International Money and Finance

L ECTURE O UTLINE  THEORY OF INTERNATIONAL FINANCE  Foreign Exchange Rates  HISTORY OF INTERNATIONAL MONETARY AND FINANCE STRUCTURE  The Classic Gold Standard  The Bretton Woods System (Fixed Exchange Rate System)  The Flexible Exchange Rate System  POLICY CONTROVERSIES  Which Policy? When? Why?

WHY DOES MONETARY AND FINANCE SYSTEM MATTER? International monetary system system of rules, mechanism and institutions that connects the national monetary systems into a consistent whole Role of the international monetary system: ensure exchange rate stability facilitate balance-of-payments equilibria ensure access to international liquidity What are social and political impacts of international monetary and finance structures?

4 Market for the US dollars JPY/USD 97 S D Quantity of USD FOREIGN EXCHANGE RATES The value of a currency is the function of demand for supply of that currency. The level of demand for U.S. dollars reflects the attempt of foreigners to buy US goods, services, assets, and travel to the U.S. The supply of dollars reflects the desire of U.S. buyers to buy foreign goods and services, assets, and to travel in foreign countries.

FOREIGN EXCHANGE RATES Determinants of Demand for a Currency The US Interest Rates The Inflation Rate Stronger business expectations in the US The increase of income in other countries Determinants of Supply of a Currency The US and other Interest Rates The Inflation Rate Stronger business expectations outside the US The increase of income in the US Speculation and Foreign Exchange Rates

THE BIG QUESTION: WHO BENEFITS? Who wins when USD depreciates? Who wins when USD appreciates?

WHAT DOES THIS GRAPH TELL US ABOUT US-JAPANESE FINANCIAL RELATIONS?

H ISTORY OF THE I NTERNATIONAL M ONETARY AND F INANCE S YSTEM The Classic Gold Standard (1876 – 1913) Different currency values were each pegged (fixed) to the price of gold. Convertibility guaranteed Currency exchange rates were in effect “fixed” Balance of trade equilibrium for all countries balance of payment deficit used to be balanced by selling of gold to earn money to pay for the deficits. The gold standard provided stability of exchange rates which served to promote international trade. 2-8

EXAMPLE: GOLD STANDARD EXCHANGE RATES 1 ounce gold = $ ounce gold = £ $20.67 = £ £1 = $4.8665

H ISTORY OF THE I NTERNATIONAL M ONETARY AND F INANCE S YSTEM Interwar period: World War I ended the classical gold standard in 1914 Economic disaster and increasing hyper inflation Predatory devaluations (recovery through exports) The failure of international monetary system 10 THE BRETTON WOODS SYSTEM

H ISTORY OF THE I NTERNATIONAL M ONETARY AND F INANCE S YSTEM The Bretton Woods System ( ) The result of Keynesian Compromise Giving nations the ability to regulate their own domestic economies, but permit the IMF to collectively manage global financial policies to avoid another depression Two financial institutions: IMF: maintaining stability in monetary system World Bank: promoting reconstruction and economic development Fixed Exchange Rate System established US Dollar pegged to gold at $35 per ounce Fixed exchange rates pegged to the US Dollar Countries allowed to fluctuate their currencies ± 1% of the fixed rate 2-11

The Collapse of the Bretton Woods System balance-of-payments adjustment problem: increasing balance-of-payments deficit in the USA continuing balance-of-payments surpluses in Germany and Japan The increasing volume of US dollars in international markets lack of confidence in the US dollar President Richard Nixon devaluated the USD in 1971, practically ending the fixed rate system. HISTORY OF THE INTERNATIONAL MONETARY AND FINANCE SYSTEM

The Flexible Exchange Rate System (1973 – Present) [2005 IMF Data] Countries are free to choose their systems provided that they inform IMF about their choices 36 countries, determined largely by market forces (US $, JPY, etc.) 50 countries, “Managed Floating” system (China, India, Russia). 41 countries, no national currencies 40 countries, pegged to another currency OTHERS: mixture of fixed and floating exchange-rate regimes.

HISTORY OF THE INTERNATIONAL MONETARY AND FINANCE SYSTEM How To Decide What to Choose Exchange rate stability Full financial integration Monetary independence Factors To be Considered inflation, unemployment, interest rate levels, trade balances, and economic growth.

CLASS DISCUSSION What are the advantages of flexible exchange rate system over the fixed exchange rate system? Is it a bad thing that the US dollar has been devalued against Euro over the last decade? What are the implications for the US and Europe?