Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon Chapter 13 The international monetary system

Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon Learning objectives 1.Apply the concept of demand and supply to the determination of the equilibrium exchange rate between nations’ currencies. 2.Revisit the determination of the exchange rate by briefly examining the polar extremes of freely flexible and fixed exchange rates. 3.Explain and evaluate the various kinds of exchange rate systems that trading nations use. 4.Describe the gradual reform of the international monetary system, including the three different exchange rate systems that the nations of the world have used. 5.Discuss the recent history of, and changes in, Australia's exchange rate.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon Exchange rate systems The two types of exchange rate system are: flexible or floating exchange rates –exchange rate is determined by demand and supply fixed exchange rates –government intervention in the foreign exchange market offsets the changes in exchange rate caused by the demand and supply factors.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon Adjustments under alternative exchange rate systems P Q Dollar price of one pound Pounds S1S1 D0D0 D1D1 D0D0 D1D1 S1S1 C X BA 2 3 1

Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon Demand and supply for pounds Demand curve –Down-sloping derived demand for pounds by Australians –When dollar price of 1 pound falls, UK goods, services and assets become cheaper and so Australians demand more pounds to buy more of them and vice versa. Supply curve –Up-sloping supply of pounds –When dollar price of 1 pound rises, Australian goods, services and assets become cheaper for UK residents and so they supply more pounds so as to get dollars to buy them and vice versa. Exchange rate determined when demand for pounds equals supply of pounds

Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon Freely floating exchange rates Depreciation and appreciation –Depreciation in the exchange rate is an increase in the number of units of a country’s currency required to buy a single unit of some foreign currency. –Appreciation is a reduction in the number of units of a country’s currency required to buy a single unit of some foreign currency.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon Determinants of exchange rates Changes in taste Relative income changes among countries Relative price changes Relative interest rates Speculation

Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon Flexible rates and the balance of payments Flexible exchange rates automatically adjust so as to eliminate balance of payments deficits or surpluses. This is one of the main advantages of flexible exchange rates.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon Flexible exchange rates Disadvantages of floating exchange rates are: uncertainty and diminished trade –uncertainty on prices due to movements in the exchange rate terms of trade instability in the macroeconomic environment.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon Fixed exchange rates Nations have often fixed or pegged the exchange rate to overcome the disadvantages of floating exchange rates. Fixed exchange rates require adequate reserves to accommodate periodic balance of payment deficits.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon Fixed exchange rates (cont.) Trade policies –To maintain a fixed exchange rate a country may enact protectionist trade policies to increase net exports. Exchange controls: rationing –Involves restricting imports to the amount of foreign exchange earned by exports Domestic macroeconomic adjustments –Use fiscal and monetary policies to adjust GDP to a level consistent with the fixed exchange rate

Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon Trade and finance problems Reform of the international monetary system has evolved gradually. –The gold standard –The Bretton Woods monetary system –The ‘managed float’

Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon The gold standard A system under which the value of a nation’s monetary unit was backed by gold rather than fiat. Gold standard conditions are: –A nation must define the monetary unit in terms of a certain quantity of gold. –A nation must maintain a fixed relationship between stock of gold and the domestic currency. –A nation must allow gold to be freely exported and imported.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon The gold standard (cont.) Gold flows ensured fixed exchange rates. Domestic macro adjustments via changes in the supply of money Advantages of gold standard: –reduction in uncertainty and risk which promotes international trade –automatically corrects balance of payments deficits or surpluses.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon The gold standard (cont.) Disadvantages of gold standard: –Nations must accept domestic adjustments in the form of higher unemployment or inflation. –Countries must have sufficient reserves of gold. Demise of the gold standard –Occurred during the Depression years of the 1930s

Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon Bretton Woods monetary system Bretton Woods international conference 1944 International Monetary Fund (IMF) created Adjustable peg system of exchange rate emerged –A system by which members of the IMF were obligated to define their monetary units in terms of gold (or US dollars), establishing par rates of exchange between the currencies of all other members, and to keep their exchange rates within 1 per cent of these par values

Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon IMF and pegged exchange rates Stabilisation funds –Supplies of both foreign and domestic moneys and gold held with the central bank or treasury for the purpose of intervention in the foreign exchange market to maintain the par value of the exchange rate IMF credit to nations with short term balance of payments deficits

Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon Bretton Woods monetary system (cont.) Fundamental imbalances: adjusting the peg Demise of the Bretton Wood –Dilemma: dollars and the deficits—was US dollar ‘as good as gold’? –Emergence of floating rates

Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon The ‘managed float’ An exchange rate system where central banks buy and sell foreign exchange to smooth out short-run or day-to-day fluctuations in rates. Encourages international trade and finance, while allowing for trend or long-term exchange rate flexibility to correct fundamental payments disequilibria.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon The ‘managed float’ (cont.) Liquidity and special drawing rights –Special drawing rights are bookkeeping entries at the IMF, available to IMF members in proportion to their IMF quotas, that may be used to settle payments deficits or satisfy reserve needs in place of foreign exchange or gold.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon The ‘managed float’: an evaluation Arguments for managed float are: trade growth managing turbulence. Arguments against are: volatility and adjustment: balance of payments imbalances still persist reinforcement of inflation.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon Exchange rate history: Australia Setting exchange rates in the 1970s Pegged to the US dollar Pegged to the trade-weighted index The floating of the exchange rate (1983) –Floating and the current account crisis –Recovery during the late 1980s –The early 1990s and the 1990 recession—reduced capital inflows due to lower interest rates –The late 1990s and the Asian crisis –Into the 2000s gradual appreciation of the AUD against the US dollar as a result of Australian relative growth, relatively high interest rates and growth in commodity prices but dampened by drought’s impact on Australia's current account

Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon $US–$AUD exchange rate

Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon Next chapter Extension Chapter 1 The theory of consumer behaviour