Foreign Exchange Operations (Chapter 2).pptx

Chapter 2
International
Monetary
System

At the end of the chapter, students will be able
to:
understand the evolution of the
international monetary system.
understand the current exchange rate
arrangements.
understand the fixed versus flexible
exchange rate regimes.
Learning Outcomes

WHAT IS MONEY?
• A current medium of exchange in the form of coins and banknotes; coins and
banknotes collectively.
• Any good that is widely accepted in exchange of goods and services, as well as
payment of debts.

WHAT ARE THE VARIOUS FUNCTIONS OF MONEY?

FUNCTIONS OF MONEY
• Medium of exchange – money used for buying and selling goods and services
• Unit of account – common standard for measuring relative worth of goods and services
• Store of value – convenient way to store wealth

INTERNATIONAL MONETARY SYSTEM
• defines the overall financial environment in which multinational corporations
and international investors operate.
• defined as the institutional framework within which international payments are
made, movements of capital are accommodated, and exchange rates among
currencies are determined.
• It is a complex whole of agreements, rules, institutions, mechanisms, and
policies regarding exchange rates, international payments, and the flow of
capital.

FEATURES OF AN INTERNATIONAL MONETARY SYSTEM
• Allow efficient and unrestricted flow of international trade and
investment.
• Stability in foreign exchange aspects.
• Providing countries with sufficient liquidity to finance temporary balance
of payments deficits.
• Should at least try avoid adding further uncertainty.
• Allowing member countries to pursue independent monetary and fiscal
policies.

EVOLUTION OF THE INTERNATIONAL MONETARY
SYSTEM
• 1. Bimetallism: Before 1875
• 2. Classical Gold Standard: 1875-1914
• 3. Interwar Period: 1915-1944 (First & Second World War)
• 4. Bretton Woods System: 1945-1972
• 5. The Flexible Exchange Rate Regime: 1973-Present

SYSTEM
1. Bimetallism: Before 1875
• A “double standard” in the sense that both gold and silver were
used as money.
• Some countries were on the gold standard, some on the silver
standard, some on both.
• Both gold and silver were used as international means of
payment and the exchange rates among currencies were
determined by either their gold or silver contents.
• Gresham’s Law implied that it would be the least valuable metal
that would tend to circulate.

SYSTEM
1. Bimetallism: Before 1875
• Gresham's law is an economic principle that states: "if coins
containing metal of different value have the same value as legal
tender, the coins composed of the cheaper metal will be used for
payment, while those made of more expensive metal will be
hoarded or exported and thus tend to disappear from
circulation.”
• It is commonly stated as: "“Bad” (abundant) money drives out
“Good” (scarce) money”

SYSTEM

SYSTEM
2. Classical Gold Standard: 1875-1914
During this period in most major countries:
• Gold alone was assured of unrestricted coinage
• There was two-way convertibility between gold and national
currencies at a stable ratio.
• Gold could be freely exported or imported.
• The exchange rate between two country’s currencies would be
determined by their relative gold contents.

SYSTEM
• Each country defined the value of its currency in terms of gold.
• Exchange rate between any two currencies was calculated as X
currency per ounce of gold/ Y currency per ounce of gold.
• These exchange rates were set by arbitrage depending on the
transportation costs of gold.
• Central banks are restricted in not being able to issue more
currency than gold reserves.

SYSTEM
Eg, if the dollar is pegged to gold at U.S.$30 =1 ounce of gold, and the British
pound is pegged to gold at £6 = 1 ounce of gold, it must be the case that the
exchange rate is determined by the relative gold contents.
1 ounce of gold – USD 30 (US)
1 ounce of gold – £6 (UK - pound sterling)
(a person in UK wants to buy something from US – the value is USD 60. How
much Pound Sterling does he need?)
• USD30 = £6
• USD5 = £1

SYSTEM
• Price Stability.
• By tying the money supply to the supply of gold, central banks
are unable to expand the money supply.
• https://www.youtube.com/watch?v=d3PCjk7YAo0

SYSTEM
3. Interwar Period: 1915-1944
• World War I ended the classical gold standard in August 1914.
• Exchange rates fluctuated as countries widely used “predatory”
depreciations of their currencies as a means of gaining
advantage in the world export market.
• Attempts were made to restore the gold standard, but
participants lacked the political will to “follow the rules of the
game”
• The world economy characterized by tremendous instability and
eventually economic breakdown, what is known as the Great
Depression (1930 – 39)

SYSTEM
3. Interwar Period: 1915-1944
• Many countries suffered during the Great Depression.
• Major economic harm was done by restrictions on international
trade and payments.
• All countries’ situations could have been bettered through
international cooperation

SYSTEM
4. Bretton Woods System: 1945-1972
• In July 1944, representatives of 44 nations gathered at Bretton
Woods, New Hampshire, to discuss and design the postwar
international monetary system.
• To design a new international monetary system that would
facilitate postwar economic growth
• The goal was exchange rate stability without the gold standard.

SYSTEM
The result was the creation of the IMF and the World Bank
• International Monetary Fund (IMF): maintain order in monetary
system
• World Bank: promote general economic development

SYSTEM
Under the new agreement :
• a fixed exchange rate system was established
• all currencies were fixed to gold, but only the U.S. dollar was
directly convertible to gold
• devaluations could not be used for competitive purposes
• a country could not devalue its currency by more than 10%
without IMF approval

SYSTEM
• Under the Bretton Woods system, the U.S. dollar was pegged to
gold at $35 per ounce and other currencies were pegged to the
U.S. dollar.
• Each country was responsible for maintaining its exchange rate
fixed : within ±1% of the adopted par value by buying or selling
foreign reserves as necessary.
• The Bretton Woods system was a dollar-based gold exchange
standard.

SYSTEM
Main difference between the Classical Gold
Standard system and the Bretton Woods
System:
GOLD SYSTEM – currency pegged to gold
BW – currency pegged to currency

SYSTEM
• Bretton Woods worked well until the late 1960s
• It collapsed when huge increases in welfare programs and the Vietnam
War were financed by increasing the money supply and causing
significant inflation.
• Other countries increased the value of their currencies relative to the
U.S. dollar in response to speculation the dollar would be devalued.
• By 1973, the world had moved to search for a new financial system: one
that no longer relied on a worldwide system of pegged exchange rates.
• https://www.youtube.com/watch?v=RtFz9q26t5A

DISCUSSION
1. Which is better, fixed exchange rates or floating
(flexible) exchange rates ?

DISCUSSION
FIXED RATES
Provides monetary discipline
Minimizes speculation
Promotes growth of international trade and investment
FLOATING RATES
removing the obligation to maintain exchange rate parity
restores monetary control to a government

SYSTEM
5. The Flexible Exchange Rate Regime: 1973-Present
• A new exchange rate system was established in 1976 at a
meeting in Jamaica
• The rules that were agreed on then are still in place today
Under the Jamaican agreement:
• floating (flexible) exchange rates were declared acceptable
• gold was abandoned as a reserve asset
• currencies are no longer backed by gold
• central banks were allowed to intervene in the exchange rate
markets to iron out unwarranted volatilities.

DISCUSSION
1. How is the USD performing against the MYR?

SYSTEM
• Since 1973, exchange rates have been more volatile and less
predictable than they were between 1945 and 1973 because of
• the 1971 and 1979 oil crises
• the loss of confidence in the dollar after U.S. inflation in 1977-78
• the rise in the dollar between 1980 and 1985
• the 1997 Asian currency crisis
• the decline in the dollar from 2001 to 2009

SYSTEM

CURRENT EXCHANGE RATE ARRANGEMENTS
**Refer to Figure 2.4 in ebook
• Free Float
The largest number of countries, about 48, allow market forces to
determine their currency’s value.
• Managed Float
About 25 countries combine government intervention with market
forces to set exchange rates.
• Pegged to another currency (such as the U.S. dollar or euro etc)
• No national currency
Some countries do not bother printing their own, they just use the
U.S. dollar. For example, Ecuador, Panama, and have dollarized.

CURRENT EXCHANGE RATE ARRANGEMENTS
PEGGED RATE SYSTEM
• A country following a pegged exchange rate system pegs the
value of its currency to that of another major currency.
• Popular among the world’s smaller nations
• Imposes monetary discipline and leads to low inflation
• Adopting a pegged exchange rate regime can moderate
inflationary pressures in a country

EUROPEAN MONETARY SYSTEM
DO YOU THINK IT WOULD BE GOOD FOR ASEAN TO COME UP WITH ITS OWN CURRENCY?
AC 1 = MYR 3
AC 333 = MYR 1000

DISCUSSION
1. What is the current rate of EURO against the
USD?
USD 1 = EURO 0.98
2. Is the Euro performing well against the USD?

DISCUSSION
1. When did UK or Great Britain join the European Union?
1973 - 2020
2. What is the meaning of BREXIT?
3. When did BREXIT happen? 2020
4. What was the cause of BREXIT?

ASIAN CURRENCY CRISIS
• The 1997 Southeast Asian financial crisis was caused by events
that took place in the previous decade including:
• An investment boom - fueled by huge increases in exports
• Excess capacity - investments were based on projections of
future demand conditions
• High debt - investments were supported by dollar-based debts
• Expanding imports – caused current account deficits
https://www.youtube.com/watch?v=dpxio4mItlY

• By mid-1997, several key Thai financial institutions were on the
verge of default.
• Speculation against the baht.
• Thailand abandoned the baht peg and allowed the currency to
float.
• The IMF provided a $17 billion bailout loan package required
higher taxes, public spending cuts, privatization of state-owned
businesses, and higher interest rates.

• Speculation caused other Asian currencies including the
Malaysian Ringgit, the Indonesian Rupaih and the Singapore
Dollar to fall.
• These devaluations were mainly driven by excess investment and
high borrowings, much of it in dollar denominated debt a
deteriorating balance of payments position.

• The IMF provided a $37 billion aid package for Indonesia
required public spending cuts, closure of troubled banks, a
balanced budget, and an end to crony capitalism.
• The IMF provided a $55 billion aid package to South Korea
required a more open banking system and economy.

Question & Answer Session
1. List two reasons that caused the Asian Currency
crisis?
2. How can a similar crisis be avoided in the future?

Foreign Exchange Operations (Chapter 2).pptx

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