MODULE 3A: THE GLOBAL MONETARY SYSTEM

LEARNING OBJECTIVES
1. Be acquainted with the factors behind foreign exchange rates;
2. Be familiar with the functions of foreign exchange market;
3. Track the evolution of International Monetary System;
4. Be familiar with the differences between floating/flexible and fixed exchange rate;
5. Be familiar with the role of IMF and the World Bank in the International Monetary System;
6. Be aware of the European Monetary System;
7. Understand the differences between translation, transaction and economic exposure, and what managers can do to manage each type of exposure.

LO1: FACTORS BEHIND FOREIGN EXCHANGE RATES

A foreign exchange rate is the price of one currency, such as the dollar ($), in terms of another, such as the euro (€).This section
addresses a key question: What determines foreign exchange rates?

Basic Supply and Demand

The concept of an exchange rate as the price of a commodity—one country’s currency—helps us understand its determinants.
Basic economic theory suggests that the price of a commodity is most fundamentally determined by its supply and demand.
Strong demand will lead to price hikes, and oversupply will result in price drops. Of course, we are dealing with a most unusual
commodity here, money, but the basic underlying principles still apply. When the United States sells products to China, US
exporters often demand that they be paid in US dollars because the Chinese yuan is useless (technically, nonconvertible) in the
United States. Chinese importers of US products will somehow have to generate US dollars to pay for US imports. The easiest
way to generate US dollars is to export to the United States, whose buyers will pay in US dollars. In this example, the dollar is
the common transaction currency involving both US imports and US exports. As a result, the demand for dollars is much
stronger than the demand for yuan (while holding the supply constant). Worldwide, a wide variety of users, such as
Chinese exporters, Russian mafia members, and Swiss bankers, prefer to hold and transact in US dollars, thus fuelling the
demand for dollars. Such a strong demand explains why the US dollar is the most sought after currency in post-war decades
(see table below):
THE ROLE OF US DOLLAR OUTSIDE THE UNITED STATES
Common Reference Most international statistics (such as exports, imports, and GDP) reported by national
governments and international organizations (such as the UN and WTO) are expressed in US
dollars.
Intervention Currency Most central banks buy and sell US dollars in their respective foreign exchange markets to
influence their exchange rates. Many countries peg their currencies to the dollar.
Reserve Currency Most central banks hold US dollars as official reserves to intervene in their respective
markets. (The US Federal Reserve System maintains its foreign currency reserves in euros
and yen.)
Vehicle Currency Transaction between two less commonly used (“exotic”) currencies, such as the Brazilian real
and the Czech koruna, is often through dollars. There is always an active market for dollars in
every country.

Because foreign exchange is such a unique commodity, its markets are influenced not only by economic factors but also by a lot
of political and psychological factors. The next question is: What determines the supply and demand of foreign exchange? The
five underlying building blocks are:
(1) Relative price differences,
(2) Interest rates and monetary supply,
(3) Productivity and balance of payments,
(4) Exchange rate policies, and
(5) Investor psychology.
1. Relative Price Differences and Purchasing Power Parity
Some countries (such as Switzerland) are famously expensive, and others (such as the Philippines) are known to have cheap
prices. How do these price differences affect exchange rate? An answer is provided by the theory of purchasing power parity
(PPP), which is essentially the “law of one price.” The theory suggests thatin the absence of trade barriers (such as tariffs), the
price for identical productssold in different countries must be the same. Otherwise, arbitragers may “buylow” and “sell high,”
eventually driving different prices for identical products to the same level around the world. The PPP theory argues that in the
long run, exchange rates should move toward levels that would equalize the prices of an identical basket of goods in any two
countries.
One of the most influential and most fun-filled applications of the PPP theory is the Big Mac index, popularized by the Economist
magazine. The Economist’s “basket” is McDonald’s Big Mac hamburger produced in about 120 countries. According to the PPP
theory, a Big Mac should cost the same everywhere around the world. In reality, it does not. In July 2007, a Big Mac cost $3.41
in the United States and 11 yuan in China. If the Big Mac indeed cost the same, the de facto exchange rate based on the Big
Mac became 3.23 yuan to the dollar (that is, 11 yuan/$3.41), whereas the nominal (official) rate at that time was 7.6 yuan to the
dollar. According to this calculation, the yuan was 58% “undervalued” against the dollar—the most extreme in the Big Mac
universe. In other words, the Big Mac sold in China has the best “value” in the world, costing only $1.45 (!) based on the official
exchange rate.
Although the Big Mac index is never a serious exercise, it has been cited by some US politicians as “evidence” that the yuan is
artificially undervalued. This claim has been disavowed by the Economist itself. More seriously, we can make four observations:
 The Big Mac index confirms that prices in some European countries are very expensive. A Big Mac in
Switzerland and Denmark was the most expensive in the world, costing $5.20 and $5.08, respectively.
 Prices in developing countries are cheaper. A Big Mac in Egypt and the Philippines cost only $1.68 and
$1.85, respectively. This makes sense because a Big Mac is a product with both traded and nontrade inputs.
To simplify our discussion, let us assume that the costs for traded inputs (such as flour for the bun) are the
same; it is obvious that nontrade inputs (such as labour and real estate) are cheaper in developing countries.
 The Big Mac is not a traded product. No large number of American hamburger lovers would travel to China
simply to get the best deal on the Big Mac and then somehow take with them large quantities of the made-in-
China Big Mac (perhaps in portable freezers). If they did that, the Big Mac price in China would be driven up,
and the price in the United States would be pushed down—remember supply and demand?
 After having a laugh, we shouldn’t read too much into this index. PPP signals where exchange rates may
move in the long run. But it does not suggest that the yuan should appreciate by 58% or the Swiss franc
should depreciate by 53% next year. According to the Economist, anyone interested in the PPP theory
“would be unwise to exclude the Big Mac from their diet, but Super-Size servings would equally be a
mistake.”

2. Interest Rates and Money Supply

The PPP theory suggests the long-run direction of exchange rate movement, but what about the short run? In the short run,
variations in interest rates have a powerful effect. If one country’s interest rate is high relative to other countries, the country will
attract foreign funds. Because inflows of foreign funds usually need to be converted to the home currency, a high interest rate will
increase the demand for the home currency, thus enhancing its exchange value. In addition, a country’s rate of inflation, relative
to that prevailing abroad, affects its ability to attract foreign funds and hence its exchange rate. A high level of inflation is
essentially too much money chasing too few goods in an economy—technically, an expansion of a country’s money supply. A
government, when facing budgetary shortfalls, may choose to print more currency, which tends to stimulate inflation. In turn, this
would cause its currency to depreciate. This makes sense because as the supply of a given currency (such as the Mexican
peso) increases while the demand stays the same, the per unit value of that currency (such as one peso) goes down. Therefore,
the exchange rate is very sensitive to changes in monetary policy. It responds swiftly to changes in money supply. To avoid
losses from holding assets in a depreciated currency, investors sell them for assets denominated in other currencies. Such
massive sell-offs may worsen the depreciation. This happened in Argentina during 2001–2002, when numerous investors sold off
assets held in the Argentinian peso and forced it to hit from parity to a low of 3.5 to the dollar.

3. Productivity and Balance of Payments

In international trade, the rise of a country’s productivity, relative to other countries, will improve its competitive position—this is a
basic proposition of the theories of absolute and comparative advantage discussed in Module 2. More FDI will be attracted to the
country, fuelling demand for its home currency. One recent example is China. All the China-bound FDI inflows in dollars, euros,
and pounds have to be converted to local currency, boosting the demand for the yuan and hence its value. Other examples are
not hard to find. The rise in relative Japanese productivity over the past three decades led to a long-run appreciation of the yen,
which rose from about ¥310 = $1 in 1975 to ¥118 = $1 in 2007.
The changes in productivity will change a country’s balance of trade. A country highly productive in manufacturing may generate
a merchandise trade surplus, whereas a country less productive in manufacturing may end up with a merchandise trade deficit.
These have ramifications for the balance of payments—officially known as a country’s international transaction statement,
including merchandise trade, service trade, and capital movement.

The Balance of Payments

A) The Balance of Payments is a country’s record of its transactions with foreigners over some period of time.
B) One account in the balance of payments is merchandise trade; another account measures a country’s inflows and outflows of
capital. While the entire balance payments always balances (that is, the total “plus” entries must equal the total “minus” entries),
specific accounts need not balance.
C) Capital flows occur when one nation saves more than it invests domestically and another country borrows the “excess”
savings. Capital flows between countries:
1. Allow capital-importing countries to raise their stock of capital.
2. Allow investors in capital-exporting countries to earn a higher and/or safer return on their investment.
3. Both capital-importing and capital-exporting countries gain from capital movements

4. Exchange Rate Policies

There are two major exchange rate policies: (1) floating rate and (2) fixed rate. Governments adopting the floating (or flexible)
exchange rate policy tend to be free market believers, willing to let the demand and supply conditions determine exchange rates
—usually on a daily basis via the foreign exchange market. However, few countries adopt a clean (or free) float, which would be
a pure market solution. Most countries practice a dirty (or managed) float, with selective government interventions. Of the
major currencies, the US, Canadian, and Australian dollars, the yen, and the pound have been under managed float since the
1970s (after the collapse of the Bretton Woods system; see next section). Since the late 1990s, several developing countries,
such as Brazil, Mexico, and South Korea, have also joined the managed float regime.

The severity of intervention is a matter of degree. Heavier intervention moves the country closer to a fixed exchange rate policy,
and less intervention enables a country to approach the free float ideal. A main objective of intervention is to prevent the
emergence of erratic fluctuations that may trigger macroeconomic turbulence. Some countries do not adhere to any particular
rates. Others choose target exchange rates—known as crawling bands or more vividly “snake in a tube” (intervention will only
occur when the snake crawls out of a tube’s upper or lower bounds)

Another major exchange rate policy is the fixed exchange rate policy—countries fix the exchange rate of their currencies
relative to other currencies. Both political and economic rationales may be at play. During the German reunification in 1990, the
West German government, for political considerations, fixed the exchange rate between the West and East German mark as 1:1.
In economic terms, the East German mark was not worth that much. Politically, this exchange rate reduced the feeling of
alienation and resentment among East Germans, thus facilitating a smoother unification process. Of course, West Germans
ended up paying more for the costs of unification. Economically, many developing countries peg their currencies to a key
currency (often the US dollar). There are two benefits for a peg policy:
First, a peg stabilizes the import and export prices for developing countries.
Second, many countries with high inflation have pegged their currencies to the dollar (the United States has relatively low
inflation) to restrain domestic inflation.

5. Investor Psychology
Although theories on price differences (PPP), interest rates and money supply, balance of payments, and exchange rate policies
predict long-run movements of exchange rates, they often fall short of predicting short-run movements. It is investor psychology,
some of which is fickle and thus very hard to predict, that largely determines short-run movements. Professor Richard Lyons at
the University of California, Berkeley, is an expert on exchange rate theories. However, he was baffled when he was invited by a
friend to observe currency trading first-hand:

“As I sat there, my friend traded furiously all day long, racking up over $1 billion in trades each day. This was a world where the
standard trade was $10 million, and a $1 million trade was a “skinny one.” Despite my belief that exchange rates depend on
macroeconomics, only rarely was news of this type his primary concern. Most of the time he was reading tea leaves that was, at
least to me, not so clear . . . It was clear my understanding was incomplete when he looked over, in the midst of his fury, and
asked me: “What should I do?” I laughed nervously.”
Investors—currency traders (such as the one Lyons observed), foreign portfolio investors, and average citizens—may move as a
“herd” at the same time in the same direction, resulting in a bandwagon effect. The bandwagon effect seemed to be at play in
the second half of 1997, when the Thai baht, Malaysian ringgit, Indonesian rupiah, and South Korean won lost approximately
50% to 70% of their value against the US dollar. Essentially, a large number of individuals and companies exchanged domestic
currencies for US dollars to exit these countries—a phenomenon known as capital flight. This would push down the demand for,
and thus the value of, domestic currencies. Then, more individuals and companies joined the herd, further depressing the
exchange rate and setting off a major economic crisis.

Overall, economics, politics, and psychology are all involved. The stakes are high, yet consensus is rare regarding the
determinants of foreign exchange rates. As a result, predicting the direction of currency movements remains an art or at best a
highly imprecise science.

LO2: BE FAMILIAR WITH THE FUNCTIONS OF THE FOREIGN EXCHANGE MARKET

One of the leading strategic goals for financial companies is to profit t from the foreign exchange market. The foreign
exchange market is a market for converting the currency of one country into that of another country. An exchange rate is
simply the rate at which one currency is converted into another.

For example, XYZ Company uses the foreign exchange market to convert the dollars it earns from selling semiconductor chips
(which are priced in dollars) into pesos. Without the foreign exchange market, international trade and international investment on
the scale that we see today would be impossible; companies would have to resort to barter. The foreign exchange market is
the lubricant that enables companies based in countries that use different currencies to trade with each other

We know from earlier chapters that international trade and investment have their risks. Some of these risks exist because
future exchange rates cannot be perfectly predicted. The rate at which one currency is converted into another can change
overtime. In January1999, for example, the U.S. dollar/European euro exchange rate stood at €1 = $1.17, by October
2000 it stood at €1 = $0.82, by December 2002 it was up to€1=$1.00, and in early 2005it stood at€1=$1.30. One function
of the foreign exchange market is to provide some insurance against the risks that arise from such volatile
changes in exchange rates, commonly referred to as foreign exchange risk. Although the foreign exchange market
offers some insurance against foreign exchange risk, it cannot provide complete insurance. It is not unusual for
international businesses to suffer losses because of unpredicted changes in exchange rates. Currency fluctuations can
make seemingly profitable trade and investment deals unprofitable, and vice versa.

FUNCTIONS OF FOREIGN EXCHANGE MARKET

1) Currency Conversion  Each country has a currency inwhich the prices of goods and services are quoted.
In the United States, it is the dollar ($); in Great Britain, the pound (£); in France,
Germany, and other members of the euro zone it is the euro (€); in Japan, the yen
(¥); peso (₱) in the Philippines; and soon. , within the borders of a particular
country, one must use the national currency. A U.S. tourist cannot walk into a store
in Edinburgh, Scotland, and use U.S. dollars to buy a bottle of Scotch whisky. Dollars
are not recognized as legal tender in Scotland; the tourist must use British pounds.
Fortunately, the tourist can go to a bank and exchange her dollars for pounds. Then
she can buy the whisky. When changing one currency into another, the tourist is
participating in the foreign exchange market. The exchange rate is the rate at which the
market converts one currency into another. For example, an exchange rate of €1=$1.30
specifies that one euro buys $1.30 U.S. dollars. The exchange rate allows us to compare
the relative prices of goods and services.
 Tourists are minor participants in the foreign exchange market; companies engaged
in international trade and investment are major ones.
 International businesses have four main uses of foreign exchange markets.
o First, the payments a company receives for its exports, the income it
receives from foreign investments, or the income it receives from licensing
agreements with foreign firms may be in foreign currencies. To use those
funds in its home country, the company must convert them to its home
 country’s currency. Consider the Scotch distillery that exports its whisky to
the United States. The distillery is paid in dollars, but since those dollars
cannot be spent in Great Britain, they must be converted into British
pounds. Similarly, when Volkswagen sells cars in the United States for
dollars, it mustconvert those dollars into Euros to use them inGermany.
o Second, international businesses use foreign exchange markets when they
must pay a foreign company for its products or services in its country’s
currency. For example, Dell buys many of the components for its
computers from Malaysian firms. The Malaysian companies must be paid
in Malaysia’s currency, the ringgit, so Dell must convert money from dollars
into ringgit to pay them.
o Third, international businesses use foreign exchange markets when they
have spare cash that they wish to invest for short terms in money markets.
For example, consider a U.S. company that has $10 million it wants to
invest for three months. The best interest rate it can earn on these funds in
the United States maybe 4 percent. Investing in a South Korean money
market account, however, may earn 12 percent. Thus, the company may
change its $10 million into Korean won and invest it in South Korea. Note,
however, that the rate of return it earns on this investment depends not
only on the Korean interest rate, but also on the changes in the value of the
Korean won against the dollar in the intervening period.
o Finally, currency speculation is another use of foreign exchange markets.
Currency speculation typically involves the short-term movement of funds
from one currency to another in the hopes of profiting from shifts in
exchange rates. Consider again a U.S. company with $10 million to invest for
three months. Suppose the company suspects that the U.S. dollar is
overvalued against the Japanese yen. That is, the company expects the value
of the dollar to depreciate (fall) against that of the yen. Imagine the current
dollar/yen exchange rate is $1 =¥120. The company exchanges its $10 million
into yen, receiving ¥1.2 billion ($10 million × 120 = ¥1.2 billion). Over
thenextthreemonths,thevalueofthedollardepreciatesagainsttheyenuntil $1 =
¥100. Now the company exchanges its ¥1.2 billion back into dollars and finds
that it has $12 million. The company has made a $2 million profit on currency
speculation in three months on an initial investment of $10 million. In general,
however, companies should beware, for speculation by definition is a very risky
business. Thecompany cannot know for sure what will happen to exchange
rates. Although a speculator may profit handsomely if his speculation about
future currency movements turns out to be correct, he can also lose vast
amounts of money if it turns out to be wrong.
2) Insuring Against  The second function of the foreign exchange market is to provide insurance against
Foreign Exchange Risk foreign exchange risk, which is the possibility that unpredicted changes in future
exchange rates will have adverse consequences for the firm. When a firm insures itself
against foreign exchange risk, we say that is it engaging in hedging. To explain how the
market performs this function, we must first distinguish among spot exchange rates,
forward exchange rates, and currency swap.

LO3: TRACK THE EVOLUTION OF INTERNATIONAL MONETARY SYSTEM

The International Monetary System is the framework within which countries borrow, lend, buy, sell and make payments across
political frontiers. The framework determines how balance of payments disequilibrium is resolved. Numerous frameworks are
possible and most have been tried in one form or another. Today’s system is a combination of several different frameworks. The
increased volatility of exchange rate is one of the main economic developments of the past years. Under the current system of
partly floating and partly fixed undergo real and paper fluctuations as a result of changes in exchange rates. Policies for
forecasting and reacting to exchange rate fluctuations are still evolving as we improve our understanding of the international
monetary system, accounting and tax rules for foreign exchange gains and losses, and the economic effect of exchange rate
changes on future cash flows and market values.

Although volatile exchange rate increase risk, they also create profit opportunities for firms and investors, given a proper
understanding of exchange risk management. In order to manage foreign exchange risk, however, management must first
understand how the international monetary system functions. The international monetary system is the structure within which
foreign exchange rates are determined, international trade and capital flows are accommodated, and balance-of-payments
(BOP) adjustments made. All of the instruments, institutions, and agreements that link together the world’s currency, money
markets, securities, real estate, and commodity markets are also encompassed within that term.

Currency Terminology
Let us begin with some terms in order to prevent confusion in reading this unit:
■ A foreign currency exchange
rate or simply exchange rate
■ Spot exchange rate
■ Forward rate
■ Forward premium or discount
It is the price of one country’s currency in units of another currency or commodity
(typically gold or silver) If the government of a country- for example, Argentina-
regulates the rate at which its currency- the peso- is exchanged for other
currencies, the system or regime is classified as a fixed or managed exchange
rate regime. The rate at which the currency is fixed, or pegged, is frequently
referred to as its par value. if the government does not interfere in the valuation of
its currency in any way, we classify the currency as floating or flexible.
It is the quoted price for foreign exchange to be delivered at once, or in two days
for inter-bank transactions. For example, ¥114/$ is a quote for the exchange rate
between the Japanese yen and the U.S. dollar. We would need 114 yen to buy
one U.S. dollar for immediate delivery.
It is the quoted price for foreign exchange to be delivered at a specified date in
future. For example, assume the 90-day forward rate for the Japanese yen is
quoted as ¥112/$. No currency is exchanged today, but in 90 days it will take 112
yen to buy one U.S. dollar. This can be guaranteed by a forward exchange
contract.
It is the percentage difference between the spot and forward exchange rate. To
calculate this, using quotes from the previous two examples, one formula is:
S– F 360 ¥114/ $- ¥112/ $ 360
- - - - - - - - X - - - - - - - X 1 0 0 = - - - - - - - - - - - - - - - - - - - - X - - - - - X100 =7.14%
F n ¥112/ $ 90

■ Devaluation of a currency
■ Weakening, deterioration, or
depreciation of a currency
■ Soft or weak
Where S is the spot exchange rate, F is the forward rate, and n is the number of
days until the forward contract becomes due.
Refers to a drop in foreign exchange value of a currency that is pegged to gold or
to another currency. In other words, the par value is reduced.
The opposite of devaluation is revaluation. To calculate devaluation as a
percentage, one formula is:
Beginning rate – ending rate
P er c en ta ge c h an g e = - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
Ending rate
Refers to a drop in the foreign exchange value of a floating currency. The opposite
of weakening is strengthening or appreciating, which refers to a gain in the
exchange value of a floating currency.
Describes a currency that is expected to devalue or depreciate relative to major
currencies. It also refers to currencies whose values are being artificially sustained
by their governments. A currency is considered hard or strong if it is expected to
revalue or appreciate relative to major trading currencies.
The international monetary system refers to the institutional arrangements that govern exchange rates. We assumed the
foreign exchange market was the primary institution for determining exchange rates, and the impersonal market forces of
demand and supply determined the relative value of any two currencies (i.e., their exchange rate). Furthermore, we explained
that the demand and supply of currencies is influenced by their respective countries’ relative inflation rates and interest rates.
When the foreign exchange market determines the relative value of a currency, we say that the country is adhering to a floating
exchange rate regime. The world’s four major trading currencies—the U.S. dollar, the EU euro, the Japanese yen, and the
British pound—are all free to float against each other. Thus, their exchange rates are determined by market forces and fluctuate
against each other day to day, if not minute to minute. However, the exchange rates of many currencies are not determined by
the free play of market forces; other institutional arrangements are adopted.

Many of the world’s developing nations peg their currencies, primarily to the dollar or the euro. A pegged exchange rate means
the value of the currency is fixed relative to a reference currency, such as the U.S. dollar, and then the exchange rate between
that currency and other currencies is determined by the reference currency exchange rate.

Other countries, while not adopting a formal pegged rate, try to hold the value of their currency within some range against an
important reference currency such as the U.S. dollar or a “basket” of currencies. This is often referred to as a dirty float. It is a
float because in theory, the value of the currency is determined by market forces, but it is a dirty float (as opposed to a clean
float) because the central bank of a country will intervene in the foreign exchange market to try to maintain the value of its
currency if it depreciates too rapidly against an important reference currency.

Still other countries have operated with a fixed exchange rate; that is, the values of a set of currencies are fixed against each
other at some mutually agreed on exchange rate. Before the introduction of the euro in 2000, several member states of the
European Union operated with fixed exchange rates within the context of the European Monetary System (EMS). For a quarter of
a century after World War II, the world’s major industrial nations participated in a fixed exchange rate system. Although this
system collapsed in 1973, some still argue that the world should attempt to re-establish it.

EVOLUTION OF THE MODERN IMS

1. The Gold Standard
 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 dates to ancient times. When international trade was limited in volume, payment for goods
purchased from another country was typically made in gold or silver. However, as the volume of international
trade expanded in the wake of the Industrial Revolution, a more convenient means of financing international trade
was needed. Shipping large quantities of gold and silver around the world to finance international trade seemed
impractical. The solution adopted was to arrange for payment in paper currency and for governments to agree to
convert the paper currency into gold on demand at a fixed rate.

I.1 Mechanics of the Gold Standard

 A country that follows the gold standard pegs its currency to gold and guarantees convertibility.
By 1880, most of the world’s major trading nations, including Great Britain, Germany, Japan, and
the United States, had adopted the gold standard. Given a common gold standard, the value of any
currency in units of any other currency (the exchange rate) was easy to determine.
o For example, under the gold standard, one U.S. dollar was defined as equivalent to
23.22 grains of “fine” (pure) gold. Thus, one could, in theory, demand that the U.S.
government convert that one dollar into 23.22 grains of gold. Since there are 480 grains
in an ounce, one ounce of gold cost $20.67 (480/23.22). The amount of a currency
needed to purchase one ounce of gold was referred to as thegold par value. The
British pound was valued at 113 grains of fine gold. In other words, one ounce of gold
cost £4.25 (480/113). From the gold par values of pounds and dollars, we can calculate
what the exchange rate was for converting pounds into dollars; it was £1 = $4.87 (i.e.,
$20.67/£4.25).

I.2 Strength of the Gold Standard

 The great strength claimed for the gold standard was that it contained a powerful mechanism for
achieving balance-of-trade equilibrium by all countries. A country is said to be in balance-of-
trade equilibrium when the income its residents earn from exports is equal to the money
 its residents pay to other countries for imports (the current account of its balance of
payments is in balance).
o Suppose there are only two countries in the world, Japan and the United States. Imagine
Japan’s trade balance is in surplus because it exports more to the United States than it
imports from the United States. Japanese exporters are paid in U.S. dollars, which they
exchange for Japanese yen at a Japanese bank. The Japanese bank submits the dollars
to the U.S. government and demands payment of gold in return. (This is a simplification
of what would occur, but it will make our point.)
 Under the gold standard, when Japan has a trade surplus, there will be a net flow of gold from the
United States to Japan. These gold flows automatically reduce the U.S. money supply and swell
Japan’s money supply. There is a close connection between money supply growth and price
inflation. An increase in money supply will raise prices in Japan, while a decrease in the U.S.
money supply will push U.S. prices downward. The rise in the price of Japanese goods will
decrease demand for these goods, while the fall in the price of U.S. goods will increase demand for
these goods. Thus, Japan will start to buy more from the United States, and the United States will
buy less from Japan, until a balance-of-trade equilibrium is achieved.

I.2 The Period between the wars (1918-1939)

 The gold standard worked reasonably well from the 1870s until the start of World War I in 1914,
when it was abandoned. During the war, several governments financed part of their massive
military expenditures by printing money. This resulted in inflation, and by the war’s end in 1918,
price levels were higher everywhere. The United States returned to the gold standard in 1919,
Great Britain in 1925, and France in 1928.
 Great Britain returned to the gold standard by pegging the pound to gold at the pre-war gold parity
level of £4.25 per ounce, despite substantial inflation between 1914 and 1925. This priced British
goods out of foreign markets, which pushed the country into a deep depression. When foreign
holders of pounds lost confidence in Great Britain’s commitment to maintaining its currency’s value,
they began converting their holdings of pounds into gold. The British government saw that it could
not satisfy the demand for gold without seriously depleting its gold reserves, so it suspended
convertibility in 1931.
 The United States followed suit and left the gold standard in 1933 but returned to it in 1934, raising
the dollar price of gold from $20.67 per ounce to $35 per ounce. Since more dollars were needed
to buy an ounce of gold than before, the implication was that the dollar was worth less. This
effectively amounted to a devaluation of the dollar relative to other currencies. Thus, before the
devaluation, the pound/dollar exchange rate was £1 = $4.87, but after the devaluation it was £1 =
$8.24. By reducing the price of U.S. exports and increasing the price of imports, the government
was trying to create employment in the United States by boosting output (the U.S. government was
basically using the exchange rate as an instrument of trade policy—something it now accuses
China of doing). However, a number of other countries adopted a similar tactic, and in the cycle of
competitive devaluations that soon emerged, no country could win.
 The net result was the shattering of any remaining confidence in the system. With countries
devaluing their currencies at will, one could no longer be certain how much gold a currency could
buy. Instead of holding onto another country’s currency, people often tried to change it into gold
immediately, lest the country devalue its currency in the intervening period. This put pressure on
the gold reserves of various countries, forcing them to suspend gold convertibility. By the start of
World War II in 1939, the gold standard was dead.

2. The Bretton Wood System

 In 1944, at the height of World War II, representatives from 44 countries met at Bretton Woods, New Hampshire,
to design a new international monetary system. With the collapse of the gold standard and the Great Depression
of the 1930s fresh in their minds, these statesmen were determined to build an enduring economic order that
would facilitate post-war economic growth. There was consensus that fixed exchange rates were desirable. In
addition, the conference participants wanted to avoid the senseless competitive devaluations of the 1930s, and
they recognized that the gold standard would not assure this. The major problem with the gold standard as
previously constituted was that no multinational institution could stop countries from engaging in competitive
 devaluations. The agreement reached at Bretton Woods established two multinational institutions: the
International Monetary Fund (IMF) and the World Bank.
 The task of the IMF would be to maintain order in the international monetary system and that of the World Bank
would be to promote general economic development. The Bretton Woods agreement also called for a system
of fixed exchange rates that would be policed by the IMF. Under the agreement, all countries were to fix the
value of their currency in terms of gold but were not required to exchange their currencies for gold. Only the dollar
remained convertible into gold—at a price of $35 per ounce. Each country decided what it wanted its exchange
rate to be vis-à-vis the dollar and then calculated the gold par value of the currency based on that selected dollar
exchange rate. All participating countries agreed to try to maintain the value of their currencies within 1% of the
par value by buying or selling currencies (or gold) as needed.

3. The Collapse of the Fixed Exchange Rate System

 By the early 1960s, the U.S. dollar's fixed value against gold, under the Bretton Woods system of fixed exchange
rates, was seen as overvalued. A sizable increase in domestic spending on President Lyndon Johnson's Great
Society programs and a rise in military spending caused by the Vietnam War gradually worsened the
overvaluation of the dollar.
 The system dissolved between 1968 and 1973. In August 1971, U.S. President Richard Nixon announced the
"temporary" suspension of the dollar's convertibility into gold. While the dollar had struggled throughout most of
the 1960s within the parity established at Bretton Woods, this crisis marked the breakdown of the system. An
attempt to revive the fixed exchange rates failed, and by March 1973 the major currencies began to float against
each other.
 Since the collapse of the Bretton Woods system, IMF members have been free to choose any form of exchange
arrangement they wish (except pegging their currency to gold): allowing the currency to float freely, pegging it to
another currency or a basket of currencies, adopting the currency of another country, participating in a currency
bloc, or forming part of a monetary union.
 Many feared that the collapse of the Bretton Woods system would bring the period of rapid growth to an end. In
fact, the transition to floating exchange rates was relatively smooth, and it was certainly timely: flexible exchange
rates made it easier for economies to adjust to more expensive oil, when the price suddenly started going up in
October 1973. Floating rates have facilitated adjustments to external shocks ever since.
 The IMF responded to the challenges created by the oil price shocks of the 1970s by adapting its lending
instruments. To help oil importers deal with anticipated current account deficits and inflation in the face of higher
oil prices, it set up the first of two oil facilities.
 The Bretton Woods system had an Achilles’ heel: The system could not work if its key currency, the U.S. dollar,
was under speculative attack. The Bretton Woods system could work only as long as the U.S. inflation rate
remained low and the United States did not run a balance-of-payments deficit. Once these things occurred, the
system soon became strained to the breaking point.

4. The Floating Exchange Rate Regime

 The floating exchange rate regime that followed the collapse of the fixed exchange rate system was formalized in
January 1976 when IMF members met in Jamaica and agreed to the rules for the international monetary system
that are in place today.


IV.1 The Jamaica Agreement

 The Jamaica meeting revised the IMF’s Articles of Agreement to reflect the new reality of floating
exchange rates. The main elements of the Jamaica agreement include the following:
a. Floating rates were declared acceptable. IMF members were permitted to enter the foreign
exchange market to even out “unwarranted” speculative fluctuations.
b. Gold was abandoned as a reserve asset. The IMF returned its gold reserves to members at
the current market price, placing the proceeds in a trust fund to help poor nations. IMF
members were permitted to sell their own gold reserves at the market price.
c. 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 while the
membership of the IMF has been expanded to include 184 countries.) Non-oil-exporting, less
developed countries were given greater access to IMF funds.
  After Jamaica, the IMF continued its role of helping countries cope with macro- economic and exchange
rate problems, albeit within the context of a radically different exchange rate regime.

o For example, if foreign exchange dealers were selling more of a country’s currency than
demanded, that country’s government would intervene in the foreign exchange markets,
buying its currency in an attempt to increase demand and maintain its gold par value.
 Another aspect of the Bretton Woods agreement was a commitment not to use devaluation as a weapon of
competitive trade policy. However, if a currency became too weak to defend, a devaluation of up to 10 % would be
allowed without any formal approval by the IMF. Larger devaluations required IMF approval.

LO4: BE FAMILIAR WITH THE DIFFERENCES BETWEEN A FIXED AND FLOATING EXCHANGE
RATE SYSTEM
Fixed exchange rate and flexible/floating exchange rate are two exchange rate systems, differ in the sense that when the
exchange rate of the country is attached to the another currency or gold prices, is called fixed exchange rate, whereas if it
depends on the supply and demand of money in the market is called flexible exchange rate.
Basis for Comparison Fixed Exchange Rate Flexible Exchange Rate
1. Meaning An exchange rate regime, also known as A monetary system, wherein the
the pegged exchange rate, wherein the exchange rate is set according to the
government and central bank attempts demand and supply forces, is known as
to keep the value of the currency is fixed flexible or floating exchange rate. The
against the value of other currencies, is economic position of the country
called fixed exchange rate. Under this determines the market demand and
system, the flexibility of exchange rate (if supply for its currency.
any) is permitted, under IMF
(International Monetary Fund)
arrangement, but up to a certain extent.
2. Determined by Government or Central Bank Demand and Supply forces
3. Changes in Currency Price Devaluation and Revaluation Depreciation and Appreciation
4. Speculation Takes place when there is rumor about Very Common
change in government policy
5. Self-adjusting Mechanism Operates through variation in supply of Operates to remove external instability
money, domestic interest rate and price. by change in forex rate.
Source: https://keydifferences.com/difference-between-fixed-and-flexible-exchange-rates.html

LO5: THE ROLE OF INTERNATIONAL MONETARY FUND AND THE WORLD BANK IN THE
INTERNATIONAL MONETARY SYSTEM
International Monetary Fund
The IMF Articles of Agreement were heavily influenced by the
worldwide financial collapse, competitive devaluations, trade
wars, and high unemployment, hyperinflation in Germany and
elsewhere, and general economic disintegration that occurred
between the two world wars. The aim of the Bretton Woods
agreement, of which the IMF was the main custodian, was to
try to avoid a repetition of that chaos through a combination of
discipline and flexibility.
a. Discipline
 A fixed exchange rate regime imposes
discipline in two ways. First, the need to
maintain a fixed exchange rate puts a brake on
World Bank
The official name for the World Bank is the International Bank
for Reconstruction and Development (IBRD). When the
Bretton Woods participants established the World Bank, the
need to reconstruct the war-torn economies of Europe was
foremost in their minds. The bank’s initial mission was to help
finance the building of Europe’s economy by providing low-
interest loans. As it turned out, the World Bank was
overshadowed in this role by the Marshall Plan, under which
the United States lent money directly to European nations to
help them rebuild. So the bank turned its attention to
“development” and began lending money to Third World
nations. In the 1950s, the bank concentrated on public-sector
 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. For example, consider what would
happen under a fixed exchange rate regime if
Great Britain rapidly increased its money supply
by printing pounds. As explained in Module 3A,
the increase in money supply would lead to
price inflation. Given fixed exchange rates,
inflation would make British goods
uncompetitive in world markets, while the prices
of imports would become more attractive in
Great Britain. The result would be a widening
trade deficit in Great Britain, with the country
importing more than it exports. To correct this
trade imbalance under a fixed exchange rate
regime, Great Britain would be required to
restrict the rate of growth in its money supply to
bring price inflation back under control. Thus,
fixed exchange rates are seen as a mechanism
for controlling inflation and imposing economic
discipline on countries.
projects. Power stations, road building, and other
transportation investments were much in favour. During the
1960s, the bank also began to lend heavily in support of
agriculture, education, population control, and urban
development.
The bank lends money under two schemes. Under the IBRD
scheme, money is raised through bond sales in the
international capital market. Borrowers pay what the bank
calls a market rate of interest—the bank’s cost of funds plus a
margin for expenses. This “market” rate is lower than
commercial banks’ market rate. Under the IBRD scheme, the
bank offers low-interest loans to risky customers whose credit
rating is often poor, such as the governments of
underdeveloped nations.
A second scheme is overseen by the International
Development Association (IDA), an arm of the bank created
in 1960. Resources to fund IDA loans are raised through
subscriptions from wealthy members such as the United
States, Japan, and Germany. IDA loans go only to the poorest
countries. Borrowers have 50 years to repay at an interest
rate of 1% a year. The world’s poorest nations receive grants
and noninterest loans.

b. Flexibility
 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. It would
probably break down just as the gold standard
had. In some cases, a country’s attempts to
reduce its money supply growth and correct a
persistent balance-of-payments deficit could
force the country into recession and create high
unemployment. The architects of the Bretton
Woods agreement wanted to avoid high
unemployment, so they built limited
flexibilityinto the system. Two major features
of the IMF Articles of Agreement fostered this
flexibility: IMF lending facilities and
adjustable parities.
 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. A pool of
gold and currencies contributed by IMF
members provided the resources for these
lending operations. A persistent balance-of-
payments deficit can lead to a depletion of a
country’s reserves of foreign currency, forcing it
to devalue its currency. By providing deficit-
laden countries with short-term foreign currency
loans, IMF funds would buy time for countries to
bring down their inflation rates and reduce their
balance-of-payments deficits. The belief was
 that such loans would reduce pressures for
devaluation and allow for a more orderly and
less painful adjustment.
 Countries were to be allowed to borrow a
limited amount from the IMF without adhering to
any specific agreements. However, extensive
drawings from IMF funds would require a
country to agree to increasingly stringent IMF
supervision of its macroeconomic policies.
Heavy borrowers from the IMF must agree to
monetary and fiscal conditions set down by the
IMF, which typically include IMF-mandated
targets on domestic money supply growth,
exchange rate policy, tax policy, government
spending, and so on.
 The system of adjustable parities allowed for
the devaluation of a country’s currency by more
than 10 % if the IMF agreed that a country’s
balance of payments was in “fundamental
disequilibrium.” The term fundamental
disequilibrium was not defined in the IMF’s
Articles of Agreement, but it was intended to
apply to countries that had suffered permanent
adverse shifts in the demand for their products.
Without devaluation, such a country would
experience high unemployment and a
persistent trade deficit until the domestic price
level had fallen far enough to restore a balance-
of-payments equilibrium. The belief was that
devaluation could help sidestep a painful
adjustment process in such circumstances.

LO6: BE FAMILIAR WITH THE EUROPIAN MONETARY SYTEM

 The European Monetary System (EMS) was created in response to the collapse of the Bretton Woods Agreement. Formed
in the aftermath of World War II (WWII), the Bretton Woods Agreement established an adjustable fixed foreign exchange
rate to stabilize economies. When it was abandoned in the early 1970s, currencies began to float, prompting members of
the EC to seek out a new exchange rate agreement to complement their customs union.
 The European Monetary System’s (EMS) primary objective was to stabilize inflation and stop large exchange rate
fluctuations between European countries. This formed part of a wider goal to foster economic and political unity in Europe
and pave the way for a future common currency, the euro.
 Currency fluctuations were controlled through an exchange rate mechanism (ERM). The ERM was responsible for pegging
national exchange rates, allowing only slight deviations from the European currency unit (ECU)—a composite artificial
currency based on a basket of 12 EU member currencies, weighted according to each country’s share of EU output. The
ECU served as a reference currency for exchange rate policy and determined exchange rates among the participating
countries’ currencies via officially sanctioned accounting methods.

 History of the European Monetary System (EMS)

 The early years of the European Monetary System (EMS) were marked by uneven currency values and
adjustments that raised the value of stronger currencies and lowered those of weaker ones. After 1986, changes
in national interest rates were specifically used to keep all the currencies stable.
 The early 90s saw a new crisis for the European Monetary System (EMS). Differing economic and political
conditions of member countries, notably the reunification of Germany, led to Britain permanently withdrawing from
the European Monetary System (EMS) in 1992. Britain's withdrawal reflected and foreshadowed its insistence on
independence from continental Europe, later refusing to join the Eurozone along with Sweden and Denmark.
  Meanwhile, efforts to form a common currency and cement greater economic alliances were ramped up. In 1993,
most EC members signed the Maastricht Treaty, establishing the European Union (EU). One year later, the EU
created the European Monetary Institute, which later became the European Central Bank (ECB).
 At the end of 1998, most EU nations unanimously cut their interest rates to promote economic growth and prepare
for the implementation of the euro. In January 1999, a unified currency, the euro, was born and came to be used
by most EU member countries. The European Economic and Monetary Union (EMU) was established, succeeding
the European Monetary System (EMS) as the new name for the common monetary and economic policy of the
EU.

 Criticism of the European Monetary System (EMS)

 Under the European Monetary System (EMS), exchange rates could only be changed if both member countries
and the European Commission were in agreement. This was an unprecedented move that attracted a lot of
criticism.
 With the global economic crisis of 2008-2009 and the ensuing economic aftermath, significant problems in the
foundational European Monetary System (EMS) policy became evident.
 Certain member states; Greece, in particular, but also Ireland, Spain, Portugal, and Cyprus, experienced high
national deficits that went on to become the European sovereign debt crisis. These countries could not resort to
devaluation and were not allowed to spend to offset unemployment rates.
 From the beginning, the European Monetary System (EMS) policy intentionally prohibited bailouts to ailing
economies in the Eurozone. With vocal reluctance from EU members with stronger economies, the EMU finally
established bailout measures to provide relief to struggling peripheral members.

LO7: UNDERSTAND THE DIFFERENCES BETWEEN TRANSALATION, TRANSACTION, AND

ECONOMIC EXPOSURE AND WHAT MANAGERS CAN DO TO MANAGE EACH TYPE OF
EXPOSURE
1) Transaction Exposure
 Transaction exposure is the extent to which the income from individual transactions is affected by fluctuations
in foreign exchange values. Such exposure includes obligations for the purchase or sale of goods and services
at previously agreed prices and the borrowing or lending of funds in foreign currencies.
 For example, suppose in 2001 an American airline agrees to purchase 10 Airbus 330 aircraft for €120 million
each for a total price of €1.20 billion, with delivery scheduled for 2005 and payment due then. When the contract
was signed in 2001 the dollar/euro exchange rate stood at $1=€1.10, so the American airline anticipates
paying $1.09 billion for the 10 aircraft when they are delivered (€1.2billion/1.1=$1.09billion). However, imagine
that the value of the dollar depreciates against the euro over the intervening period, so that one dollar only buys
€0.80 in 2005 when payment is due ($1 = €0.80). Now the total cost in U.S. dollars is $1.5 billion (€1.2 billion/
0.80 = $1.5 billion), an increase of $0.41 billion! The transaction exposure here is $0.41billion, which is the
money lost due to an adverse movement in exchange rates between the time when the deal was signed and
when the aircraft were paid for.

2) Translation Exposure
 Translation exposure is the impact of currency exchange rate changes on the reported financial statements of
a company. Translation exposure is concerned with the present measurement of past events. The resulting
accounting gains or losses are said to be unrealized—they are “paper” gains and losses—but they are still
important. Consider a U.S. firm with a subsidiary in Mexico. If the value of the Mexican peso depreciates
significantly against the dollar this would substantially reduce the dollar value of the Mexican subsidiary’s equity.
In turn, this would reduce the total dollar value of the firm’s equity reported in its consolidated balances heet.This
would raise the apparent leverage of the firm (its debt ratio), which could increase the firm’s cost of borrowing
and potentially limit its access to the capital market. Similarly, if an American firm has a subsidiary in the
European Union, and if the value of the euro depreciates rapidly against that of the dollar over a year, this will
 reduce the dollar value of the euro profit made by the European subsidiary, resulting in negative translation
exposure.

3) Economic Exposure
 Economic exposure is the extent to which a firm’s future international earning power is affected by
changes in exchange rates. Economic exposure is concerned with the long-run effect of changes in
exchange rates on future prices, sales, and costs

Reducing Translation and Transaction Exposure

Firms can minimize their foreign exchange exposure through leading and lagging payables and receivables—that is, paying
suppliers and collecting payment from customers early or late depending on expected exchange rate movements.
 A lead strategy involves attempting to collect foreign currency receivables (payments from customers) early when a
foreign currency is expected to depreciate and paying foreign currency payables (to suppliers) before they are due
when a currency is expected to appreciate.
 A lag strategyinvolves delaying collection of foreign currency receivables if that currency is expected to appreciate
and delaying payables if the currency is expected to depreciate.
Leading and lagging involves accelerating payments from weak-currency to strong-currency countries and delaying inflows from
strong-currency to weak-currency countries. Lead and lag strategies can be difficult to implement, however. The firm must be in
a position to exercise some control over payment terms. Firms do not always have this kind of bargaining power, particularly
when they are dealing with important customers who are in a position to dictate payment terms. Also, because lead and lag
strategies can put pressure on a weak currency, many governments limit leads and lags. For example, some countries set 180
days as a limit for receiving payments for exports or making payments for imports.

Reducing Economic Exposure

Reducing economic exposure requires strategic choices that go beyond the realm of financial management. The key to reducing
economic exposure is to distribute the firm’s productive assets to various locations so the firm’s long-term financial well-being is
not severely affected by adverse changes in exchange rates.

***End of Module***