10 International Monetary System Chapter Objectives Explain how

10 International Monetary System

Chapter Objectives Explain how exchange rates influence the activities of domestic and international companies Identify the factors that help determine exchange rates and their impact on business Describe the primary methods of forecasting exchange rates Discuss the evolution of the current international monetary system and explain how it operates 10 - 2

The Euro • Currency of 17 European nations • Boosted efficiency and competitiveness • Later declined with lower expectations 10 - 3

Currency Values and Business Exchange rates affect activities of both domestic and international firms Devaluation Revaluation Export prices Import prices 10 - 4

Major World Currencies Source: Based on Economic Report of the President, Table B 110, multiple years 10 - 5

Stability and Predictability Stable exchange rates • Improve accuracy of forecasts and financial planning Predictable exchange rates • Reduce surprises of unexpected rate changes 10 - 6

Value of U. S. Dollar Source: Based on Economic Report of the President, Table B 110, multiple years 10 - 7

Buying Power Example Cost in New York… $60 Purchasing Power Cost in Japan… $80 Cost in Mexico… $30 10 - 8

Discussion Question What are the key differences between the concepts of devaluation and revaluation? 10 - 9

Answer to Discussion Question Devaluation is the intentional lowering of a currency’s value by a nation’s government. It lowers the price of a country’s exports and increases the price of imports. Devaluation reduces buying power. Revaluation is the intentional raising of a currency’s value by a nation’s government. It increases the price of a country’s exports and lowers the price of imports. Revaluation boosts buying power. 10 - 10

Law of One Price Identical item must have an identical price in all countries when price is expressed in a common currency 10 - 11

Big Mac Index Uses law of one price and cost of a Big Mac Estimates undervalued and overvalued currencies Fairly good predictor of long-term rates 10 - 12

Purchasing Power Parity Relative ability of two nations’ currencies to buy the same “basket” of goods in those two nations Focuses squarely on Considers price local purchasing levels in adjusting power relative currency values of a currency 10 - 13

Effects of Inflation erodes a currency’s purchasing power! Source: Desmond Kwande/Getty Images/Newscom 10 - 14

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 interest rates lower borrowing and spending, which lowers inflation Adjustment • Exchange rates adjust to maintain PPP 10 - 15

Interest Rates Fisher Effect Nominal interest rate = real rate + inflation rate International Fisher Effect Difference in nominal interest rates supported by two nations’ currencies will cause an equal but opposite change in their spot exchange rates 10 - 16

Evaluating PPP Added costs Trade barriers Business confidence & psychology 10 - 17

Discussion Question The principle known as the _____ can be interpreted as the exchange rate between two nations’ currencies that is equal to the ratio of their price levels. a. Law of one price b. International Fisher effect c. Purchasing power parity 10 - 18

Answer to Discussion Question The principle known as the _____ can be interpreted as the exchange rate between two nations’ currencies that is equal to the ratio of their price levels. a. Law of one price b. International Fisher effect c. Purchasing power parity 10 - 19

Two Market Views Efficient market view • Forward exchange rates best predict future rates Inefficient market view • Additional information can improve rate forecasts 10 - 20

Techniques of Forecasting Fundamental analysis Statistical modeling Technical analysis Chart currency trends Forecasting difficulties Flawed data Human error 10 - 21

Gold Standard: Early Years Monetary system from the 1700 s to 1939 that linked national currencies to specific values of gold Reduced exchange-rate risk Restricted monetary policies Corrected trade imbalances 10 - 22

Gold Standard Collapse v Printing excessive money caused high inflation v British pound returns at its pre-inflation level v U. S. dollar returns at its lower (devalued) level v Competitive devaluations force system to collapse 10 - 23

Bretton Woods Agreement International monetary system based on value of U. S. dollar (1944 to 1973) Fixed exchange rates Built-in flexibility World Bank (IBRD) International Monetary Fund 10 - 24

End of Bretton Woods § Nations demand gold in return for their paper U. S. dollars § Nations raise their currency values relative to dollars § Persistently weak dollar forces nations to leave the system § Most currencies begin to float freely against the dollar 10 - 25

Discussion Question What characteristics of the gold standard lead some to call for its return today? 10 - 26

Answer to Discussion Question The gold standard linked nations’ paper currencies to values of gold and to each other. This reduced exchange rate risk. Nations had to convert their paper currency into gold on demand by currency holders so paper currency values could not grow faster than the value of gold reserves. This imposed strict monetary policies on nations. A nation experiencing a trade deficit had to decrease its supply of paper currency, which lowered domestic prices, which lowered export prices, which boosted exports until trade was balanced. This helped correct trade imbalances for nations. 10 - 27

Jamaica Agreement Formalized the managed float system of exchange rates as the new international monetary system Managed float system Currencies float with government intervention Free float system Currencies float without government intervention 10 - 28

The System Today Managed float system Pegged exchange rates Currency board European monetary system 10 - 29

Adjusting to Currency Swings Export strategies in the face of currency swings Strong currency: Weak currency: ü Prune operations ü Source domestically ü Adapt products ü Grow at home ü Source abroad ü Push exports ü Freeze prices ü Reduce expenses 10 - 30

Financial Crises v Developing nations v Mexico v Southeast Asia v Russia v Argentina 10 - 31

Europe’s Debt levels spiraled out of control in some European nations recently. The IMF and EU have organized bailouts for Greece, but the austerity measures it imposed angered the people. Source: Simela Pantzartzi/Newscom 10 - 32

Future of the International Monetary System • Greater IMF transparency • Better manage risks • Monitor “hot” money flows • Private sector 10 - 33

Discussion Question A _____ exchange rate system is one in which currencies float against one another, with governments intervening to stabilize their currencies at particular exchange rates. a. Free float b. Managed float c. Jamaica float 10 - 34

Answer to Discussion Question A _____ exchange rate system is one in which currencies float against one another, with governments intervening to stabilize their currencies at particular exchange rates. a. Free float b. Managed float c. Jamaica float 10 - 35