TYBA-SEM-VI-Economics-Paper-XIII-Advanced-Macroeconomics-III-English-Version-munotes

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AGGREGATE DEMAND AND
AGGREGATE SUPPLY UNDER IS -LM
MODEL
Unit Structure :
1.0 Objectives
1.1 Introduction
1.2 Meaning of Aggregate Demand
1.3 Aggregate Demand Curve
1.4 Introduction to IS -LM Model
1.5 Derivation of Aggregate Demand Curve in IS -LM Mod el
1.6 Aggregate Supply Curve
1.7 Determination of Aggregate National Income and Price Level under
AS-AD model
1.8 Extension of IS -LM model with Labour Market and Flexible Prices
1.9 Summary
1.10 Questions
1.0 OBJECTIVES
• To understand the derivation o f Aggregate Demand Curve with IS -LM
model
• To discuss the Aggregate Supply Curve
• To study the determination of Aggregate National Income and Price
Level under Aggregate Demand and Aggregate Supply model
• To Understand Extension of IS -LM model with Labour Mar ket and
Flexible Prices
1.1 INTRODUCTION
Before understanding the derivation of Aggregate Demand Curve with the
IS-LM model, it would be important to get familiar with the concepts of
Aggregate Demand and IS -LM as discussed below:
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2 1.2 MEANING OF AGGREGAT E DEMAND
Macroeconomics is a study of aggregates and averages.Thus,the focus, as
far as demand and supply of goods and services are concerned, is on total /
all goods and services produced by an economy. Accordingly, the demand
for all individual goods and services is also combined in macroeconomics
and is referred to as aggregate demand.
In short, Aggregate demand refers to the total demand for final goods and
services in an economy. Or It is the total (final) expenditure of all the units
of the economy, i .e., households, firms, government, and the rest of the
world on final goods and services.
Therefore,
AD = C + I + G + (X – M)
Where,
AD = Aggregate Demand
C=Household consumption expenditure
I=Investment expenditure
G=Government expenditure
(X – M)= Expo rts - Imports (Net exports)
1.3 AGGREGATE DEMAND CURVE
The Aggregate demand is determined by a number of factors; one of them
is the price level. An aggregate demand curve shows the total spending on
domestic goods and services at each price level. Thus, t he aggregate
demand curve represents the total quantity of all goods (and services)
demanded by the economy at different price levels.
Thus, the aggregate demand curve shows a relationship between aggregate
demand and the general price level.
A fall in the general price level, causes an increase in AD and similarly,
A rise in the general price level causes a decrease in AD
Therefore, the aggregate demand curve becomes a downward sloping
curve as shown in the diagram below:



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Aggregate Demand and
Aggregate Supply under
IS-LM Model
3 Figure No. 1. 1

1.4 INTRODUCTION TO IS -LM MODEL
The IS -LM model is also known as the Hicks -Hansen model. It is a
macroeconomic tool which is being used to show the relationship between
interest rates and national income .
In this model, IS (Goods Market Equilibrium) refers to Investment -Saving
while LM (Money Market Equilibrium) refers to Liquidity preference
(Demand for money) -Money supply. These curves are used to model the
general equilibrium in the economy.
The IS cu rve is downward sloping because as the interest rate falls,
investment increases, leading to increase in national income. Thus, the IS
curve is a downward sloping curve showing the inverse relationship
between interest rate and national income. While, the LM curve is upward
sloping because higher national income results in higher demand for
money, thus, resulting in higher interest rates. This is how the LM curve is
an upward sloping curve showing a direct relationship between interest
rate and national inc ome.
The intersection of both the IS and LM curves shows the equilibrium
interest rate and national income level when both goods and money
markets are in equilibrium as shown in the diagram below:






AB P P1
Y Y1 Price
Level
National Income
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Advanced Macroeconomics III
4 Figure No. 1.2


The IS – LM intersect each -other at point E. This point shows that at this
particular point both markets are in equilibrium with the equilibrium level
of income as Y0 and interest rate as i0. At point E economy is in
equilibrium for a given price level. Therefore, an important assumption for
this analysis is that the price level remains constant.
The change in price level in the above model is the basis of derivation of
Aggregate Demand curve in IS -LM model.
1.5 DERIVATION OF AGGREGATE DEMAND CURVE
IN IS -LM MODEL
As explained above, the a ggregate demand curve shows the inverse
relation between the general price level and the level of national income
and changes in the price level helps in deriving the aggregate demand
curve in the IS -LM model.
Changes in price level affect the LM curve. As suming the supply of
money is constant, if there is an increase in price level, demand for money
falls leading to a left shift in LM curve and vice -versa.
The derivation of Aggregate Demand curve on the basis of shift in the LM
curve is explained below wi th the help of diagram:






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Aggregate Demand and
Aggregate Supply under
IS-LM Model
5 Figure No. 1.3


In the above diagram -
IS= Initial Goods market equilibrium curve
LM1= Initial Money Market Equilibrium Curve
LM2 = New Money Market Equilibrium Curve after increase in price
level
AD = Aggregate demand curve
E1= Initial Equilibrium point
E2 = New equilibrium point
In the upper diagram, there is a shift in the LM curve to the right from
LM1 to LM2 due to increase in price level. This increase in price level
shifts the equilibriu m point from E1 to E2 and thereby causes a rise in
interest rate from i1 to i2. Such a rise in price level further results in
decrease in national income in the lower diagram. By shifting points E1
and E2 from upper diagram to lower diagram one can get a d ownward
sloping AD curve which shows an inverse relationship between price level
and national income level as explained above.
Thus, the aggregate demand curve is a locus of points showing various
combinations of Price level and national income levels that are consistent
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Advanced Macroeconomics III
6 with the general equilibrium of the goods market and money market, i.e.,
equilibrium interest rate and national income as shown by the intersection
of the IS and LM curves.
1.6 AGGREGATE SUPPLY CURVE
The aggregate supply curve shows the re lationship between the price level
and the quantity of goods and services supplied in an economy (with the
objective of profit maximization).
In other words, the aggregate supply curve measures the relationship
between the price level of goods supplied to the economy and the quantity
of the goods supplied. In the short run, the supply curve is relatively
elastic (flatter), whereas, in the long run, it is relatively inelastic (steeper).
Rising prices are usually an indication that businesses should increase
production to meet increased aggregate demand.When demand rises in the
face of constant supply, consumers compete for the goods available and,
as a result, pay higher prices. Due to this dynamism, the firms are induced
to increase output in order to sell more goods.
● Short -run Aggregate Supply Curve (SRAS):
The short -run is defined as the period that begins immediately after a price
increase and ends when input prices have increased in proportion to the
price increase. In the short run, sellers of finished goods receive higher
prices for their goods without a proportional increase in the cost of their
inputs. Therefore, higher the price level, the more willing these sellers will
be to supply.
(The SRAS curve is based on the assumption that input providers do not
or cannot immediately account for increases in the general price level, so
it takes some time –referred to as the short run –for input prices to fully
reflect changes in the price level for final goods.)
Thus, the SRAS curve, depicted in the below diagr am is upward sloping,
reflecting the direct/positive relationship between the price level and the
quantity of goods supplied in the short run.
Figure No. 1.4
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Aggregate Demand and
Aggregate Supply under
IS-LM Model
7 ● Long -run Aggregate Supply Curve (LRAS):
The long -run is defined as the time period during which input prices have
completely adjusted to changes in the price level of final goods.In other
words, in the long run, the increase in prices received by sellers for their
finished goods is completely offset by the proportional increase in prices
paid by sel lers for inputs.
As a result, the total amount of output (National Income) supplied by all
sellers in the economy is unaffected by changes in the price level. And
therefore, LRAS curve, depicted in the diagram below, is a vertical line,
indicating that cha nges in the price level have no effect on long -run
aggregate supply. Further, the LAS curve is vertical at full employment
level which is defined as the level of national output that occurs when all
of the economy's available resources are fully utilized.
Figure No. 1.5

1.7 DETERMINATION OF AGGREGATE NATIONAL
INCOME AND PRICE LEVEL UNDER AS -AD
MODEL
The determination of Aggregate National Income and Price Level under
AS-AD model happens at the point where aggreg ate demand curve and
aggregate supply curve (both short run and long run curves) intersect each
other as shown in the diagram below:



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Advanced Macroeconomics III
8
Figure No. 1.6

In the above diagram equilibrium price level OP and equilibrium national
income OY is determined at point E where Aggregate Demand (AD)
curve, Short run aggregate supply curve (SAS) and Long run aggregate
supply curve (LAS) are intersecting each other.
● Effects of increase in AD when the economy operate s at full
employment level:
The diagram below shows the situation when there is an increase in
aggregate demand represented by the shift in the aggregate demand curve
to the right from AD1 to AD2.
Figure No. 1.7

National Income
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Aggregate Demand and
Aggregate Supply under
IS-LM Model
9 The diagram above deals with the case where there is zero economic
growth because the economy is already at full employment level, when
aggregate demand increases.
In such a situation, when AD increases from AD1 to AD2, the equilibrium
price level increases from P1, to P2, and national increases above its full
employment level, from Y1 to Y2 this is because input prices have not yet
risen in response to the increase in the price level for final goods and the
economy is still operating along the initial SAS c urve i.e. SAS1.
However, since the economy is already operating at full employment
level, input providers will demand higher prices resultantly Production
costs will therefore increase, and the national income will be reduced. This
is represented by the sh ift of the SAS curve from SAS1 to SAS2. The end
result is a higher price level P3, at the same full employment level Y1.
● Effects of increase in AD when the economy does not operate at full
employment level:
In this case, the increase in the equilibrium pri ce level does not lead to an
increase in input prices because the economy is not fully employing all of
its input resources. When unemployed inputs are available, input prices do
not tend to rise. The result, in this case, is that the SAS curve does not
shift left (there is movement along the same SAS curve) and cancel out the
increase in national income brought about by the increase in aggregate
demand.
The effects of increase in AD when the economy does not operate at full
employment level is depicted in the diagram below:
Figure No. 1.8


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Advanced Macroeconomics III
10 As shown in the diagram above, an increase in aggregate demand from
AD1 to AD2, causes both an increase in the equilibrium price level from
P1 to P2, and an increase i n the equilibrium level of national income from
Y1 to Y2.
1.8 EXTENSION OF IS -LM MODEL WITH LABOUR
MARKET AND FLEXIBLE PRICES
This extension deals with the general equilibrium (IS -LM) that has been
shown by the three markets (goods, labour, money) having been combined
in the diagram below. Thus, the diagram shows that there is equilibrium in
all the markets simultaneously in the economy.
Figure No. 1.9

Part A contains the LM —IS curves and shows the equilibrium of good and
money markets. Part B relates the level of employment to the National
Income/output produced in the economy and Part C shows the labour
market.
In the diagram,
IS0= Initial Goods market equilibrium curve
LM0= Initial Money market equilibrium curve
Interest
rate
R1
Y0 Y1 Y2 National Income Wage Rate
Emp
l
o
yme
ntW
D0 D1 D2 L
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Aggregate Demand and
Aggregate Supply under
IS-LM Model
11 IS1= New Good s market equilibrium curve after expansionary fiscal
policy
LM1= Money market equilibrium curve after price rise
Y,N = Income -employment curve
LS= Labour supply curve
D0 = Initial demand for labour curve
D1, D2 = New demand for labour curve
The initial equilibrium in the goods market is at the point where IS0 and
LM0 intersect each other where equilibrium interest rate is R0 and
national income is Y0. At this equilibrium of national income,the number
of labourers employed in the economy are N0 at wage ra te W0, where
D0=LS.
Now with the expansionary fiscal policy, IS0 becomes IS1. Because of
this, the interest rate rises to R1 and national income increases to Y1. This
rise in Y1 results in an increase in employment level to N1 and increase in
wage rate to W1 (where D1=LS).
Under a flexible price regime, if we consider the case of price level, the
price rise will increase the size of the demand for money. If the money
supply remains fixed, this increase in demand for money will shift the LM
curve from LM0 to LM1. The interaction between LM1 and IS1, increases
interest rate to R2 and income level to Y2. This further results in the rise
in employment level to N2 and increase in wage rate to W2 (where,
D2=LS).
1.9 SUMMARY
Aggregate demand refers to the total dem and for final goods and services
in an economy and therefore, the aggregate demand curve represents the
total quantity of all goods (and services) demanded by the economy at
different price levels.Thus, the aggregate demand curve is downwards
sloping curve as it shows inverse relationship between the two variables.
Changes in price level affecting the shift in LM curve is the basis of the
derivation of Aggregate Demand curve in IS -LM model.
The aggregate supply curve shows the relationship between the price level
and the quantity of goods and services supplied in an economy and it is an
upward sloping curve, reflecting the direct/positive relationship between
the price level and the quantity of goods supplied in the short run.
However, the total amount of ou tput (National Income) supplied by all
sellers in the economy is unaffected by changes in the price level in the
long run and therefore, AS curve, is a vertical line, indicating that changes
in the price level have no effect on long -run aggregate supply.
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Advanced Macroeconomics III
12 The determination of Aggregate National Income and Price Level under
AS-AD model happens at the point where aggregate demand curve and
aggregate supply curve (both short run and long run curves) intersect each
other.
1.10 QUESTIONS
 Explain the Meaning of Ag gregate Demand and also explain the
Derivation of Aggregate Demand Curve in IS -LM Model

 Explain the Meaning of Aggregate supply and also explain the
Derivation of Aggregate Supply Curve in short -run and long run.

 Discuss the extension of IS -LM model with Labour Market and
Flexible Prices.


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13 2
LONG -RUN PHILIPS CURVE
Unit Structure :
2.0 Objectives
2.1 Introduction to Long ­run Philips Curve
2.2 Friedman's Long ­Run Philips Curve with Expectation Model
2.3 Tobin’s modified Philips Curve
2.4 Adaptive Expectations and Rational Expectations
2.5 Summary
2.6 Questions
2.0 OBJECTIVES
 To understand the nature of Long ­run Philips Curve

 To discuss Friedman’s Expectation Model, Tobin’s modified Philips
Curve with Adaptive Expectations and Rational Expectations

2.1 INTRODUCTION TO LONG -RUN PHILIPS CU RVE
Prof. Philips in his analysis of the inverse inflation ­unemployment
relationship had covered a period of about fifty years. The studies on U.S.
data in the 1960s, 1970s and 1980s reveal that the Phillips curve is valid
only in the short ­run because its position goes on shifting in the long run.
This led to the conclusion that "there exists either no or weak relationship
between inflation and unemployment in the long run".
Edumond Phelps and Milton Friedmon tried to trace the long run
behaviour of Phill ips Curve. Between the two, Friedman's theory of
Natural Rate of Unemployment is widely accepted as an explanation of
inflation ­unemployment relationship in the long run.
2.2 FRIEDMAN'S LONG -RUN PHILIPS CURVE WITH
EXPECTATION MODEL
On the basis of Philli ps Curve and macroeconomic theory Milton
Friedman tried to explain the shifts in Phillips curve in the long run and
derived a long run Philip's Curve.
In the opinion of Friedman, Philip's curve is valid only in the short ­run. He
argues that the long run i s characterised by the existence of only a single
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Advanced Macroeconomics III
14 natural rate of unemployment. This rate is known as ‘Non ­Accelerating ­
Inflation Rate of Unemployment (NAIRU)’.
Thus,the natural rate of unemployment is the rate at which the current
number of unemployed is equal to the number of employment available in
the labour market. These unemployed workers are not employed for the
reasons, like ­.the fresh graduates may spend a good deal of time se arching
for the suitable jobs or there can be unemployment in some industries
which experience decline in their production etc. It is these kinds of
unemployment that constitute the natural rate of unemployment. It is
believed that the 4% to 5% rate of une mployment represents a natural rate
of unemployment in the developed countries.
Another important thing to be noted is that expectations about the future
rate of inflation play an important role in determining the natural rate of
unemployment. Friedman put forward a theory of adaptive expectations
according to which people form their expectations on the basis of previous
and present rate of inflation, and change or adapt their expec­tations only
when the actual inflation turns out to be different from their expected rate.
According to Friedman's theory of adaptive expectations, there may be a
tradeoff between rates of infla­tion and unemployment in the short run, but
there is no such trade off in the long run.
The essential highlights of Friedman's theory ar e:
• Permanent elimination of NAIRU is not possible despite expansionary
monetary and fiscal policies.
• Expansionary policies accelerate the rate of inflation.
• These policies bring an upward shift in Philip's Curve.
• The upward movement of the Phillips cur ve indicates higher levels of
unemployment and inflation.
• Ultimately Phillips Curve becomes a vertical straight line.
Friedman's construction of the Long Run Phillips Curve (LRPC) can be
explained with reference to Fig. given below:






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Long ­Run Philips Curve
15 Figure No. 2.1

In the above figure,
SRPC1 – SRPC2 – SRPC3 — Short Run Phillips Curve
LRPC — Long Run Phillips Curve
Un — Natural Rate of Unemployment
Let us assume that the economy is currently experiencing a rate of
inflation equal to I1. The other assumption is that nominal wages have
been set on the expectations at I1 rate of inflation which will con­tinue in
the future.
Let us start with position E1 at which inflation rate is I1 and
Unemployment Rate Un. These rates are consistent with potential output.
The gov ernment, feeling that Un is a high rate of unemployment, adopts
expansionary monetary policy to reduce it. Since at E1 the economy is
producing full employment level output expansion of money supply
causes increase in prices; which reduces real wages. Fall in real wages
induces the employers to increase the demand for labour leading to higher
employment (Lower Unemployment at U). High prices and low
unemployment shifts the inflation ­unemployment trade ­off point from E1
to L along SRPC1. At this point we can notice higher inflation and lower
unemployment.
This situation will continue to exist in the short run so long as the
labourers accept low real wages for a variety of reasons such as period of
wage agreement, ignorance about futureprice rise, slow rise i n price level
causing no serious impact of inflation etc. During this time ­lag the real
wages decline as also unemployment rate is below natural rate (point 1).

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Advanced Macroeconomics III
16 Role of Expectation:
The picture, as described above, changes in the long run due to demand
for rise in money wages to push up the real wages at previous level. This
is where the role of adaptive expectations comes into the picture. In
economics, adaptive expectations is a hypothesized process by which
people form their expectations about the futu re based on what had
happened in the past. For example, if people want to create an expectation
of the future inflation rate, they can refer to past inflation rates.
The short ­run Phillips Curve Analysis did not take into account the
changes in the price increase expectations for the long ­run. This occurs at
the time of renewal of wage agreement. By this time the workers realize
the pinch of inflation through fall in real wages. The trade unions
pressurize the employers for increase in real wages through u pward
revisions of money wages. This leads to decline in the demand for labour
causing an upwards shift, in the labour market from L to E2. This implies
an increase in inflation and unemployment rates. This is stagflation which
implies increase in prices w ithout corresponding rise in employment and
output.
At point E2, with higher inflation and natural rate of unemployment the
government has to make a choice between the two. In a sense the state has
to trade ­off between the two i.e. whether to
 Accept exis ting situation
 Reduce unemployment below natural rate
 Reduce inflationary pressure.
 In case the government accepts the existing levels of inflation and
unemployment the economy will be stagnated at point E.
 If in the opinion of the policy makers the na tural rate of unemployment
is intolerable and has to be brought down to the targeted level, they
have to follow the expansionary policy like increase in money supply.
This approach will raise the price level further but will pull the
quantum of unemploymen t below the natural rate. This is revealed by
the movement from point E2 to point M and further from M to E3. It is
clear that expansionary policy causes an upward shift in Phillips Curve.
At point E3 economy operates at a natural unemployment rate with
higher level of inflation.
 Alternatively, the government may choose to reduce inflationary
pressure through the use of various anti ­inflationary devices consisting
of monetary, fiscal as well as physical measures. The lowering of price
level leads to rise in real wages causing decline in demand forlabour
and the consequent rise in unemployment. This is evident from the
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Long ­Run Philips Curve
17 Thus, in the long run the shift in Phillips Curve establishes different
equilibrium positions such as E1, E 2, E3 etc. The Long ­Run Phillips
Curve (LRPC) can be obtained by joining these positions. It can be
noticed that LRPC is obtained as a vertical straight line. This is how on
the basis of the adaptive expectations theory, Milton Friedman constructed
the lo ng run Phillips Curve. On this curve ­
'The trade ­off between inflation and unemployment is not ­existent. At any
rate of inflation the unemployment is at a natural rate.'
Further, it is important to know that adaptive expectations theory has also
been ap plied to explain the reverse process of disinflation, that is, fall in
the rate of inflation as well as inflation itself.
Criticism:
The vertical long ­run Phillips curve given by Friedman is criticised on
following grounds:
● The vertical long ­run Phillips c urve relates to a steady rate of inflation.
But this is not a correct view because the economy is always passing
through a series of disequilibrium positions with little tendency to
approach a steady state.
● Friedman does not explain how expectations are fo rmed that would be
free from theoretical and statistical bias.
● Some economists point out that people do not anticipate inflation rates
correctly, particularly when some prices are almost certain to rise faster
than others.
● Friedman himself accepts the poss ibility that the long ­run Phillips
curve might not just be vertical, but could be positively sloped with
increasing doses of inflation leading to increasing unemployment.
● Some economists have argued that wage rates do not increase at a high
rate of unemplo yment.
● Some economists believe that workers are more concerned with the
increase in their money wage rates than real wage rates.
● Saul Hyman has estimated that the long ­run Phillips curve is not
vertical but is negatively sloped. According to Hyman, the
unemployment rate can be permanently reduced if we are prepared to
accept an increase in inflation rate.
2.3 TOBIN’S MODIFIED PHILIPS CURVE
James Tobin in his presidential address before the American Economic
Association in 1971, proposed a compromise between the negatively
sloping and vertical Phillips curves. Tobin believes that there is a Phillips
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Advanced Macroeconomics III
18 According to him, as the economy expands and employment grows, the
curve becomes even more fragile and vanishes, until it becomes vertical at
some critically low rate of unemployment. Thus, Tobin’s Phillips curve is
kinked ­shaped, partly like a normal downward sloping Phillips curve and
the rest vertical like that of Friedman, as shown in Figure below:
Figure No. 2.2

In the figure Uc is the critical rate of unemployment at which the Phillips
curve becomes vertical where there is no trade ­off between unemployment
and inflation. According to Tobin, the vertical portion of the curve is not
due to increase in the demand for more wages but emerges from
imperfections of the labour market.
At the Uc level, it is not possible to provide more employment because the
job seekers have wrong skills or wrong age or sex or are in the wrong
place. Regarding the normal portion of the Phillips curve which is
negatively sloping, wages are sticky downward because labourers resist a
decline in their relative wages. For Tobin, there is a wage ­change floor in
excess supply situations. In the range of relatively high unemployment to
the right of Uc in the figure, as a ggregate demand and inflation increase
and involuntary unemployment is reduced, wage ­floor markets gradually
diminish. When all sectors of the labour market are above the wage floor,
the level of the critically low rate of unemployment Uc is reached.
2.4 ADAPTIVE EXPECTATIONS AND RATIONAL
EXPECTATIONS
Expectations play an important role in decision ­making. Eg. During the
rainy season when one moves out, he may look at the sky or listen to the
weather forecast and if he expects that it might rain later in the day, he can
carry an umbrella. In a similar manner, economic agents form expectations
about economic variables (such as prices, demand, government policy,
etc.) and make decisions. Eg. If a producer expects that demand for his
products will increase i n the coming years, he would plan to increase his
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Long ­Run Philips Curve
19 Economists have recognized the role of expectations in economic behavior
for a long time. Keynes speaks about expectations of people, but he does
not include it in his analysis. Formal treatment of expectations in
economic theory however began in the 1950s. There are two important
hypotheses of expectations, viz., (i) adaptive expectations, and (ii) rational
expectations.
1. Adaptive Expectations
Adaptive expectations take into account pa st behavior of a variable.
Suppose price level for time period (t) is t and we put a superscript ‘e’
to indicate expected price level. Thus expected price level in period (t) is
te . According to adaptive expectations,
te = te -1 +  (t-1 − te-1)
where t­1 is the price level in the previous time period, and  is a
parameter such that it takes values between 0 and 1.
The above equation can be interpreted as follows:
During previous year economic agents (say, households and firms)
expected price level to be te­1 but, Actual price however turned out to be
t­1. Thus, there is a forecast error of ( t­1 − te­1 ). Of these forecast
error, people will update their expectations by adding  (t­1 − te­1 ) to
previous year’s expecte d price. Thus, people would like to update their
expectations, and rectify part of the error they committed during the
previous year.
Eg. Suppose, in 2020 firms expected the inflation rate (P) to be 3 per cent
(te ­1). In reality, inflation rate turned o ut to be 6 per cent ( t ­1),
thereby resulting in an error of 3 per cent. What should be the expected
inflation rate in 2021 (value of te)? Obviously, firms would update their
expected inflation rate for the current year and they would expect a higher
rate of inflation in 2021. Suppose, firms have learnt from past experience
that about 50 per cent of the forecast errors ne eds to be corrected (it
means,  = 0.5) while updating their forecast about price level. Thus, the
expected inflation rate in 2021 wou ld be ­
te = te ­1 +  (t­1 − te­1 )
=3 + 0.5(6 − 3)
= 4.5 per cent.
Merits:
● Adaptive expectations hypothesis is simple to operate.
● It also brings in an important concept, i.e., expectations into
macroeconomics thereby making it mo re realistic.
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Advanced Macroeconomics III
20 Limitations -
There are however two major limitations of adaptive expectations
hypothesis.
● First, the model assumes that people do not learn from past mistakes –
they adjus t current year expect ations by  times the forecast error.
Thus, the y consistently underestimate the rate of inflation, if the actual
inflation rate is more than the expected inflation rate. Similarly, they
consistently overestimate the rate of inflation, if the actual inflation rate
is less than the expected inflation rat e.
● Second, the model assumes that people base their expectations on past
information only. It does not take into account the present or future
events. For example, under adaptive expectations, when the
government pursues an expansionary monetary policy peo ple do not
expect that inflation rate will go up. Similarly, when there is a natural
disaster such as drought, people do not expect that aggregate supply
will decline and prices will go up.
Thus, the limitations of adaptive expectations prompted economists to
look for alternative theories of expectations and one of them is Rational
Expectations Hypothesis.
2. Rational Expectations:
Rational expectations hypothesis assumes that households and firms take
decisions on the basis of the best possible information av ailable to them.
Thus, they consider not only past trends but also present and expected
future events.
According to rational expectations, people learn from past mistakes.
People may be wrong in their forecast sometimes; but on average they will
be correct .
In simple terms, expected rate of inflation in period t is given by ­
et = t + t
In the above equation t is a stochastic error, with expected value of zero.
While some people may have positive errors in their forecast, others will
have negative errors. When aggregated, such errors cancel out in the sense
that the sum of positive errors is equal to the sum of negative errors.
Secondly, the errors do not show any pattern; they are random in nature. It
is to be noted that under adaptive expectations, errors were systematic (it
followed a pattern).
There are two versions of the rational expectations hypothesis: weak and
strong.
In the weak version, it is assumed that people have access to limited
information; but they make best use of the information. Let us take a
concrete example. Suppose, every week for household consu mption milk munotes.in

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Long ­Run Philips Curve
21 is needed. A person may not know the relative prices and nutrient levels of
all the brands of milk available in the market. With limited information
available to a consumer, however, he may usually stick to the same brand
(and may be the same s hop, without knowing that other shops are charging
a lower price!).
In the strong version of the rational expectations hypothesis, it is assumed
that people have access to all information. Decisions taken are based on all
information. Thus, their expectat ions are equal to the actual values. Any
error in forecast is due to unexpected developments.
2.5 SUMMARY
Milton Friedman tried to trace the long run behaviour of Phillips Curve.
Friedman's theory of Natural Rate of Unemployment is widely accepted as
an explanation of inflation ­unemployment relationship in the long run on
the basis of Adaptive expectations (Expectations are largely based on what
has happened in the past) in which the Long run Philips Curve becomes
vertical straight line. However, Tobin’s M odified Philips Curve is based
on Rational expectations (Expectations are based on the module that is
being used by the economist) in which Phillips curve is kinked ­shaped,
partly like a normal downward sloping Phillips curve and the rest vertical
like tha t of Friedman.
2.6 QUESTIONS
1. Explain the Friedman’s Expectation Model with reference to Long ­run
Philips Curve
2. Describe the Tobin’s modified Philips Curve
3. Discuss the concepts of Adaptive Expectations and Rational
Expectation


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22 3
TRADE CYCLES – 1
Unit Structure:
3.0 Objectives
3.1 Introduction
3.2 Meaning of Trade Cycles
3.3 Features of Trade Cycles
3.4 Types of Trade Cycles
3.5 Phases of Trade Cycles
3.6 Summary
3.7 Questions
3.0 OBJECTIVES
 To know the m eaning of trade cycles.
 To study the features of trade cycles.
 To study the several types of trade cycles.
 To explain the various phases of trade cycles.
3.1 INTRODUCTION
Almost all economies of the world have suffered from economic
fluctuations at different stag es of their economic growth.
An important feature of a capitalist economy is the existence of business
cycle. The business cycle is associated with fluctuations in macro
economic activity. It may be noted that these fluctuationsas ‘cycle’ are
periodic and occur regularly. Cyclical fluctuations arewave like
movements found in the aggregate economic activity of anation. A
business cycle is characterized by recurring phases of expansion and
contraction in economic activity in terms of employment, output and
income.
The period of high income, output and employment has been called the
period of expansion, upswing or prosperity, and the period of low income,
output and employment has been called theperiod of contraction,
recession, down swing or depression. The se altering periods of expansion
and contraction in economic activity have been called business cycle.
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Trade Cycles – 1
23 3.2 MEANING OF TRADE CYCLES
Trade cycle has been defined by different economist in different ways.
According to J.M. K eynes, “A trade cycle is composed of periods of good
trade characterized by rising prices and low unemployment percentages
with periods of bad trade characterized by falling prices and high
unemployment percentages.”
In the words of Haberler, “The business cycle may be defined as an
alternation of periods of prosperity and depression of good and bad trade.”
According to Schumpeter, “the business cycle represents wave like
fluctuations in level of business activity from the equilibrium.”
According to Fredric Benham, “A trade cycle may be defined rather badly,
as a period of prosperity followed by a period of depression. It is not
surprising that economic process should beir regular, trade being good at
some time and bad at others.”
3.3 FEATURES OF TRADE CYCLE S
Though different business cycles differ in duration and intensity they have
some common features which can explain below.
1. A business cycle is a wave like movement in macro economic activity
like income, output and employment which shows upward and
downwa rd trend in the economy.
2. Business cycles are recurrent and have been occurring
periodically.They do not show some regularity.
3. They have some distinct phases such as prosperity, recession,
depression and recovery.
4. The duration of business cycles may vary from minimum of two
years to a maximum of ten to twelve years.
5. Business cycles are synchronic. That is they do not cause changes in
any single industry or sector but are of all embracing character. For
example, depression or contraction occurs simultaneou sly in all
industries or sectors of the economy. Recession passes from one
industry to another and chain reaction continues till the whole
economy is in the grip of recession. Similar process is at work in the
expansion phase or prosperity.
6. There are diff erent types of business cycles. Some are minor and
others are major. Minor cycles operate for a period of three to four
years and major business cycles operate for a period of four to eight
years. Though business cycles differ in timing, they have a common
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Advanced Macroeconomics III
24 7. Expansion and contraction phases of business cycle are cumulative in
effect.
8. It has been observed that fluctuations occur not only in level of
production but also simultaneously in other variables such as
employment, invest ment, consumption, rate of interest and price level.
9. Another important feature of business cycles is that down swing is
more sudden than the changes in upswing.
10. An important feature of business cycles is profits fluctuate more than
any other type of inco me. The occurrence of business cycles causes a
lot of uncertainty for business and makes it difficult to forecast the
economic conditions.
11. Lastly, business cycles are international in character. That is once
started in one country they spread to other cou ntries through trade
relations between.
3.4 TYPES OF TRADE CYCLES
Prof. James Arthur Estey has classified business cycles under the
following heads:
1. Major and Minor Cycles:
Major cycles may be defined as the fluctuations of business activity
occurring between successive crises. The term “crisis” maybe interpreted
here to mean the major “breakdowns” or “downturns” that interrupt from
time to time the relatively even tenor of economic activity. So the major
cycles constitute the intervals between successi ve major down turns of
business activity or between major recessions. On this basis, Prof. Hansen
recognizes twelve major cycles in the U.S.A., during the period from 1837
to 1937, with an average duration of 8.33 years. The major cycles are
sometimes referred to as Juglar Cycles, after the name of Clement Juglar,
a French economist of the nineteenth century, who on the basis of his
investigation, established the crystal nature of business fluctuations. This
cycle is also termed as the major cycle. It isdef ined “as the fluctuation of
business presentation among successive crises.” Clement Jugler, French
economist presented those periods of prosperity, crisis and liquidation
adopted each other always in the same order. Later economists have come
to theend tha t a Jugler cycle’s duration is on the average nine and a
halfyears.
It has been established from the records of business fluctuation s that each
major cycle is made up of two or three minorcycles the up swing of
business in the major cycle is often interru pted by minor down swings,
likewise, the down swings of business in the major cycle may be
interrupted by minor upswings.
These shorter cycles in major cycles are sometimes referred to asminor
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Trade Cycles – 1
25 These minor cycles have actually operated both in Great Britain and the
U.S.A. Since the distinction ‘between major and minor cycles was
observed by Prof. Joseph Kitchin, the minorcycles are sometimes referred
to as Kitchin Cycles. This is also termed as the minor cycle which is of
just about forty five months gap. It is well -known after the name of
British economist Joseph Kitchin who made a difference among a major
and a minor cycle year nineteen twenty three. He came to the termination
on the basic of his research that a major cycle is composed of two or three
minor cycles of forty five months.
2. Building cycles :
This refers to the cycle of building construction. The duration of the
building cycles is longer than that of the business cycle.
It has been discovered the building industry is also subject to fluctuations
of fairly regular duration. There are upswings and down swings in the
building cycles is 18 years -just twice the length of business cycle.
Between 1830 and 1934, there were six comple x building cycles in the
U.S.A. Another type of cycle associates to the construction of buildings
which is of fairly regular duration. Its duration is two fold that of the
major cycles and is on average of eighteen years duration. Such cycles are
related w ith the names of Warren and Pearson.
3. Long Waves or Kondratieff Cycles :
They are sometimes referred to as “long waves” occurringin a 50 or 60 -
year cycle. The long waves in economic activity were discovered by the
Russian economist, Kondratieff. Hence, th ese long waves are called
Kondratieff Cycles. Kondratieff, on the basis of statistical data pertaining
to the period 1780 -1920, was able to establish 21/2 long cycles in England
and France each full cyclebeing of the duration of 60 years.
Summing up, the f undamental changes in economic activity include three
kinds of cycles -the short or minor or the Kitchen cycles of the duration of
40 months or so, the major or the Juglarcycles, composed of three minor
cycles and of the duration of 10years or so, and final ly, the Kondratieff
cycles (or, long waves), made up of 6 Juglar cycles and of the duration of
60 years.
N.D.Kondratieff, the Russian economist came to the conclusion that there
are longer waves of cycles of more than fifty years duration made of six
Jugle r cycles. A very long cycle has come to be known as the Kondratieff
wave.
3.5 PHASES OF TRADE CYCLES
Business cycles have shown distinct phases, the study of which is useful to
understand their fundamental causes. Generally, a business cycle has four
phases.
1. Prosperity (Expansion, Boom, or Upswing)
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Advanced Macroeconomics III
26 3. Depression (Contraction or Down swing) and
4. Revival or Recovery (lower turning point)
The four phases of business cycle are shown in the following figure. It
starts from trough or lower turning point when the level of economic
activity is at the lowest level. Then it passes through recovery and
prosperity phase, but due to the causes explained below the expansion
cannot continue indefinitely, and after reaching peak , recession and
depression or down swing starts. The down swing continues till the lowest
turning point and reaches to trough. It is important to note that no phase
has any definite time period or time interval. Similarly any two business
cycles are not th e same.
The prosperity starts at trough and ends at peak. The recession starts at
peak and ends at trough. One complete period of such movementis called
as a trade cycle.
Figure No. 3.1

Four phase of trade cycles are briefly explained as follows.
1. Pros perit y: Prosperity is ‘a stage in which the money income,
consumption, production and level of employment are high or rising and
there are no idle resources or unemployed workers.’
This stage is characterized by increased production, high capital
investmen t, expansion of bank credit, high prices, high profit, a high rate
of interest, full employment income, effective demand, inflation MEC,
profits, standard of living, full employment of resources, and over all
business optimism etc.
The prosperity comes to an end when forces become weak and therefore,
bottlenecks start to appear at the peak of prosperity. Due to high profit,
inflation and over optimism make the entrepreneurs to invest more and
more. But because of shortage of raw material and scarcity of fa ctors of
production prices of goods and services rises. As a result there is fall
indemand and profit, business calculations go wrong. Thus their
overoptimism is replaced by over pessimism. Thus prosperity digs its
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Trade Cycles – 1
27 2. Recession : When the phase of prosperity ends, recession starts.
Recession is an upper turning point. This is a phase of contraction
orslowing down of economic activities. Recession is generally of a short
duration.
After boom, demand falls, production becomes excess and investment
results in over investment. Finally, it leads to recession. During this phase
profit, investment and share prices falls significantly, Because of lack of
investment the demand for bank credit,rate of interest, income
employment, and demand for goods and serv ices falls.
If recession continues for a long period of time then finally, it reaches to
the phase of depression.
3. Depression : It is a period in which business or economic activity in
acountry is far below the normal. Depression is ‘a stage in which
themoney income, consumption, production and level of employment
falls, idle resources and unemployment increases.’
It is characterized by a sharp reduction of production, mass
unemployment, low employment, falling prices, falling profits, low wages,
and cont raction of credit, fall in aggregate income, effective demand,
MEC, a high rate of business failure and atmosphere of all round
pessimism etc. The depression may be of a short duration or may continue
for a long period of time.
After a period of time, mode rate increase in the demand for goods and
services helps to increase in investment, production, employment, income
and effective demand. Finally, it leads to recovery.
4. Recovery : Depression phase is generally followed by recovery.
Various exogenous and endogenous factors are responsible for reviving
the economy. When the economy enters the phase of recovery, economic
activity once again gathers momentum in terms of income, output,
employment, investment and effective demand. But the growth rate lies
below the steady growth path.
Thus, a recovery phase starts which is called the lower turning point. It is
characterized by improvement in demand for capital stock, rise in demand
for consumption good, rise in prices and profits, improvement in the
expectation s of the entrepreneurs, slowing rising MEC, slowly increasing
investment, rise in employment, output and income, rise in bank credit,
stock market becomes more sensitive and revival slowly emerges etc.
The phase of recovery once started, it slowly takes th e economy onthe
path of expansion and prosperity. With this the cycle repeats itself.
Check your Progress:
1. What is a business cycle? What are its different features?
2. What is a business cycle? Explain the different phases of a trade cycle.
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28 3.6 SUMMAR Y
1. A business cycle is characterized by recurring phases of expansion and
contraction in economic activity in terms of employment, output and
income.
2. A business cycle has four phases:
a) Prosperity (Expansion, Boom, or Upswing)
b) Recession (upper turning poin t)
c) Depression (Contraction or Down swing) and
d) Revival or Recovery (lower turning point)
3. Prosperity is a stage in which the money income, consumption,
production and level of employment are high or rising and there are no
idle resources or unemployed wor kers.
4. When the phase of prosperity ends, recession starts. Recession is an
upper turning point. This is a phase of contraction or slowing down of
economic activities. Recession is generally of a short duration.
5. Depression is a stage in which the money in come, consumption,
production and level of employment falls, idle resources and
unemployment increases.
6. When the economy enters the phase of recovery, economic activity
once again gathers momentum in terms of income, output,
employment, investment and eff ective demand.
3.7 QUESTIONS
1. Define the term trade cycle and discuss the features of trade cycle.
2. What are the types of trade cycle?
3. Discuss the several phases of trade cycle.

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29 4
TRADE CYCLES – 2
Unit Structure:
4.0 Objectives
4.1 Introduction
4.2 Hawtrey’s Theory of Trade Cycles
4.3 Kaldor’s Theory of Trade Cycles
4.4 Paul Samuelson’s Theory of Trade Cycles
4.5 Hicks Theory of Trade Cycles
4.6 Measures to Control Tr ade Cycles
4.7 Summary
4.8 Questions
4.0 OBJECTIVES
 To know the theory of Hawtrey’s theory of trade cycles.
 To understand the Kaldor’s theory of trade cycles.
 To study the Paul Samelson’s theory of trade cycles.
 To know the Hicks theory of trade cyc les.
 To know the measure to control trade cycles.
4.1 INTRODUCTION
A trade cycle refers to fluctuations in economic activities specially in
employment, output and income, prices, profits etc. It has been defined
differently by different economists. Acco rding to Mitchell, “Business
cycles are of fluctuations in the economic activities of organized
communities. The adjective ‘business’ restricts the concept of fluctuations
in activities which are systematically conducted on commercial basis.
The noun ‘cycl e’ bars out fluctuations which do not occur with a measure
of regularity”. According to Keynes, “A trade cycle is composed of
periods of good trade characterised by rising prices and low
unemployment percentages altering with periods of bad trade
character ised by falling prices and high unemployment percentages”.
Many theories have been put forward from time to time to explain the
phenomenon of trade cycles. These theories can be classified into non -
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Advanced Macroeconomics III
30 4.2 HAWTREY’S THEORY OF T RADE CYCLES
Prof.Hawtrey considers trade cycle to be a purely monetary phenomenon.
According to him non -monetary factors like wars, strike, floods, drought
may cause only temporary depression. Hawtrey believes that expansion
and contraction of money are th e basic causes of trade cycle. Money
supply changes due to changes in rates of interest.
When rate of interest is reduced by banks, entrepreneurs will borrow more
and invest. This causes an increase in money supply and rise in price
leading to expansion. O n the other hand, an increase in the rate of interest
will lead to reduction in borrowing, investment, prices and business
activity and hence depression.
Hawtrey believes that trade cycle is nothing but small scale replica of
inflation and deflation. An in crease in money supply will lead to boom
and vice versa, a decrease in money supply will result in depression.
Banks will give more loans to traders and merchants by lowering the rate
of interest. Merchants place more orders which induce the entrepreneurs to
increase production by employing more labourers. This results in increase
in employment and income leading to an increase in demand for goods.
Thus the phase of expansion starts.
Business expands; factors of production are fully employed; price
increase s further, resulting in boom conditions. At this time, the banks call
off loans from the borrowers. In order to repay the loans, the borrowers
sell their stocks. This sudden disposal of goods leads to fall in prices and
liquidation of marginal firms. Banks will further contract credit.
Thus the period of contraction starts making the producers reduce their
output. The process of contraction becomes cumulative leading to
depression. When the economy is at the level of depression, banks have
excess reserves. Therefore, banks will lend at a low rate of interest which
makes the entrepreneurs to borrow more. Thus revival starts, becomes
cumulative and leads to boom.
Hawtrey’s theory has been criticised on many grounds:
1. Hawtrey’s theory is considered to be an inco mplete theory as it does
not take into account the non -monetary factors which cause trade
cycles.
2. It is wrong to say that banks alone cause business cycle. Credit
expansion and contraction do not lead to boom and depression. But
they are accentuated by ban k credit.
3. The theory exaggerates the importance of bank credit as a means of
financing development. In recent years, all firms resort to plough back
of profits for expansion.
4. Mere contraction of bank credit will not lead to depression if marginal
efficienc y of capital is high. Businessmen will undertake investment in -
spite of high rate of interest if they feel that the future prospects are
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Trade Cycles – 2
31 5. Rate of interest does not determine the level of borrowing and
investment. A high rate of interest will not pre vent the people to
borrow. Therefore, it may be stated that banking system cannot
originate a trade cycle. Expansion and contraction of credit may be a
supplementary cause but not the main and sole cause of trade cycle.
4.3 KALDOR’S THEORY OF TRADE CYCLES
After the publication of John Maynard Keynes' General Theory many
attempts were made to build a business cycle model. The models that were
built by American Neo -Keynesians such as Paul Samuelson proved
unstable. They could not describe why an economy shou ld cycle through
recession and growth in a stable fashion. The British Neo -Keynesian John
Hicks tried to improve the theory by imposing rigid ceilings and floors on
the model. But most people thought that this was a poor way of explaining
the cycle as it r elied on artificial, exogenous constraints. Kaldor, however,
had actually invented a fully coherent and highly realistic account of the
business cycle in 1940. He used non -linear dynamics to construct this
theory. Kaldor's theory was similar to Samuelson's and Hicks' as it used a
multiplier -accelerator model to understand the cycle. It differed from these
theories, however, as Kaldor introduced the capital stock as an important
determinant of the trade cycle. This was in keeping with Keynes' sketch of
the b usiness cycle in his General Theory.
Following Keynes, Kaldor argued that investment depended positively on
income and negatively on the accumulated capital stock. The idea that
investment depends positively on the growth of income is simply the idea
of th e accelerator model that holds that in periods of high income growth
and hence demand growth, investment should rise in the anticipation of
high income and demand growth in the future. The intuition lying behind
the negative relationship to the accumulatio n of the capital stock is due to
the fact that if firms have a very large amount of productive capacity
accumulated already they will not be as inclined to invest in more. Kaldor
was in effect integrating Roy Harrod's ideas about unbalanced growth into
his theory.
In the standard accelerator model that stood behind Samuelson's and
Hicks' business cycle theories investment was determined as such:
It = Ia + w(Y t-1 – Yt-2)
This states that investment is determined by exogenous investment and
lagged income mult iplied by the accelerator coefficient. Kaldor's model
modified this to include a negative coefficient for the capital stock:
It = Ia + w(Y t-1 – Yt-2) - jK
Kaldor then assumed that the investment and savings functions are non -
linear. He argued that at the p eaks and troughs of the cycle the marginal
propensity to save shifts in opposite ways. The intuition behind this is that
during recessions people will cut their savings to maintain their standard
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Advanced Macroeconomics III
32 proportion of their income. He also argued that at the peaks and troughs of
the cycle the marginal propensity to invest shifts. The intuition behind this
is that at the trough of the cycle there will be a large amount of excess
capacity and so busin essmen will not want to invest more, while at the
peak of the cycle rising costs will discourage investment. This creates non -
linear dynamics in the economy that then drive the business cycle.
When Kaldor combines these components we get a clear six -stage model
of the business cycle. In the first stage the economy is in equilibrium
position. Investment is taking place and the capital stock is growing. In the
second stage the growth in the capital stock leads to a downward shift in
the investment curve as bu sinessmen decide their factories become
overfull. In the third stage (which overlaps with the second stage) the high
growth in income causes higher saving which pushes the savings curve
upwards. At this point the two curves become tangential and the
equili brium becomes unstable which generates a recession. In the fourth
stage the same dynamics kick in but this time moving in the opposite
direction. By the sixth stage the equilibrium is again unstable and a boom
is produced.
Kaldor also noted the importance of income distribution in his theory of
the business cycle. He assumed that savings out of profits were higher
than savings out of wages; that is, he argued that poorer people (workers)
tend to save less than richer people (capitalists). Or: SwKaldor b elieved that the business cycle had an inherent mechanism built
into it that redistributed income across the cycle and that these mitigated
"explosive" results. As we have seen, in a cyclical upswing where planned
investment begins to outstrip planned savi ngs prices will tend to rise.
Kaldor assumed that those who set prices have more power than those
who set wages and so prices will tend to rise faster than wages. This
means that profits must also rise faster than wages. Kaldor argued that due
to the diffe rent savings propensities of capitalists and workers this will
lead to higher savings. This will then dampen the cycle somewhat. In a
recession or depression Kaldor argued that prices should fall faster than
wages for the same reasons that Keynes laid out in his General Theory.
This meant that income would be redistributed to workers as real wages
rose. This would lead savings to fall in a recession or depression and so
would dampen the cycle.
Kaldor's model assumes wage and price flexibility. If wage and p rice
flexibility are not forthcoming the economy may have a tendency to either
perpetual and rising inflation or persistent stagnation. Kaldor also makes
strong assumptions about how wages and prices respond in both inflations
and depressions. If these ass umptions do not hold Kaldor's model would
lead us to conclude that the cycle might give way to either perpetual and
rising inflation or stagnation.
Kaldor's non -linear business cycle theory overcomes the difficulty that
many economists had with Roy Harrod' s growth theory. Many of the
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Trade Cycles – 2
33 that capitalism would tend toward extremes of zero and infinite growth
and that there were no dynamics that might keep it in check. Robert
Solow, who eventual ly created the Solow Growth Model in response to
these perceived problems, summarised this view as such:
Keep in mind that Harrod’s first Essay was published in 1939 and
Domar’s first article in 1946. Growth theory, like much else in
macroeconomics, was a product of the depression of the 1930s and of the
war that finally ended it. So was I. Nevertheless it seemed to me that the
story told by these models felt wrong. An expedition from Mars arriving
on Earth having read this literature would have expected to find only the
wreckage of a capitalism that had shaken itself to pieces long ago.
Economic history was indeed a record of fluctuations as well as of growth,
but most business cycles seemed to be self -limiting. Sustained, though
disturbed, growth was not a rarity.
In fact, Kaldor's 1940 paper had already shown this to be completely
untrue. Solow was working with an erroneous and underdeveloped theory
of the business cycle that he had taken over from Samuelson. By the time
Solow was working on his growth the ory, the Cambridge UK economists
had already satisfactorily laid out a self -limiting theory of the business
cycle that they thought was a reasonable description of the real world.
This is one of the reasons that the Cambridge economists were so hostile
in their reaction to Solow's growth model and went on to attack it in the
Cambridge Capital Controversy of the 1960s. The ignorance on the part of
the American economists' knowledge of Kaldor's model also explains why
the Cambridge Post -Keynesian economists f ound the ISLM model
favoured by the American Neo -Keynesians to be crude and lacking.
4.4 PAUL SAMUELSON’S THEORY OF TRADE
CYCLES
The multiplier –accelerator model (also known as Hansen –Samuelson
model) is a macroeconomic model which analyzes the business cycle. This
model was developed by Paul Samuelson, who credited Alvin Hansen for
the inspiration. This model is based on the Keynesian multiplier, which is
a consequence of assuming that consumption intentions depend on the
level of economic activity, and the accelerator theory of investment, which
assumes that investment intentions depend on the pace of growth in
economic activity.
The multiplier –accelerator model can be stated for a closed economy as
follows:
First, the market -clearing level of economic activity is defined as that at
which production exactly matches the total of government spending
intentions, households' consumption intentions and firms' investing
intentions.
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Advanced Macroeconomics III
34 then an equation to express the idea that households' consumptio n
intentions depend upon some measure of economic activity, possibly with
a lag:
Ct = αY t-1
then an equation that makes firms' investment intentions react to the pace
of change of economic activity:
It = β[C t – Ct-1]
and finally a statement that government spending intentions are not
influenced by any of the other variables in the model. For example, the
level of government spending could be used as the unit of account:
gt= 1
where, Y t is national income, g t is government expenditure, C tis
consumption expenditure, I tis induced private investment, and the
subscript t is time. Here we can re arrange these equations and rewrite
them as a second -order linear difference equation:
Yt = 1 + α(1+β) Y t-1 – αβY t-2
Samuelson demonstrated that there are several kinds of solution path for
national income to be derived from this second order linear difference
equation. This solution path changes its form, depending on the values of
the roots of the equation or the relationships between the parameter
Criticism:
Jay Wright Forrester argues that the Accelerator -Multiplier Theory cannot
create the assumed business cycle but instead is a major contributor to the
economic long wave.
4.5 HICKS THEOR Y OF TRADE CYCLES
J.R. Hicks in his book A Contribution to the Theory of the Trade Cycle
builds his theory of business cycle around the principle of the multiplier -
accelerator interaction. To him, “the theory of the acceleration and the
theory of the mult iplier are the two sides of the theory of fluctuations.”
Unlike Samuelson’s model, it is concerned with the problem of growth
and of a moving equilibrium.
Ingredients of the Theory:
The ingredients of Hicks’s theory of trade cycle are warranted rate of
growth, consumption function, autonomous investment, an induced
investment function, and multiplier -accelerator relation.
The warranted rate of growth is the rate which will sustain itself. It is
consistent with saving -investment equilibrium. The economy is s aid to be
growing at the warranted rate when real investment and real saving are
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35 accelerator interaction which weaves the path of economic fluctuations
around the warranted growth rate .
The consumption function takes the form Ct= aYt -1 . Consumption in
period t is regarded as a function of income (Y) of the previous period (f -
1). Thus consumption lags behind income, and the multiplier is treated as
a lagged relation.
The autonomous inve stment is independent of changes in the level of
output. Hence it is not related to the growth of the economy.
The induced investment, on the other hand, is dependent on changes in the
level of output. Hence it is a function of the growth rate of the econo my.
In the Hicksian theory, the accelerator is based on induced investment
which along with the multiplier brings about an upturn.
The accelerator is defined by Hicks as the ratio of induced investment to
the increase in income. Given constant values of th e multiplier and the
accelerator, it is the ‘leverage effect’ that is responsible for economic
fluctuations.
Assumptions of the Theory:
The Hicksian theory of trade cycle is based on the following assumptions:
(1) Hicks assumes a progressive economy in which a utonomous
investment increases at a constant rate so that the system remains in a
moving equilibrium.
(2) The saving and investment coefficients are disturbed overtime in such
a way that an upward displacement from equilibrium path leads to a
lagged movement a way from equilibrium.
(3) Hicks assumes constant values for the multiplier and the accelerator.
(4) The economy cannot expand beyond the full employment level of
output. Thus “the full employment ceiling” acts as a direct restraint on
the upward expansion of the e conomy.
(5) The working of the accelerator in the downswing provides an indirect
restraint on the downward movement of the economy. The rate of
decrease in the accelerator is limited by the rate of depreciation in the
downswing.
(6) The relation between the multip lier and accelerator is treated in a
lagged manner, since consumption and induced investment are
assumed to operate with a time lag.
(7) It is assumed that the average capital -output ratio (v) is greater than
unity and that gross investment does not fall below zero. Thus the
cycles are inherently explosive but are contained by ceilings and
floors of the economy.
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36 The Hicksian Theory:
Hicks explains his theory of the trade cycle in terms of Fig. 5. Line AA
shows the path of autonomous investment growing at a con stant rate. EE
is the equilibrium level of output which depends on AA and is deduced
from it by the application of the multiplier accelerator interaction to it.
Line FF is the full employment ceiling level above the equilibrium path
EE and is growing at th e constant rate of autonomous investment. LL is
the lower equilibrium path of output representing the floor or ‘slump
equilibrium line’.
Figure No. 4.1

Time and Output and Investment
Hicks begins from a cycle less situat ion PQ on the equilibrium path EE
when an increase in the rate of autonomous investment leads to an upward
movement in income. As a result, the growth of output and income
propelled by the combined operation of the multiplier and accelerator
moves the econ omy on to the upward expansion path from Po to P1.
According to Hicks, this upswing phase relates to the standard cycle which
will lead to an explosive situation because of the given values of the
multiplier and the accelerator. But this does not happen be cause of the
upper limit or ceiling set by the full employment level FF.
Hicks writes in this connection: “I shall follow Keynes in assuming that
there is some point at which output becomes inelastic in response to an
increase in effective demand.” Thus ce rtain bottlenecks of supply emerge
which prevent output from reaching the peak and instead encounter the
ceiling at P1.
When the economy hits the full employment ceiling at P1 it will creep
along the ceiling for a period of time to P2 and the downward swin g will
not start immediately. The economy will move along the ceiling from P1
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37 The greater the investment lag, the more the economy will move along the
ceiling path. Since income at this level is d ecreasing relative to the
previous stage of the cycle, there is a decreased amount of investment.
This much of investment is insufficient to keep the economy at the ceiling
level, and then the downturn starts.
During the downswing, “the multiplier -accelera tor mechanism sets in
reverse, falling investment reducing income, reduced income reducing
investment, and so on, progressively. If the accelerator worked
continuously, output would plunge downward below the equilibrium level
EE, and because of explosive t endencies, to a greater extent than it rose
above it.” The fall in output in this case might be a steep one, as shown by
P2 P3 Q. But in the downswing, the accelerator does not work so swiftly
as in the upswing. If the slump is severe, induced investment w ill quickly
fall to zero and the value of the accelerator becomes zero.
The rate of decrease in investment is limited by the rate of depreciation.
Thus the total amount of investment in the economy is equal to
autonomous investment minus the constant rate of depreciation. Since
autonomous investment is taking place, the fall in output is much gradual
and the slump much longer than the boom, as indicated by Q1Q2. At Q2,
the slump reaches the bottom or floor provided by the LL line.
The economy does not turn upward immediately from Q2 but will move
along the slump equilibrium line to Q3 because of the existence of excess
capacity in the economy. Finally, when all excess capacity is exhausted,
autonomous investment will cause income to rise which will in turn l ead
to an increase in induced investment so that the accelerator is triggered off
which along with the multiplier moves the economy toward the ceiling
again. It is in this way that the cyclical process will be repeated in the
economy.
Criticisms:
The Hicks ian theory of the business cycle has been severely criticised by
Duesenberry, Smithies and others on the following grounds:
1. Value of Multiplier not Constant:
Hicks’s model assumes that the value of the multiplier remains constant
during the different ph ases of the trade cycle. This is based on the
Keynesian stable consumption function. But this is not a realistic
assumption, as Friedman has proved on the basis of empirical evidence
that the marginal propensity to consume does not remain stable in relatio n
to cyclical changes in income. Thus the value of the multiplier changes
with different phases of the cycle.
2. Value of Accelerator not Constant:
Hicks has also been criticised for assuming a constant value of the
accelerator during the different phases of the cycle. The constancy of the
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38 unrealistic assumptions because the capital -output ratio is itself subject to
change due to technological factors, the nature and composition of
investmen t, the gestation period of capital goods, etc. Lundberg, therefore,
suggests that the assumption of constancy in accelerator should be
abandoned for a realistic approach to the understanding of trade cycles.
3. Autonomous Investment not Continuous:
Hicks a ssumes that autonomous investment continues throughout the
different phases of the cycle at a steady pace. This is unrealistic because
financial crisis in a slump may reduce autonomous investment below its
normal level. Further, it is also possible, as poi nted out by Schumpeter,
that autonomous investment may itself be subject to fluctuations due to a
technological innovation.
4. Growth not Dependent only on changes in Autonomous
Investment:
Another weakness of the Hicksian model is that growth is made depe ndent
upon changes in autonomous investment. It is a burst of autonomous
investment from the equilibrium path that leads to growth. According to
Prof. Smithies, the source of growth should he within the system. In
imputing growth to an unexplained extraneo us factor, Hicks has failed to
provide a complete explanation of the cycle.
5. Distinction Between Autonomous and Induced Investment not
Feasible:
Critics like Duesenberry and Lundberg point out that Hicks’s distinction
between autonomous and induced inves tment is not feasible in practice.
As pointed out by Lundberg, every investment is autonomous in the short
run and a major amount of autonomous investment becomes induced in
the long run.
It is also possible that part of a particular investment may be auto nomous
and a part induced, as in the case of machinery. Hence this distinction
between autonomous and induced investment is of doubtful validity in
practice.
6. Ceiling fails to explain adequately the onset of Depression:
Hicks has been criticised for his explanation of the ceiling or the upper
limit of the cycle. According to Duesenberry, the ceiling fails to explain
adequately the onset of depression. It may at best check growth and not
cause a depression. Shortage of resources cannot bring a sudden decli ne in
investment and thus cause a depression.
The recession of 1953 -54 in America was not caused by shortage of
resources. Further, as admitted by Hicks himself, depression may start
even before reaching the full employment ceiling due to monetary factors.
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39 7. Explanation of Floor and Lower Turning Point not Convincing:
Hicks’s explanation of the floor and of the lower turning point is not
convincing. According to Hicks, it is autonomous investment that brings a
gradual movement towards the floor and it is again increase in
autonomous investment at the bottom that leads to the lower turning point.
Harrod doubts the contention that autonomous investment would be
increasing at the bottom of the depression. Depression may retard rather
than encourage autonomous investment.
Further, Hicks’s contention that revival would start with the exhaustion of
excess capacity has not been proved by empirical evidence.
RendingsFels’s study of the American business cycles in the 19th century
has revealed that the revival was n ot due to the exhaustion of excess
capacity. Rather in certain cases, revival started even when there was
excess capacity.
8. Full Employment level not Independent of Output Path:
Another criticism levelled against Hicks’s model is that the full
employment ceiling. As defined by Hicks, it is independent of the path of
output. According to Dernburg and McDougall, the full employment level
depends on the magnitude of the resources that are available to the
country.
The capital stock is one of the resources. W hen the capital stock is
increasing during any period, the ceiling is raised. “Since the rate at which
output increases determines the rate at which capital stock changes, the
ceiling level of output will differ depending on the time path of output.
One ca nnot therefore separate the long -run full employment trend from
what happens during a cycle.”
9. Explosive Cycle not Realistic:
Hicks assumes in his model that the average capital -output ratio (v) is
greater than unity for a time lag of one year or less. T hus explosive cycles
are inherent in his model. But empirical evidence shows that the response
of investment to a change in output (v) is spread over many periods. As a
result, there have been damped cycles rather than explosive cycles.
10. Mechanical Expl anation of Trade Cycle:
Another serious limitation of the theory is that it presents a mechanical
explanation of the trade cycle. This is because the theory is based on the
multiplier -accelerator interaction in rigid form, according to Kaldor and
Duesenber ry. Thus it is a mechanical sort of explanation in which human
judgement, business expectations and decisions play little or no part.
Investment plays a leading role based on formula rather than on
judgement.

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40 11. Contraction Phase not longer than Expansi on Phase:
Hicks has been criticised for asserting that the contraction phase is longer
than expansion phase of trade cycle. But the actual behaviour of the
postwar cycles has shown that the expansionary phase of the business
cycle is much longer than the c ontractionary phase.
Conclusion:
Despite these apparent weaknesses of the Hicksian model, it is superior to
all the earlier theories in satisfactorily explaining the turning points of the
business cycle. To conclude with Dernburg and McDougall, “The Hicks’ s
model serves as a useful framework of analysis which, with modification,
yields a fairly good picture of cyclical fluctuation within a framework of
growth.
It serves especially to emphasise that in a capitalist economy characterised
by substantial amount s of durable equipment, a period of contraction
inevitably follows expansion. Hicks’s model also pinpoints the fact that in
the absence of technical progress and other powerful growth factors, the
economy will tend to languish in depression for long period s of time.” The
model is at best suggestive.
4.6 MEASURES TO CONTROL TRADE CYCLES
The following are some of the measures to control business cycles.
1. Monetary policy:
Some economists advocated the monetary measure’s to control business
cycles. The centr al bank can practice the monetary measures to control
trade cycles. The Central. Bank uses both quantitative and qualitative
measures to control credit. During the terms of inflation it can increase the
bank rate and it leads to higher interest rates in th e money market. Thus,
expansion is checked. It can also sell its securities for public. As a result
the excessive purchasing power of people decreases. It can also increase
cash reserve ratios CRR to reduce the credit creation of commercial banks.
In the s ame way, during the period of depression the Central Bank can
reduce the Bank rate to stimulate investment. It can purchase securities
from bank and public to increase the credit creation of banks and the
purchasing power of the people. Cash reserve ratio to be kept by the
commercial banks is lowered enabling them to give more credit. As a
result, money and credit are increased. Due to these measures the
economy can take an upward movement.
2. Fiscal measures:
Keynes advocates fiscal measures to control tr ade cycles. Budgetary
measures, taxation, public expenditure and public debt should be used to
control trade cycles. During the period Of depression the government
should increase its expenditure and increase aggregate demand. The
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41 government spends large sums of money on public works like roads,
projects etc. and consequently employment will be increased.
This will arrest the fall of prices of goods and unemployment in those
industries. Th is can mitigate suffering and revival will start. During the
period of prosperity or inflation, public expenditure should be reduced.
Taxation and public borrowing should be increased. The government
adopt surplus budgets. All these measures can reduce the incomes of the
people, leading to a fall in the aggregate demand. This can arrest the
expansion of business.
3. Price control:
To control inflation or rising prices, price control measures should be
introduced. That means prices must he kept under check.
4. Price support:
During the period of depression prices begin t fall. This has cumulative
effect. So it is harmful. To avoid this, price support policy should be
adopted. Minimum prices should be provided. If prices fall below a
minimum level, governmen t purchases all the goods at support prices in
the market.
4.7 SUMMARY
In this unit we have studied the Hawtrey’s theory of trade cycles Kaldor’s
theory of trade cycles, Paul S amuelson’s theory of trade cycles, H icks
theory of trade cycles and measures to control trade cycles etc in detail.

4.7 QUESTIONS
1. Discuss the Hawtrey’stheory of trade cycles.
2. Elaborate the Kaldor’s theory of trade cycles.
3. Explain the Paul Samuelson’s theory of trade cycles.
4. Discuss Hicks theory of trade cy cles
5. What are the measures to control trade cycles?

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42 5
EXCHANGE RATES REGIMES

Unit Structure:
5.0 Objectives
5.1 Managed exchange rates
5.2 Policy of Managed Flexibility
5.3 Balance of Payments and Exchange Rates
5.4 Balance of Payments Always Balances
5.5 Questions
5.0 OBJECTIVES
 To study about the managed exchange rates.
 To know the policies of managed flexibility.
 To understand the concept of balance of payments (BoP).

5.1 MANAGED EXCHANGE RATES
Managed exchange rate system a system under which a government and
Central Bank actively manage the value of their currency against another
currency usually by keeping the exchange rate within the desired range of
rates by using a price ceiling and price floor for the currency. Under the
managed exchange rate system, the exchange rate is predominantly
determined in the foreign exchange market by supply of and demand for a
currency. The government intervenes only occasionally to influence the
exchange rate when it considers it to be necessary.
There has been a reduction in central bank intervention in the developed
countries over the last decade. However, any central bank still has the
discretion to intervene if it feels conditions warrant. The central banks in
many parts of the developing world still engage in intervention
Methods for managing or pegging a currency is exchange rate
1. Monetary policy:

Expansionary monetary policy is lowering the interest rates in order to
discourage people in investing. Lower interest rates reduce demand for a
currency and leads to depreciation of currency. Central Bank in tentionally
reduces interest rates through devaluation. Lower interest rates attract
foreign investors to invest in a country and there is inflow of foreign
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Exchange Rates Regimes
43 currency. Higher interest rate s should increase demand for a currency and
leads to its appreciation the central bank actively intervenes in the form of
revaluation

2. Official reserves :

It is a direct intervention in foreign exchange market to reduce the value of
a currency.it means Ce ntral Bank can buy or sell its own currency on the
forex market in order to revalue or devalue its currency against another
currency. Central Bank wishes to develop its currency it must buy the
foreign currency which adds to the central banks official rese rves and sell
its own currency on the forex market this will lead to the devaluation of a
currency

3. Exchange controls :

It is a legal limit on foreign investment at home or abroad by foreign and
domestic investors by limiting investments in a country. the government
can essentially minimise the amount of demand for its currency in forex
market
The government in order to keep its currency strong, must limit the
amount by limiting the investment done by domestic investors abroad.
Large amount of domestic inve stors abroad would increases the demand
for foreign currency and reduce demand for domestic currency. An
increase the supply of the domestic currency in forex market causes it to
get weak. A weak currency is deemed undesirable by the government. It
can set limits on the amount of foreign investment abroad done by
domestic investors.
Hence there are three tools for managing exchange rate. Central Bank can
use monetary policy by lowering interest rate .It can reduce the demand
for domestic currency in forex market .since investment in the market will
become less attractive and help to keep the currency below the price
ceiling . By raising interest rate they could make investment more
attractive causing for demand for currency to rise and keep the excha nge
rate above the price floor official reserve.Ifthe central bank wishes to
devalue it's currency in forex market it can buy foreign currencies and add
them to their official reserves and increase the supply of it's currency in
forex market. If the centra l bank wishes to re -value it's currency or
strengthen its currency against another currency it increases the supply of
foreign currencies and buy its own currencies in the forex market driving
the demand for currency and keeping the exchange rate above th e
minimum level established by the central bank .
Exchange control limits the amount of foreign investment at home or
abroad in domestic fronts.Limiting the amount of investment flowing into
or out of the country can help to keep the demand for the countri es
currency on the forex market a certain range and maintain the exchange
rate within a desire range.
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44 5.2 POLICY OF MANAGED FLEXIBILITY
In practice, different countries have attempted to adopt such exchange rate
policies that tend to combine a certain de gree of inflexibility with a
reasonable degree of flexibility . Such practices are known as the policies
of managed flexibility or controlled floating.
The fixed and flexible exchange rate policy are at the two extremes,which
suffered certain drawbacks or l imitations.
Types of Managed Flexibility
1) ADJUSTABLE PEG SYSTEM:
Under the Bretton Woods System, the exchange rates of different
currencies were pegged in terms of gold or the U.S. dollar at the rate of $
35 per ounce of gold. The nations were allowed to change the par values
of their currencies when faced with a ‘fundamental’ disequilibrium. An
adjustable peg system requires the defining of par value with a specific
permitted band of variations along with the stipulation that the par value
will be chan ged periodically and the currency devalued to correct a BOP
deficit or revalued to correct a surplus.
Thus the adjustable peg policy involves the pegging of exchange at a
given level at a given time. As the situation changes, the old peg
(exchange parity), when it is no longer feasible, is abandoned and a new
parity is established through devaluation or revaluation. In such a system,
it is important that some specific objective rules are agreed upon and
enforced to determine when a nation must readjust the par value and to
what extent it should make the adjustment. The working of adjustable peg
system can be shown through following figure.
Figure No. 5.1


In Fig. 1, the foreign exchange (dollars) is measured along the X axis. The
rate of exchange (rupees price of dollar) is measured along the Y axis.
Given the demand for and supply curves D 0 and S respectively of foreign
exchange, the original rate of exchange between dollar and rupee is R 0.
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Exchange Rates Regimes
45 Even if the demand for foreign exchange increases and the demand curve
shifts to D 1 and D 2, the rateof exchange remains pegged at the level R 0 and
adjustment is made through the use of country’s exchange reserves. It
means the supply curve, which had started from the point a ri ses positively
upto point b and then becomes horizontal upto point c where the country
exhausts its foreign exchange reserves.
If the demand curve shifts from D 2 to D 3, the country cannot maintain the
old parity. Therefore, the exchange rate is adjusted at the higher level R 1.
If the demand for foreign exchange increases and the demand curve shifts
to D 4 and D 5, the same exchange parity R 1 is maintained again through the
use of foreign exchange reserves. It means the supply curve, after moving
vertically fr om c to d, moves horizontally upto e.
At this point the exchange reserves of the country have got exhausted.
Further pegging at the level R 1 is not possible. The increase in demand,
shown by the shift of demand curve from D 5 to D 6 must be adjusted now
by p egging the exchange rate at a higher level R 2. In this system of
adjustable peg, the effective supply curve of dollar has a zig -zag path a b c
d e f and so on.
The adjustable peg system is also called as the system of maximum
devaluation. A country faced w ith BOP deficit waits for some time and
maintains the old peg through the pegging operations. When the pegging
is no longer possible, the old equilibrium rate or peg becomes non -
feasible. Then the country has to undertake a sudden big dose of
devaluation o f home currency.
In this way, the system of adjustable peg combines certain degree of
exchange rate flexibility with stability of exchange rate and attempts to
lead the economy towards a more realistic exchange rate.
Limitations:
1. In the IMF adjustable peg system, there is no clear cut operational
definition of ‘fundamental’ disequilibrium. It was referred only in
broad and vague terms like deficit or surplus persisting over the years.

2. Most of the countries often give priority to the domestic objectives
like maximum employment and price stability. This system provides
no alternative for adjustment in the short run.

3. The deficit and surplus countries are often reluctant to change the
exchange rate for protecting their economic interests, for the reasons
of prestige or to fend against the destabilising speculation. They will
change the par value only when they are practically forced to do so.

4. The adjustable peg system causes a large scale destabilising
speculation. If a country is faced with persistent defici t, the
speculators can easily anticipate the extent by which the currency will
be devalued. Hence, they start transferring funds out of a weak
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46 type of speculations has adverse effects upon a relatively weak
currency.

5. IMF fixed parity or adjustable peg collapsed in 1973. Earlier, the U.S.
dollar was the strongest currency. Most of the other countries wanted
to build their exchange reserves in terms of dollars. This brought
dollar under tremendous strain. This ultimately led the United States
to disallow the convertibility of dollar into gold. It amounted to a
collapse of IMF exchange system.

6. The system of adjustable peg involved a serious flaw in the form of
IMF insistence upon the expe nditure -reduction policies for correcting
the BOP disequilibrium. It was not welcome to many countries which
were inclined to follow the expenditure -raising policy for achieving
higher growth rate and maximum welfare. Many of the countries
adopted the expe nditure -switching policies. That was also not
acceptable to the IMF

7. Since under the adjustable peg system, the countries make change in
exchange parity only when they have no other alternative or when
they are forced to do so, it remains virtually a fixed exchange system

8. In the opinion of Milton Friedman, “…this system can neither ensure
sensitive, gradual and continuing adjustments in the rates of exchange,
nor can it provide permanent stability in expectations. Therefore, it is
clearly the worst of two worlds.”
2) CRAWLING PEG SYSTEM:
It waspopularised in mid -sixties by economists like WilliamFellner, J.H.
Williamson, J. Black, J.E. Meade and C.J. Murphy. It is a compromise
between the extremes of freely fluctuating exchange rates and perfectly
stable e xchange rates. It was devised in order to avoid the disadvantage of
relatively large changes in par values and possibly destabilising
speculation associated with the system of adjustable peg.
In adjustable peg, the authorities wait for a long time until th e reserves of
foreign exchange get exhausted. Where as in crawling peg system, the par
values are changed by small pronounced amounts or percentages at
frequent and specified intervals, such as one month or even a fortnight,
until the equilibrium exchange rate is reached. This exchange rate policy
known also as ‘trotting peg’ or ‘gliding parity”
3) POLICY OF MANAGED FLOATING:
The fluctuations in exchange rate tend to have an adverse effect upon the
flow of international trade and investments. The Smithsoni an Agreement
made on December 18, 1971 provided for the widening of margin of
fluctuations from 1 percent on each side of the exchange parity to 2.25
percent on each side of the par value of exchange.
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47 Snake in a tunnel :
The Werner Report of 1972, introduc ed a scheme intended to reduce the
fluctuations in the currencies of the members of the EC. The scheme
required that the members restrict fluctuation between their currencies to ±
1.125 percent of their par values, but subject to the constraint that each
would be allowed to fluctuate against the U.S. dollar by the full ± 2.25
percent allowed by the Smithsonian Agreement. This scheme was known
as the ‘snake in the tunnel’. The ‘tunnel’ was later abandoned, when the
member countries decided to float their cu rrencies against the dollar.
After the breakdown of Smithsonian Agreement, following the U.S.
devaluation of dollar on February 32, 1973, several countries including
Britain, Canada, Japan, Switzerland, India and some smaller countries had
floating exchan ge rates in March 1973. The countries of EC continued to
have a “joint float” even after March 1973. Since the EC currencies could
fluctuate relative to other currencies irrespective of any fixed margin or
band, the exchange rate policy of EC countries was likened to a “snake in
the lake.”
The system of floating exchange rates was not, in fact, a system of freely
flexible exchange rates but of a managed float. Under managed floating
exchange rate, the monetary authorities of different countries are entruste d
with the responsibility to intervene in foreign exchange markets to
smoothen out short run fluctuations without attempting to affect the long -
term trend in exchange rates.
At the same time, they retain the flexibility in adjusting the BOP
disequilibria . It is true that the monetary authorities are in no better
position than traders, investors or professional speculators to know what
the long -term trend in foreign exchange rate is. Such knowledge is not
even required to stabilise the short run fluctuatio ns in exchange rates,
when a country has adopted a policy of “leaning against the wind.”
The central banks intervene only to moderate the short run fluctuations
through using or absorbing the international exchange reserves. This
policy reduces the short run fluctuations in the exchange rate without
affecting the long term trend in exchange rates. It implies that even under
a policy of managed float there is need of maintaining some amount of
foreign exchange reserves.
4) CLEAN AND DIRTY FLOAT SYSTEMS :
The system of managed floatmakes a distinction between a clean float and
dirty float.
Clean Float:
In case of clean float, the rate of exchange is allowed to be determined by
the free market forces of demand and supply of foreign exchange. The
exchange rate i s permitted to move up and down. The foreign exchange
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48 without the intervention of monetary authority. Thus, the policy of clean
float is identical to the policy of freely fluctuating exch ange rates.
Dirty Float :
In case of a dirty float, the exchange rate is determined by the market
forces of demand and supply for foreign exchange. However, the
monetary authority intervenes in the foreign exchange market through the
pegging operations eith er to smoothen or to eliminate the fluctuations
altogether. It means even the long term trend in exchange rate is
manipulated by the monetary authority. Such a policy of managed float is
understood as the policy of ‘dirty float’. The clean float and dirty float are
distinguished through below figure.
Figure No. 5.2

Given the demand and supply functions of foreign exchange as D 0 and
S0 respectively, the equilibrium rate of exchange R 0 is determined at point
a. Under the alternate pressures of BOP deficits and surpluses, the demand
and supply curves undergo shifts. The policy of clean float causes the
equilibrium rate of exchange to move along the path ab 1cd1ef1g.
Whereas, under the free adjustment without central banking intervention,
the exchange rate, i n case of clean float, moves along the path a b c d e f g.
In these two cases of clean float, the exchange rate is fairly stable around
the level R 0.
On the opposite, when there is a policy of dirty float and the central bank
is prepared to intervene throu gh the sale or purchase of foreign exchange
and the variations in exchange rate are not allowed to take place. The
movement takes place directly from a to c, then from c to e and again from
e to g.The clean float policy ensures the exchange rate stability with a
certain degree of flexibility. The dirty float, on the opposite, does not
permit flexibility in the exchange rate.
A dirty float results not only in deliberate manipulations of exchange rate,
it also affects the long term trend of fluctuations. The distortions caused
by the dirty float are clearly detrimental to the smooth flow of
international trade and investment.
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49 5.3 BALANCE OF PAYMENTS AND EXCHANGE
RATES
Balance of payments is the systematic record of a country's trade with
other nations. The r elationship between balance of payments and exchange
rates under a floating -rate exchange system is driven by the supply and
demand for the country's currency and all transactions taking place with
other countries.
Balance of payments records all the finan cial transaction that a country
makes with other countries in a year. These transactions allow the transfer
of ownership of anything that has economic value and can be measured in
monetary terms for citizens of one country to citizens of the other country.
The transaction involves:
1. Tangible goods that can be products that have visible existence.
2. Intangible goods (services).
3. Income of its citizens
4. Liabilities and financial claims to other countries
Exchange rates and its relationship with bala nce of payment Exchange rate
is the value of one currency in terms of another. Both Exchange Rates and
Balance of payment have a strong relationship. Exchange rates have huge
impact on the balance of payments. Whenever a country’s exchange rate
falls, it m eans the value of its currency in terms of another country has
fall, which in return makes its exports cheaper and imports expensive.
This can lead to a current account deficit and will have negative effect on
balance of payment. On the other hand the incr ease in the rates of one
currency will help the country improve its current account and so its
balance of payment.
Exchange rate fluctuations are likely to determine economic performance.
Developingand Industrial countries have had varying experiences
regarding fluctuations in current and financial account balances. Exchange
rate fluctuations are assumed randomly to be distributed around a steady -
state stochastic trend over time. Positive shocks to the exchange rate
indicate an unanticipated increase in t he foreign currency price of
domestic currency that is, unanticipated currency appreciation. Similarly,
negative shocks indicate unanticipated depreciation of the exchange rate.
The different effects of anticipated and unanticipated currency movement
and d ifferentiate the effects of currency appreciation and depreciation on
major components of the balance of payments in developing and industrial
countries.
5.4 BALANCE OF PAYMENTS ALWAYS BALANCES
A nation’s BOP is a summary statement of all economic transact ions
between the residents of a country and the rest of the world during a given
period of time. A BOP account is divided into current account and capital
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50 Current Account is made up of trade in goods (i.e., visible) and trade in
services (i.e., i nvisibles) and unrequited transfers.
The Capital account is made up of transaction in financial assets.
These two accounts comprise Balance of Payments. A BOP account is
prepared according to the principle of double -entry book -keeping. This
accounting pr ocedure gives rise to two entries, a debit and a corresponding
credit. Any transaction giving rise to a receipt from the rest of the world is
a credit item in the BOP account. Any transaction giving rise to a payment
to the rest of the world is a debit ite m.
The left hand side of the BOP account shows the receipts of the country.
Receipts arise from the commodity export, merchandised goods, from the
sale of invisible services, unilateral transactions in the form of the receipts
of gift and grants from fore ign governments, international lending
institutions and foreign individuals, borrowing of money from foreigners
or from repayment of loans by foreigners.
The right hand side shows the payments made by the country on different
items to foreigners. like tot al of external purchasing power is used for
acquiring imports of foreign goods and services as well as purchase of
foreign assets. This is the accounting procedure.
The BOP figures are published in a single column with positive (credit)
and negative (debit ) signs. Since payments side of the account enumerates
all the uses which are made up of the total foreign purchasing power
acquired by this country in a given period, and since the receipts of the
accounts enumerate all the sources from which foreign purc hasing power
is acquired by the same country in the same period, the two sides must
balance.
The entries in the account should, therefore, add up to zero. In practice,
this is difficult to achieve where receipts equal payments. In reality, total
receipts m ay diverge from total payments because of:
i. the difficulty of collecting accurate trade information;

ii. the difference in the timing between the two sides of the balance;

iii. a change in the exchange rates.
Because of such measurement problems, resource is ma de to ‘balancing
item’ that intends to eliminate errors in measurement. The purpose of
incorporating this item in the BOP account is to adjust the difference
between the sums of the credit and the sums of the debit items in the BOP
accounts so that they ad d up to zero by construction. Hence the
proposition: ‘the BOP always balances’. It is a truism. It only suggests that
the two sides of the accounts must always show the same total.
It implies only an equality. In this book -keeping sense, BOP always
balanc es. Thus, by construction, BOP accounts do not matter. The
accounts have both economic and political implications. Mathematically,
receipts equal payments but it need not balance in economic sense. This
means that there cannot be disequilibrium in the BOP accounts. A
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Exchange Rates Regimes
51 macroeconomic goal of an economy. Again, a deficit in the current
account is also undesirable. All these suggest that BOP is out of
equilibrium.
DOES BOP ALWAYS BALANCE?
There are three tests -
i. Movements in foreign exchange reserves including gold,
ii. increase in borrowing from abroad, and
iii. movements in foreign exchange rates of the country’s currency in
question.
If foreign exchange reserves decline, a country’s BOP is considered to be
in disequilibrium or in deficit. If foreign exchange reserves are allowed to
deplete rapidly it may shatter the confidence of people over domestic
currency. This may, ultimately, lead to a run on the bank.
In order to cover the deficit a country may borrow from abroad. Thus,
such borrowing occurs when imports exceed exports. This involves
payment of interest on borrowed funds at a high rate of interest.
The foreign exchange rate of a country’s currency may tumble when it
suffers from BOP d isequilibrium. A fall in exchange rate of a currency is a
sign of BOP disequilibrium. Thus, the above (mechanical) equality
between receipts and payments should not be interpreted to mean that a
country never suffers from the BOP problem and the internatio nal
economic transactions of a country are always in equilibrium.
5.5 QUESTIONS
1. Explain the meaning and Methods for managing exchange rates
2. Discuss the merits and demerits of exchange rate system
3. Explain briefly the policy of Managed Flexibility
4. Explain w ith diagram the concepts of Adjustable Peg System and
Crawling Peg System
5. Explain the policy of Managed Floating
6. Write a note on Clean and Dirty Float Systems
7. Explain the relation between Balance of Payments and Exchange Rates
8. ‘Balance of Payments Always B alances’ - explain

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52 6
CONVERTIBILITY OF RUPEE AND
CURRENCY CRISIS
Unit Structure:
6.0 Objectives
6.1 Convertibility of Rupee
6.1.1 Current account and capital account convertibility of currency
6.1.2 Advantages of currency convertibility
6.1.3 The Benefits of Capital A ccount Convertibility:
6.1.4 Problems
6.2 Currency Crises
6.2.1 Impact of the currency crisis
6.2.3 Measures to curb currency crisis
6.3 Questions
6.0 OBJECTIVES
Basically there are mainly two objectives behind the study of this unit.
 To study the concept of convertibility of rupee.
 To study the impact and measures of currency crisis.
6.1 CONVERTIBILITY OF CURRENCY
Currency convertibility refers to how liquid a nation's currency is in terms
of exchanging with other global currencies. A convertible currency can be
easily traded on forex markets with little to no restrictions. A convertible
currency (e.g., U.S. dollar, Euro, Japanese Yen, and the British pound) is
seen as a reliable store of value, meaning an investor will have no trouble
buying and s elling the currency. on -convertible and blocked currencies
(e.g. Cuban Pesos or North Korean Won) are not easily exchanged for
other currencies and are only used for domestic exchange with their
respective borders.
Convertibility of a currency is desirable for the rapid growth of world
trade and capital flows between countries. With free and unrestricted
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53 To achieve higher rate of economic grow th and thereby to improve living
standards through greater trade and capital flows, the need for
convertibility of currencies of different nations has been greatly felt.
Under Bretton Woods system fixed exchange rate system was adopted by
large number of c ountries.
In order to maintain the exchange rate of their currencies in terms of dollar
or gold various countries imposed several controls over the use of foreign
exchange. This required some restrictions on the use of foreign exchange
and its allocation a mong different uses, the currency of a nation was
converted into foreign exchange on the basis of officially fixed exchange
rate.
When Bretton Woods system collapsed in 1971, the various countries
switched over to the floating foreign exchange rate system. Under the
floating or flexible exchange rate system, exchange rates between different
national currencies are allowed to the determined through market demand
for and supply of them. However, various countries still imposed
restrictions on the free convert ibility of their currencies in view of their
difficult balance of payment situation.
6.1.1 CURRENT ACCOUNT AND CAPITAL ACCOUNT
CONVERTIBILITY OF CURRENCY :
A currency may be convertible on current account (that is, exports and
imports of merchandise and in visibles) only. A currency may be
convertible on both current and capital accounts.
Capital account convertibility is in respect of capital flows, that is, flows
of portfolio capital, direct investment flows, flows of borrowed funds and
dividends and inte rest pay able on them, a currency is freely convertible
into foreign exchange and vice -versa at market deter mined exchange rate.
Thus, by convertibility of rupee on capital account means those who bring
in foreign exchange for purchasing stocks, bonds in Indian stock markets
or for direct investment in power projects, highways steel plants etc. can
get them freely converted into rupees without taking any permission from
the government.
Likewise, the dividends, capital gains, interest received on purchased
stock, equity etc. profits earned on direct investment get the rupees
converted into US dollars, Pound Sterlings at market determined exchange
rate between these currencies and repatriate them.
Since capital convertibility is risky and makes foreign exchan ge rate more
volatile, is intro duced only some time after the introduction of
convertibility on current account when exchange rate of currency of a
country is relatively stable, deficit in balance of payments is well under
control and enough foreign excha nge reserves are available with the
Central Bank.
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54 6.1.2 ADVANTAGES OF CURRENCY CONVERTIBILITY
1. Encourages exports:
An important advantage of currency convertibility is that it encourages
exports by increasing their profitability. Exports increase because market
foreign exchange rate is higher than the previous officially fixed exchange
rate. This implies that from given exports, exporters can get more rupees
against foreign exchange (e.g. US dollars) earned from exports. Currency
convertibility especially encourages those exports which have low import -
intensity.
2. Encourages import substitution:
Since free or market determined exchange rate is higher than the previous
officially fixed exchange rate, imports become more expensive after
convertibility of a currency. This discourages imports and encourages
import substitution.
3. Remittances from abroad:
Rupee convertibility provided greater incentives to send remittances of
foreign exchange by Indian workers living abroad and by NRI. Further, it
makes illeg al remittance such ‘hawala money’ and smuggling of gold less
attractive.
4. A self balancing mechanism:
Another important merit of currency convertibility lies in its self -
balancing mechanism. When balance of payments is in deficit due to over -
valued excha nge rate, under currency convertibility, the currency of the
country depreciates which gives boost to exports by lowering their prices
on the one hand and discourages imports by raising their prices on the
other.
Deficit in balance of payments get automati cally corrected without
intervention by the Government or its Central bank. The opposite happens
when balance of payments is in surplus due to the under -valued exchange
rate.
5. Specialisation and comparative advantage:
Currency convertibility ensures prod uction pattern of different trading
countries in accordance with their comparative advantage and resource
endowment. It is only when there is currency convertibility that market
exchange rate truly reflects the purchasing powers of their currencies
which i s based on the prices and costs of goods found in different
countries.
6. Integration of World Economy:
Finally, currency convertibility gives boost to the inte gration of the world
economy. As under currency convertibility there is easy access to foreign
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Convertibility of Rupee
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55 the countries. The expan sion in trade and capital flows between countries
will ensure rapid economic growth in the econo mies of the world. In fact,
currency convertibility is said to be a prerequisite for the success of
globalisation.
6.1.3 THE BENEFITS OF CAPITAL ACCOUNT CONVERTIBILITY:
The Tarapore Committee mentioned the following benefits of capital
account convertibility to India:
1. Availability of large funds to supplement dome stic resources and
thereby promote economic growth.
2. Improved access to international financial markets and reduction in cost
of capital.
3. Incentive for Indians to acquire and hold international securities and
assets, and
4. Improvement of the financial system in the context of global
competition.
6.1.4 PROBLEMS :
It may be noted that convertibility of currency can give rise to some
problems.
Since market determined exchange rate is generally higher than the
previous officially fixed exchange rate, prices of esse ntial imports rise
which may generate cost -push inflation in the economy.
If current account convertibility is not properly managed and monitored,
market exchange rate may lead to the depreciation of domestic currency. If
a currency depreciates heavily, th e confidence in it is shaken and no one
will accept it in its transactions. As a result, trade and capital flows in the
country are adversely affected.
Convertibility of a currency sometimes makes it highly volatile. Further,
operations by speculators make it more volatile. Further, operations by
speculators make it more volatile and unstable. When due to speculative
activity, a currency depreciates and confidence in it is shaken there is
capital flight from the country as it happened in 1997 -98 in case of South
East Asian econo mies such as Thail and, Malaysia, Indonesia, Singapore
and South Korea.
This adversely affects economic growth of the economy. In the context of
heavy depreciation of the currency not only there is capital flight but
inflow of capita l in the economy is discouraged as due to depreciation of
the currency profitability of investment in an economy is adversely
affected.
6.2 CURRENCY CRISES
A currency crisis is defined as any situation in the foreign exchange
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56 value relative to other currencies. In most cases, a currency crisis is not an
isolated event and usually follows a financial or socio -political crisis.
6.2.1 SIGNS OF A CURRENCY CRISIS:
1. Inflation A currency crisis is almost always preceded by a period of
rising inflation and inflation expectations.
2. Local banking crisis A currency crisis usually starts with domestic
financial institutions reneging on their debt payments.
6.2.2 CAUSES:
The causes of currency crises can be many. It's often difficult to see one
coming albeit in retrospect many reasons seem to arise. Some of these
causes include any combination of the following:
Speculation. That is to say, there is nothing wrong with the currency at the
heart of thing s but investors and traders may think so and devalue the
currency with their own actions.Central bank policies that may slow the
economy.
 A significant event, such as an assassination of a country's leader,
which rattles the markets

 Wars
 Sanctions placed upon a nation by another
 An over -reliance on foreign investment/foreign debt
 An over -reliance on one source of income for the economy
 Market panics based on any of the above
6.2.3 IMPACT OF THE CURRENCY CRISIS:
The effect of the currency crisis on the econ omy can take several routes.
1) Trigger a default and banking crisis :
The risk of default on foreign debt soars. Depreciation causes debts
denominated in foreign currencies to increase dramatically, reducing the
ability to repay debtors, be they government s or companies or banks.
2) Depleted foreign exchange reserves :
Currency crises can be very damaging to an economy. The central bank
took on the role of fending off speculative attacks using foreign reserves.
Its purpose is to prevent the depreciation from deepening.As a result,
foreign exchange reserves fell sharply.
How strong foreign exchange reserves can last depends on the intensity of
speculation, the severity of exchange rate depreciation, and the size of
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57 3) Uncertainty to inte rnational trade :
The sharp depreciation made domestic goods very cheap for foreigners.
That should increase exports. The effect depends on the demand for
domestic goods and on the price elasticity of the exported goods —the
more elastic the demand, the grea ter the export.
On the other hand, a severe depreciation caused foreign goods’ price to
skyrocket for domestic consumers. Imports are shrinking. Again, how
much imports will shrink depends on the price elasticity of imported
goods.
4) Severe depreciati on increases imported inflation:
The price of imported goods soared due to the depreciation of the
exchange rate. Consumers may stop buying imported goods.However,
companies cannot just stop imports. Indeed, they may delay the purchase
of imported capital goo ds. But, for raw materials, they will still buy
The increase in raw material prices raises production costs. To maintain
profits, producers pass on the increase in costs to the selling price. As a
result, domestic inflation has risen sharply.
6.2.4 MEASUR ES TO CURB CURRENCY CRISIS:
There are several possible measures to avoid a currency crisis, they are:
1) Floating exchange rate :
One of the keys to avoid the crisis is allowing the exchange rate to float
freely when speculators begin to launch their attac ks. Fixed exchange rates
require a credible policy against the market. And often, a country doesn’t
have the large reserves to do so. If the government still maintains a fixed
exchange rate, devaluation is an alternative policy.
2) Raise interest rates :
The increase keeps the spread of domestic interest rates and international
interest rates attractive. The aim is to encourage investment inflows,
thereby increasing the demand for domestic currency. Or, at least, it
prevents foreign investment from exiting the domestic market. Apart from
interest rates, central banks may also adopt other tight monetary policies in
response to currency crisis risks.
3) Fiscal policy tightening:
Governments often borrow abroad to finance deficits. Therefore, when the
governmen t lowers the deficit, it reduces the debt from the international
market.
4) Control of capital outflows:
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58 and the m assive sale of the domestic currency. However, often, the market
does not like it.
5) IMF bailout funds :
This option is usually less popular in some countries. Such bailouts
are likely to have undesirable by products such as higher taxes and lower
governme nt spending.
6.3 QUESTIONS
1. What do you mean by Convertibility of Currency? Explain briefly the
current and capital account convertibility.
2. Examine the a dvantages and disadvantages of Currency Convertibility.
3. Write a note on Currency Crises.
4. Examine the impact of the currency crisis.
5. Explain the measures to curb currency crisis.


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59 7
INTERNATIONAL MONETARY
SYSTEM – 1

Unit Structure:
7.0 Objectives
7.1 Introduction
7.2 The Gold Standard
7.3 Bretton Wood System
7.4 Monetary System after the Collapse of Bretton Woods System
7.5 The Maastricht Treaty
7.6 Features of the Eur o as EMU Currency
7.7 Euro -Currency Market
7.8 Questions
7.0 OBJECTIVES
The obectives of this unit are as follows –
 To know the concept of gold standard.
 To study about the Bretton Wood system and the collapse of Bretton
Woods systems.
 To understan d the Maastricht Treaty.
 To study about Euro Currency Market.
7.1 INTRODUCTION
An international monetary system (sometimes referred to as an
international monetary order or regime) refers to the rules, customs,
instruments, facilities, and organizatio ns for effecting international
payments. International monetary systems can be classified according to
the way in which exchange rates are determined or according to the form
that international reserve assets take. Under the exchange rate
classification, w e can have a fixed exchange rate system with a narrow
band of fluctuation about a par value, a fixed exchange rate system with a
wide band of fluctuation, an adjustable peg system, a crawling peg system,
managed floating etc.
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60 Features of a Good Internation al Monetary System :
1. A good international monetary system is one that maximizes the flow
of international trade and investments.

2. It leads to an "equitable" distribution of the gains from trade among the
nations.
3. An international monetary system can be eva luated in terms of
adjustment, liquidity, and confidence. Adjustment refers to the process
by which balance -of-payment disequilibria are corrected. A good
international monetary system is one that minimizes the cost of and the
time required for adjustment.

4. Liquidity refers to the amount of international reserve assets available
to settle temporary balance - of-payments disequilibria. A good
international monetary system is one that provides adequate
international reserves so that nations can correct balanc e- of-payments
deficits without deflating their own economies.

5. Confidence refers to the knowledge that the adjustment mechanism is
working adequately and that international reserves will retain their
absolute and relative values.
7.2 THE GOLD STANDARD
7.2.1 MEANING OF THE GOLD STANDARD:
International gold standard is means an international monetary system
wherein all participating countries have legally
(1) defined the unit of account (rupee, dollar, pound etc. monetary unit of
the country) in terms of gold ,
(2) established a mechanism whereby their local currencies are kept equal
in value to gold and to each other,
(3) fixed the external value of their currencies through the medium of
gold and,
(4) their monetary authorities are willing to buy and sell gold at a fix ed
price in unlimited amounts.
Under this system each nation defined the gold content of its currency and
passively stood ready to buy or sell any amount of gold at that price Since
the gold content in one unit of each currency was fixed, exchange rates
were also fixed. This was called the mint parity. The exchange rate could
then fluctuate above and below the mint parity (i.e., within the gold
points) by the cost of shipping an amount of gold equal to one unit of the
foreign currency between the two moneta ry centers.
A deficit nation would lose gold, its money supply would fall, and so
would its prices. This would stimulate the nation's exports and discourage
its imports until the balance -of-payments deficit was eliminated. The
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61 7.2.2 A BRIEF HISTORY OF GOLD STANDARD (1880 to 1924):
The gold standard operated from about 1880 to 1914. Chronologically
speaking, the inception of international gold standard may be found in the
last quarter of the 19th century when major tr ading countries like
Germany (in 1873), France (in 1878) and U.S.A. (in 1900) adopted the
gold coin standard, though England had already adopted as long ago as in
1816. Similarly, Russia, Holland, Austria, etc., also adopted gold
exchange standard later on , in the early 20th century. Thus, during the
years preceding World War I in 1914, gold standard which became a
universal standard of 'International Gold Standard' was in full swing. With
the outbreak of World War I, the classical gold standard came to an end
between 1919 and 1924.
Inter -War Period (1918 -36):
The gold coin standard worked remarkably well until the outbreak of the
global war in 1914, when the conditions were normal. But the First World
War in 1914 created emergencies and abnormalities throug hout the world
and as a result the gold standard was suspended during 1914 -18 and
incovertible paper currencies became the order of the day. Gold coins
were withdrawn from circulation by all the bellige - rent countries of
Europe to be replaced by notes. Th e central banks of different countries
had to resort to inflationary processes to finance the high cost of war. In
short, the rules of the gold standard game were not (and could not be)
observed and the gold standard perished.
However, with the cessation o f the war and restoration of peace, monetary
authorities of all countries again planned to revive the gold standard. The
war had created wild inflation, chaos and confusion in the international
monetary systems, and it was believed that, the restoration of the gold
standard would again ease the situation. At the International Conference at
Brussels in 1922, monetary experts agreed to reintroduce gold standard.
7.2.3 INTRODUCTION OF GOLD EXCHANGE STANDARD(1925) :
Gold exchange standard is a system in which bo th gold and currencies
convertible into gold (mostly pounds but also U.S. dollars and French
francs) were used as international reserves. This system came into
existence after World War I.
With the out break of World War I, the classical gold standard came to an
end Between 1919 and 1924, exchange rates fluctuated wildly, and this led
to a desire to return to the stability of the gold standard. In April 1925, the
United Kingdom reestablished the convertibility of the pound into gold at
the prewar price. Oth er nations followed the United Kingdom's lead and
went back to gold. This new system is called as Gold Exchange Standard.
With paper currency having become popular in many countries, and in
view of the scarcity of gold and other considerations, it was thou ght that
the gold coin standard of the past could not be revived. Instead, the gold
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62 Conference (1920). The U.S.A. was the first to adopt the gold standard in
1924, with England following suit i n May, 1925 at the pre -war gold parity
rate, i.e., £= 4.8665. Other European countries too followed the lead in
returning to the gold standard, either by introducing gold bullion standard
or gold exchange standard. With France joining late in 1928, the
restoration became complete. Countries which had adopted gold exchange
standard chose London, New York or Paris to keep their reserves. They
announced convertibility of their domestic currencies secure exchange
stability. into pounds, dollars and francs, and tried to
Thus, there was a structural difference between the gold standard of the
pre-war years and that of the inter -war period. In the revived gold standard
system, gold coins were not brought into circulation. It was in the form of
gold bullions.
7.2.4 DURING GOLD EXCHANGE STANDARD (1925 -1933):
Since the United Kingdom had lost a great deal of its competitiveness and
had liquidated a substantial portion of its foreign investments to pay for
the war effort, re -establishing the pre -war parity left the po und grossly
overvalued and led to large balance -of-payments deficits and gold losses
until the United Kingdom was forced to abandon the system in 1931 (the
United States followed suit in 1933).
7.2.5 COLLAPSE IN 1930s :
Although full -fledged gold standard was back in the field of international
monetary system by 1928, it had very short innings. In practice, it could
not function smoothly as in the pre -war era. It lasted for a bare three years
and that too in an unsatisfactory manner and ended when Great Bri tain
renounced it in September 1931. Greece, Portugal, Japan and S. Africa
also followed the U.K.,Australia, New Zealand and most of South
America had gone off the gold standard before Great Britain. U.S.A. went
off in 1933 and France in 1936. The world, i n general, thus, virtually
abandoned the gold again by 1936, leading to the final and complete
break -down of the post -war gold standard.
7.2.6 MECHANISM OF GOLD STANDARD:
a) MAINTENANCE OF EXCHANGE STABILITY GOLD POINTS:

International gold standard is basi cally concerned with the external value
of a currency and maintaining the stability of exchange rates. The process
by which gold standard maintains exchange stability is very simple.
Under the international gold standard the values of the currencies of
participating countries are fixed in terms of gold. Their exchange rates,
therefore, are also automatically fixed by gold parity. Thus, in a foreign
exchange market if the exchange rate tends to rise much above the gold
parity rate, the excess demand for for eign exchange will be met by export
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63 Similarly, if the foreign exchange rate tends to fall much below the gold
parity rate, the excess supply of foreign exchange is taken off from the
market by the import of gold. In this way the demand for any cu rrency in
foreign exchange market is kept equal to the supply, so that, stability of
the exchange rate is maintained.
The following illustration will make the point clear:
Suppose, two countries, say India and U.K., are both on the gold standard,
and that there is free import and export of gold in both countries. Now, if
in India the monetary authority has fixed the value of the rupee at 1/100th
ounce of pure gold and in U.K. its monetary authority has fixed the value
of pound as 1/5th ounce of pure gold, then the gold parity exchange rate of
the two currencies would be
Rs. =(1/5)ounce of gold/(1/100)ounce of gold = 100/5 = 20
Now, suppose that there is deficit in India's balance of payments (import
payments are more than export receipts), and surplus in U .K.'s balance of
payments (export receipts are more than import payments). Then the
demand for pound will be more than the demand for rupee, for the obvious
reason that people in India with rupees will purchase more pounds for
payments to their creditors i n U.K. than the people
in U.K. with pounds purchasing rupees for payments to their creditors in
India.Thus, the value of pound tends to rise in terms of the rupee, because
of the heavy demand for it. But this change in the exchange rate cannot go
far.
Now, if the cost of transfer (which is made up of the cost of shipment,
insurance and interest) of 1/5th ounce of gold from India to U.K. is only
50 paise, the exchange rate of pound will not rise above Rs. 20.50 per
pound, whatever, may be the excess demand for pounds in the foreign
exchange market. This is because anybody in India can get pounds by
exporting gold to U.K. The cost of getting £1 by exporting gold would be
only 50 paise, and he can buy 1/5th ounce of gold for Rs. 20 from the
Indian monetary au thority, the Reserve Bank of India, for this purpose.
Thus, in getting the pound by way of exporting gold one has to bear only
the cost of transferring gold from India to U.K., which is assumed to be 50
paise. People in India can thus, get any amount of po unds at the price of
Rs. 20.50 per pound by exporting gold. This means that the supply curve
of pound becomes perfectly elastic at this price. Therefore, when the
exchange rate rises uptoRs. 20.50 per pound in the foreign exchange
market, it will not be al lowed to rise further.
Whatever, excess demand for the pound is there, it will be taken off at this
rate from the foreign exchange market and will be shunted into the gold
market, and the excess pounds will be made available through export of
gold. This p oint of foreign exchange rate is called the upper gold point or
the gold export point (for India). It is the specific point of the foreign
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64 met by export of gold. Here, Rs. 20.50 to £ 1 is India's gold export point
and U.K.'s gold import point.
The reverse will be the case when the demand for rupee increases or the
supply of pounds increases. In that case the value of rupee will rise or that
of pound will fall. But here also the rate will n ot decline by more than 50
paise, the transfer cost of gold (from India to U.K. or from UK. to India).
Hence, the exchange rate will not fall below Rs. 19.50 per pound. Any
Englishman can get any amount of rupees at the rate of Rs. 19.50 per
pound by impor ting gold into India. For, he can get 1/5th ounce of gold
from the Bank of England for one pound, and transfer it by bearing the
transfer cost of 50 paise, in return for which he can get Rs. 20 from the
Reserve Bank of India. This means, the supply of rupe es against pounds
(i.e., the demand for pounds against rupees) becomes completely elastic at
the exchange rate of Rs. 19.50 per pound.
Thus, the demand curve for pounds becomes perfectly elastic at this rate.
This exchange rate should be regarded as the lo wer gold point or the gold
import point (for India). For, at this rate, any excess supply of pounds or
any excess supply of demand for rupees, will be taken away from the
foreign exchange market and will be shunted into the gold market, and the
excess rupe es will be made available through the import of gold in India.
Here, Rs. 19.50 to £ 1 is India's import point of U.K.'s export point.
b) GOLD STANDARD AND AUTOMATIC ADJUSTMENTS IN
BALANCE OF PAYMENTS:
A country with a deficit balance of payments loses gold, i .e, gold flows
out of the country, whereas, a country with a surplus balance of payments
receives gold, i.e., there will be an inflow of gold into the country.
(1) A nation with deficit in Balance of Payments:
When there is deficit in the balance of payments , the demand for the
foreign currency increases as a result the demand for and purchase of
gold from the central bank also increases for import payments.
Induced outflow of gold leads to a contraction of currency and credit
in the country. For, the exporte rs of gold will purchase gold from the
central bank. Thus, the gold reserve of the central bank falls and to
that extent it will have to reduce the issue of notes and currency in
circulation. So also commercial banks find reduction in their demand
deposits if withdrawals were made by these gold exporters for
purchasing gold from the central bank. To that extent commercial
banks' cash reserves are depleted and they are forced to contract credit
accordingly.
(2) Contraction in money supply (currency plus credit) will lead to a
decrease in prices.
(3) The fall in prices in the country will encourage foreigners' demand for
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65 Simultaneously, its imports will decline because people will find
foreign goods relatively costlier.
(4) The increase in exports and decrease in imports of the country would
increase the supply of and decrease the demand for foreign currency.
(5) Ultimately the deficit in the balance of payments will be wiped out
and the country may become a surplus co untry. That is to say, a
formerly gold -losing country will now become a gold - receiving
country.
Thus, the efflux of gold automatically creates conditions for the removal
of the deficit in thebalance of payments of a gold -losing country, the
deficit which was the cause of the out -flow of gold.
2. A Nation with a surplus in Balance of Payments:
1. A country with surplus balance of payments has more export receipts
than import payments. Hence the demand for the domestic currency is
more compared to foreign cur rency as the foreigners’ demand for
domestic currency rises. They buy the domestic currency by
transferring gold to the domestic country. Hence there is inflow of gold.
The inflow of gold which is caused by the surplus balance of payments,
in effect, leads to an expansion of credit and currency in the country.
For, when exporters in the surplus country receive gold from the debtor
country, they will get local currency in exchange from the central bank.
Thus,the central bank's gold reserve position is streng thened and its
capacity to issue more currencyincreases. Simultaneously, when these
people deposit their money with the commercial banks, thelatter's cash
reserves grow and so does their credit creation capacity.
2. The expansion of credit and currency will l ead to a rise in prices in the
country.
3. With the rise in prices the country's exports will decline while its
imports will increase.
4. When exports decline and imports increase in the country, its demand
for foreign currency increases, while the supply of fo reign currency in
the country declines.
5. Ultimately, the country's surplus balance of payments may turn reverse
so that, a formerly gold -receiving country will now become a gold -
losing country.
7.2.7 ADVANTAGES OF INTERNATIONAL GOLD STANDARD:
1. Internation al Medium of Exchange: International gold standard
provides the gold standard countries an international medium of exchange
and standard of value.' Because gold is an almost universally demanded
valuable commodity, it is generally acceptable as a means of payment.
Thus, payments in gold are acceptable to foreigners. Moreover, exchange
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66 when their par values are expressed in terms of gold. ready by, gold also
serves as a measure of value of efferent commodities, thus, enabling us to
mold a comparison of the worth of goods in different countries.
2. Stability of Exchange Rates: Perhaps the great advantage of the gold
standard, whatever, the form it may take (whether gold coin standard, gol d
bullion standard, or gold exchange standard), is that it provides stability of
exchange rates among the countries that adhere to it, and stability to the
internal value of the currency, maintaining at the same time its internal
value. Gold standard ensur es that exchange rates do not move beyond the
specie or gold point -within limits of slight variations. This stability of
exchange rates facilitates international capital movements and leads to
expansion of international trade.
3. Parity of Price Levels: Under international gold standard, price levels
between different countries are harmonised. The movement of gold from
country to country causes price levels to rise and fall in such a manner that
they are brought into equilibrium among all the nations which maintain
gold standard. However, this does not mean that, the price levels in
different countries are identical they are uniformly kept in equilibrium, ie,
they will be moving together. The price level in any country will neither
remain very low nor very h igh so that, it can gain permanent export
advantages over others or suffer permanent disadvantages in imports.
4. Automatic Laissez -Faire Standard: International gold standard is a
laissez -faire standard in the sense that it functions automatically and tha t it
requires no intervention of the government or the monetary authority for
adjustments. The golden rules of gold standard enjoin on the government
not to inflate currency and credit beyond proportions justified by gold
reserves. Further, it was claimed to be automatic in the sense that no
international organisation or agreements were nece - ssary for its
successful operation. It is argued that when on the gold standard the
balance of payments is automatically brought into equilibrium.
Even today, the IMF has not replaced the automatic mechanism of
international gold standard by some other system. Gold exchange standard
in a form is retained only to be supplemented and modified to the present
conditions by other suitable devices.
5. Public Confidence: Gold standard system inspires public confidence
insofar as the public has a strong bias in favour of gold. In fact,
international gold standard has strengthened the general habit of using
gold as an international means of payments. International gold standard
was, thus, in many ways a very useful monetary system for the growth of
world trade and transactions.
7.2.8 DRAWBACKS OF THE INTERNATIONAL GOLD
STANDARD
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67 1. The main drawback of the gold standard is that it deprives a country of
the power to adopt the particular monetary policy which is more
appropriate to its internal economic condition, at a time when its monetary
policy is subjected to international pressures.
2. Price stability and exchange stability, the two main objectives of
monetary policy, cannot be reconciled under the gold standard. Gold
standard forces the country to surrender the consideration of price
stability. Thus, under the gold standard mechanism exchange rates are
stabilised at the expe nse of internal economic stability and full
employment.
 In the opinion of Halm, the gold standard mechanism is a fair weather
craft. The mechanism can function only when the rules of the game are
observed. "It is fair weather craft of doubtful seaworthines s in stormy
waters. When the necessary conditions cannot be fulfilled, the gold
standard is abandoned, and it becomes the task of 'paper' standards to
manage the bad situation."

 It causes violent strains on the economic adjustments of the
participating co untries to play according to the rules of the game. In
fact, international gold standard cannot be regarded as automatic since
it is to be managed by the central banks of the countries by following
the rules of the gold standard game. Credit contractions a nd credit
expansions as per the rules are to be pursued, which are difficult and
dangerous operations. Oftentimes the central bank may not be able to
engaged in policy to reduce costs and prices sufficiently when gold
flows out, or to create enough demand for new loans when gold flows
in."

 Mrs. Joan Robinson remarked that the gold standard mechanism suffers
from an "inherent bias towards deflation." because, even when gold
begins to flow back to the gold -losing country, the central bank finds it
very diffi cult to stimulate credit expansion and overcome deflation.
For, the mechanism lacks sufficient reciprocity. The gold -losing
country will under legal compulsion to contract the currency but the
gold-receiving country is not compelled by law to expand the cu rrency.

 Further, it is easy for a central bank to contract credit through bank rate
policy and depress investment, but it is difficult to expand credit and
stimulate investment. Thus, while the gold -losing country suffers
deflation, the gold -receiving co untry may or may not experience
inflation.
3. Rules of the Gold Standard Game :
The successful working of the automatic international gold standard
presupposes that, there is no conscious management of the standard but
that participating countries adhere to what is called the rules of the gold
standard game. These rules are as follows: free import and export of gold
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68  The governments concerned must observe this golden rule of gold
standard, viz., expand be credit when gold is coming in, contract credit
when gold is going out." Thus, the gold -receiving country must make
arrangements for currency and credit expansion, and the gold -losing

 There should be a high degree of flexibility in the price systems of the
participating co untries, that, when the monetary pressure of gold
movementis exerted price levels rise or fall accompanied by smooth
adjustments of costs.

 There should be absence of distributing capital movements. The
automatic operation of the gold standard can be ensu red only when,
among other things, the investment policy of the lending countries
remains uniform. Flights of capital are independent of the variations in
the respective ratessoof interest and are capable of destroying the whole
gold standard mechanism."

 Although, free trade is not an essential condition of a successful
functioning of the gold standard, the game requires that there should be
no severe restrictions on international trade. Particularly, import quotas
hinder the automatic adjustment of gold standard mechanism.

 The monetary authorities of the gold standard countries should
maintain their gold parities bybuying and selling gold in unlimited
quantities at fixed rates. Moreover, the gold value of the domestic
currency must neither be overvalued nor undervalued. It should also be
stable. 7. Finally, the monetary authorities must be willing to conform
to the rules of the game, even at the cost of sacrificing the conflicting
aims of domestic monetary policy. The various independent objectives
of mon etary policy must be wholly subordinated to the international
monetary motives.
7.2.9 CAUSES OF THE DOWNFALL OF GOLD STANDARD:
As we have seen, during the thirties all the countries of the world one after
another went off the gold standard. A country is sa id to have gone off the
gold standard when she abandons gold as a unit of currency and when
gold ceases to serve as a medium of exchange.
The post -war gold standard monetary system failed due to its mixed
structure of international gold standard, as well as changes in the
economic philosophy and ideals and unfair practices adopted by the
participating nations. We may briefly reckon here the causes which were
responsible for the ultimate breakdown of the post -war gold standard the
automatic working of the g old standard.
1. War violently disrupted the normal course of international trade and
caused maldistributionof gold holdings as between different countries.
It, therefore, became very difficult for the various countries to maintain
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69 2. In the inter -war period the disequilibrium in the structure of costs and
prices between differentcountries was so great that it could not be
corrected by ordinary methods or the automatic workingof the gold
standard.

3. The seeds of collapse of the post -war gold standard were hidden in the
unreal and improper parities announced by important countries. The
British pound was overvalued by 10 per cent, while the French franc
was undervalued to that extent. This led to a continuous and persisting
outflow of gold from Great Britain to U.S.A. and France. These ill -
chosen parities made it difficult to correct the disequilibrium in the
balance of payments of the U.K. and the other countries holding
sterling.
4. Defiance of the rules of the sta ndard by the participating countries was
another major cause of its collapse. For instance, gold receiving
countries like the US.A. and France did not allow their increased stocks
of gold to operate upon their currencies, and tried to prevent inflation.
They sterilized the additional stocks of gold. This meant that they did
not help the deficit countries to end their deficits. This 'sterilisation
policy' was neither desirable nor necessary in the interest of the smooth
working of the international gold stan dard.
5. The automatic adjustment mechanism of the gold standard was
seriously distorted by erratic movements of short -term funds during the
thirties. People also lost faith in the stability of exchange rates during
this period. So, speculation in foreign exc hange took full swing which
endangered the gold standard
6. In the post -war era, the monetary authorities were no longer exclusively
devoted to the aimsof the gold standard. Internal price stability and full
employment were heavily stressed as againstthe mai ntenance of
exchange stability. Thus, the goals and practices of monetary policy
were contraryto the requirements of smooth working of the gold
standard.
7. Gold standard mechanism was further disturbed by the imposition of
high tariffs by the to safeguard th eir own interests.
8. According to Hawtrey, the immediate cause of the collapse was the
withdrawal of foreign money, first from Austria and Germany and then
from England. This was the result of distrust and this distrust was
directly due to the appreciation o f gold -prices.
9. The Great Depression of the thirties quickened the collapse of the gold
standard.In short, circumstances in the inter -war period were so
unfavorable that the gold standard broke down in 1936.
It may be observed that in the present era, gold standard, in all probability,
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70 development of resources on a national basis under a happy atmosphere of
internationalcooperation. However, gold will continue to play an
important role in mainta ining international relations. Gold servesand will
continue to serve as a measuring rod of international values and
exchanges. The International Monetary Fund,therefore, still retains the
significance of gold as international means of payments in its refin ed
monetary system.
7.3 BRETTON WOODS SYSTEM
7.3.1 MEANING OF THE BRETTON WOODS SYSTEM:
 At 1944 meetings in Bretton Woods, New Hampshire, representatives
of the United States, the United Kingdom, and other allies decided on
the establishment of a gold -exchange standard after the war.

 Under the Bretton Woods System, the United States was to maintain
the price of gold fixed at $35 per ounce and be ready to exchange on
demand dollars for gold at that price without restrictions or limitations.

 Other nations were to fix the price of their currencies in terms of dollars
(and thus implicitly in terms of gold) and intervene in foreign exchange
markets to keep the exchange rate from moving by more than 1 percent
above or par value.

 Within the allowed band of fl uctuation, the exchange below the rate
was determined by the forces of demand and supply. Specifically, a
nation would have to use its dollar reserves to purchase its own
currency to prevent it from depreciating by more than 1 percent from
the agreed par v alue, or the nation had to purchase dollars with its own
currency (adding to its international reserves) to prevent an
appreciation of its currency by more than 1 percent from the par value.

 Until the late 1950s and early 1960s, when other currencies bec ame
fully convertible into dollars, the U.S. dollar was the only intervention
currency, so that the new system was practically a gold -dollar
standard.)
7.3.2 OPERATION AND EVOLUTION OF THE BRETTON
WOODS SYSTEM:
The following points explain in brief the op eration of Bretton woods
system:
1. Allowing changes in the par values of the currencies:

The Bretton Woods System envisaged and allowed changes in par values
in cases of fundamental disequilibrium, industrial nations were very -
reluctant to change their par values until such action was long overdue and
practically forced upon them by the resulting destabilizing speculation.


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71 2. Industrial Nations approach to devaluation:

The unwillingness of industrial nations to change their par values as a
matter of policy when in fundamental disequilibrium robbed the system of
the mechanism for balance -of-payments adjustment and gave rise to
destabilizing international capital flows, which eventually led to the
collapse of the system.

3. Deficit nations and Surplus nations :

Deficit nations regarded devaluations as a sign of national weakness,while
surplus nations preferred to continue accumulating international reserves
instead of revaluing. Thus, from 1950 until August 1971, the United
Kingdom devalued only in 1967; France devalued only in 1957 and 1969,
West Germany revalued in 1961 and 1969; and the United States, Italy,
and Japan never changed their par values. Meanwhile, Canada (defying
the rules of the IMF) had fluctuating exchange rates from 1950 to 1962
and then reins tituted them in 1970. Developing nations, on the other hand,
devalued all too often.

4. Huge capital inflows and outflows due to rigidity :

Facing large trade deficits, the United Kingdom experienced huge capital
outflows in the expectation that the pound w ould be devalued, until it was
indeed forced to do so in 1967. On the other hand, West Germany
received huge capital inflows in the expectation that it would revalue the
mark. This made revaluation of the mark inevitable in 1961 and again in
1969.

5. Conver tibility of the dollar :

Convertibility of the dollar into gold resumed soon after World War II.
Formal convertibility for current account transactions was achieved in
1961 for major European currencies and in 1964 for the Japanese yen.
Capital account r estrictions were permitted to allow nations some
protection against destabilizing capital flows.

6. Trade Expansion Act of 1962 and GATT :

Under the Trade Expansion Act of 1962 and GATT auspices, the United
States initiated and engaged in wide -ranging multi lateral trade
negotiations (the Kennedy Round), which lowered average tariffs on
manufactured goods to less than 10 percent. Many nontariff barriers
remained, however, especially in agriculture and on simple manufactured
goods, such as textiles, which are of special importance to developing
nations. Several attempts were made at economic integration during this
period, the most successful being the European Common Market.

7. General Arrangements to Borrow (GAB) :

In 1962, the IMF negotiated the General Arra ngements to Borrow (GAB)
up to $6 billion from the so -called Group of Ten most important industrial
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72 France, Italy, Canada, the Netherlands, Belgium, and Sweden) and
Switzerland to its res ources, if needed, to help nations facing balance of
payments difficulties. GAB was renewed and expanded in subsequent
years.

8. Standby arrangements:

Starting in the early 1960s, member nations began to negotiate standby
arrangements. These refer to adv ance permission for future borrowings by
the nation at the IMF. Once a standby arrangement was negotiated, the
nation paid a small commitment charge on the amount earmarked and was
then able to borrow up to this additional amount immediately when the
need arose at a 5.5 percent charge per year on the amount actually
borrowed. Standby arrangements were usually negotiated by member
nations as a first line of defense against anticipated destabilizing hot
money flows. After several increases in quotas, the tota l resources of the
IMF reached $28.5 billion by 1971. By the end of 1971, the IMF had lent
about $22 billion, of which about $4 billion was outstanding. Member
nations were also allowed to borrow up to 50 percent of their quotas in any
one year (up from 25 percent).

9. Swap arrangements :

National central banks also began to negotiate so -called swap
arrangements to exchange each other's currency to be used to intervene in
foreign exchange markets to combat hot money flows. Swap arrangements
were negotiated f or specific periods of time and with an exchange rate
guarantee. When due, they could either be settled by a reverse transaction
or renegotiated for another period. The United States and European
nations negotiated many such swap arrangements during the 19 60s.

10. Special Drawing Rights (SDRs) :

The IMF also created Special Drawing Rights (SDRs) to supplement the
international reserves of gold and foreign exchange. Sometimes called
paper gold, SDRs are accounting entries in the books of the IMF. SDRS
are not backed by gold or any other currency, but represent genuine
international reserves. Their value arises because member nations have so
agreed. SDRS can be used only in dealings among central banks to settle
balance -of-payments deficits and surpluses, not in private commercial
dealings. A total of $9.5 billion SDRs were created from 1970 to 1972,
and these were distributed to member nations according to their quotas in
the IMF. Further allocations of SDRs were made in the 1979 -1981 period.
The value of one SD R was originally set equal to one U.S. dollar, but rose
above $1 as a result of the devaluations to the dollar in 1971 and 1973.
Starting in 1974, the value of SDRs was tied to a basket of currencies and
was $1.43 at the end of 2003.
Overall, the Bretton W oods system served the world well, until the mid -
1960s with international trade growing faster than (and there - fore
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73 7.3.3 COLLAPSE OF THE BRETTON WOODS SYSTEM :
1. Built -in Instability :

The Bretton Woods System had a built -in instability that ultimately led to
its breakdown. It was an adjustable peg system within plus or minus 1 per
cent of the par value of $ 35. In case of fundamental disequilibrium, a
country could devalue its currency with the approval of the IMF. But
countri es were reluctant to devalue their currencies because they had to
export more goods in order to pay for dearer imports from other countries.
This led countries to rely on deflation in order to cure BOP deficits
through expenditure -reducing monetary -fiscal policies. The UK often
restored to deflation such as in 1949, 1957 and 1967.

2. European Recovery:

From 1945 to 1949, the United States ran huge balance -of-payments
surpluses with Europe and extended Marshall Plan aid to help in its
reconstruction. With Eu ropean recovery more or less complete by 1950,
the U.S. balance of payments turned into deficit. Up to 1957, U.S. deficits
were small and allowed European nations and Japan to build up their
international reserves.

3. Lack of International Liquidity:

There was a growing lack of international liquidity due to increasing
demand for the dollar in world monetary markets. With the expansion of
world trade, BOP deficits (and surpluses) of countries increased. This
necessitated the supply of gold and of the dollar . But the production of
gold in Africa was increasing very little. This led to larger demand and
holdings of the dollar.

4. The Dollar shortage :

United States settled its deficits mostly in dollars. Surplus nations were
willing to accept dollars because (a ) United States stood ready to exchange
dollars for gold at the fixed price of $35 an ounce, making the dollar "as
good as gold"; (b) dollars could be used as an international currency to
transactions with any other nation; and (c) dollar deposits earned i nterest
while gold did not. As the supply of dollars was inadequate in relation to
the liquidity needs of countries, the US printed more dollars to pay for its
deficits which other countries accepted as reserves.

5. Destabilizing Speculation:

Since countri es with "fundamental disequilibrium" in BOP were reluctant
to devalue their currencies and also took time to get the approval of the
IMF, it provided speculators an opportunity to resort to speculation in
dollars. When devaluations were actually made, ther e were large doses of
devaluation than originally anticipated. This was due to destabilizing
speculation which made controls over capital flows even through
monetary - fiscal measures ineffective. This was the immediate reason for
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74 6. U.S. balance -of-payments deficits:

Starting in 1958, U.S. balance -of-payments deficits increased sharply,
first because of the huge capital outflows (mostly direct investments in
Europe) and then because of the high U.S. inflation rate (during the
Vietnam War). By 1970, foreign official dollar holdings were more than
$40 billion, up from $13 billion in 1949 in the face of U.S. gold reserves
declining from $25 billion in 1949 to $11 billion in 1970.

7. The Struggle of US for Balance of Payment cor rections:

Because the dollar was an international currency, the United States felt
that it was unable to devalue to correct its balance -of-payments deficits.
Instead, it adopted a number of other policies, with limited success. The
United States tried to encourage exports, reduced military and other
government expenditures abroad, tied most of its foreign aid, and imposed
some direct controls over capital outflows.

8. Mistakes in US Policies.

The BOP deficits of the US became steadily worse in the 1960s. To
overcome them, the policies adopted by the US government ultimately led
to the world crises. Rising US government expenditure in the Vietnam
War, the financing of US space programme and the establishment of the
"Great Society" (social welfare) programm e in the 1960s led to large
outflow of dollar from the US. But the US monetary authority (FED) did
not devalue the dollar. Rather, it adopted monetary and fiscal measures to
cut its BOP deficit.

9. Sharp decline in Gold reserves of US:

As U.S. balance -of-payments deficits continued to rise over time, U.S.
gold reserves declined to the point where they were only about one -quarter
of foreign -held dollar reserves by 1970. In 1970 and early 1971, the
expectation was that the United States would soon have to dev alue the
dollar and this led to huge destabilizing capital movements out of dollars.

10. The Triffin Dilemma :

Since the dollar acted as a medium of exchange, a unit of account and a
store of value of the IMF system, every country wanted to increase its
reserves of dollar which led to dollar holdings to a greater extent than
needed. Consequently, the US gold stock continued to decline and the US
balance of payments continued to deteriorate. Robert Triffin warned in
1960 that the demand for world liquidity wa s growing faster than the
supply because the incremental supply of gold was increasing little. Since
the dollar was convertible into gold, the supply of US dollars would be
inadequate in relation to the liquidity needs of countries. This would force
the US to abandon its commitment to convert dollars into gold. This is the
Triffin Dilemma which actually led to the collapse of the Bretton Woods
System in August 1971.

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75 11. Suspension of convertibility of dollars into gold:

On August 15, 1971, President Nixon w as forced to suspend the
convertibility of dollars into gold. The Bretton Woods System was dead.
At the same time, the United States imposed wage and price controls, as
well as a temporary 10 percent import surcharge, to be lifted after the
required curren cy realignment took place. For the benefit of seigniorage
from the use of the dollar as an international currency, the United States
had paid a heavy price by being unable to devalue, even though it was
clearly in fundamental disequilibrium. The irony was that the dollar
remained an international currency without any backing of gold.

12. Smithsonian Agreement :

With the Smithsonian Agreement in December 1971, representatives of
the Group of Ten nations agreed to increase the dollar price of gold from
$35 to $38 an ounce. This implied a devaluation of the dollar of about 9
percent. At the same time, the German mark was revalued by about 17
percent, the Japanese yen by about 14 percent, and other currencies by
smaller amounts with respect to the dollar. In add ition, the band of
fluctuation was increased from 1 percent to 2.25 percent on either side of
the new central rates, and the United States removed its 10 percent import
surcharge. Since the dollar remained inconvertible into gold, the world
was now essenti ally on a dollar standard.

13. Another devaluation in 1972:

However, with another huge U.S. balance -of-payments deficit in 1972, it
was felt that the Smithsonian Agreement was not working and that another
devaluation of the dollar was required.) This expect ation led to renewed
speculation against the dollar and became self -fulfilling in February 1973,
when the United States was once again forced to devalue the dollar, this
time by about 10 percent (achieved by increasing the official price of gold
to $42.22 an ounce), When speculation against the dollar flared up again
in March 1973, monetary authorities in the major industrial nations
decided to let their currencies float. The present managed floating
exchange rate system was born.)

While the immediate caus e of the collapse of the Bretton Woods System
was the huge balance -of-payments deficits of the United States in 1970
and 1971, the fundamental cause was the lack of a workable balance -of-
payments adjustment mechanism, the eruption of a crisis of confidence in
the US dollar. Persistent U.S. balance -of-payments deficits undermined
confidence in the dollar and led to its collapse. Thus the main cause of
breakdown of the Bretton Woods System was the problems of liquidity,
adjustment and confidence.


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76 7.4 MONE TARY SYSTEM AFTER THE COLLAPSE OF
BRETTON WOODS SYSTEM
The Present International Monetary System: A Chronological Order :
1. Floating exchange rates: At the beginning of March 1973 India,
Canada, Japan, Switzerland, the UK and several smaller countries had
floating exchange rates. However, the "joint float" of the EEC countries
continued even after March 1973 and was now called the "snake in the
lake", as there was no band within which the EEC currencies could
fluctuate relative to other currencies.

2. European Currency Unit (ECU) : In March, 1979 the European
Monetary System (EMS) was formed which created the European
Currency Unit (ECU) which is a "basket" currency of a unit of account
consisting of the major European currencies. The EMS limits the
internal exc hange rate movement of the member countries to not more
than 2.25 per cent from the "central rates" with the exception of Italy
whose lira can fluctuate up to 6 per cent.

3. The Jamaica Agreement : The Jamaica Agreement of January 1976
(ratified in April 1978 ) formalized the regime of floating exchange
rates under the auspices of the IMF. A number of factors forced the
majority of member countries of the IMF to float their currencies.
There were large short -term capital movements and central banks failed
to stop speculation in currencies during the regime of adjustable pegs.

4. The oil crisis : The oil crisis in 1973 and the increase in oil prices in
1974 led to the great recession of 1974 -75 in the industrial countries of
the world. As a result "the dollar went into a rapid decline, which, by
late 1978, had such alarming proportions that the United States
government finally decided on a policy of massive intervention in order
to prevent a further fall in the value of the dollar". At last, the system of
managed fl oating exchange rates had come to stay by 1978.

5. The Second Amendment of the IMF Charter: By the Second
Amendment of the IMF Charter in 1978, the member countries are not
expected to maintain and establish par values with gold or dollar. The
Fund has no c ontrol over the exchange rate adjustment policies of the
member countries. But it exercises international "surveillance" of
exchange rate policies of its members. The Second Amendment has
reduced the position of gold in the global monetary system in the
following ways by: (a) abolishing the official price of gold; (b)
delinking it with the dollar in exchange arrangements; (c) eliminating
the obligations of the Fund and its members to transfer or receive gold;
and (d) selling a part of Fund's gold holdings.


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77 6. SDRs: The Second Amendment has also made SDRs as the chief
reserve assets of the global monetary system whose value is expressed
in currencies and not gold. It is now a unit of account, a currency peg
and medium of transactions.

7. Managed floating: The p resent international monetary system of
floating exchange rates is not one of free flexible exchange rates but of
"managed floating". It has rarely operated without government
intervention. Periodic intervention by governments has led the system
to be call ed a "managed" or "dirty" floating system. In 1977, when the
intervention was very heavy, it was characterized as a "filthy" float.
When Governments do not intervene, it is a "clean" float. But the
possibilities of a clean float are very remote. Thus a sys tem of managed
floating exchange rates is evolving where the central banks are trying to
control fluctuations of exchange rates around some "normal" rates even
though the Second Amendment of the Fund makes no mention of
normal rates.

Managed Floating Exc hange Rate System: Meaning And Features :

Meaning : Under such a system, nations' monetary authorities can
intervene in foreign exchange markets to smooth out short -run fluctuations
in exchange rates usually without attempting to affect long -run trends.
This could be achieved by a policy of leaning against the wind.
Inception: Since March 1973, the world has had a managed floating
exchange rate system. The 1976 Jamaica Accords (ratified in 1978)
formally recognized the managed floating system and allowed na tions the
choice of foreign exchange regime as long as their actions were not
disruptive to trade partners. At the beginning of 2004, about half of the
187 members of the IMF adopted some form of exchange rate flexibility.
From 1974 to 1977; again from 198 1 to 1985, and since the early 1990s,
the United States ally followed a policy of benign neglect by not
intervening in foreign exchange markets to stabilize the value of the
dollar.
Features:
1. Need international reserves : Under the present managed float, n ations
still need international reserves in order to intervene in foreign
exchange markets to smooth out short -run fluctuations in exchange
rates. At present, such interventions are still made mostly in dollars. In
January 1975, U.S. citizens were allowed for the first time since 1933
to own gold (other than in jewelry). The price of gold temporarily rose
above $800 an ounce in January 1980, but it soon fell and stabilized at
less than half of its peak price (it was $400 in February 2004). The
official pric e of gold was abolished and the IMF suspended all gold
transactions with member nations. The old gold tranche at the IMF was
renamed the first -credit tranche. The IMF continued to value its gold
holdings at the pre -1971 official price of $35 an ounce.
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78 2. The renewal of GAB to NAB: The IMF renewed and expanded the
General Arrangements to Borrow (GAB) and in 1997 extended it with
the New Arrangement to Borrow (NAB) that provided the IMF with an
additional $49 billion in lending capability in 2003 (on top of $2 4
billion on GAB). Central bankers also expanded their swap
arrangements to $54 billion and their standby arrangements to $77
billion in 2003.

3. Relaxation of borrowing rules: Borrowing rules at the IMF were also
relaxed and new credit facilities were adde d that greatly expanded the
overall maximum amount of credit to a member nation. There is an
initial fee for borrowing, and the interest charged is based on the length
of the loan, the facility used, and prevailing interest rates. Besides the
usual surveil lance responsibilities over the exchange rate policies of its
members, the IMF has in recent years broadened its responsibilities to
include help for members to overcome their structural problems. Total
Fund credit and loans outstanding rose from $14 billi on in 1980 to
$109 billion in 2003.

4. The European Monetary System (EMS) : The formation of the
European Monetary System (EMS): In March 1979, the European
Monetary System (EMS) was formed and in January 1999 the
European Monetary Union (EMU) came into exist ence with the
creation of the euro (which began actual circulation at the beginning of
2002) and the European Central Bank (ECB) starting to operate.

5. IMF conditionality : Since 1982, the IMF has engaged in a number of
debt rescheduling and rescue operation s. As a condition for the
additional loans and special help, the IMF required reductions in
government spending, growth of the money supply, and wage increases
in order to reduce imports, stimulate exports, and make the country
more nearly self -sustaining. Such IMF conditionality, however, proved
very painful and led to riots and even the toppling of governments.
Partly in response to these accusations, the IMF has become more
flexible in its lending activities.
The problems of the present international mon etary system:
1. Excessive fluctuations and

2. Large disequilibria in exchange rates. Often countries, both developed
and developing, have been faced with either

3. Excessive appreciation or depreciation of their currencies in relation
to the dollar which conti nues to dominate the world monetary system.

4. Even the newly created Euro of the EU which was supposed to be a
strong currency has been depreciating considerably since its inception
against the dollar. This has adversely affected the world trade.

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79 Sugges tions To Reform The Present Monetary System :
Economists have suggested a number of measures in order to avoid the
excessive fluctuations and large disequilibria in exchange rates for
reforming the present world monetary system:
1. Coordination and Cooperati on of Policies: A few economists, and
McKinnon in particular, suggested international co -operation and co -
ordination of policies among the leading developed countries for
exchange rate stability. According to McKinnon', the US, Germany
and Japan should hav e the optimal degree of exchange rate stability
by fixing the exchange rates their currencies at the equilibrium level
based on the purchasing power parity. Thus, they would co-ordinate
their monetary policies for exchange rate stability.

2. Establishing Ta rget Zones: Williamson called for the establishment
of target zones within which fluctuations in exchange rates of major
currencies may be permitted. According to him, the forces of demand
and supply should determine the equilibrium exchange rate. There
should be an upper target zone of 10% above the equilibrium rate and
a lower target zone of 10% below the equilibrium exchange rate. The
exchange rate should not be allowed to move outside the two target
zones by official intervention. In February 1987, the leading five
developed countries agreed under the Louvre Agreement to have
some sort of target zones for the stability of ex - change rates among
their currencies. Despite official intervention by these countries, the
ex- change rates continued to fluctuate within wide margins than
agreed upon at Louvre. Thus Williamson's proposal has since been
discarded being impracticable.

3. Improving Global Liquidity: The reform package of the present
world monetary system should improve global liquidity. As a first
step, both BOP deficit and surplus countries should take steps to
reduce a persistent imbalance through exchange rate changes via
internal policy measures. Second, they should also cooperate in
curbing large flows of "hot money" that destabilize their currencie s.
Third, they should be willing to settle their BOP imbalances through
SDRS rather than through gold or dollar as reserve assets. Fourth,
there should be increasing flow of resources to the developing
countries.

4. Leaning Against the Wind: To reduce the fl uctuations in exchange
rates, the IMF Guidelines for the Management of Floating Exchange
Rates, 1974 suggested the idea of leaning against the wind. It means
that the central banks should intervene to reduce short -term
fluctuations in exchange rates but le ave the long -term fluctuations to
be adjusted by the market forces. 5. Richard Cooper suggests a global
central bank with a global currency which should be a global lender of
last resort.

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80 5. Jaffrey Sachs proposes the creation of an international bankruptcy court
which should deal with countries.

6. George Soros opines that the IMF should set ceilings for external
finance for each country beyond which access to private capital need
not be insured. But there should be insurance by an international credit
insura nce corporation.

7. Paul Krugman suggests reintroduction of capital controls as a "least bad
response" to an international crisis.

8. Objective Indicators: To iron out exchange rate fluctuations, the IMF
Interim Committee suggested the adoption of such objecti ve indicators
as inflation -unemployment, growth of money supply, growth of GNP,
fiscal balance, balance of trade and international reserves. The
variations in these indicators require the adoption of restrictive
monetary -fiscal measures to bring stability in exchange rates.
Conclusion : The various suggestions to reform the present monetary
system are closely inter - linked. But there is lack of unanimity over the
various proposals among the nations. Given the differences of opinion
between the developing and developed countries and among the developed
countries themselves, there is no hope that any concrete proposal to reform
the global monetary system would be acceptable to nations. So the present
system of managed floating exchange rate is likely to stay on .
7.5 THE MAASTRICHT TREATY
7.5.1 INTRODUCTION:
The early ups and downs in the working of the EMS which were
characterized by currency realignments and strict exchange controls set
the EU members to think about having a monetary union. In 1989, the
Delors Committee recommended a three -stage transition for the formation
of a European Monetary Union (EMU).
1. In the First stage: All EU members were to join the Exchange Rate
Mechanism (ERM) of the European Monetary System (EMS).

2. In the Second Stage : Exchange ra te bands were to be narrowed and
certain macroeconomic policy decisions were placed under EU
control.
3. In stage three : The national currencies of EU countries were to be
replaced by a single European currency and all monetary policy
decisions were to be ves ted in a European Central Bank.
On 10 December, 1991, the leaders of the EU countries met at Maastricht
in the Netherlands and agreed to establish a single European currency
which is called the Euro. In February 1992, the 15 -member countries
signed the Maa stricht Treaty for the European Monetary Union (EMU). It
called upon the members to start stage two of the Delors Plan on 1
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81 7.5.2 MAIN FEATURES OF THE MAASTRICHT TREATY:
The Maastricht Treaty la ys down that EU countries must satisfy four
macroeconomic convergence criteria before they can be admitted to the
EMU. They are:
a. The rate of inflation in the country must not be more than 1.5% above
the average of the three EU member countries with the lowest inflation
rate.
b. The country must have maintained a stable exchange rate under the
Exchange Rate Manage ment System without devaluation.
c. The country must not have a public deficit higher than 3% of its GDP,
except temporarily and in exceptional cir cumstances.
d. The country's public debt must be below or near 60% of its GDP.
The Treaty provides for a regular monitoring of criteria (c) and (d) by the
European Commission and for imposing penalties on countries that violate
these two criteria and fail to correct excessive deficits and debts.
7.5.3 POST -MAASTRICHT DEVELOPMENTS AND ADOPTION
OF EURO AS SINGLE CURRENCY :
Besides the Maastricht Treaty, the EU members signed the Stability and
Growth Pact (SGP) in 1997 which further tightens the fiscal measures by
laying down the medium -term budgetary objective of
being near to balance or surplus. It also sets out a timetable for levying
penalties on countries
that fail to correct excessive deficits and debts. By May 1998, eleven EU
countries had satisfied the conv ergence criteria and became founder
members of EMU. The time table for the implementation of EMU and
adoption of the EURO was divided into three stages:
1. In the first stage , the European Central Bank (ECB) was established
on 30 June, 1998 at Frankfurt (Germ any) for a smooth change over the
currencies of member nations to the Euro. The main functions of the Bank
till the circulation of Euro coins and bank notes from 1 January, 2002 were
to control inflation and create confidence of the global financial market s in
the Euro.

2. In the second stage , EU countries adopted the Euro: EU countries
adopted the Euro as a single monetary unit. In the beginning 1 January,
1999, the central banks of EU countries adopted the Euro as a single
monetary unit.

3. In the third sta geEuro coins replaced national currencies : Beginning
January, 2002 more than 14 billion Euro bank notes and 50 billion Euro
coins replaced national currencies and bank notes and coins of members.
They were made available at all banks, and post offices. Til l 31 December,
2002, banknotes of each Euro area country could be exchanged at banks in
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82 banks will exchange free of charge their old national banknotes against the
Euro. In most countr ies, the redemption periods are longer or even
indefinite.

7.6 FEATURES OF THE EURO AS EMU CURRENCY
Denominations: The EMU currency consists of Euros of 100 cents. The
Euro banknotes have seven denominations of 5, 10, 20, 50, 100, 200 and
500 Euro. The Eu ro coins have eight denominations of 1,2,5,10, 20, 50
cent and 1 and 2 Euro. Euro coins have a European side and a national
side on which national symbol of the issuing country appears. But Euro
banknotes do not have national symbols. They are uniform thro ughout the
EU. Countries like Britain which have their own currencies in circulation
have fixed exchange rates with the Euro and it circulates in such countries.
The European System of Central Banks (ESCB) : The ECB and national
central banks (NCBS) of 13 E U countries form the European System of
Central Banks (ESCB). The NCBs of the EU countries that have not
joined the Eurozone are members with special status. They conduct their
respective national policies but do not take part in decision making of the
EMU and the implementation of its policies. All heads of NCBS sit on the
ECB general council which conducts monetary policy for the entire
Eurozone. Besides this, (1) the ECB conducts foreign exchange
operations; (ii) holds and manages the official foreign ex change reserves;
(ii) promotes the smooth operation of the payment system; and (iv)
supports the policies of its member banks.
Concl usion: The Euro, as the international currency of the European
Monetary Union, was weak against the dollar in the beginning. To begin
with, it opened at 1 EUR = $ 1.16 in 1999. But when the Euro actually
started operating in January 2002, it fell to 1 EUR = $0.89. With the U.S.
budget and current account deficits widening and the U.S. Federal Reserve
(central bank) reducing the bank rate in subsequent years, it surged to a
record high of $ 1.45 in early 2008.
ADVANTAGES OF THE EURO AS THE INTERNATIONAL
CURRENCY OF THE EUROPEAN MONETARY UNION:
The following have been the advantages of adoption of the Euro:
1. The Euro has brought a greater degree of European market
integration.
2. It has removed the threat of currency realignments.
3. It has eliminated the costs and inconveniences of traders to convert
one currency to another of the EU countries.
4. There is no longer any risk of fluctuation s between currencies.
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83 7. There is freedom of capital movements.
8. People now buy, sell and borrow within a larger and more competitive
market.
9. Prices are displayed in the same currency throughout the EU. They
are easier to compare and help the buyers to make the right choice.
10. Travelling in Europe has become more convenient because a traveller
has to change money only once in the Euro. This saves both time and
money.
11. The European Central Bank has put an end to the hegemony of the
German Bundesbank in the management of EMU monetary policy.
All NCBs participate and follow monetary policy decisions taken by
the ECB's general council.
7.7 EURO – CURRENCY MARKET
7.7.1 The Meaning of Euro -Currency market:
The Eurocurrency market is the money market for currency outside of the
country where it is legal tender. The eurocurrency market is utilized by
banks, multinational corporations, mutual funds, and hedge funds. They
wish to circumvent regulatory requirements, tax laws, and interest rate
caps often present in domestic banking, particularly in the United States.
The eurocurrency market originated in the aftermath of World War II
when the Marshall Plan to rebuild Europe sent a flood of dollars overseas.
The market developed first in London, as banks needed a market for
dollar deposits outside the United States. Dollars held outside the United
States are called euro -dollars, even if they are held in markets outside
Europe, such a s Singapore or the Cayman Islands.
The eurocurrency market has expanded to include other currencies, such
as the Japanese yen and the British pound, whenever they trade outside of
their home markets. However, the euro -dollar market remains the largest.
The term eurocurrency is a generalization of euro -dollar and should
not be confused with the EU currency, the euro. The eurocurrency
market functions in many financial centres around the world, not just
Europe.
Example of Euro -dollar Market transaction: Euro -dollar transactions
are conducted by banks not resident in the United States. For instance,
when an American citizen deposits (lends) his funds with a U.S. Bank in
London, which may again be used to make advances to a business
enterprise in the U.S., then such transactions are referred as Euro -dollar
transactions.


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84 1. Short -term Money market: It has emerged as a truly international
short -term money market. It is simply a short -term money market
facilitating banks' bor rowings and lendings of US dollars. The Euro -
dollar market is principally located in Europe and basically deals in
U.S. dollars. But, in a wider sense, Euro -dollar market is confined to
the external lending and borrowing of the world's most important
conve rtible currencies like dollar, pound sterling, Swiss franc, French
Franc, Deutsche mark and Netherlands Guilder.

2. It is unofficial but profound: Euro -dollar market is the creation of the
international bankers. Though, Euro -dollar market is wholly unofficia l
in character, it has become an indispensable part of the international
monetary system. It is one of the largest markets for short -term funds.
Original customers of the Euro -dollar market were the business firms in
Europe and the Far East which found Eur o-dollars cheaper way of
financing their imports from the United States, since the lending rates
of dollars in the Euro -dollar market were relatively less.

3. Euro -dollars: By Euro -dollars is meant all U.S. dollar deposits in
banks outside the United States, including the foreign branches of U.S.
banks. A Euro -dollar is, however, not a special type of dollar. It bears
the same exchange rate as an ordinary U.S. dollar has in terms of other
currencies.

4. Unsecured credits: All Euro -dollar transactions are, howev er,
unsecured credits since the transactions in each currency are made
outside the country where that currency has originated. In short, the
term Euro -dollar is used as a common term to include the external
markets in all the major convertible currencies.

5. It is competitive: The Euro -dollar market attracts funds by offering
high rates of interest, greater flexibility of maturities and a wider range
of investment qualities.

6. It is a more flexible capital market: Euro -dollars have come into
existence on accou nt of the Regulation issued by the Board of
Governors of the U.S. Federal Reserve System, which does not permit
the banks to pay interest to the depositors above a certain limit. As
such, banks outside the United States tend to expand their dollar
business by offering higher deposit rates and charging lower lending
rates, as compared to the banks inside the U.S. But, increase or
decrease in the potential for Euro -dollar holdings depends directly upon
U.S. deficits and surpluses, respectively.

7. The Euro -dollar market has two facets:
(i) It is a market which accepts dollar deposits from the non -banking
public and gives credit in dollars to the needy non -banking public.
(ii) It is an inter -bank market in which the commercial banks can adjust
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85 8. Freedom to Commercial banks: The existence of Euro -dollar market
in a country, however, depends on the freedom given to the commerical
banks to hold, borrow and lend foreign currencies -especially dolla rs -
and to exchange them at fixed official exchange rate.
7.7.3 Benefits of the Euro -dollar Market:
Following benefits seem to have accrued to the countries involved in the
Euro -dollar market:
1. It has provided a truly international short -term capital mark et, owing to
a high degree of mobility of the Euro -dollars.

2. Euro -dollars are useful the financing of foreign trade.

3. It has enabled the financial institutions to have greater flexibility in
adjusting their cash and

4. It has enabled importers and exporters to borrow dollars for financing
trade, at cheaper rates than otherwise obtainable.

5. It has helped in reducing the profit margins between deposit rates and
lending rates.

6. It has enhanced the quantum of funds available for arbitrage.

7. It has enabled moneta ry authorities with inadequate reserves to increase
their reserves by borrowing Euro -dollar deposits.

8. It has enlarged the facilities available for short -term investment.

9. It has caused the levels of national interest rates more akin to
international infl uences.
7.7.4 EFFECTS OF EURO -DOLLAR MARKET ON
INTERNATIONAL FINANCIAL SYSTEM:
Euro -dollar market has affected the international financial system in the
following ways:
1. The position of dollar has been strengthened temporarily, since its
operations of bo rrowing of dollars has become more profitable rather
than its holdings.
2. It facilitates the financing of balance of payments surpluses and
deficits. Especially, countries having deficit balance of payments tend
to borrow funds from the Euro -dollar Market, t hereby, lightening the
pressure of their foreign exchange reserves.
3. It has promoted international monetary cooperation.
4. Over the last decade, the growth of Euro -dollar has helped in easing of
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86 7.7.5 THE MAJOR DRAWBACKS OF THE EU RO-DOLLAR
MARKET MAY BE MENTIONED AS UNDER:
1. It may lead banks and business firms to over -trade.

2. It may weaken discipline within the banking communities.

3. It involves a grave danger of sudden large -scale withdrawal of credits
to a country.

4. It has re ndered official monetary policies less effective for the countries
involved.

5. There is the danger of over -extension of the dollar credit by domestic
banks of the country: consequently, high demand pressure on the
official foreign exchange may take place.

6. The Euro -dollar market appears as another channel for the short -term
international capital movement for the country, so that, the country's
volume of outflow or inflow of capital may increase which may again
endanger the foreign exchange reserves and the effectiveness of
domestic economic policies.

7. It has destabilization effect. It increases the pressure on exchange rate
and official foreign exchange reserves. This may require additional
liquidity. If such additional reserves are not provided, it may enda nger
the existence of the present gold -exchange standard.
Above, all, the Euro -dollar market has caused the growth of semi -
independent interest rates, on which there can be no effective control by a
single country or an institution.
7.8 QUESTIONS
1. Discus s the features of a Good International Monetary System.
2. Explain the advantages and drawbacks of Good International Monetary
System.
3. Explain the c ollapse of Bretton Wood system.
4. Write an explanatory note on Euro Currency Market.
5. Discuss the Maastricht Treaty



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87 8
INTERNATIONAL MONETARY
SYSTEM – 2
Unit Structure:
8.0 Objectives
8.1 Asian Infrastructure Investment Bank (AIIB)
8.2 New Development Bank (NDB)
8.3 Questions
8.0 OBJECTIVES
 To study about Asian Infrastructure Investment Bank (AIIB) in detail.
 To study about New Development Bank (NDB) in detail.
8.1 ASIAN INFRASTRUCTURE INVESTMENT BANK
(AIIB)
8.1.1 Introduction:
The Asian Infrastructure Investment Bank (AIIB) is a new international
development bank established on 25 December, 2015, 25 and star ted its
operation in 2016. It has 104 approved members worldwide. It provides
finance for infrastructure projects in Asia.
The proposal for an 'Asian Infrastructure Investment Bank (AIIB) was
first made by the vice -chairman of China Centre for internationa l
economic exchangesin April 2009. On 25 December, 2015, the Article of
Agreement entered into force and on 16th January, 2016 the bank started
to operate.
8.1.2 Membership:
The Articles of Agreement forms the legal basis for the bank. There are 57
Prospe ctive Founding Members (PFM) of the agreement who are eligible
to sign and ratify the articles, thus becoming members of the bank. Other
states which are parties to the International Bank for Reconstruction and
Development (IBRD) or Asian Development Bank (ADB) may become
members after approval. The 57 members are the Founding Members. In
March 2017, 13 other states were granted prospective membership.In May
2017, 7 states were granted prospective membership. Subsequently more
countries became members. As o n 20 July, 2021, there were 103
members.

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88 8.1.3 Objectives:
i) To finance rail -road ports infrastructure along the ancient silk route to
help China's maritime policy.

ii) To counter US -Japan dominated IMF and ADB.

iii) To invest China's huge forex reserves in its 50 % of AIIB capita
holding so as to earn income from its investment.
8.1.4 Capital Structure:
The authorised capital stock of the bank is 100 billion US dollars divided
into 1 million shares of 1,00,000 dollars each. 20 percent are paid in shares
and 80 per cent are callable shares. The shares an based on the size of the
economy - calculated by using GDP nominal 60 percent and GDP -PPP, 40
percent. The votes of the members a of three types, that is - basic votes,
share votes and founding members votes. The bas ic votes are equal to all
members and constitute percent of the total votes. Share votes constitute
85 percent an founding member votes 3 percent. China has the largest
prospective founding members votes and Maldives has the smallest.
8.1.5 Governance:
The governance of the bank is carried out by the Board of Governors
which is the top -level and highest decision making body. It is composed of
one governor for each member state of the bank. The Board of Governors
meets once in a year. The Board of Directors composed of 12 governors,
are responsible for the daily operation. There are two non -regional
directors - one from Euro countries and the other from other European
countries.Mr. Jin Liqun (China) is the current President of the AIIB.
8.1.6 Lending :
AIIB is one of important lenders for the infrastructure project. As in
October 2021, AIIB approved 144 projects. 33 members were beneficiary
of the loans granted for infrastructure projects. More than 11 areas with 33
different projects were financed by AIIB. The important projects financed,
comprise -energy, financial institutions, ICT, public health, transport,
water, urban development, rural infrastructure and agriculture
development.
Project Preparation and Special Fund Financing of about 30.14 USD
(million ) is done by the AIIB. This indicate its involvement to build up
the basic requirement, in the form of various infrastructure facilities to
promote development. AIIB is expected to fill in the gap thedeveloping
countries' growth faces due to the lack of i nfrastructure facilities.
8.2 NEW DEVELOPMENT BANK (NDB)
8.2.1 Introduction:
The New Development Bank (NDB) formerly known as BRICS
Development Bank, is a multilateral development bank, established by
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89 proposed the idea of setting the NDB at the 4th BRICS in 2012. On the
first day of 6th BRICS Summit held in Fortaleza, Brazil on 15 July, 2014,
the BRICS nations signed the agreement on the New Development Bank.
The NDB was not established as a challenge to the existing international
financial institutions like IBRD (World Bank) and IMF, but rather
complement them.
8.2.2 The need for NDB :
The need of NDB was felt as BRICS countries' do not have the influence
or impact in world institution like World bank, IMF according to their
economic strength even though China, Brazil and India have become
bigger donors to the low -income countries. The political influence of
BRICS has increased substantially, specially among the developing
countries. This d issatisfaction with IMF and IBRD made the leading
developing countries to take initiative to establish alternate institutions.
BRICS countries account for more than one -fifth of the global economy
but they wield about 11 percent of votes at the IMF. All re forms suggested
and introduced at the Bretton Woods institutions have not succeeded in
increasing their role in decision making inspite of their economic strength.
8.2.3 Objectives:
To contribute to the development plans set up nationally through projects
that are socially, environmentally and economically sustainable. Promote
infrastructure and sustainable development projects with a significant
development impact in member countries. Establish an extensive network
of global partnerships with other multil ateral development institutions and
national development banks. Build a balanced project portfolio giving a
proper respect to their geographic location, financing requirements and
other factors.
8.2.4 Membership:
All the BRICS countries - Brazil, Russia, India, China and South Africa.
All the members of the United Nations could be members of the NDB.The
shares of BRICS nations can never be less than 55 percent of voting
power. More membership is considered to be crucial to its long -term
development.
The ND B plans to expand membership gradually so as not to overly strain
its operational and decision -making capacity. The bank's membership is
open to any member of the United Nations. The bank is targeting the big
emerging economies like Mexico and Indonesia. A t present there are 8
members in NDB.
8.2.5 Corporate Governance: The NDB is governed by:
(i) Board of Governors
(ii) Board of Directors
(iii) President and Vice -President munotes.in

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Advanced Macroeconomics III
90 The NDB President is elected on a rotational basis from one of the
founding member s and there are four vice -presidents from each of the four
founding members. Mr. K.V. Kamath from India, is the first elected
President of the NDB. He was replaced by Marcos Prado Troyjo of Brazil
since 7 July, 2020. The bank has its headquarters in Shangh ai, China and
an Africa Regional Centre is being established in Johannesburg, South
Africa. Voting power within the board is based on each countries’ shares
in the bank. While new members can join the NDB, the five BRICS will
retain a minimum of 55 percent of total shares.
8.2.6 Capital Structure:
The NDB has an initial subscribed capital of US $ 50 billion and initial
authorised capital of US $ 100 billion. The initial subscribed capital was
equally distributed among the founding members. The payment of th e
amount initially subscribed by each founding member will be made in
dollars in 7 instalments. An individual member cannot increase its share of
capital without the consent of other four members. The capital of BRICS
countries cannot fall below 55 percent .
8.2.7 Lending:
The bank finances sustainable infrastructure development projects,
renewable energy projects, projects promoting environment protection etc.
As of 6 March 2019, the bank has approved 30 projects with loans
aggregating over USD 8 billion.
8.4 SUMMARY
The NDB has been given $ 50 billion in initial capital. All the five
members have equal share -voting. The capital is to be used to finance
infrastructure and sustainable development projects in the BRICS initially,
but other low -income countri es will be able to obtain finance
subsequently. BRICS countries have also created a $ 100 billion
Contingency Reserve Arrangement (CRA) meant to provide additional
liquidity protection to member countries during balance of payment
problem. Additional capit al was raised by issuing bonds.
8.5 QUESTIONS
1. Write an explanatory note on Asian Infrastructure Investment Bank
(AIIB) .
2. Write an explanatory note on New Development Bank (NDB) .

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Question Paper Pattern (For IDOL Students Only)
TYB A SE M V I (Economics) – for all Six papers


Time: Three Hours Total Marks: 100 Marks

Please Check whether you have got the right question paper.
N.B. 1) All questions are compulsory. Attempt Sub question (A) or (B) of Question no. 5
2) Figures to the right indicate marks.
3) Draw neat diagrams wherever necessary.


Q1. Answer any TWO questions of the following. 2 0
a.
b.
c.

Q2. Answer any TWO questions of the following. 2 0
a.
b.
c.

Q3. Answer any TWO questions of the following. 2 0
a.
b.
c.

Q4. Answer any TWO questions of the following. 2 0
a.
b.
c.

Q5. (A) Write short notes on any TWO of the following. 20
a.
b.
c.
d.
OR
(B) Multiple choice questions, select an appropriate option (20 MCQs) 20

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