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Chapter 18 Notes

Chapter 18 Notes - Chapter 18 The International Financiai...

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Unformatted text preview: Chapter 18 The International Financiai System Exchange Rate Systems 0 Some countries simply allow the exchange rate to be determined by demand and supply, just as other prices are. 0 A country that aiiows demand and suppiy to determine the vaiue of its currency is said to have a floating currency. ’d‘?+€l" i’tri'i - When countries can agree on how exchange rates should be determined, economists say that there is an exchange rate system. 0 The current exchange rate system under which the value of most currencies is determined by demand and supply with occasional government intervention is known as a managed float exchange rate system. c 50339le ei C‘th‘hC ) ®W\ “3(th kafi; WWW «J’Htith‘y o The two most important alternatives to the managed float exchange rate system were the gold standard and the Bretton Woods System. - These were both fixed exchange rate systems where exchange rates remained constant for long periods — SUPER/fie t senses/in Wt o Eat (it? icy-Wire i 0 Under the gold standard, a country’ s currency consisted of gold coins and paper currency that the government was committed to redeem for gold. Because of the Great Depression, by the mid—19305, most countries, including the United States, had abandoned the gold standard. jjri‘ri’téillifi 0st Fg‘; :1 “/5 Sol/L3 C‘vi ncee V” ’l‘ 5> D to?“ “built/1 fl\ 33% "i4— ’t‘he current Exchange Rate 0 The current exchange rate system has three important aspects: 1. The United States allows the dollar to float against other major currencies. The doilar increases in value when it takes more units of foreign currency to buy one dollar and falls in value when it takes fewer units of foreign currency to buy one dollar. 2. Most countries in Western Europe have adopted a single currency, the euro. 3. Some developing countries have attempted to keep their currencies’ exchange rates fixed against the dollar or another major currency. The F touting Boiiar The dollar increases in value when it takes more units of foreign currency to buy one dollar and falls in value when it takes fewer units of foreign currency to buy one dollar. Since 1973, the value of the 15.5. dollar has fiuctuated widely against other major currencies. From the beginning of 1973 to the end of 2006, the US. dollar lost about 60 percent in value against the yen, while it increased about 15 percent in value against the Canadian dollar. What Eete‘rmines Exchange Rates in the Long Run? The two most important causes of exchange rate movements are changes in interest rates -— which cause investors to change their views of which countries’ financial investments will yield the highest returns — and changes in investors’ expectations about the future values of currencies. g; (/0593er The theory that, in the long run, exchange rates move to equalize the purchasing power of different currencies is referred to as the theory of purchasing power parity. Three reai—world complications, though, keep purchasing power parity from being a complete explanation of exchange rates, even in the long run: 1. Not all products can be traded internationaliy. 2. Products and consumer preferences are different across countries. Countries impose barriers to trade, such as tariffs and quotas. A tariff is a tax imposed by a government on imports. A quota is a limit on the quantity of a good that can be imported. w E x " hag/x155: wigjgg ; A. 1‘ ,1“, fl , I“ 1/3051?” 332 mm «m it; “2‘3 \, 0 CO); . (36*? mars, gag“ PEI: “Gm; 33 _ J 3 "fig: 3.3.3": 5| Air/1% in}; ‘2 i\ “ 8W {7/ A? JTO EgbUQ/glzfl “\AV’XQ; ijfiéfi 0%: {(‘v‘fiv do“ aéfflgg ”This ‘33 ?PP There are four determinants of exchange rates in the long run: . Relative price levels. 2. Relative rates of productivity growth. 3. Preferences for domestic and foreign goods. 4. Tariffs and quotas. {3. The Euro 0 On January I, 2002, euro coins and paper currency were introduced and, as of 2007, 13 member countries of the European Union have adopted the euro as their common currency. 0 A new European Central Bank (ECB) was also established to assume responsibility for monetary policy and for issuing currency. - Economists are divided over whether the creation of the euro will help growth in the EU countries. The experiences of the countries using the euro will provide economists with additional information on the costs and benefits to countries from using the same currency. t). ?eggtng against the hotter c When a country keeps its currency’s exchange rate fixed against another country’s currency, it is pegging its currency. 9 in the 19805 and 19905, the flow of foreign investment funds to developing countries, particularly those in East Asia, increased substantially. a Countries attempting to maintain a peg can run into problems. o By 1997, the Thai Baht was overvalued against the dollar. 0 A currency pegged at a value above the market equilibrium exchange rate is said to be overvalued. c A currency pegged at a value below the market equilibrium exchange rate is said to be undervalued. 0 When investors make it more difficult to maintain a fixed exchange rate, it is referred to as destabilizing speculation. 0 The number of countries with pegged exchange rates/declined sharply; therefore the trend has been toward replacing pegged exchange rates with managed floating exchange rates. - in 1978, China began to move away from central planning and toward a market system, which accelerated economic growth. rd“ r amt?) internatieaai Capitai Markets One important reason exchange rates fluctuate is that investors seek out the best investments they can find anywhere in the world. For exampie, if Chinese investors increase their demand for U5. Treasury biils, the demand for dollars will increase, and the dollar will appreciate. If, on the other hand, interest rates in the United States decline, foreign investors may sell U.S. investments, and the value ofthe dollar will fall. Shares of stoCk and long—term debt, including corporate and government bonds and bank loans, are bought and soid on capital markets. In the 19805 and 19905, European governments removed many restrictions on foreign investments in financial markets. There are large capital markets in Europe and Japan, and there are smaller markets in Latin America and East Asia. The three most important international financial centers today are New York, London, and Tokyo. Each day the front page of the online'version of the Wall Street Journal displays the following stocks: Dow Jones Industrial Average and Standard and Poor’s 500 stock indexes of U.S. stocks, the Nikkei 255 average of Japanese stocks, the FTSE 100 index of stocks on the London Stock Exchange, and the Euro STOXX 50 index of European stocks. By 2007, corporations, banks, and governments raised more than $1 triliion in funds on giobal financial markets. Beginning in the 19905, the flow of foreign funds into US. stocks and bonds — or portfolio investments — increased dramatically. By 2006, foreign investment in these securities was at record levels. The globalization of financial markets has helped increase growth and efficiency in the world economy. No longer are firms forced to rely oniy on the savings of domestic househoids to finance investment. Extra Economics in YOUR Life! amperage fining and Your income Question: Suppose that you work for a computer company. Because the firm has an office in Germany, you are asked to move there and work for a two-year period. Your employer gives you the option to receive pay either in dollars or in euros. Which payment option is better for you? What factors should affect your decision? Answer: Since you will be working in Germany for a two-year period, you need euros in order to pay your bills, buy food, and cover your living expenses while you are staying in Germany. Fiuctuations in the foreign exchange market for euros in terms of doliars will affect your income. if you choose to get paid in dollars, your income wili fluctuate based on the changes in the foreign exchange market. An increase in the value of the euro reiative to the US. dollar means a reduction in your salary in terms of euros. A reduction in your salary in terms of euros reduces the purchasing power of your living in Germany. So, you might be better off if you decide to get paid in euros to avoid fluctuations in your Income. Appendix ”fife " oioi ginndorci and the Brni‘ion gysinrn LEARNlNG OBJECTIVE: Expiuin the goid standard and the Breiion Woods System. A. The Gold Standard Under the Gold Standard, the exchange rate between two currencies was automaticaliy determined by the quantity of good in each currency. If there was one~fifth of an ounce of gold in a US. dollar and one ounce of goid in a British pound, the price of gold in the United States would be $5 per ounce, and the price of goid in Britain would be £1 per ounce. The exchange rate wouid be $5 = £1. B. The End of the Gold Standard When the Great Depression began in 1929, governments came under pressure to abandon the gold standard to allow their central banks to pursue active monetary poiicies. In 1931, Great Britain became the first major country to abandon the gold standard. The United States remained on the gold standard until 1933, and a few countries, including France, Italy, and Belgium, stayed on even longer. By the late 19305, the gold standard had collapsed. The earlier a country abandoned the gold standard, the easier time it had fighting the Depression with expansionary monetary policies. C. The Bretton Woods System Bretton Woods System is an exchange rate system that lasted from 1944 to 1971, under which countries pledged to buy and sell their currencies at a fixed rate against the dollar. International Monetary Fund (IMF) is an international organization that provides foreign currency loans to centrai banks and oversees the operation of the international monetary system. Devaluation refers to a reduction in a fixed exchange rate. Revaiuation refers to an increase in a fixed exchange rate. D. The Coilopse of the Bretton Woods System By the late 19605, the Bretton Woods System faced two severe problems: After 1963, the totai number of dollars held by foreign central banks was larger than the gold reserves of the United States. Some countries with undervalued currencies, particularly West Germany, were unwilling to revalue their currencies. Governments resisted revaluation because it would have increased the prices of their countries’ exports. During the 19605, most European countries, including Germany, relaxed their capital controls. Capital controls are iimits on the flow of foreign exchange and financial investment across countries. The loosening of capital controls made it easier for investors to speculate on changes in exchange rates. Investors’ actions to make a profit from the expected currency revaluation make it more difficult to maintain a fixed exchange rate and they are referred to as destabilizing speculation. ...
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