CHAPTER 11 The International Monetary System

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Learning Objectives What are the differences between fixed and floating exchange rates? What kind of business strategies do firms use to guard against the volatility of exchange rates? Current event- Currency crisis in Brazil & Role of IMF

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Chapter Focus Explain how the international monetary system works. Review the system’s evolution. The gold standard. Bretton Woods Reasons for the Bretton Woods failure. The present system. Float versus fixed. Implications for business.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved The International Monetary System The institutional arrangements that countries adopt to govern exchange rates. Dollar, Euro, Yen and Pound “float” against each other. Floating exchange rate: Foreign exchange market determines the relative value of a currency. Some countries use other institutional arrangements to fix their currency’s value.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Some countries use: Pegged exchange rate. Value of currency is fixed relative to a reference currency. Dirty float. Hold currency value within some range of a reference currency. Fixed exchange rate. Set of currencies are fixed against each other at some mutually agreed upon exchange rate. Require some degree of government intervention.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved The Gold Standard Roots in mercantile trade. Inconvenient to ship gold, changed to paper - redeemed for gold. Seeking a “balance of trade” equilibrium. Pegging currencies to gold and guaranteeing convertibility.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Balance of Trade Equilibrium Trade Surplus Gold Increased money supply = price inflation. Decreased money supply = price decline. As prices decline, exports increase and trade goes into equilibrium.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Bretton Woods 1944: 44 countries meet in New Hampshire. Fixed exchange rates deemed desirable. Agree to peg currencies to US dollar that is convertible to gold at $35/oz. Promise not to devalue currency for trade purposes and will defend currencies. Created: World Bank International Monetary Fund.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved The Role of the IMF Want to avoid problems following WWI. Discipline: Fixed rate imposes discipline: Need to maintain rate stops competitive devaluations. Imposes monetary discipline, curtailing inflation. Flexibility: Lending facility: Lend foreign currencies to countries having balance- of-payments problems. Adjustable parities: Allow countries to devalue currencies more than 10% if B of P was in “fundamental disequilibrium’.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved The Role of the World Bank International Bank for Reconstruction and Development (IBRD). Rebuild Europe’s war-torn economies. Overshadowed by the Marshall Plan. Turns to ‘development’. Lending money to Third World nations. Agriculture. Education. Population control. Urban development. IBRD raises money in bond market and lends at ‘market rate’. International Development Agency raises money through subscriptions and lends to very poor countries.

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McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Collapse of the Fixed Exchange Rate System Collapsed in Pressure to devalue dollar led to collapse. President Johnson financed both the Great Society and Vietnam by printing money. High inflation. High spending on imports. President Nixon took dollar off gold standard and kept 10% import tax. Countries agreed to revalue their currencies against the dollar. Bretton Woods fails when key currency (dollar) is under speculative attack. Now have a managed-float system.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved The Floating Exchange Rate Regime Jamaica Agreement Floating rates acceptable. Gold abandoned as reserve asset. IMF quotas increased. IMF continues role of helping countries cope with macroeconomic and exchange rate problems.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Exchange Rates Since 1973 More volatile: Oil crisis Loss of confidence in the dollar Oil crisis Unexpected rise in the dollar Rapid fall of the dollar and Partial collapse of European Monetary System Asian currency crisis

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McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Fixed versus Floating Exchange Rates Floating: Monetary policy autonomy. Restores control to government. Trade balance adjustments. Adjust currency to correct trade imbalances. Fixed: Monetary discipline. Speculation. Limits speculators. Uncertainty. Predictable rate movements. Trade balance adjustments. Argue no linkage between exchange rates and trade. Linkage between savings and investment. Which system is better? Evidence is unclear.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved IMF Members’ Exchange Rate Policies, 2000 Figure 10.2

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Target Zones: The European Monetary System in Retrospect An exchange rate system based on target zones involving a group of countries trying to keep their currencies within a predetermined ‘zone’, of other currencies in the group. Created in 1979: Create stability by reducing volatility and inflation. Control inflation by imposing monetary discipline. Coordinate exchange rates between EU and non-EU currencies such as the dollar and yen. Created the European currency unit (Ecu) and the exchange rate mechanism (ERM) to achieve objectives.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Crisis Management by the IMF Role has expanded to meet crisis. Currency crisis. Banking crisis. Foreign debt crisis.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Incidence of Currency Crises Number of Currency Crises per Country Figure 10.3a

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Mexican Currency Crises of 1995 Peso pegged to U.S. dollar. Mexican producer prices rise by 45% without corresponding exchange rate adjustment. Investments continued ($64B between Speculators began selling pesos and government lacked foreign currency reserves to defend it. IMF stepped in.

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McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Asian Crisis 1997: Investment boom. Excess capacity. Debt. Expanding imports.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Impact of the Asian Financial Crisis on US Imports

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McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Evaluating the IMF’s Policy Prescriptions Inappropriate policies: “One size fits all’. Moral hazard: People behave recklessly when they know they will be saved if things go wrong. Foreign lending banks could fail. Foreign lending banks have paid price for rash lending. Lack of Accountability. IMF has grown too powerful. Unclear as to the appropriateness of IMF actions.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Implications for Business Currency management. Business strategy. Forward exchange market (months not years ahead). Strategic flexibility. Corporate-government relations.