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Exchange Rate

Exchange rate
Gold Standard
Purchasing Power Parity
Bretton Woods
The World Bank
The International Monetary Fund
The Smithsonian Agreement
Floating Rate System
The European Monetary Unit and The European Monetary
Asian Clearing UNION (ACU)
The Group of Seven Monetary System
Liberalised Exchange Rate Monetary System
The Euro
The exchange rate is the rate at which one currency is
converted (bought or sold) in exchange to another
The growth of international trade relationship has
resulted in the need for conversion of one currency
for another.
The buyer can pay normally only in the currency of
his country while the seller would like to receive
payment in the currency of his country.
Initially all currencies were based on the gold
With the introduction of paper currency there was an
implied understanding that the currency note if
submitted to the Central Bank could be converted
into gold.
Exchange rates between currencies were frozen based
on the gold exchange standard.
Given confidence in the ability and willingness of
governments to exchange paper for gold at a fixed
rate, individuals were content to hold and use gold
Gold was the means of international settlement for
receipts & payments.

A country was on the gold standard if:

The Central Bank agreed to buy back the currency at a

certain rate for gold.
The melting down of gold was freely allowed.
There was unrestricted import and export of gold.
The total money supply in the country was determined
by the quantum of gold reserves in the country.
Currencies under the gold standard could be
exchanged freely and the value was determined on
the gold content in the currency.
This was known as the mint parity theory of
exchange rate.
The gold bullion standard under which money was
partly or entirely paper could however be converted
to gold at any time.
As it was not expected that all holders of paper
currency would require gold at the same time, the
amount of gold was never equal to the value of the
currency in circulation.
The amount of gold required to back the paper
currency was not large.
England maintained confidence in the pound sterling
with less than 5 percent of the paper currency in
circulation actually held as reserve in gold.
The modest reserve worked because apart from the
pound sterling being the most important currency at
that time, the interest rate was adjusted to offset the
demand for gold.
When there was an outflow of reserves, the
rediscount rate on commercial paper was raised
which in turn attracted new deposits.
During a shortfall in trade, the country that had a
shortfall gave gold to the other country to correct the
disequilibrium resulting in a reduction in money
supply and in deflation.
The surplus country would have an increase in gold
resulting in an increase in money supply and
Goods in the country would become more expensive
whereas in the country with deflation it would be less
Resulting in an outflow of goods from the country
with deflation and the cycle would be repeated as the
outflow of goods would result in an inflow of gold,
which would correct the disequilibrium.
This was further underlined by interest rate changes.
A country with a deficit balance of payments would
raise interest rates resulting in an inflow of capital to
correct the balance of payments disequilibrium.
The gold standard however was too inflexible.
The domestic economy could not be shielded from
the pressures imposed upon it.
The gold system was also unable to handle and
absorb large and sudden disequilibrium situations.
The gold standard continued till World War 1, after
which it was abandoned.
There were attempts to revive it but these failed.
The depression of 1930-31, the devaluation of the
pound sterling and the abandoning of the gold
standard by Europe ended the gold standard.
Under the gold standard if you could not pay, you
did not buy.
Each currency had to redeem its currency for gold.
If a country overbought an outflow of gold would
The gold outflow would cause a reduction in the
domestic money supply, which could result in a fall
in the level of economic activity causing prices to
A fall in prices would make exports cheaper and
produce a positive trade balance.
There would thus be an inflow of gold and this would
restore the equilibrium.
After the gold standard was abandoned, exchange rates
began to be determined on the basis of purchasing
power parity.

The value of currencies must be based on what it can

buy domestically and postulates that the rate should
be such that the purchasing power of the two
currencies as reflected by its purchasing power is

Theory propounded by Dr. Gustav Cassel (1918)

Unlike under the gold standard paper currency has no
intrinsic value.
The sole criterion to determine exchange rates was
the purchasing power. It submitted that market forces
would operate to remove temporary deviations.
If there were no trade barriers, the balance of
payments equilibrium would always be maintained.
If a country had a higher rate of inflation then goods
produced will cost more than in the other country.
This would result in imports becoming cheaper and
exports becoming more expensive.
Imports would rise and there would be a fall in exports
resulting in a deficit balance of payments.
Consequently there would be a fall in currency in the first
country and an increase in currency in the second country.
As there will be an excess of currency in the second country
prices will rise, as demand will begin to exceed supply (too
much money chasing too few goods).
Inflation will be on the rise and the cost of production and thus
goods will rise.
The cycle will repeat with imports being made from the first
country and exports from the second country falling.
The equilibrium will be restored.
Exchange rates under the theory move to reflect
relative inflation rates.
The currency of a high inflation currency would have
to depreciate in relation to that of a low inflation one
to maintain the parity.
The theory required free movement of goods and no
trade controls.
The theory failed as trade controls exist and there are
other costs such as freight and taxes that are added to
the cost of goods (especially imports).
Therefore like in one country and like in another
country can never be really compared.
The World Wars played havoc with the economies of most
countries and in the 1930s there was severe depression and
There were also large adverse balances of payment and several
countries devalued their currencies in the hope that the
devaluation would result in goods becoming cheaper which
would push exports up.
As many many countries devalued, this did not actually
happen and international trade came to a standstill.
In order to restore international trade, the United States made a
proposal that was accepted at the Bretton Woods Conference
at New Hampshire, USA in July 1944 where representatives of
45 governments met.
This was the foundation of the post second world war
international monetary system.
The conference took place while the second world
war was still continuing.
Most of the European economies were devastated.
The only industrial power unaffected was the United
It is against this background that the World Bank and
the International Monetary Fund were formed for
international monetary cooperation.
The Bretton Woods agreement provided much more latitude in
managing individual countrys economy.
Countries had to maintain their exchange rates relative to the
dollar but there were ways to do this without sacrificing
domestic growth.
IMF and other central bank loans could be used to buy back
the country's currency in the open market and thus support the
exchange rate.
The system was flawed as it depended on confidence.
When the United States began to develop payment problems
and trade deficits, the dollar lost confidence and in August
President Nixon bowed to the inevitable and suspended
official purchases and sales of gold by the treasury.
The Bretton Woods system collapsed for several

World liquidity measured in terms of aggregate reserves of

member countries was not keeping pace with the growth in
world trade;
the fixed rate system was rigid and adjustments in par values
could not be done quickly;
regular and continuous adverse balance of payments in the
United States eroded confidence in the USAs ability to
convert dollars into gold at US Dollars 35 per ounce.
There was a run on the U.S. Dollar. Inflation
Trade deficits led to the United States declaring in
1971 that it would no longer convert dollars into
Other countries let their currencies float.
This brought an end to parities.
It was a consequence of the deliberations at the Bretton
Woods conference that the
International Bank for Reconstruction and
(the World Bank) was formed.
Objectives were
to lend money to war ravaged countries
to lend for the development of the economies of poor

The World Bank Group consists of

the International Development Association (IDA) and
the International Finance Corporation (IFC)

There are also regional development banks similar to

the World Bank in many parts of the World.
The World Bank works on a conservative 1:1 debit
equity ratio.
The World Bank is permitted to lend with the
guarantee of governments of member countries.
It lends at half percent over its borrowing cost.
The soft lending arm of the World Bank, the IDA
gives poorer member countries 50 year zero interest
loans and charges only a small handling fee.
Its resources are raised through donations from rich
member countries.
The International Finance Corporation is also part of
the World Bank Group.
It supports private or joint sector projects in member
It assists both in equity and in loan.
The International Monetary Fund (IMF)
was established, under whose aegis an exchange rate
system was evolved and followed for 25 years to
Aims of the IMF

To promote international monetary co-operation through a

permanent institution which provided the machinery for
consultation on international monetary problems.
To facilitate the expansion and balanced growth of
international trade and to contribute to the promotion and
maintenance of high levels of employment and real income
and to the development of productive resources.
To establish an international monetary system with stable
exchange rates and to maintain orderly exchange arrangements
among members and to avoid competitive exchange
To eliminate existing exchange controls.
To bring about convertibility of all currencies.
To assist in establishment of multilateral system of
To make funds resources available to members with
safeguard to correct adjustments.
At a monetary conference was held in December 1971, USA
agreed to devalue its currency and Japan and Germany
revalued their currencies.
The gold price was raised by the United States to U.S. Dollars
38. This was in reality a devaluation.
The intention of the Smithsonian agreement was to return to
fixed parities.
This was not possible though as the United States refused to
reinstate the convertibility of the US dollar into gold but
currencies were pegged to the US dollar with a trading band of
plus or minus 2.25 percent rather than the 1 percent used
Capital inflows could therefore not be controlled and the
Smithsonian Agreement lasted less than a year.
Market pressures were too great.
On the collapse of the fixed parity system it was
agreed and realised that it is difficult to forcibly
maintain parity.
Countries began to float their currencies and value of
the currency was determined by demand and supply
and was managed by the central bank by intervening.
If there was a great demand for the dollar, the value
of the dollar would appreciate.
In order to maintain the rate, the central bank of the
country would intervene and sell dollars to bring the
dollar value down and maintain the value.
If the value of the currency was not determined solely by
demand and supply but managed by the central bank through
intervention it was known as a dirty float

If a country had an exchange rate system under which it is able

to effect devaluation or revaluation of the home currency it
was known as crawling peg.
April 1975 - European Common Market countries
decided in the Convention de Lome to express their
aid to developing countries in a common unit. The
unit of account was defined in June 1975.
December 5, 1978 - European authorities decided on
the creation of the European Monetary System
(EMS) with a view of stabilizing the exchange rates
between the different European currencies.
March 13, 1979 - System became operational.
The European unit of account became the ECU which
was the monetary basis for the EMS.
The different component currencies are permitted to
fluctuate within a limit of + or 2.5% with the
exception of the lira for which the limit is + or 6%.
The pound sterling was outside the mechanism.
The Central Bank of the country was expected to
intervene if the limits were reached.
The European Currency Unit (ECU) was originally
planned to be the reserve and payment currency
between EMS members Central Banks.
The ECU was a currency basket of 8 EMS currencies
plus the pound sterling and Greek drachma.
The weight of each currency was determined by
economic criteria which were to be reviewed every
five years.
As the constituent currencies became stronger or
weaker and their value thus fluctuates, the relative
weight of each currency as a percentage was also
The value of the ECU was defined in each of the
constituent currencies by means of an official parity.
The pound sterling and the Greek drachma which did
not belong to the EMS were given a fictitious parity.
The Central Banks of the member countries agreed to
enforce bilateral rates but with variations on either
side of any given parity upto around 2.25% (Italian
lira 6%)
9th December 1974 ACU was established with its
headquarters in Teheran, Iran at the initiative of the
United Nations Economic and Social Commission for
Asia & Pacific (ESCAP) with the Central Banks of
Iran, India, Bangladesh, Pakistan and Sri Lanka as
the original participants.
Objectives of ACU :

Facilitating payments for current international

transactions within the ESCAP region.
Reducing/ eliminating the use of extra regional
currencies to settle such transactions by promoting
the use of participants currencies.
Effecting thereby economies in the use of foreign
exchange and a reduction in transaction costs making
payments and
The union sought to provide a solution to the foreign
exchange shortage and inconvertibility of the
currencies in the region.
The value of one AMU was to be the equivalent to
one SDR as valued from time to time by the IMF.
An important condition of clearance was that all
instruments had to be denominated in AMU or in the
currency of a member country in which one party to
the transaction resides.
Settlements were done by authorised dealers debiting/
crediting their correspondents accounts.
Settlements between participant central banks were
done through the ACU.
1970s - IMF administered fixed exchange rate system
1970s - 1980s there was no international control over
exchange rates.
1980s - while the price of oil softened, the large movements in
exchange rates continued as the foreign exchange markets
grew in size.
Capital movements dwarfed international trade in goods and
1985 - the United States convened a meeting of the Finance
Ministers of the five major industrial countries with Italy and
It was agreed to bring the US Dollar down and the countries
would intervene to achieve the objective.
March 1, 1992, the Reserve Bank of India announced
the liberalised exchange rate monetary system.

Its objectives were to make the balance of payments

sustainable on an ongoing basis.
The reason for introducing this was to:

Introduce an element of equilibrium in imports &

exports automatically.
Create flexibility in exchange rate systems
Contain the current account deficit at a sustainable
Keep capital outflows under control and monitor it.
Keep the cost of imported goods within reason.
The rupee became convertible for all approved
external transactions.
Exporters were permitted to sell up to 60% of their
money at market determined rates.
Those requiring foreign exchange could buy at
market determined rates.
There was further liberalisation and it was decided to
make the rupee fully floating from March 1, 1993.
From that date all foreign exchange transactions both
under current and capital accounts of balance of
payments are at market determined prices.
Authorised dealers can retain foreign exchange
surrendered to them were not required to surrender it
to the RBI.
To promote trade within Europe and to create an
alternate currency to the Dollar the European
political leaders took several decisions on
Economic and Monetary Union (EMU).
15th and 16th December, 1995 it was decided that
the currency union would commence on January 1,
The European currency was also given its definitive
name The Euro.
The countries that agreed to participate were
Germany France, Italy, Spain, the Netherlands,
Belgium, Austria, Finland, Portugal, Ireland and
Luxembourg a total of 11 countries.
December 13-14, 1996 - an agreement was reached in
Dublin on a new exchange rate mechanism between
the euro & other E. U. countries, on the main points
of a stability pact for budgetary discipline in the
E.M.U. and on the urgent legal aspects of the
introduction of the euro.

June 16-17, 1997 - The Dublin agreement was

formally adopted during the Amsterdam Summit.
January 1, 1999 - irrevocable conversion rates were set
between the participating currencies within the EMU.

The participating currencies would not have exchange rates

but fixed conversion rates to the euro.

January 1, 1999 to 2002 - The euro would neither be

prohibited nor prescribed.

January 1, 2002 all contracts were to be converted into euros.

National currencies of participating countries would lose their
status as legal tender.
The initiative has been successful and as a
consequence in the participating countries in Europe
today there is only one currency the Euro.

All transactions are in Euro and the old currencies

such as the French franc and the German mark no
longer exist. The only franc that now exists in Europe
is the Swiss franc.
The exchange rate is the rate at which one currency is
exchanged for another.
The manner rates evolved have changed over the years from
barter, to coins, to gold and to rates being pegged either to one
currency, a basket of currencies or to supply and demand.
On account of its crucial importance all countries and world
agencies such as the World Bank are highly focused on
movements in rates and the manner of changes made.
The latest change that has taken place is the evolution of the
Euro as a currency. It is Europe's challenge to the domination
of the US dollar.
The initiative has been hugely successful and most of Europe
has only one currency the Euro.