Introduction and The International Monetary System

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Discuss the major trends that have prevailed in international business in recent years.
The 1980s brought rapid integration to capital and financial markets. The impetus for this came from the governments of industrialised countries that had begun to deregulate their foreign exchange and capital markets. Another process that is picking up speed is privatisation – that can be described as process that results in a country that divests itself of the ownership and operation of business ventures by turning it over to the free market system.
Briefly explain how the Gold standard worked.
One of the main features of the Gold standard was the adoption of the “mint parity” and allows free convertibility between domestic money and gold at that price. No restrictions were placed on the import or export of gold by private citizens, or on the use of gold for international transactions. The issue of national currency and coins was backed by gold. International arbitrage kept exchange rates within very narrow bands. Under the gold standard balance-of payment disequilibrium will be corrected by a counter-flow of gold known as the PRICE-SPECIE FLOW MECHANISM.
Discuss the advantages and disadvantages of the Gold standard.
The advantages include: (1) since the supply of gold was restricted, inflation was not a problem; (2) any balance of payments disequilibrium was corrected through cross-border flow of gold (price-specie flow mechanism). Disadvantages include (1) deflation due to a restricted supply of gold; (2) since there were no set rules that governed the enforcement of the “rules of the game”, countries could pursue economic policies that were incompatible with the gold standard.
Briefly outline the main features of the Bretton Woods system.
The main objectives of the Bretton Woods system were to achieve exchange rate stability and promote international trade and development. Its main features included the (1) Fixing of an official par value for domestic currency in terms of gold or a currency tied to gold as a numeraire (i.e. $US). The US$ was pegged to gold at $35 per ounce and other countries linked their currencies to the $US.
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(2) Keep the exchange rate pegged within 1% of its par value. The par value can be adjusted unilaterally if the IMF concurs.
(3) Short-run balance of payment imbalances is offset by the use of official reserves (usually in the form of US$) and IMF credits.
The US stood ready to buy gold at $35 and this meant that the US had to have a large stock of
gold. [By the end of WWII in 1945, the US had 60% of the world stock.]
Why did the Bretton Woods system collapse?
The reason for the collapse can be explained by the Triffin paradox. Under the Bretton-Wood system, the reserve-currency country (i.e. the US) should run balance of payment deficits to supply reserves to the world economy, but if the deficits are large and persistent, they can lead to
a crisis of confidence in the reserve currency, eventually causing the downfall of the system.
Explain the arrangements and workings of the European Monetary System.
EMS was launched in 1979 in order to (i) establish a zone of monetary stability in Europe, (ii) coordinate exchange rate policies against non-EMS currencies, and (iii) pave the way for the eventual European monetary union. The main instruments of EMS are the European Currency Unit (ECU) and the Exchange Rate Mechanism (ERM). The ECU is a basket currency constructed as a weighted average of currencies of EU member countries. The ERM is the procedure by which EMS member countries manage their exchange rates. The ERM is based on a parity grid system, with parity grids first computed by defining the par values of EMS currencies in terms of the ECU. If a country’s ECU market exchange rate diverges from the central rate by as much as the maximum allowable deviation, the country has to adjust its policies to maintain its par values relative to other currencies.
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Explain what is meant by the term ‘impossible trinity’ and why it is true.
• Countries with floating rate regimes can maintain monetary independence and financial integration but must sacrifice exchange rate stability.
• Countries with tight control over capital inflows and outflows can retain their monetary independence and stable exchange rate, but surrender being integrated with the world’s capital markets.
• Countries that maintain exchange rate stability by having fixed rates give up the ability to have an independent monetary policy.
What are the attributes of the ideal currency?
If the ideal currency existed in today’s world, it would possess three attributes, often referred to as The Impossible Trinity.
a. Exchange rate stability. The value of the currency would be fixed in relationship to other major currencies so traders and investors could be relatively certain of the foreign exchange value of each currency in the present and into the near future.
b. Full financial integration. Complete freedom of monetary flows would be allowed, so traders and investors could willingly and easily move funds from one country and currency to another in response to perceived economic opportunities or risks.
c. Monetary independence. Domestic monetary and interest rate policies would be set by each individual country to pursue desired national economic policies, especially as they might relate to limiting inflation, combating recessions, and fostering prosperity and full employment.
The reason that it is termed The Impossible Trinity is that a country must give up one of the three goals described by the sides of the triangle, monetary independence, exchange rate stability, or full financial integration. The forces of economics do not allow the simultaneous achievement of all three.
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Assess the possibility for the euro to become another global currency rivaling the U.S. dollar. If the euro really becomes a global currency, what impact will it have on the U.S. dollar and the world economy?
In light of the large transactions domain of the euro, which is comparable to that of the U.S. dollar, and the mandate for the European Central Bank (ECB) to guarantee the monetary stability in Europe, the euro may potentially become another global currency over time. A major uncertainty about this prospect is the lack of political (and fiscal) integration of Europe. If Europe becomes politically more integrated, the euro is more likely to become a global currency. If the euro becomes a global currency, it will come at the expense of the dollar. Currently, the U.S. derives substantial benefits from the dollar’s status as the dominant global currency – for instance, the U.S. can run trade deficits without having to maintain substantial foreign exchange reserves, can carry out international commercial and financial transactions in dollars without bearing exchange risk, etc. If the euro is to be used as a major denomination, reserve, and invoice currency in the world economy, dollar-based agents will start to bear more exchange risk, among other things.

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