Ch. 2 - The International Monetary System

Front 1

From the U.S. viewpoint, what is meant by the DEMAND for a currency?

Back 1

 DEMAND (BUYING pressure) for foreign exchange by U.S. corporations / traders & speculators / governments that need to purchase:
» FOREIGN-produced trade items
» FOREIGN assets (real and financial).
 DEMAND CURVE:
» Relationship between the QUANTITY of FX demanded & the PRICE of FX (exchange rate)
» Negatively sloping

Front 2

From the U.S. viewpoint, what is meant by the SUPPLY for a currency?

Back 2

 SUPPLY (SELLING pressure) of foreign exchange by foreign corporations / traders & speculators / governments that
need to purchase:
» U.S.-produced trade items
» U.S. assets (real or financial)
 SUPPLY CURVE:
» Relationship between the QUANTITY of FX demanded & the PRICE of FX (exchange rate)
» Positively sloping

Front 3

What are the effects of relative domestic inflation INCREASE in the FX Market?

Back 3

 DEMAND SCHEDULE:
»Foreign goods are relatively CHEAPER to domestic consumers.
»Merchandise imports INCREASE.
»Quantity of FX demanded at each exchange rate INCREASES.
 SUPPLY SCHEDULE:
» Domestic goods are relatively
EXPENSIVE for foreign consumers.
» Merchandise exports DECREASE.
» Quantity of FX supplied at each exchange rate (ER) DECREASES.
 EQUILIBRIUM:
» ER (price of GBP, the foreign currency) INCREASES.

Front 4

What are the effects of relative domestic inflation DECREASE in the FX market?

Back 4

 DEMAND SCHEDULE:
» Foreign goods are relatively EXPENSIVE to domestic consumers.
» Merchandise imports DECREASE.
» Quantity of FX demanded at each exchange rate DECREASES.
 SUPPLY SCHEDULE:
» Domestic goods are relatively CHEAPER for foreign consumers.
» Merchandise exports INCREASE.
» Quantity of FX supplied at each ER INCREASES.
 EQUILIBRIUM:
» ER (price of GBP, the foreign currency) DECREASES.

Front 5

What are the effects of relative domestic interest rate INCREASE in the FX market?

Back 5

 DEMAND SCHEDULE:
» Domestic capital attracted to domestic
country & domestic capital movement
overseas DECREASES.
» Quantity of FX demanded at each
exchange rate DECREASES.
 SUPPLY SCHEDULE:
» Foreign capital attracted to domestic
country & foreign capital movement into
the domestic country INCREASES.
» Quantity of FX supplied at each ER rate
INCREASES.
 EQUILIBRIUM:
» ER (price of GBP) DECREASES.

Front 6

What are the effects of relative domestic interest rate DECREASE in the FX market?

Back 6

 DEMAND SCHEDULE:
» Domestic capital attracted to domestic country & domestic capital movement overseas INCREASES.
» Quantity of FX demanded at each exchange rate INCREASES.
 SUPPLY SCHEDULE:
» Foreign capital attracted to domestic country & foreign capital movement into the domestic country DECREASES.
» Quantity of FX supplied at each ER rate
DECREASES.
 EQUILIBRIUM:
» ER (price of GBP) INCREASES.

Front 7

What are the effects of relative domestic national income INCREASE in the FX market?

Back 7

 DEMAND SCHEDULE:
» With higher income, domestic consumers purchase more foreign goods. Merchandise imports INCREASE.
» Quantity of FX demanded at each exchange rate INCREASES.
 SUPPLY SCHEDULE:
» Either foreign demand for domestic goods DOES NOT CHANGE OR INCREASES with increased foreign dollar purchasing power.
» Quantity of FX supplied at each ER DOES NOT CHANGE OR INCREASES.
 EQUILIBRIUM:
» ER (price of GBP) INCREASES.

Front 8

What are the effects of relative domestic national income DECREASE in the FX market?

Back 8

 DEMAND SCHEDULE:
» With lower income, domestic consumers purchase less foreign goods. Merchandise imports DECREASE.
» Quantity of FX demanded at each exchange rate DECREASES.
 SUPPLY SCHEDULE:
» Either foreign demand for domestic goods DOES NOT CHANGE or DECREASES with decreased foreign dollar purchasing power
» Quantity of FX supplied at each ER DOES NOT CHANGE or DECREASES.
 EQUILIBRIUM:
» ER (price of GBP) DECREASES

Front 9

How do expectations about currency prices affect trading strategy in FX market?

Back 9

 Based on expectations about future behavior of macro
economic variables, currency traders:
» Make predictions about expected changes in foreign currency prices.
» BORROW in currency that is expected to DEPRECIATE.
» LEND in currency that is expected to APPRECIATE.
» This changes the supply/demand and the PRICE for foreign currency in
the FX market

Front 10

What happens when the U.S. government INCREASES trade
restrictions?

Back 10

 Trade Restriction INCREASE in U.S.:
» Import duties on U.K. goods (tarrifs) are INCREASED.
» Quotas on goods imported from U.K. into U.S. are REDUCED.
 DEMAND SCHEDULE:
» FEWER U.K. goods will be imported.
» Quantity of FX demanded at each ER DECREASES.
 SUPPLY SCHEDULE
» Will NOT CHANGE.
 EQUILIBRIUM:
» ER (price of GBP) DECREASES.

Front 11

What happens when the U.S. government DECREASES trade
restrictions?

Back 11

 Trade Restriction DECREASE in U.S.:
» Import duties on U.K. goods (tarrifs) are DECREASED.
» Quotas on goods imported from U.K. into U.S. are INCREASED.
 DEMAND SCHEDULE:
» MORE U.K. goods will be imported.
» Quantity of FX demanded at each ER INCREASES.
 SUPPLY SCHEDULE
» Will NOT CHANGE.
 EQUILIBRIUM:
» ER (price of GBP) INCREASES.

Front 12

What happens when the foreign government INCREASES trade restrictions?

Back 12

 Trade Restriction INCREASE in US:
» Import duties on U.S. goods (tarrifs) are INCREASED in the U.K.
» Quotas on goods imported from U.S. into U.K. are DECREASED.
 DEMAND SCHEDULE:
» Will NOT CHANGE
 SUPPLY SCHEDULE:
» FEWER U.S. goods will be sold in U.K.
» Quantity of FX supplied at each ER DECREASES.
 EQUILIBRIUM:
» ER (price of GBP) INCREASES.

Front 13

What happens when the foreign government DECREASES trade restrictions?

Back 13

 Trade Restriction DECREASE in U.S.:
» Import duties on U.S. goods (tarrifs) are DECREASED in the U.K.
» Quotas on goods imported from U.S. into U.K. are INCREASED.
 DEMAND SCHEDULE:
» Will NOT CHANGE
 SUPPLY SCHEDULE:
» MORE U.S. goods will be sold in U.K.
» Quantity of FX supplied at each ER INCREASES.
 EQUILIBRIUM:
» ER (price of GBP) DECREASES.

Front 14

If GBP is undervalued (dollar is overvalued), what happens during Non-Sterilized Government Intervention in the FX Market?

Back 14

 Both Central banks BUY GBP (SELL USD dollars):
» US money supply INCREASES and the British money supply DECREASES.
» US inflation INCREASES and British inflation DECREASES.
 Appreciation of GBP (depreciation of dollar) is more due to INCREASED US inflation (decreased British inflation) rather than central bank transactions in the FX market.

Front 15

If GBP is overvalued (dollar is undervalued), what happens during Non-Sterilized Government Intervention in the FX Market?

Back 15

 Both Central banks SELL GBP (BUY USD dollars):
» US money supply DECREASES and the British money supply INCREASES.
» US inflation DECREASES and British inflation INCREASES.
 Depreciation of GBP (appreciation of dollar) is more due to DECREASED US inflation (increased British inflation) rather than central bank transactions in the FX market.

Front 16

If GBP is undervalued (dollar is overvalued), what happens during Sterilized Government Intervention in the FX Market?

Back 16

 Both Central banks BUY GBP (SELL USD):
» U.S. money supply INCREASES and the British money supply DECREASES.
 To neutralize the changes in money supply: Federal Reserve SELLS U.S. Treasury securities and the Central Bank of England BUYS British Treasury securities:
» US money supply is DECREASED and the British money supply is INCREASED.
 The GBP appreciation (dollar depreciation) due to central
bank intervention, is usually short lived.

Front 17

If GBP is overvalued (dollar is undervalued), what happens during Sterilized Government Intervention in the FX Market?

Back 17

 Both Central banks SELL GBP (BUY USD):
» U.S. money supply DECREASES and the British money supply INCREASES.
 To neutralize the changes in money supply: Federal Reserve BUYS U.S. Treasury securities and the Central Bank of England SELLS British Treasury securities:
» US money supply is INCREASED and the British money supply is DECREASED.
 The GBP depreciation (dollar appreciation) due to central
bank intervention, is usually short lived.

Front 18

For what is a monetary unit valued? What does higher monetary value lead to?

Back 18

 Store of Value: this is determined by:
» Stability of the nation’s monetary policy
» Reputation and independence of its Central bank
 medium of exchange (liquidity): this is determined by :
» GNP Growth
» Demand for the nation’s assets
 Higher monetary value leads to HIGHER demand
and HIGHER value for its currency

Front 19

What is Bimetallism?

Back 19

 A “double standard” in the sense that both gold
and silver were used as money.
 Some countries were on the gold standard, some
on the silver standard, some on both.
 Both gold and silver were used as international
means of payment and the exchange rates among
currencies were determined by either their gold or
silver contents.

Front 20

What is Gresham's Law?

Back 20

 Gresham’s Law implied that it would be the
least valuable metal that would tend to circulate.

Front 21

What is the Classical Gold Standard?

Back 21

 During this period, 1875-1914, in most major countries:
» Gold alone was assured of unrestricted coinage
»There was two-way convertibility between gold and
national currencies at a stable ratio.
» Gold could be freely exported or imported.
 The exchange rate between two country’s
currencies would be determined by their relative
gold contents.

Front 22

What were exchange rates like during the Classical Gold Standard?

Back 22

 Highly stable exchange rates under the classical
gold standard provided an environment that was
conducive to international trade and investment.
 Misalignment of exchange rates and international
imbalances of payment were automatically
corrected by the price-specie-flow mechanism.

Front 23

What is the Price-Specie-Flow Mechanism?

Back 23

 Suppose Great Britain exported more to France than
France imported from Great Britain.
 This cannot persist under a gold standard.
»Net export of goods from Great Britain to France will be
accompanied by a net flow of gold from France to Great
Britain.
» This flow of gold will lead to a lower price level in France
and, at the same time, a higher price level in Britain.
 The resultant change in relative price levels will slow
exports from Great Britain and encourage exports from
France.

Front 24

What are the shortcomings of the Classical Gold Standard?

Back 24

 The supply of newly minted gold is so restricted that
the growth of world trade and investment can be
hampered for the lack of sufficient monetary reserves.
 Even if the world returned to a gold standard, any
national government could abandon the standard.

Front 25

What is the Interwar Period?

Back 25

 Exchange rates fluctuated as countries widely
used “predatory” depreciations of their currencies
as a means of gaining advantage in the world
export market.
 Attempts were made to restore the gold standard,
but participants lacked the political will to
“follow the rules of the game”.
 The result for international trade and investment
was profoundly detrimental.

Front 26

What is the Bretton Woods System?

Back 26

1945-1972
 Named for a 1944 meeting of 44 nations at
Bretton Woods, New Hampshire.
 The purpose was to design a postwar
international monetary system.
 The goal was exchange rate stability without the
gold standard.
 The result was the creation of the IMF and the
World Bank.

Front 27

What are 3 conditions of the Bretton Woods System?

Back 27

 Under the Bretton Woods system, the U.S. dollar
was pegged to gold at $35 per ounce and other
currencies were pegged to the U.S. dollar.
 Each country was responsible for maintaining its
exchange rate within ±1% of the adopted par
value by buying or selling foreign reserves as
necessary.
 The Bretton Woods system was a dollar-based
gold exchange standard.

Front 28

What is the Flexible Exchange Rate Regime?

Back 28

 Flexible exchange rates were declared acceptable
to the IMF members.
» Central banks were allowed to intervene in the
exchange rate markets to iron out unwarranted
volatilities.
 Gold was abandoned as an international reserve
asset.
 Non-oil-exporting countries and less-developed
countries were given greater access to IMF funds.

Front 29

What is the Classification of Exchange Rate
Regimes?

Back 29

Exchange Rate Type / Reserve Assets / Convertibility

1. Fixed - Gold - Full
2. Crawling Peg - US Dollar and Hard Currencies - Dual Market
3. Managed Float - SDRs - Controlled
4. Free Float - none - none

Front 30

What are the different types of exchange rates?

Back 30

 Free Float
» The largest number of countries, about 48, allow market forces
to determine their currency’s value.
 Managed Float
 Pegged to another currency
» Such as the U.S. dollar or euro (through franc or mark).
» About 25 countries combine government intervention with
market forces to set exchange rates.
 No national currency
» Some countries do not bother printing their own currency. For
example, Ecuador, Panama, and El Salvador have dollarized.
Montenegro and San Marino use the euro.

Front 31

What is the European Monetary System?

Back 31

 European countries maintain exchange rates
among their currencies within narrow bands, and
jointly float against outside currencies.
 Objectives:
» To establish a zone of monetary stability in Europe.
» To coordinate exchange rate policies vis-à-vis non-
European currencies.
» To pave the way for the European Monetary Union.

Front 32

What is the Euro?

Back 32

 The euro is the single currency of the European
Monetary Union which was adopted by 11
Member States on 1 January 1999.
 These original member states were: Belgium,
Germany, Spain, France, Ireland, Italy,
Luxemburg, Finland, Austria, Portugal and the
Netherlands.

Front 33

What are the Maastricht Criteria?

Back 33

The Maastricht Treaty stipulated five criteria that European countries had to meet to become eligible for Euro:
 Price Stability: A country's inflation rate must not exceed the average inflation rate of the 3 best performing member states by more than 1.5%.
 The Level of Government Deficit : The government’s budget deficit must not be more than 3 % of its gross domestic product.
 The Level of Government Debt : The government’s total debt must not be more than 60 % of its gross domestic product.
 Successful EMS Membership : A country must have participated in Exchange
Rate Mechanism of the European Monetary System for at least two years, without devaluing against the currency of any other Member State.
 Interest-Rate Convergence : Its average nominal long-term interest rate should not be more than 2 % higher than those prevailing in the three best
performing Member States in terms of price stability.

Front 34

How Did the Euro Affect Contracts
Denominated in National Currency?

Back 34

 All insurance and other legal contracts
continued in force with the substitution of
amounts denominated in national currencies
with their equivalents in euro.
 Once the changeover was completed by July 1,
2002, the legal-tender status of national
currencies (e.g. German mark, Italian lira) was
cancelled, leaving the euro as the sole legal
tender in the euro zone.

Front 35

What is the long-term impact of the Euro?

Back 35

 As the euro proves successful, it will advance the
political integration of Europe in a major way,
eventually making a “United States of Europe”
feasible.
 It is likely that the U.S. dollar will lose its place as
the dominant world currency.
 The euro and the U.S. dollar will be the two major
currencies.

Front 36

What are the costs of monetary union?

Back 36

 The main cost of monetary union is the loss of national monetary and exchange rate policy independence.
» The more trade-dependent and less diversified a country’s economy is, the more prone to asymmetric
shocks that country’s economy would be.

Front 37

What are the advantages of a single European currency?

Back 37

 Next Logical Step: A single market concept cannot survive for long without a single currency
 Transaction Costs: Reduce the cost of converting currencies
 No Exchange Rate Uncertainty: Eliminates the risks of unforeseen
exchange rate revaluations or devaluations.
 Transparency & Competition : Increase direct comparability of prices and wages across Europe
 Strength: The new Euro will be the among the strongest currencies in the
world, along with the US Dollar and the Japanese Yen.
 Capital Market: A larger Euro zone will integrate the European financial markets
 No Competitive Devaluations: Countries can no longer devalue their
currencies against each other to increase their exporters
 Fiscal Discipline: Governments with a lack of fiscal discipline can be
brought into line.
 European Identity: One currency will strengthen the European identity.

Front 38

What are the disadvantages of a single European currency?

Back 38

 Cost of Introduction: Converting all bills, all wages and prices into Euro
is expensive
 Non-Synchronicity of Business Cycles: Business cycles across the various countries do not move in synchronicity.
 Fiscal Policy Spillovers: With a Europe-wide interest rate, individual
countries that increase their debt will raise interest rates in all other countries
 No Competitive Devaluations: In a recession, a country can no longer stimulate its economy by devaluing its currency and increasing exports.
 Central Bank Independence: It will be difficult for the new European
Central Bank (ECB) to maintain its independence, in spite of pressure
from member countries
 Excessive Fiscal Discipline: The pressure on a member government to limit budget deficit could adversely affect that country’s economy

Front 39

What happened in the Mexican peso crisis?

Back 39

 On 20 December, 1994, the Mexican government
announced a plan to devalue the peso against the
dollar by 14 percent.
 This decision changed currency trader’s
expectations about the future value of the peso.
 They stampeded for the exits.
 In their rush to get out the peso fell by as much as
40 percent.

Front 40

What makes the Mexican peso crisis unique?

Back 40

 The Mexican Peso crisis is unique in that it
represents the first serious international financial
crisis touched off by cross-border flight of
portfolio capital.

Front 41

What are two lessons of the Mexican peso crisis?

Back 41

 It is essential to have a multinational safety net in
place to safeguard the world financial system from
such crises.
 An influx of foreign capital can lead to an
overvaluation in the first place.

Front 42

What happened in the Asian currency crisis?

Back 42

 The Asian currency crisis turned out to be far
more serious than the Mexican peso crisis in
terms of the extent of the contagion and the
severity of the resultant economic and social
costs.
 Many firms with foreign currency bonds were
forced into bankruptcy.
 The region experienced a deep, widespread
recession.

Front 43

What happened in the Argentinean peso crisis?

Back 43

 In 1991 the Argentine government passed a
convertibility law that linked the peso to the U.S.
dollar at parity.
 The initial economic effects were positive:
» Argentina’s chronic inflation was curtailed
» Foreign investment poured in
 As the U.S. dollar appreciated on the world
market the Argentine peso became stronger as
well.

Front 44

As a result of a strong peso, what happened in Argentina?

Back 44

 The strong peso hurt exports from Argentina and
caused a protracted economic downturn that led to
the abandonment of peso–dollar parity in January
2002.
» The unemployment rate rose above 20 percent
» The inflation rate reached a monthly rate of 20 percent

Front 45

What are three factors that are related to the collapse of the currency board arrangement and the ensuing economic crisis?

Back 45

 Lack of fiscal discipline
 Labor market inflexibility
 Contagion fr Co g o om the financial crises in Brazil and Russia

Front 46

How do you explain a currency crisis?

Back 46

 In theory, a currency’s value mirrors the fundamental
strength of its underlying economy, relative to other
economies. In the long run.
 In the short run, currency trader’s expectations play a
much more important role.
 In today’s environment, traders and lenders, using the
most modern communications, act by fight-or-flight
instincts. For example, if they expect others are about to
sell Brazilian reals for U.S. dollars, they want to “get to
the exits first”.
 Thus, fears of depreciation become self-fulfilling
prophecies.

Front 47

What are the arguments for fixed versus flexible
exchange rate regimes? (SEE GRAPHS)

Back 47

 Arguments in favor of flexible exchange rates:
» Easier external adjustments.
» National policy autonomy.
 Arguments against flexible exchange rates:
» Exchange rate uncertainty may hamper international
trade.
» No safeguards to prevent crises.