Table of Contents

Introduction of Modern International Monetary System..............................................2

I. Gold System.................................................................................................................3
II. II. Bretton Woods System................................................................................................3
III. III. Floating Exchange Rate System................................................................................4
IV. Analysis of the Fixed Exchange Rate System..................................................................5
V. Analysis of the Floating Exchange Rate System.............................................................9
VI. The Reason Behind the Weakening of the U.S. Dollar.................................................11
VII. I. Monetary Policy.........................................................................................................11
VIII. II. Inflation.....................................................................................................................12
IX. III. Demand for Currency..............................................................................................12
X. IV. Economic Growth....................................................................................................12
XI. Summary..........................................................................................................................14References.........
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Describe the development of the modern international monetary system, and analyse the ‘fixed’ as well as
the ‘floating’ exchange rate system. Next, describe the reasons for the weakening of the U.S. dollar value
against other major currencies.

1.0 Introduction of historical development of the modern international monetary system

The present international monetary system has its origin in the ancient trading system of exchanging goods
and services for gold or silver which were the mediums of exchange then. However, this system has evolved
through what is known as the Gold Standard, followed by the Bretton Woods, a fixed exchange rate system
and the present floating exchange rate system.

1.1 Introduction of three modern international monetary systems.

1.1.2 The Gold Standard

This system of pegging currencies to gold and guaranteeing its convertibility into gold is known as the Gold
Standard. 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. This system created a fixed
exchange rate system because each country defined the value of its currency in terms of gold. The United
States devalued its dollar price of gold from USD20.67 per ounce to USD35.00 per ounce, effectively
making its exports cheaper and increasing the price of imports.

1.1.3 The Bretton Woods System

Towards the end of the Second World War, the Allied powers came together in 1944 to plan a new
economic order for the post-war world which would avoid a repeat of the disastrous policy mistakes of the
1920s and 1930s. At the conference in Bretton Woods, New Hampshire, 44 Allied countries met under the
intellectual leadership of Harry Dexter White a senior US Treasury official and John Maynard Keynes. The
Bretton Woods Agreement created two Bretton Woods Institutions, the IMF and the World Bank. Formally
introduced in December 1945 both institutions have withstood the test of time, globally serving as important
pillars for international capital financing and trade activities. The purpose of the IMF was to monitor
exchange rates and identify nations that needed global monetary support. The World Bank, initially called
the International Bank for Reconstruction and Development (IBRD or popularly known as the World Bank)
was established to manage funds available for providing assistance to countries that had been physically and
financially devastated by World War II. In the twenty-first century, the IMF has 189 member countries and
still continues to support global monetary cooperation.
1.1.4 The Floating Exchange Rate System

The floating exchange-rate system emerged when the old IMF system of pegged exchange rates collapsed.
The case for the pegged exchange rate is based partly on the deficiencies of alternative systems. The IMF
system of adjustable pegs proved unworkable in a world in which there were huge volumes of
internationally mobile financial capital that could be shifted out of countries in balance-of-payments
difficulties and into the stronger nations. The gold standard, it is widely held, made the Great Depression of
the 1930s even deeper than it might otherwise have been. Followed by the collapse of the fixed exchange
rate system, member countries of the IMF met in Jamaica in 1976 to formalise new rules for the
international monetary system. There are main three elements of the Jamaica agreement. First, acceptance of
floating rates and allowing IMF member countries to intervene in the foreign exchange markets to stabilise
their currencies. Seconds, gold was abandoned as a reserve asset. Gold deposited with the IMF as reserves
were returned to member countries at market price. Finally, amount of contribution to the IMF by member
countries was increased to USD41 billion (since increased to USD300 billion and membership has now
increased to 189 countries).
2.0 The 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 exchange market 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. The central
bank can 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. There are benefits and risks to using a fixed
exchange rate system.

2.1 Three Strengths of the fixed rate system

i. Elimination of Uncertainty and Risk

A fixed exchange rate is typically used to stabilize the exchange rate of a currency by directly fixing its
value in a predetermined ratio to a different, more stable, or more internationally prevalent currency to
which the currency is pegged. The first strengths of the fixed rate system is 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. For an example, if a firm relied on imported raw materials a devaluation would
increase the costs of imports and would reduce profitability.

ii. Speculation Deterred

The second strengths of the fixed rate system is 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

The third strengths of the fixed rate system is 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.
2.2 Three Weakness of the fixed rate system

I. Speculation Encouraged

The first weakness of the fixed rate system is 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

The second weakness of the fixed rate system is 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

The third weakness of the fixed rate system is 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 to the two most undesirable and
unpleasant macro-economic variables not liked by anyone.
 III.0 The floating exchange rate system.

A floating exchange rate is a regime where the currency price of a nation is set by the forex 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. Floating exchange rate systems mean long-term
currency price changes reflect relative economic strength and interest rate differentials between countries.
Short-term moves in a floating exchange rate currency reflect speculation, rumours, disasters, and everyday
supply and demand for the currency. If supply outstrips demand that currency will fall, and if demand
outstrips supply that currency will rise. Extreme short-term moves can result in intervention by central
banks, even in a floating rate environment. Because of this, while most major global currencies are
considered floating, central banks and governments may step in if a nation's currency becomes too high or
too low.

3.1 Three Strengths of Floating Exchange Rates

i. Automatic Stabilisation

Any disequilibrium in the balance of payments would be automatically corrected by a change in the
exchange rate. For example, if a country suffers from a deficit in the balance of payments then, other things
being equal, the country’s currency should depreciate. This would make the country’s exports cheaper, thus
increasing demand, while at the same time making imports expensive and decreasing demand. The balance
of payments equilibrium would therefore be restored. On the contrary, a balance of payments surplus would
be automatically eliminated through a change in the exchange rate.

ii. Freeing Internal Policy

Under the floating exchange rate system the balance of payments deficit of a country can be rectified by
changing the external price of the currency. On the country if a fixed exchange rate policy is adopted, then
reducing a deficit could involve a general deflationary policy for the whole economy, resulting in unpleasant
consequences such as unemployment and idle capacity. Thus, a floating exchange rate allows a government
to pursue internal policy objectives such as full employment growth in the absence of demand-pull inflation
without external constraints such as debt burden or shortage of foreign exchange.

iii. Absence of Crisis

The periods of fixed exchange rates were frequently characterised by crisis as too much pressure was put on
central bank to devalue or revalue the country’s currency. However, the central bank that devalued a
currency by giving out too much of it would soon either stop or run out of it. Similarly the central banks that
revalued a currency by giving out too little of it in exchange for other currencies would soon be flooded with
that currency as it would get relatively large amounts of other currencies. Under floating exchange rate
system such changes occur automatically. Thus, the possibility of international monetary crisis originating
from exchange rate changes is automatically eliminated.

3.1 Three Weakness of Floating Exchange Rates

i. Uncertainty and Confusion

Flexible exchange rate and trade presents an atmosphere of uncertainty and confusion in trade and
investment. Susceptibility to uncertainty is greater as soon as exchange rate fluctuates freely. Suppose an
Indian has despatched an export ‘invoice’ to the foreign buyers. But the Indian exporters do not know at
what price foreign currency will be converted into Indian currency. This kind of uncertainty hampers trade.
However, such uncertainty can be largely minimised through forward exchange contracts. The uncertainty
involved in this kind of exchange rate may cause trading community to lose some confidence in the system.

ii. Hampering Investment

Unregulated free- floating exchange rate often discourages foreign investment as exchange rate becomes
erratic and, hence, destabilising. Because of the uncertainty associated with this exchange rate involving
profit and loss implications of foreign investment deals, a country might experience decumulation of capital.
Hence it is destabilising in effect.

iii. Risk, Instability, and Speculation

Flexible exchange rate encourages wide speculation since foreign exchange prices are not known in advance
as in fixed exchange rate. It is because of speculation there occurs disruptive hot money flows. To put it
elaborately, it can be argued that when the exchange rate tends to decline, speculators anticipate that such
would continue to decline further and the possibility of the flight of money to another country will brighten.
This will then cause a further fall in the exchange rate. Thus, greater the speculation against a currency, the
deeper the economic crises.
 4.0 Reason behind the Weakening of the US Dollar.
i. Monetary Policy

In the United States, the Federal Reserve the country’s central bank, usually just called the Fed implements
monetary policies to either strengthen or weaken the U.S. dollar. At the most basic level, implementation of
what is known as “easy” monetary policy weakens the dollar, which can lead to depreciation. So, for
example, if the Fed lowers interest rates or implements quantitative easing measures such as the purchase of
bonds, it is said to be “easing.” Easing occurs when central banks reduce interest rates, encouraging
investors to borrow money. Since the U.S. dollar is a fiat currency, meaning that it is not backed by any
tangible commodity (gold or silver), it can be created out of thin air. When more money is created, the law
of supply and demand kicks in, making existing money less valuable.

ii. Inflation

There is an inverse relationship between U.S. inflation rate versus its' trading partners and currency
depreciation or appreciation. Relatively speaking, higher inflation depreciates currency because inflation
means that the cost of the goods and services are rising. Those goods then cost more for other nations to
purchase. Rising prices decrease demand. Conversely, imported goods become more attractive to consumers
in the higher inflation country to purchase.

iii. Demand for Currency

When a country’s currency is in demand, the currency stays strong. One of the ways a currency remains in
demand is if the country exports products that other countries want to buy and demands payment in its own
currency. While the U.S. does not export more than it imports, it has found another way to create an
artificially high global demand for U.S. dollars.

The U.S. dollar is what is known as a reserve currency. Reserve currencies are used by nations across the
world to purchase desired commodities, such as oil and gold. When sellers of these commodities demand
payment in reserve currency, an artificial demand for that currency is created, keeping it stronger than it
might otherwise have been.

In the United States, there are fears that China’s growing interest in attaining reserve currency status for the
Yuan will reduce demand for the U.S. dollars. Similar concerns surround the idea that oil-producing nations
will no longer demand payment in U.S. dollars. Reduction in the artificial demand for U.S. dollars is likely
to depreciate the dollar.

iv. Economic Growth

Strong economies tend to have strong currencies. Weak economies tend to have weak currencies. Declining
growth and corporate profits can cause investors to take their money elsewhere. Reduced investor interest in
a particular country can weaken its currency. As currency speculators see or anticipate the weakening, they
can bet against the currency, causing it to weaken further
5.0 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
unofficial one, 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.