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The International

Monetary System
2
Chapter Two
INTERNATIONAL
Chapter Objective: FINANCIAL
MANAGEMENT
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.

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Chapter Two Outline
 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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Evolution of the
International Monetary System
 Bimetallism: Before 1875
 Classical Gold Standard: 1875-1914

 Interwar Period: 1915-1944

 Bretton Woods System: 1945-1972

 The Flexible Exchange Rate Regime: 1973-

Present

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Inc. All rights res . 2-4 Copyright © 2007 by The McGraw-Hill Companies.  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. Bimetallism: Before 1875  A “double standard” in the sense that both gold and silver were used as money.

driving more scarce metal out of circulation. All rights res .  Gresham’s Law: “Bad” (abundant) money drives out “Good” (scarce) money 2-5 Copyright © 2007 by The McGraw-Hill Companies. Bimetallism: Before 1875 Gresham’s Law  Phenomenon experienced by the countries that were on the bimettalic standard. Inc. only the abundant metal was used as money.  Since exchange rate between two currency was fixed officially.

All rights res . 2-6 Copyright © 2007 by The McGraw-Hill Companies.  Gold could be freely exported or imported.  The exchange rate between two country’s currencies would be determined by their relative gold contents. Inc. Classical Gold Standard: 1875-1914  During this period in most major countries:  Gold alone was assured of unrestricted coinage  There was two-way convertibility between gold and national currencies at a stable ratio.

it must be the case that the exchange rate is determined by the relative gold contents: $30 = £6 $5 = £1 2-7 Copyright © 2007 by The McGraw-Hill Companies. and the British pound is pegged to gold at £6 = 1 ounce of gold. All rights res .S. Inc. if the dollar is pegged to gold at U. Classical Gold Standard: 1875-1914 For example.$30 = 1 ounce of gold.

2-8 Copyright © 2007 by The McGraw-Hill Companies. Classical Gold Standard: 1875-1914  Highly stable exchange rates under the classical gold standard provided an environment that was favorable to international trade and investment. All rights res . Inc.  Misalignment of exchange rates and international imbalances of payment were automatically corrected by the price-specie-flow mechanism.

2-9 Copyright © 2007 by The McGraw-Hill Companies. a higher price level in Britain. Price-Specie-Flow Mechanism  Suppose Great Britain exported more to France than France imported from Great Britain.  This flow of gold will lead to a lower price level in France and. Inc. at the same time.  Net export of goods from Great Britain to France will be accompanied by a net flow of gold from France to Great Britain. All rights res .  The resultant change in relative price levels will slow exports from Great Britain and encourage exports from France.

2. any national government could abandon the standard.  Even if the world returned to a gold standard. Copyright © 2007 by The McGraw-Hill Companies. Classical Gold Standard: 1875-1914  There are shortcomings:  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. All rights res . Inc.

Inc. 2.  The result for international trade and investment was profoundly detrimental. All rights res . Copyright © 2007 by The McGraw-Hill Companies. Interwar Period: 1915-1944  Exchange rates fluctuated as countries widely used “predatory” depreciations of their currencies as a means of gaining advantage in the world export market. but participants lacked the political will to “follow the rules of the game”.  Attempts were made to restore the gold standard.

Copyright © 2007 by The McGraw-Hill Companies. Bretton Woods System: 1945-1972  Named for a 1944 meeting of 44 nations at Bretton Woods. 2.  The result was the creation of the IMF and the World Bank. New Hampshire.  The goal was exchange rate stability without the gold standard. Inc. All rights res .  The purpose was to design a postwar international monetary system.

Inc.S. Copyright © 2007 by The McGraw-Hill Companies.S.  Each country was responsible for maintaining its exchange rate within ±1% of the adopted par value by buying or selling foreign reserves as necessary. 2. All rights res . dollar.  The Bretton Woods system was a dollar-based gold exchange standard. the U. dollar was pegged to gold at $35 per ounce and other currencies were pegged to the U. Bretton Woods System: 1945-1972  Under the Bretton Woods system.

dollar Pegged at $35/oz. Copyright © 2007 by The McGraw-Hill Companies. Bretton Woods System: 1945-1972 German British mark French pound franc r Par P Pa lue Va ar Value lue Va U.S. Gold 2. All rights res . Inc.

 Non-oil-exporting countries and less-developed countries were given greater access to IMF funds.  Flexible exchange rates were declared acceptable to the IMF members. 2. Copyright © 2007 by The McGraw-Hill Companies. The Flexible Exchange Rate Regime: 1973-Present.  Central banks were allowed to intervene in the exchange rate markets to iron out unwarranted volatilities.  Gold was abandoned as an international reserve asset. All rights res . Inc.

Panama. dollar or euro. Copyright © 2007 by The McGraw-Hill Companies.Current Exchange Rate Arrangements  Free Float  The largest number of countries. 2. Inc.S. dollar. they just use the U.S. Ecuador.  Pegged to another currency  Such as the U.  Managed Float  About 25 countries combine government intervention with market forces to set exchange rates. For example. and El Salvador have dollarized. about 48. All rights res . allow market forces to determine their currency’s value.  No national currency  Some countries do not bother printing their own.

and jointly float against outside currencies. 2.  To pave the way for the European Monetary Union.  Objectives:  To establish a zone of monetary stability in Europe. Copyright © 2007 by The McGraw-Hill Companies. All rights res .  To coordinate exchange rate policies vis-à-vis non- European currencies. Inc. European Monetary System  Eleven European countries maintain exchange rates among their currencies within narrow bands.

All rights res . Germany. 2. Spain.  These original member states were: Belgium. Portugal and the Netherlands. Finland. Luxemburg. Inc. Ireland. What Is the Euro?  The euro is the single currency of the European Monetary Union which was adopted by 11 Member States on 1 January 1999. Austria. Italy. France. Copyright © 2007 by The McGraw-Hill Companies.

and 1 euro cent.  €500. dollar. and €5. Inc. 2 euro cent.  The coins are: 2 euro. €200. €10. €50. 2. What are the different denominations of the euro notes and coins ?  There are 7 euro notes and 8 euro coins. 10. All rights res . 50 euro cent.  The euro itself is divided into 100 cents. 5 euro cent. 20 euro cent. 1 euro. Copyright © 2007 by The McGraw-Hill Companies.S. €100. €20. euro cent. just like the U.

All rights res . Inc. 2. How did the euro affect contracts denominated in national currency?  All insurance and other legal contracts continued in force with the substitution of amounts denominated in national currencies with their equivalents in euro. Copyright © 2007 by The McGraw-Hill Companies.

Copyright © 2007 by The McGraw-Hill Companies. Inc. All rights res .Euro Area 22 Countries participating in the euro:  Austria  Italy  Belgium  Latvia  Cyprus  Lithuania  Czech Republic  Luxembourg  Estonia  Malta  Finland  Poland  France  Portugal  Germany  Slovak Republic  Greece  Slovenia  Hungary  Spain  Ireland  The Netherlands 2.

eventually making a “United States of Europe” feasible. dollar will be the two major currencies.S. it will advance the political integration of Europe in a major way.  It is likely that the U. Copyright © 2007 by The McGraw-Hill Companies.  The euro and the U. 2. All rights res . Inc. The Long-Term Impact of the Euro  If the euro proves successful.S. dollar will lose its place as the dominant world currency.

 This decision changed currency trader’s expectations about the future value of the peso. All rights res . Inc. The Mexican Peso Crisis December 20. 1994. the Mexican government announced a plan to devalue the peso against the dollar by 14 percent.  In their rush to get out the peso fell by as much as 40 percent. Copyright © 2007 by The McGraw-Hill Companies. 2. 1994  On 20 December.  They stampeded for the exits.

All rights res . 1994  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. Copyright © 2007 by The McGraw-Hill Companies. 2.  Two lessons emerge:  It is essential to have a multinational safety net in place to safeguard the world financial system from such crises. The Mexican Peso Crisis December 20.  An arrival of foreign capital can lead to an overvaluation in the first place. Inc.

2. widespread recession. The Asian Currency Crisis July 2. 1997  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. Inc.  Many firms with foreign currency bonds were forced into bankruptcy. Copyright © 2007 by The McGraw-Hill Companies. All rights res .  The region experienced a deep.

dollar appreciated on the world market the Argentine peso became stronger as well.S.S. Inc.  The initial economic effects were positive:  Argentina’s chronic inflation was reduced  Foreign investment poured in  As the U. 2. All rights res . The Argentinean Peso Crisis 2002  In 1991 the Argentine government passed a convertibility law that linked the peso to the U. dollar at parity. Copyright © 2007 by The McGraw-Hill Companies.

Copyright © 2007 by The McGraw-Hill Companies. All rights res . Inc.  The unemployment rate rose above 20 percent  The inflation rate reached a monthly rate of 20 percent 2. The Argentinean Peso Crisis  The strong peso hurt exports from Argentina and caused a protracted economic downturn that led to the abandonment of peso–dollar parity in January 2002.

Copyright © 2007 by The McGraw-Hill Companies. The Argentinean Peso Crisis  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 2. All rights res . Inc.

2. Inc. a currency’s value mirrors the fundamental strength of its underlying economy. For example. In the long run. currency trader’s expectations play a much more important role.  Thus.S.  In the short run. dollars.  In today’s environment. Copyright © 2007 by The McGraw-Hill Companies. act by fight-or-flight instincts. Currency Crisis Explanations  In theory. using the most modern communications. All rights res . they want to “get to the exits first”. if they expect others are about to sell Brazilian reals for U. relative to other economies. fears of depreciation become self-fulfilling prophecies. traders and lenders.

2. Fixed versus Flexible Exchange Rate Regimes  Arguments in favor of flexible exchange rates:  Easier external adjustments. Inc. Copyright © 2007 by The McGraw-Hill Companies.  Arguments against flexible exchange rates:  Exchange rate uncertainty may hamper international trade.  National policy autonomy. All rights res .  No safeguards to prevent crises.

40/£ today. experiences trade deficits. we see that demand for British pounds far exceed supply at this exchange rate.  The U. Copyright © 2007 by The McGraw-Hill Companies. Inc. All rights res . 2.S.  In the next slide. Fixed versus Flexible Exchange Rate Regimes  Suppose the exchange rate is $1.

40 (D) Trade deficit S D Q of £ 2. Inc. All rights res . Copyright © 2007 by The McGraw-Hill Companies. Fixed versus Flexible Exchange Rate Regimes Supply Dollar price per £ (exchange rate) (S) Demand $1.

Flexible Exchange Rate Regimes  Under a flexible exchange rate regime. All rights res . 2. the dollar will simply depreciate to $1. the price at which supply equals demand and the trade deficit disappears. Copyright © 2007 by The McGraw-Hill Companies. Inc.60/£.

All rights res . Copyright © 2007 by The McGraw-Hill Companies. Fixed versus Flexible Exchange Rate Regimes Supply Dollar price per £ (exchange rate) (S) $1. Inc.40 (flexible regime) (D) Demand (D*) D=S Q of £ 2.60 Dollar depreciates Demand $1.

and thus the imbalance between supply and demand cannot be eliminated by a price change. 2. suppose the exchange rate is “fixed” at $1.40/£. Fixed versus Flexible Exchange Rate Regimes  Instead. All rights res . Copyright © 2007 by The McGraw-Hill Companies. Inc.  The government would have to shift the demand curve from D to D*  In this example this corresponds to contractionary monetary and fiscal policies.

Fixed versus Flexible Exchange Rate Regimes Supply Dollar price per £ Contractionary (exchange rate) policies (S) (fixed regime) Demand $1.40 (D) Demand (D*) D* = S Q of £ 2. Copyright © 2007 by The McGraw-Hill Companies. All rights res . Inc.