify the rates as soon as
possible.
China unified their rates in 1994 and Vietnam
did so in 1989. Unification did not give
them any big shock, and they began to
receive large amounts of FDI after that,
partly because of the improved exchange
rate system.

The government is often concerned about
the social consequences of currency
reunification, but people are usually much
better off with a unified rate than without.
The persistence of the multiple exchange
rate practice is mainly a political problem,
not economic. It is a huge and hidden
subsidy and taxation system, from which
some people benefit greatly.

The possible goals for exchange rate
management may include the following:
1. Competitiveness
2. Price stability
3. Current account adjustment
4. Domestic financial stability (protection of
balance sheets of banks and firms)
5. Public debt management
6. Avoiding speculative attacks
7. Minimizing domestic impact of a large
exogenous shock (like a regional conflict or
currency crisis)
8. Promoting FDI, growth, or industrialization

The first two goals--competitiveness and
price stability--are very fundamental and
all countries should mind them. The big
problem is that these two goals often
conflict with each other.
To maintain competitiveness (or regain it
after domestic inflation), the exchange rate
should be flexible and devaluation must be
accepted, if necessary.

On the other hand, to contain domestic
inflation or avoid imported inflation, the
exchange rate should be either stable or
even moderately overvalued (this is called
the use of the exchange rate as a nominal
anchor).
But clearly, these two requirements are not
compatible.
it keeps the exchange rate stable, it will exert a deflationary
pressure on the domestic economy so the inflation-
devaluation spiral can be avoided. But in this case,
competitiveness is lost due to overvaluation, and a
recession is likely.

The third goal--current account adjustment--is
popular but controversial. Traditionally,
devaluation is recommended to a country with a
current account (or trade) deficit. However,
whether it really works to reduce the deficit or not
must be carefully studied in the context of each
individual country. Devaluation is a double-edged
sword; as noted above, it may trigger an inflation
spiral. It may also affect the macroeconomy in
other complicated ways to offset the intended
relative-price effect

The fourth and fifth goals--protecting the
balance sheets of the private and public
sectors--are related to the question of
exchange exposure and losses. If the
currency is devalued, the value of foreign
currency-denominated debt will increase in
home currency, which creates enormous
difficulties for both the private and public
sectors. Part of this debt can be hedged,
but not all

The sixth goal--avoiding speculative attacks--can be
achieved by calming the market expectation. How can we
do this? Some economists argue that the exchange rate
should float.
Exchange rate flexibility will remind traders that the currency
can go both up as well as down, which discourages them
from betting on exchange rate stability or one-way
movement. This makes attacks less likely.
But exchange rate volatility itself may become a problem.
Perhaps the best way to avoid attacks is to avoid
overvaluation, and that is attained by frequent reviews
and proper adjustments of the exchange rate levels (i.e.,
fulfilling the competitiveness concern).

The seventh goal--minimizing impact of a large
external crisis--essentially is the question of the
timing and manner of floating. If the currency of
an important neighboring country collapses, your
currency becomes suddenly overvalued,
relatively speaking. The government must decide
whether the home currency should (partly) follow
this depreciation or remain stable.
There is no easy rule of thumb as to whether you
should float earlier, later, or not at all; it depends
on individual cases.

The eighth goal--promoting FDI, growth,
or industrialization--is, in my view, a red
herring. Such long-term real-sector
development goals cannot be pursued by
exchange rate management. The only
thing that the central bank can do for this
purpose is to maintain competitiveness
and price stability (namely, doing well in
the first two goals).

Managed float
After the Mexican (1994) and the Asian
(1997) crises, many economists began to
argue that dollar peg was dangerous. They
contend that exchange rates should be
flexible enough so adjustments are not
delayed until too late. Some even argue
that IMF should not lend to countries with a
dollar peg !

Bipolar view
Some economists--Barry Eichengreen, Stanley
Fischer and others--went even further.
According to them, the reality of the 21st century
with massive financial flows would not allow any
country to adopt a "middle" solution such as
target zones, adjustable peg, baskets, crawling
peg, etc.
They recommend that all countries, including
developing and transition ones, to converge on
either complete fix or 100% free floating.

Currency board
The currency board is an institutional arrangement to
tie money supply closely to the amount of
international reserves, so the monetary authority has
no power to issue money independently (in principle,
at least).
In the most rigid case, monetary base can be issued or
withdrawn only in exchange with foreign assets sold
or bought against the monetary authority (however,
most currency boards are not so rigid; there are
loopholes and lee ways).
With a currency board, monetary policy is not needed
so the central bank is abolished and a simpler
"monetary authority" takes over.

Dollarization
dollarization has two meanings.
Private (or inadvertent) dollarization:
people use dollars because they do not
trust domestic money or foreign money is
more convenient than domestic money.
Official dollarization: the government
declares USD to be the only official money
for the country, and abolishes domestic
money.

Multiple currency basket (proposed for East
Asia)
multiple currency baskets consisting of
dollar, yen and euro are recommended by
some economists to the developing
countries in East Asia.
These baskets are supposed to
automatically smooth the competitiveness
shocks arising from the movements of
major currencies (but they do not
automatically adjust for other shocks

Soft dollar zone (for East Asia)
Ronald McKinnon argues that neither floating
nor the currency basket is practical in East
Asia.
He notes that East Asian currencies actually
returned to the soft dollar peg after the
Asian crisis, the situation which he thinks is
desirable and reasonable.
The dollar is the key currency in the world
economy and monetary stability should be
built around it.

Virtual exchange rate stability
This is also proposed by Prof. McKinnon
(especially for major countries). There should be
a long-term, unchanging nominal exchange rate
target based on tradable PPP (for example,
$1=110 yen).
The two countries (for example, Japan and the US)
have the obligation to keep the rate within the
narrow band around this target forever. When a
large shock hits occasionally (once in a
decade?), the rate can deviate temporarily from
the target.
But after the shock is gone, the rate must return to
the original, unchanged band.

Double target zones
John Williamson (Institute of International
Economics, Washington DC) is the
champion of target zone proposals. He has
many ideas, and the double target zone is
one of them. There should be a "soft" inner
band and a "hard" outer band, so the
central bank will have three zones where
(i) it does not intervene; (ii) it can intervene;
and (iii) it must intervene.

Band-basket-crawl (BBC)
This idea, advanced by Rudiger Dornbusch
and Y. C. Park, is a variation of the target
zone proposal. The central rate should be
defined by a multiple currency basket and
there should be a band around it.
Moreover, there is a built-in inflation sliding
of the central rate. This is what I would call
a currency basket with inflation slide.

"Eclectic" view
Jeffrey Frankel wrote a paper entitled: "No
single currency regime is right for all
countries or at all times." The right choice
depends on circumstances, and each
country should adopt the most suitable
system for itself. The attempt to find a one-
size-fits-all solution is misguided.

208 gwes unit 4

Empfohlen

Empfohlen

Weitere ähnliche Inhalte

Was ist angesagt?

Was ist angesagt? (20)

Ähnlich wie 208 gwes unit 4

Ähnlich wie 208 gwes unit 4 (20)

Mehr von ASM's IBMR- Chinchwad

Mehr von ASM's IBMR- Chinchwad (20)

Kürzlich hochgeladen

Kürzlich hochgeladen (20)

208 gwes unit 4