INTERNATIONAL

FINANCIAL
MANAGEMENT
Fifth Edition
EUN / RESNICK

McGraw-Hill/Irwin Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

The International
Monetary System

Chapter Two

Chapter Objective:
This chapter serves to introduce the institutional
framework within which:
1. International payments are made.
2. The movement of capital is accommodated.
3. Exchange rates are determined.
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Chapter Two Outline

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Evolution of the International Monetary System

Current Exchange Rate Arrangements
European Monetary System
Euro and the European Monetary Union
The Mexican Peso Crisis
The Asian Currency Crisis
The Argentine Peso Crisis
Fixed versus Flexible Exchange Rate Regimes

Chapter Two Outline

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International Monetary System: Institutional

framework within which international payments
are made, movements of capital are
accommodated, and exchange rates among
currencies are determined.
A complex whole of agreements, rules,
institutions, mechanisms, and policies regarding
exchange rates, international payments, and the
flow of capital.

Evolution of the
International Monetary System
Bimetallism:

Before 1875
Classical Gold Standard: 1875-1914
Interwar Period: 1915-1944
Bretton Woods System: 1945-1972
The Flexible Exchange Rate Regime: 1973Present

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Bimetallism: Before 1875

A double

standard in the sense that both gold and

silver were used as money. (free coinage was
maintained)
Some countries were on the gold standard, some on
the silver standard, some on both. (mono-bi)

While using both, some of the countries returned to one

Coinage act of 1873.

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.

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Bimetallism: Before 1875

British

Pound (gold standard) vs. Franc (bimetal)

exchanged currencies on gold content of the two
currencies.
Franc (bimetal) and German mark (silver
standard) exchanged currencies on silver content
of the currencies.
British Pound (gold standard) vs. German mark
(silver) exchanged currencies by their exchange
rates against the franc.
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Greshams Law: bad(abundant)

money drives out good (scarce) money.
Greshams Law

implies that it would be the least

valuable metal that would tend to circulate.
Suppose that you were a citizen of Germany
during the period when there was a 20 German
mark coin made of gold and a 5 German mark
coin made of silver.

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If Gold suddenly and unexpectedly became much

more valuable than silver, which coins would you
spend if you wanted to buy a 20-mark item and
which would you keep?

Classical Gold Standard:

1875-1914 :

Gold constitutes treasure, and he who possesses it has all he needs in this world. Columbus

During this period in most major countries:

The exchange rate between two countrys currencies would be

determined by their relative gold contents.

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Gold alone was assured of unrestricted coinage

There was two-way convertibility between gold and national
currencies at a stable ratio.
Gold could be freely exported or imported.

Banknotes need to be backed by a gold reserve of a minimum stated

ratio.
Domestic money stock should rise and fall as gold flows in and out of
the country.

Classical Gold Standard:

1875-1914
For example, if the dollar is pegged to gold at
U.S. $30 = 1 ounce of gold (28.3495231 gr), and the
British pound is pegged to gold at 6 = 1 ounce
of gold, it must be the case that the exchange rate
is determined by the relative gold contents:

$30 = 1 ounce of gold = 6

$30 = 6
$5 = 1
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For the entire period USD/Pound rate was in a range of 4.84$ and 4.90$

Classical Gold Standard:

1875-1914
Highly

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.
(David Humes idea, Scottish philosopher (17111776)
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Price-Specie-Flow Mechanism

Suppose Great Britain exported more to France than

France imported from Great Britain.
This cannot persist under a gold standard.

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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.

Price-Specie-Flow Mechanism

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Classical Gold Standard:

1875-1914
Ardent

It is a hedge against price inflation. You cant increase

its quantity. Money creation will be automatic.

There

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supporters of gold:

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.

Interwar Period: 1915-1944

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Exchange 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.
Economic nationalism, economic and political instabilities, bank
failures, panicky flights of capital across borders, 1929 Great
Depression, all reasons required a new system.

Bretton Woods System:

1945-1972
Named

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-1945 and
the World Bank. (International Bank for Reconstruction and Development, IBRD)
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Bretton Woods System:

1945-1972
British

delagates led by John Maynard Keynes

proposed an international clearing union with a
reserve asset called bancor
The US delegate led by Harry Dexter White
proposed a currency pool to which member
countries would make contributions and from
which they can barrow. (IMF like)

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Bretton Woods System:

Dollar based gold exchange standart 1945-1972
German
mark

British
pound
r
Pa ue
l
Va

French
franc
P
Va ar
lue

Par
Value

U.S. dollar
Pegged at $35/oz.

Gold
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Collepse of the Bretton Woods

The system was programmed to collapse in the long run. To satisyf the
growing need for reserves, the US had to run balance of payments deficits
continuously.
This would reduce public confidence in the currency itself which is called
Triffin Paradox. [trade was positively correlated with the amount of dollars held by foreigners. Foreigners'
confidence in the U.S. dollar, however, was negatively correlated with the amount of dollars they held

Bank of France bought gold from the US Treasury, unloading its dollar
holdings.
After this to protect the system;

The US goverment taken some defence measures, Interest Equalization Tax and
Foreign Credit Restraint Program (lending limits to MNCs) (This also caused
Eurodollar market to increase more)
SDRs are created as a reserve money.

The Composition of the SDRs

Collepse of the Bretton Woods

Because of Vietnam War and Great Society program in early 1970s it

became clear that the dollar was overvalued, particularly for Mark and Yen.
German and Japan Cenral banks had to make massive interventions to
maintain their par values as the US was showing unwillingness to contral
its monetary expansion.
In August 1971, president Nixon suspended the convertibility of the dollar
into gold and imposed a 10 percent import surcharge.
To save the system again 10 countries had an agreement called
Smithsonian : 1)38$ per ounce, 2)up to 10 pcnt revaluation of par values
and 3)band expanded to 2.25
1 year later again same problem gold 1 ounce gold 38 and 42 .....

The Flexible Exchange Rate Regime:

1973-Present.

January 1976 IMF members met in Jamaica and came

out Jamaica Agreement which is:
1.

2.
3.

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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.
Non-oil-exporting countries and less-developed countries
were given greater access to IMF funds.

The Flexible Exchange Rate Regime:

1973-Present.
Exchange

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rates are now more volatile.

Current Exchange Rate Arrangements

Free Float

Managed Float

Such as the U.S. dollar or euro (through franc or mark).

No national currency

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About 25 countries combine government intervention with market

forces to set exchange rates.

Pegged to another currency

The largest number of countries, about 48, allow market forces to

determine their currencys value.

Some countries do not bother printing their own currency. For

example, Ecuador, Panama, and El Salvador have dollarized.
Montenegro and San Marino use the euro.

Current Exchange Rate Arrangements

1.

2.
3.
4.
5.
6.
7.
8.

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Exchange arrangemenets with no separate legal tender: Ecuador, El Salvador,

Panama using the US dollar.
Currency board: Legislative commitment to exchange domestic currency for a
specified foreign currecy at a fixed exchange rate.
Conventional fixed pegs: Saudi Arabia, Nigeria, Egypt, Ukraine.
Pegged exchange rates within horizontal bands: There is a central bank and the
fluctuation is wider at least 1 percent plus or minus.
Crawling pegs: Adjusting the currency in small amounts at a fixed preannounced
rate.
Exchange rates within crawling bands.
Managed floating with no preannounced path for the exchange rate: Algeria,
Russia, Singapore, India
Independent floating: market determined.
Exhibit 2.4 in your book page 36-38

European Monetary System

European countries maintain exchange rates among
their currencies within narrow bands (+- 1.125
Although Smithsonian Agreement requires 2.25), and
jointly float against outside currencies.
Objectives:

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To establish a zone of monetary stability in Europe.

To coordinate exchange rate policies vis--vis (in comparition
with) non-European currencies.
To pave the way for the European Monetary Union.

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. (Before ECU
was available)
These original member states were: Belgium,
Germany, Spain, France, Ireland, Italy,
Luxemburg, Finland, Austria, Portugal and the
Netherlands.
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What Is the Euro: Maastricht Treaty 1991

convergence criterias +from ecu to euro, ems to emu

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Two main instruments of the EMS are ECU/EURO and Exchange Rate Mechanism.

What are the Different Denominations

of the Euro Notes and Coins ?
There

are 7 euro notes and 8 euro coins.

500, 200, 100, 50, 20, 10, and 5.
The coins are: 2 euro, 1 euro, 50 euro cent, 20
euro cent, 10, euro cent, 5 euro cent, 2 euro cent,
and 1 euro cent.
The euro itself is divided into 100 cents, just like
the U.S. dollar.

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How Did the Euro Affect Contracts

Denominated in National Currency?
All

insurance and other legal contracts

continued in force with the substitution of
amounts denominated in national currencies
with their equivalents in euro.
Once the changeover was completed by July 1,
2002, the legal-tender status of national
currencies (e.g. German mark, Italian lira) was
cancelled, leaving the euro as the sole legal
tender in the euro zone.
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Euro Area
Austria,
Belgium,
Cyprus,
Finland,
France,
Germany,
Greece,

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Ireland,
Italy,
Luxembourg,
Malta,
The Netherlands,
Portugal,
Slovenia,
Spain

Value of the Euro in U.S. Dollars

2-34

End of the currencies

On

January 1, 2002, euro notes and coins were

introduced to circulation while national bills and
coins were being gradually withdrawn.
As of July 1, 2002, the legal tender status of
national currencies was canceled, leaving the
euro as the sole legal tender it the euro zone
countries.

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The Benefits of Monetary Union

Reduced transaction costs and elimination of exchange rate
uncertainty.
Reducing hedging costs
Comparison shopping
Price transparancy will lead to Europe-wide competition
Enhenced efficiency and competitiveness of the European
economy.
Improves the continental capital markets
One currency should promote political cooperation and
peace in Europe.

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The Long-Term Impact of the Euro

As

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.???? Is it?? China, Arab World, India
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Costs of Monetary Union

The

main cost of monetary union is the loss of

national monetary and exchange rate policy
independence.

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The more trade-dependent and less diversified a

countrys economy is the more prone to asymmetric
shocks that countrys economy would be.

Asymmetric shocks:

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When an economic supply or demand shock is different from one region

to another, or when the shocks do not move in tandem (together).
Example: If Germany has a positive aggregate demand shock and France
has a negative aggregate demand shock, then these two countries are
experiencing asymmetric shocks.
Having similar, or symmetric, shocks is one of the criteria of an optimal
currency area. (Theory of Robert Mondell, Colombia Uiversity in 1961)
Asymmetric shocks make it difficult for the central bank of a monetary
union to conduct monetary policy that is beneficial to each member of the
union.

Costs of Monetary Union

Finland,

a country heavily dependent on the paper

and pulp (wood) industries faces a sudden drop in
world paper and pulp prices, hurting Finnish
economy, causing unemployment and income
decline while scarcely affecting other euro zone
countries.
This is called an asymmetric shock.

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Costs of Monetary Union

2-41

If Finland had monetary independence, they lower

domestic interest rates to stimulate the weak economy as
well as letting its currency depreciate to boost foreigners
demant for Finland products.
As Finland in EMU, there is no monetary policy they
can apply. They have to act with euro zone and ECB will
not tune its policy depending on only one country.
Without monetary solution, other options: lowering wage
and price levels will have the same effects similar to the
depreciation of the Finnish currency.

Costs of Monetary Union

Or if the capital flows freely across the euro zone and
workers are willing to relocate these are also good for
asymmetric shock absorbation.
If the countries factor mobilitiy (capital, labor) is high in
a region, the countries can have one currency. The
theory of Robert Mundell, optimim currency areas.
Asymetric shocks can be in a country but the flexibility
of wage price and fiscal policy will have a successful
response to these shocks.

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Costs of Monetary Union

2-43

In the US high degree of capital and labor mobility is

available.
It would be suboptimal if each 50 states to issue its own
currency.
Unemloyed living in Helsinki not very likely to move to
Milan due to cultural, religious, linguistic and other
barriers but for the US?
If the euro zone experiences a major asymmetric shocks, a
successful response will require wage, price and fiscal
flexibility.

The Mexican Peso Crisis

On

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.
Early 1995 the peso fell against the US dollar by
as much as 40 percent.

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The Mexican Peso Crisis (1994)

This is the first cross border flight of portfolio

capital: International mutual funds investment before
crises were 54 billion dollar !!!

In

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a system like this:

1. Having multinational safety net in place to
safeguard the world financial system is important.
2. Foreign capital influx causes a higher domestic
inflation and overvalued money, that hurts trade
balances.

The Asian Currency Crisis (1997)

The

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.

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The Asian Currency Crisis

Weak

domestic financial system, free

international capital flows, contagion effects of
changing market sentiment (feeling), inconcistent
economic policies are all the factors behind the
Asian Currency Crises.
The liberalisation cause the Asian countries
inflow of foreign capital. Credit boom directed to
speculation on real estate, stock market .
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The Asian Currency Crisis

Fixed

or stable exchange rates encourage

unhedged financial transactions and excessive
risk taking by lenders/borrowers.
Asset prices declined, than quality of banks loan
portfolios (collateral)
Crony capitalism is not new for Asia too. (poor
risk managemend and supervision, political
influence, suboptimal allocation of resources...)
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The Asian Currency Crisis

Booming economy with a fixed or stable nominal
exchange rate inevitably brought about an appreciation
of the real exchange rate. Caused in a marked
slowdown in export growt.
Yens depreciation against the dollar hurt Japans
neighbours more.
Panickly flight of capital from the Asian countries cause
the crisis to become extended.
IMF intervention

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Lessons from Asian Currency Crisis

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Countries first strengthen their domestic financial system and then

liberalize their financial markets.
Financial sector regulations and supervision is the most important.
Basel Committee on Banking Supervision rules...
Encourage foreign direct investment and equity and long term bond
investment discourage short term investment even by using Tobin tax
incompatible trinity or trilemma a country can attain only two
of the following three conditions:
1. a fixed exchange rate system
2. free international flows of capital
3. an independent monetary policy.

The Argentinean Peso Crisis (2002)

In

1991 the Argentine government passed a

convertibility law that linked the peso to the U.S.
dollar at parity. (currency board)
The initial economic effects were positive:

Argentinas chronic inflation was curtailed (limited)

Foreign investment poured in

As

the U.S. dollar appreciated on the world market

the Argentine peso became stronger as well.

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The Argentinean Peso Crisis

The

strong peso hurt exports from Argentina and

caused a protracted (extended) economic
downturn that led to the abandonment of peso
dollar parity in January 2002.

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The unemployment rate rose above 20 percent

The inflation rate reached a monthly rate of 20 percent

The Argentinean Peso Crisis

There

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 inflexibility
Contagion from the financial crises in Brazil and Russia

Argentina

refused to pay its debts and offered to

pay only %25 of NPV of the debts. Foreign
bondholders have rejected this.

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Currency Crisis Explanations

2-54

In 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
currency for U.S. dollars, they want to get to the exit first.
Thus, fears of depreciation become self-fulfilling
prophecies.

Fixed versus Flexible

Exchange Rate Regimes
Which Exchange Rate Regime is better?
Arguments in favor of flexible exchange rates:

Easier external adjustments.

National policy autonomy (independence).

Arguments

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against flexible exchange rates:

Exchange rate uncertainty may hamper international

trade.
No safeguards to prevent crises.

End Chapter Two

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