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International Monetary System

Please help with the following:

1(a) What are the alleged advantages of a fixed over a flexible exchange rate system? How do advocates of flexible exchange rates respond? (b) What overall conclusion can be reached on whether flexible or fixed exchange rates are preferred?

2. What is meant by a crawling peg system? How can such a system overcome the disadvantage of an adjustable peg system?

3. Explain: (a) How economic conditions today differ from those prevailing under the gold standard period. (b) Why the different economic conditions today would make the reestablishment of a smoothly working gold standard impossible.

4. (a) With respect to a nation with a $100-million quota in the IMF, indicate how the nation was to pay in its quota to the IMF and the amount that the nation could borrow in any one year under the original rules. (b) How are the rules different today?

5. Explain the role of the dollar under the Bretton Woods System.

6. Explain briefly the operation of the present international monetary system.

7. (a) With respect to a nation with a $100-million quota in the IMF, indicate how the nation was to pay in its quota to the IMF and the amount that the nation could borrow in any one year under the original rules.

Solution Preview

Hi,

Interesting set of questions! Let's take a closer look. I also provided links and two supporting articles for further reading.

RESPONSE:

1(a) What are the alleged advantages of a fixed over a flexible exchange rate system? How do advocates of flexible exchange rates respond?

A fixed exchange rate is a country's exchange rate regime under which the government or central bank ties the official exchange rate to another country's currency (or the price of gold). The purpose of a fixed exchange rate system is to maintain a country's currency value within a very narrow band. Also known as pegged exchange rate. The alleged advantages of fixed over a flexible exchange rate system is that fixed rates provide greater certainty for exporters and importers. This also helps the government maintain low inflation, which in the long run should keep interest rates down and stimulate increased trade and investment (http://www.investopedia.com/terms/f/fixedexchangerate.asp).

Flexible exchange rate (also called floating exchange rate) is a country's exchange rate regime where its currency is set by the foreign-exchange market through supply and demand for that particular currency relative to other currencies. Thus, flexible or floating exchange rates change freely and are determined by trading in the forex market. This is in contrast to a "fixed exchange rate" regime (http://www.investopedia.com/terms/f/floatingexchangerate.asp). Proponents of this approach argue that the fixed rate is flawed in theory and does not provide greater certainty for exporters and importers in a competitive market of globalization and liberalization of markets and trade.

In some instances, if a currency value moves in any one direction at a rapid and sustained rate, central banks intervene by buying and selling its own currency reserves (i.e. Federal Reserve in the U.S.) in the foreign-exchange market in order to stabilize the local currency. However, central banks are reluctant to intervene, unless absolutely necessary, in a flexible or floating regime (http://www.investopedia.com/terms/f/floatingexchangerate.asp).

(b) What overall conclusion can be reached on whether flexible or fixed exchange rates are preferred?

It depends on the market variables in place. During periods of rapid economic growth and low inflation, driven by globalization and liberalization of markets and trade, flexible exchange rates seem to fair quite well. However, with changing market conditions, it might demand a changing exchange rate. Analysts agree that "getting the exchange rate right" is essential for economic stability and growth in developing countries.

For example, this explains why over the past two decades, many developing countries have shifted away from fixed exchange rates (that is, those that peg the domestic currency to one or more foreign currencies) and moved toward more flexible exchange rates (those that determine the external value of a currency more or less by the market supply and demand for it). During a period of rapid economic growth, driven by the twin forces of globalization and liberalization of markets and trade, this shift seems to have served a number of countries well. But as the currency market turmoil in Southeast Asia has dramatically demonstrated, globalization can amplify the costs of inappropriate policies. Moreover, the challenges facing countries may change over time, suggesting a need to adapt exchange rate policy to changing circumstances. Time will tell, however, if the currency rate will change to meet the changing economic supply and demand needs (see further discussion at http://www.imf.org/external/pubs/ft/issues13/issue13.pdf).

See URL: http://www.imf.org/external/pubs/ft/issues13/issue13.pdf attached as: IMF exchange rates.doc for convenience.

2. What is meant by a crawling peg system? How can such a system overcome the disadvantage of an adjustable peg system?

A Crawling Peg System is a system of exchange rate adjustment in which a currency with a fixed exchange rate is allowed to fluctuate within a band of rates. The par value of the stated currency is also adjusted frequently due to market factors such as ...

Solution Summary

This solutions describes and discusses various aspects of the International Monetary System and economic conditions. A number of questions are responded to. Supplemented with two article on the gold standard and exchange rates.

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