International monetary system
The first and major modern international monetary system was the gold standard that operated during the 19th and 20th centuries. The system worked through free circulation of gold coins that met certain specifications between various nations. Gold was used as the standard measure of value. Another major development in the field of exchange rates was the Bretton Woods system. This system aimed at establishing an exchange rate which was a combination of certain advantages related to gold standard and those of floating rates.
After Second World War, international trade was conducted on the basis of gold-exchange standard. Nations fixed their currencies to foreign currencies which was redeemable at the value of gold. U.S dollar was the most key powerful currency in the world and thus most countries fixed their currencies against it. In 1944, at Bretton Woods international conference, a system of fixed exchange rate was adopted (Stone, 2002, p.11). International Monetary Fund was established during the conference to spearhead a stable exchange rate globally.
In the 1960s, the U.S government was committed to draw gold reserves from the nation. This led to weakening of the dollar against other currencies and made speculators to exchange their dollars for gold. A drain in U.S gold reserves existed and two-tier system was created in late 1960s. The central bank was involved in determination of exchange rates and payment o gold to non-central banks was against the law. In the free-market tier, the value of gold was set by forces of demand and supply in the market. Most worlds central banks used gold and dollars as the major reserve assets (Dreyer, 1982, p.37). The drain on United States gold reserves continued into 1970s and U.S was forced to abandon gold convertibility. This left the world without any single unified international monetary system. The current system is not uniform and calls for optimal design in certain areas to address shortcomings in the area of exchange rates.
In the recent years the global economy has been performing badly as a result of shortcomings in the current design of international monetary system. Crisis in emerging markets has been a reflection of design defect in international monetary system. However, despite all problems developed by the monetary system, a big percentage can be attributed to natural elements. An optimal design therefore, is necessary to do away with certain weaknesses linked to the current international monetary system (Hamouda, Wolf, 1999, p.34). The current monetary system has three common areas of interest that need to be addressed. First, the system fails to adequately distribute global savings in a more efficient manner. Second, the system is subjected to irrational speculative attacks which damages strong economies. Third, the system has deflationary bias which undermines global growth below its standard.
The current international monetary system has some weakness that should be addressed in a proper and efficient manner. Instability in exchange rate during the floating-rate period is one of the major weaknesses of this current system. Instability is manifested in day to day volatility of exchange rates. Most countries consider this issue as a minor problem but in the long run it has implications in economic performance (Stone, 2002, p.65). The U.S dollar is a good example to relate in this case of instability whereby the dollar can be hard against other currencies within a period of five years and then trade badly in the next subsequent two years. This is a situation which cannot be related to optimal allocation of resources across the border. Certain reforms should be adopted to overcome the problem of instability because use of fundamental factors cannot help to change over certain years.
A second weakness of the current system is emergence of payment imbalances that are usually large. The unsustainable imbalances are linked to exchange rate trends which have been developed in the previous uniform international monetary system. The imbalances in addition, have led to situation whereby industrial or developed nations are absorbing resources from developing countries which are a threat to exchange rates (Carin, Wood, 2005, p.52). It is an optimal situation badly linked to developments in dynamic world economies.
A third development in international monetary system that has dissatisfied many participants in international trade is lack of discipline in domestic policies. The current system has no exchange rate constraints which follows that domestic fiscal and monetary policies are free from discipline needed under fixed exchange rates. A good example to illustrate lack of domestic discipline is the case of United States fiscal deficit in the recent years which increased even after U.S external deficit was under growth (Solomon, 1996, p.21). The current system perhaps has no mechanism for restraining inflation which is a major problem in the aspect of international trade.
A fourth weakness is the existence of nominal anchor which is a focus for prices and anticipation of price changes in future. In the old system of gold standard, the price of gold was equivalent to nominal anchor. The Federal Reserve performed a similar function which ensured there was stability of dollar in terms of goods (Sneddon, Oliver, 1999, p.60). The establishment of flexible exchange rates in the current system means that price levels in each country depends on various policies adopted. Absence of nominal anchor in certain circumstances may be very costly and thus it is important to reform the current system.
The four weaknesses in the current international monetary system have potential welfare cost that amounts to bad international trade around the world. One major implication of the shortcomings is the inefficient allocation of resources between economies. Volatility of exchange rates leads to creation of uncertainties that expose producers to domestic markets only. A good producer is supposed to venture the global market which is faced with high competition so as to maintain quality production. Once the businessman engages in less competitive markets he or she fails to meet market the needs of customers (Cline, 1996, p.39). In addition, such a situation leads to biasness towards sheltered markets and untraded goods thus poor allocation of resources.
Another implication of shortcomings in the current system is the cost of shifting resources once there is a large change in the exchange rates. Movements of exchange rates shift profitability so as to move resources from one use to another. Movement of production factors from traded to non-traded goods in industries is linked with fictional costs. In additional, such a situation results to transitional unemployment of resources resulting to lower levels of output. Misalignments of movement of exchange rates results to poor investment than when the exchange rates were stable (Leckow, 1999, p.5). Absence of nominal anchor reduces pressure on governments to follow stable domestic policies. This makes it hard for government to enforce its policies even in private sector and this major challenge in international trade. Participants of financial markets are usually aware of inflation and its problems in exchange rates and this requires additional incentives to enter long-term contracts (McCallum, 1996, p.44). Government is one body that is responsible for providing such incentives and once it is protected from participating in financial markets, it becomes a problem to investors.
The optimal design in international monetary system exists in development of various reforms. One important aspect of the reforms is to introduce a more fixity into exchange rates relationships. This is done through arrangements that create levels for variation in currencies. It is not possible to have fixed exchange rates because for a business to be effective and credible there is need for subjecting domestic policies to international discipline. A major reform should be done in the area of target zones which meets bands of exchange rates that fluctuate among different nations. In the recent years, target zones have been sophisticated due to the issue of dealing with certain identified difficulties (Amin, 1993, p.10). The reform targets selection of an appropriate pattern of exchange rates relationships among currencies. The optimal design aims at certain obligations that intervene in foreign exchange markets and adaptation of domestic policies so as to prevent movement of rates outside certain established bands.
Agency is a major problem in market exchange rates which results from contracting externalities and free-rider problems. The problem is that there is no coordination between security holders which results to exploitation of certain investors. Accumulation of such problem results to institutional inefficiencies and makes financial institutions to redirect their response to problems of agency. In a closed economy, there is usually a problem of dual agency that makes investors to worry about the amount borrowed and returns received (Reti, 1998, p.89). The government is responsible in such situations to enforce rules that control the problem of agency. Reforms on the current system will help to seal such loopholes that threaten the life of many prospective investors.
The exchange rates in the global markets were controlled by creation of International Monetary Fund. This fund was established to maintain a constant level of exchange rates between currencies. The performance of such a fund cannot be adequate without full support of other international bodies. In addition, the impact of globalisation has brought a lot of changes in the performance of international monetary system and has resulted to current market economic crises. It is there fore important to contain global economic integration through establishment of a global central bank (Barry, 1994, p.17). Marginal reforms are necessary and should be done in current financial institutions. My conclusion is that a strong international monetary system can be achieved through incremental improvements that present arrangements other than designing a new system with different rules.