Chapter 08

The International Monetary System

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

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Learning Objectives• LO1 Describe the international monetary system’s

evolution and its importance to international business.• LO2 Explain the impact of fluctuating currency values.• LO3 Discuss the influence of currency exchange

controls on international business.• LO4 Summarize the influences of differences in

taxation and inflation rates on international business.• LO5 Explain the significance of the balance of

payments (BOP) to international business decisions.

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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:• Monetary system from 1945 to 1971• Used 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.

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Bretton Woods System• Allied representatives met in Bretton Woods, NH, to

plan post-WWII monetary arrangements.• IMF established.• IMF Articles of Agreement:

• 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 1950ies and 1960ies.

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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

• 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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Current Currency Arrangements

• Exchange arrangement with no separate legal tenderU.S.$ in El Salvador & Ecuador; €

• Currency board arrangement, exchange at fixed rate Hong Kong, Bulgaria

• Conventional fixed peg arrangement fluctuations < 1% allowed. Saudi riyal -U.S.$

• Pegged exchange rate within horizontal band: peg with fluctuation > 1%. Danish kroner - € Crawling peg, crawling band versions

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Current Currency Arrangements

• Managed floating with no preannounced path

Monetary authority intervention in FX without disclosing goals or targets—China’s Yuan

• Independently Floating Exchange RatesMarket drives exchange rates.Interventions designed to impact rate of exchange, not establish currency’s level.

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Challenges to the Floating Exchange Rate System

• 2008 Central Bank Liquidity Crisis• G8 central bank influence on currency

movement• Explosive growth in volume of currency

trades in FX markets challenge G8 efforts• Floating currencies can move against

each other quickly and with large swings

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Financial Forces• Fluctuating Currency Values

– Freely fluctuating currencies fluctuate against each other

– Central banks can intervene in FX markets buy/sell 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

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 rate between 2 currencies deliverable within 2 business days

• Forward Market:– Market for

currency purchases at specified rates deliverable in 30, 60, 90, or 180 days

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Causes of Exchange Rate Movement

• Market forces establish 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, and currency

exchange market actions– BOP accounts– Psychological aspects

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Causes of Exchange Rate Movement

• Monetary Policies:– Government decisions

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)

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Exchange Rate Movement• Fisher Effect:

Relationship between real and nominal interest rates: Real = nominal – expected inflation rate

• International Fisher Effect:– Interest rate differentials for any 2 currencies reflect the

expected change in their exchange rates• Purchasing Power Parity (PPP)

– Units of currency needed to buy the same basked of goods & services in the home market that $1.00 would buy in the U.S

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Exchange Rate Forecasting• Exchange Rate Movements Impact:

– Production– Sourcing– Marketing– Finance

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Approaches to Exchange Rate Forecasting

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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:– Direct tax on personal and corporate income

2. Value-added Tax (VAT):– 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)

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Inflation and Interest Rates• Inflation:

– Raises prices– determines the real cost of borrowing in

capital markets– Measured by consumer price index

(CPI), the average price changes in a basket of consumer goods

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World Inflation

Rates

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Inflation and Interest Rates• Inflation:

– Encourages borrowing (debt)• Loan will be repaid with inflated, cheaper

money – High inflation rates bring high interest

rates– Inflation discourages lending

• Lenders fear that the $s repaid + interest will have less value than the $s lent

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Inflation and Interest Rates• Inflation:

– Affects currency exchange rates• Inflated currencies weaken economies• People may buy items expected to increase in value,

further fueling inflation– Causes cost of goods and services to rise,

country becomes less globally competitive• Export sales are difficult and may lead to BOP deficits in

the trade account • This leads to more trade restrictions

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WorldInterest Rates

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Balance of Payments (BOP)• BOP: a 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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GLOBAL gauntlet• Debate: Fixed FX

Rates, Perhaps Hooked on Gold, or Floating Rates, Hooked on Faith?

• What is better for the global economy, imperfect floating exchange rates or fixed exchange rates based on a gold standard?

• Your thoughts?