The current international monetary system allows exchange rates to be influenced by market forces. However Governments and central banks also influence exchange rates as they intervene in foreign exchange markets to control the macroeconomic effects of exchange rate fluctuations on their economies. Let us have a look at the evolution of international monetary system from the 1900’s:
The Gold Standard
Before 1930’s, the international monetary system was based on gold standard, under which currencies were required to be converted into gold at fixed prices. Convertibility into gold resulted in fixed exchange rates as long as nations kept the value of their currencies constant in terms of gold. For example the US dollar was worth 1/20 ounce of gold, while the British pound was worth ¼ ounce of gold. That is, in order to get one British pound, five U.S dollars was necessary because 5/20 = ¼ ounce of gold. Under the gold standard, currencies could fluctuate only within narrow bands that depended on the costs of transferring gold ownership between nations.
There were important consequences of international changes in gold ownership. Each nation used gold as an international reserve that constituted its monetary base. When a nation lost gold, its money supply usually decreased because of the resulting decline in its bank reserves. The decrease in money supply tended to reduce that nations price level in the long run. Similarly when a nation gained gold, its money supply usually increased, which tended to increase its price level in the log run. Under gold standard, changes in relative price level among nations caused by gold flows tended to keep currencies from appreciating or depreciating in the long run.
Under the gold standard, only a few nations followed the rule strictly. Nations hesitated to let their price level fall, for the fear that because of inflexible wages, reductions in the money supply would cause short run unemployment and recessions. To avoid changes in price level, nations commonly changed the official quantity of gold that could be exchanged for their currency. By devaluing their currency in terms of gold, they allowed it to officially depreciate.
The Bretton Woods system
Bretton Woods Conference, popular name of the United Nations Monetary and Financial Conference that took place July 1-22, 1944, at Bretton Woods in New Hampshire. The conference, attended by representatives of 44 nations, was convened to plan currency stabilization and credit in the post-war economic order. It resulted in the creation of the International Monetary Fund and the International Bank for Reconstruction and Development (the World Bank), to provide respectively short and long term credit for the world economy. The conference also proposed an international currency regime maintaining more or less stable exchange rates between currencies. This informal system maintained currency stability until broken apart by speculative pressures in the aftermath of the oil price rises of 1973. This system was also characterised by fixed exchange rates. However this system opted US dollar and tied the value of foreign currencies to it. At that time, US were in a strong financial position, whereas the wealth of the European countries had been shattered by World War II. In all countries dollar was directly convertible into gold and their central banks fixed the price at $35 per ounce.
This system allowed nations to officially depreciate or appreciate (devalues or revalue) their currencies in terms of dollars. Nations would devalue or revalue their currencies in a way in which they can stabilize their economies. The Bretton Woods agreement also established the International Monetary System to make loans to nations that lacked international reserve of dollars.
Dissatisfaction with the Bretton Woods system developed in 1960’s. Nations, whose currencies were undervalued relative to the equilibrium, exchange rate in terms of dollars were unwilling to allow the international price of their currencies to rise because the resulting decline in net exports would have decreased aggregate demand in those nations. Another problem was that, under Bretton Woods’s rules, the US could not devalue its currency to stimulate net exports. In 1971, the US suspended convertibility of dollar into gold and by the year 1973, all the nations under Bretton Wood’s system abandoned fixed exchange rates in favour of a system of flexible or floating rates determined in part by market forces.
The Current System
The current international monetary system allows free market determination of exchange rates, but also allows central banks to buy and sell currencies to stabilize exchange rates. In effect, the current system is a managed float in which central banks affect the supply and demand for currencies in ways that influence equilibrium in foreign exchange markets. Under the current system, central banks frequently buy their own nation’s currency on international foreign exchange markets to keep it from depreciating. They often resist currency depreciation because it makes important goods more expensive to the citizens. However when central banks buy their own nation’s currency, they lose reserves of foreign currencies such as dollars. The loss of by debtor nations is a small matter of concern. When nations such as India lose their dollar reserves, the only way they can acquire more dollars is by running a balance trade surplus with the US Nations that combine a less in dollar reserves with a decline in net exports run the risk of defaulting on their international loans. This reduces the profitability of US banks that hold these loans as assets.
The current international monetary system has a paper substitute for gold called Special Drawing Right (SDR). SDR’s are created by IMF and distributed to member nations for use as international reserves with which to make international payments. SDR fulfil the role that gold played in the settling international debts when a nation lacked the foreign exchange to do so. Gold is now completely demonetized because nomajor currency is convertible into it. Gold can be bought and sold on the free market like any other good. The central bank of a country leads a major role in monitoring the monitory policies of the country
Whereas some countries like China doesn’t follow the current system as it is ; instead they fined Yuan-dollar rate, they do so in order to maintain stability in their economy. In fact, this served China well during the Asian financial crisis of the late 1990’s. But in the wake of current recession things are moving in the wrong direction. We can observe that moving the productivity of China’s export industries soared and since Yuan-dollar rate was fixed, The Chinese goods became extremely cheap on world markets. In turn they gained a huge trade surplus. Volatility of exchange rates was allowed to prevail. Then the Chinese currency (Yuan) would have appreciated sharply against the dollar. In this recession (during recession) the global aggregate demand falls. If China pursues the current currency policy, more than half of the prevailing demand will be under their control, which would in turn hinder the growth and exports of other countries. This process of fixing currency rates is known as pegging.
Another recent news points out that Brazil took a decision to impose a two percent tax on portfolio inflows. The move is to check the sharp appreciation of the ‘Real’ (Brazilian Currency) against the U.S dollar. The ‘Real’ has appreciated 36% against the U.S dollar, undermining Brazils export competitiveness. Indian rupee has also gained against the dollar recently. I may conclude by saying that there may be chances for the emergence of a new monetary system in the near future, solving the flaws faced by the economies across the world.
No comments:
Post a Comment