FIN310 Chapter 2: International Monetary System

Multinational Financial Management

• The study notes cover material from FIN310: Multinational Financial Management

International Monetary System

• Chapter 2 entails the International Monetary System

Meaning of International Monetary System

• Refers to the structure of international finance.
• Includes international financial institutions like central banks, the International Monetary Fund, money & foreign exchange markets.
• The system determines exchange rates of currencies and helps facilitate trade as well as capital flow.

Evolution

• Gold was the primary medium of exchange in the past because of its accepted value.
• Colonial powers expanded their international trade influence, possessing gold/money to show power.
• Colonial powers competed to improve their own economy, leading to the need for structured trade systems.

Types of Monetary Systems

• Fixed Exchange Rate System: The exchange rate is set and does not fluctuate.
• Flexible Exchange Rate System: The exchange rate is allowed to fluctuate freely.
• Floating Exchange Rate System: A mix of both fixed and flexible systems.

Fixed Exchange Rate System Details

• In use in the 19th century
• Was widely adopted between countries
• The rate is maintained; countries set the value of their currency to a fixed amount of gold
• England was the first country to adopt the gold standard.
• Countries could use gold as an intermediary, tying exchange rates based on how much gold each was worth.
• Example: If the U.S. values its currency at USD 20.67 per troy ounce and Britain values GBP 4.2474 per troy ounce, the rate would be USD 4.8665 per GBP.
• Member countries had to use gold as the only monetary reserve. Governments would freely allow the import/export of gold.
• Governments would adjust the amount of money in the country to be proportional to gold reserves. Gold or backed banknotes become legal tender.
• Governments must let citizens exchange domestic money for gold.

Advantages

• Exchange rate stability.
• Balance of payments stability.
• Facilitates transactions.
• Eliminates speculation.

Disadvantages

• Affects the internal economic system
• No freedom to operate individually
• Creates economic growth obstacles
• Is unfair to countries that can mine gold vs those that cannot.
• Countries had to maintain enough gold reserves to back the amount of banknotes printed, in order to maintain stability. For example to print 20.67 million, reserves have to increase by a million troy ounces

Gold Exchange Standard System

• Used near the end of World War 2 as plans were made to arrange a financial system led by the U.S. and Britain.

• The goal was to make international trade and investment easier.

• John Maynard Keynes (UK) and Harry D. White (US) made individual plans that differed.

• Keynes' plan involved flexible exchange rates based on a country's own economic policies.

• White wanted stable exchange rates, change only happening if a fundamental disequilibrium existed.

• While Keynes wanted control over capital movement between countries, White wanted free capital movement.

• The U.S. rejected Keynes' idea to push White's; Bretton Woods, New Hampshire saw the creation of the International Monetary Fund with those aims.

• The objectives of Bretton Woods were:

  • Promote intl cooperation
  • Balanced intl trade
  • Avoid competitive exchange rate devaluations.
  • Multilateral system of payments
  • Provide confidence so members could use resources to correct maladjustments in their balance of payments.
  • Make members' payment imbalances less disruptive

• The U.S. chose a USD exchange rate linked to gold, accepting dollars for gold.

• Other countries would value their currencies in terms of USD, maintaining it by intervening in foreign exchange markets.

• A primary goal was to create a mechanism for adjusting and helping countries fix balance of payments issues, create stability and supporting free payments internationally.

• Countries had to value their money in terms of gold but didn't have to exchange currency for gold.

• Only USD could be exchanged for gold; so other countries then calculated their value from USD (Dollar-Based System) example a troy ounce per 35USD, or a Baht at 0.368

• There was a period of instability (1914-1944) where systems were unstable.

Flexible Exchange Rate System

• The exchange rate is determined by supply and demand. There are no limits
• The government doesn't interfere; rates follow the market.
• No need for funds to maintain exchange rate levels, or large foreign exchange reserves to fix payment deficit issues.

Advantages

• Prices are not affected by balance of payments.
• Less need for intl reserves.
• Makes speculation difficult

Disadvantages

• Affects the internal economic system as the government allows rates to float freely.
• No stability in intl trade.
• Internal factors change in order to accomodate external factors.

Floating Exchange Rate System

• Its exchange rate is between the Gold Standard System and Flexible Exchange Rate.
• Rate not set by comparing to gold or assets. At the same time, exchange rates are not free to fluctuate as per the market.
• Emerged from countries needing to be flexible with rules by the International Monetary Fund.
• The daily exchange rate changes according to market demand, and the government can intervene in the market by buying/selling foreign money to not allow the rate to fluctuate too much, through the fund.
• The main reason countries stopped using the fixed exchange rate system to instead float had to do with issues in liquidity and faith in the major currencies.
• Low liquidity, lack of gold reserves.
• Countries competed to devalue money.
• The fixed rate had independence in politics, where the floating model did not
• Has flexibility to switch with situations from external causes in agreement with market mechanics

Modern Day

• After ending the gold standard, members of the IMF could choose their own systems.
• It now consists of a floating model, and a system that standardises par values

Floating Rate Details

• In 1979, the European Economic Community established a joint monetary system.

• Intended to harmonise economies under different economies, it can be split into a few topics

• Reduces variation of money rates between members

• Promotes trade

• The basic outline is for Members to join European Currency Unit, which keeps balance of payments.

• How a government will work relates to the rate with member countries

• Requires involvement in the rate to change (Exchange Rate Mechanism)

• Governments have to take part to stabilise rates when one slides

• Has increased from the EU to encompass aspects such as Single European Act, meaning capital flows inside the EU are free.

• While member countries have agreed it as okay, they have freedom (with exceptions)

• This eventually may lead to Economic and Monetary Union.

Economic and Monetary Union

• A part of European combination that attempts for highest point in agreement
• Established after World War 2
• To be a premier trading ground
• To embrace free aspects such as "Euro: and policy to remove the trade restrictions
• Is now controlled by the European Central Bank

Exchange Rate System in Thailand

• Thailand has traded with other countries for a long time, more significantly with the English, leading to the Bowring Treaty of 1855.
• It adopted a managed float system on July 2, 1997.
• This is based on market mechanics that show economy, taking over from the Bank Of Thailand.
• BoT may address changes from real economy, such as in jobs due tourism due international change
• It is affected with the flow of money, being key is to be flexible with how countries affect value.

Exchange Rate Forecasting

• Chapter 5 entails Exchange Rate Forecasting.

Factors Affecting Foreign Exchange Rates

• Flexibility of the supply of foreign exchange
• Flexibility of the demand for foreign exchange
• Interest rates
• Psychological factors
• Speculation in the value of money
• Regulations for exchange that the central bank has
• The process of payments a country has
• An economic state

Freely Floating Exchange Rates

• Includes the conditions such Interest Rates, Inflation, Balance.
• Covers also International parity , it helps to look at inflation and rates an international aspect.
• Relates 2 countries in future to create the Spot Rate in future
• Understanding data is hard due different exchanges

Fixed Exchange Rates

• A basic calculation of the exchange of currency in the same rate as the price, which links between the value and price in currency depending

Purchasing Power Parity

• Is a condition where there is a the same price for both currency types
• Should be priced to match even though there is a channel for profit where you purchase goods to even the difference
• The law states both products should have the same money to make sense