Chapter 08 The International Monetary System and Financial Forces McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

The International Monetary System Key Terms To Know: – Gold Standard: The use of gold at an established number of units per currency – Bretton Woods System: The international monetary system in place from 1945 to 1971, with a par value based on gold and the U.S. dollar – Fixed Exchange Rate: Specific currency exchange equivalence upheld by government – Par Value Stated value Key Terms To Know: – Gold Standard: The use of gold at an established number of units per currency – Bretton Woods System: The international monetary system in place from 1945 to 1971, with a par value based on gold and the U.S. dollar – Fixed Exchange Rate: Specific currency exchange equivalence upheld by government – Par Value Stated value LO1 8-2

A Brief History: The Gold Standard Price of gold has risen from 1200 A.D. through today. Traders carried bullion, gold + silver coins till late 19 th C. 1717, Sir Isaac Newton put England on the gold standard based on British currency, pound sterling. Britain converted gold  currency until 1914 and WWI, except during Napoleonic Wars. British sold gold to finance WWI, then stopped gold exchange. Germany, France and Russia followed. Price of gold has risen from 1200 A.D. through today. Traders carried bullion, gold + silver coins till late 19 th C. 1717, Sir Isaac Newton put England on the gold standard based on British currency, pound sterling. Britain converted gold  currency until 1914 and WWI, except during Napoleonic Wars. British sold gold to finance WWI, then stopped gold exchange. Germany, France and Russia followed. 8-3

Bretton Woods System 1944, Bretton Woods, NH, U.S.A. –Allied representatives met to plan post-WWII monetary arrangements – IMF was established – IMF Articles of Agreement: Established the Bretton Woods system for fixed exchange rates among member’s currencies with par value based on $35/oz and the U.S.$. Bretton Woods system supported huge international trade growth in the 1950’s and 1960’s. 1944, Bretton Woods, NH, U.S.A. –Allied representatives met to plan post-WWII monetary arrangements – IMF was established – IMF Articles of Agreement: Established the Bretton Woods system for fixed exchange rates among member’s currencies with par value based on $35/oz and the U.S.$. Bretton Woods system supported huge international trade growth in the 1950’s and 1960’s. LO1 8-4

Floating Currency Exchange Rate System Precipitated by French redemption of $ holdings for gold, 1971 Nixon stops gold exchange for $ Since March 1973, major currencies floated in FX market 1976 – IMF members enact Jamaica Agreement on floating exchange rates and abandon gold as reserve currency Precipitated by French redemption of $ holdings for gold, 1971 Nixon stops gold exchange for $ Since March 1973, major currencies floated in FX market 1976 – IMF members enact Jamaica Agreement on floating exchange rates and abandon gold as reserve currency Floating Currency Exchange Rates: –Rates that are all allowed to float against other currencies and are determined by market forces. Jamaica Agreement: –1976 IMF agreement allowing flexible exchange rates among members. Floating Currency Exchange Rates: –Rates that are all allowed to float against other currencies and are determined by market forces. Jamaica Agreement: –1976 IMF agreement allowing flexible exchange rates among members. 8-5

Financial Forces Fluctuating Currency Values –Freely fluctuating currencies fluctuate against each other –Central banks can intervene in FX markets by buying/selling currency to affect supply & demand –Central banks let major currencies ($,€,£,¥) freely fluctuate –Fluctuations can be huge Fluctuating Currency Values –Freely fluctuating currencies fluctuate against each other –Central banks can intervene in FX markets by buying/selling currency to affect supply & demand –Central banks let major currencies ($,€,£,¥) freely fluctuate –Fluctuations can be huge LO2 8-6

Foreign Exchange FX Quotations: the price of 1 currency given in terms of another: $1U.S.= £ or £1.00 = $ FX Quotations: the price of 1 currency given in terms of another: $1U.S.= £ or £1.00 = $ The U.S.$ is a: Central Reserve Asset: –Currency asset held by central banks Vehicle Currency: –Currency used in international trade & investment Intervention Currency: –Currency used by gov’ts. to intervene FX markets to influence the price of a given currency The U.S.$ is a: Central Reserve Asset: –Currency asset held by central banks Vehicle Currency: –Currency used in international trade & investment Intervention Currency: –Currency used by gov’ts. to intervene FX markets to influence the price of a given currency 8-7

Exchange Rate Quotations LO2 8-8

Causes of Exchange Rate Movement Market forces set floating currency values and ease of convertibility: –Supply & demand forecasts for 2 currencies –Inflation in the 2 countries –Productivity and unit labor cost changes –Political developments – election results –Expected government fiscal, monetary, & currency exchange market actions –BOP accounts –Psychological aspects Market forces set floating currency values and ease of convertibility: –Supply & demand forecasts for 2 currencies –Inflation in the 2 countries –Productivity and unit labor cost changes –Political developments – election results –Expected government fiscal, monetary, & currency exchange market actions –BOP accounts –Psychological aspects LO2 8-9

Causes of Exchange Rate Movement Monetary Policies: – Government policies that control amount of money in circulation and its growth rate Fiscal Policies: – Address Government’s collecting and spending money Monetary Policies: – Government policies that control amount of money in circulation and its growth rate Fiscal Policies: – Address Government’s collecting and spending money Factors Affecting Exchange Rates: –Parity Relationships: Interest Rate Parity Purchasing Power Parity (PPP) Factors Affecting Exchange Rates: –Parity Relationships: Interest Rate Parity Purchasing Power Parity (PPP) LO2 8-10

Currency Exchange Controls 8-11

Taxation – A Significant Financial Force LO4 8-12

Inflation and Interest Rates Inflation: –An external financial force that determines the real cost of borrowing in capital markets Should capital be raised through equity or debt? In which capital market? In which currency? Inflation: –An external financial force that determines the real cost of borrowing in capital markets Should capital be raised through equity or debt? In which capital market? In which currency? LO4 8-13

Inflation and Interest Rates Inflation: –Affects currency exchange rates Inflated currencies weaken economies People with money may buy items expected to increase in value fueling inflation –Causes cost of goods and services in their country to rise and become less globally competitive Experts sales are difficult and may lead to BOP deficits in the trade account and lead to more trade restrictions Inflation: –Affects currency exchange rates Inflated currencies weaken economies People with money may buy items expected to increase in value fueling inflation –Causes cost of goods and services in their country to rise and become less globally competitive Experts sales are difficult and may lead to BOP deficits in the trade account and lead to more trade restrictions LO4 8-14

Balance of Payments (BOP) BOP: country’s record of global transactions BOP shows global demand for a country’s currency. –Exports > imports = high demand –Imports > exports = low demand, weak or devalued currency Possible currency or trade controls introduced BOP: country’s record of global transactions BOP shows global demand for a country’s currency. –Exports > imports = high demand –Imports > exports = low demand, weak or devalued currency Possible currency or trade controls introduced LO5 8-15

BOP Accounts Are recorded in double entry bookkeeping form Transactions are an exchange of assets with debit & credit side Funds outflow (payments to other countries) tracked as debits (-) Funds inflow (payments from other countries tracked as credits (+) Are recorded in double entry bookkeeping form Transactions are an exchange of assets with debit & credit side Funds outflow (payments to other countries) tracked as debits (-) Funds inflow (payments from other countries tracked as credits (+) LO5 8-16