The International Monetary

and Financial Environment

Chapter 13- (9 in Text Book)

DR.K.DHRUVA
 Learning Objectives

9.1 Learn about exchange rates and currencies in

international business.
9.2 Explain how exchange rates are determined.
9.3 Understand the emergence of the modern.
exchange rate system.
9.4 Describe the monetary and financial systems.
9.5 Identify the key players in the monetary and
financial systems.
9.6 Understand the global debt crisis.
DR.K.DHRUVA 9-2
 Currencies and Exchange Rates

• More than 150 currencies in use worldwide.

• Currency regimes are simplifying. e.g., The euro in
Europe; the dollar in Panama and Belize.
• Most currencies are not very convertible. The dollar,
yen, pound, euro are hard currencies – universally
accepted and preferred in international transactions.
• Exchange rate: Price of one currency in terms of
another.
• Exchange rates affect the fortunes of the firm in various
ways – costs of inputs, sales performance, which
market entry strategies to use, etc.
DR.K.DHRUVA 9-3
 Constantly fluctuating exchange rates require
international managers to keep in mind three facts

• The prices the firm charges can be quoted in the

firm’s currency or in the currency of each foreign
customer.
• Because several months can pass between
placement and delivery of an order, fluctuations in
the exchange rate during that time can cost or earn
the firm money.
• The firm and its customers can use the exchange
rate as it stands on the date of each transaction, or
they can agree to use a specific exchange rate.
DR.K.DHRUVA 9-4
 Recent Exchange Rates against the Dollar

Source: Adapted from www.x-rates.com. 9-5

DR.K.DHRUVA
The Four Risks of International Business

9-6
DR.K.DHRUVA
 Foreign Exchange Markets
• Foreign exchange: All forms of internationally-traded monies
including foreign currencies, bank
deposits, checks, and electronic transfers.
• Foreign exchange market: The global
marketplace for buying and selling national currencies.
$
Exchange rates are in constant flux. In 2012, for example, the
Indian rupee was trading at 48 rupees to the U.S. dollar. By
2013, the rate had depreciated to 58 rupees—the rupee’s
value went down relative to the dollar by more than 20
percent.
• This shift made the rupee less expensive for Americans, and
the U.S. dollar more expensive for Indians. Such shifts can
complicate international business.
DR.K.DHRUVA 9-7
 Exchange Rates Over Time

Sources: Based on data from the International Monetary Fund and World Bank.
DR.K.DHRUVA 9-8
 Example: Euro vs. the Dollar
• Suppose, last year, the exchange rate was 1 = $1.
• Now, suppose the rate has gone to: 1.50 = $1.
• What is the effect of this change on Europeans?

Effect on European Firms: $ €

European firms pay more for inputs from the U.S.
Higher costs reduce profitability; require higher prices.
European firms can increase their exports to the U.S.
European firms can raise their prices to the U.S.
Increased exports to the U.S. lead to higher revenues.

What is the effect on European consumers?

DR.K.DHRUVA 9-9
 How Exchange Rates Are Determined
In a free market, the “price” of any currency (the
exchange rate) is determined by supply and demand:
The greater the supply of a currency, the lower its
price.
The lower the supply of a currency, the higher its
price.
The greater the demand
for a currency, the higher
its price.
The lower the demand for
a currency, the lower its
price. Source: david_franklin/Fotolia

DR.K.DHRUVA 9-10
Equilibrium Price of Euros for Dollars

DR.K.DHRUVA 9-11
 Factors that Influence
the Supply and Demand for a Currency
Economic growth is the increase in value of the goods and
services produced by an economy.
• Measured as the annual increase in real GDP (in which the
inflation rate is subtracted from growth).
• Driven by entrepreneurship and innovation.
• The nation’s central bank regulates
the money supply, issues currency
and manages the exchange rate, to
accommodate economic growth.

Market psychology refers to investor behavior,

such as herding behavior or momentum trading.
DR.K.DHRUVA
9-12
 Factors that Influence the
Supply and Demand for a Currency (cont’d)

Inflation refers to increases in the prices of goods and

services; thus, money buys less than before.
• Some countries (e.g., Argentina, Israel, Russia)
have experienced hyperinflation.
• High inflation erodes a currency’s purchasing power.
• Interest rates and inflation are positively related; high inflation
forces banks to pay high interest.
Example: If inflation
• That is, investors expect to be is 10%, banks must
compensated for inflation-
pay more than 10%
induced decline in the value
to attract deposits.
of their money.

DR.K.DHRUVA 9-13
 Inflation in Selected Countries, 1985-2015

Annual percentage rate of inflation. Left-hand scale is for Turkey, Venezuela, and the United States; right-hand scale is for
Argentina, Brazil, and Poland.
Sources: Based on International Monetary Fund, World Economic Outlook Database, 2015, at http://www.imf.org;
9-14
and CIA WorldFactbook, at http://www.cia.gov.
DR.K.DHRUVA
 Factors that Influence the
Supply and Demand for a Currency (cont’d)

• Government action – Governments intervene to

influence the value of their own currencies, e.g., the
Chinese government regularly intervenes in the foreign
exchange market to keep the renminbi undervalued, to
help ensure exports.
• Balance of payments is the nation’s
balance sheet of trade, investment,
and transfer payments with the rest
of the world. It reflects the difference
between the total amount of money
coming into and going out of a country.
Source: Arto/Fotolia
DR.K.DHRUVA 9-15
 Value of the Currency
and Trade Surplus vs. Trade Deficit

• Trade surplus – Exports exceed imports; may result when

the exporter’s currency is undervalued, as in China’s official
policy regarding its currency.
Example:
• Trade deficit – Imports Japan exports cars to the U.S. Car
exceed exports; the importers in the U.S. pay exporters in
government may devalue Japan, resulting in a surplus item in
the nation’s currency to Japan’s balance of trade and a deficit
in the U.S. balance of trade.
correct a trade deficit.
If the total value of U.S. imports from
• Balance of trade – The Japan exceeds the total value of U.S.
difference between the exports to Japan, then Japan will have
value of a nation’s a trade deficit with the U.S.
exports and its imports. What other factors cause trade deficits?
DR.K.DHRUVA
9-16
 Development of the
Modern Exchange Rate System

• After the Great Depression and World War II, the world
economy and trading system were in a sorry state.
• At war’s end, seeking stability in the international
monetary and financial systems, 44 countries signed
the Bretton Woods agreement.
• Bretton Woods established a fixed exchange rate
system in which the U.S. dollar was pegged to a set
value for gold ($35 per ounce), and other major
currencies were pegged to the dollar.
• For nearly 30 years, the system kept exchange rates of
major currencies at a fixed level.
DR.K.DHRUVA 9-17
 Bretton Woods Agreement

Source: Chee-Onn Leong/123RF

The Bretton Woods Agreement, which set the course for contemporary global
financial relations, was conceived by 44 nations at the Mount Washington Hotel in
Bretton Woods, New Hampshire, United States, in 1944. 9-18
DR.K.DHRUVA
 Breakdown and Legacy of Bretton Woods

Bretton Woods dissolved in 1971, as the world

economy was evolving and governments could no
longer maintain fixed exchange rates on the gold
standard. Bretton Woods established the:
• Concept of international monetary cooperation,
especially aimed at minimizing currency risk.
• International Monetary Fund (IMF): Agency
that promotes exchange rate stability, monitors exchange
systems, provides funding to developing economies.
• World Bank: Agency that provides loans
and technical assistance to combat global
poverty around the world.
DR.K.DHRUVA 9-19
 The Exchange Rate System Today

• Today, advanced economy currencies (dollar, euro,

pound, yen) float according to market forces, their
value determined by supply and demand.
• Conversely, most developing and emerging
economies use fixed exchange rate systems.
• In fixed regimes, the value Examples
of a currency is pegged to ▪ China pegs its currency to
the value of another, or to a a basket of currencies
basket of currencies, at a ▪ Belize pegs its currency to
specified rate. the dollar.
DR.K.DHRUVA 9-20
 The International
Monetary and Financial Systems

• International monetary system: The institutional

framework, rules, and procedures by which national
currencies are exchanged for one another.

• Global financial system: The collection of financial

institutions that facilitate and regulate the flows of
investment and capital funds
worldwide. It includes the
national and international
banking systems, the
international bond market,
and national stock markets.
Source: Gang Liu/Shutterstock
DR.K.DHRUVA 9-21
 Globalization of
Financial and Monetary Activities

Growing integration of financial and monetary global

activity is due to:
• Evolution of monetary and financial regulations,
worldwide.
• Emergence of new technologies and payment
systems in global finance, e.g., the Internet.
• Increased global and regional
interdependence of financial
markets.
• Growing role of single-currency
systems, e.g., the Euro. Source: Tan Kian Khoon/Shutterstock
DR.K.DHRUVA
9-22
 Key Participants and Relationships
in the Global Monetary and Financial Systems

9-23
DR.K.DHRUVA
 Key Participants in the
Monetary and Financial Systems

• The Firm. International transactions require firms to

deal with huge sums of foreign exchange.

• National Stock
Exchanges and
Bond Markets.
Facilities for trading
securities and bonds.

The stock exchange

in Santiago, Chile
Source: Tifonimages/Fotolia
DR.K.DHRUVA 9-24
 Central Business District in Singapore

Source: Perfect Illusion/Shutterstock

9-25
DR.K.DHRUVA
 Key Participants in the
Monetary and Financial Systems

• Commercial Banks. Lend money to finance

business activity, play a key role in nations’ money
supplies, and exchange foreign currencies.

• Central Banks. Regulate money supply, issue

currency, manage exchange rates, control national
reserves.

• Bank for International Settlements. Supervises

Central Bank monetary policy and other activities.
DR.K.DHRUVA 9-26
 Global Financial Crisis
• In 2008, a major crisis emerged in the global
financial and monetary systems.
• It initially arose in the U.S., when investors lost
confidence in the value of securitized home
mortgages.
• Banks, lenders and insurance companies became
volatile, and stock markets crashed worldwide.
• Many national economies sank into recession.
• The world experienced sharp declines in consumer
wealth, economic activity, and international trade.
9-29
DR.K.DHRUVA
 Global Financial Crisis (cont’d)

• A key factor was the availability of “easy money”,

from the U.S. Federal Reserve Bank.
• Also, China had been investing huge sums in U.S.
government securities.
• These trends fostered a vast global money supply,
which facilitated high demand for housing and
commodities such as oil and food, leading to
inflation.
• Much of the money was used to finance huge U.S.
trade deficits.
DR.K.DHRUVA 9-30
 Global Financial Crisis (cont’d)

• Many bad mortgages were “securitized” – bundled

into investment assets and sold in global financial
markets.
• Over time, investors realized that many loans were
high-risk, which led to capital flight.
• Like a contagion, the crisis spread quickly to Europe
and beyond.
• As the global economy slowed, demand for exports
shrank and export-dependent countries floundered
(e.g., Japan, Mexico, countries in Eastern Europe).
DR.K.DHRUVA 9-31
 Global Financial Crisis (cont’d)

• National governments, the IMF, and World Bank

took corrective measures, such as injecting massive
sums into national economies and launching aid
packages.

• Some countries imposed trade and investment

barriers.

• The crisis highlights the importance of strong

regulation, transparency, and supervision of
institutions in the global financial system.

DR.K.DHRUVA 9-32
Gross Government Debt as a Percentage of GDP, 2015

9-33
Source: Based on International Monetary Fund, World Economic Outlook Database, 2015
DR.K.DHRUVA