Exchange rate regime is a system applied by the countries to administer their respective currencies against other major currencies of the world (Rogoff, 2004:9). Exchange rate regime has three basic types. Floating exchange rate is rate determined by the market demand and supply forces of a country currency. Usually the central banks intervenes the exchange rate in order to check or regulate depreciation or appreciation of the currency in the market. The floating exchange rate is used by some countries like USA, UK and Japan (Quirk 1987:12).
We will write a custom Essay on International monetary systems specifically for you
301 certified writers online
Pegged exchange rate pegs a nation’s currency to a given value. The currency value is monitored to avoid it from deviating from the pegged point. The Last rate is the fixed exchange rate which ties the currency to another currency and the rates can be directly converted into other currencies. Fixed exchange rates regime is important in reducing country inflation (Chamberlin & Yueh, 2006:464).
Relationship between exchange rate regime and BOP
Balance of payment (BOP) shows the trade procedures between two or more countries. Countries can engage in business by importing or exporting commodities and financial capital. The BOP should have a balance of zero with no surplus BOP or deficit BOP. For example a country exporting more than what is importing, will experience a surplus BOP therefore accumulating hoards of wealth. On the other side, a country importing more than it is exporting will have a deficit BOP.
For the country to correct the deficit, it needs to have foreign investments, run down its reserves or get loans from other countries. Deficit countries become increasingly indebted. BOP has two components the current account also and the capital account.
The current account gives the net amount a country earns from the exports and the imports. If the imports exceed exports, then the balance is deficit, but if exports are more than the imports, the difference is surplus. Current account is the total of balance of trade (BOP), factor income and cash transfers. The capital account shows the reserve account, loans and investments between the country and the others.
Balance of payment is said to be capital account subtracted from the variables of current account. The difference is supposed to be zero and this is assured by adding a statistical error (Siddaiah 2010:61).
In respect to the BOP, there are three methods used to control the imbalances. Somehow the methods have a connection with the exchange rate regime. Let us look at each of the BOP correction methods:
Rebalancing by changing the exchange rate
An increase in the nation currency value in respect to others or the appreciation, makes the exports to be competitive but imports becomes cheaper therefore the surplus is brought back to zero. On the other hand depreciation of the nation currency against the others makes imports expensive and the exports become more competitive therefore correcting a deficit BOP.
A country can employ a fixed exchange rate regime or a floating rate. If a country is exporting more than it is importing, the result will be an increased demand for its currency by the internationals. It is because other countries need the currency to pay for the exports from the country in question.
The increase in currency demand, appreciates the country currency. But if a country is buying more than it is exporting, the result will be increased currency supply. The reason is that the country will exchange more of its currency against other currencies so that it pays for the imports. The extra euro supply makes the euro value to fall. Therefore the BOP causes an effect to the exchange rates (Jain& Kaur, 2009:219).
Rebalancing BOP by adjusting internal prices and demand.
The country will correct its BOP surplus or BOP deficits by fixing a rate of its currency in respect to other currencies. A country with a favorable trade balance gets a surplus of gold. A favorable trade leads to an increased money supply and afterwards the country will experience inflation and increased prices.
The country goods also become less competitive and later the trade surplus decreases. This devalues the country currency. On the other hand, deficit BOP leads to deflationary effect. The commodities prices in the country become low as compared to other countries thereby the exports demand rises. Increase in exports reduces the deficit BOP. Likewise the country currency value increases (Cherunilam, 2008:364).
Rules based BOP rebalancing mechanisms
Under this mechanism, there is nation’s agreement to fix exchange rate against each other and the problem is corrected by use of ruled based system. For example, under the Bretton system, all countries agreed to peg the value of their currencies to gold which later became a fixed exchange rate regime.
The Bretton system provided a stable environment for international business because under the agreement each country was to maintain the value of its currency within a one percent of the country par value. An additional feature of the Bretton agreement was an adjustable peg mechanism that allowed a country to alter the value of its currency in extraordinary circumstances (Melicher&Norton2006:176).
Get your first paper with 15% OFF
The bailing out of the debt crisis countries means that German and France help the countries with crisis like Portugal to get through the difficult times. If German or France bails out the countries with crisis, the crisis will be kept from spreading to the rest of the world. Also the conditions imposed by Germany or France will help the debt crisis country accomplish the necessary economic and political reforms. On the other side, if German or France does not bail out these countries, then there will be market distortion.
The mere existence of the possibility of the German bailout may encourage debt crisis governments to follow less rigorous economic practices. Nevertheless, the given funds by Germany or France will be used to subsidize firms in debt crisis country thereby hurting competing firms that are not eligible for such funds (Eichengreen & Lindert, 1992:294).
Evolution of international monetary system support mechanisms
International monetary systems are important in trade between countries. The international monetary systems provide means of payment for different countries for instance use of deferred payment to settle down country debts. International monetary system is used by the governments to fix the exchange rates of its currency against other currencies. Also macroeconomic and financial stability is supported by adjusting real exchange rate to shifts in trade and capital flows (Kenen, Papadia & Saccomanni, 1994:17).
The international monetary system has evolved in several ways for a long time. In past, there was Bimetallism where precious metal like gold and silver were used for trade. The metallic coins were also used for monetary exchange mostly in Egypt and Mesopotamia. Money at this pre-historic time played a minor role in ordering of the economic life. Coinage developed first in china in 7th century and later in the rest of the world.
The second stage was classic gold standards in 1875-1914. During this period the international monetary system was decentralized and market based. Surplus countries frustrated the imbalance adjustment system by sterilizing gold inflows. Countries with deficit BOP experienced downward wages and the prices were not changing.
The trading operated under a fixed exchange system for example, British pound pegged to gold at 6 to one once of gold. Gold could be exported or imported freely. The exchange rate between two countries was determined by their relative gold contents. Inadequate gold supply led to deflation in the 1880s and the world trade and investment was hampered for lack of sufficient monetary reserves (Reis, 1995:15).
The third stage was interwar period in 1915-1944. The exchange rates fluctuated as countries used predatory depreciation of their currencies to gain advantage in the world export market. Some countries tried to restore the gold standard but there was lack of political will to follow the rules. The international trade and investment resulted to be so unstable because of the world wars (Eun & Resnick, 2007:25).
Bretton woods system in 1945-1972 was the fourth system. The system was named after the meeting of forty-four nations that was held with the purpose of designing a postwar international monetary system. Bretton woods system was pegged although with adjustable exchange rates.
The exchange rate was to be stabilized without the use of gold standard. Each country was to maintain its exchange rate within 1% of the adopted par value through exports and imports (Melicher & Norton2006:176). The result of the system was a creation of the international monetary fund (IMF) and the World Bank. Bretton system collapsed in the late seventies.
Exchange rate regime formed in 1973 is used up to present. The system declared flexible exchange rates to the IMF members. Many countries floated their exchange rates, made their currencies convertible and liberalized the capital flows (International Monetary Fund, 2003:16).
The debt crisis countries mostly the developing countries in Africa and Middle East receive the IMF funds to help them develop. In the near future many developed countries like USA, Japan and Britain, have started using the flexible exchange rate after citing some problems in monetary system brought by the pegged regime.
The market determined exchange rates have increased control of domestic monetary policy and inflation. Also the development of financial sectors has been speeded up leading to economic growth. Although he fixed exchange rate regime can facilitate stability, there are instances that it brings speculative attacks to the country economy by unscrupulous traders (Ghosh, Gulde &Wolf, 2002:75). Otherwise the exchange rate regime has so far proved to be the best in support of the international monetary system.
Chamberlin, G., and Yueh, L., 2006. Macroeconomics.UK: Patrick Bond publishers.
Cherunilam, F., 2008., International economics. New Delhi: McGraw-hill publishing company.
Eichengreen, B., and Lindert, P., 1992. The international debt crisis in historical perspective.USA: MIT Press.
Eun, C., and Resnick, B., 2007. International financial management.USA: McGraw-hill publishing company.
Ghosh, A., Gulde, M., and Wolf, H., 2002. Exchange rate regimes: choices and consequences. U.S.A: Asco typesetters.
International Monetary Fund., 2003. Fiscal adjustment in IMF-supported programs. Washington D.C: International monetary fund publication service.
Jain, T., and Kaur, J., 2009. Public finance and international trade. New Delhi: V.K publication.
Kenen, P., Papadia, F., and Saccomanni, F., 1994. The international monetary system. New York: Press syndicate of university of Cambridge.
Melicher, R., and Norton, E., 2006. Finance: introduction to institutions, investments, and management. U.S.A: RRD/ JC publishers.
Quirk, P., 1987. Floating exchange rates in developing countries: experience with auction. Washington D.C: External relation department publishers.
Reis, J., 1995. International monetary systems in historical perspective. Great Britain: Macmillan press ltd.
Rogoff, K., 2004. Evolution and performance of exchange rate regimes. Washington D.C: IMF multimedia services division