Transcript Lecture 2 (POWER POINT)

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 May 29, 2014: The yuan price of the dollar (known
as a “direct quotation” from China’s perspective) was:
RMB 6.2558
– 6.2558 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):
– 1/6.2558 = $0.1599 (roughly 16 cents needed to buy one
yuan).
More recently
• The RMB price of the dollar had been falling (a decline in
the direct quotation is known as an appreciation) until
January, when it reached a record low of RMB 6.0406.
– Policy intended to keep inflation in check and
potentially increase standards of living.
• According to the Wall Street Journal, on May 29, 2014,
“The overall feeling is that [yuan] is unlikely to return to an
appreciation path anytime soon, given the still uncertain growth
backdrop. However, the general sense was that the [central bank]
would not tolerate one-way depreciation expectations.”
Recently:
•“According to some analysts and people close to the
PBOC's thinking, China's central bank [had] been guiding
the yuan lower to drive out short-term speculators betting
on its continued rise, as the bank prepares to allow greater
trading fluctuations in the tightly controlled currency.”
•"Most of the analyses are reasonable, and I consent," Mr.
Zhou (PBOC President) said.
Cross currency exchange rate
• On May 29, the Japanese yen price of the
dollar had reached 101.84.
• The RMB price of the yen:
– S(RMB/$)/S(Yen/$) = 6.2558/101.84 =
RMB 0.0614.
International Monetary Arrangements
• International Monetary Arrangements
in Theory and Practice
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The International Gold Standard, 1879-1913
Interwar Period 1914-1944
Bretton Woods Agreement, 1945-1971
Smithsonian Agreement, 1971-1973
The Floating-Rate Dollar Standard, 1973-1984
The Plaza-Louvre Intervention Accords and the
Floating-Rate Dollar Standard, 1985-1999
– AND WHAT NOW?
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, 1879-1913
Fix an official gold price or “mint
parity” and allow free convertibility
between domestic money and gold at
that price.
• 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.
The International Gold Standard, 1879-1913
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 :
£4.2474 = 1 ounce of gold.
The exchange rate is determined by the
relative gold contents: $20.67 = £4.2474
$4.866 = £1
The International Gold Standard, 1879-1913
• 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 pricespecie-flow mechanism.
Price-Specie-Flow Mechanism
• Suppose Great Britain exported a great deal
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, 1879-1913
• 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.
The International Gold Standard, 1879-1913
• 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 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: 1914-1944
• 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: 1945-1971
• 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: 1945-1971
• Each currency was pegged to the U.S. dollar at an
official “par value”.
• 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 country responsible for maintaining
the gold parity, which they did at $35 per ounce.
• Under Bretton Woods, the IMF was created and World
Bank are created.
• The Bretton Woods system is also known as an
adjustable peg system. When facing serious balance
of payments problems, countries could re-value their
exchange rate. The US and Japan are the only
countries to never re-value.
The Fixed-Rate Dollar Standard, 1945-1971
• In practice, the Bretton Woods system
evolved into a fixed-rate dollar standard.
Industrial countries other than the United States :
Fix an official par value for domestic currency in terms
of the US$, 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: 1945-1971
British
pound
German
mark
French
franc
Par
Value
U.S. dollar
Pegged at $35/oz.
Gold
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
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 1971.
• Smithsonian Agreement – December 1971
The Floating-Rate Dollar Standard, 1973-1984
• 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.
• In 1976, the Jamaica Accord
demonetizes gold and the IMF declares
floating exchange rates to be acceptable.
The Floating-Rate Dollar Standard, 1973-1984
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, 1985-1999
• 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 1970