Principles of Macroeconomics
Lecture 12
INTERNATIONAL FINANCIAL SYSTEM AND
EXCHANGE RATES
Introduction

Fundamental difference between payment
transactions




Domestic transaction—use only one currency
Foreign transaction—use two or more currencies
Foreign exchange— money denominated in the
currency of another group of nations
Exchange rate—price of a currency


Number of units of one currency that buys one unit of another
currency
Exchange rate can change daily
International financial market consists of:
 International
Capital Market
 Obtaining
external financing.
 Main purpose is to provide a mechanism through which
those who wish to borrow or invest money can do so
efficiently.
 Foreign-Exchange


Market—made up of:
over-the-counter (OTC)
 commercial and investment banks
 majority of foreign-exchange activity
security exchanges
 trade certain types of foreign-exchange instruments
Essential Terms




Security - a contract that can be assigned a value and traded
(stocks, bonds, derivatives and other financial assets)
Stocks – An instrument representing ownership
Bonds - a debt agreement
Derivatives - the rights to ownership (financial instruments;
futures, forwards, options, swaps)
Essential Terms II


Stock exchange, share market or bourse - is a corporation or
mutual organization which provides facilities for stock brokers
and traders, to trade company stocks and other securities
Over-the-counter (OTC) trading - is to trade financial
instruments such as stocks, bonds, commodities or derivatives
directly between two parties. It is contrasted with exchange
trading, which occurs via corporate-owned facilities constructed
for the purpose of trading (i.e., exchanges), such as futures
exchanges or stock exchanges.
Capital Market
• System that allocates financial resources according
to their most efficient uses
• Common capital market intermediaries:
•Commercial Banks
•Investment Banks
Debt: Repay principal plus interest

Bond has timed principal & interest payments
Equity: Part ownership of a company

Stock shares in financial gains or losses
International Capital Market (ICM)
Network of people, firms, financial institutions and
governments borrowing and investing internationally
Purposes
Borrowers
 Expands money supply
 Reduces cost of money
Lenders


Spread / reduce risk
Offset gains / losses
International Capital Market Drivers
Information technology
Deregulation
Financial instruments
(securitization)
World Financial Centers


At present, the three main financial centers are London,
New York and Tokyo
London is one of the three leading world financial centres.
It is famous for its banks and Europe's largest stock
exchange, that have been established over hundreds of
years (e.g. Lloyd's of London, London Stock Exchange). The
financial market of London is also commonly referred to as
the City. It has historically been situated around the part of
London called Square Mile, but in the 1980's and 1990's a
large part of the City of London's wholesale financial
services relocated to Canary Wharf.
Offshore Financial Centers
Operational center
Extensive financial activity
and currency trading
Country or territory
whose financial sector
features few regulations
and few, if any, taxes
Booking center
Mostly for bookkeeping
and tax purposes
IMF defines OFC as:



Jurisdictions that have relatively large numbers of
financial institutions engaged primarily in business
with non-residents;
Financial systems with external assets and liabilities
out of proportion to domestic financial
intermediation designed to finance domestic
economies; and
More popularly, centers which provide some or all
of the following services: low or zero taxation;
moderate or light financial regulation; banking
secrecy and anonymity.
Main Components of ICM:
International Bond Market
Market of bonds sold by issuing companies,
governments and others outside their own countries
Eurobond
Foreign bond
Interest rates
Bond that is
issued outside the
country in whose
currency the bond
is denominated
Bond sold outside a
borrower’s country
and denominated in
the currency of the
country in which it
is sold
Driving growth are
differential interest
rates between
developed and
developing nations
International Equity Market
Market of stocks bought and sold
outside the issuer’s home country
Factors contributing towards growth:
•Spread of Privatization
•Economic Growth in Developing Countries
•Activities of Investment Banks
•Advent of Cybermarkets
Eurocurrency Market
Unregulated market of
currencies banked outside
their countries of origin




Governments
Commercial banks
International companies
Wealthy individuals
Foreign Exchange Market



Foreign exchange market: a market for
converting the currency of one country into the
currency of another.
Exchange rate: the rate at which one currency is
converted into another
Foreign exchange risk: the risk that arises from
changes in exchange rates
Foreign Exchange Market
Market in which currencies are bought and sold
and their prices are determined

Conversion: To facilitate sale or purchase, or invest directly
abroad

Hedging: Insure against potential losses from adverse
exchange-rate changes

Arbitrage: Instantaneous purchase and sale of a currency in
different markets for profit

Speculation: Sequential purchase and sale (or vice-versa) of a
currency for profit
The Functions of the
Foreign Exchange Market

The foreign exchange market serves two main
functions:
 Convert the currency of one country into the
currency of another
 Provide some insurance against foreign
exchange risk
 Foreign
exchange risk: the adverse
consequences of unpredictable changes in
the exchange rates
Currency Conversion


Consumers can compare the relative prices of
goods and services in different countries using
exchange rates
International business have four main uses of
foreign exchange markets
•To exchange currency received in
the course of doing business
abroad back into the currency of its
home country
•To pay a foreign company for its
products or services in its country’s
currency
•
•
To invest excess cash for short
terms in foreign markets
To profit from the short-term
movement of funds from one
currency to another in the
hopes of profiting from shifts
in exchange rates, also called
currency speculation
Insuring against Foreign
Exchange Risk


A spot exchange occurs
when two parties agree to
exchange currency and
execute the deal
immediately
The spot exchange rate is
the rate at which a foreign
exchange dealer converts
one currency into another
currency on a particular
day
Reported daily
 Change continually

Insuring against Foreign
Exchange Risk


Forward exchanges occur when two parties agree to exchange
currency and execute the deal at some specific date in the
future
 Exchange rates governing such future transactions are
referred to as forward exchange rates
 For most major currencies, forward exchange rates
are quoted for 30 days, 90 days, and 180 days into the
future
When a firm enters into a forward exchange contract, it is
taking out insurance against the possibility that future exchange
rate movements will make a transaction unprofitable by the
time that transaction has been executed
Insuring against Foreign
Exchange Risk


Currency swap: the simultaneous purchase and
sale of a given amount of foreign exchange for
two different value dates
Swaps are transacted between international
businesses and their banks, between banks, and
between governments when it is desirable to move
out of one currency into another for a limited
period without incurring foreign exchange risk
The Nature of the Foreign
Exchange Market




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 include: London, New York,
Tokyo, and Singapore
London’s dominance is explained by:
 History (capital of the first major industrialized nation)
 Geography (between Tokyo/Singapore and New York)
Two major features of the foreign exchange market:
 The market never sleeps
 Market is highly integrated
Institutions of
Foreign Exchange Market

Interbank Market: market in which the world’s largest
banks exchange currencies at spot and forward rates.



“Clearing mechanism”
Securities Exchanges: exchange specializing in
currency futures and options transactions.
Over-the-Counter Market: Exchange consisting of a
global computer network of foreign exchange traders
and other market participants.
Trends in Foreign-Exchange Trading
9-7
Quoting Currencies
Quoted currency = numerator
Base currency = denominator
(¥/$) = Japanese yen needed to buy one U.S. dollar
Yen is quoted currency, dollar is base currency
Currency Values
Change in US dollar against
Polish zloty
February 1: PLZ 5/$
March 1: PLZ 4/$
Change in Polish zloty against
US dollar
Make zloty base currency (1÷ PLZ/$)
February 1: $.20/PLZ
March 1: $.25/PLZ
%change = [(4-5)/5] x 100 = -20%
%change = [(.25-.20)/.20] x 100 = 25%
US dollar fell 20%
Polish zloty rose 25%
Cross Rate
• Exchange rate calculated using two other exchange rates
• Use direct or indirect exchange rates against a third currency
Dollar
Euro
Pound
SFranc
Peso
Yen
CdnDlr
Canada
1.3931
1.6466
2.4561
1.0695
0.1198
0.0122
....
Japan
114.50
135.32
201.85
87.898
9.8420
....
82.185
Mexico
11.633
13.749
20.510
8.9309
....
0.1016
8.3504
Switzerland
1.3026
1.5395
2.2965
....
0.1120
0.0114
0.9350
United Kingdom
0.5672
0.6704
....
0.4355
0.0488
0.0050
0.4071
Euro
0.8461
....
1.4917
0.6495
0.0727
0.0074
0.6073
....
1.1819
1.7630
0.7677
0.0860
0.0087
0.7178
United States
Cross Rate Example
Direct quote method
1)
2)
3)
4)
Quote on euro = € 0.8461/$
Quote on yen = ¥ 114.50/$
€ 0.8461/$ ÷ ¥ 114.50/$ = € 0.0074/¥
Costs 0.0074 euros to buy 1 yen
Indirect quote method
1)
2)
3)
4)
5)
Quote on euro = $ 1.1819/€
Quote on yen = $ 0.008734/¥
$ 1.1819/€ ÷ $ 0.008734/¥ = € 135.32/¥
Final step: 1 ÷ € 135.32/¥ = € 0.0074/¥
Costs 0.0074 euros to buy 1 yen
Currency Convertibility

Governments can place restrictions on the
convertibility of currency
A country’s currency is said to be freely
convertible when the country’s government allows
both residents and nonresidents to purchase
unlimited amounts of a foreign currency with it
 A currency is said to be externally convertible
when only nonresidents may convert it into a
foreign currency without any limitations
 A currency is nonconvertible when neither
residents nor nonresidents are allowed to convert it
into a foreign currency

Currency Convertibility

Government restrictions can include
A restriction on residents’ ability to convert the
domestic currency into a foreign currency
 Restricting domestic businesses’ ability to take
foreign currency out of the country


Governments will limit or restrict convertibility for a
number of reasons that include:
Preserving foreign exchange reserves
 A fear that free convertibility will lead to a run on
their foreign exchange reserves – known as capital
flight

Commercial and Investment Banks
Greatest volume of foreign-exchange activity takes place
with the big banks
• Top banks in the interbank market in foreign exchange are
so ranked because of their ability to:
– trade in specific market locations
– engage in major currencies and cross-trades
– deal in specific currencies
– handle derivatives
» forwards, options, future swaps
– conduct key market research
• Banks may specialize in geographic areas, instruments, or
currencies
– exotic currency—currency of a developing country
» often unstable, weak, and unpredictable
Top 10 Currency Traders
(% of overall volume, May 2005 )
Rank
1
Name
Deutsche Bank
% of volume
17.0
2
3
4
UBS
Citigroup
HSBC
12.5
7.5
6.4
5
6
7
8
Barclays
Merrill Lynch
J.P. Morgan Chase
Goldman Sachs
5.9
5.7
5.3
4.4
9
10
ABN AMRO
Morgan Stanley
4.2
3.9
International Monetary System



Rules and procedures by which different national
currencies are exchanged for each other in world
trade.
Such a system is necessary to define a common
standard of value for the world's currencies.
Refer to the institutional arrangements that
countries adopt to govern exchange rates
Floating
 Pegged exchange rate
 Dirty float
 Fixed exchange rate

International Monetary System



Floating exchange rates occur when the
foreign exchange market determines the
relative value of a currency
The world’s four major currencies – dollar,
euro, yen, and pound – are all free to float
against each other
Pegged exchange rates occur when the value
of a currency is fixed relative to a reference
currency
International Monetary System



Dirty float occurs when countries hold the value
of their currency within a range of a reference
currency
Fixed exchange rate occurs when a set of
currencies are fixed against each other at some
mutually agreed upon exchange rate
Pegged exchange rates, dirty floats and fixed
exchange rates all require some degree of
government intervention
Evolution of International Monetary System
The Gold Standard
- In place from 1700s to 1939
- a monetary standard that pegs currencies to gold
and guarantees convertibility to gold
- It was thought that gold standard contained an
automatic mechanism that contributed to the
simultaneous achievement of a balance-ofpayments equilibrium by all countries.
- The gold standard broke down during the 1930s
as countries engaged in competitive devaluations
The Gold Standard



Roots in old mercantile
trade
Inconvenient to ship
gold, changed to
paper- redeemable for
gold
Want to achieve
‘balance-of-trade
equilibrium
Japan
USA
Balance of Trade Equilibrium
Decreased
money supply
= price decline.
Trade Surplus
As prices decline, exports
increase and trade goes
into equilibrium.
Gold
Increased
money supply
= price
inflation.
Between the Wars


Post WWI, war heavy expenditures affected the
value of dollars against gold
US raised dollars to gold from $20.67 to $35 per
ounce
 Dollar

worth less?
Other countries followed suit and devalued their
currencies
Bretton Woods





In 1944, 44 countries met in New Hampshire
Countries agreed to peg their currencies to US$
which was convertible to gold at $35/oz
Agreed not to engage in competitive devaluations
for trade purposes and defend their currencies
Weak currencies could be devalued up to 10% w/o
approval
Created the IMF and World Bank
International Monetary Fund (IMF)


The International Monetary Fund (IMF) Articles of
Agreement were heavily influenced by the
worldwide financial collapse, competitive
devaluations, trade wars, high unemployment,
hyperinflation in Germany and elsewhere, and
general economic disintegration that occurred
between the two world wars
The aim of the IMF was to try to avoid a repetition
of that chaos through a combination of discipline
and flexibility
International Monetary Fund

Discipline
 Maintaining
a fixed exchange rate imposes
monetary discipline, curtails inflation
 Brake on competitive devaluations and stability
to the world trade environment

Flexibility
Lending facility:
 Lend foreign currencies to countries having
balance-of-payments problems
 Adjustable parities:
 Allow countries to devalue currencies more than
10% if balance of payments was in “fundamental
disequilibrium”

Purposes of IMF





Promoting international monetary cooperation
Facilitating expansion and balanced growth of international
trade
Promoting exchange stability, maintaining orderly exchange
arrangements, and avoiding competitive exchange devaluation
Making the resources of the Fund temporarily available to
members
Shortening the duration and lessening the degree of
disequilibrium in the international balance of payments of
member nations
International Monetary Fund


monitors economic and financial developments
and policies, in member countries and at the global
level, and gives policy advice to its members
based on its more than fifty years of experience.
For example: In its annual review of the Japanese
economy for 2003, the IMF Executive Board urged
Japan to adopt a comprehensive approach to
revitalize the corporate and financial sectors of its
economy, tackle deflation, and address fiscal
imbalances.
International Monetary Fund


The IMF commended Mexico in 2003 for good
economic management, but said structural reform of
the tax system, energy sector, the labor market, and
judicial system was needed to help the country
compete in the global economy.
In its Spring 2004 World Economic Outlook, the
IMF said an orderly resolution of global imbalances,
notably the large U.S. current account deficit and
surpluses elsewhere, was needed as the global
economy recovered and moved toward higher
interest rates.
International Monetary Fund


lends to member countries with balance of
payments problems, not just to provide temporary
financing but to support adjustment and reform
policies aimed at correcting the underlying
problems.
For example: During the 1997-98 Asian financial
crisis, the IMF acted swiftly to help Korea bolster its
reserves. It pledged $21 billion to assist Korea to
reform its economy, restructure its financial and
corporate sectors, and recover from recession.
Within four years, Korea had recovered sufficiently
to repay the loans and, at the same time, rebuild its
reserves.
International Monetary Fund

In October 2000, the IMF approved an additional
$52 million loan for Kenya to help it cope with the
effects of a severe drought, as part of a three-year
$193 million loan under the IMF's Poverty Reduction
and Growth Facility, a concessional lending program
for low-income countries.
International Monetary Fund


provides the governments and central banks of
its member countries with technical assistance
and training in its areas of expertise.
For example: Following the collapse of the Soviet
Union, the IMF stepped in to help the Baltic states,
Russia, and other former Soviet countries set up
treasury systems for their central banks as part of
the transition from centrally planned to market-based
economic systems.
IMF Quotas - each member’s monetary contribution
 Based on national income, monetary reserves,
trade balance, and other economic indicators
 Pool of money that can be loaned to members
 Basis for how much a country can borrow
 Determines voting rights of members
Board of Governors - IMF’s highest authority
 One representative from each member country
 Board of Executive Directors—24 persons
 handles day-to-day operations
IMF Assistance
Provides assistance to member countries
 Intended to ease balance-of-payment difficulties
 Recipient country must adopt policies to stabilize its
economy
Special Drawing Rights (SDRs)



An international type of monetary
reserve currency, created by the International
Monetary Fund (IMF) in 1969, which operates as a
supplement to the existing reserves of member
countries.
Created in response to concerns about the
limitations of gold and dollars as the sole means
of settling international accounts,
SDRs are designed to augment international
liquidity by supplementing the standard reserve
currencies.
Special Drawing Rights (SDRs)
Serves as the IMF’s unit of account
 unit in which the IMF keeps its records
 used for IMF transactions
 Some countries pegged their currencies’ value
 Based on the weighted average of four
currencies






1986–1990: USD 42%, DEM 19%, JPY 15%, GBP 12%, FRF 12%
1991–1995: USD 40%, DEM 21%, JPY 17%, GBP 11%, FRF 11%
1996–2000: USD 39%, DEM 21%, JPY 18%, GBP 11%, FRF 11%
2001–2005: USD 45%, EUR 29%, JPY 15%, GBP 11%
2006–2010: USD 44%, EUR 34%, JPY 11%, GBP 11%
Role of the World Bank



The official name for the world bank is the
International Bank for Reconstruction and
Development
Purpose: To fund Europe’s reconstruction and help 3rd
world countries.
Overshadowed by Marshall Plan, so it turns towards
development

Lending money raised through WB bond sales




Agriculture
Education
Population control
Urban development
Collapse of the
Fixed Exchange System

The system of fixed exchange rates established
at Bretton Woods worked well until the late
1960’s
The US dollar was the only currency that could be
converted into gold
 The US dollar served as the reference point for all
other currencies
 Any pressure to devalue the dollar would cause
problems through out the world

Collapse of the
Fixed Exchange System

Factors that led to the collapse of the fixed
exchange system include
President Johnson financed both the Great Society
and Vietnam by printing money
 High inflation and high spending on imports
 On August 8, 1971, President Nixon announces
dollar no longer convertible into gold
 Countries agreed to revalue their currencies
against the dollar
 On March 19, 1972, Japan and most of Europe
floated their currencies
 In 1973, Bretton Woods fails because the key
currency (dollar) is under speculative attack

The Floating Exchange Rate

The Jamaica agreement revised the IMF’s Articles of
Agreement to reflect the new reality of floating
exchange rates
 Floating
rates acceptable
 Gold abandoned as reserve asset
 IMF quotas increased

IMF continues role of helping countries cope with
macroeconomic and exchange rate problems
Exchange Rates Since 1973

Exchange rates have been more volatile for a
number of reasons including:
 Oil
crisis -1971
 Loss of confidence in the dollar - 1977-78
 Oil crisis – 1979, OPEC increases price of oil
 Unexpected rise in the dollar - 1980-85
 Rapid fall of the dollar - 1985-87 and 1993-95
 Partial collapse of European Monetary System 1992
 Asian currency crisis - 1997
Fixed Versus Floating Exchange Rates

Floating:


Monetary policy
autonomy
 Restores control to
government
Trade balance
adjustments
 Adjust currency to
correct trade
imbalances

Fixed:







Monetary discipline
.Speculation
Limits speculators
Uncertainty
Predictable rate
movements
Trade balance
adjustments
Argue no link between
exchange rates and
trade
 Link between savings
and investment
Exchange Rate Regimes

Pegged Exchange Rates
 Peg
own currency to a major currency ($)
 Popular among smaller nations
 Evidence of moderation of inflation

Currency Boards
 Country
commits to converting domestic currency
on demand into another currency at a fixed
exchange rate
 Country holds foreign currency reserves equal to
100% of domestic currency issued
Exchange-Rate Arrangements
IMF permitted countries to select and maintain an
exchange-rate arrangement of their choice
 IMF
surveillance and consultation programs
 designed to monitor exchange-rate policies
 determine whether countries were acting
openly and responsibly in exchange-rate
policy
From pegged to floating currencies
 Broad
IMF categories for exchange-rate regimes
 peg exchange rate to another currency or
basket of currencies with only a maximum 1%
fluctuation in value
 peg exchange rate to another currency or
basket of currencies with a maximum of 2
¼% fluctuation
 allow the currency to float in value against
other currencies
 Countries may change their exchange-rate regime
Crisis Management by the IMF

The IMF’s activities have expanded because periodic
financial crises have continued to hit many economies
Currency crisis
 When a speculative attack on a currency’s exchange
value results in a sharp depreciation of the currency’s
value or forces authorities to defend the currency
 Banking crisis
 Loss of confidence in the banking system leading to a
run on the banks
 Foreign debt crisis
 When a country cannot service its foreign debt
obligations

Determination of Exchange Rates
Floating rate regimes—allow changes in the exchange
rates between two currencies to occur for currencies
to reach a new exchange-rate equilibrium
 Currencies that float freely respond to supply and
demand conditions
 No government intervention to influence the price of
the currency
Economic Theories of
Exchange Rate Determination


Exchange rates are determined by the demand and
supply of one currency relative to the demand and
supply of another
Price and exchange rates:
 Law
of One Price
 Purchasing Power Parity (PPP)
 Money supply and price inflation

Interest rates and exchange rates
Law of One Price


In competitive markets free of transportation costs
and trade barriers, identical products sold in
different countries must sell for the same price
when their price is expressed in terms of the same
currency
Example: US/French exchange rate: $1 = .78Eur
A jacket selling for $50 in New York should retail
for 39.24Eur in Paris (50x.78)
Purchasing Power Parity


By comparing the prices of identical products in
different currencies, it should be possible to
determine the ‘real’ or PPP exchange rate - if
markets were efficient
In relatively efficient markets (few impediments
to trade and investment) then a ‘basket of goods’
should be roughly equivalent in each country
Money Supply and Inflation

PPP theory predicts that changes in relative prices
will result in a change in exchange rates
A
country with high inflation should expect its
currency to depreciate against the currency of
a country with a lower inflation rate
 Inflation occurs when the money supply
increases faster than output increases
Determination of Exchange Rates

Fisher Effect - links inflation and interest rates
nominal interest rate in a country is the real interest rate
plus inflation
because the real interest rate should be the same in every
country, the country with the higher interest rate should
have higher inflation
International Fisher Effect (IFE) - links interest rates and
exchange rates
the interest-rate differential is a predictor of future changes
in the spot exchange rate
 interest-rate differential based on differences in
interest rates
currency of the country with the lower interest rate will
strengthen in the future
•
Determination of Exchange Rates
Other factors affecting exchange rate movements
 Confidence—safe currencies considered attractive in
times of turmoil
 Technical factors
 release of national statistics
 seasonal demands for a currency
 slight strengthening of a currency following a
prolonged weakness
Helpful Reading
Economics. Samuelson, & Nordhaus (2005) Ch. 34 & 36