Multinational Financial

Management
Alan Shapiro
7th Edition
J.Wiley & Sons
Power Points by
Joseph F. Greco, Ph.D.
California State University, Fullerton
1
 CHAPTER 3

THE INTERNATIONAL
MONETARY SYSTEM
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CHAPTER OVERVIEW
I. ALTERNATIVE EXCHANGE RATE SYSTEMS
II. A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYTEM
III. THE EUROPEAN MONETARY SYSTEM AND
MONETARY UNION
IV. EMERGING MARKET CURRENCY CRISES

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PART I. ALTERNATIVE
EXCHANGE RATE SYSTEMS

I. FIVE MARKET MECHANISMS

A. Freely Floating
(Clean Float)
1. Market forces of
supply and demand
determine rates.

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ALTERNATIVE EXCHANGE RATE
SYSTEMS
2. Forces influenced by
a. price levels
b. interest rates
c. economic growth
3. Rates fluctuate randomly
over time.

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ALTERNATIVE EXCHANGE RATE
SYSTEMS
B. Managed Float (Dirty Float)
1. Market forces set rates
unless excess volatility
occurs.
2. Then, central bank determines
rate.

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ALTERNATIVE EXCHANGE RATE
SYSTEMS
C. Target-Zone Arrangement
1. Rate Determination

a. Market forces constrained

to upper and lower
range of rates.

b. Members to the arrangement

adjust their national economic
policies to maintain target.

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ALTERNATIVE EXCHANGE RATE
SYSTEMS
D.Fixed Rate System
1. Rate determination

a. Government maintains target

rates.
b. If rates threatened, central
banks buy/sell currency.
c. Monetary policies
coordinated.
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ALTERNATIVE EXCHANGE RATE
SYSTEMS
E. Current System
1. A hybrid system
a. Major currencies:use freely-
floating method

b. Other currencies move in and

out of various fixed-rate
systems.

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PART II. A BRIEF HISTORY OF THE
INTERNATIONAL MONETARY SYSTEM
I. THE USE OF GOLD
A. Desirable properties
B. In short run: High production costs limit
changes.
C. In long run: Commodity money insures
stability.

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A BRIEF HISTORY
II. The Classical Gold Standard
(1821-1914)

A. Major global currencies on gold

standard.
1. Nations fix the exchange rate
in terms of a specific amount
of gold.

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A BRIEF HISTORY
2. Maintenance involved the
buying and selling of gold at that
price.

3. Disturbances in Price Levels:

Would be offset by the price-
specie*-flow mechanism.

* specie = gold coins

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A BRIEF HISTORY
a. Price-specie-flow mechanism
adjustments were automatic:
1.) When a balance of payments
surplus led to a gold inflow;

2.) Gold inflow led to higher

prices which reduced surplus;

3.) Gold outflow led to lower

prices and increased surplus.
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A BRIEF HISTORY
III. The Gold Exchange Standard
(1925-1931)
A. Only U.S. and Britain allowed
to hold gold reserves.

B. Others could hold both gold, dollars

or pound reserves.

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A BRIEF HISTORY
C. Currencies devalued in 1931
- led to trade wars.
D. Bretton Woods
Conference
- called in order to avoid
future protectionist and
destructive economic policies
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A BRIEF HISTORY
V. The Bretton Woods System (1946-1971)

1. U.S.$ was key currency;

valued at $1 - 1/35 oz. of
gold.

2. All currencies linked to that price in

a fixed rate system.

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A BRIEF HISTORY
3. Exchange rates allowed to fluctuate
by 1% above or below initially set
rates.
B. Collapse, 1971
1. Causes:
a. U.S. high inflation rate

b. U.S.$ depreciated sharply.

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A BRIEF HISTORY
V. Post-Bretton Woods System (1971-Present)

A. Smithsonian Agreement, 1971:

US$ devalued to 1/38 oz. of gold.
By 1973: World on a freely floating
exchange rate system.

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A BRIEF HISTORY
B. OPEC and the Oil Crisis (1973-774)
1. OPEC raised oil prices four fold;

2. Exchange rate turmoil resulted;

3. Caused OPEC nations to earn

large surplus B-O-P.

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A BRIEF HISTORY
4. Surpluses recycled to debtor
nations which set up debt
crisis of 1980s.
C. Dollar Crisis (1977-78)
1. U.S. B-O-P difficulties
2. Result of inconsistent
monetary policy in U.S.

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A BRIEF HISTORY
3. Dollar value falls as confidence
shrinks.

D.The Rising Dollar (1980-85)

1. U.S. inflation subsides as the Fed
raises interest rates

2. Rising rates attracts global capital to

U.S.
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A BRIEF HISTORY
3. Result: Dollar value
rises.
E. The Sinking Dollar:(1985-87)
1. Dollar revaluated slowly
downward;
2. Plaza Agreement (1985)
G-5 agree to depress US$
further.
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A BRIEF HISTORY
3. Louvre Agreement (1987)
G-7 agree to support the
falling US$.
F. Recent History (1988-Present)
1. 1988 US$ stabilized
2. Post-1991 Confidence
resulted in stronger
dollar
3. 1993-1995 Dollar value
falls

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PART III.
THE EUROPEAN MONETARY SYSTEM
I. INTRODUCTION
A. The European Monetary System
(EMS)
1. A target-zone method
(1979)
2. Close macroeconomic
policy coordination required.

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THE EUROPEAN MONETARY SYSTEM
B. EMS Objective:
to provide exchange rate
stability to all members by
holding exchange rates
within specified limits.

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THE EUROPEAN MONETARY SYSTEM
C. European Currency Unit (ECU)
a cocktail of European currencies
with specified weights as the unit of
account.

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THE EUROPEAN MONETARY SYSTEM

1. Exchange rate mechanism

(ERM)
- each member determines mutually
agreed upon central cross rate for
its currency.

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THE EUROPEAN MONETARY SYSTEM
2. Member Pledge:
to keep within 15%
margin above or below
the central rate.

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THE EUROPEAN MONETARY SYSTEM
D. EMS ups and downs
1. Foreign exchange
interventions:
failed due to lack of
support by coordinated
monetary policies.

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THE EUROPEAN MONETARY SYSTEM
2. Currency Crisis of Sept. 1992
a. System broke down
b. Britain and Italy
forced towithdraw
from EMS.

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THE EUROPEAN MONETARY SYSTEM

G. Failure of the EMS:

members allowed political
priorities to dominate
exchange rate policies.

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THE EUROPEAN MONETARY SYSTEM
H. Maastricht Treaty
1. Called for Monetary
Union by 1999 (moved to
2002)
2. Established a single
currency:

the euro
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THE EUROPEAN MONETARY SYSTEM
3. Calls for creation of a single
central EU bank

4. Adopts tough fiscal

standards

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THE EUROPEAN MONETARY SYSTEM
I. Costs / Benefits of A Single Currency
A. Benefits
1. Reduces cost of doing
business
2. Reduces exchange rate
risk

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THE EUROPEAN MONETARY
SYSTEM
B. Costs
1. Lack of national
monetary flexibility.

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PART IV. EMERGING MARKET
CURRENCY CRISES
I. Transmission Mechanisms
A. Trade links
contagion spreads through trade
B. Financial System
-more important transmission
mechanism
-investors sell off to make up for losses

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EMERGING MARKET CURRENCY
CRISES
II. Origins of Emerging Market Crises
A. Moral hazard

B. Fundamental Policy Conflict

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EMERGING MARKET CURRENCY
CRISES
III. Policy Proposals for Dealing with
Emerging Market Crises
A. Currency Controls

B. Freely Floating Currency

C. Permanently Fixed Exchange

Rate
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