CHAPTER 3

THE INTERNATIONAL MONETARY SYSTEM

The purpose of this chapter is to help students understand what the international monetary system is and
how the choice of system affects currency values. It also provides a historical background of the
international monetary system. This enables students to gain perspective when trying to interpret the likely
consequences of new policies in the area of international finance.

This chapter describes how exchange rates are determined under four different mechanisms--free float,
managed float, fixed-rate system, and target-zone system. Under the latter three systems, governments
intervene in the currency markets in one form or another to affect the exchange rate. Regardless of the
system chosen, its design is constrained by the fundamental trilemma of international finance. This
“impossible trinity” of international finance stems from the fact that, in general, economic policy makers
would like to achieve each of the following three goals: a stable exchange rate, an independent monetary
policy, and capital market integration. The policymaker’s trilemma is that in pursuing any two of these
goals, the country must forgo the third.

KEY POINTS
1. Under a managed float, fixed-rate system, and target-zone system, which involve varying degrees of
central bank intervention, the real exchange rate is liable to change, with important implications for
exchange risk management (as discussed in Chapters 9 through 11).

2. Regardless of the form of intervention, fixed rates don't remain fixed for long. Neither do floating
rates. The basic reason that exchange rates don't stay fixed for long in either a fixed- or floating-rate
system is that governments subordinate exchange rate considerations to domestic political
considerations.

3. The gold standard is a specific type of fixed exchange rate system, one that required participating
countries to maintain the value of their currencies in terms of gold. Calls for a new gold standard
remind us of the fundamental lack of trust in fiat money due to the historical unwillingness of the
monetary authorities to desist from tampering with the money supply.

4. Intervention to maintain a disequilibrium rate is usually either ineffective or injurious when pursued
over lengthy periods of time. Seldom, if ever, have policy makers been able to outsmart for any
extended period the collective judgment of buyers and sellers. The current volatile market
environment, a consequence of unstable U.S. and world financial conditions, cannot for long be
arbitrarily directed by government officials.

5. Examining U.S. experience since the abandonment of fixed rates, we find that free-market forces did
indeed correctly reflect economic realities. The dollar's value dropped sharply from 1973 to 1980 when
the U.S. experienced high inflation and weakened economic conditions. It rose beginning in 1981
when American policies dramatically changed under the leadership of the Fed and a new president, and
fell when foreign economies strengthened relative to the U.S. economy.

6. History is full of examples of nations--including Mexico, Thailand, Indonesia, Korea, Russia and
Brazil--that ignored the principles of the trilemma by attempting to fully achieve all three policy
objectives simultaneously and experienced a currency crash.

SUGGESTED ANSWERS TO “THE BRICS SOLVE THE TRILEMMA WITH

DIFFERENT EXCHANGE RATE REGIMES”
2 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 10TH ED.

1. What are the current exchange rate regimes of the BRIC economies?

ANSWER. As of 2013, Brazil still has a floating rate system but a rapid decline in the real has led the central
bank to intervene in the foreign exchange market, not to stem the fall of the real officials said but to smooth
out the volatility as it falls to a new range. Russia, India, and China, as well, all still intervene in the foreign
exchange market on a regular basis to manage their exchange rates, with China exercising the greatest
degree of control through it crawling peg system that allows the yuan to gradually rise in value against the
U.S. dollar.

2. Why has Brazil changed its exchange rate regime over the years?

ANSWER. Historically, Brazil has heavily intervened in the foreign exchange market while also maintaining
monetary policies whose intersection with its exchange rate policy conflicted with its economic objectives
and led to periodic currency crises. In response to these periodic crises, Brazil changed its exchange rate
and monetary regimes.

3. What variable affects the Russian ruble?

ANSWER. A key variable affecting the value of the Russian ruble is the price of oil. When the price of oil
rises, the ruble tends to appreciate; conversely, a fall in the price of oil tends to result in a falling ruble.

4. By how much did the yuan appreciate against the dollar on July 21, 2005?

ANSWER. On July 21, 2005, the People’s Bank of China revalued the yuan from ¥8.28/$ to ¥8.11/$.
According to Equation 2.1 from Chapter 2, the resulting appreciation in the yuan equals (8.28 – 8.11)/8.28
= 2.10%.

5. How has the yuan’s appreciation since July 21, 2005 affected the U.S. trade deficit with China? (Why
this has happened is discussed in Chapter 5.)

ANSWER. As it turns out, for reasons explained in Chapter 5, even as the yuan appreciated against the U.S.
dollar from 2005 on, the U.S. trade deficit with China continued to rise as well.

6. How did the crawling peg system in place from 2005 to 2008 likely affect inflows of hot money to
China? To affect the PBOC’s ability to control the money supply and inflation?

ANSWER. Under the crawling peg system, the exchange rate was virtually guaranteed to continue to
appreciate on a regular basis. By removing most risk, and virtually guaranteeing a positive return, this
system would encourage hot money inflows. These speculative inflows would simultaneously inhibit the
PBOC’s ability to control the money supply (by forcing it to issue additional yuan to buy up the foreign
currency inflows) and hence inflation. The PBOC could sell additional bonds to mop up the excess supply
of yuan but that would raise interest rates and encourage further inflows.

7. What is the likely reason for the Chinese government again fixing the yuan to the dollar upon the
outbreak of the global economic crisis?

ANSWER. With the advent of the global economic crisis, China reestablished the yuan’s fixed peg to the
dollar, at ¥6.84/$, and maintained it for the next two years. The purpose of this renewed fixed peg was to
help China absorb the effects of the crisis by holding down the yuan’s value and making Chinese exports
more competitive than they would otherwise have been. The resulting stimulus to the vital manufacturing
sector helped to cushion China’s economy from the decline in economic activity that would have occurred
absent the peg.

8. Why has China adopted capital controls?

CHAPTER 3: THE INTERNATIONAL MONETARY SYSTEM 3

ANSWER. The Chinese central bank has managed its peg with widespread capital controls through
quantitative limits on both inflows and outflows. As the text points out, the objectives of the controls have
evolved over time, and include: (i) facilitating monetary independence, (ii) helping channel external
savings to desired uses; (iii) preventing firms and financial institutions from taking excessive external risks;
(iv) maintaining balance of payments equilibrium and exchange rate stability; and (v) insulating the
domestic economy from foreign financial crises. More specifically, absent these controls, especially on
inflows, the Chinese central bank could not have kept the yuan from appreciating more rapidly than it did,
at least not without seeing its money supply grow even more rapidly than it already has leading to the threat
of high inflation.

9. Why will China probably relax its capital controls eventually?

ANSWER. In order to achieve its goal of establishing Shanghai as a leading financial center, the government
will eventually be forced to liberalize capital flows and globally integrate China’s capital markets. It
remains unclear, however, whether China will yield more on monetary independence or exchange rate
stability (the other legs of the trilemma). Chinese authorities fear floating exchange rates, since they want
to avoid a rapid and large appreciation of the yuan. This could have serious effects on employment and
profits of multinationals in their export sector.

SUGGESTED ANSWERS TO “COMPETITIVE DEVALUATIONS IN 2003,

RETURN IN 2010”

1. What are competitive currency devaluations? What triggered them in 2003?

ANSWER. A competitive devaluation is a devaluation designed to improve a nation’s trade competitiveness.

Currency analysts argue that the economic environment in 2003–slow growth and the threat of deflation–
encouraged countries such as Japan, China, and the United States to pursue a weak currency policy. For
example, analysts believe that the Bush administration looked for a falling dollar to boost U.S. exports, lift
economic growth, battle deflationary pressure, push the Europeans to cut interest rates, and force Japan to
overhaul its stagnant economy.

2. What mechanisms are used to create competitive devaluations?

ANSWER. The mechanisms include foreign exchange market intervention (selling the home currency to buy
foreign currencies), expanding the domestic money supply, cutting interest rates, and restricting foreign
capital inflows.

3. What is QE2, and how does it affect the value of the U.S. dollar?

ANSWER. QE2 refers to the second round of quantitative easing launched by the Federal Reserve in 2010. It
involved the Fed buying bonds in the U.S. bond market and paying for these purchases by creating
reserves, which is a key part of the U.S. money supply. In other words, QE2 involved a massive increase in
the U.S. money supply.

4. What are the effects of QE2 on other economies and why are nations opposed to it?

ANSWER. QE2 led to capital inflows to other economies—fueling fears of asset bubbles and inflationary
pressures—and to appreciation of their currencies. The latter reduced their trade competitiveness vis-à-vis
the United States. These negative effects explains why countries around the world complained vehemently
against QE2.

5. What ignited the fear of a currency war in 2010?

4 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 10TH ED.

ANSWER. Fears of a currency war erupted again in 2010, largely because of the inauguration of QE2. They
were exacerbated by the concern in foreign countries that in a time of already high unemployment (a result
of the global financial crisis) even more jobs would be lost owing to the loss of trade competitiveness
stemming from appreciation of their currencies.

6. What are the similarities between 2003 and 2010?

ANSWER. In both years, the economic environment was characterized by slow growth, the threat of
deflation, and aggressive U.S. monetary policy designed to push down U.S. interest rates and weaken the
U.S. dollar in order to stimulate growth and exports.

SUGGESTED ANSWERS TO “THE EURO REACTS TO NEW INFORMATION”

1. Explain the differing initial and subsequent reactions of the euro to news about the European Central
Bank’s monetary policy. Give full details, drawing on any theories you are familiar with.

ANSWER. The initial reaction is based on the expectation of no tightening in the money supply. The result
will be higher inflation than previously expected and–according to purchasing power parity–a depreciating
euro. The euro’s subsequent reaction was based on the view that monetary policy would in fact be tightened
(that’s the objective of an interest rate increase) and inflation would be reduced. At the same time, a higher
real interest rate would be expected to attract more capital and boost the euro’s value as well.

2. How does a strong pound reduce the threat of imported inflation and work against higher interest rates?

ANSWER. A weak pound will bring higher prices of foreign goods and services, enabling domestic
producers to raise their prices and leading to higher inflation. Conversely, a stronger pound will bring
lower-priced foreign goods and services, putting downward pressure on domestic prices and reducing the
threat of inflation. Lower inflation will lead–via the Fisher effect–to lower interest rates. At the same time,
the expectation of lower inflation means the Bank of England will be under less pressure to raise interest
rates to fight nonexistent inflation.

3. Which U.K. manufacturers are likely to be pressured by a strong pound?

ANSWER. Those British manufacturers who compete with imports or who export will be hurt by a stronger
pound because foreign competitors will see their pound-equivalent prices fall. In addition, British
manufacturers who use domestically-sourced inputs in competition with those who use imported inputs will
suffer.

4. Why might higher pound interest rates send sterling even higher? Give two possible reasons.

ANSWER. Higher British interest rates occasioned by a tightening of monetary policy will lead to lower
expected inflation. According to purchasing power parity, countries with lower rates of inflation will tend to
see their currencies appreciate relative to those of countries with higher rates of inflation. At the same time,
if the higher nominal interest rate is also a higher real interest rate, this will attract capital to the U.K.
seeking to earn the higher real return. The greater demand for sterling for investment purposes will boost its
value.

5. What tools are available to the European Central Bank and the Bank of England to manage their
monetary policies?

ANSWER. Both central banks can use open market operations–which involves buying and selling bonds
denominated in their currencies to regulate the money supply. It may be more difficult for the ECB,
however, as it doesn’t have Treasury bonds denominated in euros but there will be other bonds issued in the
euro that it can buy or sell. The central banks can also raise or lower the interest rate at which they lend
money to banks and regulate the reserve requirements of banks. Another tool of monetary policy is foreign
CHAPTER 3: THE INTERNATIONAL MONETARY SYSTEM 5

exchange market intervention, which involves buying or selling their currencies in the foreign exchange
market.

SUGGESTED ANSWERS TO “BRITAIN–IN OR OUT FOR THE EURO”

1. Discuss the pros and cons for Britain of joining EMU.

ANSWER. By joining EMU, Britain would lock itself into a new European monetary policy. Provided this
monetary policy is dominated by Germany, it is likely to be a low-inflation policy. At the same time, the
single-currency aspect of EMU will reduce currency risk and foreign exchange trading costs for British
firms. These features are all pluses. However, Britain would also lose the ability to conduct an independent
monetary policy. To the extent that economic shocks affect Britain differently than it affects other members
of EMU, losing the flexibility to adjust monetary policy or its exchange rate to cope with these shocks
could be quite costly in terms of lost economic output. In other words, Britain combined with continental
Europe may not constitute an optimum currency area. The costs of fixing exchange rates was demonstrated
when Britain and other European nations were forced to raise their interest rates to maintain their exchange
rates fixed to the DM even as Germany was coping with the shock of reunification.

2. Commentators pointed to the fact that many people in Britain have variable rate mortgages, as opposed
to the fixed-rate mortgages more common in Europe. Britain also has the most flexible labor markets
in Europe. How would these factors likely affect Britain’s economic costs and benefits of joining the
euro?

ANSWER. To the extent that EMU is viewed as a serious inflation fighter, Britain’s entry into EMU would
be viewed as a plus by financial markets. The result would be lower interest rates in Britain, which would
benefit British homeowners holding variable rate mortgages. The biggest problem with joining a monetary
union is the loss of exchange rate and monetary policy flexibility to absorb the effects of economic ups and
downs. The most important substitute for monetary and exchange rate flexibility is labor market flexibility.
The fact that Britain’s labor market is relatively flexible will lower the costs to Britain associated with
joining EMU.

3. What types of British companies would most likely benefit from joining EMU?

ANSWER. Primary beneficiaries would be British companies that engage in extensive trade (both buying
and selling) or other business with other EMU countries, as joining EMU will reduce their currency risk
and lower their foreign exchange transaction costs (the costs associated with converting between the pound
and the euro).

4. Some large multinationals warned that they only chose to invest in Britain on the assumption it would
ultimately adopt the euro. Why would multinationals be interested in Britain joining the euro?

ANSWER. Many companies have used Britain as an export platform to other EU countries. If Britain joins
EMU, that would reduce their currency risk and transaction costs. Multinationals locating in Britain
complain that they now must bear transaction costs and exchange rate uncertainty that they could avoid by
basing themselves in EMU countries.

SUGGESTED ANSWERS TO “A GREEK TRAGEGY”

1. What event initially precipitated the Greek crisis?

ANSWER. In December 2009, the newly elected prime minister, George Papandreou, announced at an EU
meeting that Greece’s budget deficit was far worse than even the most pessimistic forecasts had indicated.
As it turns out, Greece had significantly understated its deficits in previous years as well. The cumulative
6 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 10TH ED.

effect of these deficits was a government debt/GDP ratio by the end of 2010 of 143%, the highest in the
Eurozone. These high deficits and resulting enormous debt/GDP ratio called into question Greece’s ability
to continue to service its debts. Greece’s debt rating was downgraded, triggering large-scale sales by many
private investors and pushing up yields.

2. Why was Greece in some much trouble?

ANSWER. Simply put, Greece was living beyond its means and financing the party by borrowing huge sums
of money from abroad.

3. What problems in Greece highlighted wider problems in the Eurozone?

ANSWER. Greece had too many people—especially retirees, public employees, and those receiving lavish
welfare benefits—living off the state, too few people paying taxes, and too much regulation designed to
protect special interest groups against competition that acted as a drag on economic growth.

4. How did the Greek crisis affect the euro?

ANSWER. Many observers believed that the troubles of Greece and other, similarly-situated nations (Italy,
Spain, Portugal, even France) would cause the Eurozone to break up. These beliefs pushed down the value
of the euro.

5. What pro-growth policies could the Greeks adopt that would allow them to produce more and how would
adopting them help resolve their crisis?

ANSWER. The list is straight forward: Cut tax rates, slash government regulations (especially involving the
labor market), raise the retirement age, cut the number of public employees and lower salaries and benefits
for the rest, lower welfare benefits and restrict them to the truly needy, and sell off state-owned enterprises,

SUGGESTED ANSWERS TO “A WOUNDED CELTIC TIGER HAS ITS PAWS

OUT”

1. Why was Ireland in trouble?

ANSWER. In the decade to 2006, the Irish housing market skyrocketed, facilitated by easy credit extended
by Irish banks. When the property market burst, prices fell by over a third, and the banks’ real estate loans
quickly became troubled. A run started on Irish banks. In October 2008, the Irish government stepped in
and guaranteed all bank debts–not just retail deposits but bonds and commercial deposits as well. The run
stopped, temporarily, but the problems with Ireland’s banks turned out to be much greater than expected.
The final toll for the government bailout reached €35 billion, and inflated the budget deficit to a staggering
32% of GDP.

2. What happened to Irish debt? To Irish bond ratings? Interest rates?

ANSWER. Ireland’s debt/GDP ratio before the crisis was 25%, one of the lowest in Europe. By 2010,
sovereign debt had hit 65.5% of GDP, from 44.3% a year earlier. But then came a huge bank bailout of
Anglo-Irish Bank, and Ireland’s debt/GDP ratio reached 105% in early 2011. The possibility of default sent
interest rates higher (from April to December 2010, the yield on the 10-year bond almost doubled, from
4.5% to 8.5%) and Ireland lost its AAA bond ratings. By December 2010, Ireland’s credit rating had fallen
to BBB+.

3. How did the Irish crisis highlight problems with the Eurozone?
CHAPTER 3: THE INTERNATIONAL MONETARY SYSTEM 7

ANSWER. Ireland’s financial crisis led to another run on its banks and sparked fears once again of
contagion extending to Portugal, Spain, and even countries beyond, such as Italy and Belgium that had
large budget deficits and high debt/GDP ratios. In response, Europe and the IMF in November 2010
announced a bailout of €85 billion or $115 billion, a staggering amount for an economy with a population
of roughly 4 million people.

4. What must Ireland do to solve its problem?

ANSWER. There is no easy answer to the problem faced by Ireland since they weren’t caused by a lavish
welfare state that could be cut back. Instead, Ireland must require its banks to increase their capital (so as to
reduce the likelihood that any future credit losses would be borne by taxpayers rather than shareholders,
which would also force banks to improve their lending practices) and follow all the other policies that will
stimulate economic growth—reduce the size of the state, cut personal tax rates (corporate rates are already
among the lowest in the world but personal tax rates remain high), and reduce labor market and other
regulations.

SUGGESTED ANSWERS TO CHAPTER 3 QUESTIONS

1. a. What are the five basic mechanisms for establishing exchange rates?

ANSWER. The five basic mechanisms for establishing exchange rates are free float, managed float, target-
zone arrangement, fixed-rate system, and the current hybrid system.

b. How does each work?

ANSWER. In a free float, exchange rates are determined by the interaction of currency supplies and
demands. Under a system of managed floating, governments intervene actively in the foreign exchange
market to smooth out exchange rate fluctuations in order to reduce the economic uncertainty associated
with a free float. Under a target-zone arrangement, countries adjust their national economic policies to
maintain their exchange rates within a specific margin around agreed-upon, fixed central exchange rates.
Under a fixed-rate system, such as the Bretton Woods system, governments are committed to maintaining
target exchange rates. Each central bank actively buys or sells its currency in the foreign exchange market
whenever its exchange rate threatens to deviate from its stated par value by more than an agreed-on
percentage. Currently, the international monetary system is a hybrid system, with major currencies floating
on a managed basis, some currencies freely floating, and other currencies moving in and out of various
types of pegged exchange rate relationships.

c. What costs and benefits are associated with each mechanism?

ANSWER.

Benefits of a Floating Rate System. At the time floating rates were adopted in 1973, proponents said that
the new system would reduce economic volatility and facilitate free trade. In particular, floating exchange
rates would offset international differences in inflation rates so that trade, wages, employment, and output
would not have to adjust. High-inflation countries would see their currencies depreciate, allowing their
firms to stay competitive without having to cut wages or employment. At the same time, currency
appreciation would not place firms in low-inflation countries at a competitive disadvantage. Real exchange
rates would stabilize, even if permitted to float in principle, because the underlying conditions affecting
trade and the relative productivity of capital would change only gradually; and if countries would
coordinate their monetary policies to achieve a convergence of inflation rates, then nominal exchange rates
would also stabilize. Another benefit is that–as Milton Friedman points out–with a floating exchange rate,
there never has been a foreign exchange crisis. The reason is simple: The floating rate absorbs the pressures
that would otherwise build up in countries that try to peg the exchange rate while simultaneously pursuing
an independent monetary policy. For example, the Asian currency crisis did not spill over to Australia and
8 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 10TH ED.

New Zealand because the latter countries had floating exchange rates. A floating rate system can also act as
a shock absorber to cushion real economic shocks that change the equilibrium exchange rate.

Costs of a Floating Rate System. Many economists point to excessive volatility as a major cost of a
floating rate system. The experience to date is that the dollar's ups and downs have had little to do with
actual inflation and a lot to do with expectations of future government policies and economic conditions.
Put another way, real exchange rate volatility has increased, not decreased, since floating began. This
instability reflects, in part, nonmonetary (or real) shocks to the world economy, such as changing oil prices
and shifting competitiveness among countries, but these real shocks were not obviously greater during the
1980s than they were in earlier periods. Instead, uncertainty over future government policies has increased.

Benefits of a Managed Float. The potential benefit of a managed float is that governments can reduce the
volatility associated with a freely floating exchange rate.

Costs of a Managed Float. The costs of a managed float stem from the demonstrated inability of
governments to recognize the difference between a temporary exchange rate disequilibrium and a
permanent one. By trying to manage exchange rates when a permanent shift in the equilibrium exchange
rate has occurred, governments run the risk of creating an exchange rate crisis and wasting reserves.

Benefits of a Target Zone Arrangement. The experience with the European Monetary System is that the
target zone arrangement in effect forced convergence of monetary policy to that of the country–Germany–
with the most disciplined anti-inflation policy and led to low inflation.

Costs of a Target Zone Arrangement. Maintaining a genuinely stable target zone arrangement requires
the political will to direct fiscal and monetary policies at that goal and not at purely national ones. This
turns out to be difficult for countries to achieve. In the case of the European Monetary System, the result
was periodic currency crises. Another cost of this system is that fundamental changes in the equilibrium
exchange rate cannot get reflected in actual exchange rate changes without a currency crisis occurring.

Benefits of a Fixed Rate System. A permanently fixed exchange rate system–such as that achieved by a
currency board, dollarization, or monetary union–results in currency stability and the absence of currency
crises. In a system such as existed under Bretton Woods, where there is a commitment to a fixed exchange
rate system, but no mechanism to bind that commitment, you will have more monetary discipline than in a
freely floating system and hence lower inflation than might otherwise be the case.

Costs of a Fixed Rate System. In a permanently fixed system, the exchange rate cannot cushion the effects
of real economic shocks, such as devaluation of a major competitor’s currency. Instead, prices must adjust.
Given the lack of flexibility of many prices–because of government regulations or union restrictions–the
result of these economic shocks can be higher unemployment and less economic growth. In a system such
as Bretton Woods, the result of changes in the equilibrium exchange rate will likely be currency crises and
eventual devaluation or revaluation.

Benefits of a Hybrid System. The current system gives countries the option to select the system that best
meets their needs. However, all too often, the decision is based on political rather than economic
calculations.

Costs of a Hybrid System. The costs of a hybrid system, such as the one currently in place, is that there is
no constraint on the choices that governments can make. The resulting choices can be good ones or bad
ones.

d. Have exchange rate movements under the current system of managed floating been excessive?
Explain.

ANSWER. Excessive movements would indicate that there are profits to be earned by betting against the
market. In effect, if currency fluctuations are excessive they would exhibit the phenomenon of overshooting
CHAPTER 3: THE INTERNATIONAL MONETARY SYSTEM 9

(i.e., currency rates would overreact to economic events and then return to equilibrium). There is no
evidence that one could profit by betting that rate movements are excessive.

2. Find a recent example of a nation's foreign exchange market intervention and note what the
government's justification was. Does this justification make economic sense?

ANSWER. Finding an example of foreign exchange market intervention by a government should be pretty
easy to do. The trick will be to find a coherent statement of what the government's justification was. Most
of these justifications make little or no economic sense.

3. Gold has been called "the ultimate burglar alarm." Explain what this expression means.

ANSWER. Governments "burgle" holders of their currencies by printing more money and subjecting holders
to an "inflation tax." Since gold prices respond quickly to evidence of inflation, the expectation of an
increase in inflation will cause a jump in gold prices. In this way, gold serves as a burglar alarm to warn
that politicians are tampering with fiat money.

4. Suppose nations attempt to pursue independent monetary and fiscal policies. How will exchange rates
behave?

ANSWER. Independent monetary and fiscal policies will lead to volatile exchange rates as market
participants receive and assess new information on these policies.

5. The experiences of fixed exchange-rate systems and target-zone arrangements have not been entirely
satisfactory.

a. What lessons can economists draw from the breakdown of the Bretton Woods system?

ANSWER. Adjusting monetary growth rates is the principal way to stabilize exchange rates. For example,
raising the value of the dollar relative to the yen requires tightening U.S. monetary policy relative to
Japanese monetary policy. The experience of Bretton Woods and similar experiments demonstrates that
conscious and explicit coordination of monetary policies among sovereign authorities is difficult. The
problem stems from the inability of sovereign authorities to coordinate their monetary growth rates. An
agreement to stabilize the dollar at, say, 150 yen would be relatively easy if it did not entail interdependent
monetary policies, robbing the Federal Reserve, or the Bank of Japan, or both, of important degrees of
monetary freedom.

Both Japan and the United States have their own targets for growth and inflation and their own independent
assessment of the macroeconomic policies required to attain those targets. Except by coincidence,
independent policies and preferences will not mesh at a stable exchange rate. Given clashing preferences,
the only alternatives to the "chaos" of floating are:

(1) One side persuades the other to change its policies;

(2) One side subordinates its policies to those of the other; or
(3) Both sides subordinate their monetary policies to an external mechanism, such as a gold standard.

Absent (3), "international monetary reform" is the search for new ways to implement (1) or (2), or some
combination. We saw that Bretton Woods collapsed because the subordination it entailed was intolerable to
the United State. That is, the United States refused to follow economic policies that would maintain the
value of gold at $35 an ounce. The basic lesson from Bretton Woods, therefore, is that stabilizing exchange
rates requires dependence and subordination, not the freedom for everybody to do their own thing. But
instead of changing policies to stay with the Bretton Woods system, the major countries simply dropped the
system.

b. What lessons can economists draw from the exchange rate experiences of the European Monetary
System?
10 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 10TH ED.

ANSWER. Exchange rate stability requires that monetary policies be coordinated and geared towards
maintaining exchange rate parities. The slow progress of the European community with respect to the EMS
and policy coordination exemplifies the difficulties of achieving agreements on the many facets of
economic policymaking. Implementing target zones on a wider scale would be all the more difficult.
Differences in preferences, policy objectives, and economic structures account in part for these difficulties.
More fundamentally, however, coordination of macroeconomic policies will not necessarily benefit all
participant countries equally, and those that benefit the most may not be willing to compensate those that
benefit least. In the EMS, Germany is less inflation-prone than the other members and is reluctant to
cooperate at the risk of increasing its inflation rate.

Another lesson is that in target-zone arrangements such as the EMS, a disproportionately large share of the
adjustment burden will fall on the "weak" currency countries. Countries with appreciating currencies, trade
surpluses, and increasing reserves are less prone to adjust than countries with depreciating currencies, trade
deficits, or reserve losses. The convergence of inflation rates among the EMS countries supports this view.
An equal sharing of the adjustment burden implies that inflation rates among member nations would
converge to the average rate.

Germany, however, has maintained a domestic monetary target of low or zero inflation, and often has
refused to alter domestic monetary policy because of exchange rate considerations. Because of Germany's
economic importance, the other member countries have had to adjust their domestic policies or their
exchange rates to remain competitive in international markets. As a result, inflation rates have tended to
converge toward Germany's lower rate.

6. How did the European Monetary System limit the economic ability of each member nation to set its
interest rate to be different from Germany's?

ANSWER. Each country within the European Monetary System had to fix its exchange rate relative to the
DM. If a country's exchange rate is expected to stay fixed relative to the DM, the interest rate associated
with that country's currency cannot diverge from Germany's. Otherwise, it would present a virtually risk-
free arbitrage opportunity: Borrow in the lower interest rate currency and lend the borrowed funds in the
higher interest rate currency and earn the spread between the two rates.

7. Historically, Spain has had high inflation and has seen its peseta continuously depreciate. In 1989,
though, Spain joined the EMS and pegged the peseta to the DM. According to a Spanish banker, EMS
membership means that "the government has less capability to manage the currency but, on the other
hand, the people are more trusting of the currency for that reason."

a. What underlies the peseta's historical weakness?

ANSWER. Spain has historically pursued an easy monetary policy, with an associated high rate of inflation.
High inflation, in turn, led to continual peseta devaluation.

b. Comment on the banker's statement.

ANSWER. Countries that seek to participate in the EMS are effectively forced to pursue a monetary policy
consistent with that of Germany, which eventually brings down their inflation rates. In effect, control of
Spain's monetary policy has been shifted from Spain's central bank, which has a weak reputation for
monetary discipline, to the much more reputable Bundesbank. Thus, Spaniards now are more trusting of
their money.

c. What are the likely consequences of EMS membership on the Spanish public's willingness to save and
invest?
CHAPTER 3: THE INTERNATIONAL MONETARY SYSTEM 11

ANSWER. By heightening the prospects for Spanish monetary stability, EMS membership has lowered the
risks associated with holding financial assets in Spain. The result has been to make the Spanish public more
willing to save and invest.

8. In discussing European Monetary Union, a recent government report stressed a need to make the
central bank accountable to the "democratic process." What are the likely consequences for price
stability and exchange rate stability in the EMS if the "Eurofed" becomes accountable to the
"democratic process?"

ANSWER. The only good central bank is one that can say no to politicians. Unfortunately, the proposal
makes it more difficult for the central bank to do so. Instead of assessing central bank performance in terms
of an unambiguous, verifiable goal, such as price stability, thereby complementing central bank
independence by giving it a single, long-term focus, the proposal's definition of accountability will provide
an avenue for political influence. The result will be higher inflation, and more currency volatility.

9. Comment on the following statement: "With monetary union, the era of protection for European firms
and workers has come to an end."

ANSWER. As explained in the answer to the previous question, wage flexibility is a substitute, albeit an
imperfect one, for exchange rate flexibility. If exchange rates can no longer adjust in response to domestic
imbalances, then wages need to become more flexible to avoid an increase in the already high rate of
European unemployment. But labor market institutions in Europe tend to impede such flexibility. Their
very purpose is to protect those currently working from the pressure of the unemployed. Nobody loses his
or her job, or is obliged to accept a wage cut, even though there is a large pool of unemployed who would
be willing to work at a lower wage. Job protection schemes, minimum wages, and generous unemployment
benefits make it possible for unions to negotiate wage increases that are largely independent of the state of
the labor market. Market flexibility is also critical for adapting to economic shocks without the aid of
exchange rate changes. If a country has high unemployment because of low demand for its products, it is
essential in a monetary union for firms to be able to shift resources rapidly toward products with greater
demand. But throughout Europe, state subsidies, costly regulations, insufficient competition, government
monopolies, and barriers to entry slow the pace of adjustment. Monetary union will force governments and
society to confront the prospect that maintaining the current generous social welfare state will force a
substantial increase in their already high level of unemployment, but--because of the strict Maestricht fiscal
criteria–without the possibility of more state aid to mitigate the suffering.

10. Comment on the following statement: "The French view European Monetary Union as a way to break
the Bundesbank's dominance in setting monetary policy in Europe."

ANSWER. In order to peg the franc to the DM, the French must match the Bundesbank's anti-inflationary
policy. This necessity precludes France from following the expansionary monetary policy it has historically
preferred. The only way for France to maintain a fixed exchange rate while following a more expansionary
monetary policy is to do away with the Bundesbank. European Monetary Union will take control over
monetary policy away from the Bundesbank and place it in the hands of the European Central Bank. If
France can control the ECB, as it is trying to do, the result will be a more expansionary monetary policy
with higher inflation. This scenario explains why Germans are so nervous over EMU; they distrust the
French commitment to price stability. German suspicions were intensified in late 1997 when the French
government nominated Jean-Claude Trichet, governor of the Bank of France, to be the first president of the
ECB.

The basic problem is the historical French government attachment to deficit spending, inflation, and
devaluation as remedies for French unemployment. Such policies don't work, however, for obvious reasons.
Government job creation substitutes make-believe jobs for real ones, at the same time lowering the
efficiency of the real economy through heavier tax burdens. Inflationary monetary policy meanwhile
retards capital formation and leads to slower growth. The real solution to high unemployment is economic
growth, which requires curbing the welfare state with its high taxes, incentive-destroying benefits and
subsidies, and costly labor market regulations.
12 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 10TH ED.

ADDITIONAL CHAPTER 3 QUESTIONS AND ANSWERS

1. Why has speculation failed to smooth exchange rate movements?

ANSWER. Speculation can only be expected to smooth exchange rate movements if underlying economic
processes are relatively stable. If there is a great deal of uncertainty over future government actions and
their economic impact, expectations will not be strongly held. Thus expectations can change dramatically
from day- to-day, leading to rapidly fluctuating exchange rates.

2. Is a floating-rate system more inflationary than a fixed-rate system? Explain.

ANSWER. To the extent that floating exchange rates allow monetary authorities to pursue more inflationary
policies, then a floating rate system can be more inflationary. However, this is an indirect effect, the direct
cause of inflation being rapid money expansion. According to PPP, the direction of causation runs from
price level changes to exchange rate changes, not vice versa.

3. Since 1979, the price of gold has fallen by more than 60%. What could explain such a steep price
decline? Consider the roles of inflation and new financial instruments such as swaps and options that
can provide lower-cost inflation hedges.

ANSWER. Gold traditionally has provided a safe haven when economic and political conditions are
uncertain and currencies are volatile because of the belief that it was a sounder store of value than paper
money. However, gold's value as an inflation hedge was diminished during the 1980s as inflation became a
much less serious concern. At the same time, to the extent that modern financial instruments such as swaps
and options now provide better, less costly shelters (especially since gold pays no interest, imposing a high
opportunity cost on holders), these lower cost inflation-hedge substitutes would have the effect of reducing
the demand for gold and hence its price relative to what it would be absent these lower-cost inflation-hedge
substitutes. The jump in the price of gold during 1993 may be due to the growing wealth of many Chinese
and their attempt to avoid the high inflation stemming from the Bank of China's expansionary monetary
policy. Given their lack of access to more sophisticated hedging instruments, the Chinese may have found
gold to be their best inflation hedge. Currency concerns also played a role in gold's rally during 1993. Until
recently, the Bundesbank has been the only reliable policeman putting the fight against inflation as its first
priority. That certainty became questionable as the Bundesbank had to deal with the pressures brought on
by the German recession to put economic expansion ahead of price stability as its priority. These concerns
about the DM as a store of value were reflected in a fall in its exchange rate during much of the 1990s.

4. Comment on the following statement: "A system of floating exchange rate fails when governments
ignore the verdict of the exchange markets on their policies and resort to direct controls over trade and
capital flows."

ANSWER. Floating offers, in principle, a small degree of freedom from the subordination and coordination
necessary to maintain stable exchange rates. But if governments abuse that degree, and refuse to accept the
exchange rate consequences (e.g., a drop in the exchange rate due to rapid expansion of the money supply),
the system will fail. That is, if the governments involved wish to pursue independent policies while
simultaneously stabilizing exchange rates, this can be accomplished only by imposing direct controls on
trade and capital flows.

5. Will coordination of economic policies make exchange rates more or less stable? Explain.

ANSWER. Coordination of economic policies will make exchange rates more stable, since the relative
attractiveness of the various currencies is less likely to change significantly.
CHAPTER 3: THE INTERNATIONAL MONETARY SYSTEM 13

6. Despite official parity between the Deutsche mark and the Ostmark, the black market rate in early 1990
was about ten Ostmarks for one Deutsche mark. What problems might setting the exchange rate at one
Ostmark for each DM create for Germany?

ANSWER. The basic problem is that at a one-for-one exchange rate the Ostmark will be overvalued relative
to the Deutsche mark. Unless East German wages fall, East German industry will find their cost of doing
business rising, without an offsetting gain in productivity. East German industry will become even less
competitive than it already is and there will be massive unemployment in East Germany. At the same time,
East Germans will rush to convert their Ostmarks to DMs. The resulting growth in the DM money supply
will be inflationary unless the demand for DM grows in proportion to the supply. Clearly, the demand for
DM will rise as it supplants the Ostmark as the official East German currency. Of course, the Bundesbank
can always eliminate the threat of inflation by sterilizing the increase in DM through open market activities,
that is, by issuing bonds to sop up the surplus Deutsche marks. In the event, Germany did set a one-for-one
exchange rate, more than 30% of eastern Germans were unemployed by mid-1991 (this problem was
compounded by the extremely generous German unemployment compensation system), inflation fears rose
in Germany, and fewer than 10% of eastern German companies were solvent.

7. When Britain announced its entry into the exchange-rate mechanism of the EMS on October 5, 1990,
the price of British gilts (long-term government bonds) soared and sterling rose in value.

a. What might account for these price jumps?

ANSWER. By entering the exchange-rate mechanism, Britain has effectively foresworn devaluation of the
pound against the DM. In order to maintain the pound's value, Britain must now follow a more disciplined
and anti-inflation monetary policy. Expectations of lower inflation and fewer currency swings in the future
raised the demand for British assets, including pounds, thereby reducing interest rates (the interest rate is
the inverse of the bond price) and raising the pound's value. Put another way, as we will see in Chapter 8,
expectations of lower inflation reduce interest rates (the Fisher effect) and boost the value of a nation's
currency (purchasing power parity).

b. Sterling entered the ERM at a central rate against the DM of DM 2.95, and it is allowed to move within
a band of plus and minus 6% of this rate. What are sterling's upper and lower rates against the DM?

ANSWER. Sterling's lower limit against the DM is .94 x 2.95 = DM 2.77; its upper limit is 1.06 x 2.95 =
DM 3.13.

8. What potential costs might be associated with the decision to widen the margins within which some
currencies in the ERM can float?

ANSWER. Widening the margins reduces the credibility of the system since such a system grants greater
discretion to the monetary authorities. Currency holders don't want the monetary authorities of suspect
currency nations to have greater discretion. Indeed, the monetary authorities' loss of discretion associated
with the ERM is viewed by most as the ERM's greatest value. For suspect currencies, the loss of credibility
will likely lead to higher interest rates and more speculative attacks.

9. Comment on the following headline in The Wall Street Journal (January 11, 1993): "Germany's Rate
Cut Takes Pressure Off French Franc, and the Rest of the EMS."

ANSWER. The origin of the September 1992 currency crisis was the Bundesbank's decision to maintain
high interest rates to restrain the inflationary effects of reunification. To maintain their currencies against
the D-mark, the other members of the EMS were forced to push up their own interest rates, thereby stifling
economic growth in their countries. Speculators bet that Britain, Spain, and some other countries would
find that trade-off unpalatable and would devalue their currencies. As long as German rates remained high,
this Hobson's choice would continue to face other European governments and would maintain speculative
pressure on their currencies. By cutting its discount rate, the Bundesbank allowed France and the other
EMS members to cut their interest rates and stimulate their economies without devaluing their currencies.
14 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 10TH ED.

This interest rate cut, therefore, by reducing the likelihood that they would devalue their currencies,
reduced speculative pressure.

10. The French franc was the main target of speculators during the August 1993 assault on the EMS
despite the fact that France was running a 2% inflation rate while Germany had a 4.3% inflation rate.
Why might this be?

ANSWER. Two words explain this situation: "credibility" and "expectations." Given the market's trust in the
Bundesbank, the high German inflation rate was viewed as an aberration that the Bundesbank would soon
get under control. Conversely, currency traders were less certain of the Bank of France's long-term
commitment to low inflation, especially since the Bank of France has historically been subservient to the
interests of the French government. More specifically, unlike the Bundesbank, the Bank of France did not
have 35 years of independence behind it and could not count on the unwavering support of a citizenry that
abhors inflation. Based on the high rate of unemployment and sluggish growth in France and the growing
demands by the French public for easing up on monetary policy, it was rational to assign a high probability
that the Bank of France would abandon its strong franc policy. The result would be higher French inflation
in the future. Conversely, the history of the Bundesbank would suggest lower German inflation in the
future. Given expectations of higher French inflation and lower German inflation in the future, the foreign
exchange market rationally expected a weaker French franc. Acting immediately on such expectations,
speculators sold francs and bought DM.

11. In early 1996, in response to growing doubts about the ability of EC nations to meet the Maestricht
criteria and move toward monetary union by the 1999 deadline, yields on European bonds jumped.
What is the likely link between the doubts on Maestricht and the EC bond yield increases.

ANSWER. The expectation in the financial markets is that countries that meet the Maestricht criteria will be
locked into a system that is essentially run on the same model as the Bundesbank, namely one that is
committed to price stability as its one and only goal. In other words, the view is that Germany will run
EMU and the dominant characteristic of the single currency is that it will be a low-inflation currency. To
the extent that EMU is expected to materialize, therefore, interest rates on bonds denominated in different
currencies will converge toward the rate on DM bonds, which is lower than that on other European
currency bonds. Conversely, an expected movement away from monetary union lowers the probability that
the other European countries will stick with the low-inflation German monetary policy. Anything that
lowers the probability of EMU, therefore, lowers the odds that other currencies will follow a low-inflation
monetary policy, leading to expectations of higher inflation and higher interest rates.

12. "For a fixed exchange rate system to work, the government must be able to make tight budget and
monetary policies stick from the outset." Comment.

ANSWER. A government that runs budget deficits and a lax monetary policy is unlikely to be able to
maintain its commitment to .a fixed exchange rate. Hence, one that starts out on the wrong foot will appear
to observers to be willing to make exchange rate policy subservient to other national interests. Recognizing
this apparent lack of government commitment to a fixed exchange rate, speculators are more likely to
attack its currency, making its ability to maintain the fixed exchange rate even more doubtful.

13. Upon taking office in October 1993, the Bundesbank's new president, Hans Tietmeyer, said, "Forced
reductions in central bank interest rates which are contrary to stability policies can neither solve
economic or structural problems. But they would undermine trust in currency values, drive long-term
interest rates higher and delay necessary corrections in the real economy." Explain the context in which
Mr. Tietmeyer made these comments. Do you agree or disagree with his comments. Explain.

ANSWER. Mr. Tietmeyer was responding to a chorus of complaints following the currency crisis of August
1993 which, in turn, led to the abandonment of the Exchange Rate Mechanism. The August crisis was
triggered by the (correct) belief that the Bundesbank would not reduce its interest rates sufficiently to
permit cuts in interest rates in other ERM countries such as France and Denmark where unemployment was
high and inflation low. What Tietemayer said, in effect, was "Don't blame Germany for your high
CHAPTER 3: THE INTERNATIONAL MONETARY SYSTEM 15

unemployment and slow growth. Monetary policy is not a good tool to use in stimulating an economy. You
will just wind up with high inflation and higher real interest rates. Rather, you should focus on correcting
the structural problems that are driving your high unemployment rates, such as high taxes, a less productive
workforce, a subservient central bank (leading to a risk premium), and expensive labor regulations."

14. Comment on the following statement: "Wage flexibility is a substitute, albeit an imperfect one, for
exchange rate flexibility."

ANSWER. If an economic shock leads to domestic imbalances between supply and demand, a change in the
exchange rate can bring about the necessary changes in prices and wages to reestablish competitiveness.
However, if the exchange rate is fixed, then wages and prices themselves must change to respond to
domestic imbalances. Wage flexibility will go a long way to achieving this end, but it is imperfect since
flexibility in the prices of goods and services is also an important element in adapting to changed economic
circumstances.

SUGGESTED SOLUTIONS TO CHAPTER 3 PROBLEMS

1. During the currency crisis of September 1992, the Bank of England borrowed DM 33 billion from the
Bundesbank when a pound was worth DM 2.78 or $1.912. It sold these DM in the foreign exchange
market for pounds in a futile attempt to prevent a devaluation of the pound. It repaid these DM at the
post-crisis rate of DM 2.50:£1. By then, the dollar:pound exchange rate was $1.782:£1.

a. By what percentage had the pound sterling devalued in the interim against the Deutsche mark? Against
the dollar?

ANSWER. During this period, the pound depreciated by 10.1% against the pound

2.50  2.78
= - 10.1%
2.78

and by 6.8% against the dollar

1.782  1.912
= - 6.8%
1.912

b. What was the cost of intervention to the Bank of England in pounds? In dollars?

ANSWER. The Bank of England borrowed DM 33 billion and must repay DM 33 billion. When it borrowed
these DM, the DM was worth £0.3597, valuing the loan at £11.87 billion (DM 33 billion x 0.3597). After
devaluation, the DM was worth £0.4000. Hence, the Bank of England's cost of repaying the DM loan was
£13.20 billion (DM 33 billion x 0.4), a rise of £1.33 billion. Thus, the cost to the Bank of England of this
DM borrowing and intervention was £1.33 billion.

In dollar terms, intervention cost the Bank of England $825 million. This estimate is based on the
difference of $0.025 between the DM's initial value of $0.6878 (1.912/2.78) and its ending value of
$0.7128 (1/2.50) times the DM 33 billion borrowed and spent defending the pound. Specifically, the cost
calculation is $0.025 x 33,000,000,000 = $825 million.

2. Suppose the central rates within the ERM for the French franc and DM are FF 6.90403:ECU 1 and DM
2.05853:ECU 1, respectively.
16 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 10TH ED.

a. What is the cross-exchange rate between the franc and the mark?

ANSWER. Since things equal to the same thing are equal to each other, we have FF 6.90403 = DM 2.05853.
Hence, FF1 = DM 2.05853/6.90403 = DM 0.298164. Equivalently, DM 1 = FF 6.90403/2.05853 = FF
3.35386.

b. Under the original 2.25% margin on either side of the central rate, what were the approximate upper
and lower intervention limits for France and Germany?

ANSWER. Given the answer to part a, the French franc could rise to approximately DM 0.298164 x 1.0225
= DM 0.304872 or fall as far as DM 0.298164 x 0.9775 = DM 0.291455. Similarly, the upper limit for the
DM is FF 3.42933 and the lower limit is FF 3.27840.

c. Under the revised 15% margin on either side of the central rate, what are the current approximate
upper and lower intervention limits for France and Germany?

ANSWER. Given the answer to part a, the French franc could rise to approximately DM 0.298164 x 1.15 =
DM 0.342888 or fall as far as DM 2.98164 x 0.85 = DM 0.253439. Similarly, the upper limit for the DM is
FF 3.85694 and the lower limit is FF 2.85078.

3. A Dutch company exporting to France had FF 3 million due in 90 days. Suppose that the current
exchange rate was FF 1 = Dfl 0.3291.

a. Under the exchange rate mechanism, and assuming central rates of FF 6.45863/ECU and Dfl
2.16979/ECU, what was the central cross-exchange rate between the two currencies?

ANSWER. Given central rates of DFl 2.16979:ECU and FF 6.45863:ECU for the Dutch guilder and French
franc, respectively, the central cross rate between the two currencies is DFl 1 = FF 2.97662
(6.45863/2.16979). Equivalently, FF 1 = DFl 0.335952 (2.16979/6.45863).

b. Based on the answer to part a, what was the most the Dutch company could lose on its French franc
receivable, assuming that France and the Netherlands stuck to the ERM with a 15% band on either side
of their central cross rate?

ANSWER. At worst, the French franc can fall by 15% relative to its central guilder cross rate, to a cross-
exchange rate of FF 1 = DFl 0.285559 (0.335952 x 0.85). Since the current exchange rate is FF 1 = DFl
0.3291, the most the Dutch company can lose on its FF 3 million receivable is 3,000,000 x (0.3291 -
0.285559) = DFl 130,622.

c. Redo part b, assuming the band was narrowed to 2.25%.

ANSWER. If the band were narrowed to 2.25%, then the minimum value for the French franc would be DFl
0.328393 and the maximum loss that the Dutch company could sustain would be 3,000,000 x (0.3291 -
0.328393) = DFl 2,121.

d. Redo part b, assuming you know nothing about the current cross-exchange rate.

ANSWER. Knowing nothing about the current cross-exchange rate, the worst that could happen is that the
cross rate would be at its upper bound of DFl 0.386345 (0.335952 x 1.15) and it falls to its lower bound of
0.285559 (established in the answer to part b). In this case, the maximum possible loss is 3,000,000 x
(0.386345 - 0. 285559) = DFl 302,357.

4. Panama adopted the U.S. dollar as its official paper money in 1904. There is currently about $400
million to $500 million in U.S. dollars circulating in Panama. If interest rates on U.S. Treasury
CHAPTER 3: THE INTERNATIONAL MONETARY SYSTEM 17

securities are 7%, what is the value of the seigniorage that Panama is forgoing by using the U.S. dollar
instead of its own-issue money?

ANSWER. Instead of using U.S. dollars as its currency in circulation, the Panamanian government could
substitute its own currency and invest the $400 million to $500 million in U.S. Treasury securities. This
policy would earn the Panamanian government $28 million to $35 million annually at the current 7%
interest rate. Thus, the Panamanian government is foregoing seigniorage worth $28 million to $35 million
annually. The present value of this seigniorage equals the amount of U.S. dollars in circulation, or $400
million ($28 million/.07) to $500 million ($35 million/.07).

5. By some estimates, $185 billion to $260 billion in currency is held outside the United States.

a. What is the value to the United States of the seigniorage associated with these overseas dollars ?
Assume that dollar interest rates are about 6%.

ANSWER. The annual value of seigniorage equals the foregone interest on the currency held outside the
United States. Based on the numbers presented in the question, this annual value varies between $11.1
billion (0.06 x $185 billion) and $15.6 billion (0.06 x $260 billion). If this money stays overseas
permanently, then the value of seigniorage is just equal to the amount of dollars held outside the United
States, or $185 billion to $260 billion. In other words, the United States receives goods and services worth
this amount of money from foreigners and paid for them with pieces of green paper that are never
redeemed for U.S. goods and services.

b. Who in the United States realizes this seigniorage?

ANSWER. The U.S. government realizes this seigniorage. Who in the United States benefits from this
seigniorage is an issue in political economy and depends what the government does with the money: cuts
taxes, spends it (which raises the further question of on whom), uses it to reduce the deficit, etc.

ADDITIONAL CHAPTER 3 PROBLEM AND SOLUTION

1. The central rates for the Spanish and Belgian currencies on March 20, 1997, were Ptas 163.826/ECU
and BF 39.7191/ECU. What central cross rate between these two currencies did these central rates
imply?

ANSWER. These rates imply a central cross rate between the two currencies of Ptas 4.1246/BF
(163.826/39.7191), or equivalently, BF 0.242447/Ptas (39.7191/163.826).