Alan Shapiro and Peter Moles: International Financial Management 1st Edition John Wiley & Sons, Inc

International Financial Management
Alan Shapiro and Peter Moles

1st Edition
John Wiley & Sons, Inc.
1 www.wiley.com/college/shapiro
CHAPTER 3
The International Monetary

System
www.wiley.com/college/shapiro 2
ALTERNATIVE EXCHANGE RATE
SYSTEMS
I. FIVE MARKET MECHANISMS
A. Freely floating (clean float)

1. Market forces of supply and
demand determine rates.
2. Forces influenced by
a. price levels
b. interest rates
c. economic growth
3. Rates fluctuate over time randomly.
SYSTEMS
B. Managed float (dirty float)
1. Market forces set rates unless excess

volatility occurs,
2. Then, central bank determines rate.
SYSTEMS
C. Target-zone arrangement
1. Rate determination
a. Market forces constrained to upper
and lower range of rates.
b. Members to the arrangement adjust their
national economic policies to maintain target.
SYSTEMS
D. Fixed rate system
1. Rate determination
a. Government maintains target rates.
b. If rates threatened, central banks buy/sell
currency.
c. Monetary policies coordinated.
SYSTEMS
D. Fixed rate system (cont’d)
2. Some government controls

a. On global portfolio investments.
b. Ceilings on direct foreign direct insurance.
c. Import restrictions.
SYSTEMS
E. Current system
1. A hybrid system
a. Major currencies: use freely-floating
method.
b. Others move in and out of various fixed-
rate systems.
A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM
I. THE USE OF GOLD
A. Desirable properties.
B. In short run: High production costs limit short-
run changes.
C. In long run: Commodity money insures
stability.
II. THE CLASSICAL GOLD STANDARD
(1821–1914)
A. Major currencies on gold standard.

1. Involved commitment by nations to fix the
price of domestic currency in terms of a specific
amount of gold.
2. Maintenance involved the buying and selling of

gold at that price.
3. Disturbances in price levels:
Would be offset by the price- specie*-
flow mechanism.
* specie refers to gold coins
3a. Price-specie-flow mechanism had automatic

adjustments:
1. When a balance of payments surplus

led to a gold inflow.
2. Gold inflow led to higher prices which
reduced surplus.
3. Gold outflow led to lower prices and
increased surplus.
III. THE GOLD EXCHANGE STANDARD (1925‒1931)
A. Only U.S. and U.K. allowed to hold gold

reserves.
B. Others could hold both gold, U.S. dollars or

pound reserves.
C. Currencies devalued in 1931

‒ led to trade wars.
D. Bretton Woods Conference

– called in order to avoid future
protectionist and destructive economic policies.
IV. THE BRETTON WOODS SYSTEM (1946‒
1971)
A. The Bretton Woods Agreement
1. US$ was key currency;
valued at US$1 = 1/35 oz. of gold.
2. All currencies linked to that price in a fixed
rate system.
3. Exchange rates allowed to fluctuate by 1%
above or below initially set rates.
B. Collapse, 1971
1. Causes:
a. U.S. high inflation rate.
b. US$ depreciated sharply.
V. POST-BRETTON WOODS SYSTEM
(1971–PRESENT)
A. Smithsonian Agreement, 1971
US$ devalued to 1/38 oz. of gold.
By 1973 ‒ world on a freely floating

exchange rate system.
B. OPEC and the oil crisis (1973–1974)

1. OPEC raised oil prices fourfold.
2. Exchange rate turmoil resulted.
3. Caused OPEC nations to earn
large surplus B-O-P.
4. Surpluses recycled to debtor nations
which set up debt crisis of 1980s.
C. U.S. dollar crisis (1977‒1978)

1. U.S. B-O-P difficulties.
2. Result of inconsistent monetary
policy in U.S.
3. U.S. dollar value falls as confidence
shrinks.
D. The rising U.S. dollar (1980–1985)

1. U.S. inflation subsides as the Fed
raises interest rates.
2. Rising rates attracts global capital to U.S.
3. Result: U.S. dollar value rises.
E. The sinking U.S. dollar (1985‒1987)

1. U.S. dollar revaluated slowly
downward.
2. Plaza Agreement (1985)
G-5 agree to depress US$ further.
3. The Louvre Agreement (1987)
G-7 agree to support the falling US$.
F. Recent history (1988–Present)

1. 1988 US$ stabilized.
2. Post-1991 confidence resulted in
stronger U.S. dollar.
3. 1993‒1995 U.S. dollar value falls.
4. 1996–2007 U.S. dollar fluctuates
against major currencies.
5. 2008–2009 flight to safety boosts
U.S. dollar.
6. 2008 onwards, period of
quantitative easing and ultra-low
interest rates.
THE EUROPEAN MONETARY
SYSTEM
I. INTRODUCTION
A. The European Monetary System (EMS)

1. A target-zone method (1979).
2. Close macroeconomic policy coordination
required.
SYSTEM
B. EMS objective
to provide exchange rate stability to all
members by holding exchange rates within specified
limits.
SYSTEM
C. European Currency Unit (ECU)
a “cocktail” of European currencies with
specified weights as the unit of account.
1. Exchange-Rate Mechanism (ERM)

each member determines mutually
agreed-on central cross-rate for its
currency.
SYSTEM
2. Member pledge:
to keep within 15% margin above or below
the central rate.
D. EMS ups and downs
1. Foreign exchange interventions failed due

to lack of support by coordinated monetary policies.
SYSTEM
2. Currency Crisis of Sept. 1992
a. System breaks down.
b. Britain and Italy forced to
withdraw from EMS.
E. Failure of the EMS

members allowed political priorities
to dominate exchange rate policies.
SYSTEM
F. Maastricht Treaty
1. Calls for monetary union by 1999
(moved to 2002).
2. Establishes a single currency – the euro.

3. Calls for creation of a single central EU bank.
4. Adopts tough fiscal standards.
SYSTEM
I. COSTS/BENEFITS OF A SINGLE CURRENCY
A. Benefits
1. Reduces cost of doing business.
2. Reduces exchange rate risk.
B. Costs
1. Lack of national monetary flexibility.
EUROZONE CRISIS
Post-credit crunch, Greece was the first, to be followed by
Ireland, Portugal, and Spain, created the “Eurozone crisis”.
This was caused by:

1. Divergence in prices across the EZ.
2. Structural flaws in the euro.
3. Disparate growth rates between EZ
countries.
EMERGING MARKET CURRENCY
CRISES
Tendency for EM countries to experience large and sudden
currency crises:
Mexico 1994–95
Asian crisis 1997
Russia and Brazil 1998–99
EMERGING MARKET CURRENCY
CRISES
Transmission mechanisms:
Trade links
Weak financial systems
EM countries’ debt policies
Origins:
Moral hazard
Fundamental policy conflicts

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International Financial Management

Alan Shapiro and Peter Moles

The International Monetary

A. Freely floating (clean float)

B. Managed float (dirty float)

1. Market forces set rates unless excess

2. Then, central bank determines rate.

D. Fixed rate system

D. Fixed rate system (cont’d)

2. Some government controls

A. Major currencies on gold standard.

2. Maintenance involved the buying and selling of

* specie refers to gold coins

3a. Price-specie-flow mechanism had automatic

1. When a balance of payments surplus

A. Only U.S. and U.K. allowed to hold gold

B. Others could hold both gold, U.S. dollars or

C. Currencies devalued in 1931

D. Bretton Woods Conference

A. Smithsonian Agreement, 1971

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

By 1973 ‒ world on a freely floating

B. OPEC and the oil crisis (1973–1974)

C. U.S. dollar crisis (1977‒1978)

D. The rising U.S. dollar (1980–1985)

E. The sinking U.S. dollar (1985‒1987)

F. Recent history (1988–Present)

A. The European Monetary System (EMS)

1. Exchange-Rate Mechanism (ERM)

D. EMS ups and downs

1. Foreign exchange interventions failed due

E. Failure of the EMS

2. Establishes a single currency – the euro.

4. Adopts tough fiscal standards.

This was caused by:

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