CHAPTER19The InternationalFinancial SystemChapterOutlineandLearningObjectives19.1 ExchangeRateSystems19.2 TheCurrent ExchangeRateSystem19.3International CapitalMarketsAppendix:TheGoldStandard and theBrettonWoodsSystem
1 Chapter Outline and Learning Objectives 19.1 Exchange Rate Systems 19.2 The Current Exchange Rate System 19.3 International Capital Markets Appendix: The Gold Standard and the Bretton Woods System CHAPTER 19 CHAPTER The International Financial System
ExchangeRateSystems19.1LEARNINGOBJECTIVEDescribehowdifferentexchangeratesystemsoperate@2015PearsonEducation,lnc
LEARNING OBJECTIVE © 2015 Pearson Education, Inc. 2 Exchange Rate Systems 19.1 Describe how different exchange rate systems operate
How Are Exchange Rates Determined?Intheprevious chapter,weassumedexchange ratesweredetermined by the market.. A floating currency is the outcome of a country allowing itscurrency's exchange rate to be determined by demand and supplyBut allowing the relative values of currencies to be determined bydemand and supply is just one type of exchange rate system, oragreement among countries about how exchange rates should bedetermined.: The present-day exchange rate system is best described as amanaged float exchange rate system,under whichthe value ofmost currencies is determined by demand and supply, withoccasionalgovernmentintervention.2015PearsonEducation,Inc.3
© 2015 Pearson Education, Inc. 3 How Are Exchange Rates Determined? In the previous chapter, we assumed exchange rates were determined by the market. • A floating currency is the outcome of a country allowing its currency’s exchange rate to be determined by demand and supply. But allowing the relative values of currencies to be determined by demand and supply is just one type of exchange rate system, or agreement among countries about how exchange rates should be determined. • The present-day exchange rate system is best described as a managed float exchange rate system, under which the value of most currencies is determined by demand and supply, with occasional government intervention
FixedExchangeRateSystemA fixed exchange rate system is one under which countries agree tokeep the exchange rates among their currencies fixed for longperiods.: From the 1gth century until the 1930s, countries' currencies wereredeemable for fixed amounts of golda system known as thegold standard. The amount of gold each for which currency wasredeemable determined the exchange ratesAfter the Great Depression of the 1930s, most countries abandonedthe gold standard. In 1944, a conference in Bretton Woods, NHestablished the Bretton Woods system:: The U.S. pledged to buy or sell gold at $Us 35 per ounce.Other member countries agreed to a fixed exchange rate betweentheir currency and the U.S. dollarWewill examine these systems further in this chapter's appendix2015PearsonEducation,Inc
© 2015 Pearson Education, Inc. 4 Fixed Exchange Rate System A fixed exchange rate system is one under which countries agree to keep the exchange rates among their currencies fixed for long periods. • From the 19th century until the 1930s, countries’ currencies were redeemable for fixed amounts of gold—a system known as the gold standard. The amount of gold each for which currency was redeemable determined the exchange rates. After the Great Depression of the 1930s, most countries abandoned the gold standard. In 1944, a conference in Bretton Woods, NH established the Bretton Woods system: • The U.S. pledged to buy or sell gold at $US 35 per ounce • Other member countries agreed to a fixed exchange rate between their currency and the U.S. dollar We will examine these systems further in this chapter’s appendix
TheCurrentExchangeRateSystem19.2LEARNINGOBJECTIVEDiscuss thethreekeyfeatures of the currentexchangerate system@2015PearsonEducation,lnc
LEARNING OBJECTIVE © 2015 Pearson Education, Inc. 5 The Current Exchange Rate System 19.2 Discuss the three key features of the current exchange rate system
Highlightsof the CurrentExchangeRate SystemThe current exchange rate system has three important aspects:1. The U.S. allows the dollar to float against other major currencies2. Seventeen countries in Europe have adopted a single Europeancurrency, the euro.3. Some countries have attempted to keep their currenciesexchange rates fixed against the $us or some other currencyEach of these aspects has important consequences, and we willexaminetheminturn.@2015PearsonEducation,Inc.6
© 2015 Pearson Education, Inc. 6 Highlights of the Current Exchange Rate System The current exchange rate system has three important aspects: 1. The U.S. allows the dollar to float against other major currencies. 2. Seventeen countries in Europe have adopted a single European currency, the euro. 3. Some countries have attempted to keep their currencies’ exchange rates fixed against the $US or some other currency. Each of these aspects has important consequences, and we will examine them in turn
1.TheFloatingDollarCanadianJapanesedollarsperyenperU.S.dollarU.S.dollar1.73501.63001.51.42501.32001.21501.11.01000.9500.8197319781983198819931998200320082013197319781983198819931998200320082013Figure 19.1Canadian dollar-U.S.dollarandYen-U.S.dollarexchangerates,1973-2013The Bretton Woods system of fixed exchange rates ended in 1973.Since then the value of the $US (in terms of how many units offoreign currency one U.S. dollar can buy) has floated.One U.S. dollar buys about as many Canadian dollars as it did in1973.But it only buys about a third as many Japanese yen.2015PearsonEduation.lnc
© 2015 Pearson Education, Inc. 7 1. The Floating Dollar The Bretton Woods system of fixed exchange rates ended in 1973. Since then the value of the $US (in terms of how many units of foreign currency one U.S. dollar can buy) has floated. • One U.S. dollar buys about as many Canadian dollars as it did in 1973. • But it only buys about a third as many Japanese yen. Canadian dollar-U.S. dollar and Yen-U.S. dollar exchange rates, 1973-2013 Figure 19.1
What Determines Exchange Rates in theLong Run?Why has the value of the U.S. dollar fallen so much against theJapanese yen, and yet risen then fallen to about the original levelagainst the Canadian dollar?In the short run, the two most important influences on exchange ratesare::Relative interestratesExpectations about future values of currenciesBut overthelongrun,it seems reasonable thatexchange ratesshould move to equalize the purchasing powers of differentcurrencies. This is known as the theory of purchasing power parity@2015PearsonEducation,Inc
© 2015 Pearson Education, Inc. 8 What Determines Exchange Rates in the Long Run? Why has the value of the U.S. dollar fallen so much against the Japanese yen, and yet risen then fallen to about the original level against the Canadian dollar? In the short run, the two most important influences on exchange rates are: • Relative interest rates • Expectations about future values of currencies But over the long run, it seems reasonable that exchange rates should move to equalize the purchasing powers of different currencies. This is known as the theory of purchasing power parity
Purchasing Power ParitySuppose that candy bars sell for 2 in the United Kingdom, and for $1in the United States.If the exchange rate were 1 = $1, then a clever entrepreneur could:: Buy a million candy bars in the U.S. for $1,000,000Transport them to the U.K. and sell them for 2,000,000: Exchange that currency for $2,000,000: a profit of $1,000,000minus the cost of shipping.If many people did this, there would be an increase in the supply ofBritishpounds,offeredtopurchase U.S.dollars;sowewould expectthe exchange rate to appreciate.If it appreciated to 2 = $1, currency would have equal purchasingpower in each location, and there would be no more pressure on theexchangerate to change.92015PearsonEducation,Inc
© 2015 Pearson Education, Inc. 9 Purchasing Power Parity Suppose that candy bars sell for £2 in the United Kingdom, and for $1 in the United States. If the exchange rate were £1 = $1, then a clever entrepreneur could: • Buy a million candy bars in the U.S. for $1,000,000 • Transport them to the U.K. and sell them for £2,000,000 • Exchange that currency for $2,000,000: a profit of $1,000,000, minus the cost of shipping. If many people did this, there would be an increase in the supply of British pounds, offered to purchase U.S. dollars; so we would expect the exchange rate to appreciate. If it appreciated to £2 = $1, currency would have equal purchasing power in each location, and there would be no more pressure on the exchange rate to change
What Stops Purchasing Power Parity from Occurring?When you travel, you will notice that some goods and services arecheaper overseas than here, and some are more expensive.Why doesn't purchasing power parity stop this from happening?1. Not all products can be traded internationally (especiallyservices).2. Products and consumer preferences are different acrosscountries; prices are determined by supply, but also by demand.3. Countries impose barriers to trade, like tariffs (taxes on imports)and quotas (numerical limits on imports)Example: the U.S. sugar quota ensures that purchasing powerparity cannot reduce the price of sugar in the U.S. to the “worldprice"102015PearsonEducation,Inc
© 2015 Pearson Education, Inc. 10 What Stops Purchasing Power Parity from Occurring? When you travel, you will notice that some goods and services are cheaper overseas than here, and some are more expensive. Why doesn’t purchasing power parity stop this from happening? 1. Not all products can be traded internationally (especially services). 2. Products and consumer preferences are different across countries; prices are determined by supply, but also by demand. 3. Countries impose barriers to trade, like tariffs (taxes on imports) and quotas (numerical limits on imports). Example: the U.S. sugar quota ensures that purchasing power parity cannot reduce the price of sugar in the U.S. to the “world price