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Chapter 1

Multinational corporation

A multinational corporation (MNC) is a company engaged in producing and selling goods

or services in more than one country. It ordinarily consists of a parent company located
in the home country and at least 5/6 foreign subsidiaries, typically with a high degree of
strategic interaction among the units.
Comparative advantage each nation should specialize in the production and export of
those goods that it can produce with the highest relative efficiency and import those
goods that other nations can produce relatively more efficiently. In other words, every
nation should produce goods with the lowest opportunity cost.
Classical trade theory assumes that countries differ enough in terms of resource
endowments and economic skills for those differences to be at the center of any
analysis of corporate competitiveness. Differences among individual corporate
strategies were considered only to be of a secondary issue.
However nowadays, differences among corporations are becoming more important
than aggregate differences among countries. The ability of corporations of all sizes to
use these globally available factors of production is a far bigger factor in international
competitiveness than broad macroeconomic differences among countries.
Foreign direct investment (FDI) which is the acquisition abroad of companies, property,
or physical assets such as plant and equipment.

Reasons for the rise of multinational corporations

Search for raw materials This was the earliest reason for the rising of multinational
corporations. The aim was to exploit the raw materials that could be found overseas.
Market seeking the market seeker is the type of modern multinational firm that goes
overseas to produce and sell in foreign markets. The rationale for the market seeker is
simple: foreign markets are big, even relative to the domestic market. Reverse foreign
investment is when other firms outside the US begin to acquire US firms. A reason might
be that there are restrictions on exports to the US market, so they have to directly
invest in these markets to sell in these markets. Foreign market entry may be essential
for obtaining economies of scale (the unit cost decreases that are achieved through
volume production). Firms in industries characterized by high fixed costs relative to
variable costs must engage in volume just to break even, these large volumes may be
forthcoming only if the firms expand overseas.
Cost minimization These firms seek out and invest in lower-cost production sites
overseas to remain cost competitive both at home and abroad. The offshoring of
services can be done in 2 ways internally through the establishment of wholly owned
foreign affiliates, or externally, by outsourcing a service to a third-party provider. Pg 15,
exhibit 1.5. One strategy that is often followed by firms for which cost is the key

consideration is to develop a global scanning capability to seek out lower-cost

production sites or production technologies worldwide.
Knowledge seeking Some firms enter foreign markets in order to gain information and
experience that is expected to prove useful elsewhere. In industries characterized by
rapid product innovation and technical breakthroughs by foreign competitors, it is
imperative to track overseas developments constantly. However the flow of ideas is not
all one way, if a foreign corporation invests in US markets, then US firms can learn much
from the foreign corporation.
Keeping domestic customers Suppliers of goods or services to multinationals will often
follow their customers abroad in order to guarantee them a continuing product flow.
Otherwise, it could lead the customer to select a local supplier which may be a domestic
competitor with international operations.
Exploiting financial market imperfections An alternative explanation for FDI relies on
the existence of financial market imperfections, eg, the ability to reduce taxes and
circumvent currency controls may lead to greater project cash flows and a lower cost of
funds for the MNC than for a purely domestic firm. Another motivation for FDI is the
desire to reduce risks through international diversification. This is because much of the
systematic/general market risk affecting a company is related to the cyclical nature of
the national economy in which the company is domiciled, hence the diversification
effect resulting from operating in a number of countries whose economic cycles are not
perfectly in phase should reduce the variability of MNC earnings.

The process of overseas expansion by MNC

Globalization process does not occur through conscious design, it is the unplanned
result of a series of corporate responses to a variety of threats and opportunities
appearing at random overseas.
The approach to overseas expansion is a risk-minimizing response to operating in a
highly uncertain foreign environment. By internationalizing in phases, a firm can
gradually move from a low-risk, low-return, export oriented strategy to a high-risk, high
return emphasizing international production.
The sequence of overseas expansion is on pg 19, figure 1.7
1. Exporting Firms will begin with exporting, there are many advantages to this,
capital requirements and start up costs are minimal and risk is low, profits are
immediate. Building on prior successes, companies can then expand their
marketing organisations abroad, switching from using export agents and other
intermediaries to dealing directly with foreign agents and distributors. As
communication with customers increases, the firm might set up their own sales
subsidiary and new service facilities such as a warehouse, controlling its own
distribution system.
2. Overseas production A major drawback to exporting is the inability to realize
the full sales potential of a product. By manufacturing abroad, a company can

keep abreast of market developments, adapt its products and production

schedule to changing local tastes and conditions, fill orders faster and provide
more comprehensive after-sales service. Setting up local production facilities
also shows a greater commitment to the local market, this will bring added sales
and provides increased supply stability. Associated with a firms decision to
produce abroad is the question of whether to create its own affiliates or to
acquire going concerns. A major advantage of an acquisition is the capacity to
effect a speed transfer overseas of highly developed but underutilized parent
skills. The disadvantages are the cost of buying an ongoing company. In general,
the larger and more experienced a firm becomes, the less frequently it uses
acquisitions to expand overseas. Smaller and relatively less experienced firms
often turn to acquisitions.
3. Licensing An alternative to setting up production facilities abroad is to license
a local firm to manufacture the companys products in return for royalties and
other forms of payment. The principal advantages of licensing are the minimal
investment required, faster market-entry time and fewer financial and legal
risks. But the corresponding cash flow might be relatively low and there may be
problems maintaining product quality. The foreign licensee (the holder of the
license) may even become such a strong competitor that the licensing firm will
face difficulty entering the market when the agreement expires.
There are certain circumstances under which each approach export, license, local
production will be the preferred alternative for exploiting foreign markets:
1. Exports If MNC possess intangible capital in the form of trademarks, patents,
general marketing skills and other organizational abilities. If this intangible
capital can be embodied in the form of products without adaptation, then
exporting would be preferred.
2. Licensing If the firms knowledge takes the form of specific product or process
technologies that can be written down and transmitted objectively.
3. Local production however if this intangible capital takes the form of
organizational skills that are inseparable from the firm itself, eg, quality control,
after sales service, itd be difficult to unbundle these services and sell them
apart from the firm. Then the firm would establish foreign affiliates.
Judging whether a foreign investment is desirable takes into consideration:
1. Internalization (FDI) is most likely to be economically viable in those settings in
which the possibility of contractual difficulties makes it especially costly to
coordinate economic activities via arms length transactions in the marketplace.
2. Vertical direct integration direct investment across industries that are related
to different stages of production of a particular good enables the MNC to
substitute internal production and distribution systems for inefficient markets.
3. Horizontal direct investment investment that is cross-border but within an
industry enables the MNC to utilize an advantage and avoid the contractual
difficulties of dealing with unrelated parties.

Behavioral definition of the MNC

The true MNC is characterized more by its state of mind rather than its size and
worldwide dispersion of its assets. A MNC does not limit its search for capital or
investment opportunities to any single national financial market. Hence, the essential
element that distinguishes the true multinational is its commitment to seeking out,
undertaking and integrating manufacturing etc on a global and not domestic basis.
Another important characteristic is focus, this means figuring out and building on what a
company does best. This process typically involves divesting unrelated business
activities and seeking attract investment opportunities in its core business.

Multinational financial management

The main objective of multinational financial management is to maximize shareholder

wealth as measured by share price. The focus on shareholder value stems from the fact
that shareholders are the legal owners of the firm and management has an obligation to
act in their best interests. A more compelling reason for focusing on creating
shareholder wealth is that those companies that do not are likely to be prime targets for
takeover and for forced corporate restructuring.
Companies that create value have more money to distribute to all stakeholders not just

Functions of financial management

Financial management is separated into two basic functions: The acquisition of funds
and investment of those funds. The first function is called the financing decision, which
involves generating funds from internal sources or from sources external to the firm at
the lowest long-run cost possible. The investment decision is concerned with the
allocation of funds over time in such a way that shareholder wealth is maximized.
For international financial management, we must also remember the risk management
decision which is exchange rate exposures, different regulatory systems, legal systems
and tax regimes; different systems of corporate governance; political risks.

Relationship to domestic financial management

Three concepts arise in financial economics have proved to be of particular important in

developing a theoretical foundation for international corporate finance:
1. Arbitrage defined as the purchase of assets or commodities on one market for
immediate resale on another in order to profit from a price discrepancy. Tax
arbitrage involves shifting gains or losses from one tax jurisdiction to another to
profit from differences in tax rates. Risk arbitrage is speculation.
2. Market efficiency An efficient market is one in which the prices of traded
securities readily incorporate new information. The predicative power of
markets lies in their ability to collect in one place a mass of individual judgments

from around the world. Those judgments are based on current information. If
the trend of future policies change, people will revise their expectations and
prices will change to incorporate the new information.
3. Capital asset pricing Capital asset pricing refers to the way in which securities
are valued in line with their anticipated risks and returns.
Systematic/unsystematic risk.
Total risk (systematic + unsystematic) is important to the firm because it may have a
negative impact on the firms expected cash flows. Total risk is likely to affect a firm with
a high amount of leverage, it faces a high probability of failure and therefore may incur
financial distress costs hence the higher total risk lowers the price of this firm.
Much of the general market risk facing a company is related to the cyclical nature of the
domestic economy of the home country. Operating in several nations whose economic
cycles are not perfectly in phase should reduce the variability of the firms earnings.
Thus, even though the risk of operating in any one foreign country may be greater than
the risk of operating in the home country, diversification can eliminate much of that risk.
What is true for companies is also true for investors. International diversification can
reduce the riskiness of an investment portfolio because national financial markets tend
to move somewhat independently of one another.

Chapter 2

A broker organises the trade, by introducing the buyer to the seller and the seller to
the buyer.
Brokers do not hold a position in the asset, and the transaction is between the seller and
the buyer.
The broker charges a commission for this service.


A dealer acts as a buyer to the seller and a seller to the buyer, and holds stocks of the
The dealer earns the dealers spread, buy buying at a slightly lower price than what they
sell at.


The currency has a low value or is expected to depreciate in the future.


The currency has a high value or is expected to appreciate in the future.

Exchange rates

Pegged currency: one whose value is set by the government.

Freely floating exchange rate: no government intervention to determine the exchange
rates. Set by market forces.
Devaluation/Revaluation: Refers to a decrease and increase respectively in the par value
of a pegged currency.
Depreciate/Appreciate: Refers to a loss and gain in value in the value of a floating

Setting the equilibrium spot exchange rate

An exchange rate is the price of one nations currency in terms of another currency,
called the reference currency. Eg, the yen/dollar exchange rate is just the number of yen
that one dollar will buy. If a dollar will buy 100 yen then the exchange rate would be
A spot rate is the price at which currencies are traded for immediate delivery, actual
settlement occurs 2 days later.
A forward rate is the price at which FX is quoted for delivery at a specified future date.
Exchange rates are set as market clearing prices that equilibrate supplies and demand in
the FX market.

Demand for a currency (Refer to pg 59)

Looking from the FX currency p.o.v, the demand for euro in the FX market (same as the
supply of dollars in the FX market) derives from the America demand for Euroland goods
and services and euro-denominated financial assets. Euroland prices are set in euroes,
so in order for Americans to pay for their Euroland purchases, they must first exchange
their dollars for euros. That is, they will demand euros.
To show that the demand curve for FX is downward sloping, an increase in the price of
euro is equivalent to a higher dollar price for Euroland products, thus this will reduce
the quantity demanded of euros as there is a lower demand for Euroland goods and
services. The converse is also true.

Supply for a currency (Refer to pg 59)

Looking from the FX currency p.o.v, the supply for euro in the FX market (same as the
demand of dollars in the FX market) is based on the Euroland demand for US goods and
services and dollar dollar denominated financial assets. In order for Euroland residents
to pay for their US purchases, they must first acquire dollars.
To show that the supply curve for FX is upward sloping, as the dollar value of the euro
increases, this lowers the euro cost of US goods, hence there will be an increased
Euroland demand for US goods and this will cause an increase in the quantity demanded
of dollars and hence in the quantity supplied of euros.

Factors that influence the equilibrium exchange rate

Refer to exhibit 2.2 pg 60.

Relative inflation rates: Suppose in the US, the money supply increases, this leads to a
decrease in interest rates and hence there will be more borrowing (spending) which will
increase inflation in the US. Euroland consumers are likely to buy fewer US products and
will prefer to buy domestic goods, hence Euroland consumers will buy FX (euro) and sell
USD which lowers the supply of FX. US consumers will be more likely to buy Euroland
imports rather than domestic goods, hence they will buy FX and sell USD, hence demand
for FX increases. Hence a higher inflation in the US than in Euroland will increase
Euroland exports and reduce US exports to Euroland. In general, a nation with a
relatively high level of inflation will find its currency depreciating relative to the
currencies with lower inflation rates.
Relative interest rates: A rise in US interest rates relative to Euroland rates will cause
investors in both nations to switch from euro to dollar denominated securities to take
advantage of the higher dollar interest rates. Thus Euroland consumers will increase
supply of FX since they are selling FX to buy dollar to invest in dollar denominated
securities. Likewise, US consumers will decrease the demand for FX since they are selling
FX to buy dollar to also invest in dollar denominated securities, the net result is a
depreciation of FX. Notice here we are talking about real interest rate differentials, only
real interest rate changes will cause this change in exchange rates, not nominal.
Remember that nominal interest rates have inflation in them, whereas real inflation has
been adjusted for inflation, ie, subtracted inflation from nominal.
Relative economic growth rates: A nation with strong economic growth will attract
investment capital seeking to acquire domestic assets. Thus foreigners will increase the
supply of FX since they are selling FX to acquire dollars to invest in domestic assets. This
lowers the value of the FX hence appreciating the domestic currency.
Political and economic risk: Investors prefer to hold lesser amounts of riskier assets;
thus low-risk currencies (those associated with more politically and economically stable
nations) are more highly valued than high risk currencies.

Trade weighted (effective) and bilateral exchange rates

Bilateral exchange rates are when one currency appreciates against another, then the
other currency has simultaneously fallen against the other one.
A trade-weighted exchange rate is a similar concept to a consumer price index. The
trade-weighted exchange rate of a particular currency is a weighted average of its
exchange rate against the currencies of its trading partners; weighted, of course, by the
proportion of trade with each country.
NEER: Nominal Effective Exchange Rates. NEERs are indexes, and they are usually
expressed such that an increase in the index implies a strengthening of the currency.

More useful in many ways is the REER real effective exchange rates. The REER is the
NEER adjusted for the inflation differential between the country and its trading
partners. The REER is used by economists and policymakers to get an idea of a countrys
A currency is considered overvalued if its NEER is greater than 100. A currency is
considered undervalued if its NEER is less than 100
Overvalued currencies tend to be associated with a loss of competitiveness countries
can be priced out of export markets. Imported goods are relatively cheap. Businesses
can suffer both a loss of export revenue at the same time as bearing more competition
in the local market due to cheaper imports. The main benefit of an overvalued currency
stems from the fact that domestic markets become more competitive moderation in
inflation. There is little benefit in having an overvalued currency in the current world
economic environment.
Undervalued currencies are associated with greater export competitiveness exports
are relatively cheap. Imported goods are more expensive. Undervalued currencies can
be associated with inflationary pressures.

Calculating exchange rate changes

The amount of FX (euro) appreciation or depreciation is computed as the fractional

increase or decrease in the home (dollar) value of the FX (euro).
Amount of FX appre/depre = (New home value of 1 FX Old home value of 1 FX)/Old
home value of 1 FX
If we let e be the exchange rate, ie, e is defined such that 1 FX = e home currency. Hence
1/e FX = 1 home currency. So the above formula becomes (e_1-e_0)/e_0
Amount of home appre/depre = (New FX value of 1 home Old FX value of 1 home)/Old
FX value of 1 home.
Also can be denoted as (1/e_1-1/e_0)/(1/e_0) = (e_0-e_1)/e_1

Expectations and the asset market model of exchange rates

Although currency values are affected by current events and current supply and demand
they are also dependent on expectations (forecasts) about future exchange rate
The role of expectations in determining exchange rates depends on the fact that
currencies are financial assets and that an exchange rate is simply the relative price of
two financial assets. Thus currency prices are determined the same manner that prices
of stocks, bonds are determined.
The value of a given currency (dollar) today depends on whether or not people still want
the amount of dollars and dollar denominated assets they held yesterday. This is known
as the asset market model of exchange rate determination, thus the exchange rate
between two currencies represents the price that just balances the relative supplies of
and demands for assets denominated in those currencies.

The desire to hold a currency also depends on the expectations of the factors that can
affect the currencys future value. Therefore, what matters is not only what is
happening today but what markets expect will happen in the future. Thus, currency
values are forward looking, they are set by investor expectations of their issuing
countries future economic prospects rather than by contemporary events alone.

Relationship between the nature of money and currency values

The value of money depends on its purchasing power, money also provides liquidity
(you can readily exchange it for goods and other assets), thus money represents both a
store of value and store of liquidity.
Factors that increase the demand for the home currency should also increase the price
of the home currency on the FX market. Thus the economic factors that affect a
currencys FX value include its usefulness as a store of value (determined by its expected
rate of inflation), the demand for liquidity (determined by the volume of transactions in
that currency) and the demand for assets denominated in that currency (determined by
the risk-return pattern on investment in that nations economy and by the wealth of its
The first factor depends primarily on the countrys future monetary policy whereas the
latter two factors depend largely on expected economic growth and political/economic

Relationship between central bank reputations and currency values

Another critical determinant of currency values is central bank behavior. A central bank
is the nations official monetary authority. Its job is to use the instruments of monetary
policy to achieve one or more of the following: price stability, low interest rates, target
currency value. Note that only the central bank has the sole power to create money.
Fiat money is money which is nonconvertible paper money, today no major currency is
linked to a commodity, with a commodity base, usually gold, there was a stable, long
term anchor to the price level. With fiat money, there is no anchor to the price level,
that is there is no standard of value that investors can use to find out what the
currencys future value might be. Instead, a currencys value is largely determined by
the central bank through its control of the money supply. If the central bank creates too
much money, inflation will occur and the value of money will fall. Expectations of central
bank behavior will also affect exchange rates today, ie, a currency will decline if people
think that the central bank will expand the money supply in the future.
Price stability and central bank independence: A reputable central bank is very
important in order to adopt rules for price stability that are verifiable and enforceable,
due to this reason, central banks should be independent. Central banks that lack
independence are also forced to monetize the deficit meaning that they have to finance
the public sector (government) deficit by buying government debt with newly created
money (which increases inflation as MS increases). Independent central banks, on the

other hand, are better able to avoid interference from politicians concerned by shortterm economic fluctuations. With independence, a central bank can credibly commit
itself to a low-inflation monetary policy and stick to it.
Currency boards: Under a currency board system there is no central bank, instead the
currency board issues notes and coins (of local currency) that are convertible on
demand and at a fixed rate into a foreign reserve (holdings of foreign currency held by a
government) hard currency (ie, USD, euro). The board has no discretionary monetary
policy, rather market forces alone determine the money supply. The exchange rate is
fixed against this hard currency. The notes and coins in circulation are fully backed by
hard currency reserves. As long as the country kept their boards, price is relatively stable
and in addition, a currency board compels governments to follow a responsible fiscal
(spending/tax) policy. If the budget is not balanced (in deficit), the government must
convince the private sector (households etc) to lend to it, it no longer has the option of
forcing the central bank to monetize the deficit.
Dollarization: this is the complete replacement of the local currency with the US dollar.
The desirability of dollarization depends on whether monetary discipline is easier to
maintain by abandoning the local currency altogether than under a system in which the
local currency circulates but is backed by the dollar (currency boards). The downside of
dollarization is the loss of seignorage, the central banks profit on the currency it prints.
Dollarization is no guarantee of economic success, it can provide price stability, however
it is not a substitute for sound economic policies.

Central bank intervention

Real exchange rates and relative competitiveness

Real (inflation adjusted) exchange rate is measured as the nominal (actual) exchange
rate adjusted for changes in relative price levels (inflation). Advantages and
disadvantages of strong/weak dollar is on pg 83.

FX market intervention

Most governments will be tempted to intervene in the FX market to move the exchange
rate to the level consistent with their goals or beliefs. FX market intervention refers to
official purchases and sales of FX that nations undertake through their central banks to
influence their currencies.
Refer to pg 60 to associate the following with:
If the central bank (of foreign country) wants to reduce the value of the currency (FX)
relative to another countrys currency (lets assume the US dollar) it sells the domestic
currency, and buys the dollar.
It thus accumulates reserves of dollars.
This transaction is associated with an increase in the money supply.

If the central bank (of foreign country) wants to increase the value of the currency (FX)
relative to the US dollar, it buys the domestic currency and sells the dollar.
It thus depletes dollar reserves.
This transaction is associated with a reduction in the money supply.
If the central bank (of home country) wants to reduce the value of its domestic currency
(hence increase the value of the FX), it will buy FX and sell USD.
It thus accumulates reserves of FX.
This transaction is associated with an increase in the money supply.
If the central bank (of home country) wants to increase the value of its domestic
currency (hence decrease the value of the FX), it will sell FX and buy USD.
It thus depletes reserves of FX.
This transaction is associated with a reduction in the money supply.
Also when doing questions using the above concepts, note that Supply of FX = Demand
for HC and Demand of FX = Supply for HC.

Sterilized vs unsterilized intervention

Unsterilized intervention means that the monetary authorities have not insulated their
domestic money supplies from the FX transactions. If MS increase/decrease then
inflation will increase/decrease. To neutralize these effects, the central bank can
sterilize the impact of their foreign exchange market intervention on the domestic
money supply through open market operation, which is just the sale or purchase of
treasury securities.
When the central bank is intervening to reduce the value of its currency or to keep it
low, the increase in the money supply is potentially inflationary.
This additional money supply can be sterilized that is mopped up by open market
In this case, the central bank issues (sells) treasury securities.
If the central bank is doing the opposite intervening to keep a currency high
(depleting reserves) then sterilization involves buying treasury securities.

Chapter 3
Types of exchange rate systems

The international monetary system refers to the policies, institutions, regulations and
mechanisms that determine the rate at which one currency is exchanged for another.
Nations prefer economic stability and often equate this objective with a stable exchange
rate. However fixing an exchange rate often leads to currency crises if the nation
attempts to follow a monetary policy that is inconsistent with that fixed rate. On the
other hand, economic shocks can be absorbed more easily when exchange rates are
allowed to float freely, but freely floating exchange rates may exhibit excessive volatility,
which hurts trade and stifles economic growth.

Free float

Free market exchange rates are determined by the interaction of currency supplies and
demands. The supply and demand are influenced by price level changes, interest
differentials, and economic growth.
In a free float, as these economic parameters change, market participants will adjust
their current and expected future currency needs. Over time, the exchange rate will
fluctuate randomly as market participants assess and react to new information.
Such a system of freely floating exchange rates is referred to as a clean float.

Managed float

The fear is that too abrupt a change in the value of a nations currency could imperil its
export industries (if currency appreciates) or lead to a higher rate of inflation (if the
currency depreciates). Exchange rate uncertainty reduces economic efficiency by acting
as a tax on trade and foreign investment.
Most countries with floating currencies have attempted, through central bank
intervention. Such a system is called a managed float or a dirty float. There are 3 types:
1. Smoothing out daily fluctuations governments follow this route attempt only
to preserve an orderly pattern of exchange rate changes. Rather than resisting
fundamental market forces, these governments occasionally enter the market
on the buy or sell side to ease the transition from one rate to another, the
smoother the transition tends to bring about longer term currency appreciation
or depreciation.
2. Leaning against the wind this approach is an intermediate policy designed to
moderate or prevent abrupt short and medium term fluctuations brought about
by random events whose effects are expected to be only temporary. The
rationale for this policy is primarily aimed at delaying rather than resisting,
fundamental exchange rate adjustments. Government intervention can reduce
for exporters and importers the uncertainty caused by disruptive exchange rate
3. Unofficial pegging this strategy evokes memories of a fixed exchange rate
system. It involves resisting, for reasons unrelated to the exchange market
forces, any fundamental upward or downward exchange rate movements.

Target zone arrangement

Under this arrangement, countries adjust their national economic policies to maintain
their exchange rates within a specific margin around agreed-upon, fixed central
exchange rates.

Fixed rate system

Under a fixed rate system, such as the Bretton Woods system, governments are
committed to maintaining target exchange rates. Each central bank actively buys or sells
its currency in the FX market whenever its exchange rate threatens to deviate from its
stated par value by more than an agreed-upon percentage. The resulting coordination
of monetary policy ensures that all member nations have the same inflation rate.
Put another way, for a fixed rate system to work, each member must accept the groups
joint inflation rate as its own. A corollary is that monetary policy must become
subordinate to exchange rate policy. However, maintain the fixed exchange rate could
mean a high interest and a resultant slowdown in economic growth and job creation.
Note that the currency can be fixed to a particular currency or a basket of currencies
and includes hard fixed systems such as currency boards, dollarisation and monetary
union. The monetary authority uses its stock of foreign exchange reserves to intervene
in the market to keep the rate pegged at or near its par or target value.
In effect, governments controls take over the allocative function of the foreign exchange
market. The most drastic situation occurs when all foreign exchange earnings must be
surrendered to the central bank, which, in turn, apportions these funds to users on the
basis of government priorities. Types of currency controls are on pg 104.
Note the inverse relationship between interest rates and inflation whereas the direct
relationship between money supply and inflation.

Current system

The current system is a hybrid with major currencies floating on a managed basis, some
currencies freely floating and other currencies moving in and out of various types of
pegged exchange rate relationships.
De jure and de facto currency arrangements: The term de jure is used to describe the
currency arrangement that a country claims that it is operating. De facto is the term
used to describe the currency system is actually in place.
When a currency is fixed against one currency (say the dollar), it floats against other

IMF classification of exchange rate systems

Fixed exchange systems

No separate legal tender: a country adopts another currency as its sole legal tender; eg
Panama, Ecuador. Often called dollarised systems. Also under this category are
currency zones including Eurozone.
Currency board: a fixed exchange rate system in which the local currency is fully backed
by another.
Other fixed exchange rate systems: a country pegs its currency to another or to a basket
of currencies; fluctuations around par value at most +/-1%.

Pegged exchange rate systems

Pegged exchange rates within horizontal bands: This is like other fixed exchange rate
systems but with wider range of allowable fluctuation.
Crawling peg: involves periodical adjustments to the peg, usually in response to select
economic indicators.
Exchange rates within crawling pegs: as above; band is also moved.

Floating exchange rate systems

Managed float: Central bank resists inappropriate trends.

Independent float: market determined; intervention is to prevent undue fluctuations.

Variation on managed float (this would be Sharpiros classifications)

Pegged exchange rates within horizontal bands: This is like other fixed exchange rate
systems but with wider range of allowable fluctuation.
Crawling peg: involves periodical adjustments to the peg, usually in response to select
economic indicators.
Exchange rates within crawling pegs: as above; band is also moved.
Managed float: Central bank resists inappropriate trends.

History of international monetary system

Classical gold standard: 1876-1913, Interwar period: 1919-1944, Bretton Woods system:
1945-1973, The current system: 1973-present.

Classical gold standard

This was an informal fixed exchange rate system. Gold was used as a medium of
exchange because of its desirable properties, it is durable, storable, portable and easily
recognized, divisible and easily standardized. Another valuable attribute is that short run
changes in its stock are limited by high production costs, making it costly for
governments to manipulate.
The gold standard involved a commitment by the participating countries to fix the prices
of their domestic currencies in terms of a specified amount of gold.
Each currency was expressed in terms of its convertibility to gold, so the exchange rate
between two countrys currencies would be determined by their relative gold contents.
For example, in Britain, gold was 4.2474/oz; in the US $20.67/oz. $/ = 20.67/4.2474 =
The value of gold relative to other goods and services does not change much over long
periods of time, so the monetary discipline imposed by a gold standard should ensure
long-run price stability for both individual countries and groups of countries. Central

banks were obliged to convert currency to gold if requested; gold was the reserve
asset. Instead of FX reserves, they had gold reserves.
The gold standard can be thought of as a type of currency board each unit of currency
is fully backed by a certain amount of gold (instead of a hard currency as with todays
currency boards). Gold was used to settle international transactions.
Notice that governments can make a 100% profit by issuing more fiat money, however
the net profit margin on issuing more money under a gold standard is 0. The
government must acquire more gold before it can issue more money (in order to fix the
exchange rate to ounces of gold) and the governments cost of acquiring the extra gold
equals the value of the money it issues. Thus expansion of the money supply is
constrained by the available supply of gold. So if supply of gold increase, then MS must
increase to keep fixed exchange rate b/w gold and currency.
Under the classical gold standard, disturbances in the price level in one country would
be partially or wholly offset by an automatic bop adjustment mechanism called the
price-specie (gold)-flow mechanism.
The process works like this:
1. Assume US price falls, so imports<exports (initially bop surplus)-> gold inflow
(this offsets the bop surplus by the following chain of events) -> domestic
reserve will increase hence MS will increase -> increase in price and decrease in
interest rates -> decrease in exports and decrease in capital inflows reducing the
gold reserve and MS, hence bop is no more in surplus.
2. Assume US price rise, so imports>exports (initially bop deficit)-> gold outflow
(this offsets the bop deficit by the following chain of events) -> domestic reserve
will decrease hence MS will decrease -> decrease price and increase interest
rates -> increase in exports and increase in capital inflows increasing the gold
reserve and MS, hence bop is no more in deficit.
Refer to exhibit 3.7 pg 110.
Thus the operation of the price-specie-flow mechanism tended to keep prices in line for
those countries that were on the gold standard. As long as the world was on a gold
standard, all adjustments were automatic. However a problem is that any sudden
shocks to the balance of payments led to severe shocks in domestic economies.
The disadvantage is that the gold supply is likely to be unrelated to the worlds needs for
additional liquidity. In times of growth, the world money supply could grow only at the
rate of new gold extraction. It is wasteful to use a tangible, expensive-to-produce asset
as a reserve asset. Also gold has an opportunity cost storage etc.

The interwar period

Several attempts were made to restore the gold standard. Exchange rates fluctuated as
countries used predatory depreciations of their currencies. Everyone wanted a weak
currency to promote exports and make imports more expensive. This led to increased

protectionism around the world. The result for international trade and investment was
profoundly detrimental.
The Bretton Woods system

Each government pledged to maintain a fixed, or pegged, exchange rate for its currency
via the dollar or gold. As one ounce of gold was set to equal $35, then fixing a currencys
gold price was equivalent to setting its exchange rate relative to the dollar.
The rationale for a fixed exchange system was that they wanted a system of fixed
exchange rates to keep currency volatility to a minimum and prevent predatory
depreciations to promote trade. And allow for limited flexibility to adjust exchange
rates when necessary to limit the effects of external imbalances on the real economy.
This established the Gold Exchange Standard: The US adopted a par value expressed in
gold ($35 per ounce); All other members pegged to the dollar. Overseen by
International Monetary Fund (IMF). With the IMFs permission countries were allowed
to devalue or revalue. Hard currencies used as reserve currencies (mainly the dollar).
Each country was responsible for maintaining its exchange rate within 1% of the
adopted US dollar par value. The system worked as long as there was sufficient
confidence in convertibility of the dollar to gold.
The fixed exchange rates were maintained by official intervention in the foreign
exchange markets. Eg, a country that had policies which lead to a higher rate of inflation
than experienced by its trading partners will experience a bop deficit as it has reduced
exports and increased imports. This deficit means that there will be an increased supply
of that countrys currency in the FX markets (since they sell their domestic currency and
buy FX to pay for its imports). The excess supply of this countrys currency will depress
the exchange value of that countrys currency, forcing officials to intervene. The country
would be obligated to buy with its reserves the excess supply of its own currency. So the
country will buy its own currency and sell FX, hence demand for FX decrease so MS will
decrease. This reduction in MS will reduce the inflation and increase the value of home
currency bringing it in line with the rest of the world.

The current system

The system eventually broke down, in 1971 convertibility to gold was abandoned. By
1973 many developed countries had adopted flexible (floating) rates. Most developing
countries, however, have managed exchange rate systems. USD still plays a major
unofficial role as a reserve currency.

The macroeconomic trilemma

Only two of the following three policy objectives, or attributes of the ideal currency,
can be achieved: Use of monetary policy oriented toward domestic goals, Exchange rate
stability, Full financial integration (free capital mobility).

The theory assumes that exchange rate stability is good as it promotes trade. Fixed
exchange rate systems provide exchange rate stability. Therefore, exchange rate
volatility is bad.

Floating exchange rate systems

Under a floating exchange system we can only achieve Use of monetary policy oriented
toward domestic goals and Full financial integration (free capital mobility). In most
developed countries, it is generally considered that the benefit of being able to freely
use monetary policy outweighs the disadvantage of exchange rate volatility.
The reason is because floating exchange rate systems have the ability to self-equilibrate:
1. In response to changes in relative interest rates If the country needs to take
the heat off a booming economy, then monetary policy can be used to increase
interest rates to reduce inflation and inflation expectations. This will cause an
increase in capital inflow (due to increase in exports) and hence exchange rate
rises. If interest rates are reduced (so inflation increases) to stimulate an
economy in recession, then capital outflows can result (due to increased
imports), then exchange rate falls.
2. In case of external imbalances case 1, assume there is a current account deficit
which means imports rise and exports fall. Immediately, this means there is
excess demand for FX (since we must buy FX to pay for imports), this implies
that domestic currency will fall in value to eliminate the excess supply. Now in
the medium to long term, as the currencys value falls, exports become cheaper
on world markets, and imports become more expensive, therefore exports
increase and imports decrease, this fixes the current account deficit. Case 2,
assume there is a current account surplus (exports > imports), so immediately
the value of the currency rises. Then in the medium to long term, exports
become uncompetitive reducing export volume and revenue whilst imports
become cheaper, so imports increase and exports decrease. Current account
surplus is thus fixed.
A floating exchange rate system is said to be the economys external shock absorber.
This is the j-curve effect.
So, in theory, current account deficits in floating exchange rate systems are selfcorrecting.
Recall that an implicit assumption of the trilemma framework is that exchange rate
volatility somehow impedes trade and international business. Does it? In general, no
for the (mostly developed) countries that have floating exchange rate systems.
There are many tools available in the capital markets, particularly derivative markets, to
assist firms in managing the problem of exposure to exchange rate movements.

Fixed exchange rate systems

Under a fixed exchange rate system, only Exchange rate stability and Full financial
integration (free capital mobility) are satisfied.
It has an advantage and a disadvantage.