Lecture 5 GOLD BRETTON FIXED AND FLOAT

PowerPoint Presentation: 

International Business ---- Lecture 4

Foreign Exchange Rates & Quotations: 

2 Foreign Exchange Rates & Quotations A foreign exchange rate is the price of one currency expressed in terms of another currency. A foreign exchange quotation (or quote) is a statement of willingness to buy or sell at an announced rate.

Bid & Ask Quotes: 

3 Bid & Ask Quotes Foreign currency dealers provide two quotes: Bid Price: Price at which the dealer is willing to buy foreign currency from you. Ask Price: Price at which the dealer is willing to sell foreign currency to you. It is always the case that the Ask Price > Bid Price. The difference is the Bid-Ask spread. The less traded and more volatile a currency, the greater is the spread.

Example: 

4 Example Bid Ask $/£ 1.4482 1.4484 Bid: Dealer buys £ for $ at the Bid, Client sells £ for $ (i.e., dealer will buy £1,000,000 for $1,448,200). Ask: Dealer sells £ for $ at the Ask, Client buys £ with $ (i.e., dealer will sell £1,000,000 for $1,448,400).

Bid – Ask Spread: 

5 Bid – Ask Spread Banks act as market makers and realise their profits from the spread: Bid-Ask Spread = ( Ask-Bid )/Ask Consider the DIRECT quote of $ 1.4482 – 1.4484/ £

International Monetary System: 

International Monetary System The institutional arrangements that govern exchange rates Evolved from the: ancient Gold Standard until its collapse in the 1930’s before the 1944 Bretton Woods system established the: fixed exchange system International Monetary Fund (IMF) and World Bank before it collapsed in 1973 resulting in today’s: mixed system of floating, managed and pegged currencies

Exchange Rate Systems: 

Exchange Rate Systems Floating Exchange Rate Foreign exchange market forces determine the relative value of a currency against each other Some government intervention, but not required Euro, US Dollar, Japanese Yen, British Pound

Exchange Rate Systems: 

Exchange Rate Systems Pegged Exchange Rate Value of the currency is fixed relative to a reference currency, such as the US dollar Exchange rate between that currency and the other currencies is determined by the reference currency exchange rate Requires government intervention

Exchange Rate Systems: 

Exchange Rate Systems Managed-Float or “Dirty Float” Value of the currency is determined by market forces…. but the country’s central bank will intervene in the foreign exchange market Attempts to maintain the value of its currency against: an important reference currency or basket of currencies (Yuan to Euro, US$, Yen) within some trading range

Exchange Rate Systems: 

Exchange Rate Systems Fixed Exchange Rate Values of a set of currencies are fixed against each other at some mutually agreed-on exchange rate European Monetary System (EMS) operated with this system before the introduction of the Euro For 25 years after WWII, industrial nations belonged to fixed exchange rate system before its collapse in 1973

Gold Standard: 

Gold Standard Pegging the value of currencies to gold and guaranteeing their convertibility Gold coins as a medium of exchange dates back to ancient times International trade grew and it became inconvenient to ship and transport gold coins changed to paper currency redeemable for gold governments converted paper currency into gold on demand at a fixed exchange rate by 1880, most of the world’s major trading nations had adopted the gold standard Great Britain, Germany, Japan, United States

Balance of Trade Equilibrium: 

Balance of Trade Equilibrium Trade Surplus Gold Increased money supply= price inflation Decreased money supply= price decline As prices decline, exports increase and trade goes into equilibrium

End of the Gold Standard: 1918-1939: 

End of the Gold Standard: 1918-1939 Nations abandoned gold standard at start of WWI in 1914 War costs led nations to print money creating inflation and higher prices at the end of WWI in 1918 Resulting in the U.S. (1919), Great Britain (1925), France(1928) to return to the gold standard Britain used old pre-war parity rate to lower their export prices in foreign markets US followed suit and changed gold/$ ratio devaluing the dollar to increase exports and decrease imports Other countries did similar competitive devaluations Resulted in lack of confidence in system Created a “run” on countries gold reserves By the start of WWII in 1939 the gold standard was dead

Bretton Woods: 1944: 

Bretton Woods: 1944 During WWII, 44 countries met in New Hampshire Agreed to an international monetary system: creation of World Bank and International Monetary Fund fixed exchange rate system policed by the IMF nations pegging currencies to gold at $35 per ounce only the US dollar was convertible into gold nations would defend their currency to maintain its value within 1% of the par value nations would not devalue currency for trade purposes if a currency was too weak to defend, a devaluation of no more than 10% was allowed ….larger than 10% required IMF approval

1973 Collapse of the Fixed Exchange Rate System: 

1973 Collapse of the Fixed Exchange Rate System

What Led to the Collapse?: 

What Led to the Collapse? Central Role of the US dollar in the Fixed Exchange Rate System As the only currency that could be converted into gold and serving as a reference currency…. ….any pressure on the US dollar to devalue would wreak havoc with the system

What Led to the Collapse?: 

What Led to the Collapse? President Johnson financed both the Great Society and Vietnam War by increasing the money supply resulting in high inflation high spending on imports created B-o-P deficit increased market speculation for dollar devaluation Increase in inflation and the worsening US trade position gave rise to speculation in the foreign exchange markets that the dollar would be devalued To devalue the dollar under Bretton Woods required all countries agreed to simultaneously revalue their currency against the dollar But countries hesitated to revalue their currency because this would make their exports more expensive

What Led to the Collapse?: 

What Led to the Collapse? President Nixon’s desire to reduce the US trade deficit and to pressure the other countries to revalue their currency announced the dollar was no longer convertible into gold levied an 10% tax on imports Countries finally agreed to revalue their currencies against the dollar by 8% and the US import tax was removed But a continued US trade deficit and inflation rate fueled speculation on a further dollar devaluation resulting in the other currencies appreciating against the dollar Other countries failed to keep their currencies from appreciating and abandoned fixed exchange rates and allowed their currencies to float against the dollar…. game over for fixed exchange rates!

Floating Exchange Rate Regime: 

Floating Exchange Rate Regime

Floating Exchange Rate Regime: 

Floating Exchange Rate Regime Jamaica Agreement - 1976 Revised the IMF Articles of Agreement floating rates acceptable gold abandoned as reserve asset IMF annual quotas increased IMF continued role of helping countries cope with macroeconomic and exchange rate problems

Exchange Rates since 1973: 

Exchange Rates since 1973 Rates became more volatile and less predictable 1971 OPEC oil crisis and 400% price increase 1977-78 Loss of confidence in the dollar 1979 OPEC oil crisis and 200% price increase 1980-85 Unexpected rise in the dollar 1985-87 Rapid fall of the dollar 1992 Collapse of European Monetary System 1993-95 Rapid fall of the dollar 1997 Asian currency crisis 2008 Global credit crisis

When to Change the Rate?: 

When to Change the Rate? Why might a government want to change the exchange value of its currency? It might do so in order to promote, for example, greater export volume.

When to Change the Rate?: 

When to Change the Rate? What is a pegged exchange rate? The term pegged exchange rate refers to setting a targeted value for a country’s foreign exchange, and it indicates the govt. has some ability to move the peg.

When to Change the Rate?: 

When to Change the Rate? Governments attempt to keep the value fixed for relatively long periods of time to reduce trade uncertainties. What is an adjustable peg? The government may change the pegged rate if a substantial disequilibrium in the country’s international position develops ( e.g., demand for the currency is too weak to maintain the desired value).

When to Change the Rate?: 

When to Change the Rate? A crawling peg can be changed often (monthly, say) according to a set of indicators or the judgment of the country’s monetary authority. Indicators: The difference of inflation rates International reserve assets Growth of the money supply

In Conclusion: 

In Conclusion Fixed exchange rates are government controlled. Floating exchange rates are market driven . Governments have always preferred the improved business climate of fixed rates They reduce the uncertainty of unstable currency values

In Conclusion: 

In Conclusion But as financial markets have developed to accommodate for flexible exchange rates, more and more countries have come to appreciate the value of market determination.

Fixed vs. Floating Exchange Rates Which is Better?: 

Fixed vs. Floating Exchange Rates Which is Better?

Fixed vs. Floating Exchange Rates: 

Fixed vs. Floating Exchange Rates Floating: Arguments in Favor Monetary policy autonomy Allows a country to expand or contract it money supply Restores control to government to manage inflation and exchange rate parity Automatic trade balance adjustments Currency adjusts to correct trade imbalances

Fixed vs. Floating Exchange Rates: 

Fixed vs. Floating Exchange Rates Fixed: Arguments in Favor Monetary Discipline Government required to maintain fixed exchange parity and control monetary supply and inflation Speculation and Uncertainty limits destabilizing effects of speculation nurtures predictable exchange rate movements promotes growth of international trade and investment Trade Balance Adjustments exchange rates and trade balance are not always linked trade deficits are result of the balance between savings and investment and not by the external value of a its currency

Fixed vs. Floating Exchange Rates Who is Right? The evidence is not clear: 

Fixed vs. Floating Exchange Rates Who is Right? The evidence is not clear

Current Exchange Rate Regimes: 

Current Exchange Rate Regimes A range of different exchange rate policies exist as of 2006: 28% intervene on a limited basis as a managed float 26% peg their currency to other currency or basket of currencies 22% have no separate tender by giving up their own currency (Euro) 14% allow their currency to freely float 6% allow currency to fluctuate within a target zone as adjustable peg dhawan.herry@gmail.com Herry Dhawan Subject: PG401 --- IBT

Pegged Exchange Rates: 

Pegged Exchange Rates Country pegs the value of its currency to another major currency Popular among smaller nations Imposes monetary discipline Evidence suggests it moderates inflation Many countries operate with only a nominal peg and are willing to devalue their currency rather than pursue a tight monetary policy Difficult for a small nation to maintain a peg if capital is flowing out of the country and currency is under a speculative attack

Floating Rates and Globalization : 

Floating Rates and Globalization Is globalization causing drastic currency swings? Governments are increasingly reluctant to act together against big currency swings Big currency swings force firms to change where they produce and market their products Some central bankers are wondering if a modified system of fixed exchange rates should return

Mexican Currency Crisis of 1995: 

Mexican Currency Crisis of 1995 Peso pegged to U.S. dollar Mexican producer prices rise by 45% without corresponding exchange rate adjustment Investments continued ($64B between 1990 -1994) Speculators began selling pesos and government lacked foreign currency reserves to defend it IMF stepped in

Asian Financial Crisis of 1997: 

Asian Financial Crisis of 1997 Causes Investment boom Cronyism and poor loans Lack of transparency in the financial sector Excess capacity in many sectors Dependence on speculative capital inflows Increasing debt service and current account deficits Currencies and debt tied to strengthening dollar Expanding imports Weak Japanese economy

Asian Financial Crisis of 1997: 

Asian Financial Crisis of 1997 Several key Thai financial institutions on the verge of default Result of speculative overbuilding and poor loans Excessive dollar-denominated debt investment Deteriorating balance-of payments position Thailand asks IMF for help 17.2 billion in loans, given with restrictive conditions After Thai baht devaluation, currency speculation hit Malaysia Singapore Indonesia Korea