Chapter_5

Chapter 5 The International Monetary System and Exchange Rate Arrangements

Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Objectives To classify international monetary systemsTo outline the history of exchange rate arrangementsTo outline the pros and cons of fixed and flexible exchange ratesTo examine the Australian exchange rate arrangements5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Definition The IMS is the framework of rules, regulations and conventions that govern the financial relations among countries5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Components of the IMS A public component consisting of a series of agreementsA private component represented by the banking and finance industry5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Criterias of ClassificationTwo criteria's

Nature of International reserves held by central bankDegree of Flexibility of exchange rate

5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Classification according to reserve assets Pure commodity standards (e.g. the gold standard)Pure fiat standardsMixed standards (e.g. the Bretton Woods system)5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Classification according to flexibility of exchange rates Several systems may arise by restricting, or otherwise, movement of the exchange rate5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Fixed exchange rates The exchange rate is fixed by the central bank and is not allowed to moveThe FX market is likely to be out of equilibrium5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Perfectly flexible exchange rates The exchange rate moves continuously, propelled by market forces, to maintain equilibrium in the FX marketUnder this system, currencies appreciate and depreciate5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Fixed but adjustable exchange rates Countries alter the fixed values of their exchange ratesDevaluation and revaluation are implemented to correct some economic fundamentals such as the BOP5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Fixed exchange rates and flexible within a band Exchange rates are flexible within upper and lower limits defined by a band around the par valueCentral bank intervention is required to keep the exchange rate within the band5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Crawling peg The par value of the exchange rate is revised periodically according to its recent behaviour or economic indicators such as inflation5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Dual exchange rates A commercial (fixed) rate is used for imports and exportsA financial (flexible) rate is used for trading in financial assets5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Managed floating The exchange rate is flexible, but the central bank intervenes to limit the frequency and amplitude of exchange rate fluctuations5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Target zones Major countries establish a set of mutually consistent targets for real effective exchange rates5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


The classical gold standard This system operated between approximately 1870 and 1914It is remembered with nostalgia because the world economy prospered during that period5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Pillars of the gold standard The monetary authorities fix the price of gold in terms of their currencies, which produces a fixed exchange rateThe market exchange rate can move above or below the fixed rate by certain limits: the gold points5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


The collapse of the gold standard The gold standard collapsed in 1914 as the warring countries suspended the convertibility of their currencies and prohibited the export of gold5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


The inter-war period Between the end of World War I and 1926 a system of flexible exchange rates was adoptedIn 1925, Britain re-established the convertibility of the pound into gold, signalling the creation of the gold exchange standard5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


The collapse of the gold exchange standard In 1931 Britain abolished the convertibility of the pound, bringing to an end the era of the gold exchange standardThis was followed by the decade of the Great Depression (1931-1939)5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Failure of the inter-war experiment: reasons The golden age was a mythThe world economy experienced significant changes5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


The Bretton Woods system Forty-four countries signed the BW agreement in 1944The creation of the system was accompanied by the creation of international institutions (the IMF and IBRD or the World Bank)5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


The BW exchange rate system Fixed but adjustable exchange ratesThe US dollar was pegged to gold, whereas other currencies were pegged to the dollarExchange rates could move within a 1% band5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Problems of the BW system The adjustment mechanism lacked flexibility and stabilitySpeculation could be destabilisingThere were defects in the liquidity creation mechanism (Triffin Paradox)5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


The collapse of the BW system In 1971, the United States suspended the convertibility of the dollar into gold. As a result, the system collapsed5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


The present system In 1971, the Smithsonian Agreement was signed, but it failed to salvage the BW systemIn 1973, floating became widespread5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


The US dollars effective exchange rate under the present system 5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Current exchange rate arrangements The Jamaica Accord gave countries the freedom of choosing the arrangements they deemed appropriate for their economiesNot all countries opted for floating5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Arrangements with no separate legal tenderUnder this arrangement, the currency of another country circulates as the sole legal tenderAlternatively, the country belongs to a monetary or currency union in which the same legal tender is shared by members of the union5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Currency boardsA currency board is an arrangement that is based on an explicit legislative commitment to exchange the domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligation5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Other fixed peg arrangementsPegging to a single currencyPegging to a basket of currencies5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Pegged exchange rates with horizontal bandsUnder this arrangement the exchange rate is allowed to fluctuate within a band that is wider than 1 per cent



Crawling pegUnder a crawling peg, the exchange rate is adjusted periodically at a fixed, pre-announced small rate or in response to changes in some quantitative indicators (for example, inflation)5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Crawling bandsThis arrangement requires the exchange rate to be maintained within a certain band around a central rate that is adjusted periodically at a fixed, pre-announced rate or in response to changes in some indicators



Managed floating without a preannounced path Under this arrangement, the exchange rate is determined by market forces but the monetary authority intervenes actively in the foreign exchange market without specifying a path for the exchange rate



Independent floatingUnder independent floating the exchange rate is determined by market forces. Any intervention in the foreign exchange market aims at curbing exchange rate volatility5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


The EMS The system started functioning in March 1979 when the Snake ceased to existIt is a system of fixed but adjustable exchange rates as governed by the exchange rate mechanism (ERM)5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Realignments The first realignment involving all currencies took place in March 1983The period January 1987-September 1992 was tranquil5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Speculative attacks In September 1992, speculative attacks forced the pound and the lira out of the ERM5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


The EMU and the euro The EMU was established by the 1991 Maastricht TreatyIn January 1999, the euro was introducedIn January 2002, the euro replaced national currencies5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Arguments for the euro Currency stability reduces inflationReduction in transaction and hedging costsEfficiency gains Transparency gainsBenefits to trade and capital markets5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Arguments against the euro For the system to work well, countries should be similarIndividual countries have to give up national interest and exchange rate policies5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


The AUD exchange rate arrangements Until December 1971, the AUD was pegged to the poundUntil September 1974, the AUD was pegged to the US dollar(cont.)5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


The AUD exchange rate arrangements (cont.)Until December 1983, the AUD was pegged to a basketIn December 1983, the AUD was floated5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Arguments for flexible exchange ratesThe BOP adjustment mechanism is smoother and less painfulLarge and persistent BOP deficits do not ariseLiquidity problems do not arise or are less acute(cont.)5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Arguments for flexible exchange rates (cont.)Flexible rates are conducive to free tradeFlexible rates are conducive to policy independence5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


Arguments against flexible exchange ratesThey cause uncertainty and inhibit international trade and investmentThey cause destabilising speculationThey are not suitable for small countriesThey are unstable5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


New international financial architectureLinking IMF loans to crisis prevention effortsImposition of holding-period taxes on short-term capital flows in countries characterized by financial fragility(cont.)5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


New international financial architecture (cont.)Making the private sector partly responsible for the consequences of sovereign bond issuesDiscouraging fixed but adjustable exchange rates in favour of either managed floating or currency boards(cont.)5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


New international financial architecture (cont.)Directing the IMF to lend less freely and to distinguish between country crises and systemic crisesRemoving overlap from the responsibilities of the IMF and the World Bank5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


A global currency?ConvenienceLoss of exchange rate policyA small open economy has more to gain from the convenience5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


The Tobin taxProposed by James Tobin in 1972, it is a uniform international tax payable on all spot FX transactionsAlthough the idea sounds appealing, there are serious implementation problems5-*Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa


*

Chapter_5

Documents

international finance

mcgrawhill australia

analytical approach

afaf moosacopyright

finance industry5

afaf moosaclassification

afaf moosacomponents

afaf moosaobjectives