Finance 476 Lecture 2

Brief History of the International Monetary System prior to 1945 (WW II): often used gold standard currencies were pegged to gold a currency was convertible into a set amount of gold Question: Today we do not use gold standard, what gives money value?

Properties of Gold Standard 1. Little inflation 2. Exchange rate set by government 3. Because of (2), exchange rate may not be in sync with underlying economy. 4. Little control of money supply. 5. Strict currency controls.

Currency Crisis under Gold Standard Example: Importer in France wants to buy goods from exporter in Germany needs German currency (marks) Bank of France Importer francs marks

Where does French central bank get marks? Bank of France Bundesbank marks gold If importing (spending gold) more than exporting (earning gold), the country eventually runs out of gold reserves. MAJOR CRISIS

Bretton Woods Agreement countries used US dollar (and £) as reserves instead of gold pegged value of currency to $US US kept the $US pegged to gold ($35 US per ounce) International Monetary Fund (IMF) was created to help countries with declining reserves currencies became tradable by public beginning of modern currency markets

End of Bretton Woods early 1970’s: US rapidly increased money supply because of fixed exchange rates, US inflation was exported to other countries countries began dropping out and US goes off gold standard in 1973

Unprecedented Change in Currency Markets Recently… 1999 – introduction of the euro (€) common currency for: ItalyAustria FrancePortugal NetherlandsSpain GermanyIreland BelgiumLuxembourg GreeceFinland Good or Bad for these countries?

Exchange Rate Systems Today’s currency markets a mixture of different currency systems 1)Fixed Rate: a country pegs the value of its currency to the value of some other currency (usually $US) 2) Clean Float (Free Float): country allows value of currency (i.e. exchange rates) to be determined freely in the market 3) Dirty Float (Managed Float): country allows value of currency to be determined in market in long term, but may intervene to slow a depreciation or appreciation in the short term - intervention through use of central bank’s FOREX reserves

Determinants of the Exchange Rate in Floating System Quantity Price (exchange rate) demand supply Exchange rates are determined by supply and demand!

Determinants of Supply and Demand for Currency 1. Trade Surplus/Deficit 2. Strength of Economy 3. Central Bank Intervention 4. Risk 5. Inflation 6. Interest Rates (real rates)

Flow of Investment Funds and Exchange Rates Froot and Ramadorai (2002, Harvard working paper) examine flow of institutional investor’s funds between currencies look at fundamental values of currencies based on inflation and interest rate differentials find flow of funds into or out of a currency related to temporary changes in exchange rates long term currency values correlated with fundamentals little correlation between flows and fundamentals, flows seem to be correlated with short term departures from fundamental value