MONETARY MONETARY SYSTEMSYSTEM

Monetary SystemMonetary System

Relationship between monetary system and foreign exchange rates

Historical development Fixed vs floating exchange rates Role of the IMF and World Bank Implications for managers

International Monetary SystemInternational Monetary System

Currency exchange rates depend on the structure of the international monetary system

In 2003 of all IMF members currencies◦Only 19% were free floating◦25% were managed float◦8% were adjustable peg◦22% were fixed peg◦4% were fixed by a currency board◦22% were not currency of their own (use Euro, US Dollar)

Evolution of the International Evolution of the International Monetary SystemMonetary System

Gold Standard: currencies pegged to gold value◦Convertibility guaranteed◦By 1880 most on gold standard◦Balance of trade equilibrium for all countries Value of exports should equal value of imports

Flow of gold used to make up differences◦Abandoned in 1914

Failed resumption after WWI Great Depression

Bretton Woods (1944 - 1973)Bretton Woods (1944 - 1973)

44 countries met to design a new system in 1944

Established:International Monetary Fund (IMF) and World Bank◦IMF: maintain order in monetary system◦World Bank: promote general economic development

◦Fixed exchange rates pegged to the US Dollar

◦US Dollar pegged to gold at $35 per ounce◦Countries maintained their currencies ± 1% of the fixed rate; buy/sell own currency to maintain level

The Role of the IMFThe Role of the IMF IMF maintained exchange rate

◦discipline National governments had to manage inflation through their money supply

◦flexibility Provides loans to help members states with temporary balance-of-payment deficit; ◦Allows time to bring down inflation◦Relieves pressures to devalue

Excessive drawing from IMF funds came with IMF supervision of monetary and fiscal policies

◦Allowed to 10% devaluations and more with IMF approval

187 members by 2003

The Role of the World BankThe Role of the World BankWorld Bank (IBRD) role

(International Bank for Reconstruction & Development)◦Refinanced post-WWII reconstruction and development

◦Provides low-interest long term loans to developing economies

The International Development Agency (IDA), an arm of the bank created in 1960◦Raises funds from member states◦Loans only to poorest countries◦50 year repayment at 1% per year interest

Collapse of Bretton WoodsCollapse of Bretton WoodsDevaluation pressures on US dollar

after 20 years◦Lyndon Johnson policies

Vietnam war financing Welfare program financing

◦Nixon ended gold convertibility of US dollar in 1971

◦US dollar was devalued and dealers started speculating against it for further devaluation

◦Bretton Woods fixed exchange rates abandoned in January 1972

Jamaica Agreement 1976Jamaica Agreement 1976

Floating rates declared acceptableGold abandoned as reserve asset;

◦ IMF returned gold reserves to members at current prices

◦ Proceeds placed in trust fund to help poor nations

◦ IMF quotas – member country contributions – increased; membership now 182 countries

◦ Less-develop, non-oil exporting countries given more access to IMF

IMF continued its role of helping countries cope with macroeconomic and exchange rate problems

◦Monetary policy autonomy◦Trade balance adjustments helped

The Case for Fixed The Case for Fixed Exchange RatesExchange Rates

◦Monetary discipline◦Speculation limited◦Uncertainty reduced◦Trade balance adjustment effects on

inflation controlled

Who is right?

Case for Floating Exchange RatesCase for Floating Exchange Rates

Recent Activities and the IMFRecent Activities and the IMF Mexican Crisis 1995 Russian Ruble crisis1995 Asian crisis 1997/1998

◦Events The investment boom Excess capacity The debt bomb Expanding imports The crisis

How does the IMF achieve results?◦Inappropriate policies?◦Moral Hazard?◦Lack of accountability?

Managerial ImplicationsManagerial ImplicationsCurrency management

◦Currency market does not always work as expected

◦Government intervention◦Speculative activity

Business strategy◦Movements in exchange rates are difficult to

predict◦Forward market is imperfect predictor of

exchange rate movements◦Forward exchange rate market covers risk for

months not years◦Maintenance of strategic flexibility required

Disperse manufacturing Outsource

◦Corporate-government relations