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International Finance FINA 5331 Lecture 2: Historical and current monetary arrangements: Please Read Chapter 2 Aaron Smallwood Ph.D. Exchange Rate Markets: Brief Introduction • A spot contract is a binding commitment for an exchange of funds, with normal settlement and delivery of bank balances following in two business days (one day in the case of North American currencies). • A forward contract, or outright forward, is an agreement made today for an obligatory exchange of funds at some specified time in the future (typically 1,2,3,6,12 months). Foreign Exchange Market Example • On March 12, 2014: The yuan price of the dollar (known as a “direct quotation” from China’s perspective) was: RMB 6.1432 – 6.1432 units of Chinese currency were needed to buy one dollar • At the same time, the dollar price of the RMB was (known as an indirect quotation from China’s perspective): – 1/6.1432 = $0.1628 (roughly 16 cents needed to buy one yuan). More recently • The RMB price of the dollar had been falling (a decline in the direct quotation is known as an appreciation) until January, when it reached a record low of RMB 6.0406. – Policy intended to keep inflation in check and potentially increase standards of living. • According to the Wall Street Journal, on March 3, 2014, “Many analysts say Beijing may soon widen the daily trading band to permit gains or losses of 1.5% or 2%, compared with the 1% limits currently.” And more recently: •“According to some analysts and people close to the PBOC's thinking, China's central bank has been guiding the yuan lower to drive out short-term speculators betting on its continued rise, as the bank prepares to allow greater trading fluctuations in the tightly controlled currency.” •"Most of the analyses are reasonable, and I consent," Mr. Zhou (PBOC President) said. •As of March 12, 2014, the RMB price of the dollar stood at: 6.1418 Cross currency exchange rate • On March 12, the yen price of the dollar had reached 102.71. • The RMB price of the yen: – S(RMB/$)/S(Yen/$) = 6.1418/102.71 = RMB 0.0598. International Monetary Arrangements • International Monetary Arrangements in Theory and Practice – – – – – – The International Gold Standard, 1879-1913 Interwar Period 1914-1944 Bretton Woods Agreement, 1945-1971 Smithsonian Agreement, 1971-1973 The Floating-Rate Dollar Standard, 1973-1984 The Plaza-Louvre Intervention Accords and the Floating-Rate Dollar Standard, 1985-1999 – AND WHAT NOW? Additionally • What exchange rate systems exist today? – The choice between a fixed system and a flexible system. • How does another country’s exchange rate system affect you? How does China’s changing exchange rate system affect you? • What are currency crises and how can they impact your business? • What is the euro? Will the euro-zone expand? How does expansion of the euro-zone affect you? The International Gold Standard, 1879-1913 Fix an official gold price or “mint parity” and allow free convertibility between domestic money and gold at that price. • Countries unilaterally elected to follow the rules of the gold standard system, which lasted until the outbreak of World War I in 1914, when European governments ceased to allow their currencies to be convertible either into gold or other currencies. The International Gold Standard, 1879-1913 For example, during the gold standard, the dollar is pegged to gold at : U.S.$20.67 = 1 ounce of gold The British pound is pegged at : £4.2474 = 1 ounce of gold. The exchange rate is determined by the relative gold contents: $20.67 = £4.2474 $4.866 = £1 The International Gold Standard, 1879-1913 • Highly stable exchange rates under the classical gold standard provided an environment that was conducive to international trade and investment. • Misalignment of exchange rates and international imbalances of payment were automatically corrected by the pricespecie-flow mechanism. Price-Specie-Flow Mechanism • Suppose Great Britain exported a great deal more to France than France imported from Great Britain . • This cannot persist under a gold standard. – Net export of goods from Great Britain to France will be accompanied by a net flow of gold from France to Great Britain. – This flow of gold will lead to a lower price level in France and, at the same time, a higher price level in Britain. • The resultant change in relative price levels will slow exports from Great Britain and encourage exports from France. The International Gold Standard, 1879-1913 • With stable exchange rates and a common monetary policy, prices of tradable commodities were much equalized across countries. • Real rates of interest also tended toward equality across a broad range of countries. • On the other hand, the workings of the internal economy were subservient to balance in the external economy. The International Gold Standard, 1879-1913 • There are shortcomings: – The supply of newly minted gold is so restricted that the growth of world trade and investment can be hampered for the lack of sufficient monetary reserves. – Even if the world returned to a gold standard, any national government could abandon the standard. The Relationship Between Money and Growth • Money is needed to facilitate economic transactions. • MV=PY →The equation of exchange. • Assuming velocity (V) is relatively stable, the quantity of money (M) determines the level of spending (PY) in the economy. • If sufficient money is not available, say because gold supplies are fixed, it may restrain the level of economic transactions. • If income (Y) grows but money (M) is constant, either velocity (V) must increase or prices (P) must fall. If the latter occurs it creates a deflationary trap. • Deflationary episodes were common in the U.S. during the Gold Standard. Interwar Period: 1914-1944 • Exchange rates fluctuated as countries widely used “predatory” depreciations of their currencies as a means of gaining advantage in the world export market. • Attempts were made to restore the gold standard, but participants lacked the political will to “follow the rules of the game”. • The result for international trade and investment was profoundly detrimental. • Smoot-Hawley tariffs • Great Depression Economic Performance and Degree of Exchange Rate Depreciation During the Great Depression Bretton Woods System: 1945-1971 • Named for a 1944 meeting of 44 nations at Bretton Woods, New Hampshire. • The purpose was to design a postwar international monetary system. • The goal was exchange rate stability without the gold standard. • The result was the creation of the IMF and the World Bank. Bretton Woods System: 1945-1971 • Each currency was pegged to the U.S. dollar at an official “par value”. • Each country was responsible for maintaining its exchange rate within ±1% of the adopted par value by buying or selling foreign reserves as necessary. • The U.S. was only country responsible for maintaining the gold parity, which they did at $35 per ounce. • Under Bretton Woods, the IMF was created and World Bank are created. • The Bretton Woods system is also known as an adjustable peg system. When facing serious balance of payments problems, countries could re-value their exchange rate. The US and Japan are the only countries to never re-value. The Fixed-Rate Dollar Standard, 1945-1971 • In practice, the Bretton Woods system evolved into a fixed-rate dollar standard. Industrial countries other than the United States : Fix an official par value for domestic currency in terms of the US$, and keep the exchange rate within 1% of this par value indefinitely. United States : Remain passive in the foreign change market; practice free trade without a balance of payments or exchange rate target. Bretton Woods System: 1945-1971 British pound German mark French franc Par Value U.S. dollar Pegged at $35/oz. Gold Purpose of the IMF The IMF was created to facilitate the orderly adjustment of Balance of Payments among member countries by: • encouraging stability of exchange rates, • avoidance of competitive devaluations, and • providing short-term liquidity through loan facilities to member countries Collapse of Bretton Woods • Triffin paradox – world demand for $ requires U.S. to run persistent balance-of-payments deficits that ultimately leads to loss of confidence in the $. • SDR was created to relieve the $ shortage. • Throughout the 1960s countries with large $ reserves began buying gold from the U.S. in increasing quantities threatening the gold reserves of the U.S. • Large U.S. budget deficits and high money growth created exchange rate imbalances that could not be sustained, i.e. the $ was overvalued and the DM and £ were undervalued. • Several attempts were made at re-alignment but eventually the run on U.S. gold supplies prompted the suspension of convertibility in September 1971. • Smithsonian Agreement – December 1971 The Floating-Rate Dollar Standard, 1973-1984 • Without an agreement on who would set the common monetary policy and how it would be set, a floating exchange rate system provided the only alternative to the Bretton Woods system. • In 1976, the Jamaica Accord demonetizes gold and the IMF declares floating exchange rates to be acceptable. The Floating-Rate Dollar Standard, 1973-1984 Industrial countries other than the United States : Smooth short-term variability in the dollar exchange rate, but do not commit to an official par value or to long-term exchange rate stability. United States : Remain passive in the foreign exchange market; practice free trade without a balance of payments or exchange rate target. No need for sizable official foreign exchange reserves. The Plaza-Louvre Intervention Accords and the Floating-Rate Dollar Standard, 1985-1999 • Plaza Accord (1985): – Allow the dollar to depreciate following massive appreciation…announced that intervention may be used. • Louvre Accord (1987) and “Managed Floating” – G-7 countries will cooperate to achieve exchange rate stability. – G-7 countries agree to meet and closely monitor macroeconomic policies. Value of $ since 1970