978-0134890494 Chapter 10

subject Type Homework Help
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subject Authors John J. Wild, Kenneth L. Wild

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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
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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.
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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-
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
3. Forward exchange rates reflect all relevant publicly available
4. The inefficient market view says prices of financial instruments do
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
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
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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
2. Law of one price says an identical product must have an identical
3. If price were not identical in each country, an arbitrage opportunity
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.
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.
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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 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.
3. Role of Interest Rates
The interest rate a bank quotes a borrower is the nominal interest
rate.
a. Fisher Effect
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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
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
£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.
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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
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
£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
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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
Extended the right to exchange gold for dollars only to
national governments.
2. Built-In Flexibility
a. Allowed devaluation only in extreme circumstances called
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 members189
countries belong today. Purposes of the IMF are to:
a. Promote international monetary cooperation.
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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
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
2. Later Accords
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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,
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
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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
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
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.
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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
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
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
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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
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
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.
Quick Study 1
1. Q: For a country with a currency that is weakening (valued low relative to other
countries), what will happen to the price of its exports and the price of its
imports?
2. Q: Unfavorable movements in exchange rates can be costly for business, so
managers prefer that exchange rates be what?
A: Stable exchange rates improve the accuracy of financial planning, including
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3. Q: The view that prices of financial instruments reflect all publicly available
information at any given time is called what?
Quick Study 2
1. Q: The principle that an identical item must have an identical price in all
countries when price is expressed in a common currency is called what?
A: The law of one price is a principle that an identical product must have an
identical price in all countries when expressed in the same currency. This product
2. Q: A unique aspect of purchasing power parity in the context of exchange rates is
that it is only useful when applied to what?
A: Purchasing power parity is the relative ability of two countries’ currencies to
3. Q: What is the impact on purchasing power when growing demand for products
outstrips a stagnant supply?
4. Q: What factors influence the power of purchasing power parity to accurately
predict exchange rates?
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A: There are limitations to the PPP concept. First, purchasing power parity is
better at predicting long-term exchange rates than short-term rates. Unfortunately,
short-term forecasts are often more beneficial to managers. Second, although PPP
Quick Study 3
1. Q: The gold standard is an example of what type of international monetary
system?
A: In the earliest days of international trade, gold was the internationally accepted
2. Q: What are the main advantages of the gold standard?
A: There are three main advantages associated with an international monetary
system based on the gold standard. First, because the gold standard maintained
highly fixed exchange rates between currencies, it drastically reduced exchange-
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reserves. As the money supply falls, so do prices of goods and services in the
country because demand is falling while supply is unchanged. The falling prices
of the country’s goods make its exports cheaper on world markets. Exports rise
until the nation’s international trade is once again in balance.
The fundamental principle of the gold standard was violated when nations
involved in the First World War needed to finance their enormous war expenses
by printing additional paper currency. This caused rapid inflation for these nations
and caused them to abandon the gold standard altogether. Britain returned to the
gold standard in the early 1930s at the same par value that existed before the war.
However, the United States returned to the gold standard at a new, lower par
value that reflected the inflation of previous years. The decision by the United
States to devalue its currency and Britain’s decision not to do so lowered the price
of U.S. exports on world markets and increased the price of British (and other
nations’) goods imported into the United States. Countries retaliated against one
another through “competitive devaluations” to improve their own trade balances.
Faith in the gold standard vanished--it no longer indicated a currency’s true value.
3. Q: What is the name of the international monetary system that formed in 1944
following the demise of the gold standard?
Quick Study 4
1. Q: An exchange rate system in which currencies float against one another with
governments intervening to stabilize currencies at target rates is called what?
2. Q: What do we call the arrangement whereby a nation lets its currency float
within a margin around the value of another more stable currency?
3. Q: A currency board is a monetary regime based on an explicit commitment to
exchange domestic currency for what?
1. Q: Suppose you and several classmates are a marketing team assembled by your
Brazil-based firm to estimate demand in the U.S. market for its newly developed
product. The market research firm you hired requires $150,000 to perform a
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thorough study. But your group is informed that the total research budget for the
year is 3 million Brazilian real and that no more than 20 percent of the budget
can be spent on any one project.
(3a.) If the current exchange rate is 5 real/$, will you have the market study
conducted? Why or why not?
A: The answer is no. Converting real into dollars at an exchange rate of 5 real/$,
1. Q: You are the chair of an IMF task force. Your job is to reevaluate the policy of
bailing out national governments that suffer losses in the private sector. Current
policy is to enlist the governments of industrialized countries in bailing out
emerging nations in the midst of financial crises. Taxpayers in industrial
countries typically foot the bill for IMF activities, with total loans running into the
many billions of dollars. Recent examples are the bailouts of Mexico, Indonesia,
and Thailand. Some critics call this system a kind of “remnant socialism” that
rescues financial institutions and investors from their own mistakes with money
from taxpayers. For instance, the financial crisis in Thailand was largely a
private-sector affair. Thai banks and insurance companies were heavily in debt
and the central bank had recklessly pledged its foreign exchange reserves to
shore up the currency. As chair of the task force, what is your position on this
dilemma? Do you believe that the current system socializes losses (the
government bails them out) and privatizes profits? Explain exactly who benefits
from such bailouts. What is an alternative to an IMF bailout?
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A: Students might look at the recent events in the U.S. financial system meltdown
Banking on Forgiveness
1. This item can be assigned as a Discussion Question in MyManagementLab.
Student responses will vary. Q: The World Bank and the IMF had once argued
that the leniency of debt forgiveness would make it more difficult for the lenders
themselves to borrow cheaply on the world’s capital markets. If you were a World
Bank donor, would you support the HIPC Debt Initiative or argue against it?
Explain your answer.
A: This question could set up a debate between groups arguing for and against
2. Q: In negotiating the HIPC Debt Initiative, the World Bank and the IMF worked
closely together. At one point, however, the plan came to a standstill when the two
organizations produced different figures for Uganda’s coffee exports, with the
IMF giving a more optimistic forecast and so arguing against the need for debt
relief. In your opinion, is there any benefit to these organizations working
together? Explain. Which organization do you think should play a greater role in
aiding economic development? Why?
A: Students should be encouraged to visit the Web sites of the International

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