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Multinational Financial Management Alan Shapiro 7th EditionJ.Wiley & SonsPower Points byJoseph F. Greco, Ph.D.California State University, Fullerton

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CHAPTER 3

THE INTERNATIONAL MONETARY SYSTEM

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CHAPTER OVERVIEWI. ALTERNATIVE EXCHANGE RATE

SYSTEMSII. A BRIEF HISTORY OF THE

INTERNATIONAL MONETARY SYTEMIII. THE EUROPEAN MONETARY

SYSTEM AND MONETARY UNIONIV. EMERGING MARKET CURRENCY

CRISES

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PART I. ALTERNATIVE EXCHANGE RATE SYSTEMS

I. FIVE MARKET MECHANISMSA. Freely Floating

(“Clean Float”)1. Market forces of

supply and demand determine rates.

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ALTERNATIVE EXCHANGE RATE SYSTEMS

2. Forces influenced by

a. price levels

b. interest rates

c. economic growth

3. Rates fluctuate randomly

over time.

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ALTERNATIVE EXCHANGE RATE SYSTEMS

B. Managed Float (“Dirty Float”)1. Market forces set rates

unless excess volatility occurs.

2. Then, central bank determines rate.

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ALTERNATIVE EXCHANGE RATE SYSTEMS

C. Target-Zone Arrangement1. Rate Determination

a. Market forces constrainedto upper and lower range of rates.

b. Members to the arrangement

adjust their national economic policies to maintain target.

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ALTERNATIVE EXCHANGE RATE SYSTEMS

D. Fixed Rate System1. Rate determination

a. Government maintains target rates. b. If rates threatened, central banks buy/sell currency.c. Monetary policies coordinated.

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ALTERNATIVE EXCHANGE RATE SYSTEMS

E. Current System1. A hybrid system

a. Major currencies: use freely- floating method

b. Other currencies move in and out of various fixed-rate

systems.

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PART II. A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM

I. THE USE OF GOLD

A. Desirable properties

B. In short run: High production costs limit changes.

C. In long run: Commodity money insures stability.

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A BRIEF HISTORYII. The Classical Gold Standard

(1821-1914)

A. Major global currencies on gold standard.

1. Nations fix the exchange rate in terms of a specific amount of gold.

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A BRIEF HISTORY2. Maintenance involved the

buying and selling of gold at that price.

3. Disturbances in Price Levels:Would be offset by the price-

specie*-flow mechanism.

* specie = gold coins

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A BRIEF HISTORYa. Price-specie-flow mechanism

adjustments were automatic:1.) When a balance of payments surplus led to a gold inflow;

2.) Gold inflow led to higher prices which reduced surplus;

3.) Gold outflow led to lower prices and increased surplus.

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A BRIEF HISTORYIII. The Gold Exchange Standard

(1925-1931)A. Only U.S. and Britain allowed

to hold gold reserves.

B. Others could hold both gold, dollars or pound reserves.

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A BRIEF HISTORYC. Currencies devalued in 1931- led to trade wars.D. Bretton Woods Conference- called in order to avoid future protectionist and destructive economic policies

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A BRIEF HISTORYV. The Bretton Woods System (1946-

1971)

1. U.S.$ was key currency;valued at $1 - 1/35 oz. of

gold.

2. All currencies linked to that price in a fixed rate system.

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A BRIEF HISTORY3. Exchange rates allowed to

fluctuate by 1% above or below initially set rates.B. Collapse, 1971

1. Causes:a. U.S. high inflation rate

b. U.S.$ depreciated sharply.

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A BRIEF HISTORY

V. Post-Bretton Woods System (1971-Present)

A. Smithsonian Agreement, 1971:US$ devalued to 1/38 oz. of

gold.By 1973: World on a freely

floating exchange rate system.

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A BRIEF HISTORYB. OPEC and the Oil Crisis (1973-774)

1. OPEC raised oil prices four fold;

2. Exchange rate turmoil resulted;

3. Caused OPEC nations to earn large surplus B-O-P.

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A BRIEF HISTORY4. Surpluses recycled to debtor

nations which set up debt crisis of 1980’s.

C. Dollar Crisis (1977-78)1. U.S. B-O-P difficulties2. Result of inconsistent

monetary policy in U.S.

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A BRIEF HISTORY3. Dollar value falls as confidence

shrinks.

D. The Rising Dollar (1980-85)1. U.S. inflation subsides as the

Fed raises interest rates

2. Rising rates attracts global capital to U.S.

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A BRIEF HISTORY3. Result: Dollar value

rises.E. The Sinking Dollar:(1985-87)

1. Dollar revaluated slowly downward;

2. Plaza Agreement (1985)G-5 agree to depress US$further.

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A BRIEF HISTORY3. Louvre Agreement (1987)

G-7 agree to support the falling US$.

F. Recent History (1988-Present)1. 1988 US$ stabilized2. Post-1991 Confidence

resulted in stronger dollar

3. 1993-1995 Dollar value falls

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PART III.THE EUROPEAN MONETARY SYSTEM

I. INTRODUCTIONA. The European Monetary System (EMS)

1. A target-zone method (1979)

2. Close macroeconomic policy coordination

required.

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THE EUROPEAN MONETARY SYSTEM

B. EMS Objective:

to provide exchange rate stability to all members

by holding exchange rates within specified

limits.

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THE EUROPEAN MONETARY SYSTEM

C. European Currency Unit (ECU)

a “cocktail” of European currencies with specified weights as the unit of account.

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THE EUROPEAN MONETARY SYSTEM

1. Exchange rate mechanism (ERM)

- each member determines mutually agreed upon central cross rate for its currency.

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THE EUROPEAN MONETARY SYSTEM

2. Member Pledge:to keep within 15%

margin above or below the central rate.

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THE EUROPEAN MONETARY SYSTEM

D. EMS ups and downs

1. Foreign exchange interventions:

failed due to lack of support by

coordinated monetary policies.

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THE EUROPEAN MONETARY SYSTEM

2. Currency Crisis of Sept. 1992a. System broke downb. Britain and Italy

forced towithdraw from EMS.

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THE EUROPEAN MONETARY SYSTEM

G. Failure of the EMS:

members allowed political

priorities to dominate

exchange rate

policies.

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THE EUROPEAN MONETARY SYSTEM

H. Maastricht Treaty1. Called for Monetary

Union by 1999 (moved to 2002)

2. Established a single currency:

the euro

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THE EUROPEAN MONETARY SYSTEM

3. Calls for creation of a single

central EU bank

4. Adopts tough fiscal standards

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THE EUROPEAN MONETARY SYSTEM

I. Costs / Benefits of A Single CurrencyA. Benefits

1. Reduces cost of doing business

2. Reduces exchange rate risk

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THE EUROPEAN MONETARY SYSTEM

B. Costs1. Lack of national

monetary flexibility.

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PART IV. EMERGING MARKET CURRENCY CRISES

I. Transmission MechanismsA. Trade links

contagion spreads through tradeB. Financial System

-more important transmission mechanism-investors sell off to make up for losses

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EMERGING MARKET CURRENCY CRISES

II. Origins of Emerging Market CrisesA. Moral hazard

B. Fundamental Policy Conflict

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EMERGING MARKET CURRENCY CRISES

III. Policy Proposals for Dealing with Emerging Market Crises

A. Currency Controls

B. Freely Floating Currency

C. Permanently Fixed Exchange Rate