Chapter 19 Notes on International Financial System

Exchange Rate System: An agreement among countries on how exchange rates should be determined.
Floating Currency:
- Definition: A currency whose exchange rate is determined by the forces of demand and supply in the foreign exchange market.
- Implication: Reflects the market's perception of economic conditions.

Uncertainty and Trade Impact:
- Flexible exchange rates can create uncertainty in international transactions, potentially leading to diminished trade levels.
Terms of Trade:
- Flexible exchange rates could worsen a nation's terms of trade, affecting trade balances negatively.
Economic Stability:
- If the exchange rate system is unstable, it can lead to economic destabilization, hampering growth and investment.

Managed Float Exchange Rate System:
- Definition: A system where the value of most currencies is primarily determined by market forces (demand and supply), with occasional interventions by governments or central banks to stabilize or steer the currency value.
- Characteristic: Balance between market forces and government intervention.
Fixed Exchange Rate System:
- Definition: A system where countries agree to keep the exchange rates among their currencies fixed to a specific value or to each other.
- Example: Currency boards and pegged currencies.

Gold Standard:
- Characteristics:
- Currency was directly backed by gold, with transactions conducted in gold coins or paper currency redeemable in gold.
- Drawbacks:
- Central banks lacked control over the money supply due to the rigid nature of the gold standard.
Bretton Woods System:
- Definition: An international monetary system established post-WWII, lasting from 1944 to 1971, where countries pledged to exchange their currencies at fixed rates against the US dollar, which was convertible to gold.
- Institutions involved:
- International Monetary Fund (IMF): A major international organization that lends foreign currency to central banks and oversees the operations of the international monetary system.

Devaluation:
- Definition: A reduction in the fixed exchange rate of a currency.
Revaluation:
- Definition: An increase in the fixed exchange rate of a currency.

Challenges Leading to Collapse:
- By the late 1960s, the Bretton Woods system encountered significant issues:
- The amount of dollars held by foreign central banks exceeded US gold reserves.
- Some countries, notably West Germany, with undervalued currencies were resistant to currency revaluation, undermining system stability.

US Dollar Float: The United States allows the dollar to float freely against other major currencies.
Euro Adoption: Many Western European countries have adopted the euro as a common currency.
Fixed Rates in Developing Countries: Some developing nations have attempted to maintain fixed exchange rates against the dollar or another major currency.

Key Features: The current system includes a flexible exchange system where major currencies can fluctuate against one another.

Two Primary Causes: In the short term, exchange rate movements are primarily influenced by:
- Changes in interest rates: A rise in interest rate can attract foreign capital and strengthen the currency.
- Changes in investors' expectations about future currency values: Market speculation can result in immediate demand shifts impacting currency values significantly.

Purchasing Power Parity (PPP): A long-term economic theory that suggests that exchange rates should adjust to equalize the purchasing power of different currencies, meaning that identical goods should cost the same when expressed in a common currency.

Real-World Complications affecting the complete application of purchasing power parity include:
- Not all products can be traded internationally, which may limit the scope for equalization of purchasing power.
- Differences in product availability and consumer preferences across countries can lead to subsets of different price levels.
- Countries may impose trade barriers (tariffs, quotas) that disrupt or distort the straightforward application of purchasing power parity.

Four Key Determinants: The determination of exchange rates in the long run can be influenced by:
1. Relative price levels: Differences in inflation rates can influence currency value.
2. Relative rates of productivity growth: Productivity gains in one country compared to another can impact exchange rates.
3. Preferences for domestic vs. foreign goods: Changes in consumer preferences can influence trade balances and hence currency values.
4. Tariffs and quotas: Trade restrictions can impact demand for currencies, thus affecting exchange rates.

Background: The establishment of the Euro followed the Treaty of Rome, which aimed at creating the European Economic Community (EEC) in 1957, and later transitioning into the eurozone.
Adoption of the Euro: Countries currently using the euro (data as of July 2007) include members of the European Union, while non-EU countries may also be involved in direct trading and financial activities with the euro.

Pegging: A system where a country keeps its currency's exchange rate fixed to another major currency.
Purpose: Countries may decide to peg their currency to stabilize their economy, control inflation, or attract foreign investment by ensuring a stable exchange rate environment.