International monetary system
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International Monetary System. International Corporate Finance P.V. Viswanath. Learning Objectives. Alternative Exchange Rate Systems Equilibrium under different exchange rate systems Categories of Central Bank Intervention. Alternative Exchange Rate Systems: Free Float.

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International Monetary System

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International monetary system

International Monetary System

International Corporate Finance

P.V. Viswanath


Learning objectives

Learning Objectives

  • Alternative Exchange Rate Systems

  • Equilibrium under different exchange rate systems

  • Categories of Central Bank Intervention

P.V. Viswanath


Alternative exchange rate systems free float

Alternative Exchange Rate Systems: Free Float

  • In a free market, exchange rates are determined by the interaction of currency supplies and demands.

  • Supply and demand schedules are influenced by price level changes, interest differentials and economic growth.

  • In a free float, as these economic parameters change, market participants will adjust their current and expected future currency needs. These adjustments will lead to changing exchange rates.

P.V. Viswanath


Free float

Free Float

P.V. Viswanath


Managed dirty float

Managed/Dirty Float

  • Three types of central bank intervention

    • Smoothing out daily fluctuations – something akin to a specialist on the NYSE.

    • Leaning against the wind – maintaining an exchange rate against temporary “irrational” values.

    • Unofficial pegging – attempt to manipulate fundamental exchange rates without public announcements

P.V. Viswanath


Other exchange rate systems

Other Exchange Rate Systems

  • Target Zone Arrangement – countries adjust their national economic policies to maintain their exchange rates within a specific margin around agreed-upon, fixed central exchange rates. Example – European Monetary System.

  • Fixed-Rate System – Governments are committed to maintaining target exchange rates. All participants must, effectively, have the same monetary policy; else, equilibrium rates would shift. Example – Bretton Woods.

P.V. Viswanath


Classical gold standard

Classical Gold Standard

  • Countries on the Gold Standard agree to maintain convertibility of their currency into gold.

  • This ensures predictability of exchange rates

  • Gold is a durable, storable, portable, easily recognized, divisible commodity. Short-run changes in its stock are limited by high production costs; hence it is difficult for governments to manipulate its value.

  • Its value as a commodity, relative to other commodities taken as a whole is relative stable.

P.V. Viswanath


Gold standard

Gold Standard

  • Great Britain maintained a fixed price of gold from 1821 to 1914 at £4.2474 an ounce.

  • The US maintained the price of gold at $20.67 an ounce from 1834-1933 (except 1861-1878).

  • This led to long-run price stability as well as international trade, facilitated by exchange rate stability.

  • However, governments’ monetary policy is forced by changes in the supply of gold – e.g., greater exports lead to greater inflows of gold, which, in turn, imply a larger money supply and ensuing inflation.

P.V. Viswanath


How the gold standard works

How the Gold Standard Works

Suppose higher productivity in the non-gold producing sector of the US lowers the prices of other goods relative to gold and the US price level declines.

Prices are equal again, but probably at a lower level than before.

P.V. Viswanath


Post gold standard

Post-Gold Standard

  • The Gold-Exchange Standard operated from 1925-1931; the US and England could hold only gold reserves, but other nations could hold both gold and dollars or pounds as reserves. In 1931, England suffered due to massive capital flows and devalued the pound.

  • Other countries devalued competitively. This led to a trade war. Protectionist exchange rate policies fueled the global depression of the 1930s.

P.V. Viswanath


Bretton woods

Bretton Woods

  • The Bretton Woods Agreement was implemented in 1946. Each government agreed to maintain a pegged exchange rate for its currency vis-à-vis the dollar or gold ($35/oz.). The exchange rate could fluctuate only within 1% of its stated par value.

  • The fixed rates were maintained by official intervention in foreign exchange markets.

  • However, in practice, governments were unwilling to suffer the political costs of such intervention.

  • The lack of US monetary discipline due to the Vietnam war made it difficult for the US to maintain the official $35/oz. gold price.

  • W. Germany, Japan and Switzerland refused to accept the inflation that a fixed exchange rate would have forced on them.

  • The dollar therefore depreciated rapidly. Subsequently, rates have, more or less, floated.

P.V. Viswanath


Assessment of floating rate system

Assessment of Floating-Rate System

  • Currency Volatility has increased; this is partly due to real shocks, such as changing oil prices and shifting competitiveness among countries.

  • However, not only nominal exchange rate volatility, but also real exchange rate volatility has increased. Hence there have been calls for a return to fixed rates.

  • Currency stability with fixed rates requires that markets believe that countries will act to keep the currency stable; this requires a willingness to accept coordinated monetary policies.

  • Countries are not willing to accept the political price of such subordination. A monetary union is an alternative to fixed rates.

  • Under monetary union, individual countries replace their local currencies with a common currency. For example, in the United States, all 50 states share the same dollar.

P.V. Viswanath


Europe and the ems

Europe and the EMS

  • Europe started out in March 1979 with the European Monetary System (EMS), which is an example of a target zone arrangement.

  • The heart of the EMS was an exchange rate mechanism. Each member of the EMS agreed on a central exchange rate for its currency in terms of the ECU (European Currency Unit). Members were required to support the agreed upon exchange rates.

  • However, due to widely differing economic policies, the EMS did not last. The EMS was abandoned in 1993.

P.V. Viswanath


European monetary union

European Monetary Union

  • On January 1, 1999, the 11 founding members of the EMU surrendered their monetary autonomy to the new European Central Bank and gave up their right to create money. Only the ECB can create money.

  • However, governments can issue their own euro-denominated bonds, just as individual American states can issue bonds.

  • Individual countries in the EMU can attract investors only by convincing them that they have the financial ability through taxes and other revenues to generate the euros to repay the debt.

  • An important advantage of the EMU was the ability of member countries to use the requirements of the monetary union to rein in the expensive welfare state and its costly regulations.

P.V. Viswanath


Advantages of a common currency

Advantages of a Common Currency

  • Greater convenience for travelers from one part of the common currency area to another

  • Eliminates the risk of currency fluctuations and facilitates cross-border price comparisons

  • Lower risk and improved price transparency encourages the flow of trade and investments among member countries.

  • This allows greater integration of the region’s capital, labor and commodity markets and a more efficient allocation of resources within the region.

  • Increased trade and price transparency will spur area-wide competition in goods and services and encourage corporate restructurings and mergers and acquisitions.

P.V. Viswanath


Disadvantages of a common currency

Disadvantages of a Common Currency

  • Monetary policy could not be used to affect relative prices of domestic goods versus foreign goods.

  • For example, if there were a decrease in demand for French goods, France could increase local money and allow the franc to depreciate. This would increase demand for French goods.

  • However, in a monetary union, this is not possible. This would only be achieved through reduced demand for French goods leading to unemployment, which would then enable French manufacturers to reduce wages, allowing French goods to be once again competitive.

  • The social and economic costs of this process could be high.

P.V. Viswanath


Emerging market crises

Emerging Market Crises

  • In the 1990s, there were several emerging market currency crises in fixed exchange rate countries – the Mexican crisis in 1994/5, the Asian crisis in 1997, the Russian crisis in 1998, and the Brazilian crisis in 1998/9.

  • There are two different transmission mechanisms for currency crises:

    • Trade links – from one emerging market to another through their trade links; e.g. when Argentina is in crisis, it imports less from Brazil, its principal trading partner. As Brazil contracts, its currency will likely weaken.

    • Financial system – trouble in one market leads to investors seeking to exit other countries with similar risky characteristics. Investors may become more risk averse and rebalance their portfolios by selling off other risky assets.

P.V. Viswanath


Dealing with emerging market crises

Dealing with Emerging Market Crises

  • Currency Controls – abandoning free capital movement, as in the case of Malaysia.

  • Freely Floating Currency – Australia and New Zealand were protected against the Asian crises because they had floating exchange rates.

  • Permanently fixed exchange rates – dollarization, currency boards or monetary union.

P.V. Viswanath


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