The International Financial System Chapter 13 © 2003 South-Western/Thomson Learning

Slide 2 Learning Objectives  How and why international financial system is changing  Role of international financial system under Bretton Woods Accord  How present managed floating exchange rate system works  Role the dollar plays in international financial system  Roles of International Monetary Fund, World Bank, and Bank for International Settlements

Slide 3 International Financial System The numerous rules, customs, instruments, facilities, markets, and international payments to be made and funds to flow across borders.

Slide 4 International Financial System 1944 to 1973  Fixed Exchange Rate System  Exchange rate system  Currency values do not fluctuate  Official Reserve Currency  Currency used by other countries to define their own currency  U.S. dollar was official reserve currency under Bretton Woods Accord

Slide 5 International Financial System 1944 to 1973  Bretton Woods Accord  1944 agreement  Negotiated by major industrialized countries  Established fixed exchange rates with U.S. dollar serving as official reserve currency  Official Reserve Account  Balance of payments account  Records official government transactions in foreign exchange market to bring balance of payments into balance

Slide 6 International Financial System 1944 to 1973  Devalue  Under a fixed exchange rate system  To decrease value of a country’s currency  Revalue  Under a fixed exchange rate system  To increase the value of a country’s currency

Slide 7 Managed Float Exchange Rate System A system in which currency values fluctuate with changes in supply and demand, but central banks may intervene if currency values are thought to be over- or under-valued.

Slide 8 Managed Float Exchange Rate System since 1973  Floating (Flexible) Exchange Rate System  Exchange rate system  Currency values:  Determined by supply and demand  Fluctuate in response to changes in supply and demand

Slide 9 Major International Financial Organizations  International Monetary Fund (IMF)  Oversees monetary and exchange rate policies of its members who pay quotas (membership fees) used to assist countries with temporary imbalances in their balance of payments  World Bank  Investment bank  Issues bonds to make long-term loans at low interest rates to poor countries for economic development projects

Slide 10 Major International Financial Organizations  World Bank consists of  International Bank for Reconstruction & Development  Makes year loans to poor (not poorest) countries  Charges an interest rate just above the rate at which bank borrows  International Development Association  Makes interest-free loans with a maturity of years to world’s poorest countries

Slide 11 Major International Financial Organizations  International Finance Corporation  Legally separate from the World Bank, but closely associated with it  Mobilizes funding for private enterprise projects in poor countries  Bank for International Settlements (BIS)  An international financial organization that promotes international cooperation among central banks and provides facilities for international financial operations

Slide 12 Appendix: Comparing Returns in Globalized Financial System  When comparing financial instruments denominated in the same currency, investors consider return, maturity, and default risk.  If instruments are denominated in different currencies, investors and borrowers must also consider the exchange rate risk.

Slide 13 Appendix: Comparing Returns in Globalized Financial System I US = nominal U.S. return on an investment in foreign instrument that earns the nominal foreign interest rate I FOR E = expected percentage change in exchange rate plus an exchange rate risk factor I US = I FOR + E  Financial market players compare expected rates of return  They must convert all returns to an equivalent return in domestic currency

Slide 14 Comparing Returns in Globalized Financial System  Interest Rate Parity Condition when interest rates have adjusted so that rates between countries differ only by expected appreciation or depreciation of currency.

Slide 15 Appendix: Comparing Returns in Globalized Financial System Where P us = the expected U.S. inflation rate R US = I US - P US = I FOR + E - P us  Real interest rate (return) is the nominal return less expected inflation  To arrive at the equilibrium real U.S. interest rate in terms of foreign real rate and domestic and foreign expected inflation R US = R FOR + P FOR + E - P US