Chapter 10 Outline

Introduction

Although we discussed the workings of the foreign exchange market in some depth in Chapter 9, we did not mention the international monetary system's role in determining exchange rates. Rather, we assumed that currencies were free to "float" against each other; that is, that a currency's relative value on the foreign exchange market is determined primarily by the impersonal market forces of demand and supply. In turn, we explained, the demand and supply of currencies is influenced by their respective countries' relative inflation rates and interest rates. Only at the end of the chapter, in our discussion of currency convertibility, did we admit the possibility that the foreign exchange market might not work as we had depicted.

Our explanation in Chapter 9 of how exchange rates are determined is oversimplified. Contrary to our implicit assumption, many currencies are not free to float against each other. Rather, exchange rates are determined within the context of an international monetary system in which the ability of many currencies to float against other currencies is limited by their respective governments or by intergovernmental arrangements. In 1997, only 51 of the world's viable currencies were freely floating; this includes the currencies of many of the world's larger industrial nations such as the United States, Canada, Japan, and Britain. A further 50 currencies were "pegged" to the exchange rates of certain major currencies--particularly the US dollar and the French franc--or to "baskets" of other currencies, while another 45 currencies were allowed by their governments to float as long as they stayed within a broad range relative to another currency, such as the US dollar.¹

This chapter will explain how the international monetary system works and point out its implications for international business. To understand how the international monetary system works, we must review the system's evolution. We will begin with a discussion of the gold standard and its breakup during the 1930s. Then we will discuss the Bretton Woods conference, which took place in 1944. This established the basic framework for the post-World War II international monetary system. The Bretton Woods system called for fixed exchange rates against the US dollar. Under this fixed exchange rate system, the value of most currencies in terms of US dollars was fixed for long periods and allowed to change only under a specific set of circumstances. The Bretton Woods conference also created two major international institutions, both of which are discussed in the opening case, the International Monetary Fund (IMF) and the World Bank. The IMF was given the task of maintaining order in the international monetary system; the World Bank's role was to promote development.

Today, both these institutions continue to play major roles in the world economy. In 1997 and 1998, for example, the IMF helped several Asian countries deal with the dramatic decline in the value of their currencies that occurred during the Asian financial crisis that started in 1997. By early 1998, the IMF had programs in 75 countries. As the opening case on Zaire illustrates, however, there is a growing debate about the role of the IMF and to a lesser extent the World Bank and the appropriateness of their policies for many developing nations. In the case of Zaire, several prominent critics claim that IMF policy contributed to the country's economic misery, rather than curing it. The debate over the role of the IMF has taken on new urgency given the institution's extensive involvement in the economies of Asia and Eastern Europe during the latter part of the 1990s. Accordingly, we shall discuss the issue in depth.

The Bretton Woods system of fixed exchange rates collapsed in 1973. Since then, the world has operated with a mixed system in which some currencies are allowed to float freely, but many are either managed by government intervention or pegged to another currency. We will explain the reasons for the failure of the Bretton Woods system as well as the nature of the present system. We will also discuss how pegged exchange rate systems work.

Two decades after the breakdown of the Bretton Woods system, the debate continues over what kind of exchange rate regime is best for the world. Some economists advocate a system in which major currencies are allowed to float against each other. Others argue for a return to a fixed exchange rate regime similar to the one established at Bretton Woods. This debate is intense and important, and we will examine the arguments of both sides.

Finally, we will discuss the implications of all this material for international business. We will see how the exchange rate policy adopted by a government can have an important impact on the outlook for business operations in a given country. If government exchange rate policies result in a currency devaluation, for example, exporters based in that country may benefit as their products become more price competitive in foreign markets. Alternatively, importers will suffer from an increase in the price of their products. We will also look at how the policies adopted by the IMF can have an impact on the economic outlook for a country and, accordingly, on the costs and benefits of doing business in that country.