Table of ContentsChapter
Free Float
3
Managed Float
3
Target Zone
4
Fixed Rate System
4
The Current System
4
International Monetary System History
4
Prior to 1875
4
1875 to 1914
4
1915 to 1945
4
1945 to 1972
4
1973 to Present
4
European Monetary System
5
European Monetary Union
5
European Union
5
The Mexican and Asian Crises
6
Fixed vs. Flex Exchange Rate System
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Chapter
I C O N
K E Y
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Key Point
Exercise
International Monetary System
Speculators and Hedgers are like opposite sides of the same coin.
F
ree float exchange rates, managed float exchange rates, target-zone arrangements, and
fixed-rate exchange rates are systems largely determined by the degree of government
intervention in controlling the exchange rate system.
Free Float
Free float or “clean float” exchange rate systems are determined solely by the interaction of
currency supply and demand or by market fundamentals without intervention by the government.
The exchange rate is affected by external shocks, as well as changes in inflation, interest rates, or
the strength of the economy. This is the current system for most of the major currencies;
including U.S. Dollar, European Euro, Japanese Yen, Swiss Franc, and British Pound.
Advantages
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The country is less affected by the inflation from other countries
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The country is less affected by unemployment problems in other countries
Disadvantages
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A country with high inflation is less protected
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A country with high unemployment is less protected
Managed Float
Managed float or “dirty float” is basically a floating system where governments intervene in the
foreign exchange market to smooth out exchange rate fluctuations. While the exchange rates are
allowed to fluctuate on a daily basis, governments sometimes intervene if the rate fluctuates too
far in one direction. For example South Korea successfully imposed a band around their currency
in 1997.
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Government intervention can be done in 2 different approaches, direct and indirect. Direct
intervention is a mechanism of controlling the currency supply. A reduction in supply increases
both the strength and price of a currency. This includes open market operations, changing the
discount rate, or changing the reserve requirements. Indirect intervention is done through control
of macroeconomic factors, such as increase/decrease of interest rate and inflation.
Some criticize the managed float system pointing out that a government may purposely weaken
the currency to help stimulate a poorly performing economy.
.
Target-Zone
In a target-zone arrangement countries maintain their exchange rates within a specific margin
around agreed-upon fixed exchange rates similar to the bands some countries use in the managed
float system.
An example of target-zone system was used by the European Monetary System (EMS), which
existed before the European Union. The EMS created the European Currency Unit (ECU), and
required all member countries to stabilize their currency values relative to the ECU. This was
done by establishing a target rate for each currency, and allowing the rate to fluctuate only within a
certain margin.
The exchange rates were originally set with a target rate and allowed to move 2.25% up or down.
If the exchange rate reached the upper or lower limit, then the country’s central bank would step
in to stabilize the value of the currency back to the target rate. This was accomplished through
the indirect and direct intervention methods explained above. Later, The margin was decreased
to 1.125%, which caused all of the EMS currency values to move closely together in a pattern that
is referred to as a snake. Eventually the margin was decreased to zero, which created one
currency called the Euro.
For more information on the EMS visit:
http://en.wikipedia.org/wiki/European_Monetary_System
Fixed-Rate System
In the fixed-rate system, governments are committed to maintaining target exchange
rates. The Bretton Woods agreement is an example. Some countries impose a fixed
exchange rate for their currency where the rate is either held constant or allowed to
fluctuate within very narrow margins. Often times, this fixed exchange rate is pegged
relative to a major currency, such as the Dollar, Pound or Euro.
This allows the MNCs to engage in international trade without worrying about the future
exchange rate, thus making the managerial duties less rigorous. However, sometimes the
government will suddenly raise or lower the exchange rate without notice which causes
risk for the MNC.
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The Current System
The current system varies from country to country but by and large the world’s economy is
centered on a flexible exchange rate that moves according to market forces. Usually when a
government imposes a fixed rate the economy is in disarray and the fixed rate backfires.
International Monetary System History
The international monetary system has gone through many changes in its history.
Prior to 1875 – Bi-Metallism
Prior to 1875 bimetallism or the silver standard dominated the exchange rate. During this
time period, both silver and gold were acceptable for payment, there was a fixed exchange
rate of 16 oz. Silver = 1 oz. Gold. However this created a problem because in the mid 1800s
many new gold mines were discovered which created an abundance of gold compared to
silver. Instead of allowing market forces to adjust the new silver/gold ratio, the government
insisted on maintaining the fixed 16/1 exchange rate. This caused people to use gold for
payments because they perceived it to be less valuable since it was more abundant. The
consequence was that silver was driven out of circulation.
Gresham’s Law can be used to explain the phenomena that occurred. This states that bad
(abundant) money, drives good (scarce) money out of circulation. People will use gold as
much as possible in this situation, and will drive silver out of circulation.
1875 to 1914 – Classical Gold Standard
From 1875 to 1914 the classical gold standard controlled the currency exchange. Gold coins
and paper money were used for exchange, both of which were backed by gold reserves. All
foreign currencies were fully convertible into gold.
During the classical gold standard, the price-specie-flow mechanism can be observed. This
is an automatic adjustment to achieve trade balance between 2 countries, when there is a
temporary trade deficit/surplus. The country with the trade surplus will have exported more
goods and therefore will have more (a surplus of) gold. Whereas the country running a trade
deficit will have a limited supply of gold, because the quantity available is fixed. This will
cause the prices in the country with a deficit to decrease due to the decrease in money
supply, and the prices in the surplus country to increase because they will have an abundance
of gold. People in the surplus country will begin to buy products from the country with
lower prices, and vice versa. In this way the gold will move in the opposite direction causing
a trade balance to occur without government intervention. This is able to occur because of
the fixed amount of gold available. Any trade imbalance will be temporary.
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1915 to 1945 – No Coherent System
During this period there was no coherent system, as WWI and WWII created turmoil
between the countries of the world.
1945 to 1972 – Gold Exchange System
During this time period the Gold Exchange System prevailed, which was put in place by the
Bretton Woods conference held at the end of WWII. The Gold Exchange system fixed all
countries exchange rates to the dollar. The dollar was the only currency fully convertible
into gold, at a fixed rate of $35/1oz.gold. In this way all countries were able to get gold
indirectly by exchanging their currency to U.S. Dollars and then to gold.
Triffin Paradox- is a phenomena that was observed during the Gold Exchange System. As
international trade increased, countries around the world increased their holding of U.S.
Dollars. As this occurred, they began to loose faith that the U.S. Government could
continue to back the dollars with gold.
The Bretton Woods System is a very important part of international finance history. To learn
more, visit
http://en.wikipedia.org/wiki/Bretton_Woods_system
1973 to present – Flexible Exchange System
From 1973 on, the flexible exchange rate system that we use today came into play. A
decrease in the dollar value because of too many dollars printed by the US government to
finance the Vietnam War and the Great Society Movement caused the collapse of the gold
exchange system and the US government no longer backed the fixed rate of $35/1oz.gold.
European Monetary System
The European monetary system was founded in 1979 and attempted to link European Currency
values with the exchange rate mechanism (ERM). However it floundered in 1992 paving the way
for the introduction of the “euro” in 1999. The euro provides a constant currency throughout
Europe, thus consolidating the monetary policy.
European Monetary Union
The European Monetary Union
http://ue.eu.int/emu/en/index.htm Council of the European Union Monetary Policies
The European Central Bank (ECB)
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Based in Frankfurt Germany, the ECB sets the monetary policy for all participating European
countries. Their goal is to stabilize the value of the euro and control inflation.
http://www.ecb.int/ Visit the European Central Bank (ECB)
European Union
The European Union has a parliament, council, commission, court of justice, and other bodies.
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European Parliament (elected by the peoples of the Member States);
Council of the Union (composed of the governments of the Member States);
European Commission (driving force and executive body);
Court of Justice (compliance with the law);
Court of Auditors (sound and lawful management of the EU budget).
The process of European integration was launched on in May 1950 when France officially
proposed to create 'the first concrete foundation of a European federation. Six countries
(Belgium, Germany, France, Italy, Luxembourg and the Netherlands) joined from the very
beginning. Today, after four waves of accessions (1973: Denmark, Ireland and the United
Kingdom; 1981: Greece; 1986: Spain and Portugal; 1995: Austria, Finland and Sweden) the EU
has 15 Member States and is preparing for the accession of 13 eastern and southern European
countries.
http://europa.eu.int/indexen.htm Visit the European Union
http://www.europa.eu.int/euro/html/home5.html?lang=5 The Union’s Euro policy
The Mexican and Asian Crises
The Mexican and Asian crisis affected the world economy and caused the IMF to bail out a
number of countries whose currencies were in a downward spiral. The Asian crisis had the most
dramatic affect.
The Asian Crisis
The Asian Crisis had worldwide repercussions.
Thailand
From 1985 to 1994 Thailand’s economy grew faster than any other. Thai citizens saved less and
spent more than other Southeast Asian countries, thereby putting upward pressure on real estate
prices and consumer products, and on the local interest rate.
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Foreign investors found Thailand to be an attractive investment due to the high interest rates, and
the investors felt safe because the Baht, Thailand’s currency, was linked to the dollar. This resulted
in Thailand’s banks having more money, literally, than they could spend. In an attempt to use all
the funds, the banks made risky loans.
This massive inflow of funds made Thailand susceptible to a massive outflow of funds, and this is
what started the Asian Crisis in 1997. In the beginning of 1997, the dollar strengthened making
Japanese and European products more attractive to U.S. importers. Thailand’s products were not
as competitively priced. This loss of exports caused the Baht to weaken and some foreign
investors recognized the Baht’s potential weakness and the funds began to flow out of Thailand.
Over a five-week period it declined over 20 percent against the dollar.
Despite the intervention of Thailand’s central bank, they used more than 20 billion Dollars to
purchase Baht in the foreign exchange market, Thailand needed 16 billion from the IMF ((Japan
also chipped in) and agreed to reduce its budget deficit, prevent inflation from rising above 9
percent, raise its value-added tax to 10 percent, and clean up the financial statements of the local
banks.
Other Asian countries had also experienced very high growth in recent years. Since the economies
of the Southeastern Asian area are related, and the other countries also offered high interest rates
with a great deal of foreign investment, when Thailand fell it set off a chain reaction. In the
summer of 1997, the Malaysian Ringgit, the Singapore Dollar, the Philippine Peso, the Taiwan
Dollar and the Indonesia Rupiah also declined.
Hong Kong
On October 23, 1997 the Hong Kong stock market declined by 10.2 percent. The cumulative 4day affect was a whopping decline of 23.3 percent. The decline was attributed to speculation that
the Hong Kong currency would be devalued and that Hong Kong would experience financial
woes similar to Asia. Hong Kong responded by raising interest rates.
Russia
The Asian Crisis caused investors to rethink other countries where similar situations existed.
Russia was one of those countries. Investors lost confidence in the Russian Ruble and began to
transfer funds out of Russia. Despite a 22.6 billion dollar loan package in July of 1998, in August
of 1998, market forces caused the ruble to lose 50 percent of its value. The next day, called
“Bloody Thursday”, stock markets around the world experienced declines. The U.S. stock market
fell more than 4 percent.
South Korea
In November of 1997, seven of South Korea’s conglomerates (chaebols) collapsed. The banks
that financed these firms had 52 billion in bad debt as a result, and their credit ratings were
downgraded. Like Thailand, South Korean banks had issued loans without doing a complete
credit check. In November the Won declined substantially.
On December 3, 1997, the IMF loaned South Korea 55 billion dollars. The World Bank and the
Asian Development Bank provided a 35 billion dollar credit line. The U.S. and Japan agreed to
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provide a credit line of 20 billion if the 35 billion wasn’t sufficient. This amounted to the largest
bailout in history. South Korea agreed to reduce its economic growth and restrict conglomerates
from excessive borrowing.
Latin America
The Asian Crisis caused a decline in the demand for products from Latin American countries.
Latin America also lost some business to Asian countries when other countries switched to the
lower priced Asian products. The Asian Crisis also caused the bond ratings of many large
corporations to be downgraded.
Currency values in Latin America were affected due to the Asian Crisis. In particular, Brazil’s
“real” currency was adversely affected. The central bank of Brazil spent 7 billion dollars of
reserves to purchase the real in the foreign exchange market to protect the real from depreciation,
and raised interest rates.
Japan
Japan is a major exporter to Asian countries. As the Asian economies faltered, so did their
imports from Japan. Japan had an assortment of problems as well. In November of 1997 one the
20 largest banks in Japan defaulted. On its heals Yamaichi Securities Co., Japan’s largest brokerage
firm shut down. The continued weakening of the Yen against the U.S. dollar put even more
pressure on the Asian countries that wanted to export to the U.S. because of the weakened
currencies in their countries.
Europe
European firms, especially banks who had loaned heavily into Asia, suffered when those Asian
firms defaulted. Even though Europe experienced strong economic growth during the period, a
reduced demand for their exports as a result of the weakened Asian currencies hurt many firms.
United States
In the U.S., firms that marketed their products in Asia, like Nike and Motorola, saw their stocks
decline. Many engineering and construction firms with contracts in that area reduced their plans
to improve the infrastructure as the monies for the projects dried up. U.S. exporters to Asia saw
their stocks and exports decline because a stronger dollar made the exports more expensive. U.S.
Commercial banks experienced stock declines due to loans and bond holdings in Asian countries.
Fixed vs. Flex Exchange Rate System
In a fixed system the government controls the exchange rates and the exchange rates usually stay
constant. Once in awhile the government will raise or lower the rate. This can cause abrupt
changes for the MNCs involved in that foreign currency.
Countries with fixed exchange rates often impose tight controls on capital flows, and outflows of
currency that might destabilize the fixed exchange rate target. Currently China, Hong Kong,
Malaysia and Argentina are using such a regime. Some advantages of a fixed exchange rate system
are the elimination of uncertainty and exchange rate risk. In addition, a fixed rate system will
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promote economic integration and international trade. Disadvantages of a fixed exchange rate
system are that small countries loose their economic autonomy or independence. Also, fixed rate
systems could create economic crisis if a country is not managing it properly, as seen in the Asian
Crisis.
In a flex exchange rate system the rates are subject to market forces and can fluxuate with
the market. This system has been working well since 1972 and most countries allow their
exchange rates to flow with the market.
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