International Monetary System Exchange Rate Determination

Environment of International
Financial Management: Part
II

Shahadat Hossain, Ph.D.

Course: Multinational Corporate Finance (FIN 641)
Department of Finance
University of Chittagong

February 2024
International Monetary System Exchange Rate Determination

Outline

1 International Monetary System

2 Exchange Rate Determination

International Monetary System Exchange Rate Determination

Why do we study the International

Monetary System?

The purpose of this chapter is to help students

understand what the international monetary system is
and how the choice of system affects currency values.

It also provides a historical background of the

international monetary system. This enables students to
gain perspective when trying to interpret the likely
consequences of new policies in the area of international
finance.
International Monetary System Exchange Rate Determination

International Monetary System

The international monetary system refers primarily to the set of policies,

institutions, practices, regulations, and mechanisms that determine the rate at
which one currency is exchanged for another.

Five market mechanisms for establishing exchange rates: free float, managed
float, target-zone arrangement, fixed-rate system, and the current hybrid sys-
tem.

each of these mechanisms has costs and benefits associated with it and none
has worked flawlessly in all circumstances

The Trilemma or ”impossible trinity” and Exchange Rate Regime Choice:

a stable exchange rate
an independent monetary policy
capital market integration
International Monetary System Exchange Rate Determination

Trilemma or ”impossible trinity”

If a country (such as Panama or Hong Kong) values exchange rate stability

and capital market integration, it must give up monetary independence.
Instead, it must have the same monetary policy as the country it pegs to,
which is the United States.
Countries (such as China) that favor monetary independence and exchange
rate stability must impose capital controls.
International Monetary System Exchange Rate Determination

Alternative Exchange Regime: Free Float

Free Float free-market exchange rates are determined by the interaction of

currency supplies and demands. The supply-and-demand schedules, in turn, are
influenced by price level changes, interest differentials, and economic growth

a system of freely floating exchange rates is usually referred to as a clean float.

A negative shock to the economy usually results in a fall in the exchange rate,
which cushions the adjustment to the shock by stimulating exports and con-
tracting imports.

A freely floating exchange also helps lessen the impact on the economy of real
shocks by allowing the central bank to pursue an independent monetary policy.

On the downside, the exchange rate volatility a free float gives rise to increases
risk and often substantially affects multinationals’ profits and production sourc-
ing decisions.
International Monetary System Exchange Rate Determination

Exchange Rate Adjustment: Free Float

International Monetary System Exchange Rate Determination

AER: Managed Float

The Managed float, also known as a dirty float, is an exchange rate regime
where a country’s currency price is generally allowed to float freely according
to changes in the foreign exchange market. However, the country’s central
bank will intervene, buying or selling currencies, to moderate the exchange
rate’s movements and prevent excessive volatility or achieve specific economic
objectives.
This regime is a middle ground between a fully fixed exchange rate and a
completely floating exchange rate system.
Managed floats fall into three distinct categories of central bank intervention.

Smoothing out daily fluctuations

Leaning against the wind
Unofficial pegging

Under a target-zone arrangement, countries adjust their national economic poli-

cies to maintain their exchange rates within a specific margin around agreed-
upon, fixed central exchange rates. This system existed for the major European
currencies participating in the European Monetary System (or EMS, discussed
later in this chapter) and was the precursor to the euro.

A fixed exchange rate system, also known as a pegged exchange rate system, is
where a country’s currency value is tied to the value of another single currency,
International Monetary System Exchange Rate Determination

Target zone and Fixed Rate

Under a target-zone arrangement, countries adjust their national economic poli-

cies to maintain their exchange rates within a specific margin around agreed-
upon, fixed central exchange rates. This system existed for the major European
currencies participating in the European Monetary System (or EMS, discussed
later in this chapter) and was the precursor to the euro.

A fixed exchange rate system, also known as a pegged exchange rate system, is
where a country’s currency value is tied to the value of another single currency,
a basket of other currencies, or another measure of value, such as gold.
In a fixed rate system, the country’s central bank commits to maintain its
currency’s value within a very narrow margin to the pegged currency or value
by standing ready to buy or sell its own currency in exchange for the foreign
currency or asset to which it is pegged.
International Monetary System Exchange Rate Determination

Equilibrium Exchange Rate

An exchange rate is the price of one nation’s currency in terms of another

currency, often termed the reference currency. For example, the yen/dollar
exchange rate is just the number of yen that one dollar will buy. If a dollar will
buy 100 yen, the exchange rate would be expressed as ¥100/$, and the yen
would be the reference currency.

Direct Exchange Rate is the number of units of the domestic currency required
to purchase one unit of foreign currency.
For example, if you’re in the United States and the direct exchange rate for
euros is 1.2 USD/EUR, it means you need 1.2 US dollars to buy one euro.
Direct exchange rates are commonly used in Europe.

Indirect Exchange Rate is the number of units of foreign currency that can be
obtained with one unit of domestic currency.
Using the same example as above, if the indirect exchange rate for euros is
0.8333 EUR/USD, it means you can obtain 0.8333 euros with one US dollar.
Indirect exchange rates are commonly used in the United States.

Mathematically, these two rates are reciprocal of each other: Direct exchange
rate (e.g., USD/EUR) * Indirect exchange rate (e.g., EUR/USD) = 1
International Monetary System Exchange Rate Determination

Spot and Forward rates

A spot rate is the price at which currencies are traded for immediate delivery;
actual delivery takes place one/two days later. A forward rate is the price at
which foreign exchange is quoted for delivery at a specified future date.

The foreign exchange market, where currencies are traded, is not a physical
place; rather, it is an electronically linked network of banks, foreign exchange
brokers, and dealers whose function is to bring together buyers and sellers of
foreign exchange.

Spot Currency Market In the spot market, currencies are traded for immediate
delivery, usually settled within two business days (T+2).

Forward Currency Market contracts are traded to buy or sell currencies at a

predetermined exchange rate at a future date, typically beyond the spot settle-
ment date. Forward contracts can be customized to suit specific needs, such
as the amount of currency, exchange rate, and maturity date.

Future contracts Unlike forward contracts, futures contracts are standardized

agreements to buy or sell currencies at a specified price on a predetermined
future date. Futures contracts are traded on organized exchanges, such as the
Chicago Mercantile Exchange (CME).
The futures market is regulated and operates under the supervision of regulatory
authorities.
International Monetary System
Equilibrium Exchange Rate: e.g. U.S. and EU
Exchange rates are market clearing
prices that equilibrate supplies and
demands in the foreign exchange
market.
The demand for the euro in the
foreign exchange market (which in
this two-currency model is equiva-
lent to the supply of dollars) derives
from the American demand for Eu-
rozone goods and services and euro-
denominated financial assets.
Exchange Rate Determination
An increase in the euro’s dollar value is
equivalent to an increase in the dollar price
of Eurozone products. This higher dollar
price normally will reduce the U.S. demand
for Eurozone goods, services, and assets.
(conversely)
The supply of euros (which for the model is
equivalent to the demand for dollars) is
based on Eurozone demand for U.S. goods
and services and dollar-denominated
financial assets.
As the dollar value of the euro increases,
thereby lowering the euro cost of U.S.
goods, the increased Eurozone demand for
U.S. goods will cause an increase in the
Eurozone demand for dollars and, hence, an
increase in the amount of euros supplied
International Monetary System Exchange Rate Determination

Determinants of Exchange Rate: Inflation effect

As the supply and demand schedules for a currency change over time, the
equilibrium exchange rate will also change. Some of the factors that influence
currency supply and demand are inflation rates, interest rates, economic
growth, and political and economic risks.

Inflation rates: a higher rate of inflation in the United States than in the
Eurozone will simultaneously increase Eurozone exports to the United States
and reduce U.S. exports to the Eurozone.
Suppose that the supply of dollars increases relative to its demand. This excess
growth in the money supply will cause inflation in the United States, which
means that U.S. prices will begin to rise relative to prices of goods and services
in the Eurozone.
Eurozone consumers are likely to buy fewer U.S. products and begin switching
to Eurozone substitutes, leading to a decrease in the amount of euros supplied
at every exchange rate.
Similarly, higher prices in the United States will lead American consumers to
substitute Eurozone imports for U.S. products, resulting in an increase in the
demand for euros
see the shifts in demand and supply curves due to a higher rate of inflation in
the United States than in the Eurozone in the next slide
International Monetary System Exchange Rate Determination

Exchange rate: inflation effect

International Monetary System Exchange Rate Determination

Calculating Exchange Rate Change

International Monetary System Exchange Rate Determination

Calculating Exchange Rate Change: Exercises

International Monetary System Exchange Rate Determination

Exchange Rate: Interest rate, growth rate and economic & political

risk factors

A rise in U.S. (real) interest rates relative to Eurozone rates, all else being equal,
will cause investors in both nations to switch from euro- to dollar-denominated
securities to take advantage of the higher dollar rates.
The net result will be depreciation of the euro in the absence of government
intervention

other things being equal, a nation with strong economic growth will attract
investment capital seeking to acquire domestic assets. The demand for domestic
assets, in turn, results in an increased demand for the domestic currency and a
stronger currency.

Investors prefer to hold lesser amounts of riskier assets; thus, low risk currencies—
those associated with more politically and economically stable nations—are
more highly valued than high-risk currencies.
International Monetary System Exchange Rate Determination

Pros and Cons of a strong vs weak currency

International Monetary System Exchange Rate Determination

References & Warnings!

Never use these slides as a substitute of text books.
These slides should help to keep you on track, as a
guiding assistance of reading text books that has come
to you along with these slides.
Please use the relevant sections of the following text
books in reading the slides.
References:
Alan C. Shapiro : Multinational Financial Management,
Tenth Edition, Wiley