MAN 441: Internatıonal Finance International Monetary System.

MAN 441: Internatıonal FinanceMAN 441: Internatıonal Finance

International Monetary SystemInternational Monetary System

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Objective

Understand Understand

(a) what the ınternational monetary system is and (a) what the ınternational monetary system is and

(b) how the choice of system affects currency value.(b) how the choice of system affects currency value.

alsoalso

(c)(c) provide a historical background of the international monetary system provide a historical background of the international monetary system

We will describe We will describe how exchange rates are determined under how exchange rates are determined under fivefive different different mechanisms‑‑free float, managed float, fixed‑rate system, target‑zone systemmechanisms‑‑free float, managed float, fixed‑rate system, target‑zone system and and the current hybrid system.the current hybrid system.

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PART I. ALTERNATIVE EXCHANGE RATE SYSTEMS

A.A. Freely Floating (Clean Float)Freely Floating (Clean Float)

1.1. Market forces of supply Market forces of supply and demand determine and demand determine

rates.rates.2.2. Forces influenced byForces influenced by

a. price levelsa. price levelsb. interest ratesb. interest ratesc. economic growthc. economic growth

3.3. Rates fluctuate over time Rates fluctuate over time randomlyrandomly (participants will react to new information) (participants will react to new information)..

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PART I. ALTERNATIVE EXCHANGE RATE SYSTEMS – Free Float

0.7850.79

0.795

0.80.805

0.810.815

0.82

0.8250.83

0.835

0 10 20 30 40

Pric

e of

US

dolla

rPrice of US dollar in terms of Euro is plotted below - September 1st to October 22nd 2004.

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EUR/USD - Sep012003 to Oct222004

0.760.78

0.80.82

0.840.86

0.880.9

0.920.94

0 50 100 150 200 250 300 350

Volatility of EUR/USD exchange rate is much lower now than before as indicated by standard errors.

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USD/DM 5-minute rates for November 25th 1996.

USD/DM

0.719

0.72

0.721

0.722

0.723

0.724

0.725

0 10 20 30 40 50 60 70 80

Variance of EUR/USD exchange rate is 0.0018

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ALTERNATIVE EXCHANGE RATE SYSTEMS

B.B. Managed Float (Dirty Float)Managed Float (Dirty Float) – – It is difficult to resist to intervene in the It is difficult to resist to intervene in the market to reduce the economic uncertainty associated with a clean float. An brupt change can negatively market to reduce the economic uncertainty associated with a clean float. An brupt change can negatively impact the export industry (ıf appreciation) or lead to higher inflation (depreciation). impact the export industry (ıf appreciation) or lead to higher inflation (depreciation).

1.1. Market forces set rates unless Market forces set rates unless excess excess volatility occurs.volatility occurs.

2.2. Then, central bank determines Then, central bank determines rate. rate.

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Three categories of interventionThree categories of intervention

(1) Smoothing out daily fluctuations(1) Smoothing out daily fluctuations

intervene to preserve an orderly pattern of exchange rate changes. For example, Brazilian Peso is allowed to depreciate monthly by about 0.6 intervene to preserve an orderly pattern of exchange rate changes. For example, Brazilian Peso is allowed to depreciate monthly by about 0.6 percent against the dollar. percent against the dollar.

(2) Leaning against the wind(2) Leaning against the wind

designed to prevent short and medium term fluctuations brought about by temporary random events. It delays the impacts. Determination of designed to prevent short and medium term fluctuations brought about by temporary random events. It delays the impacts. Determination of temporary or fundamental effects.temporary or fundamental effects.

(3) Unofficial pegging(3) Unofficial pegging

Involves resisting any fundamental upward or downward exchange rate movements – Involves resisting any fundamental upward or downward exchange rate movements –

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C.C. Target-Zone ArrangementTarget-Zone ArrangementCountries adjust their national economic policies to maintain their exchange rates within a specific margin around agreed-Countries adjust their national economic policies to maintain their exchange rates within a specific margin around agreed-upon, fixed exchange rates.upon, fixed exchange rates.

1.1. Rate DeterminationRate Determination

a.a. Market forces constrained Market forces constrained to upper and lower range of rates.to upper and lower range of rates.

b.b. Members to the arrangement adjust theirMembers to the arrangement adjust their

national economic policies to maintain target.national economic policies to maintain target.

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D.D. Fixed Rate SystemFixed Rate System

1.1. Rate determinationRate determination

a.a. Government maintains target Government maintains target rates.rates.

b.b. If rates are threatened, central If rates are threatened, central banks buy/sell banks buy/sell currency.currency.

c.c. Monetary policies coordinatedMonetary policies coordinated – – all have the same inflation rateall have the same inflation rate.. No control No control over monetary policy.over monetary policy.

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2.2. Some Government ControlsSome Government Controls – the most drastic occurs when all foreign exchange – the most drastic occurs when all foreign exchange earnings must be surrendered to the central bankearnings must be surrendered to the central bank::

a.a. On global portfolioOn global portfolio investments.investments.

b.b. Ceilings on direct foreign direct insurance.Ceilings on direct foreign direct insurance.

c.c. Import restrictions.Import restrictions.

d. d. Imposition of taxes and limitations on foreign-owned bank deposits.Imposition of taxes and limitations on foreign-owned bank deposits.

e. e. Limitations on prepayments for imports.Limitations on prepayments for imports.

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E.E. Current SystemCurrent System

1.1. A hybrid systemA hybrid system

a.a. Major currencies:Major currencies: useuse

freely-floating methodfreely-floating method

b.b. Others move in and outOthers move in and out

of various fixed-rate systems.of various fixed-rate systems.

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PART II. A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM

I.I. THE USE OF GOLDTHE USE OF GOLD

A.A. Desirable propertiesDesirable properties – durable, storable, portable, easily – durable, storable, portable, easily recognized, divisible and easily standardized.recognized, divisible and easily standardized.

B.B. In short run: High production costs limit In short run: High production costs limit short-run changes.short-run changes.

C.C. In long run: In long run: CCommodity money insuresommodity money insures

stability.stability.

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The Gold Standard involved a commitment to fix the prices of The Gold Standard involved a commitment to fix the prices of their domestic currencies in terms of a specified amount of gold. their domestic currencies in terms of a specified amount of gold. They are willing to buy or sell gold to anyone at that price.They are willing to buy or sell gold to anyone at that price.For example, Great Britain maintained a fixed price of gold at 4.2474 per ounce. The US maintained For example, Great Britain maintained a fixed price of gold at 4.2474 per ounce. The US maintained the price of gold at $20.67 per ounce. Hence, dollar-pound exchange rate can easily determined as:the price of gold at $20.67 per ounce. Hence, dollar-pound exchange rate can easily determined as:

($20.67 per ounce of gold)/(pound 4.2474 per ounce of gold)=$4.8665 per one pound($20.67 per ounce of gold)/(pound 4.2474 per ounce of gold)=$4.8665 per one pound

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Fiat money is nonconvertible paper money backed only by faith that the Fiat money is nonconvertible paper money backed only by faith that the monetary authorities will not cheat by issuing more money (100% profit margin). monetary authorities will not cheat by issuing more money (100% profit margin). By contrast, the net profit margin on issuing more money under gold standard is By contrast, the net profit margin on issuing more money under gold standard is zero. zero.

Under the classical gold standard, dUnder the classical gold standard, disturbances in Price Levelsisturbances in Price Levels would be wholly would be wholly or partly offset by automatic balance of payments adjustment mechanism called or partly offset by automatic balance of payments adjustment mechanism called thethe price- price- specie*-flow mechanism.specie*-flow mechanism.* specie refers to gold coins* specie refers to gold coins

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A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM

a.a. Price-specie-flow mechanismPrice-specie-flow mechanism

had automatic adjustments :had automatic adjustments :

1.)1.) When a balance of payments When a balance of payments surplus led to a gold surplus led to a gold inflow;inflow;

2.)2.) Gold inflow led to higher prices which Gold inflow led to higher prices which reduced surplus;reduced surplus;

3.)3.) Gold outflow led to lower prices and Gold outflow led to lower prices and increased surplus.increased surplus.

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II.II. The Classical Gold Standard The Classical Gold Standard

(1821-1914)(1821-1914)

- - Major currencies on gold standard.Major currencies on gold standard.

Characterized by: free international trade, stable Characterized by: free international trade, stable exchange rates and prices, rapid economic growth, free exchange rates and prices, rapid economic growth, free flow of labor and capital across borders and world peace. flow of labor and capital across borders and world peace.

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III.III. The Gold Exchange Standard (1925-19The Gold Exchange Standard (1925-194444))Gold standard broke down during WWIGold standard broke down during WWI

A.A. Only U.S. and Britain allowed to Only U.S. and Britain allowed to hold gold reserves.hold gold reserves.

B.B. Other countries could hold both Other countries could hold both gold, dollars or pound reserves. gold, dollars or pound reserves.

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C.C. Currencies devalued in 1931Currencies devalued in 1931

- - “beggar-thy-neighbor” devaluations - “beggar-thy-neighbor” devaluations - led to trade wars.led to trade wars.

D.D. Bretton Woods ConferenceBretton Woods Conference

- called in order to avoid future protectionist and destructive economic policies- called in order to avoid future protectionist and destructive economic policies

- created two new institutions: - created two new institutions: IMF and World Bank. IMF and World Bank.

- IMF was created to promote monetary stability. - IMF was created to promote monetary stability.

- WB to lend money to countries so that they can build their infrastructure- WB to lend money to countries so that they can build their infrastructure

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Role of IMF evolve over time.Role of IMF evolve over time.

- oversees exchange rate policies- oversees exchange rate policies

- advises developing countries how to turn their economies around- advises developing countries how to turn their economies around

It has become lender of last resort which creates a moral hazard problem. IMF bailouts causes (a) It has become lender of last resort which creates a moral hazard problem. IMF bailouts causes (a) governments persist with bad policies and (b) investors to underestimate the risksgovernments persist with bad policies and (b) investors to underestimate the risks

In theory, IMF makes short term loans conditional on the borrower’s implementation of policy changes. In theory, IMF makes short term loans conditional on the borrower’s implementation of policy changes. Conditionality has little credibility. Conditionality has little credibility.

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V.V. The Bretton Woods System (1946-1971)The Bretton Woods System (1946-1971)

1.1. U.S.$ was key currency;U.S.$ was key currency;

valued at $1 - 1/35 oz. of gold.valued at $1 - 1/35 oz. of gold.

2.2. All currencies linked to that price in All currencies linked to that price in a fixed rate system.a fixed rate system.

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3.3. Exchange rates allowed to fluctuate by 1% above or below initially set rates.Exchange rates allowed to fluctuate by 1% above or below initially set rates.Fixed exchange rates were maintained by official intervention in the foreign exchange market.Fixed exchange rates were maintained by official intervention in the foreign exchange market.

Withot price stability, balance of payment deficits was the result. Withot price stability, balance of payment deficits was the result.

Experienced foreign exchange crisis as governments were reluctant to adjust their economic policies.Experienced foreign exchange crisis as governments were reluctant to adjust their economic policies.

B.B. Collapse, 1971Collapse, 1971

1.1. Causes:Causes:

a.a. U.S. high inflation rateU.S. high inflation rate (by printing money) (by printing money)

b.b. U.S.$ depreciated sharply.U.S.$ depreciated sharply.

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V.V. Post-Bretton Woods System (1971-Present)Post-Bretton Woods System (1971-Present)

A.A. Smithsonian Agreement, 1971Smithsonian Agreement, 1971

US$ devalued to 1/38 oz. of gold.US$ devalued to 1/38 oz. of gold.

By 1973: World on a freely By 1973: World on a freely floating exchange rate system.floating exchange rate system.

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B.B. OPEC and the Oil Crisis (1973-1974)OPEC and the Oil Crisis (1973-1974)

1. 1. OPEC raised oil prices four fold;OPEC raised oil prices four fold;

2. 2. Exchange rate turmoil resulted;Exchange rate turmoil resulted;

3. 3. Caused OPEC nations to earnCaused OPEC nations to earn large surplus B-O-P.large surplus B-O-P.

4. 4. Surpluses recycled to debtor nations Surpluses recycled to debtor nations which set up debt crisis of 1980’s.which set up debt crisis of 1980’s.

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C.C. Dollar Crisis (1977-78)Dollar Crisis (1977-78)

1.1. U.S. B-O-P difficultiesU.S. B-O-P difficulties

2.2. Result of inconsistent monetary policy in U.S.Result of inconsistent monetary policy in U.S.

3.3. Dollar value falls as Dollar value falls as confidence shrinks.confidence shrinks.

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D.D. The Rising Dollar (1980-85)The Rising Dollar (1980-85)

1.1. U.S. inflation subsides as the Fed U.S. inflation subsides as the Fed raises raises interest ratesinterest rates

2.2. Rising rates attracts global capital to Rising rates attracts global capital to U.S.U.S.

3.3. Result: Dollar value rises.Result: Dollar value rises.

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E.E. The Sinking Dollar:(1985-87)The Sinking Dollar:(1985-87)

1.1. Dollar revaluated slowly downward;Dollar revaluated slowly downward;

2.2. Plaza Agreement (1985) G-5 agree Plaza Agreement (1985) G-5 agree to depress US$ further.to depress US$ further.

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3.3. Louvre Agreement (1987) G-7 Louvre Agreement (1987) G-7 agree to support the falling US$.agree to support the falling US$.

F.F. Recent History (1988-Present)Recent History (1988-Present)

1.1. 1988 US$ stabilized1988 US$ stabilized

2.2. Post-1991 Confidence resulted in Post-1991 Confidence resulted in stronger dollarstronger dollar

3.3. 1993-1995 Dollar value falls1993-1995 Dollar value falls

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PART III.THE EUROPEAN MONETARY SYSTEM

I.I. INTRODUCTIONINTRODUCTION

A.A. The European Monetary System (EMS)The European Monetary System (EMS) – – goal was to foster monetary stability in the European goal was to foster monetary stability in the European CommunityCommunity

1.1. A target-zone method A target-zone method (1979)(1979)

2.2. Close macroeconomic policyClose macroeconomic policy

coordination required.coordination required.

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THE EUROPEAN MONETARY SYSTEM

B.B. EMS Objective:EMS Objective:

to provide exchange rate stability to all to provide exchange rate stability to all members by holding exchange rates within specified members by holding exchange rates within specified limits.limits.

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C.C. European Currency Unit (ECU)European Currency Unit (ECU)

A “cocktail” of European currenciesA “cocktail” of European currencies (composite currency) (composite currency) with specified with specified weights as the unit of account.weights as the unit of account.

1. Exchange rate mechanism (ERM)1. Exchange rate mechanism (ERM)

each member determines mutually agreed each member determines mutually agreed upon central cross rate upon central cross rate for its currency.for its currency.

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2.2. Member Pledge:Member Pledge:

To keep within 15% margin above or below the central rate.To keep within 15% margin above or below the central rate.

D.D. EMS ups and downsEMS ups and downs

1. Foreign exchange interventions failed due to lack of support by coordinated 1. Foreign exchange interventions failed due to lack of support by coordinated monetary monetary policies.policies.

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2.2. Currency Crisis of Sept. 1992Currency Crisis of Sept. 1992 – – Bundesbank’s decision to tighten the monetary policy (high R); high cost of Bundesbank’s decision to tighten the monetary policy (high R); high cost of intervention by other countries (R was 500% in Sweden)intervention by other countries (R was 500% in Sweden)

a. a. System broke downSystem broke down

b.b. Britain and Italy forced toBritain and Italy forced to

withdraw from EMS.withdraw from EMS.

G.G. Failure of the EMSFailure of the EMS

members allowed political prioritiesmembers allowed political priorities

to dominate exchange rate policies.to dominate exchange rate policies.EMS has succeeded to lower inflation in Europe.EMS has succeeded to lower inflation in Europe.

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H.H. Maastricht TreatyMaastricht Treaty

1.1. Called for Monetary Union by 1999 Called for Monetary Union by 1999 (moved to 2002).(moved to 2002).

2.2. Established a single currency: the euroEstablished a single currency: the euro

3.3. Calls for creation of a single central EU Calls for creation of a single central EU bank.bank.

4.4. Adopts tough fiscal standards.Adopts tough fiscal standards.

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Maastrich Criteria:Maastrich Criteria:

Government debt could be no more than 60 % of GDPGovernment debt could be no more than 60 % of GDP

Government budget deficit could not exceed 3% of GDPGovernment budget deficit could not exceed 3% of GDP

Inflation rate could not be more than 1.5 percentage points above the average rate of Inflation rate could not be more than 1.5 percentage points above the average rate of Europe’s three lowest-inflation nationsEurope’s three lowest-inflation nations

Long-term interest rates could not be more than 2 percentage points higher than the Long-term interest rates could not be more than 2 percentage points higher than the average interest rate in the three lowest-inflation nations.average interest rate in the three lowest-inflation nations.

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I.I. Costs / Benefits of A Single CurrencyCosts / Benefits of A Single Currency

A. A. BenefitsBenefits

1.1. Reduces cost of doing businessReduces cost of doing business (e.g. Philips (e.g. Philips saves a $300 million a year from a single currency transactions cost; easier saves a $300 million a year from a single currency transactions cost; easier corporate planning, pricing and invoicing)corporate planning, pricing and invoicing)..

2.2. Reduces exchange rate riskReduces exchange rate risk

B.B. CostsCosts

1.1. Lack of national monetary flexibility.Lack of national monetary flexibility.

It can also impose high costs if wages and prices are inflexible.It can also impose high costs if wages and prices are inflexible.

- What happens if demand for French goods fall sharply?- What happens if demand for French goods fall sharply?

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Emerging Market Currency Crisis

Currency crisis tend to be contagious. Two major Currency crisis tend to be contagious. Two major contagion channels. contagion channels.

(1)(1) Trade links: Trade links: can sperad from one nation to another through trade. For example, can sperad from one nation to another through trade. For example,

when Argentina is in crisis, it imports less from Brazilwhen Argentina is in crisis, it imports less from Brazil..

(2)(2) Financial System: Financial System: Trouble in one market as a wake-up call for similar Trouble in one market as a wake-up call for similar countries. Investors seek to exit these similar countries. For example, Asian currency countries. Investors seek to exit these similar countries. For example, Asian currency crisis in 1997. Financial contagion can also occur if investors start selling their assests crisis in 1997. Financial contagion can also occur if investors start selling their assests in other countries to cover their losses.in other countries to cover their losses.

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Sources:Sources:

(1)(1) Moral Hazard - IMFMoral Hazard - IMF

(2)(2) Fundamental policy conflict among policy objectivesFundamental policy conflict among policy objectives

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Possible ways to avoid currency crisisPossible ways to avoid currency crisis

(1)(1) Currency controlsCurrency controls

(2)(2) Freely floating currencyFreely floating currency

(3)(3) Permanently fixed exchange rate (Permanently fixed exchange rate (money supply adjusts to the money supply adjusts to the

balance of paymentsbalance of payments))

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Official Currency Conversion ratesCountry Currency Currency Units per euroAustria schilling 13.7603Belgium franc 40.3399Finland markka 5.94573France franc 6.55957Germany mark 1.95583Greece drachma 340.75Ireland punt 0.787564Italy lira 1936.27Luxembourg franc 40.3399Netherlands guilder 2.20371Portugal escudo 200.482Spain peseta 166.386

Currency units per euro

MAN 441: Internatıonal Finance International Monetary System.

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