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Chapter Objective:
Chapter Two
This chapter serves to introduce the student to the institutional framework within which:
a. International payments are made. Fourth Edition b. The movement of capital is accommodated. EUN / RESNICK c. Exchange rates are determined.
2-0 Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Evolution of the International Monetary System Current Exchange Rate Arrangements European Monetary System The Mexican Peso Crisis The Asian Currency Crisis The Argentine Peso Crisis Fixed versus Flexible Exchange Rate Regimes
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Bimetallism: Before 1875 Classical Gold Standard: 1875-1914 Interwar Period: 1915-1944 Bretton Woods System: 1945-1972 The Flexible Exchange Rate Regime: 1973Present
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A double standard in the sense that both gold and silver were used as money. Both gold and silver were used as international means of payment and the exchange rates among currencies were determined by either their gold or silver contents.
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Phenomenon experienced by the countries that were on the bimettalic standard. Since exchange rate between two currency was fixed officially, only the abundant metal was used as money, driving more scarce metal out of circulation.
Greshams Law: Bad (abundant) money drives out Good (scarce) money
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Gold alone was assured of unrestricted coinage There was two-way convertibility between gold and national currencies at a stable ratio. Gold could be freely exported or imported.
The exchange rate between two countrys currencies would be determined by their relative gold contents.
2-5 Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Highly stable exchange rates under the classical gold standard provided an environment that was favorable to international trade and investment. Misalignment of exchange rates and international imbalances of payment were automatically corrected by the price-specie-flow mechanism.
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Price-Specie-Flow Mechanism
Suppose Great Britain exported more to France than France imported from Great Britain.
Net export of goods from Great Britain to France will be accompanied by a net flow of gold from France to Great Britain. This flow of gold will lead to a lower price level in France and, at the same time, a higher price level in Britain.
The resultant change in relative price levels will slow exports from Great Britain and encourage exports from France.
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The supply of newly minted gold is so restricted that the growth of world trade and investment can be hampered for the lack of sufficient monetary reserves. Even if the world returned to a gold standard, any national government could abandon the standard.
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Exchange rates fluctuated as countries widely used predatory depreciations of their currencies as a means of gaining advantage in the world export market. Attempts were made to restore the gold standard, but participants lacked the political will to follow the rules of the game. The result for international trade and investment was profoundly detrimental.
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Named for a 1944 meeting of 44 nations at Bretton Woods, New Hampshire. The purpose was to design a postwar international monetary system. The goal was exchange rate stability without the gold standard. The result was the creation of the IMF and the World Bank.
2-11 Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Under the Bretton Woods system, the U.S. dollar was pegged to gold at $35 per ounce and other currencies were pegged to the U.S. dollar. Each country was responsible for maintaining its exchange rate within 1% of the adopted par value by buying or selling foreign reserves as necessary. The Bretton Woods system was a dollar-based gold exchange standard.
2-12 Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
German mark
Par Value
French franc
U.S. dollar
Pegged at $35/oz.
Gold
2-13 Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
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.
2-14 Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Free Float
The largest number of countries, about 48, allow market forces to determine their currencys value.
Managed Float
About 25 countries combine government intervention with market forces to set exchange rates.
Such as the U.S. dollar or euro. Some countries do not bother printing their own, they just use the U.S. dollar. For example, Ecuador, Panama, and El Salvador have dollarized.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
No national currency
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Eleven European countries maintain exchange rates among their currencies within narrow bands, and jointly float against outside currencies. Objectives:
To establish a zone of monetary stability in Europe. To coordinate exchange rate policies vis--vis nonEuropean currencies. To pave the way for the European Monetary Union.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
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On 20 December, 1994, the Mexican government announced a plan to devalue the peso against the dollar by 14 percent. This decision changed currency traders expectations about the future value of the peso. They stampeded for the exits. In their rush to get out the peso fell by as much as 40 percent.
2-22 Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
The Mexican Peso crisis is unique in that it represents the first serious international financial crisis touched off by cross-border flight of portfolio capital. Two lessons emerge:
It is essential to have a multinational safety net in place to safeguard the world financial system from such crises. An arrival of foreign capital can lead to an overvaluation in the first place.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
2-23
The Asian currency crisis turned out to be far more serious than the Mexican peso crisis in terms of the extent of the contagion and the severity of the resultant economic and social costs. Many firms with foreign currency bonds were forced into bankruptcy. The region experienced a deep, widespread recession.
2-24 Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
In 1991 the Argentine government passed a convertibility law that linked the peso to the U.S. dollar at parity. The initial economic effects were positive:
As the U.S. dollar appreciated on the world market the Argentine peso became stronger as well.
2-25 Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
The strong peso hurt exports from Argentina and caused a protracted economic downturn that led to the abandonment of pesodollar parity in January 2002.
The unemployment rate rose above 20 percent The inflation rate reached a monthly rate of 20 percent
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There are at least three factors that are related to the collapse of the currency board arrangement and the ensuing economic crisis:
Lack of fiscal discipline Labor market inflexibility Contagion from the financial crises in Brazil and Russia
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In theory, a currencys value mirrors the fundamental strength of its underlying economy, relative to other economies. In the long run. In the short run, currency traders expectations play a much more important role. In todays environment, traders and lenders, using the most modern communications, act by fight-or-flight instincts. For example, if they expect others are about to sell Brazilian reals for U.S. dollars, they want to get to the exits first. Thus, fears of depreciation become self-fulfilling prophecies.
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Easier external adjustments. National policy autonomy. Exchange rate uncertainty may hamper international trade. No safeguards to prevent crises.
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Suppose the exchange rate is $1.40/ today. In the next slide, we see that demand for British pounds far exceed supply at this exchange rate. The U.S. experiences trade deficits.
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$1.40
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Under a flexible exchange rate regime, the dollar will simply depreciate to $1.60/, the price at which supply equals demand and the trade deficit disappears.
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$1.60 $1.40
D=S
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Instead, suppose the exchange rate is fixed at $1.40/, and thus the imbalance between supply and demand cannot be eliminated by a price change. The government would have to shift the demand curve from D to D*
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Supply (S)
(fixed regime)
$1.40
D* = S
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