TOPIC ONE

INTERNATIONAL FINANCE AND INTERNATIONAL

MONETARY SYSTEM

PART A: INTERNATIONAL FINANCE

1. Introduction to International Finance (IF)
1.1 Definition of International Finance

International Finance is the study of the financial operations of corporate firms in an open and
integrated financial market. It focuses on the financial interactions of corporations operating
between two or more countries. Key aspects include:

• Investment: Acquiring assets with the aim of generating income or appreciation.

• Financing: Providing funds for business activities, purchases, or investments.
• Working Capital Management: Managing net current assets for daily operations.
• Hedging: Reducing risks or volatility associated with price changes.
• Arbitrage: Simultaneously buying and selling currencies in different markets to profit
from price differences.
• Speculation: Profiting from price differences, albeit with significant risks.

1.2 Importance of Studying International Finance

The globalized nature of economic functions—consumption, production, and investment—

makes International Finance essential. Examples include:

• Consumption of goods from international sources (e.g., Tanzania importing products

from Japan, India, etc.).
• Globalized production processes (e.g., Japanese cars assembled in South Africa).
• The presence of multinational companies and diversified international portfolios.

Understanding International Finance helps financial managers:

• Anticipate international events and their impacts on firms.

• Make profitable decisions regarding exchange rates, interest rates, national income
changes, and political environments.

1.3 Differences Between International Finance and Domestic Finance

1. Foreign Exchange and Political Risk: Firms face exchange rate volatility and
geopolitical risks in international transactions.

INTERNATIONAL FINANCE AND INTERNATIONAL MONETARY SYSTEM

 2. Market Imperfections: Legal restrictions, high transaction costs, and discriminatory
taxation can hinder global business activities.
3. Expanded Opportunity Set: Access to global capital markets and economies of scale
allows firms to raise funds and deploy assets globally.

1.4 Role of Financial Managers in International Finance

Financial managers are crucial decision-makers and must focus on:

• Fluctuations in exchange and interest rates that affect costs and returns.
• Balance of payments issues influencing national economic performance.
• International debt risks that impact decisions on engaging with specific countries.

Key knowledge areas include:

• Economic indicators: Growth, inflation, unemployment, and balance of payments.

• Government policies: Monetary, fiscal, and structural measures.

Benefits of Knowledge in International Finance

1. Understanding global events and their effects on firms.

2. Anticipating economic changes to capitalize on opportunities and mitigate risks.

2. Evolution of International Finance

Phase I: World War II to Early 1970s

• Fixed exchange rate systems and stringent capital controls.

• Segmentation of capital markets.
• International transactions primarily limited to exports and imports.
• Limited exposure to foreign exchange risks and hedging concerns.

Phase II: 1973 to Present

• Collapse of the Bretton Woods system led to flexible exchange rates.

• Volatile currency markets necessitated the need to hedge foreign exchange risks.
• Key trends:
o Flexible exchange rate systems.
o Abolition of capital controls.
o Integration of financial markets.

Academic and Practical Implications

• Focus on exchange rate determination and its consequences.

INTERNATIONAL FINANCE AND INTERNATIONAL MONETARY SYSTEM

 • Importance of foreign exchange risk management for domestic and international firms.

3. Recent Trends in the World Economy

3.1 Integration of Financial Markets

• Global financial markets have become unified, enabling:

o Free capital movement across countries.
o Substitution of domestic assets with foreign assets.

3.2 Liberalization and Deregulation of Financial Markets

1. Developed Markets:
o Eliminated market segmentation and increased competition.
o Allowed foreign financial institutions to enter domestic markets.
o Functional unification of financial services (e.g., commercial and investment
banking).
2. Developing Markets:
o Developing countries, like Tanzania, liberalized their financial systems starting in
the 1990s.
o Opened markets to foreign investors.

Summary of Key Trends

1. Blurred boundaries between global financial markets.

2. Increased presence of foreign institutions in domestic markets.
3. Disappearance of traditional segmentation in financial services.

4. Indicators of Internationalization of Finance

Several factors indicate the increasing internationalization of finance:

1. Increase in International Bank Lending:

o Includes cross-border lending and domestic lending denominated in foreign
currency.
o Banks’ cross-border claims reached $37.7 trillion by June 2023.
o Source: BIS Statistics.
2. Increase in Securities Transactions with Foreigners:
o Reflects the benefits of international diversification despite foreign exchange
risks.

INTERNATIONAL FINANCE AND INTERNATIONAL MONETARY SYSTEM

 o Cross-border claims stood at $41.35 trillion by the end of 2021.
o Source: Statista.
3. Increase in Daily Turnover in Global Foreign Exchange Market:
o Trading in OTC FX markets reached $7.5 trillion per day in April 2022, up 14%
from $6.6 trillion three years earlier.
o Source: BIS FX Statistics.

5. Forms of Business Firms Engaged in International

Business
1. International Company:
o Engaged in traditional international activities like importing and exporting.
o Focuses on payment processes between foreign buyers and domestic sellers.
2. Multinational Company (MC):
o Produces and sells goods/services in more than one country.
o Comprises a parent company and foreign subsidiaries.
o Reasons for expansion:
▪ Competitive pressures in domestic markets.
▪ Desire for efficient production and lower operating costs.

Steps to Becoming an MC

1. Exporting:
o Producing domestically and exporting to foreign markets.
2. Overseas Production:
o Allows adaptation to local tastes, increased supply stability, and provision of
after-sales services.
3. Licensing Agreement:
o Granting a local producer the right to use the firm’s technology in exchange for
fees or royalties.
o Advantages: Minimal investment, faster market entry, and reduced risks.
4. Joint Venture:
o Establishing partnerships with local manufacturers to minimize political risks.

6. Operational Environment of Multinational Companies

Risks Faced by Multinational Firms

1. Political Risks:
o Ranges from mild interference to confiscation of assets.
o Assessed through consultants or internal advisory committees.
2. Exchange Rate Risks:

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 o Transaction Exposure: Risk of fluctuating currency rates after financial
obligations are made.
o Translation Exposure: Gains or losses from converting foreign subsidiary
financial statements into the parent’s currency.
o Economic Exposure: Changes in future cash flows due to unexpected currency
volatility.

7. The Transnational Company

As multinational firms expand their global network of branches, affiliates, suppliers, and
distributors, they evolve into transnational firms. Examples include Unilever, Philips, Ford, and
Sony. These firms have:

• Intricate networks for products, processes, and capital.

• Multiple home offices defined differently for operations, taxation, and more.

INTERNATIONAL FINANCE AND INTERNATIONAL MONETARY SYSTEM

 TOPIC ONE PART B
INTERNATIONAL MONETARY SYSTEM
(IMS)
Definition

• The international monetary system comprises the policies, institutions, regulations, and
mechanisms that determine currency exchange rates.
• Governs how nations exchange currencies, facilitating international trade and finance.

Historical Overview of IMS

1. Bimetallism (Before 1875):

o Gold and silver served as international means of payment.
o Collapse due to Gresham's Law: "Bad money drives out good."
2. Classical Gold Standard (1876–1913):
o Currency value fixed to a specific weight of gold.
o Ensured stable exchange rates and controlled inflation.
o Collapse: World War I disrupted trade and gold flow.
3. Interwar Period (1914–1944):
o Currencies fluctuated without a fixed system, leading to instability.
o U.S. adopted a modified gold standard in 1934.
4. Bretton Woods System (1945–1972):
o Created a dollar-based system where currencies were pegged to the U.S. dollar,
convertible to gold.
o Institutions: IMF and World Bank established.
o Collapse: U.S. ended dollar convertibility to gold in 1971.
5. Floating Exchange Rate Regime (1973–Present):
o Exchange rates determined by market forces.
o Variants include free float, managed float, and intermediate systems.

What is an exchange rate regime?

An exchange rate regime refers to the way a country manages its currency in respect to foreign
currencies and the foreign exchange market.

Floating Exchange Rate System

• Free Float System: Exchange rate is determined purely by market forces. Also known as
an independent or clean float.
• Managed Float System: The monetary authority intervenes directly or indirectly to
stabilize the exchange rate and keep it within desired limits. Also referred to as a dirty
float system.

INTERNATIONAL FINANCE AND INTERNATIONAL MONETARY SYSTEM

Intermediate Exchange Rate System

• Band (Target Zone): Allows only tiny variations around a fixed exchange rate against
another currency, typically within plus or minus 2%.
o Example: Denmark has fixed its exchange rate against the euro, maintaining it
very close to 7.44 krone = 1 euro (0.134 euro = 1 krone).
• Crawling Peg: A hybrid of fixed and flexible exchange rate systems where a country
establishes a par value of its currency in relation to another currency or a basket of
currencies and then allows the par value to change gradually.
• Crawling Band: The currency is adjusted periodically in small amounts at a fixed,
preannounced rate or in response to changes in selective quantitative indicators.
• Currency Basket Peg: A portfolio of selected currencies with different weightings. The
peg minimizes the risk of currency fluctuations.
o Example: Kuwait shifted its peg to a currency basket consisting of the currencies
of its major trade and financial partners.

Fixed Exchange Rate System

• Currency Board: Pegs the domestic currency to a foreign currency and allows the
unlimited exchange of domestic currency for the foreign currency at a fixed rate. The
currency board must maintain reserves of foreign currency equivalent to the amount of
domestic currency issued.
o Example: A developing country might fix its exchange rate against the US dollar.
For every banknote issued, the board must hold equivalent value in US dollars as
financial assets.
• Dollarization: The adoption of the US dollar as the official currency of a country. Often
used by countries that have suffered currency devaluation due to inflation.
• Currency Union/Currency Bloc: Exists formally or unofficially. Countries within the
bloc try to fix their exchange rates against a major trading currency.
o Example: Countries in a US dollar currency bloc try to fix their exchange rates
against the dollar.

Attributes of the Ideal Currency ("Impossible Trinity")

1. Exchange Rate Stability: Predictable exchange rates.

2. Full Financial Integration: Free movement of capital across borders.
3. Monetary Independence: Control over domestic monetary policy.
o Achieving all three simultaneously is not possible (e.g., U.S. has financial
integration and monetary independence but lacks exchange rate stability).

International Financial Institutions

1. International Monetary Fund (IMF):

o Founded in 1944 at Bretton Woods.
o Functions: Promote financial cooperation, provide credit to balance payments
deficits, manage international liquidity (e.g., Special Drawing Rights).
o Limitations: Limited resources, stigmatization, harsh austerity measures.

INTERNATIONAL FINANCE AND INTERNATIONAL MONETARY SYSTEM

 2. World Bank (IBRD):
o Founded at Bretton Woods to finance post-war reconstruction.
o Now focuses on development in low-income countries.
o Components: IDA, IFC, MIGA, ICSID.
3. World Trade Organization (WTO):
o Established in 1995 (replacing GATT).
o Oversees global trade rules and ensures smooth trade flows.
4. Bank for International Settlements (BIS):
o Established in 1930 in Switzerland.
o Acts as a clearinghouse and banker for central banks, facilitates international
financial cooperation.

TASK
1. Explain the advantages and disadvantages of fixed and floating exchange rate
systems:
o Definition of Fixed Exchange Rate System: A fixed exchange rate system pegs
a country's currency value to another currency or a basket of currencies,
maintaining a stable exchange rate through government or central bank
intervention.
o Advantages of Fixed Exchange Rate System:
▪ Provides stability in international prices, reducing uncertainty in trade and
investment.
▪ Helps in controlling inflation by anchoring the currency to a stable foreign
currency.
▪ Encourages foreign investment due to reduced exchange rate risk.
▪ Prevents competitive devaluations, promoting economic stability.
o Disadvantages of Fixed Exchange Rate System:
▪ Requires large foreign exchange reserves to maintain the peg.
▪ Limits monetary policy independence as it must prioritize maintaining the
fixed rate.
▪ Vulnerable to speculative attacks if the market perceives the fixed rate as
unsustainable.
▪ Can lead to overvaluation or undervaluation of the currency, affecting
trade competitiveness.
o Definition of Floating Exchange Rate System: A floating exchange rate system
allows the currency's value to fluctuate freely based on market forces such as
supply and demand without direct government or central bank intervention.
o Advantages of Floating Exchange Rate System:
▪ Automatically adjusts to economic conditions, promoting balance of
payments equilibrium.
▪ Allows independent monetary policy to address domestic economic issues.
▪ Eliminates the need for large foreign exchange reserves.
▪ Reflects the true market value of the currency, aiding in efficient resource
allocation.
o Disadvantages of Floating Exchange Rate System:
▪ High volatility can discourage trade and investment.

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 ▪ Can lead to inflation if the currency depreciates significantly.
▪ Speculative trading may cause excessive fluctuations unrelated to
economic fundamentals.
▪ Uncertainty in exchange rates may increase the cost of hedging for
businesses.
2. Explain the ways in which MNCs( MULTNATIONAL CORPORATIONS) can
lower political risks:

Definition of MNCs: MNC stands for , a company that operates in multiple countries
beyond its home nation. MNCs manage production or deliver services in more than one
country through subsidiaries, branches, or affiliates, leveraging global markets for
resources, labor, and sales.
The following are ways to they can lower risks

o Diversification: MNCs can spread investments across multiple countries to

reduce exposure to political risks in any single region.
o Local Partnerships: Forming joint ventures or alliances with local businesses
can help mitigate risks by leveraging local knowledge and relationships.
o Insurance: Purchasing political risk insurance from agencies like the Multilateral
Investment Guarantee Agency (MIGA) or private insurers to cover losses from
expropriation, political violence, or currency inconvertibility.
o Lobbying and Advocacy: Engaging with host governments and international
organizations to create favorable policies or resolve conflicts.
o Operational Adjustments: Structuring operations to minimize assets at risk,
such as leasing rather than owning assets and using local suppliers.
o Hedging Strategies: Using financial instruments to hedge against currency and
interest rate fluctuations.
o Corporate Social Responsibility (CSR): Contributing to local communities
through social programs to build goodwill and reduce hostility.

Reference: Giambona, E., Graham, J.R., & Harvey, C.R. (2017). The management of
political risk. J Int Bus Stud 48, 523–533. https://doi.org/10.1057/s41267-016-0058-4

INTERNATIONAL FINANCE AND INTERNATIONAL MONETARY SYSTEM

 TUTORIAL ONE

INTERNATIONAL FINANCE AND INTERNATIONAL MONETARY SYSTEM

TQ1: Managing Political Risk in Foreign Investment Projects

In evaluating investment opportunities in foreign countries, it is crucial to assess the political

risks that may arise due to the location of the investments. Discuss the different strategies used to
manage political risks in international projects.

ANSWER

Investments in foreign countries come with inherent political risks that can impact their success.
Political risk refers to the possibility that political actions, such as changes in government,
regulations, or social unrest, can adversely affect an investment. There are several ways to
manage these risks:

1. Political Risk Assessment: Companies should conduct thorough research on the political
environment of the host country. This includes understanding the stability of the
government, the legal system, and the likelihood of political changes or conflicts.
2. Diversification: Spreading investments across multiple countries or regions can reduce
the impact of political risk in any single country. If one country experiences political
instability, other investments may remain unaffected.
3. Political Risk Insurance: Companies can purchase insurance from institutions like the
Multilateral Investment Guarantee Agency (MIGA) or private insurers to protect against
losses caused by political events such as expropriation, nationalization, or war.
4. Lobbying and Negotiation: Companies can engage with local governments and political
leaders to help shape policies in their favor and negotiate favorable terms that minimize
political risk.
5. Contractual Safeguards: Including political risk clauses in contracts (e.g., force majeure
clauses) can protect against disruptions due to political instability.
6. Strategic Alliances: Partnering with local companies can provide a layer of protection,
as local firms may have better knowledge of the political landscape and established
relationships with key political actors.

TQ2: Multinational Corporations (MNCs) and Political Risk

(a) What defines a Multinational Corporation (MNC)?

(b) Identify at least six (6) strategies that MNCs can employ to mitigate political risks.
(c) Discuss the advantages and disadvantages of the following methods for conducting
international business:

• Exporting
• Licensing

INTERNATIONAL FINANCE AND INTERNATIONAL MONETARY SYSTEM

 • Joint ventures

ANSWER:

(a) Definition of a Multinational Corporation (MNC):

A Multinational Corporation (MNC) is a company that operates in multiple countries, managing
production or delivering services in more than one country. MNCs are typically large, with
significant global operations, and they generate a substantial portion of their revenue from
international markets.

(b) Six Ways MNCs Can Lower Political Risks:

1. Geographic Diversification: Spreading operations across different countries reduces the

impact of political risks in any single country.
2. Local Partnerships: Collaborating with local businesses allows MNCs to benefit from
local knowledge and influence, reducing exposure to political risks.
3. Lobbying: Engaging in political lobbying or building relationships with key
policymakers can help MNCs influence regulations and mitigate potential political risks.
4. Political Risk Insurance: Purchasing insurance from institutions like MIGA or private
insurers can protect MNCs against losses resulting from political instability.
5. Hedging: Using financial instruments to hedge against currency fluctuations or political
risks can provide financial protection in unstable markets.
6. Strategic Alignment with Local Governments: Ensuring that business operations align
with the host country’s development goals can result in favorable treatment and reduced
political risks.

(c) Advantages and Disadvantages of International Business Methods:

• Exporting:
o Advantages: Low initial investment and risk, ease of market entry.
o Disadvantages: Limited control over marketing and distribution, vulnerability to
trade barriers or tariffs.
• Licensing:
o Advantages: Low cost, no need for large capital investment, access to local
expertise.
o Disadvantages: Loss of control over quality and operations, potential for
intellectual property theft.
• Joint Venture:
o Advantages: Shared risk and resource pooling, access to local knowledge, and
market networks.
o Disadvantages: Potential for conflicts with local partners, complex management
structures, and shared profits.

INTERNATIONAL FINANCE AND INTERNATIONAL MONETARY SYSTEM

TQ3: The Growing Importance of International Finance

What are the main factors that have contributed to the rise of international finance as both an
academic field and a business activity? Discuss with examples.

ANSWER:

The prominence of international finance as both an academic discipline and a business activity
has grown due to several key factors:

1. Globalization of Trade and Investment: As markets and economies become more

interconnected, international finance is essential for managing cross-border financial
flows and investments.
2. Growth of Multinational Corporations (MNCs): MNCs require international finance
to manage their global operations, exchange rate risks, and capital flows between
subsidiaries.
3. Technological Advancements: Innovations in technology, particularly in the areas of
banking, financial markets, and communication, have made it easier to conduct
international financial transactions and monitor global markets.
4. Financial Markets Integration: The liberalization of financial markets and the
development of global capital markets have created a need for expertise in managing
foreign exchange, investments, and risks in multiple countries.
5. Emerging Markets: The rapid development of emerging economies has led to increased
foreign investment and the need for financial strategies to navigate new and volatile
markets.
6. Economic and Political Instability: Global financial crises and political instability in
various regions have underscored the importance of managing financial risks and
uncertainties on an international scale.

Examples of the growing importance of international finance include the expansion of foreign
exchange markets, the role of global investment banks in financing international projects, and the
increasing participation of sovereign wealth funds in global capital markets.

TQ4: Key Indicators of the Internationalization of Finance

What are the main indicators that signify the internationalization of finance? Provide examples to
support your explanation.

Answer:

The internationalization of finance refers to the growing interconnectedness of financial markets

and the increasing movement of capital, investments, and financial services across borders. The
key indicators of this trend include:

INTERNATIONAL FINANCE AND INTERNATIONAL MONETARY SYSTEM

 1. Global Financial Market Expansion: The rise in global stock markets, bond markets,
and foreign exchange markets reflects the internationalization of finance. For example,
the New York Stock Exchange (NYSE) and the London Stock Exchange (LSE) host
companies from around the world, facilitating the global flow of capital.
2. Cross-Border Investments: Increased foreign direct investment (FDI) and foreign
portfolio investments (FPI) are clear signs of international finance. For instance, large
multinational companies like Apple and Toyota invest in markets outside their home
countries to expand operations and access new consumers.
3. Development of Global Financial Institutions: The growth of institutions such as the
International Monetary Fund (IMF) and the World Bank, which provide financial
assistance and support to countries globally, shows the spread of financial influence
across borders.
4. Foreign Exchange (Forex) Markets: The Forex market is the largest and most liquid
market in the world, where currencies are traded globally. Daily trading volume in the
Forex market exceeds $6 trillion, showcasing the active international exchange of
currencies.
5. Globalization of Financial Products: Financial instruments such as international bonds,
global mutual funds, and derivatives now allow investors to access opportunities
worldwide. For example, the development of Eurobonds enables companies and
governments to raise capital internationally.
6. Financial Market Liberalization: The removal of restrictions on international trade and
capital flows in many countries, such as China's financial market reforms, reflects the
push towards global financial integration.

TQ5: The Role of the Financial Manager in the Modern International

Environment

How has the role of the financial manager evolved in the context of today’s globalized economy?
Provide examples.

Answer:

In the present international environment, financial managers are tasked with overseeing financial
strategies and operations that span multiple countries, requiring a broad understanding of global
financial dynamics. Their role has expanded to include:

1. Global Financial Planning and Strategy: Financial managers now have to account for
international factors such as currency fluctuations, global tax policies, and regulatory
differences. For example, companies like Amazon must tailor their financial strategies to
adapt to diverse markets across continents.
2. Risk Management: With operations in various countries, financial managers must
mitigate risks like exchange rate volatility and political instability. A firm like Coca-Cola
may use hedging strategies to manage currency risk when it operates in countries with
volatile currencies.

INTERNATIONAL FINANCE AND INTERNATIONAL MONETARY SYSTEM

 3. Capital Investment Decisions: Financial managers are responsible for making
investment decisions that cross borders. For instance, a company like Microsoft may
decide to invest in expanding operations in India, which requires assessing the financial,
economic, and regulatory risks associated with the Indian market.
4. Funding and Capital Structure Management: They decide how to raise capital for
international operations, whether through issuing bonds in international markets or
securing loans from global financial institutions. Companies like Tesla often raise capital
in international markets to fund expansion projects globally.
5. Multinational Cash Flow Management: Financial managers oversee cash flows across
borders, ensuring liquidity for the company’s operations. For example, PepsiCo manages
its working capital to ensure smooth operations in over 200 countries.
6. Compliance with Global Financial Reporting: Financial managers ensure adherence to
international accounting standards, such as IFRS, and local regulations. Companies like
BP must ensure compliance with both UK and global financial reporting standards when
they operate in different markets.

TQ6: The Gold Standard and the Balance of Payments

What are the advantages and disadvantages of the gold standard, and how did the gold standard
mechanism restore balance of payments equilibrium when it was disrupted? Provide examples.

Answer:

The gold standard was a system where currencies were directly linked to a specified amount of
gold, and its main purpose was to provide stable exchange rates and foster confidence in
international trade. The advantages and disadvantages of the gold standard are:

Advantages:

1. Stability in Exchange Rates: Because currencies were tied to gold, exchange rates were
fixed, making international trade more predictable. For example, the exchange rate
between the British pound and the U.S. dollar was fixed when both currencies were
backed by gold.
2. Trust and Credibility: The system ensured that governments couldn’t manipulate
currency values to suit political needs. This created a level of trust in the value of
currencies, as seen during the period when the gold standard was in place, especially in
the late 19th century.
3. Control of Inflation: As the money supply was linked to gold reserves, inflation was
generally low. For example, in the 19th century, the U.S. economy saw stable price levels
due to this constraint.

Disadvantages:

1. Limited Flexibility: Governments could not easily adjust their money supply to
stimulate economic growth or combat recessions. This was evident during the Great

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 Depression when countries were unable to expand their money supply due to the
constraints of the gold standard.
2. Vulnerability to Gold Discoveries: Large discoveries of gold could lead to inflation,
while a lack of gold discovery could lead to deflation. For instance, the California Gold
Rush of the 19th century increased the global supply of gold, affecting price levels.
3. Balance of Payments Issues: A country facing a persistent trade deficit would lose gold,
reducing its money supply and potentially leading to a recession.

Mechanism to Restore Balance of Payments Equilibrium: Under the gold standard, if a

country experienced a balance of payments deficit, it would lose gold to other nations, resulting
in a reduction of the money supply. This contraction would lead to a fall in prices, making the
country's exports cheaper and imports more expensive, which would eventually restore the trade
balance. For example, in the 1920s, the U.K. adjusted its gold reserves and money supply to
restore equilibrium after a trade deficit.

TQ7: Flexible Exchange Rate Regime

What are the advantages and disadvantages of a flexible exchange rate regime? What criteria
should be used to determine a "good" international monetary system? Provide examples.

Answer:

A flexible exchange rate regime is one where the value of a country’s currency is determined
by market forces (supply and demand) rather than being pegged to another currency or
commodity. The advantages and disadvantages are:

Advantages:

1. Automatic Adjustment: In response to changes in economic conditions, such as trade

imbalances or shifts in investor sentiment, exchange rates adjust automatically. For
example, when the U.S. experiences a trade deficit, the dollar may depreciate, making
U.S. exports cheaper and imports more expensive.
2. Independence in Monetary Policy: Countries can independently manage their monetary
policies without worrying about maintaining a fixed exchange rate. The U.S. Federal
Reserve, for instance, can adjust interest rates without being constrained by the need to
defend a currency peg.
3. Buffer Against External Shocks: A flexible exchange rate acts as a cushion against
global economic shocks. When the 2008 global financial crisis hit, currencies in
emerging markets like the Brazilian real depreciated, helping those countries’ exports
become more competitive.

Disadvantages:

1. Exchange Rate Volatility: The value of a currency can fluctuate unpredictably, creating
uncertainty for international businesses and investors. For example, the British pound

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 experienced significant volatility following Brexit, making planning for businesses
operating in the UK more difficult.
2. Speculative Attacks: Financial markets may engage in speculative activities, leading to
sharp currency movements. The 1997 Asian Financial Crisis saw several currencies in
Southeast Asia undergo massive devaluations as a result of speculative attacks.
3. Inflation Risks: A devalued currency can lead to higher import costs, which can
contribute to inflation. For instance, when the Argentine peso depreciated sharply in
recent years, the country faced rising import prices and inflation.

Criteria for a “Good” International Monetary System:

1. Stability: A good system should provide stability in exchange rates to promote

international trade and investment. For instance, the European Union's euro zone offers
stability for its member countries, reducing exchange rate risks.
2. Flexibility: The system should allow for necessary adjustments in response to global
economic conditions. A good example is the flexibility of the U.S. dollar in adjusting to
changes in global demand.
3. Predictability: A transparent and predictable system enables businesses to plan for the
future. The U.S. Federal Reserve’s policies often provide predictable guidance, helping
international investors assess risks.
4. Fairness: A system should avoid disproportionate advantages for certain countries. The
International Monetary Fund (IMF) works to ensure global financial stability by offering
fair financial assistance to both developed and developing nations.
5. Transparency: Clear and transparent rules are essential for a functioning system. For
example, the rules of the World Trade Organization (WTO) ensure that trade and
financial policies are predictable for global markets.

TQ8: The Fixed Exchange Rate System

What are the arguments for and against a fixed exchange rate system? Why might a government
want its currency's exchange rate to rise, and how could it achieve this?

Answer:

A fixed exchange rate system is one in which a country's currency value is pegged to another
major currency (such as the U.S. dollar) or a basket of currencies. Here are the arguments for and
against such a system:

Advantages of a Fixed Exchange Rate:

1. Stability in International Trade: A fixed rate provides stability in the value of the
currency, which can reduce exchange rate risks for businesses engaged in international
trade. For example, Hong Kong has maintained a fixed exchange rate with the U.S. dollar
to ensure predictability for trade.
2. Control Over Inflation: Fixed exchange rates help control inflation by tying the
domestic currency to a stable currency, like the U.S. dollar. For instance, countries in the

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 Eurozone benefit from a stable currency that is less prone to fluctuations compared to
other global currencies.
3. Investor Confidence: A stable currency encourages foreign investment, as investors are
more confident in the predictability of returns. Countries like Saudi Arabia benefit from a
fixed exchange rate with the U.S. dollar to attract international investors.

Disadvantages of a Fixed Exchange Rate:

1. Loss of Monetary Policy Independence: A country cannot easily adjust its interest rates
or control the money supply without affecting the value of its currency. For example,
countries that peg their currency to the U.S. dollar cannot adjust their monetary policy to
address domestic inflation or recession without affecting the exchange rate.
2. Vulnerability to External Shocks: Countries with a fixed exchange rate system are
vulnerable to external economic shocks, such as changes in global oil prices, which can
create imbalances. A fixed system requires frequent interventions to maintain the peg,
leading to potential depletion of foreign currency reserves.
3. Speculative Attacks: If a country’s currency becomes overvalued or undervalued,
speculators might attack the currency, betting against the peg. This happened in the 1992
Black Wednesday crisis in the UK when the pound was forced to devalue after
speculators bet against it.

Why a Government Might Want a Currency’s Exchange Rate to Rise:

1. Lower Import Costs: A stronger currency reduces the cost of imports, which can help
control inflation and improve the country’s trade balance. For example, Japan may prefer
a strong yen to reduce the cost of imported raw materials and energy.
2. Enhanced Investor Confidence: A rise in the exchange rate can signal economic
strength, attracting foreign investment. For instance, countries like Switzerland aim for a
stronger franc to attract stable long-term investments.
3. International Debt Reduction: A stronger currency can reduce the burden of foreign-
denominated debt, as it takes fewer units of the domestic currency to pay off foreign
obligations.

How Governments Achieve a Higher Exchange Rate:

1. Increase Interest Rates: Raising interest rates can attract foreign capital, increasing
demand for the currency. For example, when the European Central Bank raises rates, it
strengthens the euro.
2. Foreign Exchange Market Intervention: A government or central bank can directly
buy its currency on the foreign exchange market to increase demand. China has
historically used this method to maintain a stable currency value.
3. Improving Economic Fundamentals: Strengthening the country’s economic
performance, such as lowering the fiscal deficit and improving exports, can increase
investor confidence, leading to a stronger currency.

TQ9: Floating or Flexible Exchange Rate System

INTERNATIONAL FINANCE AND INTERNATIONAL MONETARY SYSTEM

What are the main advantages and disadvantages of a floating or flexible exchange rate system?

Answer:

A floating exchange rate system is one where the value of a country’s currency is determined
by market forces (supply and demand) without direct government intervention. Here are the key
advantages and disadvantages of this system:

Advantages of a Floating Exchange Rate:

1. Automatic Adjustment: A floating exchange rate system automatically adjusts to

changes in economic conditions, such as trade imbalances or economic growth. For
instance, the U.S. dollar tends to depreciate during times of trade deficit, making exports
cheaper and helping to restore trade balance.
2. Monetary Policy Flexibility: Countries with floating exchange rates can implement
independent monetary policies, such as adjusting interest rates to control inflation or
stimulate economic growth. The Federal Reserve can change U.S. interest rates without
needing to defend a fixed exchange rate.
3. Protection from External Shocks: A floating exchange rate can buffer the economy
against external economic shocks, such as oil price changes or financial crises. In 1997,
Asian countries that had pegged their currencies to the U.S. dollar were more vulnerable
during the financial crisis compared to countries with floating currencies.

Disadvantages of a Floating Exchange Rate:

1. Exchange Rate Volatility: Floating rates can fluctuate significantly, leading to

uncertainty for international businesses and investors. For example, the British pound has
been subject to significant fluctuations due to political events like Brexit, creating risks
for international trade.
2. Risk of Speculation: Currency markets can be subject to speculative activities that may
lead to sharp and potentially harmful movements in exchange rates. The Mexican peso
crisis in 1994 saw massive depreciation due to speculative attacks, harming the economy.
3. Higher Transaction Costs: With currency fluctuations, businesses engaging in
international trade face higher costs for hedging against exchange rate risk. For example,
companies like General Motors may need to hedge against currency risk when buying
parts from overseas.

TQ10: The IMF: Principal Functions

What are the principal functions of the International Monetary Fund (IMF), and what factors
have limited its role as a source of international finance?

Answer:

INTERNATIONAL FINANCE AND INTERNATIONAL MONETARY SYSTEM

The International Monetary Fund (IMF) is an international financial institution that aims to
promote global financial stability and economic growth. Its principal functions include:

1. Monitoring Global Economic Stability: The IMF tracks global economic trends,
providing analysis and policy advice to member countries. It helps nations address fiscal
imbalances, inflation, and other macroeconomic issues. For example, the IMF has
provided advice to countries like Greece during its debt crisis.
2. Providing Financial Assistance: The IMF offers financial support to countries facing
balance of payments crises by providing loans with conditional terms to stabilize
economies. Argentina, for example, received loans from the IMF during its economic
crises in the early 2000s.
3. Technical Assistance and Capacity Building: The IMF provides training and technical
assistance to countries in areas such as monetary policy, exchange rate management, and
financial system stability.
4. Facilitating International Trade: The IMF works to promote international trade by
ensuring a stable global financial system. It helps countries stabilize their currencies,
promoting trade and investment.

Factors Limiting the Role of the IMF as a Source of International Finance:

1. Political Influence: The IMF’s decision-making power is heavily influenced by its

largest member countries, particularly the U.S., which holds significant voting power.
This can limit the institution’s ability to act impartially in certain situations, as seen in the
IMF's response to the Greek debt crisis, where some critics claimed the IMF was overly
influenced by the preferences of European countries.
2. Conditionality and Austerity Measures: The IMF often imposes stringent conditions on
its loans, such as fiscal austerity measures, which can be politically unpopular and can
lead to social unrest. For example, many Latin American countries have experienced
protests against IMF-imposed austerity policies.
3. Limited Financial Resources: While the IMF is a major global financial institution, its
financial resources are finite and may not be sufficient to address large-scale global
crises, such as the 2008 global financial crisis. For larger emergencies, the IMF often
requires supplementary support from other international institutions like the World Bank.
4. Global Economic Power Shifts: As emerging economies like China and India have
gained economic influence, there is ongoing debate about the IMF's representation and
relevance. Critics argue that the IMF needs to reform its governance structure to better
reflect the current global economic order.

TQ11: The Bretton Woods System

How did the Bretton Woods system differ from the Gold Standard, and why was the system
designed around the U.S. dollar rather than gold or silver?

Answer:

INTERNATIONAL FINANCE AND INTERNATIONAL MONETARY SYSTEM

The Bretton Woods system, established in 1944, was a system of fixed exchange rates where
currencies were pegged to the U.S. dollar, and the U.S. dollar was convertible to gold at a fixed
rate of $35 per ounce. It replaced the Gold Standard, which was a system where currencies
were directly pegged to gold.

Differences from the Gold Standard:

1. Currency Peg: Under the Gold Standard, currencies were pegged directly to gold,
whereas under Bretton Woods, currencies were pegged to the U.S. dollar, which was
itself convertible to gold. This allowed for greater flexibility in the global economy, as
countries did not need to hold large reserves of gold.
2. International Monetary Organization: The Bretton Woods system also established
institutions like the International Monetary Fund (IMF) and the World Bank to provide
financial stability and support to countries. The Gold Standard had no such institutional
framework.

Why the System Was Designed Around the U.S. Dollar:

1. U.S. Economic Power: After World War II, the U.S. was the world’s largest and most
stable economy, holding the largest gold reserves. The dollar became the most trusted
and widely used currency for global trade and reserves.
2. Global Trade Dominance: The U.S. dollar’s central role in global trade and finance
made it a natural anchor for the Bretton Woods system. The U.S. had the largest share of
global economic output, and countries were willing to peg their currencies to the dollar
because of its stability.
3. Practicality: By tying the system to the U.S. dollar rather than gold, the system allowed
for more liquidity and easier management of global reserves. The dollar’s widespread use
meant that countries could hold it as a reserve currency without needing to maintain large
gold stocks.

TQ12: Functions of the IMF

What are the principal functions of the IMF, and what factors have limited its role as a source of
international finance?

Answer:

(See TQ10 above for detailed answer.)

INTERNATIONAL FINANCE AND INTERNATIONAL MONETARY SYSTEM