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CHAPTER 3 THE INTERNATIONAL MONETARY SYSTEM This chapter helps students understand the international monetary system and how the choice of system affects currency values. It also provides a historical background of the international monetary system. This enables students to gain perspective when trying to interpret the likely consequences of new policies in the area of international finance. This chapter describes how exchange rates are determined under four different mechanisms – free float, managed float, fixed rate system, and target zone system. Under the latter three systems, governments intervene in the currency markets in one form or another to affect the exchange rate. Key Points 1. Under the latter three systems, which involve varying degrees of central bank intervention, the real exchange rate is liable to change, with important implications for exchange risk management (discussed in Chapters 9 and 10). 2. Regardless of the form of intervention, neither fixed nor floating rates remain fixed for long, governments subordinate exchange rate considerations to domestic political considerations. 3. The gold standard is a specific type of fixed exchange rate system that required participating countries to maintain the value of their currencies in terms of gold. Calls for a new gold standard remind us of the fundamental lack of trust in fiat money due to the historical unwillingness of the monetary authorities to desist from tampering with the money supply. 4. Intervention to maintain a disequilibrium rate is usually either ineffective or injurious when pursued over lengthy periods. Seldom, if ever, have policymakers been able to outsmart for any extended period the collective judgment of buyers and sellers. The current volatile market environment, a consequence of unstable U.S. and world financial conditions, cannot for long be arbitrarily directed by government officials. 5. Examining U.S. experience since the abandonment of fixed rates, we find that free market forces did indeed correctly reflect economic realities. The dollar’s value dropped sharply from 1973 to 1980 when the U.S. experienced high inflation and weakened economic conditions. It rose beginning in 1981 when American policies dramatically changed under the leadership of the Fed and a new president, and fell when foreign economies strengthened relative to the U.S. economy. SUGGESTED ANSWERS TO “THE EURO REACTS TO NEW INFORMATION” 1. Explain the differing initial and subsequent reactions of the euro to news about the European Central Bank’s monetary policy. Answer: The initial reaction is based on the expectation of no tightening in the money supply. The result will be higher inflation than previously expected and – according to purchasing power parity – a depreciating euro. The euro’s subsequent reaction was based on the view that monetary policy would in fact be tightened (that’s the objective of an interest rate increase) and inflation would be reduced. At the same time, a higher real interest rate would be expected to attract more capital and boost the euro’s value as well. 2. How does a strong pound reduce the threat of imported inflation and work against higher interest rates? Answer: A weak pound will bring higher prices of foreign goods and services, enabling domestic producers to raise their prices and leading to higher inflation. Conversely, a stronger pound will bring lower-priced foreign goods and services, putting downward pressure on domestic prices and reducing the threat of inflation. Lower inflation will lead – via the Fisher Effect – to lower interest rates. At the same time, the expectation of lower inflation means the Bank of England will be under less pressure to raise interest rates to fight nonexistent inflation. 3. Which U.K. manufacturers are likely to be pressured by a strong pound? Answer: Those British manufacturers that compete with imports or that export will be hurt by a stronger pound because foreign competitors will see their pound-equivalent prices fall. In addition, British manufacturers that use domestically sourced inputs in competition with those that use imported inputs will suffer. 4. Why might higher pound interest rates send sterling even higher? Give two possible reasons. Answer: Higher British interest rates occasioned by a tightening of monetary policy will lead to lower expected inflation. According to purchasing power parity, countries with lower rates of inflation will tend to see their currencies appreciate relative to those of countries with higher rates of inflation. At the same time, if the higher nominal interest rate is also a higher real interest rate, this will attract capital to the U.K. seeking to earn the higher real return. The greater demand for sterling for investment purposes will boost its value. 5. What tools are available to the European Central Bank and the Bank of England to manage their monetary policies? Answer: Both central banks can use open market operations – which involve buying and selling bonds denominated in their currencies to regulate the money supply. It may be more difficult for the ECB, however, as it doesn’t have Treasury bonds denominated in euros, but there will be other bonds issued in the euro that it can buy or sell. The central banks can also raise or lower the interest rate at which they lend money to banks and regulate the reserve requirements of banks. Another tool of monetary policy is foreign exchange market intervention, which involves buying or selling their currencies in the foreign exchange market. SUGGESTED ANSWERS TO “BRITAIN–IN OR OUT FOR THE EURO” 1. Discuss the pros and cons for Britain of joining EMU. Answer: By joining the EMU, Britain would lock itself into a new European monetary policy. Provided this monetary policy is dominated by Germany, it is likely to be a low-inflation policy. At the same time, the single-currency aspect of EMU will reduce currency risk and foreign exchange trading costs for British firms. These features are all pluses. However, Britain would also lose the ability to conduct an independent monetary policy. To the extent that economic shocks affect Britain differently than they affect EMU members, losing the flexibility to adjust monetary policy or its exchange rate to cope with these shocks could be costly in terms of lost economic output. In other words, Britain combined with continental Europe may not constitute an optimum currency area. The costs of fixing exchange rates were demonstrated when Britain and other European nations were forced to raise their interest rates to maintain their exchange rates fixed to the DM even as Germany was coping with the shock of reunification. 2. Commentators pointed to the fact that many people in Britain have variable rate mortgages as opposed to the fixed-rate mortgages more common in Europe. Britain also has the most flexible labor markets in Europe. How would these factors likely affect Britain’s economic costs and benefits of joining the euro? Answer: To the extent the EMU is viewed as a serious inflation fighter, Britain’s entry would be viewed as a plus by financial markets. The result would be lower interest rates in Britain, which would benefit British homeowners holding variable-rate mortgages. The biggest problem with joining a monetary union is the loss of exchange rate and monetary policy flexibility to absorb the effects of economic fluctuations. The most important substitute for monetary and exchange rate flexibility is labor market flexibility. The fact that Britain’s labor market is relatively flexible will lower the costs to Britain associated with joining EMU. 3. What types of British companies would most likely benefit from joining the EMU? Answer: Primary beneficiaries would be British companies that engage in extensive trade (both buying and selling) or other business with other EMU countries, as joining the EMU will reduce their currency risk and lower their foreign exchange transaction costs (the costs associated with converting between the pound and the euro). 4. Some large MNCs warned that they only chose to invest in Britain on the assumption it would ultimately adopt the euro. Why would MNCs be interested in Britain joining the euro? Answer: Many companies have used Britain as an export platform to other EU countries. If Britain joins EMU, that would reduce their currency risk and transaction costs. MNCs locating in Britain complain that they now must bear transaction costs and exchange rate uncertainty that they could avoid by basing themselves in EMU countries. SUGGESTED ANSWERS TO CHAPTER 3 QUESTIONS 1.a. What are the five basic mechanisms for establishing exchange rates? Answer: The five basic mechanisms for establishing exchange rates are free float, managed float, target-zone arrangement, fixed-rate system, and the current hybrid system. 1.b. How does each work? Answer: In a free float, exchange rates are determined by the interaction of currency supplies and demands. Under a system of managed floating, governments intervene actively in the foreign exchange market to smooth out exchange rate fluctuations to reduce the economic uncertainty associated with a free float. Under a target-zone arrangement, countries adjust their national economic policies to maintain their exchange rates within a specific margin around agreed-on fixed central exchange rates. Under a fixed-rate system, such as the Bretton Woods system, governments are committed to maintaining target exchange rates. Each central bank actively buys or sells its currency in the foreign exchange market whenever its exchange rate threatens to deviate from its stated par value by more than an agreed-on percentage. Currently, the international monetary system is a hybrid system, with major currencies floating on a managed basis, some currencies freely floating, and other currencies moving in and out of various types of pegged exchange rate relationships. 1.c. What costs and benefits are associated with each mechanism? Answer: Benefits of a Floating Rate System. When floating rates were adopted in 1973, proponents said the new system would reduce economic volatility and facilitate free trade. In particular, 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. Another benefit is that – as Milton Friedman points out – with a floating exchange rate, there never has been a foreign exchange crisis. The reason is simple: 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. For example, the Asian currency crisis did not spill over to Australia and New Zealand because the latter countries had floating exchange rates. 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. Many economists point to excessive volatility as a major cost of a floating-rate system. The experience to date is that the dollar’s fluctuations have had little to do with actual inflation and a lot to do with expectations of future government policies and economic conditions. Put another way, 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 in earlier periods. Instead, uncertainty over future government policies has increased. Benefits of a Managed Float. The potential benefit of a managed float is that governments can reduce the volatility associated with a freely floating exchange rate. Costs of a Managed Float. The costs of a managed float stem from the demonstrated inability of governments to recognize the difference between temporary and permanent exchange rate disequilibrium. 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 goals. This turns out to be 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. A permanently fixed exchange rate system – such as that achieved by a currency board, dollarization, or monetary union – results in currency stability and the absence of currency crises. A system such as existed under Bretton Woods, whereby there is a commitment to a fixed exchange rate system but no mechanism to bind that commitment, will have more monetary discipline than in a freely floating system and hence lower inflation than might otherwise be the case. Costs of a Fixed Rate System. In a permanently fixed system, the exchange rate cannot cushion the effects of real economic shocks, such as devaluation of a major competitor’s currency. Instead, prices must adjust. Given the lack of flexibility of many prices – because of government regulations or union restrictions – the result of these economic shocks can be 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. The current system gives countries the option to select the system that best meets their needs. However, all too often the decision is based on political rather than economic considerations. Costs of a Hybrid System. The cost of a hybrid system, such as the one currently in place, is that there is no constraint on the choices that governments can make. The resulting choices can be good or bad. 1.d. Have exchange rate movements under the current system of managed floating been excessive? Explain. Answer: Excessive movements would indicate that there are profits to be earned by betting against the market. In effect, if currency fluctuations are excessive they would exhibit the phenomenon of overshooting (i.e., currency rates would overreact to economic events and then return to equilibrium). There is no evidence that one could profit by betting that rate movements are excessive. 2. Find a recent example of a nation’s foreign exchange market intervention and note what the government’s justification was. Does this justification make economic sense? Answer: Finding an example of foreign exchange market intervention by a government should be pretty easy to do. The trick will be to find a coherent statement of what the government’s justification was. Most of these justifications make little or no economic sense. 3. Gold has been called “the ultimate burglar alarm.” Explain what this expression means. Answer: Governments “burgle” holders of their currencies by printing more money and subjecting holders to an “inflation tax.” Since gold prices respond quickly to evidence of inflation, the expectation of an increase in inflation will cause a jump in gold prices. In this way, gold serves as a burglar alarm to warn that politicians are tampering with fiat money. 4. Suppose nations attempt to pursue independent monetary and fiscal policies. How will exchange rates behave? Answer: Independent monetary and fiscal policies will lead to volatile exchange rates as market participants receive and assess new information on these policies. 5. The experiences of fixed exchange-rate systems and target zone arrangements have not been entirely satisfactory. 5.a. What lessons can economists draw from the breakdown of the Bretton Woods system? Answer: Adjusting monetary growth rates is the principal way to stabilize exchange rates. For example, raising the value of the dollar relative to the yen requires tightening U.S. monetary policy relative to Japanese monetary policy. The experience of Bretton Woods and similar experiments demonstrates that conscious and explicit coordination of monetary policies among sovereign authorities is difficult. The problem stems from the inability of sovereign authorities to coordinate their monetary growth rates. An agreement to stabilize the dollar at, say, 150 yen would be relatively easy if it did not entail interdependent monetary policies, robbing the Federal Reserve, or the Bank of Japan, or both, of important degrees of monetary freedom. Both Japan and the U.S. have their own targets for growth and inflation and their own independent assessment of the macroeconomic policies required to attain those targets. Except by coincidence, independent policies and preferences will not mesh at a stable exchange rate. Given clashing preferences, the only alternatives to the “chaos” of floating are: i) One side persuades the other to change its policies; ii) One side subordinates its policies to those of the other; or iii) Both sides subordinate their monetary policies to an external mechanism, such as a gold standard. Absent (iii), “international monetary reform” is the search for new ways to implement (i) or (ii), or some combination. Bretton Woods collapsed because the subordination it entailed was intolerable to the U.S. That is, the U.S. 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. 5.b. What lessons can economists draw from the exchange rate experiences of the European Monetary System? Answer: Exchange rate stability requires that monetary policies be coordinated and geared toward maintaining exchange rate parities. The slow progress of the European community with respect to the EMS and policy coordination exemplifies the 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 account in part for these difficulties. More fundamentally, however, coordination of macroeconomic policies will not necessarily benefit all participant countries equally, and those that benefit the most may not be willing to compensate those that benefit least. In the EMS, Germany is less inflation prone than the other members and is reluctant to cooperate at the risk of increasing its inflation rate. Another lesson is that in target zone arrangements such as the EMS, a disproportionately large share of the adjustment burden will fall on the “weak” currency countries. Countries with appreciating currencies, trade surpluses, and increasing reserves are less prone to adjust than countries with depreciating currencies, trade deficits, or reserve losses. The convergence of inflation rates among the EMS countries supports this view. An equal sharing of the adjustment burden implies that inflation rates among member nations would converge to the average rate. Germany, however, has maintained a domestic monetary target of low or zero inflation and has often refused to alter domestic monetary policy because of exchange rate considerations. Because of Germany’s economic importance, the other member countries have had to adjust their domestic policies or their exchange rates to remain competitive in international markets. As a result, inflation rates have tended to converge toward Germany’s lower rate. 6. How did the European Monetary System limit the economic ability of each member nation to set its interest rate to be different from Germany’s? Answer: 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. 7. Historically, Spain has had high inflation and has seen its peseta continuously depreciate. In 1989, though, Spain joined the EMS and pegged the peseta to the DM. According to a Spanish banker, EMS membership means that “the government has less capability to manage the currency but, on the other hand, the people are more trusting of the currency for that reason.” 7.a. What underlies the peseta's historical weakness? Answer: Spain has historically pursued an easy monetary policy with an associated high rate of inflation. High inflation, in turn, led to continual peseta devaluation. 7.b. Comment on the banker’s statement. Answer: 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 Spain’s monetary policy has been shifted from Spain’s central bank, which has a weak reputation for monetary discipline, to the much more reputable Bundesbank. Thus, Spaniards now are more trusting of their money. 7.c. What are the likely consequences of EMS membership on the Spanish public’s willingness to save and invest? Answer: By heightening the prospects for Spanish monetary stability, EMS membership has lowered the risks associated with holding financial assets in Spain. The result has been to make the Spanish public more willing to save and invest. 8. In discussing EMU, a recent government report stressed a need to make the central bank accountable to the “democratic process.” What are the likely consequences for price stability and exchange rate stability in the EMS if the “Eurofed” becomes accountable to the “democratic process?” Answer: The only good central bank is one that can say no to politicians. Unfortunately, the proposal makes it more difficult for the central bank to do so. Instead of assessing 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, the proposal’s definition of accountability will provide an avenue for political influence. The result will be higher inflation and more currency volatility. 9. In 1996, Chancellor Kenneth Clarke called for a national debate on whether Britain should join the EMU. Discuss the pros and cons for Britain of joining EMU. Answer: By joining the EMU, Britain would lock itself into a new European monetary policy. Provided this monetary policy is dominated by Germany, it is likely to be a low-inflation policy. At the same time, the single-currency aspect of the EMU will reduce currency risk and foreign exchange trading costs for British firms. These features are all pluses. However, Britain would also lose the ability to conduct an independent monetary policy. To the extent that economic shocks affect Britain differently than it affects other EMU members, losing the flexibility to adjust monetary policy or its exchange rate to cope with these shocks could be quite costly in terms of lost economic output. In other words, Britain combined with continental Europe may not constitute an optimum currency area. The costs of fixing exchange rates were demonstrated when Britain and other European nations were forced to raise their interest rates to maintain their exchange rates fixed to the DM even as Germany was coping with the shock of reunification. ADDITIONAL CHAPTER 3 QUESTIONS AND ANSWERS 1. Why has speculation failed to smooth exchange rate movements? Answer: 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. 2. Is a floating rate system more inflationary than a fixed rate system? Explain. Answer: To the extent that floating exchange rates allow monetary authorities to pursue more inflationary policies, then a floating-rate system can be more inflationary. However, this is an indirect effect, 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. 3. Since 1979, the price of gold has fallen by more than 60%. What could explain such a steep price decline? Consider the roles of inflation and new financial instruments such as swaps and options that can provide lower-cost inflation hedges. Answer: Gold has traditionally provided a safe haven when economic and political conditions are uncertain and currencies are volatile because of the belief that it was a sounder store of value than paper money. However, gold’s value as an inflation hedge was diminished during the 1980s as inflation became a much less serious concern. At the same time, to the extent that 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), these lower cost inflation-hedge substitutes would have the effect of reducing the demand for gold and hence its price relative to what it would be absent these lower-cost inflation-hedge substitutes. 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 also played a role in gold’s rally during 1993. Until recently, the Bundesbank has been the only reliable policeman putting the fight against inflation as its first priority. That certainty became questionable as the Bundesbank had to deal with the pressures brought on by the German recession to put economic expansion ahead of price stability as its priority. These concerns about the DM as a store of value were reflected in a fall in its exchange rate during much of the 1990s. 4. Comment on the following statement: “A system of floating exchange rate fails when governments ignore the verdict of the exchange markets on their policies and resort to direct controls over trade and capital flows.” Answer: In principle, floating offers a small degree of freedom from the subordination and coordination necessary to maintain stable exchange rates. But if governments abuse that degree of freedom and refuse to accept the exchange rate consequences (e.g., a drop in the exchange rate due to rapid expansion of the money supply), the system will fail. That is, if the governments involved wish to pursue independent policies while simultaneously stabilizing exchange rates, this can be accomplished only by imposing direct controls on trade and capital flows. 5. Will coordination of economic policies make exchange rates more or less stable? Explain. Answer: Coordination of economic policies will make exchange rates more stable, since the relative attractiveness of the various currencies is less likely to change significantly. 6. Despite official parity between the DM and the Ostmark, the black market rate in early 1990 was about ten Ostmarks for one DM. What problems might setting the exchange rate at one Ostmark for each DM create for Germany? Answer: The basic problem is that, at a one for one exchange rate, the Ostmark will be overvalued relative to the DM. Unless East German wages fall, East German industry will find its cost of doing business rising without an offsetting gain in productivity. East German industry will become even less competitive than it already is, with massive unemployment resulting. At the same time, East Germans will rush to convert their Ostmarks to DMs. The resulting growth in the DM money supply will be inflationary unless the demand for DM grows in proportion to the supply. Clearly, the demand for DM will rise as it supplants the Ostmark as the official East German currency. Of course, the Bundesbank can always eliminate the threat of inflation by sterilizing the increase in DM through open market activities, that is, by issuing bonds to absorb the surplus DMs. Germany did set a one-for-one exchange rate, more than 30% of eastern Germans were unemployed by mid-1991 (this problem was compounded by the extremely generous German unemployment compensation system), inflation fears rose in Germany, and fewer than 10% of eastern German companies were solvent. 7. When Britain announced its entry into the exchange rate mechanism of the EMS on October 5, 1990, the price of British gilts (long term government bonds) soared and sterling rose in value. 7.a. What might account for these price jumps? Answer: By entering the exchange-rate mechanism, Britain has effectively foresworn devaluation of the pound against the DM. To maintain the pound’s value, Britain must follow a more disciplined and anti-inflation monetary policy. Expectations of lower inflation and fewer currency swings in the future raised the demand for British assets, including pounds, thereby reducing interest rates (which are the inverse of the bond price) and raising the pound’s value. Put another way, expectations of lower inflation reduce interest rates (the Fisher Effect) and boost the value of a nation’s currency (purchasing power parity). 7.b. Sterling entered the ERM at a central rate against the DM of DM 2.95, and it is allowed to move within a band of +/- 6% of this rate. What are sterling’s upper and lower rates against the DM? Answer: Sterling’s lower limit against the DM is 0.94 * 2.95 = DM 2.77; its upper limit is 1.06 * 2.95 = DM 3.13. 8. What potential costs might be associated with the decision to widen the margins within which some currencies in the ERM can float? Answer: Widening the margins reduces the credibility of the system since such a system grants greater discretion to the monetary authorities. Currency holders don’t want the monetary authorities of suspect currency nations to have greater discretion. Indeed, the monetary authorities’ loss of discretion associated with the ERM is viewed by most as the ERM’s greatest value. For suspect currencies, the loss of credibility will likely lead to higher interest rates and more speculative attacks. 9. Comment on the following headline in The Wall Street Journal (January 11, 1993): “Germany’s Rate Cut Takes Pressure Off French Franc, and the Rest of the EMS.” Answer: The origin of the September 1992 currency crisis was the Bundesbank’s decision to maintain high interest rates to restrain the inflationary effects of reunification. To maintain their currencies against the DM, the other members of the EMS were forced to push up their own interest rates, thereby stifling economic growth in their countries. Speculators bet that Britain, Spain, and some other countries would find that trade-off unpalatable and would devalue their currencies. As long as German rates remained high, this Hobson’s choice would continue to face other European governments and would maintain speculative pressure on their currencies. By cutting its discount rate, the Bundesbank allowed France and the other EMS members to cut their interest rates and stimulate their economies without devaluing their currencies. Therefore, by reducing the likelihood that they would devalue their currencies, this interest rate cut reduced speculative pressure. 10. The French franc was the main target of speculators during the August 1993 assault on the EMS despite the fact that France was running a 2% inflation rate while Germany had a 4.3% inflation rate. Why might this be? Answer: Two words explain this situation: credibility and expectations. Given the market’s trust in the Bundesbank, the high German inflation rate was viewed as an aberration that the Bundesbank would soon get under control. Conversely, currency traders were less certain of the Bank of France’s long-term commitment to low inflation, especially since the Bank of France has historically been subservient to the interests of the French government. More specifically, unlike the Bundesbank, the Bank of France did not have 35 years of independence behind it and could not count on the unwavering support of a citizenry that abhors inflation. Based on the high rate of unemployment and sluggish growth in France and the growing demands by the French public for easing up on monetary policy, it was rational to assign a high probability that the Bank of France would abandon its strong franc policy. The result would be higher French inflation in the future. Conversely, the history of the Bundesbank would suggest lower German inflation in the future. Given expectations of higher French inflation and lower German inflation in the future, the foreign exchange market rationally expected a weaker French franc. Acting immediately on such expectations, speculators sold francs and bought DM. 11. In early 1996, in response to growing doubts about the ability of EC nations to meet the Maestricht criteria and move toward monetary union by the 1999 deadline, yields on European bonds jumped. What is the likely link between the doubts on Maestricht and the EC bond yield increases? Answer: The expectation in the financial markets is that countries that meet the Maestricht criteria will be locked into a system that is essentially run on the same model as the Bundesbank, namely one that is committed to price stability as its one and only goal. In other words, the view is that Germany will run the EMU and the dominant characteristic of the single currency will be a low-inflation currency. To the extent the EMU is expected to materialize, therefore, interest rates on bonds denominated in different currencies will converge toward the rate on DM bonds, which is lower than that on other European currency bonds. Conversely, an expected movement away from monetary union lowers the probability that the other European countries will stick with the low-inflation German monetary policy. Anything that lowers the probability of EMU, therefore, lowers the odds that other currencies will follow a low-inflation monetary policy, leading to expectations of higher inflation and higher interest rates. 12. “For a fixed exchange rate system to work, the government must be able to make tight budget and monetary policies stick from the outset.” Comment. Answer: A government that runs budget deficits and a lax monetary policy is unlikely to be able to maintain its commitment to a fixed exchange rate. Hence, one that starts out on the wrong foot will appear to observers to be willing to make exchange rate policy subservient to other national interests. Recognizing this apparent lack of government commitment to a fixed exchange rate, speculators are more likely to attack its currency, making its ability to maintain the fixed exchange rate even more doubtful. 13. On taking office in October 1993, the Bundesbank’s new president, Hans Tietmeyer, said, “Forced reductions in central bank interest rates which are contrary to stability policies can neither solve economic or structural problems. But they would undermine trust in currency values, drive long-term interest rates higher and delay necessary corrections in the real economy.” Explain the context in which Mr. Tietmeyer made these comments. Do you agree or disagree with his comments? Explain. Answer: Mr. Tietmeyer was responding to a chorus of complaints following the currency crisis of August 1993, which in turn led to the abandonment of the Exchange Rate Mechanism. The August crisis was triggered by the (correct) belief that the Bundesbank would not reduce its interest rates sufficiently to permit cuts in interest rates in other ERM countries such as France and Denmark where unemployment was high and inflation low. What Tietemayer said, in effect, was “Don't blame Germany for your high unemployment and slow growth. Monetary policy is not a good tool to use in stimulating an economy. You will just end up with high inflation and higher real interest rates. Rather, you should focus on correcting the structural problems that are driving your high unemployment rates, such as high taxes, a less productive workforce, a subservient central bank (leading to a risk premium), and expensive labor regulations.” 14. Comment on the following statement: “Wage flexibility is a substitute, albeit an imperfect one, for exchange rate flexibility.” Answer: 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. However, if the exchange rate is fixed, then wages and prices themselves must change to respond to domestic imbalances. Wage flexibility will go a long way to achieving this end, but it is imperfect since flexibility in the prices of goods and services is also an important element in adapting to changed economic circumstances. SUGGESTED SOLUTIONS TO CHAPTER 3 PROBLEMS 1. During the currency crisis of September 1992, the Bank of England borrowed DM33 billion from the Bundesbank when a pound was worth DM2.78, or $1.912. It sold these DM in the foreign exchange market for pounds in a futile attempt to prevent a devaluation of the pound. It repaid these DM at the post-crisis rate of DM2.50:£1. By then, the dollar: pound exchange rate was $1.782:£1. 1.a. By what percentage had the pound sterling devalued in the interim against the DM? Against the dollar? Answer: During this period, the pound depreciated by 10.1% against the pound and by 6.8% against the dollar. 1.b. What was the cost of intervention to the Bank of England in pounds? In dollars? Answer: The Bank of England borrowed DM 33 billion and must repay DM33 billion. When it borrowed these DM, the DM was worth £0.3597, valuing the loan at £11.87 billion (DM33 billion * 0.3597). After devaluation, the DM was worth £0.4000. Hence, the Bank of England’s cost of repaying the DM loan was £13.20 billion (DM33 billion * 0.4), a rise of £1.33 billion. Thus, the cost to the Bank of England of this DM borrowing and intervention was £1.33 billion. In dollar terms, intervention cost the Bank of England $825 million. This estimate is based on the difference of $0.025 between the DM’s initial value of $0.6878 (1.912/2.78) and its ending value of $0.7128 (1/2.50) times the DM33 billion borrowed and spent defending the pound. Specifically, the cost calculation is $0.025 * 33,000,000,000 = $825 million. 2. Suppose the central rates within the ERM for the French franc and DM are FF 6.90403:ECU 1 and DM 2.05853:ECU 1, respectively. 2.a. What is the cross-exchange rate between the franc and the DM? Answer: Since things equal to the same thing are equal to each other, FF 6.90403 = DM2.05853. Hence, FF1 = DM2.05853/6.90403 = DM0.298164. Equivalently, DM 1 = FF6.90403/2.05853 = FF3.35386. 2.b. Under the original 2.25% margin on either side of the central rate, what were the approximate upper and lower intervention limits for France and Germany? Answer: Given the answer to part a, the French franc could rise to approximately DM0.298164 * 1.0225 = DM0.304872 or fall as far as DM0.298164 * 0.9775 = DM0.291455. Similarly, the upper limit for the DM is FF3.42933 and the lower limit is FF3.27840. 2.c. Under the revised 15% margin on either side of the central rate, what are the current approximate upper and lower intervention limits for France and Germany? Answer: Given the answer to part a, the French franc could rise to approximately DM0.298164 * 1.15 = DM0.342888 or fall as far as DM2.98164 * 0.85 = DM 0.253439. Similarly, the upper limit for the DM is FF3.85694 and the lower limit is FF2.85078. 3. A Dutch company exporting to France has FF3 million due in 90 days. Suppose that the current exchange rate is FF1 = Dfl0.3291. 3.a. Under the exchange rate mechanism, and assuming central rates of FF6.45863/ECU and DFl2.16979/ECU, what is the central cross-exchange rate between the two currencies? Answer: Given central rates of DFl2.16979:ECU and FF6.45863:ECU for the Dutch guilder and French franc, respectively, the central cross rate between the two currencies is DFl1 = FF2.97662 (6.45863/2.16979). Equivalently, FF1 = DFl0.335952 (2.16979/6.45863). 3.b. Based on the answer to part a, what is the most the Dutch company could lose on its French franc receivable, assuming that France and the Netherlands stick to the ERM with a 15% band on either side of their central cross rate? Answer: At worst, the French franc can fall by 15% relative to its central guilder cross rate, to a cross-exchange rate of FF1 = DFl0.285559 (0.335952 * 0.85). Since the current exchange rate is FF 1 = DFl 0.3291, the most the Dutch company can lose on its FF 3 million receivable is 3,000,000 * (0.3291 - 0.285559) = DFl130,622. 3.c. Redo part b, assuming the band was narrowed to 2.25%. Answer: If the band were narrowed to 2.25%, then the minimum value for the French franc would be DFl0.328393 and the maximum loss that the Dutch company could sustain would be 3,000,000 * (0.3291 - 0.328393) = DFl2,121. 3.d. Redo part b, assuming you know nothing about the current cross-exchange rate. Answer: Knowing nothing about the current cross-exchange rate, the worst that could happen is that the cross rate would be at its upper bound of DFl0.386345 (0.335952 * 1.15) and it falls to its lower bound of 0.285559 (established in the answer to part b). In this case, the maximum possible loss is 3,000,000 * (0.386345 - 0. 285559) = DFl302,357. 4. Panama adopted the U.S. dollar as its official paper money in 1904. Currently, about $400 million to $500 million in U.S. dollars is circulating in Panama. If interest rates on U.S. Treasury securities are 7%, what is the value of the seigniorage that Panama is forgoing by using the U.S. dollar instead of its own-issue money? Answer: Instead of using U.S. dollars as its currency in circulation, the Panamanian government could substitute its own currency and invest the $400 million to $500 million in U.S. Treasury securities. This policy would earn the Panamanian government $28 million to $35 million annually at the current 7% interest rate. Thus, the Panamanian government is foregoing seigniorage worth $28 million to $35 million annually. The present value of this seigniorage equals the amount of U.S. dollars in circulation, or $400 million ($28 million/.07) to $500 million ($35 million/.07). 5. By some estimates, $185 billion to $260 billion in currency is held outside the U.S. 5.a. What is the value to the U.S. of the seigniorage associated with these overseas dollars? Assume that dollar interest rates are about 6%. Answer: The annual value of seigniorage equals the foregone interest on the currency held outside the U.S. Based on the numbers presented in the question, this annual value varies between $11.1 billion (0.06 * $185 billion) and $15.6 billion (0.06 * $260 billion). If this money stays overseas permanently, then the value of seigniorage is just equal to the amount of dollars held outside the U.S., or $185 billion to $260 billion. In other words, the U.S. receives goods and services worth this amount of money from foreigners and paid for them with pieces of green paper that are never redeemed for U.S. goods and services. 5.b. Who in the United States realizes this seigniorage? Answer: The U.S. government realizes this seigniorage. Who in the U.S. benefits from this seigniorage is an issue in political economy and depends what the government does with the money: cuts taxes, spends it (which raises the further question of on whom), uses it to reduce the deficit, etc. ADDITIONAL CHAPTER 3 PROBLEM AND SOLUTION 1. The central rates for the Spanish and Belgian currencies on March 20, 1997, were Ptas 163.826/ECU and BF 39.7191/ECU. What central cross rate between these two currencies did these central rates imply? Answer: These rates imply a central cross rate between the two currencies of Ptas 4.1246/BF (163.826/39.7191), or equivalently, BF 0.242447/Ptas (39.7191/163.826). Solution Manual for Foundations of Multinational Financial Management Atulya Sarin, Alan C. Shapiro 9780470128954
