Transcript International Monetary Markets

International Monetary
Markets
Mikkeli 2005
Compiled by Rulzion Rattray
International Monetary System
• For 5,000 years Gold was the major medium of exchange.
• Gold Standard (1876-1914).
– Every country fixed the price of its currency against the value of gold
e.g. 1$ =1ounce
– This meant that the government in question had to buy and sell gold
at this value
• 1914-1944.
– Currencies allowed to fluctuate after the war the US $ was the only
currency that remained convertible to gold.
• Bretton Woods System (1944-1973)
– Countries agreed to a fixed rate of exchange with the dollar or with
gold.
• Post Bretton Woods to present:
– Typified by Floating exchange systems
Exchange Rate Systems
• Fixed Rate:
– Determined by national government & controlled by the
central bank
– May help economic stability, help prioritise important
projects, provide stability in international trade prices.
– Can result in resource misallocation, distortion of foreign
exchange demand and restrict company performance
• Crawling Peg System:
– Automatic; determined by a formulae set around a par
value and a variation around this figure.
– Overvalued currencies can result in a country being
forced to defend its value
Exchange Rate Systems
• Target Zone Systems
– E.g. ERM (European Exchange Rate Mechanism)
– Euro
• Managed Float System (Dirty Float)
– Based on the governments view of an appropriate
rate; + o- 40 countries e.g. China,
• Independent Float System (Clean Float)
– Exchange rates allowed to float freely.
– Continuous adjustment, prevent persistent deficits, by
lowering the exchange rate.
– Central bank not required to hold reserves
– Can ensure the independence of trade policies
– Depreciating currencies will reduce cost of goods on
world markets, however in medium term will raise
inflation and hence demand for higher wages.
Determination of Exchange Rates
• Purchasing Power Parity (PPP)
– Exchange rates between countries should in
long run should equalise the price of goods.
– Absolute PPP argues that exchange rates
should be determined by relative prices of
same goods. Difficult in practice because of
use of different products.
– Relative PPP this concentrates on using the
change in prices between countries to change
the exchange rate.
Exchange Rates PPP
• PPP principles assume free movement of
all goods ignoring barriers to trade.
• Many items not traded e.g. land buildings
etc. Can allow departures from PPP to
persist.
• Fails to recognise cross border
transportation costs
• PPP ignores the importance of capital
flows
Exchange Rates
Interest Rate Parity (IRP)
• IRP principle looks at how interest rates
are linked between different countries.
– IRP suggests difference in national interest
rates for securities of similar risk should be
equal but opposite to forward rate discount or
premium for the foreign currency.
• Forward Rate:
– The rate at which a bank is willing to
exchange one currency for another at some
point in the future.
Interest Rate Parity (IRP)
• Like PPP, IRP can be deviated by transaction
costs, tax factors and political risk. Investors will
expect to be rewarded for the greater risk of
investing on a foreign country.
• International Fisher Effect argues that the spot
exchange rate should change in equal amount
but in the opposite direction to the difference in
interest rates between two countries.
– 10 year yen bond earning 4% compared to 6%
interest available in $, assumes a 2% appreciation
per year in the value of the Yen against the $.
Predicting Exchange Rates
• PPP suggest that in the long run
exchange rates determined by price of
identical goods
• IRP holds that the interest difference will
be matched by the premium of forward
exchange rates.
• Forecasting future exchange rates
requires the analysis of economic and
non economic factors as well as
reference to black market exchange
rates.
Interpretation
• Balance of Payments:
– Summary of all economic transactions carried
out by a country, using double entry
bookkeeping.
– Increasing globalisation has meant that
MNE’s investing abroad and exporting back
products can increase Balance of payments
deficit, but be seen as positive.
• E.g. $52.6 billion trade deficit with China but a
large proportion of this is US MNE’s exporting to
US
Foreign Exchange Markets
• Markets where currencies are bought and
sold, average daily turnover $1.5 Trillion,
in 2001 80% of this in US $.
– London largest FE market in world.
– Main functions; international payment, short
term supply of foreign currencies and hedging
against FE risk
• Stock Markets
– Increasingly global & interconnected
References
• Cesarano, F., (1999), “Competitive money supply: the international
monetary system in perspective”, Journal of Economic Studies, Vol.
26 No. 3, pp. 188-200., MCB University Press. (Available Emerald)
• Eichengreen, B. (1995), ``The endogeneity of exchange-rate
regimes'', in Kenen, P.B. (Ed.) (1995), “Understanding
Interdependence”, Princeton University Press, Princeton,NJ.
• Griffiths, A., and Wall, S., (Eds), (1999), “Applied Economics”,
Prentice Hall.
• Jackson, J.H., (1997), “The World Trading System”, Cambridge, MA:
MIT Press.
• Kenen, P.B., Papadia, F. and Saccomanni, F. (Eds) (1994), “The
International Monetary System”, Cambridge University Press,
Cambridge.
• Pilbeam, K., (2001), “The East Asian financial crisis: getting to the
heart of the issues”, Managerial Finance, Vol 27 pp 111-133.
(Available Emerald)
• Shenkar, O. and Luo, Y.(2004), “International Business”, John Wiley
and Sons, Inc. (Available Library)