International Monetary System Term Paper Assignment (Term Paper Sample)

DALMAS OLOO
POLS 375
5/30/2014
PROF. JOHN DUGAS.
INTERNATIONAL MONETARY SYSTEM SUMMARY PAPER
In the analysis of international political economy, various concepts come to core which help in the discussion. One of the concepts is the idea of the International Monetary System. It is a concept that incorporates the notion of global trade, global financial management and global monetary institutions like the World Bank. Over time, especially during the twentieth century, the evolution and stabilization of the international monetary system has been evident. This evolution has been shaped by a number of factors. These factors are the need to reform global financial and monetary management, the need for financial development especially among developing countries and more important, the factor of debt crisis. Global Financial crisis has been the major factor propelling the evolution of the international monetary system.
This evolution has also been led by dominance of the dollar. Since the mid-20th century, the share of dollar assets in international reserve holdings, the amount of US currency held and exchanged outside the USA. The evolution of the global monetary system has been characterized by three major principal exchange rate mechanisms. The first exchange rate mechanism is the fixed exchange rate. Under this mechanism, the currency is attached to an item of value like gold, and countries held their official international reserves in form of gold. “Governments were committed to converting domestic currency into gold at the fixed rate, and individuals could export and import gold. By stabilizing national currency values, the gold standard facilitated trade and other transactions”( Cohn 2012,140). According to Cohn, the idea of using gold forthe fixed exchange rate worked well because it was backed by British hegemony and cooperation among the major powers. He argues that the gold standard was based on the idea of promoting monetary openness and stability by maintaining stable exchange rates. However good, the system was criticized; critics argued that the gold standard imposed the burden of adjustment in welfare and unemployment on the poor states. (Cohn 2012, 140)
The second rate exchange mechanism is the flexible exchange rate system. It was as a result of the spectacular rise and fall of the US dollar and the burden of pegging the exchange rate to gold. Major industrial countries agreed to cooperate on the means of exchange rather than using gold. As a result of this, European countries agreed on a common currency (euro). It helped to solve the problem of using dollar as the global vehicle currency. This led to the idea of converting one currency to the other. The system helped especially the European countries to reduce transaction costs and elimination of exchange rate uncertainty. The exchange has been basically between different currencies to the dollar. “Most countries also preferred US dollars to gold, because dollars earned interest and vital for global liquidity purposes” (Cohn 2012, 144). Unfortunately, this paradigm fails to clearly explain the nature and functioning of a flexible rate system.
The third mechanism is the managed exchange rate system. It is a system in which the government of a particular country intervenes to keep the currency’s value within a pre-determined range. It is usually done by the central bank of the country. It is sometimes referred to as the `dirty float`. While using this method, the value of the currency is determined by market demand for and supply of the currency. The intervention by states can be through policies on interest rates. There are some factors that determine the value of a currency under a flexible exchange rate mechanism. One of the factors is government intervention. Under various circumstances the government may be required to intervene when there exist problem in the exchange rate. The government can intervene by raising or lowering interest rates. When there is too much flow of capital into the country as a result of the flexible exchange rate then in most cases, the government would increase the interest rates so as rectify the anomaly in the market. The government can also sell and buy currency directly. For example, if the value of dollar is falling compared to the pound, the US government would the sell its pound reserves and purchase the dollar. The purchase of the dollar would increase its value. This will ensure that the dollar economy does not collapse.
Other than government intervention, private currency trading also determines the value of a currency in a flexible foreign exchange rate system. Ordinary business transactions in the market economy also determine the value of the currency through the self-mechanisms in the market. The private currency trading can also be through currency speculation; inflation, interest rates, political stability and electronic herding, all influence the decisions of currency speculations. For example, a lower inflation rate in a country will make that country`s currency be more competitive thus resulting in a high, a demand of that currency. Likewise when there exist political stability in a country, there would be increased trade and investment that will consequently determine the value of the flexible exchange in that country.
There are broader effects to an economy of a change in the foreign exchange rate. For example, currency depreciation has number of effects: it encourages exports, since a devaluation of currency makes a country`s exports more competitive and cheaper to foreigners, this consequently leads to an increase in demand for exports. Devaluation discourages imports, since the currency value is low, its competitive nature is limited in global market, and therefore foreign products become expensive to buy with the decreasing value of the currency. Some of the other effects of currency depreciation are an increase in inflation, since imports are more expensive, the exchange rate of the currency is limited thus resulting in inflation. Devaluation also encourages foreign direct investment in the domestic economy because local goods are cheaper; however, it discourages foreign direct investment in overseas economies. With exports becoming cheaper manufactures may have less incentive to cut costs and become more efficient and overtime, costs may increase, as a result improvement in competitiveness is discouraged.
Currency appreciation also has various effects in an economy, when a currency gains value; the exports of that country become more expensive, thus resulting in the fall of the export commodities. The gain of currency`s value will enhance imports since they will be cheaper. Currency appreciation lowers inflation because prices are cheaper; the cost of imported goods eventually falls. Foreign direct investment in domestic economy is discouraged however the foreign direct investment in overseas economies is encouraged. With export prices more expensive, manufactures have greater incentive to cut costs therefore competitiveness is improved and encouraged.
Theodore H. Cohn argues that the World Bank is the largest lender of multilateral funds for international development (2012, 301). The main purpose of the World Bank is to finance long-term economic development. “The IMF was created to monitor a system of pegged or fixed exchange rates, in which each currency had an official exchange rate in relation to gold and the US dollar” (Cohn 2012,22-23). The main difference between the World Bank and the IMF is that as World Bank basically deals with funds for international development, while the “IMF provides short-term loans to help states deal with temporary balance-of-payments deficits and maintaining the fixed exchange rates of their currencies” (Cohn 2012, 23). The main goal of the IMF is to maintain order and stability in the international monetary system.
Since the founding of the World Bank, a lot of transformation has taken place especially in terms of the Bank group institutions that specialize in different programs. The first institution of the Bank was the International Bank for Reconstruction and Development (IBRD). It specialized in giving loans for large public infrastructure projects and structural adjustment. The second institution is the International Finance Corporation (IFC), created 1956. “The IFC gives loans to private ventures in LDCs without a government guarantee. The IFC is also more sensitive to business risk than the IBRD” (Cohn 2012, 303). The third is the International Development Association (IDA), established in 1960. It gives concessionary loans to the poorest less developed countries. The loans have no interest. The fourth institution is the International Center for Settlement of Investment Disputes (ICSID) instituted in1966. It was formed to provide a neutral forum for conciliation and arbitration of investment disputes. The last institution is the Multilateral Investment Guarantee Agency (MIGA) which originated in 1988.
In my opinion, we still need the services provided by the World Bank, however some changes need to be put in place. Since the majority of the countries are in the third World, for them to grow and compete with others, economic assistance is necessary . “When it is most effective, the World Bank shares knowledge; develops long-lasting markets, institutions, and capacity and offers diverse financing” (Zoellick 2012, 68). However, people may criticize the Bank for its willingness to criticize. Cohn writes, “Willing to criticize government failure than market failure” (2012, 306). The bank has helped improve both individual lives and countries especially the developing countries. Borrowing from the argument by Zoellick, the services of the Bank are much needed considering the changes and diverse approaches the Bank has take...