World Financial Infrastructure and Money

World Financial Infrastructure and Money : Sukumar Nandi
World Financial Infrastructure and Money
Sukumar Nandi
Indian Institute of Management Lucknow
Lucknow – 226013, India
Email:: nandi@iiml.ac.in
1
Chapter 1
Money: History and Evolution
One major event of human civilization is the invention of money as a medium of

exchange. Money in circulation, both paper and metallic currency, is the interest free
liability of the government1 and against this there are claims to virtually nothing . This
is because present- day money is hardly backed by gold and other foreign asset by the
government . This is fiat money and it is a legal tender, which the citizens of the
country are legally bound to accept as a medium of exchange. So money in circulation is
not backed by government liability and the government has virtual monopoly on the
provision of fiat money. Further, the government also controls the quantity of money.2
In the historical context, fiat money is very recent in origin with a lifespan of
a few decades. Its earlier form was commodity money. From history we find that use
of gold as money began in the sixth century B. C. in Turkey. Lumps of gold found in
the river bed were melted and converted into pieces of uniform sizes and then
stamped to give it legal sanction. This is the early form of commodity money with face
value equal to its intrinsic value. The commodities chosen were generally precious
metals with lighter weight for the convenience of carrying to distant places . But
sometimes seashells, cattle were also used as money. The technical characteristics of
commodities selected to serve as money are of minor importance. But the important
thing is that there should exist social institutions condoned by customs and/or law that
enable the economic agents to trade efficiently by following the specific rule that one
commodity traded in every exchange should be socially sanctioned as an exchange
intermediary. In the money using economy the rule of the game is very precise that
commodities buy money and vice versa ,but commodities do not buy commodities in any
organized market ( Clower,1969).
Money in the Early Period

The emergence of money in the early period can be known from the following :
"In primitive traffic the economic man is awaking but very gradually to
an understanding of the economic advantage to be gained by exploitation
of existing opportunities of exchange… Consider how seldom this is
1
Here the central bank's role is not neglected. Actually the central bank works on behalf of the
government of the country. The concept of money as a fiduciary issue and a legal tender is true for all
countries irrespective of the level of development .
2
The central bank enjoys hardly any autonomy except in a few countries and so it is taken as granted that
the central bank follows the wishes of the government. Technically the currency in circulation are the
liability of the central bank.
2
the case, that a commodity owned by somebody is of less value in use

than another commodity owned by someone else! And for the latter just
the opposite relation is the case. But how much more seldom does it
happen that these two bodies meet! …. Even in the relatively simple
and so often recurring case, when an economic unit A requires a
commodity possessed by B, and B requires one possessed by C , while
C wants one that is owned by A -----even here, under a rule of mere
barter , the exchange of goods in question would as a rule be of necessity
left undone ." [ page 242]
Carl Menger (1892)
In the early dawn of history when people realized the problem of barter, they
started using precious metal as medium of exchange. In 2500 BC. the people in
Egyptians produced metal rings for the use as money. By 700 BC. a Group of
seafaring people called the Lydians became the first in the western world to make
coins The Lydians (of western Turkey, 700 – 637 BC.) used coins to expand their
vast empire . The Greeks and Romans continued to make coins and they passed that
tradition to later generations. Greek Drachma was found in 400- 344 BC at Thessaly
in Eastern Greece. In the eighteenth century trade and commerce increased in
Europe and coins became wide in circulation. One of the most widely used coins was
the Spanish 8 Real and it was split into fraction like half a coin or 4 bits, a quarter
was 2 bits etc.
Metallic coins made of precious metal are the example of commodity money
and it was acceptable because it had the intrinsic value. At times the metal value used
to differ with the face value leading to large scale hoarding or melting down of the
coins as the situation warranted.
Paper money was first invented by the Chinese and it began in the T’ang
Dynasty ( 618- 907 AD.). During the Ming Dynasty in 1300 AD. , the Chinese
placed the emperor’s seal and the signature of the treasurer on a crude paper . The
latter was made of mulberry burke and it was of the size of a notebook paper. After the
Chinese the paper currency the experiment spread to other countries . Also
representative money was developed in some countries which are token or pieces of
paper that could be exchanged for a specific commodity such as gold or silver. In
the later years of 19th century, the government of the USA and some European
countries issued gold and silver certificates. This type of money was very useful
to make large payments. Thus is seems that the authorities in those early years
realized the need for high denomination currencies to facilitate trade and commerce.
A Stable Numeiraire
One important aspect of commodity money is that it is a stable numeraire and it
helps keeping the price stability. Even Aristotle, in his book, Ethics, noted that
commodity money was well suited for the price stability. According to him:
“Money, it is true, is liable to the same fluctuation of demand as other commodities, for
its purchasing power varies at different times; but it tends to be comparatively constant.”
(Ethics, translation 1943)
3
The commodity money system delivers a nominal anchor for the price level, and this is
realized through the profit-maximization principle. This was applicable in the case of
mint producing coins in the middle ages and later. The mechanism can be as follows.
Suppose there is a way to convert goods into silver and silver into goods at a constant
cost, that is, in ounces of silver per unit of goods. This can be considered as (1) the
extraction cost of silver, or (2) the world price of silver in case of small open economy.
The mint converts silver into coins after the purchase of silver in bulk from the market, it
also decides when to melt the coins to make it into silver bars. This is a private sector
activity, and the rule of the government is limited to two actions. It specifies how much
silver goes into a coin and it collects a seigniorage tax (Sargent & Velde, 1997).
The profit maximization principle will dictate the private sector mint to
adjust the revenue with the cost , the latter being the cost of buying silver bars from the
market along with the cost of production. This includes again the cost of labour. Again
the mint itself can be engaged in the extraction of silver, which determines the unit price
of silver. The revenue of the mint is the value of the coins produced and, assuming that
each coin is of the same weight, the revenue depends on the number of coins and their
denominations. The mint will find equilibrium when the following equality holds::
Market Value of Coins (or, the Inverse of Price level ) = Cost of

Silver + Seigniorage Tax + Cost of Production
The above rule will ensure that the mint will continue minting coins. When this is
violated, i.e. the market value of coins is less than the combined total of the right hand
side, minting of coins will stop. This also determines whether the mint will produce
new coins or start melting the existing coins, and this ultimately depends on how the
price level relates to the following parameters : the cost of silver content, cost of
production and seigniorage rate. The price level can not go too low, or the mint could
not make unlimited profits by minting new coins and spending them. Again, the price
level cannot go too high, or the mint would make profits by melting down the coins.
Thus the absence of arbitrage facility for the mint places restriction on the price
level and this remain within an interval determined by the minting point and the
melting point ,as shown in the figure (Figure 1).
Figure 1. Price level within a domain
Minting Point Melting Point

------*--------------I----------------------*----------
Price Level
The system described above has some unique features. Here the quantity of money is
not controlled by the government. The additions or deductions to existing money stock
( stock of coins ) are made by the mint run in the private sector on the basis of the
movement of price level. The price incentive in the market operate and this makes the
system self-regulatory. When coins become too few, their value increases and price
level falls. The mint point is reached and more coins are added to the existing stock.
This increases the supply of money, and the price level (i.e., price of coins falls ). When
4
the number becomes too large , the market value reaches the intrinsic metal value and
even below, and it becomes imperative for the mint to melt the coins and reduce the
number.
Within the interval the price level depends on how the money stock is related to the
volume of transactions and this follows the famous Quantity of Money Equation of
Irving Fisher
PT = M V …. (1)
Where P, T,M and V are price level, total transactions , money stock and velocity of
circulation respectively. As long as the price level remains within the interval , the
stock of money (the number of coins ) does not change. The changes in the volume of
transactions or income will shift the price level up or down within the interval. When
the push is severe so that it touches the melting point or the minting point , money
supply changes.
One important implication of the above system of private sector minting of coins
is that run-away inflation of the type seen in the twentieth century is not possible in
the commodity money regime. Inflation is the product of the fiat money system.
Machines and Change in Production Process:

Around 1550 AD a major shift in minting technology took place in Germany.
Two processes were developed to mechanize the minting process using machines to
cut into shape uniform blanks and impress these with a design. The screw-press
technology had been proved to be better than the alternative, known as the cylinder-
press technology; but because of cost consideration, the latter became popular in
many countries. The King of Spain heard about the cylinder –press technology and
installed the technology in his state mint. The coins produced in the mint had been
smooth and uniform This experiment then spread to other states in Europe .
The laissez -faire Experiment:

Royal Charter created private monopolies during 1613- 44 AD and various
individual firms were allowed exclusive right to issue token coinage , though these
were not made legal tender and the quantities were limited. The laissez-faire regime
was typified by the absence of government- issued small denomination coins and by
the issue of tokens by private parties and local governments. In the late sixteenth
century about 3000 London merchants issued tokens . During the period 1644 – 1672,
more than 12700 different type of tokens were catalogued and these were issued
in 1700 English towns. Though privately issued, some of these issues were
authorized by the government. The experiences in France and other parts of Europe
were more or less similar . In 1672 private tokens were declared illegal and
government monopoly was asserted. The Royal mint started minting copper coins.
With the invention of steam engine the minting technology was further upgraded and
scale of production increased. Boulton’s steam presses produced copper coins for
the government in France, and the British government also entrusted the company for
the same task. But the government later bought the technology and established state
monopoly in minting in 1817. What happened in England quickly spread to other
parts of Europe.
5
With the spread of technology, the kings realized the need of issuing coins
of small denominations using different metal (copper) and maintaining a fixed exchange
relation between the value of two metals. Sometimes, smaller amount of metal was
used to make coins of smaller denominations. But the advantage of large scale
production paved the way for debasement of metallic currency by the use of inferior
quality metals whose face value was much higher that the metal value.
The above issue relates to the value of money and long ago N. W. Senior(1969)
wrote:
'… …the value of money… does not depend primarily by the quantity of it
possessed by a given community , or in the rapidity of its circulation, or
on the prevalence of exchanges, or on the use of barter or credit,……
excepting the cost of its production."[ p. 78]
The need for increased volume of physical money with an increase of trade and
commerce along with an improvement in technology made it possible for the government
to look for metal or non-metal objects which could be used as token money serving the
purposes of money as a medium of exchange. Here the face value of money was much
higher compared to the intrinsic value and the cost of production of money will be much
lower. Thus, the cost of production was no longer a hindrance to the expansion of money
supply if the situation warranted. This was the beginning of the emergence of fiat
money and the states realized the potential of this mechanism to command
resources from the society without much effort.
Fiat Money
In modern world, money is the typically paper currency with no intrinsic value
of its own. People hold this currency because money is the only asset that provides
exchange services which other assets cannot provide. The emergence of fiat money has
been due to the fact that commodity money is not a cost less affair and when paper
money was introduced ,it was realized that the cost of the production of money had been
much less compared to commodity money. The production and maintenance of money
requires the use of economic resources. So the welfare aspect of the resource using
money ,which is much higher in case of commodity money , increases when paper money
is used. For this reason society should have an incentive to replace high-cost commodity
money by low cost paper money. Because the latter requires few resources for production
and maintenance, its use increases welfare. This welfare aspect of money is sometimes
missed in the academic discussions. Money is not really a veil in the modern world!
The need for money and its evolution has been studied from different angles. In
the search-theoretic literature, trade results from chance encounters . In such a situation
,need for money arises because it minimizes the cost of transactions due to a double
coincidence of wants. In the absence of the latter, money is used in exchange or nothing
takes place ,and they change commodities when double coincidence of wants are
satisfied ( Kiyotaki and Wright, 1993, Thronton, 2000 ).
6
This chapter introduces money in the historical perspective and there is indication
that money as a commodity is global in nature . The exchange of commodities may also
happen between two individuals who by the whims of history now belong to two
different nations! That induced mankind to make some arrangement for facilitating
international movement of money. The historical evolution of the global financial
architecture and its consequence on the demand for money in the domestic economy on
the one hand and the price of the domestic money in the international field on the other is
a complex question. This is discussed in the next chapter.
Chapter 2
Alternative Monetary Regimes and World Financial Architecture
"Money, I consider is a device which facilitates the working of markets."

[ Sir John Hicks ,1989, p. 2.]
" As science joins with technology to reduce man's ignorance and appease
his wants at appalling speed, human institutions lag behind, the victim of
memory, convention and obsolete education in man's life cycle. We see the
consequence of this lag …. At the nerve center of national sovereignties:
international economic arrangements".
[ Robert Mundell, 1968 ]
The world has seen a number of financial systems depending on the level of
integration of the world economy and the level of technology. Recent history has
documented the gold standard, gold exchange standard, dollar standard and the recent
flexible exchange rate system. Each system evolved depending on the need of the time
and the will of the leading nations of the world who were able to carry the 'burden' of
7
the world currency. But the major characteristics of the financial system determine the
dynamics of the money supply of the countries who are the partners of trade and the
common world system. We need to know about the different financial system that
prevailed in the world to understand the evolution of world money. A better
understanding of the world monetary system would help understand how the domestic
money supply in member countries was affected by the change in the world financial
system. Though we are aware today that the domestic financial system can not be fully
insulated from the global phenomenon, the situation in the immediate post-war period
was not much different in the Group-of-ten countries3.4 The level of economic integration
among these countries made them inter-dependent.
Sometimes a distinction is drawn between a monetary system and a monetary
order and as Professor Robert Mundell put it :
"A system is an aggregation of diverse entities united by regular interaction
according to some forms of control. When we speak of international monetary system we
are concerned with the mechanisms governing the interactions between trading nations,
and in particular the money and credit instruments of national communities in foreign
exchange, capital, and commodity markets. The control is exerted through policies at the
national level interacting with one another in that loose form of supervision that we call
co-operation.
An order , as distinct from a system , represents a framework and setting in which
the system operates. It is a framework of laws, conventions, regulations, and mores that
establish the setting of the system and the understanding of the environment by the
participants in it. A monetary order is to a monetary system somewhat like a constitution
is to a political or electoral system. We can think of the monetary system as the modus
operandi of the monetary order." [ Mundell, 1972, p.92.].
The distinction Professor Mundell makes between a monetary system and a monetary
order is important in the sense that the chronological order that is followed here will
facilitate the understanding of the working of the world financial architecture and its
impact on the domestic monetary policies of the member countries.
3
1.The group of ten were Belgium, Canada, France, West Germany, Italy, Japan ,Netherlands, Sweden,
United Kingdom and the United States.
4
8
THE GOLD STANDARD
The classical gold standard emerged as a true international standard by 1880

when majority of independent countries agreed to switch from bimetallism, silver
monometallism and paper to the gold as the basis of their currencies. The key rule
was maintenance of gold convertibility at the established par. When the countries
adhered to the fixed price of gold vis-a vis their currencies and maintained it, it
amounted to a fixed exchange rate. According to recent evidence, the exchange rates
throughout the period 1880- 1914 were characterized by high degree of fixity of the
main countries, and violations of gold-parity points and devaluation was rare. The
stability in the price of gold and the ease of the supply of gold compared to world
demand did facilitate this situation. The period was an ideal example of classical full-
employment equilibrium situation in the industrial world with real income changing very
little and so the increase in the demand for monetary gold was small enough to be met by
available production and supply.
According to established literature, a time- consistent credible commitment
mechanism is necessary for an international monetary arrangement to be effective
among the countries. The adherence to the gold convertibility rule provided such a
mechanism. Also, apart from the reputation of the domestic gold standard and the
constitutional provisions regarding the same, some other mechanism like improved
access to international capital market, the operation of the rules of the game, and the
hegemonic power of England might have enforced the countries to adhere to the
international gold standard rules.
The main countries at the time realized that gold standard did provide the
improved access to the international capital markets and for this the support for the
regime increased. Also countries believed that gold convertibility would be a signal to
creditors of sound government finance. Again this had been the case for both developing
and developed countries seeking access to long- term capital, such as Austria-Hungary
9
and Latin America. Also Japan used short -term loans to finance Russo-Japanese war
during 1905-06. The example of England being on the gold standard was an added
attraction for other countries to be on the same standard. In fact England had been the
center of the world monetary system because of her economic might and political
influence .The fixed relation of British pound with gold assured the countries to stick to
the gold standard.
The success of the gold standard had been largely due to the commitment
mechanism the participating countries used to follow regarding the internal adjustment of
policies faced with external shocks. Since rules were followed sincerely and adjustment
facilitated, the commitment to the convertibility of gold was strengthened and there
was less the chance of leaving the gold standard. Further the hegemonic power of
England acted as an anchor. The literature mentions that the classical gold standard of
1880 - 1914 was a British - managed standard. There were several reasons for this. At
that time London was the centre for the world's gold , commodities and capital markets.
Second, many countries substituted sterling for gold as an international reserve
currency . Third, there had been extensive outstanding sterling-denominated asset
outside Britain. Fourth, the Bank of England could attract whatever gold it needed by the
manipulation of its bank rate and other central banks would adjust their discount rates
accordingly.. In this way, the Bank of England did exert a strong influence on the money
supply and price level of the member countries. The central banks of other countries
accepted the leadership of the Bank of England because they benefited from using
sterling as a reserve asset , even though they might have been constrained from
following independent discretionary policies that might have hurt the cause of gold
standard.
Gold standard was an asymmetric system [Giovannini,1989].England was the

centre country and the Bank of England used the bank rate to maintain gold
convertibility. While Britain could follow an independent monetary policy, other
countries like France, Germany etc. accepted the dictates of fixed parities and allowed
their money supply to adjust passively. England, as the leader, had been benefited in
10
multiple ways. It enjoyed the seigniorage earned on foreign -held sterling balances.
Also financial institutions in London used to have handsome returns for the central
location and easy access to international capital markets.
In an influential study Professor Nurkse ( 1944) has argued that in crucial times the
principal member countries did not behave properly in the sense that they partially
sterilized their gold inflows , and the results had been that domestic and foreign assets of
these countries moved in opposite directions during this period of gold standard. The
rules of the game dictated that they should not interfere with the influence of gold flows
on the money supply. Perhaps they became concerned about the potential inflation and
thus became pro-active in the control of money supply.
THE DEMISE OF CLASSICAL GOLD STANDARD
World War I created a massive shock that the financial system could not endure
and the classical gold standard ended. The war reduced the economic strength of the main
European countries in general, and England in particular. The anchor role England used
to provide for the stability of the system ended as the United States pushed England back
from the leadership role. A reformed system-- gold exchange standard -- prevailed for a
short period 1920- 1929; it was an attempt to restore the salient positive features of the
classical gold standard while allowing a significant role of domestic stabilization policy
in response to specific needs. But frictions emerged as the conflict between adherence to
gold standard rule and discretion of policy for domestic compulsion could not always be
resolved. Also there was an attempt to economize the use of gold as reserve by
restricting its use to central banks and also by encouraging the use of foreign exchange
as a substitute for gold.
The gold exchange standard was destined to be a failure as it suffered from a
number of defects. First, the use of two reserve currencies--- sterling and US dollar---
was creating problems as there was an absence of leadership as a hegemonic power
unlike the earlier period when Britain shouldered the role. Second, there was little
cooperation among the key members - Britain, France and United States. Two strong
11
members, i. e., France and the United States, were reluctant to follow the rules of the
game. They created deflationary pressures in the world by persistent sterilization of their
balance-of-payments surpluses. The system could not bear it and ultimately it collapsed
with the Great Depression. But by that time it had transmitted deflation and depression
across the world [Eichengreen,1989; Friedman and Schwartz,1963; Temin, 1989 ]
THE BRETTON WOODS INTERNATIONAL MONETARY SYSTEM
With the end of the World War II, the victors assembled at Bretton Woods, New
Hampshire, USA to build up the World Monetary System, which came to be known as
Bretton Woods International Monetary System (BWIMS). The principal objectives were
to remove the ills from the financial system and to create a stable world monetary order.
For this several measures were adopted. First, the floating exchange rate system was
stopped. Second, the gold exchange standard was scrapped as it was thought to be
responsible for the international transmission of deflation in the early 1930s due to its
vulnerability to the problems of adjustment, liquidity and confidence. Third, the new
system sought to stop the beggar-thy-neighbour devaluation, trade restrictions, exchange
controls and bilateralism prevalent after 1933.
A group of economists led by J. M. Keynes, E.N. White and Ragnar Nurkse

argued for an adjustable peg system, which had been expected to combine the goods
features of stability of the exchange rate under the fixed exchange rate gold standard, on
the one hand, and the monetary and fiscal independence under the flexible exchange rate
standard, on the other. Also the coordination role of an international monetary agency
was planned. The latter was supposed to have considerable control over domestic
financial policy of the members. But the two sides had differences over minor details.
The Keynes plan contained more domestic policy autonomy than the White plan, and the
latter put more emphasis on exchange rate stability. While both the teams - the British
and the American - were not in favour of a rule-based system, the British team was
12
primarily interested to prevent the deflation of the 1930s, and it attributed that partly to
the deflationary monetary policies of the United States and partly to the constraints of the
gold standard rules. Thus the British team was in favour of an expansionary system.
But the American team led by the US Assistant Secretary of the Treasury, Harry
Dexter White presented a system which was closer to the gold standard as it put emphasis
on the fixity of the exchange rates. The nature of the proposed system were as follows.
Though the importance of rules as a credible commitment mechanism was not formally
mentioned but they proposed strict regulations on the linkages between unitas(the
proposed international measure account) and gold. In case any member country did face
fundamental disequilibrium in the external sector, it could change the exchange rate
parity with approval from three quarter majority of all the members of the new
institution.
Ultimately the prescription of both the teams prevailed as the Articles of

Agreements of the International Monetary Fund incorporated the elements of both the
Keynes plan and the White plan, with an emphasis on the latter. The acceptance of the
Plan became in conformity with the ground reality that it was the United States who was
going to shape the international financial system.
Two institutions emerged out of the Bretton Woods Agreement --- the
International Monetary Fund (IMF) and the International Bank for Reconstruction and
Development (IBRD). The latter was planned to take care of the long run growth of the
war ravaged economies of the world and the IMF was assigned the role of maintaining
the world monetary order and stability of the exchange rate system. With these
objectives in mind the articles of the IMF were written. The main points of articles were :
- The creation of par value system
- Multilateral payments
- The use of Fund's resources
- The powers of IMF
- The nature of the organisation
13
The Par Value System

Articles IV of IMF defines the numeraire of the international monetary system as
either US dollar or gold of the weight and fineness on July 1, 1944. All the members of
the Fund were asked to declare a par value of their currencies and maintain it within 1
per cent margin on both sides. If any country faces fundamental disequilibrium, she can
exchange the parity after consultation with other members. If the change of parity is
within 10 per cent, the decision of the members will not be rejected. However, if the
change is more than 10 per cent, the country concerned needs to have approval of the
IMF. In case a decision is made for a uniform change in par value of all currencies in
terms of gold, it is to be done by the approval by a majority of all voting members of the
Fund and by each member separately with voting quota more than 10 per cent.
The Article IV, Section I (a) of the Agreement reads as
Expression of par values. The par value of the currency of each member
country shall be expressed in term of gold as a common denominator or in
terms of the United States dollar of the weight and fineness in effect on
July 1, 1944.
The importance of gold as the numeraire was obscured mostly when most of the countries
excluding the USA had chosen to define their par values in terms of US dollar. John
Williamson suggested that the neutral gold numeraire had been chosen to give the United
States the symmetrical option to change its exchange rate of dollar along with other
countries. Gold was chosen as a conveniently neutral numeraire for defining par values of
the exchange rates of the currencies, but gold was not perceived as the fundamental asset
which would act as a brake on the issue of currencies and help in the determination of the
common price level of the commodities in the member countries the way it had been in
the nineteenth century ( Williamson, 1977 ). Even no single currency, nor even US
dollar, had been recognized as the "key" currency linking the principal currencies in the
world in 1945.
14
Multilateral Payments Mechanism
Article VIII of the IMF states that members are supposed to make their currencies
current account convertible though they can keep capital control as stated in Article
VI(3). The members are to avoid discriminatory currency and multiple currency
arrangements. Again Article XIV allows the countries to keep their currencies not
convertible for a period of three years and, during this period, exchange control can be
maintained. In fact, it had taken a long time for the developing countries to make their
currencies convertible in current account transactions.
Countries would adjust their exchange rates depending on the domestic equilibrium
for which the current account balance is one important parameter. Here Professor
Mundell raised one interesting issue when he stated the following:
Only (N-1) independent balance of payments instruments are needed in an N-
country world because equilibrium in the balance of (N-1) countries implies
equilibrium in the balance of Nth country. The redundancy problem is the
problem of deciding how to utilize the extra degree of freedom ( Mundell, 1968,
p.195: ).
Because of the demonetization of gold in all private transactions, as well as its virtual
demonetization in official transactions too, the redundancy problem as stated by Mundell
had arisen in a very strong form after 1945. All currencies operating in the system were
potentially independent national fiat monies. The amount of these fiat monies were not
related to their base of monetary gold, neither the exchange rates of these monies were
tied to the traditional gold parity. As gold failed to act as the Nth currency, US dollar
slowly took its place. This created the conditions for the Fixed-Rate Dollar Standard.
Resources of IMF
15
The size of the total fund of IMF, contributed by the members' quota in the form
of 25 per cent in gold and 75 per cent in national currencies, was initially US $ 8.8
billion, and the amount could be increased every five years if the majority of the
members wanted. Under the scheme of White Plan, members could obtain resources from
IMF to help finance short and medium term payments, disequilibrium in external
transactions. IMF established a number of conditions on the use of its resources by the
countries suffering from balance of payments deficits. It sets the requirements and
conditions for the repurchase, i.e. the repayment of loan. All these are to facilitate the
management of currencies which are of greater demand for the payments of international
obligations. The conditions imposed on the member country seeking loans from IMF are
derived from a monetarist model of Professor Polok, and in many cases this has been
resisted by the countries.
The Powers of IMF
The articles in the agreement delineated the powers of the two institutions created
for the creation and sustainability of the system. The International Monetary Fund has
the powers to approve the changes made in the parity by the members to approve or
otherwise on the use of multiple exchange rates or other discriminatory practices. The
fund has considerable power to influence the international monetary system and it
exercises its power in consultation with national and international monetary authorities.
The Structure of Organisation

IMF is governed by a Board of Governors who are appointed on the voting
strength of the members. The Board makes the policy decision regarding the actions of
the members. Also a number of Executive Directors and one Managing Director are
selected by the members. The power of the members is reflected in the voting rights,
which are proportional to the members' quota (of contribution)
16
Under the agreement the USA had to maintain a fixed price of gold at US$35 per
ounce, and when the members are maintaining fixed parity, the gold price used to be an
anchor of the system, which converted the gold standard into a dollar standard.
The architects of the Bretton Woods Agreement were not very much specific
about the system of the functioning of the system. The evolution of the system was
partly based on subsequent interpretations of the economists who were engaged in
research. Several important features were mentioned (Tew 1988; Williamson, 1985).
One such feature is that all currencies were treated as equal in the articles of agreement,
which implies that each country was required to maintain its par value by intervening in
the currency of other countries. This position dictated by theory would not have been
meaningful, as other countries can fix their parities in terms of US dollar as the United
States was the only country that pegged her currency in terms of gold.
Historical Stages of the Bretton Woods Agreement: 1946-1960
The period of transition from the war to peace in the post World War II was very
long and painful and the functioning of the Bretton Woods system had not been on the
desired lines. The system started functioning normally by 1955 and till 1958 full
convertibility of the currencies of the major industrial countries could not be achieved.
Under the Article XIV of the Bretton Woods Agreement, the countries could continue to
use exchange controls for an indefinite period of transition after the establishment of the
IMF in March, 1947. The countries used exchange control to preserve their foreign
exchange and also every country had negotiated a series of bilateral payments agreements
with each of its trading partners. The countries in war ravaged Europe were in desperate
need for the imports of raw materials and capital goods and thus the allocation of scarce
foreign exchange had come under the control of the government.
Even before the start of the World War-II, political uncertainty in Europe induced
massive capital flight from Europe to the United States. In 1934, American
administration resorted to the devaluation of dollar and the price of gold was raised from
17
$20.67 per ounce to $35.00. These phenomena induced the flow of gold to the USA from
rest of the world and when the War came to an end, the United States had become the
holder of the two-thirds of the world's monetary gold stock. Simultaneously, Europe
experienced depletion of the dollar and gold stock and the economy had been running
well below capacity. The Organisation for European Economic Cooperation (OEEC)
experienced a huge trade deficit with its trade with the United States. OEEC was
established in 1948 to coordinate the funding of the Marshall Plan, and the latter
facilitated huge inflow of capital to the economies of Europe for reconstruction and
development. In fact, huge amount of foreign capital , mainly from the United States, was
invested in the countries of Europe to lead the economies towards reconstruction and
development.
The period 1946-1960 saw some events which were both dynamic and having
significant effect on the international financial system.
In 1949, Great Britain devalued pound sterling by 30.5 per cent and after this 23
countries reduced their parities with US dollar by more or less similar magnitude. This
spate of devaluation helped the European countries to adjust their external sector
efficiently and, as a result, they could eliminate their large trade deficit. But large scale
changes in the parity conditions by a number of countries created the impression that
monetary authorities could perpetuate their disequilibrium situation for some time and
that would create condition for speculation. In any case, there were perceptible
resistance from the monetary authorities to change their parity and slowly the Bretton
Woods system had been reduced to a fixed exchange rate regime even though it was an
adjustable peg system in the initial thinking stage. It is interesting from academic
standpoint that the authorities preferred the spill over of domestic disequilibrium into the
external sector in their adverse balance of payments rather than correcting their exchange
rates.
Even before the British devaluation of pound, France devalued French franc in
January 1948, and this created a multiple exchange rate system, which created problem in
18
the form of broken cross rates between pound and dollar. The system was rectified with
the devaluation of pound. In 1950, Canada also floated its dollar and this situation
continued till 1961.
There was another problem towards the end of 1950s and it was the inadequacy
of the IMF's resources to meet the liquidity problem of the world, which the growth of
the world's monetary gold stock could not meet. The gap was bridged by the holding of
US dollar. The supply of the latter was due to the balance-of-payments deficits of the
United States. During this period the latter used to have surplus in the current account,
but owing to huge investment abroad and the outflow of capital in the capital account,
the balance of payment became negative. The important thing was that dollar substituted
gold in a significant way and the problem of the shortage of gold was taken care of.
The Period 1960--67
From the year 1960 the Bretton Woods system started functioning normally as the
principal members started intervention in the foreign exchange market to buy or sell US
dollars for the maintenance of parity of their currencies. Also the US Treasury started
buying or selling gold with the central banks of other countries at the pegged price of
$35 per ounce. The member countries on their part pegged their currencies with US
dollar at fixed rate within a band of 2 per cent on either side of the parity. Thus each
currency being anchored to US dollar had been indirectly pegged to gold.
The evolution of the system in the sixties turned out to be a bit different compared
to the ideal situation the architects had visualized. Instead of the original system of
equal currencies, the mechanism evolved into a variant of the gold exchange standard in a
sort of gold-dollar system. The British pound lost its importance in the international field
and US dollar became the single important international currency. The decline of pound
happened because of multiplicity of reasons, the principal reason being the relative
decline of the British economy in the world. As it had been fully convertible, by the end
of sixties dollar was used as a currency of international reserve.
19
Further, while the intention of the Bretton Woods Agreement had been the
adjustable peg system in the exchange rate mechanism, the system that evolved over time
could be called a fixed rate system. The reason that monetary authorities became too
much conservative regarding the adjustment of the parities was perhaps they were
unwilling to take the risks of changing the parities as that might lead to the possibility of
speculative capital flows and follow up behaviour by others. Thus the resulting system
took the shape of a fixed exchange rate dollar gold standard. This evolution created
some problems in the international financial systems which were not uncommon in the
inter-war period also and these can be placed into two categories: liquidity and
confidence.
The Liquidity Problem

Towards the end of sixties the United States started experiencing deficit in its
balance of payments and this was mainly due to huge capital outflow in the capital
account transactions. Since the USA is a reserve currency country, it did not have to
adjust its domestic policies to the changes in the balance of payments. The dollar
outflows had been sterilized by the federal reserve as a matter of routine. The outflows of
dollar meant that other countries, particularly European countries, had been holding
dollar reserve. This created different perception in some main European countries and
there was resentment against the do-nothing attitude of the US federal reserve on the
deficit balance of payment situation. In 1965 France began to convert outstanding dollar
liabilities into gold through the gold window. That created some pressure on the price of
gold.
Meanwhile US monetary authorities responded to the emerging world situation
by initiating measures to improve the balance of trade, changing the fiscal-monetary
policies, imposing curb on the export of capital and taking measures to prevent the
conversion of outstanding dollars into gold. But these policies could not change the
situation much and the liquidity problem continued.
The liquidity problem in the international scene was due to the maladjustment of
the demand and supply of gold, as the short-fall of the latter began to be felt in the early
20
1960s. All through the forties, the price of gold had been declining, and this reduced the
production and supply of gold. The stagnant price of gold also reduced its production in
the mid-sixties and it was apparent that the supply of gold from the Soviet Union would
not bridge the excess demand gap. Meanwhile, the demand for gold had been increasing.
Apart from a significant increase of private demand, the demand was increasing also due
to increased volume of trade and commerce among the countries. The prospect of the
world monetary gold stock growing fast enough to finance the growing world real output
and the value of international trade seemed to be impossible. Even during 1957--58, the
gap between the two in the group of seven countries had been significant.
Professor Robert Triffin (1960) pointed out that the supply of dollars arising out
of the negative balance of payments of the United States could not substitute monetary
gold on a permanent basis as the US monetary gold reserve would decline significantly
relative to the dollar liability held in foreign countries. The level of the world monetary
gold stock held in Group of Ten countries did not grow in proportion to the growth of
real gross domestic product and volumes of trade. The gap between the demand for
monetary gold (to support the increasing money supply) and the available supply had
been bridged by the dollar reserve. So long the dollar-gold convertibility at fixed rate had
been there, dollar was considered as a substitute for gold. But everything has a limit and
this was no exception, and some countries started thinking about the apprehension of the
USA not adhering to the gold-dollar convertibility.
Special Drawing Rights ( SDR )
The discussion on the liquidity problem as stated in the previous paragraph implies also
that there had been a feeling that the growth of international reserves had not been
adequate enough to supply reasonable liquidity to the growing international trade and
commerce. Though apparently no real strain was visible, there was a fear that the lack of
liquidity might act as a constraint on the economic growth of the world. Moreover, the
mechanism of increasing the international reserve was too much dependent on the
running of deficit balance of payments on the part of the United States. This was
unstable by design, as Professor Triffin had shown . So the members of the IMF felt the
21
need to create a supplementary reserve which would bolster international trade and
commerce.. The results had been the First Amendment of the IMF Articles of Agreement
in 1967 and this empowered the IMF to create a Special Drawing Account to supplement
its quota system that operates under its General Account. Under the new scheme a
reserve asset was to be created by the IMF and that would be called Special Drawing
Rights (SDR ), and this will not be backed by the deposits of the members, but the value
of SDR as a reserve asset will rest on it being regarded as an acceptable means of
exchange between the IMF and the central banks of the member countries.
The value of SDR was initially set equivalent to $1 or set at 1/35 th of an ounce of
gold. Under the scheme each member was allocated a specified annual amount of SDR
in proportion to their quota with the IMF, and the country could draw upon its SDR
allocation if it experiences a balance of payments difficulties. The member is required to
consult the IMF in the case of drawing the quota, but in drawing the SDR allocation the
member need not consult with IMF. Further there is no conditionality attached with SDR
drawing and it is not subject to repayment. The last thing implies that SDR has increased
the amount of international reserve.
The cumulative total holdings of SDR allocated to a country is known as the 'net
cumulative allocation' of the country and over a 5-year period the member has to
maintain its SDR balance at an average of 30 per cent of its net cumulative allocation.
This percentage was reduced to 15 in 1979. The first allocation of SDR during the
period 1970 -- 72 was to the amount of US $ 9.5 billion. In July 1976, the value of SDR
was changed from $1 to a weighted basket of 16 currencies. Later in January 1981, the
value of SDR was redefined and pegged to a basket of 5 currencies and these currencies
are Pound sterling, French franc, Japanese yen, US dollar and German mark.
A country upon drawing the SDR can exchange the same with other foreign
currency and can increase its reserve. All members of the IMF are bound to accept the
SDR in exchange for their currencies up to three times their net cumulative allocation.
The country that draws its SDR allocation is to pay rate of interest to the Fund and the
country that exchanges the allocated SDR with its currency gets the rate of interest. Thus
the SDR is an indirect loan mechanism through the international liquidity increases.
22
Market Price of Gold and Confidence Issues:
Gold had been the anchor of the system and it was supposed to give stability to it.
But the pegging of the official price of gold at $35 per ounce by the US Treasury attracted
attention of the speculators, who pushed the free market price of gold in London market
to $40 per ounce from the US Treasury buying price of $35.20. But gold served as
backing to the US dollar with a 25 per cent gold reserve requirement against federal
reserve notes. So, US monetary authority apprehended that the speculation in the gold
market might spill over to the official demand for the conversion of dollar into gold. As a
remedial measure, US Treasury supplied gold to the Bank of England to restore stability
and requested the monetary authorities of Group of Ten countries not to buy gold at
prices higher than $35.20 per ounce. In November 1961, the London Gold Pool was
formed by the United States and seven other countries, and it could stabilize the price of
gold. The central banks of the seven countries supplied 40 per cent of the gold stock in
this pool.
The sixties witnessed two phenomena not conducive to the stability of the
financial system. First, there had been a growing scarcity of the gold as the production of
the yellow metal leveled off by 1965-66. Also the demand for gold increased mainly
from the private sector. Second, there had been a perceptible increase in the U.S.
inflation rate as the money supply increased partly due to Vietnam war. Some economists
think that the USA followed an inflationary policy at home that time because of
domestic compulsion.
The two phenomena cited above created a crisis of confidence regarding US

dollar and during 1967-68, the London Gold Pool became a net seller of gold, losing gold
of about $3 billion equivalent at the pegged price. There was apprehension about the
devaluation of dollar, though the scarcity of gold in the world was one reason (Gilbert,
1968, Johnson, 1968). The resulting situation had its consequences. In March 1968 the
London Gold Pool was abolished and it was replaced by a two-tier arrangement. The
monetary authorities of gold pool stopped buying and selling sold in the market, but
23
instead they started transaction of gold only among themselves at fixed price $35 per
ounce. Along with that the United States removed the 25 per cent gold reserve
requirement against Federal Reserve currency. Thus, the link between gold production
and other market resources of gold and official reserves was severed. The result of these
new arrangements was that gold had been demonetized at the margin. The system
evolved into a de facto dollar standard, though gold convertibility remained.
By 1968 the system also reduced to a de facto fixed exchange rate system. The
major industrial countries agreed not to convert their huge dollar reserve into gold.
Meanwhile European countries and Japan became economic power houses and they
became increasingly reluctant to absorb more dollar liabilities. These countries also were
not ready to readjust their exchange rate upwards as they expected the United States to
make the readjustment. Faced with these contradictory pulls and pressures the
International Monetary Fund found itself helpless as its resources were not enough to
prevent devaluation by major industrial countries by providing them adequate assistance
for adjustment (Dominguez, 1993).
The establishment of the two-tier system after the closure of the London Gold
Pool could not maintain the stability of the gold-dollar parity for long and the United
States was forced to close the gold window in August 1971. With this the Bretton Woods
System collapsed, but the institutions created as a result of the agreement --- IMF and
IBRD --- survived. IMF still had an important role as a clearing house for different
views on monetary policies, as a centre of information, as the primary source of
adjustment of the countries outside the Group of Ten and as a monitor of the world
financial system. Particularly, the developing countries need the guidance and help of the
IMF to standardize their financial system.
Gresham's law in International Level
24
In the 1960s the adverse price movements in the international level brought
asymmetry in the intrinsic values of two principal assets--- gold and US dollar. Under the
Bretton Woods System, gold and US dollar parity was fixed at $35 per ounce of gold and
at this rate US authorities was committed to buy and sell gold with foreign central banks.
As the US economy experienced inflation by approximately 40 per cent during the 1960s,
it was presumed that price of gold too had risen. There was persistent upward pressure in
the gold market. The market perception of gold being officially undervalued, US
authority secured an agreement from the foreign central banks not to convert their US
dollar reserve into gold. But that could not save the situation and US president Nixon
announced the suspension of dollar- gold convertibility in 1971. Thus US dollar had
driven out gold from the market which was stated in a Law by Thomas Gresham in the
sixteenth century. The Law states that whenever there exists a discrepancy in the prices
of two assets by market perception, and if the nominal values are the same, the asset
which is undervalued will disappear from the market and the asset which is over valued
will remain. This is an explanation of the decline of the Bretton woods System given by
Jurg Niehans (1984) and Paul De Grauwe (1989).
Decline of the System:
The Bretton Woods Agreement had the design of making the United States the
centre country so that it could perform the anchor role for the stability of the system.
Unfortunately the United States could not perform that role because of a set of reasons.
The United States was to fix the price of gold at $35 per ounce and also to maintain
domestic price stability to safeguard the intrinsic value of dollar. Of course, the price of
gold could be adjusted with the consent of the majority of the members having quotas in
IMF at 10 per cent or more. But there was no enforcement mechanism for the USA and
only the credibility of the country and a commitment to gold convertibility had assured
the sustainability of the system. The rest of the world, the (n-1) countries, had to accept
the price level set by the United States through their commitment to fixed parities of their
25
currencies vis-à-vis US dollar. This had the implication that the (n-1) countries had to
follow a definite set of fiscal and monetary policies which were consistent with the fixed
parities. But the countries could change their parities because of the adjustable peg. In
the process disequilibrium in the domestic economy might happen but this contingency
was not spelled out in the sense that there had been no constraints placed on the member
countries regarding the extent to which the domestic monetary and fiscal policy could
deviate from the pattern set by the United States (Giovannini, 1993; Mundell, 1968).
The crisis of liquidity in the world financial system had not been properly
addressed. The countries were to keep reserves against their currencies either in the form
of gold, or in some principal currencies such as dollar. But in reality US dollar had been
the main currency which was used as the reserve currency because of the gold
convertibility. There had been the gold convertibility clause and a crisis of confidence
too and these prevented the United States to supply the monetary reserve demanded by
the (n-1) countries. In addition to it, the USA followed an inflationary policy in the late
sixties, but was unwilling to devalue the dollar. This reinforced the confidence problem
regarding US dollar. So when some countries tried to liquidate their dollar liabilities and
transform that into gold, the United States got panicky and closed the gold window in
1971, signaling the collapse of the system.
Post Bretton Woods Era: Managed Floating Exchange Rate
The period between 1971 and 1973 had been one of the shock and adjustment for
the major countries of the world and in March 1973 the world turned to a generalized
floating exchange rate. In the new system the monetary authorities started extensive
intervention to influence both the levels of volatility and the exchange rates of their
currencies. By 1980, the dynamism of the system stabilized and members started
intervening only to control the volatility of the system. The Group of Seven countries
started a coordinated attempt of exchange market intervention to bring stability. The
decade following 1980 witnessed enormous capital flows across political boundaries and
a relative dis-intermediation of the international banking system. This had an impact on
26
the world financial system, particularly on the viability of the international banking
system. Some banks in Japan could mobilize enough capital and became very large in
terms of the asset size. The countervailing power emerged and the Basle Committee
introduced capital adequacy norms for all banks operating in the international market.
The capital adequacy ratio (CAR) initially proposed as 8 per cent of the risk-weighted
assets acted as a constraint on the expansion of credit portfolio of the banks. The latter
had an important impact on the money supply of the member countries.
The Second Amendment of IMF Article

The Second Amendment of the IMF Articles came into effect on April 1978 and it
formally gave the IMF members a large degree of discretion in the selection of their
exchange rate arrangements. IMF had been urged to adopt a policy of " firm surveillance"
over the exchange rate policies of the members.
The Second Amendment Article IV defined the responsibility of the members.
Each member was obliged to notify the IMF of its exchange rate arrangement. The
members were free to select the exchange rate arrangement they would think right for
their interest, but they were to supply information to the Fund. Also a member was to
avoid manipulating exchange rates in order to prevent effective balance of payments
adjustments or to gain an unfair competitive advantage over other member which might
hurt the interest of the latter. In a way the Second Amendment reduced the power of the
IMF drastically.
Appreciation of US dollar
During the period 1980 - 1985, US dollar experienced substantial appreciation
against major currencies. The nominal effective exchange rate appreciated by 50 per cent
and the same thing happened with the real rate. This was the results of the divergent
macroeconomic policies pursued by the United States, Japan and European countries. The
US authorities followed a relaxed fiscal policy but a tight monetary policy, with the
27
budget deficit skyrocketing from USD 16 billion in 1979 to USD 204 billion in 1986. As
the US real interest rate increased relative to other countries, capital from other countries
flowed in the United States to finance the growing current account deficits and dollar
appreciated. The US government argued that the dollar appreciation was the reflection of
the growing strength of the domestic US economy.
The appreciation of dollar hurt the export and import competing industries of the USA
and this increased the balance of payments problems. The public sentiments went in
favour of protection and the trade partners of the United States were convinced that the
negative balance of payments of the United States was the reflections of its growing
budget deficits. But a parallel thinking also developed that US dollar should be allowed
to have its true level.
The Plaza Accord

Finance ministers of G-5 countries ---France, West Germany, Japan, United States,
United Kingdom-- met at Plaza Hotel in September 1985 and after the deliberations of
their respective view points, they issued a Communique which is known a Plaza Accord.
According to the Accord, the exchange rate of US dollar did not accurately reflect the
changes in the economic fundamentals like the measures Japan was to take to stimulate
domestic demand, or the US commitment to reduce budget deficits. There was also
agreement for the depreciation of dollar and the countries agreed to cooperate on this
issue. The dollar started to decline and the extent of the decline of dollar caused concern
among the members.
In February 1987, the G-7 countries (Canada and Australia together with G-5
group) met in Paris to consider the situation of declining US dollar and reached an
agreement known as Louvre Accord. In this, the G-7 countries agreed that further decline
of dollar was not desirable and the then exchange rates were true reflections of the
economic fundamentals. Implicit had been the agreement that the US dollar should be
kept within a 5 per cent target band against the deutschmark and the yen. But the accord
could not completely prevent the decline of dollar.
In October 1987, there had been a collapse in the stock markets around the world and
as a consequence the dollar came under pressure as the crash in the stock market induced
28
the fear of world recession. The governments of some industrialized countries started the
loosening of their monetary policies and reducing the interest rates. In January 1988, the
trade deficits of the United States showed the sign of improvements, and US dollar
started the recovery phase.
International Capital Flows
The flexible exchange rate system in the world had been associated with an
increasing strength of the international money managers who were able to make large
scale capital movement from one country to another within a very short time. The trans-
border capital flows had been effected to make profit either from the possible fluctuations
of the exchange rates due to the potential changes in the short-term interest rates or the
potential changes in the prices of the stocks in well-integrated stock exchanges of
different countries. The first reason had been man-made on some occasions leading to a
pre-planned attack on a currency and this has led to a destabilization of the currency,
when the concerned central bank failed to take care of its total liability denominated in
the form of total currency in circulation with the banks and the public. This type of
situation had been very common in the 1990s when several countries became victims of
the international currency predators. However, we will discuss this aspect in detail in
Chapter 15.
The Financial Architecture

The period 1990s had been marked by a series of currency crises and the
intervention of different governments in response to these crises first in the European
Monetary System (EMS) countries and then in Mexico. The crisis then spread to South
East Asia and it soon spread to other countries like Brazil and Russia. Though each
country had its own unique features in the currency crisis, there were certain stylized
facts in this phenomenon. The EMS crisis of 1992 was initiated by German reunification
and the reluctance of other member states to pursue policies, which could have checked
inflation. The Mexican crisis had resulted as a combination of several factors after
Mexico experienced huge capital inflow till 1994 when the crisis occurred. The forces
29
were as follows: First, interest rates increased in the United States making investment in
Mexico less attractive. Second, a rebellion in the state of Chiapas increased doubts
among the investors about the political stability. Along with that when one presidential
candidate of a political party was assassinated, capital inflow to Mexico reduced
drastically and Mexico had to use its depleted reserve to save the currency.
The Russian crisis in the aftermath of 1998 was a culmination of external shock
like a decline in the prices of raw materials to an asymmetric expectations of the
creditors. The decline of tax receipts of the government due to the fall in the price of oil
led to an imbalance in the budget of the Russian government. The parliament blocked the
reform proposal of the government and the currency became weak due to capital flight.
In this situation Russia sought help from the IMF and after some controversy got a loan
of $11.4 billion. This created an upward expectation in the financial market and investors
started buying short-term rouble debt to earn very high interest rates. Interestingly no
one understood that rouble might depreciate further because of high interest rates, and
this precisely did happen. In August 1998 Russia allowed the rouble to float and
suspended the redemption of rouble denominated debt. The depreciation of rouble
initiated a 'run' on the bank, as depositors wanted to withdraw roubles to buy dollars.
The banks were the holders of large debts which were 'frozen' and so they could not pay
their depositors. The country had to suffer for the irrational decision of the investors first
to put money with wrong expectations and then withdraw capital leading to the collapse.
Looking at the evolution of the international monetary system one finds several
important conclusions. First, the maintenance of the fixed exchange rate system in the
beginning and the flexible exchange rate system since the early 1970s always had to face
the n-country problems as the number of independent exchange rates would be always
smaller than the number of currencies. Thus, it is impossible in theory for all the
governments to pursue independent exchange rate policies. The history of the evolution
of the system since 1950 has shown how the governments had to solve the n-country
problem at different times. IMF had not been successful to control exchange rate policies,
though it had been the source of balance of payments credit. The willingness of the
30
United States to allow other countries adjust their exchange rates vis-à-vis US dollar
solved the n-th country problem in the initial years till 1960. Later on the United States
experienced deficit in the balance of payments and other countries accumulated dollar
reserves and they substituted gold reserves by dollars. The United States tried to solve
this problem by a realignment of the exchange rates by Smithsonian Agreement in 1971.
But this arrangement fell apart in 1973 when the USA devalued the dollar unilaterally.
This induced other governments to float their currencies.
The second lesson of the evolution of the international financial system is the
market behaviour in the pegged exchange rate system. When the latter is firmly in order,
investors are tempted to take advantage of the interest rate differences without covering
their foreign exchange exposure. But the moment market suspects the durability of the
pegged rate system, the investors rush for cover. The resulting conversion of currencies
and the large amount of capital flows can produce the anticipated exchange rate change,
which the investors apprehended. This has happened time and again; this happened in
Europe in 1992-93, Mexico in 1995, Asia in 1997-98 and in Russia in 1998 (Goldstein,
1998; Adams et al, 1998). The repeated crises has reopened the debate about whether
restrictions should be imposed on the international capital flows, what should be the
appropriate exchange rate arrangement for the new market economies and whether IMF
needs restructuring. Some economists are in favour of introducing some sort of a tax on
the international capital flows as suggested by Tobin. This will make the transfer a bit
costly but opinion differs on this issue. However, we will have a close look at this issue
later in this chapter. Again the enormity of the crisis as seen in Asia in 1997-98 has
induced thinking along the line whether the IMF in its present form can take care this sort
of problem in future.
Exchange Rate Arrangements

In recent times different countries have arranged different types of exchange rate
arrangements and broadly these can be put in the following categories:
----Currency pegged to another strong currency or SDR
----Currency pegged to a currency composite
31
---- flexible exchange rates of a single currency

---- flexible exchange rate under cooperative arrangement
---- More flexible or managed floating exchange rate
---- Independent floating exchange rate
Countries like Angola, Liberia, Iraq, Oman, Panama, Syria and Beliz have pegging
arrangements with US dollar. Again countries like Benin, Cameroon, Congo, Mali and
Senegal have a fixed peg system with French franc. The countries like Lybia and
Myanmar have pegged their currency with SDR, while some countries have pegging
arrangement with specific currency---e.g., Bhutan with Indian rupee, Brunei with
Singapore dollar, Estonia with German mark and San Marino with Italian Lira.
The countries who have a pegging arrangement with a currency composite are:
Bangladesh, Burundi, Cyprus, Fiji, Iceland, Jordan, Malta, Slovak Republic, Tonga and
Vanuatu.
The countries like Bahrain, Qatar, Saudi Arabia and UAE have currency which are
quite flexible though not of the elite group. On the other hand the countries like Austria,
Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands,
Portugal and Spain have flexible and elite currencies which are also stable through
cooperative arrangements. These countries belong to the elite OECD group.
Some countries have currencies whose exchange rates are described as managed
floating. Their list is quite long and the principal countries in this group are--- Algeria,
Brazil, Chile, China, Costa Rica, Egypt, Georgia, Hungary, Indonesia, Israel, Iran,
Malaysia, Pakistan, Russia, Singapore, Sri Lanka, Thailand, Venezuela and Vietnam. This
position was as on June 1997.
Some countries have opted for an independent floating exchange rate regime and this
list is very long. Some of these countries are: India, Albania, Australia, Canada, Ghana,
Jamaica, Kenya, Lebanon, Mexico, Peru, Sweden, Switzerland, United States and
Zambia.
The above shows that the exchange rate arrangements of the different members of the
IMF are of various nature and this has made the system much more complex. Each
country follows a course regarding its currency's exchange rate according to the strength
32
of the economic fundamentals. In fact the Second Amendment of IMF Articles in 1978
has empowered the members to choose their own exchange rate regime and supply
information to the Fund accordingly.
The Tobin Tax Proposal on Capital Movement

Professor James Tobin argues that in a world of flexible exchange rates the
dynamics of the short term capital flows has a destabilizing effects on the stability of the
exchange rates and in fact it can disrupt the whole process ( Tobin, 1978):
National economies and national governments are not capable of adjusting to
massive movements of funds across the foreign exchanges, without the real
hardship and without significant sacrifice of the objectives of national economic
policy with respect to employment, output, and inflation (p.154.).
Tobin argues that in the highly integrated world of today it is difficult for the
national economies to pursue independent monetary policies. If domestic interest rate
rises, this can induce a sharp appreciation of the currency in real sense. Again, a fall in
the interest rate will lead to a real depreciation. This sort of effect will have adverse
impact on the economic parameters of the economy and Tobin suggests that a tax can be
imposed on all foreign exchange transactions so that the destabilizing effects are
reduced . The proposed tax will reduce the incentive for the speculators to instigate huge
capital flow in and flow out of the economy in response to a small interest rate change.
Tobin suggests that this type of tax should be imposed on all types of foreign exchange
transactions without exception and then only it will be effective. Though it may have a
negative effect on the international trade, Tobin thinks that the trade-off is worthwhile as
it will have a stabilizing effects on the exchange rate and through that on employment and
income.
Many economists believe that Tobin's tax is a bit harsh measure as a flat tax on all
foreign exchange movements can reduce the depth and breadth of the markets and the
consequent reduction in liquidity can increase the volatility of the market, and it is an
opposite and unwelcome situation than what is desired. Also with today's innovative
financial markets, it is highly probable that the tax will be circumvented as financial
33
innovation will induce a replication of instruments that would remain unaffected by the
tax.
The G-7 Study for World Monetary Reform
The Asian crisis in 1997 induced the G-7 countries [ the 7 countries are--- the
USA, Canada, United Kingdom, France, Germany, Italy and Japan ] for a fresh study for
revamping the world monetary system and the finance ministers of the seven countries
bought out a Report entitled " Strengthening the International Financial Architecture"
which was accepted in a summit in Cologne in June 1999. The Report identifies five
main areas which are to looked into for strengthening the world monetary system ( G-7,
1999).The areas are:
-- transparency and best practices
-- strong financial regulation in industrial countries
-- strong macroeconomic policies and financial system in emerging countries
-- improving crisis and management with private sector involvement
-- promoting social policies to protect the poor
Regarding the transparency the Report emphasizes that transparency is needed to

ensure that information about existing conditions, decisions and actions of the authority
should be made accessible, and easily understood by the economic agents. When the
latter get sufficient market information, they can efficiently allocate the resources to
minimize the risks. Transparency also promotes healthy market expectations of the agents
that help maintain stability in the system.
Monetary authorities should publish information about their reserve position, the
leverage position and external indebtedness. The countries are to be encouraged to apply
uniform standards and sound practices to foster the development of sound financial
system. International institutions should disclose their evaluations of the respective
countries' financial system.
34
Stronger Financial Regulation

The Report emphasizes that inadequate and inefficient evaluation of the credit
proposals are also responsible for the creation of bad asset. Excessive risk taking along
with high degree of leverage can make the financial system fragile and spread negative
expectations. The Report identifies three areas which are to be addressed by the
industrial countries and these are:
--improving risk measurement and its management
--assessing the implications of the activity of the highly leveraged institutions,
and,
--evaluation of the implications of the activities of the Offshore Financial Centres
The three areas are inter-connected as it is the offshore regions where the probability is
very high that highly leveraged financial institutions are engaged in high risk business.
The resultant loss, when it happens, erodes the bottom line of the parent institutions.
Strong Macroeconomic Policy

The Report devotes considerable space to discuss the spectrum of
macroeconomic and financial policies the emerging countries should adopt in the current
global scenario. One important area is the exchange rate regime which should be
supported by consistent macroeconomic and fiscal policies by the respective
governments. The financial system should also work in an efficient manner by
maintaining a proper leverage position.
The Report also asks the G-7 group for its firm commitment to work together with
the important financial institutions of the world to improve the standard of supervision of
banking and financial system. It also requests the governments of the emerging countries
to narrow down the zone of the government guarantee for private sector loan so that the
problem of moral hazards can be minimized.
The G-7 countries also caution the emerging countries [ there are 11 in the group
and they are---- Argentina, Australia, Brazil, China, India, Mexico, Russia, Saudi Arabia,
Korea, South Africa and Turkey ] to proceed for capital account liberalization with proper
sequencing of policies and creation of necessary infrastructure. The International
35
Monetary Fund (IMF) and other similar institutions are asked to monitor closely the
trans-border capital flows to minimize the potential destabilizing effects of the latter. It is
recognized that the international capital market has an important role for the
improvement of productivity in the emerging countries.The report also asks the emerging
countries to adopt best practices regarding debt management with greater reliance on long
term debt, if possible, denominated in domestic currency and removal of biases that
encourage short term .
Crisis Prevention and Crisis Management

Regarding crisis prevention the G-7 report envisages a framework for preventing
crisis without introducing moral hazards. The main element in this framework is the
involvement of private creditors in all the aspects of debt management strategies. The
Report recognizes that the official financial assistance in certain situations can play an
important role in the prevention of crisis, and even when crisis occurs, in limiting the
risk of contagion. Also the Report urges the emerging countries to develop a mechanism
for a more consistent and systematic dialogue with the main creditors for the
restructuring of loan and thus spreading the liability over a larger time horizon so that the
risk of contagion remains limited.
The Report advises the debtor countries to establish sound and efficient
bankruptcy procedures and strong judiciary to promote transparency and equity in the
insolvency regime. The Report puts emphasis on both the commitment of countries to
meet their obligations and market discipline.
Formation of a New Group: G-20
On the initiative of G-7 a new group has been created in the world scene and it is
called G-20, which comprises 7 members of G-7, a Representative each of European
Union and jointly of the International Monetary Fund and the World Bank, and 11 major
emerging countries. On this, the G-7 is of the view that they propose to establish a new
mechanism for informal dialogue in a framework of Bretton Woods institutional system ,
and to broaden the dialogue on key economic and financial issues among major emerging
36
economies for the promotion of world growth and stability. Some sort of a collective
management of the world financial system has been the motivating force behind the
formation of G-20, as this group constitute the largest mass of the world economy on the
basis of market size. Whether countries outside this grouping will cooperate with this
idea is a question which future will answer.
New Initiative of IMF and the Poor

The financial crisis of 1997 had proved that it was the poor in the affected
countries who were hit the hardest and a realization dawned among the academics that
there should remain some safeguards for the protection of the people in the lower rung of
economic ladder in case financial crisis erupts. The World Bank has taken the initiative
in this field and it has developed a set of Principles and Good Practices in Social Policy
in April 1999 with the objective of identifying and managing the social dimension of
financial crisis. Also the IMF programme " Enhanced Structural Adjustment Facility" has
been renamed as Poverty Reduction and Growth Facility. This exercise signals an
important shift of emphasis toward the achievement of social objective in the
programmes supported by the IMF.
Both the World Bank and the IMF are committed to achieve significant result and
these twin institutions supported other measures which are consistent with the objective
of poverty reduction. They also supported the G-7 initiative of debt reduction of heavily
indebted poor countries. But the approach relies on the positive aspects of the market
mechanism and they advise the poor countries to do the necessary reforms so that the
fruits of the progress reaches the real poor.
The New International Financial Architecture

In the last two decades the world financial system has undergone significant
changes and there is a growing concern among the academic community about the
37
stability of this system ( Eichengreen, 1999; Blinder,1999, Goldstein,1999 ). There has

been a broad consensus about what the emerging countries should do regarding external
financial transactions and these are: adoption of a floating exchange rate regime, less
reliance on foreign currency borrowing and extreme cautious approach regarding capital
account liberalization. Along with these elements there has been an emphasis on the role
of market in the new scheme of things.
There are still certain gray areas which are to be looked into. The stability of the
world system depends on the interdependence between the macroeconomic policies of
the global financial powers, particularly the United States, European Union and Japan.
But the present arrangement may not be considered as sufficient. As for example, the low
interest rate policy as well as weak yen policy pursued by Bank of Japan since the middle
of 1995 had been necessary to fight the domestic recession. But this policy led to a huge
Japanese investment in the USA at a cheap cost and also huge Japanese loan to South
Asia. In early 1999 there had been a sharp reversal of the yen decline vis-à-vis US dollar
and the G-7 passively accepted that though it was not good for the recovery of Japan. The
market took the signal that yen was going to appreciate further which was consistent with
the American attempt to reduce the deficit in current account in its trade with Japan.
There is perhaps another issue which should be addressed properly and it is the
liquidity of IMF, which obtains its resources through quota subscriptions from members.
In return, IMF creates international liquidity. This is supplemented with the creation of
the Special Drawing Rights(SDR). But in the present scenario of market-led world
financial system what is feared is that IMF may create too much liquidity in the system
which it may not endure. Being the international lender of last resort IMF should not
create any moral hazard problem so far as the management of the current account of
individual member is concerned. But the market perception should be clear that IMF has
the means to prevent a crisis situation of a particular member from degenerating into a
systemic instability.
This chapter explains in detail the evolution of the world's financial system, and
the description of the new financial architecture will not be complete without a
38
discussion of the new experiment of the twentieth century, i.e., the formation of
European Union and the new currency Euro. We will discuss this in the next section.
European Union and Euro

The single currency of European Union Euro was launched on January 1, 1999
and it is a composite currency consisting of 12 currencies whose weights are
proportionate to the importance of the economy. The currencies with their respective
weights are discussed in detail in Chapter 4. Here we discuss the systemic impact of the
Euro on the global financial system.
At the time of launch, Euro 1 = Us $ 1.17 and that was the theoretical value. But
during the last two years Euro has lost heavily against US dollar and in December 2000,
Euro was quoted around US $ 0.88 , which means a depreciation of about 24 per cent .
Euro will be in physical existence from January , 2002 as it will come in
circulation as a medium of exchange, and the countries who have taken up the currency
will have a dual currency system for the period January to June, 2002. Meanwhile, the
legacy currencies will be withdrawn and in July, 2002, Euro will be the only legal tender
in the Euro zone. At present twelve countries have accepted Euro as the currency and
they are: Austria, Belgium, Finland, France, Germany, Ireland, Luxembourg, the
Netherlands, Portugal, Spain and Greece( from January1, 2001). Three other countries are
the members of the European Union, but they have not adopted the Euro yet and they are:
Denmark, Sweden, and the United Kingdom.
European Union as Optimum Currency Area

The success of the Euro becoming the single currency of the European Union
(EU) depends on the EU becoming an optimum currency area. To fulfil the latter criterion
EU should satisfy some conditions. First, the members of EU should possess similar
economies in the sense that they should have compatible economic structures with same
level of economic diversification. In that case the countries would get same type of
external shocks and same type of exchange rate they can follow. In the absence of the
39
similarity, same type of external shocks would create different type of effects and the
countries would require different exchange rate policies.
Second, the economies of the countries under EU should be properly integrated
such that they face the same phase of business cycles at the same time. This will facilitate
adopting same interest rate policy and one monetary policy. This condition is tough but
very important, because if interest rates deviates from one another, diverse capital
movements will create problems for the single monetary policy. The latter is crucial for
the credibility of Euro being the single currency in EU. It will be a difficult proposition
for the European Central Bank (ECB) to fight inflation in one country with high interest
rate and tackle recession in another country with lower rate of interest.
Third, the member states should have a common economy in the sense that the
movement of capital, labour as well as commodities should face no restrictions across the
political borders. This implies a single market condition and the industries in the
concerned countries should be ready to face this competition.
The three conditions as outlined above are necessary for the establishment of the
optimum currency areas. The fact is that EU member states are yet to achieve this stage.
But the Maastricht Treaty tried to ensure that the eleven countries were similar by
imposing four convergence criteria related to the exchange rate, inflation rate, interest
rates and the public deficit ( budget deficit) in relation to the gross domestic product.
First, the exchange rate of the country must remain within the normal fluctuation margin
of the Exchange Rate Mechanism [ ERM] for 2 years. Second, the rate of inflation should
be no more than 1.5 per cent above the average rate of the three best performing member
states. Third, the long term interest rate should be in line with the best countries in term
of performances. Fourth, the budget deficit should be no more than 3 per cent of the
gross domestic product of the country.
On the surface the success of the convergence criteria in the case of 11 countries
shows the success of the common currency. But ground reality may remain different.
When all capital market instruments are converted to common currency, the interest rates
will converge, but that will not ensure the similarity of the objective situations of the
capital markets of the member states. Failure of this implies that capital will not move to
40
the capital poor regions as expected initially. All these show the difficulties in the way of
the member states under EU forming the optimum currency areas.
The literature explains the optimum currency areas as an ideal state and it defines
whether a group of countries can enter into a monetary union without much negative
externality. In a sense every country with its own currency is a monetary union, but that
does not guarantee that the country presents an optimum currency areas. Big countries
like the United States, Russia, China and India are not optimum currency areas, as
different states either in the United States or in India do not exhibit the similarity of the
economic structures as described under the optimum currency areas.
But the monetary unions do function and this they do with relative success
because of the functioning of some adjustment mechanism like flexibility of factor prices
and mobility of labour and capital across the regions. Flexible wages and interest rates
will clear the markets and that takes care of the unemployment and under employment of
factors of production. Free and unrestricted mobility of capital and labour is very
important in this adjustment mechanism without which sectoral unemployment will
prevail.
What is the real situation in European Union? Different studies suggest that the
cultural and linguistic differences among the countries in Europe form a significant
barrier to labour mobility. It has to try hard to achieve the type of labour mobility as seen
in the United States. But sociologists raise a more fundamental issue and that is whether
the social friction that may result duo to labour mobility in the face of cultural differences
are desirable from the stability aspect of the society. This is an apprehension and for this
economics has no answer.
The success of the Euro will depend largely on the role of the European Central
Bank ( ECB), which is located in Frankfurt and which is controlled by a set of
independent central bankers who are not vulnerable to the political opinion. The ECB
will see rough days ahead as it tries to impose strict monetary and fiscal discipline on the
weaker countries for the stability of Euro and its success will depend to what extent it can
withstand the potential political pressure. The formation of European Union and its
41
impact is discussed in this chapter from the perspective of the theory of optimum
currency areas. The structure of the currency Euro and its recent changes are explained in
Chapter 4.
Chapter 3.
International Movement of Money: The Institutions
"In a world of banks and insurance companies, money markets

and stock exchanges, money is quite different thing from what it
was before these institutions came into being".
[ Hicks, 1967: p. 158 ]
Money as a commodity is global by nature and its movement is facilitated by

well-established institutions like money market, capital market and the market for foreign
currencies. The latter is part of money market but for the convenience of analysis we
discuss it separately. In today's world of integrated treasury operations of banks and
other financial institutions the persons involved in the movement of money across the
political boundaries are the same working simultaneously in the three markets as
mentioned. The money market and the capital market have been described earlier, and let
us take the foreign exchange market.
Foreign exchange is generally referred to as the instruments , communications or

orders that results in a change of ownership of demand bank balances abroad. Thus
42
foreign exchange is defined as any order, communication or any instrument that

necessitates the receipt or payment of funds in a currency other than the currency of the
market where the settlement for the order or communication is made. The instruments are
generally wire transfers, checks, airmail payment orders and bills of exchange. So any
instrument that can be sent to another country and effect a transfer in the ownership of
demand balances in banks is a piece of foreign exchange. We can thus include within this
definition foreign cash, foreign stocks and bonds, credit card vouchers, traveler's checks
etc..
The Market for Foreign Currencies
The market for foreign currencies or foreign exchange market (FEM) is the
market for trading in diverse currencies which are all sovereign money guaranteed by the
respective governments and issued by the central banks with adequate reserves as the
backing of the respective liabilities. Each transaction involves the exchange of one
currency, say US dollar, by the currency of another country, say Indian rupee, and in most
of the cases it is by changing ownership of deposit balances in banking system. It is
always money against money. At the smallest level it can be as artless as the tout
changing US dollar against rupee in the market place at Mumbai or the porter changing
the dollar for rupee at the Palam airport. At the other extreme it may be sophisticated
electronic hook-up tables with computer and telephones, fax machines and telex in the
foreign exchange dealing rooms of the banks in major financial centres like Mumbai,
London, New York etc. transacting in millions of currencies of different denominations
within a short time. The essential process is the same , only modern technology has
facilitated the transfer of huge volume within a very short time. The world has become a
very short place in the dealing room. It is not a market where two parties meet each other
face to face, but it is an electronically operated market and this sort of market functions
24-hours a day around the globe and handles over 95 per cent of total business.
The players in the market are individuals, traders, financial institutions,

commercial banks, brokers and central banks. The traders in the market operating from
43
the dealing rooms are dedicated to ordering the movement of money in and out of the
account their banks maintain in other banks and correspondent institutions around the
world. The FEM is closely linked with both the capital market and the money market
since in the recent globalization of finance, many investors and other participating agents
are to go through financial intermediation across the political borders and from one
currency to another to reach their counter-party. The modern arrangement of integrated
treasury management is the logical outcome of the close integration of the three markets.
The nature of the movement of the exchange rates of different currencies are a
subject matter hotly pursued by both the academicians and the traders who man the
terminals in the dealing rooms. The theoretical explanations are complex and sometimes
tricky ( Nandi,1996 ) and one non-mathematical way of understanding the market is
provided in the Technical Analysis literature. The latter is not pursued in this book as it is
too specialized a subject and the reader is advised to see any book on the subject for
further discussion.
The FEM and Time Zones

The global FEM operations is a 24-hour cycle. On any week day this market
opens in Auckland, Wellington and Sydney, then Tokyo opens, followed by Hong Kong
and Singapore an hour later. When it is mid-day in the far east, Bahrain and other Middle
east markets open and a few hours later the European markets open. It is then mid-
afternoon in the Far East as centre as Zurich, Basle, Geneva, Frankfurt, Munich and
London open in the early trade hours. After lunch in these markets, the eastern markets
close, but New York opens. The market then spreads towards the western side of the
United States in places as Chicago, Los Angeles. When the evening sets in America, New
Zealand and Australian banks open the next day and thus the 24-hour cycle becomes
complete.
The respective country's rules and regulations being unique that way guide the
operation in each market. In some exchange rate is fixed, in others it is flexible and
relatively free while in some places it is a managed float type. But the players are of a
44
common mould anywhere in the world and the product is the foreign exchange. In spite
of the fact that foreign exchange regimes vary across the countries, the players in the
market determine the exchange rate and make the market. This they do by changing the
spreads between the bid /ask rates and sometimes through the help of the brokers and
also by creating positions in the expectations of influencing the future rates of the
currencies.
Foreign Exchange Market: Microstructural Dynamics

The foreign exchange market is characterized by the Reuters' D2000-2 electronic
broking system which display bid/ask of the inter- bank dealers as well as the firm deals
which occur though the Reuters' terminal. Limit orders input by some dealers in the inter-
bank to D2000- 2 are automatically matched with the market orders of others, that
results in yielding data on the best current bid and ask quotations, the transaction prices
and volumes as well as the inside spreads of the quotes. Thus enormous data are
generated through the trading in the forex market and the Reuters' terminal exhibit that
data set on a continuous basis-- 24 hours a day on a 5-day week..
Some researchers have studied that data set and they have established one
important feature of the data. They find that the firm quotes have attenuated negative
first order autocorrelation in returns, but the time series of deals show no autocorrelation
in the returns ( Goodhart et al, 1996). This phenomenon has been explained this way.
This is mainly due to forces which cause the limit order book in a competing market
system to be thin. Therefore, if the best bid is exhausted by a deal, the price will typically
fall a comparatively long way until it hits , or provokes a still lower entry. The sharp fall
in the bid is most likely to take the bid below the level where a deal can reasonably be
expected. This means that the spreads will become excessively large. This will induce a
competing market maker to increase the inventory to reverse the prior fall ( Goodhart and
Payne, 1996). This is a picture of "thin market", first explanation of which was given in
Ho and Stoll (1983 ).
Foreign Exchange Brokers
45
The brokers in the FEM operate in the inter-bank markets and in some countries
between the customers and the banks. The brokers do not set the rates in the markets, but
their bids and offers are passed on to the commercial banks and these reflect the demand-
supply factors in the markets. These facilitate the determination of final rates by the
banks. The existence of brokers broadens the markets and makes it more efficient.
Brokers generally do not take a position in the markets and they work as liaison. When
the trade occurs between the customer and the bank, brokers do not appear in between,
banks often take their services when market is volatile . Of course the brokers have their
own customer base and they take commissions from both sides of transactions. Banks
often use brokers in foreign exchange transactions to maintain anonymity until the
closing of the deals and/or when they want to reduce the paper work of their own. The
importance of brokers is related to the nature and organization of the markets, and if there
is a drastic change in the organization of the markets ( as are seen now-a-days with the
arrival of new technology and new types of money), position of the brokers will change
also.
Commercial Banks
The commercial banks are the largest players in the foreign exchange market and
they conduct their operations through their dealing rooms. The latter are connected with
the global markets by all modern gadgets of telecommunications. The traders in these
dealing rooms determine the aggregate demand and supply of any currency and through
these they determine the price. The dealing rooms have electronic trading arrangements
with the help of on-line computers, the latter link participating banks on a one-on-one
basis so that traders car recognize on their monitor who the counter-party is, the amount
of bid or offer, the rates etc. The deal ,if agreed upon, can be closed with the stroke of a
single key of the computer. The reliability of the deal is guaranteed as every transaction is
electronically stored and thus documented. The market information and the dealing
facility are provided by companies like Reuter. Also other providers like Bloomberg
and Knight Rider are in the same category of business.
46
All over the world the dealing rooms are busy with the trade of five principal
currencies - US dollar, German mark, Swiss franc, British pound and Japanese yen. Now
another currency has joined the league and that is Euro. A second layer of currency is
composed of French franc, Italian lira, Belgian franc, Canadian dollar and Dutch
guilders. Other currencies are traded in low volumes , and one reason for this is that
traders do not create positions in third layer currencies .
Commercial banks maintain demand accounts at major banks in all the countries
whose currencies are traded. Leading banks may maintain several correspondents at main
financial centers of the same country to handle business of the customers. In the major
dealing room of the bank several traders may be involved in trade operations of one
major currency, and the Chief Dealer remains responsible for the bank's global position
in the currency, as he must be continuously monitoring the net position of that currency.
The chief dealer must be alert about the likely movement of the currency in near future,
which may be a day, one week or one month. Banks engaged in international operations
do essentially international banking and it is taken up in Chapter 5.
Eurocurrency Markets
Eurocurrency markets are specialized money and capital markets, controlled and
administered mainly by commercial banks in offshore financial centers ( OFC ). The
assets and customers are generally outside the countries of the centers. Euro-currencies
are currencies handled by the banks outside the countries of their origin. These are mostly
hard currencies like US dollar, yen, German mark, Swiss francs and French francs. Euro-
banks in offshore centers maintain accounts in different currencies in banks in New York,
London and such main financial centers and they transfer money according to the needs
of the customers from these accounts.
The history of the eurocurrency markets is very interesting. In the 1950s banks in
London and Paris began accepting US dollar time deposits from non-residents, mainly
from east European countries and People's Republic of China. The latter believed that
under the tension of cold war the United States may block their balances in American
47
banks. The modern Eurocurrency markets developed from these first roots and today the
potential of this market has attracted many financial centers in this business like Geneva,
Luxembourg, Amsterdam, Brussels, Toronto etc. At present more than 50 countries have
banking regulations that permit the opening of time deposits accounts in foreign
currencies on the books of their financial institutions on behalf of their non-resident
foreigners. The currencies circulating in this business are currencies which are capital
account convertible, though major currencies are only a few in number. The countries of
origin of these currencies have banking regulations allowing their banks to incorporate
local subsidiary financial institutions to be treated as offshore institutions for the
acquiring of the national currency as deposits and doing the important role of the
financial intermediary.
The size of the eurocurrency market is huge, though no precise estimate available. One
rough estimate put it in between 7 and 8 trillion US dollars (Reed,1998 ) equivalent and
US dollar constitutes about 70 per cent of it. The rest are shared by other currencies.
The major OFCs have accumulated huge business because they allow foreign
individuals, corporations and governments to participate in their markets as investors and
also borrowers. These markets in England, Germany and Switzerland also offer tax-free
platforms and in the process they have attracted huge intermediation businesses in Euro-
bonds, debentures, Euro-notes etc.
The Supply and Demand for Eurodollar
The supply of Eurodollar deposits grew from the advantage for US banks in
moving operations overseas. This they do to avoid Federal Reserve Regulation M. The
latter requires the keeping of reserves against deposits. This Regulation did not apply to
the foreign branches of US banks till 1969. The non-keeping of reserves against the
deposits reduces the cost of funds for the operations outside the United States, and this
induced the US banks to move some of their funds abroad for creating interest earning
assets. Thus US came and became concentrated in London and other European financial
centers.
48
Since 1960, the growth of the Eurodollar has been induced by factors other than the
Federal Regulations. Europeans and other non-Americans have uneven cash flows in US
dollars , having a large time mis-match. They could sell the US dollars for their home
currency in times of higher inflows and repurchase the same when in need. But this
involves transaction costs and exchange risks. These can be avoided if these dollars they
keep as deposits in European banks so that they can avail these when they need . This
way the Eurocurrency market has expanded rapidly.
The European banks including the branches of the US banks were seeking avenues
for the deployments of the dollar funds. These funds they could not bring to the USA as
that would attract the Federal Regulations. Also as a result of limitations in the 1970s on
obtaining loans within the United States that are not applicable to overseas, there had
been a significant demand for US dollar overseas and the US banks could redeploy the
US dollar deposits in Europe for this purpose. The interest equalization tax in the USA
was also responsible for the demand for US dollar abroad. This tax was functional during
the period 1963 - 1974 and this was a tax on US residents' earnings on foreign
securities. Thus the foreign borrowers had to pay higher returns (interest) to compensate
the tax. But this could be dodged if funds were sent first to Europe and then used for the
creation of asset portfolio. This way the US banks in Europe could offer lower interest
rates.
Thus it was the set of Federal regulations like Regulation Q and Regulation M,
the convenience of banking and profit considerations that influenced both the demand
and supply of Eurodollars. In fact taking a Eurodollar loan was much more convenient
compared to taking a US dollar loan in USA and a loan in other currency in Europe. The
Eurodollar market could achieve its own momentum and in the 1970s when most of the
Regulations in the USA were removed, the growth of Eurodollar market was not
adversely affected.
Eurocurrency Interest Rates
49
Both the demand and supply of Eurodollars were affected by raw business sense.
The depositors of Eurodollars were interested in higher returns, which was possible as
cost of funds was less, and the borrowers also could get funds at a relatively lower rate
compared to credit created in the USA because of the absence of Federal regulations in
case of banking outside the United States. Thus the Eurocurrency interest rates are
generally lower and these give the borrowers an advantage provided the exchange rate
risks are taken care of.
Derivative Markets
Derivatives are financial instruments which are used to hedge against potential
risks in any financial transactions. The value of derivatives are derived from the
underlying financial assets. The common underlying factors for business on which
derivatives are based are the prices of stocks, commodities, bonds, currencies, metals,
real estate and the like. The derivatives contracts from these elements are stock index,
stock options, commodity futures, currency swaps, options, interest rate options etc. The
corporate, individuals, banks and other economic agents buy and sell different derivative
products.
The size of the market is huge and one estimate reveals that the total outstanding
derivative business is approaching about 20 trillion US dollars equivalent. The market is
growing steadily.
The derivative market depends on many other markets like commodity
exchanges, stock exchanges, metal exchanges, foreign exchange and eurocurrency
departments of commercial banks, specialized option and futures exchanges in London,
Chicago etc. The business depends on fees at banks, security houses and insurance
companies and the determination of these fees are done with the help of sophisticated
mathematical models which are very complex and hard at times to understand.
With the evolution of the derivative markets in the principal financial centres of
the world, the functional aspects of the derivative instruments have influenced the
macroeconomic policies of the countries. This issue has been taken in a later chapter.
EURO IN THE NEW MILLENIUM
50
In Chapter 3 we have seen the system of the European Union from the angle of
the world financial architecture. But the micro- level system of the currency was not
discussed in detail. This we can do now. The last year of the 20 th Century saw the
emergence of a new currency in Europe which was a culmination of a long drawn process
of desire of the unification of the Continent which is still on in the new millennium. It is
Euro, which is the logical transformation of the European Currency Unit (ECU) as per
Maastricht Treaty. The European Council, on its meeting on December 5, 1978 took the
resolution in which the following lines were stated:
(i) A European Currency Unit will be at the center of the European Monetary System
and ECU will be used as the denominator of the exchange rate mechanism and for
operations for both the intervention and the credit mechanism;
(ii) The ECU will be used as a means of settlement between monetary authorities of
the European communities;
(iii) The weights of the currency in the ECU will be reexamined and if necessary
revised within six months of the entry into force of the system, and thereafter
every five years ,or on request if the weight of a particular currency of the Union
has changed by 25 per cent or more.
Under the Maastricht Treaty the option for revisions every 5 years has been abolished
and ECU has been renamed as EURO with the weights of 12 currencies as show below in
Table1::
Table 1.. EURO and its components
-------------------------------------------------------------------------------------------------------------------------------------
Currency Portion of national currencies Relative weights Exchange rate
in basket with EURO
(1) (2) (3) (4)
------------------------------------------------------------------------------------------------------
Deutsche mark .6242 33.34 1.96825
French franc 1.332 20.49 6.59950
British Pound 0.08784 10.44 0.678113
Italian lira 151.8 7.17 1942.19
Dutch guilder 0.2198 10.47 2.21939
Belgian franc 3.301 8.57 40.5889
51
Spanish peseta 6.885 4.24 167.129

Danish krone 0.1976 2.72 7.50144
Irish punt 0.00855 1.04 0.783061
Portuguese escudo 1.393 0.71 201.442
Greek drachma 1.44 0.47 327.522
Luxembourg franc 0.13 0.34 40.5889
-----------------------------------------------------------------------------------------------------------
-
Source:: Annex to the 2 May 1998 Communique
The figures in Col.4 is derived by using the exchange rate of US dollar as on July 30,
1998 and also taking ECU= Euro 1= USD 1.1151571. All these figures will remain fixed
for the time being and the exchange rates of the currencies of the countries who joined
later were determined by the cross rates with USD as prevailing as on July 30, 1998. The
formula will remain the same for other countries also who might join later. It implies that
the countries who will join later will simply accept Euro as the currency and their
original currencies will be the things of the past. Euro shall remain tied to the original 12
currencies forever in the relations as stated earlier.
Post Euro situation:

Euro came into being on January 1, 1999 . Initially there had been lot of speculation
about the potential of the new currency regarding its possibility of becoming the vehicle
currency and also to what extent it can compete with the supremacy of US dollar. The
dynamics of the situation has been explained in the literature ( Temperton,1998;
Nandi,1999.). But the initial promise could not be sustained and Euro started losing its
glitter very soon and during its 18 months existence it has lost about 15 per cent of its
value vis-à-vis US dollar. Today the value of Euro is : Euro 1 = USD 0.9430
(approx.).We are to remember that Euro is a notional currency based on its relation with
12 currencies as explained in table and it will come into existence in physical form on
January 1 2002, and Euro will be the sole currency of European Union on July 1, 2002.
The Period between January 1 and July 1, 2002 will be a period when the countries in EU
52
will have a dual currency system and during this phase the national currencies like DM
etc. will be withdrawn and replaced by Euro.
The reasons for the decline of Euro against USD are many and we can document
the principal ones as follows:
1. At the end of 1997 the founding 11 countries [ United Kingdom did not join the Euro
system] held approximately USD 271 bn of foreign currency reserve , of which an
estimated USD 45 bn was held in Euro-zone currencies. If the European Central bank
(ECB) decided to replenish all of the USD 45 bn reserve in Euro-zone currencies by
selling these for USD, it should create an upward pressure on USD.
2. The ECB tried hard to maintain a stable interest rate for the steady state level for
Euro, but the central banks of the member states could not afford a high interest
regime because of unemployment and recession. In fact some of the central banks
started following a soft interest regime to promote growth. This had a negative effect
on the exchange rates of the concerned currencies and since the latter constitute the
Euro in the aggregate , Euro must be weaker.
3. Some of the member countries ,particularly the weaker ones, kept their promise of
maintaining their fiscal deficit within 3 per cent of their Gross domestic Product
(GDP) by default and even the allegations of fudging GDP figures to lower the
critical ratio were not uncommon.
4. Even the promise of Euro becoming the vehicle currency was not achieved. A vehicle
currency is one which the exporters and importers choose for invoicing and
settlement which can be bought and sold at low transaction cost and has a high
degree of acceptability for other transactions. As a result , a thick externalities are
created ,or concentration in the use of currency---- the more a currency is used for
invoicing and trade the more it will continue to be used replacing other currencies.
The advent of Euro ironically reduced the use of DM, French franc and Italian lira( as
Euro is supposed to be in their place), and USD began to be used more as vehicle
currency. This has increased the demand for USD.
5. The increasing strength of USD is due to a reason quite unrelated to the above
argument. In some former communist countries USD has become an important
53
medium of exchange alongside with their national currencies. This phenomenon has
put an upward pressure on USD vis-à-vis all the major European currencies.
6. Since the formation of EMU in 1957 till the signing of the Maastricht Treaty the
power that be in Europe has maintained the belief that the monetary union is a change in
the unit of account only. But it is not properly appreciated that for an object to be
accepted as money ,it must serve both as a unit of account and a medium of exchange.
To serve as a medium of exchange the entity should have some value. In a world of paper
currency the value comes through the conferral of value on the medium of exchange by
legislation on legal tender , central banking and the protection of deposits. All these are
political acts and these must have the political power of the state. This is not there,
though the political elite of Europe is conscious of this as leaders are expressing their
opinion about the formation of united Europe ( Financial Times, June 28, 2000 ). At
present there is European parliament but without legislative powers. This is the inherent
weakness of Euro.
What will be the impact of Euro on trade and commerce? So far as India is
concerned empirical studies have failed to identify specific effects of the introduction of
Euro on India's trade with EU. But things in the international arena are changing fast and
the EU is on a expansion mode. The formation of a bloc of the size of European Union
should have significant effects on global trade and commerce. For the unfolding of the
full potential we are to wait for some more time.
The main problem will arise in the capital markets where the instruments are
denominated in different currencies and different interest structures are involved.
Meanwhile the countries within the EU are to achieve the convergence of the interest
rates and this is a difficult tasks for some soft countries. The latter are finding it difficult
to have a high interest regime because that will complicate further the unemployment
problem there. Also by January 2002, all capital market instruments are to be converted
into Euro denomination. This itself is not a problem, but the interest rate structure by that
time should be similar. To what extent that can be achieved is an open question.
54
Money and the State: The Process of Monetization

What is the role of money in the society? This question has surfaced again as the
world has been witnessing the process of transition in a large number of countries both in
Europe and Asia--- the countries being the former communist countries. There is a
consensus in the literature that the monetization of an economy is a public good as the
efficiency gains that accrue to the economy from the transition from barter to the money
economy are shared by everyone in the society. The role of the state in the process of
monetization can be better explained if we analyze the transition of the command
economies of east Europe and Russia. The essence of the problem these countries faced
are difficulties for the moving from a socialist command economy to a market economy
, and at another level it was a movement from a non-monetary to a monetary economy.
Though money had been there in the socialism experience, its primary function was a
claim ticket to a discretionary portion of the social dividend (Taylor, 2000). There had
been savings in the economy , and this savings were invested also as the pools of fluid
capital existed, but these capital were directed to the end uses by the command of the
state, and not through a process of monetization and market price system. When the
soviet empire collapsed, the command system was no more, but there was no institution
and experience in place to monetize the stocks of fluid capital and use that investment
and production through a market oriented price system. The monetization started from
the scratch, and there had been a fall in productivity compared to what had been in the
command economy. This happened in Russian in 1991-92. Money had been there in the
economy, but it was not there at the right places at right time. This requires a banking
system which will facilitate the monetization of fluid capital existing in the economy on
an efficient basis.
The process of new monetization as mentioned in the earlier paragraph implies
the emergence of a set of financial institutions for channeling the pool of fluid capital. It
also implies the birth of a system of relative prices for guiding production , investment
and consumption decisions. In a command economy prices are set by the authority and
these are not formed on the basis of relative scarcities and the willingness to pay of the
consumers. In the absence of all these, how prices will emerge in the transition
economies becomes an important area of study. The experience of Russia in the early
55
1990s shows that the economy apparently lacked a viable fiduciary structure. The
banking system was largely absent and as a result the banks could not facilitate the
funding of current production by the creation of money through the self- liquidating
short term loans ( Woodruff, 1999 ). Much of the Russian economy at that time was
barter driven and money had little role. In such a situation the people's confidence on the
domestic currency should be restored first. This can be done by pegging the exchange
rate of the domestic currency with a world level currency like US dollar. The economy
can then fix the prices of the traded goods with the help of international prices and then
relate these prices with prices of other goods.
The above exposition of the transition process of the command economies and the
problems they face in the attempt of monetization shows the institutional importance of
money in a society. This again shows money as an institution is an important innovation
in human civilization.
Chapter 4
Money and Capital Markets - Interrelations
The Money Market

The money market provides a channel for the sale and purchase of financial assets
for money. It establishes "a mechanism through which holders of temporary cash
surpluses meet the holders of temporary cash deficits". Also the money market provides
the opportunities to meet the short term cash requirements of financial institutions, firms
and governments through the mechanism of granting loans as short as over-night and as
long as one year to maturity. On the other hand, money market provides an investment
outlet for the economic units like corporations etc. that hold surplus cash for short period
of time.
56
In most countries the money market is broad and deep as it can absorb a very
large volume of transactions without any significant effects on security prices or interest
rates. The market consists of a vast network of securities dealer, banks and brokers who
remain alert to any bargain being constant in touch with one another. This is a very
efficient market. Speed is the essence of the market as volumes of cash remaining out of
investment even for a day means huge loss for the holder. Money is a highly perishable
commodity.
Recent research has observed that national money markets are broadly of two
types - those that are security market dominated and those that are bank dominated. In
the former most borrowing and lending are through open-market trading of financial
instruments. The money market in the developed countries are generally of this nature.
But in the developing countries we find that bank borrowing and lending are at the centre
of most transactions. The principal financial instruments traded in the money market are
Treasury bills, government securities, dealer loans, repurchase agreements, commercial
paper, financial futures, bankers' acceptance etc. The importance of these instruments
varies from country to country depending on the structure of the market and the level of
development.
The rate of return on money market securities is anchored on the government

securities which have zero default risk and thus lowest possible return. Thus the return
on other securities are scaled upwards depending on perception of risks and also maturity.
The relationship between the rates of return on the instruments of different maturity is
based on the risks associated with time and this gives the term structure of the interest
rates, which shows the relationship between the long term interest rate and various short
term interest rates. This is yield curve and the shape and level of this yield curve are used
to predict the movement of other macro variables in the real sector of the economy. As
for example, the changing slope of the yield curve is used to predict the future course of
inflation.
57
The Yield Curve
The relationship between the rates of return on the financial instruments and their
maturity is called the term structure of interest rates. The latter is presented visually by a
curve which is known as Yield curve. The Yield curve shows the relationship between
the maturity of a security and its rate of return (yield) at one point of time all other factors
held constant.
The slope of the yield curve is explained by a theory known as unbiased

expectation hypothesis. This argues that investor expectations regarding future changes
in the short term interest rates influence the shape of the curve. When the investors
expect that short term interest rates may increase above the current level, the yield curve
will have a positive slope and it will be a rising curve. When the investors in the market
expect the current short term interest rate to prevail at the same level in the future, the
yield curve will be horizontal. If unbiased expectation is true, the yield curve can be used
for forecasting the possible future movement of short term interest rates. Based on this
theory the position of yield curve is used empirically to predict the future inflation in a
country.
The Expectation Theory and the Term Structure of Interest Rates
Let us examine the securities with maturity of one and two periods - and these are
pure discount securities. Let P1(t) and P2(t) be the prices at time t of securities that will
pay Re 1 at times (t+1) and (t+2) respectively. The securities are assumed to have zero
risk of default. Let i1(t) and i2(t) be the continuously compounded per period yields to
maturity of the two securities. Then by definition
i1t 2.i2t
P 1t.e = P 2t.e = 1
From this i1t = -ln P1t and i2t = - (ln P2t) / 2
58
Let us now consider an agent who has no net borrowing needs at time t, but he needs to
borrow money at time (t+1) to be repaid at (t+2). Let us also assume that the borrowing
need can be expressed as the requirement to repay Re 1. at (t+2). The agent can wait
until (t+1), and borrow Pt+1 dollars at an interest rate of it+1.
An alternative transaction would lock in an interest rate at time t. The agent can issue a
2-year bond, and invest the fund p2t in p2t/p1t one year bonds. Here the agent will carry
a zero balance from t to (t+1). At (t+1) the one year bond matures and the agent would
receive p2t/p1t rupees with the requirement to repay Re 1.00 at time (t+2).
Here the implied interest rate from (t+1) to (t+2) on this transaction is :
ft = -ln (p2t/p1t) = 2. i2t - it
and this is called the one-year-ahead, one year forward rate. It is the one year rate of
interest that can be locked in one year ahead of time. It thus implies that the 2-year rate is
the average of one year rate and the forward rate.
When the agent is faced with a choice between locking funds in the forward rate at time t
and waiting to borrow at time (t+1), he is likely to compare the forward rate to the one-
year rate which is expected to prevail at (t+1). The expectations hypothesis assumes that
the market forces will drive the forward rate to be equal to the expected one year spot rate
plus a "term premium". The latter is supposed to be constant over time.
The expectation hypothesis can be stated as
ft = Et (it+1) + Q
59
where Q as term premium is commonly understood to reflect the differing risk of

alternative two strategies and in principle it can be positive, negative or zero.
If Q = 0, in risk neutral case, the expectation hypothesis in fact cannot hold for all
maturities simultaneously. When Q is non-zero, there are no compelling reasons why
they should remain constant all the time.
The expectation theory of term structure implicitly assumes profit maximization

hypothesis. In stead of that the market participants may be guided by risk minimization.
This change of stance gives an alternative explanation of the changes in the slope of the
yield curve and this is known as market segmentation theory. We will have more
discussion on the term structure of interest rates in a later chapter.
Market Segmentation Theory (MST)
The MST assumes that all securities are not perfect substitutes in the mind of the
investors. The latter may have preferences over maturity and they will not change their
desired maturity range unless some additional yields or other favourable terms come as
an inducement to change their preferred maturity structure. It is assumed that the
investors in the market minimize the risk in their portfolio and they prefer to hedge
against the risks of fluctuations in the prices and yields of securities through the
balancing of the maturity structure of their asset with the same of the liabilities.
The existence of maturity preferences among investor groups implies that so far as fixing
of maturity preferences of investors are concerned, the financial markets are not one large
pool of loanable funds but these are segmented into a series of sub-markets. This type
of segmented markets do not rule out the possible influence of expectations in shaping
the term structure of interest rates. It only argues that the factors related to the maturity
specific demand and supply of bonds are also important to influence the shape of the
yield curve.
60
It is generally seen that interest rate moves back to its historic mean value over a very
long period of time, which is known as mean reversion. This aspect enables researchers
to make long run forecast of interest rates based on yield curve. Though investors in
general do not regard all maturities of securities as perfect substitutes, there are a large
number of traders in the market who do not have specific maturity preferences. They are
guided by the relative expected return on different securities. The combined result of
their behaviour pattern can lead to a position which more or less conform to the
prediction of the expectation theory. Thus the latter gives a benchmark expected figure.
Liquidity in the Market

Liquidity in the financial market is an important aspect which influences the shape of the
yield curve. Some researches have revealed that there exist liquidity premium or term
premium attached to the yields on longer term securities, which compensate the investors
for additional risks related to time. The term premium is dependent on business
conditions and to some extent random in nature. This makes the forecast a difficult
proposition.
Capital Market
The money market consists of institutions through which market participants i.e.,
individuals and institutions with temporary surpluses of funds meet the needs of the
borrowers who feel the temporary fund shortages. Thus money market is designed to
make short term loans. But the capital market is designed to fund long term investments
by businesses, governments and households. While time dimensions are used to
distinguish the different nature of these two markets, in today's financial world of a large
number of sophisticated financial instruments this distinction if often blurred. But for
initial understanding we can proceed from this premise.
The text book view of capital market is as follows:
The buying and selling of existing stock is important in ensuring that
quoted firms remain efficient and seek to maximize their profits. ……The
stock market encourages efficiency and profitability of firms and thereby
benefits the economy in general ………A well developed stock market
61
with a high degree of liquidity therefore helps to both increase the volume
of new issues and their costs….
The performance of stock market also has both a direct wealth
effect on expenditure decisions and also an important confidence influence
on economic agents.
[ Pilbeam, 1989, pp.176-77. ]
The construction of factories, highways, homes and other type of capital goods is
possible through the channeling of funds through the capital market by the financial
instruments having maturity of more than one year. The gestation period of capital stock
of this nature is generally long and that explain the long duration of financial
intermediation in the capital market.
Compared to the money market, the principal suppliers and demands of funds in
the capital markets are more varied. Government tap the capital market for funds for the
construction of social capital like schools, highways etc. Business houses are the most
important borrowers as they issue long term bonds to finance the purchase of new
equipments for their factories. Again, the main suppliers of funds in the capital market
are insurance companies, pension funds, development banks apart from millions of
individuals who participate directly in the market of shares.
Capital market is subdivided into smaller markets each having its own characteristics.
The most organized section of capital market is the same for corporate stock represented
by the major exchanges in the country like BSE, NSE, etc. Another big section of the
capital market is the market devoted to residential and commercial mortgage loans to
finance the construction of homes and business premises. Many specialised institutions
and subsidiaries of commercial banks are principal partners in this market.
Eurocurrency Markets
Today more than 50 countries have banking regulations that allow the opening of time
deposits accounts in foreign currencies on the books of the domestic commercial banks
62
and other financial institutions on behalf of non-resident foreigners. It all started in a big
way in the early 1950s when banks in London and Paris began accepting US dollar time
deposits from non-residents. These deposits came mainly from east European countries
and mainland China. These countries believed that under the tension of cold war the
United States might block the dollar balances of these countries in American banks. From
this first beginning the modern Euro-currency market flourished and a global customer
base has been created. Now the financial centers around the world like Geneva, Zurich,
Brussels, Frankfurt, Toronto, Panama Singapore, Hong Kong and other places carry out
huge amount of Euro-currency business.
Euro-currency has nothing to do with Europe, and technically, Euro-currency business
are financial transactions in currencies, both deposits acceptances and credit creation,
other than the currency of the country where the bank is operating. Thus the markets of
Tokyo and Hong Kong talk of Asian dollars. It is basically a market in offshore time
deposits and loans in hard currencies like US dollars, German mark, French franc, British
pound and Japanese yen. The rules of the game, the nomenclature and the expressions
vary across regions but the essence of the game is the same and today it is a multi-trillion
dollar business. The principal players are commercial banks, IMF, World Bank, Bank for
International Settlements , central banks and government agencies.
The euro-currency market has grown as a large global inter-bank market and this trading
is done for a number of reasons like the requirement of maintaining deposit-to-loan and
other operating ratios or the matching between the deposits and loans. These
eurocurrency loans from one bank to another is called in financial world as 'placement',
and this amounts to a transfer of the underlying hard currency fund through the respective
offshore accounts of the two banks.
63
Chapter 5
Linkages Between Sectors, Monetary Policy and Transmission Mechanism
"All theorizing is simplifying, cutting out the unimportant and

leaving what is thought to be important, in the hope that by
simplifying we may increase understanding"
[ Hicks, 1967; p. 156 ]
The central banks of the developed countries are keen to exercise their
independence by formulating suitable monetary policy with the twin objectives of
stability of price level and the stability of the exchange rate of the domestic currency.
These two objectives are complementary to each other and the central banks study the
channels of transmission of their different policies to have a fair idea about what is
known as leads and lags of monetary policy. In fact the entity what is known as the
`Economy' of a country is hardly compartmentalized and its stylized different sectors are
linked through the dynamic functioning of different economic parameters some of which
are heavily dependent on social conditions. We assume that the social conditions remain
fixed or some sort of social stability becomes the ground reality of their assumption.
When a person buys a house through the HDFC loans at a specific interest rate, he
seldom realizes that the intrinsic value of his property may change by the changes in the
market interest rate, though his property is tied to the contract rate of HDFC. Neither
does he realize that his decision may have some impact in the linkages between the
money market and the asset market.
64
The linkages between the sectors are important in the sense that the impact of the
monetary policy spreads through the sectors with the help of those linkages. The effects
of monetary policy through the linkages in different sectors, what is known as the
transmission mechanism, are also different in the developing countries compared to the
developed ones. In the latter, monetary expansion is supposed to affect output in the
short run, even if the effects simply lead to the changes in the price level over a long
period of time. But in the developing countries, an expansion in money supply may
inflate the prices immediately and still have little transitional effects on other real
variables. This situation occurs when the credibility of the central bank is low and
inflationary expectations are dominant. The situation may be aggravated if the financial
markets are shallow and volatile, and in this case the effects of the monetary expansion
on the real sector becomes difficult to predict. Price stability should be the objective of
the monetary policy in this case.
In recent literature there has emerged a near-consensus among the economists that
monetary policy cannot influence the long run growth of the economy, though it can
affect the real sector in the short run. Even the effectiveness of influencing the short run
situations has been under doubt as the lags in recognizing turns in the business cycle,
and the subsequent lag effects in the response of the economy to the changes in the policy
make it difficult for the policy maker to choose the correct time for the announcement of
the policy for fine tuning the business cycle.
Price stability has been the principal objective of the monetary policy. Generally
it is agreed that an approximate 3 per cent inflation should be tolerated which can take
care of the difficulties of the measurement and the adjustment of the relative prices that
reflect differential productivity trends in different sectors of the economy.
In the developing countries the tolerable limit of inflation should be higher, say 5
to 6 per cent as the relative price adjustment will be more significant and pronounced in
such economies because productivity gains in the tradable sector is high and the
differences of productivity gains in different sectors are high also.
65
The developing countries have another dimension which make it imperative that
monetary policy should have objectives other than price stability. It is generally seen that
the concentration of output occurs in a smaller number of products. Also, the financial
markets are not developed with relevant expertise lacking. All these may make the
developing country more vulnerable to the destabilizing shocks. This necessitates the
usefulness of counter cyclical monetary policy. There is another aspect. Since the
financial system is weak, the apex bank can use monetary policy to direct credit to the
sectors considered to be vital for the growth of the economy.
Even when price stability is the sole objective of monetary policy, the effects of
the latter on the output and employment cannot be neglected when inflation-control
becomes the priority of the monetary policy, the pace of deflation will have a contraction
effects on output and employment. It is generally seen that various features of high
inflation developing economies, including lack of credibility, the wage-rigidities in the
markets, etc. may create an inflation inertia and this increases the output cost of anti-
inflation monetary policy. Considering all these many developing countries follow
monetary policy with multiple objectives consistent to their local conditions.
The Transmission Channels of Monetary Policy :
In a modern monetary system four channels of transmission mechanism of

monetary policy have been identified. The first is through the direct interest rate effects,
and this affects both the cost of credit and the cash flow of debtors and creditors. The
second channel is through the impact of monetary policy on domestic asset prices i.e.
prices of bond, stocks and real estates. The third channel is through the exchange rates
and the fourth channel is the credit availability. In an economy the nature of the
functioning of these four channels depends on the structure and macroeconomic
environment. One recent phenomenon is the globalization and the liberalization. This
has changed the structure of the domestic financial system and thus the dynamics of the
functioning of these channels has changed too.
The Interest Rate Channel :
66
In the traditional Keynesian model of monetary transmission, a policy induced change in

the money supply, for a given money demand, will lead to a change in the interest rate.
Change in the interest rates induces change in the marginal cost of borrowing, which
leads to change in investment and savings and so aggregate demand.
In Keynesian framework an expansionary monetary policy will have effects that can be
characterized as the following schematic form:
M ↑ => i ↓ => I ↑ => Y ↑

where the symbol (↑ ) indicates an increase.
Thus M↑ indicates an expansionary monetary policy that will lead to a fall in the interest
rate, a rise in investment and aggregates output.
Keynes emphasized that the interest rate channel operates mainly through business
decision about investment spending. But recent research reveals that interest rate
channels work equally well through the consumer expenditure on durable consumer
goods and housing.
Short-term and Long-term Interest Rates :

The behaviour of the short term and long term interest rates in the face of the changes
in the monetary policy can be put in a stylized fashion in the simple framework. Suppose
that a monetary policy change takes place that changes the short term interest rate. The
latter should have effects both on the exchange rate and on the long term interest rates.
But short term interest rate is not the sole determinant of the changes in long term rate
and exchange rate, and the effects of the short term interest rate is uncertain. The
changes in the nominal exchange rate and interest rate will change the real exchange rate
and real interest rate. The change in the latter will have effects on exports, imports,
consumption, investment and gross domestic product (GDP). In the long run, real
interest rate and real exchange rate return to their fundamental level and GDP comes to
normal level. So the linkages are from the short term interest rate, to the exchange rates
and long term interest rates and then to the level of inflation and real GDP.
67
How is the short term interest rate determined? In a model with a stable demand
for money, aggregate money demand depends on short term interest rate and income.
The apex bank can affect the interest rate by controlling the supply of money. As money
supply increases, a decline in the interest rate will clear the market. But this traditional
analysis suffers from two inadequacies. First, the money demand functions are not stable
enough to give reliable estimated value of the parameters essential for policy making.
Second, the behaviour of the apex bank is not accurately described by one-time changes
in the money supply. Today, many central banks take multiple actions in the money
market to guide the short term interest rate in a particular way. Thus a description of the
central bank's reaction function can show how it adjusts the short term interest rate in
response to various factors in the economy like inflation, exchange rate and real GDP.
The Long Term Rate of Interest :
Following the financial market prices view of the monetary transmission

mechanism, long term interest rate is given by the expected weighted average of future
short rates appropriate for the maturity of the long bond. If the central bank initiates
action to increase short term rates and the agents in the market expect the short term rate
to decline gradually back to the starting value in the future, then the rate of increase of the
long rate will be lower than the short rate. Again, if the central bank initiates action to
increase the short term rates, but the agents in the market think that this is just the first
phase of a longer sequence of events, then the increase in the long rate will be higher than
the short rates. Thus market expectations can play an important role in making the
changes in the short and long rates asymmetrical.
The expectation model of the term structure of interest rate generally work well
when the risks of interest rate changes is covered, but when the risks are not covered, it
lacks precision. That way it has similarity with the covered interest parity condition in
the exchange rate movement. While one should keep this in mind, it is true that changes
in the short term rate is empirically significant factors in determining the changes in the
long rate. Given the rigidities in the price structure in the market, lower short term rate
68
will reduce the real long term rate, may be for a specific period of time. In the long run
real long term rate will return to the path determined by the fundamental economic
factors and the change in money supply will have no impact on the real gross domestic
product.
Interest Rate Change and Asset Prices : Asset Price Channel :
The change in the interest rate being the result of the change in the monetary
policy can also influence the level and structure of the asset prices in the economy. The
prices of bond, equity and real estate depend on interest rate. In the case of long term
fixed interest bond market, higher short term rate may result in a decline in the bond
prices. This link becomes stronger as market develops though complications are there.
The expectations theory of the term structure implies that long term interest rate
represents the average of future expected short rates plus a risk premium, and the prices
of the equity can be interpreted as reflecting the discounted present value of expected
future earnings of the enterprises. Also the principle of uncovered interest parity implies
that exchange rate changes are determined by the changes in interest rate differentials.
Thus, the changes in the short-term interest rates will influence long rates and asset prices
and to what extent this may happen depends upon how monetary policy affects the path
of expected future short-term rates enterprise earnings and rents.
But even in mature economies the response of long rates and asset prices to the
changes in the short term interest rates has been difficult to predict and this is for the
following reasons; First, this depends on how the expected future path of short term
interest rates is affected by the policy decision of the central bank, especially how market
expectations are changed. Second, asset prices are also dependent on the expectations of
future macroeconomic performance and this again affects both future short term interest
rates and future asset prices. Since future macroeconomic variables are difficult to
predict, the response of the long term interest rate and asset prices to a change in the short
term rates becomes uncertain. The problem becomes more complex as the causality
between asset prices and macroeconomic variables runs both ways.
69
Third, many a time asset prices are seen to deviate significantly from the results
of the expectations model as these reflect changing risk premiums, speculative bubbles
and other random factors not directly related to expected future returns. Also asset
markets are seen to be shallow and less competitive in the developing countries and this
makes the asset market response to the monetary policy changes less certain. Volatility in
the asset market prices is reinforced by the greater availability of credit in the wake of
financial reforms. The participants in the market are less experienced and information
about many near firms are not complete. All these make price determination less
efficient. All these consideration contribute to uncertainties about the appropriate level of
asset prices and the response of the latter to the changes in monetary policy.
Asset Market in an Imperfect Situation :

In an uncertain and volatile world a small change in monetary policy might have
large effects on asset market and aggregate demand. A small dose of expansionary
monetary policy may lead to a sharp increases in all but very short run interest rates, if it
brings concerns about a new surge of an inflation. This induces a sharp fall in equity
prices and exchange rate and the net effects of all these movements will be contractionary
and not expansionary as originally planned. The movement of asset market prices may
be such that it may offset the direct effects of a monetary policy action in mature
economy also, though empirical evidence suggests that the offset experience is much
more pronounced in developing countries.
Q - Theory and James Tobin :
Monetary policy induced change in the asset prices can affect the aggregate
demand and this is Q-Theory of investment of Professor Tobin. When the monetary
policy is easy and expansionary, equity prices will rise on the wave of inflationary
process, and this increases the market price of firms relative to the replacement cost of
their capital. Also newly issued equity in the primary market can command a higher
price relative to the cost of real plant and equipment and this reduces the effective cost of
70
capital. Thus, even in bank loan rates react little to the policy easing, monetary policy
can influence the cost of capital and investment expenditure.
The changes in asset prices induced by monetary policy can also affect demand by
altering the net worth of households and enterprises. This type of changes may trigger a
revision in income expectations and induce the households to adjust their consumption
expenditure. Again, the change in the value of assets held by firms will change the
quantum of resources available for investment.
When the asset prices decline, it will have negative effects on spending as the
resultant change in debt-to-asset ratios make it difficult for the firms and households to
meet their debt obligations. A large fall in stock and bond prices may reduce the value of
liquid assets available to the firms and households to repay loans. All these explain the
effects of monetary policy changes on aggregate demand and their transmission
mechanism working through the asset prices may become amplified as the pace of
economic activity begins to respond in a more dynamic fashion. A decrease in the
interest rate increases the asset prices and improve the balance sheets of firms. This leads
to an initial increase in output and income and thus improved economic activity increases
the cash flow of firms and households. All these induces a second round, expansion of
expenditure and prolonged upward swing in economic activity may continue for
sometime even when monetary policy may be reversed.
Exchange Rate Channel :

Consistent with its overall objectives the central bank of a country tries to affect
the exchange rate through the operation of its monetary policy. In many developing
countries the markets for equities, bonds and real estate are not mature and deep and
exchange rate is probably the most important asset price which is affected by the
monetary policy. In a flexible exchange rate regime, a tight money policy increases the
interest rate leading to an increase in the demand for domestic asset. This induces an
71
appreciation of the nominal and real exchange rate in the beginning. This appreciation is
transmitted to the increase in the expenditure in two ways. First, the appreciation of the
exchange rate makes the foreign goods cheaper, and thus the latter substitute the domestic
goods to some extent. Thus this relative price effects reduces the domestic aggregate
demand.
Second, the result of the change in the exchange rate may have a balance-sheet
effects, as the firms and households in many countries may have huge foreign debt. If the
latter is not offset by the holding of foreign exchange reserve and foreign currency asset,
changes in the exchange rate should have effects on the net worth of the firms and
households.
In many developing countries domestic households and firms are net debtors in
foreign currency through the banking system. When the domestic currency appreciates,
this leads to an improvement in the balance-sheet situation of the firms and thus this
induces an expansion of domestic aggregate demand. Sometimes, this sort of balance-
sheet effects dominates the relative price effects.
The above explains how the exchange rate channels can affect the aggregate
demand when monetary policy changes. But it can affect the aggregate supply also
domestically. An expansionary monetary policy will reduce the interest rate, increase
domestic price level and leads to a depreciation of the exchange rate. The latter increases
the import costs and this induces the firms to increase their domestic producer prices even
when there has been no expansion in the aggregate demand. In many countries with
weak financial structure and not-so-developed market mechanism exchange rate changes
are seen as a signal of future price movements, and thus wages and price may change
even before the adjustment time works it out through the change in the import costs
having effects on the cost structure.
Fixed Exchange Rate Regime and Monetary Policy
72
When a country is having a fixed exchange rate, the effect of monetary policy on
the latter is constrained. For a long time, fixed exchange rate has provided a helpful
environment for faster economic growth to many developing countries. Even when
flexible exchange rate has become the dominant paradigm, many countries with weak
financial system prefer exchange rate as the nominal anchor and they pay their currency
with one strong currency in the world i.e. US dollar, French franc or German mark.
One major defect of the fixed exchange rate policy is that the central bank cannot
pursue independent monetary policy, as it is forced to accept the international level of
interest rate. This means that the central bank is unable to use the domestic interest rate
to influence aggregate demand. A single objective policy (fixed exchange rate) may lead
to the persistence of disequilibrium in the domestic economy.
When domestic currency becomes over-valued, the balance of payments crises

may come in the form of deficit in current account. The adjustment mechanism while
maintaining the fixed exchange regime is painful for the economy as downward rigidities
in the domestic prices mean that current account deficits should be adjusted by monetary
outflows and demand compression. This causes disruption in the economy in the form of
unemployment and decline in output.
But it has been observed that in the developing countries domestic and foreign
assets are not perfect substitutes. In such situation, with capital flow regulated by the
authority, there is some scope for independent monetary policy even under fixed
exchange rate regime. As the rates of return on domestic and foreign asset diverge, the
effects of monetary policy through the asset market cannot fully offset by the reverse
capital flow as the latter is regulated. So in the short run, the changes in the monetary
policy may have some effects.
Institutional factors also have some influence in the divergence of rates of return
of domestic and foreign assets. When the financial markets are segmented and become
clear through the non-price rationing mechanism, the participants in the market cannot
73
successfully arbitrage deviations of domestic rates of return from international norms.

Suppose domestic money market is well integrated with international capital markets,
even then the changes in the money market rates may not lead to immediate
corresponding movements in deposit or loan rates. This sort of situation prevailed in
some east-Asian countries as they used to enjoy some independence in monetary policy
through market segmentation.
One fall out of the type of monetary policy followed in the Asian countries is the
existence of financial fragility and the dilemma of the central bank to maintain the
pegged exchange rate. When the country is having a huge foreign currency debt, the
central bank cannot afford the downward revision of the exchange rate as that would
impose huge burden on the domestic front. Again, if the banks are in poor financial
position, the central bank is constrained to raise the interest rate to defend the pegged
exchange rate. The dilemma continues and the economy remains in a highly leveraged
state. This sort of constraint posed by financial fragility on the monetary policy does not
vanish even when the currency is floated as the depreciation of the domestic currency
imposes heavy burden on the firms and households and lead to a crises of confidence in
the economy.
We come back again to the importance of institutional factors as the country with
weak financial system should adopt structural reforms first so that it can grasp the
benefits of independent monetary policy. Before we take up that issue, another
important policy perspective should be discussed briefly. This is the situation of
sterilized intervention in the money market.
Policy Intervention and Foreign Exchange market

When the central bank resorts to sterilized intervention in the money market, what
is its effects in the foreign exchange market? The literature is confused in this aspect as
the question whether sterilized intervention can be used independent of the monetary
policies so that the monetary authorities can pursue twin objectives of exchange rate and
domestic stabilization. Theoretical discussion suggests that there may exist one or more
74
channels through which the intervention can affects the exchange rate of the domestic
currency.
In a system of independently floating exchange rate regime without capital
control the inflow of foreign money will increase the money supply. If the authority
follows a money supply target policy or a policy of inflation rate targeting, it is to control
the money supply. Faced with an automatic increase in money supply, the central bank
can perform open market operations to suck money out of the system so that the stock of
money available in the market does not change significantly. In short, the effect of the
inflow of foreign money into the economy is sterilized so that it can not destabilize the
domestic equilibrium. This is sterilized intervention (SI ) which is widely practiced by the
central banks all over the world.
In theoretical analysis sterilized interventions can influence the exchange rate of
the domestic currency in four channels:
---- the portfolio balance channel:: SI induces disequilibrium in the private portfolios and
the adjustment takes place within the portfolio through the change in the exchange rate,
----the market efficiency channel:: SI focuses the attention of the public on the neglected
information which are important for exchange rate adjustments,
-------superior information channel:: SI transmits otherwise unavailable information
that induces the economic agents to make necessary adjustments in the foreign exchange
market,
-------future anticipation channel:: the SI creates future anticipation about the potential
changes of other policy related to money supply and exchange rate and the resultant
adjustment of the economic agents in their respective market positions can change the
exchange rate.
If SI operates through the first two channels, the influence of SI is independent of the
other present and potential domestic policies. But if SI operates through the third and
fourth channels, that may signal the changes of other policies in the future.
Whether the SI will have impact on the exchange rate through the changes in the
portfolio depends on the degree of substitutions among the assets. If the investors think
that the identical assets denominated in different currencies are perfect substitutes , then
the SI which increase the supply of securities denominated in pound sterling and reduce
75
the supply of the securities denominated in French franc will have little effects on the
exchange rate of GBP/ F franc, as the investors will continue to hold the changed stock
of securities without any expectation of exchange rate changes. But if the investors think
the assets denominated in different currencies as imperfect substitutes, the SI will cause
the relocation in the portfolio as the changed incipient demand and supply situation
will come to an equilibrium through a change in the exchange rate of GBP in terms og
French franc.
If the investors know before hand the impending SI, they will use this information
in their forecasts of the future spot exchange rates, and this altered behaviour will
ultimately change the exchange rate. The influence of the prior knowledge of the SI can
induce the investors to neglect the structural variables affecting the exchange rates and
rely only on the information on future SI.
The portfolio balance model of exchange rate determination depends on the
uncovered interest parity condition, and the latter is found to experience deviations in
real life as the interest rate movements may not ensure the constancy of the real
interest rate . The deviations from the uncovered interest parity will induce the changes
in the exchange rates and these are quite consistent with the operations of the first two
channels.
Credit Availability Channel :
The credit availability channel is explained on the assumption that banks play a
special role in the financial system as they are well suited to deal with certain type of
borrowers who are important from the standpoint of the economy. There exists a large
number of small firms in any economy who confront asymmetric information regarding
the financial system and these firms require funds for their operations. They approach the
banks who are to meet their liquidity problem. The big firms can approach the capital
market directly.
In many developing countries private markets for credit are poorly developed
because of structural reasons. Again such private markets may be prevented by
76
government regulations from operating freely on efficiency consideration alone. In such

situation monetary policy is likely to affect aggregate demand more by changing the
availability of credit than through the direct or indirect effect of the changes in the price
of credit. This is true when the banks are directed to channel a certain quantum
(percentage) of credit to some priority sectors. Again, sometimes there exists binding,
ceilings on the interest rates to be charged by the banks. In such cases banks use non-
price means of rationing loans and this increases the importance of credit availability
effects.
Sometimes government of some countries get involved directly in the market for
loans either through public sector or government controlled development banks or
through fiscal subsidies on the loans of commercial banks. This sort of situation also will
have the credit availability effects as explained above.
Recently, the financial sector in many developing countries has been liberalized.
This liberalization does not eliminate the credit availability effects. Recently economists
have established that imperfect information and contract enforcement problems are
important in the sense that they change the means by which credit market clear. In
response to tight money policy, banks may not rely exclusively on increasing the interest
rate on the loans to ratio credit, as this may encourage riskier investment behaviour on the
part of borrowers. To prevent the risk-lover borrowers coming as customers, banks do
tighten credit worthiness standards apart from increasing the loan interest rates. This
leads to a decline in the supply of credit along with the increase in the price of credit.
We see that credit can play a special role even in the liberalized financial sector.
For this central banks in many countries including India closely monitor credit growth in
the evaluation of their own monetary policy.
Again, monetary policy has its effects on the credit availability through its effects
on the value of assets of both the borrowers and the banks. As monetary policy alters the
monetary conditions, asset prices change which changes the value of the collateral for
77
bank loans. The latter changes the power of access of the borrowers. The changes in the
credit worthiness of the bank customers and the financial conditions of the banks together
would induce the changes in the credit rationing when the banks perceive the constraints
in the economy.
Transmission Mechanism, Intervention and Recent Changes :
Leaving out the extreme situations like high inflation and recession in the
economy, when normal conditions prevail, the monetary authorities in many countries
have abandoned monetary targeting. Because it has been observed that changes in the
demand for money have caused the relationship between the monetary aggregates,
aggregate demand and prices to shift over time. Some central banks give importance to
the real rate of interest, though the definition of inflation for the determination of the real
interest rate is still debated.
In many developing countries, uncertainties about the channels of transmission of

monetary policy have been made more complex by the structural changes in these
channels themselves. All these have made the interpretation of the indicators of monetary
situation difficult. Sometimes, the volatility of the financial markets and macroeconomic
instability may loosen the linkage between indicators of monetary conditions and future
economic situation of the country even when the channels of monetary transmission
mechanism are stable.
78
Chapter 6
Monetary Policy, Interest Rates and Capital Mobility
"It is impossible that an organization should be entirely handed down as a

blueprint from above. It has to grow, being based at every moment on
what has gone before".
[ Hicks, 1969; p.11 ]
Monetary policy operational through the actions of the central bank affects both
short term and long term interest rate. Also the latter is linked with inflation and real
output. The apex bank determines the interest rate in response to the deviations of
inflation and real sector economic variables from some desired levels as prescribed by the
policy objectives. When the economy is open, the change in the monetary policy may
become both the cause and the effects of the capital mobility across the political
boundaries. The degree of openness of the economy of course affects the level of capital
flows both ways.
The standard models of capital mobility in the literature explain the channels of
transmission of the effects of monetary policy in the open economy set up. At present
situation has become much more pronounced as the globalization of the capital markets
of the countries of the world is much more advanced than what is generally believed.
The change in the nature of international banking, the volume of business in the
79
international capital market, the volatility in the international currency market and the
phenomenal development of information technology have revolutionized the integration
of the world financial system. The stylized versions of the world financial system help us
understand it better. Perhaps it would not be improper to remember that in spite of the
limitations associated with the model building exercises, the analysis through the model
facilitate better understanding of the various nuances of the linkages existing among the
sectors. The models associated with the names of Mundell, Flemong and others have tried
to explain the working of the macro-economy through the different linkages. We take
these models in the following paragraphs.
Mundell - Fleming Model

The Mundell-Fleming (MF) model can be presented by the following equations :
m - p = Gy - A r ... (8.1)
y = -Br +Ly* + (e + p*- P) + g ... (8.2)

p = p* ... (8.3)
r = r* ... (8.4)
Where all the variables except r and r* are in logarithm (natural log) and
m = money stock
y = real output
r = interest rate
e = exchange rate (price of foreign exchange)
p = domestic price level
80
g = government spending
r* = foreign interest rate
Y* = foreign real output

Assuming that domestic prices are held constant at p and because of perfect international
capital mobility equation (8.4) holds and in that case the level of real output y depends
only on m. An increase in money supply m produces significant change in real output y,
even when r remains unchanged as these are accompanied by a depreciation in e. An
expansionary monetary policy induces downward pressure on rate of interest r, which
induces incipient capital outflow from the domestic economy. The latter happens as the
international investment demand in response to the differences between domestic and
international rate of interest (r and r* ) is infinitely elastic. But capital outflow causes the
depreciation of the currency and so e changes, which shall have effects on both exports
and imports.
In the fixed exchange rate regime, when the domestic interest rate starts to fall in the face
of expansionary monetary policy, capital outflow starts and the central bank in that
situation is to sell its foreign exchange from the reserve to defend the currency. This
intervention in the financial market by the central bank would have to be non-sterilized in
order to be effective, the money stock would have to return to the original level. Thus
when perfect capital mobility is associated with a fixed exchange rate regime, monetary
policy becomes ineffective to have its impact on the macroeconomics variables.
The MF model depends on some assumptions which are extreme and do not conform to
modern day conditions. The model ignores wealth effects and portfolio considerations.
Also inflation and expected change in the exchange rate are set equal to zero. The
domestic price level p is insensitive to the changes in the exchange rate. The modal also
ignores aggregate supply effects and capacity constraints are ignored. All these
restrictions make the model a real Keynesian one. In the MF model the domestic interest
rate r move only in response to change in foreign interest rate and thus it has no
independent role in the transmission of monetary policy. This sort of situation is unlikely
to hold in real world situation. What is more common to see is that the change in the
monetary policy will induce a combination of real exchange rate effects and interest rate
81
effects. In fact independent movement of domestic interest rate vis-a-vis the foreign
interest rate is related to the nature of capital mobility.
International Mobility of Capital

There are four alternative definitions of international capital mobility depending
on the narrowness or specificity and these are:
i) Covered interest parity and capital mobility

ii) Uncovered interest parity and perfect asset substitution
iii) Ex ante and ex post real rates of interest at home and abroad.
iv) Zero investment saving correlation.
We discuss these four issues in turn.
Covered Interest Parity and Capital Mobility

If domestic and international assets are perfect substitutes, then returns on
comparable assets in different markets of the world would be equal provided there are no
transaction costs, exchange control, tax distortions, investment restrictions and political
risks. The equality would be established through arbitrage operations by market
participants. This is known as the condition of covered interest parity and it can be
shown as :
(i - i*) - (f - e) = z ...(8.5)
where i = domestic nominal interest rate
i* = foreign nominal interest rate

(f - e) = forward premium,
z = Covered interest differential
82
When it is seen that the value of z is significantly different from zero, it means that
Capital mobility is lacking. Thus even when the domestic and foreign nominal interest
differ by the amount of forward premium (meaning that z is zero), perfect capital
mobility is ensured. Also, this model does not presume that domestic and foreign real
interest rates should be equal.
Uncovered Interest Parity and Perfect Asset Substitution

Sometimes investors may be willing to shift funds between uncovered assets
denomination in two different currencies, on the assumption that covered interest parity
condition is satisfied. This behaviour in the limiting case leads to perfect asset
substitution as investors treat two assets of two different countries equivalent and expect
the same expected rate of return. Thus no exchange rate risk premium is required to
induce
investors to shift funds between foreign and domestic currency assets. The condition can
be written as :
(i - i* ) - (ê - e) = w = o ...(8.6)
where
ê = expected exchange rate of the domestic currency
w = exchange risk premium, and others same.
The equation (8.6) is called uncovered interest parity and the capital mobility implied by
it is somewhat broader in scope compared to the case of covered interest parity. A
comparison of the two cases imply that if both perfect capital mobility and perfect asset
substitution are satisfied, the forward premium on covered transaction (f- e ) in equation
(8.5) will be equal to the expected rate of depreciation of domestic currency in equation
(8.6) or we can write :
(i - i* ) = (f-e) = (ê - e) ...(8.7 )
We find from (8.7 ) that it is not necessary for the domestic interest rate to move in lock-
step fashion in both the covered interest parity and the uncovered interest parity cases.
But both the cases imply a close relationship between the two interest rates which reveal
the integration of the two capital markets.
83
Ex ante and Ex post Real Interest Rates

Some researchers argue that in the context of integration of world capital markets,
the real interest rates of different countries will be equal. The implicit assumption is that
the real interest rate differentials on domestic and foreign currency assets will be smaller
and smaller as the degree of integration of the world capital markets becomes more
perfect. If the uncovered interest parity holds, one can ensure that ex ante (equilibrium)
real rate of interest will be equal on domestic and foreign currency assets if one
additional condition is imposed on equation (8.7 ). This condition is known as "ex ante
purchasing power parity" and it implies that expected change in the real exchange rate is
zero. This can be satisfied in the following way :
The nominal exchange rate can be assumed to change in perfect compensation for the
change in relative inflation rate. This is sometimes called relative purchasing power
parity (PPP). Thus ex ante PPP together with perfect mobility of capital and asset
substitution guarantee that the long term difference between the two real interest rates
(domestic and foreign) will be zero.
So far the discussion of the transmission of the monetary policy is carried out
without the implication of fiscal policy, though fiscal implications will be there. In the
above case it becomes interesting if taxes are introduced into the picture. IN the latter
case, even when foreign and domestic taxes being t* and t respectively, ex ante PPP
requires that
(ê - e) = E (Π - Π* ) = 0 ....(8.8 )
In order to equate net real rates of return across the countries and ensure that the nominal
interest rates adjust to expected changes in inflation rate, the following condition should
hold :
84
i = E (r + Π ) /(I - t) = i* = E (r*+Π*) / (I- t* ) ...(8.9)
Assuming that foreign and domestic tax rates are same, t = t*,
equation (8.9) can be written as
E (r - r*) = (i-i*) (i - t) - E ( Π - Π*)
= (i - i*) (i-t) - (ê - e) ...(8.10)
From (8.10) it is clear that unless E(r -r *) is non-zero, (8.10) is not consistent with
uncovered interest parity. This way taxation complicates the problem in equalizing the
real interest rates in the context of perfect capital mobility.
Zero Investment-Saving Correlation :
Feldstein and Horioka (F-H) in their model (1980) have suggested that if capital
markets are perfectly integrated internationally, then the correlation between national
servings and investment should be zero. When demand for new investment increases,
capital inflow takes place and thus there will be no significant change in the sharing and
real interest rate of the country. The relation in mathematical form is
(I/Y) = a + b (S/Y) ...(8.11)
with null hypothesis (HO) : b = 0.

The idea is that when we estimate the above relation econometrically, that is the
least square regression is applied on
( I / Y) = a + b ( S /Y ) + e … ( 8.12 )
we see whether the estimate of the coefficient b ( that is b -hat ) is statistically
significant. If we fail to reject the null hypothesis ( that is, b= 0), it implies that invest-
85
income ratio in a country is independent of the saving-income ratio. This creates the case
for international mobility of capital.
For the satisfaction of (8.11), it is essential that the real rates of return on all
classes of domestic real and financial assets should be equal to the real rate of return of
comparable foreign assets. It is clear that the above condition holds only if two other
conditions are satisfied and these are perfect capital mobility and perfect asset
substitution.
But what has been observed in the behaviour pattern of the governments is that
the latter change the fiscal variables drastically whenever they face large deviation in the
balance of payments and this reduces the scope of large scale capital inflows so essential
in the (F-H) model. The suggested unit correlation between the current account and
domestic investment expressed as ratio of gross domestic product is unlikely to be
satisfied by the behaviour pattern of the governments as described. Perhaps no
government wants to expose the domestic capital market to the fluctuations of the
international capital market and that explains why the authority reacts in the fiscal side to
stabilize the situation.
One can appreciate the above situation better if he compares the Indian capital
market situation at this first year of the millenium. Thanks to globalization the Bombay
stock exchange closely follows the stock market of New York and the volatility exhibited
in the foreign markets are transmitted easily in the domestic markets. The situation will
be more complex once Indian rupee becomes capital account convertible. This will make
capital mobility without any hindrance and the portfolio investment may become volatile
with a very small change in the parameters like prices and interest rates. The stability in
such a situation demands an efficient combination of fiscal and monetary policies and
selective intervention of the government with fiscal instruments.
This chapter has examined the issue of capital mobility from a theoretical
perspective. An understanding of the different economic parameters will facilitate the
understanding of the complexities of the international capital flows described in detail in
Chapter 15. In today's context of global integration the M-F framework and also the F-H
framework assume importance since the domestic economic parameters like interest
rates, inflation rates have become dependent on the global economic situations.
86
Chapter 7
Monetary policy and Channels of Transmission
"Like all serious schools of thought, monetarism has differing

emphases and degrees".
[ P. A. Samuelson, 1985; p.326 ]
" The delicate, invisible web you wove….. "

[ T. S. Eliot ]
The principal objective of the monetary policy is to influence the real and the
nominal macro variables through the changes in the money supply with the help of some
transmission channels often presumed to be working in the economy. The strength of
these channels and their linkages depend on the aggregate structure of the economy
including the level of integration of different sectors. The literature discuss about two
principal channels of transmission and these are--- the money view channel and the
interest rate channel. The former is also called the credit view channel. The debate
sometimes centres on the relative strength of the two channel.
Sometime the question is asked whether the `money view' channel is all powerful
or not. The name comes from the philosophy that money matters and money is
87
exogenous and that the central bank can control it. In this view the financial
intermediaries offer no special services on the asset side of the balance sheets. On the
liability side of the balance sheet, the financial intermediaries perform a special role, i.e.,
the banking system creates money by issuing demand deposits. The presumption is that
the capital structures do not influence real decisions of the borrowers and the lenders,
which is the result of Modigliani and Miller (1958). Applying the MM thesis it was
argued later in the literature that portfolio preferences of the public regarding bank
deposits, bonds or stocks should have no effect on real outcomes, i.e., the financial
system is merely a veil.
The explanation of the above observation is given as follows : Suppose that there
are two assets - money and bonds. In the phase of monetary contractions the central bank
reduces reserves, which limit the banks' ability to sell deposits. Now the depositors must
hold more bonds and less money in the portfolios. If the prices do not adjust
simultaneously the changes in money supply, the decline in the money holdings of the
households represents a decline in the real money balances. To restore equilibrium there
should be an increase in the real interest rates of bonds, and this increases the user cost of
capital and thus the expenditure which is sensitive to interest rate declines. Thus interest
rate provides the linkage between the money market and the capital market.
The above describes the money view of the transmission mechanism or the
interest rate channel. It depends on four assumptions : First, the central bank must
control the supply of `outside money' for which there are imperfect substitutes. Second,
the central bank can influence both the real and the nominal short term interest rates.
Third, the changes in the real short term interest rates affects longer term interest rates.
Fourth, the plausible changes in the interest sensitive expenditure in response to monetary
policy intervention match well with the observed changes in the real sector.
Some economists have characterized that the money view focuses on the
aggregate side as opposed to the distribution- related consequences of policy actions.
The latter implies that a higher interest rate following a monetary contraction does
88
depress desired investment by firms and households. When the investments falls, there is
a reduction in business and production. Because of this consideration there has been a
search for a broader transmission mechanism addressing both the macro concern as
explained above and the micro concern. The micro concern relates to the impact of
imperfections in information system in the case of insurance and credit markets. Here the
problems of asymmetric information between the borrowers lead to a gap between the
cost of external finance and internal finance. The conventional interest rate channel
depends on complete market approach, but the notion of costly external finance is sharply
different and it does not consider the links between the real and the financial decisions.
In contrast to the money view the above description is the "credit view" of the
transmission channel. This considers the financial constraints on the borrowers, as some
borrowers face high cost of external finance. Further, this view accommodates the idea
that the spread between the cost of external and internal funds varies inversely with the
borrower's net worth. The latter depends on the interest rate movement, as an increase in
the interest rate increases the debt service burden of the borrowers, and also it reduces the
present value of the net worth. The latter consideration influences the decision of the
lender regarding the new loan. Perhaps in this context we may discuss in depth the role of
banks in the conduct of monetary policy.
Bank Lending and Monetary Policy

Though the importance of interest rate channel is well accepted, there are several
situations where the lending from the banks has some importance. First, credit market
imperfections have certain implications for the firms who approach the banks for finance.
Banks do play a role through the evaluation and monitoring of small firms with little
publicly disclosed financial information.
Second, the financial conditions of the firms will change over time through the
phases of the business cycles and so the responses of these firms to the changes in the
monetary policy will vary according to the objective conditions. So the effects of the
changes in the monetary policy will be sensitive to the health of the banking institutions
and the financial health of the firms.
89
Third, future financial innovations and changes in the regulations may change the
future effectiveness of the monetary policy. This may require the policy makers to adjust
their policy actions so as to incorporate the impact of these structural changes on the
transmission of monetary policy.
Apart from the above three aspects the nature and the size of the effects of
monetary policy transmitted to the economy through the banking sector will depend on
the financial conditions of the banks and the policy of regulations. For example, the size
of the effects operating through the credit channel will be sensitive with differing results
from one to other as more number of banks come under statutory capital requirements
(i.e., the amount of capital the banks are to maintain as a percentage of their risk-
weighted asset portfolio). The central banks should take into account the financial
position of the banks and also the regulatory framework in time of formulating the
monetary policy.
In recent times there have been substantial changes in the financial markets and
financial regulations implying what is known as change of regime in the econometrics.
This means that historical data on the transmission of monetary policy will not be a
reliable guide to the central banks for the conduct of monetary policy in future.
Though we discuss the role of bank lending in the transmission of monetary

policy in the above paragraphs, we are to explain the interest rate channel again.
The interest rate channel of monetary policy becomes broader when we consider
the credit view along with the traditional money view. This also shows the link between
the money market and the capital market. Though it is a fact that sometimes it becomes
difficult to make distinction between these two views, as the contractionary monetary
policy may have two consequences. Because in both the cases the current real wealth and
the portfolio overheads becomes lower in magnitude.
The change in portfolio overheads can emerge either from any combination of a
change in the return on an outside asset, or a change in the covariance structure of the
returns, or a shift in the consumption process. Considering the differences arising out of
the relative importance of the shifts in loan demand and loan supply, a credit view also
90
predicts cross sectional differences arising from balance sheet considerations. Of course
this is an empirical question.
The linkages between the money market and the capital market remains
functional through the effectiveness of the different channels of transmission operating in
the economy. This also depends on the financial structure along with the conventions
ruling in the money market. The empirical questions pointing out the relative strength of
different channels and the sizes of different parameters is an interesting one, but this has
not been attempted in the present study. Perhaps a general equilibrium macro model can
address this interesting question. We may keep this expectation for the future.
One interesting aspect which has been the center of brainstorming in the
academic world is whether the change in the exchange rate causes the change in the price
level of the domestic economy. This amounts to an export of inflation to other countries
through the exchange rate channel. The fact is that the change in the interest rate of a
currency may happen for a number of reasons and the movements in the capital market
belong to that set. Thus the changes in the capital market can spread its influence in the
money market through the changes in both the interest rate and the exchange rate. A
better appreciation of the channel of transmission facilitates the adoption of correct
policy. This is perhaps one important issue which requires proper examination for the
effectiveness of policy.
Central Bank Targets and Strategic Issues

In general, central banks now-a-days try to achieve price stability and this is taken
as a single intermediate target. Again some European central banks are using monetary
aggregates as intermediate targets in the belief that monetary aggregates are linked with
the medium term changes of nominal variables in a predictable fashion. Thus these
variables can be controlled by the central banks and public opinion can be educated
through the changes in the medium term monetary policies.
Central banks are generally not in favour of making a direct inflation target. The
problem emerges from the combination of long lags in the effects of monetary policy, and
also uncertainty about the future shocks and the response of the structure of the
economic systems. Because of uncertainty and the lags in the policy,, the quantum of
91
change required in the monetary variables to keep inflation rate within a specific band is
difficult to identify. Because of these problems some central banks in some OECD
countries desire to get inflation down to or below the target level instead of advancing
the rate to the target zone. Of course, the literature documents the inflationary bias of
monetary authorities for the simple reasons that the opposite, i.e., the deflationary bias
may hurt the rate of growth of the real sector of the economy. This has emerged through
the cost benefit analysis of the two approaches as the fear of recession along with
potential unemployment are associated with the policy of deflation.
Exchange Rate Targets

The central banks face problems to maintain the exchange rate targets , because it
is related to the nominal interest rate. But the latter required to maintain the exchange rate
link may represent a real interest rate which may not be suitable for the partner country. If
the real interest rate lying under the nominal interest rate is considered as not sustainable,
the nominal interest rate may not be effective to perform twin functions-- maintaining the
exchange rate and ensuring the inflow of capital. In other words, one instrument, interest
rate, fails to achieve two targets---- exchange rate stability and capital inflow. One
proposal in such a situation is imposition of exchange control so as to enable the interest
rate to keep capital inflow steady.
But the shortcomings of the exchange control are well known, and also attempts
to influence the interest rates through the fiscal policy are also troublesome. Because of
these problems many economists find it difficult to reconcile to the idea that a pegged but
adjustable exchange rate regime may ensure a stable equilibrium in a situation of free
capital movement.
While the central banks are serious about the implementation of the monetary
targets, the important operational issues in this context are:
--choice of monetary aggregates
--the relevant reference period over which the instruments are set
-- the speed with which the deviations from the targets are corrected
-- whether the drift in the base will be allowed.
92
To have decisions regarding the above issues the central banks use information which are
available through their knowledge of other monetary and financial variables. Through
this procedure the central banks may change the planning horizon and skip some steps
suggested in the literature. So long the central banks enjoy reputation and credibility, they
can utilize even mild deviations from the monetary aggregates to their benefits and may
conduct policy with few informational inefficiencies.
When a country is having a fixed exchange rate regime, money supply becomes
endogenous under the following conditions:
 the country is not in a position to influence the international interest rate
 international capital mobility is perfect and no country is imposing any
restriction, and
 there exists perfect substitution between domestic and foreign bonds.
In these circumstances the monetary authority loses control on the growth of total money
supply, it can only influence the breakdown of the growth of money supply between the
domestic and external sources. The target rate of money growth can be fixed ex ante so as
to make it compatible with the stability of the exchange rate, but in the event of any
external shocks , the actual [ ex post ] growth of money may differ from the ex ante one if
the central banks wish to maintain exchange rate stability. Which one the central banks
will choose is a hard policy decision and it depends on other monetary aggregates and
also macroeconomic information.
93
Chapter 8
Money, Markets and Institution
"If everybody minded their own business," the Duchess said

in a hoarse growl, "the world would go round a deal faster
than it does."
---- Lewis Carroll
Alice's Adventure in Wonderland
In the circulation of commodities and services, trade and exchange with any form of
money and other financial instruments take place with some form of market structure, the
latter varies from country to country depending on socioeconomic conditions. We can
define the market structure in a theoretical framework. In reality most markets are far
from the 'model-form' portrayed in the general equilibrium theory--- that is, idealized,
timeless, non-institutional and a price generating mechanism. An attempt can be made to
characterize some of the broad features a market mechanism should exhibit for the ideal
functioning of the economy.
The literature has defined the market mechanism in precise manner ( Dubey and
Sahi, 1992; Shubik, 1999 ). The market as a relation can involve any subset of traders on
either side trading a set of commodities against another. It follows then that the number
of market structures can increase astronomically for even a modest number of traders
94
and commodities, and this may leave out the multiplicity of exchange mechanism that
might be used for the clearing of the market when a set of commodities are being traded
for another set. When a single commodity is exchanged for another commodity, there is a
natural way to aggregate bids and offer and to form a final market price. The quantities of
commodity i offered by all sellers can be aggregated, and the quantities of commodity j
supplied by all buyers of commodity i can be aggregated. The exchange rate between the
two commodities or the price of commodity i in terms of j can be defined as the ratio of
the two quantities.
Markets in Microeconomic Theory

In mainstream analysis of microeconomic theory we assume that there exists a
anonymous market mechanism that satisfies the following conditions:
1. Openness. A market is open in the sense that that entry and exit are completely free
and anybody can enter and go out of the market any time. The market is not exclusive
in the sense an auction by invitation is.
2. Aggregation. By aggregation it is meant that an individual's trade depends only on
his message and the aggregation of the messages of all other agents participating in
the markets. The messages are processed and these are both associative and
commutative.
3. Feasibility. A processed message will facilitate trade so that individual X will
deliver a specific bundle of goods in the market. This condition requires that no
matter how the message of individual X is processed, the person X will always be
able to supply the commodities in the market.
4. Anonymity. A market is anonymous in the sense that no single individual's entry or
exit has any bearing on the outcome of the market. In fact, this rules out monopoly
situation.
5. Orthogonality. Messages sent to the markets by the agents are subject to a restriction
in the sense that these are specific to the markets sent for and these can refer to trades
95
that take place in these markets. It implies that the variables contained in the
messages are used in the trades specific to these.
6. Simplicity. The messages sent by the agents are simple and these are understood by
all equally well. The information sent through all these messages are symmetric
regarding the moves of all traders. This way the market can avoid complex strategy
based on the availability of all information.
7. Connectedness. A market structure satisfies connectedness if any commodity i can
be exchanged for any other commodity j through a series of exchanges in a set of
markets. The exchanges take place in an ordered sequence.
8. Moneyness. A market structure contains a medium of exchange (money) if there
exists one commodity that can be exchanged directly for every other commodity and
it has acceptability among the agents.
9. Completeness. A market structure is complete if every commodity can be exchanged
for every other commodity, and in this sense every commodity is as good as money.
The above conditions describe a market structure in a stylized situation. In an

exchange economy with a finite number of traders , it is observed that as the number
of traders increases, the nature of market equilibrium approaches a situation what is
called the competitive equilibrium in microeconomic theory. As long as the number is
finite and there are no transaction costs, the individual can maintain some influence in
the demand or supply situation in the market. For this the infinite number of
individuals are taken as the theoretical requirement for model building in market
structure.
Primitive and Ceremonial Monies:

Professor Einzig (1948 ) has defined primitive money as " a unit or object conforming
to a reasonable degree to some standard of uniformity, which is employed for
reckoning or for making a large proportion of the payments customary in the
community concerned, and which is accepted in payment largely with the intention
of employing it for making payments".
96
Einzig also offers a check list for the classification of primitive money. Following
Shubik (1999 ) we can put the criteria as follows:
a. Does it have an existence?

b. Does it assume the form of credit or currency?
c. What form does it assume, or what material it consists of?
d. Is it fiduciary issue , or it has some intrinsic value?
e. Is it a luxury or necessity?
f. Is it used exclusively for monetary purposes?
g. Whether its use is confined to commercial payments?
h. Is it used for internal payments only?
i. Is it produced locally or being imported?
j. Is it convertible into other objects?
k. Which of the monetary function does it perform?
A close look at the criteria confirms that these lead to a definition of money which is
close to its modern form.
Evidences from history and anthropology show that primitive societies had used
some commodities as ceremonial monies which were meant not for the use as
medium of exchange. Examples are the famous stone money of the Yap Islanders , or
the tokens of value the people of Palau Islands had used in marriage, divorce, births
and other social rites and similar occasions ( Herskovits, 1940 ). This is explained in
detail in earlier chapter. Ceremonial monies depend for their scope of use upon the
laws and customs of the society and also the ability of the society to enforce the rule
of law. In all societies we find relationships among money, prestige and power and
this phenomenon is common for all time. The anthropological evidences suggest that
the use of ceremonial monies in special occasions without its use as a general medium
of exchange reveals the extent of domain of economic measurement.
97
The etymology of the word money and some names of famous monetary units
suggests that there has always been a close and strong relationship among the use of
money, the development of the legal system and the use of weights and measures. For
example, the word 'mark' in the German monetary unit deutsche mark is explained
as a coin or weight unit that has been marked by the government. On the other hand it
has been suggested in the literature that the word dollar of the currency of the United
States (and some other countries ) is derived from the word Thaler. The latter in turn
is derived from Joachimsthal in Bohemia, in the latter place the counts of Schlick
coined silver coins known in history as Joachimsthalers ( Shubik, 1999 ).
Money itself is an institution and it is a network phenomenon. The economic use

of money brings efficiency in the system when the society is able to create some
institutions which can generate services required by the society for the circulation of
commodities including money. During the course of historical evolution the character
of the institutions have changed, same has happened to the nature and form of money
One example is the use of gold , which is near- money and which has close relation
with money. The ancient literature defines gold as " Precious non-rusting metal
sometimes used in the Middle Ages in thin leaves for wrapping some paste and
certain roast birds. Gold is still used for this purpose in the Far East [ Larousse
Gastronomique, English edition, 1961 ].
The use of the yellow metal as near- money is relevant even today as countries
unable to cover their balance of payments gap even by borrowings are to export gold
abroad , and gold here plays the role of money due to its wide acceptability. In India
people buy gold and accumulate the yellow metal either in the form of jewelry or
plain gold bars . This they do both as a hedge against the declining value of rupee and
also as a source of savings thinking this as good as money. The demand for gold in
the developing countries has more to it than simply as a substitute of money. The
demand for the yellow metal in India is more than 700 ton per year , this much gold
must be used for purposes other than ornaments. This is yet to be properly explained.
98
Money, Markets and Global Finance

The creation of markets for money and other near-money assets is generally
associated with the role of the state mechanism, though it is often difficult to show
this with objectivity. This is because of the following factors:
First, the last two decades of the 20th century had seen rapid development of
transnationalization regarding the development of financial markets. This is caused
mainly by the capital mobility across the political boundaries. Capital movement
takes place as short time and volatile capital can move quickly in response to
unpleasant regulatory and political interventions. All these are done to dodge the rules
and may be temporary in nature.
Second, the anarchic nature of competitive dynamics among the developing
countries for getting a fair share of foreign capital has led to frequent changes in the
rules and regulations of the country in the name of liberalization. All these are done to
facilitate the inflow of foreign capital. In the financial markets these are referred to as
regulatory competition. The economic agents with the necessary capital seek the most
soft areas to get the maximum return of the investment, and thus 'regulatory
arbitrage' continues. This makes the position of the market agents much stronger and
it becomes difficult for the state to exercise effective control on the market process.
This aspect is often lost sight of and the authority makes the situation complex by the
attempt to control the market.
Third, the existence of a huge global market space outside the effective control
of the state authority has greatly affected the conduct of macroeconomic policies,
particularly monetary policies and policies regarding exchange rates. In a bid to
attract more foreign capital states are seen to go for more liberalization, and then try
to stabilize the fluctuations of economic parameters which are the consequence of
capital flows. In extreme situations states are seen to be at the mercy of the market
makers and agents with the money power. Also there exist parallel pressure on the
state to pursue orthodox macroeconomic policies to preserve the stability of the
exchange rate of the national currency and the balance of payments.
Since 1980 the world has been seeing the volatility of the flexible exchange
rate regime and the countries have been facing the problems of balance-of-payments
99
financing problems. To solve the latter problem, central banks and national treasuries
had searched for new sources of finance beyond the domestic markets as internal
savings were not sufficient. Alternatively, faced with easy availability of foreign
capital, national fiscal deficits began to mushroom, which someone can interpret as a
moral hazard problem. Also existing policies consistent with welfare state and related
paradigm are often compromised for more liberalization with a view to attract more
capital. In either case states began to depend on the global market place for their
financial requirements. One implication of this phenomenon is that state has emerged
as an important player in the global financial markets.
The attitude of the different countries towards the global financial markets have
become ambiguous . Faced with chronic downslide of important economic
parameters, countries are increasingly relying on the global market place with
increased market-friendly policies inducing more innovation and growth in the
financial system. But in the process the countries are losing control on their economic
systems to the private market players. The central banks and the government
treasuries are less neutral observers and regulatory referees today in the globalization
of financial markets, and being a part of the system they are more and more interested
in the success of the process of global financial integration (Helleiner, 1994; Cerny,
1993 ). While the state has been downsizing itself leaving more space to the
markets for efficient operation, the evolving system calls for more orderly
monitoring with improved rules and regulations.
The above evidence shows that the state has played a significant role in the
development of modern financial markets. This has induced contradictory
macroeconomic policies being pursued simultaneously in a country as are often seen.
As for example, while the central bank follows tight monetary regime to keep the
exchange rate stable, the state treasury gives sufficient inducements for increased
inflow of foreign capital, and the latter increases money supply to make the task of
the central bank difficult.
Globalization and Institutions
100
The term globalization describes the process of intensification of international

economic relations under a specific circumstances when the international economic
relations have twin roles. On the one hand these cause economic growth and an
improvement in the living standards, on the other these are responsible for the
disequilibrating problems that cause serious imbalances in the form of
unemployment and intra and inter-sector loss of production. The development of the
international economic relations in the real and nominal sphere induces changes in the
organizational forms and also in the institutional framework of the society. Thus
international laws are developing towards the supranational laws forcing the nations
to bridge the gaps in the legal frameworks. The MNCs are establishing their own
hierarchies irrespective of country affiliations and they are taking new measures to
upgrade their efficiencies. Whether it is the location of new establishments, or the
recruitment of personnel the MNCs do not consider the country perspectives.
The process of internationalization process describe above has two aspects---
intensification of international economic transactions and the changes in their
organizational forms. These two aspects are closely interconnected and often they
reinforce each other. While the new trade regime under WTO leads to liberalization of
the financial sectors and more trans-border integration, the latter induces the
concerned countries to formulate new rules and regulations to safeguard the stability
of the domestic system . This aspect comes again and again as country after country
faces instability in their financial system as the latter can not absorb the shocks
coming from the external sector. Argentina, Chile in Latin America, Indonesia and
Thailand in Asia , and Russia and some east European countries have experienced
convulsions in their financial system when the latter failed to withstand the external
shocks. One remedy to this type of problem , as suggested in the literature for the
stability of the regional currencies, is the Currency Board System which we discuss in
the next section.
Currency Board System

A currency board system (CBS) is a part of the monetary system in any
country that has commercial banks and other financial institutions. The system is also
101
characterized by a certain type of behaviour of the financial institutions regarding

convertibility, exchange rates, government finances and other related matters which
are explained below.
A currency board system is defined as a monetary institution that issues base
money which is fully backed by a foreign "anchor" or reserve currency , and the
money thus issued is fully convertible into the reserve currency at a fixed rate on
demand.
The currency under CBS is fully convertible and the board exchanges its
currency for the reserve currency at a fixed rate without limit. But a currency board
does not guarantee that deposits at commercial banks are convertible into currency
board currency, and it is the responsibility of the concerned commercial bank.
Under CBS the monetary policy is rule bound and the board has little
discretion in this regard. The currency board is not allowed to alter the exchange rate ,
nor its reserve ratio or the regulations affecting the commercial banks. The board
remains passive regarding the change in the demand for money. Market forces
determine the money supply. But under the usual central banking system, the central
bank has a discretion in pursuing the monetary policy and this is done in response to
specific situations whether it refers to exchange rate, or inflation ,or normal business
cycles. Though the degree of independence enjoyed by the central banks of various
countries differ , a central bank usually can alter the exchange rate, the reserve ratio ,
or regulations affecting the commercial banks and also a broad spectrum of
macroeconomic variables.
A central bank is a lender of the last resort, but a currency board is not. The
currency board does not lend to commercial bank or other financial institutions in
case of need. Neither the board can finance a fiscal deficit of the government. The
latter will have to balance its budget if it is unable to borrow. Under the CBS
discipline is enforced on the price fronts as the domestic currency is pegged to the
anchor reserve currency at a fixed rate and the board is committed to unlimited
conversion between the two currencies. This brings credibility to the domestic
currency.
Table:: A Central Bank versus a Currency Board
------------------------------------------------------------------------------------------------------
Central Bank Currency Board
------------------------------------------------------------------------------------------------------
1. Variable foreign currency reserves 1. Foreign reserve 100 per cent
2. Pegged or floating exchange rate and 2. Fixed exchange rate and full limited
convertibility convertibility
102
3. Discretionary monetary policy 3. Rule-bound monetary policy

4. Lender of last resort 4. Not a lender of last resort
5. Regulates the commercial banks 5. No power to regulate banks
6. Can finance fiscal deficits 6. Can not finance fiscal deficits
7. Requires preconditions for monetary 7.Requires no preconditions for
reforms monetary reforms.
---------------------------------------------------------------------------------------------------------
Source:: Schuler, 1996.
---------------------------------------------------------------------------------------------------------
The above table compares the two system in a brief way as the principal
characteristics of the system are contrasted. A currency board holds reserve currency
bonds, bank deposits and also a small amount of currency--- all these against its
liabilities of currency issued to the public. Many boards have held more than 100 per
cent reserves ( sometimes 110 per cent or more) to have a margin of protection in
case the value of the asset declines. But a typical central bank will have a variable
reserves in foreign currency and assets , and it can hold also domestic assets.
A currency board has good credibility. Its more than 100 per cent reserves,
rule- bound monetary policy, transparency in functioning, protection from political
pressure and fixed exchange rate with full convertibility --- all these make the
currency a good choice in the foreign currency markets. Again, inflation is also kept
under control. In contrast to that most central banks, except a few in OECD countries,
have a poor record of controlling inflation.
Historical Perspective
More than 70 countries have had currency boards and the first currency board
was established in 1849 in Mauritius, then a British colony. Till 1900 currency
board spread slowly, though Argentina established it. After 1900 British colonies
made the CBS as the system of monetary management. In the 1950s currency boards
reached their greatest extent with most of the countries in Africa, the Caribbean, and
South Asia had the currency boards system. In Asia, besides Hong Kong,
Singapore, Malaysia, Philippines, Burma and Brunei were the countries having the
CBS.
The CBS of the orthodox type as explained in the earlier paragraphs exists
today in Hong Kong, Gibralter, the Cayman Islands, the Falkland Islands, Bermuda
103
and the Faroe Islands. Since 1988 the government of Hong Kong has changed the
system which gives a diluted version of the currency board. In some countries we
see currency board- like system that does not have all the features and these
countries are --- Argentina, Bosnia, Bulgaria, Brunei, Djibouti and Estonia.
The record of the currency boards are very good as all of them have
successfully maintained fixed exchange rates and full convertibility into their anchor
currencies, and this they could do even during the Great Depression years. The
currency board in Falkland has been maintaining the fixed exchange rate of GBP 1 =
Falkland pound 1 ever since the creation of it in 1899.
Despite success stories many countries converted currency boards into a
central banking system in 1950s and 1960s after attaining independence as the CBS
was becoming synonymous with the colonial system. Also creation of the central
banks gives the political masters the sort of leverage which is not available with the
currency board system. It is no wonder that many central banks in small and new
countries have lost their credibility due to excess political influence.
Money Supply
The currency board does not have any active role in the determination of the
monetary base. The reserve of 100 per cent and a fixed exchange rate with the anchor
currency with unlimited convertibility make it impossible for the board to use any
discretion. The board also does not change the relation between the money supply
and money base as it maintain the 100 per cent or more reserve and it does not
change the ratio. The supply of money in this system is determined by the market
forces. In general, under CBS, the starting point in the sequence of events for an
increase in the supply of monetary base and hence money is an increase in the foreign
demand for good of the home country. Changes in the demand for goods originate in
the markets, and that reflect the desire of the public. But this induces a positive
element in the current account of the balance-of- payments. This is neutralized by the
inflow of foreign money and this increases the money base.
The currency board is unable to create reserve for the commercial banks at its
own discretion, and money supply responds to the changes in the market demand and
104
it is quite elastic. As the system acquires fresh foreign reserves ( in anchor currency),
money supply increases, and for this it is not necessary that the country should have
a current account surplus. The missing link is the capital inflow which can increase
the money base in this system even when the current account balance is negative.
Thus it is not necessary for a CBS to have a surplus in the current account of the
country so that it can expand the money supply. Foreign capital inflow can offset or
exceed the deficits in the current account and that means an increase in reserves and
also money supply.
Anchor Currency
Historically, British pound had been the anchor currency of the reserves of the
currency boards of many countries before 1950 and particularly in the former British
colonies. Later on, US dollar has taken a predominant position, though Japanese yen
and German Mark have been selected by some currency boards as the currencies of
reserves. One feature of the anchor currency is that it must be a stable one and with a
good credibility. After 1946 US dollar has become the international currency and that
has facilitated its position in the world.
Is the CBS a desirable institution? The answer is positive but in an abnormal

situation. Take the case of Indonesia, which introduced the system in February 1998.
At the time, more precisely in 1997, the Bank Indonesia devalued the currency rupiah
and it lost the credibility. Take some figures--- the current rupiah replaced the old
1965 rupiah at a rate of
1 current rupiah = 1000 old rupiah of 1965 vintage.
Also 3.80 of old rupiah of 1949 vintage = 0.00380 current rupiah, and this sort of
instability continued in the history of Indonesia. Surely, for the stability of the
financial system a strong medicine was required and CBS was prescribed and it was
adopted.
105
The CBS is a disciplined and rigid system and it is not amenable to sudden
changes if these are warranted to fight the business cycles ( Schuler, 1996:
Williamson, 1995). Sometimes it is also argued that CBS is an extreme solution for a
very unstable situation and it can not be an ideal one for the normal situation of a
country. Actually, no country wants to sacrifice the freedom of pursuing an
independent monetary and fiscal policy and this becomes the case under CBS.
There are certain other disadvantages in CBS. Apart from the initial
mobilization of the 100 per cent reserves in the anchor currency, the reserves position
ideally should be more to earn credibility of the system. Moreover, CBS is totally
passive to the changes in the monetary conditions. There is a tendency that the
domestic liquidity tends to be pro-cyclical--- in the upswing phase, money flows in
and the long term rate of interest tends to fall and the economy moves towards boom
conditions, and it becomes reverse in the downswing phase. This causes fluctuations.
Though currency board can give new currencies a quick start, it hardly
provide a lasting foundation. As the economy develops, the change in its industrial
structure requires its prices and the values of the assets to shift relative to those of the
trade partners. In this perspective, a currency board may aggravate the volatility of
prices and the returns on the assets in the developing countries.
To conclude, the introduction of CBS in an economy facing extreme

macroeconomic instability may be not without risk as the economy may be subject to
large amount of stress in the initial period. But once the economy becomes able to
withstand the pressure, the system gains credibility, rates of interests stabilize,
growth process starts and the economy catches up the growth trajectory. Thus it is
more important that the economy is able to absorb the initial shocks and the social
tensions are contained within reasonable limits. It is the apprehension of the latter
which propels many economists not to recommend the CBS for a country even
though it becomes the perfect solution. Politics stands in the way of Economics.
106
Chapter 9
Financial Derivatives and Macroeconomic Policy
The development of derivatives is an important innovation in the financial world

in the last two decades of the twentieth century. Derivatives are financial instruments,
which, while shadowing the underlying asset, give the owner a guarantee regarding the
intrinsic value of the asset. The growth of this market is phenomenal. The notional
amount outstanding of the exchanges in derivatives in OTC markets was US $72 trillion
in June 1998, according to Bank for International Settlements (BIS, 1999 ), while the
gross market value in OTC markets was US $ 2.6 trillion. At the same time the gross
domestic product (GDP) of the world in 1998 was US $ 29.2 trillion (IMF, 1999 ). The
average daily turnover on OTC markets was US $ 1.26 trillion per day in April, 1998.
These figures show the great leverage allowed by the derivative contract in the markets.
Principal Markets
The principal markets of derivatives in the world show the different levels of
technology functional in these markets. The Chicago Board of Trade (CBOT) and
Chicago Mercantile Exchange (CME) are the largest derivative markets in the world. The
European Exchange (Eurex) and the London International Financial Future Exchange
107
(LIFFE) are important markets in Europe which saw most of the innovation in
derivatives. These markets show different trading systems. LIFFE is famous for its open
outcry system for most of its products, but Eurex is an electronic trading platform, and it
allows the traders to function through the computer terminals. Recently LIFFE launched
a new electronic trading system called LIFFE CONNECT. This system will replace the
open outcry gradually.
There are certain other important markets like New York Mercantile Exchange
(NYMEX ), Mercato Italiano Future (MIF), Marche a′ Term Future (MATIF), Singapore
International Exchange (SIMEX) along with other centres spread all over the world. But
there is skewed distribution of the derivative business regarding geographical
distribution, as 32 per cent of the total transactions take place in LIFFE, and 18 per cent
take place in the United States. The future development of the derivative exchanges will
be largely shaped by the evolution of trading technology.
The size of the derivative markets reveal their importance in the functioning of
the economies, where the close link between financial innovation and investment,
banking and the activities in the industrial sectors are documented. The functioning of the
derivative markets are crucial as these influence the economic policies particularly in the
monetary field. In the following sections we will first take a brief overview of the
different categories of derivative instruments available in the market and then analyze
the relationship between derivatives and underlying assets and the implications of this in
monetary policies.
Derivative Instruments: An Overview

Derivatives can be broadly classified into Over-the -counter (OTC) type and
Exchange traded. Most debt instruments are traded over-the-counter with large
brokerage firms making markets in specific issues. Derivatives like forwards, Swaps and
customized options are traded over-the -counter (OTC). These are tailored according to
the needs of the customers and these are non-transferable agreements between two
parties.
108
A financial instrument is exchange traded if it is traded in a formal exchange.

Currency futures, standardized options and highly capitalized stocks are exchange
traded. These contracts are transferable as the counter-party to the exchange is the
exchange itself.
Forward contracts are simple derivatives for which two parties enter into an
agreement to buy or sell an asset at a fixed price at a certain future time. It is not traded in
an exchange and it is generally between two financial institutions or between one
financial institution and a client. One of the parties in a forward contract agrees to buy
the underlying asset on a certain future date for a specified price and thus takes a long
position. The other party agrees to sell the asset and assumes a short position. A forward
contract is settled at maturity as the holder of the short position delivers the asset to the
holder of the long position in return for the delivery price specified in the contract.
Swaps
Swaps are OTC instruments in which two parties agree to exchange streams of
payments or cash flows over time. There are two main categories--- interest rate swap and
currency swaps , but more esoteric type of swaps are possible depending on the needs of
the counter parties. An interest rate swap is an agreement between two parties to
exchange stated interest obligations for a certain period in respect of a notional principal
amount.
A currency swap is an agreement to buy and sell foreign exchange at pre-
specified exchange rates where the buying and selling are separated in time, i.e.,
borrowing one currency and simultaneously lending another. The contract also involves
the exchange of interest payment in one currency for those denominated in other
currency.
A swap is sometimes a combination of two simultaneous trades: an outright
forward contract and an opposite spot deal. For example, a bank may swap in three
month dollar by simultaneously buying spot dollar and selling three-month forward
dollar.
Futures and Options
109
A futures contract is a legally binding agreement between two parties. It is a

standardized contract with a standard underlying asset and the specifications relate to the
standard quantity and quality of the underlying asset. Futures are traded for assets like
commodities, stocks, Treasury bonds etc.
An option contract is defined as an agreement between two parties in which one
party grants to the other the right to buy or sell an asset under specified conditions and
assumes the obligations to sell or buy it. The party who buys the right to buy , but no
obligation to it, is called the buyer of the option and as a buyer he/she pays a price to the
seller (writer) of the option. The underlying asset can be currency, bonds, stocks or
commodities.
Options may be esoteric and in recent times a set of derivative instruments have
been developed to meet the complex nature of market demands. Taken as whole the
markets of derivatives , being a product of the complex financial system, have changed
the dynamics of the global financial structure. We are to see the implications of this two-
way relationships.
The Growth of Derivatives
At the international level the growth of derivatives is one important phenomenon

in the international financial system. There has been discussion in the literature about the
principal causes of this phenomenal growth. Sometimes it has been argued that the
derivative instruments have come in an evolutionary way to hedge the systemic risks of
the financial system which had been increasing since the beginning of the flexible
exchange rate regime. But Kaufman (2000) argues that with the slow down of inflation
at the world level investors started investments in financial assets like stocks and bonds in
a big way. As the size and scope of the professionally managed portfolio increased and it
assumed international dimension, the managers began to limit the exposure of the
portfolio with the help of derivative instruments. Thus the size of the derivatives markets
and the dimension became proportional to the size of the investment portfolio and also
the market uncertainty. Also that has been a steady source of business of the financial
institutions who specialize in the are of dealing with the derivatives.
110
With the slow down of global inflation particularly in the OECD countries, the
term structure of interest rates became stabilized and the yield curve attained the normal
shape with a positive slope. The normal shape of the curve has had the indirect but
significant effect that enabled a wide range of market participants to improve their
profitability without taking too much exposure in credit risk. This has induced the
financial institutions to participate more effectively in the derivatives markets for
business reasons. The result has been an explosive growth of the market for the
derivatives( Kaufman, 2000).
The world has also seen the emergence of a large pool of risk capital under the
control of the fund managers who want an aggressive deployment of these funds for a
high returns. In the market ,for every cautious portfolio manager willing to take cover
behind the wall of derivatives, there must be a willing risk taker who can provide the
desired product. The existence of the speculators of the latter type prevents the markets
from becoming lop-sided and the result is that price of derivative remain within
reasonable limits.
A relatively stable global price level, a stable and rising yield curve, too much
liquidity in the world financial markets under the control of aggressive fund managers
intent on investing these funds in the search of higher returns along with a dis-
intermediation process in international banking have created an ideal situation for the
explosive growth of derivative markets. But whether the high growth of derivatives has
created a situation of instability through excess speculation is a point which is being
debated in the literature.
111
Derivatives and Underlying Asset
The financial health of the derivatives markets are better known by three
characteristics:
--the liquidity of the market
--the bid /ask spread and its movement
--the volatility of the asset prices or that of returns
Research has been conducted to test the effects of derivatives on these three features of
the financial markets. It is shown that the introduction of futures has reduced the
volatility of the underlying asset and it has also reduced the asymmetry of information.
The proof that derivatives help in the reduction of volatility in the markets is important as
the level of volatility is an index of the efficiency of market operation while it shows the
amount of risk ( Conrad, 1999; Bhanot,1998 ). The introduction of derivatives such as
options and futures increases the liquidity in the market and this again reduces the noise
component in the stock prices. As a result of this volatility in prices reduces. The noise
component which is the additional part apart from the random one is the outcome of a
complex process whose chemistry consists of guess work, panic reaction, additional
mark-up and certain other factors.
The introduction of derivatives has also reduced the bid/ask spread in the price
quotations and markets are much more stable with higher percolation of information to
the participants. With investors better informed in a symmetric fashion, there has been
more scope that the allocation of resources has become efficient. In an important study
Tse, Lee and Booth (1996) have analyzed the functioning of three markets--- LIFFE for
Europe, IMM for the United States and SIMEX for Asia--- with different trading hours so
that these three can be considered as a single market , and the paper proves that the
transmission of information among the three markets about the underlying asset has
improved with the introduction of futures. The volatility is lower in the trading hours
than in the non-trading hours.
The consensus in the financial economics literature on the introduction of
derivatives is that the market shows the following tendencies:
112
--The volatility and the variance of the prices decreases

--The liquidity of the market improves
--The bid/ask spread reduces.
One important aspect of the introduction of derivatives in the market is that it

increases the liquidity, which in effect means an increase in money supply and also an
increase in instability in the system. This has an effect on the interest rates. The function
of the derivatives is also to minimize the price distortion in the market which is
sometimes called as price discovery effect. It is seen that the ability of the future price to
anticipate the future interest rates is related to the liquidity of the market. Some
econometric studies have confirmed the effects of derivatives on the short term interest
rates through the change in the liquidity.
Derivatives, Money and Monetary Policy
There are several definitions of money in the economics literature. The

instrumental definition associated with Professor Milton Friedman identifies the
monetary base through the instruments by which it is made ( Friedman and Schwartz,
1963). Alternatively, the functional definition specifies that the monetary base is
composed of those instruments whose function is of compulsory reserve at the central
bank or free reserve held by the commercial banks. From these two definitions it is
difficult to distinguish between monetary base and money when a new instrument is
introduced in the market. Also at the international level there is no compulsory reserve on
bank deposits in foreign currencies as applicable for domestic money. In this perspective
any classification between the two categories of definitions will generate many
conceptual problems.
113
The analytical distinction between monetary base and monetary assets is

established in the literature through the liquidity effects. The monetary base is composed
of all those instruments that reveal an inverse relationship with interest rates, but the
relationship with money and interest rates is direct. This needs some explanation. The
negative correlation between the interest rate and monetary base holds when the
economic agents have unchanged inflation expectations. Therefore, it is an unanticipated
change in the monetary base that affects both the nominal and the real interest rates. In
the absence of this qualification the relationship will change. If the existing expectations
in the market are rational, the market will react to an increase in the creation of
monetary base by a rise in the interest rate to incorporate higher inflation expectations.
Thus the market will be guided by the Fisher Equation as the nominal interest rate will
exactly compensate the real interest rate as well as the anticipated rate of inflation.
Apart from the interest rate aspect of derivatives, the combination of a set of
derivative products can create a synthetic assets that are substitutes for existing financial
and monetary instruments. As for example, a portfolio consisting of a long bond position
and of a short three-month future on the same bond is financially equivalent to a three
month fixed deposit. But the latter is a component of broad money or M3 and attracts the
compulsory reserve ration provision, but the synthetic portfolio is not considered that
way. But the minimum rate of return of the investment and the cost of transaction can
influence the choice between a three-month fixed deposit and a synthetic portfolio as
described. But one point is clear. The monetary effects of two situations are different.
One implication of this conclusion is that portfolio reallocation can modify the impact of
monetary actions. If the economic agents who are more sensitive to interest rate changes
take cover against the risk with the help of derivatives, the final effects of interest rate
change on the macro economy will be much less than what is anticipated.
In many instances central banks try to influence the short term money market
when their long term objective is to control inflation. For this they always monitor and
control the supply of money by frequent change in the compulsory reserve and free
reserves of the commercial banks. Sometimes central banks also try to change the interest
114
rate structure, like an increase in the interest rate if they think that market is suffering
from too much liquidity. In this case the existence of a large and effective derivative
market can reduce the impact of interest rate changes on the macro parameters , because
the economic agents will take hedge behind the wall of derivative instruments. This is a
new phenomenon. It is not entirely new as the knowledge was there in the literature, but
the enormous size of the market of derivatives and the way these influence the potential
impact of interest rate changes on the yield curve is something new in the recent
monetary theory.
With the development of financial markets and more awareness about risk
management derivatives have become the potential instruments of the monetary policy of
the central banks and the latter can utilize the huge liquidity to invest in the derivative
markets for hedge purposes. One implication is that derivatives have introduced a new
mechanism of money creation, and for this the existing monetary aggregates are to be re-
examined for a better monetary policy. For example, the less liquid components of
monetary aggregates like fixed deposits and certificates of deposits (CP) can be used as
underlying assets for the creation of derivative instruments which become more liquid in
the markets and these are good substitutes for speculative money. This phenomenon
implies that the important underlying assets should be included when we talk about
liquidity. This will facilitate better management of the monetary policy with the help of a
stable growth of money.
In the banks derivatives are not accounted separately from the other financial
instruments and generally these are not classified in relation to the type of risk these
instruments hedge. Derivatives are the off-balance-sheet items in the banking system and
so these are not considered as part of a bank's resources. Therefore, it does not attract the
compulsory reserve provision. Though commercial banks invest in derivative market,
the whole amount of resources invested is not generally calculated in the traditional
banking aggregates, though the latter is included in the monetary targets of the central
bank ( IMF, 1998; BIS, 1999 ). Banks also invest a part of their free reserves in
derivatives for a short period . All these behaviour regarding the commercial banks'
investment in derivative markets affects the size of the money multiplier, as its size
115
increases compared to the situation when banks do not invest in derivatives. Because the
latter affects the behavioural coefficients like banks' propensity to liquidity, public's
propensity to liquidity and the compulsory reserve ratio. All these three ratios determine
the size of the money multiplier.
To the extent the size of the multiplier changes as a result of the derivatives, bank
can lend a greater amount of money to the corporate sector with the help of the synthetic
reserves they create with their investment in the derivative markets. When the central
banks works with a credit target , monetary policy may be off the target if the potential
credit creation by the banks with the help of derivatives is not taken into consideration.
The existence of derivatives influences the size of money supply as explained in

the previous paragraph, and so the monetary policy is to address that issue. Also the
central bank is to monitor the movement of the long term interest rates which are
determined by the markets. When the yield curve of the money market is stable and
steady, the long term interest rates are functions of the short term rates. Also the short
term rates are influenced by the rates of the repos ( repurchase agreements) central banks
conduct on a regular basis to monitor the liquidity in the system.
The long term interest rates establish the link between the domestic money
market and the global one. The central bank should check that properly as the interest
rates differential affects the movement of the external value of the domestic currency,
i.e., the exchange rate. Any large scale deviations of the interest rate can cause instability
in the system and the central banks can face financial loss either through the changes in
the exchange rates or through short term capital flows.
Use of Derivatives in Monetary Policy
In recent times some central banks are seen to use derivative instruments as a
supplements to their monetary policy and many a time derivative instruments have
strengthened the power of specific policy of the central bank.
116
First, in some countries the secondary markets for government bonds are not
developed and in such situations the central banks use derivatives as a substitutes for the
secondary short term markets for securities. The examples are the central banks of
Holland and Switzerland. When the trading desks of the central banks issue derivative
securities, it can better integrate the connections between policy intentions for the short
term rates and current long term interest rates. Since the central banks are to have two
sets of policies simultaneously, and since inter-temporal planning on the part of the banks
involves portfolio management over time, a better coordination between short term and
long term policies is an imperative for the central banks. When the market becomes
narrow and the short term rates approach a near -zero level, the channel of information
becomes meaningless as the spot rate fails to give the necessary signal. In such a
situation central banks can operate directly on the long bond rates through the purchase
or sale of bonds.
Second, central banks sometimes use the derivative instruments to defend their
monetary targets. As an instrument of monetary policy derivatives can be purchased
either through the banking system or through the central banks of other countries. In the
case of the former, the quantity of the domestic monetary base changes, while in case of
the latter, no new money creation is involved.
Third, sometimes central banks try to influence the money market either by a
change in the interest rate or through inducing a change in the supply of credit. The first
is known as money view , while the second is known as credit view. These two
alternatives give the ambience in the literature about the instruments of monetary policy
the central banks will use to influence the course of events of the broad macroeconomic
parameters.
According to the money view it is the money supply which affects the growth of
gross domestic product (GDP) in the long run and hence the central banks should control
money supply to stabilize the growth rates of GDP. In the credit view it is said that bank
credit availability has a positive effect on the macroeconomic activity and hence the
central banks should control the bank credit expansion. The findings in the empirical
literature broadly agree that while money supply has the largest effects on the GDP, bank
117
credit has a fairly strong effect that is larger than the price effects in the short run. In case
of a longer run, bank credit remains a salient factor but it is the price effects which
dominate.
In the money view, the central bank can employ the convenience of having
money in lieu of financial assets and when the substitution between the two is not perfect,
then the central bank can alter the composition of portfolio. When derivatives are
introduced, the participants get more information and they have more space for
operations. As a result the market efficiency increases, but the ability of the central bank
to influence the choice of the investors get reduced. Because, the investors can take a
hedge against the potential moves of the central banks.
But in the perspective of the credit view, the central banks control the feasibility
of substitution between credit and financial assets. Perfect substitution may not be
achieved because of the asymmetry in the information flow and/ or because of barriers
in the financial markets. The latter are generally due to domestic rules and regulations,
but the former, i.e., asymmetry can be largely reduced with the introduction of
derivatives in the markets. When the central banks change the interest rates, the investors
can take a hedge against this through the purchase of an interest rate swap. Thus the
power of the central banks gets reduced to influence the market at least in the short run.
Fourth, central banks also use derivatives for the defense of the external value of
the currency at crisis times. This they do by taking an open position in the OTC market
with a small initial payment and thus try to influence the rate. But the banks do secretly
and do not let the market know that they are using derivatives to defend the currency.
The reason is simple. If the credibility of the central bank is not good and the currency is
not strong, the market participants believe that the behaviour of the central bank is far
from consistent with the stated intention. The market closely watches the central bank
and the strategy of the bank may not work.
The Thailand Example
118
During 1995 and 1996 Thailand faced acute problems in her balance of trade and
the currency Baht started showing the signs of weakness. The central bank of Thailand
was not ready to devalue the currency as that would give wrong signal to the inflow of
foreign capital. So the central bank tried to defend Baht through the purchase of futures
of two- week maturity in the summer of 1996. This could not be kept a secret. Once the
futures contracts reached maturity, the operators in the markets realized that Baht had to
be devalued and they accordingly took position. The central bank did not have enough
foreign exchange reserve to frustrate the design of the market speculators. The result was
that the central bank had to devalue the currency in 1997 and with this realignment of
Baht the Asian crisis started. The rest is history.
One implication of Thailand case is that the country had been following a pegged
exchange rate system to facilitate a steady inflow of foreign direct investment. But
through this adherence of fixed exchange rate policy, the central bank lost a large part of
its freedom in pursuing the domestic monetary policy. When the exchange rate came
under pressure, the central bank had to take certain measures which should be consistent
with other economic parameters. This was difficult to achieve and sliding down of Baht
continued.
The evolution of the financial markets with the development of derivatives was an
important event in the last two decades of the 20th century. Derivatives not only brought
depth in the markets, these also helped the operators in the markets to hedge against the
new type of risks which became very common in the last two decades of 20 th century. It
was also natural for other market participants to use the hedge tools for bringing finer
spreads in the financial intermediation, for better portfolio management , for the
minimization of risks and also for supplementing macroeconomic policies with the use
of derivatives to achieve better results.
The wide use of the derivatives in the international financial system has changed
the complexion of the international money as the set of derivatives are being used as
119
good substitutes for other category of financial assets. In recognition of this the IMF has
introduced certain norms which the commercial banks are to comply if they are involved
in derivative business Also IMF Committee on Balance-of-Payments Statistics has
introduced new rules to make the BOP statistics more consistent. Financial derivatives
are removed from the general items contained in the current account and the Committee
has introduced a new category of financial account and a new item is inserted in the
annex of the balance of payments, which is called Supplementary Information ( IMF,
1998). This covers the detailed break down of different type of derivative instruments,
classes of risks and the counter party.
Derivatives are still new instruments and a significant gray areas exists in the
proper understanding of the dynamic of these. The example of LTCM failure in the
United States point to the fact that the fragility of the financial system is something
which the international community should take care of. In this age of unhindered capital
mobility across the national boundaries the financial chaos can easily be transmitted to
other countries. This is something for which the emerging economies should be properly
cautioned.
References::
Aghion, P., Bacchetta, P. and A. Banerjee, Currency Crisis and Monetary policy in an economy with credit
constraints, European Economic Review, June 2001, 45(7), 1121 – 50.
Aghion, P., Bacchetta, P. and A. Banerjee , A Simple Model of Monetary Policy and Currency Crisis,
European Economic Review, May, 2000, 44 (4 -6), pp 728- 38.
Akelis, Stephen B., Technical Analysis from A to Z, Moscow, Diagramma, 1999.
Alexander, S. S., Effects of Devaluation on the Trade Balance, IMF Staff Papers, 2, April, 1952.
120
Argy, V., The Mundell- Fleming Model : Its Strength and Limitations, in V. Argy, International
Macroeconomics: Theory and Policy, NY., Routledge, 1994.
Balassa, Bela, The Purchasing Power Parity doctrine: A Reappraisal, Journal of Political Economy, 72,
December, 1964, 584- 596 .
Bank for International Settlement ( BIS), International Banking and Financial Market Development, Basle,
November, 1991.
Bergin, Paul, and Robert Feenstra, Pricing- to- Market, Staggered Contracts, and Real Exchange rate
Persistence, Journal of International Economics, 54, August, 2001, 333—59.
Betts, Caroline, and Michael B. Devereux, Exchange Rate Dynamics in a Model of Pricing – to- Market,
Journal of International Economics, 50, February, 2000, 215-44.
Bhagawati, J. N. ( ed), Illegal transactions in Foreign Trade, Asterdam, North Holland, 1974.
Bhagawati, J.N. Anatomy and Consequences of Exchange Control Regimes , Cambridge, MIT Press, 1978.
Black, S., “Seignorage”, in J. Eatwell, M. Milgate and P. Newman (eds), The New Palgrave Money , New
York, Norton, 1989.
Black, S. W., Exchange Policies for Less developed Countries in a World of Floating Rates, in D. M.
Leipzig ( ed), The International Monetary System and the Developing Nation, Washington D.C., 1976.
Black, F. and M. Scholes, The Pricing of Options and Corporate Liabilities, Journal of Political
Economy, 81, May-June, 1973.
Blejer, M., Exchange Restriction and the Monetary Approach to the Exchange Ratio, in Frenkel and
Johnson (1978).
Blejer, M. and A. Cheasty, The Measurement of Fiscal Deficits: Analytical and Methodological Issues,
Journal of Economic Literature , 29 (4), December, 1991.
Branson, W.H., Asset Markets and Reserve Prices in Exchange Rate Determination, Institute of
International Economic Studies, Reprint Series No. 98, 1977.
Bresman, H., Birkinshaw, J. and R. Nobel, Knowledge Transfer in International Acquisitions, Journal of
International Business studies, 30(3), 11999, 439—462
Buckley, P. and M. Casson, Analysing Foreign Market Entry Strategies: extending the internalization
Approach, Journal of International Business Studies, 1998, 29 (2).
Cagan, P., “ Hyperinflation” in J. Eatwell et el (eds.) , 1989, op. cit.
Calvo, G, L. Leiderman, and Carmen Reinhart, Inflows of Capital to developing Countries in the 1990s,
Journal of Economic Perspective, 10(2), Spring, 1996, 126-36.
Calvo, G. and Carmen Reinhart, Fixing for your Life, Brookings Trade Forum 2000, 2001, 1- 39.
------------------------------------, Fear of Floating, Quarterly Journal of Economics, 117, (2), 2002.
Cassel, G., Abnormal Deviations in International Exchange, Economic Journal, 28, December, 1918, 413 –
15.
121
Caves, R. E., Multinational Enterprises and Economic Analysis, Second Edition, 1996.
Chang, R., Financial Integration with and without International Policy Coordination, International
Economic Review, 38 (3), 1997, 547—64.
Colbie, Robert V. and Thomas A. Meyers, Encyclopaedia of Technical market Indicators, Alpina
Publishers, 1998.
Corsetti, G., and P Pesenti, Welfare and Macroeconomic Interdependence, Quarterly Journal of Economics,
August, 2001.
Devereux, M. B., Exchange Rate Pass-Through, Exchange Rate Volatility, and Exchange Rate Disconnect,
NBER working Paper No. 8858, NBER, April, 2002.
-------------------- , Real Exchange Rates and Macroeconomics : Evidence and Theory, Canadian Journal of
Economics, 30, 1997, 773- 808.
Dollar, D., Outward Oriented Developing Countries Really Do Grow More Rapidly: Evidence from 95
LDCs, 1976 – 85, Economic Development and Cultural Change, April, 1992.
Dooley, M.P. and P. Isard, The Portfolio Balance Model of Exchange Rates and Some Structural Estimates
of the Risk Premium, IMF Staff Papers, 30, 1983, 683-92.
Dooley, M. P., A Survey of Literature on Controls over International Capital Transactions, IMF Staff
papers, 43 (4 ), December, 1996, 639—687.
Dornbusch, R., Expectations and Exchange Rate Dynamics, Journal of Political Economy, 84, 1976, 1161
—76.
Dornbusch, R., Special Exchange Rates for Capital Account Transactions, NBER Working paper, No. 1659,
NBER, 1985.
Dornbusch, R. and S. Fischer, Exchange Rates and Current Account, American Economic Review, 70, 1980,
960—71.
Dornbusch, R. and J.A. Frankel, The Flexible Exchange Rate System: Experience and Alternatives, NBER
Working Paper, No. 2464.
Dornbusch, R., Y.C. park and S. Claessens, Contagion: How it Spreads and How it can be stopped,
Proceedings of the World Bank Conference on International financial Contagion, Washington D.C., Feb 3
—4, 2001.
Duarte, Margarida, International Pricing in New Open- Economy Models, Federal Reserve Bank of
Richmond Economic Quarterly, 87, Fall, 2001, 53—70.
Dunbar, Nicholas, Meriwether’s Meltdown, Risk, October, 1998.
Edison, H. and J T Klovland, A Quantitative Reassessment of the Purchasing Power Hypothesis: Evidence
from Norway and the United Kingdom, Journal of Applied Econometrics, 2, 1987, 209—33.
Edwards, F. R., Hedge Funds and the Collapse of Long-Term Capital Management, Journal of Economic
Perspectives, 13(2), spring, 1999, 198—210.
122
Eichengreen, Barry, Towards a New International Financial Architecture, Institute for International
Economics, Washington D.C. 1999.
Eichengreen, B., A. rose, and C. Wyplosz, Contagious Currency Crisis, Scandinavian Journal of
Economics, December 1996, 98(4).
Engel, Charles, real exchange Rates and Relative Prices: An Empirical Investigation, Journal of Monetary
Economics, 32, August, 1993, 35—50.
Evans, M. and R. Lyons, Order Flow and Exchange Rate Dynamics, Journal of Political Economy, 110,
2002, 170- 180.
Financial Action Task Force (FATF), 1998 – 1999 Report on Money Laundering Typologies, FATF
Secretariat, Paris, 1999.
Fiorentini, G. and S. Peltman, The Economics of Organized Crime, Cambridge, Cambridge University
Press, 1997.
Fischer , S. and W. Easterly, The Economics of the Government Budget Constraint, World Bank Research
Observer , 5 (2), July, 1990.
Fischer, S., Seignorage and the Case for a National Money, The Journal of Political Economy, 90 (2),
1982, 295—313.
Fleming, J.M., Domestic Financial Policies under Fixed and under Floating Exchange Rates, IMF Staff
Papers, 9 (3 ), November, 1962, 369—379.
Flood, Robert and P. Garber, Collapsing Exchange Rate Regimes: Some Linear Examples, Journal of
International Economics, 17(1-2), 1984, 1—13.
Frankel, J. A., International Nominal Targeting (INT): A Proposal for Monetary Policy Coordination in the
1990s, The World Economy, 13(20, 1990, 263—73.
Frankel, J., S. Schmukler and L. Serven, Verifiability and the vanishing Intermediate Exchange Rate
Regime, Journal of Development Economics, 66 (2), 2001, 351- 386.
Frenkel, J. A., Flexible Exchange Rates, Prices and the Role of news: Lessons from the 1970s, Journal of
Political Economy, 89, 1981, 665—705.
-----------------, Global Transmission of Interest Rates: Monetary Independence and Currency Regime,
NBER Working Paper series, Paper No. 8828, march, 2002.
Frenkel, J and H. Johnson (eds.), The Economics of Exchange Rates : Selected Studies, Reading, Mass.,
Addison Wesley Publishing Co. 1978.
Fry, M. J., Money, Interest and Banking in Economic Development, Baltimore, John Hopkins University
Press, 1988.
Gandolfo, Giancarlo, International Finance and Open Economy Macroeconomics, Heidelberg, Springer –
Verlag, 2001.
Ganesh, S., Who is Afraid of Foreign Firms ? Current Trends in FDI, Economic and Political Weekly,
March, 1997.
Gibson, Rajna, Option Valuation: Analyzing and Pricing Standardized Option Contracts, McGraw- Hill,
New York, 1999.
123
Giovannetti, G., A Survey of recent Empirical Test of the Purchasing Power Parity Hypothesis, Banca
Nazionzle del Lavaro Quarterly Review, 180, march, 1992, 81—101.
Goldberg, Pinelopi, and Michael Knetter, Goods Prices and Exchange Rates : What have we Learned?
Journal of Economic Literature, 35, September, 1997, 1243—72.
Goldstein, M and Phillip Turner, Banking Crises in Emerging Economies: Origin and Policy Options,
B.I.S. Economic Papers, No. 46, October, 1996.
Hamada, K., The Political Economy of International Monetary Independence, Cambridge, Mass, USA.,
MIT Press, 1985.
Hanke, S. H. and K. Schuler, Currency Boards for Developing Countries, San Francisco, ICG press, No. 9
in ICG Sector Study Series, 1994.
Hartmann, Phillip, Currency Competition and Foreign Exchange Markets; the Dollar, the Yen and the
Euro, Cambridge University Press, Cambridge, 1998.
Hau, Harald, Exchange rate Determination: The Role of Factor Price Rigidities and Nontradables, Journal
of International Economics, April, 2000, 50 (20, 421- 47.
Hausmann, R., Ugo Panniza, and Ernesto Stein, Why Do Countries Float the way They Float ?, Journal of
Development Economics, 66 (2), 2001, 387- 414.
Hayek, F. A. von, Denationalisation of Money: An Analysis of the Theory and Practice of Concurrent
Currencies, London, Institute of Economic Affairs, 1976.
----------------------, The Use of Knowledge in Society, American Economic Review, September, 1945.
Heller, H.R. and R. R. Rhomberg ( eds.), The Monetary Approach to Balance of Payments, Washington,
International Monetary Fund, 1977.
Hoover, Kevin D., Causality in Macroeconomics, Cambridge, Cambridge University Press, 2001.
Hume, David, (1739), A Treatise of Human Nature, Oxford, Clarendon Press, 1888.
--------------------, ( 1754), Essays: Moral, Political, and Literary, Indianapolis, Liberty Classics, 1985.
Isard, P., Exchange Rate Economics, New York, Cambridge University Press, 1995.
Johnson, H., Tariffs and Economic Development: Some Theoretical Issues, Journal of Development
Studies, Vol. 1, 1964.
Kaldor, N., The Effects of Devaluation on Trade in Manufactures, in Further Essays on Applied
Economics, London, Duckworth, 1978.
Kenen, P. B., (ed), Understanding Interdependence: The Macroeconomics of the Open Economy, Princeton,
Princeton University Press, 1995.
Keynes, J. M., Social Consequences of Changes in the Value of Money, in J. M. Keynes, Essays in
Persuasion, New York, W. W. Norton, 1963.
Kindleberger, C., International Public Goods without International Government, American Economic
Review, 76 (1), 1986, 1—13.
124
Kokko, A., Technology, market Characteristics and spillovers, Journal of Development Economics, 43,
1994.
Kumar, N., Multinational enterprises and Industrial Organisation, The case of India, Sage Publications,
Delhi, 1994.
Kollmann, Robert, Incomplete Asset Markets and the Cross- Country Consumption Correlation Puzzle,
Journal of Economic Dynamics and Control, May, 1996, 20 (5), 945-61.
Krugman, Paul, a Model of Balance of Payments crisis, Journal of Money Credit and Banking, August,
1979, 11(3), 311 – 25.
Krugman, P., Balance Sheets, the Transfer problem, and Financial Crisis, International tax and Public
Finance, November, 1999, 6(4), 459 –72.
Laidler, David, The Quantity Theory is Always and Everywhere Controversial – Why?, Economic Record,
67, December, 1991, 289 – 306.
Lilley, Peter, Dirty Dealing : The Untold Truth of Global Money Laundering, London, Kogan Page Ltd,
2000.
Lincoln, A., Many Free countries Have Lost Their Liberty, a Speech on the Sub treasury, Springfield,
Illinois, December 26, 1839.
Lucas, Robert E., Interest Rates and Currency Prices in a Two –Country World, Journal of Monetary
Economics, November, 1982, 10 (3), 335—59.
Lyons, R. K. , Foreign Exchange: Macro Puzzles, Micro Tools, Economic Review , (Federal Reserve bank
of San Francisco), 2002.
MacDonald, R., Floating Exchange Rates: Theories and Evidence, London, Unwin Hyman, 1988.
Marshal, A., Money, Credit and Commerce, London, Macmillan, 1924.
McCombie, J. and A. P. Thirlwall, East Asian Financial Crisis: Retrospect and Prospect, Asia and
Australasia: Regional Overview, 3rd. Quarter, 1999, Economist Intelligence Unit.
McKinnon, R.I. , Mundell, the Euro, and the World Dollar Standard, American Economic Review, May,
2000.
------------------------, Money in International Exchange, New York, Oxford University Press, 1979.
------------------------ , The Exchange Rate and Macroeconomic Policy: Changing Post war perceptions,
Journal of Economic Literature, 19, June, 1981, 531—557.
Meese, R A. and K. Rogoff, Empirical Exchange Rate Models of the Seventies: Do they fit out of sample?
Journal of International Economics, 14, 1983, 3—29.
Misselden, E., The Centre of the Circle of Commerce, London, J. Dawson for N. Bowne, 1623.
Mundell, R.A., International Economics, Macmillan, 1967.
------------------- , Capital Mobility and Stabilization Policy under Fixed and Flexible exchange Rates, The
Canadian Journal of Economics and Political Science, 29 ( 4), 1963, 487—99.
-------------------, The Future of the Exchange Rate System, Paper prepared for the Rocca de Salimbeni
Conference, Siena, Italy, November, 1994.
125
-------------------, What the Euro Means for the Dollar and the International Monetary System?, Atlantic
Economic Journal, 26(3), September, 1998.
Murphy, John J., Technical Analysis of Future Market: Theory and Practice, Sokol, 1996.
Nandi, Sukumar, International Money and Finance, Samskriti, New Delhi, 2001.
--------------------, International Money and Capital, Business Publications Inc., Mumbai, 1999.
Nandi, Sukumar, Growth , Financial Cycles and Bank Efficiency: An Analysis of Indian Money Market,
Business Publications Inc., Mumbai, 1998.
--------------------, Essays on International Finance: The Indian Perspective, National Institute of Bank
Management, Pune, 1996.
Nandi, Sukumar, Exchange Rate Behavior of Indian Rupee: A Cointegration Approach, Journal of Indian
School of Political Economy, January – March , 1994.
-------------------, An Empirical Study of Demand for International Reserve, Journal of Foreign Exchange
and International Finance ( JFEIF), April- June , 1996.
-------------------, Exchange Rate of Indian Rupee and Price Level Behaviour in India, in D. K. Das (ed),
Trade ad Development: Experiences and Challenges, New Delhi, Deep and Deep Publications, 1999.
-------------------, Hong Kong Dollar and Chinese Renminbi (RMB), Two Currencies in One country, JFEIF,
July- September , 1998.
Nayyar, D., Transnational Corporations and Manufacturing exports from Poor Countries, Economic
Journal, 88, 1978.
Neumann, M.J.M. , Seignorage in the United States: How Much Does the U. S. Government Make from
Money Production?, Federal Reserve Bank of St. Louis REVIEW, 74 (2), March – April, 1992, 29—40.
Noussair, C.N., C.R. Plott and R.G. Reizman, The Principle of Exchange Rate Determination in an
International Finance Experiment, Journal of Political Economy, 105, 1997, 822 – 61.
Obstfeld, Maurice, The Global Capital market: Benefactor of Menace? Journal of Economic Perspective,
12 (4), Fall, 1998, 9—30.
---------------------, Rational and Self-Fulfilling Balance of Payments Crises, American Economic Review,
March, 1986, 76, 72—81.
--------------------, The Logic of Currency Crises, cahiers Economiques et Monetaires 43, Bank of France,
1994, 189—213 .
Obstfeld, Maurice, International Capital Mobility in the 1990s, in Peter Kenen (ed.), Understanding
Interdependence, Princeton University Press, 1995.
Obstfeld, Maurice, and Kenneth Rogoff, New Directions for Stochastic Open economy Models, Journal
of International Economics, 50, February, 2000, 117 – 53.
------------------------------, Exchange Rate Dynamics Redux, Journal of Political Economy, 103, 1995a, 624
-660.
126
Obstfeld, Maurice, and Kenneth Rogoff, The Intertemporal Approach to the Current Account, in, G.
Grossman and K. Rogoff, ( eds.), Handbook of International Economics, vol. 3, Amsterdam, North-
Holland, 1995b.
--------------------------------, Foundations of International Macroeconomics, Cambridge, Mass., MIT Press,

1996.
--------------------------------, Risk and Exchange Rates, Working Paper No. 6694, National Bureau of
Economic Research, August, 1998.
---------------------------------, New Directions for Stochastic Open Economy Models, Journal of

International Economics, 50, 2000, 117 – 153.
Officer, L.H., The Purchasing Power Parity Theory of Exchange Rates: A Review Article, IMF Staff
Papers, 83, 1976, 1—60.
Payne, R. , Informed Trade in Spot Foreign Exchange market markets: An Empirical Investigation,
London School of Economics, ( Typescript), 1999.
Pick, F., Pick’s Currency Yearbook, Pick Publishing Corporation, New York, 1960, 1968.
Polak, J. J. , Monetary Analysis of Income Formation, IMF Staff Papers, 4, 1957.
Polak, J. J., The IMF Monetary Model : A Hardy Perennial, Finance and Development, December, 1997,
16—19.
-------------------, The IMF Monetary Model at Forty, IMF Working Paper No. 97 / 49, Washington D.C.,
April, 1997.
Porter, R.D. and R.A. Judson, The Location of the US Currency: How Much is Abroad?, Federal Reserve
Bulletin, October, 1996, 883—903.
Quirk, Peter J. , Money Laundering: Muddying the Macroeconomy, Finance and Development, IMF, 34
(1), 1997.
Reinhart, C. and V. Reinhart, What Hurts Most? G-3 Exchange Rate or Interest rate Volatility, NBER
working Paper No. 8535, 2002.
Ricardo, David, On the Principles of Political Economy and Taxation, edited by Piero Sraffa, Cambridge,
UK, Cambridge University Press, 1951.
Rogoff, Kenneth, The Purchasing Power Parity Puzzle, Journal of Economic Literature, 34, June, 1996,
647 - 68.
Sachs, J. D., A. Tornell and A. Velasco, The Collapse of the Mexican peso: what have we learned?
Economic Policy, 22, April, 1996, 15—63.
Sachs, J. D. and F. Larrain B., Macroeconomics in the Global Economy, Englewood Cliffs, Prentice Hall,
1993.
Samuelson, Paul, Theoretical Note on Trade Problems, Review of Economics and Statistics, 46, May 1964,
145 – 154 .
Sargent, T., Dynamic Macroeconomic Theory, Cambridge, Harvard University Press, 1987.
127
Sarno, Lucio, Towards a New Paradigm in Open Economy Modeling: Where Do We Stand?, Federal
Reserve Bank of St. Louis Review, 83 (3 ), May- June, 2001.
Smith, V.L., Experimental Methods in Economics, in The New Palgrave: A Dictionary of Economics,
London, Macmillan, Vol. 2, 1987.
Stern, R., Balance of Payments Theory and Economic Policy, London, Macmillan, 1973.
Taylor, Alan, Potential Pitfalls for the Purchasing- Power – Parity Puzzle? Sampling and Specification
Biases in Mean- Reversion tests of the Law of One Price, Econometrica, 69, March, 2001, 473 -98.
Tobin, J., Agenda for International Coordination of Macroeconomic Policies, in International Monetary
Cooperation : Essays in honor of Henry C. Wallich, Essays on International Finance, No. 169, Princeton,
Princeton University Press, 1987, 61—69.
Triffin, R., Gold and the Dollar Crisis: Yesterday and Tomorrow, Essaays in International Finance, No. 132,
Princeton University, December, 1978.
Ugur, Mehmet, Extensions on the Mundell – Fleming Model; Perfect capital mobility and Flexible Prices,
in Ugur, M. (ed), An Open Economy Macroeconomics Reader, New York, Routledge, 2002, 42—50.
UNCTAD, World Investment Report 1998: Trend and Determinants, Geneva, UNCTAD, 1998.
UNCTAD, World Investment Report 1999: Foreign Direct Investment and the Challenge of Development,
Geneva, 1999.
Wacziard, R., Measuring the Dynamic Gains From Trade, World Bank Economic Review, 15(3), 2001.
Wallich, H. C., Institutional Cooperation in the World Economy, in J. a. Frenkel and M. L. Mussa ( eds),
The World Economic System : Performance and Prospects, Dover, MA., Auburn House, 1984.
Wang, J. Y. and M. Blomstrom, Foreign Investment and Technology Transfer: A Simple Model, European
Economic Review, 36, 1992.
Williamson, J., A Survey of the Literature on the Optimal Peg, Journal of Development Economics, 11,
1982, 39—61.
Williamson, J., Democracy and the Washington Consensus, World Development, 21(8), 1993.
Williamson, J (ed), Latin American Adjustment: How Much Has happened, Washington D.C., Institute of
International economics, 1990.
Williamson, J. and M. H. Miller, Targets and Indicators: A Blueprint for International Coordination of
Economic Policy, Policy Analysis in International Economics, 22., Washington D.C. Institute for
International Economics, 1987.
World Bank, The East Asia miracle: Economic Growth and Public Policies, Washington DC. World Bank,
1993.
128
129

World Financial Infrastructure and Money

Caricato da

Informazioni sul documento

Descrizione originale:

Copyright

Formati disponibili

Condividi questo documento

Condividi o incorpora il documento

Opzioni di condivisione

Hai trovato utile questo documento?

Questo contenuto è inappropriato?

Copyright:

Formati disponibili

World Financial Infrastructure and Money

Caricato da

Copyright:

Formati disponibili

World Financial Infrastructure and Money : Sukumar Nandi

World Financial Infrastructure and Money

Indian Institute of Management Lucknow

Lucknow – 226013, India

Money: History and Evolution

One major event of human civilization is the invention of money as a medium of

Money in the Early Period

the case, that a commodity owned by somebody is of less value in use

Market Value of Coins (or, the Inverse of Price level ) = Cost of

Figure 1. Price level within a domain

Minting Point Melting Point

Machines and Change in Production Process:

The laissez -faire Experiment:

"Money, I consider is a device which facilitates the working of markets."

THE GOLD STANDARD

The classical gold standard emerged as a true international standard by 1880

Gold standard was an asymmetric system [Giovannini,1989].England was the

THE DEMISE OF CLASSICAL GOLD STANDARD

THE BRETTON WOODS INTERNATIONAL MONETARY SYSTEM

A group of economists led by J. M. Keynes, E.N. White and Ragnar Nurkse

Ultimately the prescription of both the teams prevailed as the Articles of

The Par Value System

Multilateral Payments Mechanism

The Powers of IMF

The Structure of Organisation

Historical Stages of the Bretton Woods Agreement: 1946-1960

The Period 1960--67

The Liquidity Problem

Special Drawing Rights ( SDR )

Market Price of Gold and Confidence Issues:

The two phenomena cited above created a crisis of confidence regarding US

Gresham's law in International Level

Decline of the System:

Post Bretton Woods Era: Managed Floating Exchange Rate

The Second Amendment of IMF Article

The Plaza Accord

International Capital Flows

The Financial Architecture

Exchange Rate Arrangements

---- flexible exchange rates of a single currency

The Tobin Tax Proposal on Capital Movement

The G-7 Study for World Monetary Reform

Regarding the transparency the Report emphasizes that transparency is needed to

Stronger Financial Regulation

Strong Macroeconomic Policy

Crisis Prevention and Crisis Management

Formation of a New Group: G-20

New Initiative of IMF and the Poor

The New International Financial Architecture

stability of this system ( Eichengreen, 1999; Blinder,1999, Goldstein,1999 ). There has

European Union and Euro

European Union as Optimum Currency Area

International Movement of Money: The Institutions

"In a world of banks and insurance companies, money markets

Money as a commodity is global by nature and its movement is facilitated by

Foreign exchange is generally referred to as the instruments , communications or

foreign exchange is defined as any order, communication or any instrument that

The Market for Foreign Currencies

The players in the market are individuals, traders, financial institutions,

The FEM and Time Zones

Foreign Exchange Market: Microstructural Dynamics

Foreign Exchange Brokers

The Supply and Demand for Eurodollar

i = E (r + Π ) /(I - t) = i* = E (r+Π) / (I- t* ) ...(8.9)

E (r - r) = (i-i) (i - t) - E ( Π - Π*)