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Global Business Today Ninth Edition Chapter 11
The International Monetary System
Chapter Outline
OPENING CASE: The IMF and Iceland’s Economic Recovery
INTRODUCTION
THE GOLD STANDARD
Mechanics of the Gold Standard
Strength of the Gold Standard
The Period between the Wars, 1918-1939
THE BRETTON WOODS SYSTEM
The Role of the IMF
The Role of the World Bank
THE COLLAPSE OF THE FIXED EXCHANGE RATE SYSTEM
THE FLOATING EXCHANGE RATE REGIME
The Jamaica Agreement
Exchange Rates Since 1973
Country Focus: The U.S. Dollar, Oil Prices, and Recycling Petrodollars
FIXED VERSUS FLOATING EXCHANGE RATES
The Case for Floating Exchange Rates
The Case for Fixed Exchange Rates
Who is Right?
EXCHANGE RATE REGIMES IN PRACTICE
Pegged Exchange Rates
Currency Boards
CRISIS MANAGEMENT BY THE IMF
Financial Crisis in the Post-Bretton Woods Era
Country Focus: The Mexican Currency Crisis of 1995
Evaluating the IMF’s Policy Prescriptions
Global Business Today Ninth Edition Chapter 11
IMPLICATIONS FOR MANAGERS
Currency Management, Business Strategy and Government Relations
Currency Management
Business Strategy
Management Focus: Airbus and the Euro
Corporate - Government Relations
SUMMARY
CRITICAL THINKING AND DISCUSSION QUESTIONS
CLOSING CASE: Currency Trouble in Malawi
Learning Objectives
1. Describe the historical development of the modern global monetary system.
2. Explain the role played by the World Bank and the IMF in the international monetary system.
3. Compare and contrast the differences between a fixed and a floating exchange rate system.
5. Understand the debate surrounding the role of the IMF in the management of financial crises.
6. Explain the implications of the global monetary system for currency management and business
strategy.
Chapter Summary
The objective of this chapter is to explain how the international monetary system works and its
implications for international business. The chapter begins by reviewing the historical evolution of
the monetary system, starting with the gold standard and the Bretton Woods System. The chapter
explains the role of the International Monetary Fund (IMF) and the World Bank, both of which
were initiated by the Bretton Woods Conference. The fixed exchange rate system that was
initiated by the Bretton Woods Conference collapsed in 1973. The majority of the chapter explains
the workings of the current international monetary system. The pluses and minuses of fixed
exchange rates versus floating exchange rates are discussed. Scholars differ in regard to which
system is best. The current role of the IMF and the World Bank are discussed, including the
manner in which the IMF has helped nations restructure their debts.
Global Business Today Ninth Edition Chapter 11
Opening Case: The IMF and Iceland’s Economic Recovery
Summary
The opening case describes the economic crisis in Iceland in 2008. In the years prior to the crisis,
Iceland’s banks grew through international expansion financed by debt. When, because of the
global financial crisis in 2008, the banks were unable to refinance their debt, the banks went into
bankruptcy sending the economy into a nosedive. To stem the fall, Iceland turned to the IMF for
assistance. Thanks to the IMF and other foreign loans, Iceland was able to begin to turn its
economy around. The low value of the krona helped spark an export-led economic recovery. In
2013, Iceland’s economy grew at 4 percent and its unemployment rate continued to fall.
Discussion of the case can revolve around the following questions:
Suggested Discussion Questions
QUESTION 1: What type of exchange rate system does Iceland follow? Explain how this system
helped the country to recover from the 2008-2009 global financial crisis.
QUESTION 2: How would you characterize the financial crisis in Iceland in 2008? Was it a
currency crisis, a banking crisis, or a foreign debt crisis? Explain your response.
Chapter Outline with Lecture Notes, Video Notes, and Teaching Tips
INTRODUCTION
A) The international monetary system refers to the institutional arrangements that countries
adopt to govern exchange rates. When the foreign exchange market determines the relative value
Global Business Today Ninth Edition Chapter 11
of a currency, that country is adhering to a floating system. The world’s four major trading
currencies - the U.S. dollar, the European Union’s euro, the Japanese yen, and the British pound –
are all floating currencies.
B) A pegged exchange rate means that the value of a currency is fixed to a reference country and
then the exchange rate between that currency and other currencies is determined by the reference
currency exchange rate. The opening case describes Malawi’s peg to the U.S. dollar.
C) A dirty float occurs when the value of a currency is determined by market forces, but with
central bank intervention if it depreciates too rapidly against an important reference currency.
China has adopted this policy in 2005.
D) Countries that adopt a fixed exchange rate system fix their currencies against each other.
Prior to the introduction of the euro, some European Union countries operated with fixed exchange
rates within the context of the European Monetary System (EMS).
E) To understand how the current monetary system works, we must understand its evolution.
THE GOLD STANDARD
A) The gold standard had its origin in the use of gold coins as a medium of exchange, unit of
account, and store of value - a practice that stretches back to ancient times. As the volume of
international trade increased, governments agreed to convert paper currency into gold on demand
at a fixed rate.
Lecture Note: In 1961, Former Federal Reserve Board Chairman, Alan Greenspan, wrote an article
on the advantages of the gold standard. The article, which is available at
{http://www.usagold.com/gildedopinion/Greenspan.html}, is well worth reading.
Mechanics of the Gold Standard
B) The practice of pegging currencies to gold and guaranteeing convertibility is known as the gold
standard. For example, under the gold standard one U.S. dollar was defined as equivalent to
23.22 grains of "fine (pure) gold.
C) The exchange rate between currencies was determined based on how much gold a unit of each
currency would buy. The amount of a currency needed to purchase one ounce of gold was referred
to as the gold par value.
The Strength of the Gold Standard
D) The great strength claimed for the gold standard was that it contained a powerful mechanism
for simultaneously achieving balance-of-trade equilibrium (when the income a country’s
residents earn from its exports is equal to the money its residents pay for imports) by all countries.
Global Business Today Ninth Edition Chapter 11
The Period between the Wars, 1918-1939
E) The gold standard worked fairly well from the 1870s until the start of World War I. Trying to
spur exports and domestic employment, a number of countries started regularly devaluing their
currencies, with the end result that people lost confidence in the system and started to demand gold
for their currency. This put pressure on countries' gold reserves, and forced them to suspend gold
convertibility.
F) By the start of World War II, in 1939, the gold standard was dead.
THE BRETTON WOODS SYSTEM
A) In 1944, at the height of World War II, representatives from 44 countries met at Bretton
Woods, New Hampshire, to design a new international monetary system. With the collapse of the
gold standard and the Great Depression of the 1930s fresh in their minds, these statesmen were
determined to build an enduring economic order that would facilitate postwar economic growth.
The agreement reached at Bretton Woods established two multinational institutions - the
International Monetary Fund (IMF) and the World Bank. The task of the IMF would be to
maintain order in the international monetary system and that of the World Bank would be to
promote general economic development.
Video Note: The World Bank {www.worldbank.org}has been the subject of some controversy
recently. More details can be found in the video in the International Business Library on Pinterest
(http://www.pinterest.com/mheibvideos/) New World Bank Chief Zoellick Tasked with Reputation
Repair.
B) The U.S. dollar was the only currency to be convertible to gold, and other currencies would set
their exchange rates relative to the dollar. Devaluations were not to be used for competitive
purposes, and a country could not devalue the currency by more than 10% without IMF approval.
Teaching Tip: Additional information about the Bretton Woods Agreement is available at
{http://avalon.law.yale.edu/20th_century/decad047.asp}.
The Role of the IMF
C) The aim of the Bretton Woods agreement, of which the IMF was the main custodian, was to try
to avoid a repetition of the chaos that occurred between the wars through a combination of
discipline and flexibility.
Teaching Tip: More information on the IMF is available at {http://www.imf.org}. Students can
click on either “About the IMF” to get an overview of the IMF and its activities.
Discipline
Global Business Today Ninth Edition Chapter 11
D) A fixed exchange rate regime imposes discipline in two ways. First, the need to maintain a
fixed exchange rate puts a brake on competitive devaluations and brings stability to the world trade
environment. Second, a fixed exchange rate regime imposes monetary discipline on countries,
thereby curtailing price inflation.
Flexibility
E) Although monetary discipline was a central objective of the Bretton Woods agreement, it was
recognized that a rigid policy of fixed exchange rates would be too inflexible. The IMF stood
ready to lend foreign currencies to members to tide them over during short periods of balance-of-
payments deficit, when a rapid tightening of monetary or fiscal policy would hurt domestic
employment.
The Role of the World Bank
F) The official name of the World Bank is the International Bank for Reconstruction and
Development (IBRD). The bank lends money under two schemes. Under the IBRD scheme,
money is raised through bond sales in the international capital market. Borrowers pay what the
bank calls a market rate of interest - the bank's cost of funds plus a margin for expenses. A second
scheme is overseen by the International Development Agency (IDA), an arm of the bank created in
1960. IDA loans go only to the poorest countries.
Teaching Tip: More information on the World Bank can be accessed at
{http://www.worldbank.org/index.html}. Click on “Data and Research” to pull information on
World Bank activities, or on “Countries” to explore World Bank activities by country.
THE COLLAPSE OF THE FIXED EXCHANGE RATE SYSTEM
A) The collapse of the exchange rate system established in Bretton Woods can be traced to U.S.
macroeconomic policy decisions from 1965 to 1968. Under President Johnson, the U.S. financed
huge increases in welfare programs and the Vietnam War by increasing its money supply, leading
to significant inflation.
B) Speculation that the dollar would have to be devalued relative to most other currencies, as well
as underlying economics and some forceful threats by the U.S. forced other countries to increase
the value of their currencies relative to the dollar
C) The key problem with the Bretton Woods system was that, since the dollar was the base
currency, the system relied on an economically well-managed United States. When the United
States began to print money, run high trade deficits, and experience high inflation, the system was
strained to the breaking point
THE FLOATING EXCHANGE RATE REGIME
Global Business Today Ninth Edition Chapter 11
A) The floating exchange rate regime that followed the collapse of the fixed exchange rate system
was formalized in January 1976 when IMF members met in Jamaica and agreed to the rules for the
international monetary system that are in place today.
The Jamaica Agreement
B) The purpose of the Jamaica meeting was to revise the IMF's Articles of Agreement to reflect
the new reality of floating exchange rates. The three main elements of the Jamaican agreement
include the following:
i) Floating rates were declared acceptable.
ii) Gold was abandoned as a reserve asset.
iii) Total annual IMF quotas - the amount member countries contribute to the IMF - were
increased to $41 billion. Since then, they have been increased to $311 billion and
membership in the IMF has expanded to 184 countries.
Exchange Rates since 1973
C) Since March 1973 exchange rates have become much more volatile and far less predictable
than they were between 1945 and 1973. The volatility has been partly due to a number of
unexpected shocks to the world monetary system including:
• The oil crisis in 1971.
• The loss of confidence in the dollar that followed the rise of U.S. inflation in 1977-
1978.
• The oil crisis of 1979.
• The unexpected rise in the dollar between 1980 and 1985.
• The partial collapse of the European Monetary System in 1992.
• The 1997 Asian currency crisis.
• The global financial crisis of 2008-2010 and the sovereign debt crisis in the
European Union during 2010-2011.
Country Focus: The U.S. Dollar, Oil Prices, and Recycling Petrodollars
Summary
This feature explores what oil producing nations are likely to do with the dollars they have earned.
In 2008, oil prices reached new highs as a result of higher than expected demand, tight supplies,
and perceived geopolitical risks. Since oil is priced in dollars, oil producers have seen their dollar
reserves increase significantly. Now, speculation abounds as to what will happen to the
petrodollars. Some believe that the dollars will go toward public infrastructure projects, others
think that it is more likely that investments will be made in dollar denominated assets like U.S.
bonds, stocks, and real estate, or in non-dollar denominated assets such as European or Japanese
bonds and stocks. Discussion of the feature can revolve around the following questions:
Suggested Discussion Questions
Global Business Today Ninth Edition Chapter 11
1. With oil prices at record highs, there is significant speculation as to what oil producing states
will do with the dollars they are earning. Discuss how a decision to invest in non-dollar
denominated assets could affect the value of the U.S. dollar.
2. How could a decision by oil producing countries to invest their petrodollars in public
infrastructure projects help the value of the dollar?
Lecture Note: To extend this discussion, consider {http://www.bbc.com/news/business-29643612}
and {http://www.businessweek.com/magazine/keeping-petrodollars-out-of-despots-pockets-
08252011.html}.
Video Note: To extend this discussion, consider {http://www.businessweek.com/videos/2012-03-
19/dmd1203190711-scarlet-dot-mpg}.
Video Note: The videos in the International Business Library on Pinterest
(http://www.pinterest.com/mheibvideos/) Oil and Gas Prices Rise Due to Pipeline Shutdown and
C) It is argued that a floating exchange rate regime gives countries monetary policy autonomy.
Under a fixed system, a country's ability to expand or contract its money supply as it sees fit is
limited by the need to maintain exchange rate parity. Advocates of a floating exchange rate
regime argue that removal of the obligation to maintain exchange rate parity restores monetary
control to a government.
Trade Balance Adjustments
D) Under the Bretton Woods system, if a country developed a permanent deficit in its balance of
trade that could not be corrected by domestic policy, IMF approval was needed for a currency
devaluation. Critics of this system argue that the adjustment mechanism works much more
smoothly under a floating exchange rate regime.
Crisis Recovery
E) Advocates of floating exchange rates argue that exchange rate adjustments can help a country
deal with economic crises. The devaluation of a currency that typically follows a currency crisis
promotes export-led economic growth. Critics point out however, that the devalued currency also
causes import prices to rise and consequently increases inflation.
The Case for Fixed Exchange Rates
F) The case for fixed exchange rates rests on arguments about monetary discipline, uncertainty,
and the lack of connection between the trade balance and exchange rates.
Video Note: The video in the International Business Library on Pinterest
(http://www.pinterest.com/mheibvideos/) Federal Reserve Moves to Stabilize Market fits in well
with this discussion.
Monetary Discipline
G) The need to maintain a fixed exchange rate parity ensures that governments do not expand their
money supplies at inflationary rates.
Speculation
H) Critics of a floating exchange rate regime also argue that speculation can cause fluctuations in
exchange rates. A fixed exchange rate system limits the destabilizing effects of speculation.
Uncertainty
I) Speculation also adds to the uncertainty surrounding future currency movements that
characterizes floating exchange rate regimes, and can negatively affect the growth of international
trade and investment.
Global Business Today Ninth Edition Chapter 11
Trade Balance Adjustments and Economic Recovery
J) Those in favor of floating exchange rates argue that floating rates help adjust trade imbalances.
Who is Right?
K) There is no real agreement as to which system is better. We do, however, know that a fixed
exchange rate regime modeled along the lines of the Bretton Woods system will not work. It is
telling that speculation ultimately broke the system - a phenomenon that advocates of fixed rate
regimes claim is associated with floating exchange rates. Nevertheless, a different kind of fixed
exchange rate system might be more enduring and might foster the kind of stability that would
facilitate more rapid growth in international trade and investment.
Lecture Note: In uncertain times, calls for a return to the gold standard are not uncommon. To
extend this discussion, consider {http://www.bbc.com/news/magazine-19422104} and
{http://www.businessweek.com/news/2014-10-23/gold-losing-to-dollar-as-global-haven-with-low-
inflation}.
EXCHANGE RATE REGIMES IN PRACTICE
A) A number of different exchange rate policies are pursued around the world. Twenty-one
percent of IMF members follow a free float policy, 23 percent a managed float system, and 5
percent have no legal tender of their own (excludes the European Union countries that have
adopted the euro). The remaining countries use less flexible systems such as pegged
arrangements, or adjustable pegs.
Pegged Exchange Rates
B) Under a pegged exchange rate regime a country will peg the value of its currency to that of
another major currency. Pegged exchange rates are popular among the world’s smaller nations
C) There is some evidence that adopting a pegged exchange rate regime does moderate
inflationary pressures in a country.
Currency Boards
D) 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 this commitment credible, the
currency board holds reserves of foreign currency equal at the fixed exchange rate to at least 100%
of the domestic currency issued.
CRISIS MANAGEMENT BY THE IMF
A) With the introduction of the floating rate system and the emergence of global capital markets,
many of the original reasons for the IMF's existence have disappeared. Financial difficulties have
Global Business Today Ninth Edition Chapter 11
not disappeared however, and the IMF has found a way to grow and redefine its mission. With a
2014 membership of 188 countries, the IMF has focused, in some cases amid controversy, on
lending money to countries experiencing financial crises. In 2012, some 52 members had an IMF
program in place.
Video Note: There are two videos in the International Business Library on Pinterest
(http://www.pinterest.com/mheibvideos/) that pertain directly to this discussion. The first is
Greece Faces Debt Deadlines As Financial Markets Watch The EU and the second is Greek
Budget Crisis Could Stagnate U.S. Recovery.
Financial Crisis in the Post Bretton Woods Era
B) A number of broad types of financial crisis have occurred over the last quarter of a century,
many of which have required IMF involvement. 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 in order to defend prevailing exchange rate.
C) A banking crisis refers to a situation in which a loss of confidence in the banking system leads
to a run on the banks, as individuals and companies withdraw their deposits.
D) A foreign debt crisis is a situation in which a country cannot service its foreign debt
obligations, whether private sector or government debt.
E) In terms of IMF involvement, two main crises are explored in greater depth: the 1995 Mexican
currency crisis, and the Asian financial crisis.
Country Focus: The Mexican Currency Crisis of 1995
Summary
This feature explores the Mexican currency crisis of 1995. The crisis was a result of high Mexican
debts, and a pegged exchange rate that did not allow for a natural adjustment of prices. In order to
keep Mexico from defaulting on its debt, a $50 billion aid package was put together by the
International Monetary Fund, the U.S. government, and the Bank for International Settlements.
Thanks to the financial bailout, Mexico was able to get its economy back on track by 1997. The
following questions can be helpful in directing the discussion:
Suggested Discussion Questions
1. What led to Mexico’s 1995 financial crisis? What challenges face governments dealing with a
financial crisis like the one that Mexico experienced?
