INTERNATIONALFINANCIALMANAGEMENTEUN / RESNICKFifth EditionCopyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Evolution of the International Monetary SystemCurrent Exchange Rate ArrangementsEuropean Monetary SystemEuro and the European Monetary UnionThe Mexican Peso CrisisThe Asian Currency CrisisThe Argentine Peso CrisisFixed versus Flexible Exchange Rate RegimesChapter Two Outline2-*

Evolution of the International Monetary SystemBimetallism: Before 1875Classical Gold Standard: 1875-1914Interwar Period: 1915-1944Bretton Woods System: 1945-1972The Flexible Exchange Rate Regime: 1973-Present2-*

Bimetallism: Before 1875A double standard in the sense that both gold and silver were used as money.Both gold and silver were used as international means of payment and the exchange rates among currencies were determined by either their gold or silver contents. 2-*

Greshams LawGreshams Law implied that it would be the least valuable metal that would tend to circulate. 2-*

Classical Gold Standard: 1875-1914During this period in most major countries:Gold alone was assured of unrestricted coinageThere was two-way convertibility between gold and national currencies at a stable ratio.Gold could be freely exported or imported.The exchange rate between two countrys currencies would be determined by their relative gold contents.2-*

Classical Gold Standard: 1875-1914Highly 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 price-specie-flow mechanism.2-*

Price-Specie-Flow MechanismSuppose Great Britain exported 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.2-*

Classical Gold Standard: 1875-1914There 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.2-*

Interwar Period: 1915-1944Exchange 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.2-*

Bretton Woods System: 1945-1972Named 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.2-*

Bretton Woods System: 1945-1972Under the Bretton Woods system, the U.S. dollar was pegged to gold at $35 per ounce and other currencies were pegged to the U.S. dollar.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 Bretton Woods system was a dollar-based gold exchange standard.2-*

Bretton Woods System: 1945-1972U.S. dollarGoldPegged at $35/oz.2-*

The Flexible Exchange Rate Regime: 1973-Present.Flexible exchange rates were declared acceptable to the IMF members.Central banks were allowed to intervene in the exchange rate markets to iron out unwarranted volatilities.Gold was abandoned as an international reserve asset.2-*

Current Exchange Rate ArrangementsFree Float The largest number of countries, about 48, allow market forces to determine their currencys value.Managed Float About 25 countries combine government intervention with market forces to set exchange rates.Pegged to another currency Such as the U.S. dollar or euro (through franc or mark).No national currencySome countries do not bother printing their own currency. For example, Ecuador, Panama, and El Salvador have dollarized. Montenegro and San Marino use the euro.2-*

European Monetary SystemEuropean countries maintain exchange rates among their currencies within narrow bands, and jointly float against outside currencies.Objectives:To establish a zone of monetary stability in Europe.To coordinate exchange rate policies vis--vis non-European currencies.To pave the way for the European Monetary Union.2-*

What Is the Euro?The euro is the single currency of the European Monetary Union which was adopted by 11 Member States on 1 January 1999. These original member states were: Belgium, Germany, Spain, France, Ireland, Italy, Luxemburg, Finland, Austria, Portugal and the Netherlands.2-*

Euro AreaAustria, Belgium,Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, The Netherlands,Portugal, Slovenia, Spain2-*

The Long-Term Impact of the EuroAs the euro proves successful, it will advance the political integration of Europe in a major way, eventually making a United States of Europe feasible.It is likely that the U.S. dollar will lose its place as the dominant world currency.The euro and the U.S. dollar will be the two major currencies.2-*

Costs of Monetary UnionThe main cost of monetary union is the loss of national monetary and exchange rate policy independence.The more trade-dependent and less diversified a countrys economy is the more prone to asymmetric shocks that countrys economy would be.2-*

Costs of Monetary UnionAs an example, if the economy of Oklahoma was dependent on gas and oil, and oil prices fall on the world market, then Oklahoma might be better off if it had its own currency rather than relying on the U.S. dollar.This example shows that perhaps the benefits of monetary union typically outweigh the costs.2-*

The Mexican Peso CrisisOn 20 December, 1994, the Mexican government announced a plan to devalue the peso against the dollar by 14 percent.This decision changed currency traders expectations about the future value of the peso.They stampeded for the exits. In their rush to get out the peso fell by as much as 40 percent.2-*

The Mexican Peso CrisisThe Mexican Peso crisis is unique in that it represents the first serious international financial crisis touched off by cross-border flight of portfolio capital.

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The Mexican Peso CrisisTwo lessons emerge:It is essential to have a multinational safety net in place to safeguard the world financial system from such crises.An influx of foreign capital can lead to an overvaluation in the first place.

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The Asian Currency CrisisThe Asian currency crisis turned out to be far more serious than the Mexican peso crisis in terms of the extent of the contagion and the severity of the resultant economic and social costs.Many firms with foreign currency bonds were forced into bankruptcy.The region experienced a deep, widespread recession.2-*

The Argentinean Peso CrisisIn 1991 the Argentine government passed a convertibility law that linked the peso to the U.S. dollar at parity.The initial economic effects were positive:Argentinas chronic inflation was curtailedForeign investment poured inAs the U.S. dollar appreciated on the world market the Argentine peso became stronger as well.2-*

The Argentinean Peso CrisisThe strong peso hurt exports from Argentina and caused a protracted economic downturn that led to the abandonment of pesodollar parity in January 2002.The unemployment rate rose above 20 percentThe inflation rate reached a monthly rate of 20 percent2-*

The Argentinean Peso CrisisThere are at least three factors that are related to the collapse of the currency board arrangement and the ensuing economic crisis:Lack of fiscal discipline Labor market inflexibilityContagion from the financial crises in Brazil and Russia

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Currency Crisis ExplanationsIn theory, a currencys value mirrors the fundamental strength of its underlying economy, relative to other economies. In the long run.In the short run, currency traders expectations play a much more important role.In todays environment, traders and lenders, using the most modern communications, act by fight-or-flight instincts. For example, if they expect others are about to sell Brazilian reals for U.S. dollars, they want to get to the exits first. Thus, fears of depreciation become self-fulfilling prophecies.2-*

Fixed versus Flexible Exchange Rate RegimesArguments in favor of flexible exchange rates:Easier external adjustments.National policy autonomy.Arguments against flexible exchange rates:Exchange rate uncertainty may hamper international trade.No safeguards to prevent crises.2-*

Fixed versus Flexible Exchange Rate RegimesSuppose the exchange rate is $1.40/ today.In the next slide, we see that demand for euro far exceeds supply at this exchange rate.The U.S. experiences trade deficits.2-*

Fixed versus Flexible Exchange Rate RegimesQ of Dollar price per (exchange rate)2-*

Flexible Exchange Rate RegimesUnder a flexible exchange rate regime, the dollar will simply depreciate to $1.60/, the price at which supply equals demand and the trade deficit disappears. 2-*

Fixed versus Flexible Exchange Rate RegimesSupply (S)Demand (D)Demand (D*)QD = QSQ of Dollar price per (exchange rate)$1.402-*

Fixed versus Flexible Exchange Rate RegimesInstead, suppose the exchange rate is fixed at $1.40/, and thus the imbalance between supply and demand cannot be eliminated by a price change.The government would have to shift the demand curve from D to D* In this example this corresponds to contractionary monetary and fiscal policies.2-*

Fixed versus Flexible Exchange Rate RegimesSupply (S)Demand (D)Demand (D*)QD* = QSContractionary policies(fixed regime)Q of Dollar price per (exchange rate)$1.402-*

**Cyprus, Denmark, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia, Sweden and the United Kingdom are members of the EU but are not currently participating in the single currency. Denmark is a member of the Exchange Rate Mechanism II (ERM II). This means that the Danish krone is linked to the euro, but the exchange rate is not fixed. This map is used with permission