Download The Gold Standard

International Finance
FIN456 ♦ Fall 2012
Michael Dimond
Market Efficiency & Exchange Rates
• The Efficient Market Hypothesis (EMH)
• Efficiency means prices come into equilibrium
• An exchange rate is the “price” of one unit of a foreign
currency expressed as a certain price in local currency.
• For example: $0.99/€ means the euro is worth $0.99 in the United States
• The exchange rate is based on the demand for foreign
currency by another economy
• The demand for currency is driven by the demand for a
foreign country’s goods & services
• Buyers must convert their spending power into foreign
currency to make purchases
Michael Dimond
School of Business Administration
Equilibrium is based on supply & demand
• At a higher exchange rate, would American demand more
euros to make purchases or fewer?
• Would Germans demand more dollars or fewer?
Michael Dimond
School of Business Administration
How Exchange Rates Change
• Increased demand for currency as more foreign goods are
demanded, more of the foreign currency is demand at each
possible exchange rate
• The price of the foreign currency in local currency increases.
• Home Currency Depreciation happens when the foreign
currency’s “price” rises. In other words, the foreign currency’s
value has appreciated against the home currency.
• There are many factors which affect exchange rates, but the
three most important are growth in an economy, inflation in
an economy and interest rates in an economy.
• There is a lot of jargon involved in foreign exchange, and the
best way to learn this is by solving some simple problems.
• See: Ch 1-3 Key Computations & Concepts
Michael Dimond
School of Business Administration
The International Monetary System
• The international monetary system has evolved from the gold
standard to an eclectic currency arrangement
• In the modern world, there are five basic models for foreign
exchange:
•
•
•
•
•
Free Float (“Clean Float”)
Managed Float (“Dirty Float)
Target Zone Arrangement
Fixed Rate System
Hybrid System
Michael Dimond
School of Business Administration
Trade-offs in Currency Management
Michael Dimond
School of Business Administration
The Gold Standard
• The Gold Standard, 1876-1913
• Countries set par value for their currency in terms of gold
• This came to be known as the gold standard and gained acceptance
in Western Europe in the 1870s
• The US adopted the gold standard in 1879
• The “rules of the game” for the gold standard were simple
• Example: US$ gold rate was $20.67/oz, the British pound was pegged at
£4.2474/oz
• US$/£ rate calculation is $20.67/£4.2472 = $4.8665/£
Michael Dimond
School of Business Administration
The Gold Standard
• Because governments agreed to buy/sell gold on demand
with anyone at its own fixed parity rate, the value of each
currency in terms of gold, the exchange rates were therefore
fixed
• Countries had to maintain adequate gold reserves to back its
currency’s value in order for regime to function
• The gold standard worked until the outbreak of WWI, which
interrupted trade flows and free movement of gold thus
forcing major nations to suspend operation of the gold
standard
Michael Dimond
School of Business Administration
The Gold Standard between 1914 & 1944
• During WWI, currencies were allowed to fluctuate over wide
ranges in terms of gold and each other, theoretically, supply
and demand for imports/exports caused moderate changes in
an exchange rate about an equilibrium value
• The gold standard has a similar function
• In 1934, the US devalued its currency to $35/oz from
$20.67/oz prior to WWI
• From 1924 to the end of WWII, exchange rates were
theoretically determined by each currency's value in terms of
gold.
• During WWII and aftermath, many main currencies lost their
convertibility. The US dollar remained the only major trading
currency that was convertible
Michael Dimond
School of Business Administration
Bretton Woods & the IMF
• Allied powers met in Bretton Woods, NH and created a postwar international monetary system in 1944
• The agreement established a US dollar based monetary
system and created the IMF and World Bank
• Under original provisions, all countries fixed their currencies
in terms of gold but were not required to exchange their
currencies
• Only the US dollar remained convertible into gold (at $35/oz
with Central banks, not individuals)
Michael Dimond
School of Business Administration
Ramifications of Bretton Woods
• Each country established its exchange rate vis-à-vis the US
dollar and then calculated the gold par value of their currency
• Participating countries agreed to try to maintain the currency
values within 1% of par by buying or selling foreign or gold
reserves
• Devaluation was not to be used as a competitive trade policy,
but if a currency became too weak to defend, up to a 10%
devaluation was allowed without formal approval from the
IMF
Michael Dimond
School of Business Administration
Fixed exchange rates, 1945-1973
• Bretton Woods and IMF worked well post WWII, but diverging
fiscal and monetary policies and external shocks caused the
system’s demise
• The US dollar remained the key to the web of exchange rates
• Heavy capital outflows of dollars became required to meet
investors’ and deficit needs and eventually this overhang of
dollars held by foreigners created a lack of confidence in the
US’ ability to meet its obligations
Michael Dimond
School of Business Administration
The End of Fixed Rates
• This lack of confidence forced President Nixon to suspend
official purchases or sales of gold on Aug. 15, 1971
• Exchange rates of most leading countries were allowed to
float in relation to the US dollar
• By the end of 1971, most of the major trading currencies had
appreciated vis-à-vis the US dollar; i.e. the dollar depreciated
• A year and a half later, the dollar came under attack again
and lost 10% of its value
• By early 1973 a fixed rate system no longer seemed feasible
and the dollar, along with the other major currencies was
allowed to float
• By June 1973, the dollar had lost another 10% in value
Michael Dimond
School of Business Administration
The IMF’s Exchange Rate Index of the Dollar
Michael Dimond
School of Business Administration
Returns on gold (as of 2010)
House
5.8%
6.0%
6.6%
5.3%
5.3%
6.4%
Annualized Return since 1950
Annualized Return since 1960
Annualized Return since 1970
Annualized Return since 1980
Annualized Return since 1990
Annualized Return since 2000
Gold
6.2%
7.4%
9.3%
2.5%
6.2%
16.3%
Stock
7.3%
6.1%
6.4%
8.2%
5.9%
-2.5%
Inflation
3.7%
4.1%
4.4%
3.3%
2.6%
2.4%
Gold Price ($/oz)
1,400
1,200
In 1971, President Richard Nixon
ended the direct convertibility of
the dollar to gold
1,000
800
600
400
200
1790
1810
1830
1850
1870
1890
1910
1930
1950
1970
1990
2010
Michael Dimond
School of Business Administration
Hedge against inflation?
House
5.8%
6.0%
6.6%
5.3%
5.3%
6.4%
Annualized Return since 1950
Annualized Return since 1960
Annualized Return since 1970
Annualized Return since 1980
Annualized Return since 1990
Annualized Return since 2000
Stock
7.3%
6.1%
6.4%
8.2%
5.9%
-2.5%
Inflation
3.7%
4.1%
4.4%
3.3%
2.6%
2.4%
(year/year)
Do you see much Inflation
correlation
between gold and inflation
since Nixon ended the direct
convertibility of the dollar to
gold?
30%
25%
20%
15%
10%
5%
0%
-5%
-10%
-15%
-20%
1790
Gold
6.2%
7.4%
9.3%
2.5%
6.2%
16.3%
1810
1830
1850
1870
1890
1910
1930
1950
1970
1990
2010
Michael Dimond
School of Business Administration
Hindsight: Gold vs other investments
House
5.8%
6.0%
6.6%
5.3%
5.3%
6.4%
Annualized Return since 1950
Annualized Return since 1960
Annualized Return since 1970
Annualized Return since 1980
Annualized Return since 1990
Annualized Return since 2000
Gold
6.2%
7.4%
9.3%
2.5%
6.2%
16.3%
Stock
7.3%
6.1%
6.4%
8.2%
5.9%
-2.5%
Inflation
3.7%
4.1%
4.4%
3.3%
2.6%
2.4%
Gold Price ($/oz)
1,400
In 1971, President Richard Nixon
ended the direct convertibility of
the dollar to gold
1,200
1,000
800
600
400
200
1790
1810
1830
1850
1870
1890
1910
1930
1950
1970
1990
2010
Michael Dimond
School of Business Administration
Notable World Currency Events
Michael Dimond
School of Business Administration
Notable World Currency Events
Michael Dimond
School of Business Administration
Notable World Currency Events
Michael Dimond
School of Business Administration
Notable World Currency Events
Michael Dimond
School of Business Administration