International Finance Multiple choice questions, finish within 30 mins
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Multinational Financial Management
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CHAPTER 3
THE INTERNATIONAL MONETARY SYSTEM
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CHAPTER OVERVIEW
I. ALTERNATIVE EXCHANGE RATE SYSTEMS
II. A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYTEM
III. THE EUROPEAN MONETARY SYSTEM AND MONETARY UNION
IV. EMERGING MARKET CURRENCY CRISES
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PART I. ALTERNATIVE
EXCHANGE RATE SYSTEMS
I. FIVE MARKET MECHANISMS
A. Freely Floating (“Clean Float”)
1. Market forces of supply and demand determine rates.
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ALTERNATIVE EXCHANGE RATE SYSTEMS
2. Forces influenced by
a. price levels
b. interest rates
c. economic growth
3. Rates fluctuate randomly over time.
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ALTERNATIVE EXCHANGE RATE SYSTEMS
B. Managed Float (“Dirty Float”)
1. Market forces set rates unless excess volatility occurs.
2. Then, central bank determines rate.
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ALTERNATIVE EXCHANGE RATE SYSTEMS
C. Target-Zone Arrangement
1. Rate Determination
a. Market forces constrained to upper and lower range of rates.
b. Members to the arrangement
adjust their national economic policies to maintain target.
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ALTERNATIVE EXCHANGE RATE SYSTEMS
D. Fixed Rate System
1. Rate determination
a. Government maintains target rates.
b. If rates threatened, central banks buy/sell currency.
c. Monetary policies coordinated.
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ALTERNATIVE EXCHANGE RATE SYSTEMS
E. Current System
1. A hybrid system
a. Major currencies: use freely- floating method
b. Other currencies move in and out of various fixed-rate systems.
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PART II. A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM
I. THE USE OF GOLD
A. Desirable properties
B. In short run: High production costs limit changes.
C. In long run: Commodity money insures stability.
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A BRIEF HISTORY
II. The Classical Gold Standard
(1821-1914)
A. Major global currencies on gold standard.
1. Nations fix the exchange rate in terms of a specific amount of gold.
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A BRIEF HISTORY
2. Maintenance involved the
buying and selling of gold at that price.
3. Disturbances in Price Levels:
Would be offset by the price- specie*-flow mechanism.
* specie = gold coins
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A BRIEF HISTORY
a. Price-specie-flow mechanism
adjustments were automatic:
1.) When a balance of payments surplus led to a gold inflow;
2.) Gold inflow led to higher prices which reduced surplus;
3.) Gold outflow led to lower prices and increased surplus.
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A BRIEF HISTORY
III. The Gold Exchange Standard (1925-1931)
A. Only U.S. and Britain allowed to hold gold reserves.
B. Others could hold both gold, dollars or pound reserves.
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A BRIEF HISTORY
C. Currencies devalued in 1931
- led to trade wars.
D. Bretton Woods Conference
- called in order to avoid
future protectionist and
destructive economic policies
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A BRIEF HISTORY
V. The Bretton Woods System (1946-1971)
1. U.S.$ was key currency;
valued at $1 - 1/35 oz. of gold.
2. All currencies linked to that price in a fixed rate system.
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A BRIEF HISTORY
3. Exchange rates allowed to fluctuate by 1% above or below initially set rates.
B. Collapse, 1971
1. Causes:
a. U.S. high inflation rate
b. U.S.$ depreciated sharply.
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A BRIEF HISTORY
V. Post-Bretton Woods System (1971-Present)
A. Smithsonian Agreement, 1971:
US$ devalued to 1/38 oz. of gold.
By 1973: World on a freely floating exchange rate system.
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A BRIEF HISTORY
B. OPEC and the Oil Crisis (1973-774)
1. OPEC raised oil prices four fold;
2. Exchange rate turmoil resulted;
3. Caused OPEC nations to earn large surplus B-O-P.
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A BRIEF HISTORY
4. Surpluses recycled to debtor nations which set up debt crisis of 1980’s.
C. Dollar Crisis (1977-78)
1. U.S. B-O-P difficulties
2. Result of inconsistent monetary policy in U.S.
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A BRIEF HISTORY
3. Dollar value falls as confidence shrinks.
D. The Rising Dollar (1980-85)
1. U.S. inflation subsides as the Fed raises interest rates
2. Rising rates attracts global capital to U.S.
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A BRIEF HISTORY
3. Result: Dollar value rises.
E. The Sinking Dollar:(1985-87)
1. Dollar revaluated slowly downward;
2. Plaza Agreement (1985)
G-5 agree to depress US$
further.
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A BRIEF HISTORY
3. Louvre Agreement (1987)
G-7 agree to support the falling US$.
F. Recent History (1988-Present)
1. 1988 US$ stabilized
2. Post-1991 Confidence resulted in stronger dollar
3. 1993-1995 Dollar value falls
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PART III.
THE EUROPEAN MONETARY SYSTEM
I. INTRODUCTION
A. The European Monetary System (EMS)
1. A target-zone method (1979)
2. Close macroeconomic policy coordination required.
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THE EUROPEAN MONETARY SYSTEM
B. EMS Objective:
to provide exchange rate stability to all members by holding exchange rates within specified limits.
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THE EUROPEAN MONETARY SYSTEM
C. European Currency Unit (ECU)
a “cocktail” of European currencies with specified weights as the unit of account.
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THE EUROPEAN MONETARY SYSTEM
1. Exchange rate mechanism (ERM)
- each member determines mutually agreed upon central cross rate for its currency.
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THE EUROPEAN MONETARY SYSTEM
2. Member Pledge:
to keep within 15% margin above or below the central rate.
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THE EUROPEAN MONETARY SYSTEM
D. EMS ups and downs
1. Foreign exchange interventions:
failed due to lack of support by coordinated monetary policies.
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THE EUROPEAN MONETARY SYSTEM
2. Currency Crisis of Sept. 1992
a. System broke down
b. Britain and Italy forced towithdraw from EMS.
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THE EUROPEAN MONETARY SYSTEM
G. Failure of the EMS:
members allowed political priorities to dominate exchange rate policies.
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THE EUROPEAN MONETARY SYSTEM
H. Maastricht Treaty
1. Called for Monetary Union by 1999 (moved to 2002)
2. Established a single currency:
the euro
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THE EUROPEAN MONETARY SYSTEM
3. Calls for creation of a single
central EU bank
4. Adopts tough fiscal standards
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THE EUROPEAN MONETARY SYSTEM
I. Costs / Benefits of A Single Currency
A. Benefits
1. Reduces cost of doing business
2. Reduces exchange rate risk
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THE EUROPEAN MONETARY SYSTEM
B. Costs
1. Lack of national monetary flexibility.
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PART IV. EMERGING MARKET CURRENCY CRISES
Transmission Mechanisms
A. Trade links
contagion spreads through trade
B. Financial System
-more important transmission mechanism
-investors sell off to make up for losses
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EMERGING MARKET CURRENCY CRISES
Origins of Emerging Market Crises
A. Moral hazard
B. Fundamental Policy Conflict
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EMERGING MARKET CURRENCY CRISES
Policy Proposals for Dealing with Emerging Market Crises
A. Currency Controls
B. Freely Floating Currency
C. Permanently Fixed Exchange Rate