The monetary system

1. The monetary system Outline Definition of monetary system Elements of monetary system Types of monetary system

2. Definition and elements of monetary system • Monetary system is the set of laws regarding to the nation’s currency, and to the mechanisms and institutions by which a government provides money in a country’s economy. • It usually consists of a Mint, Central Bank (CB), and commercial banks: • most monetary systems are managed by a CB which is given the authority to print money and control the money supply in the economy. • Monetary system can be any formal structure adapted by a government that issues a currency which is accepted as the medium of exchange by its citizens and by other governments. • There are some important elements that characterizes monetary system: • monetary standard • monetary unit • types of money • money convertibility

3. Monetary standard • Monetary standard is the material representation or the value behind the money in a monetary system, used for the definition of monetary unit. • Depending on the monetary standard adopted, there existed different types of monetary systems: • Metallic standard system (monetary systems based on monetary metal): • Monometallic standard system (single standard ) • Silver standard system • Gold standard system • Bimetallic standard system (double standard: silver and gold) • Mixed system – gold exchange standard (reserve currency standard + gold standard) • Paper currency standard system (managed currency standard)

4. Silver standard • It functioned between the late 15th century and the late 18th century, when was replaced by bimetallism system. • The silver standard is a monetary system in which the basic unit of currency (monetary unit) is defined as a fixed weight of silver: • For example, 1 monetary unit would contain x grams of silver. • Silver was adopted as the standard money and was made legal tender for all payments. • Features of silver standard system: • gold coins weren’t considered standard money, but simple commercial coins, and their prices were expressed in comparison with the silver coin; • convertibility of other money into silver was unrestricted; • import and export of the silver for the settlement of international obligations were free; • divisionary coins were made of common metal, and there was a fixed exchange rate between them and the silver coin.

5. Bimetallic standard (I) • Many19th century systems were bimetallic systems. • Two metals were adopted as standard money: gold and silver. • A legal ratio was established between the value of the two metal coins. • Gold and silver circulated as legal tender money and there was a legally fixed ratio of exchange between them: • the ratio between the two metal coins was expressed in terms of weight: • e.g. 15 ounce of silver equals 1 ounce of gold a ratio of 15 to 1. • Monetary unit was defined by law in terms of fixed quantities of gold and silver. • People could bring gold or silver bars (bullions) to the Mint (the agency responsible with for coining money) and they would get gold or silver coins in exchange. • This system was very unstable: • there was a great difficulty in maintaining the mint ratio (legal ratio) between the two metals because market ratio often fluctuated: the change in the circulation of the two coins.

6. Bimetallic standard (II) • Gresham’s Law that says “Bad money drives out good money” have operated: • if coins containing metal of different value have the same value as legal tender, the coins composed of the cheaper metal (silver) will be used for payment, while those made of more expensive metal (gold) will be melt or stored gold coins tend to disappear from circulation. • Example: • if the legal gold price of silver (how many tons of silver you need to buy one ton of gold) was 15:1 • and the market gold price of silver was 16:1 people preferred to pay their debt in the cheapest coin (silver) and melt or store the other (gold), although they could pay either in gold or in silver at the legal ratio. • Whenever the market gold price of silver is sufficiently far from the legal ratio, economy switches to a monometallic standard, using the relatively cheapest metal as money and removing the other from circulation. • As a result bimetallic standard became in effect a silver standard.

7. Gold standard • It replaced the bimetallic standard in the late of 19th century. • It is a monetary system in which the basic unit of currency is defined as a fixed weight of gold. • The gold standard was an international standard: • it allowed the determining of the value of a country’s currency in terms of other countries’ currencies by comparing the content in gold of two currencies. this represents the metal parity between the two currencies. • Because exchange rates were fixed, the gold standard caused the price levels around the world to move together. • The types of gold standard were: • Gold coin standard • Gold bullion standard • Gold exchange standard

8. Gold coin standard • Before World War I, the world economy operated under the gold coin standard, meaning that the currency of most countries was convertible directly into gold. • It was the classical form of gold standard. • Gold was recognized as a means of settling domestic and international payments. • There were no restrictions on the use of gold and it could be melted down or be sent to a Mint for conversion to coins. • Import and export of gold were freely allowed. • It allowed the full convertibility of banknotes into gold on demand (at a fixed price) at the issuing bank. • The exchange rate between currencies was fixed by comparing their gold content. • Tying currencies to gold resulted in an international financial system with fixed exchange rates between currencies. • The fixed exchange rates under the gold standard had the important advantage of encouraging world trade by eliminating the uncertainty that occurs when exchange rates fluctuate.

9. Gold bullion standard • It was adopted by some countries after the World War I, as increased expenditures to fund the war effort exposed the weaknesses of the gold coin standard. • Paper money was the main form of exchange and it could be however exchanged for gold at any time: • but the convertibility of banknotes into gold was limited as an equivalent amount to one bullion of gold. • As it was unlikely that there would be a great demand for converting banknotes to gold at any given time: • the banks could issue banknotes in excess of the value of the gold they were holding. • This monetary system could not last long as many major currencies were highly over and under valued, leading to a distortion in the balance of payment position. • England withdrew from the gold standard in 1931, USA in 1933, and Italy, France, Belgium, Switzerland and Holland kept it until 1936.

10. Gold exchange standard (I) • During the World War II, international trade was affected by high inflation and devaluation of currencies: • the need for a new monetary system that would be stable and favour international trade. • This was set up at the conference in Bretton Woods in 1944 and aimed to: • bring about convertibility of all currencies; • eliminate exchange controls; • and establish an international monetary system with stable exchange rates. • The system was a mixed system consisting of a cross between a reserve currency standard and a gold standard. • US dollar remained the single currency convertible in gold: • American authorities agreed to exchange gold for its own currency with other CBs, upon demand, at the fixed price of $35/ounce. • The Bretton Woods system ended in 1971, when USA ended trading of gold at the fixed price of $35/ounce.

11. Gold exchange standard (II) • It included the following rules: • A reserve currency was chosen: • All non-reserve countries agreed to fix their exchange rates to the reserve currency at some announced rate (a fix parity). • To maintain the fixity, these non-reserve countries would hold a stock of reserve currency assets. • The reserve currency country agreed to fix its currency value to a weight in gold. • The reserve country agreed to exchange gold for its own currency with other CBs within the system, upon demand. • One key difference between this system and the gold standard was that the reserve country did not agree to exchange gold for currency with the general public, only with other CBs. • If the non-reserve countries accumulated the reserve currency, they could demand exchange for gold from the reserve country’s CB. • Thus, gold reserve flowed away from the reserve currency country.

12. Paper currency standard system (Managed currency standard) • In the 20th century, both silver and gold lost their former importance within monetary systems, and monometallic system was abandoned by all nations. • It was set up in 1976 at the Conference in Kingston (Jamaica), when the gold lost its role of monetary standard: • Under this system, the currency of the country is made of paper. • Generally, the currency system is managed by the CB of the country. • Today, almost all countries in the world have managed currency standard systems. • The paper currency standard system is a fiat system: • does not allow free convertibility of the currency into a metallic standard; • money is given value by government fiat (is intrinsically useless) • The value of the money is set by the supply and demand for money and by the supply and demand for other goods and services in the country. • The value of the money depends on its purchasing power.

13. Advantages of paper currency system • Paper money is economical. • Its cost of production is negligible. • It is convenient to handle and it is easily portable. • It is homogeneous. • Its supply can be made elastic. • Its value can be kept stable by proper management. • Paper currency can function very effectively as money, provided, there is proper control of it by the managing authority. • It is ideal for internal trade. • But for international trade and payments, gold is still found necessary.

14. Disadvantages of paper currency system • First important disadvantage: • There is the danger of over-issue of paper money by the managing authorities: • Over-issue of currency will result in a rise in prices, adverse foreign exchange rates and many other evils. • The over-issue of paper money has ruined many countries in the past. • Second important disadvantage: • It will not have universal acceptance: • It is recognized as money only in the country where it is issued. • For others, paper money is just bits of paper. • Gold, on the other hand, has universal acceptance.

15. Monetary unit • There are three notions regarding to monetary unit: 1) Par value – is the official value of a currency unit fixed by monetary authority through the law : • Example: in 1933, 1 USD = 1.50463 grams of gold; 2) Currency parity – a ratio between two par values (official exchange rate): • Mint (metal) parity – when par values are expressed in gold or silver. • Example: in 1912 the par values of two currencies were 1 GBP = 7.322382 gr. gold and 1 USD = 1.50463 gr. gold gold parity:

16. Monetary unit • Foreign exchange parity – when par values are expressed in a foreign currency. • Example: in 1966 official exchange rates of two currencies were 1 USD = 180 Congolese franc and 1 USD = 10 Indian rupee par values: and foreign exchange parity: and • Special Drawing Rights (SDR) parity – par values are expressed in SDRs. 3) Exchange rate

17. Exchange rate • It represents the price of one currency expressed in other currency (how much one currency is worth in terms of the other). • Exchange rate quotation is stating the number of units of “term currency” (“price currency”) that can be bought in terms of 1 “unit currency” (“base currency”). • Example: in a quotation that says the EUR/USD is 1.3 (1.3 USD per EUR), the term currency is USD and the base currency is EUR. • There are two kinds of quotations: • Direct quotation – uses country’s home currency as the term currency: • 1 foreign currency unit = x home currency units: in Bucharest, quotations are: 1 USD = 4.2866 RON or 1 EUR = 4.5634 RON) • Indirect quotation – uses country’s home currency as the unit currency: • 1 home currency unit = x foreign currency units: in London, quotations are: 1 GBP = 1.238950 USD, or 1 GBP = 1.172074 EUR) • Majority of countries use direct quotation. • Indirect quotations is specifically for the Anglo-Saxon countries (Great Britain, Australia, New Zeeland) and the eurozone.

18. Types of exchange rates (I) • Depending on how exchange rates are set: • Official exchange rate – is set by the monetary authority; it can be: • a fixed exchange rate – is set by taking into account the par values of currencies; • a free-floating exchange rate – is allowed to vary against that of other currencies and is determined by the market forces of demand and supply. • a pegged exchange rate – is a fixed exchange rate but with a provision for the devaluation of currency (with a fluctuation band). • Market exchange rate – is the price recorded on market depending on the demand and supply. • Depending on the economic implications: • Single exchange rates – are applied by the developed countries for all international transactions. • Multiple exchange rates – are used by the developing countries for diverse transactions in order to favor or to discourage some transactions.

19. Types of exchange rates (II) • Depending on the bank’s position: • Selling exchange rate • Buying exchange rate • Direct quotation: banks buy foreign currency cheaply and sell it expensively (in Bucharest, the selling exchange rate for EUR is 1 EUR = 4.5830 RON, and the buying exchange rate is 1 EUR = 4.4830 RON). • Indirect quotation: the buying exchange rate of foreign currency results from the selling exchange rate of domestic currency (in London, the selling exchange rate for USD is 1 GBP = 1.237850 USD, and the buying exchange rate is 1 GDP = 1.239250 USD). • Depending on the settlement date of transaction: • Spot exchange rate – refers to the current exchange rate. • Forward exchange rate – refers to an exchange rate that is quoted and traded today for delivery and payment on a specific future date.

20. Types of exchange rates (III) • Depending on the influence of inflation rate: • Nominal exchange rate (e) – is the price in domestic currency of one unit of a foreign currency. • Real exchange rate – is defined as RER = e*(Pf/Pd), where Pf is the foreign price level and Pd is the domestic price level: • RER is nominal exchange rate multiplied by the price level ratio of the two countries: the nominal exchange rate adjusted to inflation. • Example: if the price level in the US is higher than the price level in India, then the real exchange rate of the rupee versus the dollar will be greater than the nominal exchange rate. • RER describes how many of a good or service in one country can be traded for one of that good or service in another country: • Example: a real exchange rate might state how many European bottles of wine can be exchanged for one US bottle of wine.

21. Types of money (I) • During the time many types of money have circulated. • They can be classified according to some criteria. • Depending of the form of existence: • Cash money: banknotes and metallic money • Deposit money (bank money, scriptural money) – money placed into a banking institution for safekeeping. • Depending on the intrinsic value: • Money with intrinsic value – its value is given by the content of precious metal. • Fiduciary money – has fiat value lower than their intrinsic value. • Depending on the obligations assumed by the issuing institution: • Convertible money – is money convertible in precious metal (in the past) or in other currency (in the present). • Nonconvertible money – circulates only in the domestic territory.

22. Types of money (II) • Depending on the ability to pay (payment capacity): • Legal money – is national money which can be used for payment in all amounts, no matter how large they are. • Fractional money – is divisionary money, which can be used only for payment in small amounts. • Depending on the issuing institution: • Money created by the public – it existed in the gold standard. • Money created by the government – refers to government securities issued by government, especially in some critical periods (wars), in order to finance its own increased expenditures and often imposed by law to be used as money (to be legal tender). • Money created by banks: banknotes issued by central bank and scriptural money created by commercial banks.

23. Money convertibility (I) • Convertibility represents the ability to exchange money for some other kind of value (gold or other currencies): • Under the gold standard, banknotes were payable in gold coins. • Under the silver standard, banknotes were payable in silver coins. • Under the bimetallic standard, banknotes were payable in either gold or silver coins at the option of the debtor (issuing bank). • Under the gold exchange standard, issuing banks were obliged to redeem their currencies in gold bullion or in US Dollars, which in turn were redeemable in gold bullion at the rate of $35/ounce. • The US abandoned the gold standard, and thus bullion convertibility, in 1971. • In a broad sense, convertibility represents the legal feature of a currency to be freely exchanged on market in other currencies without restrictions regarding the purpose, the solicitant, and the amount required for exchange.

24. Money convertibility (II) • The IMF statute groups the member countries’ currencies in: • Convertible currencies (Article VIII): Each member shall buy balances of its currency held by another member if the latter, in requesting the purchase, shows that: • the balances to be bought have been recently acquired as a result of current transactions; or • their conversion is needed for making payments for current transactions. • The buying member shall have the option to pay either in special drawing rights (SDR), or in the currency of the member making the request. • Inconvertible currencies (Article XIV): currencies of the countries which maintain restrictions on payments and transfers for current international transactions. • Freely usable currencies (Article XXX): a member’s currency that: • 1) is widely used to make payments for international transactions, and 2) is widely traded on the principal exchange markets: • U.S. dollar, euro, Japanese yen pound sterling and Chinese renminbi. 

25. Types of convertibility • Depending on the types of operations allowed for convertibility: • Current account convertibility – refers to current transactions. • Capital account convertibility – refers to capital flows. • Depending on the solicitant: • Internal convertibility – only residents are accepted. • External convertibility – both residents and nonresidents are accepted. • Depending on the amount of exchange: • Limited convertibility – limited amount • Unlimited convertibility – any amount • Depending on the type of exchange rate used: • Official convertibility – is based on the fixed exchange rate. • Market convertibility – is based on the float exchange rate.

26. Convertibility in Romania • Romania proceeded to a gradual adoption of convertibility. • 1991: the adoption of internal current account convertibility • 1997: the adoption of external current convertibility: • introduction in Romanian legislation of Article VIII of IMF statute • 1999: liberalization of long and medium term of capital inflows • April 2005: operations in ROL denominated deposits accounts opened by foreigners with resident financial institutions • June 2005: operations in current and deposits account opened by residents abroad • September 2006: operations in securities and other open market instruments. • The last liberalization of capital flows represented the full liberalization of capital account full convertibility of RON.