8/10/2019 AFC3240 Notes

1/18

Chapter 1

Multinational corporation

A multinational corporation (MNC) is a company engaged in producing and selling goods

or services in more than one country. It ordinarily consists of a parent company located

in the home country and at least 5/6 foreign subsidiaries, typically with a high degree of

strategic interaction among the units.

Comparative advantageeach nation should specialize in the production and export of

those goods that it can produce with the highest relative efficiency and import those

goods that other nations can produce relatively more efficiently. In other words, every

nation should produce goods with the lowest opportunity cost.

Classical trade theory assumes that countries differ enough in terms of resource

endowments and economic skills for those differences to be at the center of any

analysis of corporate competitiveness. Differences among individual corporate

strategies were considered only to be of a secondary issue. However nowadays, differences among corporations are becoming more important

than aggregate differences among countries. The ability of corporations of all sizes to

use these globally available factors of production is a far bigger factor in international

competitiveness than broad macroeconomic differences among countries.

Foreign direct investment (FDI)which is the acquisition abroad of companies, property,

or physical assets such as plant and equipment.

Reasons for the rise of multinational corporations

Search for raw materialsThis was the earliest reason for the rising of multinational

corporations. The aim was to exploit the raw materials that could be found overseas.

Market seekingthe market seeker is the type of modern multinational firm that goes

overseas to produce and sell in foreign markets. The rationale for the market seeker is

simple: foreign markets are big, even relative to the domestic market. Reverse foreign

investment is when other firms outside the US begin to acquire US firms. A reason might

be that there are restrictions on exports to the US market, so they have to directly

invest in these markets to sell in these markets. Foreign market entry may be essential

for obtaining economies of scale (the unit cost decreases that are achieved through

volume production). Firms in industries characterized by high fixed costs relative to

variable costs must engage in volume just to break even, these large volumes may be

forthcoming only if the firms expand overseas.

Cost minimizationThese firms seek out and invest in lower-cost production sites

overseas to remain cost competitive both at home and abroad. The offshoring of

services can be done in 2 waysinternally through the establishment of wholly owned

foreign affiliates, or externally, by outsourcing a service to a third-party provider. Pg 15,

exhibit 1.5. One strategy that is often followed by firms for which cost is the key

8/10/2019 AFC3240 Notes

2/18

8/10/2019 AFC3240 Notes

3/18

keep abreast of market developments, adapt its products and production

schedule to changing local tastes and conditions, fill orders faster and provide

more comprehensive after-sales service. Setting up local production facilities

also shows a greater commitment to the local market, this will bring added sales

and provides increased supply stability. Associated with a firms decision to

produce abroad is the question of whether to create its own affiliates or to

acquire going concerns. A major advantage of an acquisition is the capacity to

effect a speed transfer overseas of highly developed but underutilized parent

skills. The disadvantages are the cost of buying an ongoing company. In general,

the larger and more experienced a firm becomes, the less frequently it uses

acquisitions to expand overseas. Smaller and relatively less experienced firms

often turn to acquisitions.

3.

LicensingAn alternative to setting up production facilities abroad is to license

a local firm to manufacture the companys products in return for royalties and

other forms of payment. The principal advantages of licensing are the minimal

investment required, faster market-entry time and fewer financial and legal

risks. But the corresponding cash flow might be relatively low and there may be

problems maintaining product quality. The foreign licensee (the holder of the

license) may even become such a strong competitor that the licensing firm will

face difficulty entering the market when the agreement expires.

There are certain circumstances under which each approachexport, license, local

productionwill be the preferred alternative for exploiting foreign markets:

1. ExportsIf MNC possess intangible capital in the form of trademarks, patents,

general marketing skills and other organizational abilities. If this intangible

capital can be embodied in the form of products without adaptation, then

exporting would be preferred.

2.

LicensingIf the firms knowledge takes the form of specific product or process

technologies that can be written down and transmitted objectively.

3. Local productionhowever if this intangible capital takes the form of

organizational skills that are inseparable from the firm itself, eg, quality control,

after sales service, itd be difficult to unbundle these services and sell them

apart from the firm. Then the firm would establish foreign affiliates.

Judging whether a foreign investment is desirable takes into consideration:

1. Internalization (FDI) is most likely to be economically viable in those settings in

which the possibility of contractual difficulties makes it especially costly to

coordinate economic activities via arms length transactions in the marketplace.

2.

Vertical direct integrationdirect investment across industries that are related

to different stages of production of a particular goodenables the MNC to

substitute internal production and distribution systems for inefficient markets.

3. Horizontal direct investmentinvestment that is cross-border but within an

industryenables the MNC to utilize an advantage and avoid the contractual

difficulties of dealing with unrelated parties.

8/10/2019 AFC3240 Notes

4/18

Behavioral definition of the MNC

The true MNC is characterized more by its state of mind rather than its size and

worldwide dispersion of its assets. A MNC does not limit its search for capital or

investment opportunities to any single national financial market. Hence, the essential

element that distinguishes the true multinational is its commitment to seeking out,undertaking and integrating manufacturing etc on a global and not domestic basis.

Another important characteristic is focus, this means figuring out and building on what a

company does best. This process typically involves divesting unrelated business

activities and seeking attract investment opportunities in its core business.

Multinational financial management

The main objective of multinational financial management is to maximize shareholder

wealth as measured by share price. The focus on shareholder value stems from the fact

that shareholders are the legal owners of the firm and management has an obligation to

act in their best interests. A more compelling reason for focusing on creating

shareholder wealth is that those companies that do not are likely to be prime targets for

takeover and for forced corporate restructuring.

Companies that create value have more money to distribute to all stakeholders not just

shareholders.

Functions of financial management

Financial management is separated into two basic functions: The acquisition of funds

and investment of those funds. The first function is called the financing decision, which

involves generating funds from internal sources or from sources external to the firm atthe lowest long-run cost possible. The investment decision is concerned with the

allocation of funds over time in such a way that shareholder wealth is maximized.

For international financial management, we must also remember the risk management

decision which is exchange rate exposures, different regulatory systems, legal systems

and tax regimes; different systems of corporate governance; political risks.

Relationship to domestic financial management

Three concepts arise in financial economics have proved to be of particular important in

developing a theoretical foundation for international corporate finance:

1.

Arbitragedefined as the purchase of assets or commodities on one market for

immediate resale on another in order to profit from a price discrepancy. Tax

arbitrage involves shifting gains or losses from one tax jurisdiction to another to

profit from differences in tax rates. Risk arbitrage is speculation.

2. Market efficiencyAn efficient market is one in which the prices of traded

securities readily incorporate new information. The predicative power of

markets lies in their ability to collect in one place a mass of individual judgments

8/10/2019 AFC3240 Notes

5/18

from around the world. Those judgments are based on current information. If

the trend of future policies change, people will revise their expectations and

prices will change to incorporate the new information.

3. Capital asset pricingCapital asset pricing refers to the way in which securities

are valued in line with their anticipated risks and returns.

Systematic/unsystematic risk.

Total risk (systematic + unsystematic) is important to the firm because it may have a

negative impact on the firms expected cash flows. Total risk is likely to affect a firm with

a high amount of leverage, it faces a high probability of failure and therefore may incur

financial distress costs hence the higher total risk lowers the price of this firm.

Much of the general market risk facing a company is related to the cyclical nature of the

domestic economy of the home country. Operating in several nations whose economic

cycles are not perfectly in phase should reduce the variability of the firms earnings.

Thus, even though the risk of operating in any one foreign country may be greater than

the risk of operating in the home country, diversification can eliminate much of that risk.

What is true for companies is also true for investors. International diversification can

reduce the riskiness of an investment portfolio because national financial markets tend

to move somewhat independently of one another.

Chapter 2

Definitions

Broker

A brokerorganises the trade, by introducing the buyer to the seller and the seller to

the buyer.

Brokers do not hold a position in the asset, and the transaction is between the seller and

the buyer.

The broker charges a commissionfor this service.

Dealer

A dealeracts as a buyer to the seller and a seller to the buyer, and holds stocks of the

asset.

The dealer earns the dealers spread, buy buying at a slightly lower price than what they

sell at.

Soft/weak

The currency has a low value or is expected to depreciate in the future.

Hard/strong

The currency has a high value or is expected to appreciate in the future.

8/10/2019 AFC3240 Notes

6/18

Exchange rates

Pegged currency: one whose value is set by the government.

Freely floating exchange rate: no government intervention to determine the exchange

rates. Set by market forces.

Devaluation/Revaluation: Refers to a decrease and increase respectively in the par valueof a pegged currency.

Depreciate/Appreciate: Refers to a loss and gain in value in the value of a floating

currency.

Setting the equilibrium spot exchange rate

An exchange rate is the price of one nations currency in terms ofanother currency,

called the reference currency. Eg, the yen/dollar exchange rate is just the number of yen

that one dollar will buy. If a dollar will buy 100 yen then the exchange rate would be

Y100/$.

A spot rate is the price at which currencies are traded for immediate delivery, actual

settlement occurs 2 days later.

A forward rate is the price at which FX is quoted for delivery at a specified future date.

Exchange rates are set as market clearing prices that equilibrate supplies and demand in

the FX market.

Demand for a currency (Refer to pg 59)

Looking from the FX currency p.o.v, the demand for euro in the FX market (same as the

supply of dollars in the FX market) derives from the America demand for Euroland goods

and services and euro-denominated financial assets. Euroland prices are set in euroes,so in order for Americans to pay for their Euroland purchases, they must first exchange

their dollars for euros. That is, they will demand euros.

To show that the demand curve for FX is downward sloping, an increase in the price of

euro is equivalent to a higher dollar price for Euroland products, thus this will reduce

the quantity demanded of euros as there is a lower demand for Euroland goods and

services. The converse is also true.

Supply for a currency (Refer to pg 59)

Looking from the FX currency p.o.v, the supply for euro in the FX market (same as the

demand of dollars in the FX market) is based on the Euroland demand for US goods and

services and dollar dollar denominated financial assets. In order for Euroland residents

to pay for their US purchases, they must first acquire dollars.

To show that the supply curve for FX is upward sloping, as the dollar value of the euro

increases, this lowers the euro cost of US goods, hence there will be an increased

Euroland demand for US goods and this will cause an increase in the quantity demanded

of dollars and hence in the quantity supplied of euros.

8/10/2019 AFC3240 Notes

7/18

Factors that influence the equilibrium exchange rate

Refer to exhibit 2.2 pg 60.

Relative inflation rates: Suppose in the US, the money supply increases, this leads to a

decrease in interest rates and hence there will be more borrowing (spending) which will

increase inflation in the US. Euroland consumers are likely to buy fewer US products andwill prefer to buy domestic goods, hence Euroland consumers will buy FX (euro) and sell

USD which lowers the supply of FX. US consumers will be more likely to buy Euroland

imports rather than domestic goods, hence they will buy FX and sell USD, hence demand

for FX increases. Hence a higher inflation in the US than in Euroland will increase

Euroland exports and reduce US exports to Euroland. In general, a nation with a

relatively high level of inflation will find its currency depreciating relative to the

currencies with lower inflation rates.

Relative interest rates: A rise in US interest rates relative to Euroland rates will cause

investors in both nations to switch from euro to dollar denominated securities to take

advantage of the higher dollar interest rates. Thus Euroland consumers will increasesupply of FX since they are selling FX to buy dollar to invest in dollar denominated

securities. Likewise, US consumers will decrease the demand for FX since they are selling

FX to buy dollar to also invest in dollar denominated securities, the net result is a

depreciation of FX. Notice here we are talking about real interest rate differentials, only

real interest rate changes will cause this change in exchange rates, not nominal.

Remember that nominal interest rates have inflation in them, whereas real inflation has

been adjusted for inflation, ie, subtracted inflation from nominal.

Relative economic growth rates: A nation with strong economic growth will attract

investment capital seeking to acquire domestic assets. Thus foreigners will increase the

supply of FX since they are selling FX to acquire dollars to invest in domestic assets. This

lowers the value of the FX hence appreciating the domestic currency.

Political and economic risk: Investors prefer to hold lesser amounts of riskier assets;

thus low-risk currencies (those associated with more politically and economically stable

nations) are more highly valued than high risk currencies.

Trade weighted (effective) and bilateral exchange rates

Bilateral exchange rates are when one currency appreciates against another, then the

other currency has simultaneously fallen against the other one.

A trade-weighted exchange rate is a similar concept to a consumer price index. Thetrade-weighted exchange rate of a particular currency is a weighted average of its

exchange rate against the currencies of its trading partners; weighted, of course, by the

proportion of trade with each country.

NEER: Nominal Effective Exchange Rates. NEERs are indexes, and they are usually

expressed such that an increase in the index implies a strengthening of the currency.

8/10/2019 AFC3240 Notes

8/18

More useful in many ways is the REERrealeffective exchange rates. The REER is the

NEER adjusted for the inflation differentialbetween the country and its trading

partners. The REER is used by economists and policymakers to get an idea of a countrys

competitiveness.

A currency is considered overvalued if its NEER is greater than 100. A currency is

considered undervalued if its NEER is less than 100

Overvalued currencies tend to be associated with a loss of competitivenesscountries

can be priced out of export markets. Imported goods are relatively cheap. Businesses

can suffer both a loss of export revenue at the same time as bearing more competition

in the local market due to cheaper imports. The main benefit of an overvalued currency

stems from the fact that domestic markets become more competitive moderation in

inflation. There is little benefit in having an overvalued currency in the current world

economic environment.

Undervalued currencies are associated with greater export competitivenessexports

are relatively cheap. Imported goods are more expensive. Undervalued currencies can

be associated with inflationary pressures.

Calculating exchange rate changes

The amount of FX (euro) appreciation or depreciation is computed as the fractional

increase or decrease in the home (dollar) value of the FX (euro).

Amount of FX appre/depre = (New home value of 1 FXOld home value of 1 FX)/Old

home value of 1 FX

If we let e be the exchange rate, ie, e is defined such that 1 FX = e home currency. Hence

1/e FX = 1 home currency. So the above formula becomes (e_1-e_0)/e_0

Amount of home appre/depre = (New FX value of 1 homeOld FX value of 1 home)/OldFX value of 1 home.

Also can be denoted as (1/e_1-1/e_0)/(1/e_0) = (e_0-e_1)/e_1

Expectations and the asset market model of exchange rates

Although currency values are affected by current events and current supply and demand

they are also dependent on expectations (forecasts) about future exchange rate

movements.

The role of expectations in determining exchange rates depends on the fact that

currencies are financial assets and that an exchange rate is simply the relative price of

two financial assets. Thus currency prices are determined the same manner that prices

of stocks, bonds are determined.

The value of a given currency (dollar) today depends on whether or not people still want

the amount of dollars and dollar denominated assets they held yesterday. This is known

as the asset market model of exchange rate determination, thus the exchange rate

between two currencies represents the price that just balances the relative supplies of

and demands for assets denominated in those currencies.

8/10/2019 AFC3240 Notes

9/18

The desire to hold a currency also depends on the expectations of the factors that can

affect the currencys future value. Therefore, what matters is not only what is

happening today but what markets expect will happen in the future. Thus, currency

values are forward looking, they are set by investor expectations of their issuing

countries future economic prospects rather than by contemporary events alone.

Relationship between the nature of money and currency values

The value of money depends on its purchasing power, money also provides liquidity

(you can readily exchange it for goods and other assets), thus money represents both a

store of value and store of liquidity.

Factors that increase the demand for the home currency should also increase the price

of the home currency on the FX market. Thus the economic factors that affect a

currencys FX value include its usefulness as a store of value (determined by its expected

rate of inflation), the demand for liquidity (determined by the volume of transactions in

that currency) and the demand for assets denominated in that currency (determined bythe risk-return pattern on investment in that nations economy and by the wealth of its

residents).

The first factor depends primarily on the countrys future monetary policy whereas the

latter two factors depend largely on expected economic growth and political/economic

stability.

Relationship between central bank reputations and currency values

Another critical determinant of currency values is central bank behavior. A central bank

is the nations official monetary authority. Its job is to use the instruments of monetary

policy to achieve one or more of the following: price stability, low interest rates, target

currency value. Note that only the central bank has the sole power to create money.

Fiat money is money which is nonconvertible paper money, today no major currency is

linked to a commodity, with a commodity base, usually gold, there was a stable, long

term anchor to the price level. With fiat money, there is no anchor to the price level,

that is there is no standard of value that investors can use to find out what the

currencys future value might be. Instead, a currencys value is largely determined by

the central bank through its control of the money supply. If the central bank creates too

much money, inflation will occur and the value of money will fall. Expectations of central

bank behavior will also affect exchange rates today, ie, a currency will decline if people

think that the central bank will expand the money supply in the future.

Price stability and central bank independence: A reputable central bank is very

important in order to adopt rules for price stability that are verifiable and enforceable,

due to this reason, central banks should be independent. Central banks that lack

independence are also forced to monetize the deficit meaning that they have to finance

the public sector (government) deficit by buying government debt with newly created

money (which increases inflation as MS increases). Independent central banks, on the

8/10/2019 AFC3240 Notes

10/18

8/10/2019 AFC3240 Notes

11/18

If the central bank (of foreign country) wants to increasethe value of the currency (FX)

relative to the US dollar, it buys the domestic currency and sells the dollar.

It thus depletesdollar reserves.

This transaction is associated with a reduction in the money supply.

If the central bank (of home country) wants to reduce the value of its domestic currency

(hence increase the value of the FX), it will buy FX and sell USD.

It thus accumulates reserves of FX.

This transaction is associated with an increase in the money supply.

If the central bank (of home country) wants to increase the value of its domestic

currency (hence decrease the value of the FX), it will sell FX and buy USD.

It thus depletes reserves of FX.

This transaction is associated with a reduction in the money supply.

Also when doing questions using the above concepts, note that Supply of FX = Demand

for HC and Demand of FX = Supply for HC.

Sterilized vs unsterilized intervention

Unsterilized intervention means that the monetary authorities have not insulated their

domestic money supplies from the FX transactions. If MS increase/decrease then

inflation will increase/decrease. To neutralize these effects, the central bank can

sterilize the impact of their foreign exchange market intervention on the domestic

money supply through open market operation, which is just the sale or purchase of

treasury securities.

When the central bank is intervening to reduce the value of its currency or to keep it

low, the increase in the money supply is potentially inflationary.

This additional money supply can be sterilizedthat is mopped up by open marketoperations.

In this case, the central bank issues (sells) treasury securities.

If the central bank is doing the oppositeintervening to keep a currency high

(depleting reserves) then sterilization involves buying treasury securities.

Chapter 3

Types of exchange rate systems

The international monetary system refers to the policies, institutions, regulations and

mechanisms that determine the rate at which one currency is exchanged for another.

Nations prefer economic stability and often equate this objective with a stable exchange

rate. However fixing an exchange rate often leads to currency crises if the nation

attempts to follow a monetary policy that is inconsistent with that fixed rate. On the

other hand, economic shocks can be absorbed more easily when exchange rates are

allowed to float freely, but freely floating exchange rates may exhibit excessive volatility,

which hurts trade and stifles economic growth.

8/10/2019 AFC3240 Notes

12/18

Free float

Free market exchange rates are determined by the interaction of currency supplies and

demands. The supply and demand are influenced by price level changes, interest

differentials, and economic growth.

In a free float, as these economic parameters change, market participants will adjusttheir current and expected future currency needs. Over time, the exchange rate will

fluctuate randomly as market participants assess and react to new information.

Such a system of freely floating exchange rates is referred to as a clean float.

Managed float

The fear is that too abrupt a change in the value of a nations currency could imperil its

export industries (if currency appreciates) or lead to a higher rate of inflation (if the

currency depreciates). Exchange rate uncertainty reduces economic efficiency by acting

as a tax on trade and foreign investment.

Most countries with floating currencies have attempted, through central bank

intervention. Such a system is called a managed float or a dirty float. There are 3 types:

1. Smoothing out daily fluctuationsgovernments follow this route attempt only

to preserve an orderly pattern of exchange rate changes. Rather than resisting

fundamental market forces, these governments occasionally enter the market

on the buy or sell side to ease the transition from one rate to another, the

smoother the transition tends to bring about longer term currency appreciation

or depreciation.

2. Leaning against the windthis approach is an intermediate policy designed to

moderate or prevent abrupt short and medium term fluctuations brought about

by random events whose effects are expected to be only temporary. The

rationale for this policy is primarily aimed at delaying rather than resisting,

fundamental exchange rate adjustments. Government intervention can reduce

for exporters and importers the uncertainty caused by disruptive exchange rate

changes.

3. Unofficial peggingthis strategy evokes memories of a fixed exchange rate

system. It involves resisting, for reasons unrelated to the exchange market

forces, any fundamental upward or downward exchange rate movements.

Target zone arrangement

Under this arrangement, countries adjust their national economic policies to maintain

their exchange rates within a specific margin around agreed-upon, fixed central

exchange rates.

Fixed rate system

8/10/2019 AFC3240 Notes

13/18

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 FX market whenever its exchange rate threatens to deviate from its

stated par value by more than an agreed-upon percentage. The resulting coordination

of monetary policy ensures that all member nations have the same inflation rate.

Put another way, for a fixed rate system to work, each member must accept the groups

joint inflation rate as its own. A corollary is that monetary policy must become

subordinate to exchange rate policy. However, maintain the fixed exchange rate could

mean a high interest and a resultant slowdown in economic growth and job creation.

Note that the currency can be fixed to a particular currency or a basket of currencies

and includes hard fixed systems such as currency boards, dollarisation and monetary

union. The monetary authority uses its stock of foreign exchange reserves to intervene

in the market to keep the rate peggedat or near itspar ortarget value.

In effect, governments controls take over the allocative function of the foreign exchange

market. The most drastic situation occurs when all foreign exchange earnings must be

surrendered to the central bank, which, in turn, apportions these funds to users on the

basis of government priorities. Types of currency controls are on pg 104.

Note the inverse relationship between interest rates and inflation whereas the direct

relationship between money supply and inflation.

Current system

The current system is a hybrid 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.

De jureand de factocurrency arrangements: The term de jureis used to describe thecurrency arrangement that a country claims that it is operating. De factois the term

used to describe the currency system is actually in place.

When a currency is fixed against one currency (say the dollar), it floats against other

currencies.

IMF classification of exchange rate systems

Fixed exchange systems

No separate legal tender: a country adopts another currency as its sole legal tender; eg

Panama, Ecuador. Often called dollarised systems.Also under this category arecurrency zonesincluding Eurozone.

Currency board: a fixed exchange rate system in which the local currency is fully backed

by another.

Other fixed exchange rate systems: a country pegs its currency to another or to a basket

of currencies; fluctuations around par value at most +/-1%.

8/10/2019 AFC3240 Notes

14/18

Pegged exchange rate systems

Pegged exchange rates within horizontal bands: This is like other fixed exchange rate

systems butwith wider range of allowable fluctuation.

Crawling peg: involves periodical adjustments to the peg, usually in response to select

economic indicators. Exchange rates within crawling pegs: as above; band is also moved.

Floating exchange rate systems

Managed float: Central bank resists inappropriate trends.

Independent float: market determined; intervention is to prevent undue fluctuations.

Variation on managed float (this would be Sharpiros classifications)

Pegged exchange rates within horizontal bands: This is like other fixed exchange rate

systems butwith wider range of allowable fluctuation. Crawling peg: involves periodical adjustments to the peg, usually in response to select

economic indicators.

Exchange rates within crawling pegs: as above; band is also moved.

Managed float: Central bank resists inappropriate trends.

History of international monetary system

Classical gold standard: 1876-1913, Interwar period: 1919-1944, Bretton Woods system:

1945-1973, The current system: 1973-present.

Classical gold standard

This was an informal fixed exchange rate system. Gold was used as a medium of

exchange because of its desirable properties, it is durable, storable, portable and easily

recognized, divisible and easily standardized. Another valuable attribute is that short run

changes in its stock are limited by high production costs, making it costly for

governments to manipulate.

The gold standard involved a commitment by the participating countries to fix the prices

of their domestic currencies in terms of a specified amount of gold.

Each currency was expressed in terms of its convertibility to gold, so the exchange rate

between two countrys currencies would be determined by their relative gold contents. For example, in Britain, gold was 4.2474/oz; in the US $20.67/oz. $/ = 20.67/4.2474 =

4.8665

The value of gold relative to other goods and services does not change much over long

periods of time, so the monetary discipline imposed by a gold standard should ensure

long-run price stability for both individual countries and groups of countries. Central

8/10/2019 AFC3240 Notes

15/18

banks were obliged to convert currency to gold if requested; gold was the reserve

asset.Instead of FX reserves, they had gold reserves.

The gold standard can be thought of as a type of currency board each unit of currency

is fully backed by a certain amount of gold (instead of a hard currency as with todays

currency boards).Gold was used to settle international transactions.

Notice that governments can make a 100% profit by issuing more fiat money, however

the net profit margin on issuing more money under a gold standard is 0. The

government must acquire more gold before it can issue more money (in order to fix the

exchange rate to ounces of gold) and the governments cost of acquiring the extra gold

equals the value of the money it issues. Thus expansion of the money supply is

constrained by the available supply of gold. So if supply of gold increase, then MS must

increase to keep fixed exchange rate b/w gold and currency.

Under the classical gold standard, disturbances in the price level in one country would

be partially or wholly offset by an automatic bop adjustment mechanism called the

price-specie (gold)-flow mechanism.

The process works like this:

1. Assume US price falls, so imports gold inflow

(this offsets the bop surplus by the following chain of events) -> domestic

reserve will increase hence MS will increase -> increase in price and decrease in

interest rates -> decrease in exports and decrease in capital inflows reducing the

gold reserve and MS, hence bop is no more in surplus.

2. Assume US price rise, so imports>exports (initially bop deficit)-> gold outflow

(this offsets the bop deficit by the following chain of events) -> domestic reserve

will decrease hence MS will decrease -> decrease price and increase interest

rates -> increase in exports and increase in capital inflows increasing the goldreserve and MS, hence bop is no more in deficit.

Refer to exhibit 3.7 pg 110.

Thus the operation of the price-specie-flow mechanism tended to keep prices in line for

those countries that were on the gold standard. As long as the world was on a gold

standard, all adjustments were automatic. However a problem is that any sudden

shocks to the balance of payments led to severe shocks in domestic economies.

The disadvantage is that the gold supply is likely to be unrelated to the worlds needs for

additional liquidity. In times of growth, the world money supply could grow only at the

rate of new gold extraction. It is wasteful to use a tangible, expensive-to-produce asset

as a reserve asset. Also gold has an opportunity coststorage etc.

The interwar period

Several attempts were made to restore the gold standard. Exchange rates fluctuated as

countries used predatory depreciations of their currencies. Everyone wanted a weak

currency to promote exports and make imports more expensive. This led to increased

8/10/2019 AFC3240 Notes

16/18

protectionism around the world. The result for international trade and investment was

profoundly detrimental.

The Bretton Woods system

Each government pledged to maintain a fixed, or pegged, exchange rate for its currency

via the dollar or gold. As one ounce of gold was set to equal $35, then fixing a currencys

gold price was equivalent to setting its exchange rate relative to the dollar.

The rationale for a fixed exchange system was that they wanted a system of fixed

exchange rates to keep currency volatility to a minimum and prevent predatory

depreciationsto promote trade. And allow for limited flexibility to adjust exchange

rates when necessaryto limit the effects of external imbalances on the real economy.

This established the Gold Exchange Standard: The US adopted a par value expressed in

gold ($35 per ounce); All other members pegged to the dollar. Overseen by

International Monetary Fund (IMF). With the IMFs permission countries were allowed

to devalue or revalue. Hard currencies used as reservecurrencies (mainly the dollar).Each country was responsible for maintaining its exchange rate within 1% of the

adopted US dollar par value. The system worked as long as there was sufficient

confidence in convertibility of the dollar to gold.

The fixed exchange rates were maintained by official intervention in the foreign

exchange markets. Eg, a country that had policies which lead to a higher rate of inflation

than experienced by its trading partners will experience a bop deficit as it has reduced

exports and increased imports. This deficit means that there will be an increased supply

of that countrys currency in the FX markets (since they sell their domestic currency and

buy FX to pay for its imports). The excess supply of this countrys currency will depress

the exchange value of that countrys currency, forcing officials to intervene. The countrywould be obligated to buy with its reserves the excess supply of its own currency. So the

country will buy its own currency and sell FX, hence demand for FX decrease so MS will

decrease. This reduction in MS will reduce the inflation and increase the value of home

currency bringing it in line with the rest of the world.

The current system

The system eventually broke down, in 1971 convertibility to gold was abandoned. By

1973 many developed countries had adopted flexible (floating) rates. Most developing

countries, however, have managed exchange rate systems. USD still plays a major

unofficial role as a reserve currency.

The macroeconomic trilemma

Only two of the following three policy objectives, or attributes of the ideal currency,

can be achieved: Use of monetary policy oriented toward domestic goals, Exchange rate

stability, Full financial integration (free capital mobility).

8/10/2019 AFC3240 Notes

17/18

The theory assumes that exchange rate stability is good as it promotes trade. Fixed

exchange rate systems provide exchange rate stability. Therefore, exchange rate

volatility is bad.

Floating exchange rate systems

Under a floating exchange system we can only achieve Use of monetary policy oriented

toward domestic goals and Full financial integration (free capital mobility).In most

developed countries, it is generally considered that the benefit of being able to freely

use monetary policy outweighs the disadvantage of exchange rate volatility.

The reason is because floating exchange rate systems have the ability to self-equilibrate:

1. In response to changes in relative interest ratesIf the country needs to take

the heat off a booming economy, then monetary policy can be used to increase

interest rates to reduce inflation and inflation expectations. This will cause an

increase in capital inflow (due to increase in exports) and hence exchange rate

rises. If interest rates are reduced (so inflation increases) to stimulate aneconomy in recession, then capital outflows can result (due to increased

imports), then exchange rate falls.

2. In case of external imbalancescase 1, assume there is a current account deficit

which means imports rise and exports fall. Immediately, this means there is

excess demand for FX (since we must buy FX to pay for imports), this implies

that domestic currency will fall in value to eliminate the excess supply. Now in

the medium to long term, as the currencys value falls, exports become cheaper

on world markets, and imports become more expensive, therefore exports

increase and imports decrease, this fixes the current account deficit. Case 2,

assume there is a current account surplus (exports > imports), so immediatelythe value of the currency rises. Then in the medium to long term, exports

become uncompetitive reducing export volume and revenue whilst imports

become cheaper, so imports increase and exports decrease. Current account

surplus is thus fixed.

A floating exchange rate system is said to be the economys external shock absorber.

This is the j-curve effect.

So, in theory, current account deficits in floating exchange rate systems are self-

correcting.

Recall that an implicit assumption of the trilemma framework is that exchange rate

volatility somehow impedes trade and international business. Does it? In general, nofor the (mostly developed) countries that have floating exchange rate systems.

There are many tools available in the capital markets, particularly derivative markets, to

assist firms in managing the problem of exposure to exchange rate movements.

Fixed exchange rate systems

8/10/2019 AFC3240 Notes

18/18

Under a fixed exchange rate system, only Exchange rate stability and Full financial

integration (free capital mobility) are satisfied.

It has an advantage and a disadvantage.