Chapter 7
International Monetary System
and Foreign Exchange Market
International Monetary System
What Is The International Monetary System?
The international monetary system refers to the
institutional arrangements that countries adopt to
govern exchange rates
Gold Standard
Monetary system from the 1700s to 1939 that linked national
currencies to specific values of gold.
The gold standard refers to a system in which countries peg
currencies to gold and guarantee their convertibility
The gold standard dates back to ancient times when gold coins
were a medium of exchange, unit of account, and store of value.
➢ payment for imports was made in gold or silver
Advantages of Gold Standard:
✓ Reduced exchange-rate risk
✓ Restricted monetary policies
✓ Corrected trade imbalances
Gold Standard Collapse
Many governments financed their World War I expenditures by
printing excessive amounts of money which caused high
inflation.
In an effort to encourage exports and improve trade
balances, many countries engaged in competitive
devaluations.
The Gold Standard ended in 1939.
Bretton Woods System
In 1944, representatives from 44 countries met at Bretton Woods, New
Hampshire, to design a new international monetary system
The goal was to build an enduring economic order that would facilitate
postwar economic growth.
Bretton Woods had four main features:
1) A fixed exchange rate between US dollar and gold was established and
other currencies are tied to the value of dollar.
2) Flexibility - in cases of a trade deficit caused a permanent negative shift
in a nation’s balance of payments, devaluations were permitted.
3) World Bank was established to fund national economic development
efforts.
4) International Monetary Fund was established to regulate exchange rates
and enforce the rules of the international monetary system.
The Collapse of the Fixed System
Bretton Woods worked well until the late 1960s.
The collapse of the Bretton Woods system can be traced to U.S.
macroeconomic policy decisions (1965 to 1968)
It collapsed when huge increases in welfare programs and the Vietnam
War were financed by increasing the money supply and causing
significant inflation
Other countries increased the value of their currencies relative to the U.S.
dollar in response to speculation the dollar would be devalued
However, because the system relied on an economically well managed
U.S., when the U.S. began to print money, run high trade deficits, and
experience high inflation, the system was strained to the breaking point –
the U.S. dollar came under speculative attack.
A persistent trade deficit and high inflation in the United States kept the
dollar weak on currency markets. Around the world, governments had
difficulty maintaining their own exchange rates with a continually weaker
dollar and abandoned the system.
The Bretton Woods Agreement collapsed in 1973
Jamaica Agreement
In 1976, the Jamaica Agreement formalized a managed float system of
exchange rates in which governments were to stabilize their currencies
around target exchange rates.
Ratified the end of the Bretton Wood monetary systems.
Under Jamaica Agreement:
✓ Floating rates were declared acceptable
✓ Gold was abandoned as reserve asset
▪ A floating exchange rate system exists when the foreign exchange rate
market, or supply and demand, determine the relative values of
currencies. This is the type of system used in the U.S., the EU, Japan,
and Great Britain.
▪ Their value are determined by market forces and fluctuate day by day.
▪ Today, the international monetary system remains a managed float
system.
The System Today
A country following a pegged exchange rate system, pegs the
value of its currency to that of another major currency.
➢ popular among the world’s smaller nations
➢ adopting a pegged exchange rate regime can moderate
inflationary pressures in a country.
Countries using a currency board commit to converting their
domestic currency on demand into another currency at a
fixed exchange rate.
Foreign Exchange Market
Foreign exchange market is a market for converting the currency of one
country into that of another country.
Exchange rate is the rate at which one currency is converted into another.
Four main purposes of foreign exchange market:
1. Conversion: use to convert the currency of one country into the
currency of another
2. Hedging: provides some insurance against foreign exchange risk - the
adverse consequences of unpredictable changes in exchange rates
3. Arbitrage: buy the currency at a low price in one market, and sell if for
a high price in another market/ purchase and sale of a currency in
different markets for profit
4. Speculation: short-term movement of funds from one currency to
another in the hopes of profiting from shifts in exchange rates
Insuring Against Foreign Exchange Risk
1. Spot exchange rate is the rate at which a foreign exchange dealer
converts one currency into another currency on a particular day.
Spot rates change continually depending on the supply and demand
for that currency and other currencies
The spot market helps companies to:
• Convert income from sales abroad into the home-country currency.
• Convert funds into the currency of an international supplier.
• And convert funds into the currency of a country in which it will invest.
2. Forward exchange rate occurs when two parties agree to exchange
currency and execute the deal at some specific date in the future.
To insure or hedge against a possible adverse foreign exchange rate
movement, firms engage in forward exchanges.
forward rates for currency exchange are typically quoted for 30, 90, or
180 days into the future
Insuring Against Foreign Exchange Risk
3. Swap exchange rate is the simultaneous purchase and sale
of a given amount of foreign exchange for two different
dates.
A currency swap is used to reduce exchange-rate risk
and lock in a future exchange rate
24-Hour Trading
The foreign exchange market is a global network of banks, brokers, and
foreign exchange dealers connected by electronic communications
systems.
The most important trading centers are London, New York, Tokyo, and
Singapore.
The dollar is commonly used as a vehicle currency to facilitate the
exchange of other currencies. Other popular vehicle currencies - euro,
the Japanese yen, and the British pound
For example: If you have won, but you need yen, you might first
convert your won into dollars and then the dollars into yen.
Currency Value
Exchange rates can increase or decrease world prices
and, therefore, demand of a nation’s exports.
➢Devaluation: lowering the value of a currency, reduces
the price of exports on world markets and increases the
price of imports.
➢Revaluation: raising the value of a currency, increases
the price of exports on world markets and reduces the
price of imports.
How Do Prices
Influence Exchange Rates?
To understand how prices and exchange rates are linked, we need to
understand the law of one price, and the theory of purchasing power
parity.
The law of one price states that an identical product must sell at the
same price in all countries when expressed in a common currency.
Purchasing power parity (PPP) is the relative ability of two countries’
currencies to buy the same “basket” of goods in those two countries.
✓ PPP considers price levels in adjusting the relative values of two
currencies.
✓ Economic forces push a market exchange rate toward that
calculated by PPP or an arbitrage opportunity arises.
Effects of Inflation
A positive relationship exists between the inflation rate and the level of money
supply
➢ When the growth in the money supply is greater than the growth in output,
prices rise and inflation will occur. Inflation then erodes a currency’s purchasing
power.
Inflation key factors:
✓ Money supply
Monetary policy involves buying or selling government securities on the open market
to influence the money supply and, therefore, the rate of inflation.
Fiscal policy involves using taxes and government spending to influence the money
supply indirectly.
✓ Employment - High rates of employment puts upward pressure on wages, high labor
cost contribute to higher prices
✓ Interest rates - Low interest rates encourage consumers and businesses to borrow and
spend money, which adds to inflationary pressures.
✓ Adjustment - Exchange rates adjust to different rates of inflation between countries. If
inflation in Mexico is higher than that in the United States, the peso is losing more value
than is the dollar. The peso/dollar exchange rate will adjust to reflect a now less
valuable peso.
Techniques of Forecasting
Fundamental analysis
▪ Statistical modeling
Technical analysis
▪ Chart currency trends
Forecasting difficulties
✓ Flawed data
✓ Human error
