INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 9TH ED.
CHAPTER 3
SUGGESTED ANSWERS TO CHAPTER 3 QUESTIONS
1. a. What are the five basic mechanisms for establishing exchange rates?
ANSWER. The five basic mechanisms for establishing exchange rates are free float, managed float, target-zone
arrangement, fixed-rate system, and the current hybrid system.
b.
How does each work?
ANSWER. In a free float, exchange rates are determined by the interaction of currency supplies and demands. Under
a system of managed floating, governments intervene actively in the foreign exchange market to smooth out
exchange rate fluctuations in order to reduce the economic uncertainty associated with a free float. Under a targetzone arrangement, countries adjust their national economic policies to maintain their exchange rates within a
specific margin around agreed-upon, fixed central exchange rates. Under a fixed-rate system, such as the Bretton
Woods system, governments are committed to maintaining target exchange rates. Each central bank actively buys or
sells its currency in the foreign exchange market whenever its exchange rate threatens to deviate from its stated par
value by more than an agreed-on percentage. Currently, the international monetary system is a hybrid system, with
major currencies floating on a managed basis, some currencies freely floating, and other currencies moving in and
out of various types of pegged exchange rate relationships.
c.
What costs and benefits are associated with each mechanism?
ANSWER.
Benefits of a Floating Rate System. At the time floating rates were adopted in 1973, proponents said that the new
system would reduce economic volatility and facilitate free trade. In particular, floating exchange rates would offset
international differences in inflation rates so that trade, wages, employment, and output would not have to adjust.
High-inflation countries would see their currencies depreciate, allowing their firms to stay competitive without
having to cut wages or employment. At the same time, currency appreciation would not place firms in low-inflation
countries at a competitive disadvantage. Real exchange rates would stabilize, even if permitted to float in principle,
because the underlying conditions affecting trade and the relative productivity of capital would change only
gradually; and if countries would coordinate their monetary policies to achieve a convergence of inflation rates, then
nominal exchange rates would also stabilize. Another benefit is that–as Milton Friedman points out–with a floating
exchange rate, there never has been a foreign exchange crisis. The reason is simple: The floating rate absorbs the
pressures that would otherwise build up in countries that try to peg the exchange rate while simultaneously pursuing
an independent monetary policy. For example, the Asian currency crisis did not spill over to Australia and New
Zealand because the latter countries had floating exchange rates. A floating rate system can also act as a shock
absorber to cushion real economic shocks that change the equilibrium exchange rate.
Costs of a Floating Rate System. Many economists point to excessive volatility as a major cost of a floating rate
system. The experience to date is that the dollar's ups and downs have had little to do with actual inflation and a lot
to do with expectations of future government policies and economic conditions. Put another way, real exchange rate
volatility has increased, not decreased, since floating began. This instability reflects, in part, nonmonetary (or real)
shocks to the world economy, such as changing oil prices and shifting competitiveness among countries, but these
real shocks were not obviously greater during the 1980s than they were in earlier periods. Instead, uncertainty over
future government policies has increased.
Benefits of a Managed Float. The potential benefit of a managed float is that governments can reduce the volatility
associated with a freely floating exchange rate.
Costs of a Managed Float. The costs of a managed float stem from the demonstrated inability of governments to
recognize the difference between a temporary exchange rate disequilibrium and a permanent one. By trying to
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CHAPTER 3: THE INTERNATIONAL MONETARY SYSTEM
manage exchange rates when a permanent shift in the equilibrium exchange rate has occurred, governments run the
risk of creating an exchange rate crisis and wasting reserves.
Benefits of a Target Zone Arrangement. The experience with the European Monetary System is that the target
zone arrangement in effect forced convergence of monetary policy to that of the country–Germany–with the most
disciplined anti-inflation policy and led to low inflation.
Costs of a Target Zone Arrangement. Maintaining a genuinely stable target zone arrangement requires the
political will to direct fiscal and monetary policies at that goal and not at purely national ones. This turns out to be
difficult for countries to achieve. In the case of the European Monetary System, the result was periodic currency
crises. Another cost of this system is that fundamental changes in the equilibrium exchange rate cannot get reflected
in actual exchange rate changes without a currency crisis occurring.
Benefits of a Fixed Rate System. A permanently fixed exchange rate system–such as that achieved by a currency
board, dollarization, or monetary union–results in currency stability and the absence of currency crises. In a system
such as existed under Bretton Woods, where there is a commitment to a fixed exchange rate system, but no
mechanism to bind that commitment, you will have more monetary discipline than in a freely floating system and
hence lower inflation than might otherwise be the case.
Costs of a Fixed Rate System. In a permanently fixed system, the exchange rate cannot cushion the effects of real
economic shocks, such as devaluation of a major competitor’s currency. Instead, prices must adjust. Given the lack
of flexibility of many prices–because of government regulations or union restrictions–the result of these economic
shocks can be higher unemployment and less economic growth. In a system such as Bretton Woods, the result of
changes in the equilibrium exchange rate will likely be currency crises and eventual devaluation or revaluation.
Benefits of a Hybrid System. The current system gives countries the option to select the system that best meets
their needs. However, all too often, the decision is based on political rather than economic calculations.
Costs of a Hybrid System. The cost of a hybrid system, such as the one currently in place, is that there is no
constraint on the choices that governments can make. The resulting choices can be good ones or bad ones.
d.
Have exchange rate movements under the current system of managed floating been excessive? Explain.
ANSWER. Excessive movements would indicate that there are profits to be earned by betting against the market. In
effect, if currency fluctuations are excessive they would exhibit the phenomenon of overshooting (i.e., currency rates
would overreact to economic events and then return to equilibrium). There is no evidence that one could profit by
betting that rate movements are excessive.
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INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 9TH ED.
2.
Find a recent example of a nation's foreign exchange market intervention and note what the government's
justification was. Does this justification make economic sense?
ANSWER. Finding an example of foreign exchange market intervention by a government should be pretty easy to do.
The trick will be to find a coherent statement of what the government's justification was. Most of these justifications
make little or no economic sense.
3.
Gold has been called "the ultimate burglar alarm." Explain what this expression means.
ANSWER. Governments "burgle" holders of their currencies by printing more money and subjecting holders to an
"inflation tax." Since gold prices respond quickly to evidence of inflation, the expectation of an increase in inflation
will cause a jump in gold prices. In this way, gold serves as a burglar alarm to warn that politicians are tampering
with fiat money.
4.
Suppose nations attempt to pursue independent monetary and fiscal policies. How will exchange rates behave?
ANSWER. Independent monetary and fiscal policies will lead to volatile exchange rates as market participants
receive and assess new information on these policies.
5.
The experiences of fixed exchange-rate systems and target-zone arrangements have not been entirely
satisfactory.
a.
What lessons can economists draw from the breakdown of the Bretton Woods system?
ANSWER. Adjusting monetary growth rates is the principal way to stabilize exchange rates. For example, raising the
value of the dollar relative to the yen requires tightening U.S. monetary policy relative to Japanese monetary policy.
The experience of Bretton Woods and similar experiments demonstrates that conscious and explicit coordination of
monetary policies among sovereign authorities is difficult. The problem stems from the inability of sovereign
authorities to coordinate their monetary growth rates. An agreement to stabilize the dollar at, say, 150 yen would be
relatively easy if it did not entail interdependent monetary policies, robbing the Federal Reserve, or the Bank of
Japan, or both, of important degrees of monetary freedom.
Both Japan and the United States have their own targets for growth and inflation and their own independent
assessment of the macroeconomic policies required to attain those targets. Except by coincidence, independent
policies and preferences will not mesh at a stable exchange rate. Given clashing preferences, the only alternatives to
the "chaos" of floating are:
(1) One side persuades the other to change its policies;
(2) One side subordinates its policies to those of the other; or
(3) Both sides subordinate their monetary policies to an external mechanism, such as a gold standard.
Absent (3), "international monetary reform" is the search for new ways to implement (1) or (2), or some
combination. We saw that Bretton Woods collapsed because the subordination it entailed was intolerable to the
United State. That is, the United States refused to follow economic policies that would maintain the value of gold at
$35 an ounce. The basic lesson from Bretton Woods, therefore, is that stabilizing exchange rates requires
dependence and subordination, not the freedom for everybody to do their own thing. But instead of changing
policies to stay with the Bretton Woods system, the major countries simply dropped the system.
b.
What lessons can economists draw from the exchange rate experiences of the European Monetary System?
ANSWER. Exchange rate stability requires that monetary policies be coordinated and geared towards maintaining
exchange rate parities. The slow progress of the European community with respect to the EMS and policy
coordination exemplifies the difficulties of achieving agreements on the many facets of economic policymaking.
Implementing target zones on a wider scale would be all the more difficult. Differences in preferences, policy
objectives, and economic structures account in part for these difficulties. More fundamentally, however,
coordination of macroeconomic policies will not necessarily benefit all participant countries equally, and those that
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benefit the most may not be willing to compensate those that benefit least. In the EMS, Germany is less
inflation-prone than the other members and is reluctant to cooperate at the risk of increasing its inflation rate.
Another lesson is that in target-zone arrangements such as the EMS, a disproportionately large share of the
adjustment burden will fall on the "weak" currency countries. Countries with appreciating currencies, trade
surpluses, and increasing reserves are less prone to adjust than countries with depreciating currencies, trade deficits,
or reserve losses. The convergence of inflation rates among the EMS countries supports this view. An equal sharing
of the adjustment burden implies that inflation rates among member nations would converge to the average rate.
Germany, however, has maintained a domestic monetary target of low or zero inflation, and often has refused to
alter domestic monetary policy because of exchange rate considerations. Because of Germany's economic
importance, the other member countries have had to adjust their domestic policies or their exchange rates to remain
competitive in international markets. As a result, inflation rates have tended to converge toward Germany's lower
rate.
6.
How did the European Monetary System limit the economic ability of each member nation to set its interest rate
to be different from Germany's?
ANSWER. Each country within the European Monetary System had to fix its exchange rate relative to the DM. If a
country's exchange rate is expected to stay fixed relative to the DM, the interest rate associated with that country's
currency cannot diverge from Germany's. Otherwise, it would present a virtually risk-free arbitrage opportunity:
Borrow in the lower interest rate currency and lend the borrowed funds in the higher interest rate currency and earn
the spread between the two rates.
7.
Historically, Spain has had high inflation and has seen its peseta continuously depreciate. In 1989, though,
Spain joined the EMS and pegged the peseta to the DM. According to a Spanish banker, EMS membership
means that "the government has less capability to manage the currency but, on the other hand, the people are
more trusting of the currency for that reason."
a.
What underlies the peseta's historical weakness?
ANSWER. Spain has historically pursued an easy monetary policy, with an associated high rate of inflation. High
inflation, in turn, led to continual peseta devaluation.
b.
Comment on the banker's statement.
ANSWER. Countries that seek to participate in the EMS are effectively forced to pursue a monetary policy consistent
with that of Germany, which eventually brings down their inflation rates. In effect, control of Spain's monetary
policy has been shifted from Spain's central bank, which has a weak reputation for monetary discipline, to the much
more reputable Bundesbank. Thus, Spaniards now are more trusting of their money.
c.
What are the likely consequences of EMS membership on the Spanish public's willingness to save and invest?
ANSWER. By heightening the prospects for Spanish monetary stability, EMS membership has lowered the risks
associated with holding financial assets in Spain. The result has been to make the Spanish public more willing to
save and invest.
8.
In discussing European Monetary Union, a recent government report stressed a need to make the central bank
accountable to the "democratic process." What are the likely consequences for price stability and exchange rate
stability in the EMS if the "Eurofed" becomes accountable to the "democratic process?"
ANSWER. The only good central bank is one that can say no to politicians. Unfortunately, the proposal makes it
more difficult for the central bank to do so. Instead of assessing central bank performance in terms of an
unambiguous, verifiable goal, such as price stability, thereby complementing central bank independence by giving it
a single, long-term focus, the proposal's definition of accountability will provide an avenue for political influence.
The result will be higher inflation, and more currency volatility.
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INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 9TH ED.
9.
Comment on the following statement: "With monetary union, the era of protection for European firms and
workers has come to an end."
ANSWER. As explained in the answer to the previous question, wage flexibility is a substitute, albeit an imperfect
one, for exchange rate flexibility. If exchange rates can no longer adjust in response to domestic imbalances, then
wages need to become more flexible to avoid an increase in the already high rate of European unemployment. But
labor market institutions in Europe tend to impede such flexibility. Their very purpose is to protect those currently
working from the pressure of the unemployed. Nobody loses his or her job, or is obliged to accept a wage cut, even
though there is a large pool of unemployed who would be willing to work at a lower wage. Job protection schemes,
minimum wages, and generous unemployment benefits make it possible for unions to negotiate wage increases that
are largely independent of the state of the labor market. Market flexibility is also critical for adapting to economic
shocks without the aid of exchange rate changes. If a country has high unemployment because of low demand for its
products, it is essential in a monetary union for firms to be able to shift resources rapidly toward products with
greater demand. But throughout Europe, state subsidies, costly regulations, insufficient competition, government
monopolies, and barriers to entry slow the pace of adjustment. Monetary union will force governments and society
to confront the prospect that maintaining the current generous social welfare state will force a substantial increase in
their already high level of unemployment, but--because of the strict Maestricht fiscal criteria–without the possibility
of more state aid to mitigate the suffering.
10. Comment on the following statement: "The French view European Monetary Union as a way to break the
Bundesbank's dominance in setting monetary policy in Europe."
ANSWER. In order to peg the franc to the DM, the French must match the Bundesbank's anti-inflationary policy.
This necessity precludes France from following the expansionary monetary policy it has historically preferred. The
only way for France to maintain a fixed exchange rate while following a more expansionary monetary policy is to do
away with the Bundesbank. European Monetary Union will take control over monetary policy away from the
Bundesbank and place it in the hands of the European Central Bank. If France can control the ECB, as it is trying to
do, the result will be a more expansionary monetary policy with higher inflation. This scenario explains why
Germans are so nervous over EMU; they distrust the French commitment to price stability. German suspicions were
intensified in late 1997 when the French government nominated Jean-Claude Trichet, governor of the Bank of
France, to be the first president of the ECB.
The basic problem is the historical French government attachment to deficit spending, inflation, and devaluation as
remedies for French unemployment. Such policies don't work, however, for obvious reasons. Government job
creation substitutes make-believe jobs for real ones, at the same time lowering the efficiency of the real economy
through heavier tax burdens. Inflationary monetary policy meanwhile retards capital formation and leads to slower
growth. The real solution to high unemployment is economic growth, which requires curbing the welfare state with
its high taxes, incentive-destroying benefits and subsidies, and costly labor market regulations.
ADDITIONAL CHAPTER 3 QUESTIONS AND ANSWERS
1.
Why has speculation failed to smooth exchange rate movements?
ANSWER. Speculation can only be expected to smooth exchange rate movements if underlying economic processes
are relatively stable. If there is a great deal of uncertainty over future government actions and their economic impact,
expectations will not be strongly held. Thus expectations can change dramatically from day- to-day, leading to
rapidly fluctuating exchange rates.
2.
Is a floating-rate system more inflationary than a fixed-rate system? Explain.
ANSWER. To the extent that floating exchange rates allow monetary authorities to pursue more inflationary policies,
then a floating rate system can be more inflationary. However, this is an indirect effect, the direct cause of inflation
being rapid money expansion. According to PPP, the direction of causation runs from price level changes to
exchange rate changes, not vice versa.
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3.
Since 1979, the price of gold has fallen by more than 60%. What could explain such a steep price decline?
Consider the roles of inflation and new financial instruments such as swaps and options that can provide lowercost inflation hedges.
ANSWER. Gold traditionally has provided a safe haven when economic and political conditions are uncertain and
currencies are volatile because of the belief that it was a sounder store of value than paper money. However, gold's
value as an inflation hedge was diminished during the 1980s as inflation became a much less serious concern. At the
same time, to the extent that modern financial instruments such as swaps and options now provide better, less costly
shelters (especially since gold pays no interest, imposing a high opportunity cost on holders), these lower cost
inflation-hedge substitutes would have the effect of reducing the demand for gold and hence its price relative to
what it would be absent these lower-cost inflation-hedge substitutes. The jump in the price of gold during 1993 may
be due to the growing wealth of many Chinese and their attempt to avoid the high inflation stemming from the Bank
of China's expansionary monetary policy. Given their lack of access to more sophisticated hedging instruments, the
Chinese may have found gold to be their best inflation hedge. Currency concerns also played a role in gold's rally
during 1993. Until recently, the Bundesbank has been the only reliable policeman putting the fight against inflation
as its first priority. That certainty became questionable as the Bundesbank had to deal with the pressures brought on
by the German recession to put economic expansion ahead of price stability as its priority. These concerns about the
DM as a store of value were reflected in a fall in its exchange rate during much of the 1990s.
4.
Comment on the following statement: "A system of floating exchange rate fails when governments ignore the
verdict of the exchange markets on their policies and resort to direct controls over trade and capital flows."
ANSWER. Floating offers, in principle, a small degree of freedom from the subordination and coordination necessary
to maintain stable exchange rates. But if governments abuse that degree, and refuse to accept the exchange rate
consequences (e.g., a drop in the exchange rate due to rapid expansion of the money supply), the system will fail.
That is, if the governments involved wish to pursue independent policies while simultaneously stabilizing exchange
rates, this can be accomplished only by imposing direct controls on trade and capital flows.
5.
Will coordination of economic policies make exchange rates more or less stable? Explain.
ANSWER. Coordination of economic policies will make exchange rates more stable, since the relative attractiveness
of the various currencies is less likely to change significantly.
6.
Despite official parity between the Deutsche mark and the Ostmark, the black market rate in early 1990 was
about ten Ostmarks for one Deutsche mark. What problems might setting the exchange rate at one Ostmark for
each DM create for Germany?
ANSWER. The basic problem is that at a one-for-one exchange rate the Ostmark will be overvalued relative to the
Deutsche mark. Unless East German wages fall, East German industry will find their cost of doing business rising,
without an offsetting gain in productivity. East German industry will become even less competitive than it already is
and there will be massive unemployment in East Germany. At the same time, East Germans will rush to convert
their Ostmarks to DMs. The resulting growth in the DM money supply will be inflationary unless the demand for
DM grows in proportion to the supply. Clearly, the demand for DM will rise as it supplants the Ostmark as the
official East German currency. Of course, the Bundesbank can always eliminate the threat of inflation by sterilizing
the increase in DM through open market activities, that is, by issuing bonds to sop up the surplus Deutsche marks. In
the event, Germany did set a one-for-one exchange rate, more than 30% of eastern Germans were unemployed by
mid-1991 (this problem was compounded by the extremely generous German unemployment compensation system),
inflation fears rose in Germany, and fewer than 10% of eastern German companies were solvent.
7.
When Britain announced its entry into the exchange-rate mechanism of the EMS on October 5, 1990, the price
of British gilts (long-term government bonds) soared and sterling rose in value.
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INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 9TH ED.
a.
What might account for these price jumps?
ANSWER. By entering the exchange-rate mechanism, Britain has effectively foresworn devaluation of the pound
against the DM. In order to maintain the pound's value, Britain must now follow a more disciplined and antiinflation monetary policy. Expectations of lower inflation and fewer currency swings in the future raised the demand
for British assets, including pounds, thereby reducing interest rates (the interest rate is the inverse of the bond price)
and raising the pound's value. Put another way, as we will see in Chapter 8, expectations of lower inflation reduce
interest rates (the Fisher effect) and boost the value of a nation's currency (purchasing power parity).
b.
Sterling entered the ERM at a central rate against the DM of DM 2.95, and it is allowed to move within a band
of plus and minus 6% of this rate. What are sterling's upper and lower rates against the DM?
ANSWER. Sterling's lower limit against the DM is .94 x 2.95 = DM 2.77; its upper limit is 1.06 x 2.95 = DM 3.13.
8.
What potential costs might be associated with the decision to widen the margins within which some currencies
in the ERM can float?
ANSWER. Widening the margins reduces the credibility of the system since such a system grants greater discretion
to the monetary authorities. Currency holders don't want the monetary authorities of suspect currency nations to
have greater discretion. Indeed, the monetary authorities' loss of discretion associated with the ERM is viewed by
most as the ERM's greatest value. For suspect currencies, the loss of credibility will likely lead to higher interest
rates and more speculative attacks.
9.
Comment on the following headline in The Wall Street Journal (January 11, 1993): "Germany's Rate Cut Takes
Pressure Off French Franc, and the Rest of the EMS."
ANSWER. The origin of the September 1992 currency crisis was the Bundesbank's decision to maintain high interest
rates to restrain the inflationary effects of reunification. To maintain their currencies against the D-mark, the other
members of the EMS were forced to push up their own interest rates, thereby stifling economic growth in their
countries. Speculators bet that Britain, Spain, and some other countries would find that trade-off unpalatable and
would devalue their currencies. As long as German rates remained high, this Hobson's choice would continue to face
other European governments and would maintain speculative pressure on their currencies. By cutting its discount
rate, the Bundesbank allowed France and the other EMS members to cut their interest rates and stimulate their
economies without devaluing their currencies. This interest rate cut, therefore, by reducing the likelihood that they
would devalue their currencies, reduced speculative pressure.
10. The French franc was the main target of speculators during the August 1993 assault on the EMS despite the fact
that France was running a 2% inflation rate while Germany had a 4.3% inflation rate. Why might this be?
ANSWER. Two words explain this situation: "credibility" and "expectations." Given the market's trust in the
Bundesbank, the high German inflation rate was viewed as an aberration that the Bundesbank would soon get under
control. Conversely, currency traders were less certain of the Bank of France's long-term commitment to low
inflation, especially since the Bank of France has historically been subservient to the interests of the French
government. More specifically, unlike the Bundesbank, the Bank of France did not have 35 years of independence
behind it and could not count on the unwavering support of a citizenry that abhors inflation. Based on the high rate
of unemployment and sluggish growth in France and the growing demands by the French public for easing up on
monetary policy, it was rational to assign a high probability that the Bank of France would abandon its strong franc
policy. The result would be higher French inflation in the future. Conversely, the history of the Bundesbank would
suggest lower German inflation in the future. Given expectations of higher French inflation and lower German
inflation in the future, the foreign exchange market rationally expected a weaker French franc. Acting immediately
on such expectations, speculators sold francs and bought DM.
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CHAPTER 3: THE INTERNATIONAL MONETARY SYSTEM
11. In early 1996, in response to growing doubts about the ability of EC nations to meet the Maestricht criteria and
move toward monetary union by the 1999 deadline, yields on European bonds jumped. What is the likely link
between the doubts on Maestricht and the EC bond yield increases?
ANSWER. The expectation in the financial markets is that countries that meet the Maestricht criteria will be locked
into a system that is essentially run on the same model as the Bundesbank, namely one that is committed to price
stability as its one and only goal. In other words, the view is that Germany will run EMU and the dominant
characteristic of the single currency is that it will be a low-inflation currency. To the extent that EMU is expected to
materialize, therefore, interest rates on bonds denominated in different currencies will converge toward the rate on
DM bonds, which is lower than that on other European currency bonds. Conversely, an expected movement away
from monetary union lowers the probability that the other European countries will stick with the low-inflation
German monetary policy. Anything that lowers the probability of EMU, therefore, lowers the odds that other
currencies will follow a low-inflation monetary policy, leading to expectations of higher inflation and higher interest
rates.
12. "For a fixed exchange rate system to work the government must be able to make tight budget and monetary
policies stick from the outset." Comment.
ANSWER. A government that runs budget deficits and a lax monetary policy is unlikely to be able to maintain
commitment to .a fixed exchange rate. Hence, one that starts out on the wrong foot will appear to observers to
willing to make exchange rate policy subservient to other national interests. Recognizing this apparent lack
government commitment to a fixed exchange rate, speculators are more likely to attack its currency, making
ability to maintain the fixed exchange rate even more doubtful.
its
be
of
its
13. Upon taking office in October 1993, the Bundesbank's new president, Hans Tietmeyer, said, "Forced reductions
in central bank interest rates which are contrary to stability policies can neither solve economic or structural
problems. But they would undermine trust in currency values, drive long-term interest rates higher and delay
necessary corrections in the real economy." Explain the context in which Mr. Tietmeyer made these comments.
Do you agree or disagree with his comments. Explain.
ANSWER. Mr. Tietmeyer was responding to a chorus of complaints following the currency crisis of August 1993
which, in turn, led to the abandonment of the Exchange Rate Mechanism. The August crisis was triggered by the
(correct) belief that the Bundesbank would not reduce its interest rates sufficiently to permit cuts in interest rates in
other ERM countries such as France and Denmark where unemployment was high and inflation low. What
Tietemayer said, in effect, was "Don't blame Germany for your high unemployment and slow growth. Monetary
policy is not a good tool to use in stimulating an economy. You will just wind up with high inflation and higher real
interest rates. Rather, you should focus on correcting the structural problems that are driving your high
unemployment rates, such as high taxes, a less productive workforce, a subservient central bank (leading to a risk
premium), and expensive labor regulations."
14. Comment on the following statement: "Wage flexibility is a substitute, albeit an imperfect one, for exchange
rate flexibility."
ANSWER. If an economic shock leads to domestic imbalances between supply and demand, a change in the exchange
rate can bring about the necessary changes in prices and wages to reestablish competitiveness. However, if the
exchange rate is fixed, then wages and prices themselves must change to respond to domestic imbalances. Wage
flexibility will go a long way to achieving this end, but it is imperfect since flexibility in the prices of goods and
services is also an important element in adapting to changed economic circumstances.
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SUGGESTED SOLUTIONS TO CHAPTER 3 PROBLEMS
1.
During the currency crisis of September 1992, the Bank of England borrowed DM 33 billion from the
Bundesbank when a pound was worth DM 2.78 or $1.912. It sold these DM in the foreign exchange market for
pounds in a futile attempt to prevent a devaluation of the pound. It repaid these DM at the post-crisis rate of DM
2.50:£1. By then, the dollar:pound exchange rate was $1.782:£1.
a.
By what percentage had the pound sterling devalued in the interim against the Deutsche mark? Against the
dollar?
ANSWER. During this period, the pound depreciated by 10.1% against the pound
2.50 − 2.78
= - 10.1%
2.78
and by 6.8% against the dollar
1.782 − 1.912
= - 6.8%
1.912
b.
What was the cost of intervention to the Bank of England in pounds? In dollars?
ANSWER. The Bank of England borrowed DM 33 billion and must repay DM 33 billion. When it borrowed these
DM, the DM was worth £0.3597, valuing the loan at £11.87 billion (DM 33 billion x 0.3597). After devaluation, the
DM was worth £0.4000. Hence, the Bank of England's cost of repaying the DM loan was £13.20 billion (DM 33
billion x 0.4), a rise of £1.33 billion. Thus, the cost to the Bank of England of this DM borrowing and intervention
was £1.33 billion.
In dollar terms, intervention cost the Bank of England $825 million. This estimate is based on the difference of
$0.025 between the DM's initial value of $0.6878 (1.912/2.78) and its ending value of $0.7128 (1/2.50) times the
DM 33 billion borrowed and spent defending the pound. Specifically, the cost calculation is $0.025 x
33,000,000,000 = $825 million.
2.
Suppose the central rates within the ERM for the French franc and DM are FF 6.90403:ECU 1 and DM
2.05853:ECU 1, respectively.
a.
What is the cross-exchange rate between the franc and the mark?
ANSWER. Since things equal to the same thing are equal to each other, we have FF 6.90403 = DM 2.05853. Hence,
FF1 = DM 2.05853/6.90403 = DM 0.298164. Equivalently, DM 1 = FF 6.90403/2.05853 = FF 3.35386.
b.
Under the original 2.25% margin on either side of the central rate, what were the approximate upper and lower
intervention limits for France and Germany?
ANSWER. Given the answer to part a, the French franc could rise to approximately DM 0.298164 x 1.0225 = DM
0.304872 or fall as far as DM 0.298164 x 0.9775 = DM 0.291455. Similarly, the upper limit for the DM is FF
3.42933 and the lower limit is FF 3.27840.
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CHAPTER 3: THE INTERNATIONAL MONETARY SYSTEM
c.
Under the revised 15% margin on either side of the central rate, what are the current approximate upper and
lower intervention limits for France and Germany?
ANSWER. Given the answer to part a, the French franc could rise to approximately DM 0.298164 x 1.15 = DM
0.342888 or fall as far as DM 2.98164 x 0.85 = DM 0.253439. Similarly, the upper limit for the DM is FF 3.85694
and the lower limit is FF 2.85078.
3.
A Dutch company exporting to France had FF 3 million due in 90 days. Suppose that the current exchange rate
was FF 1 = Dfl 0.3291.
a.
Under the exchange rate mechanism, and assuming central rates of FF 6.45863/ECU and Dfl 2.16979/ECU,
what was the central cross-exchange rate between the two currencies?
ANSWER. Given central rates of DFl 2.16979:ECU and FF 6.45863:ECU for the Dutch guilder and French franc,
respectively, the central cross rate between the two currencies is DFl 1 = FF 2.97662 (6.45863/2.16979).
Equivalently, FF 1 = DFl 0.335952 (2.16979/6.45863).
b.
Based on the answer to part a, what was the most the Dutch company could lose on its French franc receivable,
assuming that France and the Netherlands stuck to the ERM with a 15% band on either side of their central
cross rate?
ANSWER. At worst, the French franc can fall by 15% relative to its central guilder cross rate, to a cross-exchange
rate of FF 1 = DFl 0.285559 (0.335952 x 0.85). Since the current exchange rate is FF 1 = DFl 0.3291, the most the
Dutch company can lose on its FF 3 million receivable is 3,000,000 x (0.3291 - 0.285559) = DFl 130,622.
c.
Redo part b, assuming the band was narrowed to 2.25%.
ANSWER. If the band were narrowed to 2.25%, then the minimum value for the French franc would be DFl 0.328393
and the maximum loss that the Dutch company could sustain would be 3,000,000 x (0.3291 - 0.328393) = DFl
2,121.
d.
Redo part b, assuming you know nothing about the current cross-exchange rate.
ANSWER. Knowing nothing about the current cross-exchange rate, the worst that could happen is that the cross rate
would be at its upper bound of DFl 0.386345 (0.335952 x 1.15) and it falls to its lower bound of 0.285559
(established in the answer to part b). In this case, the maximum possible loss is 3,000,000 x (0.386345 - 0. 285559)
= DFl 302,357.
4.
Panama adopted the U.S. dollar as its official paper money in 1904. There is currently about $400 million to
$500 million in U.S. dollars circulating in Panama. If interest rates on U.S. Treasury securities are 7%, what is
the value of the seigniorage that Panama is forgoing by using the U.S. dollar instead of its own-issue money?
ANSWER. Instead of using U.S. dollars as its currency in circulation, the Panamanian government could substitute its
own currency and invest the $400 million to $500 million in U.S. Treasury securities. This policy would earn the
Panamanian government $28 million to $35 million annually at the current 7% interest rate. Thus, the Panamanian
government is foregoing seigniorage worth $28 million to $35 million annually. The present value of this
seigniorage equals the amount of U.S. dollars in circulation, or $400 million ($28 million/.07) to $500 million ($35
million/.07).
5.
By some estimates, $185 billion to $260 billion in currency is held outside the United States.
a.
What is the value to the United States of the seigniorage associated with these overseas dollars ? Assume that
dollar interest rates are about 6%.
ANSWER. The annual value of seigniorage equals the foregone interest on the currency held outside the United
States. Based on the numbers presented in the question, this annual value varies between $11.1 billion (0.06 x $185
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INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 9TH ED.
billion) and $15.6 billion (0.06 x $260 billion). If this money stays overseas permanently, then the value of
seigniorage is just equal to the amount of dollars held outside the United States, or $185 billion to $260 billion. In
other words, the United States receives goods and services worth this amount of money from foreigners and paid for
them with pieces of green paper that are never redeemed for U.S. goods and services.
b.
Who in the United States realizes this seigniorage?
ANSWER. The U.S. government realizes this seigniorage. Who in the United States benefits from this seigniorage is
an issue in political economy and depends what the government does with the money: cuts taxes, spends it (which
raises the further question of on whom), uses it to reduce the deficit, etc.
ADDITIONAL CHAPTER 3 PROBLEM AND SOLUTION
1.
The central rates for the Spanish and Belgian currencies on March 20, 1997, were Ptas 163.826/ECU and BF
39.7191/ECU. What central cross rate between these two currencies did these central rates imply?
ANSWER. These rates imply a central cross rate between the two currencies of Ptas 4.1246/BF (163.826/39.7191), or
equivalently, BF 0.242447/Ptas (39.7191/163.826).
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