International Exchange Rate, Traditional Gold Standard - Assignment Example

Monetary exchange rate plays an important role in international trade. Different countries have different currency and to make an exchange of the same in terms of global trade is a challenging task. This currency exchange rate keeps on fluctuating on basis of various factors which affects its volatility. Countries develop different monetary policy as per the economic environment prevailing in their respective country. This monetary policy depends on various factors such as inflation or deflation rate, purchasing power of the currency, recessions, economic stability etc and exchange rate plays an important role in all these factors. International exchange rate has gone through various changes right from its vey inception in the year 1870 of the Classical Gold Standard System to the present operating Floating Exchange Rate System. To understand The Bretton Woods System it is important to evaluate and understand the reason for the creation of the system, its salient features and reason for its abolishment. The same has been discussed as under Requirement of an international exchange rate can be traced back to the year 1870 when the world economy saw the enactment of the Traditional Gold Standard. It was during the Gold Standard that paper currency of a country got its value in real terms. The Gold Standard implied that any nation adapting to the international exchange rate has to follow the rules laid down in the Gold Standard. As per Gold Standard, any person holding a currency of the country could exchange the same with the gold reserve that the country possessed or vice-versa (Cohen, 2002). Thus, a countries currency was equally backed by par value of gold reserves that the country possessed. In no circumstances could the country inflict new currency without backing the same with gold reserves of the country.Thus the standard provided long term stability to the countries and was so designed that it could adhere and response to shocks in the economy and move towards maintaining an equilibrium in the economy. Gold Standard thus was a huge achievement in itself and maintained equilibrium for some time in the economy. However, it showing signs of loopholes and soon became a global concern since with more and more development in the global economy, countries felt the shortage of paper currency and found its gold reserves restrictive to inflict new currency as in no circumstances could the country introduce new currency without a par value of gold (Rajan & Subramanian, 2004). Even most powerful countries like Great Britain realized the shortage of currency during the period of Great Depression and the trend was soon followed in other countries of the world. The situation worsened during the World War-1 as there was huge requirement of funds to buy war equipment’s and for social programs and welfare. Further The Federal Bank kept rising its interest rate to make dollar the most powerful currency in the world which was followed by huge Recessions all around the world. It was finally decided by the countries together to abolish the Gold Standard (Frankel, 2005). With The Great Britain abolishing The Traditional Gold Standard in 1914, the period between 1918 to1939 which is regarded as the Interwar Period saw many ups and downs as different countries which had abandoned the Gold Standard from their country again reverted back to the Gold Standard at different interval of time. Powerful countries like United States soon reverted back to the Gold Standard followed by The Great Britain in the year 1925 (Bordo and Eichengreen, 2008). However The Great Britain once again shifted from the Gold Standard in the year 1931 due to economic instability it faced after the World War and during the period OF Great Depression. Even United States followed Great Britain and abolished Gold Standard in 1933 but soon again reverted back to the same in 1934 with a standard rate of $35 per ounce of gold. It was the post war consequences in the economy and huge deficit in the Balance of Payment with international liquidity crunch that the Gold Standard finally came to a complete end and it lead to the development of a new system of Bretton Woods (Roubini, 2004). To develop a standard of freely convertible currency and to maintain equilibrium in the global economy, 730 delegates from all Allied nations gathered at Bretton Woods, New Hampshire, United States and signed on a new agreement which came to be known as The Bretton Woods Agreement. United States dollar has emerged as the most powerful currency by then and it was decided in the agreement to maintain a fixed exchange rate which was pegged to U.S. dollars and other countries pegged their currency with the U.S. dollars, making U.S. Dollar as base of all exchange rates which was tied to fixed rate of gold. The Traditional Gold Standard thus came to a complete end once most countries of the world signed the new Bretton Woods Agreement. The salient features highlighted in the agreement had been discussed as under (Meltzer, 1991) To regulate the international exchange system and international trade in a smooth manner, new international bodies like International Monetary Fund (IMF) and World Bank came into existence. Gold Standard was completely abolished, however, gold still had its importance since U.S. dollars which became the most powerful currency of the world was pegged to gold at a fixed rate of $35 per ounce of gold and became a base of all exchange rate since other currencies were pegged with U.S. dollars. Members of the IMF were responsible for maintaining the exchange rate of their currency with a slight allowable variance of 1% on either side of the fixed par value of dollar by trading in its foreign reserves as per the requirement. The new system can be regarded as U.S. dollar based exchanged rate in legal sense at all other currencies dependent on the fixed value of dollar to gold. Major problem of deficit in Balance of Payment was tackled in a better sense as each member country could change its par value on approval of the IMF. Bretton Woods System aimed at maintaining liquidity crunch and thus further maintain equilibrium since to become a member of IMF each member has to subscribe as per the quota allotted to it which consisted of 25% subscription in terms of $or gold and balance in their respective currency. The Bretton Woods System did not maintained any provision of reserve for emergency and contingency situations. All restrictions on Current Account Transactions were removed thus ensuring global trade freely. Traditional Gold Standard had only one choice of deflationary policy in cases of deficit in the Balance of Payment scenarios. However, Bretton Woods System was much flexible as it also offered a country top devalue its currency to maintain equilibrium. International Monetary Fund (IMF) allowed its member nations to borrow in situation of temporary Balance of Payment to maintain a stable exchange rate system and achieve equilibrium. Thus, we see that Bretton Woods Agreement was designed as per the requirement of the situation and aimed at maintaining equilibrium. Special consideration was given to ensure international liquidity in the economy with strict adherence to removal of problems related with deficit Balance of Payment. Similar to the Traditional Gold Standard, Even Bretton Woods System became a concern for global economy after a few years of stability that it provided. The major problem that the system faced was it failed to consider the real and changing value of gold which was linked with the U.S. dollars at a fixed rate of $35 ounce of gold. It was impossible to devalue United States Dollar since all exchange rates were pegged to it and it became a serious concern for United States as its deficit in the Balance of Payment was increasing at the rapid pace. Further purchasing power of dollars was on a decline trend and prices shoot up in United States with alarming rise in the inflation rate of the country. The situation further worsened during the World War-2 and many European countries tried to back up their reserves which led to huge drainage of gold reserves from United States and the country stood at the brink of a large liquidity crunch in its economy. To remove this international liquidity crunch many reforms and new policy were introduced in the Bretton Woods system such as increase in the number of member nations of the fund and introduction of Special Drawing Rights (SDR) which were distributed among the member nations on the basis of proportion and the same could be used by the holder to increase its monetary reserve in the country or to maintain an equilibrium in cases of deficit Balance of Payment situations (Kenen, 1993). However in spite of all efforts, the system failed to maintain international liquidity and deficit in the Balance of Payment. Finally United States was forced to devalue Dollar by about 9%, from $35 per ounce of gold to $38 ounce of gold and the variance was uplifted from the previous 1% to 2.25% to the new devalued dollar amount. This resulted in huge panic in United States and much of its funds were drained up with rise in its interest rates. It was then finally decided by United States to suspend the convertibility of dollar into gold which led to collapse of the Bretton Wood System which came to a complete end in the year 1973 (Hunt, 2008). Thus major reasons for collapse of the Bretton Woods System were over reliance on the U.S. dollars, huge deficit in Balance of Payments, International liquidity crunch and the very assumption of Bretton Woods System to maintain a fixed rate of gold in the longer run which failed to consider the real value of gold with changing time. Realising the real reason of fixed exchange rate problem in Bretton Woods System, all member of IMF decided to introduce a floating exchange rate system and disregarded gold as an international asset (Goldstein and Lardy, 2005). As per the new Floating Exchange Rate System, different countries were allowed to lay objective of their macroeconomic and was allowed to choose a different inflation rate based on the international exchange rate prevailing and purchasing power of the currency. Floating Exchange Rate has many advantages as it was a complete change of the scenario from the existing fixed rate to flexible exchange rate. It was so designed that it could easily absorb minor shocks in the economy and lowered the problem of maintaining equilibrium in cases of deficit in Balance of Payment. Individual country could frame their monetary policy as the economic condition prevailing in their country (Bordo, 1993). The new system encouraged more development and equal chance to all currency to dominate their trade which was not in case of Bretton Woods System where U.S. dollar was given a special importance and dominance. It promoted international trade freely and smoothly and thus also helped in maintaining international liquidity. However, it has its own limitations and constraints since it has a low elasticity due to fluctuating international exchange rates thus affecting both international trade of imports and exports and also affecting the Economic Structure of a country. Fluctuating exchange rates further invited speculations in the international exchange market creating liquidity problems on a global level. Each country has to be very proactive in maintaining its inflation rate to avoid recession in the country. Here in this assignment we saw how the economy has responded to different systems of exchange rates from the Traditional Gold Standard to Bretton Woods System and then finally to a Floating Exchange Rate System. Today almost all countries follow the Floating Exchange Rate System which has its own advantages and disadvantages as discussed earlier. It has helped in maintaining equilibrium to certain extent with international liquidity. However, IMF and World Bank needs to seriously put checks on speculation over exchange rate as it leads to unnecessary drainage of huge funds from the country and different countries should make strict rules to fight against such speculations and further control its inflation rate. References Bordo, M. (1993). ‘The Bretton Woods International Monetary System: A Historical Overview’, in M. Bordo and B. Eichengreen (eds), A Retrospective on the Bretton Woods System, Chicago, University of Chicago Press, 3-108. Bordo, M. D. and Eichengreen, B. (2008). ‘Bretton Woods and the Great Inflation’, NBER Working Paper 14532. Cohen, B. J. (2002). Bretton Woods System’ in R. J. B. Jones (ed) Routledge Encyclopaedia of International Political Economy, London, Routledge Frankel, J. (2005). Three Notes on the Logavity of the Revived Bretton Woods System: Comments. Brookings Papers on Economic Activity, 188-204 Goldstein, M. and Lardy, N. (2005). China’s Role in the Revived Bretton Woods System: A Case of Mistaken Identity. Institute for International Economics, Working Paper 05-2 Hunt, C. (2008). Financial Turmoil and Global Imbalances: the End of Bretton Woods II? Reserve Bank of New Zealand, Bulletin, 71 (3), 44-55 Kenen, P. B., (1993). ‘Bretton Woods System’, in P. Newman, M. Milgate and J. Eatwell (eds), The New Palgrave Dictionary of Money and Finance, 1, London, Macmillan. Meltzer, A. (1991). ‘U.S. Policy in the Bretton Woods Era’, Federal Reserve Bank of St. Louis Review, 73, 54-83 Rajan, R. and Subramanian. A. (2004). Exchange Rate Flexibility Is in Asia’s Interest’, Financial Times, September 26. Roubini, N. (2004). BW2: Are We Back to a New Stable Bretton Woods Regime of Global Fixed Exchange Rates? Nouriel Roubini’s Global Economics Blog Read More