International Financial Management

Benefits of a Floating Rate System.

• 1973, proponents said :
  • reduce economic volatility and facilitate free trade.
  • floating exchange rates would offset international differences in inflation rates so that trade, wages, employment, and output would not have to adjust.
  • High-inflation countries would see their currencies depreciate, allowing their firms to stay competitive without having to cut wages or employment.
    • At the same time, currency appreciation would not place firms in low-inflation countries at a competitive disadvantage.
  • Real exchange rates would stabilize, even if permitted to float in principle, because the underlying conditions affecting trade and the relative productivity of capital would change only gradually
  • and if countries would coordinate their monetary policies to achieve a convergence of inflation rates, then nominal exchange rates would also stabilize.
• Milton Friedman
  • with a floating exchange rate, there never has been a foreign exchange crisis.
    • The floating rate absorbs the pressures that would otherwise build up in countries that try to peg the exchange rate while simultaneously pursuing an independent monetary policy. 
  • A floating rate system can also act as a shock absorber to cushion real economic shocks that change the equilibrium exchange rate.

Costs of a Floating Rate System.

• excessive volatility
  • dollar's ups and downs have had little to do with actual inflation and a lot to do with expectations of future government policies and economic conditions.
  • Real exchange rate volatility has increased, not decreased, since floating began.
  • This instability reflects, in part, nonmonetary (or real) shocks to the world economy, such as changing oil prices and shifting competitiveness among countries, but these real shocks were not obviously greater during the 1980s than they were in earlier periods.
    • Instead, uncertainty over future government policies has increased.

Benefits of a Managed Float.

• governments can reduce the volatility associated with a freely floating exchange rate.

Costs of a Managed Float.

• Demonstrated inability of governments to recognize the difference between a temporary exchange rate disequilibrium and a permanent one.
• By trying to manage exchange rates when a permanent shift in the equilibrium exchange rate has occurred, governments run the risk of creating an exchange rate crisis and wasting reserves.

Benefits of a Target Zone Arrangement.

• The experience with the European Monetary System is that the target zone arrangement in effect forced convergence of monetary policy to that of the country–Germany–with the most disciplined anti-inflation policy and led to low inflation.

Costs of a Target Zone Arrangement.

• Maintaining a genuinely stable target zone arrangement requires the political will to direct fiscal and monetary policies at that goal and not at purely national ones - difficult for countries to achieve.
  • In the case of the European Monetary System, the result was periodic currency crises.
• Another cost of this system is that fundamental changes in the equilibrium exchange rate cannot get reflected in actual exchange rate changes without a currency crisis occurring.

Benefits of a Fixed Rate System.

• currency board, dollarization, or monetary union
  • currency stability and the absence of currency crises.
• Bretton Woods (commitment to a fixed exchange rate system, but no mechanism to bind it)
  • more monetary discipline than in a freely floating system and hence lower inflation.

Costs of a Fixed Rate System.

• the exchange rate cannot cushion the effects of real economic shocks,
  • such as devaluation of a major competitor’s currency.
  • Prices must adjust, but sticky (government regulations or union restrictions)
    • higher unemployment and less economic growth.
• In a system such as Bretton Woods, the result of changes in the equilibrium exchange rate will likely be currency crises and eventual devaluation or revaluation.

Benefits of a Hybrid System.

• Countries have the option to select the system that best meets their needs

Costs of a Hybrid System.

• decision is based on political rather than economic calculations.
• no constraint on the choices that governments can make.
  • Choices can be good ones or bad ones.

                                              Complete Capital Control

Monetary Independance                                                        Exchange rate stability

                                 Pure Float                                 Credibly fixed

                                               Capital market integration

Independent monetary and fiscal policies will lead to volatile exchange rates as market participants receive and assess new information on these policies.

• Adjusting monetary growth rates is the principal way to stabilize exchange rates.
• Conscious and explicit coordination of monetary policies among sovereign authorities is difficult.
  • Inability of sovereign authorities to coordinate their monetary growth rates.
  • Countrieshave their own targets for growth and inflation and their own independent assessment of the macroeconomic policies required to attain those targets.
• Given clashing preferences, the only alternatives to the "chaos" of floating are:
  • (1)  One side persuades the other to change its policies;
  • (2)  One side subordinates its policies to those of the other; or
  • (3)  Both sides subordinate their monetary policies to an external mechanism, such as a gold standard.
• Bretton Woods collapsed because the subordination it entailed was intolerable to the United State. That is, the United States refused to follow economic policies that would maintain the value of gold at $35 an ounce.

The basic lesson from Bretton Woods, therefore, is that stabilizing exchange rates requires dependence and subordination, not the freedom for everybody to do their own thing. But instead of changing policies to stay with the Bretton Woods system, the major countries simply dropped the system.

• Exchange rate stability requires that monetary policies be coordinated and geared towards maintaining exchange rate parities.
• difficulties of achieving agreements on the many facets of economic policymaking.
• Implementing target zones on a wider scale would be all the more difficult
• Differences in preferences, policy objectives, and economic structures
• Coordination of macroeconomic policies will not necessarily benefit all participant countries equally,
• disproportionately large share of the adjustment burden will fall on the "weak" currency countries with depreciating currencies, trade deficits, or reserve losses.

• Each country within the European Monetary System had to fix its exchange rate relative to the DM.
  • If a country's exchange rate is expected to stay fixed relative to the DM, the interest rate associated with that country's currency cannot diverge from Germany's.
  • Otherwise, it would present a virtually risk-free arbitrage opportunity
    • Borrow in the lower interest rate currency and lend the borrowed funds in the higher interest rate currency and earn the spread between the two rates.

Easy monetary policy -> high rate of inflation -> currency devaluation.

Higher inflation rate -> reduce the value of the currency because:

• High inflation = goods increase in price -> goods become less competitive -> Demand for exports will fall -> less demand for curreny // Imports will inscrease -> Supply currency to Buy foreign currencies -> Decrease value of currency.

Countries that seek to participate in the EMS are effectively forced to pursue a monetary policy consistent with that of Germany, which eventually brings down their inflation rates. In effect, control of the country's monetary policy has been shifted from its central bank, which has a weak reputation for monetary discipline, to the much more reputable Bundesbank. Thus, the people now are more trusting of their money.

By heightening the prospects for a country's monetary stability, EMS membership has lowered the risks associated with holding financial assets in the country. The result has been to make the people more willing to save and invest.

The only good central bank is one that can say no to politicians.

Need to assess central bank performance in terms of an unambiguous, verifiable goal, such as price stability, thereby complementing central bank independence by giving it a single, long-term focus.

If there is political influence, the result will be higher inflation, and more currency volatility.

• Speculation can only be expected to smooth exchange rate movements if underlying economic processes are relatively stable.
  • If there is a great deal of uncertainty over future government actions and their economic impact, expectations will not be strongly held.
    • Thus expectations can change dramatically from day‑ to‑day, leading to rapidly fluctuating exchange rates.

The direct cause of inflation being rapid money expansion.

According to PPP, the direction of causation runs from price level changes to exchange rate changes, not vice versa.

• Gold = safe haven when economic and political conditions are uncertain & currencies are volatile
  • the belief that it was a sounder store of value than paper money.
  • Inflation Hedge
• Modern financial instruments such as swaps and options now provide better, less costly shelters (especially since gold pays no interest, imposing a high opportunity cost on holders)
  • the effect of reducing the demand for gold and hence its price
• The jump in the price of gold during 1993 may be due to the growing wealth of many Chinese and their attempt to avoid the high inflation stemming from the Bank of China's expansionary monetary policy. Given their lack of access to more sophisticated hedging instruments, the Chinese may have found gold to be their best inflation hedge.
• Currency concerns
  • the Bundesbank has been the only reliable policeman putting the fight against inflation as its first priority.

Coordination of economic policies will make exchange rates more stable, since the relative attractiveness of the various currencies is less likely to change significantly.

• Widening the margins reduces the credibility of the system
  • grants greater discretion to the monetary authorities.
  • Currency holders don't want the monetary authorities of suspect currency nations to have greater discretion. I
    • For suspect currencies, the loss of credibility will likely lead to higher interest rates and more speculative attacks.

• If an economic shock leads to domestic imbalances between supply and demand, a change in the exchange rate can bring about the necessary changes in prices and wages to reestablish competitiveness.
• If the exchange rate is fixed :
  • then wages and prices themselves must change to respond to domestic imbalances.
    • flexibility in the prices of goods and services is low (sticky)
    • Wage flexibility will go a long way to achieving this end, but it is imperfect.