EXCHANGE RATE SYSTEM

GROUP MEMBERS Ronak Shah 115

Shreyas Mehta 116

Shaily Mehta 117

Libin Moni 118

Introduction• International Transactions have to

effect payment from one party to other party

• Payments may be gifts or remittances

• Trade of merchandise as well as services is to be considered

• Capital Purchases have a different modes of payment such as forfeiting

What is Money???

• Store Value

• Medium of Exchange

• Unit of account

Barter System works when two individuals each possessing a commodity the other wanted or needed would enter into an agreement to trade their goods

Limitations:-

Lack of Transferability

Lack of Divisibility

Problem of Stocking

Fair Pricing

To solve the problem of barter system came commodity money

It is a kind of currency based on the value of underlying commodity

They are widely desired , valuable, durable, portable and easily storable

In past salt, tea, tobacco, cattle and seeds were commodities & therefore were once used as money

Metal objects were introduced as money around 5000 B.C

Metal was used because it was readily available, easy to work with & could be recycled

Earliest Paper Money became common from about AD 960 onwards in China

With the introduction of Paper Currency, Commodity Money evolved into representative money

Representative money has now been replaced by Fiat Money

Fiat Money is paper or low value metal coins) money authenticated by the government

Fiat is the Latin word for “let it be done”

Money is now given value by a government fiat or decree, in other words enforceable legal tender laws were made

Years Form of moneySome time unknown Barter

9000 BC to 6000 BC Cattle

1200 BC Cowries shells

1000 BC First metal money and coins

500 BC Modern coin age

118 BC Leather money

806 AD Paper currency

1816 AD Gold standard

There are three known kinds of gold standard that have been adopted since the early 1700s - gold specie, gold exchange, gold bullion standards

In this gold standard, the unit of currency is linked to the gold coins that are in circulation

More specifically, the monetary unit is associated with the unit of value of a specific gold coin in circulation along with that of any secondary coinage (coins made of metal that is valued less than gold)

The central bank of the country concerned had to back the currency, promising to buy or sell the metal in unrestricted amount at the price fixed

Extending this reasoning, a person who possessed gold could approach the State mint and have the right to have coin struck from gold, whatever the amount

By the same reasoning, he could also melt the gold as and when he wished to do so;Gold could be freely imported and exported

Money in circulation is a paper note

On these notes is the written promise of monetary authorities that if you demand, on submission of this note, they would give you specified quantity of gold

This means currency is pegged with gold

Unconditional conversion

We can say in this gold standard , gold bullion is sold on demand at a fixed cost. The currency-to-bullion ratio i.e. sold on demand at a fixed cost

In this mechanism, money in circulation is a paper note or coins of lesser valuable metals

On these notes/low-value-metal-coins was the promise by monetary authorities to give specified number of notes/gold coins of other specified country’s currency ,on demand

This means currency is pegged with the other currency

The other specified currency was either in the form of gold coin itself or paper notes with the promise to give gold on submission by monetary authority of that country

Mechanism of Exchange of Two Currencies

It imposes discipline on policy makers regarding expansion of money supply as it is limited by reserve of gold with them

Control on money supply, so it has in-built anti-inflationary system

Exchange rates are more stable

Exchange rates are more predictable

They should never change the ratio of conversion of paper money to gold

They should be ready to convert unlimited amount of paper currency to gold at any time whatsoever

There should not be any restriction on transfer of gold from one country to another. It should be free flow in all respects

They should issue notes exactly proportionate to the quantity of gold they have in reserve

If this quantity decreases, they should reduce note in circulation contracts of money supply)

It imposes very rigid discipline on the policy makers and monetary authority

In order to adhere to success elements, often many economic compromises and sacrifices are required. For instance , full employment may not be targeted

Political cost of such compromises is very high

It is not possible to maintain gold parity ratio) in critical times such as war, earthquake

Free trade of gold with all countries all the time is not practical in order to prevent permanent loss of gold

The USA undertook to convert the US Dollar freely into gold at a fixed parity of $ 35 per ounce. (1 ounce = 28.35 grams)

Other countries agreed to maintain their currencies at specific parties with US Dollar. 1% variation in this parity was allowed

If the exchange rate of these member countries tended to exceed this 1% limit, then their monetary authorities shall take the necessary measures to restore it

This was supposed to be done by buying or selling dollars. For example, if their market is buying dollars heavily, then authorities should sell dollars in order to maintain the parity

In order to follow this parity-maintaining obligation, if required, member countries may borrow from IMF

If there is a genuine problem in maintaining parity to a particular member country, then it can change its parity itself by 10% (+ or -), without consulting IMF

If it desired to exceed 10% limit, it has to inform IMF and seek its consent. Because of this feature, this system was often referred as ADJUSTABLE PEG SYSTEM

Adjustable Peg System An adjustable peg exchange rate is a

system where a currency is fixed to a certain level against another strong currency such as the Dollar or Euro

Usually the peg involves a degree of flexibility of 2% against a certain level

However, if the exchange rate fluctuates by more than the agreed level, the central bank needs to intervene to maintain the target exchange rate peg

Dollar was the universally accepted exchange currency

US did not have freedom to change gold parity of its currency

All other countries were willing to accumulate dollars by selling goods and services to US

US can buy these goods from other countries by simple ‘printing’ dollars

Reason for collapse ofBRETTON WOOD SYSTEM

The system was dependent on dollar as the key currency

United States free from external economic pressures

Member countries were not willing to accept the high inflation rates

Another fundamental problem was the delayed adjustment of the parties to changes in the economic environment of the countries

IMF members have been free to choose any form of exchange arrangement they wish

By allowing the currency to float freely

pegging it to another currency or a basket of currencies

adopting the currency of another country,

participating in a currency bloc or forming part of monetary union

Exchange Arrangements with No Separate Legal Tender

Currency Board Arrangements

Other Conventional Fixed Peg Arrangements

Pegged Exchange Rates within Horizontal Bands

Crawling Pegs

Exchange Rates within Crawling Bands

Managed floating with no Predetermined Path for the Exchange Rate

Independently Floating

I. Fixed (pegged) with one currency (Hard peg or Conventional peg)

Features Central banks buy and sell currencies at

fixed price

Defending of Currency Rate

Central Bank hold foreign currency

Central Bank ultimately devalues its currency

ADVANTAGES

Certainty of Exchange Rate Less inflationary Smooth working Prevents monetary shock

DISADVANTAGES

Heavy burden Need sufficient reserves Fails to solve balance of payments Does not prevent real shocks No long term solution

ll. Free Float and Independent Float (Flexible Exchange Rate System)

ADVANTAGES Simple operation, smoother, more fluid

adjustment Brings realism in forest transactions Disequilibrium in balance of payment

auto stabilize No need to manage exchange rate Prevents real shocks Reinforces monetary policy

effectiveness

DISADVANTAGES

Exchange rate risk to exporters and importers which need to be hedged

Adverse effect of speculation

Encourages inflation

Crawling peg system is that there exists an exchange rate which equilibrates the international supply and demand for particular currency

Possibilities The peg he allowed to ‘crawl’ not more than

one sixth of 1 % in any one month, with the timing of such changes subject to the discretion of govt. officials

Adopt a plan such that the peg’s crawl is automatic. the rate would be allowed to move freely within a band around the crawling peg

Snake in tunnel

The concept was accepted by the European Economic Community since 1972,though was called differently as Joint Float Snake

The graph of the currency moving against each other would look like snake in tunnel

In 1978 snake turn into a worm

Liberalized Exchange Rate Management System

Under the LERMS, 40 percent of foreign exchange earnings had to be surrendered at an official rate determined by the reserve bank

The balance 60 percent of exchange earnings were to be converted at rates determined by the market