The International Monetary System
Lessons learnt
Today, we discussed the international monetary system in depth. By definition, the international monetary system is the structure used to determine the rates of foreign exchange. In addition, the structure accommodates international trade flows, capital flows and adjustment of balance-of-payments. Moreover, the international monetary system includes all the institutions, instruments and agreements that link the global money markets, commodities, currencies, securities and real estates. Therefore, we realised that the system has abroad definition.
We learnt that over the last four decades, there has been an increase in the volatility of international exchange rates, which has been one of the main economic developments. Despite an increase in knowledge and improvement of methods for handling international monetary system, we realised that policies for forecasting as well as reacting to fluctuations in the rate of exchange are still developing.
In our discussion, we found that volatility of exchange rates has both positive and negative sides. For instance, while it increases financial risks to the affected economies, it equally increases the levels of profitability for investors and businesses.
Within the international monetary system, we made a number of definitions. First, we defined foreign currency exchange rate as the price of a nation’s currency when expressed in units of another currency. It can either be floating or in a fixed state. Secondly, “spot exchange rate” was defined as the quoted price for an immediate delivery of exchange rate or within two days for bank-to-bank transactions. Thirdly, “forward rate” was defined as the quoted price for future delivery of foreign exchange. Forward discount t or premium was defined as the difference between the spot and forward rate expressed as a percentage.
A number of other definitions were made, including the definition for weakening, deterioration and depreciation of currency, currency devaluation and softness/weakness or hardness/softness of currencies.
On the history of the international monetary system, we learnt that it started around 1876 with “The Gold Standard” that lasted until 1913. In this era, gold was used as the standard rate of exchange. Between 1914 and 1944, two world wars took place. At this time, the international monetary system, European currencies fluctuated constantly before failing to work during the Second World War. After the war in 1944, the American dollar became the world’s standard currency after the creation of the IMF and WB.
IMF was supposed to aid nations in defending their currencies and solving structural problems. On the other hand, we learnt that the WB was set to assist in the reconstruction and developed after the war was over. In 1945, Fixed Exchange Rates was the predominant form of international monetary system, lasting up to 1973. Since 1973, the eclectic currency arrangement protocol has been in effect, which allows currencies to be flexible and volatile.
We also learnt that the modern international monetary system functions under 8 categories of exchange rate regimes, spanning the exchange rate spectrum from rigid to independently floating.
We learnt that the first category is the “fixed versus flexible rate of exchange”. In this case, national priorities about all aspects of an economy determine the currency regime that a country chooses. These include the rates of unemployment, economic growth, levels of interest and trade balances. In addition, a nation may change from fixed to flexible rates or vice versa with time due to change in national priorities. A fixed rate is preferred because it allows stability in global prices. In addition, it has anti-inflationary nature of prices. However, it puts pressure on individual central banks to maintain large volumes of currencies as well as gold. It also makes central banks maintain rates that may sometimes be inconsistent with the fundamentals of the economy.
We learnt that in economics, an ideal currency, though hard to achieve, has three attributes known as “the impossible trinity”- stability of exchange rate, complete financial integration and interdependence of the monetary system.
In our discussion, we took a number of examples of how emerging markets take different regime choices to spur growth and development. For instance, Argentina decided to adopt a currency board to replace managed exchange rate in 1991. However, due to political unrest and economic turmoil, the country terminated its currency board and reinstated the old method. We also learnt that other nations might use the US dollar as their official currencies through a process known as “dollarization”. Good examples are Panama and Ecuador, which have been using the US dollar since 1907 and 2000 respectively.
Another important aspect of the choice of currencies is the birth of the regional currency. An example is the Euro, a strong currency that kicked off as the official currency for the members of the European Union in 1991. However, each member state is responsible for managing its nominal rates of inflation, fiscal deficits, national debt and rates of long-term interests. We also learnt that the European Central Bank (ECB) was established with an aim of controlling the Euro. Since its establishment, the euro has had significant impacts. For instance, we learnt that ECB allows cheaper transactions in the nations it applies (Euro Zone), reduces currency risks and costs of uncertainty and allows price transparency and increased competition on prices.
Finally, we discussed the success of monetary unification, taking the case of euro as an example. In this case, we learnt that there must be a solid economic foundation for a monetary union like euro to succeed. In addition, it must be able to maintain its purchasing power as a drive of its value. However, it is threatened by inflation, which has seen the EU struggling to prevent inflation from undermining the currency.
Difficulties in understanding and the importance of the information in future
In this class session, I had difficulties understanding the eight categories of exchange rate regimes as defined by the IMF. In addition, I found it difficult to assess the need for one nation’s currency, like the US dollar, being the gold standard for international monetary system, yet the IMF has been established to control the monetary system. In future, I hope to use the knowledge in this class in my research as well as in my career.
Additional research conducted
After the class, I did some research to enhance my knowledge on the topic. In particular, I researched on the future of the international monetary system, the need for restructuring the system and the impact of using the US dollar on the international monetary system (especially in reference to recent global financial crisis). Here are the links to the materials I used for my personal research:
D’Arista*, J. (2009). The evolving international monetary system. Camb. J. Econ, 33 (4), 633-652. Web.
Dorrucci, E., & McKay, J. (2010). The International Monetary System after the financial crisis. Web.
Farhi, E., Gourinchas, P., & Rey, H. (2011). Reforming the International Monetary System. Web.
Linda S. Goldberg, Craig Kennedy, and Jason Miu (2011). Central Bank Dollar Swap Lines and Overseas Dollar Funding Costs. FRBNY, Economic Policy Review.
Trade, the Balance of Payments and Exchange Rates
Lessons learnt
Our aim was to discuss how trade, payment balances and exchange rates function in the international trade system. To start, we discussed “Trade”. First, we defined trade as the simple act of buying and selling goods and services between countries. We defined imports (M) and Exports (X), taking the UK currency as a case study. Imports (M) involve the purchase of goods and services from other countries into the UK, leading to outflow of currency. For Exports (X), we defined it as the sale of goods and services to other nations, which leads to inflow of currency from the UK. Whisky, which is sold from UK to Italy, was taken as an example of X, whereas oil sold to UK from Russia was taken as an example of M.
What is specialization and trade? Then we proceeded to discuss this question. Here, we learnt that due to different factors, some nations could produce goods and services with efficiency as compared to others, leading to specialization. We defined “Absolute Advantage” as the state in which a country produces more with minimum resources than others. Comparative advantage is the state at which one country produces goods and services with a lower opportunity cost than others by using few resources. In this case, we compared the case of Russia and Scotland, where Russia specializes in Oil production while Scotland specializes in the production of whisky. We realised that one unit of labour in Russia can produce 10 barrels of oil or only five litres of whisky.
Still taking the example of Russia and Scotland, we discussed “comparative advantage”. We learnt that opportunity cost is equal to the ratio of sacrifice to gain. Thus, we argued that the two countries could gain economically if each of them specializes in producing the product with comparative advantage- oil for Russia and whisky for Scotland.
In the next section, we discussed “Terms of Trade”. We learnt that terms of trade examines the relationship between the export prices and the volume of imports that can be bought with the money from export. Mathematically, we expressed terms of trade as the ratio of the average price of exports to the average price of imports.
When defining the balance of payments, we looked at a record of the trade between one country and the rest of the world. In this case, we took the UK as the reference nation in relationship to the rest of the world. We wanted to look at trade in goods, services and income flows as pointers to current accounts for the country. In addition, we looked at the transfer of funds as well as trade in liabilities and assets as pointers to capital accounts. To discuss this phenomenon, we obtained the balance of payments for the UK between 1998 and 2004 from the department of statistics. We found that the balance of payments was high in 1998 but fell rapidly in 1999. Between 2000 and 2002, it was roughly lower but rose again in 2003 before falling to its lowest (below negative five).
The next topic in our discussion was “exchange rates”. In this case, we defined exchange rates as the rate at which a given monetary currency can be exchanged for another currency. Taking the example of the Pound Sterling and the US dollar, we realised that there is a specific rate at which the two currencies can be exchanged, with the pound sterling maintaining a stronger value over the dollar. We learnt that it needs simple arithmetic to exchange some amount of money from one currency to another. For instance, one needs to know the current rate of exchange of one unit of UK pound to US dollar in order to convert £5 into dollars and vice versa. Thus, it involves simple multiplication and division.
We also wanted to know what determines the rates of exchange between currencies. First, we discussed the impact of demand and supply on the exchange rates. We found that these two factors are the most important determinants of the rate at which one currency will be exchanged fro another. On the other hand, we came to realise that demand of supply for a currency in a foreign market is also determined by other factors. These factors are several and include the demand for imports and exports, opportunities for investments, patterns of global trade, changes in the rates of inflation and relative interest rates.
We also learnt that it is difficult for a currency to maintain one value over a long time. Each must fluctuate with time and circumstances. Here, we discussed appreciation and depreciation of currencies. Appreciation is the rise in the value of a given currency over the others. The currency gains the ability to purchase more of the other currencies. On the other hand, a depreciation of a given currency is defined as the fall of its values compared to the value of other currencies. In this case, more of the currency can be bought with the other currencies.
Next, we wanted to examine the impact of appreciation and depreciation of a currency on the economy. Here, we realised that when the exchange rate appreciates, there is always a rise in the demand for imports but a fall in the demand for exports in the reference country. In such a case, the balance of payments worsens. On the other hand, a depreciation of exchange for a currency leads to a fall in the demand for imports but a rise in the demand for exports, leading to improvement of the balance of payments.
We also discussed the three types of exchange rates. Floating exchange rates are rates in which prices are determined by the forces of demand and supply of the reference currency. Here, there is a free market concept, which must be obtained when the government has no control over the trade. On the contrary, fixed exchange rates exist in cases where authorities are in control of the currency, which means that the value of the reference currency is fixed and maintained in reference to an “anchor currency”. Managed or “dirty floating” exchange rate is the rate that is influenced by the authorities but through institutions like the central bank. The aim is to ensure that the rate of exchange is maintained at a preferred level.
Finally, we discussed the relationship between purchasing power parity and exchange rates, where we found that the rates of exchange for a given currency serve as an appropriate reflection of the purchasing power in a given economy. However, this would be possible if relative values of currency had the power to purchase the same amount of goods in every nation.
Difficulties in understanding and the importance of the lesson in future
This is one of the easiest topics learnt this semester in this course because I found little areas of concern. In fact, the only area that needs much attention, although it did not prove to be a problem to be, is the concept of comparative advantage. The topics discussed in this log will prove to be of importance when doing my future studies, research and at the workplace
Additional research conducted
After the discussion, I wanted to increase my knowledge on specialization and comparative advantage in finance and economics. Therefore, I carried out additional research in these topics. The following articles added a lot of information to the class notes
- Peri, G., & Sparber, C. (2007). Task specialization, comparative advantages, and the effects of immigration on wages. NBER 13389. Web.
- Jambor, A. (2013). Comparative advantages and specialisation of the Visegrad countries agri-food trade. Acta Oeconomica et Informatica, 1(2), 22–34. Web.
- Vlachosb, J., & Svaleryda, H. (2005). Financial markets, the pattern of industrial specialization and comparative advantage: Evidence from OECD countries. European Economic Review 49(1), 113–144. Web.
- Costacurta, P., & Canuto dos Santos, O. (2010). Trade Specialization, Regional Flows and Economic Integration: Brazil’s Comparative Advantages by Region and by Country Bloc. Web.
International Banking Services
Today, we dedicated our session to discuss “international banking services” with an aim of examining how international banks operate, types of international banks and their functions. We learnt that international banks operate just like domestic banks in that they trade in financing, arrange foreign exchange, and offer investment on banking services and hedging for foreign currencies. We mentioned some example of international banks, including the Bank of America, Citgroup and Chase Bank of the USA, HSBC Holdings of the UK, Credit Agricole Group of France and Deutsche Bank of Germany. In addition, we considered China’s Industrial and commercial Bank as an international bank.
We also discussed the need for international banks, where we realised that international banks offer low marginal costs. For instance, they develop marketing and managerial knowledge at the domestic market and use it in foreign markets at low marginal costs. The development of this form of knowledge acts as an advantage to the bank because once it sets its subsidiaries in foreign markets. The new branches can draw the knowledge of the parent company in their new locations.
Such knowledge could include awareness of personal contacts or credit investigations. Another important need for an international bank information service developed at the domestic market. Domestic firms in a foreign market are in a position to acquire complete information on financial markets and trade from the parent bank. Such information, for instance, could be less complete in foreign markets than it is in the domestic market.
We also discussed prestige as a reason for setting up international banks in foreign nations. For instance, international banks such as HSBC Holdings and Chase Bank Manhattan are internationally recognized, giving them high prestige. This is an advantage over local banks because the prestige is likely to attract more customers who will feel comfortable and proud to be associated with a renowned organization. Multinational banks may also be exempted from certain regulatory procedures imposed on local banks. We also discussed how international banks follow their clients as they move from one country to another.
In this case, we realised that an international bank can influence its clients to stick to its services regardless of the country they reside. In this way, such a bank is likely to avoid losing clients both at home and in foreign markets. Since they are located in various countries, multinational banks are sometimes able to circumvent regulatory controls in a foreign market. On the client’s side, multinational banks offer its foreign customers a growth opportunity that might be lacking in the domestic market. Finally, we leant that diversification is an important aspect for multinational banks as they reduce risks associated with stability of earnings.
Our next topic was “types of international banking offices” within the context of international banking system. We mentioned a number of banking services offered internationally. For instance, multinational banks set up correspondence banks, representative offices, overseas branches or subsidiaries. In addition, a bank may decide to operate offshore banking sectors, affiliate banks, edge act banks or offer international banking facilities.
We sought to understand what each type of banking office means within the context of international banking. First, we agreed that a correspondent baking is a relationship between an international bank and a local bank, where each takes the role of maintaining deposits at the local market and transmitting to the partner on the foreign market. A client to the local bank has the advantage of conducting business worldwide through his local bank or the affiliates of the partner. On the other hand, a representative office is a mere office set up in a foreign market to help customers of a multinational bank in their local and international transactions.
In fact, it operates in the same manner as the local banks but is answerable to the parent company. A parent company may also decide to collaborate with a foreign company to set up a subsidiary bank or set up its owned subsidiary bank. One important characteristic of a subsidiary bank is that it is incorporated in the foreign market as a company by its own. An affiliate bank is a domestic bank owned by an international bank fully or partly is partly, but has the responsibility of controlling its finances free from the influence of the parent company.
We also decided to look at the offshore banking as a subtopic because it involves a number of characteristics. Countries such as Bahamas, Hong Kong, Cayman Islands, Bahrain Singapore, Panama and the Netherlands Antilles are some of the internationally recognised offshore banks.
We also looked at shell branch bank, a special kind of bank set up by a multinational bank in a foreign market but whose function is nothing more than acting like the parent company’s post office box. In this case, the actual banking services are conducted by the parent bank.
Our next topic was international banking facility. In actual sense, such a service is not a unique legal or physical entity.
We also discussed the international monetary market in depth. We looked at the Eurocurrency as an international money market because the Euro is traded with other world currencies in foreign markets.
We also discussed Euronotes as a subtopic, where we learnt that they are short-term notes underwritten by a group of multinational banks with an aim of selling them from face value at a discount. They must be paid after three to six months. We also learnt how Eurocommercial papers and Euro-Medium-term notes operate.
Finally, we discussed the international debt crisis as a problem facing international banking system. This has been going on over the last three decades. The developing nations owned multinational banks more then 1.2 trillion dollars by 2009. This is a lesson to multinational banks, especially warning them not to count international lending as the only form of large-scale investment. It has its own risks and advantages.
Difficulties in understanding and the future use of information gained
I encountered some few difficulties in this session, especially in understanding topic under the international money market. For instance, the position of the euro in relation to other currencies proved somehow difficult to understand. I intend to use this knowledge in my future research as well as at my workplace.
References
Committee on global financial system. (2011). Long-term issues in international banking. Web.
Costacurta, P., & Canuto dos Santos, O. (2010). Trade Specialization, Regional Flows and Economic Integration: Brazil’s Comparative Advantages by Region and by Country Bloc. Web.
D’Arista*, J. (2009). The evolving international monetary system. Camb. J. Econ, 33 (4), 633-652. Web.
Dorrucci, E., & McKay, J. (2010). The International Monetary System after the financial crisis. Web.
Farhi, E., Gourinchas, P., & Rey, H. (2011). Reforming the International Monetary System. Web.
Jambor, A. (2013). Comparative advantages and specialisation of the Visegrad countries agri-food trade. Acta Oeconomica et Informatica, 1(2), 22–34. Web.
Linda S. Goldberg, Craig Kennedy, and Jason Miu (2011). Central Bank Dollar Swap Lines and Overseas Dollar Funding Costs. FRBNY, Economic Policy Review,
Pantelidis, P., Rania, V., George, D., & Anastasiadou, K. (2011). International Banking System. Conceptual Approach, Advantages and Risks. Web.
Peri, G., & Sparber, C. (2007). Task specialization, comparative advantages, and the effects of immigration on wages. NBER 13389. Web.
Sbracia, M., & Zaghini, A. (2012). The Role of the Banking System in the International Transmission of Shocks. Web.
Shrestha, P. K. (2012). Banking Systems, Central Banks and International Reserve Accumulation in East Asian Economies. Web.
Vlachosb, J., & Svaleryda, H. (2005). Financial markets, the pattern of industrial specialization and comparative advantage: Evidence from OECD countries.European Economic Review 49(1), 113–144. Web.
Worthington, S., & Welch, P. (2011) Banking without the banks. International Journal of Bank Marketing, 29(2), 190-201.