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Chapter 08
The International Monetary
System
and Financial Forces
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives
• LO1 Describe the international monetary system’s
evolution.
• LO2 Explain the Triffin paradox.
• LO3 Describe the floating currency exchange rate
system, including the IMF currency arrangements.
• LO4 Discuss the purpose of the Bank for International
Settlements.
• LO5 Explain the impact of fluctuating currency values.
8-2
Learning Objectives cont’d
•LO6 Discuss how foreign exchange is quoted.
•LO7 Describe the factors that influence exchange
rate movement.
•LO8 Outline the approaches to exchange rate
forecasting.
•LO9 Discuss the influence of currency exchange
controls on international business.
•LO10 Summarize the influences of differences in
taxation and inflation rates on international business.
•LO11 Explain the significance of the balance of
payments (BOP) to international business decisions.
8-3
International Monetary System
• Key Terms
Gold Standard
• The use of gold at an established number of units per currency
Bretton Woods System
• Monetary system from 1945 to 1971
• Used a par value based on gold and the U.S. dollar
Fixed Exchange Rate
• Specific currency exchange equivalence upheld by government
Par Value
• Stated value
8-4
Brief History of the Gold
Standard
• Price of gold has risen from 1200 A.D. through today.
• Traders carried bullion, gold + silver coins till late 19th C.
• 1717, Sir Isaac Newton put England on the gold standard based
on British currency, pound sterling.
• Britain converted gold  currency until 1914 and WWI, except
during Napoleonic Wars.
• British sold gold to finance WWI, then stopped gold exchange.
Germany, France and Russia followed.
8-5
Bretton Woods System
• Bretton Woods, NH,meeting of WWII Allies to plan postWWII monetary arrangements.
• IMF established.
• IMF Articles of Agreement:
• Bretton Woods system for fixed exchange rates among
member’s currencies, with par value based on gold @ $35/oz
and the U.S.$.
• Bretton Woods system supported huge international trade
growth in the 1950ies and 1960ies.
8-6
Floating Currency Exchange
Rate System
Floating Currency Exchange Rates
Rates allowed to float against other currencies and determined
by market forces.
Jamaica Agreement
• 1976 IMF agreement for flexible exchange rates among members.
• Precipitated by 1971 French redemption of $ for gold.
• Nixon stopped gold exchange for $, abandoned gold as reserve
currency
8-7
8 IMF Currency Arrangements
Exchange arrangement with no separate legal tender
U.S.$ in El Salvador & Ecuador; €
Currency board arrangement, exchange at fixed rate
Hong Kong, Bulgaria
Conventional fixed peg arrangement
fluctuations < 1% allowed. Saudi riyal -U.S.$
Pegged exchange rate within horizontal band
peg with fluctuation > 1%. Danish kroner - €
8-8
Currency Arrangements cont’d
Crawling peg
Readjusted at pre-announced rate periodically
Crawling band
Readjusted to maintain fluctuation margins
Managed floating with no preannounced path
Monetary authority intervention in FX without
disclosing goals or targets: Algeria, India
Independently Floating Exchange Rates
Market drives exchange rates-- US, Canada, Japan, UK
8-9
Challenges to the Floating
Exchange Rate System
• 2008 central bank liquidity crisis
• Explosive growth in volume of currency
trades in FX markets
• Japanese yen issues after 2011 quake
8-10
8-11
Financial Forces
Fluctuating Currency Values
• Freely floating currencies move against each
other
• Central banks can buy/sell currency to affect
supply & demand in FX markets
• Central banks let major currencies ($,€,£,¥)
freely fluctuate
• Fluctuations can be huge
8-12
Foreign Exchange
FX Quotation
the price of 1 currency given in terms of another:
• $1U.S.= £0.642767
• £1.00 = $1.55577
8-13
Exchange Rate Quotations
Spot Rate
Exchange rate between 2
currencies deliverable
within 2 business days
Forward Market
Market for currency
purchases at specified
rates deliverable in 30,
60, 90, or 180 days
8-14
Exchange Rate Movement Caused by
•
•
•
•
•
•
•
Supply & demand forecasts
Inflation
Productivity and unit labor cost changes
Political developments
Government fiscal, monetary, and fx market actions
BOP accounts
Psychological aspects
8-15
Exchange Rate Movement
Parity Relationships rest on law of one price
• Interest Rate Parity
• Purchasing Power Parity (PPP)
8-16
Exchange Rate Movement
Fisher Effect
Relationship between real and nominal interest rates:
Real = nominal – expected inflation rate
International Fisher Effect
Interest rate differentials for any 2 currencies reflect the
expected change in their exchange rates
Purchasing Power Parity (PPP)
Units of currency needed to buy the same basked of goods &
services in the foreign market that $1.00 would buy in the U.S
8-17
Exchange rate movements impact
•
•
•
•
Production
Sourcing
Marketing
Finance
8-18
Approaches to
Exchange Rate Forecasting
8-19
Currency Exchange Controls
8-20
Taxation – A Significant Financial Force
Income Tax
Direct tax on personal and corporate income
Value-added Tax (VAT)
Charged on the value added to a good from raw material, to
production, to final purchaser
Withholding Tax
Indirect tax on passive income (dividends, royalties, interest)
8-21
Inflation
• raises prices
• determines the real cost of borrowing in
capital markets
• measured by consumer price index (CPI),
the average price changes in a basket of
consumer goods
8-22
Inflation and Interest Rates
Inflation
• encourages borrowing (debt)
loan will be repaid with inflated, cheaper money
• high inflation rates bring high interest rates
• inflation discourages lending
lenders fear that the $s repaid + interest will have
less value than the $s lent
8-23
Inflation and Interest Rates
Inflation
• Affects currency exchange rates
• Inflated currencies weaken economies
• People may buy items expected to increase in value, further
fueling inflation
• Causes cost of goods and services to rise,
country becomes less globally competitive
• Export sales are difficult and may lead to BOP deficits in the
trade account
• This leads to more trade restrictions
8-24
Sample
Interest
Rates
8-25
Balance of Payments (BOP)
BOP: a country’s record of global transactions
BOP shows global demand for country’s currency.
• Exports > imports = high demand
• Imports > exports = low demand, weak or devalued
currency
• possible currency or trade controls introduced
8-26