Functions of International Monetary Fund

Functions of International Monetary Fund

Specifically, the basic objectives of the IMF are fourfold:

• Achieving balanced growth of world trade
• Ensuring stability of the exchange rate
• Preventing Competitive Devaluation
• Resolving balance of payments problems

Achieving balanced growth of world trade

World economies have been subject to violent fluctuations and therefore world trade has also fluctuated. Besides, protectionist trade policies and exchange controls not only affected world trade adversely, but also made developed countries gain at the cost of the less developed countries. One of the main functions of the IMF was to ensure balanced growth in international trade and the equitable distribution of trade benefits.

For this purpose, the IMF Board of Governors held an annual meeting with member-countries to review their macroeconomic policies in the context of world economic conditions and advised them on the kind of economic policies they had to adopt to promote economic growth and stabilize the exchange rate.

The IMF advised the member countries to reconcile their external policies—trade and exchange rate policies—with their internal policy objectives of economic growth, full employment, and price stability. The system worked quite smoothly, in general, until the breakdown of the Bretton Woods system in 1971.

Ensuring stability of the exchange rate

The exchange rate fluctuated wildly during the period of the Great Depression and World War II owing to the scarcity of gold and conflicting internal and external policies of member countries. One of the basic functions of the IMF has been to create conditions for the stability of the exchange rate. With this purpose, the IMF established a system of gold exchange standard.

Under this system, the US, the greatest economic power, was required to maintain the price of gold at $35 per ounce and to exchange dollar for gold unconditionally. Other member nations were required to fix the price of their currency in terms of the dollar (implicitly in terms of gold) and to change the exchange rate in the band of ±1 per cent of the par value.

However, a member country facing ‘fundamental disequilibrium’—a large and persistent balance-of-payments deficit or surplus—could change the exchange rate by less than 10 per cent without the Fund’s approval. Thus, the IMF created an adjustable peg system—a system of exchange rate stability with some flexibility. In a way, the IMF had established a flexible exchange rate system.

Preventing Competitive Devaluation

Competitive devaluation had become the general practice of countries to protect their economies during the post World War II period, particularly by countries facing persistent balance of payments deficits. These countries went for devaluation with the objective of increasing their exports and, thereby, reducing their unemployment. This led to competitive devaluation.

Competitive devaluation affected world trade and the world economy adversely. So an important function of the IMF has been to prevent member countries from indulging in competitive devaluation of their domestic currency. However, under the IMF rules, members are allowed to devalue their currency by 1 percent. Acountry facing a fundamental balance of payments disequilibrium could devalue its currency by 5 per cent with the permission of the IMF.

Resolving balance of payments problems

Another important function of the IMF has been to assist member-countries facing a balance of payments disequilibrium to resolve their problems. In performing this function, the IMF provide two kinds of financial facilities for two different kinds of balance of payment disequilibrium, especially deficit disequilibrium:

• temporary disequilibrium
• fundamental disequilibrium

The lending facilities of the IMF are described here briefly.

In the case of a country facing a temporary disequilibrium of deficit nature, the IMF provides loans in terms of country’s own currency from its own quota or in terms of foreign currency to help it tide over its balance of payments problems. The member country is entitled to use its own currency to purchase gold from the IMF or foreign currencies equal to the value of its gold quota.

However, in case a country is facing fundamental disequilibrium—a large and persistent BOP deficit—it can borrow in excess of its quota provision in terms of gold or foreign currency, up to a limit, of course. Under the IMF conditionality, the fund keeps a strict watch on the macroeconomic policies of the borrowing countries and forces them to reform their economic policies.

For example, during the foreign exchange crisis in India in 1990–91, the IMF provided loans on condition that India reform its economic policies.