Finance 319 Lecture 3 Galina A Schwartz Department of Finance Lecture Notes 01.15.2001 Finance 319 Lecture 3 Galina A Schwartz Department of Finance University of Michigan Business School 01.15.2001 Lecture Notes Finance 319 International Finance

Practical Matters Office Hours Change Lecture Notes 01.15.2001 Practical Matters Office Hours Change My office: D3270A (Davidson Hall) My e-mail: galka@umich.edu My office hours: Mon., 10am -12pm &, Th., 1 pm -3 pm or by appointment Notice a change: was Th., 3 pm - 5 pm 01.15.2001 Lecture Notes Finance 319 International Finance

Overview of International Monetary System I Lecture Notes 01.15.2001 Overview of International Monetary System I Readings: Levich, Chapter 2 History (seven episodes, see Levich, boxes 2.1 - 2.7) Current Trends to float [from fixed] to less [capital] controls 01.15.2001 Lecture Notes Finance 319 International Finance

Overview of International Monetary System II Lecture Notes 01.15.2001 Overview of International Monetary System II Current rules of the game volatility  (due to float)  need to hedge Emerging markets: currency board, issues: credibility, commitment Europe: common currency (EURO): will it last? 01.15.2001 Lecture Notes Finance 319 International Finance

Rules of the Game: a set of explicit and implicit rules Lecture Notes 01.15.2001 Rules of the Game: a set of explicit and implicit rules laws & regulations customs & conventions IFS as a factor of production (i.e. financial infrastructure) Government Objective is twofold: 1. Domestic Agenda & Gov-t Promises 2. International Agenda & Gov-t Promises 1 & 2 are contradictory 01.15.2001 Lecture Notes Finance 319 International Finance

1. The Gold Standard, 1879 - 1913, Box 2.1, p. 24 Lecture Notes 01.15.2001 1. The Gold Standard, 1879 - 1913, Box 2.1, p. 24 I. - a definition II. - a rule used (no capital controls) III. - a result of I and II. VI. - the means to sustain the system. V. - the means to sustain the system VI. - a major system feature: common price level. - a drawback - no variability allowed 01.15.2001 Lecture Notes Finance 319 International Finance

2. Bretton Woods, Box 2.2, p. 27 I. & II. - a definition Lecture Notes 01.15.2001 2. Bretton Woods, Box 2.2, p. 27 I. & II. - a definition III. - free convertibility - a result of I. III. (capital controls) & VI. - the means to sustain the system & achieve national macroeconomic autonomy V. - a major system feature: macro autonomy a drawback - need of capital controls, an advantage - variability across the countries 01.15.2001 Lecture Notes Finance 319 International Finance

3. Fixed-Rate Dollar Standard, 1950 - 1970, Box 2.3, p. 29 Lecture Notes 01.15.2001 3. Fixed-Rate Dollar Standard, 1950 - 1970, Box 2.3, p. 29 growing foreign reserves = U.S. Balance of Payment deficits countries peg exchange rates to US$ within 1% of par value which is : US Dollar is used as a gold 01.15.2001 Lecture Notes Finance 319 International Finance

Why the rules of the game change? Lecture Notes 01.15.2001 Why the rules of the game change? When does the change happen? How fast does it happen? Is it easy to change the rules? Could it possibly be an easy and fast process? 01.15.2001 Lecture Notes Finance 319 International Finance

More Rules of the Game: 4. Floating-Rate Dollar Standard, 1973 - 1984, Lecture Notes 01.15.2001 More Rules of the Game: 4. Floating-Rate Dollar Standard, 1973 - 1984, Box 2.4, p. 33 5. Plaza-Louvre Accord & Floating-Rate Dollar Standard, 1985-1996, Box 2.5, p. 35 01.15.2001 Lecture Notes Finance 319 International Finance

6. & 7. The Spirit of EMU & the Current Rules, Box 2.6-7, pp. 38-9 Lecture Notes 01.15.2001 6. & 7. The Spirit of EMU & the Current Rules, Box 2.6-7, pp. 38-9 Benefits of the union: Exchange rate uncertainty is reduced Price transparency Political cooperation & economic convergence. Costs of the union: Loss of monetary independence Difficulty adjusting to external shocks. 01.15.2001 Lecture Notes Finance 319 International Finance

An Example (US - Mexico) Lecture Notes 01.15.2001 An Example (US - Mexico) Does Trade Deficit matter? Reasons for Trade Deficit corporate --tax & regulatory exchange rate dis-equilibrium dynamic: production & consumption adjustment 01.15.2001 Lecture Notes Finance 319 International Finance

Next Lecture To read: Levich, Chapter 3 Lecture Notes 01.15.2001 Next Lecture To read: Levich, Chapter 3 Millman, Gregory, 1995, The Vandals' Crown: How Rebel Currency Traders Overthrew the World's Central Banks, Free Press. (further Millman) The golden vanity, pp.65-94. (S) 01.15.2001 Lecture Notes Finance 319 International Finance

Summary of Today Basic Concepts, See Lecture 2 notes Rules of the Game 01.15.2001 Summary of Today Basic Concepts, See Lecture 2 notes Rules of the Game history of international monetary system features of the system & its support mechanisms pluses and minuses of different rules of the game One central bank speculation 01.15.2001 Lecture Notes Finance 319 International Finance