Classical Gold Standard (1870-1914)

Until the 1870s, most monetary systems were based on a bimetallic standard. Only Britain was on the gold standard, after Sir Isaac
Newton in his capacity as Master of the Mint, set the wrong gold-silver price ratio in 1717 and drove silver out of circulation. But by
1870 Britain had become the world’s preeminent commercial power, creating an incentive for her trading partners to adopt her
mono-metallic standard. After Germany went onto gold in 1871 and the US in 1873, the preponderance of the world’s industrial
countries followed suit, such that by 1900 only China and a few Central American countries remained on silver.

The gold standard ensured stable exchange rates by fixing them in terms of gold. Central banks were willing to convert paper
currency for a specified amount gold. The corollary of this was that countries could not run persistent trade imbalances. When a
country ran a trade deficit, it experienced a gold outflow, initiating a self-correcting chain of events known as the price-specie flow
mechanism. With less gold-backed money circulating internally, prices fell in the deficit country, making imports more expensive and

exports cheaper and thus eliminating the deficit. But in practice, external adjustments typically took place in the absence of
substantial movements of gold. When a country ran a deficit, its central bank could intervene to accelerate the adjustment of the
money supply by adjusting its discount rate. If the bank raised the rate to make discounting more expensive, fewer intermediaries
would be inclined to present bills for discount to obtain cash from the central bank. This would decrease the volume of domestic
credit and restore the balance of payments equilibrium without requiring gold flows.

The lynchpin of the classical gold standard was the priority attached by governments to maintaining convertibility. Political pressures
to subordinate currency stability to other objectives such as growth and full employment were not a feature of the pre-1914 world –
wages and prices were flexible, allowing a balance of payments shock to be accommodated by a fall in costs and wages. Investors
were aware of these priorities so did not fear devaluation prior to 1914 and when currency fluctuations did occur, investors reacted
in a stabilising fashion. If the exchange rate fell to the point where gold arbitrage would become profitable, funds would flow in from
abroad in anticipation of the profits that would be made by investors in domestic assets when the central bank intervened to
strengthen the exchange rate.

The gold standard had two major advantages. First, it provided long-run price stability since it obliged governments to commit to
time-consistent monetary and fiscal policies. Governments could not autonomously adjust their money supply without suffering
debilitating gold flows. That is why Sir Winston Churchill considered it “knave-proof”. Second, the gold standard era was marked by
low interest rates since bond markets regarded the gold standard as a “Good Housekeeping Seal of Approval”. Currencies tethered
to gold were unlikely to be debased and their governments were unlikely to engage in reckless fiscal policy so it was relatively safe to
lend and invest money in countries that were on gold. For these reasons, the gold standard was associated with a spectacular
increase in world trade.

However, not all was rosy in the garden. The corollary of the monetary authorities’ commitment to maintaining stable exchange
rates was that they could not pay much attention to unemployment and growth. Moreover, pegging the international monetary
system to a scarce metal placed a real constraint on the growth of credit. Indeed, the gold standard frequently generated deflation
since world growth often outstripped the availability of gold for monetary uses. This was particularly the case before the invention of
the cyanide extraction process and the major gold discoveries in Klondike and South Africa in the late 1890s. Agricultural
commodities such as wheat experienced secular price declines during the gold standard era, causing major hardship to farmers.
Another disadvantage was that the gold standard had the capacity to readily transmit crises around the world, courtesy of the
aforesaid price-specie flow mechanism. The panics of 1857, 1973, 1907 and 1929 emanated from the US but ended up dragging
down much of the rest of world.

The Demise of the Gold Standard (1914-1930s)

The Classical Gold Standard ended abruptly in 1914 with the outbreak of WWI. Private trade and gold exports were suspended and
individual countries began financing their war debts by issuing bonds and printing money, resulting in differing interest rates. After
the war, the major countries attempted to restore the gold standard but with disastrous consequences. Britain’s decision to return
to gold at the pre-war parity in 1925, motivated by a sense of duty to Britain’s creditors, left the pound 10% overvalued against the
dollar due to the inflation gap since 1914. France, meanwhile, not feeling any such compunction, joined at a lower parity, allowing it
to steal trade from under the noses of its rivals.

In 1931, Britain abandoned the gold standard again, followed by most other countries, resulting in an immediate return to growth.
The US grimly clung on, though reduced the gold value of the dollar from $20/oz to $35/oz in 1933. These measures freed the
world’s currencies from their golden fetters but the damage had already been done – the failure to accommodate the fall-out from
the 1929 Wall Street Crash encouraged the rise of protectionism and trading blocs, to the detriment of world trade and growth.

Bretton Woods (1945-1971)

A new monetary order emerged from the agreement at Bretton Woods at the end of WWII to prevent nations from engaging in the
currency and trade wars that had so damaged the world economy in the 1930s. This involved the creation of the International
Monetary Fund, the World Bank, the General Agreement on Tariffs and Trade (the forebear of the WTO), and the international gold-
exchange standard.

Under Bretton Woods, countries pegged their currencies to the dollar at specified parities, which in turn was convertible into gold at
the official rate of $35/oz. However this only applied to dollars held by central banks and governments and not by private citizens.
The US provided price stability but did not engage in currency intervention – other countries had to intervene to fix their exchange
rates against the dollar. These pegs were intended to be adjustable if “fundamental disequilibria” occurred, and were accompanied
by tight capital controls that were designed to prevent speculative attacks and afford central banks a modicum of policy
independence. In the event that any balance of payments problems arose, the IMF stood ready to extend credits to the affected
nation(s). In sum, the system was intended to marry flexibility and stability, overcoming the inadequacies of the Classical Gold
Standard.

There are mixed views on the record of Bretton Woods. For some, it was an important component of the post-war golden age of
growth, delivering exchange rate stability, in marked contrast to the preceding and subsequent volatility. It dissipated payments
problems, allowing the phenomenal expansion of international trade and investment that fuelled the 1950s and 1960s worldwide
boom. Others contend that Bretton Woods was a consequence rather than a cause of the post-war growth and suffered from a
number of structural weaknesses that sealed its fate from the outset. The wonder, they contend, is that it managed to survive so
long. So what were these weaknesses?

First, there was no automatic mechanism for dealing with current account imbalances. Unlike the gold standard, European nations
could no longer resolve balance of payments problems by adjusting interest rates or adjusting domestic prices. Governments could
no longer subordinate growth and full employment to exchange rate stability. Exchange controls and import restrictions such as
those employed by European nations during the early years of Bretton Woods, ceased to be an option after the restoration of
current account convertibility in 1958 and the development of Eurodollars in the 1960s. This only left parity adjustments for
removing disequilibrium which nations refused to do for fear of embarrassment – parity adjustments were a conspicuous sign of
failure.

Second, the centrality of the dollar to the system posed a number of problems. It was natural for central banks to supplement their
gold reserves with the dollar, given the US’s dominant position in trade and finance and its large gold stock. However, this permitted
the US to run chronic trade deficits, allowing Americans to live beyond their means and put off attempts to strengthen their current
account. Many nations bristled at this ‘exorbitant privilege’ and De Gaulle even threatened to liquidate France’s dollar balances. A
related problem was the Triffin dilemma. Confidence in the dollar was based on the perception that the US would convert it into
gold. Therein lay a paradox. World trade depended on the ready supply of dollars but providing these dollars would reduce the US’s
credibility to convert all of them into gold. This became a real problem after 1960 when the world’s dollar balances exceeded US
gold reserves at the ordained rate of $35/oz.

Third, Bretton Woods was highly reliant on foreign support for the dollar. International cooperation was possible during the early
years when the dollar provided price stability, but was less forthcoming when the US began inflating in the 1960s due to deficit
spending on the Vietnam War and Lyndon Johnson’s Great Society initiative. Inflation-averse countries such as Germany were loath
to import US inflation. An example of the necessity for international cooperation is furnished by the London Gold Pool. In 1961, a
number of European central banks pledged not to convert their dollars and sold gold from their reserves to relieve speculative
pressure on the dollar. But when it later became clear that the US would not subordinate its economic and political objectives to
defend the dollar price of gold, the Pool unravelled in 1968 under heavy speculative pressure. To prevent the Fed from being
completely drained of gold, a two-tier gold market was instituted, whereby private gold prices could rise but the price for official
transactions remained unchanged. When the private market price immediately rose to $40, there was a strong incentive for foreign
central banks to cash in their dollars at the original rate of $35/oz.
The Demise of Bretton Woods (1971-73)

Eventually, in spring 1971, large defections from the dollar to the deutschmark prompted Germany to suspend intervention and
allow the mark to float upwards. Once the dollar flight had started, it couldn’t be contained and by mid-August it was reported that
France and Britain intended to convert dollars to gold. On 13 August, President Nixon closed the Fed’s gold window, suspending the
commitment to provide gold to foreign central banks at $35/oz or any other rate. He also introduced a 10% import surcharge to
coerce other countries into revaluing their currencies, so as to avoid the ignominy of devaluing the dollar. Together, these actions
are known as the Nixon Shock.

Over the following four months, the world’s major nations engaged in negotiations over the reform of the international monetary
system, culminating in the Smithsonian Agreement in December. It was agreed that dollar devaluation would be limited to 8% with
the rest of the change in relative prices provided by revaluing the yen, Swiss franc and deutschmark. Bretton Woods’ currency
fluctuation bands were widened from 1% to 2.25% and the US import surcharge was abolished but the US was not obliged to reopen
its gold window. In reality, little had changed. US policy remained too expansionary to be consonant with pegging the dollar to
foreign currencies and having devalued once, there was no reason to suppose the dollar wouldn’t be devalued again. A speculative
attack on the sterling forced Britain to float out of its band in 1972, followed by Switzerland in early 1973 and when the dollar was
devalued by 10% against the major European currencies in February, dollar flight resumed perforce. Things reached a head in March
when the deutschmark and the other EEC currencies floated upwards, delivering the final coup de grace to Bretton Woods.

Washington Consensus (1973 – Present)

After the collapse of the Smithsonian Agreement, the major currencies of North America, Europe and Japan floated. During the
1970s, the dollar depreciated as inflation bit and then commenced its dramatic ascent following the 1979-80 Volcker Shock when US
interest rates were hiked to unprecedented levels. By 1985, the dollar’s strength was harming US competitiveness, prompting the
US, Japan, Germany, France to sign the Plaza Accord, under which they jointly intervened to lower the dollar. Their intervention was
so effective that they had to sign another agreement in 1987 - the Louvre Accord - to stop the further fall of the dollar. Prior to these
meetings, free floating exchange rates were considered the best but thereafter, the major countries began to cooperate more.

The main tenets of the Plaza-Louvre Accord, which still persists today, are:

1. Unannounced, soft target zones for the major currencies. Ordinarily the market is left to decide exchange rates but when
rates move out of the target zones, there should be joint intervention.
2. Interventions must be sterilised (i.e. central banks must soak up the inflows with bonds) such that the they do not affect the
domestic money supply.
3. Capital mobility must be preserved.

The Evolution of the Euro (1972-Present)

Seeking exchange rate stability in the wake of the Nixon Shock, Germany and several other European nations created a new system
in 1972 dubbed the “Snake in the Tunnel”, under which their currencies were kept within +/- 2.25% of each other and a band of
4.5% against the dollar. It didn’t live up to expectations however, with frequent realignments and a couple of wholesale withdrawals.
Essentially, there was a tug of war between Germany which favoured low inflation and other countries such as France which sought
to expand. In the absence of an overarching monetary/fiscal authority, strong-currency countries such as Germany couldn’t be
certain that weak-currency countries would undertake the necessary policy adjustments to maintain their pegs, so were loath to
intervene on their behalf.

The European Monetary System (EMS) was created by France and Germany in 1979 to resolve these deficiencies. Participating
currencies were still held within their bilateral margins of +/- 2.25% but were now accompanied by capital controls to allow a degree
of monetary policy autonomy. More importantly, a new entity - the European Monetary Fund - was established to provide credits
known as ecus to members experiencing balance of payment problems. In practice, the EMS was a Deutschmark-centred system
with German monetary policy serving as the nominal anchor – other countries reduced their inflation towards Germany’s which was
the lowest in Europe. This time none of participants had to withdraw and a far greater degree of exchange rate stability was
achieved, particularly after 1985.

In 1991, the EMS members were full of optimism. The EMS had proven resilient to the collapse of the USSR and German
reunification. In this spirit, they set out their commitment to monetary union under the Maastricht Treaty, agreeing that by 1999
they would:

1. hold their currency within the EMS band for at least two years
2. run an inflation rate over the preceding year that did not exceed that of the three lowest inflation member states by more
than 1.5%
3. reduce their public debt as a percentage of GDP and GDP growth to 60% and 3%, respectively
4. maintain a nominal long-term interest rate in the preceding year that did not exceed 2% of the three most price-stable
members

Yet the following year, the EMS faced its severest test. In mid-September, Britain crashed through its EMS limit and ignominiously
withdrew from the system, less than two years after joining. Italy likewise fell through its band and was forced to float but somehow
remained part of the system. Most other EMS currencies came under speculative pressure and were forced to realign. Essentially the
crisis stemmed from the inability of European governments to raise interest rates in the face of grinding recession but speculative
attacks such as that of George Soros’s on the pound also played a role, creating self-fulfilling crises in otherwise solvent national
economies.

Following the early 1990s crisis, the situation improved – with expansion in Europe, austerity became easier to implement and the
absence of laggards such as Britain removed a drag. EMS members locked in their exchange rates in 1999 and the euro was
introduced in 2002. The euro brought numerous benefits such as fewer disruptions to intra-European trade, improved price
transparency, and a reduced cost of capital for European firms. Yet there were several structural weaknesses with which we are now
well acquainted. Adapting to a single monetary policy wasn’t easy. Slow-growing economies such as Italy preferred looser European
Central Bank (ECB) policy and a weaker euro whilst fast growing economies such as Ireland preferred tighter policy to cool down
their overheated economies. Moreover, the interest rates of “convergence economies” – EU slang for poor, peripheral economies
such as Greece and Portugal - suddenly fell to German levels. Consumption and investment surged, and wages were pushed up
dramatically. After their booms, convergence economies were saddled with excessive wages, lagging competitiveness and increasing
unemployment, necessitating painful austerity measures.

Bretton Woods II (2000 - Present)

At the turn of the millennium a new system was emerging, dubbed Bretton Woods II. A savings glut in the Middle East and the Far
East was superimposed on a US savings drought, resulting in chronic US current account deficits.

From the late 1990s, China grew at a phenomenal rate, fuelled by investment of over 40% of GDP. National saving was even higher
at 50% of GDP. Middle Eastern oil exporters and other ASEAN countries also had savings gluts. The US meanwhile was in the throes
of the dot com boom, with investment levels exceeding national savings. The disparity between national investment and savings
grew still further when President Bush’s tax cuts reduced US government savings.

Accordingly, foreign governments parked their excess savings in US assets, chiefly treasuries. This status quo was tolerated by both
sides for different reasons. Asian export-orientated economies such as China were keen to accumulate dollar reserves to smooth
international payments and boost the competitiveness of their manufactured exports by holding down their currencies against the
dollar. The US on the other hand was able to service its debt more cheaply than would otherwise be the case and its residents were
able to live beyond their means, courtesy of the world’s developing nations. These global imbalances were christened Bretton
Woods II in homage the Bretton Woods era when Europe and Japan ran net surpluses against the US.

By 2005, the US changed its stance, blaming China and its neighbours for harming its domestic manufacturers and for not letting
their currencies rise. To forestall trade sanctions, China began letting the renminbi appreciate but only to a fraction of what was
required to restore balance globally. Understandably, it did not want to mess with economic success. China feared that suspending
its currency peg might trigger a dollar crash, harming global growth and causing it to suffer a loss on the value of its dollar reserves.

The Impossible Triangle

When it comes to the modern international monetary system, the Rolling Stones’ aphorism “You can’t always get what you want”
rings true. You want exchange rate stability, capital mobility and monetary independence but can only ever achieve two of these at
any given time. As we’ve seen, the Gold Standard and Euro combined capital mobility and currency stability but sacrificed monetary
independence. Conversely, Bretton Woods married stable exchange rates with central bank autonomy but imposed capital controls
so stringent that some travellers resorted to smuggling cash in hollowed loaves. The Washington Consensus, meanwhile, has been
marked by free capital flows and monetary policy autonomy but exchange rate instability.

Even allowing for the abovementioned trilemma, the current state of the international monetary system leaves a lot to be desired.
Chronic imbalances and the potential for long-term dollar devaluation cause considerable anguish to policymakers. Nevertheless, a
grand redesign along the lines of Bretton Woods is not likely to be imminent. The world has a great deal invested in the current
monetary status quo and there is no clear consensus on how the current system might be replaced. Historically, it has taken a major
upheaval such as a world war or the prospect of an immediate national bankruptcy to effect a transition, and it is not clear that the
late financial crisis constituted enough of a jolt. However, as witnessed during the twilight years of Bretton Woods, there comes a
point where nations take matters into their own hands; where their vested interest in not rocking the boat is surpassed by their
desire to escape a sinking boat. The nations of the Arabian Gulf have been mooting a return to a gold-based currency in recent years
and it is perhaps significant that the central banks of Russia and China have been steadily accumulating gold. And where
governments fear to tread, private citizens have been busily establishing their own monetary system courtesy of bitcoin.

In our next article, we shall consider what came before the modern international monetary system - a journey which will take us
from the money markets of Assyria and Babylon to the demise of bimetallism.

The history of international monetary system

1. The international monetary system refers to the institutional arrangements that countries adopt to govern exchange rates. It
consist of sets of internationally agreed rules, conventions, supporting institutions, instruments, and procedures, all of which are
involved in the international transfers of money that facilitate international trade, cross border investment, the reallocation of
capital between nation states and all other international business matters. Different international monetary systems posses different
features including flow of international trade and investment according to comparative advantage, Stability in foreign exchange and
should be stable, Promoting Balance of Payments adjustments to prevent disruptions associated with temporary or chronic
imbalances, Providing countries with sufficient liquidity to finance temporary balance of payments deficits, and Allowing member
countries to pursue independent monetary and fiscal policies. The international monetary system establishes the rules by which
countries value and exchange their currencies. It is the basis and system of international flow of money. HISTORY/ STAGES ON
INTERNATIONAL MONETARY SYSTEM The internationary monetary system that exist today has evolved over a period of more than
150 years. In the evolution process, several monetary system came into existance that either collapsed due to their weakness or
were modified to cope with the changing international economic order. These stages consist of the following 1.THE GOLD
STANDARD (1816- 1914) The gold standard involved Buying and selling of paper currency in exchange for gold on the request of any
individual of firm. In this system Gold is freely transferable between countries. Participants in this system included UK, France,
Germany & USA This is the first modern international monetary system, in this system each currency was linked to a weight of gold.
Under gold standard, each country had to establish the rate at which its currency could be converted to a weight of gold.

2. This system created a fixed exchange rate system because each country defined the value of its currency in terms of gold. Suppose
the US announces a willingness to buy gold for $200/oz and Great Britain announces a willingness to buy gold for £100. Then £1=$2
ADVANTAGES OF THE GOLD STANDARD SYSTEM 1. Highly stable exchange rates under the classical gold standard provided an
environment that was conducive to international trade and investment. 2. Misalignment of exchange rates and international
imbalances of payment were automatically corrected by the price-specie-flow mechanism DIFFICULTIES IN THE SYSTEM 1. The
problem was every country needed to maintain adequate reserves of gold in order to back its currency. 2.Also transacting in gold
was expensive, 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, and Moreover, because of the slowness of sailing ships contibuted to the failure of this system. DEMISE
OF THE GOLD SYSTEM In 1914 when the outbreak of the first world war crushed the first economic world order. 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. 2. THE BRETTON WOODS SYSTEM (1945-1971) On brettons
woods system. There was an agreement conference which was held in New hamisphere that created a post-war international
monetary system which consisted of 44 country represantatives. It created IMF( international monetary finance) and World bank to
promote international financial stability. IMF had agenda to foster global growth and economic stability while the world bank had a
primary function of lending to nations devastated by the world war.

3. Brettons woods system arised due to world war II impacts that created inflation, unemployment and an instable political situation.
Every country was struggling to rebuild their war-torn economy. The Bretton Woods system was a dollar-based gold exchange
standard. USD become the key currency, the U.S. dollar was pegged to gold at $35 per ounce and other currencies were pegged to
the U.S. dollar.. Exachange rate were arrowed to fluctuate by 1% above or below intial base price. The fixed exchange rate were
maintained by official intervation by central banks in the form of sales and purchase of dollars with the IMF providing the foreign
exchange rate. ADVANTAGES 1.Stabililty of exchange rates removed a great deal of uncertainity from international trade and
investment transactions 2.It also imposed a great deal of discipline on the participating nations economic policies. 3.Technical
aspects of the system had practical implications on the participating countries THE KEY DIFFERENCE BETWEEN GOLD STANDARD AND
BRETTON WOODS The key difference was that the dollar was the only currency that was backed by and convertible into gold on
breeton Woods system while on gold standard other currencies were also allowed to be convertible into gold THE DEMISE OF
BRETTONS WOODS STANDARD The system Bretton Woods worked well until the late 1960’s. The trade balance of the USA became
highly negative and a very large amount of US dollars was held outside the USA; it was more than the total gold holdings of the USA.
On 15th Aug. 1971, President Nixon suspended the system of convertibility of gold and dollar and decided for floating exchange rate
system and By March 1973, the major currencies began to float against each other in which values being determined by supply and
demand in the foreign-exchange market.

4. 3. EXCHANGE RATE REGIMES (FIXED AND FLEXIBLE) Exchange rate regime is the way an authority manages its currency in relation
to other currencies and the foreign exchange market. Exchange rates are affected by inflation differences and interest rates. An
exchange rate change is simply the price of one currency expressed in terms of another There various types of exchange rate
regimes but the two major exchange rate regimes are fixed exchange rate system and floating/flexible exchange rate system FIXED
EXCHANGE RATE SYSTEM A fixed, or pegged,rate is a rate the government (central bank) sets and maintains as the official exchange
rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as
the euro, the yen, or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own
currency on the foreign exchangemarket in return for the currency to which it is pegged. If, for example, it is determined that the
value of a single unit of local currency is equal to USD3.00, the central bank will have to ensure that it can supply the market with
those dollars. In order to maintain the rate, the central bank must keep a high level of foreign reserves. This is a reserved amount of
foreign currency held by the central bank which it can use to release (or absorb) extra funds into (or out of) the market. This ensures
an appropriate money supply, appropriate fluctuations in the market (inflation/deflation), and ultimately, the exchange rate. The
central bankcan also adjust the official exchange rate when necessary The purpose of a fixed rate system is to maintain a country’s
currency value within a very narrow band. ADVANTAGES OF FIXED EXCHANGE RATE SYSTEM 1. Avoid Currency Fluctuations. If the
value of currencies fluctuate significantly this can cause problems for firms engaged in trade. Example : If a firm relied on imported
raw materials a devaluation would increase the costs of imports and would reduce profitability

5. 2. Stability encourages investment. The uncertainty of exchange rate fluctuations can reduce the incentive for firms to invest in
export capacity. Some Japanese firms have said that the UK’s reluctance to join the Euro and provide a stable exchange rates maker
the UK a less desirable place to invest. 3. Keep inflation Low. Governments who allow their exchange rate to devalue may cause
inflationary pressures to occur. This is because AD increases, import prices increase and firms have less incentive to cut costs. 4. A
rapid appreciation in the exchange rate will badly effect manufacturing firms who export, this may also cause a worsening of the
current account. 5. Joining a fixed exchange rate may cause inflationary expectations to be lower 6.Helpful for Small Nations 7. It
promote international trade DISADVANTAGES OF FIXED EXCHANGE RATE SYSTEM 1. Conflict with other objectives. To maintain a
fixed level of the exchange rate may conflict with other macroeconomic objectives. · If a currency is falling below its band the
government will have to intervene. It can do this by buying sterling but this is only a short term measure. · The most effective way to
increase the value of a currency is to raise interest rates. This will increase hot money flows and also reduce inflationary pressures. ·
However higher interest rates will cause lower AD and economic growth, if the economy is growing slowly this may cause a
recession and rising unemployment 2. Less Flexibility. It is difficult to respond to temporary shocks. For example an oil importer may
face a balance of payments deficit if oil price increases, but in a fixed exchange rate there is little chance to devalue. 3. Join at the
Wrong Rate. It is difficult to know the right rate to join at. If the rate is too high, it will make exports uncompetitive. If it is too low, it
could cause inflation.

6. 4. Current Account Imbalances. Fixed exchange rates can lead to current account imbalances. For example, an overvalued
exchange rate could cause a current account deficit. 5. It does not reflect the true value of the currency 6. It may lead to the Black
markets emerge 7. It can be expensive or even impossible to hold FLEXIBLE EXCHANGE RATE SYSTEM A flexible exchange rate is
determined by the foreign exchange market through supply and demand. A flexible rate is often termed "self-correcting", as any
differences in supply and demand will automatically be corrected in the market. For example if demand for a currency is low, its
value will decrease, thus making imported goods more expensive and thus stimulating demand for local goods and services. This in
turn will generate more jobs, andhence an auto-correction would occur in the market. A floating exchange rate is constantly
changing. ADVANTAGES OF FLEXIBLE EXCHANGE RATE SYSTEM 1. Independent Monetary Policy. Under flexible exchange rate
system, a country is free to adopt an independent policy to conduct properly the domestic economic affairs. The monetary policy of
a country is not limited or affected by the economic conditions of other countries 2. Shock Absorber. A fluctuating exchange rate
system protects the domestic economy from the shocks produced by the disturbances generated in other countries. Thus, it acts as
a shock absorber and saves the internal economy from the disturbing effects from abroad 3. Promotes Economic Development. The
flexible exchange rate system promotes economic development and helps to achieve full employment in the country. The exchange
rates can be changed in accordance with the requirements of the monetary policy of the country to achieve the planned national
objectives 4. Solutions to Balance of Payment Problems. The system of flexible exchange rates automatically removes the
disequilibrium in the balance of payments. When, there is deficit in the balance of payments, the external value of a country's
currency falls. As a result, exports

7. are encouraged, and imports are discouraged thereby, establishing equilibrium in the balance of payment 5. Promotes
International Trade. The system of flexible exchange rates does not permit exchange control and promotes free trade. Restrictions
on international trade are removed and there is free movement of capital and money between countries 6. Increase in International
Liquidity. The system of flexible exchange rates eliminates the need for official foreign exchange reserves, if the individual
governments do not employ stabilization funds to influence the rate. Thus, the problem of international liquidity is automatically
solved. In fact, the present shortage of international liquidity is due to pegging the exchange rates and the intervention of the IMF
authorities to prevent fluctuations in the rates beyond a narrow limit DISADVANTAGES OF FLEXIBLE EXCHANGE RATES 1. Unstable
conditions. Flexible exchange rates create conditions of instability and uncertainty which, in turn, tend to reduce the volume of
international trade and foreign investment. Long- term foreign investments arc greatly reduced because of higher risks involved 2.
Adverse Effect on Economic Structure. The system of flexible exchange rates has serious repercussion on the economic structure of
the economy. Fluctuating exchange rates cause changes in the price of imported and exported goods which, in turn, destabilise the
economy of the country 3. Inflationary Effect. Flexible exchange rate system involves greater possibility of inflationary effect of
exchange depreciation on domestic price level of a country. Inflationary rise in prices leads to further depreciation of the external
value of the currency. 4. Low Elasticities. The elasticities in the international markets are too low for exchange rate, variations to
operate successfully in bringing about automatic equilibrating adjustments. When import and export elasticities are very low, the
exchange market becomes unstable. Hence, the depreciation of the weak currency would simply tend to worsen the balance of
payments deficit further

8. HOW DO COUNTRIES CHOOSE EXCHANGE RATE REGIMES The following are the Socio – Economic Variables that Affecting choice
of exchange rate regimes 1. Financial depth indicators. Deeper the financial markets prone to adopting Floating Exchange rates 2.
Openness, size, trade concentration and economic volatility indicators. A country is less likely to adopt a fixed exchange rate if it is
relatively large and closed, if its external trade is concentrated, and if the business cycle is more volatile. This suggests that what
matters for the choice of the exchange rate regime is the exposure to external shocks. 3. Political variables. Fragmented
policymaking calls for a Float probably because greater discretion makes it easier to settle conflicts among agents involved in the
decision-making process. The use of monetary policy to raise consensus in the elections 4. Inflation IMPORTANCE OF EXCHANGE
RATE REGIMES 1. Stock market trading 2. Symbolizes growth 3. Indicates Demand of currency 5. Position of currency in world
CONCLUSION In reality, no currency is wholly fixed or flexible. In a fixed regime, market pressures can also influence changes in the
exchange rate. Sometimes, when a local currency does reflect its true value against its pegged currency, a "black market" which is
more reflective of actual supply and demand may develop. A central bank will often then be forced to revalue or devalue the official
rate so that the rate is in line with the unofficialone, there by halting the activity of the black market. In a floating regime, the central
bank may also intervene when it is necessary to ensure stability and to avoid inflation; however, it is less often that the central bank
of a floating regime will interfere.

Fixed Exchange Rate System: Advantages and Disadvantages

Advantages:

(i) Elimination of Uncertainty and Risk:

The necessary condition for an orderly and steady growth of trade demands stability in exchange rate. Any undue fluctuations in
exchange rate cause problems to the plans and programmes of both exporters and imports.

In other words, incomes of export-earners and the cost of imports of the importers tend to become uncertain if the exchange rate
fluctuates. This uncertainty can be removed by a fixed exchange rate method. Further, the risks associated with international trade
and investment get minimised largely if exchange rates are not allowed to vary.

(ii) Speculation Deterred:

As exchange rate remains unchanged for a fairly long period of time, people expect that such rate would not change in the
immediate future. This then eliminates speculation in the foreign exchange market.

Further, as stability in the exchange rate over longish period eliminates the threat of speculation, it discourages the flight of capital.
In a world of free fluctuating exchange rate, the danger of the flight of capital is rather high as this kind of exchange rate induces
people to speculate. As exchange rates remain fixed, traders have a sense of confidence that international payments can be made
safely without the danger of losses.

(iii) Prevention of Depreciation of Currency:

In poor developing countries, one experiences BOP difficulties of a permanent type. Under the circumstances, any frequent changes
in exchange rate will tend to aggravate the BOP crisis, like continuous depreciation of home currency in terms of currencies of other
countries. In other words, unstable exchange rates result in depreciation of currencies. This can be prevented by the stable exchange
rate.

(iv) Adoption of Responsible Macroeconomic Policies:

Stable exchange rate system prevents government from adopting irresponsible macro- economic policies like devaluation of
currencies. Above all, under the fixed exchange rate system, deflationary policies can even be pursued to tide over the BOP deficit,
even without bringing any change in domestic policies.

(v) Attraction of Foreign Investment:

Exchange rate stability may encourage foreigners to perk their investible funds in a country. If the exchange rate changes rather
frequently, it will deter them to invest in a country. Of course, such foreign investment having multiplier effect leads to higher
economic growth.

(vi) Anti-inflationary:

Fixed exchange rate system is anti-inflationary in character. If exchange rate is allowed to decline, import goods tend to become
dearer. High cost import goods then fuels inflation. Such a situation can be prevented by making the exchange rate fixed.

Disadvantages:

(i) Speculation Encouraged:

In fact, uncertainty and, hence, speculative activities, tend to get a boost even under the fixed exchange rate system. Under a fixed
rate system, if a country faces huge BOP deficit then the possibility of speculation gets brightened. If the speculators can guess that
such BOP deficit will persist in the days ahead and the authority may go for a cut in foreign exchange rate then these people will be
more enthusiastic to sell domestic currencies in the foreign exchange market.

If such sale of home currencies continues for a longer period, the central bank will then be forced to reduce exchange rate, instead
of keeping it at the old fixed rate. Under the circumstance, speculators go on buying home currencies where exchange rates have
been reduced. This will make these people to earn profit. The Bretton Woods System of the IMF collapsed in 1971 because of such
speculation made with the US dollars.

(ii) Adequacy of Foreign Exchange Reserves:

For the effectiveness of a stable exchange rate, the necessary condition is the adequacy of holding, foreign exchange reserves. Poor
developing countries find it difficult to maintain an adequate volume of foreign exchange reserves. Speculators then anticipate
currency devaluation in advances if BOP needs to be corrected. Before 1970, fixed exchange rate, in fact, prevailed because of low
volume of global trade and, hence, low volume of foreign exchange reserves.

(iii) Internal Objectives of Growth and Full Employment Sacrificed:

When countries experience large and persistent deficits or ‘fundamental disequilibrium’ in BOP, they are down with the foreign
exchange reserves. Countries then opt for devaluation of their currencies and take some internal measures to reduce their deficits.

These harsh internal measures tend to contract economies. But the fallouts of these measures are rising prices and rising
unemployment. These then reduce economic growth. Thus, fixed exchange rate—in the ultimate analysis—go for currency
depreciation that results in lower economic growth and higher unemployment coupled with high inflation—the two most
undesirable and unpleasant macro- economic variables not liked by anyone.

(iv) International Competitive Environment Bypassed:

The continuous changes in international competitive environment do not get reflected under the fixed exchange rate system. Thus,
to make the home product more competitive in the foreign market, what is required is the change in domestic economic policies so
that the country’s export products get larger foothold in the foreign market. In other words, the fixed exchange rate system fails to
gloss over the international competitive environment.

This kind of exchange rate developed after the World War II. The International Monetary Fund set up by the Bretton Woods
Agreement of 1944 came into operation in March 1947. The period 1947-1971 came to be known as ‘fixed but adjustable exchange
rate system’ or ‘par value system’ or the ‘pegged exchange rate system’ or the ‘Bretton Woods System’.

As the Bretton Woods System collapsed, this exchange rate was abandoned in 1971. Several stop-gap measures were taken but
uncertainty and confusion in the exchange rate systems continued. Ultimately, in 1973, the world’s exchange rate system came to
be known as the ‘managed floating’—in the sense that currencies tend to float more or less freely in the foreign exchange market.

2. Pros and Cons of Each System

Since exchange rates and economies of all countries have experienced significant instability in 20th century, there have appeared a
lot of arguments concerning the choice of exchange rate system. Since the fixed exchange rate system has been widely used before,
there have been a lot of its supporters. The main their argument has been that floating exchange rates mean instability. However,
there appeared a number of researchers offering arguments in favor of floating exchange rate system.

2.1. Advantages of fixed exchange rate system

First of all, fixed exchange rates offer much greater stability for the enterprisers and stimulate international trade; since the
exchange rates stay on the same level, the importers and exporters can plan their policy without begin afraid of depreciation or
appreciation of the currency. Moreover, fixed exchange rates make the producers more disciplined, i.e. they are forced to keep up
with the quality of their production and to control the costs of the production to stay competitive compared to international
enterprisers. This advantage of fixed exchange rates allows the government to decrease inflation level and stimulate international
trade and economical growth in the long period [10, p. 37].

Secondly, it is believed that fixed exchange rates stimulate the reduction of speculative activity worldwide; but this statement is true
under the condition that the adopted exchange rates are profitable for the foreign dealers as well as for domestic ones (closer
examination of this condition shows us that monetary and fiscal policies attempting to protect domestic producers – which are often
required to preserve economical stability – violate this condition and therefore create the ground for speculative intervention).

2.2. Disadvantages of fixed exchange rate system

The main disadvantage of it is the high vulnerability of the economical system to speculative attacks. Any economy experiences
excess supply and demand in either national or foreign currency: and if the national banks are unable to cover the gap between the
existing resources and demand, the fixed rate needs to be changed; this situation reduces the positive effects of the fixed rate
exchange system and decreases the credibility of the currency.

One more disadvantage of this system is that if the government artificially supports the exchange rate, which is not adjusted to
changed economical condition, the development of the country’s economy is not as efficient as it could be if the rate was adjusted
to the situation. Moreover, interest rates, which directly depend on the exchange rate, can stop possible economical growth in case
of their disparity to market needs.

In the conditions when the national currency is tied to some international currency, there exists very significant dependence of the
condition of these countries’ economical stability. In this case the government is actually forced to solve the economical problems of
the countries, with currency of which it is linked. This situation creates the possibility for dominating countries to improve the state
of their economy at the expense of related countries with weaker economies; and at the same time destabilizes the market situation
in these related countries.

I think that taking into consideration the growing economical and political integration, the strengthening of the economical
connection between countries, the fast development of world trade and economical specialization, the advantages of fixed interest
rates do not cover the losses caused by the restrictions imposed by this system.

2.3. Advantages of floating interest rate system

The main advantage of this system is its flexibility and the possibility for the country’s economy to be quickly adjusted to changing
market conditions. If the balance of payments deficit is violated, the floating exchange rate system allows to adjust a currency
outflow or inflow into the country; this automatically makes the domestic goods either more competitive (in case of appreciation on
the currency market) or makes foreign goods more competitive (in case of the currency’s depreciation).

The second advantage of floating exchange rate system is that it automatically determines interest rates within the country and
therefore allows controlling the economical balance more effectively.

2.4. Disadvantages of floating rate exchange system

It is believed that this exchange rate system leads to instability on the market and does not stimulate the development of trade and
production; floating exchange rates destabilize economical situation and lead to economical crises. The instability of exchange rates
after the end of Bretton-woods system and the whole depression in world economy at that time illustrated this point of view;
however, with the flow of time the economists started regarding this system from a different point of view: the work of Milton
Friedman in 1953 opposed the common belief that instability was caused by the float of exchange rates. Friedman stated that
instability was caused by wrong economical policy of the governments and other factors, not depending on the exchange rates
mechanism. Indeed, the effects of flexible exchange rates on the stability of prices and production have appeared to be much
smaller than they were expected to be; for example, in Germany in 1980s the purchasing power of DM shifted from 20% above the
purchasing power of USD to 25% below this level, and then returned to 25% above USD purchasing power. According to the
predictions, this shift has to cause significant disbalance in German economy; but contrary to these assumptions, the changes were
very modest. It has appeared that most producers chose to keep up with the strategy of “pricing to market”. This means that the
prices of the goods remained stable in the currency of importing country, and therefore they were not heavily destabilized by the
shift in exchange rates.

The instability of exchange rates is the main argument of floating exchange rates opponents. However, besides Friedman’s
explanations, there have been other attempts to explain this great instability. For example, Dornbush in 1976 suggested that there
existed a phenomenon of “over-shooting”. This means that to be successful in the long run the economy needs to depreciate its
currency, in order to reduce inflation and stimulate economical growth. However, in the short period depreciation will cause the
decrease of interest rates and the fall of activity; in order to stimulate the activity of firms, the currency needs to be expected to rise
in future. The only variant that can provide depreciation in the long run together with the expected rise of the purchasing power of
the currency is the fall of the currency lower than it’s needed in the long run; for example, if the money supply of the country rises
by 5%, its currency needs to be depreciated by 5% in the long run – but to stimulate economical activity, the currency needs to be
depreciated by 15% with expected rise by approximately 10% (the so-called mechanism of “over-shooting”).

Another advantage of floating rate system is that it allows the government to introduce separate monetary and fiscal policies, which
is rather difficult under the conditions of a fixed exchange rate system. In general, the arguments between the supporters and
opponents of floating exchange rate system lie in the relation between the price paid for the instability of exchange rates and the
possibility to introduce independent monetary and fiscal policy, and therefore to adjust quickly to changing economical conditions.