Lecture 2:The International

Monetary System
A Discussion of Foreign Exchange
Regimes (i.e., The Arrangement
by which a Countrys Exchange
Rate is Determined)
Cable Rate: GBP/USD (1855-1866)
First Words: "Thank God, the Cable is Laid."
What is the International Monetary
System?
It is the overall financial environment in which global
businesses and global investors operate.
It is represented by the following 3 sub-sectors:
International Money and Capital Markets
Banking markets (loans and deposits)
Bond markets (offshore, or euro-bond markets)
Equity markets (cross listing of stock)
Foreign Exchange Markets
Currency markets (and foreign exchange regimes)
Derivatives Markets
Forwards, futures, options
This lecture will focus on the foreign exchange
market
Concept of an Exchange Rate Regime
The exchange rate regime refers to the arrangement
by which the price of countrys currency is determined
within foreign exchange markets.
This arrangement is determined by individual
governments (essentially how much control if any
they wish to exert on the actual exchange rate).
Foreign currency price is:
The foreign exchange rate (referred to as the spot rate).
Expresses the value of a countys currency as a ratio of
some other country.
Since the 1940s that other currency has been the U.S. dollar.
Century before (and under the Classical Gold Standard) it was
the British pound.
Foreign Exchange Rate Quotations
There are two generally accepted ways of
quoting a currencys foreign exchange rate
(i.e., the ratio of one currency to the U.S.
dollar).
American terms and European Terms quotes
American terms quotes: Expresses the
exchange rate as the amount of U.S. dollars
per 1 unit of a foreign currency.
For Example: $1.65 per 1 British pound
Or $1.45 per 1 European euro
Or $1.06 per 1 Australian dollar
Foreign Exchange Rate Quotations
European terms quote: Expresses the
exchange rate as the amount of foreign currency
per 1 U.S. dollar
For Example: 76.67 yen per 1 U.S. dollar
Or 7.80 Hong Kong dollars per 1 U.S. dollar
Or 6.38 Chinese yuan per 1 U.S. dollar
For reporting and trading purposes, most of the
worlds major currencies are quoted on the basis
of American terms (Pound and Euro); however,
the majority of the worlds currencies are quoted
on the basis of European terms.
http://www.bloomberg.com/markets/currencies/
A Model for Illustrating Exchange
Rate Regimes
We can think of current exchange rate regimes as
falling along a spectrum as represented by a
national governments involvement in affecting
(managing) their countrys exchange rate.
No Very Active
Involvement by Involvement by
Government Government

Market forces Government is

are Determining or
Determining Managing the
Exchange rate Exchange rate
Exchange Rate Regimes Today
Minimal (if any) Active
Involvement by Involvement by
Government Government

Market forces Government is

are Determining or
Determining Managing the
Exchange rate Exchange rate

Managed Pegged
Floating Rate
Rate Rate
(Dirty Float) Regime
Regime Regime
Classification of Exchange Rate
Regimes: Floating Rate Regimes
Floating Currency Regime:
No (or at best occasional) government involvement
(i.e., intervention) in foreign exchange markets.
Market forces, i.e., demand and supply, are the
primary determinate of foreign exchange rates
(prices).
Financial institutions (global banks, investment firms),
multinational firms, speculators (hedge funds),
exporters, importers, etc.
Central banks may intervene occasionally to offset what
they regard as inappropriate or disorderly exchange
rate levels.
Classification of Exchange Rate
Regimes: Managed Rate Regimes
Managed Currency (Dirty Float) Regime:
High degree of intervention of government in foreign
exchange market (perhaps on a daily basis).
Purpose: to offset moderate market forces and produce an
desirable exchange rate level or path.
Usually done because exchange rate is seen as
important to the national economy (e.g., export sector
or the price of critical imports or as a means to control
inflation).
Currencys exchange rate will be managed in relation
to another currency (or a market basket of currencies)
Preferred currencies are the US dollar and Euro.
Classification of Exchange Rate
Regimes: Pegged (Fixed) Rate Regimes
Pegged Currency Regime
Governments directly link (i.e., peg) their currencys
rate to another currency.
Government sets the exchange rate with a certain band (e.g.,
+ or 1%) of a fixed rate or within a narrow margin, or
sometimes use a crawling peg (e.g., + or 2%) of a trend.
Occurs when governments are reluctant to let market
forces determine rate.
Exchange rate seen as essential to countrys
economic development and or trade relationships.
Governments are also concerned about the potential
negative impacts of a open capital market (i.e.,
disruptive flows of short term funds hot money.)
Examples of Currencies by Regime
Floating Rate Currencies:
Canadian dollar (1970), U.S. dollar (1973), Japanese yen (1973), British
pound (1973), Australian dollar (1985), New Zealand dollar (1985), South
Korean Won (1997), Thailand baht (1997), Euro (1999), Brazilian real
(1999), Chile peso (1999), Argentina Peso (2002).
Managed (Floating) Rate Currencies:
Singapore dollar, 1981, Costa Rica colon (U.S. dollar), Malaysia ringgit
(2005, Market Basket), Vietnam dong (11/08 U.S. dollar).
Pegged Rate Currencies to a fixed rate (against the U.S. dollar
or market basket):
Hong Kong dollar, since 1983 (7.8KGD = 1USD), Saudi Arabia riyal
(3.75SAR = 1USD), Oman rial (0.385OMR = 1USD)
Pegged Rate Currencies (Crawling Peg) to a trend (against
the U.S. dollar or market basket):
China yuan (7/05 Market Basket), Bolivia boliviano (U.S. dollar)
Note: The IMF notes that 66 out of 192 countries they classify use
the U.S. dollar as a anchor. Data above as of 2009.
Changing Exchange Rate Regimes:
1970 -2010 (IMF Classifications)
% by Number of Countries % by GDP of Countries
Simplified Model of Floating Exchange
Rates (Market Determined Rates)
The market equilibrium exchange rate at any point
in time can be represented by the point at which the
demand for and supply of a particular foreign
currency produces a market clearing price, or:

Supply (of a certain FX)

Price
Demand (for a certain FX)

Quantity of FX
Simplified Model: Strengthening FX
Any situation that increases the demand (d to d) for a
given currency will exert upward pressure on that
currencys exchange rate (price).
Any situation that decreases the supply (s to s) of a
given currency will exert upward pressure on that
currencys exchange rate (price).

s s s
p p

d d d
q q
Simplified Model: Weakening FX
Any situation that decreases the demand (d to d) for a
given currency will exert downward pressure on that
currencys exchange rate (price).
Any situation that increases the supply (s to s) of a
given currency will exert downward pressure on that
currencys exchange rate (price).

s s s
p p

d d d
q q
Factors That Affect the Equilibrium
Exchange Rate: Changes in Demand
Relative (short-term) interest rates.
Affects the demand for financial assets (increase demand for high
interest rate currencies).
Relative rates of inflation.
Affects the demand for real (goods) and financial assets; hence
the demand for currencies
Low inflation results in increase global demand for a countrys goods.
Low inflation results in high real returns on financial assets.
Relative economic growth rates.
Affects longer term investment flows in real capital assets (FDI)
and financial assets (stocks and bonds).
Changes in global and regional risk.
Safe Haven Effects: Foreign exchange markets seek out safe
haven countries during periods of uncertainty.
Safe Haven Effect: September 11, 2001
Factors That Affect the Equilibrium
Exchange Rate: Government Intervention
Foreign exchange intervention policy if a
government feels its currency is too weak
Government will buy their currency in foreign
exchange markets
Create demand and push price up.
Foreign exchange intervention policy if
government feels its currency is too strong
Government will sell their currency in foreign
exchange markets
Increase supply to bring price down.
Market Intervention by Central Banks

Use the model below to explain how intervention by a

central bank can respond to (1) a weak currency
and (2) a strong currency (assume it wants to offset
either condition):

Supply (of a certain FX)

Price
Demand (for a certain FX)

Quantity of FX
Factors That Affect the Equilibrium
Exchange Rate: Government Interest Rate
Adjustments
Some governments may also use interest rate
adjustments to influence their currencies.
When a currency become too weak:
Governments might raise short term interest rates to
encourage short term foreign capital inflows.
Higher interest rates make investments more attractive and
increase demand for the currency.
When a currency becomes too strong:
Governments might lower short term interest rates to
discourage short term foreign capital inflows.
Lower interest rates will make investments less attractive and
reduce the demand for the currency.
Factors That Affect the Equilibrium
Exchange Rate: Carry Trade Strategies
Carry trade strategy: A foreign exchange trading strategy in which a
trader sells a currency with a relatively low interest rate and uses the
funds to purchase a different currency yielding a higher interest rate.
This strategy offers profit not only from the interest rate difference
(overnight interest rate) but additionally from the currency pairs
fluctuation.

An example of a "yen carry trade": A trader borrows Japanese yen

from a Japanese bank, converts the funds into Australian dollars
and buys an Australian bond for the equivalent amount. If we
assume that the bond pays 4.5% and the Japanese borrowing rate
is 1.0%, the trader stands to make a profit of 3.5% as long as the
exchange rate between the countries does not change.
In this example, the trader is short on yen and long on Australian dollars.
Impact of Carry Trades on
Exchange Rates
Carry trades can result in a huge amount of capital flows in and
out of currencies.
High interest rate currency will experience increase demand.
Low interest rate currency will experience increase in supply.
Combined this will result in a strengthening of the high interest rate
currency against the low interest rate currency.
However, when traders reverse their positions, the opposite
exchange rate effects will occur.
When do they reverse: During periods of increasing global
uncertainty about interest rates and exchange rates.
For a case which combines carry trade and government
intervention, please see: Case Study: New Zealand Central Bank
Intervention in the Foreign Exchange Market, June 11, 2007
(posted on course web site).