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i “Chapter-2(3rd*Proof)” — 2011/2/5 — 10:08 — page 31 — #1 i i i International Monetary System IN THIS CHAPTER 2 Specie commodity standard Gold standard Decline of the gold standard Bre on Woods system Chronology of the Bre on Woods system Smithsonian arrangement Exchange rate system Independent oating Managed oating Currency pegging Crawling peg Currency band Snake and the Worm Currency boards European monetary system € : A single European currency Prospects of € Summary Questions Project work Case studies i i i i i “Chapter-2(3rd*Proof)” — 2011/2/5 — 10:08 — page 33 — #3 i i i International Monetary System The foreign exchange market allows currencies to be exchanged in order to facilitate international trade and commerce. MNCs depend on the foreign exchange market to exchange their home currency for a foreign currency and also to exchange a foreign currency they receive into their home currency. 2.1 SPECIE COMMODITY STANDARD In earlier days trade payments were settled through barter arrangement. On account of inconsistency and inconvenience, traders began using metals like gold and silver to settle the payments. Subsequently metals took the form of coins that had the stamp of sovereignty on the basis of weight and fineness of the metal and that was the beginning of the Specie Commodity Standard. The coins were called full-bodied coins meaning that their value was equal to the value of the metal contained in it. Over a period of time other metals with a lower value was mixed with the gold coin, as a result the value of the metal came to be lower than the face value of the coin. These coins were known as debased coins. Full-bodied coins were primarily used for store of value. To act as a store of value, coins must be able to be reliably saved, stored, and retrieved and also be usable as a medium of exchange when it is retrieved. The value of the money must also remain stable over time. The full-bodied coins were driven out of circulation by the year 1560 by the debased coins. The Coinage Act or the Mint Act of 1792, of the United States established dollar as the monetary unit of the country, declared it to be lawful tender, created a decimal system for the US currency and also fixed its value in terms of gold and silver. The mint ratio between gold and silver was 1:15 in the United States and 1:15.5 in France. Thus was the beginning of the bimetallic standard. In the beginning of 1800, the value of gold rose in comparison to silver, resulting in the removal from commerce of nearly all the gold coins, and their subsequent melting. The difference in the bimetallic standard between the US and the France led to the export of gold from the US to France for the purchase of silver. This led to diminution of gold stock in the US and the country was forced to adopt a mono metallic silver standard. Therefore in 1834, the 15:1 ratio of silver to gold was changed to a 16:1 ratio by reducing the weight of the nation’s gold coinage. This created a new U.S. dollar that was backed by 1.50 g (23.22 grains) of gold. However, the previous dollar had been represented by 1.60 g (24.75 grains) of gold. The result of this revaluation, which was i i i i i “Chapter-2(3rd*Proof)” — 2011/2/5 — 10:08 — page 35 — #5 i i i International Monetary System 35 The essential features of gold standard were: 1. The country adopting the gold standard shall fix the value of currency in terms of specific weight and fineness of gold and guarantees a two way convertibility 2. Export and import of gold shall be allowed so that it can flow freely among the countries adopting the gold standard 3. The apex monetary institution shall hold gold reserves in relationship to the currency it has issued and 4. The government shall allow unrestricted minting of gold and melting of gold coins at the option of the holder Since fixed weight of gold had formed the basis for a unit of the currency and since free flow of gold was permitted among the countries adopting the gold standard, the gold standard carried an automatic mechanism for domestic price stability, fixed exchange rates and adjustment in balance of payment. The exchange rate mechanism depended upon the content of gold in different countries. Let us say that the pound sterling contained a half ounce of gold and one dollar bill contained one fourth ounce of gold, the exchange rate was fixed at £1 = $2. The United States set the value of the dollar at $20.67 per ounce of gold and the British pound was pegged at £4.2474 per ounce of gold. Thus the dollar to pound ($/£) exchange rate was determined as follows: $20.67 per ounce of gold = $4.8665 per £ £4.2474 per ounce of gold The rate was known as the mint rate or the mint exchange rate. The actual exchange rate remained close to mint rate and the free flow of gold between the two countries ensured not much deviation in the exchange rate. This led to fixed parity between the currencies and helped to preserve the value of each individual currency in terms of gold. In the event of occurrence of a transportation cost or transaction cost, the dollar pound exchange rate would fluctuate above or below the fixed rate. Let us assume hypothetically that the value of the dollar had depreciated to $5 per £. This will give an opportunity for the arbitrageurs to move in. The arbitrageurs would buy one ounce of gold in the US for $20.67 and sell it in Great Britain for £4.24 and then exchange the pound for the dollar in the forex market for $5 $4.24 = $21.20, thus making a profit of $21.20 $20.67 = $0.53 per × − ounce. This process would continue till the original parity was established. i i i i i “Chapter-2(3rd*Proof)” — 2011/2/5 — 10:08 — page 36 — #6 i i i 36 International Financial Management The gold standard maintained a reasonable equilibrium through the principles of price-specie flow mechanism. This arrangement restored automatic adjustment in the balance of payments. Say, in the event Great Britain faced a deficit on its trade account leading to outflow of gold for trade settlement and reducing the money supply with in the country, the emerging deflation would make the British exports competitive and the resultant rise in exports would eventually wipe out any deficit on this account. On the other side, reduced money supply pushes up the interest rate and the credit restrictions imposed by the apex banks will push up the bank interest rate, resulting in the foreign investment moving into the economy and off-setting any deficit on the capital account. 2.3 DECLINE OF THE GOLD STANDARD The gold standard as an international monetary system was accepted by most of the countries until the First World War broke out in 1914. The warring nations required huge money supply for financing the activities borne out of war. This was not possible under the gold standard. The strained relations among the warring nations further impeded the free flow of gold from one nation to another. The exchange rate parity hither to followed by the various nations went hay wire. At the onset of the war, US corporations had large debts payable to European entities, who began liquidating their debts in gold. With debts looming to Europe, the dollar to British pound exchange rate reached as high as $6.75, far above the parity of $4.8665. This caused large outflow of gold. In July 1914, the New York Stock Exchange was closed and the gold standard was temporarily suspended. In order to defend the exchange value of the dollar, the US Treasury authorised state and nationally-charted banks to issue emergency currency under the Aldrich-Vreeland Act, and the newly-created Federal Reserve organised a fund to clear the debts to foreign creditors. These efforts were largely successful, and the Aldrich-Vreeland notes were retired starting in November 1914 and the gold standard was restored when the New York Stock Exchange re-opened in December 1914. As the United States remained neutral in the war, it remained the only country to maintain its gold standard, doing so without restriction on import or export of gold from 1915-1917. US also banned gold export, thereby suspending the gold standard for foreign exchange. US demanded repayment of war debts from France and France asked compensation from Germany to meet the war debt. The United States finally joined the war in 1917. Already it enjoyed a huge trade surplus with the European Nations. Hence the dollar became stronger and the European currencies became weaker and the United States began to assume the role of the leading creditor nation. For the reasons mentioned above, the gold standard was suspended during the First World War. After the end of the First World War, the nations on the gold standard during the pre-war years came back to it. The United States returned to gold in 1919, the Great Britain in i i i i i “Chapter-2(3rd*Proof)” — 2011/2/5 — 10:08 — page 37 — #7 i i i International Monetary System 37 1925, France in 1926 and Switzerland in 1928. All other European countries followed soon after.
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