1. c h a p t e r eighteen © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. Prepared by: Fernando & Yvonn Quijano The International Financial System

2. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 18: The International Financial System 2 of 28 After studying this chapter, you should be able to: Understand how different exchange rate systems operate. Discuss the three key aspects of the current exchange rate system. Discuss the growth of international capital markets. Fluctuating Exchange Rates Cause Molson Breweries to Sell the Canadiens LEARNING OBJECTIVES 1 2 3 In this chapter, we look further at the international financial system and at the role central banks play in the system.

3. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 18: The International Financial System 3 of 28 Floating currency The outcome of a country allowing its currency’s exchange rate to be determined by demand and supply. Exchange rate system An agreement among countries on how exchange rates should be determined. Exchange Rate Systems LEARNING OBJECTIVE 1

4. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 18: The International Financial System 4 of 28 Exchange Rate Systems Remember That Modern Currencies Are Fiat Money Managed float exchange rate system The current exchange rate system under which the value of most currencies is determined by demand and supply, with occasional government intervention. Fixed exchange rate system A system under which countries agree to keep the exchange rates among their currencies fixed.

5. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 18: The International Financial System 5 of 28 The Current Exchange Rate System LEARNING OBJECTIVE 2 Euro The common currency of many European countries. The Floating Dollar 18 - 1 U.S. Dollar-Canadian Dollar and U.S. Dollar-Yen Exchange Rates, 1973-2004

6. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 18: The International Financial System 6 of 28 What Determines Exchange Rates in the Long Run? THE THEORY OF PURCHASING POWER PARITY Purchasing power parity The theory that in the long run exchange rates move to equalize the purchasing power of different currencies. Three real-world complications keep purchasing power parity from being a complete explanation of exchange rates, even in the long run:  Not all products can be traded internationally.  Products and consumer preferences are different across countries.  Countries impose barriers to trade. Tariff A tax imposed by a government on imports. Quota A limit on the quantity of a good that can be imported. The Current Exchange Rate System

7. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 18: The International Financial System 7 of 28 The Big Mac Theory of Exchange Rates 18 - 2 Is the price of a Big Mac in Finland the same as the price of a Big Mac in Chicago? COUNTRY BIG MAC PRICE IMPLIED EXCHANGE RATE ACTUAL EXCHANGE RATE Argentina4.74 pesos 1.55 pesos per dollar 2.89 pesos per dollar Japan250 yen 82 yen per dollar 107 yen per dollar Britain1.88 pounds 0.61 pound per dollar 0.55 pound per dollar Switzerland 6.30 Swiss francs 2.06 Swiss francs per dollar 1.25 Swiss francs per dollar Indonesia14,599 rupiahs 4,771 rupiahs per dollar 9,542 rupiahs per dollar Canada 3.27 Canadian dollars 1.07 Canadian dollars per U.S. dollar 1.24 Canadian dollars per U.S. dollar

8. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 18: The International Financial System 8 of 28 Calculating Purchasing Power Parity Exchange Rates Using Big Macs 18-1 LEARNING OBJECTIVE 2 COUNTRYBIG MAC PRICE IMPLIED EXCHANGE RATE ACTUAL EXCHANGE RATE Brazil5.91 reals 1.93 reals per dollar 2.47 reals per dollar Poland6.49 zlotys 2.12 zlotys per dollar 3.31 zlotys per dollar South Korea2,500 won 817 won per dollar 1,004 won per dollar Czech Republic56.30 korunas 18.4 korunas per dollar 24.5 korunas per dollar

9. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 18: The International Financial System 9 of 28 What Determines Exchange Rates in the Long Run? THE FOUR DETERMINANTS OF EXCHANGE RATES IN THE LONG RUN There are four main determinants of exchange rates in the long run:  Relative price levels.  Relative rates of productivity growth.  Preferences for domestic and foreign goods.  Tariffs and quotas. The Current Exchange Rate System

10. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 18: The International Financial System 10 of 28 The Euro The Current Exchange Rate System 18 - 2 Countries Adopting the Euro

11. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 18: The International Financial System 11 of 28 Pegging Against the Dollar THE EAST ASIAN EXCHANGE RATE CRISIS OF THE LATE 1990s Pegging The decision by a country to keep the exchange rate fixed between its currency and another currency. The Current Exchange Rate System 18 - 3 By 1997 the Thai Baht Was Overvalued Against the Dollar

12. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 18: The International Financial System 12 of 28 Pegging Against the Dollar THE EAST ASIAN EXCHANGE RATE CRISIS OF THE LATE 1990s The Current Exchange Rate System 18 - 4 Destabilizing Speculation Against the Thai Baht

13. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 18: The International Financial System 13 of 28 Crisis and Recovery in South Korea 18 - 4 The South Korea economy was able to rapidly recover from the late 1990s currency crisis.

14. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 18: The International Financial System 14 of 28 Coping with Fluctuations in the Value of the U.S. Dollar 18-2 LEARNING OBJECTIVE 2

15. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 18: The International Financial System 15 of 28 International Capital Markets LEARNING OBJECTIVE 3 18 - 5 Growth of Foreign Portfolio Investment in the United States

16. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 18: The International Financial System 16 of 28 International Capital Markets 18 - 6 The Distribution of Foreign Purchases of U.S. Stocks and Bonds by Country, 2004

17. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 18: The International Financial System 17 of 28 Euro Exchange rate system Fixed exchange rate system Floating currency Managed float exchange rate system Pegging Purchasing power parity Quota Tariff

18. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 18: The International Financial System 18 of 28 Appendix 18: The Gold Standard and The Bretton Woods System The Gold Standard The End of the Gold Standard

19. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 18: The International Financial System 19 of 28 Appendix 18: The Gold Standard and The Bretton Woods System Bretton Woods System An exchange rate system that lasted from 1944 to 1971, under which countries pledged to buy and sell their currencies at a fixed rate against the dollar. International Monetary Fund (IMF) An international organization that provides foreign currency loans to central banks and oversees the operation of the international monetary system. The Bretton Woods System

20. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 18: The International Financial System 20 of 28 The Bretton Woods System Appendix 18: The Gold Standard and The Bretton Woods System 18A - 1 A Fixed Exchange Rate above Equilibrium Results in a Surplus of Pounds

21. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 18: The International Financial System 21 of 28 The Bretton Woods System Devaluation A reduction in a fixed exchange rate. Revaluation An increase in a fixed exchange rate. Appendix 18: The Gold Standard and The Bretton Woods System

22. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 18: The International Financial System 22 of 28 The Collapse of the Bretton Woods System Appendix 18: The Gold Standard and The Bretton Woods System 18A - 2 West Germany’s Undervalued Exchange Rate

23. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 18: The International Financial System 23 of 28 The Collapse of the Bretton Woods System Capital controls Limits on the flow of foreign exchange and financial investment across countries. Appendix 18: The Gold Standard and The Bretton Woods System 18A - 3 Destabilizing Speculation against the Deutsche Mark, 1971

24. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 18: The International Financial System 24 of 28 Bretton Woods System Capital controls Devaluation International Monetary Funds (IMF) Revaluation