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Final Exam Study Notes - Chapter 10-The International Monetary System

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University of Toronto Mississauga

MGT491 FINAL EXAM NOTES Chapter 10: The International Monetary System N International monetary system refers to the institutional arrangements that govern exchange rates N Chapter 9 assumed that the foreign exchange market was the primary institution for determining exchange rates and the impersonal market forces of DD and SS determined the relative inflation rates and interest rates N When a foreign exchange market determines the relative value of a currency country is adhering to a floating exchange rate regime N US $, EU euro, Japanese and British all use a floating system against each other their exchange rates are determined by market forces and fluctuate against each other day to day, if not minute by minute N However the exchange rates of many currencies are not determined by the free play of market forces, some governments adopt other institutional arrangements N Pegged Exchange Rate o ,3419K0Z47O80;0O45L3J3,9L43850J9K0L7.:7703.L0857L2,7LO949K04OO,7479K00:74 o Pegged exchange rate means the value of the currency is fixed relative to a reference currency, and then the exchange rate between that currency and other currencies is determined by the reference currency exchange N Dirty Float o Other countries try to hold the value of their currency within some range against an important reference currency, or a basket of currencies Float because in theory the value is determined by market forces, but it is a dirty float because the central bank of a country will intervene in the foreign exchange market to try to maintain the value of its currency if it depreciates too rapidly against an important reference currency N Fixed Exchange Rate o Other countries have operated with a fixed exchange rate, in which the values of a set of currencies are fixed against each other at some mutually agreed-on exchange rate o Before the euro was introduced, several member states of the European union operated with fixed exchange rates within the context of the European Monetary System (EMS) The Gold Standard N Origin in the use of gold coins as a medium of exchange, unit of account and store of value practice that dates to ancient times o When international trade was limited in volume, payment for goods purchased from another country was typically made in gold or silver o However as the volume of international trade expanded after the industrial revolution, a more convenient means of financing international trade was needed shipping large quantities of gold and silver around the world was impractical o Solution was to arrange for payment in paper currency and for governments to agree to convert the paper currency into gold on demand at a fixed rate Mechanics of the Gold Standard N The Gold Standard pegging currencies to gold and guaranteeing convertibility N Given a common gold standard, the value of any currency in units of any other currency (the exchange rate) was easy to determine N Gold Par Value the amount of a currency needed to purchase one ounce of gold N From the gold par values of two currencies, it was possible to calculate what the exchange rate was for converting one currency into the other Strength of the Gold Standard N Contained a powerful mechanism for achieving balance-of-trade equilibrium by all countries N Country it said to be in balance-of-trade equilibrium when the income its residents earn from exports is equal to the money its residents pay to other countries for imports (the current account of its balance of payments is in balance) N Adjustment mechanism if Japan has a trade surplus, there is a net flow 41J4O1742&$94-,5,3 &$82430 8:55OL870:.0-,5,38L3.70,80 0.,:80419KL8ZLOO80057L.0L31O,9L43 ,824308:55OL3.70,808L31O,9L43 increases) in Japan. Rise in price of Japanese goods will decrease demand for these goods, while fall in price of US goods will increase demand for those. Japan will buy more from the US and the US will buy less from Japan until equilibrium is achieved. The Period between the Wars: 1918-1939 N The Gold Standard worked well from 1870s until start of WW1 in 1914 when it was abandoned
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