International Money and Finance

LECTURE OUTLINE

THEORY OF INTERNATIONAL FINANCE Foreign Exchange Rates

HISTORY OF INTERNATIONAL MONETARY AND FINANCE STRUCTURE

The Classic Gold Standard The Bretton Woods System (Fixed Exchange Rate System) The Flexible Exchange Rate System

POLICY CONTROVERSIES Which Policy? When? Why?

WHY DOES MONETARY AND FINANCE SYSTEM MATTER? International monetary system

system of rules, mechanism and institutions that connects the national monetary systems into a consistent whole

Role of the international monetary system: ensure exchange rate stability facilitate balance-of-payments equilibria ensure access to international liquidity

What are social and political impacts of international monetary and finance structures?

4

Market for the US dollars

JPY/USD

97

S

DQuantity ofUSD

FOREIGN EXCHANGE RATES The value of a currency is the function of demand for supply of that currency.

The level of demand for U.S. dollars reflects the attempt of foreigners to buy US goods, services, assets, and travel to the U.S.

The supply of dollars reflects the desire of U.S. buyers to buy foreign goods and services, assets, and to travel in foreign countries.

FOREIGN EXCHANGE RATES

Determinants of Demand for a Currency The US Interest Rates The Inflation Rate Stronger business expectations in the US The increase of income in other countries

Determinants of Supply of a Currency The US and other Interest Rates The Inflation Rate Stronger business expectations outside the US The increase of income in the US

Speculation and Foreign Exchange Rates

THE BIG QUESTION: WHO BENEFITS?

Who wins when USD depreciates?

Who wins when USD appreciates?

WHAT DOES THIS GRAPH TELL US ABOUT US-JAPANESE FINANCIAL RELATIONS?

HISTORY OF THE INTERNATIONAL MONETARY AND FINANCE SYSTEM

The Classic Gold Standard (1876 – 1913) Different currency values were each pegged

(fixed) to the price of gold. Convertibility guaranteed

Currency exchange rates were in effect “fixed”

Balance of trade equilibrium for all countries balance of payment deficit used to be balanced by selling

of gold to earn money to pay for the deficits.The gold standard provided stability of

exchange rates which served to promote international trade.

2-8

EXAMPLE: GOLD STANDARD EXCHANGE RATES

1 ounce gold = $ 20.67

1 ounce gold = £ 4.2474

$20.67 = £ 4.2474

£1 = $4.8665

HISTORY OF THE INTERNATIONAL MONETARY AND FINANCE SYSTEM Interwar period: 1915-1944

World War I ended the classical gold standard in 1914 Economic disaster and increasing hyper inflation Predatory devaluations (recovery through exports) The failure of international monetary system

10

THE BRETTON WOODS SYSTEM

HISTORY OF THE INTERNATIONAL MONETARY AND FINANCE SYSTEM

The Bretton Woods System (1944-1971) The result of Keynesian Compromise

Giving nations the ability to regulate their own domestic economies, but permit the IMF to collectively manage global financial policies to avoid another depression

Two financial institutions: IMF: maintaining stability in monetary system World Bank: promoting reconstruction and economic

development

Fixed Exchange Rate System established US Dollar pegged to gold at $35 per ounce Fixed exchange rates pegged to the US Dollar Countries allowed to fluctuate their currencies ± 1% of

the fixed rate2-11

The Collapse of the Bretton Woods System balance-of-payments adjustment problem:

increasing balance-of-payments deficit in the USA continuing balance-of-payments surpluses in Germany and

Japan The increasing volume of US dollars in international

markets lack of confidence in the US dollar

President Richard Nixon devaluated the USD in 1971, practically ending the fixed rate system.

HISTORY OF THE INTERNATIONAL MONETARY AND FINANCE SYSTEM

HISTORY OF THE INTERNATIONAL MONETARY AND FINANCE SYSTEM

The Flexible Exchange Rate System (1973 – Present) [2005 IMF Data] Countries are free to choose their systems

provided that they inform IMF about their choices 36 countries, determined largely by market forces (US

$, JPY, etc.) 50 countries, “Managed Floating” system (China, India,

Russia). 41 countries, no national currencies 40 countries, pegged to another currency OTHERS: mixture of fixed and floating exchange-rate

regimes.

HISTORY OF THE INTERNATIONAL MONETARY AND FINANCE SYSTEM

How To Decide What to Choose Exchange rate stability Full financial integration Monetary independence

Factors To be Considered inflation, unemployment, interest rate levels, trade balances, and economic growth.

CLASS DISCUSSION

What are the advantages of flexible exchange rate system over the fixed exchange rate system?

Is it a bad thing that the US dollar has been devalued against Euro over the last decade? What are the implications for the US and Europe?