INT 113 Chapter 10 notes
Annotations for Chapter 10: The Method Used to Determine Exchange Rates The quantity of one
currency needed to purchase one unit of another is represented by an exchange rate. Global
Financial Institutions Global Financial Institution (GFI): a multi-governmental organization
established in 1945 to support exchange-rate stability and ease the movement of currencies
internationally. The IMF's primary goal is to promote international monetary cooperation. o
Ensure monetary stability. Facilitate global commerce. Promote high employment and long-term
economic expansion. Reduce poverty on a global scale. The IMF analyzes both the global
economy and the economies of individual nations through a surveillance procedure and provides
recommendations on necessary policy changes. Along with monitoring, it also offers technical
assistance—primarily to low- and middle-income countries—and loans to nations that have
balance-of-payments issues.
The Par Value Principle and Bretton Woods According to the Bretton Woods Agreement, a
system of fixed exchange rates was established, and each IMF member nation determined a par
value for its currency based on gold and the US dollar. This par value was used as a standard to
compare the currencies of different nations. Depending on supply and demand, currencies were
permitted to fluctuate within 1% of their par value (which was increased to 2.25 % in December
1971). Formal modifications in par value were feasible with IMF permission. When the IMF
shifted to more exchange-rate flexibility, par values were eliminated. In spite of the transition
from fixed rates to variable exchange rates, the dollar established itself as the global standard for
currency trade and has maintained this status.
The Quota System in the Modern IMF When a nation joins the IMF, it makes a financial
contribution known as a quota that is largely determined by its relative size in the global
economy. The entire amount assessed to each country, known as the IMF quota, forms a fund
from which the IMF can borrow money to lend to other nations. It serves as the foundation for
each nation's voting power; the greater a nation's individual quota, the more votes it possesses.
The SDR is an international reserve asset that is provided to every government to aid in boosting
its reserves. The unit of account used by the IMF to record its financial transactions. Special
Drawing Rights (SDRs) are units of account that the World Bank issues to nations in order to
increase the size of their retained earnings holdings.
A nation could only purchase its currency using U.S. dollars or gold to sustain its exchange rate
monetary policies. The SDR was established as an additional attractive investment destination
currency to nations' official holdings of gold, foreign currency, and IMF backup placements. The
SDR may be used for IMF transactions and activities and acts as the IMF's unit of account—the
unit in which the IMF keeps its records. The U.S. dollar, the euro, the Chinese yuan, the Japanese
yen, and the British pound are the currencies that make up the SDR basket. In 2016, the Chinese
renminbi (yuan) was introduced. The new weights for the dollar, euro, yuan, yen, and pound will
be 42 percent, 31 percent, 11 percent, 8 percent, and 8 percent, respectively. The dollar's weight
stayed constant, while the other three currencies' weights decreased to make room for the
renminbi.
The IMF's role in global financial crises is to monitor and evaluate the vulnerabilities of member
nations' economic and financial policies in relation to domestic and global stability. The IMF can
offer preventative credit lines to struggling nations. These loans are intended to provide
short-term emergency assistance, and in order to be eligible, a nation must guarantee that it will
implement good fiscal and monetary policies that are chosen in consultation with IMF experts.
Moving toward floating exchange rates The IMF's first approach used fixed exchange rates. As
the foundation of the global monetary system, the U.S. dollar's value was fixed in relation to the
price of platinum. Smithsonian Convention The deal led to an 8 percent decline in the value of
the dollar (an official drop in the value of the dollar against gold) and a rise in the value of
certain other currencies (an official increase in the value of each currency against gold).
Increased exchange-rate flexibility (from 1 to 2.25 percent on either side of par value).
Exchange-rate flexibility from par value was increased from 1% to 2.25 % in 1971. However, the
global currency markets remained unstable throughout 1972, and at the beginning of 1973, the
dollar was devalued once again by 10%. Major currencies started to float against one another,
depending on the market to decide how much they were worth. The Bretton Woods system was
abandoned during the years 1972–1981 and alternative currencies were introduced.
Procedures for Currency Movements As part of this shift toward greater freedom, the IMF
allowed nations to choose and keep an exchange-rate arrangement of their own, so long as they
informed the IMF of their choice. A de jure system is the official choice made by a nation to use
a specific exchange-rate mechanism. A country's de facto or real exchange-rate system is
determined by the IMF surveillance program. Every year, nations advise the IMF of the
arrangement they intend to adopt. The IMF then assigns each country to a certain category on the
data they offer and confirmation of their actions in the trade. The IMF mandates that nations
specify whether their exchange-rate policies are flexible, soft pegged, or hard pegged. There are
three options: floating arrangement, soft peg, and hard peg. The IMF divides currencies into
three major groups, going from the least flexible to the most flexible. If they have a firm peg
(13.1 percent of the total), they fixate on that amount and refuse to let it go. They are somewhat
stiff but not as rigid as the hard peg if they have selected a soft peg (43.5%). If they have selected
a floating structure (34.0%), the supply side market determines how much they are worth. Some
nations are not categorized.
