CHAPTER 10
INTERNATIONAL MONETARY SYSTEM
LEARNING OBJECTIVES:
10.1 Describe the importance of exchange rates to business activities.
10.2 Outline the factors that help determine exchange rates.
10.3 Explain attempts to construct a system of fixed exchange rates.
10.4 Describe efforts to create a system of floating exchange rates
CHAPTER OUTLINE:
Introduction
Importance of Exchange Rates
Desire for Stability and Predictability
Efficient versus Inefficient Market View
Efficient Market View
Inefficient Market View
Forecasting Techniques
Fundamental Analysis
Technical Analysis
Difficulties of Forecasting
What Factors Determine Exchange Rates?
Law of One Price
McCurrency
Purchasing Power Parity
Numerical Example
Role of Inflation
Impact of Money-Supply Decisions
Impact of Unemployment and Interest Rates
How Exchange Rates Adjust to Inflation
Role of Interest Rates
Fisher Effect
Evaluating PPP
Impact of Added Costs
Impact of Trade Barriers
Impact of Business Confidence and Psychology
Fixed Exchange Rate Systems
The Gold Standard
Par Value
Advantages of the Gold Standard
Collapse of the Gold Standard
Bretton Woods Agreement
Fixed Exchange Rates
Built-In Flexibility
Copyright © 2019 Pearson Education, Inc.
World Bank
International Monetary Fund
Special Drawing Right (SDR)
Collapse of the Bretton Woods Agreement
Smithsonian Agreement
Final Days
System of Floating Exchange Rates
Jamaica Agreement
Later Accords
Today’s Exchange-Rate Arrangements
Pegged Exchange-Rate Arrangement
Currency Board
European Monetary System
How the System Worked
Recent Financial Crises
Developing Nations’ Debt Crisis
Mexico’s Peso Crisis
Southeast Asia’s Currency Crisis
Russia’s Ruble Crisis
Argentina’s Peso Crisis
Future of the International Monetary System
Implications for Business Strategy
Forecasting Earnings and Cash Flows
A comprehensive set of specially designed PowerPoint slides is available for use with Chapter 10.
These slides and the lecture outline below form a completely integrated package that simplifies the
teaching of this chapter’s material.
Lecture Outline
I. INTRODUCTION
This chapter explores factors that determine exchange rates and various international attempts
to manage them. It also presents different methods of forecasting exchange rates, and the
functioning of the international monetary system.
II. IMPORTANCE OF EXCHANGE RATES
Exchange rates affect demand for products. When a country’s currency is weak, the price of its
exports declines, making the exports more appealing on world markets. (See Figure 10.1)
Devaluation is the intentional lowering of the value of a currency by the nation’s
government. Gives domestic producers an edge on world markets, but also reduces citizens’
buying power.
Revaluation is the intentional raising of the value of a nation’s currency. Increases the
price of exports and reduces the price of imports.
Exchange rates affect profits earned abroad when repatriated by the parent company
into the home currency. Translating subsidiary earnings from a weak host country currency into
a strong home currency reduces earnings, and vice versa.
A. Desire for Stability and Predictability
1. Stability makes for accurate financial planning and cash flow forecasts.
2. Predictability reduces odds that a company will be caught off-guard by
unexpected rate changes. Reduces the need for costly insurance (currency
hedging) against possible adverse exchange rates.
3. Figure 10.2 shows how the value of the U.S. dollar has changed over time. The
figure reveals the dollar’s periods of instability, which challenged the financial
management capabilities of international companies. Before undertaking any
international business activity, managers should forecast future exchange rates
and consider the impact of currency values on earnings.
B. Efficient versus Inefficient Market View
1. In an efficient market, prices of financial instruments quickly reflect new public
information made available to traders. The efficient market view says prices of
financial instruments reflect all publicly available information at any given time.
2. Forward exchange rates are accurate forecasts of future rates, and reflect market
expectations about the future values of two currencies. (See Chapter 9)
3. Forward exchange rates reflect all relevant publicly available information at any
given time and they are considered the best possible predictors of exchange
rates.
4. The inefficient market view says prices of financial instruments do not reflect all
publicly available information. Proponents believe that companies can search for
information to improve forecasting.
5. This view is more compelling considering private information (e.g., if a currency
trader holds privileged information, the trader can act on this information to
make a profit).
C. Forecasting Techniques
1. Fundamental Analysis
Fundamental analysis employs statistical models based on fundamental
economic indicators to forecast exchange rates. Economic variables in these
models include inflation, interest rates, the money supply, tax rates, government
spending, the nation’s balance-of-payments situation, and government
intervention in foreign exchange markets.
2. Technical Analysis
Technical analysis employs past trends in currency prices and other factors to
forecast exchange rates. Using statistical models and past data trends, analysts
estimate the conditions prevailing during changes in exchange rates and estimate
the timing, magnitude, and direction of future changes.
D. Difficulties of Forecasting
Beyond problems with data used, failings can be traced to human error (e.g., people
might miscalculate the importance of certain economic events, placing too much
emphasis on some elements and ignoring others).
III. WHAT FACTORS DETERMINE EXCHANGE RATES?
To understand what determines rates, must know: (1) the law of one price and (2) purchasing
power parity. Each tells the level at which an exchange rate should be.
A. Law of One Price
1. Exchange rates do not guarantee or stabilize the buying power of a currency;
purchasing power fluctuates.
2. Law of one price says an identical product must have an identical price in all
countries when expressed in the same currency. Product must be identical in
quality or content and be entirely produced within each country.
3. If price were not identical in each country, an arbitrage opportunity would arise.
Traders would buy in the low-priced market and sell in the high-priced market;
buying drives up the price in one market and drives down the price in the other.
4. The Economist publishes its “Big Mac Index” using the law of one price to
determine the exchange rate between the U.S. dollar and other currencies. Fair
predictor of the “direction” rates should move.
B. Purchasing Power Parity
1. NUMERICAL EXAMPLE – PPP is the relative ability of two countries’
currencies to buy the same “basket” of goods in those two countries. Tells how
much of currency “A” a person in nation “A” needs to buy the same amount of
products that someone in nation “B” can buy with currency “B.”
Considers price levels in adjusting the relative values of the two currencies.
Economic forces will push a market exchange rate toward that calculated by
PPP or an arbitrage opportunity arises.
Holds for internationally traded products not restricted by trade barriers and
entailing few or no transportation costs.
2. Role of Inflation
Inflation erodes purchasing power. If money is injected into an economy not
producing greater output, a greater amount of money is spent on a static amount
of products. Demand soon outstrips supply and prices rise.
a. Impact of Money-Supply Decisions
i. Governments manage the supply of and demand for currency with
policies that influence the money supply.
ii. Monetary policy refers to activities that directly affect a nation’s
interest rates or money supply. Governments buy or sell
government securities on the open market to influence the money
supply.
iii. Fiscal policy involves using taxes and government spending to
influence the money supply indirectly. Governments can increase
or lower taxes, or increase or decrease government spending.
b. Impact of Unemployment and Interest Rates
i. Threat of a company moving abroad for lower wages holds down
wages at home. Companies then need not raise prices to pay
higher wages, lowering inflationary pressures.
ii. Low unemployment puts upward pressure on wages. To maintain
profit margins with higher labor costs, producers pass the cost of
higher wages on to consumers in higher prices, causing
inflationary pressure.
iii. Low interest rates encourage consumers and businesses to borrow
and spend, causing inflationary pressure.
c. How Exchange Rates Adjust to Inflation
i. Exchange rates adjust to different rates of inflation across
countries, which is necessary to maintain purchasing power parity
between nations.
ii. For example, if inflation in Mexico is higher than in the United
States, the exchange rate adjusts to reflect that a dollar will buy
more pesos due to higher inflation in Mexico.
iii. U.S. goods become more expensive for Mexican firms, and
Mexican goods become cheaper for U.S. companies.
3. Role of Interest Rates
The interest rate a bank quotes a borrower is the nominal interest rate.
a. Fisher Effect
i. The Fisher effect is the principle that the nominal interest rate is
the sum of the real interest rate and the expected rate of inflation
over a specific period.
ii. The real rate of interest should be the same in all countries
because of arbitrage.
iii. The International Fisher Effect is the principle that a difference in
nominal interest rates supported by two countries’ currencies will
cause an equal but opposite change in their spot exchange rates.
iv. Because real interest rates are theoretically equal across countries,
any difference in interest rates in two countries is due to inflation.
4. Evaluating PPP
PPP is better at predicting long-term exchange rates than short-term rates. Short-
term forecasts, however, are most beneficial to managers.
a. Impact of Added Costs
PPP assumes no transportation costs, and thus overstates the threat of
arbitrage. The presence of transportation costs can allow unequal prices
between markets to persist, causing PPP to fail.
b. Impact of Trade Barriers
PPP assumes no trade barriers. But a high tariff or outright ban on a
product can impair price leveling, causing PPP to fail to predict exchange
rates accurately.
c. Impact of Business Confidence and Psychology
PPP overlooks business confidence and human psychology. Yet nations
try to maintain confidence of investors, businesspeople, and consumers in
their economies and currencies.
IV. FIXED EXCHANGE RATE SYSTEMS
A. The Gold Standard
Gold was internationally accepted for paying for goods and services. Pros: its limited
supply caused high demand and it can be traded, stored, and melted into coins or bars
making a good medium of exchange. Cons: its weight made transport expensive, and if a
ship sank, the gold was lost.
Gold Standard was an international monetary system in which nations linked the
value of their paper currencies to a specific value of gold. The gold standard operated
from the early 1700s until 1939.
1. Par Value
a. The value of a currency expressed in terms of gold. All nations fixing
their currencies to gold also indirectly linked their currencies to one
another. Thus, the gold standard was a fixed exchange rate system—one
in which the exchange rate for converting one currency into another is
fixed by international governmental agreement.
b. The U.S. dollar was fixed at $20.67/oz of gold, the British pound at
£4.2474/oz.; exchange rate was $4.87/£ ($20.67 ÷ £4.2474).
2. Advantages of the Gold Standard
a. Reduced the risk in exchange rates because it locked exchange rates
between currencies. Fixed exchange rates reduced the risks and costs of
trade and grew as a result.
b. Imposed strict monetary policies that required nations to convert paper
currency into gold if demanded by holders of the currency. This forced
nations to keep adequate gold reserves on hand. A nation could not let
paper currency grow faster than the value of its gold reserves, which
controlled inflation.
c. Helped correct a nation’s trade imbalance.
i. If a nation imports more than it exports, gold flowed out to pay
for imports. The government must decrease the supply of paper
currency in the domestic economy because it could not have
paper currency in excess of gold reserves. As the money supply
falls, so do prices of goods and services because fewer dollars are
chasing the same supply of goods and services. Falling prices
make its exports cheaper on world markets and exports rise until
the nation’s international trade is in balance.
ii. In the case of a trade surplus, the inflow of gold supports an
increase in the supply of paper currency. This increases the
demand for and cost of goods and services; exports fall in
reaction to their higher prices until trade is in balance.
3. Collapse of the Gold Standard
a. Gold standard was violated when nations in the First World War financed
the war by printing paper currency. This caused rapid inflation and
caused nations to abandon the gold standard.
b. Britain returned to the gold standard in the early 1930s at the same par
value that existed before the war. The United States returned to the gold
standard at a new, lower par value that reflected the inflation of previous
years.
c. The U.S. decision in 1934 to devalue its currency and Britain’s decision
not to do so lowered the price of U.S. exports and increased the price of
British goods imported; it had previously required $4.87 to purchase one
British pound, but it now took $8.24 to buy a pound ($35.00 ÷ £4.2474).
So, for example, this forced the cost of a £10 tea set exported from
Britain to the United States to go from $48.70 before devaluation to
$82.40 after devaluation. This drastically increased the price of imports
from Britain (and other countries), lowering its export earnings.
d. Countries retaliated against one another through “competitive
devaluations” to improve their own trade balances. Faith in the gold
standard vanished, as it was no longer an accurate indicator of a
currency’s true value.
B. Bretton Woods Agreement
1944 accord among nations to create a new international monetary system based on the
value of the U.S. dollar. Designed to balance strict discipline of the gold standard with
flexibility to manage temporary domestic monetary difficulties.
1. Fixed Exchange Rates
a. Incorporated fixed exchange rates by tying the value of the U.S. dollar
directly to gold, and the value of other currencies to the value of the
dollar.
b. Fixed U.S. dollar par value at $35/oz of gold; other currencies had par
values against the U.S. dollar, not gold.
c. Members were to keep their currencies from deviating more than 1.0
percent above or below their par values. Extended the right to exchange
gold for dollars only to national governments.
2. Built-In Flexibility
a. Allowed devaluation only in extreme circumstances called fundamental
disequilibrium—when a trade deficit causes a permanent negative shift in
the balance of payments.
b. Devaluation in such situations was to reflect a permanent economic
change in a country, not temporary misalignments.
3. World Bank
Created the World Bank (IBRD) to fund national economic development.
a. World Bank’s immediate purpose was to finance European
reconstruction after the Second World War. It later shifted its focus to the
general financial needs of developing countries.
b. World Bank finances economic development projects in Africa, South
America, and Southeast Asia, and offers funds to countries unable to
obtain capital for projects considered too risky. It often undertakes
projects to develop transportation networks, power facilities, and
agricultural and educational programs.
4. International Monetary Fund
IMF was created to regulate fixed exchange rates and enforce the rules of the
international monetary system. At the time of its formation, the IMF
(www.imf.org) had just 29 members—189 countries belong today. Purposes of
the IMF are to:
a. Promote international monetary cooperation.
b. Facilitate expansion and balanced growth of international trade.
c. Promote exchange stability with orderly exchange arrangements, and
avoid competitive exchange devaluation.
d. Make resources temporarily available to members.
e. Shorten the duration and lessen the degree of disequilibrium in the
international balance of payments of member nations.
5. World financial reserves of dollars and gold grew scarce in the 1960s, at a time
when the activities of the IMF demanded greater amounts of dollars and gold.
The IMF reacted by creating what is called a special drawing right (SDR)—an
IMF asset whose value is based on a weighted “basket” of five currencies,
including the U.S. dollar, European Union (EU) euro, Chinese renminbi,
Japanese yen, and British pound. Figure 10.3 shows the “weight” each currency
contributes to the overall value of the SDR.
6. Collapse of the Bretton Woods Agreement
Bretton Woods faltered in the 1960s because of U.S. trade and budget deficits.
Nations holding U.S. dollars doubted the U.S. government had gold reserves to
redeem all its currency held outside the United States. Demand for gold in
exchange for dollars caused a large global sell-off of dollars.
a. Smithsonian Agreement
In 1971, the U.S. government held less than one-fourth of the amount of
gold needed to redeem all U.S. dollars in circulation. The Smithsonian
Agreement was to restructure and strengthen the international monetary
system: (1) lowered the value of the dollar in terms of gold to $38/oz. of
gold, (2) required that other countries increase the value of their
currencies against the dollar, and (3) increased the 1 percent floatation
band to 2.25 percent.
b. Final Days
Many nations abandoned the system in 1972 and 1973, and currency
values floated freely against the dollar.
V. SYSTEM OF FLOATING EXCHANGE RATES
The new system of floating exchange rates was to be a temporary solution. Instead of the
emergence of a new international monetary system, there emerged several efforts to manage
exchange rates.
1. Jamaica Agreement
IMF accord (1976) formalized the present system of floating exchange rates.
Three main provisions included: (1) endorsement of a managed float system of
exchange rates (This is in contrast to a free float system—a system in which
currencies float freely against one another without governments intervening in
currency markets); (2) elimination of gold as the primary reserve asset of the
IMF; and (3) expansion of the IMF to act as a “lender of last resort” for nations
with balance-of-payments difficulties.
2. Later Accords
Between 1980 and 1985 the U.S. dollar rose against other currencies, pushing up
prices of U.S. exports and adding to a U.S. trade deficit.
a. The Plaza Accord (1985) was an agreement among the largest
industrialized economies known as the G5 (Britain, France, Germany,
Japan, and the United States) to act together in forcing down the value of
the U.S. dollar.
b. The Louvre Accord (1987) was an agreement among the G7 nations (the
G5 plus Italy and Canada) that affirmed the dollar was appropriately
valued and that they would intervene in currency markets to maintain its
current market value.
A. Today’s Exchange-Rate Arrangements
Remains a managed float system, but some nations maintain more stable exchange rates
by tying their currencies to other currencies
1. Pegged Exchange-Rate Arrangement
a. Pegged exchange-rate arrangements “peg” a country’s currency to a more
stable and widely used currency in international trade.
b. Many small countries peg their currencies to the U.S. dollar, the EU euro,
the special drawing right (SDR) of the IMF, or another individual
currency. Belonging to this first category are the Bahamas, El Salvador,
Iran, Malaysia, Netherlands Antilles, and Saudi Arabia. Other nations
peg their currencies to groups, or “baskets,” of currencies. For example,
Bangladesh and Burundi tie their currencies (the taka and Burundi franc,
respectively) to those of their major trading partners. Other members of
this second group are Botswana, Fiji, Kuwait, Latvia, Malta, and
Morocco.
2. Currency Board
a. A currency board is a monetary regime based on a commitment to
exchange domestic currency for a specified foreign currency at a fixed
exchange rate. The government is legally bound to hold an amount of
foreign currency equal to the amount of domestic currency; this helps cap
inflation.
b. The currency board’s survival depends on sound budget policies.
B. European Monetary System
Europe looked for a system that could stabilize currencies and reduce exchange-rate
risk. In 1979, they created the European Monetary System (EMS) to stabilize exchange
rates. It was ended in 1999 when the EU adopted a single currency.
1. How the System Worked
a. The exchange rate mechanism (ERM) limited fluctuations of EU member
currencies within a trading range (or target zone).
b. The EMS was successful; currency realignments were infrequent and
inflation was controlled. Problems arose in 1992 and the EMS was
revised in 1993 to allow currencies to fluctuate in a wider band from the
midpoint of the target zone.
c. ERM II introduced in 1999 to link the euro to the currencies of nations
applying for membership in the EU.
C. Recent Financial Crises
Despite nations’ best efforts to head off financial crises within the international
monetary system, the world has seen several wrenching crises.
1. Developing Nations’ Debt Crisis
a. By the early 1980s, developing countries (especially in Latin America)
had amassed huge debts payable to large international commercial banks,
the IMF, and the World Bank. To prevent a meltdown of the entire
financial system, international agencies revised repayment schedules.
b. In 1989, the Brady Plan called for large-scale reduction of poor nations’
debt, exchange of high-interest loans for low-interest loans, and debt
instruments tradable on world financial markets.
2. Mexico’s Peso Crisis
a. Rebellion and political assassination shook investors’ faith in Mexico’s
financial system in 1993–1994. Mexico’s government responded slowly
to the flight of portfolio investment capital.
b. In late 1994, the Mexican peso was devalued, forcing a large loss of
purchasing power on ordinary Mexican people. The IMF and private
commercial banks in the United States provided about $50 billion in
loans to shore up Mexico’s economy.
c. Mexico repaid the loans ahead of schedule and once again has a sizable
reserve of foreign exchange.
3. Southeast Asia’s Currency Crisis
a. On July 11, 1997, the speculators sold off Thailand’s baht on world
currency markets; the baht plunged and every other economy in the
region was in a slump.
b. The shock waves of Asia’s crisis could be felt throughout the global
economy. Indonesia, South Korea, and Thailand needed IMF and World
Bank funding. As incentives to begin economic restructuring, IMF loan
packages came with strings attached.
c. Crisis likely caused by a combination of: (1) Asian style capitalism (lax
regulation, loans to friends and relatives, lack of financial transparency);
(2) currency speculators and panicking investors; and (3) persistent
current account deficits.
4. Russia’s Ruble Crisis
a. Russia’s problems in the 1990s included: (1) spillover from the Southeast
Asia crisis; (2) depressed oil prices; (3) falling hard currency reserves;
(4) unworkable tax system; and (4) inflation.
b. In 1996 as currency traders dumped the ruble, the Russian government
attempted to defend the ruble on currency markets. The government
received a $10 billion aid package from the IMF and promised to reduce
debt, collect taxes, cease printing sums of currency, and peg its currency
to the dollar.
c. Things improved for a while, but then in mid-1998 the government found
itself once again trying to defend the ruble. By late 1998, the IMF had
lent Russia more than $22 billion.
5. Argentina’s Peso Crisis
a. By late 2001, Argentina had been in recession for nearly 4 years.
Argentina’s goods remained expensive because its currency was linked to
a strong U.S. dollar through a currency board.
b. The country finally defaulted on its $155 billion of public debt in early
2002, the largest default by any country ever.
c. The government scrapped its currency board that linked the peso to the
U.S. dollar and the peso quickly lost about 70 percent of its value on
currency markets.
d. Argentina has in many respects recovered. It has registered growth of around
9 percent a year and unemployment around 8 percent in 2008, down from
a high of 25 percent in 2002.
e. Argentina’s plan of boosting wages, imposing price controls, keeping the
peso low, and increasing public spending seems to be working. Growth
was expected to be around 4 percent to 5 percent but inflation soon
reached double digits, hitting around 40 percent in 2016, cutting
consumers’ purchasing power and increasing poverty. Though the
economy had again shrunk in 2016, leaders were hopeful that the country
would turn the corner and return to growth in 2017.
f. As of 2012, another economic collapse was unlikely although Argentina was
experiencing 26 percent inflation.
D. Future of the International Monetary System
1. Recurring crises are raising calls for a new system designed to meet the
challenges of a global economy.
2. Revision of the IMF and its policy prescriptions are likely; transparency on the
part of the IMF is being increased to instill greater accountability. The IMF is
increasing its surveillance of members’ macroeconomic policies and abilities in
the area of financial sector analysis.
3. Ways must be found to integrate international financial markets to manage risks.
The private sector must become involved in the prevention and resolution of
financial crises.
VI. IMPLICATION FOR BUSINESS STRATEGY
Exchange rates influence all sorts of business activities for domestic and international
companies. A weak currency (valued low relative to other currencies) lowers the price of a
nation’s exports on world markets and raises the price of imports. Lower prices make the
country’s exports more appealing on world markets. This gives companies the opportunity to
take market share away from companies whose products are priced higher in comparison.
Understanding this material improves managers’ knowledge of financial risks in international
business.
VII. FORECASTING EARNINGS AND CASH FLOW
This knowledge must be paired with vigilance of financial market conditions to manage
businesses in the global economy effectively.