International Monetary System

Eva Lyn E. Fuentes

Global Business Environment MBA Philippine Christian University Engr. Mario Mecate

Chapter Preview

List the benefits of stable and predictable exchange rates Discuss the law-of-one-price principle Describe purchasing power parity and the factors that affect exchange rates Explain how the gold standard functioned Discuss the experience with Bretton Woods

Currency Values and Business

Exchange rates affect activities of both domestic and international firms Devaluation
lowers raises

Revaluation export prices import prices

raises

lowers

Stability and Predictability

Stable exchange rates Predictable exchange rates

Improve accuracy Improve accuracy of financial planning of financial planning

Reduce surprises Reduce surprises of unexpected of unexpected rate changes rate changes

Law of One Price

Identical item must have an identical price in all countries when expressed in a common currency
Undervalued or overvalued

McCurrency

Fairly good rate predictor Limited use in business decisions

Purchasing Power Parity

Relative ability of two nations currencies to buy the same basket of goods in those two nations Considers price Purchasing power levels in adjusting of a currency is relative currency values eroded by inflation

Inflation: Key Factors

Money supply Monetary policy directly affects interest rates and money supply Fiscal policy indirectly affects taxes and spending Employment High employment raises wages, which are embodied in consumer prices Interest rates High rates lower borrowing and spending, which lowers inflation Adjustment Exchange rates adjust to maintain PPP

Interest Rates

Fisher Effect Fisher Effect

Nominal Interest rate = Nominal Interest rate = real interest rate + inflation rate real interest rate + inflation rate

International International Fisher Effect Fisher Effect

Difference in nominal interest rates Difference in nominal interest rates supported by two nations currencies supported by two nations currencies will cause an equal but opposite will cause an equal but opposite change in their spot exchange rates change in their spot exchange rates

Adjusting to Currency Swings

Export strategies in the face of currency swings

Strong currency:
Prune operations Adapt products Source abroad Freeze prices

Weak currency:
Source domestically Grow at home Push exports Reduce expenses

Gold Standard
International monetary system that linked nations currencies to specific values of gold
In place from 1700s to 1939 Reduced exchange-rate risk Restricted monetary policies Corrected trade imbalances Ended by competitive devaluation

Bretton Woods Agreement

International monetary system based on value of U.S. dollar (1944 to 1973)
Fixed exchange rates Built-in flexibility World Bank and IMF Ended by weak U.S. dollar

Jamaica Agreement
Formalized the system of floating exchange rates as the new international monetary system (1976)

Managed float system

Currencies float with government intervention

Free float system

Currencies float without government intervention

The System Today

Managed float system Pegged exchange rates Currency board

uropean European monetary system

The Foreign Exchange Market

Key Issues
What is the form and function of the foreign exchange market? What is the difference between spot and forward exchange rates? How are currency exchange rates determined? What is the role of the foreign exchange market in insuring against foreign exchange risk? What are the merits of different approaches toward exchange rate forecasting? Why are some currencies not always convertible into other currencies? How is countertrade used to mitigate problems associated with an inability to convert currencies?

Foreign Exchange
The foreign exchange market - Is the market where one buys (or sells)
the currency of country A with (or for) the currency of country B

A currency exchange rate - Is simply the ratio of a unit of currency of

country A to a unit of the currency of country B at the time of the buy or sell transaction

The Foreign Exchange Market

Currency conversion in the foreign exchange market - Is necessary to complete private and commercial transactions across borders - A tourist needs to pay expenses on the road in local currency - A firm Buys/sells goods and services in the other countrys local currency Uses the foreign exchange market to invest excess funds Is used to speculate on currency movements

The Foreign Exchange Market

Minimizes foreign exchange risk (unpredictable rate swings) There are different ways to trade currencies - Spot exchange rates: the days rate offered by a dealer/bank - Forward exchange rates: Agreed in advance rates to buy/sell a currency on a future date Usually quoted 30, 90, 120 days in advance The market is open 24 hours Arbitrage: buying low and selling high given slightly different exchange rate quotes in one location vs another (e.g., London vs Tokyo)

Prices and Exchange Rates

The law of one price: - In competitive markets free of transportation costs and trade barriers, identical products sold in different countries must sell for the same price when their price is expressed in the same currency Purchasing Power Parity (PPP): - If the law of one price holds for all goods and services, the PPP exchange rate can be found by comparing the prices of identical products in different countries - Changes in relative prices will change exchange rates...

Money Supply and Currency Value

Changes in relative prices in two countries will change the exchange rate of their currencies; the country with the highest price inflation should see its currency decline in value. Relative inflation rate levels and trends can predict relative exchange rate movements Inflation happens when the quantity of money in circulation rises faster than the stock of goods and services; money supply growth is related to currency value

Interest Rates and Exchange Rates

Interest rates reflect expectations about likely future inflation rates; - high interest rates reflect high inflation expectation - Fisher Effect: i = r + I i: nominal interest rate in a country r: real interest rate I: inflation over the period the funds are to be lent - International Fisher Effect: (S1-S2)/S2 X 100 = i$ - i For any two countries the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries S1: spot rate at time 1, S2 : spot rate at time 1; i$, i: nominal interest rates in the US and Japan

Exchange Rate Forecasting

The efficient market school - Prices reflect all available public information The inefficient market school - Prices do not reflect all available public information Approaches to forecasting future movements - Fundamental analysis: predictions with econometric models based on economic theory - Technical analysis: extrapolation/interpretation of past trends assuming they predict future

Convertibility
Convertibility and government policy - Currency freely convertible: residents/non-residents allowed to purchase unlimited amounts of a foreign currency with the local currency - Currency not freely convertible: residents/nonresidents not allowed to purchase unlimited amounts of a foreign currency with the local currency Countertrade - Barter-like agreements by which goods and services can be traded for other goods and services - Used to get around the non-convertibility of currencies