10 International Monetary System Welcome to Chapter 10, International Monetary System. Copyright © 2014 Pearson Education, Inc.

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 In this chapter, you will explore what factors determine exchange rates and recent attempts to manage them. You will also: Learn how exchange rates affect all sorts of business activities. Examine different methods of forecasting exchange rates. And understand how the international monetary system functions. Copyright © 2014 Pearson Education, Inc.

The Euro Currency of 17 European nations Boosted efficiency and competitiveness Later declined with lower expectations The euro is the currency of 17 European countries. When the euro was introduced, the rise in its value demonstrated confidence in the future growth of nations using the currency. A common currency increased efficiency by eliminating exchange-rate risk for business transactions within the euro zone. It also sparked a wave of mergers and acquisitions that boosted competitiveness due to synergies and economies of scale. But nearly a decade after the euro began circulating, the global credit crisis and recession that followed exposed the excessive debt levels of some European nations. The value of the euro fell along with lower expectations for Europe’s growth. Copyright © 2014 Pearson Education, Inc. 10 - 3 3

Currency Values and Business Exchange rates affect activities of both domestic and international firms Devaluation Revaluation Export prices Import prices Exchange rates can increase or decrease world prices and, therefore, demand of a nation’s exports. Devaluation, which entails lowering the value of a currency, reduces the price of exports on world markets and increases the price of imports. Revaluation, which involves raising the value of a currency, increases the price of exports on world markets and reduces the price of imports. Copyright © 2014 Pearson Education, Inc.

Major World Currencies Exchange rates are used to translate earnings abroad into the home currency. Translating subsidiary earnings from a weak host country currency into a strong home currency reduces earnings. On the other hand, translating earnings from a strong host country currency into a weak home currency increases earnings. Source: Based on Economic Report of the President, Table B110, multiple years Copyright © 2014 Pearson Education, Inc.

Stability and Predictability Stable exchange rates • Improve accuracy of forecasts and financial planning Predictable exchange rates • Reduce surprises of unexpected rate changes Stable exchange rates improve the accuracy of forecasts and financial planning. Predictable exchange rates lessen the odds for surprises, and reduce the need for costly currency hedging practices. Copyright © 2014 Pearson Education, Inc.

Value of U.S. Dollar This figure reveals periods of stability and instability of the U.S. dollar over time. Source: Based on Economic Report of the President, Table B110, multiple years Copyright © 2014 Pearson Education, Inc.

Buying Power Example Purchasing Power Cost in Japan… $80 Cost in New York… $60 Purchasing Power Cost in Japan… $80 Cost in Mexico… $30 Stable exchange rates do not guarantee a currency’s buying power because purchasing power fluctuates. Suppose the same dinner costs you $60 in New York, $80 in Japan, and $30 in Mexico. This means that your dollars lost purchasing power in Japan and gained purchasing power in Mexico. Copyright © 2014 Pearson Education, Inc.

Discussion Question What are the key differences between the concepts of devaluation and revaluation? What are the key differences between the concepts of devaluation and revaluation? Copyright © 2014 Pearson Education, Inc.

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. Answer: 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. Copyright © 2014 Pearson Education, Inc.

Law of One Price Identical item must have an identical price in all countries when price is expressed in a common currency The law of one price says that an identical product must have an identical price in all countries when expressed in a common currency. If price were not identical in each country, arbitrage traders would buy the product in a low-priced market and sell it in a high-priced market. Copyright © 2014 Pearson Education, Inc.

Estimates undervalued and overvalued currencies Big Mac Index Uses law of one price and cost of a Big Mac Estimates undervalued and overvalued currencies The Economist magazine uses the law of one price to explore the overvaluation or undervaluation of currencies. It compares the price of a Big Mac sandwich in the United States with its price in other nations. Despite its simplicity, the index is a fairly good predictor of the direction, although perhaps not the magnitude, that rates will move in the future. Fairly good predictor of long-term rates Copyright © 2014 Pearson Education, Inc.

Purchasing Power Parity Relative ability of two nations’ currencies to buy the same “basket” of goods in those two nations Focuses squarely on local purchasing power of a currency Considers price levels in adjusting relative currency values Purchasing power parity (or PPP) is the relative ability of two countries’ currencies to buy the same “basket” of goods in those two countries. PPP considers price levels in adjusting the relative values of two currencies. Economic forces push a market exchange rate toward that calculated by PPP or an arbitrage opportunity arises. Copyright © 2014 Pearson Education, Inc.

Effects of Inflation Inflation erodes a currency’s purchasing power! If money is injected into an economy that is not producing greater output, a greater amount of money is spent on a static amount of products. Demand for products soon outstrips their supply, prices rise, and inflation then erodes purchasing power. Source: Desmond Kwande/Getty Images/Newscom Copyright © 2014 Pearson Education, Inc.

Inflation: Key Factors Monetary policy directly affects interest rates and money supply Fiscal policy indirectly affects taxes and spending High employment raises wages, which are embodied in consumer prices High interest rates lower borrowing and spending, which lowers inflation Exchange rates adjust to maintain PPP Money supply Employment Monetary policy involves buying or selling government securities on the open market to influence the money supply and, therefore, the rate of inflation. Fiscal policy involves using taxes and government spending to influence the money supply indirectly. High rates of employment puts upward pressure on wages. To maintain profit margins with higher labor costs, producers then pass the cost of higher wages on to consumers in the form of higher prices. Low interest rates encourage consumers and businesses to borrow and spend money, which adds to inflationary pressures. Exchange rates adjust to different rates of inflation between countries. If inflation in Mexico is higher than that in the United States, the peso is losing more value than is the dollar. The peso/dollar exchange rate will adjust to reflect a now less valuable peso. Interest rates Adjustment Copyright © 2014 Pearson Education, Inc.

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 The Fisher effect is the principle that the nominal interest rate is the sum of the real interest rate plus the expected rate of inflation over a specific period. The international Fisher effect is the principle that a difference in nominal interest rates supported by two countries’ currencies will cause an equal but opposite change in their spot exchange rates. Because real interest rates are theoretically equal across countries, inflation must be the cause of any difference in interest rates between two countries. Copyright © 2014 Pearson Education, Inc.

Evaluating PPP Added costs Trade barriers Business confidence & psychology Several factors may explain why PPP is a better predictor of long-term exchange rates than short-term rates. It assumes no added costs, such as transportation costs between nations. This can overstate the presence of arbitrage opportunities. Such costs between markets can allow unequal prices to persist and PPP to fail. It assumes no trade barriers. But a high tariff or outright ban on a product can impair price leveling and cause PPP to fail to predict exchange rates accurately. It overlooks business confidence and human psychology. Yet, nations try to maintain the confidence of investors, businesspeople, and consumers in their economies and their currencies. Copyright © 2014 Pearson Education, Inc.

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 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 Copyright © 2014 Pearson Education, Inc.

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 The correct answer is c. Purchasing Power Parity Copyright © 2014 Pearson Education, Inc.

Two Market Views Efficient market view Inefficient market view Forward exchange rates best predict future rates Inefficient market view Additional information can improve rate forecasts In an efficient market, prices of financial instruments quickly adjust to reflect new public information coming available to traders. The efficient market view says that prices of financial instruments reflect all publicly available information at any given time. This implies that forward exchange rates are the best possible predictors of future exchange rates and it is worthless to seek additional information. The inefficient market view says that prices of financial instruments do not reflect all publicly available information and that additional information can improve forecasts. This view is more compelling considering private information, such as when a currency trader who holds privileged information acts on this information to earn a profit. Copyright © 2014 Pearson Education, Inc.

Techniques of Forecasting Fundamental analysis Statistical modeling Technical analysis Chart currency trends Forecasting difficulties Flawed data Human error Fundamental analysis uses statistical models based on economic indicators to forecast exchange rates. Such indicators include inflation, interest rates, the money supply, tax rates, government spending, and a nation’s balance-of-payments situation. Technical analysis uses past trends in currency prices and other factors to forecast exchange rates. Using past data trends, analysts examine conditions that prevailed during past changes in exchange rates and estimate the timing, magnitude, and direction of future changes. Forecasting difficulties include flawed data and human error. For example, a forecaster may underestimate the importance of certain economic events and overestimate the importance of others. Copyright © 2014 Pearson Education, Inc.

Gold Standard: Early Years Monetary system from the 1700s to 1939 that linked national currencies to specific values of gold Reduced exchange-rate risk Restricted monetary policies The gold standard was a fixed exchange rate system that linked the paper currencies of nations to specific values of gold and, indirectly, to one another. The gold standard offered several advantages. First, fixed exchange rates between currencies reduced exchange rate risk and, in turn, helped expand world trade. Second, the gold standard imposed strict monetary policies on nations because they could not let the value of their paper currency grow faster than the value of their gold reserves. Third, the system helped correct a nation’s trade imbalances. For example, a nation experiencing a trade deficit would experience a declining supply of gold and thus a fall in the value of its paper currency in circulation. A declining money supply would lower prices for products as fewer dollars would be available to purchase a static supply of products. Falling domestic prices would make the nation’s exports cheaper on world markets. Exports would then increase until the nation’s trade was again balanced. Corrected trade imbalances Copyright © 2014 Pearson Education, Inc.

Gold Standard Collapse Printing excessive money caused high inflation British pound returns at its pre-inflation level U.S. dollar returns at its lower (devalued) level Competitive devaluations force system to collapse Nations violated the gold standard by printing excessive amounts of paper currency during the First World War. This caused rapid inflation and forced governments to abandon the gold standard. Britain later returned to the gold standard, but at the pound’s value that existed prior to the war. The United States also returned to the gold standard, but at the dollar’s lower value that accounted for inflation and a devalued dollar. This reduced world prices of U.S. exports and increased prices of British exports. Many nations then engaged in competitive devaluations to improve their own trade balances. The gold standard was no longer a true indicator of currency values and the system collapsed. Copyright © 2014 Pearson Education, Inc.

Bretton Woods Agreement International monetary system based on value of U.S. dollar (1944 to 1973) Fixed exchange rates Built-in flexibility The Bretton Woods Agreement aimed to balance the strict discipline of the gold standard with the flexibility needed to manage temporary monetary difficulties. It had four main features. First, it fixed the exchange rate between gold and the U.S. dollar, and tied other currencies to the value of the dollar instead of gold. Second, it built flexibility into the system by allowing a nation to devalue its currency if a trade deficit caused a permanent negative shift in its balance of payments. Third, it created the World Bank to fund national economic development efforts, such as projects to develop transportation networks, power facilities, educational systems, and agricultural programs. Fourth, it created the International Monetary Fund to regulate exchange rates and enforce the rules of the international monetary system. World Bank (IBRD) International Monetary Fund Copyright © 2014 Pearson Education, Inc.

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 The Bretton Woods system faltered in 1971 when nations holding paper dollars doubted that the U.S. had enough gold to redeem all of its currency held abroad. In fact, the U.S. government held less than one-fourth of the amount of gold it needed. A global sell-off of dollars erupted as nations demanded gold in exchange for paper dollars. Markets calmed after nations agreed to increase the value of their currencies against the dollar. But a persistent trade deficit and high inflation in the United States kept the dollar weak on currency markets. Around the world, governments had difficulty maintaining their own exchange rates with a continually weaker dollar and abandoned the system. Copyright © 2014 Pearson Education, Inc.

Discussion Question What characteristics of the gold standard lead some to call for its return today? What characteristics of the gold standard lead some to call for its return today? Copyright © 2014 Pearson Education, Inc.

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. Answer: 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. Copyright © 2014 Pearson Education, Inc.

Jamaica Agreement Formalized the managed float system of exchange rates as the new international monetary system Managed float system Currencies float with government intervention The free float system of exchange rates that emerged from the ashes of the Bretton Woods Agreement was meant to be temporary. In 1976, the Jamaica Agreement formalized a managed float system of exchange rates in which governments were to stabilize their currencies around target exchange rates. Later agreements arose as needed and nations agreed to continue intervening in currency markets to stabilize exchange rates. Free float system Currencies float without government intervention Copyright © 2014 Pearson Education, Inc.

European monetary system The System Today Managed float system Pegged exchange rates Currency board European monetary system Today, the international monetary system remains a managed float system. But some governments achieve more stable exchange rates by tying their currencies to those of other countries. A country that ties its currency to a more stable and widely used currency in international trade follows a “pegged” exchange rate arrangement. Countries commonly peg their currencies to the dollar, the euro, or to a “basket” of several currencies. A country that commits to exchange domestic currency for a specified foreign currency at a fixed exchange rate uses a currency board. The government is legally bound to hold a stated amount of foreign currency that is equal to the amount of domestic currency to help cap inflation. The European monetary system stabilized currencies and reduced exchange-rate risk from 1979 until 1999, when the European Union adopted its single currency, the euro. The system kept members’ currencies trading within a specific range, made currency realignments infrequent, and helped control inflation. Copyright © 2014 Pearson Education, Inc.

Adjusting to Currency Swings Export strategies in the face of currency swings Strong currency: Prune operations Adapt products Source abroad Freeze prices Weak currency: Source domestically Grow at home Push exports Reduce expenses Companies facing a strong or rising home-country currency may wish to: Prune operations to cut costs and boost efficiency. Adapt products to better suit international customers. Source abroad for inputs if this reduces costs. Or freeze prices to keep sales moving. Companies facing a weak or falling home-country currency may wish to: Source domestically to shorten the supply chain and avoid exchange rate risk. Grow at home against the higher priced imports of competitors. Push exports to exploit the price advantage gained from a weak currency. Or reduce expenses by using the latest communication and transport technologies. Copyright © 2014 Pearson Education, Inc. 10 - 30 30

Financial Crises Developing nations Mexico Southeast Asia Russia Argentina Despite efforts to manage the international monetary system and stabilize currencies, some nations have experienced wrenching financial crises. By the early 1980s, it appeared that developing nations may default on huge debts owed to global commercial banks, the IMF, and the World Bank. Repayment schedules were revised to prevent a global financial meltdown. The Brady Plan of 1989 called for large reductions in poor nations’ debts, new lower-interest loans, and the issuance of marketable debt instruments. When social unrest struck Mexico in 1993, its government responded slowly to the departure of foreign investment. Mexico devalued its peso in 1994, forcing it to lose purchasing power. The IMF and private U.S. banks needed to lend Mexico around $50 billion. Southeast Asia fell into a severe economic slump in 1997 after currency traders sold massive amounts of regional currencies on world markets. In the end, Indonesia, South Korea, and Thailand needed IMF and World Bank funding. Russia experienced problems due to spillover from the Southeast Asia crisis, depressed oil prices (Russia’s main export), falling hard currency reserves, and high inflation. Currency traders dumped the ruble on currency markets in 1996. By late 1998, the IMF had lent Russia more than $22 billion. And after a four-year-long recession, Argentina defaulted on its $155 billion of public debt in 2002. A currency board that linked Argentina’s peso to a strong U.S. dollar had made its exports very expensive on world markets. Argentina scrapped its currency board and the peso fell by around 70 percent. The country still experiences the effects of poor economic management. Copyright © 2014 Pearson Education, Inc.

Europe’s Debt 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. More recently, some nations in the European Union let their debt soar to unsustainable levels. The IMF and European Union have organized bailouts for Greece, but the Greek people reacted with anger and protests to the austerity measures forced upon them. Later, Portugal had also received a bailout and Italy and Spain looked as though they may be next. These financial crises underscore the need for managers to fully understand the complexities of the international financial system. Source: Simela Pantzartzi/Newscom Copyright © 2014 Pearson Education, Inc.

Future of the International Monetary System Greater IMF transparency Better manage risks Monitor “hot” money flows Private sector involvement Recurring crises are raising calls for a new international monetary system that is designed to meet today’s challenges. Many critics want the IMF to increase transparency and accountability, better mange financial risks and monitor flows of “hot” money, and revise its policy prescriptions. The private sector can also play a larger role in preventing and resolving financial crises through more careful lending practices and by cooperating more with the IMF and national governments. Copyright © 2014 Pearson Education, Inc.

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 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 Copyright © 2014 Pearson Education, Inc.

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 The correct answer is b. Managed float Copyright © 2014 Pearson Education, Inc.

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