PR0JECT REPORT ON INTERNATIONAL MONETARY SYSTEM (IMS)

PROJECT REPORT

ON

INTERNATIONAL MONETARY SYSTEM

IN PARTIAL FULFILLMENT OF THE REQUIREMENT

IN SEMISTER IV IN THE SUBJECT OF IFM
MASTER OF BUSINESS ADMINISTRATION

SUBMITTED TO:

Ms. KHUSHBU SHAH

SUBMITTED BY:

CHAUDHARY SURESH (805)

DAYMA HIRAL (806)
DAVE RAVI (807)
DESAI AJAY (809)

S.P.B. PATEL ENGG. COLLEGE (MBA PROGRAM), MEHSANA Page - 1 -

PR0JECT REPORT ON INTERNATIONAL MONETARY SYSTEM (IMS)

CONTENT

Sr.no. Particulars P.no.

1. INTRODUCTION 1

2. HISTORY OF IMS 2

a. BIMETALLISM 2

b. CLASSICAL GOLD 3
STANDARD

c. INTERWAR PERIOD 4

d. BRETTON WOODS 5
SYSTEM

e. FLEXIBLE 6
EXCHANGE RATES

3. EURO CURRENCY 7

4. CURRENCY CRISES 8

5. BIBLIOGRAPHY 9

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PR0JECT REPORT ON INTERNATIONAL MONETARY SYSTEM (IMS)

Introduction
1. What “system”? The phrase “international monetary system” (IMS) refers to the rules and
institutions for international payments. Less abstractly, it refers to the currency/monetary regimes of
countries, the rules for intervention if an exchange rate is fixed or managed in some way, and the
institutions that back those rules if there is a problem (through official credits, controls, or parity
changes). With the world divided into a camp of major currencies that float freely and permit the
free flow of capital, and another camp with varying degrees of control over exchange rates and
cross-border flows, today’s IMS is something of a “non-system.” A key notion in this setup is that
of reserve asset: so long as a country fixes or manages its exchange rate, it needs a liquid
international asset of stable value to intervene with. Since the demise of real assets like gold as
monetary anchors, the U.S. dollar has been the world’s principal reserve asset. For the most part,
that system has worked reasonably well—except when it has not.

2. What is the issue? In a nutshell, the concern brought to the fore by the crisis is the tension
between (1) the scale and volatility of global capital flows, which motivates ever larger reserve
buffers, and (2) questions about the desirability of anchoring the IMS on one country’s currency
(the U.S. dollar), given the origins of this crisis in the U.S. heart of the global financial system. As
discussed below, these tensions are not new, and to some extent reprise the difficulties experienced
by the previous—and also dollar-based—Britton Woods Monetary System. The goal of this paper is
to shed some light on the underlying tensions and touch on the reform proposals that have been
floated.

3. Outline. In offering perspectives on tensions in the IMS and possible avenues for resolving
these, this paper does not attempt definitive conclusions and remedies
—not least because many of the ideas discussed require dramatic changes in the scale of global
policy coordination, and amendments to the IMF’s Articles of Agreement. Section II begins by
outlining the problem with current arrangements for meeting the world’s demand for reserve assets
(e.g., the lack of adjustment by the reserve issuer and its “exorbitant”—if earned— privilege of low-
cost access to foreign capital). Section III asks how the demand side can be ameliorated by reducing
incentives for reserve accumulation. Although some of the proposed remedies could be
implemented quickly, they would only address part of the problem. Thus, section IV looks at the
alternatives on the supply side, ranging from competing reserve currencies to multilateral assets like
the SDR or a really new global currency. These remedies share a longer timeframe of
implementation, but present difficult trade-offs in terms of stability, efficiency, sovereignty, and
practicality. All this suggests that the current system, suitably strengthened, may endure for some
time longer.

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PR0JECT REPORT ON INTERNATIONAL MONETARY SYSTEM (IMS)

International Monetary System - Institutional framework within which:

1. International payments are made
2. Movements of capital are accommodated
3. Ex-rates are determined

An international monetary system is required to facilitate international trade, business,

travel, investment, foreign aid, etc. For domestic economy, we would study Money and
Banking to understand the domestic institutional framework of money, monetary policy,
central banking, commercial banking, check-clearing, etc. To understand the flow of
international capital/currency we study the IMS. IMS - complex system of international
arrangements, rules, institutions, policies in regard to ex-rates, int'l payments, capital flows.
IMS has evolved over time as int'l trade, finance, and business have changed, as technology
has improved, as political dynamics change, etc. Example: evolution of the European Union
and the Euro currency impacts the IMS. "Spontaneous Order."

HISTORY OF THE IMS

1. BIMETALLISM (pre-1875)

Commodity money system using both silver and gold (precious metals) for int'l payments
(and for domestic currency). Why silver and gold? (Intrinsic Value, Portable, Recognizable,
Homogenous/Divisible, Durable/Non-perishable). Why two metals and not one (silver
standard or gold standard vs. bimetallism)? Some countries' currencies in certain periods
were on either the gold standard (British pound) or the silver standard (German DM) and
some on a bimetallic (French franc). Pound/Franc ex-rate was determined by the gold
content of the two currencies. Franc/DM was determined by the silver content of the two
currencies. Pound (gold) / DM (silver) rate was determined by their ex-rates against the
Franc.

Under a bimetallic standard (or any time when more than one type of currency is acceptable
for payment), countries would experience "Gresham's Law" which is when "bad" money
drives out "good" money.

The more desirable, superior form of money is hoarded and withdrawn from circulation, and
people use the inferior or bad money to make payments. The bad money circulates, the good
money is hoarded. Under a bimetallic standard the silver/gold ratio was fixed at a legal rate.
When the market rate for silver/gold differed substantially from the legal rate, one metal
would be overvalued and one would be undervalued. People would circulate the
undervalued (bad) money and hoard the overvalued (good) money.

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PR0JECT REPORT ON INTERNATIONAL MONETARY SYSTEM (IMS)

Examples: a) From 1837-1860 the legal silver/gold ratio was 16/1 and the market ratio was
15.5/1. One oz of gold would trade for 15.5 oz. of silver in the market, but one oz of gold
would trade for 16 oz of silver at the legal/official rate. Gold was overvalued at the legal
rate, silver was undervalued. Gold circulated and silver was hoarded (or not minted into
coins), putting the US on what was effectively a gold standard.

b) France went from a bimetallic standard to effectively a gold standard after the discovery
of gold in US and Australia in the 1800s. The fixed legal ratio was out of line with the true
market rate. Gold became more abundant, lowering its scarcity/value, silver became more
valuable. Only gold circulated as a medium of exchange.

2. CLASSICAL GOLD STANDARD (1875-1914).

For about 40 years most of the world was on an international gold standard, ended with
WWI when most countries went off gold standard. London was the financial center of the
world, most advanced economy with the most int'l trade.

Gold Standard exists when most countries:

1. Use gold coins as the primary medium of exchange.
2. Have a fixed ex-rate between ounce of gold and currency.
3. Allow unrestricted gold flows - gold can be exported/imported freely.
4. Banknotes had to be backed with gold to assure full convertibility to gold.
5. Domestic money stock had to rise and fall with gold flows.

Under a gold standard, ex-rates would be kept in line by cross-country gold flows. Any
mis-alignment of ex-rates would be corrected by gold flows. Payments could in effect be
made by either gold or banknotes. If market ex-rates ever deviated from the official ex-rate,
it would be cheaper to pay in gold than in banknotes.

Example: Suppose that the U.K. Pound is pegged to gold at: £6/oz., and the French franc is
pegged to gold at FF12/oz., then the ex-rate should be FF2/Pound. If the market rate was
FF1.80/£, then the pound is undervalued in the market (one pound should buy 2 FF, it only
buys 1.8 FF). Arbitrage would re-align the ex-rate:

1. Take £500 and buy 83.33 oz of gold (£500 / 6) in U.K.

2. Sell the gold for FF1000 in France (83.33 oz. x 12)
3. Sell 1000 FF for £555.56 (FF1000 / 1.8FF/£), for an arbitrage profit of £55.56

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PR0JECT REPORT ON INTERNATIONAL MONETARY SYSTEM (IMS)

Advantages of Gold Standard:

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

Disadvantages of Gold Standard:

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

3. INTERWAR PERIOD: 1915-1944

When WWI started, countries abandoned the gold standard, suspended redemption of
banknotes for gold, and imposed embargoes on gold exports (no gold could leave the
country). After the war, hyperinflationary finance followed in many countries such as
Germany, Austria, Hungary, Poland, etc. Price level increased in Germany by 1 trillion
times!! Why hyperinflation then?? What are the costs of inflation??

US (1919), UK (1925), Switzerland, France returned to the gold standard during the 1920s.
However, most central banks engaged in a process called "sterilization" where they would
counteract and neutralize the price-specie-flow adjustment mechanism. Central banks
would match inflows of gold with reductions in the domestic MS, and outflows of gold with
increases in MS, so that the domestic price level wouldn't change. Adjustment mechanism
would not be allowed to work. If the US had a trade surplus, there would be a gold inflow
which should have increased US prices, making US less competitive. Sterilization would
involve contractionary monetary policy to offset the gold inflow.

In the 1930s, what was left of the gold standard faded - countries started abandoning the
gold standard, mostly because of the Great Depression, bank failures, stock market crashes.
Started in US, spread to the rest of the world. Also, escalating protectionism (trade wars)
brought int'l trade to a standstill. (Smoot-Hawley Act in 1930), slowing int'l gold flows. US
went off gold in 1933, France lasted until 1936.

Between WWI and WWII, the gold standard never really worked, it never received the full
commitment of countries. Also, it was period of political instability, the Great Depressions,
etc. So there really was no stable, coherent IMS, with adverse effects on int'l trade, finance
and investment.

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PR0JECT REPORT ON INTERNATIONAL MONETARY SYSTEM (IMS)

4. BRETTON WOODS SYSTEM: 1945-1972

At the end of WWII, 44 countries nations met at Bretton Woods, N.H. to develop a postwar
IMS. The International Monetary Fund (IMF) and the World Bank were created as part of a
comprehensive plan to start a new IMS. The IMF was to supervise the rules and policies of a
new fixed ex-rate regime; the World Bank was responsible for financing development
projects for developing countries (power plants, roads, infrastructure investments).

IMS established by Bretton Woods was a dollar-based, gold-exchange standard of fixed

exchange rates. The US dollar was pegged to gold at a fixed price of $35/ounce, and then
each currency had a fixed ex-rate with the $. See Exhibit 2.1 on p. 30.

Examples: $2.80/£, DM4.20/$, FF3.50/$, etc.

Advantages of Gold-Exchange System/Bretton Woods in SR:

1. Economizes on scarce resources (gold) by allowing foreign reserves ($s) to be used for
IMS payments. Easier to transfer dollars vs. shipping gold overseas under pure gold std.

2. By holding $ instead of gold as reserves, foreign central banks can earn interest vs. non-
interest bearing gold.

3. Ex-rate stability reduced currency risk, provided a stable IMS, and facilitated int'l trade
and investment, led to strong economic growth around the world in 50s and 60s.

In long run, Bretton Woods (gold-exchange system) was unstable. There was no way to:
1) devalue the reserve currency ($) even when it became overvalued or
2) force a country to revise its ex-rate upward (appreciate its currency). A country could
agree, or be pressured into devaluation, but there was no way to "revalue" a currency
upward (appreciate through contractionary policy). In the 1960s, US pursued expansionary
monetary policy (printed money) to reduce unemployment, resulting in the dollar being
overvalued and foreign currencies being undervalued according to the fixed ex-rate system.
There was no way to devalue the $, and other countries were not willing to revalue their ex-
rates upward (appreciate). Why?

Bretton Woods started to collapse in 1971, temporary measure (Smithsonian Agreement)

didn't work, fixed ex-rate regime was abandoned in 1973. Also, Nixon put wage and price
controls went into effect in 1971, were then lifted, first oil shock started in 1973 (Arab oil
embargo after Nixon gave $2.5B to Israel after Egypt attacked), oil prices doubled, no way
to stabilize the dollar. 1973- Fixed ex-rates/Bretton Woods were abandoned.

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PR0JECT REPORT ON INTERNATIONAL MONETARY SYSTEM (IMS)

5. FLEXIBLE EXCHANGE RATES: 1973-PRESENT

IMF members met in Jamaica in 1976 to agree to a new IMS including:

a. Flexible ex-rates allowed, central banks could intervene in currency markets. (Under
fixed ex-rates, you lose control over your monetary policy. Monetary policy must be
committed to maintaining the fixed ex-rate, and cannot be used to pursue other
macroeconomic goals)
b. Gold was abandoned as a reserve asset.
c. Developing countries were to get more assistance from IMF.

IMF was to provide assistance to countries facing BP/currency difficulties. (Brazil

example). IMF provides grants and loans to countries with problems under the conditions
that they follow IMF's policy prescriptions - "strings attached to aid." Reduced budget
deficits, reduced govt. spending/cutting subsidies, contractionary monetary policy, i.e.
responsible fiscal and monetary policies.

Advantages of Flexible Ex-Rates:

a. Countries have control over monetary policy

b. A true market value is established for currency, fluctuates daily to reflect market forces of
S and D.
c. Flexible ex-rates maintain BP equilibrium. Example: U.S. has trade deficit, M>X, excess
dollars in world currency markets, $ depreciates, £ appreciates, US exports will go up,
restore trade balance.

Disadvantages:

a. MNCs must be concerned about currency risk.

b. Potential abuse by central bank, reckless monetary expansion.

Major currencies like $, £ Yen, etc. are freely floating ex-rates, changing daily to reflect
market forces. Most of the rest of the world is under some type of system of "pegged ex-
rates" or "managed floating," where central bank intervention is required to maintain a
certain level of ex-rates. One system results in trading 1:1 with the dollar (Panama,
Bahamas, Belize 2:1, and Liberia), other systems trade within a certain band (range).
Currencies pegged to $, FF, SDRs, others. 36 are independently floating, no pegging or
targeting. More than 40 have "managed floating" systems that combine market forces with
pegging.

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PR0JECT REPORT ON INTERNATIONAL MONETARY SYSTEM (IMS)

European Monetary System has been replaced by the Euro, the single currency in Europe (1
ECU = 1 Euro). To qualify for euro, countries had to meet certain economic criteria:
1) Deficits/GDP less than 3%,
2) Price level stability - low and stable inflation, etc. Of the 15 countries in the European
Union, three countries decided not to join (UK, Denmark, and Sweden).

As of Jan 1, 1999:
1) the 12 countries fixed their ex-rates against each other and against the Euro, and
2) the Euro became a unit of account. For example, 3.35FF/DM. 6.55 FF/Euro. FF and DM
will float against the $, £ and Yen, but will be fixed against each other and against the Euro.
Fixed ex-rate system for the 12 countries.

Euro currency (euro as a medium of exchange) started to circulate on Jan. 1, 2002. Old
currency and Euros BOTH circulated for the first 6 months, then old currency was taken out
of circulation and only Euros now exist.
Changes:
1) Stores now quote prices in Euros.
2) Payment in Euros can be made with charge cards and checking accounts
3) Euro currencies options are now traded
4) Stock prices/indexes are quoted in Euros.
5) European Central Bank (ECB) established to conduct monetary policy in Europe.
Governing Council made up of 12 ECB governors, one from each country, and 6 member
Executive Board.

Main Advantages of Euro (€):

1. Significant reduction in transaction costs for consumers, businesses, governments, etc.
(estimated to be .4% of European GDP, about $50B!)
European Saying: If you travel through all 15 countries and exchange money in each
country but don't spend it, you end up with 1/2 of the original amount!
2. Elimination of currency risk, which will save companies hedging costs.
3. Promote corporate restructuring via M&A activity (mergers and acquisitions), encourage
optimal business location decisions.

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PR0JECT REPORT ON INTERNATIONAL MONETARY SYSTEM (IMS)

Main Disadvantage of Euro:

Loss of control over domestic monetary policy and exchange rate determination.

Suppose that the Finnish economy is not well-diversified, and is dependent on exports of
paper/pulp products, it might be prone to "asymmetric shocks" to its economy. If there is a
sudden drop in world paper/pulp prices, the Finnish economy could go into recession,
unemployment could increase. If independent, Finland could use monetary stimulus to
lower interest rates and lower the value of its currency, to stimulate the domestic economy
and increase exports. As part of EU, Finland no longer has those options, it is under the EU
Central Bank, which will probably not adjust policy for the Eurozone to accommodate
Finland's recession. Finland may have a prolonged recession. There are also limits to the
degree of fiscal stimulus through tax cuts, since budget deficits cannot exceed 3% of GDP, a
requirement to maintain membership in EMU (to discourage irresponsible fiscal behavior).

General Consensus: Euro has been a success, and will likely emerge as the second global
currency, with the Yen as a junior partner. The success of the Euro may encourage other
areas to explore cooperative monetary arrangements (Asia, S. America). Three world
currencies at some point (¥, €, $)?

CURRENCY CRISES

Trilema: A country can attain only 2 of the following 3 conditions at one time: a) fixed
exchange rate, b) free international flows of capital, and c) independent monetary policy.

If you have an independent monetary policy and free capital flows (U.S., U.K., Euro), then
you can't maintain a fixed exchange rate, it will float.

To maintain a fixed ex-rate and allow free capital flows, you cannot have independent
monetary policy, like Hong Kong (7.8 HK$ to one USD) or Argentina (used to be 1:1) with
currency boards.

If you maintain a fixed ex-rate and pursue independent monetary policy, then you have to
impose capital controls, like China.

To avoid currency crises, a country can have: a) a really fixed ex-rate or b) a flexible ex-
rate, but NOT a fixed yet adjustable ex-rate when int'l. capital markets are integrated. See
Friedman article.

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PR0JECT REPORT ON INTERNATIONAL MONETARY SYSTEM (IMS)

BIBLIOGRAPHY

 WWW.BUSINESSWORLD.COM
 WWW.WHEREISDOC.COM
 BOOK:-
INTERNATIONAL FINANCIAL MANAGEMENT

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