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Assignment on--

History of International Monetary System

Prepared ForMd. Shariat Ullah Lecturer, Dept. Management Studies Faculty of Business Studies University of Dhaka

Prepared ByMd. Azim Ferdous Roll No: 121, Section: B, Batch: 11th Dept. of Management Studies University of Dhaka

Date of SubmissionMay 7, 2008

Page | 2 The international monetary system establishes the rules by which countries value and exchange their currencies. It also provides a mechanism for correcting imbalances between a countrys international payments and its receipts. Further, the cost of converting foreign money into firms home currency-a variable critical to the profitability of international operations depends on the smooth functioning of the international monetary system. The history of monetary system started when in ancient time (seventh century B.C.1) tribes & city-states of India, Babylon & Phoenicia used gold & silver as media of exchange in trade. The total history of international monetary system is discussed below in a chronological order.

1. The Gold Standard


Meaning: Buying and selling of paper currency in exchange for gold on the request of any individual of firm2. The theory of the gold standard rests on the idea that inflation is caused by an increase in the supply of money, an idea advocated by David Hume, and that uncertainty over the future purchasing power of currency depresses business confidence and leads to reduced trade and capital3. First to Adopt: In United Kingdom at 1821. Upshot: It created a fixed exchange rate system because each country tied the value of its currency. Advantage: The gold standard created a fixed exchange rate system. For example, the United Kingdom pledged to buy or sell an ounce of gold for 4.247 pounds sterling, thereby establishing the pound per value or official price in terms of gold. The United States agreed to buy or sell an ounce of gold to a par value of $20.67. The two currencies could be freely exchanged for the stated amount of gold making 4.247 = 1 ounce of gold = $20.67. This implied a fixed exchanging rate between the pound and the dollar of 1= $4.867, or $20.67/ 4.247. Representative money and the Gold Standard protect citizens from hyperinflation and other abuses of monetary policy, as were seen in some countries during the Great Depression. However, they were not without their problems and critics, and so were partially abandoned via the international adoption of the Bretton Woods System. That system eventually collapsed in 1971, at which time all nations had switched to full fiat money4.

Del Mar, A History of Money in Ancient Countries (New York: Burt Franklin, 1968), p.71. I. Drummond, The Gold Standard and the International Monetary System 1900-1939 (London: McMillan Education Group, 1987), pp.10-11. 3 http://en.wikipedia.org/wiki/Gold_standard 4 In which paper notes are backed only by the traders' "full faith and credit" in the government, in particular by its acceptability for payments of debts to the government (usually taxes).
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Page | 3 The Gold Standard variously specified how the gold backing would be implemented, including the amount of specie per currency unit. The currency itself is just paper and so has no innate value, but is accepted by traders because it can be redeemed any time for the equivalent specie. A US silver certificate, for example, could be redeemed for an actual piece of silver5. Difficulty: Transacting in gold was expensive. For example, suppose Jardine Matheson, a Hong Kong trading company, sold 100,000 worth of tea to Twining & Company, a London distributor of fine teas. If it wanted to be paid in gold by Twining & Company upon delivery of the tea, Jardine Matheson had to bear the costs of loading the gold into the cargo hold of a ship, guarding it against theft, transporting it, and insuring it against possible disasters. Moreover, because of the slowness of sailing ships, Jardine Matheson would be unable to earn interest on the 100,000 payment while the gold was in transit from London to Hong-Kong. On the other hand, if Jardine Matheson was willing to he paid in British pounds, Twining could draft a check to Jardine Matheson and give it to the firms London agent. The London agent could then either immediately deposit the check in Jardine Matheson's interest-bearing London bank account or transfer the funds telegraph of the firm's account at its Hong Kong bank. Starling-Based Gold Standard: From 1821 until the end of 1918, the most important currency in international commerce was the British pound sterling because of the United Kingdoms large territory6 due to dominant economic and military power. So, most of the people relayed on pound that time. As a result international monetary system during this period is also called starling-based gold standard7. Because of the international trust London became a dominant international center in the 19 th century, a position it still holds8.

2. The Collapse of Gold Standard


World War I: During World War 1, the sterling-based gold standard unraveled. With the outbreak of war, normal commercial transactions between the Allies (France, Russia, and the United Kingdom) and the Central Powers (Austria-Hungary, Germany, and the Ottoman Empire) ceased. The economic pressures of war caused country after country to suspend their pledges to buy or sell gold at their currencies' par values. Post-War Conferences & Re-adaptation of Gold Standard: After the war, conferences at Brussels (1920) and Genoa (1922) yielded genera agreements among the major economic powers to return to the prewar gold standard. Most countries, including the United States, the United Kingdom, and France, readopted the gold standard in the 1920s
5 http://en.wikipedia.org/wiki/Gold_standard

United Kingdoms territory that time was consisted of Canada, Australia, New Zealand, Hong Kong, Singapore, India, Pakistan, Bangladesh, Kenya, Zimbabwe, South Africa, Gibraltar, Bermuda, and Belize. 7 At the turn of the century, the French franc & the German mark were used in addition to sterling for setting private international transactions. 8 B. Cohen, The Future of Sterling as an international Currency (London: McMillan, 1971), pp.6061.
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Page | 4 despite the high levels of inflation, unemployment, and political instability that were wracking Europe.9 Implementation of Floating Rate System By Bank of England: The standard of gold standard was doomed by economic stresses triggered by the worldwide Great Depression. The Bank of England, the United Kingdom's central bank, was unable to maintain its new pledges under the gold standard. On September 21, 1931, it allowed the pound to float, meaning that the pound's value would be determined by the forces of supply and demand and the Bank of England would no longer guarantee to redeem British paper currency for gold at par value10. Competitive Devaluation of Currencies & Increased Tariff Rate: After the United Kingdom abandoned the gold standard, a "sterling area emerged as some countries, primarily members of the British Commonwealth, pegged their currencies to the pound and relied on sterling balances held in London as their international reserves.11 Other countries tied the value of their currencies to the U.S. dollar or the French franc. Some countries (United States, France, United Kingdom, Belgium, Latvia, the Netherlands, Switzerland & Italy) were deliberately & artificially devaluating their official value of currencies to make their goods cheaper in the international markets, which is stimulating its exports and reducing its imports. But, none were getting the benefit due to competitive devaluation at almost same percentage that is each currency's value relative to the other remains the same. Most countries also raised the tariffs they imposed on imported goods in the hope of protecting domestic jobs in import-competing industries. Nations adversely affected by trade barriers of any kind are quite likely to impose retaliatory or reciprocal tariffs12. Effect of beggar-thy-neighbor policies (World War II): As more and more countries adopted beggar-thy-neighbor policies like devaluation of currencies and increasing the tariff rate on imported goods, international trade contracted that hurt employment in each country's export industries. More ominously, this international economic conflict was soon replaced by international military conflict that was the outbreak of World War II in 1939.

3. The Bretton Woods Era


Post-War Situation: World War II created inflation, unemployment and an instable political situation. Every country was struggling to rebuild their war-torn economy. Bretton Woods Conference: Not to repeat the mistakes that had caused World War II, to promote worldwide peace & prosperity and to construct the postwar international monetary system representatives of 44 countries met at a resort in Bretton Woods, New Hampshire in 1944.
I. Drummond, The Gold Standard and the International Monetary System 1900-1939 (London: McMillan Education Group, 1987), p.31 10 Ibid., pp.40. 11 B. Cohen, The Future of Sterling as an international Currency (London: McMillan, 1971), p.68. 12 http://www.csusm.edu/politicalscience/golich/money-module/
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Decisions & Outcome of the Bretton Woods Conference: The Bretton Woods Conference has presented the world two historic agreements. These are as follows: A. Agreement of conferees to renew the gold standard on a modified basis. B. Agreement to create two new international organizations to assist the rebuilding of the world economy and the international monetary system. These area. International Bank for Reconstruction and Development (IBRD) b. International Monetary Fund (IMF) a. The International Bank for Reconstruction and Development (IBRD) The International Bank for Reconstruction and Development (IBRD) is the official name of the World Bank. Established in 1945, the World Bank's initial goal was to help finance reconstruction of the war-torn European economics. With the assistance of the Marshall Plan, the World Bank accomplished this task by the mid-1950s. The Bank then adopted a new missionto build the economies of the world's developing countries. As its mission has expanded over time, the World Bank created three affiliated organizations: a. International Development Association (IDA) b. International Finance Corporation (IFC) c. Multilateral Investment Guarantee Agency (MIGA)

International Bank for Reconstruction and Development (IBRD)

International Development Association (IDA)

International Finance Corporation (IFC)

Multilateral Investment Guarantee Agency (MIGA)

Offers soft loans

Promotes private sector development

Provides political risk insurance

Together with the World Bank, these constitute the World Bank Group. The World Bank is currently owned by the 185 member countries. The World Banks activities are focused on the reduction of global poverty, focusing on the achievement of the Millennium Development Goals (MDGs), goals calling for the elimination of poverty and the implementation of sustainable development. United States is the banks largest shareholder.

Page | 6 b. International Monetary Fund (IMF) International Monetary Fund (IMF) was created to monitor and control the functioning of the international monetary system. It is an international organization that oversees the global financial system by observing exchange rates and balance of payments, as well as offering financial and technical assistance. Its objectives are as follows: i. To promote international monetary cooperation. ii. To facilitate the expansion and balanced growth of international trade. iii. To promote exchange stability, to maintain orderly exchange arrangements among members, and to avoid competitive exchange depreciation. iv. To assist in the establishment of a multilateral system of payments. v. To give confidence to members by making the general resources of the Fund temporarily available to them and to correct maladjustments in their balances of payments. vi. To shorten the duration and lessen the degree of disequilibrium in the interactional balances of payments of members. At first 29 countries signed its Articles of Agreement of IMF. But now it has 186 Members. Its Headquarters are at Washington, D.C., USA. Current Managing Director is Dominique Strauss-Kahn. Its Central Bank of Base borrowing rate 5.50%. A Dollar-Based Gold Standard: The IMF and the World Bank provided the institutional framework for the postwar international monetary system. All countries agreed to peg the value of their currencies to gold. However, only the United States pledged to redeem its currency for gold at the request of a foreign central bank. Thus the U.S. dollar became the key-stone of the Bretton Woods system. In the early postwar years, only the U.S. and Canadian dollars were convertible currencies, that is, ones that could be freely exchanged for other currencies without legal restrictions. Countries had faith in the U.S. economy and so were willing to accept U.S. dollars to settle their transactions. As the British pound sterling had been in the nineteenth century, the U.S. dollar became the preferred vehicle for settling most international transactions. The effect of the Bretton Woods conference was thus to establish a U.S. dollar-based gold standard. Under the Bretton Woods Agreement each country pledged to maintain the value of its currency within 1% of its par value. If the market value of its currency fell outside that range, a country was obligated to intervene in the foreign-exchange market to bring the value back within 1% of par value. This stability in exchange rates benefited international businesses, since the Bretton Woods system generally provided an assurance that the value of each currency would remain stable. Bretton Woods System as Adjustable Peg : The Bretton Woods system is often described as using an adjustable peg because currencies were pegged to gold but the pegs themselves could be altered under certain conditions. The arrangement of Bretton Woods System worked well as long as pessimism about a countrys economy was

Page | 7 temporary. But, if a country suffered from structural macroeconomic problems, major difficulties could arise.

4. The End of the Bretton Woods System


Shortcoming of Dollar-Based Gold Standard Under Bretton Woods System & Triffin Paradox: The British and French central banks were a precursor to a run on the most important bank in the Bretton Woods systemthe U.S. Federal Reserve Bank. Ironically, the reliance of the Bretton Woods system on the dollar ultimately led to the system's undoing. Because the supply of gold did not expand in the short run, the only source of the liquidity needed to expand international trade was the U.S. dollar. Under the Bretton Woods system, the expansion of international liquidity depended on foreigners' willingness to continually increase their holdings of dollars. Foreigners were perfectly happy to hold dollars as long as they trusted the integrity of the U.S. currency, and during the 1950s and 1960s the number of dollars held by foreigners rose steadily. As foreign dollar holdings increased, however, people began to question the ability of the United States to live up to its Bretton Woods obligation. This led to the Triffin paradox, named after Robert Triffin13, who first identified the problem. The paradox arose because foreigners needed to increase their holdings of dollars to finance expansion of international trade. But the more dollars they owned, the less faith they had in the ability of the United States to redeem those dollars for gold. The less faith foreigners had in the United States, the more they wanted to rid themselves of dollars and get gold in return. But if they did this, international trade and the international monetary system might collapse because the United States didn't have enough gold to redeem all the dollars held by foreigners. The shortcomings are listed below in briefLimited gold. Liquidity problem. Foreigners behavior of continuous increasing in dollar holding. Foreigners less faith on United States. Agreement to Create Special Drawing Rights (SDRs): To inject more liquidity into the international monetary system while reducing the demands placed on the dollar as a reserve currency, IMF members created the special drawing rights in 1967. SDR is a credit granted by the IMF that can be used to settle official transactions among central banks. Thus SDRs are sometimes called "paper gold". As of 1993, approximately 21.4 billion SDRs, representing about 2% of the world's total reserves, had been distributed to IMF members in proportion to their IMF quotas. The value of an SDR is a function of the current value of five different currencies from which it is comprised. They include the U.S. dollar, the Japanese yen, the United Kingdom pound sterling, and the respective euro values of Germany and France. An SDR's value is currently calculated daily as a weighted average of the market value of five major currencies (U.S. dollar, German mark, French franc, Japanese yen, and

13

A Belgian-born Yale University economist

Page | 8 pound sterling) with the weights revised every five years14. As of May 1995, the SDR was worth $1.54 in U.S. dollars. Outcome of Creating SDRs: SDRs solved the liquidity problem for the international monetary system, but if failed to solve the problem related to the glut of dollars held by foreigners & faith. By mid 1971, the Bretton Woods system was tottering, the victim of fears about the dollar's instability. In the first seven months of 1971, the United States sold one third of its gold reserves15. It became clear to the marketplace that the United States did not have sufficient gold on hand to meet the demands of those who still wanted to exchange their dollars for gold. Official Ending of Bretton Woods System: The Bretton Woods system officially ended when in a dramatic address on August 15, 1971, President Richard M. Nixon announced that the United States would no longer redeem gold at $35 per ounce.

5. Post Bretton Woods System & the Floating Rate Era


After President Nixon's speech, most foreign currencies began to float, their values being determined by supply and demand in the foreign-exchange market. The value of the U.S. dollar fell relative to most of the world's major currencies. But the nations of the world were not yet ready to abandon the fixed exchange-rate system. At the Smithsonian Conference, held in Washington, D.C. in December 1971, central bank representatives from the Group of Ten16 agreed to restore the fixed exchange-rate system but with restructured rates of exchange between the major trading currencies. The U.S. dollar was devalued to $38 per ounce but remained inconvertible into gold, and the par values of strong currencies such as the yen were revalued upward. Currencies were allowed to fluctuate around their new par values by =2.25%, which replaced the narrower 1.00% range authorized by the Bretton Woods Agreement. Recent changes in international monetary policy17: US$ 100 Trillion estimated total world assets, including real estate. US$ 30 Trillion worldwide liquidity held by pension funds which traditionally invest in long term assets: formerly gold, today government bonds. US$ 15-18 Trillion cash, mainly in Japan. US$ 3-4 Trillion "hot money" in offshore trusts.

International Monetary Fund, 1990 Annual Report, p.133. The European Financial Common Market (Luxembourg: Office for Official Publications of the European Communities, 1989), pp. 43ff.; The European Community in the nineties (Washington, D.C.: EC Delegation to the United States, 1992), pp.12ff.; Directorate-General for Economic and Financial Affairs, European Economy, No. 44 (October 1990), p. 42. 16 Group of Ten means the group consists of following countries who have worlds top most GDP shares: United States, Japan, Germany, France, Italy, United Kingdom, Canada, Netherlands, Belgium & Sweden. 17 http://www.gold-eagle.com
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