NPTEL International Finance Vinod Gupta School of Management, IIT. Kharagpur.

Module - 7 International Monetary System: Paper Currency Standard, Purchasing Power Parity & Bretton Woods Agreement

Prepared by: Dr. A.K.Misra Assistant Professor, Finance Vinod Gupta School of Management Indian Institute of Technology Kharagpur, India Email: [email protected]

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Lesson - 7 International Monetary System: Paper Currency Standard, Purchasing Power Parity & Bretton Woods System

Learning Objectives: In this session, the historical development of currency system is outlined and also the transition from Gold Standard to the regime of autonomous paper currency standard is discussed.

Highlights & Motivation:

In this session, the following details about international monetary system are discussed.

• Paper Currency Standard

• Theories of Purchasing Power Parity

• International Monetary System- The Bretton Woods System

The session would help readers to understand the historical development of international monetary system, the operational aspects of gold standard and the autonomous paper currency standard.

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7.1 Paper Currency Standard & Purchasing Power Parity

With the breakdown of the gold standard during the period of the First World War, gold parities and free movements of gold ceased, therefore the mint par of exchange lost significance in the exchange markets. Exchange rates fluctuated far beyond the traditional gold points and there was complete confusion. Hence, to explain this phenomenon and the problem of determination of the equilibrium exchange between inconvertible currencies, the theory of purchasing power parity was enunciated.

The basic idea underlying the purchasing power parity theory is that the foreign currencies are demanded by the nationals of a country because it has power to command goods in its own country. When domestic currency of a nation is exchanged for foreign currency, what is in fact done is that domestic purchasing power is exchanged for foreign purchasing power. It follows that the main factor determining the exchange rate is the relative purchasing power of the two currencies. For, when two currencies are exchanged, what is exchanged, in fact, is the internal purchasing power of the two currencies. Thus, the equilibrium rate of exchange should be such that the exchange of currencies would involve the exchange of the equal amounts of purchasing power. It is the parity of the purchasing power that determines the exchange rate. Thus, the purchasing power theory states that exchange rate tends to rest at the point at which there is equality between the respective purchasing power of the currencies. In other words, rate of exchange between two inconvertible paper currencies tends to close to their purchasing power ratio. Hence, the Purchasing Power Theory (PPT)seeks to explain that under the system of autonomous paper standard the external value of a currency depends ultimately and essentially on the domestic purchasing power of that currency relative to that of another currency. The PPT has been presented in two versions, namely

(1) Absolute Version of Purchasing Power Parity and

(2) Relative Version of Purchasing Power Parity.

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7.1.1 Absolute Purchasing Power Parity

The absolute version of the purchasing power parity theory stresses that the exchange rates should normally reflect the relation between the internal purchasing power of the various national currency units.

The price of a tradable commodity in one country should theoretically be equal to the price of the same commodity in another country, after adjusting for the foreign exchange rate. The theory is known as the international law of one price. When the international law one price applied to the representative good or basket of goods, it is called the absolute purchasing power parity condition.

To illustrate the point, let us assume that a representative collection of goods costs Rs.9,625/- in India and US$ 195 in USA. As per the Absolute PPP theory, the exchange rate between US$ and Indian Rupee is the ratio of two price indices.

Spot price (In Indian Rupee) = Price Index of India/ Price Index of USA

Spot Rate = PRupee / PUSA

As per the example mentioned above, the exchange rate would be;

Spot (in Rupee) = 9625/195 = Rs.47.5128

The theoretical argument behind the Absolute PPP condition is that a country’s goods are relatively cheap internationally; goods market arbitrage would create pressure on both foreign prices and goods prices to correct, and thereby conform to uniform international prices.

7.1.2 Relative Purchasing Power Parity

Purchasing Power for two currencies can be different not because of differences in their internal purchasing power, but some other factors also. Relative purchasing power parity relates the change in two countries' expected inflation rates to the change in their exchange rates. Inflation reduces the real purchasing power of a nation's currency. If a country has an annual inflation rate of 5%, that country's currency will be able to purchase 5% less real goods at the end of one year. Relative purchasing power parity examines the relative changes in price levels between two countries and maintains the exchange rates, which will compensate for inflation differentials between the two countries.

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The relationship can be expressed as follows, using indirect quotes:

t St / S0 = (1 + iy) ÷ (1 + ix)

Where, S0 is the spot exchange rate at the beginning of the time period (measured as the "y" country price of one unit of currency x)

St is the spot exchange rate at the end of the time period.

iy is the expected annualized inflation rate for country y, which is considered to be the foreign country.

ix is the expected annualized inflation rate for country x, which is considered to be the domestic country.

Example

The annual inflation rate is expected to be 8% in the India and that for the US is 3%. The current exchange rate is Rs.46.5500/- per US $. What would the expected spot exchange rate be in six months for Indian Rupee relative to US$.

Answer: So the relevant equation is:

St / S0 = (1 + iy) ÷ (1 + ix)

0.5 = S6month ÷ Rs.46.5500 = (1.08 ÷ 1.03)

Which implies S6month = (1.023984) × Rs.46.550 = Rs.47.6665.

So the expected spot exchange rate at the end of six months would be Rs.47.6665 per US$.

Inflation, taxes, quality of products, and other circumstances that change the market also have bearing on the price or internal purchasing power. All these factors need to be adjusted while estimating the exchange rate under in-convertible paper currency standard. PPP theory may not reflect the true exchange rate in the short-run however; it actually indicates the fundamental equilibrium exchange rate in the long-run.

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7.2 : International Monetary System - The Bretton Woods System

Attempts were initiated to revive the Gold Standard after the World War I, but it collapsed entirely during the Great Depression of the 1930s. It was felt that adherence to the Gold Standard prevented countries from expanding the money supply significantly so as to revive economic activity. However, after the Second World War, representatives of most of the world's leading nations met at Bretton Woods, New Hampshire, in 1944 to create a new international monetary system. United States of America, at that time, was accounted for over half of the world's manufacturing capacity and held most of the world's gold, the leaders decided to tie world currencies to the US dollar, which, in turn, they agreed should be convertible into gold at $35 per ounce. Under the Bretton Woods system, Central Banks of participating countries were given the task of maintaining fixed exchange rates between their currencies and the US-dollar. They did this by intervening in foreign exchange markets. If a country's currency was too high relative to the US-dollar, its central bank would sell its currency in exchange for US-dollars, driving down the value of its currency. Conversely, if the value of a country's money was too low, the country would buy its own currency, thereby driving up the price. The purpose of the Bretton Woods meeting was to set up new system of rules, regulations, and procedures for the major economies of the world. The principal goal of the agreement was economic stability for the major economic powers of the world. The system was designed to address systemic imbalances without upsetting the system as a whole.

The Bretton Woods System continued until 1971. By that time, high inflation and trade deficit in the USA were undermining the value of the dollar. Americans urged Germany and Japan, both of which had favorable payments balances, to appreciate their currencies. But those nations were reluctant to take that step, since raising the value of their currencies would increase prices for their goods and hurt their exports. Finally, the USA abandoned the fixed value of the US-dollar and allowed it to "float" against other currencies, which led to collapse of the Bretton Woods System.

The Bretton Woods system established the US Dollar as the reserve currency of the world. It also required world currencies to be pegged to the US-dollar rather than gold. The demise of Bretton woods started in 1971 when Richard Nixon took the US off of the Gold Standard to stem the outflow of gold. By 1976 the principles of Bretton Woods were abandoned all together and the world currencies were once again free floating.

World leaders tried to revive the system with the so-called “Smithsonian Agreement” in 1971, but the effort could not yield. Economists call the resulting system a "managed float regime," meaning that even though exchange rates most currencies float, central Banks still intervene to prevent sharp changes. As in 1971, countries with large trade surpluses often sell their own currencies in an effort to prevent them from appreciating. Similarly, countries with large trade deficits buy their own currencies in order to prevent depreciation, which raises domestic prices. But there are limits to what can be accomplished through intervention, especially for countries with large trade deficits. Eventually, a country that intervenes to support its currency may deplete its international reserves, making it unable to

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At present almost all countries having their own paper currencies standard which is neither linked to gold or US-dollar or any other foreign currencies and they have adopted the currency system which is “managed floating” in nature.

References ¾ International Financial Management, 3nd Edition, by Eun and Resnick, Irwin, 2004. ¾ Multinational Financial Management by Jeff Madura, Thomson Publications ¾ Multinational Financial Management, by Alan C. Shapiro, Wiley India, 8th Edition. ¾ Barry Eichengreen 1 and Raul Razo-Garcia; “The international monetary system in the last and next 20 years”; Economic Policy, Vol. 21, Issue: 47, InterScience Publication

Model Questions 1. While describing the Purchasing Power Parity theory, articulate the difficulties of assessing exchange rates in case of inconvertible paper currency standard.

2. Discuss the arrangement, under Bretton Woods system, for international monetary stability.

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