2. The International Monetary System
Chapter Eleven
The International Monetary System

3. Introduction
The international monetary system refers to the institutional arrangements that govern exchange rates.
Floating exchange rates occur when the foreign exchange market determines the relative value of a currency
The world’s four major currencies – dollar, euro, yen, and pound – are all free to float against each other

4. Introduction
Pegged exchange rates occur when the value of a currency is fixed relative to a reference currency
Dirty float occurs when countries hold the value of their currency within a range of a reference currency
Fixed exchange rate occurs when a set of currencies are fixed against each other at some mutually agreed upon exchange rate
Pegged exchange rates, dirty floats and fixed exchange rates all require some degree of government intervention

5. The Gold Standard Roots in old mercantile trade
Inconvenient to ship gold, changed to paper- redeemable for gold
Want to achieve ‘balance-of-trade equilibrium
Trade
USA
Japan
Gold

6. Balance of Trade Equilibrium
Trade Surplus
Gold
Increased money supply = price inflation.
Decreased money supply = price decline.
As prices decline, exports
increase and trade goes
into equilibrium.

7. Between the Wars
Post WWI, war heavy expenditures affected the value of dollars against gold
US raised dollars to gold from $20.67 to $35 per ounce
Dollar worth less?
Other countries followed suit and devalued their currencies

8. Bretton Woods In 1944, 44 countries met in New Hampshire
Countries agreed to peg their currencies to US$ which was convertible to gold at $35/oz
Agreed not to engage in competitive devaluations for trade purposes and defend their currencies
Weak currencies could be devalued up to 10% w/o approval
Created the IMF and World Bank

9. International Monetary Fund
The International Monetary Fund (IMF) Articles of Agreement were heavily influenced by the worldwide financial collapse, competitive devaluations, trade wars, high unemployment, hyperinflation in Germany and elsewhere, and general economic disintegration that occurred between the two world wars
The aim of the IMF was to try to avoid a repetition of that chaos through a combination of discipline and flexibility

10. International Monetary Fund
Discipline
Maintaining a fixed exchange rate imposes monetary discipline, curtails inflation
Brake on competitive devaluations and stability to the world trade environment
Flexibility
Lending facility:
Lend foreign currencies to countries having balance-of-payments problems
Adjustable parities:
Allow countries to devalue currencies more than 10% if balance of payments was in “fundamental disequilibrium”

11. Role of the World Bank
The official name for the world bank is the International Bank for Reconstruction and Development
Purpose: To fund Europe’s reconstruction and help 3rd world countries.
Overshadowed by Marshall Plan, so it turns towards development
Lending money raised through WB bond sales
Agriculture
Education
Population control
Urban development

12. Collapse of the Fixed Exchange System
The system of fixed exchange rates established at Bretton Woods worked well until the late 1960’s
The US dollar was the only currency that could be converted into gold
The US dollar served as the reference point for all other currencies
Any pressure to devalue the dollar would cause problems through out the world

13. Collapse of the Fixed Exchange System
Factors that led to the collapse of the fixed exchange system include
President Johnson financed both the Great Society and Vietnam by printing money
High inflation and high spending on imports
On August 8, 1971, President Nixon announces dollar no longer convertible into gold
Countries agreed to revalue their currencies against the dollar
On March 19, 1972, Japan and most of Europe floated their currencies
In 1973, Bretton Woods fails because the key currency (dollar) is under speculative attack

14. The Floating Exchange Rate
The Jamaica agreement revised the IMF’s Articles of Agreement to reflect the new reality of floating exchange rates
Floating rates acceptable
Gold abandoned as reserve asset
IMF quotas increased
IMF continues role of helping countries cope with macroeconomic and exchange rate problems

15. Exchange Rates Since 1973
Exchange rates have been more volatile for a number of reasons including:
Oil crisis -1971
Loss of confidence in the dollar
Oil crisis – 1979, OPEC increases price of oil
Unexpected rise in the dollar
Rapid fall of the dollar and
Partial collapse of European Monetary System
Asian currency crisis

16. Long-Term Exchange Rate Trends From 1973 - 2003
Figure 11.1

17. Fixed Versus Floating Exchange Rates
Monetary policy autonomy
Restores control to government
Trade balance adjustments
Adjust currency to correct trade imbalances
Fixed:
Monetary discipline
.Speculation
Limits speculators
Uncertainty
Predictable rate movements
Trade balance adjustments
Argue no link between exchange rates and trade
Link between savings and investment
Which side is right in the vigorous debate between those who favor a fixed exchange rate and those who favor a floating exchange rate? Economists cannot agree. Business, as a major player on the international trade and investment scene, has a large stake in the resolution of the debate. Would international business be better off under a fixed regime, or are flexible rates better? The evidence is not clear. We do, however, know that a fixed exchange rate regime modeled along the lines of the Bretton Woods system will not work. Speculation ultimately broke the system, a phenomenon that advocates of fixed rate regimes claim is associated with floating exchange rates! Nevertheless, a different kind of fixed exchange rate system might be more enduring and might foster the stability that would facilitate more rapid growth in international trade and investment

18. Exchange Rate Regimes Pegged Exchange Rates Currency Boards
Peg own currency to a major currency ($)
Popular among smaller nations
Evidence of moderation of inflation
Currency Boards
Country commits to converting domestic currency on demand into another currency at a fixed exchange rate
Country holds foreign currency reserves equal to 100% of domestic currency issued

19. Exchange Rate Policies for IMF Members 2004
Figure 11.2, p. 380

20. Crisis Management by the IMF
The IMF’s activities have expanded because periodic financial crises have continued to hit many economies
Currency crisis
When a speculative attack on a currency’s exchange value results in a sharp depreciation of the currency’s value or forces authorities to defend the currency
Banking crisis
Loss of confidence in the banking system leading to a run on the banks
Foreign debt crisis
When a country cannot service its foreign debt obligations
These crises tend to have common underlying macroeconomic causes: high relative price inflation rates, a widening current account deficit, excessive expansion of domestic borrowing, and asset price inflation (such as sharp increases in stock and property prices). At times, elements of currency, banking, and debt crises may be present simultaneously, as in the 1997 Asian crisis and the 2000–2002 Argentinean crisis (see the Country Focus).

21. Incidence of Currency and Banking Crises 1975 - 1997
Figure 11.3, p. 384

22. Mexican Currency Crisis of 1995
Peso pegged to U.S. dollar
Mexican producer prices rise by 45% without corresponding exchange rate adjustment
Investments continued ($64B between )
Speculators began selling pesos and government lacked foreign currency reserves to defend it
IMF stepped in

23. Russian Ruble Crisis
Financial markets’ loss of confidence in Russia’s ability to meet national and international payments
Led to loss of international reserves and roll over of treasury bills reaching maturity
Financial markets unable to determine ‘who’s in charge’

24. Russian Ruble Crisis Persistent decline in value of ruble:
High inflation
Artificial low prices in Communist era
Shortage of goods
Liberalized price controls
Too many rubles chasing too few goods
Growing public-sector debt
Refusal to raise taxes to pay for government

25. Government Actions: Exacerbating the Situation
Defacto devaluation of the ruble
Unilateral restructuring of ruble-denominated public debt
90-day moratorium on foreign credits repayment
Hike in interest rates to defend ruble
Duma rejects measures designed to alleviate problems

26. Decline of the Ruble

27. The Asian Crisis Factors leading to the Asian financial crisis of 1997
The investment boom
Excess capacity
The debt bomb
Expanding imports

28. The Asian Crisis
Mid 1997 several key Thai financial institutions were on the verge of default
Result of speculative overbuilding
Excess investment (dollar denominated debt)
Deteriorating balance-of payments position
Thailand asks IMF for help
17.2 billion in loans, given with restrictive conditions
Following devaluation of Thai baht speculation hit other Asian currencies
Malaysia, Singapore, Indonesia, and Korea

29. Problems in Asian Market Economies
Cronyism
Too much money, dependence on speculative capital inflows
Lack of transparency in the financial sector
Currencies tied to strengthening dollar
Increasing current account deficits
Weakness in the Japanese economy

30. Evaluating the IMF Policy Prescriptions
Inappropriate policies
The IMF’s ‘one-size-fits-all’ approach to macroeconomic policy is inappropriate for many countries
Moral hazard
People behave recklessly when they know they will be saved if things go wrong
Lack of Accountability
The IMF has become too powerful for an institution that lacks any real mechanism for accountability
This slide outlines many of the criticisms of the IMF,

31. Implications for Managers
Currency management
Business strategy
Faced with uncertainty about the future value of currencies, firms should utilize the forward exchange market to insure against exchange rate risk
Firms should pursue strategies that will increase the company’s strategic flexibility in the face of unpredictable exchange rate movements — that is, to pursue strategies that reduce the economic exposure of the firm
Corporate-government relations

32. Looking Ahead to Chapter 12
The Strategy of International Business
Strategy and the Firm
Global Expansion, Profitability, and Profit Growth
Cost Pressures and Pressures for Local Responsiveness
Choosing a Strategy