10522296 the international monetary system chapter 11

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McGraw-Hill/IrwinInternational Business, 6/e

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

Introduction

• The international monetary system refers to the institutional arrangements that govern exchange rates.

• Floating exchange rates occur when the foreign exchange market determines the relative value of a currency

• The world’s four major currencies – dollar, euro, yen, and pound – are all free to float against each other

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Introduction

• Pegged exchange rates occur when the value of a currency is fixed relative to a reference currency

• Dirty float occurs when countries hold the value of their currency within a range of a reference currency

• Fixed exchange rate occurs when a set of currencies are fixed against each other at some mutually agreed upon exchange rate

• Pegged exchange rates, dirty floats and fixed exchange rates all require some degree of government intervention

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The Gold Standard

• Roots in old mercantile trade

• Inconvenient to ship gold, changed to paper- redeemable for gold

• Want to achieve ‘balance-of-trade equilibrium

USAJapan

Gold

Trade

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Balance of Trade Equilibrium

Trade Surplus

GoldIncreased

money supply = price

inflation.

Decreased money supply

= price decline.

As prices decline, exportsincrease and trade goes

into equilibrium.

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Between the Wars

• Post WWI, war heavy expenditures affected the value of dollars against gold

• US raised dollars to gold from $20.67 to $35 per ounce

- Dollar worth less?

• Other countries followed suit and devalued their currencies

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Bretton Woods

• In 1944, 44 countries met in New Hampshire• Countries agreed to peg their currencies to US$

which was convertible to gold at $35/oz• Agreed not to engage in competitive devaluations for

trade purposes and defend their currencies• Weak currencies could be devalued up to 10% w/o

approval• Created the IMF and World Bank• The Bretton Woods system was a dollar-based gold

exchange standard

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International Monetary Fund

• The International Monetary Fund (IMF) Articles of Agreement were heavily influenced by the worldwide financial collapse, competitive devaluations, trade wars, high unemployment, hyperinflation in Germany and elsewhere, and general economic disintegration that occurred between the two world wars

• The aim of the IMF was to try to avoid a repetition of that chaos through a combination of discipline and flexibility

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International Monetary Fund

• Discipline- Maintaining a fixed exchange rate imposes monetary

discipline, curtails inflation- Brake on competitive devaluations and stability to the

world trade environment• Flexibility

- Lending facility:• Lend foreign currencies to countries having balance-of-

payments problems- Adjustable parities:

• Allow countries to devalue currencies more than 10% if balance of payments was in “fundamental disequilibrium”

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Role of the World Bank

• The official name for the world bank is the International Bank for Reconstruction and Development

• Purpose: To fund Europe’s reconstruction and help 3rd world countries.

• Overshadowed by Marshall Plan, so it turns towards development

- Lending money raised through WB bond sales • Agriculture• Education• Population control• Urban development

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Collapse of the Fixed Exchange System

• The system of fixed exchange rates established at Bretton Woods worked well until the late 1960’s

- The US dollar was the only currency that could be converted into gold

- The US dollar served as the reference point for all other currencies

- Any pressure to devalue the dollar would cause problems through out the world

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Collapse of the Fixed Exchange System

• Factors that led to the collapse of the fixed exchange system include

- President Johnson financed both the Great Society and Vietnam by printing money

- High inflation and high spending on imports- On August 8, 1971, President Nixon announces dollar no longer

convertible into gold- Countries agreed to revalue their currencies against the dollar- On March 19, 1972, Japan and most of Europe floated their

currencies- In 1973, Bretton Woods fails because the key currency (dollar) is

under speculative attack

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Fixed Versus Floating Exchange Rates

• Floating:- Monetary policy autonomy

• Restores control to government

- Trade balance adjustments• Adjust currency to correct

trade imbalances

• Fixed:- Monetary discipline- .Speculation- Limits speculators- Uncertainty- Predictable rate movements- Trade balance adjustments- Argue no link between

exchange rates and trade• Link between savings and

investment

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The Flexible Exchange Rate Regime: 1973-Present.

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• Flexible exchange rates were declared acceptable to the IMF members.

- Central banks were allowed to intervene in the exchange rate markets to iron out unwarranted volatilities.

• Gold was abandoned as an international reserve asset.• Non-oil-exporting countries and less-developed countries were

given greater access to IMF funds.

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Exchange Rate Regimes

• Pegged Exchange Rates- Peg own currency to a major currency ($)- Popular among smaller nations- Evidence of moderation of inflation

• Currency Boards- Country commits to converting domestic currency on

demand into another currency at a fixed exchange rate- Country holds foreign currency reserves equal to 100% of

domestic currency issued

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Current Exchange Rate Arrangements

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• Free Float - The largest number of countries, about 48, allow market forces

to determine their currency’s value.

• Managed Float - About 25 countries combine government intervention with

market forces to set exchange rates.

• Pegged to another currency - Such as the U.S. dollar or euro (through franc or mark).

• No national currency- Some countries do not bother printing their own, they just use

the U.S. dollar. For example, Ecuador has recently dollarized.

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Crisis Management by the IMF

• The IMF’s activities have expanded because periodic financial crises have continued to hit many economies

- Currency crisis• When a speculative attack on a currency’s exchange value

results in a sharp depreciation of the currency’s value or forces authorities to defend the currency

- Banking crisis• Loss of confidence in the banking system leading to a run on

the banks

- Foreign debt crisis• When a country cannot service its foreign debt obligations

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Evaluating the IMF Policy Prescriptions

• Inappropriate policies- The IMF’s ‘one-size-fits-all’ approach to macroeconomic

policy is inappropriate for many countries

• Moral hazard- People behave recklessly when they know they will be

saved if things go wrong

• Lack of Accountability- The IMF has become too powerful for an institution that

lacks any real mechanism for accountability

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What Is the Euro?

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• The euro is the single currency of the European Monetary Union which was adopted by 11 Member States on 1 January 1999.

• These member states are: Belgium, Germany, Spain, France, Ireland, Italy, Luxemburg, Finland, Austria, Portugal and the Netherlands.

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EURO CONVERSION RATES

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1 Euro is Equal to:

40.3399 BEF Belgian franc

1.95583 DEM German mark

166.386 ESP Spanish peseta

6.55957 FRF French franc

.787564 IEP Irish punt

1936.27 ITL Italian lira

40.3399 LUF Luxembourg franc

2.20371 NLG Dutch gilder

13.7603 ATS Austrian schilling

200.482 PTE Portuguese escudo

5.94573 FIM Finnish markka

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What is the subdivision of the euro?

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• During the transitional period up to 31 December 2001, the national currencies of the member states (Lira, Deutsche Mark, Peseta, Franc. . . ) will be "non-decimal" subdivisions of the euro.

• The euro itself is divided into 100 cents.

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What is the official sign of the euro?

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It was inspired by the Greek letter epsilon, in reference to the cradle of European civilization and to the first letter of the word 'Europe'.

The sign for the new single currency looks like an “E” with two clearly marked, horizontal parallel lines across it.

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What are the different denominations of the euro notes and coins ?

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• There will be 7 euro notes and 8 euro coins. • The notes will be: 500, 200, 100, 50, 20, 10, and 5 euro. • The coins will be: 2 euro, 1 euro, 50 euro cent, 20 euro cent, 10,

euro cent, 5 euro cent, 2 euro cent, and 1 euro cent.

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How will the euro affect contracts denominated in national currency?

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• All insurance and other legal contracts will continue in force with the substitution of amounts denominated in national currencies with their equivalents in euro.

• Euro values will be calculated according to the fixed conversion rates with the national currency unit adopted on 1 January 1999.

• Generally, the conversion to the euro will take place on 1 January 2002, unless both parties to the contract agree to do so beforehand.

10522296 the international monetary system chapter 11

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