Chap18pp

© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.

Fernando & Yvonn Quijano

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Chapter

18

The International Financial System

© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 2 of 35

Molson Coors Deals with Fluctuating Exchange Rates

18.1 Understand how different exchange rate systems operate.

18.2 Discuss the three key features of the current exchange rate system.

18.3 Discuss the growth of international capital markets.

APPENDIX Explain the gold standard and the Bretton Woods system.

Learning Objectives

The “exchange rate exposure” results from Molson Coors earning revenue and incurring costs in several currencies, particularly the U.S. dollar, the Canadian dollar, and the British pound.

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Exchange Rate Systems

Floating currency The outcome of a country allowing its currency’s exchange rate to be determined by demand and supply.

Exchange rate system An agreement among countries onhow exchange rates should be determined.

Learning Objective 18.1

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Exchange Rate Systems

Managed float exchange rate system The current exchange rate system, under which the value of most currencies is determined by demand and supply, with occasional government intervention.

Fixed exchange rate system A system under which countries agree to keep the exchange rates among their currencies fixed.


Don’t Let This Happen to YOU!Remember That Modern Currencies Are Fiat Money

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The Current Exchange Rate System

1 The United States allows the dollar to float against other major currencies.

2 Most countries in Western Europe have adopted a single currency, the euro.

Euro The common currencyof many European countries.

3 Some developing countries have attempted to keep their currencies’ exchange rates fixed against the dollar or another major currency.


The current exchange rate system has three important aspects:

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The Floating Dollar

FIGURE 18-1

U.S. Dollar–Canadian Dollar and U.S. Dollar–Yen Exchange Rates, 1973–2006

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The Toronto Blue Jays Gain from the Rising Value of the Canadian Dollar

Makingthe

Connection

The Toronto Blue Jays have benefited from the rising value of the Canadian dollar.

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The Theory of Purchasing Power Parity

What Determines Exchange Rates in the Long Run?

Purchasing power parity The theory that in the long run, exchange rates move to equalize the purchasing powers of different currencies.

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Three real-world complications keep purchasing power parity from being a complete explanation of exchange rates, even in the long run:

• Not all products can be traded internationally.

• Products and consumer preferences are different across countries.

• Countries impose barriers to trade.

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Tariff A tax imposed by a government on imports.

Quota A government-imposed limit on the quantity of a good that can be imported.

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The Big Mac Theory of Exchange RatesMaking

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Is the price of a Big Mac in Beijing the same as the price of a Big Mac in Chicago?

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Makingthe

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COUNTRY BIG MAC PRICE IMPLIED EXCHANGE RATE ACTUAL EXCHANGE RATE

Argentina 8.25 pesos 2.56 pesos per dollar 3.11 pesos per dollar

Japan 280 yen 87 yen per dollar 121 yen per dollar

Britain 1.99 pounds 0.62 pound per dollar 0.51 pound per dollar

Switzerland 6.30 Swiss francs 1.96 Swiss francs per dollar 1.25 Swiss francs per dollar

Indonesia 15,900 rupiahs 4,398 rupiahs per dollar 9,100 rupiahs per dollar

Canada 3.63 Canadian dollars 1.13 Canadian dollars per U.S. dollar

1.18 Canadian dollarsper U.S. dollar

China 11.0 yuan 3.42 yuan per dollar 7.77 yuan per dollar

The Big Mac Theory of Exchange Rates

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Solved Problem 18-2ACalculating Purchasing Power Parity Exchange Rates Using Big Macs

Learning Objective 18.2A

COUNTRY BIG MAC PRICEIMPLIED

EXCHANGE RATEACTUAL

EXCHANGE RATE

Brazil 6.40 reals 1.99 reals per dollar 2.13 reals per dollar

Poland 6.90 zlotys 2.14 zlotys per dollar 3.01 zlotys per dollar

South Korea 2,900 won 901 won per dollar 942 won per dollar

Czech Republic 52.1 korunas 16.2 korunas per dollar 21.6 korunas per dollar

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The Four Determinants of Exchange Rates in the Long Run


• Relative price levels.

• Relative rates of productivity growth.

• Preferences for domestic and foreign goods.

• Tariffs and quotas.

There are four main determinants of exchange rates in the long run:

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The Euro

FIGURE 18-2

Countries Adopting the Euro

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Was the Euro Undervalued or Overvalued in 2007?

Makingthe

Connection

Determining whether a currency is undervalued or overvalued can be difficult.

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Pegging against the Dollar

A final key aspect of the current exchange rate system is that some developing countries have attempted to keep their exchange rates fixed against the dollar or another major currency.

Pegging The decision by a country to keep the exchange rate fixed between its currency and another currency.

The East Asian Exchange Rate Crisis of the Late 1990s

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FIGURE 18-3

By 1997, the Thai Baht Was Overvalued against the Dollar

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FIGURE 18-4

Destabilizing Speculation against the Thai Baht

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The Decline in Pegging

Following the disastrous events experienced by the East Asian countries, the number of countries with pegged exchange rates declined sharply.

The Chinese Experience with Pegging

In 1978, China began to move away from central planning and toward a market system.

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Crisis and Recovery in South KoreaMaking

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Solved Problem 18-2BCoping with Fluctuations in the Value of the U.S. Dollar


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International Capital Markets


FIGURE 18-5

Growth of Foreign Portfolio Investment in the United States

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International Capital Markets


FIGURE 18-6

The Distribution of Foreign Purchases of U.S. Stocks and Bonds by Country, 2006

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An Inside LOOK Should the International Financial System Limit Currency Speculation?

Can Asia Control the “Hot Money”?

Foreign investors speculating in a currency create large fluctuations in the foreign exchange value of that currency.

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Euro

Exchange rate system

Fixed exchange rate system

Floating currency

Managed float exchange rate system

Pegging

Purchasing power parity

Quota

Tariff

K e y T e r m s

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The Gold Standard and the Bretton Woods System

Appendix

Under the gold standard, the currency of a country consisted of gold coins and paper currency that could be redeemed in gold.

The Gold Standard

From a modern point of view, the greatest drawback to the gold standard was that the central bank lacked control of the money supply.

The End of the Gold Standard

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Appendix

Bretton Woods system An exchange rate system that lasted from 1944 to 1971, under which countries pledged to buy and sell their currencies at a fixed rate against the dollar.

The Bretton Woods System

International Monetary Fund (IMF) An international organization that provides foreign currency loans to central banks and oversees the operation of the international monetary system.

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Appendix


FIGURE 18A-1

A Fixed Exchange Rate above Equilibrium Results in a Surplus of Pounds

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Appendix


Devaluation A reduction in a fixed exchange rate.

Revaluation An increase in a fixed exchange rate.

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Appendix

The Collapse of the Bretton Woods System

By the late 1960s, the Bretton Woods system faced two severe problems.

The first was that after 1963, the total number of dollars held by foreign central banks was larger than the gold reserves of the United States.

The second problem the Bretton Woods system faced was that some countries with undervalued currencies, particularly West Germany, were unwilling to revalue their currencies.

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Appendix


FIGURE 18A-2

West Germany’s Undervalued Exchange Rate

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Appendix


Capital controls Limits on the flow of foreign exchange and financial investment across countries.

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Appendix


FIGURE 18A-3

Destabilizing Speculation against the Deutsche Mark, 1971

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