BF464 Lecture3

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Published on April 17, 2008

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BF464: International Finance:  BF464: International Finance International Monetary System Objective:  Objective Understand (a) what the international monetary system is and (b) how the choice of system affects currency value. also (c) provide a historical background of the international monetary system We will describe how exchange rates are determined under five different mechanisms‑‑free float, managed float, fixed‑rate system, target‑zone system and the current hybrid system. PART I. ALTERNATIVE EXCHANGE RATE SYSTEMS:  PART I. ALTERNATIVE EXCHANGE RATE SYSTEMS A. Freely Floating (Clean Float) 1. Market forces of supply and demand determine rates. 2. Forces influenced by a. price levels b. interest rates c. economic growth 3. Rates fluctuate over time randomly (participants will react to new information). PART I. ALTERNATIVE EXCHANGE RATE SYSTEMS – Free Float:  PART I. ALTERNATIVE EXCHANGE RATE SYSTEMS – Free Float Price of US dollar in terms of Euro is plotted below - September 1st to October 22nd 2004. PART I. ALTERNATIVE EXCHANGE RATE SYSTEMS – Free Float:  PART I. ALTERNATIVE EXCHANGE RATE SYSTEMS – Free Float Volatility of EUR/USD exchange rate is much lower now than before as indicated by standard errors. PART I. ALTERNATIVE EXCHANGE RATE SYSTEMS – Free Float:  PART I. ALTERNATIVE EXCHANGE RATE SYSTEMS – Free Float USD/DM 5-minute rates for November 25th 1996. Variance of EUR/USD exchange rate is 0.0018 ALTERNATIVE EXCHANGE RATE SYSTEMS:  ALTERNATIVE EXCHANGE RATE SYSTEMS B. Managed Float (Dirty Float) – It is difficult to resist to intervene in the market to reduce the economic uncertainty associated with a clean float. An brupt change can negatively impact the export industry (ıf appreciation) or lead to higher inflation (depreciation). 1. Market forces set rates unless excess volatility occurs. 2. Then, central bank determines rate. ALTERNATIVE EXCHANGE RATE SYSTEMS:  ALTERNATIVE EXCHANGE RATE SYSTEMS Three categories of intervention (1) Smoothing out daily fluctuations intervene to preserve an orderly pattern of exchange rate changes. For example, Brazilian Peso is allowed to depreciate monthly by about 0.6 percent against the dollar. (2) Leaning against the wind designed to prevent short and medium term fluctuations brought about by temporary random events. It delays the impacts. Determination of temporary or fundamental effects. (3) Unofficial pegging Involves resisting any fundamental upward or downward exchange rate movements – ALTERNATIVE EXCHANGE RATE SYSTEMS:  ALTERNATIVE EXCHANGE RATE SYSTEMS C. Target-Zone Arrangement Countries adjust their national economic policies to maintain their exchange rates within a specific margin around agreed-upon, fixed exchange rates. 1. Rate Determination a. Market forces constrained to upper and lower range of rates. b. Members to the arrangement adjust their national economic policies to maintain target. ALTERNATIVE EXCHANGE RATE SYSTEMS:  ALTERNATIVE EXCHANGE RATE SYSTEMS D. Fixed Rate System 1. Rate determination a. Government maintains target rates. b. If rates are threatened, central banks buy/sell currency. c. Monetary policies coordinated – all have the same inflation rate. No control over monetary policy. ALTERNATIVE EXCHANGE RATE SYSTEMS:  ALTERNATIVE EXCHANGE RATE SYSTEMS 2. Some Government Controls – the most drastic occurs when all foreign exchange earnings must be surrendered to the central bank: a. On global portfolio investments. b. Ceilings on direct foreign direct insurance. c. Import restrictions. d. Imposition of taxes and limitations on foreign-owned bank deposits. e. Limitations on prepayments for imports. ALTERNATIVE EXCHANGE RATE SYSTEMS:  ALTERNATIVE EXCHANGE RATE SYSTEMS E. Current System 1. A hybrid system a. Major currencies: use freely-floating method b. Others move in and out of various fixed-rate systems. PART II. A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM:  PART II. A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM I. THE USE OF GOLD A. Desirable properties – durable, storable, portable, easily recognized, divisible and easily standardized. B. In short run: High production costs limit short-run changes. C. In long run: Commodity money insures stability. PART II. A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM:  PART II. A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM The Gold Standard involved a commitment to fix the prices of their domestic currencies in terms of a specified amount of gold. They are willing to buy or sell gold to anyone at that price. For example, Great Britain maintained a fixed price of gold at 4.2474 per ounce. The US maintained the price of gold at $20.67 per ounce. Hence, dollar-pound exchange rate can easily determined as: ($20.67 per ounce of gold)/(pound 4.2474 per ounce of gold)=$4.8665 per one pound PART II. A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM:  PART II. A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM Fiat money is nonconvertible paper money backed only by faith that the monetary authorities will not cheat by issuing more money (100% profit margin). By contrast, the net profit margin on issuing more money under gold standard is zero. Under the classical gold standard, disturbances in Price Levels would be wholly or partly offset by automatic balance of payments adjustment mechanism called the price- specie*-flow mechanism. * specie refers to gold coins A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM:  A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM a. Price-specie-flow mechanism had automatic adjustments : 1.) When a balance of payments surplus led to a gold inflow; 2.) Gold inflow led to higher prices which reduced surplus; 3.) Gold outflow led to lower prices and increased surplus. A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM:  A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM II. The Classical Gold Standard (1821-1914) - Major currencies on gold standard. Characterized by: free international trade, stable exchange rates and prices, rapid economic growth, free flow of labor and capital across borders and world peace. A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM:  A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM III. The Gold Exchange Standard (1925-1944) Gold standard broke down during WWI A. Only U.S. and Britain allowed to hold gold reserves. B. Other countries could hold both gold, dollars or pound reserves. A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM:  A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM C. Currencies devalued in 1931 - “beggar-thy-neighbor” devaluations - led to trade wars. D. Bretton Woods Conference - called in order to avoid future protectionist and destructive economic policies - created two new institutions: IMF and World Bank. - IMF was created to promote monetary stability. - WB to lend money to countries so that they can build their infrastructure A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM:  A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM Role of IMF evolve over time. - oversees exchange rate policies - advises developing countries how to turn their economies around It has become lender of last resort which creates a moral hazard problem. IMF bailouts causes (a) governments persist with bad policies and (b) investors to underestimate the risks In theory, IMF makes short term loans conditional on the borrower’s implementation of policy changes. Conditionality has little credibility. A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM:  A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM V. The Bretton Woods System (1946-1971) 1. U.S.$ was key currency; valued at $1 - 1/35 oz. of gold. 2. All currencies linked to that price in a fixed rate system. A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM:  A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM 3. Exchange rates allowed to fluctuate by 1% above or below initially set rates. Fixed exchange rates were maintained by official intervention in the foreign exchange market. Withot price stability, balance of payment deficits was the result. Experienced foreign exchange crisis as governments were reluctant to adjust their economic policies. B. Collapse, 1971 1. Causes: a. U.S. high inflation rate (by printing money) b. U.S.$ depreciated sharply. A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM:  A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM V. Post-Bretton Woods System (1971-Present) A. Smithsonian Agreement, 1971 US$ devalued to 1/38 oz. of gold. By 1973: World on a freely floating exchange rate system. A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM:  A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM NEER: Nominal Effective Exchange Rate A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM:  A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM Volatility is calculated as the rolling standart deviation over the past 24 months using NEER PART III. THE EUROPEAN MONETARY SYSTEM:  PART III. THE EUROPEAN MONETARY SYSTEM I. INTRODUCTION A. The European Monetary System (EMS) – goal was to foster monetary stability in the European Community 1. A target-zone method (1979) 2. Close macroeconomic policy coordination required. THE EUROPEAN MONETARY SYSTEM:  THE EUROPEAN MONETARY SYSTEM B. EMS Objective: to provide exchange rate stability to all members by holding exchange rates within specified limits. THE EUROPEAN MONETARY SYSTEM:  THE EUROPEAN MONETARY SYSTEM C. European Currency Unit (ECU) A “cocktail” of European currencies (composite currency) with specified weights as the unit of account. 1. Exchange rate mechanism (ERM) each member determines mutually agreed upon central cross rate for its currency. THE EUROPEAN MONETARY SYSTEM:  THE EUROPEAN MONETARY SYSTEM National currency weights to the ECU value THE EUROPEAN MONETARY SYSTEM:  THE EUROPEAN MONETARY SYSTEM 2. Member Pledge: To keep within 15% margin above or below the central rate. D. EMS ups and downs 1. Foreign exchange interventions failed due to lack of support by coordinated monetary policies. THE EUROPEAN MONETARY SYSTEM:  THE EUROPEAN MONETARY SYSTEM 2. Currency Crisis of Sept. 1992 – Bundesbank’s decision to tighten the monetary policy (high R); high cost of intervention by other countries (R was 500% in Sweden) a. System broke down b. Britain and Italy forced to withdraw from EMS. G. Failure of the EMS members allowed political priorities to dominate exchange rate policies. EMS has succeeded to lower inflation in Europe. THE EUROPEAN MONETARY SYSTEM:  THE EUROPEAN MONETARY SYSTEM H. Maastricht Treaty 1. Called for Monetary Union by 1999 (moved to 2002). 2. Established a single currency: the euro 3. Calls for creation of a single central EU bank. 4. Adopts tough fiscal standards. THE EUROPEAN MONETARY SYSTEM:  THE EUROPEAN MONETARY SYSTEM I. Costs / Benefits of A Single Currency A. Benefits 1. Reduces cost of doing business (e.g. Philips saves a $300 million a year from a single currency transactions cost; easier corporate planning, pricing and invoicing). 2. Reduces exchange rate risk B. Costs 1. Lack of national monetary flexibility. It can also impose high costs if wages and prices are inflexible. - What happens if demand for French goods fall sharply? Emerging Market Currency Crisis:  Emerging Market Currency Crisis Currency crisis tend to be contagious. Two major contagion channels. Trade links: can sperad from one nation to another through trade. For example, when Argentina is in crisis, it imports less from Brazil. Financial System: Trouble in one market as a wake-up call for similar countries. Investors seek to exit these similar countries. For example, Asian currency crisis in 1997. Financial contagion can also occur if investors start selling their assests in other countries to cover their losses. Emerging Market Currency Crisis:  Emerging Market Currency Crisis Sources: Moral Hazard - IMF Fundamental policy conflict among policy objectives Emerging Market Currency Crisis:  Emerging Market Currency Crisis Possible ways to avoid currency crisis Currency controls Freely floating currency Permanently fixed exchange rate (money supply adjusts to the balance of payments) Slide37:  Currency units per euro

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