Chapter 08 The International Monetary System and Financial Forces McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 08

The International Monetary System

and Financial Forces

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

The International Monetary System

• Key Terms To Know:– Gold Standard:

• The use of gold at an established number of units per currency– Bretton Woods System:

• The international monetary system in place from 1945 to 1971, with a par value based on gold and the U.S. dollar

– Fixed Exchange Rate:• Specific currency exchange equivalence upheld by

government

– Par Value• Stated value

• Key Terms To Know:– Gold Standard:

• The use of gold at an established number of units per currency– Bretton Woods System:

• The international monetary system in place from 1945 to 1971, with a par value based on gold and the U.S. dollar

– Fixed Exchange Rate:• Specific currency exchange equivalence upheld by

government

– Par Value• Stated value

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A Brief History:The Gold Standard

• Price of gold has risen from 1200 A.D. through today.• Traders carried bullion, gold + silver coins till late 19th C.• 1717, Sir Isaac Newton put England on the gold standard

based on British currency, pound sterling.• Britain converted gold currency until 1914 and WWI,

except during Napoleonic Wars.• British sold gold to finance WWI, then stopped gold

exchange. Germany, France and Russia followed.

• Price of gold has risen from 1200 A.D. through today.• Traders carried bullion, gold + silver coins till late 19th C.• 1717, Sir Isaac Newton put England on the gold standard

based on British currency, pound sterling.• Britain converted gold currency until 1914 and WWI,

except during Napoleonic Wars.• British sold gold to finance WWI, then stopped gold

exchange. Germany, France and Russia followed.

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Bretton Woods System• 1944, Bretton Woods, NH, U.S.A.

– Allied representatives met to plan post-WWII monetary arrangements

– IMF was established – IMF Articles of Agreement:

• Established the Bretton Woods system for fixed exchange rates among member’s currencies with par value based on gold @ $35/oz and the U.S.$.

• Bretton Woods system supported huge international trade growth in the 1950’s and 1960’s.

• 1944, Bretton Woods, NH, U.S.A.– Allied representatives met to plan post-WWII

monetary arrangements– IMF was established – IMF Articles of Agreement:

• Established the Bretton Woods system for fixed exchange rates among member’s currencies with par value based on gold @ $35/oz and the U.S.$.

• Bretton Woods system supported huge international trade growth in the 1950’s and 1960’s.

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Floating Currency Exchange Rate System

• Precipitated by French redemption of $ holdings for gold, 1971

• Nixon stops gold exchange for $

• Since March 1973, major currencies floated in FX market

• 1976 – IMF members enact Jamaica Agreement on floating exchange rates and abandon gold as reserve currency

• Precipitated by French redemption of $ holdings for gold, 1971

• Nixon stops gold exchange for $

• Since March 1973, major currencies floated in FX market

• 1976 – IMF members enact Jamaica Agreement on floating exchange rates and abandon gold as reserve currency

• Floating Currency Exchange Rates:– Rates that are all

allowed to float against other currencies and are determined by market forces.

• Jamaica Agreement:– 1976 IMF agreement

allowing flexible exchange rates among members.

• Floating Currency Exchange Rates:– Rates that are all

allowed to float against other currencies and are determined by market forces.

• Jamaica Agreement:– 1976 IMF agreement

allowing flexible exchange rates among members.

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Financial Forces

• Fluctuating Currency Values– Freely fluctuating currencies fluctuate

against each other– Central banks can intervene in FX markets

by buying/selling currency to affect supply & demand

– Central banks let major currencies ($,€,£,¥) freely fluctuate

– Fluctuations can be huge

• Fluctuating Currency Values– Freely fluctuating currencies fluctuate

against each other– Central banks can intervene in FX markets

by buying/selling currency to affect supply & demand

– Central banks let major currencies ($,€,£,¥) freely fluctuate

– Fluctuations can be huge

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Foreign Exchange• FX Quotations:

the price of 1 currency

given in terms ofanother:

• $1U.S.= £0.642767 or

• £1.00 = $1.55577

• FX Quotations:the price of 1

currencygiven in terms ofanother:

• $1U.S.= £0.642767 or

• £1.00 = $1.55577

The U.S.$ is a:• Central Reserve Asset:

– Currency asset held by central banks

• Vehicle Currency:– Currency used in

international trade & investment

• Intervention Currency:– Currency used by

gov’ts. to intervene FX markets to influence the price of a given currency

The U.S.$ is a:• Central Reserve Asset:

– Currency asset held by central banks

• Vehicle Currency:– Currency used in

international trade & investment

• Intervention Currency:– Currency used by

gov’ts. to intervene FX markets to influence the price of a given currency

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Exchange Rate Quotations• Spot Rate:

– Exchange rates between 2 currencies deliverable within 2 business days

• Forward Currency Market:– Locked in

currency rate purchases deliverable in 30, 60, 90, or 180 days

• Spot Rate:– Exchange rates

between 2 currencies deliverable within 2 business days

• Forward Currency Market:– Locked in

currency rate purchases deliverable in 30, 60, 90, or 180 days

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Causes of Exchange Rate Movement

• Market forces set floating currency values and ease of convertibility:– Supply & demand forecasts for 2 currencies– Inflation in the 2 countries– Productivity and unit labor cost changes– Political developments – election results– Expected government fiscal, monetary, & currency

exchange market actions– BOP accounts– Psychological aspects

• Market forces set floating currency values and ease of convertibility:– Supply & demand forecasts for 2 currencies– Inflation in the 2 countries– Productivity and unit labor cost changes– Political developments – election results– Expected government fiscal, monetary, & currency

exchange market actions– BOP accounts– Psychological aspects

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Causes of Exchange Rate Movement

• Monetary Policies:– Government policies

that control amount of money in circulation and its growth rate

• Fiscal Policies:– Address Government’s

collecting and spending money

• Monetary Policies:– Government policies

that control amount of money in circulation and its growth rate

• Fiscal Policies:– Address Government’s

collecting and spending money

• Factors Affecting Exchange Rates:– Parity

Relationships:• Interest Rate Parity• Purchasing Power

Parity (PPP)

• Factors Affecting Exchange Rates:– Parity

Relationships:• Interest Rate Parity• Purchasing Power

Parity (PPP)

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Currency Exchange Controls

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Taxation – A Significant Financial Force

• Governments use 3 types of tax to generate revenue:

1. Income Tax:– A direct tax on personal & corporate income

2. Value-added Tax (VAT):– Tax charged on the value added to a good from raw

material, to production, to final purchaser3. Withholding Tax:

– Indirect tax on passive income (dividends, royalties, interest) paid to nonresidents, people or companies in another tax jurisdiction

• Governments use 3 types of tax to generate revenue:

1. Income Tax:– A direct tax on personal & corporate income

2. Value-added Tax (VAT):– Tax charged on the value added to a good from raw

material, to production, to final purchaser3. Withholding Tax:

– Indirect tax on passive income (dividends, royalties, interest) paid to nonresidents, people or companies in another tax jurisdiction

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Inflation and Interest Rates

• Inflation:– An external financial force that

determines the real cost of borrowing in capital markets• Should capital be raised through equity or

debt?• In which capital market?• In which currency?

• Inflation:– An external financial force that

determines the real cost of borrowing in capital markets• Should capital be raised through equity or

debt?• In which capital market?• In which currency?

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Inflation and Interest Rates

• Inflation:– Affects currency exchange rates

• Inflated currencies weaken economies• People with money may buy items expected to increase

in value fueling inflation

– Causes cost of goods and services in their country to rise and become less globally competitive

• Experts sales are difficult and may lead to BOP deficits in the trade account and lead to more trade restrictions

• Inflation:– Affects currency exchange rates

• Inflated currencies weaken economies• People with money may buy items expected to increase

in value fueling inflation

– Causes cost of goods and services in their country to rise and become less globally competitive

• Experts sales are difficult and may lead to BOP deficits in the trade account and lead to more trade restrictions

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Balance of Payments (BOP)• BOP: country’s record of global transactions• BOP shows global demand for a country’s

currency.– Exports > imports = high demand– Imports > exports = low demand, weak or

devalued currency• Possible currency or trade controls introduced

• BOP: country’s record of global transactions• BOP shows global demand for a country’s

currency.– Exports > imports = high demand– Imports > exports = low demand, weak or

devalued currency• Possible currency or trade controls introduced

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BOP Accounts• Are recorded in

double entry bookkeeping form

• Transactions are an exchange of assets with debit & credit side

• Funds outflow (payments to other countries) tracked as debits (-)

• Funds inflow (payments from other countries tracked as credits (+)

• Are recorded in double entry bookkeeping form

• Transactions are an exchange of assets with debit & credit side

• Funds outflow (payments to other countries) tracked as debits (-)

• Funds inflow (payments from other countries tracked as credits (+)

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