International

Business 7e

by Charles W.L. Hill

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 10

The International Monetary System

 Introduction

The institutional arrangements that countries adopt to

govern exchange rates are known as the international
monetary system
When a country allows the foreign exchange market to
determine the relative value of a currency, a floating
exchange rate system exists
When a country fixes the value of its currency relative to
a reference currency, a pegged exchange rate system
exists

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 Introduction

When a country tried to hold the value of its currency

within some range of a reference currency, dirty float exists
Countries that adopt a fixed exchange rate system fix
their currencies against each other
Prior to the introduction of the euro, some European
Union countries operated with fixed exchange rates within
the context of the European Monetary System (EMS)

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 Classroom Performance System

A ________ exchange rate system exists when the foreign

exchange market determines the relative value of a
currency.

a) Fixed
b) Floating
c) Pegged
d) Market

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 The Gold Standard

The gold standard dates back to ancient times when gold

coins were a medium of exchange, unit of account, and
store of value
Payment for imports was made in gold or silver
Later, as trade grew, payment was made in paper
currency which was linked to gold at a fixed rate

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 Mechanics Of The Gold Standard

Pegging currencies to gold and guaranteeing

convertibility is known as the gold standard
In the 1880s, most of the world’s trading nations followed
the gold standard
Under the gold standard one U.S. dollar was defined as
equivalent to 23.22 grains of "fine (pure) gold
The amount of a currency needed to purchase one ounce
of gold was called the gold par value

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 Strength Of The Gold Standard

The great strength of the gold standard was that it

contained a powerful mechanism for achieving balance-of-
trade equilibrium (when the income a country’s residents
earn from its exports is equal to the money its residents
pay for imports) by all countries

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 Classroom Performance System

What type of exchange rates system was the gold

standard?

a) Fixed
b) Floating
c) Pegged
d) Market

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 The Period Between The Wars: 1918-1939

The gold standard worked fairly well from the 1870s until
the start of World War I in 1914
During the war, many governments financed their war
expenditures by printing money, and in doing so, created
inflation
People lost confidence in the system and started to
demand gold for their currency putting pressure on
countries' gold reserves, and forcing them to suspend gold
convertibility
By 1939, the gold standard was dead

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 The Bretton Woods System

In 1944, representatives from 44 countries met at Bretton

Woods, New Hampshire, to design a new international
monetary system that would facilitate postwar economic
growth

Under the new agreement:

a fixed exchange rate system was established
all currencies were fixed to gold, but only the U.S. dollar
was directly convertible to gold
devaluations could not to be used for competitive
purposes
a country could not devalue its currency by more than
10% without IMF approval

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 The Bretton Woods System

The Bretton Woods agreement also established two

multinational institutions:
 the International Monetary Fund (IMF) to maintain order
in the international monetary system
 the World Bank to promote general economic
development

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 The Role Of The IMF

The IMF was charged with executing the main goal of the
Bretton Woods agreement - avoiding a repetition of the
chaos that occurred between the wars through a
combination of discipline and flexibility

Discipline mean that:

the need to maintain a fixed exchange rate put a brake
on competitive devaluations and brought stability to the
world trade environment
a fixed exchange rate regime imposed monetary
discipline on countries, thereby curtailing price inflation

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 The Role Of The IMF

Flexibility meant that:

while monetary discipline was a central objective of the
agreement, a rigid policy of fixed exchange rates would be
too inflexible
the IMF was ready to lend foreign currencies to members
to tide them over during short periods of balance-of-
payments deficit, when a rapid tightening of monetary or
fiscal policy would hurt domestic employment

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 The Role Of The World Bank

The World Bank is also called the International Bank for

Reconstruction and Development (IBRD)

There are two ways to borrow from the World Bank:

1. under the IBRD scheme, money is raised through bond
sales in the international capital market
 borrowers pay what the bank calls a market rate of
interest - the bank's cost of funds plus a margin for
expenses.
2. through the International Development Agency, an arm
of the bank created in 1960
 IDA loans go only to the poorest countries

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 The Collapse Of The Fixed
Exchange Rate System

Bretton Woods worked well until the late 1960s

It collapsed when huge increases in welfare programs
and the Vietnam War were financed by increasing the
money supply and causing significant inflation
Other countries increased the value of their currencies
relative to the dollar in response to speculation the dollar
would be devalued
However, because the system relied on an economically
well managed U.S., when the U.S. began to print money,
run high trade deficits, and experience high inflation, the
system was strained to the breaking point

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 The Floating Exchange Rate Regime

In 1976, following the collapse of Bretton Woods, IMF

members formalized a new exchange rate system at a
meeting in Jamaica
The rules that were agreed on then, are still in place
today

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 The Jamaica Agreement

Under the Jamaican agreement:

floating rates were declared acceptable
gold was abandoned as a reserve asset
total annual IMF quotas - the amount member countries
contribute to the IMF - were increased to $41 billion

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 Exchange Rates Since 1973

Since 1973, exchange rates have become more volatile and less
predictable than they were between 1945 and 1973

Volatility has increased because of:

The 1971 oil crisis
The loss of confidence in the dollar that followed the rise of U.S.
inflation in 1977 and 1978
The 1979 oil crisis
The unexpected rise in the dollar between 1980 and 1985
The partial collapse of the European Monetary System in 1992
The 1997 Asian currency crisis

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 Exchange Rates Since 1973
Figure 10.1: Major Currencies Dollar Index, 1973-2006

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 Classroom Performance System

Which agreement deemed floating exchange rates to be

acceptable?

a) The Bretton Woods Agreement

b) The Gold Standard
c) The Jamaica Agreement
d) The Louvre Accord

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 Fixed Versus Floating Exchange Rates

The merit of a fixed exchange rate versus a floating

exchange rate system continues to be debated
Many countries today are disappointed with the floating
exchange rate system

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 The Case For Floating Exchange Rates

The case for floating exchange rates has two main

elements:
1. monetary policy autonomy
2. automatic trade balance adjustments

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 The Case For Floating Exchange Rates

Supporters of floating exchange rates argue that

removing the obligation to maintain exchange rate parity
restores monetary control to a government
Under a fixed system, a country's ability to expand or
contract its money supply as it sees fit is limited by the
need to maintain exchange rate parity
So, under the Bretton Woods system, if a country
developed a permanent deficit in its balance of trade that
could not be corrected by domestic policy, the IMF would
have to agree to a currency devaluation

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 The Case For Fixed Exchange Rates

Supporters of fixed exchange rates focus on monetary

discipline, uncertainty, and the lack of connection between
the trade balance and exchange rates
Having to maintain a fixed exchange rate parity ensures
that governments do not expand their money supplies at
inflationary rates
They also claim that speculation that is associated with
floating exchange rates can cause uncertainty
Advocates of floating exchange rates also argue that
floating rates help adjust trade imbalances

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 Who Is Right?

There is no real agreement as to which system is better

We know that a fixed exchange rate regime modeled
along the lines of the Bretton Woods system will not work
A different kind of fixed exchange rate system might be
more enduring and might foster the kind of stability that
would facilitate more rapid growth in international trade and
investment

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 Exchange Rate Regimes In Practice

Various exchange rate regimes are followed today

Currently:
14% of IMF members follow a free float policy
26% of IMF members follow a managed float system
28% of IMF members have no legal tender of their own
the remaining countries use less flexible systems such as
pegged arrangements, or adjustable pegs

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 Exchange Rate Regimes In Practice
Figure 10.2: Exchange Rate Policies, IMF Members, 2006

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 Classroom Performance System

Which type of exchange rate system do most IMF countries

follow today?

a) Free float
b) Managed float
c) Fixed peg
d) Adjustable peg

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 Pegged Exchange Rates

A country following a pegged exchange rate system,

pegs the value of its currency to that of another major
currency
Pegged exchange rates are popular among the world’s
smaller nations
There is some evidence that adopting a pegged
exchange rate regime does moderate inflationary
pressures in a country

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 Currency Boards

Countries using a currency board commit to converting

their domestic currency on demand into another currency
at a fixed exchange rate
To make this commitment credible, the currency board
holds reserves of foreign currency equal at the fixed
exchange rate to at least 100% of the domestic currency
issued

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 Crisis Management By The IMF

Since many of the original reasons for the IMF no longer

exist, the organization has redefined its mission
The IMF now focuses on lending money to countries
experiencing financial crises
However, critics claim that IMF policies in these countries
have actually made the situation worse

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 Financial Crises In The
Post-Bretton Woods Era

A currency crisis occurs when a speculative attack on the

exchange value of a currency results in a sharp
depreciation in the value of the currency, or forces
authorities to expend large volumes of international
currency reserves and sharply increase interest rates in
order to defend prevailing exchange rates
A banking crisis refers to a situation in which a loss of
confidence in the banking system leads to a run on the
banks, as individuals and companies withdraw their
deposits
A foreign debt crisis is a situation in which a country
cannot service its foreign debt obligations, whether private
sector or government debt

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 Classroom Performance System

A _________ is a situation in which a country cannot

service its foreign debt obligations, whether private sector
or government debt.

a) currency crisis
b) banking crisis
c) foreign debt crisis
d) foreign exchange crisis

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 Mexican Currency Crisis Of 1995

The Mexican currency crisis of 1995 was a result of:

high Mexican debts
a pegged exchange rate that did not allow for a natural
adjustment of prices

To keep Mexico from defaulting on its debt, a $50 billion

aid package was created

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 The Asian Crisis

The 1997 Southeast Asian financial crisis was caused by a

series of events that took place in the previous decade:
huge increases in exports that helped fuel a boom in
commercial and residential property, industrial assets, and
infrastructure
investments that were made on the basis of projections
about future demand conditions that were unrealistic and
created significant excess capacity Investments made on
the basis of unrealistic projections about future demand
conditions created significant excess capacity
investments were often supported by dollar-based debts

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 The Asian Crisis

when inflation and increasing imports put pressure on the

currencies, the resulting devaluations led to default on
dollar denominated debts
by the mid 1990s, imports were expanding across the
region
by mid-1997, it became clear that several key Thai
financial institutions were on the verge of default
foreign exchange dealers and hedge funds started to
speculate against the Baht, selling it short
after struggling to defend the peg, the Thai government
abandoned its defense and announced that the Baht would
float freely against the dollar

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 The Asian Crisis

With its foreign exchange rates depleted, Thailand lacked

the foreign currency needed to finance its international
trade and service debt commitments, and was in desperate
need of the capital the IMF could provide
Following the devaluation of the Baht, speculation
caused other Asian currencies including the Malaysian
Ringgit, the Indonesian Rupaih and the Singapore Dollar to
fall
These devaluations were mainly driven by similar factors
to those that led to the earlier devaluation of the Baht--
excess investment, high borrowings, much of it in dollar
denominated debt, and a deteriorating balance of
payments position

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 Evaluating The IMF’s Policy Prescriptions

By 2006, the IMF was committing loans to some 59 countries in

economic and currency crisis
All IMF loan packages require a combination of tight macroeconomic
policy and tight monetary policy

However, critics worry:

 the “one-size-fits-all” approach to macroeconomic policy is
inappropriate for many countries
the IMF is exacerbating moral hazard (when people behave
recklessly because they know they will be saved if things go wrong)
The IMF has become too powerful for an institution without any real
mechanism for accountability
 As with many debates about international economics, it is not clear
who is right

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 Implications For Managers

For managers, understanding the international monetary

system is important for:
currency management
business strategy
corporate-government relations

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 Currency Management

Managers must recognize that the current international

monetary system is a managed float system in which
government intervention can help drive the foreign
exchange market
Under the present system, speculative buying and selling
of currencies can create volatile movements in exchange
rates

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 Business Strategy

Managers need to recognize that while exchange rate

movements are difficult to predict, their movement can
have a major impact on the competitive position of
businesses
To contend with this situation, managers need strategic
flexibility

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 Corporate-Government Relations

Managers need to recognize that businesses can

influence government policy towards the international
monetary system
So, companies should promote an international monetary
system that facilitates international growth and
development

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 Classroom Performance System

Managers need to understand the implications of changing

exchange rates from all of the following perspectives
except

A) corporate-governance relations
B) business strategy
C) foreign relations
D) currency management

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