International Monetary System
History: Monetary System
• Every nation has a monetary system which guides
monetary policy and economic framework of government
• Monetary standards refer to the principal method of
regulating and the quantity and exchange value of standard
money
• Standard money is suppose to perform various functions
like:
– Unit of account
– Measure of value
– Medium of exchange
– Means of payment and
– Store of value
Contd..
• Barter System: For long time people used to follow barter system to exchange
goods and services, however, due to its failure to serve as a common measure of
value among items bartered it collapsed
• Commodity Money: Commodities like Ivory, copper, tobacco, gold and silver
became the medium of exchange at different times in different places. Metal coins
can be dated back to as far as 7th Century BC.
– Gold and silver became the prominent currencies due to their special features like rarity,
beauty, immunity to corrosion and economic value. Also because of their religious values like
gold was compared to sun and silver to moon
– When only one metal is used as a currency it is known as monometallic like Britain was on
silver standard till 1816.
– If two metals are adopted as standard money it is called as bimetallism. eg: France on gold and
silver in 1803 followed by Belgium, Switzerland etc.
• Paper Money: China was first to adopt paper money way back in AD 1300. They
placed emperor’s seal and signatures of treasurers on crude paper made from
mulberry bark.
– Later on many countries adopted paper currency like Brazil in 1810.
– As it is managed by respective governments it is also known as managed currency standard.
– It is a very useful system with the danger that it can be over issued which may result in rise in
prices, interest rates, adverse forex rates etc.
– It is the main currency and is the unlimited legal tender and that’s why it is also known as fiat
money.
– It’s value is determined by the reputation of the government in order and not by the intrinsic
value of paper like in case of gold
Need For International Monetary System
• Various nations have different monetary
standards
• Therefore, International Monetary System is
required to define a common standard of value
for various currencies.
International Monetary System
• International Monetary System is a set of
internationally framed rules ,conventions and
supporting institutions that facilitates
international trade, cross border investments
and re-allocation of capital among nations.
Main Functions of IMS
• Stable IMS leads to:
• Reducing global poverty: by sharing financial
resources and investments
• Encouraging International Trade: stable
international monetary system promotes
international trade
• Promoting financial stability
• Economic Development
History of IMS
• Exchange Rate Regime: is the way a monetary
authority of a country manages the currency
of its country vis a vis other countries
• It includes forex risk management
Exchange Rate Systems
• Fixed Exchange Rate System
• Floating Exchange Rate System
• Managed Exchange Rate System
Fixed or Pegged Exchange Rate System
• It is a system in which a currency’s value is
fixed or pegged by a monetary authority
against the value of other currencies or basket
of other currencies or of commodity like gold
• Four countries maintain their exchange rate
system against basket of currencies and peg
the value of their currency to that basket
which are Fizi, Morocco, Libya, Kuwait
Merits and Demerits of Fixed Exchange
rate
• Merits
– Removes exchange rate risk
– Helps in promoting trade
• Demerits
– Potential of sudden devaluation
– Non-transparent
Government Interventions: Zimbabwe
Example
• In June 2004, Zimbabwean Government
announced nationalization of all farm lands
and abolished privatization
• Government tried to redistribute land by
taking it from Whites to native Africans
• UN forecasted that Zimbabwe once an agri
exporter will not be able to feed its own
population in 2004
Zimbabwe History and Genesis of Crisis
• Zimbabwe was a mineral and metal rich country
• In 1880s British tycoon Cecil Rohdes made in roads to Zimbabwe by
getting diamond mining rights from King Lobengula
• It became British colony in 1923 and post that freedom struggle started
in the form of two main parties i.e. ZAPU (Zimbabwe African Peoples’
Union) and ZANU (Zimbabwe African National Union)
• Zimbabwe got independence in 1980 under Robert Mugabe who
became Prime Minister and later on declared himself to be Executive
President with all powers vested in him
• In the initial days both white and black population were working
together for the progress of Zimbabwe but there was apartheid being
followed in South Africa
• It was blamed that many assassination attempts were made on
President Mugabe in order to create conflict between native Africans
and Whites who had settled there
• Whites were having major portion of farm lands and they had great
international connections and by using modern techniques they made
Zimbabwe and export dominant nation
Zimbabwe History and Genesis of Crisis
• The genesis of crisis was in 2000 when the
incumbent government started nationalization.
• After pressure built on Mugabe, he declared to
redistribute wealth among the native Africans
and declared nationalization of farm lands and
confiscating land from whites
• Another reason for economic turmoil in
Zimbabwe is considered to be sending army to
suppress civil war in Democratic Republic of
Congo in 1998
• Z$ was on a fixed exchange rate against US$
• In 2000 there was a sudden devaluation of
Zimbabwe $(Z$) from Z$38 to Z$49.
Crisis Onslaught
• In April 02, Z$ was at around Z$56.
• If there were pure market forces then Z$ would have weekend as
risk was increasing
• The reason could have been capital flight and hence more supply of
Z$ and less demand and hence weakening of Z$
• What happened to its exports and imports?
– Once they were regional bread basket of Africa
– But now they didn’t have enough farms and they became net importer
rather than exporter
– Hence, they were selling Z$ which means weakening of Z$ under pure
market forces
• Hence, both in current as well as capital A/C Z$ should have
weekend
• However, government said that we are going to keep Z$ at fixed
price
How did Zimbabwe Government Did
it?
How did Zimbabwe Government did
it?
• Zimbabwe government bought Z$ from market through
government intervention in markets with US$
• Zimbabwe BoP
Z Weakening
Current A/C
Import (M) Zimbabwe buy cars
from US
Capital A/C
Zimbabwe people invest in US
• So, in both current A/C and Capital A/C their dollars weakened
• Government artificially kept it strong through official account
and market interventions
Repercussion of Government
Intervention
• They did not have unlimited supply of US$, so
after a particular point they won’t be able to
sell dollars to keep their currency fixed
• Result: Government will have to devalue and
that’s what happened in Zimbabwe
• Is devaluation popular or unpopular and why?
Contd..
• Ans. Unpopular because it reduces value of
local currency and that’s why generally
government would do it after elections if due
– Eg: if you have Z$100,000 and government
devalues currency and says now that are worth
Z$40,000!!!
Currency Devaluation in Zimbabwe
• On 4th April,03, exchange rate was about Z$56.86/$
and 2 years before it was Z$38/$
• 25th April, 03 it devalued to Z$814.62/$ an overnight
drop of 93% in value
• On 28th Feb,04 another devaluation of Z$4000/$
• On 27th April, 04 another devaluation of Z$5200/$
• On 9th June 04: Wall Street Journal (WSJ) reported,
Zimbabwe announces intention to nationalize all farms
and abolish private land ownership
• It led to another devaluation on 26th April 05 to
Z$9015
Contd..
• 31st July 06 government came out with new idea to print
new bank notes and announced Z$1000 old = Z$1 new (i.e.
loss of 000)
• But did it create wealth?
– It was just like stock split where actual wealth is not created
• On 1st August,08: Government cuts off more zeros i.e.
Z$10,000,000 old =Z$ 1new
• On 2nd February 2009 government cuts off 12 more zeros
i.e.
• Z$1000,000,000,000 old =Z$1 new
• On 18th August 2009 government cuts off 5 more zeros
• Z$10,000 old = Z$1 New
Q. Moot question is: Is government creating value and
winning faith of people by doing it?
Contd..
• Finally people lost faith in government and currency and government allowed
people to trade in other currencies locally
• In 2009 Zimbabwe allowed $, Euro and South African Rand to be used for local
purchases
Q. Is it death blow to local currency?
• In March 2010: Zimbabwe government passed order that all foreign firms over a
value of $500,000 must cede 51% to locals
• It further increased risk and currency further depreciated:
• Z$373,000,000,000,000,000,000,000,000,000,000,000,000 in terms of old currency
• Result was tremendous increase in inflation leading to hyperinflation
• Inflation was estimated at 5,000,000,000,000,000,000 (3rd Feb. 09)
• There was a saying that “price doubles every 24 hours”
• The drawback is that as a business man it becomes very difficult to do business
there
• People exchanged Z$ to US$ to buy goods which led to inflation
• However, when other currencies were allowed to be exchanged the inflation came
down to 1.25% in July 2013 as reserve bank of Zimbabwe.
• In 2015 Zimbabwe announced to completely switch to US$
100 Trillion Dollar Zimbabwe Note
Floating Exchange Rate System
• Currency price of a country is fixed by forex
market which is dependent of demand and
supply of other currency
• It is contrary to fixed exchange rate system
wherein government sets the price of a
currency
Managed Floating Exchange Rate
System
• It is similar to floating rate system with a slight
difference that country’s central bank may
occasionally intervene in order to drive the
currency’s value in certain direction
• India follows it from 1994 onwards
• It may be done to curtail economic shocks or
volatility of currency
Five Stages of development of
Currency System
• Bimetallism: Before 1875
• Gold Standard: Value of currency fixed in
terms of Gold: 1875-1914
• Fluctuating Exchange Rate System: Inter-War
Period i.e. 1915-1944
• Bretton Wood System: Dollar based fixed
exchange rate system (1945-1972)
• Present System: Floating Exchange Rate
System: 1972 to present
Bimetallism: Before 1875
• It is the standard in which the value of monetary unit is defined as
equivalent to certain quantities of two metals, typically gold and
silver, creating a fixed rate of exchange between them
• A “double standard” in the sense that both gold and silver were
used as money
• Both gold and silver were used as international means of payment
and exchange rates among currencies was determined by either
their gold or silver contents
• Exchange ratio between two metals was fixed
• Some countries were on gold standard, some on silver and some on
both
• Gold and silver were used for international payments and
determining the exchange rates
contd..
• Suppose there are three countries UK, France and India
• UK has only Gold coins, France has both gold and silver while India has only
silver as means for international payment
• Presence of bimetallic country is must
• Exchange rate determination:
• Suppose UK wants to import goods from France, say Good “a” then it has to
be valued in Gold as both have gold as common currency
• Countries can decide what amount UK is required to pay to France for import
• Similarly, India and France can trade in silver same Good “a”. France can
import it and both can value it in terms of silver
• However, if UK wants to trade with India and UK wants to import good “a”,
they can not directly determine the value of goods and determine the
exchange rate of their currencies
• It is possible only via France because UK can value goods in terms of Gold and
India in term of Silver and France can value goods both in terms of Gold as
well as silver
• So, only with help of France India and UK can trade
• If France does not exist, trade between UK and India is not possible as there
is not country with Bimetallism
Collapse of Bimetallism
• International monetary system was not possible unless there is bimetallic
country
• Reserves of all the countries started getting lesser and lesser because of
GRESHAM’S LAW
• It said that bad money drives away good money leading to Uni-metallism
• Bad money refers to abundant money and good money refers to scarce
money
• Suppose as in our earlier example France over a period of time realize that it
has lot of gold mines so it has abundant of gold in comparison to silver
• So, gold because of abundance in France, gold was undervalued and silver
overvalued as citizens started using lot of gold coins in international
payments and less use of silver as it was considered to be more valuable due
to scarcity
• So, silver was totally out of circulation and went out of usage by
international payment and as result of it France only started using gold and
it became unimetallic
• Hence, the system collapsed
Gold Standard: 1875-1914
• Each country fixed the value of it’s currency in terms of gold
• Exchange rate between countries used to remain fixed
– eg: 1 ounce of gold = 20 pounds by UK
– and 1 ounce of gold = 10 dollars
– It means 1 Dollar = 2 pounds or 1 pound = 0.5 dollars
• It had free convertibility of currency
• Each country allowed its currency to be converted into gold on demand and there
was no restrictions on movement of gold from one nation to another
• Each country maintained gold reserves in order to back the value of its currencies
• Payment between countries were settled by exchange of gold as there was free
export and import of gold
• If a country imported more than it exported, gold flowed out and vice- versa
• Gold standard facilitated automatic correction in balance of payment disequilibrium
of a country
• eg: if Germany had trade deficit then gold flowed out of Germany for settlement of
trade leading to contraction in Germany’s money supply which pushed down prices
in Germany making it ‘s goods cheaper and competitive. It in turn led to increase in
demand for Germany’s exports thus wiping out deficit.
• This system lasted for 40 years
Three rules of game for “Classical Gold
Standard”
• Only gold to be used for international payments
• Two way convertibility between gold and currency at a
fixed rate
• Free Import and Export of Gold
• The implication was that balance of payment would
automatically be settled as in long term no country would
be in surplus or deficit
• eg: Suppose In India 1 ounce of gold =Rs.30
• If someone in India wants to transact with country X, they
will go to any government institution and convert rupee
into gold and transact with other country
• If you need rupees you can also exchange gold with rupees
Advantages of Gold Standard
• It received positive view of public much more easily than
other standards as gold was easily available
• It was an easy system to introduce and operate
• It gave stable price level in the country. When the country is
on Gold standard, currency can not be over issued ,so
prices remain stable
• It provides currency with universal acceptability
• In international dealings it provides stability of exchange
rates thereby making gold standard very useful for the
settlement of international trade
• The deficit or surplus in balance of payment is
automatically brought into balance by import or export of
gold
Disadvantages of Gold Standard
• After world war most of countries on gold standard did
not obey the rules of gold standard and even all new
forms of gold standard failed to function smoothly.
Following are the main defects of this system:
• It worked smoothly in period of peace and prosperity
while in periods of war and crisis it always failed
• It is an expensive standard which can not be afforded by
all countries because a lot of precious metal is wasted as
gold has to be converted to coins
• It sacrifices the internal stability to external stability.
• The changes in output of gold can bring changes in price
levels
• In gold standard independent monetary policy can not
be adopted.
Collapse of Gold Standard
• Gold Standard was abandoned in 1914 with outbreak of 1st world war
because:
– During war countries started printing more money to finance war activities
– They restricted the free movement of gold from one nation to another and
suspended the convertibility of currency into gold
• After end of World War1 countries started to came back to Gold standard
• US became first country to adopt Gold standard in 1919 followed by Britain
in 1925
• Following Great Depression in 1929, Britain started experiencing recurring
balance of trade deficit
• It’s gold reserves were depleting at very fast rate and it became impossible
for them to maintain Gold standard, so in Sept. 1931 British Govt.
suspended Gold standard and let the pound float
• Many countries like Japan, Austria and Sweden followed it by end of 1931
• Investors started preferring gold to foreign currency dominated securities
which affected US gold reserves adversely and led the US govt. to abandon
Gold Standard in 1933
• It gave rise to Bretton Wood System or Pegged Exchange Rate System
Inter-War Period (1915-1944)
• After war started in 1914, Gold standard was abandoned
as countries were not able to manage it
• World war I ended the classical gold standard in august
1914 as major countries like Great Britain, France,
Germany and Russia suspended redemption of bank
notes in gold and imposed restrictions on import of gold
• Countries were devaluing their currencies in order to
increase exports
• So, the system prevailing was fluctuating exchange rate
system
• Reasons for collapse of inter war system:
– Hyperinflation which led to massive increase in prices
– Depression and financial crisis: countries having gold reserves
with them stopped or suspended convertibility of gold
Bretton Wood System (1945-1972)
• Dollar was taken as a base for fixing exchange rate of other
currencies
• Bretton Woods conference was organized after 2nd world
war which was attended by 44 countries, including India, in
July 1944 at Bretton Wood in US
• Aim was to design a new monetary system post world war II
• Two Multilateral institutions were set up namely,
International Monetary Fund (IMF) and World Bank (also
known as International bank for Reconstruction and
Development (IBRD)) for reconstruction and development
• IMF was made responsible for monitoring and managing
exchange rates between countries while World bank was
made responsible for financing individual development
projects
• In conference a new monetary system was created
Bretton Wood System (1945-1972)
• Here, only US fixed value of its currency to gold and
other currencies were pegged to US dollar and could
fluctuate at around 1% band
• Initial Peg was I ounce of gold =$35
• US dollar was main reserve currency held by central
banks and the only currency that was directly convertible
to gold
• Each country was required to maintain market value of
its currency within plus or minus 1% of it’s adopted par
value, however, member countries were allowed to
change their par value if they faced fundamental
disequilibrium in the balance of payments
• For changes upto 10% IMF approval was not required
but for changes beyond 10% IMF approval was necessary
Collapse of Bretton Wood System
• During 1960’s various expansionary programs were undertaken by US due
to which its balance of payment swung into deficit
• Member countries lost confidence in $ and started converting their $
reserves into gold
• The gold stock with US treasury began to fall drastically
• Due to recurring balance of payment deficits in August, 1971, US suspended
convertibility of dollar into gold and also levied a surcharge of 10% on
imports until the revaluation of other currencies against dollar
• In order to save and restore Bretton Wood System a conference was held in
Dec. 1971 at Smithsonian Institute in Washington DC and an agreement was
reached to devalue dollar to $38 per ounce from $35.
• Currencies of surplus countries were re-valued upward and fluctuation band
was widened to plus-minus 2.25%
• Smithsonian agreement could not go forward as devaluation of dollar was
not enough to stabilize the situation
• In 1973 parity value was further revised upward to $42 per ounce
• By March 1973 major currencies were allowed to float and Bretton wood
system came to an end
Flexible Exchange Rate System Since 1971
• After collapse of Bretton Wood System, IMF constituted a
committee to evolve a new International Monetary System
• The committee members came out with a new set of rules which
were formally accepted by all member countries in a meeting
Jamaica in Jan. 1973 (Jamaican Agreement)
• New system was a flexible exchange rate, where in the exchange
rate was not fixed by governments, rather it was determined by the
market forces of demand and supply in international markets
• Under the new Exchange rate System the countries can chose from
the following systems:
– Managed Float System
– Free Float System
– Crawling Peg System
– Currency Board Arrangement
– Target Zone Arrangement
•
contd..
Free Float System: determined solely by demand and supply by
interaction of market forces and no government intervention. It is also
known as clean float or independent float system
• Managed Float: Country’s monetary authorities intervene directly or
indirectly to stabilize the exchange rate and to keep it within desired
limits. It is also known as dirty floating
• Crawling Peg System: Hybrid of fixed and flexible exchange rate system
where country establishes the par value of its currency in relation to a
foreign currency or a basket of currencies and then allows the par value to
change gradually
• Currency Board Arrangement: Country has a currency board that pegs the
domestic currency to a foreign currency and allows the unlimited
exchange of domestic currency for the foreign currency at the fixed
exchange rate. Currency board is required to build the reserves of the
foreign currency equivalent to the amount of domestic currency it has
issued
• Target Zone Arrangement: A group of nations with common goals and
interests agree to either maintain exchange rates within a specified band
or to replace their domestic currency with a common currency
Floating Exchange Rate System (1972
to Present)
• Bretton Wood System collapsed in 1972 as
countries were founding it difficult to peg
their currencies against dollar
• Then world moved into flexible rate system
and some countries moved into managed
floating rate system
• India went with managed floating rate system
• Many nations stuck to the dollarization even
after 1972
Free Float System
• System depends on sources of demand and
supply without any intervention
• However, in practice some intervention is
found in this system, typically to prevent any
undue fluctuation in exchange rates
• Countries: Japan, US, UK, Switzerland, Brazil,
Canada and Mexico
Managed Float System
• In case of direct interventions, Monetary authorities
attempt to buy and sell foreign currencies in forex
market to stabilize their exchange rates in domestic
market
• When they buy foreign currency, it’s demand increases
and domestic currency depreciates against foreign
currency and vice-versa
• In case of indirect interventions, the monetary
authorities try to stabilize their currency by changing
interest rates and flush out excess volatility
• Some countries which are following it are India, Russia,
Egypt, Singapore, Thailand and Czech Republic
Crawling Peg System
• Hybrid between Fixed and Floating Rate
System
• Countries like Jordan, Bahamas, Iraq, Qatar,
Maldives, Lebanon, Kuwait, Saudi-Arabia have
peg their currency to USD
• Countries like Fiji, Libya and Morocco have peg
their currency to basket of currency
Currency Board Arrangement
• Currency board pegs the domestic currency to foreign
currency and allows unlimited exchange of domestic
currency for foreign currency at fixed exchange rate.
• In this system, currency board is required to build reserves
of foreign currency at fixed exchange rate equivalent to
amount of domestic currency it has issued
• With this system money supply can be controlled
effectively because additional currency will be issued only if
there are foreign currency reserves to back it.
• It also helps to control inflation
• Countries: Hong Kong Pegged to US$ at 7.8H$/USD
• If they can back H$ with foreign currency always, they can
maintain that exchange rate
Example: Currency Board
• Suppose Argentina Pegs it currency against USD
1000 1000 $ in
Peso in Argentina
World official
Economy reserves
• Suppose there are 1000 Peso in world and Argentina has exactly
$1000 in their official reserves to back them up
• If I give them 1 Peso, they have give me a $.
• Since they have given me a $ they can not allow that peso to move
in their economy
• So, now they have $999 and peso also 999.
• With fewer Pesos in economy will banks demand higher interest
rates or lower?
Contd..
• Higher interest rates and thus, interest rates would
automatically adjust
• Advantages of Currency Board:
– If exchange rate risk is negligible, trade is more attractive
and investment is also more attractive
– It’s a good system for countries which can not make use of
their monetary policy wisely
• Disadvantage:
– Lot of monetary power is not with central government, so
it becomes harder to manage country’s growth as interest
rates under currency board automatically adjust
– Governments don’t have liberty to print money
Target Exchange Rate System
• Group of nations with common goals and
interest agree to either maintain exchange
within a specific band or to replace their
domestic currencies with a common currency
• Example: European Monetary System in 1979
European Monetary System
• After demise of Smithsonian agreement in 1971, six European countries agreed to
maintain the parity value within a band of plus-minus 1.125% as against 2.25%. This
system came to be known as ‘SNAKE’
• SNAKE was replaced with European Monetary System (EMS) in March 1979 after
collapse of Bretton Wood and when world was looking at other systems
• European Currency Unit (ECU) was also introduced in 1979 as the weighted average
of member countries currency.
• EMS was based on parity grade system where the exchange rate between any two
currencies was determined based on their weights in ECU basket
• Due to differing economic conditions and policies of different members countries,
parity grid experience serious damage and in Sept. 1993 the band was widened to
plus-minus 15%.
• In order to address recurring problem in EMS, the European Union members met in
Maastricht in 1992 and signed Maastricht treaty and agreed to replace their
individual currencies by a common currency by Jan 1st, 1999.
• European Central Bank (ECB) was established in 1998 and it worked in conjunction
with national central banks to achieve price stability
• In Jan. 2002, Euro Notes and coins were introduced and by end of 2002 local
currencies were completely replaced by Euro.
• EMU (European Monetary Union) aimed at establishing an exchange rate system to
reduce the volatility of exchange rates between European economies and stability in
European monetary system
• Recently Brexit has happened wherein Britain has exited European Union
Contd..
• Member countries were required to meet the
following criteria:
– Keep fiscal deficit to GDP ratio below 3%
– Keep Government Debt to GDP ratio below 60%
– Achieve high degree of price stability
• ECB has its headquarters in Frankfurt,
Germany
• EMS became EMU in 1992.
Exchange Rate of Indian Rupee
• Historically INR was linked to GBP and RBI was empowered to buy and sell
forex as needed
• After creation of IMF, India declared its par value of INR = 1s6d (s= shillings
and d= pennies which were smaller denominations of British pound
sterling).
• Indian currency was devalued in September 1949 and again in June 1966
wherein INR 100= GBP 4.7619
• At that time US dollar parity was also set at INR100 =USD 13.3333
• Exchange rate remained unchanged till 1971 but after the collapse of
Bretton Wood System in 1971, major currencies were allowed to float
• INR was linked with Pound Sterling which itself was linked with USD under
Smithsonian Agreement of 1971
• Since all countries were floating and India had trade with different
countries, therefore from 25th September, 1975 RBI pegged INR to basket
of countries with weights being given to each country as per its trade with
India but their names were kept confidential
Contd..
• However, British Pound remained the major intervention currency for the
RBI
• In 1978 for the first time Banks were permitted to do intra-day trading in
forex market but RBI kept strict control over the forex flow and
administered prices
• All this led to lot of hawala money flowing into India
• The period of 1980s and 1990s was the most turbulent time in economic
history of India and gulf crisis accentuated it
• Current Account deficit increased to 3.2% of GDP in 1991 and capital flows
dried up.
• The Indian rupee was devalued by 9% and 11% within 2 days on 1 July and 3
July 1991
• India had to stopped regime of pegged exchange rate system
• Under this backdrop India had to take economic reforms followed by
recommendations of high level committee chaired by Dr. C Rangarajan
• In 1992, RBI instituted a dual exchange rate system under Liberalized
Exchange Rate system (LERMS) according to which 40% of export proceeds
and inward remittances had to be purchased at administered official
exchange rate and rest could be done through market exchange rate
system.
Contd..
• However, capital receipts and capital
payments remained under the tight control of
RBI
• But this dual system could not continue for
long and GOI decided to merge the two
systems on 1 March 1993 and Indian adopted
Managed float
Some Important Terms
• Depreciation and Appreciation of Currency
• Revaluation and Devaluation of Currency
• Full Convertibility and partial Convertibility
• Intervention and Sterilization
Government Intervention and
Sterilization
• Japanese government has lot of times
intervened in markets to make yen weak as
Japan is primarily an exporting country
• So weak Yen helps them. Why?
• How do they do it?
– Government use Yen to buy $
• Q. Why would governments intervene?
Contd..
• Governments generally intervene to reduce the
volatility in currency markets
• When government increase interest rates cost of
capital goes up and investments decrease (low positive
NPV projects)
• And Vice-versa
• When they don’t want to do it through monetary
policy, they intervene in currency market
• Japan did that in 1980
• They used Yen to buy $
• Q. What is the potential problem in it?
Contd..
• Increased supply of Yen would lead to inflation
• Q. What could be the solution?
– They could borrow yen in their local markets by
issuing Yen T-bills to take supply out
– Of course they have to pay it back so it’s a temporary
solution of inflation
• Sterilized Vs Unsterilized Intervention
– If Japan use Yen to buy $ and simultaneously issues
Yen T-bills, it is called as sterilization
– If Japan does not issue T-bills it is called as
unsterilized intervention
The Impossible Trinity
Difference between Fixed and Flexible
Exchange Rate System
Fixed Exchange Rate Flexible Exchange Rate
Exchange rate is determined by Determined by market forces
government
Periodically adjusted by government to Exchange rate adjust automatically in
keep them in line with changes in macro- response to market factors
economic variables
Government needs to keep large amount No such requirement
of reserves to maintain the exchange rate
at desired level
Exchange rate are fixed and stable but Exchange rates fluctuate but remain
may lead to market distortions in long run stable around equilibrium in long run
