bus280 7th ed chapter 10 ppt
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Copyri ght 2011 by The McGraw-H il l Companies, Inc. All ri ghts reserved.McGraw-Hill/Irwin
Global Business Today7e
by Charles W.L. Hill
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Chapter 10
The International
Monetary System
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Introduction
Question:What is the international monetary system?
Answer:
The international monetarysystem refers to theinstitutional arrangements that govern exchange rates
recall that the foreign exchange market is the primaryinstitution for determining exchange rates
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Introduction
A floating exchange rate systemexists in countrieswhere the foreign exchange market determines therelative value of a currency
Examples - the U.S. dollar, the European Unions
euro, the Japanese yen, and the British poundA pegged exchange rate systemexists when the value
of a currency is fixed to a reference country and then theexchange rate between that currency and other
currencies is determined by the reference currencyexchange rate
Many developing countries have pegged exchangerates
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Introduction
A dirty floatexists when the value of a currency isdetermined by market forces, but with central bankintervention if it depreciates too rapidly against animportant reference currency
China adopted this policy in 2005 With a fixed exchange ratesystemcountries fix their
currencies against each other at a mutually agreed uponvalue
prior to the introduction of the euro, some EuropeanUnion countries operated with fixed exchange rateswithin the context of the European Monetary System(EMS)
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Introduction
Question: What role does the international monetary
system play in determining exchange rates?
Answer:To answer this question, we have to look at the evolution
of the international monetary system
The Gold Standard
The Bretton Woods systemThe International Monetary Fund
The World Bank
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The Gold Standard
Question:What is the Gold Standard?
Answer:The origin of the gold standard dates back to ancient
times when gold coins were a medium of exchange, unitof account, and store of valueTo facilitate trade, a system was developed so that
payment could be made in paper currency that couldthen be converted to gold at a fixed rate of exchange
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Mechanics of the Gold Standard
The gold standardrefers to the practice of peggingcurrencies to gold and guaranteeing convertibility
under the gold standard one U.S. dollar was definedas equivalent to 23.22 grains of "fine (pure) gold
The exchange rate between currencies was based onthe gold par value- the amount of a currency needed topurchase one ounce of gold
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Strength of the Gold Standard
The key strength of the gold standard was its powerfulmechanism for simultaneously allowing all countries toachieve balance-of-trade equilibrium- when the incomea countrys residents earn from its exports is equal to the
money its residents pay for imports
many people today believe the world should return tothe gold standard
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1918 - 1939
The gold standard worked fairly well from the 1870s untilthe start of World War I
After the war countries started regularly devaluing theircurrencies to try to encourage exports
Confidence in the system fell, and people began todemand gold for their currency putting pressure oncountries' gold reserves, and forcing them to suspendgold convertibility
The Gold Standard ended in 1939
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The Bretton Woods System
A new international monetary system was designed in1944 in Bretton Woods, New Hampshire
The goal was to build an enduring economic order thatwould facilitate postwar economic growth
The Bretton Woods Agreement established twomultinational institutions1. The International Monetary Fund (IMF)to maintain
order in the international monetary system2. The World Bankto promote general economic
development
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The Bretton Woods System
Under the Bretton Woods Agreement the US dollar was the only currency to be convertible
to gold, and other currencies would set theirexchange rates relative to the dollar
devaluations were not to be used for competitivepurposes a country could not devalue its currency by more than
10% without IMF approval
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The Role of the IMF
The IMF was responsible for avoiding a repetition ofthe chaos that occurred between the wars through acombination of
1.Discipline
a fixed exchange rate puts a brake on competitivedevaluations and brings stability to the world tradeenvironment
a fixed exchange rate regime imposes monetarydiscipline on countries, thereby curtailing priceinflation
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The Role of the IMF
2.Flexibility
A rigid policy of fixed exchange rates would be tooinflexible
So, the IMF was ready to lend foreign currencies to
members to tide them over during short periods ofbalance-of-payments deficits
A country could devalue its currency by more than 10percent with IMF approval
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The Role of the World Bank
The World Bank lends money in two ways
under the IBRD scheme, money is raised throughbond sales in the international capital market andborrowers pay what the bank calls a market rate of
interest - the bank's cost of funds plus a margin forexpenses.
under the International Development Agency scheme,loans go only to the poorest countries
The official name of the World Bank is the InternationalBank for Reconstruction and Development (IBRD)
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The Collapse of the Fixed System
Question:What caused the collapse of the BrettonWoods system?
Answer:
The collapse of the Bretton Woods system can be tracedto U.S. macroeconomic policy decisions (1965 to 1968)During this time, the U.S. financed huge increases in
welfare programs and the Vietnam War by increasing itsmoney supply which then caused significant inflation
Speculation that the dollar would have to be devaluedrelative to most other currencies forced other countriesto increase the value of their currencies relative to thedollar
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The Collapse of the Fixed System
The Bretton Woods system relied on an economicallywell managed U.S.
So, when the U.S. began to print money, run high tradedeficits, and experience high inflation, the system wasstrained to the breaking point
The Bretton Woods Agreement collapsed in 1973
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The Floating Exchange Rate Regime
Question:What followed the collapse of the BrettonWoods exchange rate system?
Answer:
Following the collapse of the Bretton Woods agreement,a floating exchange rate regime was formalized in 1976in Jamaica
The rules for the international monetary system thatwere agreed upon at the meeting are still in place today
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The Jamaica Agreement
At the Jamaica meeting, the IMF's Articles of Agreementwere revised to reflect the new reality of floatingexchange rates
Under the Jamaican agreement
floating rates were declared acceptable
gold was abandoned as a reserve asset
total annual IMF quotas - the amount member
countries contribute to the IMF - were increased to$41 billion (today, this number is $300 billion)
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Exchange Rates Since 1973
Since 1973, exchange rates have become more volatileand less predictable because of
the oil crisis in 1971
the loss of confidence in the dollar after U.S. inflation
jumped between 1977 and 1978the oil crisis of 1979
the rise in the dollar between 1980 and 1985
the partial collapse of the European Monetary System
in 1992
the 1997 Asian currency crisis
the decline in the dollar in the mid to late 2000s
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Fixed vs. Floating Exchange Rates
Question:Which is bettera fixed exchange rate systemor a floating exchange rate system?
Answer:Disappointment with floating rates in recent years has
led to renewed debate about the merits of a fixedexchange rate system
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The Case for Floating Rates
A floating exchange rate system provides twoattractive features
1. monetary policy autonomy
2. automatic trade balance adjustments
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The Case for Floating Rates
1.Monetary Policy Autonomy
The removal of the obligation to maintain exchangerate parity restores monetary control to a government
with a fixed system, a country's ability to expand orcontract its money supply is limited by the need tomaintain exchange rate parity
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The Case for Floating Rates
2.Trade Balance Adjustments
The balance of payments adjustment mechanismworks more smoothly under a floating exchange rateregime
under the Bretton Woods system (fixed system),IMF approval was needed to correct a permanentdeficit in a countrys balance of trade that could notbe corrected by domestic policy alone
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The Case for Fixed Rates
A fixed exchange rate system is attractive because
1. of the monetary discipline it imposes
2. it limits speculation
3. it limits uncertainty4. of the lack of connection between the trade balance
and exchange rates
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The Case for Fixed Rates
1.Monetary Discipline
Because a fixed exchange rate system requiresmaintaining exchange rate parity, it also ensures thatgovernments do not expand their money supplies at
inflationary rates
2.Speculation
A fixed exchange rate regime prevents destabilizingspeculation
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The Case for Fixed Rates
3.Uncertainty
The uncertainty associated with floating exchangerates makes business transactions more risky
4.Trade Balance Adjustments
Floating rates help adjust trade imbalances
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Who is Right?
There is no real agreement as to which system isbetter
History shows that fixed exchange rate regimemodeled along the lines of the Bretton Woods system
will not work A different kind of fixed exchange rate system might be
more enduring and might foster the kind of stability thatwould facilitate more rapid growth in international tradeand investment
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Exchange Rate Regimes in Practice
Currently, there are several different exchange rateregimes in practice
In 200614% of IMF members allow their currencies to float
freely26% of IMF members follow a managed float system28% of IMF members have no legal tender of their
ownthe remaining countries use less flexible systems
such as pegged arrangements, or adjustable pegs
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Exchange Rate Regimes in Practice
Figure 10.2: Exchange Rate Policies, IMF Members, 2008
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Pegged Exchange Rates
Under a pegged exchange rate regime countries peg thevalue of their currency to that of other major currencies
popular among the worlds smaller nations
There is some evidence that adopting a peggedexchange rate regime moderates inflationary pressuresin a country
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Currency Boards
A country with a currency boardcommits to convertingits domestic currency on demand into another currencyat a fixed exchange rate
The currency board holds reserves of foreign currency
equal at the fixed exchange rate to at least 100% of thedomestic currency issued
additional domestic notes and coins can beintroduced only if there are foreign exchange reservesto back it
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Crisis Management by the IMF
Question:What has been the role of the IMF in theinternational monetary systems since the collapse ofBretton Woods?
Answer:The IMF has redefined its mission, and now focuses on
lending money to countries experiencing financial crisesin exchange for enacting certain macroeconomic policies
Membership in the IMF has grown to 186 countries in2010, 54 of which has some type of IMF program inplace
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Financial Crises Post-Bretton Woods
Three types of financial crises that have requiredinvolvement by the IMF are
1.Acurrency crisis- occurs when a speculative attack onthe exchange value of a currency results in a sharp
depreciation in the value of the currency, or forcesauthorities to expend large volumes of internationalcurrency reserves and sharply increase interest rates inorder to defend prevailing exchange rates
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Financial Crises Post-Bretton Woods
2.A banking crisis - refers to a situation in which a loss ofconfidence in the banking system leads to a run on thebanks, as individuals and companies withdraw theirdeposits
3.A foreign debt crisis - a situation in which a countrycannot service its foreign debt obligations, whetherprivate sector or government debt
Two crises that are particularly significant are
1. the 1995 Mexican currency crisis
2. the 1997 Asian currency crisis
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The Mexican Currency Crisis of 1995
The Mexican currency crisis of 1995 was a result of highMexican debts, and a pegged exchange rate that did notallow for a natural adjustment of prices
in order to keep Mexico from defaulting on its debt, a
$50 billion aid package was created by the IMF
By 1997, Mexico was well on the way to recovery
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The Asian Crisis
Question:What were the causes of the1997 Asianfinancial crisis?
Answer:
The causes of the crisis can be traced to the previousdecade when the region was experiencingunprecedented growth
1.The Investment Boom
fueled by export-led growthlarge investments were often based on projections
about future demand conditions that were unrealistic
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The Asian Crisis
2.Excess Capacity
investments made on the basis of unrealistic projections aboutfuture demand conditions created significant excess capacity
3.The Debt Bomb
investments were often supported by dollar-based debts when inflation and increasing imports put pressure on the
currencies, the resulting devaluations led to default on dollardenominated debts
4.Expanding Imports
by the mid 1990s, imports were expanding across the regioncausing balance of payments deficits
The balance of payments deficits made it difficult for countries tomaintain their currencies against the U.S. dollar
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The Asian Crisis
By mid-1997, it became clear that several key Thaifinancial institutions were on the verge of default
Foreign exchange dealers and hedge funds started tospeculate against the Thai baht, selling it short
After struggling to defend the peg, the Thai governmentabandoned its defense and announced that the bahtwould float freely against the dollar
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The Asian Crisis
Thailand turned to the IMF for helpSpeculation continued to affect other Asian countries
including Malaysia, Indonesia, Singapore which all sawtheir currencies dropthese devaluations were mainly a result of excess
investment, high borrowings, much of it in dollardenominated debt, and a deteriorating balance ofpayments position
South Korea was the final country in the region to fall
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Evaluating the IMFs Policies
Question:How successful is the IMF at getting countriesback on track?
Answer:
In 2009, 54 countries were working IMF programsAll IMF loan packages come with conditions attached,generally a combination of tight macroeconomic policyand tight monetary policy
Many experts have criticized these policy prescriptions
for three reasons
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Evaluating the IMFs Policies
1.Inappropriate Policies
The IMF has been criticized for having a one-size-fits-all approach to macroeconomic policy that isinappropriate for many countries
2.Moral HazardThe IMF has also been criticized for exacerbating moral
hazard(when people behave recklessly because theyknow they will be saved if things go wrong)
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Evaluating the IMFs Policies
3.Lack of AccountabilityThe final criticism of the IMF is that it has become too
powerful for an institution that lacks any real mechanismfor accountability
Question:Who is right?
Answer:As with many debates about international economics, it
is not clear who is right
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Implications for Managers
Question:What are the implications of the internationalmonetary system for managers?
Answer:
The international monetary system affects internationalmanagers in three ways
1. Currency management
2. Business strategy
3. Corporate-government relations
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Currency Management
1.Currency ManagementThe current exchange rate system is a managed float
government intervention and speculative activityinfluence currency values
Firms can protect themselves from exchange ratevolatility through forward markets and swaps
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Business Strategy
2.Business StrategyExchange rate movements can have a major impact on
the competitive position of businessesthe forward market can offer some protection from
volatile exchange rates in the shorter termFirms can protect themselves from the uncertainty of
exchange rate movements over the longer term bybuilding strategic flexibility into their operations thatminimizes economic exposurefirms can disperse production to different locationsfirms can outsource manufacturing
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Classroom Performance System
When the foreign exchange market determines the relativevalue of a currency, a ________ exchange rate systemexists.
a)Fixed
b)Floatingc)Pegged
d)Market
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Classroom Performance System
The gold standard was a ______ exchange rate system.
a)Fixed
b)Floating
c)Peggedd)Market
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Classroom Performance System
Floating exchange rates were deemed acceptable under
a)The Bretton Woods Agreement
b)The Gold Standard
c)The Jamaica Agreementd)The Louvre Accord
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Classroom Performance System
The most common exchange rate policy among IMFmembers today is the
a)Free float
b)Managed float
c)Fixed peg
d)Adjustable peg
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