Chapter 2 Flashcards

1
Q

It defines the overall financial environment in which multinational corporations and international investors operate.

A

The international monetary system

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2
Q

This situation makes it necessary for many firms to carefully measure and manage their exchange risk exposure.

A

The fact that corporations nowadays are operating in an environment in which exchange rate changes may adversely affect their competitive positions in the marketplace.

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3
Q

How is the euro a measure to face exchange risk exposure?

A

Because European countries have adopted it as common currency, and so, trade and investment much less susceptible to exchange risk.

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4
Q

It can be defined as the institutional framework within which international payments are made, movements of capital are accommodated, and exchange rates among currencies are determined.

A

The international monetary system.

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5
Q

What are the stages that international monetary system went through?

A
  1. Bimetallism: Before 1875.
  2. Classical gold standard: 1875-1914.
  3. Interwar period: 1915-1944.
  4. Bretton Woods system: 1945-1972.
  5. Flexible exchange rate regime: Since 1973.
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6
Q

This was a double standard, prior to 1870, in that free coinage was maintained for both gold and silver.

A

Bimetallism

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7
Q

In Great Britain, bimetallism was maintained until…

A

Until 1816 (after the conclusion of the Napoleomc Wars) when Parliament passed a law maintaining free coinage of gold only, abolishing the free coinage of silver.

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8
Q

Until what year did bimetallism was maintained in United States?

A

Remained a legal standard until 1873, when Congress dropped the silver dollar from the list of coins to be minted.

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9
Q

Countries that were on the bimetallic standard often experienced this well-known phenomenon.

A

Gresham’s law.

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10
Q

Explain the Gresham’s law.

A

Since the exchange ratio between the two metals was fixed officially, only the abundant metal was used as money, driving more scarce metal out of circulation.

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11
Q

When was the first fully-fledged gold standard established?

A

In 1821 in Great Britain.

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12
Q

When did the majority of countries got off golf? How much did this system last?

A

In 1914 when World War I broke out. The classical gold standard as an international monetary system thus lasted for about 40 years.

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13
Q

Is the gold standard used nowadays?

A

No, not by any country.

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14
Q

When is gold standard said to exist?

A

When:

(1) gold alone is assured of umestricted coinage
(2) there is two-way convertibility between gold and national currencies at a stable ratio, and
(3) gold may be freely exported or imported.

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15
Q

It is is attributed to David Hume, a Scottish philosopher.

A

Price-specie-flow mechanism

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16
Q

Explain price-specie-flow mechanism.

A

Used with gold standard. Fluctuations in prices in a country adjusted completely or partially by an inflow or outflow of gold or specie. This adjusts the price levels across borders and equalized them bringing balance in international transactions and payments.

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17
Q

Five one example of price-specie-flow mechanism.

A

Consider a situation where Great Britain exported more to France than the former imported from the latter. This land of trade imbalance will not persist under the gold standard. Net export from Great Britain to France will be accompanied by a net flow of gold in the opposite direction. This international flow of gold from France to Great Britain will lead to a lower price level in France and, at the same time, a higher price level in Great Britain. (Recall that under the gold standard, the domestic money stock is supposed to rise or fall as the country experiences an inflow or outflow of gold.) The resultant change in the relative price level, in turn, will slow exports from Great Britain and encourage exports from France. As a result, the initial net export from Great Britain will eventually disappear.

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18
Q

Provide examples of countries that suffered hyperinflation after WWI.

A

Germany, Austria, Hungary, Poland, and Russia

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19
Q

What’s hyperinflation?

A

Hyperinflation is extremely rapid or out of control inflation. Hyperinflation occurs when price increases are so out of control that the concept of inflation is meaningless.

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20
Q

Explain the sterilization of gold, the policy implemented after the “international gold standard of the late 1920s” facade.

A

It was the matching inflows and outflows of gold respectively with reductions and increases in domestic money and credit. Sterilization is a form of monetary action in which a central bank seeks to limit the effect of inflows and outflows of capital on the money supply.

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21
Q

It was characterized by economic nationalism, halfhearted attempts and failure to restore the gold standard, economic and political instabilities, bank failures, and panicky flights of capital across borders.

A

The interwar period.

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22
Q

It constitutes the core of the Bretton Woods system. Where and when were they signed?

A

The Articles of Agreement of the International Monetary Fund (IMF). They were signed on In July 1944, when representatives of 44 nations gathered at Bretton Woods, New Hampshire.

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23
Q

Explain the American proposal, headed by Harry Dexter White, that was incorporated into the Articles of Agreement of the IMP.

A

They proposed a currency pool to which member countries would make contributions and from which they might borrow to tide themselves over dur- ing short-term balance-of-payments deficits.

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24
Q

How can the Bretton Woods system can be described?

A

As a dollar-based gold-exchange standard. A country on the gold-exchange standard holds most of its reserves in the form of currency of a country that is really on the gold standard.

British Pund —> UD Dollar—Pegged at $35/oz—>Gold

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25
Q

Dilemma that was responsible for the eventual collapse of the dollar-based gold- exchange system in the early 1970s.

A

Triffin paradox.

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26
Q

Explain the Triffin paradox.

A

This dilemma pointed out that the country whose currency, being the global reserve currency, foreign nations wish to hold, must be willing to supply the world with an extra supply of its currency to fulfill world demand for these foreign exchange reserves, thus leading to a trade deficit.

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27
Q

What are the special drawing rights (SDRs)?

A

They refer to an international type of monetary reserve currency (essentially an artificial currency) created by the International Monetary Fund (IMF) in 1969, that operates as a supplement to the existing reserves of member countries, as a response to concerns about the limitations of gold and dollars as the sole means of settling international accounts.

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28
Q

What was initially the value of the SDR?

A

Initially, the SDR was designed to be the weighted average of 16 currencies.The percent- age share of each currency in the SDR was about the same as the country’s share in world exports.

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29
Q

In 1981, however, the SDR was greatly simplified to comprise only five major currencies. What were those currencies?

A
U.S. dollar
German mark
Japanese yen
British pound, and 
French franc.
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30
Q

How are the SDRs currently comprised?

A
In four major currencies:
U.S. dollar (41.9 percent weight)
euro (37.4 percent)
British pound (11.3 percent)
Japanese yen (9.4 percent)
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31
Q

What was the last attempt to save the Bretton Woods system? How long did it last?

A

10 major countries, known as the Group of Ten, met at the Smithsonian Institution in Washington, D.C., in December 1971. They reached the Smithsonian Agreement. It lasted a little more than a year before it cracked.

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32
Q

It completed the decline and fall of the Bretton Woods system.

A

When European and Japanese currencies were allowed to float, in March 1973.

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33
Q

Key elements of the Jamaica Agreement.

A
  1. Flexible exchange rates were declared acceptable to the IMP members, and central banks were allowed to intervene in the exchange markets.
  2. Gold was officially abandoned (i.e., demonetized) as an international reserve asset.
  3. Non-oil-exporting countries and less-developed countries were given greater access to IMF funds.
34
Q

The Louvre Accord marked the inception of the managed-float system. Explain it.

A

The G-7 countries would jointly intervene in the exchange market to correct over- or undervaluation of currencies.

35
Q

The IMP currently classifies exchange rate arrangements into 10 separate regimes. Which are those?

A
  1. No separate legal tender
  2. Currency board
  3. Conventional peg
  4. Stabilized arrangement
  5. Crawling peg
  6. Crawl-like arrangement
  7. Pegged exchange rate within horizontal bands
  8. Other managed arrangement
  9. Floating
  10. Free floating
36
Q

Exchange rate arrangement in which currency of another country circulates as the sole legal tender. Adopting such an arrangement implies complete surrender of the monetary authorities’ control over the domestic monetary policy.

A

No separate legal tender.

37
Q

Name examples of No separate legal tender arrangement.

A

Ecuador, EI Salvador, and Panama.

38
Q

Type of exchange rate agreement that is a monetary arrangement based on an explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligation. This implies that domestic currency is usually fully backed by foreign assets, eliminating traditional central bank functions.

A

Currency board.

39
Q

Name examples of a Currency board agreement.

A

Hong Kong, Bulgaria, and Lithuania.

40
Q

For this category of exchange agreement, the country formally (de jure) pegs its currency at a fixed rate to another currency or a basket of currencies, where the basket is formed, for example, from the currencies of major trading or financial partners arid weights reflect the geographic distribution of trade, services, or capital flows.

A

Conventional peg.

41
Q

Name examples of Conventional peg.

A

Jordan, Saudi Arabia, and Morocco.

42
Q

Type of exchange rate agreement that remains within a margin of 2 percent for six months or more (with the exception of a specified number of outliers or step adjustments) and is not floating. The required margin of stability can be met either with respect to a single currency or a basket of currencies.

A

Stabilized arrangement.

43
Q

Examples of Stabilized arrangement.

A

China, Angola, and Lebanon.

44
Q

Type of exchange rate agreement that involves the confrrmation of the country authorities’ de jure exchange rate arrangement.

A

Crawling peg.

45
Q

Examples of Crawling peg.

A

Bolivia, Iraq, and Nicaragua.

46
Q

Type of exchange rate agreement must remain within a narrow margin of’2 percent relative to a statistically identified trend for six months or more (with the exception of a specified number of outliers), and the exchange rate arrangement cannot be considered as floating.

A

Crawl-like arrangement.

47
Q

Examples of Crawl-like arrangement.

A

Ethiopia.

48
Q

Type of exchange rate agreement in which the value of the currency is maintained within certain margins of fluctuation of at least ± 1 percent around a fixed central rate, or the margin between the maximum and minimum value of the exchange rate exceeds 2 percent.

A

Pegged exchange rate within horizontal bands.

49
Q

Examples of Pegged exchange rate within horizontal bands

A

Kazakhstan and Syria.

50
Q

This category is a residual, and is used when the’exchange rate arrangement does not meet the criteria for any of the other categories.

A

Other managed arrangement.

51
Q

Examples of Other managed arrangement.

A

Costa Rica, Vietnam, and Russia.

52
Q

This exchange rate is largely market determined, without an ascertainable or predictable path for the rate. Foreign exchange market intervention may be either direct or indirect, and serves to moderate the rate of change and prevent undue fluctuations in the exchange rate.

A

Floating

53
Q

Examples of Floating

A

Brazil, Mexico, Turkey, and India.

54
Q

An exchange rate can be classified in this group if intervention occurs only exceptionally and aims to address disorderly market conditions and if the authorities have provided information or data confirming that intervention has been limited to at most three instances in the previous six months, each lasting no more than three business days.

A

Free floating

55
Q

Examples of Free floating

A

Canada, Japan, Korea, U.K., U.S., and euro zone.

56
Q

Why would a country peg its currency?

A
  • It’s easier to control inflation
  • Favorable exchange rate terms
  • Countries with large import sector can benefit from exchange rate (due to minimizing the risk of fluctuation)
57
Q

What happens when the demand of a fixed rate economy falls? How does the government interviene?

A

The central banks:

  • Sells international reserves
  • Buys domestic currency

This raises domestic interest rate and stabilizes the currency value

The negative effects is that the International reserves fall and the monetary base declines.

58
Q

Why do countries overvalue the exchange rate peg?

A
  • It results on higher interests that attract foreign investment
  • Emerging market countries can facilitate growth through foreign direct investment
59
Q

What is a problem of overvaluing the exchange rate peg?

A

Central banks can run out of international reserves. This would provoke a rapid devaluation rate, which would be a great impact considering that most of the debts are denominated in foreign currency (such as dollar, euro or yen).

60
Q

Examples of crisis provoked by running out of reserves (due to overvaluation of exchange rates).

A
British ERM (1992)
Mexico (1994)
Asian countries (1990s)
61
Q

Why would countries undervalue an exchange rate peg?

A
  • It encourages domestic exports (net exports increases)
  • It discourages imports
  • Can develop/ protect manufactured goods sectors from international competition
  • Can accumulate vast international reserves
62
Q

What are some of te problems of undervalue exchange rates?

A
  • Accumulating large amounts of international reserves can be risky/have low returns
  • Potentially inflationary
  • Trade problems
63
Q

The snake arrangement was replaced by the ______ in 1979.

A

European Monetary System (EMS)

64
Q

When and by whom was the European Monetary System (EMS) originally proposed?

A

By German Chancellor Helmut Schmidt, it was formally launched in March 1979.

65
Q

It is a “basket” currency constructed as a weighted average of the currencies of member countries of the European Union (EU)

A

European Currency Unit (ECU)

66
Q

It refers to the procedure by which EMS member countries collectively manage their exchange rates. The ERM is based on a “parity grid” system, which is a system of par values among ERM currencies.

A

Exchange Rate Mechanism (ERM)

67
Q

What are the responsibilities of each European country in order to convergence properly?

A

(1) keep the ratio of government budget deficits to gross domestic product (GDP) below 3 percent
(2) keep gross public debts below 60 percent of GDP
(3) achieve a high degree of price stability, and
(4) maintain its currency within the prescribed exchange rate ranges of the ERM.

68
Q

It is in a way similar to the Federal Reserve System of the United States.

A

Eurosystem

69
Q

What are the benefits of adopting a common currency?

A
  • Reduced transaction costs

- Elimination of exchange rate uncertainty.

70
Q

What is the main cost of monetary union?

A

The loss of national monetary and exchange rate policy independence.

71
Q

When is a country more prone to suffer from “asymmetric shock.”

A

When the less diversified and more trade-dependent its economy is.

72
Q

Will the euro survive and succeed in the long run? What would be the major test that the euro zone can face?

A

When the euro zone experiences major asymmetric shocks. A successful response to these shocks will require wage, price, and fiscal flexibility.

73
Q

Date on which the Mexican government under new president Ernesto Zedillo announced its decision to devalue the peso against the dollar by 14 percent.

A

On December 20, 1994.

74
Q

What are the two lessons emerge from the peso crisis?

A

First, it is essential to have a multinational safety net in place to safeguard the world financial system from the peso-type crisis. No single country or institution can handle a potentially global crisis alone.
Second, Mexico excessively depended on foreign portfolio capital to finance its economic development. In hindsight, the country should have saved more domesti- cally and depended more on long-term rather than short-term foreign capital investments.

75
Q

it was the third major currency crisis of the 1990s, preceded by the crises of the European Monetary System (EMS) of 1992 and the Mexican peso in 1994-95.

A

The 1997 Asian crisis

76
Q

Mention some factors of the 1997 Asian crisis.

A
  • A weak domestic financial system
  • Free international capital flows
  • The contagion effects of changing market sentiment, and
  • Inconsistent economic policies.
77
Q

It was drafted by the Basle Committee on Banking Supervision and to monitor its compliance with the principle.

A

“Core Principle of Effective Banking Supervision”

78
Q

According to the so-called “trilemma” that economists are fond of talking about, a country can attain only two of the following three conditions:

A

(1) a fixed exchange rate
(2) free international flows of capital, and
(3) an independent monetary policy.

79
Q

It is describes that If a country would like to maintain monetary policy independence to pursue its own domestic economic goals and still would like to keep a fixed exchange rate between its currency and other currencies, then the country should restrict free flows of capital.

A

Incompatible trinity

80
Q

What are some key arguments for flexible exchange rates?

A

(1) easier external adjustments

(2) national policy autonomy.

81
Q

What’s a possible drawback for flexible exchange rate regime?

A

Exchange rate uncertainty may hamper international trade and investment.

82
Q

What should an ideal international monetary system provide?

A

(1) liquidity
(2) adjustment
(3) confidence

It should be able to provide the world economy with sufficient monetary reserves to support the growth of international trade and investment. It should also provide an effective mechanism that restores the balance-of-payments equilibrium whenever it is disturbed. Lastly, it should offer a safeguard to prevent crises of confidence in the system that result in panicked flights from one reserve asset to another.