INTERNATIONAL

FINANCIAL
MANAGEMENT
Fifth Edition
EUN / RESNICK

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

Chapter Two Outline

2-2

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

Questions
Discuss the advantages and disadvantages of the gold
standard.
What were the main objectives of the Bretton Woods
system?
Explain the arrangements and workings of the European
Monetary System (EMS).
In an integrated world financial market, a financial crisis in
a country can be quickly transmitted to other countries,
causing a global crisis. What kind of measures would you
propose to prevent the recurrence of a Asia-type crisis.
Discuss the criteria for a good international monetary
system.

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

2-4

Bimetallism: Before 1875

A double

standard in the sense that both gold

and silver were used as money.

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.

2-5

Greshams Law

Greshams Law implied that it would be the least

valuable metal that would tend to circulate.

Bad (abundant) money drives good (scarce) money

out of circulation.
In 1850s the California and Australia had discovered
gold mines. This increase the gold supplies in
market. And as a result, a gold franc to a silver
franc becomes 15.5 times heavy. As a result, the
franc effectively became a gold currency.

2-6

Classical Gold Standard:

1875-1914
During

this period in most major countries:

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.

The

exchange rate between two countrys

currencies would be determined by their relative
gold contents.

2-7

 For

example, suppose that the pound is

pegged/cover to gold at 6 pound per ounce and
franc is pegged at 12 pound per ounce. The
exchange rate between the pound and franc
should then be 2 franc per pound.
Highly stable exchange rates under the classical
gold standard provided an environment that was
favorable to international trade and investment.

2-8

 Misalignment

of exchange rates and international

imbalances of payment were automatically
corrected by the price-specie-flow mechanism.
E.g. If 1 pound is equal to 2 franc. One can buy
83.33 ounce of gold in own country. If this ratio
is violated, for e.g 1 pound=1.8 franc. Then
pound become overvalued and franc become
undervalued. One can buy 555.55 pound from
1,000 franc and buy 92.59 ounce gold. Sell back
gold to franc and earn profit of 111.12 franc
(92.59*12=1111.12). The exchnage rate will be 1
pound = 2 franc.

Classical Gold Standard:

1875-1914

The

Gold standard worked up to world war 1. The

advantages of gold standard were
Gold is a natural product and it will going to be in
shortage. No one can increase supply of gold. So, if
gold serves as the sole base, then supply of currency
will never be get out of control and cause inflation.
And if gold is used as the sole international means of
payment, then countries balance of payments will be
regulated automatically via the movement of gold.
2-10

 There

2-11

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

After world war I, Germany, Austria, Hungary, Poland
and Russia suffered hyperinflation. The WPI of
Germany reached 1 trillion times than the prewar WPI.
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. The
US had lifted the ban on gold export in 1919. In 1925
Great Britain was succeed in establishing gold
standard.

Interwar Period: 1915-1944

Gold standard failed due to lacked the political will to
follow the rules of the game.
Countries were failed to match the inflows and out flows
of gold respectively with reduction and increases in
domestic money and credit. The result for international
trade and investment was profoundly detrimental.
The great depression of 1929 hearted the stock market
and the countries like Austria, Germany and US. Britain
faced massive outflow of gold. In 1931, British govt
suspended gold payments and let the pound float. Same
was followed by US and other nation. Paper Standards
came into existance.

2-13

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 and the
World Bank.

2-14

Bretton Woods System:

1945-1972
Under

the Bretton Woods system, the U.S. dollar

was pegged to gold at $35 per ounce and other
currencies were pegged to the U.S. dollar.
Each country was responsible for maintaining its
exchange rate within 1% of the adopted par value
by buying or selling foreign reserves as necessary.
The Bretton Woods system was a dollar-based gold
exchange standard.

2-15

Bretton Woods System:

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
2-16

The US need to run balance of payments deficit to supply

reserves, but US was failed to maintain the same and the
countries were started to distrusting dollar this was
known as the Triffin Para-dox.
The IMF create new reserve asset, Special Drawing
Rights-SDR. Under SDR, a basket currency comprising
major country. The percentage share of each currency in
the SDR was about the same as the countrys share in
world export.
In 1963, US imposed the Interest Equalization Tax on US
purchase of foreign securities in order to stem the outflow
of dollars. In 1965, US introduced Foreign Credit
Restraint Program. These regulations let a strong impetus
to rapid growth of EU.

By 1971, it appeared that some currency values would need to

be adjusted to restore a more balanced flow of payments
between countries. In December 1971, a conference of
representatives from various countries concluded with the
Smithsonian Agreement, which called for a devaluation of
the U.S. dollar by about 8 percent against other currencies. In
addition, boundaries for the currency values were expanded to
within 2.25 percent above or below the rates initially set by the
agreement.
In little more than a year, again dollar came under heavy selling
pressure and central bank need to buy dollar. The gold price
was raised from $38 to $42 per ounce. By March 1973,
European and Japanese currencies were allowed to float. And
Dollar Gold base was removed.

The Flexible Exchange Rate Regime: 1973Present.

In

1976 IMF members met and did Jamaica

Agreement.
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 nations were give greater access to
IMF funds.
2-19

Collapse of Bretton woods

Jamica Agreement
Reagan Era due to high interest rates, US was successful in
attracting higher foreing capital inflow, which raise the
demand of dollar. US rate was at highest in 1985 and trade
deficiet was about $160 billion.
Plaza Accord In 1985 5 countries(France, Japan, Germany,
UK and US) met in hotel Plaza, New York. To control the
downward of dollar. They decide to depreciate the dollar.

Lourve Accord - Dollar continued to decline and create

major concerned among the member nations. To control the
volatility G-7 summit was held in Paris.

Current Exchange Rate Arrangements

Free Float

Managed Float

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

No national currency

2-21

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.

This is a list of the 10 countries and territories with the largest deficit
in current account balance (CAB), 2015 as CIA World Factbook.

Rank
1
2
3
4
5
6
7
8
9
10

Country
United States
United Kingdom
Brazil
Australia
Canada
Saudi Arabia
Mexico
Turkey
Algeria
India

CAB (billion
US dollars)
484,100
123,500
58,910
56,200
51,380
41,480
32,380
32,190
27,040
26,220

Year
2015
2015
2015
2015
2015
2015
2015
2015
2015
2015

Countries having Highest Inflation

South Sudan

Last - 2016
661.30
Jul/16

Venezuela
Suriname
North Korea

180.90
63.80
55.00

Dec/15
Jun/16
Jul/13

48.09
40.50
38.04

Dec/15
Apr/16
Feb/16

35.30
27.40
23.50
20.68

Jul/16
Jun/16
Jul/16
Jul/16

Syria
Argentina
Central African Republic
Angola
Libya
Malawi
Mozambique

European Monetary System

European

countries maintain exchange rates among

their currencies within narrow bands, and jointly
float against outside currencies. Snake
Objectives:

2-26

To establish a zone of monetary stability in Europe.

To coordinate exchange rate policies vis--vis nonEuropean currencies.
To pave the way for the European Monetary Union.

Creation of the European Monetary System (EMS). Due to

continued problems with the snake arrangement, the European
Monetary System (EMS) was pushed into operation in March
1979. The EMS concept was similar to the snake, but the specific
characteristics differed. Under the EMS, exchange rates of
member countries were held together within specified limits and
were also tied to the European Currency Unit (ECU), which was
a unit of account. Its value was a weighted average of exchange
rates of the member countries; each weight was determined by a
members relative gross national product and activity in intraEuropean trade.
The currencies of these member countries were allowed to
fluctuate by no more than 2.25 percent (6 percent for some
currencies) from the initially established values. The method of
linking European currency values with the ECU was known as
the exchange rate mechanism (ERM).

Demise of the European Monetary System. In the fall of 1992,

the German government was mostly concerned about inflation
because its economy was relatively strong. It increased local
interest rates to prevent excessive spending and inflation. Other
European governments, however, were more concerned about
stimulating their economies to lower their high unemployment
levels, so they wanted to reduce interest rates.
In October 1992, the British and Italian governments suspended
their participation in the ERM because their interest rates were so
highly influenced by German interest rates.
In 1993, the ERM boundaries were widened substantially, allowing
more fluctuation in exchange rates between European currencies.
The demise of the exchange rate mechanism caused European
countries to realize that a pegged system would work in Europe
only if it was set permanently. This provided momentum for the
single European currency (the EURO), which began in 1999

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.
These original member states were: Belgium,
Germany, Spain, France, Ireland, Italy,
Luxemburg, Finland, Austria, Portugal and the
Netherlands.

2-29

Membership: The agreement to adopt the euro was a major historical

event. Countries that had previously been at war with each other at
various times in the past were now willing to work together toward a
common cause.
Together, the participating countries comprise almost 20 percent of the
worlds gross domestic product, a proportion similar to that of the United
States.
Three countries that were members of the EU in 1999 (the United
Kingdom, Denmark, and Sweden) decided not to adopt the euro at that
time. The 10 countries in Eastern Europe (including the Czech Republic
and Hungary) that joined the EU in 2004 are eligible to participate in the
euro if they meet specific economic goals. Slovenia adopted the euro in
2007.
Countries that participate in the EU are supposed to abide by the
Stability and Growth pact before they adopt the euro. This pact requires
that the countrys budget deficit be less than 3 percent of its gross
domestic product.

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.
The implementation of a common monetary policy may
promote more political unity among European countries
with similar national defence and foreign policies.
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.

2-31

The euro enables residents of participating countries to

engage in cross-border trade flows without converting to a
different currency.
The elimination of currency movements among European
countries also encourages more long-term business
arrangements between firms of different countries, as they
no longer have to worry about adverse effects due to
currency movements.
Prices of products are now more comparable among
European countries.
When firms consider acquiring targets in Europe, they can
more easily compare the prices (market values) of targets
among countries because their values are denominated in
the same currency (the euro).

A single European currency forces the interest rate

offered on government securities to be similar across the
participating European countries.
Stock/Bond prices are now more comparable among the
European countries because they are denominated in the
same currency. Thus, there is more cross-border investing
than there was in the past.
One major advantage of a single European currency is the
complete elimination of exchange rate risk between the
participating European countries, which could encourage
more trade and capital flows across European borders. In
addition, foreign exchange transaction costs associated
with transactions between European countries have been
eliminated.

Costs of Monetary Union

The

main cost of monetary union is the loss of

national monetary and exchange rate policy
independence.

2-34

The more trade-dependent and less diversified a

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

Costs of Monetary Union

As

an example, if the economy of Oklahoma was

dependent on gas and oil, and oil prices fall on the
world market, then Oklahoma might be better off
if it had its own currency rather than relying on
the U.S. dollar.
This example shows that perhaps the benefits of
monetary union typically outweigh the costs.

2-35

The Mexican Peso Crisis

The

Mexican central bank enforced the link through

frequent intervention. In fact, it partially supported its
intervention by issuing shortterm debt securities
denominated in dollars and using the dollars to
purchase pesos in the foreign exchange market.
Limiting the depreciation of the peso was intended to
reduce inflationary pressure that can be caused by a
very weak home currency. Mexico experienced a
large balance-of-trade deficit in 1994

2-36

Many speculators based in Mexico recognized that the peso

was being maintained at an artificially high level, and they
speculated on its potential decline by investing their funds in
the United States. They planned to liquidate their U.S.
investments if and when the pesos value weakened so that
they could convert the dollars from their U.S. investments
into pesos at a favorable exchange rate.
By December 1994, there was substantial downward
pressure on the peso. On December 20, 1994, Mexicos
central bank devalued the peso by about 13 percent.
Mexicos stock prices plummeted. On December 22, the
central bank allowed the peso to float freely, and it declined
by 15 percent.

 As

Mexicos short-term debt obligations

denominated in dollars matured, the Mexican
central bank used its weak pesos to obtain dollars
and repay the debt. Since the peso had weakened,
the effective cost of financing with dollars was
very expensive for the central bank.
In the 4 months after December 20, 1994, the value
of the peso declined by more than 50 percent.
The Mexican Peso crisis is unique in that it
represents the first serious international financial
crisis touched off by cross-border flight of
portfolio capital

The Mexican Peso Crisis

Two

2-39

lessons emerge:

It is essential to have a multinational safety net in

place to safeguard the world financial system from
such crises.
An influx of foreign capital can lead to an
overvaluation in the first place.

The Asian Currency Crisis

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.

2-40

The Argentinean Peso Crisis

In

1991 the Argentine government passed a

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

Argentinas chronic inflation was curtailed

Foreign investment poured in

As

the U.S. dollar appreciated on the world market

the Argentine peso became stronger as well.

2-41

The Argentinean Peso Crisis

The

strong peso hurt exports from Argentina and

caused a protracted economic downturn that led to
the abandonment of pesodollar parity in January
2002.

2-42

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:

2-43

Lack of fiscal discipline

Labor market inflexibility
Contagion from the financial crises in Brazil and Russia

Currency Crisis Explanations

2-44

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

Fixed versus Flexible

Exchange Rate Regimes
Arguments

Easier external adjustments.

National policy autonomy.

Arguments

2-45

in favor of flexible exchange rates:

against flexible exchange rates:

Exchange rate uncertainty may hamper international

trade.
No safeguards to prevent crises.

Fixed versus Flexible

Exchange Rate Regimes
Suppose

the exchange rate is $1.40/ today.

In the next slide, we see that demand for euro far
exceeds supply at this exchange rate.
The U.S. experiences trade deficits.

2-46

Fixed versus Flexible

Exchange Rate Regimes
Dollar price per
(exchange rate)

Supply
(S)

Demand
(D)

$1.40

Trade deficit
QS
2-47

QD

Q of

Flexible
Exchange Rate Regimes
Under

a flexible exchange rate regime, the dollar

will simply depreciate to $1.60/, the price at
which supply equals demand and the trade deficit
disappears.

2-48

Fixed versus Flexible

Exchange Rate Regimes
Dollar price per
(exchange rate)

Supply
(S)

$1.60
$1.40

Demand
(D)

Dollar depreciates
(flexible regime)

Demand (D*)
QD = Q S
2-49

Q of

Fixed versus Flexible

Exchange Rate Regimes
Instead,

suppose the exchange rate is fixed at

$1.40/, and thus the imbalance between supply
and demand cannot be eliminated by a price
change.
The government would have to shift the demand
curve from D to D*

2-50

In this example this corresponds to contractionary

monetary and fiscal policies.

Dollar price per

(exchange rate)

Fixed versus Flexible

Exchange Rate Regimes
Supply
(S)

Contractionary
policies

(fixed regime)

Demand
(D)

$1.40

Demand (D*)
QD* = QS
2-51

Q of

Advantages of Fixed rate

It

ensures stability in exchange rate which

encourages foreign trade,
It contributes to the coordination of macro policies of
countries in an interdependent world economy.
Fixed exchange rate ensures that major economic
disturbances in the member countries do not occur.
It prevents capital outflow.
Fixed exchange rates are more conducive to
expansion of world trade because it prevents risk and
uncertainty in transactions.
It prevents speculation in foreign exchange market.

Disadvantages of Fixed Rate

Fear

of devaluation. In a situation of excess

demand, central bank uses its reserves to maintain
foreign exchange rate. But when reserves are
exhausted and excess demand still persists,
government is compelled to devalue domestic
currency. This is the main flaw or demerit of fixed
exchange rate system.
Benefits of free markets are deprived.
There is always possibility of under-valuation or
over-valuation.

Advantages of Floating rate

Deficit

or surplus in BOP is automatically corrected.

There is no need for government to hold any foreign
exchange reserve.
It helps in optimum resource allocation.
It frees the government from problem of BOP

Disadvantages of Floating rate

It

encourages speculation leading to fluctuations

in foreign exchange rate.
Wide fluctuation in exchange rate hampers
foreign trade and capital movement between
countries.
It generates inflationary pressure when prices of
imports go up due to depreciation of currency.