International Monetary System Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 10.

InternationalMonetary System

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall

10

10 - 2Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall

Currency Values and BusinessCurrency Values and Business

Exchange rates affect activities of both domestic and international firms

Devaluation Revaluation

Export prices

Import prices

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Major World CurrenciesMajor World Currencies

Source: Based on Economic Report of the President, Table B110, multiple years

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Stability and PredictabilityStability and Predictability

Stable exchange rates• Improve accuracy of forecasts and financial planning

Predictable exchange rates

• Reduce surprises of unexpected rate changes

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Value of U.S. DollarValue of U.S. Dollar

Source: Based on Economic Report of the President, Table B110, multiple years

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Buying Power ExampleBuying Power Example

Cost in New York… $60 Purchasing Power

Cost in Japan… $80

Cost in Mexico… $30

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Law of One PriceLaw of One Price

Identical item must have an identical price in all countries when

price is expressed in a common currency

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Big Mac IndexBig Mac Index

Uses law of one priceand cost of a Big MacUses law of one priceand cost of a Big Mac

Fairly good predictorof long-term rates

Fairly good predictorof long-term rates

Estimates undervaluedand overvalued currencies

Estimates undervaluedand overvalued currencies

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Purchasing Power ParityPurchasing Power Parity

Relative ability of two nations’ currenciesRelative ability of two nations’ currenciesto buy the same “basket” of goods into buy the same “basket” of goods in

those two nationsthose two nations

Focuses squarely onFocuses squarely onlocal purchasing powerlocal purchasing power

of a currencyof a currency

Considers priceConsiders pricelevels in adjustinglevels in adjusting

relative currency valuesrelative currency values

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Effects of InflationEffects of Inflation

Inflation erodes a currency’s purchasing power!

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Inflation: Key FactorsInflation: Key Factors

• Monetary policy directly affects interest rates and money supply

• Fiscal policy indirectly affects taxes and spending

• High employment raises wages, which are embodied in consumer prices

• High interest rates lower borrowing and

spending, which lowers inflation

• Exchange rates adjust to maintain PPP

Money supply

Employment

Interest rates

Adjustment

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Fisher Effect

InternationalFisher Effect

Nominal interest rate =real rate + inflation rate

Difference in nominal interest ratessupported by two nations’ currencies

will cause an equal but oppositechange in their spot exchange rates

Interest RatesInterest Rates

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Evaluating PPPEvaluating PPP

Addedcosts

Tradebarriers

Businessconfidence & psychology

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Two Market ViewsTwo Market Views

Efficient market view• Forward exchange rates best predict future rates

Inefficient market view• Additional information can improve rate forecasts

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Techniques of ForecastingTechniques of Forecasting

Fundamental analysis• Statistical modeling

Technical analysis• Chart currency trends

Forecasting difficulties• Flawed data• Human error

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Adjusting to Currency SwingsAdjusting to Currency Swings

Strong currency: Prune operations

Adapt products

Source abroad

Freeze prices

Export strategies in the face of currency swings

Weak currency: Source domestically

Grow at home

Push exports

Reduce expenses

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Gold Standard: Early YearsGold Standard: Early Years

Monetary system from the 1700s to 1939 that linked national currencies to specific values of gold

Restricted monetary policiesRestricted monetary policies

Reduced exchange-rate riskReduced exchange-rate risk

Corrected trade imbalancesCorrected trade imbalances

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Gold Standard CollapseGold Standard Collapse

Printing excessive money caused high inflation

British pound returns at its pre-inflation level

U.S. dollar returns at its lower (devalued) level

Competitive devaluations force system to collapse

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Fixed exchange rates

Fixed exchange rates

Built-in flexibilityBuilt-in flexibility

International Monetary FundInternational

Monetary FundWorld Bank (IBRD)World Bank (IBRD)

Bretton Woods AgreementBretton Woods Agreement

International monetary system based onvalue of U.S. dollar (1944 to 1973)

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End of Bretton WoodsEnd of Bretton Woods

Nations demand gold in return for their paper U.S. dollars

Nations raise their currency values relative to dollars

Persistently weak dollar forces nations to leave the system

Most currencies begin to float freely against the dollar

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Jamaica AgreementJamaica Agreement

Formalized the managed float system of exchangerates as the new international monetary system

Free float system

Currencies float withoutgovernment intervention

Free float system

Currencies float withoutgovernment intervention

Managed float system

Currencies float withgovernment intervention

Managed float system

Currencies float withgovernment intervention

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The System TodayThe System Today

Managed float system

Pegged exchange rates

Currency board

European monetary system

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Financial CrisesFinancial Crises

Developing nations

Mexico

Southeast Asia

Russia

Argentina

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Europe’s DebtEurope’s Debt

Debt levels spiraled out of control in some European nations recently. In 2010, the IMF and EU organized a bailout for Greece, but the austerity measures it imposed angered the people.

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Future of the InternationalFuture of the InternationalMonetary SystemMonetary System

• Greater IMF transparency

• Better manage risks

• Monitor “hot” money flows

• Private sector involvement