CHAPTER 8
The International Monetary System and Financial Forces
Learning Objectives
LO8-1 Describe the international monetary system’s evolution
LO8-2 Explain the Trin paradox
LO8-3 Describe the oating currency exchange rate system, including the
IMF currency arrangements
LO8-4 Discuss the purpose of the Bank for International Settlements
LO8-5 Explain the impact of fluctuating currency values
LO8-6 Discuss how foreign exchange is quoted
LO8-7 Describe the factors that inuence exchange rate movement
LO8-8 Outline the approaches to exchange rate forecasting
LO8-9 Discuss the influence of currency exchange controls on international business.
LO8-10 Summarize the influences of differences in taxation and inflation rates on international
business.
LO8-11 Explain the significance of the balance of payments (BOP) to international business
decisions.
NOTE:
International business statistics, data, and facts about countries, regions, governments, and companies can
change rapidly and dramatically. We recommend that you update this information regularly and on an
as-needed basis to present your students with timely data reflecting current global events.
As an adopter of this text, McGraw-Hill Irwin offers you a complementary online resource each month,
the International Business Newsletter. The IB Newsletter gives you an array of timely and relevant
articles, videos, country profiles, teaching suggestions, and data resources to add breadth, depth, and
richness to the ever-changing topic of international business.
Overview
Today’s international monetary system consists of institutions, agreements, rules, and processes that allow
for the payments, currency exchange, and movements of capital required by international transactions.
The main institutions are the International Monetary Fund (IMF) and the World Bank (International Bank
for Reconstruction and Development—IBRD). Here we look more closely at one of them, the IMF,
because the IMF sets the rules for the international monetary system, so its role is central. We look at the
evolution of the monetary system starting approximately 1200 A.D. through the 21st Century, with
information on The Gold Standard, Bretton Woods, and how floating currency exchange rates came into
being with the demise of The Gold Standard in 1971.
We look at external financial forces with which managers need to contend. These forces include
fluctuating currency values, currency exchange controls, taxation, and inflation and interest rates. BOP
positions can be seen as a useful guide for managers trying to negotiate these forces.
Trading in the foreign exchange (FX) currency markets can be for investment, or speculation. For
example, if you believe that the Japanese yen (¥) will weaken in terms of the U.S. dollar (U.S. $) over the
next six months, you might sell the (¥) short in the six months forward market. You are obliged to deliver
the agreed-upon number of yen in return for the agreed-upon number of U. S. $s in six months at the
exchange rate at the date of the agreement. If you are correct, and the (¥) is weaker in six months, it will
cost you less in U.S.$ to buy the agreed upon number of (¥) than it would have cost you at the agreement
date. The difference is your profit. Of course, as with any investment, there is some risk. The ¥ and U.S.$
exchange rate may not change or, even worse, from your point of view, the ¥ may strengthen against the
U.S. It is fundamental that students understand FX quotations and their relevance.
Lastly we present information on factors that cause exchange rate movement, currency exchange controls,
and the Balance of Payments and how BOP accounts work.
Suggestions and Comments
1. You can illustrate the changes of currency exchange rates over time by comparing the rates in
the text with current rates. Students feel they have learned something when they are able to use
the FX rate quotations, and this can be nicely explained in real time on any one of the many FX
websites.
2. The force of inflation can be brought home with simple comparison of common consumer
products prices today with prices last year, five, ten years ago. Inflation and then the
subsequent deflation in the housing market is a good place to begin. Food and gas prices offer
relevant examples to students as well.
3. The student who may lack confidence in quantitative skills can do well in this chapter and
build a sense of accomplishment because, although finance is quantitative, financial forces may
be presented as measures of influence.
Student Involvement Exercises
1. Have your students do research to locate examples of the effects fluctuating currency exchange
rates have on import costs.
2. When the students understand FX quotations, divide them into teams and assign each team the
same amount of money. Have them trade the currencies reported in the FT or online and see
which team has the most money at the end of a given period.
3. Students might benefit from studying two countries that have very different inflation rates and
attempting to explain the reasons.
4. Many international banks and FX websites allow you to set up a dummy FX account to both
learn and see the mechanics of currency trading. Have your students try one of these to
experience FX risk and cash free.
Guest Lecturers
1. If a nearby bank has an international department, an officer of the bank could expand on
currency trading and risks.
2. Several commodity traders and brokers deal in currency. Their insights could be interesting.
3. A U.S. Commerce Department officer might speak on BOP problems and adjustments.
4. Someone from your economics department could expand on monetary and fiscal policies and
their effects on BOP. This could also be a source for discussion of inflation, cause and effect.
5. An export/import company officer or a customs official could share examples of tariff impacts.
6. Accountants or lawyers who specialize in international taxes would be helpful for the tax
material.
Lecture Outline
I. The International Monetary System
A. A Brief History: The Gold Standard – gold at an established number of units per currency
B. Bretton Woods System – global monetary system with par value based on gold & U.S.$
Leads to Triffin paradox (deficit by reserve currency nation is unavoidable, eventually leads to
lack of confidence in reserve currency, which leads to a financial crisis
C. Floating Currency Exchange Rate System – FX rates float based on market forces
D. Current Currency Arrangements (established by IMF):
1.Exchange agreement with no separate legal tender
2.Currency board arrangement
3.Conventional fixed peg arrangement
4.Pegged exchange rate with a horizontal band
5.Crawling peg
6.Managed floating with no preannounced path for the exchange rate
7.Independently floating exchange rates
E. Bank for International Settlements (BIS) — the central bankers’ bank
II. Financial Forces
A. Fluctuating Currency Values
Values of currencies in terms of each other do not remain fixed but can rapidly fluctuate, as
they are traded in the world’s financial centers.
B. Foreign Exchange
The Yen (¥), Euro (€), British pound (£) and U.S.$ are the most widely used currencies. They are
used as:
1. Central reserve asset – asset held by government’s central bank
2. Vehicle currencies – currency used for international trade or investment
3. Intervention currencies – 3rd currency used to intervene in FX market to strengthen home
country’s currency
C. Exchange Rate Quotations
1. Forward currency market – currency contracts deliverable in 30, 60, 90 or 180 days
2. Spot rate – currency exchange rates deliverable within 2 business days
3. Forward rate – exchange rates between 2 currencies deliverable in 30, 60, 90 or 180 days
III. Causes of Exchange Rate Movement
A. Parity relationships –
1. Law of one price – like products have like prices in efficient markets
2. Arbitrage – buying & selling currency for profit with no risk
3. Fisher effect – real interest rate is nominal rate less expected rate of inflation
4. International Fisher effect – interest rate differentials for any 2 currencies reflects expected
change in their exchange rates
5. Purchasing power parity (PPP) – units of currency need to buy same basket of goods in
another country and the U.S. (“Big Mac index”)
B. Exchange Rate Forecasting
1. Efficient market approach – market prices reflect all available information
2. Random walk hypothesis – today’s prices are best predictor of tomorrow’s prices
3. Fundamental approach – econometric models capture variables and their relationships
4. Technical analysis – forward trend projection based on data analysis
IV. Currency Exchange Controls
A. Governments can limit the amount of currency exchanged in particular transactions
B. Convertible currencies can be exchanged without restrictions
V. Taxation – 3 types used to generate revenue:
A. Income tax
B. Value-added tax (VAT)
C. Withholding tax
VI. Inflation and Interest Rates
1. Monetary policies deal with the amount of money in circulation and whether and how
fast the amount grows. Fiscal policies deal with the collecting of money (taxes) and the
spending of money by governments.
B. Importance of Inflation for Business (Table 8.4)
1. Inflation is the trend of rising prices and measured by a consumer price index (CPI)
2. High inflation rates may encourage borrowing as borrowers hope to repay the loan with
cheaper money.
3. For the same reason such rates discourage lending. The money holder tends to buy
something expected to increase in value rather than lending or investing the money in
business.
4. High inflation makes capital expenditure spending planning more difficult.
C. International business must deal with different inflation rates in more than one country.
1. The countries with higher rates see their currencies decrease in value; their goods and
services become more expensive. Governments may impose currency or other controls
or tighten their monetary and fiscal policies.
2. Business in countries with lower inflation rates may look for the opposite effects.
3. Countries where an IC raises and invests capital are affected by relative inflation rates.
VII. Balance of Payments (BOP)
A. BOP is important to management, which should foresee and adjust to government
measures to correct BOP disequilibrium, particularly if it is a deficit.
B. BOP Accounts
1. debits (-) are funds flowing out to other counties
2. credits (+) are funds flowing in from other countries
C. Deficits and Surpluses in BOP Accounts
1. Deficits are responses to local conditions – excessive inflation, low productivity, or
inadequate savings.
2. Current account deficits mean country is importing capital
3. Surpluses will pay for imports and come back as foreign-owned investments
Global Debate
The focus of this Global debate explores the debate: “Fixed FX Rates, Perhaps Hooked to Gold, or
Floating Rates Hooked to Faith?” Currency is the “lubricant” for global trade but what backs a
country’s currency was long-considered a determinant of global FX stability. Stepping away from the
Gold Standard created floating exchange rates and has been the focus of debate as to its causes of global
economic and currency volatility. This serves as a starting point for a stimulating class discussion on the
viability of fixed or floating exchange rates
Global Debate
Debate: Fixed FX Rates, Perhaps Hooked to Gold, or Floating Rates, Hooked to Faith?
Most economists support the idea that floating exchange rates are beneficial for the world
economy. A small minority of experts advocates a return to the gold standard and fixed exchange
rates. Let’s further consider this choice.
Worldview 1
Central Reserve/National Currency Conflict
Every member of the IMF keeps a reserve account, a bit like a savings account, with holdings the country
can draw on when needed to finance trade or investments or to intervene in currency
markets. Countries with the largest reserve accounts are China, Japan, Taiwan, Russia, Korea, India, and
Hong Kong. The reserve assets are gold, foreign exchange, SDR, and reserve
positions in the IMF. The U.S. dollar has been the most used central reserve asset in the world since the
end of World War II, and at the end of March, 2011, roughly 34 percent of the world’s reserve assets were
held in dollars and 15 percent in euros. Since 2007, the trend has been downward for the dollar and the
euro. The dollars, held in the form of U.S. Treasury bonds, earn interest, so the more dollars held in the
central reserve account, the better. But the countries holding those U.S. dollars in their foreign reserve
accounts don’t want their central reserve asset to lose value, and therein lies a contradiction: at some
point, holding large numbers of U.S. dollars (or any other product) in supply causes them to lose value.
Worldview 2
G7 FX Intervention
After the Japanese earthquake that struck on the east coast of Honshu on
March 11, 2011, the yen strengthened considerably. In the *rst week after
the earthquake, it had hit an all-time high against the U.S. dollar of Y76.25.
This strengthening may seem illogical at *rst, since we would expect that a
country facing a disaster would have a weakening currency. There was
severe damage to Japan’s economy and the Bank of Japan’s pumped in
liquidity to provide market
stability. All the more reason to expect that the yen would weaken. But
instead, the yen strengthened, threatening the stability of global economic
markets.