Chapter 5 - The international monetary system and exchange rate arrangements. In this chapter, the learning objectives are: To classify international monetary systems, to outline the history of exchange rate arrangements, to outline the pros and cons of fixed and flexible exchange rates, to examine the Australian exchange rate arrangements.
Chapter The International Monetary System and Exchange Rate Arrangements Objectives • To classify international monetary systems • To outline the history of exchange rate arrangements • To outline the pros and cons of fixed and flexible exchange rates • To examine the Australian exchange rate arrangements Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5-2 Definition • The IMS is the framework of rules, regulations and conventions that govern the financial relations among countries Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5-3 Components of the IMS • A public component consisting of a series of agreements • A private component represented by the banking and finance industry Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5-4 Classification according to reserve assets • Pure commodity standards (e.g the gold standard) • Pure fiat standards • Mixed standards (e.g the Bretton Woods system) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5-5 Classification according to flexibility of exchange rates • Several systems may arise by restricting, or otherwise, the exchange rate Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5-6 Fixed exchange rates • The exchange rate is fixed by the central bank and is not allowed to move • The FX market is likely to be out of equilibrium Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5-7 Perfectly flexible exchange rates • The exchange rate moves continuously, propelled by market forces, to maintain equilibrium in the FX market • Under this system, currencies appreciate and depreciate Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5-8 Fixed but adjustable exchange rates • Countries alter the fixed values of their exchange rates • Devaluation and revaluation are implemented to ‘correct’ some economic fundamentals such as the BOP Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5-9 Fixed exchange rates and flexible within a band • Exchange rates are flexible within upper and lower limits defined by a band around the par value • Central bank intervention is required to keep the exchange rate within the band Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5-10 The EMU and the euro • The EMU was established by the 1991 Maastricht Treaty • In January 1999, the euro was introduced • In January 2002, the euro replaced national currencies Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5-39 The EUR/USD exchange rate Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5-40 Arguments for the euro • • • • • Currency stability reduces inflation Reduction in transaction and hedging costs Efficiency gains Transparency gains Benefits to trade and capital markets Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5-41 Arguments against the euro • For the system to work well, countries should be similar • Individual countries have to give up national interest and exchange rate policies Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5-42 The AUD exchange rate arrangements • Until December 1971, the AUD was pegged to the pound • Until September 1974, the AUD was pegged to the US dollar (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5-43 The AUD exchange rate arrangements (cont.) • Until December 1983, the AUD was pegged to a basket • In December 1983, the AUD was floated Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5-44 The USD/AUD exchange rate Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5-45 Arguments for flexible exchange rates • The BOP adjustment mechanism is smoother and less painful • Large and persistent BOP deficits not arise • Liquidity problems not arise or are less acute (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5-46 Arguments for flexible exchange rates (cont.) • Flexible rates are conducive to free trade • Flexible rates are conducive to policy independence Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5-47 Arguments against flexible exchange rates • They cause uncertainty and inhibit international trade and investment • They cause destabilising speculation • They are not suitable for small countries • They are unstable Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5-48 New international financial architecture • Linking IMF loans to crisis prevention efforts • Imposition of holding-period taxes on short-term capital flows in countries characterised by financial fragility (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5-49 New international financial architecture (cont.) • Making the private sector partly responsible for the consequences of sovereign bond issues • Discouraging fixed but adjustable exchange rates in favour of either managed floating or currency boards (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5-50 New international financial architecture (cont.) • Directing the IMF to lend less freely and to distinguish between country crises and systemic crises • Removing overlap from the responsibilities of the IMF and the World Bank Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5-51 A global currency? • Convenience • Loss of exchange rate policy • A small open economy has more to gain from the convenience Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5-52 The Tobin tax • Proposed by James Tobin in 1972, it is a uniform international tax payable on all spot FX transactions • Although the idea sounds appealing, there are serious implementation problems Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5-53 ... McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5- 9 Fixed exchange rates and flexible within a band • Exchange... Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5- 6 Fixed exchange rates • The exchange rate is fixed by the central bank and is not... 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 5- 7 Perfectly flexible exchange rates • The exchange rate