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Chapter Outline
OPENING CASE: China's Exchange Rate Regime
INTRODUCTION
KEY TERMS
SUMMARY
Learning Objectives
11.1 Describe the historical development of the modern global monetary system.
11.2 Explain the role played by the World Bank and the IMF in the international monetary system.
11.3 Compare and contrast the differences between a fixed and a floating exchange rate system.
11.4 Identify exchange rate regimes used in the world today and why countries adopt different
exchange rate regimes.
11.5 Understand the debate surrounding the role of the IMF in the management of financial crises.
11.6 Explain the implications of the global monetary system for management practice.
Chapter Summary
The objective of this chapter is to explain how the international monetary system works and its
implications for international business. The chapter begins by reviewing the historical evolution of
the monetary system, starting with the gold standard and the Bretton Woods System. The chapter
explains the role of the International Monetary Fund (IMF) and the World Bank, both of which
were initiated by the Bretton Woods Conference. The fixed exchange rate system that was initiated
by the Bretton Woods Conference collapsed in 1973. The majority of the chapter explains the
workings of the current international monetary system. The pluses and minuses of fixed exchange
rates versus floating exchange rates are discussed. Scholars differ regarding which system is best.
The current role of the IMF and the World Bank are discussed, including the way the IMF has
helped nations restructure their debts.
Chapter Activity
Ask students to think about how challenging it is for an SME to suddenly conduct business in a
new currency. Consider a local firm: select one, or invent one and give it a name, such as Gamma
Co., that has always issued quotes and received payment in British pounds, and suddenly it must
prepare quotes in Mexican pesos and German euros for potential foreign customers. How does the
company do this? How can it prepare quotes that assure that when it is paid, it will receive the
price charged?
Further, if Gamma Co. has to increase capacity at its home-country plant to meet the new demand
placed on it by exports, how will it finance the new materials, equipment, and labor it needs? Will
the local bank finance this increased capacity for international sales? Assuming Gamma Co. is
paid on time, how will the additional income be accounted for and taxed? Must Gamma Co. pay
taxes on the income it earns from selling in Germany and Mexico? Students may research
international banking products that help business customers manage currency risk and commercial
risk, and protect receivables. One international bank offering global trade services is JPMorgan
Chase https://commercial.jpmorganchase.com/pages/commercial-banking/services/gb-trade-
services. U.S. students should research the U.S. Export-Import Bank, http://www.exim.gov/, which
is not a bank at all but a program of the federal government that provides trade financing solutions,
such as export credit insurance, working capital guarantees, and guarantees of commercial loans to
foreign buyers to help exporters of U.S. goods and services be successful in foreign markets.
Summary
The opening case describes the development of China's monetary policy over time. The Chinese
yuan was pegged to the U.S. dollar at a fixed exchange rate for most of its history. However, after
opening to foreign trade and investment in the 1980s, the yuan was devalued for the country to be
a more competitive exporter. By 2005, there was a general consensus that the Chinese currency
was undervalued. As a result, the country introduced a managed floating exchange rate system.
This allowed the yuan to appreciate against foreign currencies. After a general slowdown in the
Chinese economy and a subsequent depreciation of the yuan in late 2015, the government's
monetary policy led to the purchase of the country's currency with U.S. dollars to maintain the
value of the yuan and prevent many Chinese companies for going bankrupt.
Discussion Questions
QUESTION 1: Explain the managed floating exchange rate system that China introduced in July
2005. Why was it introduced?
ANSWER 1: The managed floating exchange rate system introduced by China set the yuan to a set
of foreign currencies that included the U.S. dollar, the euro, the Japanese yen, and the British
pound. The daily exchange rate was permitted to float within 0.3% of the central parity. This rate
was expanded to 0.5% in 2007, 1% in 2012, and 2% in 2014. This system was introduced because
there was concern that China's currency, using a fixed exchange rate policy, was undervalued.
QUESTION 2: Have the Chinese artificially depressed the value of the yuan as some have claimed
in the United States? Explain your position.
ANSWER 2: The evidence indicates that the Chinese, since 2015, have been allowing for the
relative appreciation of the yuan versus foreign currencies. In fact, the managed float system
introduced has allowed the currency to appreciate considerably against other major world
currencies.
Chapter Outline with Lecture Notes, Video Notes, and Teaching Tips
Introduction
A) The international monetary system refers to the institutional arrangements that countries
adopt to govern exchange rates. When the foreign exchange market determines the relative value
of a currency, that country is adhering to a floating exchange rate. The world’s four major trading
currencies—the U.S. dollar, the European Union’s euro, the Japanese yen, and the British pound—
are all floating currencies.
B) A pegged exchange rate means that 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. The opening case describes Malawi’s peg to the U.S. dollar.
C) A managed float system or dirty float occurs 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 has adopted this policy in 2005.
D) Countries that adopt a fixed exchange rate system fix their currencies against each other. 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).
E) To understand how the current monetary system works, we must understand its evolution.
A) The gold standard had its origin in the use of gold coins as a medium of exchange, unit of
account, and store of value - a practice that stretches back to ancient times. As the volume of
international trade increased, governments agreed to convert paper currency into gold on demand
at a fixed rate.
C) The exchange rate between currencies was determined based on how much gold a unit of each
currency would buy. The amount of a currency needed to purchase one ounce of gold was referred
to as the gold par value.
F) By the start of World War II, in 1939, the gold standard was dead.
Discipline
D) A fixed exchange rate regime imposes discipline in two ways. First, the need to maintain a
fixed exchange rate puts a brake on competitive devaluations and brings stability to the world trade
environment. Second, a fixed exchange rate regime imposes monetary discipline on countries,
thereby curtailing price inflation.
Flexibility
E) Although monetary discipline was a central objective of the Bretton Woods agreement, it was
recognized that a rigid policy of fixed exchange rates would be too inflexible. The IMF stood
ready to lend foreign currencies to members to tide them over during short periods of balance-of-
payments deficits, when a rapid tightening of monetary or fiscal policy would hurt domestic
employment.
B) Speculation that the dollar would have to be devalued relative to most other currencies, as well
as underlying economics and some forceful threats by the U.S., forced other countries to increase
the value of their currencies relative to the dollar
C) The key problem with the Bretton Woods system was that, since the dollar was the base
currency, the system relied on an economically well-managed United States. When the United
States began to print money, run high trade deficits, and experience high inflation, the system was
strained to the breaking point
B) The purpose of the Jamaica meeting was to revise the IMF's Articles of Agreement to reflect
the new reality of floating exchange rates. The three main elements of the Jamaican agreement
include the following:
1) Floating rates were declared acceptable.
2) Gold was abandoned as a reserve asset.
3) Total annual IMF quotas—the amount member countries contribute to the IMF—were
increased to $41 billion. Since then, they have been increased to $311 billion and
membership in the IMF has expanded to 184 countries.
A) The breakdown of the Bretton Woods system has not stopped the debate about the relative
merits of fixed versus floating exchange rate regimes. Indeed, disappointment with the system of
floating rates in recent years has led to renewed debate about the merits of a fixed exchange rate
system.
Crisis Recovery
E) Advocates of floating exchange rates argue that exchange rate adjustments can help a country
deal with economic crises. The devaluation of a currency that typically follows a currency crisis
promotes export-led economic growth. Critics point out, however, that the devalued currency also
causes import prices to rise and consequently increases inflation.
Monetary Discipline
G) The need to maintain a fixed exchange rate parity ensures that governments do not expand their
money supplies at inflationary rates.
Speculation
H) Critics of a floating exchange rate regime also argue that speculation can cause fluctuations in
exchange rates. A fixed exchange rate system limits the destabilizing effects of speculation.
Uncertainty
I) Speculation also adds to the uncertainty surrounding future currency movements that
characterizes floating exchange rate regimes, and can negatively affect the growth of international
trade and investment.
WHO IS RIGHT?
K) There is no real agreement as to which system is better. We do, however, know that a fixed
exchange rate regime modeled along the lines of the Bretton Woods system will not work. It is
telling that speculation ultimately broke the system, a phenomenon that advocates of fixed rate
regimes claim is associated with floating exchange rates. Nevertheless, a different kind of fixed
exchange rate system might be more enduring and might foster the kind of stability that would
facilitate more rapid growth in international trade and investment.
C) There is some evidence that adopting a pegged exchange rate regime does moderate
inflationary pressures in a country.
CURRENCY BOARDS
D) A country that introduces a currency board commits itself to converting its domestic currency
on demand into another currency at a fixed exchange rate. To make this commitment credible, the
currency board holds reserves of foreign currency equal at the fixed exchange rate to at least 100%
of the domestic currency issued.
currency, or forces authorities to expend large volumes of international currency reserves and
sharply increase interest rates in order to defend the prevailing exchange rate.
C) 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.
D) A foreign debt crisis is a situation in which a country cannot service its foreign debt
obligations, whether private sector or government debt.
E) The causes of the financial crisis that erupted across Southeast Asia during the fall of 1997 were
sown in the previous decade when these countries were experiencing unprecedented growth.
F) Huge increases in exports, and hence the incoming funds, helped fuel a boom in commercial
and residential property, industrial assets, and infrastructure. As the volume of investments
ballooned during the 1990s, often at the bequest of national governments, the quality of many of
these investments declined significantly.
G) Investments made on the basis of unrealistic projections about future demand conditions
created significant excess capacity. These investments were often supported by dollar-based debts.
When inflation and increasing imports put pressure on the currencies, the resulting devaluations
led to default on dollar denominated debts. A final complicating factor was that by the mid-1990s
although exports were still expanding across the region, so were imports.
H) The Asian meltdown began in mid-1997 in Thailand when it became clear that several key Thai
financial institutions were on the verge of default. Following the devaluation of the Thai Baht,
wave after wave of speculation hit other Asian countries. These devaluations were largely driven
by similar factors to those that underlay the earlier devaluation of the Thai Baht. A combination of
excess investment, high borrowings, much of it in dollar denominated debt, and a deteriorating
balance of payments position.
Inappropriate Policies
J) The IMF’s policies have recently come under fire. One criticism is that the IMF’s “one-size-fits-
all” approach to macroeconomic policy is inappropriate for many countries.
Moral Hazard
K) A second criticism of the IMF is that its rescue efforts are exacerbating a problem known to
economists as moral hazard. Moral hazard arises when people behave recklessly because they
know they will be saved if things go wrong.
Lack of Accountability
L) The final criticism of the IMF is that it has become too powerful for an institution that lacks any
real mechanism for accountability.
Observations
M) As with many debates about international economics, it is not clear which side has the winning
hand about the appropriateness of IMF policies.
Currency Management
B) An obvious implication with regard to currency management is that companies must recognize
that the foreign exchange market does not work quite as depicted in Chapter 10. The current
system is a managed float system in which government intervention can help drive the foreign
exchange market. Companies need to be aware of this and adjust their foreign exchange
transactions accordingly.
C) A second message contained in this chapter is that under the present system, speculative buying
and selling of currencies can create volatile movements in exchange rates.
Business Strategy
D) The volatility of the present floating exchange rate regime presents a conundrum for
international businesses. Exchange rate movements are difficult to predict, and their movement can
have a major impact on the competitive position of businesses. One response to the uncertainty
that arises from a floating exchange rate regime might be to build strategic flexibility to minimize
the economic exposure of the firm.