Chapter 10 Internatioal Monetary System

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EXPORT declines

IMPORT rises

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EFFECT OF EXCHANGE RATE ON BUSINESS

When a country’s currency is weak(valued low relative to other currencies), the price of its exports on worldmarkets _______ (making exports more appealing on world markets) and the priceof imports _______.

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strong

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EFFECT OF EXCHANGE RATE ON BUSINESS

Acompany can improve profits if it sells in a country with a _______ currency(one that is valued high relative to other currencies) while paying workers athome in its own weak currency.

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devaluation

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The intentional lowering of the value of a currency by the nation’s government

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revaluation

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the intentional raising of the value of a currency by the nation’s government

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to give its domestic companies an edge over competition from other countries.

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Pros for Devaluation

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*reduces the buying power of consumers in the nation.

*allows inefficiencies to persist in domestic companies because there would then be less pressure to be concerned with production costs

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Cons for Devaluation

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*stable exchange rates improve the accuracy of financial planning and make cash-flow forecasts more precise.

*reduce the likelihood to be caught off guard by sudden and unexpected rate changes.

* reduce the need for costly insurance (usually by currency hedging) against possible adverse movements in exchange rates.

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Why is it desirable for exchange rates to be stable and predictable?

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-law of one price

-purchasing power parity

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Factors that determine Exchange Rates

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law of one price

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Principle that an identical item must have an identical price in all countries when the price is expressed in a common currency.

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arbitrage opportunity

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an opportunity to buy a product in one country and sell it in a country where it has a higher value

*arises if law of one price is violated

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too simplistic a method for estimating exchange rates.

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Drawbacks of McCurrency

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McCurrency

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index that uses the law of one price to determine the exchange rate that should exist between the U.S. dollar and other major currencies. It employs the McDonald’s Big Mac as its single product to test the law of one price

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Purchasing Power Parity

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relative ability of two countries’ currencies to buy the same “basket” of goods in those two countries.

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Purchasing Power Parity

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Interpreted as the exchange rate between two nations’ currencies that is equal to the ratio of their price levels.

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Inflation

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result of the supply and demand for a currency

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If additional money is injected into an economy that is not producing greater output, people will have more money to spend on the same amount of products as before. As growing demand for products outstrips stagnant supply, prices will rise and devour any increase in the amount of money that consumers have to spend.

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How does inflation erode people’s purchasing power?

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Monetary Policy

Fiscal Policy

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2 types of policy implemented by government to prevent inflation

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Monetary policy

*selling government securities

* buying its own securities

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activities that directly affect a nation’s interest rates or money supply.

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Fiscal policy

*increasing/reducing taxes

*increasing/reducing government spending

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involves using taxes and government spending to influence the money supply indirectly.

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Unemployment

Interest rates

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Key Factors in the equation of inflation

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When unemployment rates are low, there is a shortage of labor and employers pay higher wages to attract employees. To maintain reasonable profit margins with higher labor costs, companies then usually raise the prices of their products, passing the cost of higher wages on to the consumer and causing inflation.

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How does unemployment rates affect inflation?

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Low interest rates encourage people to take out loans to buy items. High interest rates prompt people to cut down on the amount of debt they carry because higher rates mean larger monthly payments on debt.

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How interest rates affect inflation?

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raise the interest rates

Raising the cost of debt reduces consumer spending and makes business expansion more costly

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Way to cool off inflation

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Ee = Eb(1 + i1)>(1 + i2)

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Formula for Adjusting exchange rate

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real interest rates

nominal interest rates

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2 types of interest rates

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nominal interest rates

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real interest rate + inflation rate

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The lender must be compensated for the erosion of its purchasing power during the loan period caused by inflation.

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Rationale behind nominal interest rates

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Fisher effect

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the principle that the nominal interest rate is the sum of the real interest rate and the expected rate of inflation over a specific period.

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international fisher effect

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Principle that a difference in nominal interest rates supported by two countries’ currencies will cause an equal but opposite change in their spot exchange rates

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- Impact of added cost (i.e transportation)

- Impact of trade barriers

- Impact of business confidence and psychology

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Limitations of PPP in predicting exchange rates

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efficient market view

inefficient market view

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Views in forecasting exchange rates

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efficient market view

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Principle that a difference in nominal interest rates supported by two countries’ currencies will cause an equal but opposite change in their spot exchange rates

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inefficient market view

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Principle that prices of financial instruments do not reflect all publicly available information.

*cost of searching for further information must not outweigh the benefits of its discovery.

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Fundamental analysis

Technical analysis

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2 Main forecasting techniques

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Fundamental analysis

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uses statistical models based on fundamental economic indicators to forecast exchange rates.

*economic variables such as inflation, interest rates, money supply, tax rates, and government spending, balance-of-payments situation and tendency to intervene

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Technical analysis

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a technique that uses charts of past trends in currency prices and other factors to forecast the timing, magnitude, and direction of future changes.

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Difficulties of Forecasting

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international monetary system

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the collection of agreements and institutions that govern exchange rates.

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gold standard

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International monetary system in which nations link the value of their paper currencies to specific values of gold.

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(1) limited supply made it a commodity in high demand

(2) highly resistant to corrosion, able to be traded and stored for hundreds of years.

(3) could be melted into either small coins or large bars, a good medium of exchange for both small and large purchases.

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Advantages of gold as currency

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(1) weight of gold made transporting it expensive.

(2) when a transport ship sank at sea, the gold also sank to the ocean floor and was lost

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Disadvantages of gold as currency

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Par value

*calculation of each currency’s par value was based on the concept of purchasing power parity.

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value of a currency expressed in terms of gold

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fixed exchange-rate system

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System in which the exchange rate for converting one currency into another is fixed by international agreement.

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1. reduced the risk in exchange rates

(it maintains highly fixed exchange rates between currencies & reduced risk resulted to rapid international trade)

2. imposed strict monetary policies

(government could not allow the volume of its paper currency to grow faster than the growth in its reserves of gold controlling inflation)

3. help correct a nation’s trade imbalance.

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Advantages of the Gold Standard

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Bretton Woods Agreement (1944)

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accord among nations to create a new international monetary system based on the value of the U.S. dollar.

* designed to balance the strict discipline of the gold standard with the flexibility that countries needed in order to deal with temporary domestic monetary difficulties.

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Fixed Exchange rates

- tied the value of the U.S. dollar to gold and value of other currencies to the value of USD

Built-inflexibility

World Bank

- International Bank for Reconstruction and Development (IBRD) funding for economic development

IMF

- agency to regulate the fixed exchange rates and to enforce the rules of the international monetary system

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Important Features of the Bretton Woods Agreement

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fundamental disequilibrium

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an economic condition in which a trade deficit causes a permanent negative shift in a country’s balance of payments.

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• Promoting international monetary cooperation.

• Facilitating expansion and balanced growth of international trade.

• Promoting exchange stability, maintaining orderly exchange arrangements, and avoiding competitive exchange devaluation.

• Making the resources of the fund temporarily available to members.

• Shortening the duration and lessening the degree of disequilibrium in the international balance of payments of member nations.

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Purposes of IMF

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special drawing right (SDR)

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IMF asset whose value is based on a “weighted basket” of four currencies.

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1. US trade deficit (imports were exceeding exports) and a budget deficit (expenses were outstripping revenues).

--->doubt that the U.S. government had an adequate amount of gold reserves to redeem all its paper currency held outside the country. When they began demanding gold in exchange for dollars, a large sell-off of dollars on world financial markets followed.

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What brought the collapse of bretton woods agreement?

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Smithsonian agreement Agreement (1971)

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accord among IMF members to restructure and strengthen the international monetary system created at Bretton Woods.

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(1) to lower the value of the dollar in terms of gold to $38/oz,
(2) to increase the values of other countries’ currencies against the dollar
(3) to increase to 2.25 percent from 1 percent the band within which currencies were allowed to float.

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Accomplishments of Smithsonian Agreement

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Jamaica agreement Agreement (1976)

1. managed float system of exchange rates

2. gold is no longer a primary reserve asset of IMF

3. IMF's mission as lender of last resort for nations with balance of payments difficulties

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accord among IMF members to formalize the existing system of floating exchange rates as the new international monetary system.

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managed float system

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Exchange-rate system in which currencies float against one another, with governments intervening to stabilize their currencies at particular target exchange rates.

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free float system

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Exchange-rate system in which currencies float freely against one another, without governments intervening in currency markets

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Pegged Exchange Rate Arrangement
Currency Board

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Current Exchange Rate Arrangements

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currency board

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Monetary regime based on an explicit commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate.