Chapter 5 understanding the international monetary system
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Chapter 5 - Understanding the International Monetary System. International Business by Ball, McCulloch, Frantz, Geringer, and Minor. Chapter Objectives. Explain the developments shaping the world monetary system Understand balance of payments

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Chapter 5 - Understanding the International Monetary System

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Chapter 5 understanding the international monetary system

Chapter 5 - Understanding the International Monetary System

International Business

by Ball, McCulloch, Frantz,

Geringer, and Minor


Chapter objectives

Chapter Objectives

  • Explain the developments shaping the world monetary system

  • Understand balance of payments

  • Compare relative strengths and weaknesses of currencies

  • Identify the major foreign exchange markets of the world

  • Understand changes being caused in the FX markets

  • Understand the central reserve asset/national conflict of the U.S. dollar

  • Discuss the euro and its present state of acceptance by EU countries


A brief gold standard history

A Brief Gold Standard History

  • From about A.D. 1200 to the present

    • Direction of the price of gold has been generally up.

    • During this time, the price of gold rose from about $21 per ounce to just under $200 in December 1976.


A brief gold standard history1

A Brief Gold Standard History

  • Most trading or industrial countries adopted the gold standard.

    • The gold standard is when countries agree to buy or sell gold for an established number of currency units.

      • However, a government cannot create money that is not backed by gold.


A brief gold standard history2

A Brief Gold Standard History

  • Return to the Gold Standard?

    • Argument that the U.S. dollar is currently a reserve asset of nations is unsustainable.

    • Because of its high value, gold is very portable.


Bretton woods and the gold exchange standard

Bretton Woods and the Gold Exchange Standard

  • In 1944, representative of the major Allied powers met at Bretton Woods, New Hampshire to plan for the future.

  • General consensus

    • Stable exchange rates were desirable.

    • Floating or fluctuating exchange rates had proved unsatisfactory.

    • The government controls of trade, exchange, and production, that had developed through WWII were wasteful and discriminatory.


Bretton woods and the gold exchange standard1

Bretton Woods and the Gold Exchange Standard

  • To achieve its goals, the Bretton Woods Conference established

    • The International Monetary Fund (IMF)

      • The IMF Articles of Agreement entered into force in December 1945.

      • From 1945-1971, IMF agreement was the basis of the international monetary system.

      • The US$ was agreed to be the only central reserve asset.

      • An ounce of gold was agreed to be worth US$35.


Balance of payment bop

Balance of Payment (BOP)

  • A country’s BOP is a very important indicator of what may happen to the country’s economy.

  • If country’s BOP is in deficit

    • Inflation is often the cause.

    • A company doing business there must adjust its pricing, inventory, accounting, and other practices to inflationary conditions.

    • The government may take measures to deal with inflation and the deficit.


Balance of payments bop

Balance of Payments (BOP)

  • Actions the government may take to deal with inflation and the BOP deficit include

    • Market measures

      • Deflating the economy

      • Devaluing the currency

    • Nonmarket measures

      • Currency controls

      • Tariffs

      • Quotas


Balance of payments bop1

Balance of Payments (BOP)

  • Debits and Credits in International Transactions

    • International Debit Transactions

      • Involve payments by domestic residents to foreign residents.

    • International Credit Transactions

      • Involve payments by foreign residents to domestic residents.


Balance of payments bop2

Balance of Payments (BOP)

  • Examples of Debit Transactions

    • (from the U.S. Perspective)

  • Dividend, interest, and debt repayment services on foreign-owned capital in America.

  • Merchandise imports.

  • Purchases by Americans traveling abroad.


Balance of payments bop3

Balance of Payments (BOP)

  • Examples of Debit Transactions (cont’d)

    • Transportation services bought by Americans on foreign carriers.

    • Foreign investment by Americans.

    • Gifts by Americans to foreign residents.

    • Imports of gold.


Balance of payments bop4

Balance of Payments (BOP)

  • Double-Entry Accounting

    • The BOP is presented as double-entry accounting statement

      • Total credits and debits are always equal.

    • Statement of a country’s BOP is divided into several accounts.

      • Current Account

      • Capital Account

      • Official Reserves Account


Balance of payments bop5

Balance of Payments (BOP)

  • Current Account

    • Subaccounts include

      • Goods or merchandise

      • Services

      • Unilateral transfers


Balance of payments bop6

Balance of Payments (BOP)

  • Current Account

    • Goods or merchandise

      • Deals with “visibles,” such as autos, grain, machinery, and equipment.

      • The net balance on merchandise transactions is referred to as the country’s trade balance.


Balance of payments bop7

Balance of Payments (BOP)

  • Current Account

    • Services

      • Deals with “invisibles” that are exchanged or bought internationally.

      • Examples include dividends or interest on foreign investments, royalties on patents or trademarks held abroad, travel, insurance, banking, and transportation.


Balance of payments bop8

Balance of Payments (BOP)

  • Current Account

    • Unilateral transfers

      • Transfers with no quid pro quo.

      • Some of these transfers are made by private persons or institutions, and some by governments.

      • Some private unilateral transfers are for charitable, educational, or missionary purposes.

      • The largest government unilateral transfers are aid.


Balance of payments bop9

Balance of Payments (BOP)

  • Capital Account

    • Records the net changes in a nation’s international financial assets and liabilities over the BOP period.

  • Subaccounts include

    • Direct investment

    • Portfolio investment

    • International movements of short-term capital


Balance of payments bop10

Balance of Payments (BOP)

  • Capital Account

    • Direct investment

      • Investments in enterprises or properties located in one country that are effectively controlled by residents in another country.


Balance of payments bop11

Balance of Payments (BOP)

  • Capital Account

    • Direct investment

      • Effective control is assumed for BOP purposes

        • When residents of one country owns 50 percent or more of the voting stock of a company in another country.

        • When one resident or an organized group of residents of one country owns 25 percent or more of the voting stock of a company in another country.


Balance of payments bop12

Balance of Payments (BOP)

  • Capital Account

    • Portfolio investment

      • Includes all long-term—more than one year—investments that do not give the investors effective control over the object of the investment.

        • Such transactions typically involve the purchase of stocks or bonds of foreign issuers for investment—not control—purposes.


Balance of payments bop13

Balance of Payments (BOP)

  • Capital Account

    • International movements of short-term capital.

      • Involve changes in international assets and liabilities with an original maturity of one year or less.

        • Some of the fastest-growing types of short-term flows are for currency exchange rate and interest rate hedging in the forward, futures, option, and swap markets.


Balance of payments bop14

Balance of Payments (BOP)

  • Official Reserves Account

    • Total credits and debits must be equal because of the double-entry accounting system used to report the BOP.

  • Deals with the following

    • Gold imports and exports.

    • Changes in foreign exchange held by the government.

    • Changes in liabilities to foreign central banks.


Balance of payments bop15

Balance of Payments (BOP)

  • Temporary BOP deficit

    • Can be corrected by the country’s monetary policies or fiscal policies.

    • May be corrected by short-term IMF loans and advice.


Balance of payments bop16

Balance of Payments (BOP)

  • Fundamental BOP deficit

    • Too severe to be repaired by any monetary or fiscal policies the country can apply.

    • There are economic, social, and political limits to how much a country can deflate its economy or devalue its currency.


Gold exchange standard

Gold Exchange Standard

  • Gold and Dollars Go Abroad

    • From 1958 through 1971, United States cumulative deficit was $56 billion.

      • Deficit was financed partly by use of the U.S. gold reserves.

      • Deficit partly financed by incurring liabilities to foreign central banks.


August 15 1971 and the next two years

August 15, 1971, and the Next Two Years

  • By 1971, many more dollars were in the hands of foreign central banks than the gold held by the U.S. Treasury could cover.


August 15 1971 and the next two years1

August 15, 1971, and the Next Two Years

  • August 15, 1971

    • President Nixon “closed the gold window.”

    • Currencies began to float.

    • Stated US$ value of 35 dollars per ounce of gold was now meaningless.

    • The gold exchange was ended.


August 15 1971 and the next two years2

August 15, 1971, and the Next Two Years

  • December 1971

    • Smithsonian Accord was signed.

    • Agreement on trade obstacles reached along with new currency exchange rates.

      • This led to the devaluation of the US$.

    • However, new rates could not be maintained.

      • By 1973 currencies were floating.


1973 to the present

1973 to the Present

  • Two kinds of currency floats

    • Free (clean) float

    • Managed (dirty) float


1973 to the present1

1973 to the Present

  • Currency Floats

    • Free (clean) Float

      • Closest approach to perfect competition.

      • No government intervention.

      • Billions of the product (units of money) are traded by thousands of buyers and sellers.


1973 to the present2

1973 to the Present

  • Currency Floats

    • Managed (dirty) Float

      • Governments intervene in the currency markets as they perceive their national interests to be served.

      • Nations may explain their interventions in terms of “smoothing market irregularities” or “assuring orderly markets”


1973 to the present3

1973 to the Present

  • Currency Areas

    • Currencies that float against each other and against the euro include the

      • U.S. dollar

      • Canadian dollar

      • Japanese yen

      • Swiss franc


1973 to the present4

1973 to the Present

  • Currency Areas

    • Most currencies of developing countries are pegged (fixed)

      • In value to one of the major currencies.

      • To a currency basket such as the special drawing rights.

      • To some specially chosen currency mix or basket.


1973 to the present5

1973 to the Present

  • Snake

    • In Europe during the mid-1970 a currency grouping called the “snake” was created.

      • The snake included several European currencies, led by the German deutsche mark.

      • The snake was so called because of how it appeared on a graph showing the member currencies floating against nonmember currencies.


1973 to the present6

1973 to the Present

  • Snake

    • The snake was damaged by the departure of several currencies.

    • The systems inflexibility explains the snake’s ultimate demise.

    • The snake was the forerunner of the European Monetary System.


Experience with floating

Experience with Floating

  • The euro

  • The 1997 Asian Financial Crisis

  • Study of Worldwide PPP

    • The Economist used the price of a Big Mac as its “basket” of goods.


Money markets foreign exchange

Money Markets, Foreign Exchange

  • London is the world’s largest foreign exchange market.

    • It has 30 percent share of foreign exchange turnover.

  • New York is the second largest foreign exchange market.

  • Asia, Tokyo, Hong Kong, and Singapore are fighting for foreign exchange supremacy.


Money markets foreign exchange1

Money Markets, Foreign Exchange

  • Asian Currencies to the Rescue

    • Asian currencies are no longer thought of as exotic since their markets have emerged.

    • The more liquid currencies include the

      • Singapore dollar

      • Thai baht

      • Indonesian rupiah

      • Malaysian ringgit

      • Hong Kong dollar


Money markets foreign exchange2

Money Markets, Foreign Exchange

  • The US$ is the most traded currency.

  • The US$-deutsche mark market is the busiest, closely followed by the US$-yen.

    • Third, fourth, and fifth are US$-sterling, US$-Swiss franc, and mark-yen.

  • Virtually all trading in the Asian foreign exchange market is conducted through the dollar.


Money markets foreign exchange3

Money Markets, Foreign Exchange

  • SDRs in the Future

    • Special drawing rights (SDRs)

      • May be a step toward a truly international currency.

      • The US$ has been the closest thing to such a currency since gold in the pre-WWI gold standard system.

      • The objective was to make the SDR the principal reserve asset in the international monetary system.


Money markets foreign exchange4

Money Markets, Foreign Exchange

  • Value of the SDR

    • The SDR’s value is based on a basket of the following five currencies

      • U.S. dollar (41.3%)

      • euro Germany (19%)

      • euro France (10.3%)

      • Japanese yen (17%)

      • British pound (12.4%)

    • The percentages are changed periodically.


Money markets foreign exchange5

Money Markets, Foreign Exchange

  • Uses of the SDR

    • The SDR’s value remains more stable than that of any single currency.

  • Holders of SDRs include

    • The International Monetary Fund (IMF)

    • Most of the 181 members of the IMF

    • 16 official institutions

      • These institutions typically regional development or banking institutions prescribed by the IMF.

  • “Equity Issue”


Money markets foreign exchange6

Money Markets, Foreign Exchange

  • European Monetary System (EMS)

    • The European countries prefer fixed currency exchange rates to floating ones.

    • The EMS is a grouping of most Western European nations cooperating to maintain their currencies at fixed exchange rates.


Money markets foreign exchange7

Money Markets, Foreign Exchange

  • From the European Currency Unit (ECU) to the Euro

    • The ECU was established as the EMS bookkeeping currency.

    • The ECU was more popular than the SDR because

      • Neither the US$ nor the yen was included in the currency basket that determined its value.

      • Of active sponsorship of the ECU by European governments, banks, and businesses.


Money markets foreign exchange8

Money Markets, Foreign Exchange

  • The European Currency Unit (ECU)

    • The ECU was a weighted basket of currencies, and its uses include

      • Denominating bonds.

      • Calculating the EU budget.

      • Raising levies.

      • Distributing funds that were translated into domestic, national currencies.


Money markets foreign exchange9

Money Markets, Foreign Exchange

  • The European Currency Unit (ECU)

    • The euro has replaced the ECU and is supposed to replace some national currencies.

    • The euro will be a retail currency, whereas the ECU was only a wholesale and debt market currency


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