Transcript The Current Account and the Exchange Rate

International Financial Management
Chapter 2 The history of money and finance
Michael Connolly
School of Business Administration,
University of Miami
Michael Connolly © 2007
Chapter 2
1
Summary







The role of money
Money and exchange rates
The history of monies
Foreign exchange history
Banks and banking
The international monetary institutions
History of stock exchanges
Chapter 2
Page 2
The role of money

Money serves three important roles in an
economy:
 It is a unit of account – a yardstick by
which to measure the value of goods
and assets.


A medium of exchange to facilitate
transactions, avoiding barter.
A store of value in which to
temporarily hold liquid wealth.
Chapter 2
Page 3
Money and exchange rates


The Bank of England and the Banque de France, had gold
windows where they bought and sold gold at a fixed
currency price in the 19th century. In doing so, their
currency rates were fixed. For example, if the Bank of
England sets ten pounds per ounce of gold as the buy/sell
rate and the Banque of France 100 francs, the equilibrium
exchange rate is set at 100 francs per 10 pounds or 10
francs a pound.
Arbitrage in gold kept the exchange rates within a narrow
band of gold points. Let’s say the exchange rate falls to
9.5 francs a pound. A gold arbitrageur purchases 10
pounds for 95 francs, presents the 10 pounds to the Bank
of England gold window in exchange for an ounce of gold.
The arbitrageur then insures and ships the gold to the
Banque de France, selling it for 100 francs, pocketing 5
francs less insurance and shipping as profit.
Chapter 2
Page 4
Money and exchange rates




With floating exchange rates, the exchange rate
moves roughly according to the relative purchasing
power of monies. This is known as purchasing power
parity.
Countries with high money growth experience higher
rates of inflation and consequently,
Greater depreciations in their exchange rate.
A fixed exchange rate serves as a monetary anchor, while
a floating exchange rate permits independent money
growth.
Chapter 2
Page 5
The history of monies

Ancient Chinese monies: Circa 900-500BC
Chapter 2
Page 6
The history of monies


Ancient Chinese monies: copper coins used
before 221 BC
Coin issued in 221 BC by the Qin Dynasty,
the first feudal dynasty to unify China and its
coins.
Chapter 2
Page 7
The history of monies


The Lydian Lion’s Head: circa 600-575 BC is
thought by many to be the world’s first coin.
It was made of electrum, a precious alloy of
gold and silver that consisting of about 54
percent gold, 44 percent silver, and 2 percent
copper.
Chapter 2
Page 8
The history of monies


Ancient Chinese monies: The Yibi Circa 500BC
Made of copper and known as the creeping
ant-nose coin.
Chapter 2
Page 9
The history of monies


Ancient Chinese monies: The Guinian (Ghost
face) copper coin circa B.C 400 to 300
Both the Yibi and the Guinian coin have the
shape of shells, the earliest currency in China.
Chapter 2
Page 10
The history of monies

Ancient Chinese monies: Issued in 621 AD
under the Tang Dynasty.
Chapter 2
Page 11
The history of monies

Ancient Chinese monies: The first uniform
paper money in the world, the Jiaozi, issued
in 1023 under the Song Dynasty.
Chapter 2
Page 12
The history of monies


The first world money, the Spanish silver
dollar or “pieces of eight” minted in Spain,
Mexico and Peru.
The Spanish peso contained 0.821791 troy
ounce (25.560 grams) pure silver and was also
used as domestic money in Asia, Latin America,
America and Europe. Chapter 2
Page 13
The history of monies
The last paper monies of the feudal dynasties: 1875 to1908
Chapter 2
Page 14
Seigniorage



The early definitions of seigniorage referred
to the difference in the value of a money,
and its mint costs.
For example, say a silver coin has value $10
and its silver content and cost of manufacture
is only 50 cents, then seigniorage is $9.50.
Seigniorage on paper money is generally
greater due to the higher nominal values as
money and the lower costs of printing in terms
of paper, ink, anti-counterfeit measures such
as filaments, water marks, color changing ink
and the like.
Chapter 2
Page 15
Seigniorage


For example the US $100 bill costs
about 12 cents to manufacture.
Consequently seigniorage is $99.88.
These profits to the Treasury can be
spent, just as with any other tax receipt.
The issue of money is usually the right
of the sovereign government (i.e. the
seigneur), so that the right to strike
money has historically been used to
finance wars and emergency expenditures
by the “printing press.”
Chapter 2
Page 16
Seigniorage

More formally, seigniorage is the residual
finance of any fiscal deficit that is not
completely covered by new borrowing. That is:
*

dM
dB dB 

 G  T   

dt
dt 
 dt

Where dM/dt is new seigniorage, (G-T) the
fiscal and quasi-fiscal deficit, dB/dt new
domestic borrowing, and dB*/dt new foreign
borrowing.
Chapter 2
Page 17
Seigniorage

It is often instructive to express new
seigniorage as a percentage of GDP, that is:
*


dB
dB
dM



dt 
dt  G  T    dt
GDP
GDP
GDP

When deficits become large as a percent of
GDP, say above 5 or 6%, it may become
difficult to finance it by new borrowing, so
resort to the printing press may take place,
causing high inflation.
Chapter 2
Page 18
Seigniorage


There are, however, limits as to the amount
of seigniorage finance may take place.
This is because the demand for money
collapses when inflation is high, so that real
seigniorage collections, ΔM/P, decline after a
certain point, yielding what is known as a
“Laffer curve in seigniorage.”
Chapter 2
Page 19
Seigniorage
Real seigniorage revenue
as a percent of real money balances
M M  M 



P
P M 
CHINA
M
M
13.8%
0
14.6%
1/ 
100 Seigniorage
tax rate (%)
Between 1952 and 1995, China has issued new seigniorage at a 14.6% rate,
M
collecting 13.8% in new real seigniorage revenue.

Note: Technically speaking, the seigniorage tax rate is 1  M so that in the

limit it approaches 1 or 100% when money growth approaches infinity.
Chapter 2
Page 20
Seigniorage
Real seigniorage revenue per annum
as a percent of real money balances
M M  M 



P
P M 
USA
M
M
3.1%
0
6.7%
1/ 
100 Seigniorage
tax rate (%)
1960-1995, averages.
Chapter 2
Page 21
Seigniorage
Real seigniorage revenue
as a percent of income
M M  M 

 
Y
M Y 
CHINA
M
M
1.2%
0
14.6%
1/ 
100 Seigniorage
tax rate (%)
As a percent of GDP (Y), this represents an annual collections rate of 1.2%
of GDP in China from 1952 to 2005.
Chapter 2
Page 22
Seigniorage
Real seigniorage revenue
as a percent of annual income
M M

Y
M
M 
 
Y 
USA
M
M
0.36%
0
6.7%
1/ 
100 Seigniorage
tax rate (%)
As a percent of GDP (Y), this represents an annual collections rate of 0.36%
of GDP in the United States from 1960 to 2005.
Chapter 2
Page 23
The revenue maximizing rate of seigniorage
In equilibrium, money demand, L, equals money supply, M. The demand
for money, however, is inversely related to its rate of seigniorage issue
(and inflation), so that we may write real revenue as determined by the
rate of seigniorage issue times real money balances.
M
For simplicity, define  
so that the real revenue collected from
M
seigniorage is:
M 
R      ky e 
 P
Which is the money demand equation according to Philip Cagan, “The
Monetary Dynamics of Inflation,” in Milton Friedman, editor Studies in
the Quantity Theory of Money, Chicago: University of Chicago Press
1956.
k is a constant
y is real GDP
η is the income elasticity of demand for money
α is the semi-elasticity of the demand for money with
respect to the rate of seigniorage issue
Chapter 2
Page 24
The revenue maximizing rate of seigniorage
The rate of seigniorage issue that maximizes real revenue from
seigniorage is given by:


dR
 ky e     kyy e   0
d
Or
dR
 1    0
d
Which yields the revenue maximizing issue of seigniorage equal to:
ˆ 
1

The greater the semi-elasticity of demand for money, the lower is the
revenue maximizing rate of inflation, as illustrated graphically.
Chapter 2
Page 25
Seigniorage
The reason why a relatively high percent of seigniorage can be collected in
China is due firstly, to the high real rate of growth in income, leading to
increased demand for money, and secondly to a high income elasticity of
demand for money. Thus, virtually no inflation has resulted.
Summary Monetary Statistics for China: 1952-2005
Income elasticity of demand for money
Money growth
14.6%
Money/GDP
9.8%
Real seigniorage
Data sources:
1.8
13.8%
Inflation
0.1%
Real growth
8.1%
Seigniorage/GDP
1.2%
Money growth less real growth
6.5%
Increase in Cambridge K
6.3%
Comprehensive Statistic Data and Materials on 50 Years of New China, China Statistics Press, 1999:189-190.
"China Statistic Yearbook 2005", China Statistics Press, 2006, chaps. 20,28.
"Statistic Communique of the People's Republic of China on the 2005 National Economic and Social Development", Feb.28, 2006.
Chapter 2
Page 26
Foreign exchange history



Bills of exchange were used primarily in
international trade, and is a written order by
one person to pay another a specific sum on a
specific date sometime in the future.
Since carrying large amounts of coins was
risky, bills of exchange were used in order to
facilitate currency and trade transactions.
The bill of exchange allowed trade to take
place without the use of coinage, a precursor
of the modern letter of credit (L/C).
Chapter 2
Page 27
Foreign exchange history



Furthermore, the bills were traded as financial
instruments in trade fairs. They were
discounted and converted into foreign exchange.
The trade fairs were the precursors of modern
stock and foreign exchanges.
An important feature of the foreign exchange
market was an interest-bearing loan disguised
as a foreign exchange transaction. Merchants
and financiers were able to make loans evading
usury laws using a sequence of two bill
transactions – a precursor of today’s foreign
exchange swap.
Chapter 2
Page 28
Foreign exchange history



An important 16th century development was the
appearance of a system of ‘betting’ on future
exchange rates: a non-deliverable forward
market. The betters made forecasts on future
exchange rates.
The difference between the realized rate and
the forecasted rate determined who won the bet
and how much the loser would pay the winner.
This form of forward exchange still exists today
in the form of non-deliverable futures (NDFs) in
the Chinese yuan (formally Renminbi, the
“People’s Currency) in Singapore and Hong Kong.
Chapter 2
Page 29
Foreign exchange history


The 1944 Bretton Woods sytem of pegged but
adjustable exchange rates triggered foreign
exchange intervention in spot markets to
maintain exchange rates near their “par” values.
Floating exchange rates began in the early
1970s, and global markets were being
integrated. The resulting need of
multinational businesses to hedge their
currency exposures caused the rapid growth of
foreign exchange trading in the 1980s and
1990s.
Chapter 2
Page 30
Foreign exchange history



London is still by far the largest FOREX
market today in terms of daily foreign
exchange turnover.
In 2004, daily turnover net of double-counting
on the London foreign exchange market was a
staggering $753 billion in currency spots,
swaps, forwards and options.
This represents 31% of daily foreign exchange
transactions, compared to 19% in the United
States, and 8% in Japan.
Chapter 2
Page 31
Banks and banking


The first modern bank was the Bank of
Amsterdam, founded in 1609. The Amsterdam
bank was quickly followed by other major
cities.
The Bank of Hamburg was formed in 1619 and
the Bank of Sweden in 1656. Sweden issued
the first European paper bank notes in 1661.
Chapter 2
Page 32
Banks and banking


The Bank of England was founded in 1694 as
a commercial bank by William Paterson with
the right to issue notes up to the amount of
its capital, initially £1.2 million.
It was nationalized by Parliament in 1946.
The shareholders received compensation and
the Bank of England thereafter ceased its
private business, becoming the banker of
government
Chapter 2
Page 33
Banks and banking


Since 1977, The Bank of England has the
responsibility for setting monetary policy.
Prudential oversight of the British commercial
banking system was simultaneously transferred
to the Securities and Investments Board.
Chapter 2
Page 34
Banks and banking




In the United States, the Federal Reserve
Act established the Federal Reserve System
(the FED) in 1913 with 12 districts.
The Federal Reserve Banks provide liquidity,
clear transactions, and control the money
supply.
The FED was established primarily as a
reserve institution, a lender of last resort to
prevent bank runs and liquidity crises.
The Federal Deposit Insurance Corporation
(FDIC) insuring deposits was begun in March
1933.
Chapter 2
Page 35
The international monetary institutions


The International Monetary Fund (IMF) was
established in 1944 at the Bretton Woods
Conference in New Hampshire.
Its purpose was to establish orderly exchange
rate arrangements based on a par value
system, to eliminate exchange controls, and to
provide temporary short term balance of
payments assistance via conditional loans to
member countries that are short of foreign
exchange reserves.
Chapter 2
Page 36
The international monetary institutions


The World Bank, a sister institution of the
IMF created in 1944 at the Bretton Woods
Conference initially made long term
development loans for projects such as dams,
airports, rubber and concrete production,
water systems, and the like.
It got involved in Structural Adjustment Loans
(SALs) in the 1990s in tandem with the IMF
requiring structural adjustments to economic
policy. This could mean privatization of state
enterprises, lifting price and exchange
controls, and improving monetary and fiscal
policies, for instance. Chapter 2
Page 37
The international monetary institutions



The Bank of International Settlements (BIS)
is often referred to as the bank of central
banks. Located in Basel, Switzerland,
It was established May 17, 1930 at the
Hague convention. As such, it is the oldest
international monetary organization.
It does not do business with private
individuals or corporations; only with central
banks and international institutions.
Chapter 2
Page 38
The history of the stock exchanges


The New York Stock Exchange established
May 17, 1792 on Wall Street. Traders met
at the old wooden wall, no longer in existence,
but giving its name to the street.
The Dow Jones Industrial Average (DJIA)
started out with 12 stocks in October 1928.
Only General Electric remains of the original
twelve. The S&P 500 Index covers the 500
most widely held companies.
Chapter 2
Page 39
The history of the stock exchanges


The London Stock Exchange was established in
1773, formerly Jonathan’s Coffee House
where trades met. Trading has since moved
off the floor with the introduction of the
Stock Exchange Automated Quotations (SEAQ)
system.
The Footsie 100 Index is the Financial Times
Stock Exchange Index of the 100 largest
companies listed on the London Stock
Exchange.
Chapter 2
Page 40
The history of the stock exchanges



The Tokyo Stock Exchange was established on
May 15, 1878. Japan's Nikkei 225 Index is
an average of stock market prices similar to
the Dow Jones Industrial Average.
The Paris Bourse was established in Paris by
the order of the Royal council in 1724. In
1986, the futures exchange – Le MATIF was established .
The CAC 40 Index is the acronym for
“Compagnie des Agents de Change 40 Index,”
40 French companies listed on the Paris Stock
Exchange.
Chapter 2
Page 41
The history of the stock exchanges


The Frankfurt Stock Exchange dates from the
9th century when trade fairs were authorized.
In 1585 it was organized as a bourse to fix
exchange rates and by 1894 had became a
formal stock exchange.
Its main index, the DAX consists of the 30
largest issues traded on the exchange.
Chapter 2
Page 42
The history of the stock exchanges



The Shanghai Stock Exchange (SSE) was
founded in 1904, mainly dealing in rubber
shares. The Japanese occupation brought an
end to its operations.
The modern Shanghai Stock Exchange was
founded in 1990 but suffers from
transparency, disclosure and monitoring issues
that have put it into a serious slump from
which it is just now recovering.
The Shanghai Composite Index is a composite
of hard-currency B shares sold to foreigners
and yuan-denominated A shares sold to
Chinese.
Chapter 2
Page 43
The history of the stock exchanges



The performances of the international stock
markets indices are related.
In fact, this is one aspect of the increased
globalization of international trade and finance.
The following table reports the correlation
between the monthly real rates of return on
major world stock indices
Chapter 2
Page 44
The history of the stock exchanges

Correlations between the monthly real rates
of return of major stock indices: 1995-2004.
** Correlation is significant at the 0.01 level (2-tailed).
* Correlation is significant at the 0.05 level (2-tailed).
Chapter 2
Page 45
Conclusion


Money serves as a medium of exchange, a unit
of account, and a store of value. Different
monies must be converted into the same unit
of account by the exchange rate in order to
compare prices and rates of return.
This currency conversion gives rise to foreign
exchange risk in investing and operating
internationally. The foreign exchange
markets have arisen to deal with spot and
forward transactions in different monies, as
well as currency options to either hedge or
speculate.
Chapter 2
Page 46
Conclusion



The largest FOREX market remains London.
accounting for 31% of daily turnover in the
foreign exchanges.
The exchange costs on the FOREX market are
mainly the difference between the ask and
the bid price of foreign currency – the bidask spread – as well as any commission
associated with the conversion.
These costs are not insignificant, amounting
to approximately a billion USD daily.
Chapter 2
Page 47
Conclusion


There is increasing financial integration in the
world financial markets, making for a more
efficient distribution of worldwide finance.
The adoption of the euro by twelve countries
as the same currency has removed exchange
rate risk and conversion costs from the
financial landscape of Europe.
Chapter 2
Page 48
Conclusion




The issue of seigniorage has been the “root of all evils” in many
emerging markets, especially developing countries in Latin
America and Africa. Money has become worthless, so that
“currency reforms” – a change of the monetary unit – have been
necessary in Argentina, Bolivia, Peru, Mexico and Ecuador (which
has officially dollarized)
It is often the “finance of last resort” when a government runs
a high fiscal deficit it cannot finance by borrowing at home and
abroad. It’s last resort is to print money – the “printing press.”
China and the United States have since the 1950s restrained
the issue of seigniorage and consequently have had low inflation.
At the same time, China’s high income elasticity of demand for
money and its high growth rate have allowed 1.2% of GDP to be
collected as seigniorage revenues.
Chapter 2
Page 49