Bus280 7th Ed Chapter 10 Ppt

8/14/2019 Bus280 7th Ed Chapter 10 Ppt

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Copyri ght 2011 by The McGraw-H il l Companies, Inc. All ri ghts reserved.McGraw-Hill/Irwin

Global Business Today7e

by Charles W.L. Hill


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Chapter 10

The International

Monetary System


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Introduction

Question:What is the international monetary system?

Answer:

The international monetarysystem refers to theinstitutional arrangements that govern exchange rates

recall that the foreign exchange market is the primaryinstitution for determining exchange rates


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Introduction

A floating exchange rate systemexists in countrieswhere the foreign exchange market determines therelative value of a currency

Examples - the U.S. dollar, the European Unions

euro, the Japanese yen, and the British poundA pegged exchange rate systemexists when the value

of a currency is fixed to a reference country and then theexchange rate between that currency and other

currencies is determined by the reference currencyexchange rate

Many developing countries have pegged exchangerates


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Introduction

A dirty floatexists when the value of a currency isdetermined by market forces, but with central bankintervention if it depreciates too rapidly against animportant reference currency

China adopted this policy in 2005 With a fixed exchange ratesystemcountries fix their

currencies against each other at a mutually agreed uponvalue

prior to the introduction of the euro, some EuropeanUnion countries operated with fixed exchange rateswithin the context of the European Monetary System(EMS)


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Introduction

Question: What role does the international monetary

system play in determining exchange rates?

Answer:To answer this question, we have to look at the evolution

of the international monetary system

The Gold Standard

The Bretton Woods systemThe International Monetary Fund

The World Bank


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The Gold Standard

Question:What is the Gold Standard?

Answer:The origin of the gold standard dates back to ancient

times when gold coins were a medium of exchange, unitof account, and store of valueTo facilitate trade, a system was developed so that

payment could be made in paper currency that couldthen be converted to gold at a fixed rate of exchange


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Mechanics of the Gold Standard

The gold standardrefers to the practice of peggingcurrencies to gold and guaranteeing convertibility

under the gold standard one U.S. dollar was definedas equivalent to 23.22 grains of "fine (pure) gold

The exchange rate between currencies was based onthe gold par value- the amount of a currency needed topurchase one ounce of gold


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Strength of the Gold Standard

The key strength of the gold standard was its powerfulmechanism for simultaneously allowing all countries toachieve balance-of-trade equilibrium- when the incomea countrys residents earn from its exports is equal to the

money its residents pay for imports

many people today believe the world should return tothe gold standard


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1918 - 1939

The gold standard worked fairly well from the 1870s untilthe start of World War I

After the war countries started regularly devaluing theircurrencies to try to encourage exports

Confidence in the system fell, and people began todemand gold for their currency putting pressure oncountries' gold reserves, and forcing them to suspendgold convertibility

The Gold Standard ended in 1939


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The Bretton Woods System

A new international monetary system was designed in1944 in Bretton Woods, New Hampshire

The goal was to build an enduring economic order thatwould facilitate postwar economic growth

The Bretton Woods Agreement established twomultinational institutions1. The International Monetary Fund (IMF)to maintain

order in the international monetary system2. The World Bankto promote general economic

development


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The Bretton Woods System

Under the Bretton Woods Agreement the US dollar was the only currency to be convertible

to gold, and other currencies would set theirexchange rates relative to the dollar

devaluations were not to be used for competitivepurposes a country could not devalue its currency by more than

10% without IMF approval


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The Role of the IMF

The IMF was responsible for avoiding a repetition ofthe chaos that occurred between the wars through acombination of

1.Discipline

a fixed exchange rate puts a brake on competitivedevaluations and brings stability to the world tradeenvironment

a fixed exchange rate regime imposes monetarydiscipline on countries, thereby curtailing priceinflation


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The Role of the IMF

2.Flexibility

A rigid policy of fixed exchange rates would be tooinflexible

So, the IMF was ready to lend foreign currencies to

members to tide them over during short periods ofbalance-of-payments deficits

A country could devalue its currency by more than 10percent with IMF approval


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The Role of the World Bank

The World Bank lends money in two ways

under the IBRD scheme, money is raised throughbond sales in the international capital market andborrowers pay what the bank calls a market rate of

interest - the bank's cost of funds plus a margin forexpenses.

under the International Development Agency scheme,loans go only to the poorest countries

The official name of the World Bank is the InternationalBank for Reconstruction and Development (IBRD)


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The Collapse of the Fixed System

Question:What caused the collapse of the BrettonWoods system?

Answer:

The collapse of the Bretton Woods system can be tracedto U.S. macroeconomic policy decisions (1965 to 1968)During this time, the U.S. financed huge increases in

welfare programs and the Vietnam War by increasing itsmoney supply which then caused significant inflation

Speculation that the dollar would have to be devaluedrelative to most other currencies forced other countriesto increase the value of their currencies relative to thedollar


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The Collapse of the Fixed System

The Bretton Woods system relied on an economicallywell managed U.S.

So, when the U.S. began to print money, run high tradedeficits, and experience high inflation, the system wasstrained to the breaking point

The Bretton Woods Agreement collapsed in 1973


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The Floating Exchange Rate Regime

Question:What followed the collapse of the BrettonWoods exchange rate system?

Answer:

Following the collapse of the Bretton Woods agreement,a floating exchange rate regime was formalized in 1976in Jamaica

The rules for the international monetary system thatwere agreed upon at the meeting are still in place today


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The Jamaica Agreement

At the Jamaica meeting, the IMF's Articles of Agreementwere revised to reflect the new reality of floatingexchange rates

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 (today, this number is $300 billion)


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Exchange Rates Since 1973

Since 1973, exchange rates have become more volatileand less predictable because of

the oil crisis in 1971

the loss of confidence in the dollar after U.S. inflation

jumped between 1977 and 1978the oil crisis of 1979

the rise in the dollar between 1980 and 1985

the partial collapse of the European Monetary System

in 1992

the 1997 Asian currency crisis

the decline in the dollar in the mid to late 2000s


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Fixed vs. Floating Exchange Rates

Question:Which is bettera fixed exchange rate systemor a floating exchange rate system?

Answer:Disappointment with floating rates in recent years has

led to renewed debate about the merits of a fixedexchange rate system


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The Case for Floating Rates

A floating exchange rate system provides twoattractive features

1. monetary policy autonomy

2. automatic trade balance adjustments


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1.Monetary Policy Autonomy

The removal of the obligation to maintain exchangerate parity restores monetary control to a government

with a fixed system, a country's ability to expand orcontract its money supply is limited by the need tomaintain exchange rate parity


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2.Trade Balance Adjustments

The balance of payments adjustment mechanismworks more smoothly under a floating exchange rateregime

under the Bretton Woods system (fixed system),IMF approval was needed to correct a permanentdeficit in a countrys balance of trade that could notbe corrected by domestic policy alone


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The Case for Fixed Rates

A fixed exchange rate system is attractive because

1. of the monetary discipline it imposes

2. it limits speculation

3. it limits uncertainty4. of the lack of connection between the trade balance

and exchange rates


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1.Monetary Discipline

Because a fixed exchange rate system requiresmaintaining exchange rate parity, it also ensures thatgovernments do not expand their money supplies at

inflationary rates

2.Speculation

A fixed exchange rate regime prevents destabilizingspeculation


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3.Uncertainty

The uncertainty associated with floating exchangerates makes business transactions more risky

4.Trade Balance Adjustments

Floating rates help adjust trade imbalances


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Who is Right?

There is no real agreement as to which system isbetter

History shows that fixed exchange rate regimemodeled 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 thatwould facilitate more rapid growth in international tradeand investment


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Exchange Rate Regimes in Practice

Currently, there are several different exchange rateregimes in practice

In 200614% of IMF members allow their currencies to float

freely26% of IMF members follow a managed float system28% of IMF members have no legal tender of their

ownthe 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, 2008


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Pegged Exchange Rates

Under a pegged exchange rate regime countries peg thevalue of their currency to that of other major currencies

popular among the worlds smaller nations

There is some evidence that adopting a peggedexchange rate regime moderates inflationary pressuresin a country


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Currency Boards

A country with a currency boardcommits to convertingits domestic currency on demand into another currencyat a fixed exchange rate

The currency board holds reserves of foreign currency

equal at the fixed exchange rate to at least 100% of thedomestic currency issued

additional domestic notes and coins can beintroduced only if there are foreign exchange reservesto back it


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Crisis Management by the IMF

Question:What has been the role of the IMF in theinternational monetary systems since the collapse ofBretton Woods?

Answer:The IMF has redefined its mission, and now focuses on

lending money to countries experiencing financial crisesin exchange for enacting certain macroeconomic policies

Membership in the IMF has grown to 186 countries in2010, 54 of which has some type of IMF program inplace


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Financial Crises Post-Bretton Woods

Three types of financial crises that have requiredinvolvement by the IMF are

1.Acurrency crisis- occurs when a speculative attack onthe exchange value of a currency results in a sharp

depreciation in the value of the currency, or forcesauthorities to expend large volumes of internationalcurrency reserves and sharply increase interest rates inorder to defend prevailing exchange rates


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Financial Crises Post-Bretton Woods

2.A banking crisis - refers to a situation in which a loss ofconfidence in the banking system leads to a run on thebanks, as individuals and companies withdraw theirdeposits

3.A foreign debt crisis - a situation in which a countrycannot service its foreign debt obligations, whetherprivate sector or government debt

Two crises that are particularly significant are

1. the 1995 Mexican currency crisis

2. the 1997 Asian currency crisis


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The Mexican Currency Crisis of 1995

The Mexican currency crisis of 1995 was a result of highMexican debts, and a pegged exchange rate that did notallow for a natural adjustment of prices

in order to keep Mexico from defaulting on its debt, a

$50 billion aid package was created by the IMF

By 1997, Mexico was well on the way to recovery


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The Asian Crisis

Question:What were the causes of the1997 Asianfinancial crisis?

Answer:

The causes of the crisis can be traced to the previousdecade when the region was experiencingunprecedented growth

1.The Investment Boom

fueled by export-led growthlarge investments were often based on projections

about future demand conditions that were unrealistic


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The Asian Crisis

2.Excess Capacity

investments made on the basis of unrealistic projections aboutfuture demand conditions created significant excess capacity

3.The Debt Bomb

investments were often supported by dollar-based debts when inflation and increasing imports put pressure on the

currencies, the resulting devaluations led to default on dollardenominated debts

4.Expanding Imports

by the mid 1990s, imports were expanding across the regioncausing balance of payments deficits

The balance of payments deficits made it difficult for countries tomaintain their currencies against the U.S. dollar


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The Asian Crisis

By mid-1997, it became clear that several key Thaifinancial institutions were on the verge of default

Foreign exchange dealers and hedge funds started tospeculate against the Thai baht, selling it short

After struggling to defend the peg, the Thai governmentabandoned its defense and announced that the bahtwould float freely against the dollar


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The Asian Crisis

Thailand turned to the IMF for helpSpeculation continued to affect other Asian countries

including Malaysia, Indonesia, Singapore which all sawtheir currencies dropthese devaluations were mainly a result of excess

investment, high borrowings, much of it in dollardenominated debt, and a deteriorating balance ofpayments position

South Korea was the final country in the region to fall


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Evaluating the IMFs Policies

Question:How successful is the IMF at getting countriesback on track?

Answer:

In 2009, 54 countries were working IMF programsAll IMF loan packages come with conditions attached,generally a combination of tight macroeconomic policyand tight monetary policy

Many experts have criticized these policy prescriptions

for three reasons


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1.Inappropriate Policies

The IMF has been criticized for having a one-size-fits-all approach to macroeconomic policy that isinappropriate for many countries

2.Moral HazardThe IMF has also been criticized for exacerbating moral

hazard(when people behave recklessly because theyknow they will be saved if things go wrong)


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3.Lack of AccountabilityThe final criticism of the IMF is that it has become too

powerful for an institution that lacks any real mechanismfor accountability

Question:Who is right?

Answer:As with many debates about international economics, it

is not clear who is right


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Implications for Managers

Question:What are the implications of the internationalmonetary system for managers?

Answer:

The international monetary system affects internationalmanagers in three ways

1. Currency management

2. Business strategy

3. Corporate-government relations


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Currency Management

1.Currency ManagementThe current exchange rate system is a managed float

government intervention and speculative activityinfluence currency values

Firms can protect themselves from exchange ratevolatility through forward markets and swaps


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Business Strategy

2.Business StrategyExchange rate movements can have a major impact on

the competitive position of businessesthe forward market can offer some protection from

volatile exchange rates in the shorter termFirms can protect themselves from the uncertainty of

exchange rate movements over the longer term bybuilding strategic flexibility into their operations thatminimizes economic exposurefirms can disperse production to different locationsfirms can outsource manufacturing


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Classroom Performance System

When the foreign exchange market determines the relativevalue of a currency, a ________ exchange rate systemexists.

a)Fixed

b)Floatingc)Pegged

d)Market


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The gold standard was a ______ exchange rate system.

a)Fixed

b)Floating

c)Peggedd)Market


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Floating exchange rates were deemed acceptable under

a)The Bretton Woods Agreement

b)The Gold Standard

c)The Jamaica Agreementd)The Louvre Accord


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The most common exchange rate policy among IMFmembers today is the

a)Free float

b)Managed float

c)Fixed peg

d)Adjustable peg

Bus280 7th Ed Chapter 10 Ppt

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