International Monetary System Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 10

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall Currency Values and Business Exchange rates affect activities of both domestic and international firms Devaluation Revaluation Export prices Import prices

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall Major World Currencies Source: Based on Economic Report of the President, Table B110, multiple years

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall Stability and Predictability Stable exchange rates Improve accuracy of forecasts and financial planning Predictable exchange rates Reduce surprises of unexpected rate changes

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall Value of U.S. Dollar Source: Based on Economic Report of the President, Table B110, multiple years

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall Buying Power Example Cost in New York… $60 Purchasing Power Cost in Japan… $80 Cost in Mexico… $30

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall Law of One Price Identical item must have an identical price in all countries when price is expressed in a common currency

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall Big Mac Index Uses law of one price and cost of a Big Mac Uses law of one price and cost of a Big Mac Fairly good predictor of long-term rates Fairly good predictor of long-term rates Estimates undervalued and overvalued currencies Estimates undervalued and overvalued currencies

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall Purchasing Power Parity Relative ability of two nations’ currencies to buy the same “basket” of goods in those two nations Focuses squarely on local purchasing power of a currency Considers price levels in adjusting relative currency values

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall Effects of Inflation Inflation erodes a currency’s purchasing power!

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall Inflation: Key Factors Monetary policy directly affects interest rates and money supply Fiscal policy indirectly affects taxes and spending High employment raises wages, which are embodied in consumer prices High interest rates lower borrowing and spending, which lowers inflation Exchange rates adjust to maintain PPP Money supply Employment Interest rates Adjustment

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall Fisher Effect International Fisher Effect Nominal interest rate = real rate + inflation rate Difference in nominal interest rates supported by two nations’ currencies will cause an equal but opposite change in their spot exchange rates Interest Rates

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall Evaluating PPP Added costs Trade barriers Business confidence & psychology

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall Two Market Views Efficient market view Forward exchange rates best predict future rates Inefficient market view Additional information can improve rate forecasts

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall Techniques of Forecasting Fundamental analysis Statistical modeling Technical analysis Chart currency trends Forecasting difficulties Flawed data Human error

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall Adjusting to Currency Swings Strong currency: Prune operations Adapt products Source abroad Freeze prices Export strategies in the face of currency swings Weak currency: Source domestically Grow at home Push exports Reduce expenses

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall Gold Standard: Early Years Monetary system from the 1700s to 1939 that linked national currencies to specific values of gold Restricted monetary policies Reduced exchange-rate risk Corrected trade imbalances

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall Gold Standard Collapse  Printing excessive money caused high inflation  British pound returns at its pre-inflation level  U.S. dollar returns at its lower (devalued) level  Competitive devaluations force system to collapse

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall Fixed exchange rates Built-in flexibility International Monetary Fund World Bank (IBRD) Bretton Woods Agreement International monetary system based on value of U.S. dollar (1944 to 1973)

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall End of Bretton Woods  Nations demand gold in return for their paper U.S. dollars  Nations raise their currency values relative to dollars  Persistently weak dollar forces nations to leave the system  Most currencies begin to float freely against the dollar

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall Jamaica Agreement Formalized the managed float system of exchange rates as the new international monetary system Free float system Currencies float without government intervention Managed float system Currencies float with government intervention

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall The System Today Managed float system Pegged exchange rates Currency board European monetary system

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall Financial Crises  Developing nations  Mexico  Southeast Asia  Russia  Argentina

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall Europe’s Debt Debt levels spiraled out of control in some European nations recently. In 2010, the IMF and EU organized a bailout for Greece, but the austerity measures it imposed angered the people.

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall Future of the International Monetary System Greater IMF transparency Better manage risks Monitor “hot” money flows Private sector involvement