978-1259929441 Chapter 11 Part 2

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Chapter 11 ‒ The International Monetary System

11-8

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

The 1997 Southeast Asian financial crisis was caused by a series of events that took place

in the previous decade.

Evaluating the IMF Policy Prescriptions

Critics of the IMF worry:

• The “one-size-fits-all” approach to macroeconomic policy is inappropriate for

many countries.

• The IMF is exacerbating moral hazard. (This can occur when people behave

recklessly because they know they will be saved if things go wrong.)

• The IMF has become too powerful for an institution without any real mechanism

for accountability.

Slides 11-21 ‒ 11-22 Implications for Managers

The present floating rate system mandates that firms carefully manage their foreign

exchange transactions and exposures.

Managers must recognize that the current international monetary system is a managed

float system in which government intervention can help drive the foreign exchange

market.

Managers need strategic flexibility.

Companies should promote an international monetary system that facilitates international

growth and development.

CRITICAL THINKING AND DISCUSSION QUESTIONS

QUESTION 1: Why did the gold standard collapse? Is there a case for returning to some

type of gold standard? What is it?

ANSWER 1: The gold standard worked reasonably well from the 1870s until the start of

World War I in 1914, when it was abandoned. During the war, several governments

financed their massive military expenditures by printing money. This resulted in

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inflation, and by the war’s end in 1918, price levels were higher everywhere. Several

countries returned to the gold standard after World War I. However, the period that

ensued saw so many countries devalue their currencies that it became impossible to be

certain how much gold a currency could buy. Instead of holding on to another country’s

currency, people often tried to exchange it into gold immediately, lest the country

devalue its currency in the intervening period. This put pressure on the gold reserves of

various countries, forcing them to suspend gold convertibility. As a result, by the start of

World War II, the gold standard was dead. The great strength of the gold standard was

that it contained a powerful mechanism for simultaneously achieving balance-of-trade

equilibrium by all countries. This strength is the basis for reconsidering the gold standard

as a basis for international monetary policy.

QUESTION 2: What opportunities might current IMF lending policies to developing

nations create for international businesses? What threats might they create?

ANSWER 2: The IMF lending policies require the recipient countries to implement

QUESTION 3: Do you think the standard IMF policy prescriptions of tight monetary

policy and reduced government spending are always appropriate for developing nations

experiencing a currency crisis? How might the IMF change its approach? What would the

implications be for international business?

ANSWER 3: Critics argue that the tight macroeconomic policies imposed by the IMF in

the recent Asian crisis are not well-suited to countries that are suffering NOT from

QUESTION 4: Debate the relative merits of fixed and floating exchange rate regimes.

From the perspective of an international business, what are the most important criteria for

choosing between the systems? Which system is the more desirable for an international

business?

ANSWER 4: The case for fixed exchange rates rests on arguments about monetary

discipline, speculation, uncertainty, and the lack of connection between the trade balance

and exchange rates. In terms of monetary discipline, the need to maintain fixed exchange

rate parity ensures that governments do not expand their money supplies at inflationary

rates. In terms of speculation, a fixed exchange rate regime precludes the possibility of

speculation. In terms of uncertainty, a fixed rate regime introduces a degree of certainty

in the international monetary system by reducing volatility in exchange rates. Finally, in

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terms of trade balance adjustments, critics question the closeness of the link between the

exchange rate and the trade balance. The case for floating exchange rates has two main

elements: monetary policy autonomy and automatic trade balance adjustments. In terms

of the former, it is argued that a floating exchange rate regime gives countries monetary

policy autonomy. Under a fixed rate 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. In

terms of the latter, 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, the IMF

would agree to a currency devaluation. Critics of this system argue that the adjustment

mechanism works much more smoothly under a floating exchange rate regime. They

argue that if a country is running a trade deficit, the imbalance between the supply and

demand of that country’s currency in the foreign exchange markets will lead to

depreciation in its exchange rate. An exchange rate depreciation should correct the trade

deficit by making the country’s exports cheaper and its imports more expensive. It is a

matter of personal opinion in regard to which system is better for an international

business. We do know, however, that a fixed exchange rate regime modeled along the

lines of the Bretton Woods system will not work. 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.

QUESTION 5: Imagine that Canada, the United States, and Mexico decide to adopt a

fixed exchange rate system. What would be the likely consequences of such a system for

(a) international businesses, and (b) the flow of trade and investment among the three

countries?

ANSWER 5: Were North America to adopt a common currency, it would become

increasingly attractive for foreign investment and would increase trade and investment

QUESTION 6: Reread the Country Focus on the U.S. dollar, oil prices, and recycling

petrodollars, then answer the following questions:

a. What will happen to the value of the U.S. dollar if oil producers decide to invest most

of their earnings from oil sales in domestic infrastructure projects?

b. What factors determine the relative attractiveness of the dollar-, euro-, and yen-

denominated assets to oil producers flush with petrodollars? What might lead them to

direct more funds toward non-dollar-denominated assets?

c. What will happen to the value of the U.S. dollar if OPEC members decide to invest

more of their petrodollars toward non-dollar-denominated assets, such as euro-

denominated stocks and bonds?

d. In addition to oil producers, China is also accumulating a large stock of dollars,

currently estimated to total $3.3 trillion. What would happen to the value of the dollar if

Chapter 11 ‒ The International Monetary System

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China and oil-producing nations all shifted out of dollar-denominated assets at the same

time? What would be the consequence for the United States economy?

ANSWER 6:

a. If oil producers decide to invest their earnings in domestic infrastructure projects, it

would be expected that the countries involved would see a boost in economic growth and

b. The relative attractiveness of an investment whether it is denominated in dollars, euro,

or yen depends on expected returns and the degree of risk associated with the investment.

c. Oil producers have significantly increased their holdings of dollars as a result of higher

d. If China and the oil producers simultaneously decide to sell off their dollars, there

CLOSING CASE: China’s Exchange Rate Regime

Summary

The closing case explores China’s exchange rate regime. China has been accused of

manipulating its currency to help boost exports; however, data show that these claims are

untrue, at least since China adopted its managed float system in 2005. Prior to that, China

pegged its currency to the U.S. dollar. When the Chinese economy began to take off in

the later 1990s, China’s currency was undervalued relative to others. This policy was

apparently designed to improve the competitiveness of its exports. China reevaluated its

currency policy in the 2000s, and made the decision to move to the managed float it

follows today. Discussion of the case can begin with the following questions:

QUESTION 1: Why do you think that the Chinese historically pegged the value of the

yuan to the U.S. dollar?

Chapter 11 ‒ The International Monetary System

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ANSWER 1: Most students will probably suggest that the United States has been a

QUESTION 2: Why did the Chinese move to a managed float system in 2005?

ANSWER 2: China’s export-led economy was booming in the 2000s prompting calls for

QUESTION 3: What are the benefits that China might gain by allowing the yuan to float

freely against other major currencies such as the U.S. dollar and the euro? What are the

risks? What do you think they should do?

ANSWER 3: Responses to this question will vary by student. Some students might argue

QUESTION 4: Is there any evidence that the Chinese kept the level of their currency

artificially low in the past to boost exports? Are they keeping it artificially low today?

ANSWER 4: Donald Trump’s assertions that China is keeping its currency artificially

QUESTION 5: What policy stance should the U.S. and EU adopt toward China with

regard to how it manages the value of its currency?

ANSWER 5: Responses to this question will vary by students, but most will probably

Another Perspective: For more information on China’s policy toward its currency, go to

{https://www.nytimes.com/2017/04/11/business/economy/trump-china-currency-

manipulation-trade.html} and {https://www.cnbc.com/2017/03/15/china-currency-

manipulator-claims-are-false-sp-global-ratings.html}.

Chapter 11 ‒ The International Monetary System

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Teaching Tip: To extend the discussion of China and exchanges rates, consider IMF: The

Chinese…Ask the IMF in the International Business Library at:

http://bit.ly/MHEIBVideo. Click “Ctrl+F” on your keyboard to search for the video title.

MHE INTERNATIONAL BUSINESS VIDEO LIBRARY

Please click here to visit our International Business Video Library which provides an

ongoing stream of updated video suggestions correlated by key concept and major topic.

Every new clip posted is supported by teaching notes and discussion questions. Please

feel free to leave comments in the library that you feel might be helpful to your

colleagues.

INCORPORATING globalEDGE™ EXERCISES

Use the globalEDGE™ website {globaledge.msu.edu/} to complete the following

exercises:

Exercise 1

The Global Financial Stability Report is a semiannual report published by the

International Capital Markets division of the International Monetary Fund (IMF). The

report includes an assessment of the risks facing the global financial markets. Locate and

download the latest report to get an overview of the most important issues currently under

discussion. Also, download a report from five years ago. How do the issues from five

years ago compare with financial issues identified in the current report?

Exercise 2

An important element to understanding the international monetary system is keeping

updated on current growth trends worldwide. A German colleague told you yesterday that

Deutsche Bank Research provides an effective way to stay informed on important topics

in international finance from a European perspective. Find an emerging market research

report for analysis. On which emerging market region did you choose to focus? What are

the key takeaways from your chosen report?

Answers to Exercises

Exercise 1 Answer

Chapter 11 ‒ The International Monetary System

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McGraw-Hill Education.

The report is published semiannually by the Capital Markets Division of the International

Monetary Fund and examines current risks facing the global financial system and policy

actions that may mitigate these. As a result, it provides a great overview of the state of

the global financial system.

Exercise 2 Answer