Exchange Rate Arrangement

Exchange Rate Arrangement

The nature of exchange rate arrangement has undergone changes over past couple of centuries. There was a time when costly metal was used as medium of international exchange of commodities under a specific arrangement, known as commodity specie standard, It was followed by gold standard that was a more sophisticated version of the exchange rate arrangement and that had set rules. It enjoyed merits, but at the same time, there were some limitations to that system that led to its suspension for some time and subsequently to its abandonment. The abandonment of the gold standard led to upheavals in the exchange rates and then to check it, the-IMF was established. These different regimes need some explanation.

 

• Commodity Specie Standard

Under the commodity specie standard, the value of the commodities was expressed in terms of gold and silver coins that were used for the settlement of international payments. There was a fixed ratio between the gold coin and the silver coin. It was known as the mint ratio. For example, the mint ratio was 15.5:1 between silver and gold coins in France during the early nineteenth century.

In many cases, coins were full-bodied coins meaning that the value of the metal used in the coin was the same as its face value, In other cases, there were debased coins with greater face value than the value of the metal used in them.

 

• Gold Standard

Although pound had been minted of gold as far back as in the 17th century, gold standard originated in England in 1816 when gold became the official tender. By 1870s, gold standard stood widely accepted among countries and it reigned with full fervor till the outbreak of the Great War in 1914.

 

• Forms

Gold standard had three forms; One was the gold specie standard in which coins were minted of gold. The paper currency could be converted into gold on demand. The price of gold was fixed under law. The second form was the gold bullion standard with no compulsion to mint gold coins, Paper currency was not convertible into gold on demand; rather gold bars could be bought from the central bank at fixed rates. The third was the gold exchange standard with no compulsion to mint gold coins, nor the exchange of paper currency into gold either on demand or through purchase of gold bars. The currency being on gold exchange standard was convertible into the currency being on the gold specie standard and the latter was convertible into gold, For example, rouble could be exchanged for gold via British pound.

Whatever the form might be, there was no restriction on the inter-country flow of gold. The central bank of a gold-specie/gold bullion standard country did have 100 percent backing of gold behind its currency.

Broad Rules:- The broad rules of the gold standard were manifest in automatic mechanism for;

1. 1. Fixed exchange rate.
   2. Adjustment in the balance of payments.
   3. Domestic price stability.

The exchange rate depended upon the content of gold in different currencies. In practice, one ounce of gold was then valued at £ 4.24 and the same weight of gold with similar fineness was valued at $ 20.67. Naturally, one pound was exchanged for $ 20.67 14.24 or $ 4.87. This rate was known as mint parity or mint exchange rate. The actual exchange rate remained close to mint parity because free flow of gold between two countries helped avoid any major deviation. Suppose the value of dollar depreciated to $ 5.25/£, the arbitraguer would buy one ounce of gold in the United States for $ 20.67 and sell it in the United Kingdom for £ 4.24 and then they could exchange the pound for dollar in the foreign exchange market for $ 5.25 x 4.24 = $ 22.26. This brought them a profit of $ 22.26 – 20.67 = $ 1.59. The process of arbitrage continued till the original parity was reestablished. It may be noted that this process involved transaction cost or transportation cost of gold that might not help equate the actual exchange rate to mint parity. But the difference from the mint parity was limited to only that amount.

Turning to automatic adjustment in the balance of payments, one finds that any deficit was made up through price-specie flow. Suppose that England faced a deficit on trade account. It could lead to outflow of gold for the settlement of trade. The outflow of gold lessened the money supply within the country. The emerging deflation in the wake of shrinkage of money supply would make the English exports competitive. This led to a rise in the export wiping out any deficit on this account.

There was one more explanation for automatic adjustment in the balance of payments. Reduced money supply raised interest rate. The banking system restricted credit in view of reduced money supply and to this end the central bank raised the bank rate. Ultimately, in lure of higher interest rate, foreign investment moved into the economy meeting any deficit on the capital account.

Last but not least, domestic price was stable. Currency was backed fully by gold. Money supply was constant in view of constant gold reserves. With constant money supply, prices were constant. Any deviation could occur only after discovery of gold mines that was the case in the USA when Californian gold mines were discovered in 1847. Prices increased and this increase was transmitted to other countries through the flow of gold.

 

• Suspension And Subsequent Abandonment

Gold standard was not tenable during the War. It is because the War needed greater amount of money, but the printing of currency was not possible in view of 100 percent backing of gold behind the currency. So it was suspended. After the War, when it was readopted, the international economic scenario was-too different to sustain it, Germany and Austria were in the grip of hyperinflation. Pound stood over-valued when France devalued its currency. And again, the expansionary monetary policy was to be introduced to combat the Great Depression of 1930s that was not feasible under the gold standard. In short, the gold standard of the inter-War years failed to fit in the changed international economic scenario. Finally, the UK abandoned it in 1931. The USA got rid of it in 1933 and France took the step in 1936.

 

• IMF And The Fixed Parity System

What led to the establishment of the IMF in 1945? In fact, after the abandonment of the gold standard, the exchange rate fluctuated widely. That, in turn, affected the global trade. It is true that the currency areas were created in 1930s. The intro-area exchange rate was fixed, but there was no control on the inter-currency area exchange rate. Thus in order to bring the situation under control, it was resolved at the Bretton Woods Conference of 1944 to create an international monetary institution that could design the exchange rate system based on then international economic scenario and could have surveillance over it. The IMF came into being as a Bretton Woods child.

 

• Broad Features

What were the features of the exchange rate regime then designed ? The exchange rate regime was known as the fixed parity system with adjustable pegs. In fact, it was designed at Bretton Woods and so it was also known as the Bretton Woods exchange rate system.

In the fixed parity system, each member country was to set a fixed value-called the par value of its currency in terms of gold or US dollar. It was the par value that determined the rate of exchange between two currencies. Minor fluctuations in the exchange rate within a narrow band of one per cent above and below the established parities could not be ruled out. They were to be corrected through active intervention of the monetary authorities of that country.

It may, however, be mentioned that the fixed parity under the Bretton Woods system was not like that of gold standard of 1880-1914. It was a fixed parity with adjustable peg meaning that any member country could alter the value of its currency or, in other words, could devalue its currency in case of “fundamental disequilibrium” in the balance of payments. Changes up to five per cent did not require prior approval of the IMF, but beyond it, IMF’s approval was necessary. Fundamental disequilibrium was never formally defined; but in practice, it meant continued and chronic balance of payments problem and colossal loss of reserves. The purpose of the adjustable peg system was, therefore, to establish a balance between the objectives of stable exchange rates and the macro-economic goals of the countries going for such adjustments as also to help avoid any use of exchange control and trade-restrictive measures. In other words, it brought flexibility in the fixed exchange rate system for the purpose of attaining equilibrium in the balance of payments. The provisions also contained cautions so that there might not be competitive devaluation. It was maintained through supervision and scrutiny over desired exchange rate changes.

Again, an important aspect of the Bretton Woods exchange rate system was that the US dollar was convertible into gold at a fixed rate of $ 35 a troy ounce of gold. The other currencies were convertible into gold via US dollar. This currency was given the position or intervention currency in the system in view of the fact that in the immediate post-War period, it was the strongest currency. This system was, therefore, likened with the gold exchange standard where countries redeemed their currency into gold-convertible currency and not necessarily into gold directly. In the post-War system, the US dollar came to be the intervention currency what was the British pound during the early decades of the twentieth century.

 

• Collapse Of The System

The system performed well during 1940s and till late 1950s. The US dollar did do well as an intervention currency insofar as it was as good as gold in view of the strong position of the US economy. The central bank in many countries held the dollar-denominated securities as reserves. But when the US balance of payments began experiencing growing deficits on account of widening trade deficit and outflow of dollar, the real value of dollar turned lower compared to its nominal value. It shook confidence in dollar and the central banks began converting the US dollar denominated securities into gold. It led to the outflow of gold from the USA that in turn slashed further the real value of dollar. A vicious circle emerged between falling real value of dollar, loss of confidence in dollar, conversion of US dollar denominated securities into gold and the outflow of gold from the USA. The outflow of gold was so huge in August 1971 that the then President Nixon suspended the convertibility of US dollar into gold. This decision threatened the very fundamentals of the fixed parity system.

In order to bring back confidence in US dollar, the Smithsonian Committee resolutions of December 1971 devalued dollar and re-valued upwardly some major currencies. At the same time, the normal fluctuation band was widened to +/- 2.25 per cent. But the Smithsonian measures failed to generate confidence. A few currencies came on to float, and finally, the fixed parity system collapsed in February 1973.

A committee was formed to suggest a feasible system. The new system, as suggested by the Committee, provided various options to the member countries. The member countries adopted them depending upon their convenience, although the system was given a legal shape through amending the Articles of Agreement of the IMF that came into force from April 1978. The system is still in vogue.

 

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