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 November 16, 2011: The yuan price of the dollar (known as a “direct quotation” from China’s perspective) was: RMB 6.34 –6.34 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): –1/6.34 = $ (roughly 16 cents needed to buy one yuan).

More recently The RMB price of the dollar has been falling (a decline in the direct quotation is known as an appreciation). Through 2011, the yuan appreciated by 4.7% against the dollar. –Policy intended to keep inflation in check and potentially increase standards of living. According to the Wall Street Journal, on January 5, “The PBOC on Thursday set the dollar-yuan central parity at RMB , significantly above Wednesday's , which was an all-time low.”

Cross currency exchange rate On Thursday, the yen price of the dollar fell to The RMB price of the yen: –S(RMB/$)/S(Yen/$) = /76.73 = RMB

International Monetary Arrangements International Monetary Arrangements in Theory and Practice –The International Gold Standard, –Bretton Woods Agreement, –Smithsonian Agreement, –The Floating-Rate Dollar Standard, –The Plaza-Louvre Intervention Accords and the Floating-Rate Dollar Standard,

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, 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. Fix an official gold price or “mint parity” and allow free convertibility between domestic money and gold at that price.

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 : £ = 1 ounce of gold. The exchange rate is determined by the relative gold contents: The International Gold Standard, $20.67 = £ $4.866 = £1

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 price- specie-flow mechanism. The International Gold Standard,

Price-Specie-Flow Mechanism Suppose Great Britain exported 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, 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.

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 International Gold 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: 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: 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: Under the Bretton Woods system, the U.S. dollar was pegged to gold at $35 per ounce and other currencies were pegged to the U.S. dollar. 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 responsible for maintaining the gold parity. Under Bretton Woods, the IMF was created. The Bretton Woods 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, 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: German mark British pound French franc U.S. dollar Gold Pegged at $35/oz. Par Value

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

Composition of SDR (Special Drawing Right)

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 Smithsonian Agreement – December 1971

The Floating-Rate Dollar Standard, 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.

The Floating-Rate Dollar Standard, 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, 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 1965

IMF Classification of Exchange Rate Regimes Independent floating Managed floating Exchange rate systems with crawling bands Crawling peg systems Pegged exchange rate systems within horizontal bands Conventional pegs Currency board Exchange rate systems with no separate legal tender

Independent Floating Exchange rate determined by market forces, with intervention aimed at minimizing volatility: Example: United States

Managed Floating There is no pre-announced path for the exchange rate, although intervention is common. Policy makers will try to influence the “level” of the exchange rate: example: India

Crawling Band The currency is maintained within bands around a central target for the domestic currency against another currency (or group of currencies). The bands themselves are periodically adjusted, sometimes in response to changes in economic indicators. Example: Costa Rica, Mexico in 1994.

Example: Belarus through Feb 2008

Crawling pegs The domestic currency is pegged to another currency or basket of currencies at an established target rate. The target rate is periodically adjusted, perhaps in response to changing economic indicators. Example: Bolivia, China China allows for a daily revaluation of the RMB against a basket of currencies.

Birr/$ between Apr 10 and Apr 11

Exchange rates within horizontal bands The domestic currency is pegged to another currency or group of currencies. The exchange rate is maintained within bands that are wider than 1% of the established target: Example: Any ERM II country, including Denmark

Conventional pegs The country pegs its currency at a fixed rate to another currency (or group of currencies). The currency cannot fluctuate by more than 1% relative to the established target: Example: Saudi Arabia, formerly China

Currency boards Currency board countries are sometimes called “hard peggers”. Example: Hong Kong…. The currency board is a separate government institution whose only responsibility is to buy and sell foreign currency at an established price. The country will typically maintain foreign currency reserves equivalent to 100% of the total amount of outstanding domestic money and credit.

Hong Kong Jim Rogers a famed currency trader has noted: “If I were the Hong Kong government, I would abolish the Hong Kong dollar. There's no reason for the Hong Kong dollar. It's a historical anomaly and I don't know why it exists anymore…. You have a gigantic neighbor who is becoming the most incredible economy in the world.”

No separate legal tender The country uses another country’s (or group of countries’) currency as its own: Example: Ecuador (US dollar)