INTERNATIONAL MONETARY SYSTEM

Financial markets are getting more and more integrated in recent years due to
globalization and people and corporates are entering into more and more cross-boarder
financial deals and international trade. In order to make these transactions feasible, a
system for determination of the amount and method of payment of underlying financial
flows is needed. Since the domestic currencies of the parties involved will be different,
the flows will take place in some mutually acceptable currencies. The set of rules,
regulations, institutions, procedures, practices, and mechanisms which determine the
exchange rate between currencies and the movements in exchange rate over a period is
called the international monetary system. Thus, it is the institutional framework within
which international payments are made, exchange rates among currencies are determined,
international trade and capital flows are accommodated, and balance-
of-payments adjustments made.

International monetary system forms the backbone of all cross-border transactions

because it makes the settlement of international payments possible. A well-functioning
monetary system will facilitate international trade and investment and smooth adaptation
to change.

Alternative Exchange Rate Systems (Exchange Rate Regimes)

An exchange rate is the price of one currency in terms of another currency. As in the case
of any other goods, the price of a currency is affected by supply and demand. As demand
for a currency increases (or supply decreases) its price will rise. This is referred as an
appreciation. Conversely, as demand for a currency decreases, or supply increases, its
value will depreciate. The prospect of large and rapid swings in exchange rates introduces
uncertainty into the business environment. A well-functioning international monetary
system ensures stability in the exchange rates. The central element of the international
monetary system involves the arrangements by which exchange rates are set. The purpose
of an exchange-rate system is to facilitate and promote international trade and finance.
There have been three major exchange rate regimes from a historical perspective – fixed,
floating, and managed exchange rates.

Fixed Exchange Rate System

A fixed (or pegged) exchange rate system is one where governments or central banks set
official exchange rates and defend the set rates through foreign exchange market
intervention and monetary polices. Under this system, the currency is pegged to another
currency (or basket of currencies) and the central bank promises to exchange currency at
a specified rate against the other currency. Each central bank actively buys or sells its
currency in foreign exchange market whenever its exchange rate threatens to deviate
from its stated par value by more than an agreed-upon percentage.

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For example, Bahrain pegs its dinar to the U.S. dollar at a rate of 0.40 dinar per dollar.
The Bahrain central bank must always be willing to buy dinar with dollars or to buy
dollars with dinar in any amount at the fixed rate of 0.40 dinar per dollar. Otherwise, there
could be excess supply of or demand for dinar, and its value would depreciate or appreciate
to restore equilibrium. For example, if there were excess demand for dinar, the dinar would
become more valuable relative to the dollar, and the number of dinar to buy a dollar would
decrease, implying an appreciation of the dinar. In order to prevent such a move in the
exchange rate, the Bahrain central bank intervenes in foreign exchange markets to meet
the excess demand by increasing the supply of dinar through buying dollars. Thus, while
the exchange rate does not move, the dollar reserves of the central bank do change.
Were these reserves to run out, the Bahrain central bank would indeed have little choice
but to float the dinar (or, more precisely, watch the dinar float).

In order to avoid the need to respond to all movements in the supply and demand for
currency, a country may fix its currency within a band to allow some fluctuation in value.
For example, from 1979 to 1998, a number of countries participated in the European
Monetary System. Under this system, countries' exchange rates were fixed but allowed to
fluctuate up or down by as much as 6% (widened to 15% in 1993) relative to an assigned
par value. The bands allowed countries some latitude with choosing monetary policies
and also were intended to reduce the risks of speculative attacks. In 2004, only one large
economy-Denmark-used this type of exchange rate regime.

The gold standard, the Bretton Woods system, and the European Monetary System
(EMS) are historical examples of fixed exchange rate regimes, although they differ in
specific aspects.

The key features of the fixed exchange rate system are:

• Domestic currency is pegged to an anchor currency.

• Prices and interest rates have to be in line with the anchor

currency, which ensures monetary discipline.

• Central bank has responsibility to defend exchange rate by foreign

exchange market intervention.

• Central bank has to maintain adequate international reserves to

intervene in the foreign exchange market.

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The various forms of fixed exchange rate system are as follows:

1. Conventional Fixed Peg Arrangement: In this system, a country pegs its

currency at a fixed rate to a major currency or a basket of currencies with a band
of variation not exceeding plus or minus 1% around the central rate.

2. Currency Board System: Under the currency board system a country pegs its
currency with another major currency and fixes the rate of its domestic currency
in terms of that foreign currency. Its exchange rate in terms of other
currencies depends on the exchange rates between the domestic currency and
the currency to which it is pegged. . The monetary policies and the economic
variables are kept in line with that of the reference country by the central
monetary authority, called the currency board. The currency board maintains
reserves of the anchor currency up to 100% or more of the domestic currency
in circulation. This means that a unit of domestic currency cannot be
introduced into the economy without an additional unit of foreign exchange
reserves being obtained first. Currency board commits to convert its domestic
currency on demand into the anchor foreign currency to an unlimited extent,
at the fixed exchange rate. Thus, a currency board has three important
components: the establishment of a fixed exchange rate, the requirement that central
bank reserves cover 100% of the monetary base at that exchange rate, and the
obligation that the central bank meets all demand for anchor currency. As such, a
currency board imposes discipline on governments by prohibiting increases in money
supply beyond the level of reserves. It also prohibits the central bank from extending
credit to commercial banks and rules out a role as lender of last resort. Clearly, a
currency board does not make a country immune to speculative attack. But it
provides a more credible guarantee of a country's commitment to a fixed
exchange rate by limiting the ability of traders to launch speculative attacks against
the local currency.

3. Crawling Pegs: Another variation on a fixed exchange rate regime is the

crawling peg or crawling band. Under a crawling peg, the central bank adjusts the
value of its currency periodically in small amounts at a fixed, preannounced rate
or in response to changes in specific indicators.

4. Target Zone Arrangement: A group of countries agree to maintain the

exchange rate between the currencies within the certain band around fixed
central exchange rates. The system is called the target zone arrangement in
which convergence of economic policies of the participating countries are a
prerequisite for this system.

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 5. Monetary Union: Under this system the member nations of monetary unions
agree to use a common currency, instead of their individual currencies. This
wipes out the fluctuations of exchange rates and the attendant inefficiencies
completely. A common central bank of member countries is set up, which has
the sole authority to issue currency and to determine the monetary policy of
the group as a whole. The central bank has the power to alter economic
variables of member nations to maintain the same inflation rate in all the member
nations. European monetary union is an example of a monetary union. It has
its own common currency (Euro) and has a common central bank.

The ability of the central bank to defend its currency under a fixed exchange rate regime is
limited by its stock of foreign exchange reserves and by its ability to raise interest rates. If
there is persistent excess demand for anchor currency, the central bank must sell anchor
currency, and its reserves therefore fall. If the central bank's reserves run low and it is
unable to secure financing from private markets, it may have to devalue the
exchange rate. Likewise, countries may be unable to increase interest rates to the
levels necessary to defend their national currency, maybe because unemployment is too high
already or the public debt is becoming unsustainable.

Advantages of a fixed exchange rate regime

• It leads to orderly foreign exchange market.

• Fixed exchange rates require countries to adopt restrictive

monetary and fiscal policies that foster an anti-inflationary environment. Thus it
ensures monetary and fiscal discipline on the domestic economy.

• Fixed exchange rate regimes promote institutional credibility by

signaling monetary discipline.

• It promotes international trade by providing stability in

international prices and reducing the cost of trading.

Disadvantages of fixed exchange rate regime

• Loss of monetary independence: Central bank cannot use money

supply as a tool to
stimulate the economy. The central bank would also be unable to respond to
unemployment through lowering the interest rate to stimulate investment because of
concerns about the effect on the exchange rate.

• Burden to keep adequate reserves.

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 • It is subject to destabilizing speculative attacks. Example,
speculative attacks on British pound in 1992, on east Asian currencies in 1997 and
Argentinean peso in 2001.

• Danger of sudden collapse of system and financial and economic

instability.

• Fixed rates may be maintained at rates that are inconsistent with

economic fundamentals, thereby exacerbating periods of recession.

Floating or Flexible Exchange Rate System

A floating or flexible exchange rate system is one in which the exchange rate between
currencies is determined purely by supply and demand of the currencies without any
government invention. The rates depend on the flow of money between the countries,
which may either result due to international trade in goods or services, or due to purely
financial flows. Hence in case of a deficit or surplus in the balance of payment, the
exchange rates get automatically adjusted and this leads to a correction of the
imbalance.

In a floating exchange rate system, economic parameters like price level changes,
interest differentials, economic growth and government policies have an impact on
the exchange rate as these factors influence the supply and demand of currencies.

A purely floating exchange rate system is more of a theoretical benchmark rather than
reality in practice. Most economies fall in between the two extremes – a rigidly fixed
system and a purely floating system. The United States, the EU, and Japan are close to
the flexible exchange rate system, although central banks of these countries intervene in
the foreign exchange market from time to time.

Key features of a floating exchange rate system are:

• No government intervention required.

• Exchange rate determined by market forces.

• Frequent fluctuations.

• Balance of payments adjusts simultaneously with the exchange

rate.

Floating exchange rates can be of two types:

• Free float and

• Managed float

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Free float: Under the free float, market exchange rates are determined by the interaction
of currencies' supply and demand. The supply and demand schedules, in turn, are
influenced by price level changes, interest differentials and economic growth. As
these economic parameters change, market participants will adjust their current and
expected future currency needs. There is no intervention either by the government or by
the central bank.

Managed float: In the free float, there is always an uncertainty in exchange rate
movements that reduce economic efficiency by acting as a tax on trade and
foreign investments. In order to reduce the volatility associated with the free float, the
central bank generally intervenes in the currency markets to smoothen the fluctuations.
Such a system of managed exchange rates is referred to as a managed float or a dirty float.

There are three approaches to manage the float:

1. Smoothing out daily fluctuations: The central bank may occasionally enter the
market on the buy or sell side to ease the transition from one rate to another,
rather than resist fundamental market forces, tending to bring about long-term
currency appreciation or depreciation.
2. “Leaning against wind”: This approach is an intermediate policy designed to
moderate an abrupt short and medium-term fluctuations brought about by random
events whose effects are expected to be only temporary. Intervention may take
place to prevent these short and medium-term effects, while letting the markets
find their own equilibrium rates in the long-term, in accordance with the
fundamentals.
3. Unofficial pegging: In the third variation, though officially the exchange rate
may be floating, in reality the central bank may intervene regularly in the
currency market, thus unofficially keeping it fixed.

Advantages of Floating Exchange Rate System

• Since the country is not required to defend the exchange rate at a

certain level, the government and central bank are free to choose independent
domestic macroeconomic policies to deal with domestic issues such as inflation or
unemployment.

• Under floating exchange rate regime, market intervention by the

central bank is not required to defend the exchange rate.

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 • Since there is no need for market intervention, there is only very
low requirement for international reserves.

• For countries that lack monetary and fiscal disciplines, a floating

exchange rate sets no pressure for a country to observe these disciplines.

Disadvantages of Floating Exchange Rate System

• Floating exchange rate system is susceptible to large swings in the

exchange rate causing substantial swings in the real economy, especially in the case
of small emerging market economies where exports, imports, and international capital
flows make up a relatively large share of the economy.

• Floating exchange rate system provides uncertainty and exchange

rate risk in international trade and investment. Although exchange rate risk could be
hedged under a floating exchange rate regime, such hedges could be expensive.

• Since the volatility in exchange rate is higher under floating

exchange rate system, any depreciation of the domestic currency may disrupt the
financial system, especially in the case of a country where banks make significant
loans in foreign currency.

Managed Exchange Rate System

A managed-exchange-rate system is a hybrid of fixed and flexible rates in which

governments attempt to affect their exchange rates directly by buying or selling foreign
currencies or indirectly, through monetary policy, by raising or lowering interest rates.

Other Exchange Rate Regimes

There have been other arrangements that are variations of the one of the three regimes.
Each of these exchange rate regimes has its own characteristics which may be classified
in the following dimensions: the role of the government, how the exchange rate is
determined, and how a balance of payments imbalance is adjusted. For example, under a
purely floating exchange rate system, the central bank does not intervene in the foreign
exchange market; the exchange rate is determined purely by market forces; the balance of
payments and the exchange rates adjust simultaneously to equilibrium.

Convertibility of currency

In addition to exchange rate policy (what type of exchange rate regime to adopt), a
country also has to decides whether to allow free convertibility of its currency to other
currencies. Based on the two major parts of the balance of payments, convertibility can
be applied to either account alone or both. Current account convertibility means that
foreign exchange can be freely bought and sold provided its use is associated with
international trade in goods and services. But there are still restrictions when the intended

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use of the foreign exchange is to purchase foreign financial assets or to make equity
investments. Free trade in currencies for the latter purpose is called capital account
convertibility. If convertibility is allowed for transactions in both the current and the
capital accounts, we say there is full convertibility. Full convertibility is equivalent to
free capital mobility. Restrictions on convertibility are referred to as foreign exchange
control.

A Brief History of the International Monetary System

The international monetary system went through several distinct stages of evolution in
the past. These stages can be summarized as follows:

1. The Bimetallism: Before 1875

2. Classical Gold Standard: 1875-1914
3. The Gold-Exchange Standard: Inter-war period 1915-1944
4. Bretton Woods System: 1945-1972
5. Flexible Exchange Rate Regime: Since 1973.

These five stages are briefly examined in the following sections.

Bimetallism

Prior to 1870 many countries had bimetallism, that is, a double standard in that free
coinage was maintained for both gold and silver. The international monetary system
before 1870s can be characterized as “bimetallism” in the sense that both gold and silver
were used as international means of payment and that the exchange rates among
currencies were determined by either their gold or silver contents.

Gold Standard

The gold standard, which is a fixed exchange rate system, in its classical form, was
followed from 1875 to 1914. Under the gold standard, all major countries set values for their
currencies in terms of gold and agreed to buy and sell gold on demand with any other
country at that rate. As such, all exchange rates were fixed against one another. For
example, the United States agreed to buy and sell gold for $20.67 per ounce, while
Britain set the rate at 4.2474 pounds per ounce. The dollar-pound exchange rate was
therefore fixed at 4.8665 dollars per pound. If the exchange rate veered from this value to,
say, 5 dollars per pound, gold traders could buy gold in the United States for $20.67 and
sell it in London for $21.237. With excess demand for U.S. gold, the exchange rate would
quickly be pushed back to 4.8665 dollars per pound.

In order to fix their exchange rates in this way, countries had to maintain adequate gold
reserves.

Some of the characteristics of the gold standard include the gold contents of currencies,
money supply being determined by a country’s gold stock, and automatic adjustment of

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the balance of payments and prices (and the entire economy) or no requirement of
government intervention.

The main advantages of the gold standard were its monetary discipline and symmetric
monetary adjustment. There was monetary discipline because central banks throughout
the world were obliged to fix the money price of gold. They could not allow their money
supplies to grow more rapidly than real money demand, since such rapid monetary
growth eventually raises the money prices of all goods and services, including gold.
Symmetric monetary adjustment refers to the fact that no country in the system
occupied a privileged position by being relieved of the commitment to intervene (or to
defend the value of its currency). Countries shared equally in the cost or burden (relative
prices changes, unemployment or recession) of balance of payments adjustment.

The gold standard had a number of drawbacks as well. Since the money supply was tied
up to the stock of gold in a country, there were constraints on the use of monetary policy
to fight unemployment. In a worldwide recession, it might be desirable for all countries to
expand their money supplies jointly even if this were to raise the price of gold in terms of
national currencies. But they could not do that if they were to keep the gold standard. A
second drawback was a reserve shortage. As the economy grew, more money would be
needed to facilitate the increasing economic transactions. But limits in gold supply might
not keep up with economic growth and therefore would hinder economic growth.
Another drawback of the gold standard was the asymmetric distribution of gold
production and stock. The gold standard could give countries with potentially large gold
production considerable ability to influence macroeconomic conditions throughout the
world through market sales of gold.

Failure of Gold Standard

The gold standard was suspended with the outbreak of World War I, which interrupted
trade flows, restricted the free movement of gold, and resulted in high inflation for many
countries.

The outbreak of World War I was a direct cause for the collapse of the gold standard.
Governments abandoned the gold standard during the war and financed part of their
massive military expenditures by printing money without the backing of gold. Further,
labor forces and productive capacity had been reduced sharply through war losses. As a
result, price levels were higher everywhere at the war's conclusion in 1918. The loss of
confidence in the British pound as a reserve currency was another reason. A reserve
currency is one that the central banks hold in their international reserves, and under a
fixed exchange regime, each nation’s central bank fixes its currency’s exchange rate
against the reserve currency by standing ready to trade domestic money for reserve assets

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at that rate. Under gold standard, the British pound was the reserve currency and was
regarded as good as gold. The U.K. deficits in its balance of payments made other
countries worry about the U.K.’s inability to convert £s into gold.

During the inter-war years (1918-1939), several countries returned briefly to gold
standard. But as the great depression continued, many countries renounced their gold
standard obligations and allowed their currencies to float in the foreign exchange market.
Inflation was rampant in some economies at the end of WWI. The loss of confidence in
the U.K., the existence of multiple reserve currencies (£, $, French franc) and the
hyperinflation in Germany all contributed to the failure to restore the gold standard.
Multiple attempts in the following years to revive the gold standard failed.

The Gold-Exchange Standard

After the gold standard broke down during the World War I, it was briefly reinstated from
1925 to 1931 as the Gold exchange Standard. Under this standard, the United States and
England could only hold gold reserves, but other nations could hold both gold and dollars or
pounds as reserves. In 1931, England departed from gold in the face of massive gold and
capital flows, owing to an unrealistic exchange rate, leading to the failure of the gold
exchange standard.

The Bretton Woods System of Exchange Rates

In 1944 the major Allied trading nations met in Bretton Woods, New Hampshire, to lay the
basis for the post-World War II payments and trading system. In addition to designing
the framework for a new international monetary system, they created two
international institutions - the International Bank for Reconstruction and Development (the
World Bank) and the International Monetary Fund. Since the participating officials believed
that the inter-war Great Depression had been aggravated by the instability of exchange rates
and restrictions on currency convertibility, representatives to the Bretton Woods meetings
concluded that the post-War system should be governed by fixed exchange rates.

Following the perceived success of the classical gold standard prior to 1914, the new system was
to include a link to gold. However, in 1944 about 70 percent of the world's monetary gold
was in the hands of the United States. Thus, there emerged a system that has been called the
"gold exchange standard."

Under the Bretton Woods gold exchange standard, the United States committed itself
to buy gold from, or sell gold to, any participating country's official monetary institution
for $35 per ounce. But - in contrast to the classical gold standard - the United States
undertook no commitment to transact in gold with private parties, whether they were U.S.
citizens or foreign citizens. The other participating countries agreed to constrain the
value of their currencies within plus or minus one percent of an announced "par rate" with the

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U.S. dollar. A country was only allowed to change this par rate (devalue or revalue) in
response to a "fundamental disequilibrium" in its balance of payments. The system was to
be overseen by the International Monetary Fund, which had the capacity to lend, in limited
amounts, currencies to countries in temporary need, and which was supposed to
be consulted about any proposed changes in par values.

Under the Bretton Woods arrangements, a country was obligated to intervene in the foreign
exchange market if its exchange rate began to move outside the one percent band
around its announced par value with the dollar. If, for example, the German mark began to fall
in value and approach its one percent limit from the par value, the German central bank would
buy marks in the foreign exchange markets. It would generally use dollars for such an
intervention, although it was free to use any currency. If it needed dollars to sell for
marks, it could sell gold from its reserves to the United States, which was obligated to buy
them for dollars. It could then use those dollars to support the mark. On the other hand,
if the mark were to rise in value, the German central bank would be expected to sell marks in
the market; generally, it would acquire dollars in exchange, which it could hold in
reserve (and earn interest, if it invested them, in US Treasury securities, for
example) for future intervention, or it could sell them to the United States in exchange for
gold.

Since a major goal of the participants in the Bretton Woods meetings was expansion of
international trade, member countries were encouraged to make their currencies freely
convertible for trade-related (or current account) transactions. Most Western
European countries achieved this goal in 1958, and Japan followed in the early 1960s.
Most countries maintained some kind of controls over capital account transactions for a
number of years. Until October 1979, for example, a British citizen could not use his
or her pounds to buy dollars for capital transactions (say to buy foreign stocks)
without the permission of the British government. The United States, however, did not
impose foreign exchange controls, with the exception of a period in the late 1960's when it
limited foreign direct investment by U.S. firms and imposed a tax on the purchases by
Americans of bonds and equities from foreign countries.

Key features of Bretton Woods System are:

Reserves:

Gold, U.S. $ and SDR (added in 1960s)

The U.S. dollar replaced the British pound as the reserve currency and was treated as
good as gold.

Fixed parities

Under the original provisions of the Bretton Woods agreement, all countries fixed the
value of their currencies in terms of gold but were not required to exchange their
currencies for gold. Only the dollar remained convertible into gold (at $35 per ounce).
Therefore each country established its exchange rate vis-à-vis the dollar. This is often

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called the two-tier system: (1) US $ pegged to gold: $35/ounce of gold → dollar-gold
parity, and (2) other currencies pegged to dollar. For example, the British pound was
fixed to the dollar at $2.80/£, and Japanese yen was pegged to the dollar at ¥360/$.

Adjustable parities

Although each country's exchange rate was fixed, it could be changed – devalued or
revalued against the dollar – if the IMF agreed that the country's balance of payments was
in a situation of "fundamental disequilibrium."

Narrow band (1% on either side of parity)

The exchange rates were allowed to fluctuate within 1% of its stated par value. Other
countries would buy and sell U.S. dollars to keep market exchange rates within the 1
percent band around par value – foreign exchange market intervention (as required by the
system).

An integral part of the Bretton Woods system was the establishment of the IMF, which
still administers the international monetary system and operates as a central bank for
central banks. Member nations subscribe by lending their currencies to the IMF; the IMF
then re-lends these funds to help countries in balance-of-payments difficulties. The main
function of the IMF is to make temporary loans to countries to help them tide over
difficulties with current account deficits and financial crises. Member countries are
entitled to borrowing from the IMF up to a certain limit – its contribution to the IMF.
Beyond that limit, the IMF’ lending is conditional upon the borrowing country’s
accepting the IMF surveillance over its policies.

One of the differences between the gold standard and the Bretton Woods system is that,
while both are fixed exchange rate systems, the Bretton Woods system allowed a member
country to adjust the values of its currency, the exchange rate, when there was a
fundamental problem with the country’s balance of payments.

Failure of Bretton Wood System

With its currency as the sole reserve currency, the United States was in a unique position
in the Bretton Woods system. Its money supply, unlike other countries’, was not tied up
to defend the exchange rate system. The expansionary policy in the United States in the
1960s led to higher inflation in the U.S. than in Japan and West Germany. The U.S.
balance of payments suffered increasing deficits. In the meantime, Japan and West
Germany became increasingly competitive in the world market and their currencies were
under pressure to revalue. While the United States called on Japan and West Germany to
revalue their currencies, Japan and West Germany called upon the United States to
control its government spending and inflation.

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From purchasing power parity, we know that when the exchange rates are fixed, inflation
rates for countries under the fixed exchange rate system have to be the same. That is,
countries have to coordinate their macroeconomic policies. But policy coordination is
often difficult due to issues of sovereignty.

The coordination failures among the large economies led to the collapse of the Bretton
Woods system. In August 1971, the United States suspended total convertibility of the
dollar to gold. This resulted in no parity between currencies. Most major currencies
began to float against the dollar. Attempts to re-adopt the fixed rate system failed by 1973
(coupled with first oil shock). . By early 1973, the Bretton Woods system of fixed
exchange rates was abandoned altogether. Countries eventually accepted what is now the
current exchange rate system – a hybrid of different exchange rate regimes.

The biggest advantage of the Bretton Woods regime was that it provided a stable
exchange rate environment that nurtured the reconstruction of the world economy and the
growth of international trade and finance. The main disadvantage was that it required
coordination of policies among member countries.

European Monetary System

After the break down of the Bretton Woods system in 1973, several European countries
attempted various mechanisms to fix their exchange rates to each other. While allowing
their currencies to float against the dollar, these European countries tried progressively to
narrow the extent to which they let their currencies fluctuate against each other. Six
members of the European Economic Community (EEC), including France and Germany,
jointly floated their currencies against the dollar. The currencies of the participating
countries were allowed to fluctuate in a narrow band with respect to each other (1.125%
on either side of the parity exchange rate), and the permissible joint float against other
currencies was also limited (to 2.5% on either side of the parity). This fixed exchange
rate system that arose concurrently with the fall of the Bretton Wood System was called
the “snake” as this gave the currency movement the look of a “snake”.

In 1979, eight European countries created a formal system of mutually fixed exchange
rates, called the European Monetary system (EMS). They fixed their exchange
rates relative to each other, floating jointly against the dollar. The system was quite
similar to the Bretton Wood System, with the exception that instead of the currencies
being pegged to the currency of one of the participating nations, a new currency was
created for the purpose. It was named the European Currency Unit (ECU) and was
defined as a weighted average of the various European currencies. Each member had to
fix the value of its currency in terms of the ECU. This had the effect of pegging these
currencies with each other. Each currency could vary against the ECU and against other
currencies within a certain band on either side of the parity rate thereby forming a “parity
grid”. When EMS was first set up, a currency was allowed to deviate from parities with
other currencies by a maximum of plus or minus 2.25%, with the exception of Italian lira,
for which a maximum deviation of plus or minus 6% was allowed. In September 1993,

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however the band was widened to a maximum of plus or minus 15%. When a currency is
at the lower or upper bound, the central bank of both countries are required to intervene
in the foreign exchange markets to keep the market exchange rate within the band. To
intervene in the exchange markets, the central bank can borrow from a credit fund to
which member countries contribute gold and foreign reserves.
For example, if the French franc depreciates to its lower limit relative to the DM, it is
obligated to sell DM reserves to make Franc appreciate. German central bank is obligated
to loan DM to France.

Initially there had been capital controls that limited the ability of private citizens to trade
in foreign currencies. This was to prevent speculators from starting a currency crisis.
These restrictions were later relaxed in 1987.

Since the EMS members were less than fully committed to coordinating their
economic policies, the EMS went through a series of realignments. Despite the recurrent
turbulence in the EMS, European Union members met at Maastricht (Netherlands) in
December 1991 and signed the Maastricht Treaty. According to the treaty, the
European Union will irrevocably fix exchange rates among the member currencies by
January 1, 1999, and subsequently introduce a common European currency, replacing
individual national currencies. The European Central Bank, to be located in Frankfurt,
Germany, will be solely responsible for the issuance of common currency and conducting
monetary policy in the European Union. To pave the way for the European Monetary
Union (EMU), the member countries of the European Union agreed to closely
coordinate their fiscal, monetary, and exchange rate policies and a achieve a
convergence of their economies.

European Monetary Union

On January 1 2002, 12 European countries finalized their monetary union. This meant
that they had a common central bank in Frankfurt in Germany, at which all 12
countries had to agree on a common monetary policy. Eleven European countries
adopted a common currency called the euro, voluntarily giving up
their monetary sovereignty. With the launching of the euro on January
1, 1999, the European Monetary Union (EMU) was created. The EMU is
a logical extension of the EMS, and the European Currency Unit (ECU)
was the precursor of the euro. As the euro was introduced, each
national currency of the euro-11 countries was irrevocably fixed to the
euro at a conversion rate as of January 1, 1999. National currencies
such as the French franc, German mark, and Italian lira are no longer
independent currencies. Rather, they are just different denominations
of the same currency, the euro. Once the changeover is completed the legal-
tender status of national currencies will be canceled, leaving the euro as the sole legal tender
in the euro countries. Monetary policy for the euro countries will be conducted by the
European Central Bank (ECB) headquartered in Frankfurt, Germany, whose primary
objective is to maintain price stability. The independence of the ECB is legally
guaranteed so that in conducting its monetary policy, it will not be unduly subjected

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to political pressure from any member countries or institutions. The national central
banks of the euro countries will not disappear. Together with the European Central
Bank, they form the European System of Central Banks (ESCB). The tasks of the
ESCB are threefold: (1) to define and implement the common monetary policy of the Union;
(2) to conduct foreign exchange operations; and (3) to hold and manage the official foreign
reserves of the euro member states. Although national central banks will have to follow
the policies of the ECB, they will continue to perform important functions in their
jurisdiction such as distributing credit, collecting resources, and managing payment
systems.

Current Exchange Rate Regimes

The current exchange rate system is a hybrid of many different arrangements. The
International Monetary Fund classifies these exchange rate regimes into eight specific
categories. The eight categories span the spectrum of exchange rate regimes from rigidly
fixed to independently floating:

1. Exchange Arrangements with No Separate Legal Tender: The currency of

another country circulates as the sole legal tender or the member belongs to a
monetary or currency union in which the same legal tender is shared by the members
of the union.

2. Currency Board Arrangements: A monetary regime based on an implicit

legislative commitment to exchange domestic currency for a specified foreign
currency at a fixed exchange rate, combined with restrictions on the issuing
authority to ensure the fulfillment of its legal obligation.

3. Other Conventional Fixed Peg Arrangements: The country pegs its currency at
a fixed rate to a major currency or a basket of currencies , where the exchange rate
fluctuates within a narrow margin or at most ±1% around a central rate.

4. Pegged Exchange Rates within Horizontal Bands: The value of the currency is
maintained within margins of fluctuation around a formal fixed peg that are wider
than ±1% around a central rate.

5. Crawling Pegs: The currency is adjusted periodically in small amounts at a fixed,

pre-announced rate or in response to changes in selective quantitative indicators.

6. Exchange Rates within Crawling Pegs: The currency is maintained within certain
fluctuation margins around a central rate that is adjusted periodically at a fixed pre-
announced rate or in response to change in selective quantitative indicators.

7. Managed Floating with No Pre-Announced Path for the Exchange

Rate: The monetary authority influences the movements of the exchange rate
through active intervention in the foreign exchange market without specifying or
pre-committing to a pre-announced path for the exchange rate.

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 8. Independent Floating: The exchange rate is market determined, with central bank
intervening only to moderate the speed of change and to prevent excessive
fluctuations, but not attempting to maintain it at or drive it to any particular level.

The United States, the EU, Japan, the United Kingdom, Switzerland, and Canada are
among the major countries that follow an independent floating policy. At the other end of
the exchange rate regime spectrum (from floating to fixed) is the currency board, which
is a monetary regime based on an explicit legislative commitment to exchange domestic
currency for a specified foreign currency at a fixed rate, combined with restrictions on the
issuing authority to ensure the fulfillment of its legal obligation. Argentina was an
example before the system failed in 2002. Currently, Hong Kong is a well known
example of such an arrangement.

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