International Monetary Markets Mikkeli 2005 Compiled by Rulzion Rattray

International Monetary System For 5,000 years Gold was the major medium of exchange. Gold Standard ( ). –Every country fixed the price of its currency against the value of gold e.g. 1$ =1ounce –This meant that the government in question had to buy and sell gold at this value –Currencies allowed to fluctuate after the war the US $ was the only currency that remained convertible to gold. Bretton Woods System ( ) –Countries agreed to a fixed rate of exchange with the dollar or with gold. Post Bretton Woods to present: –Typified by Floating exchange systems

Exchange Rate Systems Fixed Rate: –Determined by national government & controlled by the central bank –May help economic stability, help prioritise important projects, provide stability in international trade prices. –Can result in resource misallocation, distortion of foreign exchange demand and restrict company performance Crawling Peg System: –Automatic; determined by a formulae set around a par value and a variation around this figure. –Overvalued currencies can result in a country being forced to defend its value

Exchange Rate Systems Target Zone Systems –E.g. ERM ( European Exchange Rate Mechanism ) –Euro Managed Float System ( Dirty Float ) –Based on the governments view of an appropriate rate; + o- 40 countries e.g. China, Independent Float System ( Clean Float ) –Exchange rates allowed to float freely. –Continuous adjustment, prevent persistent deficits, by lowering the exchange rate. –Central bank not required to hold reserves –Can ensure the independence of trade policies –Depreciating currencies will reduce cost of goods on world markets, however in medium term will raise inflation and hence demand for higher wages.

Determination of Exchange Rates Purchasing Power Parity (PPP) –Exchange rates between countries should in long run should equalise the price of goods. –Absolute PPP argues that exchange rates should be determined by relative prices of same goods. Difficult in practice because of use of different products. –Relative PPP this concentrates on using the change in prices between countries to change the exchange rate.

PPP principles assume free movement of all goods ignoring barriers to trade. Many items not traded e.g. land buildings etc. Can allow departures from PPP to persist. Fails to recognise cross border transportation costs PPP ignores the importance of capital flows Exchange Rates PPP

IRP principle looks at how interest rates are linked between different countries. –IRP suggests difference in national interest rates for securities of similar risk should be equal but opposite to forward rate discount or premium for the foreign currency. Forward Rate: –The rate at which a bank is willing to exchange one currency for another at some point in the future. Exchange Rates Interest Rate Parity ( IRP )

Interest Rate Parity ( IRP ) Like PPP, IRP can be deviated by transaction costs, tax factors and political risk. Investors will expect to be rewarded for the greater risk of investing on a foreign country. International Fisher Effect argues that the spot exchange rate should change in equal amount but in the opposite direction to the difference in interest rates between two countries. –10 year yen bond earning 4% compared to 6% interest available in $, assumes a 2% appreciation per year in the value of the Yen against the $.

Predicting Exchange Rates PPP suggest that in the long run exchange rates determined by price of identical goods IRP holds that the interest difference will be matched by the premium of forward exchange rates. Forecasting future exchange rates requires the analysis of economic and non economic factors as well as reference to black market exchange rates.

Interpretation Balance of Payments: –Summary of all economic transactions carried out by a country, using double entry bookkeeping. –Increasing globalisation has meant that MNE’s investing abroad and exporting back products can increase Balance of payments deficit, but be seen as positive. E.g. $52.6 billion trade deficit with China but a large proportion of this is US MNE’s exporting to US

Foreign Exchange Markets Markets where currencies are bought and sold, average daily turnover $1.5 Trillion, in % of this in US $. –London largest FE market in world. –Main functions; international payment, short term supply of foreign currencies and hedging against FE risk Stock Markets –Increasingly global & interconnected

References Cesarano, F., (1999), “Competitive money supply: the international monetary system in perspective”, Journal of Economic Studies, Vol. 26 No. 3, pp , MCB University Press. (Available Emerald) Eichengreen, B. (1995), ``The endogeneity of exchange-rate regimes'', in Kenen, P.B. (Ed.) (1995), “Understanding Interdependence”, Princeton University Press, Princeton,NJ. Griffiths, A., and Wall, S., (Eds), (1999), “Applied Economics”, Prentice Hall. Jackson, J.H., (1997), “The World Trading System”, Cambridge, MA: MIT Press. Kenen, P.B., Papadia, F. and Saccomanni, F. (Eds) (1994), “The International Monetary System”, Cambridge University Press, Cambridge. Pilbeam, K., (2001), “The East Asian financial crisis: getting to the heart of the issues”, Managerial Finance, Vol 27 pp (Available Emerald) Shenkar, O. and Luo, Y.(2004), “International Business”, John Wiley and Sons, Inc. (Available Library)