Chapter 10 International Monetary Systems

Chapter 10 International Monetary Systems - lecture notes...

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lecture notes for chapter 10 Chapter 10 International Monetary Systems 1. INTRODUCTION This chapter explores factors that determine exchange rates and various international attempts to manage them. It also presents different methods of forecasting exchange rates, and the functioning of the international monetary system. 2. HOW EXCHANGE RATES INFLUENCE BUSINESS ACTIVITIES Exchange rates affect demand for products. When a country’s currency is weak , the price of its exports declines, making the exports more appealing on world markets. Devaluation is the intentional lowering of the value of a currency by the nation’s government. Gives domestic producers an edge on world markets, but also reduces citizens’ buying power. Revaluation is the intentional raising of the value of a nation’s currency. Increases the price of exports and reduces the price of imports. Exchange rates affect profits earned abroad when repatriated by the parent company into the home currency . Translating subsidiary earnings from a weak host country currency into a strong home currency reduces earnings, and vice versa.
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A. Desire for Stability and Predictability 1. Stability makes for accurate financial planning and cash flow forecasts. 2. Predictability reduces odds that a company will be caught off-guard by unexpected rate changes. Reduces the need for costly insurance (currency hedging) against possible adverse exchange rates. 3. WHAT FACTORS DETERMINE EXCHANGE RATES? To understand what determines rates, must know: (1) the law of one price and (2) purchasing power parity. Each tells the level at which an exchange rate should be. A. Law of One Price 1. Exchange rates do not guarantee or stabilize the buying power of a currency; purchasing power fluctuates. 2. Law of one price says an identical product must have an identical price in all countries when expressed in the same currency. Product must be identical in quality or content and be entirely produced within each country.
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3. If price were not identical in each country, an arbitrage opportunity would arise. Traders would buy in the low-priced market and sell in the high-priced market; buying drives up the price in one market and drives down the price in the other. 4. The Economist publishes its “Big Mac Index” using the law of one price to determine the exchange rate between the U.S. dollar and other currencies. Fair predictor of the “direction” rates should move. B. Purchasing Power Parity PPP is the relative ability of two countries’ currencies to buy the same “basket” of goods in those two countries. Tells how much of currency “A” a person in nation “A” needs to buy the same amount of products that someone in nation “B” can buy with currency “B.” · Considers price levels in adjusting the relative values of the two currencies.
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