International Finance: International Monetary System 1925-1960 - Essay Example

? International Finance: (International Monetary System 1925-1960) Table of Contents a. 4 b. 9 Reference 13 a. Introduction: International monetary system facilitates international trade, cross border investment and reallocation of capital between nation states. They promote means of payment between buyers and sellers of different nations including deferred payments. It provides the framework for ensuring liquidity without fuelling inflation and corrects the global imbalances or restricts their emergence, while facilitating an orderly payment system. The Industrial Revolution increased the production of goods and widened the basis of world trade (Hodge, 2008, p.287). At that time the necessary condition to promote world trade was a stable exchange rate system. Background World War I World War I (1914-1918) is also known as the Great War. It caused huge loss of property and human life. It destroyed four empires i.e. Austro-Hungarian, German, Romanov and Ottoman. 10 million were killed and around 21 million were wounded (Digitalhistory, p.1). France suffered innumerable property damage. It created circumstances in Balkans, in Russia and in Germany for which people not prepared. It also resulted in uncertainties, instability and economic collapse which were very difficult to deal with. World War II There were many similar reasons of World War I for which World War II was fought. This time the alliance system was Axis powers i.e. Italy, Germany, Japan and the Allied Powers i.e. Russia, Great Britain and France. Hitler’s invasion of Poland in September 1939 drove Great Britain and France to declare war on Germany and this gave rise to World War II (Boisestate, p.1). The Great Depression also led to the coming of World War II. Monetary System before World War I From the 1870’s to the outbreak of World War I in 1914, the world benefited from a well integrated financial orders also known as First Stage of Globalization. The monetary system before World War I was the traditional Gold Standard 1875-1914. During the classical gold standard system, major countries agreed that gold would be guaranteed of unobstructed coinage, there would be cooperative convertibility between national currencies and gold at a constant ratio and gold would be liberally exported and imported.(Gaspar, 2012, p.1). Monetary System before World War II World War I ended the traditional gold standard as most important countries balanced recovery of banknotes in gold and forced embargo on gold exports. The U.S, which replaced Britain as the dominant financial power, spearheads efforts to store the gold standard again. The gold standard of the late 1920s was a facade as major countries gave priority to stabilization of domestic economies by similar inflows and outflows of gold with reduction and increase in domestic money and credit. Moreover, after the World War II Bretton Woods System came into picture (Eun and Resnick, 2010, p.29). Steps taken to regain normalcy after World War I The Paris Peace Conference of 1919 accredited the end of four great empires at the end of World War I. Its mission was to promote the liberal and democratic values. American Peace Societies signed the major agreement amongst great powers to decrease their number of battleships. Most of the nations signed the Kellogg Briand Pact, where they pledged that they will never again go to war with one another. Steps taken to regain normalcy after world war II Following steps has been taken to regain normalcy after World War II: The changes in Government Policies: After the World War II most European Governments, by more government investments stimulated the economic growth of their country. More government investment encouraged private investment, created employment opportunities and led to continuing economic growth of Europe. The French decided to provide the financial resources for constructing more houses and for improving farming facilities. Growth in world trade: Tariffs were reduced between European States for both the organizations. Intra-European traffic increases as a result of the decrease in tariffs (Ferraro, Santos, and Ginocchio, 1997, p.1). After 1945 by the general increases in the price of raw material, the primary producers in Asia and Africa were also benefitted. Critical Review Monetary System of World War I: World War I marked the beginning of the end of the Gold Standards. During the war, countries suspended the convertibility of their currencies into gold. After WWI various attempts were made to restore the “classical” gold standards. Those were: United States returned to a gold standard in 1919 and Great Britain joined, followed by France and Switzerland in 1925(Bordo, 1998, p.1). Monetary system of World War II: In July 1944 World War II came to an end and all 44 allied countries met in Bretton Woods for the purpose of establishing a new international monetary system. At Bretton Woods countries agreed upon fixed exchange rates regime for restarting world trade and global investment (Nyu, 2007, p.1). The key points of Bretton Woods were pegging the U.S. dollar to gold at $35 per ounce and all other countries peg their currencies to the U.S. dollar. Analytical and theoretical aspects of International Monetary Fund (IMF) At the end of World War II, IMF was established, at a conference in Bretton Woods. IMF provides loan to the government who are facing economic crisis. Recently it focuses on policy reduction policies and creating economic stability. It has promoted transparency of pursued governance reforms and financial market within the organization, to cope with the increasing challenges of the global economy (Brooking, 2013, p.1). Analytical and theoretical aspects of World Bank It is the world’s largest public lender, created after World War II to avoid Great Depression. It supplies money to the member government to overcome short-term credit crunches (Globalexchange, 2011, p.1). Analytical and theoretical aspects of Gold Standard It lasted before the occurrence of World War I. During this period, most industrial nations connected their currencies to gold and the rate of inflation was about 0.1 percent. No treaty was signed and there were no formal agreements with other nations, when these nations were on gold standard. But, during the war countries suspended the convertibility of their currencies into gold. It came to an end because limited supply of gold caused deflation. According to the Gold Standard Act, 1900 $1 was equal to the value of 23.22 grains of pure gold (Econ, p.1). Analytical and theoretical aspects of Great Depression Stock market crash led to Great Depression. Due to Great Depression millions of people were also out of work across the United States. The New Deal programs introduced by Herbert Hoover aimed at helping the farmers, and to curb the unemployment. The entry of United States into World War II ended the Great Depression in the U.S (Ushistory, 2013, p.1). Analytical and theoretical aspects of Hyperinflation in Germany The hyperinflation in Germany took place in 1923. The prices were doubled from 1914-1919 and it again doubled in 1922. It wipes out the purchasing power of public and private saving and deforms the economy in favor of excessive consumption and hoarding of real assets. Germany hadn’t increased their wartime taxes and after it was defeated the money was worthless (Goodman, 1981, p.1). Argument and Implications U.S. balance of payment move towards the deficit stage. Dollar is “overestimated”. Foreigners become alarmed about holding overestimated U.S. dollar at a rate of $35 an ounce. The Bretton Woods fixed exchange rate system came to an end and floating exchange rate system came into picture. Managed rate regime also took place where governments’ managing their currency’s with regard to a reference currency. And in Pegged exchange regime, governments link the value of its currency relative to a reference currency ( Drabek, and Brada, 1998, p.6. p.7. and p.8). b. Introduction Purchasing Power Parity (PPP) is an economic theory that is used to determine the economic value of currencies. It states that, in two countries how much money would be needed to purchase same goods and services, and uses it to calculate the inherent foreign exchange rate. Therefore the amount of money thus has the similar purchasing power in different countries using that PPP rate. It shows how the exchange rate of two currencies should reflect the purchasing power of the people in two countries ( wisegeek, 2013, p.1). The concept is based on the law of one price, which means that in the absence of transaction cost and official trade barriers, the goods which are identical will have the same price in different markets when the prices are expressed in the same currency. If there comes a deviation from parity then it implies differences in purchasing power of a “basket of goods” across countries. Background Absolute Purchasing Power Parity For absolute PPP following conditions must be met. First the price index for each of the two countries must be comprised of the same basket of goods. Second the goods of each country must be freely tradable on the international market. And third, all of the prices need to be indexed to the same year ( Officer, 1978, p.562). Relative Purchasing Power Parity It predicts a relationship between the inflation rates of two countries over a specified period and the movement in the exchange rate between their two currencies over the same period which means that the exchange rate of two currencies reflects the effect of inflation rate. It states that the country having the higher inflation rate is the weaker currency because inflation reduces the real purchasing power of a nation’s currency. And this is measured over a period of time ( Murphy, p.1). Critical Review Comparison between Relative PPP and Absolute PPP Absolute PPP is base on the law of 1 price, which state that the similar basket of goods should be sold for the similar price all over the place. On the other hand, relative PPP state that the exchange rates can be attuned according to the inflation differential accessible in two markets ( econ, 2000, p.1). Empirical evidence of Absolute and Relative PPP Example of absolute PPP: A mango costs 2 dollar in country X and the same mango costs 4 dollars in country Y. This means 2 dollar in country X equals to 4 dollar in country Y. This exchange rate is based on cost of mango and it is assumed that the cost of mango is same worldwide. Example of relative PPP: Mexico’s anticipated annual rate of inflation is equal to 8% per year, while the anticipated annual inflation rate for the U.S. is 4%. As an approximation, it is expected that the Mexican peso would devalued at the rate of 4% a year. Argument against Purchasing Power Parity The forex market does not take into consideration the purchasing power parity because the whole concept is based on unrealistic assumptions such as consumptions patterns are the same all over the world, basket of goods and services in the CPI is the same in all countries, and no transportation cost. Measurement problem in testing for PPP For Absolute PPP: Suppose soybeans are currently priced at $5 a bushel in the U.S., that soybeans are prices at -5.50 per bushel in Europe, and that the exchange rate is 1.10 Euros per dollar. Now suppose that the price of soybeans goes up to -6.05 per bushel (a 10% increase) in Europe, while the price of soybeans in the U.S. only goes up on 5%, to $5.25 a bushel. If there is no depreciation in the euro to offset the 5% difference, then European soybeans will not be competitive on the international market and trade flowing from the U.S. to Europe will greatly decrease. For Relative PPP: Suppose that the annual inflation rate is expected to be 8% in the Eurozone and 2% in the U.S. The current exchange rate is $1.20 per euro (-1.00 = $1.20). What would be the expected spot exchange rate be in 6 months for the euro? Ans: S1 /S0 = (1 + Iy) / (1 + Ix) Therefore S0.5 /S0 = ((1 + IUS) / (1 + Ieurozone))0.5 = S0.5 / $1.20 per euro = (1.02 / 1.08)0.5 ; which implies S0.5 = (1.20) * 0.978125 = 1.1662 So the expected spot exchange rate at the end of 6 month would be $1.1662 per euro. Critical evaluation of Absolute and Relative PPP Exchange rates are influenced by many factors but the most important one is inflation. The connection between the exchange rates and inflation is known as purchasing power parity. Absolute PPP follows the law of one price. The concept of law of one price is that in competitive markets which is free of official barriers to trade and transportation cost, homogenous goods can’t have more than one price and that should be measured in any one currency. If the price of goods increases domestically, the domestic currency will reduce so that the price of the goods remains same which is denominated in the foreign currency. The absolute PPP is: s = p – p* where as s is the exchange rate which is expressed as the domestic price of foreign currency, p* is the corresponding foreign price index and p is the domestic price index. On the other hand, relative PPP is less stringent condition and requires that the proportion of variation in the relative price is same as the proportion of exchange rate variations. It is expressed as: s = c + p – p* whereas c is constant and other things are same. Real exchange rate persistence is used to assume the validity of PPP. The real exchange rate is constant if PPP holds continuously. A constant exchange rate is not observed in reality, that’s why most empirical exercise mostly focuses on long-run PPP. Under long-run PPP, divergence from parity is possible but they are often short-lived. Over time, the exchange rate and the relative price adjust to bring back the parity condition and the related real exchange converges to its equilibrium value (Cheung, pp.942-943). Reference Hodge, C., 2008. Encyclopedia of the Age of Imperialism. Westport: Greenwood Publishing Group. Digitalhistory., Overview of World War I. [online]. Available at: http://www.digitalhistory.uh.edu/era.cfm?eraid=12&smtid=1. [Accessed 11 March 2013]. Boisestste., Causes of World War II. [online]. Available at: http://edtech2.boisestate.edu/lockwoodm/WorldWar/causes_of_world_war_ii.htm. [Accessed 11 March 2013]. Gaspar, J., 2012. The International Monetary System. [pdf]. Available at: http://cibs.tamu.edu/Gaspar/handouts/IMS-ERS.pdf. 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