This terms denotes the institutions under which payments are made for transactions that cross national

boundaries In particular, it determines how foreign exchange rates are set and how governments can affect exchange rates A well-functioning monetary system facilitates international trade and investment & smooth adaptation to change

The central element of international monetary system involves the arrangements by which exchange rates are set

In recent years, nations have used one of the following three major exchange-rate systems: A system of fixed exchange rates A system of flexible or floating exchange rates, where exchange rates are determined by market forces Managed exchange rates, in which nations intervene to smooth exchange rate fluctuations or to move their currency toward a target zone

Historically the most important fixed exchange rate system was the Gold Standard, which was used off & on from 1717 until 1936. In this system, each country defined the value of its currency in terms of fixed amount of gold, thereby establishing fixed exchange rates among countries

Once gold became the medium of exchange or money, foreign trade was no different than domestic trade as everything could be paid for in gold. The only difference being, countries could choose different units for their gold coins. Example, if Britain chose to make its coins = ounce of gold (the pounds) and US chose to make its coins = 0 ounce of gold (the dollar. In that case, British pound being 5 times as heavy as dollar, had an exchange rate of $5/1 In practice, countries tended to use their own coins. But anyone was free to melt them and sell them at going price of gold. Thus, exchange rates were fixed for all countries on the gold standard. The exchange rates (also called par value) for different currencies were determined by the gold content of their monetary units
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To promote international trade To promote international finance To facilitate adjustment to shocks The first two functions have already been understood in the course of our discussion earlier. The third needs to be explained.

Let there be only two countries A & B. Let country As wages & prices rise. Implications for A: As domestic goods becoming uncompetitive in world marketX falls & M rises X-M. To pay for its deficit, A would have to ship gold to B A would run out of goldmoney supply in A P in A would fall proportinately (the quantity theory of money) cost would also fall proportionatelyincome too would fall in same proportioneconomy experiences deflation Further, A lowers imports from B & is able to increase its exports as its domestic prices fall Implications for B: Bs exports rise rapidly and receives gold for the same its money supply Prices & costs rise in B (the quantity theory of money) Bs exports to A fall but Bs import from A rises as As prices are less

A has BoP deficit A loses gold & B gains gold As money supply decrease Bs money supply increase

Prices decline in A

Prices rise in B
Step 3: rise in Bs import Step 4: decline in Bs export

Step 1: decline in As import

Step 2: rise in in As export

As BoP equilibrium restored

Bs BoP equilibrium restored

Figure showing Humes four-pronged International adjustment mechanism

This is an improvement in BoPs of the country losing gold and worsening in that of the country gaining gold. Eventually, an equilibrium of international trade and finance is reestablished at new relative prices, which keep trade and international lending in balance with no net gold flow. This equilibrium is a stable one and requires no tariffs or government intervention

The essence of Humes argument is to explain the adjustment mechanism for imbalances between countries under fixed exchange rate. The fixed exchange rate might be a gold standard (as existed before 1936), a dollar standard (as under the Bretton Woods system from 1945 to 1971) or a Euro standard (among European Union countries toady) Under fixed exchange rate system, when the prices or income of different countries get out of line, them domestic output & prices must adjust to restore equilibrium. If under fixed exchange rate, domestic prices become too high relative to import prices, full adjustment can come only when domestic prices fall. This in turn happens when domestic output falls to the extent that the countrys price level will decline relative to world pricesthe countrys BoP return to equilibrium

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Under fixed exchange rate, a countrys domestic real output and employment must adjust to ensure that the countrys relative prices are aligned with those of its trading partners

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After World war II, international institutions were developed to foster economic cooperation among nations. These institutions continue to be the means by which nations coordinate their economic policies and seek solutions to common problems. The major international economic institutions of the post war period were: General agreement on Tariffs & Trade (re-chartered as WTO in 1995) The Bretton Woods exchange rate system The International Monetary Fund (IMF) The World Bank

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This system replaced the gold standard after World War II This was a system of fixed exchange rates with the rates being fixed but adjustable- it was more flexible than the gold standard Functioned effectively for quarter of a century after World War II Broke down when dollar became overvalued with USA abandoning the system in 1973

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Gold standard collapsed during the Great Depression of 1930s Leading nations met at Bretton Woods, New Hampshire, in 1944 to create a new international monetary system. As the US at the time accounted for over half of the world's manufacturing capacity and held most of the world's gold, it was decided that world currencies would be tied to the dollar, which, in turn, was convertible into gold at $35 per ounce. Central banks of other countries were to maintain fixed exchange rates between their currencies and the dollar by intervening in foreign exchange markets. If a country's currency was too high relative to the dollar, its central bank would sell its currency in exchange for dollars, driving down the value of its currency. Conversely, if the value of a country's money was too low, the country would buy its own currency, thereby driving up the price.
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The Bretton Woods system lasted until 1971. By that time, inflation in the United States and a growing American trade deficit were undermining the value of the dollar. Americans urged Germany and Japan, both of which had favorable BoP to appreciate their currencies. But those nations were reluctant to do this, as it would increases prices for their goods and hurt their exports. Finally, the United States abandoned the fixed value of the dollar and allowed it to "float" -- that is, to fluctuate against other currencies. The dollar promptly fell. World leaders sought to revive the Bretton Woods system with the so-called Smithsonian Agreement in 1971, but the effort failed. By 1973, the United States and other nations agreed to allow exchange rates to float.

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An integral part of the Bretton Woods system was the establishment of the International Monetary Fund The IMF's fundamental mission is to help ensure stability in the international system. It does so in three ways: keeping track of the global economy and the economies of member countries; lending to countries with balance of payments difficulties; and giving practical help to members

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During the Great Depression 1930s, countries attempted to shore up their failing economies by raising trade barriers, devaluing their currencies to compete for export markets, and curtailing their citizens' freedom to hold foreign exchange. These attempts proved to be self-defeating. Volume of trade, employment and income fell sharply across the World. This necessitated the formation of an institution charged with overseeing the international monetary and ensuring exchange rate stability and encourage its member countries to eliminate exchange restrictions that hindered trade. The IMF was conceived in July 1944, at Bretton Woods, New Hampshire and came into formal existence in December 1945, when its first 29 member countries signed its Articles of Agreement. It began operations on March 1, 1947. Later that year, France became the first country to borrow from the IMF. The IMF's membership began to expand in the late 1950s and during the 1960s as many African countries became independent and applied for membership.
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Surveillance: When a country joins the IMF, it agrees to subject its economic and financial policies to the scrutiny of the international community. It also makes a commitment to pursue policies that are conducive to orderly economic growth and reasonable price stability, to avoid manipulating exchange rates for unfair competitive advantage, and to provide the IMF with data about its economy. The IMF's regular monitoring of economies and associated provision of policy advice is intended to identify weaknesses that are causing or could lead to financial or economic instability. This process is known as surveillance.

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Technical assistance: The IMF shares its expertise with member countries by providing technical assistance and training in a wide range of areas, such as central banking, monetary and exchange rate policy, tax policy and administration, and official statistics. The objective is to help improve the design and implementation of members' economic policies, including by strengthening skills in institutions such as finance ministries, central banks, and statistical agencies. The IMF has also given advice to countries that have had to reestablish government institutions following severe civil unrest or war. In 2008, the IMF embarked on an ambitious reform effort to enhance the impact of its technical assistance. The reforms emphasize better prioritization, enhanced performance measurement, more transparent costing and stronger partnerships with donors.

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Lending: Any member country, whether rich, middle-income, or poor, can turn to the IMF for financing if it has a balance of payments IMF loans are meant to help member countries tackle balance of payments problems, stabilize their economies, and restore sustainable economic growth. This crisis resolution role is at the core of IMF lending. At the same time, the global financial crisis has highlighted the need for effective global financial safety nets to help countries cope with adverse shocks. A key objective of recent lending reforms has therefore been to complement the traditional crisis resolution role of the IMF with more effective tools for crisis prevention. The IMF's lending resources come mainly from the money that countries pay as quota subscriptions (countries pay 25 % of their quota subscriptions in SDRs &remaining 75 % in their own currencies )when they become members

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The World Bank is another financial institution created in 1944 It is capitalized by high-income nations that subscribe in proportion to their economic importance in terms of GDP and other factors It is a vital source of financial and technical assistance to developing countries around the world. It makes long-term low-interest loans to countries for projects which are economically sound but cannot get private sector financing It comprises of two institutions managed by 187 member countries: the International Bank for Reconstruction and Development (IBRD) and the International Development Association (IDA). The IBRD aims to reduce poverty in middle-income and creditworthy poorer countries, while IDA focuses exclusively on the worlds poorest countries. These institutions are part of a larger body known as the World Bank Group.

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