CHAPTER 7

THE GLOBAL TRADING AND

MONETARY SYSTEM

06/13/2024
7.1
The International Monetary
System
 Introduction

 The international monetary system refers to the

institutional arrangements that govern exchange
rates
 Recall that the foreign exchange market is the
primary institution for determining exchange
rates

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 Introduction
 A floating exchange rate system exists in
countries where the foreign exchange market
determines the relative value of a currency
Examples include the U.S. dollar, the
European Union’s euro, the Japanese yen,
and the British pound
 A pegged exchange rate system exists when the
value of a currency is fixed to a reference
country and then the exchange rate between
that currency and other currencies is
determined by the reference currency exchange
rate
Many developing countries have pegged
exchange rates
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 Introduction
 A dirty float exists when the value of a currency
is determined by market forces, but with central
bank intervention if it depreciates too rapidly
against an important reference currency
China adopted this policy in 2005
 With a fixed exchange rate system countries fix
their currencies against each other at a mutually
agreed upon value
Prior to the introduction of the euro, some
European Union countries operated with
fixed exchange rates within the context of the
European Monetary System (EMS)
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 The Gold Standard

 The origin of the gold standard dates back to

ancient times when gold coins were a medium
of exchange, unit of account, and store of value
 To facilitate trade, a system was developed so
that payment could be made in paper currency
that could then be converted to gold at a fixed
rate of exchange

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Mechanics of the Gold Standard
The gold standard refers to the practice of
pegging currencies to gold and
guaranteeing convertibility
Under the gold standard one U.S.
dollar was defined as equivalent to
23.22 grains of "fine (pure) gold
The exchange rate between currencies
was based on the gold par value (the
amount of a currency needed to purchase
one ounce of gold)
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 Strength of the Gold Standard
 For example, under the gold standard, one U.S. dollar was
defined as equivalent to 23.22 grains of “fine” (pure) gold.
Thus, one could, in theory, demand that the U.S.
government convert that one dollar into 23.22 grains of
gold. Since there are 480 grains in an ounce, one ounce of
gold cost $20.67 (480/23.22).
 The amount of a currency needed to purchase one ounce of
gold was referred to as the gold par value. The British
pound was valued at 113 grains of fine gold. In other
words, one ounce of gold cost £4.25 (480/113). From the
gold par values of pounds and dollars, we can calculate
what the exchange rate was for converting pounds into
dollars; it was £1 5 $4.87 (i.e., $20.67/£4.25).
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 The Bretton Woods System
 A new international monetary system was
designed in 1944 in Bretton Woods, New
Hampshire
 The goal was to build an enduring economic
order that would facilitate postwar economic
growth
 The Bretton Woods Agreement established two
multinational institutions
1. The International Monetary Fund (IMF) to
maintain order in the international monetary
system
2. The World Bank to promote general
economic development
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 The Role of the World Bank
 The official name of the World Bank is the
International Bank for Reconstruction and
Development (IBRD)
 The World Bank lends money in two ways
under the IBRD scheme, money is raised
through bond sales in the international capital
market and borrowers pay what the bank calls
a market rate of interest - the bank's cost of
funds plus a margin for expenses.
under the International Development Agency
scheme, loans go only to the poorest countries

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 The Jamaica Agreement

 At the Jamaica meeting, the IMF's Articles of

Agreement were revised to reflect the new
reality of floating exchange rates
 Under the Jamaican agreement
floating rates were declared acceptable
gold was abandoned as a reserve asset
 total annual IMF quotas - the amount
member countries contribute to the IMF -
were increased to $41 billion (today, this
number is $311 billion)
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 Exchange Rates Since 1973
 Since 1973, exchange rates have become more
volatile and less predictable because of
the oil crisis in 1971
the loss of confidence in the dollar after U.S.
inflation jumped between 1977 and 1978
the oil crisis of 1979
the rise in the dollar between 1980 and 1985
the partial collapse of the European Monetary
System in 1992
the 1997 Asian currency crisis
the decline in the dollar in the mid to late 2000s
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 The Case for Floating
Exchange Rates
 A floating exchange rate system provides two
attractive features
1. monetary policy autonomy
2. automatic trade balance adjustments

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 The Case for Floating
Exchange Rates
1. Monetary Policy Autonomy
 The removal of the obligation to
maintain exchange rate parity restores
monetary control to a government
 In contrast, with a fixed system, a
country's ability to expand or contract
its money supply is limited by the need
to maintain exchange rate parity

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 The Case for Floating
Exchange Rates

2. Trade Balance Adjustments

 The balance of payments adjustment mechanism works
more smoothly under a floating exchange rate regime
 Under the Bretton Woods system (fixed system), IMF
approval was need to correct a permanent deficit in a
country’s balance of trade that could not be corrected by
domestic policy alone

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 The Case for Fixed Exchange Rates

 A fixed exchange rate system is attractive because

1. of the monetary discipline it imposes
2. it limits speculation
3. it limits uncertainty
4. of the lack of connection between the trade balance and
exchange rates

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 The Case for Fixed Exchange Rates

1. Monetary Discipline
 Because a fixed exchange rate system requires maintaining
exchange rate parity, it also ensures that governments do
not expand their money supplies at inflationary rates
2. Speculation
 A fixed exchange rate regime prevents destabilizing
speculation

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The Case for Fixed Exchange Rates
3. Uncertainty
 The uncertainty associated with
floating exchange rates makes business
transactions more risky
4. Trade Balance Adjustments
 Floating rates help adjust trade
imbalances

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Crisis Management by the IMF

The IMF has redefined its mission, and

now focuses on lending money to
countries experiencing financial crises
in exchange for enacting certain
macroeconomic policies

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 Financial Crises in
the Post-Bretton Woods Era
Three types of financial crises that have
required involvement by the IMF are
1. A currency crisis - occurs when a
speculative attack on the exchange value
of a currency results in a sharp
depreciation in the value of the currency,
or forces authorities to expend large
volumes of international currency
reserves and sharply increase interest
rates in order to defend prevailing
exchange rates
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 Financial Crises in
the Post-Bretton Woods Era
2. A banking crisis - refers to a situation in which
a loss of confidence in the banking system
leads to a run on the banks, as individuals and
companies withdraw their deposits
3. A foreign debt crisis - a situation in which a
country cannot service its foreign debt
obligations, whether private sector or
government debt
 Two crises that are particularly significant are
1. the 1995 Mexican currency crisis
2. the 1997 Asian currency crisis

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The Mexican Currency Crisis of 1995
 The Mexican currency crisis of 1995 was a
result of high Mexican debts, and a pegged
exchange rate that did not allow for a natural
adjustment of prices
 In order to keep Mexico from defaulting on its
debt, a $50 billion aid package was created by
the IMF
 By 1997, Mexico was well on the way to
recovery

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 The Asian Crisis
 By mid-1997, it became clear that several
key Thai financial institutions were on the
verge of default
 Foreign exchange dealers and hedge funds
started to speculate against the Thai baht,
selling it short
 After struggling to defend the peg, the Thai
government abandoned its defense and
announced that the baht would float freely
against the dollar

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 Evaluating the IMF’s
Policy Prescriptions

In 2006, 59 countries were working IMF

programs
All IMF loan packages come with
conditions attached, generally a
combination of tight macroeconomic
policy and tight monetary policy
Many experts have criticized these
policy prescriptions for three reasons

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 Evaluating the IMF’s
Policy Prescriptions
1. Inappropriate Policies
 The IMF has been criticized for having a
“one-size-fits-all” approach to
macroeconomic policy that is
inappropriate for many countries
2. Moral Hazard
The IMF has also been criticized for
exacerbating moral hazard (when people
behave recklessly because they know
they will be saved if things go wrong)
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 Evaluating the IMF’s
Policy Prescriptions
3. Lack of Accountability
The final criticism of the IMF is that it
has become too powerful for an
institution that lacks any real mechanism
for accountability

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7.2

The Foreign Exchange Market

 Introduction

A firm’s sales, profits, and strategy are affected by events in the

foreign exchange market
The foreign exchange market is a market for converting the
currency of one country into that of another country
The exchange rate is the rate at which one currency is
converted into another

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 The Functions Of The
Foreign Exchange Market
The foreign exchange market:
is used to convert the currency of one country
into the currency of another
provide some insurance against foreign
exchange risk (the adverse consequences of
unpredictable changes in exchange rates)

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 Currency Conversion
International companies use the foreign exchange market when:
 the payments they receive for exports, the income they receive
from foreign investments, or the income they receive from
licensing agreements with foreign firms are in foreign currencies
 they must pay a foreign company for its products or services in
its country’s currency
 they have spare cash that they wish to invest for short terms in
money markets
 they are involved in currency speculation (the short-term
movement of funds from one currency to another in the hopes of
profiting from shifts in exchange rates)

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 Insuring Against Foreign Exchange Risk

The foreign exchange market can be used to provide insurance

to protect against foreign exchange risk (the possibility that
unpredicted changes in future exchange rates will have adverse
consequences for the firm)
A firm that insures itself against foreign exchange risk is
hedging

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 Insuring Against Foreign Exchange Risk

The spot exchange rate is the rate at which a foreign exchange

dealer converts one currency into another currency on a particular
day
Spot rates change continually depending on the supply and
demand for that currency and other currencies

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 Insuring Against Foreign Exchange Risk

To insure or hedge against a possible adverse

foreign exchange rate movement, firms engage in
forward exchanges
A forward exchange occurs when two parties
agree to exchange currency and execute the deal at
some specific date in the future
 A forward exchange rate is the rate governing
such future transactions
Rates for currency exchange are typically quoted
for 30, 90, or 180 days into the future
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 Insuring Against Foreign Exchange Risk

A currency swap is the simultaneous purchase and sale of a

given amount of foreign exchange for two different value dates
Swaps are transacted between international businesses and their
banks, between banks, and between governments when it is
desirable to move out of one currency into another for a limited
period without incurring foreign exchange rate risk

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 The Nature Of The
Foreign Exchange Market

The foreign exchange market is a global

network of banks, brokers, and foreign exchange
dealers connected by electronic communications
systems—it is not located in any one place
The most important trading centers are
London, New York, Tokyo, and Singapore
The markets is always open somewhere in the
world—it never sleeps

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 The Nature Of The
Foreign Exchange Market
High-speed computer linkages between trading centers
around the globe have effectively created a single market
—there is no significant difference between exchange
rates quotes in the differing trading centers
If exchange rates quoted in different markets were not
essentially the same, there would be an opportunity for
arbitrage (the process of buying a currency low and
selling it high), and the gap would close
Most transactions involve dollars on one side—it is a
vehicle currency along with the euro, the Japanese yen,
and the British pound

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 Economic Theories Of
Exchange Rate Determination
Exchange rates are determined by the demand
and supply for different currencies.

Three factors impact future exchange rate

movements:
 a country’s price inflation
 a country’s interest rate
 market psychology

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 Prices And Exchange Rates
The law of one price states that in competitive
markets free of transportation costs and barriers
to trade, identical products sold in different
countries must sell for the same price when their
price is expressed in terms of the same currency
Purchasing power parity (PPP) theory argues
that given relatively efficient markets (markets in
which few impediments to international trade and
investment exist) the price of a “basket of goods”
should be roughly equivalent in each country
PPP theory predicts that changes in relative
prices will result in a change in exchange rates
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 Prices And Exchange Rates
A positive relationship between the inflation rate and the level
of money supply exists
 When the growth in the money supply is greater than the
growth in output, inflation will occur
 PPP theory suggests that changes in relative prices between
countries will lead to exchange rate changes, at least in the short
run
A country with high inflation should see its currency depreciate
relative to others
Empirical testing of PPP theory suggests that it is most accurate
in the long run, and for countries with high inflation and
underdeveloped capital markets

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 Interest Rates And Exchange Rates
There is a link between interest rates and exchange rates
The International Fisher Effect states that for any two countries
the spot exchange rate should change in an equal amount but in the
opposite direction to the difference in nominal interest rates
between two countries
 In other words:
(S1 - S2) / S2 x 100 = i $ - i ¥
where i $ and i ¥ are the respective nominal interest rates in
two countries (in this case the US and Japan), S1 is the spot
exchange rate at the beginning of the period and S2 is the spot
exchange rate at the end of the period

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 Investor Psychology
And Bandwagon Effects
Investor psychology also affects exchange rates
The bandwagon effect occurs when
expectations on the part of traders can turn into
self-fulfilling prophecies, and traders can join the
bandwagon and move exchange rates based on
group expectations
 Governmental intervention can prevent the
bandwagon from starting, but is not always
effective

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 Summary
Relative monetary growth, relative inflation
rates, and nominal interest rate differentials are all
moderately good predictors of long-run changes
in exchange rates
 So, international businesses should pay
attention to countries’ differing monetary growth,
inflation, and interest rates

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 Exchange Rate Forecasting
Should companies use exchange rate forecasting services
to aid decision-making?

The efficient market school argues that forward

exchange rates do the best possible job of forecasting
future spot exchange rates, and, therefore, investing in
forecasting services would be a waste of money
The inefficient market school argues that companies
can improve the foreign exchange market’s estimate of
future exchange rates by investing in forecasting services

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 The Efficient Market School
An efficient market is one in which prices reflect all
available information
If the foreign exchange market is efficient, then
forward exchange rates should be unbiased predictors of
future spot rates
Most empirical tests confirm the efficient market
hypothesis suggesting that companies should not waste
their money on forecasting services

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 The Inefficient Market School
An inefficient market is one in which prices do not
reflect all available information
So, in an inefficient market, forward exchange rates
will not be the best possible predictors of future spot
exchange rates and it may be worthwhile for
international businesses to invest in forecasting services
However, the track record of forecasting services is not
good

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 Approaches To Forecasting
There are two schools of thought on forecasting:
Fundamental analysis draw upon economic factors
like interest rates, monetary policy, inflation rates, or
balance of payments information to predict exchange
rates
Technical analysis charts trends with the assumption
that past trends and waves are reasonable predictors of
future trends and waves

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 Currency Convertibility
A currency is freely convertible when a government
of a country allows both residents and non-residents to
purchase unlimited amounts of foreign currency with
the domestic currency
 A currency is externally convertible when non-
residents can convert their holdings of domestic
currency into a foreign currency, but when the ability of
residents to convert currency is limited in some way
 A currency is nonconvertible when both residents and
non-residents are prohibited from converting their
holdings of domestic currency into a foreign currency
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 Currency Convertibility
Most countries today practice free convertibility,
although many countries impose some restrictions on
the amount of money that can be converted
Countries limit convertibility to preserve foreign
exchange reserves and prevent capital flight (when
residents and nonresidents rush to convert their holdings
of domestic currency into a foreign currency)
When a country’s currency is nonconvertible, firms
may turn to countertrade (barter like agreements by
which goods and services can be traded for other goods
and services) to facilitate international trade
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 Implications For Managers
Firms need to understand the influence of exchange
rates on the profitability of trade and investment deals
There are three types of foreign exchange risk:
1. Transaction exposure
2. Translation exposure
3. Economic exposure

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 Transaction Exposure
Transaction exposure is the extent to which the income
from individual transactions is affected by fluctuations in
foreign exchange values
It includes obligations for the purchase or sale of goods
and services at previously agreed prices and the
borrowing or lending of funds in foreign currencies

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 Translation Exposure
Translation exposure is the impact of currency
exchange rate changes on the reported financial
statements of a company
It is concerned with the present measurement of past
events
Gains or losses are “paper losses” –they’re unrealized

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 Economic Exposure
Economic exposure is the extent to which a firm’s
future international earning power is affected by changes
in exchange rates
 Economic exposure is concerned with the long-term
effect of changes in exchange rates on future prices,
sales, and costs

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 Reducing Translation
And Transaction Exposure
To minimize transaction and translation exposure, firms
can:
buy forward
use swaps
leading and lagging payables and receivables (paying
suppliers and collecting payment from customers early or
late depending on expected exchange rate movements)

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 Reducing Translation
And Transaction Exposure
A lead strategy involves attempting to collect foreign
currency receivables early when a foreign currency is
expected to depreciate and paying foreign currency
payables before they are due when a currency is expected
to appreciate
A lag strategy involves delaying collection of foreign
currency receivables if that currency is expected to
appreciate and delaying payables if the currency is
expected to depreciate
Lead and lag strategies can be difficult to implement

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 Reducing Economic Exposure
To reduce economic exposure, firms need to:
distribute productive assets to various locations so the
firm’s long-term financial well-being is not severely
affected by changes in exchange rates
ensure assets are not too concentrated in countries
where likely rises in currency values will lead to
damaging increases in the foreign prices of the goods
and services the firm produces

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 Other Steps For Managing
Foreign Exchange Risk
In general, firms should:
have central control of exposure to protect resources
efficiently and ensure that each subunit adopts the correct
mix of tactics and strategies
distinguish between transaction and translation exposure
on the one hand, and economic exposure on the other hand
attempt to forecast future exchange rates
establish good reporting systems so the central finance
function can regularly monitor the firm’s exposure position
produce monthly foreign exchange exposure reports

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