International Finance

INTRODUCTION:

The International monetary systems is the structure within which foreign exchange
rates are determined, international trade and capital flows are accommodated and balance of
payment adjustments are made. It is basically a set of internationally agreed rules,
conventions and supporting institutions that facilitate international trade, cross border
investment and generally the reallocation of capital between nation states. It consists of laws
and procedures which involves international transfer of money. These elements affect foreign
exchange rates, international trade and capital flow and Balance of Payment which plays a
critical role in the financial management of multinational business and economic policies of
individual countries. An efficient international monetary system is a necessary precondition
for the smooth functioning and expansion of the international business. Under the current
system of partly floating and partly fixed exchange rate, earning of multinational firms ,
banks and individual investors undergo real and paper fluctuations as a result of changes in
exchange rates. These elements affect the foreign exchange rates, internal trade and capital
flow. The main elements of the international monetary system are the currency exchange rate
mechanism and the function of reserve currency preferences.

Functions:

 Transact business in different currencies, requiring conversion from one type of

money to another.
 It governs how debts are honored and paid between and among nations with different
national monies.
 When the system is functioning smoothly, all countries gain from international flows
of goods, services, and capital and when it breaks down or is poorly organized,
nations are unable to sustain high levels of trade and investments.

History of International Monetary System:

THE GOLD STANDARD (1876-1913)

From the early nineteenth century until the post- World War I period which was regarded as
the great age of internationalism, most of the major nations of the world and their trading
partners operated under the fixed exchange system called the gold standard. Under the gold

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standard accounts between countries were settled by the exchange of gold. In addition each
country agreed to convert its paper money into gold on demand and there were no restrictions
on the shipment of gold from one country to another. If a country imported goods worth more
than its export, gold flowed out. As a result of reduction in these resources due to deficit in
the balance of payment caused, a contraction in the money supply leads to decline in imports
and increase in demand leads to exports which enables to restore the BOP equilibrium.
Maintaining adequate reserves of gold to back its currency’s value was very important for a
country under this system. The system also had the effect of implicitly limiting the rate at
which any individual country could expand its money supply. Any growth in the amount of
money was limited to the rate at which official authorities could acquire additional gold. One
country after another set a par value for its currency in terms of gold and then adhere the so-
called “rule of the game”, which means to expand credit when gold is coming in and contract
credit when gold is going out. The “rule of the game” under the gold standard was clear and
simple. Each country set the rate at which its currency units could be converted to a weight of
gold. This later came to be known as the classical gold standard.

The gold standard worked adequately until the World War I interrupted trade flows and the
free movement of gold, which caused the main trading nations to suspend operations of gold
standard.

THE BRETTON WOOD SYSTEM (1944-1971)

The united nation monetary and financial conference held at Bretton wood in July
1944 proposed the establishment of International Monetary Fund to achieve exchange rate
stability and to help member countries to finance short term Balance of payment deficit and
the International Bank for reconstruction and Development popularly known as World Bank
to assist in the post war reconstruction and development of member countries.

The Bretton Woods system of monetary management established the rules for commercial
and financial relations among the world's major industrial states in the mid 20th century. The
chief features of the Bretton Woods system were an obligation for each country to adopt a
monetary policy that maintained the exchange rate by tying its currency to the U.S. dollar and
the ability of the IMF to bridge temporary imbalances of payments. Under the original
provision of the Bretton Woods Agreement, all the countries fixed the value of their
currencies in terms of gold but were not required to exchange their currencies for gold. Only

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dollar remained convertible into gold. Therefore each country established to create the
desired dollar exchange rate. Devaluation was not to be used as a competitive trade policy,
but if a currency became too weak to defend, a devaluation of up to 10 % was allowed
without formal approval by the IMF. The Bretton Wood system evolved into fixed rate dollar
standard and worked fairly well during the post-world war II period of reconstruction and
rapid growth in world trade. The US dollar was the main reserve currency held by the central
banks and was the key to the web of exchange rate values. A heavy capital outflow of dollars
was required to finance these deficits and to meet the growing demand for dollars from
investors and businesses. Towards the end of the Bretton Woods era, the central role of the
dollar became a problem as international demand eventually forced the US to run a persistent
trade deficit, which undermined confidence in the dollar. This, together with the emergence
of a parallel market for gold where the price soared above the official US mandated price, led
to speculators running down the US gold reserves.

Prior to 1976 member countries were required to pay part of their quota, normally 25% in
gold or American dollars and the rest in member’s own currency. Now members pay part of
its quota in foreign currency and the rest in its own currency. The fund also extends some
special Drawing rights which is an international reserve asset created to supplement foreign
exchange reserves.

Breakdown of the Bretton Woods System:

Despite severe strains the Bretton wood system collapsed in 1971. The stabilization process
required reserve assets. The difference was that nations kept their reserves not only in gold
but also in dollars. An expansion in trade required an increase in the international liquidity. In
the early period, the supply of dollars outside the US came from American aid programmes,
contribution from World Bank, multinational investments. Any small deficits were welcomed
and it appeared that the Bretton wood system by permitting the expansion of world monetary
reserves at a much faster rate than a system restricted by the supply of gold solved one of the
major problems of the gold standard. The system could collapse, if anything happened that
would have shaked the worlds confidence in the ability or desire of the United States to
continue exchanging dollars for gold. And the Bretton wood system did collapsed in 1971
because of the huge accumulation of dollars abroad.

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AN ECLECTIC CURRENCY ARRANGEMENT, 1973-PRESENT

The dollar was devalued a first time in 1971, a second time in 1973 to eventually
started floating. Since 1973, the world has experienced more volatile exchange rates. Since
March 1973, exchange rates have become much more volatile and less predictable than they
were during the ―fixed exchange rate period, when changes occurred infrequently. In
general the dollar has been volatile and has weakened somewhat over the long run. On the
other hand, the Japanese yen and German mark have strengthened. The emerging market
currencies have been exceptionally volatile and have generally weakened.

INTERNATIONAL MONETARY FUND

OVERVIEW

The IMF is the central institution of the international monetary system. It was established on
Dec. 27, 1945 with 29 countries and began it financial operations on March 1; 1947.It was
initially established to discuss major international economic problems, including
reconstruction of the economies ravaged by the World War II, and to evolve practical
solution for them.

At present, IMF is an organization of 187 countries, working to foster global monetary

cooperation, secure financial stability, facilitate international trade, promote high
employment and sustainable economic growth, and reduce poverty around the world.

WHAT IMF DOES

With its near-global membership of 187 countries, the IMF is uniquely placed to help
member governments take advantage of the opportunities—and manage the challenges—
posed by globalization and economic development more generally. The IMF tracks global
economic trends and performance, alerts its member countries when it sees problems on the
horizon, provides a forum for policy dialogue, and passes on know-how to governments on
how to tackle economic difficulties. The IMF provides policy advice and financing to
members in economic difficulties and also works with developing nations to help them
achieve macroeconomic stability and reduce poverty.

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KEY IMF ACTIVITIES

 Provide a forum for cooperation on international monetary problems

 Facilitate the growth of international trade, thus promoting job creation, economic
growth, and poverty reduction;
 Promote exchange rate stability and an open system of international payments.
 Lend countries foreign exchange when needed, on a temporary basis and under
adequate safeguards, to help them address balance of payments problems.
 Policy advice to governments and central banks based on analysis of economic trends
and cross-country experiences.
 Research, statistics, forecasts, and analysis based on tracking of global, regional, and
individual economies and markets.
 Loans to help countries overcome economic difficulties.
 Concessional loans to help fight poverty in developing countries.
 Technical assistance and training to help countries improve the management of their
economies.

HOW IMF DOES IT

The IMF's main goal is to ensure the stability of the international monetary and financial
system. It helps resolve crises, and works with its member countries to promote growth and
alleviate poverty. It has three main tools at its disposal to carry out its mandate:
surveillance, technical assistance and training, and lending.

Surveillance

The IMF promotes economic stability and global growth by encouraging countries to adopt
sound economic and financial policies. To do this, it regularly monitors global, regional, and
national economic developments. It also seeks to assess the impact of the policies of
individual countries on other economies.

This process of monitoring and discussing countries’ economic and financial policies is
known as bilateral surveillance. On a regular basis, usually once each year, the IMF conducts
in depth appraisals of each member country's economic situation. It discusses with the
country's authorities the policies that are most conducive to a stable and prosperous economy.

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The IMF also has the option to bring together, on an as-needed basis, groups of systemically
relevant economies to address issues of broad importance to the global economy. These
meetings are called multilateral consultations.

The IMF works with the World Bank to promote resilient financial systems around the world

through the joint Financial Sector Assessment Program (FSAP). Supported by experts from a
range of national agencies and standard-setting bodies, IMF and World Bank staffs assess the
stability of a country’s financial system by identifying its strengths and vulnerabilities,
determine how key sources of risks are being managed, ascertain the sector's developmental
needs, and help prioritize policy responses.

Technical assistance and training

IMF offers technical assistance and training to help member countries strengthen their
capacity to design and implement effective policies. Technical assistance is offered in several
areas, including fiscal policy, monetary and exchange rate policies, banking and financial
system supervision and regulation, and statistics.

The IMF provides technical assistance and training mainly in four areas:

 Monetary and financial policies (monetary policy instruments, banking system

supervision and restructuring, foreign management and operations, clearing settlement
systems for payments, and structural development of central banks)
 Fiscal policy and management (tax and customs policies and administration, budget
formulation, expenditure management, design of social safety nets, and management
of domestic and foreign debt)
 Compilation, management, dissemination, and improvement of statistical data
 Economic and financial legislation.

Lending

In the event that member countries experience difficulties financing their balance of
payments, the IMF is also a fund that can be tapped to facilitate recovery. A policy program
supported by financing is designed by the national authorities in close cooperation with the

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IMF. Continued financial support is conditional on the effective implementation of this

program.

The IMF also provides low-income countries with loans at a concessional interest rate
through the Poverty Reduction and Growth Facility (PRGF) and the Exogenous Shocks
Facility (ESF).

MEMBERSHIP

The IMF currently has a near-global membership of 187 countries. If any country wishes to
become member of International Monetary Fund, it has to apply to IMF for the same. The
application is first reviewed by the executive board of International Monetary Fund and after

it is considered fit by the above board; report is submitted regarding the same to the Board of
Governors of IMF. All the recommendations made by the executive board are also attached
with it in the form of Membership resolution. These recommendations made by the executive
board also cover the quota amount in the form of payment of the subscription. Apart from
this, there are also many other terms and conditions that are applicable to all the countries
that wish to become member of IMF.

Once the membership resolution is adopted by the Board of Governors, the applicant country
is required to make all the necessary amendments in its law so that it can easily sign the
Articles of Agreement of International Monetary Fund and fulfill all other required
obligations. The quote of member country in the International Monetary Fund determines the
required amount of subscription, the voting weight it can be granted, the access of the
member country to the financing made by IMF and the allocation of renowned Special
Drawing Rights. It is very important to understand here that the member country cannot
increase its given quote unilaterally and if it wishes to do so, the same has to be approved by
the Executive Board of IMF. However, the increase in quota is restricted by number of
formulae like the contribution of country in the economy at world level etc.

QUOTA

The IMF's resources come mainly from the money that countries pay as their capital
subscription when they become members.

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Quotas broadly reflect the size of each member's economy: the larger a country's economy in
terms of output and the larger and more variable its trade, the larger its quota tends to be. For

example, the world's biggest economy, the United States, has the largest quota in the IMF.
Quotas, together with the equal number of basic votes each member has, determine countries'
voting power. They also help determine how much countries can borrow from the IMF and
their share in allocations of special drawing rights or SDRs

Countries pay 25 percent of their quota subscriptions in SDRs or major currencies, such as
U.S. dollars, euros, pounds sterling, or Japanese yen. They pay the remaining 75 percent in
their own currencies. When a country joins the IMF, it is assigned an initial quota in the same
range as the quotas of existing members that are broadly comparable in economic size and
characteristics. The IMF uses a quota formula to guide the assessment of a member's relative
position.

ROLE OF QUOTA IN THE IMF

A member's quota delineates basic aspects of its financial and organizational relationship
with the IMF, including:

Subscriptions (quota share): A member's quota subscription determines the maximum

amount of financial resources the member is obliged to provide to the IMF. A member must
pay its subscription in full upon joining the Fund: up to 25 percent must be paid in SDRs or
widely accepted currencies (such as the U.S. dollar, the euro, the yen, or the pound sterling),
while the rest is paid in the member's own currency.

Voting power (voting share): The quota largely determines a member's voting power in
IMF decisions. Each IMF member has 250 basic votes plus one additional vote for each SDR
100,000 of quota. Accordingly, the United States currently has 371,743 votes (16.74 percent
of the total), and Tuvalu currently has 268 votes (0.01 percent).

Access to financing: The amount of financing a member can obtain from the IMF (its access
limit) is based on its quota. For example, under Stand-By and Extended Arrangements, a
member can borrow up to 200 percent of its quota annually and 600 percent cumulatively.
However, access may be higher in exceptional circumstances.

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SDR allocations: Allocations of SDRs, the IMF's unit of account, is used as an international
reserve asset. A member's share of general SDR allocations is established in proportion to its
quota.

HOW QUOTA REVIEWS WORK

The IMF's Board of Governors conducts general quota reviews at regular intervals (usually
every five years). Any changes in quotas must be approved by an 85 percent majority of the
total voting power, and a member's quota cannot be changed without its consent. There are
two main issues addressed in a general quota review: the size of an overall increase and the
distribution of the increase among the members. First, a general quota review allows the IMF

to assess the adequacy of quotas both in terms of members' balance of payments financing
needs and in terms of its own ability to help meet those needs. Second, a general review
allows for increases in members' quotas to reflect changes in their relative positions in the
world economy.

SPECIAL DRAWING RIGHTS (SDRs)

The SDR is an international reserve asset, created by the IMF in 1969 to supplement its
member countries’ official reserves. Its value is based on a basket of four key international
currencies, and SDRs can be exchanged for freely usable currencies. With a general SDR
allocation that took effect on August 28 and a special allocation on September 9, 2009, the
amount of SDRs increased from SDR 21.4 billion to SDR 204 billion (equivalent to about
$308 billion, converted using the rate of August 31, 2010).

THE ROLE OF THE SDR

The SDR was created by the IMF in 1969 to support the Bretton Woods fixed exchange rate
system. A country participating in this system needed official reserves—government or
central bank holdings of gold and widely accepted foreign currencies—that could be used to
purchase the domestic currency in foreign exchange markets, as required to maintain its
exchange rate. But the international supply of two key reserve assets—gold and the U.S.
dollar, proved inadequate for supporting the expansion of world trade and financial
development that was taking place. Therefore, the international community decided to create
a new international reserve asset under the auspices of the IMF.

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However, only a few years later, the Bretton Woods system collapsed and the major
currencies shifted to a floating exchange rate regime. In addition, the growth in international
capital markets facilitated borrowing by creditworthy governments. Both of these
developments lessened the need for SDRs.

The SDR is neither a currency, nor a claim on the IMF. Rather, it is a potential claim on the
freely usable currencies of IMF members. Holders of SDRs can obtain these currencies in
exchange for their SDRs in two ways: first, through the arrangement of voluntary exchanges
between members; and second, by the IMF designating members with strong external

positions to purchase SDRs from members with weak external positions. In addition to its
role as a supplementary reserve asset, the SDR, serves as the unit of account of the IMF and
some other international organizations.

BASKET OF CURRENCIES THAT DETERMINES THE VALUE OF THE SDR

The value of the SDR was initially defined as equivalent to 0.888671 grams of fine gold—
which, at the time, was also equivalent to one U.S. dollar. After the collapse of the Bretton
Woods system in 1973, however, the SDR was redefined as a basket of currencies, today
consisting of the euro, Japanese yen, pound sterling, and U.S. dollar. The U.S. dollar-
equivalent of the SDR is posted daily on the IMF’s website. It is calculated as the sum of
specific amounts of the four basket currencies valued in U.S. dollars, on the basis of
exchange rates quoted at noon each day in the London market.

The basket composition is reviewed every five years by the Executive Board to ensure that it
reflects the relative importance of currencies in the world's trading and financial systems. In
the most recent review (in November 2010), the weights of the currencies in the SDR basket
were revised based on the value of the exports of goods and services and the amount of
reserves denominated in the respective currencies that were held by other members of the
IMF. These changes become effective on January 1, 2011. The next review will take place by
2015.

THE SDR INTEREST RATE

The SDR interest rate provides the basis for calculating the interest charged to members on
regular (non-concessional) IMF loans, the interest paid to members on their SDR holdings

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and charged on their SDR allocations, and the interest paid to members on a portion of their
quota subscriptions. The SDR interest rate is determined weekly and is based on a weighted
average of representative interest rates on short-term debt in the money markets.

SDR allocations to IMF members

Under its Articles of Agreement, the IMF may allocate SDRs to members in proportion to
their IMF quotas. Such an allocation provides each member with an asset (SDR holdings) and

an equivalent liability (SDR allocation). If a member’s SDR holdings rise above its
allocation, it earns interest on the excess; conversely, if it holds fewer SDRs than allocated, it
pays interest on the shortfall. There are two kinds of allocations:

General allocations of SDRs. General allocations of SDRs have to be based on a long-term

global need to supplement existing reserve assets.

Special allocations of SDRs. A proposal for a special one-time allocation of SDRs was
approved by the IMF's Board of Governors in September 1997 through the proposed Fourth
Amendment of the Articles of Agreement. Its intent is to enable all members of the IMF to
participate in the SDR system on an equitable basis and correct for the fact that countries that
joined the Fund after 1981—more than one-fifth of the current IMF membership—had never
received an SDR allocation.

INTERNATIONAL LIQUIDITY:

A major function of the IMF is to provide international liquidity in accordance wiyh the
purpose of the fund specified in the articles of Agreement.

International liquidity encompasses the international reserves and the facilities for
international borrowing for financing the balance of payments deficit. In other words, we can
say the relative amount of resources available to a nation’s monetary authorities that could be
used to settle a balance of payments deficit. International reserves are defined to include
official holdings of gold, foreign exchange, SDRs and reserve position in IMF. International
liquidity does not include private holdings of gold, private holdings of foreign exchange and
long term international financing.

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Part of the liquidity supplied by the IMF takes the form of reserve assets that can be used for
balance of payments financing (unconditional liquidity),while part takes the form of credit to
members that is generally subject to conditions(conditional liquidity).

Conditional liquidity is provided by the IMF under its various lending facilities. Most of the
fund’s credit extended under these arrangements requires an adjustment programme for the
member that is intended to promote a sustainable external position.

Unconditional liquidity is supplied through the allocations of SDRs and also in the form of
reserve position in the fund which are the claims corresponding to the resources that countries
have made available to the fund. Member countries holdings SDRs and the reserve positions
in the fund can use them to finance balance of payments deficits without having to enter into
policy commitments with the fund.

WORLD BANK

The World Bank is an international financial institution that provides loans to developing
countries for capital programmes. The World Bank has a goal of reducing poverty.

The World Bank Group consists of five institutions, each institution playing the distinct role
in the mission to fight poverty and improve living standards for people in the developing
world. They are:

 The International Bank for Reconstruction and Development (IBRD, est. 1945).

 The International Finance Corporation (IFC, est. 1956).

 The International Development Association (IDA, est. 1960).

 The International Centre for the Settlement of Investment Disputes (ICSID, est. 1966)

 The Multilateral Investment Guarantee Agency (MIGA, est. 1988).

The World Bank differs from the World Bank Group, is that the World Bank
comprises only two institutions: IBRD and IDA.

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ORGANIZATION

Nearly 10,000 staff members perform the work of the IBRD and IDA, both at headquarters in
Washington, DC, and in over 109 country offices. The World Bank is the third largest
employer in Washington, DC.

The World Bank is owned by 186 member governments. Each member government is a
shareholder of the Bank, and the number of shares a country has is based roughly on the size
of its economy. This "one-dollar-one-vote" structure affords richer countries greater power in
decisions-making processes at the institutions than poor, borrowing countries.

The United States is the largest single shareholder, with 16.41 percent of votes, followed by
Japan (7.87%), Germany (4.49%), the United Kingdom (4.31%) and France (4.31%). The
remaining shares are divided among the other member countries. All developing country
borrowers have 39% of the voting share combined. The 47 sub-Saharan African nations
command less than 6% of the votes.

The World Bank organizes its operations primarily through 27 Vice-Presidential Units. Six
regional vice-presidencies control a large-degree of decision making on Bank operations
within their own regions: Africa, East Asia & Pacific, Europe & Central Asia, Latin America
& the Caribbean, Middle East & North Africa, and South Asia. Other vice presidencies
include 7 "Network Vice Presidential Units"-responsible for certain cross-cutting issue areas
such as the financial sector or private sector development. The rest 13 cover such areas as
external affairs, development economics, legal, and human resources.

1. The International Bank for Reconstruction and Development (IBRD)

 The IBRD is an international organization whose original mission was to finance the
reconstruction of nations devastated by World War II.

 Now, its mission has expanded to fight poverty by means of financing states.

 Its operation is maintained through payments as regulated by member states.

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Purposes of IBRD

 To assist in the reconstruction and development of the territories of the members, by

facilitating the investment of capital for productive purposes.

 To promote private foreign investment or participation in loans and other investments

made by private investors.

 To promote the long range balanced growth of international trade and the
maintenance of equilibrium in the balance of payments.

2. The International Development Association (IDA)

 The IDA was established in 1960 to provide concessional assistance to countries that
are to poor to borrow at commercial rates.

 It helps to promote growth and reduce poverty in the same ways as does the IBRD,but
IDA uses interest free loans(which are known as IDA credit),technical assistance etc.

 IDA assistance is concentrated on the very poor countries.

 The IDA works hand in hand with the International Bank Of Reconstruction and
Development. The IDA mostly caters to the African countries.

 The IDA receives its funds from the government of the rich member countries.

3. International Financial Corporation (IFC)

 The International Finance Corporation was founded in 1956 with the intention of
enhancing the private investment in the developing countries.

 The objective of IFC is to assist the economic development of less developed

countries by promoting growth in the private sector of their economies and helping
mobilise domestic and foreign capital for this purpose.

 The IFC promotes private sector investment, both foreign and domestic, in developing
member countries.

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 Its investment and advisory activities are designed to reduce poverty and improve
people’s lives in an environmentally and socially responsible manner.

 The underdeveloped regions that are covered by the IFC are the Sub-Saharan Africa,
East Asia and the Pacific, South Asia, Europe and Central Asia, Latin America an the
Caribbean, North Africa and the Middle East.

4. The Multilateral Investment Guarantee Agency (MIGA)

 To promote foreign direct investment by offering political risk insurance (guarantees)

to investors and lenders.

 Projects MIGA supports typically convey many direct benefits to host countries, such
as:

i. Jobs created for local people.

ii. Accompanying and enduring investments in skills and training for

employees.

iii. General impact on national economy as a whole was provided by tax

revenues and foreign exchange earnings through exports.

5. The International Centre for settlement of Investment Disputes (ICSID):

It main objective is to provide facilities for the settlement – by conciliation or arbitration-of

investment disputes between foreign investors and their host countries.

ACHIEVEMENTS OF THE WORLD BANK GROUP

 World Bank is the largest source of finance in Education.

 World Bank is one of the largest financier in its war with HIV/AIDS
 They have led the world in the fight for corruption.
 They provide the strongest debt relief to the heavily indebted countries in the world.
 They are one of the prominent financiers of biodiversity projects.
 They are helping in bringing the basic amenities to the poor people.
 The guiding force in the work of the World Bank is the civil society.

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CURRENCY REGIMES

The international monetary system is comprises of national currencies, artificial currencies

(such as SDRs) and one new currency (the Euro).

The IMFs Exchange rate regime classification

The International Monetary Fund classifies all exchange rates into eight specific categories.
The eight categories widely range from rigidly fixed to independently floating.

1. Exchange Arrangements with no separate legal tender:

In this category the currency of another country circulates as the sole legal tender or the
member belongs to a monetary or currency union in which the same legal tender is shared by
the members of the union. Almost 39 countries adopt this policy. The most prominent
example of this type is the Euro area, in which the Euro is the single currency for its member
countries.

2. Currency Board Arrangements:

A currency board exists when a country’s central bank commits to back its monetary base i.e.
its money supply entirely with foreign reserves at all times. This means that a unit of
domestic currency cannot be introduced into a economy without an additional unit of foreign
exchange reserves being obtained first.

A monetary regime based on an implicit legislative commitment to exchange domestic

currency for a specified foreign currency at a fixed exchange rate, combined with restrictions
on the issuing authority to ensure the fulfillment of its legal obligation. Almost 8 countries
such as Hong-Kong, Argentina etc adopted this policy.

3. Other conventional Fixed peg Arrangements:

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The country using this process peg its currency at a fixed rate to a major currency or a basket
of currencies (a composite), where the exchange rate fluctuates within a narrow margin or at
most +- 1 % around a central rate.

4. Pegged exchange rates within horizontal bands:

The value of the currency is maintained within margins of fluctuations around a formal or
fixed peg that are wider than +- 1% around a central rate.

5. Crawling pegs:

The currency is adjusted periodically in small amounts at a fixed, pre announced rate or in
response to changes in selective quantitative indicators.

6. Exchange rates within crawling pegs:

The currency is maintained within certain fluctuation margins around a central rate that is
adjusted periodically at a fixed, pre announced rate or in response to changes in selective
quantitative indicators.

7. Managed floating with no pre-announced path for the exchange rate:

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

8. Independent floating:

The exchange rate is market determined, with any foreign exchange intervention aimed at
moderating the rate of change and preventing undue fluctuations in the exchange rate, rather
than establishing a level for it.

This includes most of the developed countries such as Japan, United States, UK etc.

EXCHANGE RATE SYSTEMS

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1. FIXED EXCHANGE RATE

Fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate
regime which agrees to keep their currencies at a fixed rate and to change their value only at
fairly infrequent intervals, when the economic situation forces them to do so.

ARGUMENT FOR SUPPORTING STABLE EXCHANGE RATE

 Exchange rate stability is necessary for orderly development and growth of foreign
trade.
 Exchange rate stability is necessary to attract foreign capital investment.
 A stable exchange rate system eliminates speculation in the foreign exchange market
 A stable exchange rate system is also necessary for the growth of international money
and capital markets

2. FLEXIBLE EXCHANGE RATE

A flexible exchange rate or fluctuating exchange rate is a type of exchange rate regime
wherein a currency's value is allowed to fluctuate according to the foreign exchange market.

 Under flexible exchange rate system, the first impact of any tendency towards surplus
or deficit in the balance of payments is on the exchange rate.
 A surplus in BOP will create an excess demand for the country’s currency and the
exchange rate will tend to rise.
 A deficit in BOP will give rise to an excess supply of the country’s currency and the
exchange rate will tend to fall.

THE BIRTH OF A EUROPEAN NATION:

The common market countries wanted to have stability of fixed exchange rates among
themselves, while at the same time, having flexibility in exchange rates with the rest of the
world. They therefore adopted the system of common margin arrangements known as the
European Monetary System in 1979.

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 At the Maastricht summit held in December 1991, leaders of the member countries of
the European Community (EC) concluded an agreement on the requirements and the
timetable for the European Economic & Monetary Union and for the accompanying
move to a common European Monetary policy.
 It laid down certain eligibility criteria for member countries to join the EMU, such as
maintaining budget deficit, public debt, inflation, long term interest rates and
exchange rate within defined limit.

THE BIRTH OF A EUROPEAN CURRENCY: THE EURO

 Euro, the common currency of the European Union, was launched by the 15 members
of the union, on January 1, 1999.
 This group has tried to form an island of fixed exchange rates among themselves in a
sea of major floating currencies.
 Member of European Monetary System rely heavily on trade with each other, so they
perceived that day to day benefits of fixed exchange rates between them are great.

CONSEQUENCES OF EURO

 Idea of introducing a single currency was originally motivated by the overall political
arguments that an increased integration of the European countries would reduce the
risk of war and crises on the continent.
 on a macroeconomic level, a single monetary policy in the euro area which is firmly
geared towards price stability will enhance political and economic stability, not only
in the euro area, but also in a global context;
 On a microeconomic level, the use of the same currency in the euro area will increase
cross-border competition and market integration, thereby improving the efficiency of
the markets for goods, services and capital in the participating countries.

BENEFITS OF EURO:

 Countries within the Euro Zone enjoy cheaper transaction cost.

 Currency risk and cost related to exchange rate uncertainty are reduced.
 All consumers and business both inside and outside of the Euro Zone enjoy price
transparency and increased price based competition.

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