80.
Increasingly the _____ has been acting as macroeconomic police of the
world economy, insisting that countries seeking significant borrowings
adopt certain macroeconomic policies.
A.
ECOSOC
B.
IMF
C.
UN
D.
World Bank
Increasingly the IMF has been acting as macroeconomic police of the world
economy, insisting that countries seeking significant borrowings adopt IMF-
mandated macroeconomic policies.
Essay Questions
81.
What is international monetary system? What are the major trading
currencies?
The international monetary system refers to the institutional arrangements
that govern exchange rates. The four major trading currencies are the U.S.
dollar, the European Union’s euro, the Japanese yen, and the British pound.
82.
Explain the floating exchange rate regime. Give examples.
When the foreign exchange market determines the relative value of a
currency, the country is adhering to a floating exchange rate system. The
world’s four major trading currencies, the Japanese yen, the U.S. dollar, the
British pound, and the European Union’s euro are all free to float against
each other. Consequently, their exchange rates are determined by market
forces and fluctuate against each other daily.
83.
Compare and contrast a pegged exchange system with a dirty float system
of exchange rates.
A pegged exchange rate means the value of the currency is fixed relative to
a reference currency, such as the U.S. dollar, and then the exchange rate
between that currency and other currencies is determined by the reference
currency exchange rate. Some countries, while not adopting a formal
pegged rate, try to hold the value of their currency within some range
against an important reference currency such as the U.S. dollar, or a
“basket” of currencies. This is referred to as a dirty float.
84.
How does a fixed exchange rate system work?
In a fixed exchange rate system, the values of a set of currencies are fixed
against each other at some mutually agreed upon exchange rate. Prior to
the introduction of the euro, many EU countries participated in a fixed
exchange rate system.
85.
What is gold standard? What was the major advantage of the system?
Pegging currencies to gold and guaranteeing convertibility is known as the
gold standard. By 1880, most of the world’s major trading nations, including
Great Britain, Germany, Japan, and the United States, had adopted the gold
standard. Because each currency was linked to gold under the system, it
was easy to determine the value of any currency in units of any other
currency.
The great strength claimed for the gold standard was that it contained a
powerful mechanism for achieving balance-of–trade equilibrium by all
countries.
86.
With the help of an example, explain how balance-of-trade equilibrium is
maintained under the gold standard.
A country is in balance-of-trade equilibrium when the income its residents
earn from exports is equal to the money its residents pay to other countries
for imports (the current account of its balance of payments is in balance).
Under the gold standard, when Japan has a trade surplus, there will be a
net flow of gold from the U.S. to Japan. These gold flows automatically
reduce the U.S. money supply and swell Japan’s money supply. An increase
in money supply will raise prices in Japan, while a decrease in the U.S.
money supply will push U.S. prices downward. The rise in the price of
Japanese goods will decrease demand for these goods, while the fall in the
prices of U.S. goods will increase demand for these goods. Thus, Japan will
start to buy more from the U.S., and the U.S. will buy less from Japan, until
a balance-of-trade equilibrium is achieved.
87.
What is the Bretton Woods agreement? How was it different from the gold
standard?
The Bretton Woods agreement, signed in 1944, called for a system of fixed
exchange rates whereby countries would fix the value of their currency to
gold. Unlike the gold standard, countries were not required to exchange
their currencies for gold. Instead, only the dollar remained convertible to
gold, and each country decided what its exchange rate relative to the dollar
was to be and then calculated the gold par value of the currency based on
that selected dollar exchange rate. All participating countries agreed to try
to maintain the value of their currencies within 1 percent of the par value by
intervening in the market as necessary.
88.
Identify the multinational institutions that were established at the Bretton
Woods agreement. What were their roles in the international monetary
system?
At the Bretton Woods meeting in 1944, two multinational institutions, the
International Monetary Fund (IMF) and the World Bank, were established.
The IMF was established to maintain order in the international monetary
system. The IMF sought to achieve this goal through a combination of
discipline and flexibility. The World Bank, also known as the International
Bank for Reconstruction and Development, was established to help the
war-torn economies of Europe rebuild. However, the World Bank soon
turned its attention to providing assistance to other countries, particularly
Third World countries.
89.
Explain the events that led to the failure of the Bretton Woods system.
The Bretton Woods system started to fall apart in the late 1960s, and finally
collapsed in 1973. The system fell apart because the U.S. dollar, which
played a central role in the regime, was being pressured to devalue. To
finance both the Vietnam conflict and his welfare programs, President
Lyndon Johnson backed an increase in U.S. government spending that was
not financed by an increase in taxes. Instead, it was financed by an increase
in the money supply, which led to a rise in price inflation from less than 4
percent in 1966 to close to 9 percent by 1968.
The increase in inflation and the worsening of the U.S. foreign trade
position gave rise to speculation in the foreign exchange market that the
90.
Discuss the significance of the Jamaica Agreement.
The 1976 Jamaica Agreement formalized the floating exchange rate regime
that followed the collapse of Bretton Woods. The agreement established the
rules for the international monetary system that are in place today. Under
the agreement, floating rates were declared to be acceptable, gold was
abandoned as a reserve asset, and total annual IMF quotas were increased.
Under the Jamaica Agreement, the IMF continued in its role of helping
countries cope with macroeconomic and exchange rate problems.
91.
Discuss the arguments that favor a floating exchange rate system against a
fixed exchange rate system.
There are two main elements in the case for floating exchange rates:
monetary policy autonomy and automatic trade balance adjustments. Under
a fixed exchange rate system, a country’s ability to expand or contract its
money supply is limited by the need to maintain exchange rate parity. Under
a floating exchange rate system, however, monetary control is restored to
the government enabling a government to pursue domestic polices that
involve expanding or contracting the money supply without worrying about
maintaining exchange rate parity. Similarly, a floating exchange rate system
a country can correct a trade imbalance through currency adjustments, a
practice that is impossible under a fixed rate system.
92.
Present the common arguments that favor fixed exchange rates.
The case for fixed exchange rates revolves around arguments about
monetary discipline, speculation, uncertainty, and the lack of connection
between the trade balance and exchange rates. Supporters of a fixed
exchange rate system suggest that the monetary discipline required by a
fixed exchange rate system allows a government to ignore political
pressures that might result in a rapid expansion of the money supply and
high inflation.
Advocates of fixed exchange rates argue that the system limits the
destabilizing effects of speculation. Similarly, because the fixed rate system
is more predictable, according to supporters, international trade and
investment will be encouraged. Finally, advocates of fixed exchange rates
suggest that trade deficits are determined by the balance between savings
and investment in a country, not by the external value of its currency.
Therefore, the need for floating exchange rates to correct trade imbalances
93.
Describe the different exchange rate policies that are in practice today.
Governments around the world pursue a number of different exchange rate
policies. These range from a pure “free float” where the exchange rate is
determined by market forces to a pegged system that has some aspects of
the pre-1973 Bretton Woods system of fixed exchange rates. Some 14
percent of the IMF’s members allow their currency to float freely. Another
26 percent intervene in only a limited way (the so-called managed float). A
further 22 percent of IMF members now have no separate legal tender of
their own.
The remaining countries use more inflexible systems, including a fixed peg
arrangement (28 percent) under which they peg their currencies to other
currencies, such as the U.S. dollar or the euro, or to a basket of currencies.
Other countries have adopted a system under which their exchange rate is
allowed to fluctuate against other currencies within a target zone (an
adjustable peg system).
94.
Discuss the pegged exchange rate regime.
Under a pegged exchange rate regime, a country will peg the value of its
currency to that of a major currency so that, for example, as the U.S. dollar
rises in value, its own currency rises too. Pegged exchange rates are
popular among many of the world’s smaller nations. As with a full fixed
exchange rate regime, the great virtue claimed for a pegged exchange rate
is that it imposes monetary discipline on a country and leads to low
inflation.
95.
What is a currency board? Why do countries choose this type of system?
What are the disadvantages of this type of arrangement?
A country that introduces a currency board commits itself to converting its
domestic currency on demand into another currency at a fixed exchange
rate. To make the commitment credible, the currency board holds reserves
of foreign currency equal at the fixed exchange rate to at least 100 percent
of the domestic currency issued. The system is attractive because it limits
the ability of the government to print money, and thereby create inflationary
pressure. Under a strict currency board, interest rates will adjust
automatically. However, critics point out that if local inflation rates remain
higher than the inflation rate in the country to which the currency is pegged,
the currencies of countries with currency boards can become uncompetitive
and overvalued. Also, the system does not permit governments to set
interest rates.
96.
Compare currency crisis, banking crisis, and foreign debt crisis.
A currency crisis occurs when a speculative attack on the exchange value of
a currency results in a sharp depreciation in the value of the currency or
forces authorities to expend large volumes of international currency
reserves and sharply increase interest rates to defend the prevailing
exchange rate. In contrast, a banking crisis refers to a loss of confidence in
the banking system that leads to a run on banks as individuals and
companies withdraw their deposits. Finally, a foreign debt crisis is a
situation in which a country cannot service its foreign debt obligations,
whether private sector or government debt.
These crises tend to have common underlying macroeconomic causes: high
relative price inflation rates, a widening current account deficit, excessive
expansion of domestic borrowing, and asset price inflation (such as sharp
increases in stock and property prices).
97.
Recent policies of the IMF have drawn a lot of criticism. Discuss these
criticisms.
The IMF‘s policies designed to cool overheated economies by reining in
inflation and reducing government spending have been highly criticized. One
criticism is that the IMF’s “one-size-fits-all” approach to macroeconomic
policy is inappropriate for many countries. The IMF has also been accused
of intensifying moral hazard through its rescue packages. Finally, it has
been suggested that the IMF has become too powerful for an institution
that lacks any real mechanism for accountability.
98.
Discuss the criticism that IMF is exacerbating a problem called moral
hazard.
Moral hazard arises when people behave recklessly because they know they
will be saved if things go wrong. The IMF has been criticized for
exacerbating moral hazard with its rescue programs. According to critics,
many Japanese and Western banks made loans to overleveraged Asian
companies during the 1990s, and should now be forced to pay the price for
their actions. Instead, the IMF, through its rescue package, is reducing the
probability of debt default and effectively bailing out the banks.
99.
How can international companies reduce their economic exposure in a
world of constantly fluctuating exchange rates?
For companies operating in a world of volatile exchange rates, it is
important to pursue strategies that reduce the economic exposure of the
firm. One way to maintain strategic flexibility is to disperse production to
different locations around the globe. This strategy allows companies to
hedge currency fluctuations. Companies can also build strategic flexibility
by contracting out their manufacturing. This strategy allows a company to
shift suppliers from country to country in response to changes in relative
costs brought about by exchange rate movements. Finally, companies
should be aware of IMF macroeconomic policies that might affect their
operations. IMF policies often result in a sharp contraction in demand in the
short run, and an expansion of demand in the long run. Companies need to
follow the IMF policies and adjust their strategies accordingly.
100.
Do you think businesses can influence government policies? Explain your
answer.
As major players in the international trade and investment environment,
businesses can influence government policy toward the international
monetary system. For example, intense government lobbying by U.S.
exporters helped convince the U.S. government that intervention in the
foreign exchange market was necessary. With this in mind, business can
and should use its influence to promote an international monetary system
that facilitates the growth of international trade and investment. Student
answers will vary for this question.