DIRE-DAWA UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ACCOUNTIG AND FINANCE

Program: MSc in Accounting and Finance

Individual Assignment Material preparation

International Business Finance

Prepared by: Hukuba Saniyo DDU1400052

Submitted to Mesfen Y. (Ass. Prof. of Accounting and Finance)

June, 2022

Chiro, Ethiopia
 Table content
Content page
1 The International Monetary System …………………………………………………..1
1.1. The Gold Standard, The Bretton Woods System and, The Floating Exchange
Rate
regime……………………………………………………………………………………..1
1.2. The case for and against fixed versus floating exchange
rates……………………………6
1.3. Exchange rate regimes in Practice: Pegged system and currency
boards………………..10

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 1. The International Monetary System
An international monetary system is a set of internationally agreed rules, conventions and
supporting institutions that facilitate international trade, cross border investment and generally
the reallocation of capital between states that have different currencies.
International monetary system refers to the system and rules that govern the use and exchange of
money around the world and between countries. Each country has its own currency as money
and the international monetary system governs the rules for valuing and exchanging these
currencies.
The international monetary system can be seen as a network effecting international payments
through institutions, rules, and regulations. In order to fulfill its role effectively, an international
monetary system should possess certain characteristics:
• A time element regarding the elimination of balance of payments disequilibrium among
countries, that is countries must be allowed sufficient time to adjust without severe recessions or
high inflation but, at the same time, should not be allowed to avoid adjustment at the expense of
other countries.
• The choice of the unit of account, that is the agreed measure of the value of currencies.
• International cooperation with respect to adjustment methods, concerted intervention, and
reserve assets
. • Promotion of free international trade so that productive resources are optimally allocated. We
can now briefly examine the different systems that have prevailed throughout modern economic
history.
1.1. The Gold Standard, The Bretton Woods System and, The Floating
Exchange Rate regime
A. The Gold Standard
The gold standard is the only example in history when exchange rates were truly fixed. It was a
system whereby the values of currencies were fixed relative to the value of gold, which was used
as a unit of account and the main reserve asset. Each country participating in the gold standard
fixed the value of its currency relative to gold and maintained gold reserves. The difference
between the quantity demanded and supplied of a country’s currency was determined by the
purchase or sale of gold so that the value of the currency in terms of gold remained fixed. The
amount of purchase or sale depended on the balance of payments deficit or surplus, respectively.
A country with a balance of payments surplus would sell its currency (i.e., buy gold) in order to
hold the revaluation (appreciation) of its currency. Because the domestic money supply was
based on gold, the inflow of gold would increase the money supply and lower interest rates.
Lower interest rates would provoke capital outflows while the resulting expansionary monetary
policy would increase income and cause domestic inflation, which encouraged imports and
discouraged exports. All these forces would work toward the elimination of the balance of
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payments surplus. On the other hand, a balance of payments deficit would necessitate the
purchase of the home currency (i.e., sale of gold) in order to keep the exchange rate from falling.
The resulting money supply contraction would dampen domestic demand and output, decrease
imports, and bring about a rise in interest rates. As a result, the balance of payments deficit
would be eliminated. It is apparent that the system provided an automatic method of adjustment
so that no management was needed. Since the money supply was directly tied to gold, the
government could not pursue an independent monetary policy in order to achieve domestic goals.
The gold standard was suspended in 1914, just before World War I. It was reintroduced in the
1920s and finally collapsed following the financial chaos of the Great Depression and World
War II.

Features of Gold Standard:

The basic features of the gold standard are:
(i) The monetary unit is defined in terms of certain weight and fineness of gold.
(ii) All gold coins are held as standard coins and considered unlimited legal tender.
(iii) All other types of money (paper money or token money) are freely convertible into gold or
equivalent of gold.
(iv) There is unlimited coinage of gold at no cost.
(v) There is free and unlimited melting of gold.
(vi) Import and export of gold is freely allowed.
(vii) The monetary authority is under permanent obligation to buy and sell gold at the fixed price
without limit.
Advantage of Gold Standard:
1. Simplicity:
Gold standard is considered to be a very simple monetary standard. It avoids the complicacies of
other standards and can be easily understood by the general public.
2. Public Confidence:
Gold standard promotes public confidence because (a) gold is universely desired because of its
intrinsic value, (b) all kinds of no-gold money (paper money, token coins, etc.) are convertible
into gold, and (c) total volume of currency in the country is directly related to the volume of gold
and there is no danger of over-issue currency.
3. Automatic Working:
Under gold standard, the monetary system functions automatically and requires no interference
of the government. Given the relationship between gold and quantity of money, changes in gold
reserves automatically lead to corresponding changes in the supply of money.
4. Price Stability:
Gold standard ensures internal price stability. Under this monetary system, gold forms the
currency base and the prices of gold do not fluctuate much because of the stability in the
monetary gold stock of the world and also because the annual production of gold is only a small
fraction of world’s total existing stock of monetary gold.
5. Exchange Stability:
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Gold standard ensures stability in the rate of exchange between countries. Stability of exchange
rate is necessary for the development of international trade and the smooth flow of capital
movements among countries. Fluctuations in the exchange rate adversely affect the foreign trade
Disadvantages of Gold standard
The disadvantages are that;
(1) it may not provide sufficient flexibility in the supply of money, because the supply of newly
mined gold is not closely related to the growing needs of the world economy for
a commensurate supply of money,
(2) a country may not be able to isolate its economy from depression or inflation in the rest of the
world, and
(3) the process of adjustment for a country with a payments deficit can be long and painful
whenever an increase in unemployment or a decline in the rate of economic expansion occurs.

B. The Bretton Woods System

The Bretton Woods System is a set of unified rules and policies that provided the framework
necessary to create fixed international currency exchange rates. Essentially, the agreement
called for the newly created IMF to determine the fixed rate of exchange for currencies around
the world.
Following the collapse of the gold standard, the Great Depression, and the years before and
during World War II, massive unemployment and severe recessions induced many countries to
resort to protectionism, that is insulating domestic industries from foreign competition while
interest rates were used as a purely domestic monetary policy instrument. When the war ended,
the Allies met at Bretton Woods, New Hampshire, in 1944 in an attempt to establish a stable
international monetary system that would restore international trade. The resulting agreement led
to the adoption of fixed, but adjustable, exchange rates based on the free convertibility of the US
dollar to gold and the establishment of the International Monetary Fund (IMF). It was clearly an
attempt to create a “new order.”
There were two basic weaknesses inherent in the Bretton Woods system. First, exchange rate
adjustments reflecting fundamental imbalances were not timely and, as a result, deficits became
chronic. When devaluations were allowed, exchange rate adjustments were of sizeable
proportions. In addition, they could be foreseen with almost perfect certainty and speculators
realized large profits when they “attacked” weak currencies by selling them in large amounts.
Second, there was a shortage of official reserves and international liquidity. The IMF created the
Special Drawing Rights (SDRs), a type of international money, to offset these shortages but the
SDRs were never established as an international currency and the US dollar was the main
international reserve asset.
While deficit nations were ultimately forced to devalue, surplus nations resisted revaluations in
order to avoid recessions. Because the US dollar was fixed in terms of gold, the United States
could not devalue the dollar to restore competitiveness and the only way the exchange rate of the
dollar against other currencies could change was if surplus countries revalued their currencies.

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Since such revaluations were stringently resisted, the dollar became overvalued and the United
States ran a large balance of payments deficit. The number of dollars held by foreigners grew
dramatically in the 1960s and by the early 1970s that number exceeded the amount of gold held
by the United States. As a result, the depletion of foreign exchange reserves and the
accumulation of foreign debt forced the United States to end its policy of exchanging gold for
dollars at $35 per ounce. And that was the death of the Bretton Woods system.

Features of Bretton Woods System

Reserves: Gold, U.S. $ and SDR (added in 1960s) The U.S. dollar replaced the British pound as
the reserve currency and was treated as good as gold.
Fixed parities Under the original provisions of the Bretton Woods agreement, all countries fixed
the value of their currencies in terms of gold but were not required to exchange their currencies
for gold. Only the dollar remained convertible into gold (at $35 per ounce). Therefore each
country established its exchange rate vis-à-vis the dollar. This is often called the two-tier system:
(1) US $ pegged to gold: $35/ounce of gold Î dollar-gold parity, and (2) other currencies pegged
to dollar. For example, the British pound was fixed to the dollar at $2.80/£, and Japanese yen
was pegged to the dollar at ¥360/$.
Adjustable parities Although each country's exchange rate was fixed, it could be changed –
devalued or revalued against the dollar – if the IMF agreed that the country's balance of
payments was in a situation of "fundamental disequilibrium."
Narrow band (1% on either side of parity) The exchange rates were allowed to fluctuate
within 1% of its stated par value. Other countries would buy and sell U.S. dollars to keep market
exchange rates within the 1 percent band around par value – foreign exchange market
intervention (as required by the system).
ADVANTAGES OF BWS:
1) The advantage of Bretton woods system was that the number countries had to maintain
only there serve of dollars which helped them in over coming the problem of maintain
gold reserve.
2) The countries could also earn interest on their dollar reserve unlike in the gold reserve
system.
3) The Bretton woods system sought to secure the advantage of the gold standard with out
its advantage.
4) The gold standard maintained fixed exchange rates. Fixed exchange rates were seen as
desirable because they reduced the risk of trading with other countries
5) The benefits of the Bretton woods system were a significant expansion of international
trade and investment as well as an able macro economic performance.
DISADVANTAGES OF BWS:

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 1. Weaknesses of the system were capital movement restrictions throughout the Bretton
woods years ,government needed to limit capital flows in order to have a certain extent of
control
2. Another negative aspect was the pressure Bretton woods put on the united states, which
was not willing to supply the amount of gold the rest of the world demanded ,because the
gold reserve decline the confidence in the dollar.
3. There was note nough gold available to allow people to buy all the new goods and service
that could be produced .and the gold that was available was mainly located in the soviet
union.
4. The success of Bretton woods system was essentially based on the un condition al supply
of dollars by US. How ever US could not do it for along time as it was still under the
system of gold standard.
C. The Floating Exchange Rate regime
A floating exchange rate is a regime where the currency price of a nation is set by the for ex
market based on supply and demand relative to other currencies. This is in contrast to a fixed
exchange rate, in which the government entirely or predominantly determines the rate.
Under a flexible or freely floating exchange rate system the monetary authorities do not
intervene in the foreign exchange market. The price of a currency is allowed to rise or fall
according to prevailing demand and supply conditions. In other words, the exchange rate adjusts
to clear the market and, as a result, balance of payments equilibrium is achieved automatically.
Thus, debit items in the current and capital accounts are equal to the corresponding credit items
as payments to foreign residents are exactly equal to receipts from foreign residents.
ADVANTAGE OF FLOATING EXCHANGE RATE:
 Autonomy of monetary authorities:
 Boost international liquidity
 Equilibrium provider to balance of payment
 Flexible monetary policy
 Improvement in current account position
 Market forces of demand and supply
 Optimum utilizing of monetary resource
 Protects domestic economy
 Reflects the true position of account
 Support planned economic development
DISADVANTAGE OF FLOATING EXCHANGE RATE:
 Increases exchange rate volatility
 Increases the exchange rate risk
 Inflationary pressures
 Makes the economy more vulnerable
 Monetary disorder in the economy
 Reduce the volume of international trade
 Serious impact on the economic structure
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  Speculative capital movements
 Speculative capital movements
 Worsen the balance of payments deficit
1.2. The case for and against fixed versus floating exchange rates
i. The Case for Floating Exchange Rates
There are three arguments in favor of floating exchange rates:
• Monetary policy autonomy
• Symmetry
• Exchange rates as automatic stabilizers
 Monetary Policy Autonomy
Floating exchange rates: – Restore monetary control to central banks. Allow each country to
choose its own desired long-run inflation rate
 Symmetry
Floating exchange rates remove two main asymmetries of the Bretton Woods system and allow:
– Central banks abroad to be able to determine their own domestic money supplies
– The U.S. to have the same opportunity as other countries to influence its exchange rate
against foreign currencies
 Exchange Rates as Automatic Stabilizers
Floating exchange rates quickly eliminate the “fundamental disequilibriums” that had led to
parity changes and speculative attacks under fixed rates.
ii. The Case against Floating Exchange Rates
There are five arguments against floating rates:
• Discipline
• Destabilizing speculation and money market disturbances
• Injury to international trade and investment
• Uncoordinated economic policies
• The illusion of greater autonomy
 Discipline
Floating exchange rates do not provide discipline for central banks.
– Central banks might embark on inflationary policies (e.g., the German hyperinflation of the
1920s).
The pro-floaters’ response was that a floating exchange rate would bottle up inflationary
disturbances within the country whose government was misbehaving.
 Destabilizing Speculation and Money Market Disturbances
Floating exchange rates allow destabilizing speculation.
– Countries can be caught in a “vicious circle” of depreciation and inflation.
Advocates of floating rates point out that destabilizing speculators ultimately lose money.
Floating exchange rates make a country more vulnerable to money market disturbances.

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  Injury to International Trade and Investment
Floating rates hurt international trade and investment because they make relative international
prices more unpredictable:
– Exporters and importers face greater exchange risk.
– International investments face greater uncertainty about their payoffs
. --Supporters of floating exchange rates argue that forward markets can be used to protect
traders against foreign exchange risk.
– The skeptics replied to this argument by pointing out that forward exchange markets would be
expensive.
 Uncoordinated Economic Policies
• Floating exchange rates leave countries free to engage in competitive currency depreciations.
Countries might adopt policies without considering their possible beggar-thy-neighbor aspects.
 The Illusion of Greater Autonomy
• Floating exchange rates increase the uncertainty in the economy without really giving
macroeconomic policy greater freedom. A currency depreciation raises domestic inflation due to
higher wage settlements.

iii. The Case for Fixed Exchange Rates

The main arguments in support of Fixed exchange rates are as follows:

 Promotion of International Trade:

If the exchange rates are fixed or stable, the prices of internationally traded goods become more
stable and predictable. Under this system, the exporters know in advance what they will receive
in terms of the domestic currency and importers know how much they will have to pay.
 International Division of Labour and Specialisation:
The system of fixed exchange rate not only promotes international trade but also contributes in
raising productivity and absolute output through increased international division of labour and
specialisation.
 Promotion of Economic Integration:
In an economic union, member countries strive to evolve a common currency. That is the
necessary requirement for integrating their economic policies. The system of fixed exchange rate
is just like a common currency in which the exchange value of the currency remains unchanged
in terms of the domestic currency of a particular country.
 Long-Term Capital Investments:
In case of stable exchange rates there is little uncertainty and risk. As a consequence, the
investors can plan long-term international investments. Large scale capital inflows from abroad

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can facilitate the achievement of a higher rate of growth. The greater uncertainty and risk under
the flexible exchange system, in contrast, is likely to impede the long- term capital flows.
 No Adverse Effect of Speculation:
Since the exchange rate remains stable under the fixed exchange system, there is little scope for
speculation and the consequent adverse effects. The advocates of fixed exchange system point
out that the speculation is destabilising under the flexible exchange system. The speculation is
said to be destabilising, if speculators purchase a foreign currency when exchange rate is rising,
and sell it when exchange rate is falling in the expectation that the exchange rate will change
even more in the same direction.
 Confidence in the Strength of Currency:
This exchange system does not involve appreciation or depreciation of currency. There is no fear
of risk of loss due to larger holding of foreign currency, if the value of currency declines. This
imparts greater confidence in the strength of the domestic currency.
 Suited to Currency Areas:
The system of fixed exchange rates is more suited to countries included in such regional
arrangements as dollar area or sterling area or Euro-area. A fixed rate of exchange between
dollar and sterling with other currencies is likely to have very positive effect on trade. BOP
adjustments, capital flows and growth. 
 Growth of Money and Capital Markets:
The system of stable exchange rate stimulates the growth of money and capital markets through
facilitating rapid expansion of trade and international capital flows. When there existed stable
exchange rates under gold standard, smooth flow of international lending continued and that
brought about steady expansion in international money markets.
 Price Discipline:
Fixed exchange rates, involve a price discipline on the nation that is not present under a flexible
exchange system. The democratically elected governments are often tempted to follow
expansionary policies which reduce unemployment but cause inflationary pressures. A country
having a higher rate of inflation than the rest of the world is likely to face persistent BOP deficits
and loss of reserves. This cannot go on forever. Therefore, the country under a fixed exchange
rate will have to adopt measures to restrain inflation.
iv. Arguments against Fixed Exchange Rates:

The main arguments against the fixed rates of exchange are as follows:
 Primacy to Exchange Stability:

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A serious defect in this system of exchange rates is that the authorities become concerned
primarily with the maintenance of exchange rate at some official level. It often results in the
sacrifice of the objectives of price stability and full employment.
 International Transmission of Economic Variations:
The fixed or stable exchange rates can be responsible for transmitting the economic disturbances
in one country to another. Suppose there are deflationary conditions in one country. It will export
its low-price goods to other countries. The industries of foreign countries, faced with competition
from cheap goods, will be forced to lower their prices.
 Need to Build Exchange Reserves:
The necessity of maintaining the exchange rate at an official level makes the authorities to
undertake pegging operations. For this purpose, it is necessary to maintain sufficient reserves of
foreign currencies. Unless these reserves are maintained, a country faced with BOP deficit will
have to depend upon devaluation.
 Heavy Burden upon the Authorities:
If a country is under continuous pressure on account of the BOP deficit, the government or
monetary authority may not be in a position to mobilise sufficient international liquid resources
for undertaking the pegging operations. In the event of failure to mobilise reserves of foreign
currencies, the home currency has to be devalued.
 Difficulty in Building Up of Exchange Reserves:
Under a fixed exchange system, every country is required to build up idle stock of foreign
currencies. It necessitates the BOP surplus at least for some years. The LDC’s will find it
difficult to have BOP surpluses for building up sufficient foreign exchange reserves. It is often
beyond their capacity to even offset the persistent BOP deficit.
 Possibility of Speculation:
It is generally believed that in a system of fixed exchange rate, there is little scope for
speculation in foreign exchange. In this connection, it must be recognised that speculation,
undoubtedly, will not occur in respect of variations in exchange rates but the speculators can still
make anticipations about the timing and extent of possible devaluation or about the timing and
scale of pegging operations.
 Exchange Controls
The policy of fixed or stable exchange rates requires quite complicated exchange control
mechanism. This can result in misallocation of economic resources, bureaucratic inefficiency
and corruption.
 No Solution of BOP Problem:

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 The policy of fixed exchange rates cannot help in resolving the problem of BOP deficit. It simply
suppresses it through the government intervention. The forces underlying the BOP
disequilibrium remain to be tackled through monetary, fiscal and other policies. Under this
system, the entire attention is paid to the stabilization of exchange rate rather than dealing with
the BOP disequilibrium..
 Suited only of Short Period:
The policy of fixed exchange rates cannot be pursued as a long-term policy. As technological
and structural changes take place, the official rate of exchange may be rendered unrealistic. The
BOP difficulties and fluctuations in international commodity prices can force the different
countries to revise the exchange rates.
 Greater Need of Institutional Arrangements:
In case of a flexible exchange system, the BOP adjustments can take place automatically through
free movements of exchange rates. But in the fixed exchange system, the BOP adjustments
require accommodating transactions.
1.3. Exchange rate regimes in Practice: Pegged system and currency boards
A currency board is an extreme form of a pegged exchange rate. Management of the exchange
rate and the money supply are taken away from the nation's central bank, if it has one. In
addition to a fixed exchange rate, a currency board is also generally required to maintain
reserves of the underlying foreign currency .

Under a currency board, the management of the exchange rate and money supply are given to a
monetary authority that makes decisions about the valuation of a nation’s currency. Often, this
monetary authority has direct instructions to back all units of domestic currency in circulation
with foreign currency. When all domestic currency is backed with foreign currency, it is called
a 100% reserve requirement. With a 100% reserve requirement, a currency board operates
similarly to a strong version of the gold standard.
The currency board allows for the unlimited exchange of the domestic currency for foreign
currency. A conventional central bank can print money at will, but a currency board must back
additional units of currency with foreign currency. A currency board earns interest from foreign
reserves, so domestic interest rates usually mimic the prevailing rates in the foreign currency.

A currency peg is a policy in which a national government sets a specific fixed exchange

rate for its currency with a foreign currency or a basket of currencies. Pegging a currency
stabilizes the exchange rate between countries. Doing so provides long-term predictability of
exchange rates for business planning. However, a currency peg can be challenging to maintain
and distort markets if it is too far removed from the natural market price.

The primary motivation for currency pegs is to encourage trade between countries by
reducing foreign exchange risk. Profit margins for many businesses are low, so a small shift in

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exchange rates can eliminate profits and force firms to find new suppliers. That is particularly
true in the highly competitive retail industry.
Countries commonly establish a currency peg with a stronger or more developed economy so
that domestic companies can access broader markets with less risk. The U.S. dollar, the euro,
and gold have historically been popular choices. Currency pegs create stability between trading
partners and can remain in place for decades. For example, the Hong Kong dollar has been
pegged to the U.S. dollar since 1983.

Reference

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