Topic 3: International Monetary System

Question 1

 Describe and illustrate the main factors that determine a country’s exchange rate using demand/supply analysis

Answer 1

o Exchange rate: The price of one currency expressed in terms of another currency, and like any price, exchange rates are determined by the forces of demand and supply

o Relative Interest rates: Higher interest rates in Australia than the rest of the world will
 Attract more foreign money into Australia (increases demand)
 Reduce the outflow of domestic funds to foreign debt markets (decrease supply)
 Results in an appreciation of the AUD

o Relative inflation rates: Higher inflation rates in Australia than overseas
 Reduce foreign demand for Australia’s expensive exports (decrease demand)
 Increase Australia’s demand for relatively cheap foreign goods and services (increase supply)
 Results in depreciation of AUD

o Commodity Prices
 Higher commodity prices mean that foreigners require more AUD’s to purchase our commodity exports (increase in demand)
 Appreciation of AUD

Question 2

 Describe Fixed exchange rate regime

Answer 2

o Typically, the central bank or a currency board is responsible for maintaining the fixed value

o What can be done to influence it?
 Change domestic interest rates
 The central bank enters the FOREX market using its reserves

o Both actions are a form of monetary policy, a fixed exchange rate regime means the monetary policy must focus on the exchange rate, not able to focus on maintaining low inflation

o Monetary policy is not autonomous

Question 3

 Advantages of a fixed exchange rate

Answer 3

o Avoid currency fluctuations
 Can cause problems for firms engaged in trade
 A rapid appreciation for eg. May cause exports to become uncompetitive

o Stability encourages investment
 Uncertainty of exchange rate fluctuations can reduce incentive for firms to invest in export capacity.

o Keep Inflation Low

o Implores monetary discipline
 Cannot print a large amount of money
 Prevents corruption

Question 4

 Disadvantages of a fixed exchange rate

Answer 4

o Conflict with other objectives
 Maintain a fixed level of the exchange rate may conflict with other macroeconomic objectives
 E.g. currency is falling below its band therefore need to use foreign reserves
 Or increase interest rates but that can harm economic growth and can cause recession and rising unemployment

o Less flexibility
 It is difficult to respond to temporary shocks as you cannot devalue your currency
o Requires a large amount of foreign exchange reserves to keep it at that price

Question 5

 Advantages of a floating exchange rate

Answer 5

o Independent Monetary Policy
 Interest rates are autonomous of the exchange rate, and free to target inflation

o Shock Absorber
 Protects the economy from external shocks

o No need for foreign exchange reserves

o No need for central bank intervention

o No need for capital flow restrictions

Question 6

 Functions of an international monetary system

Answer 6

o Adjustment
 Provide an orderly adjustment mechanism by which countries can correct internal and external imbalances. (domestic as in loss of economic stability, international in terms of adverse impacts on economies of other countries)

o Liquidity
 International trade and investment requires money and a stable international finance system. As there is no single global currency, international liquidity is comprised of a mix of other currencies (USD) or assets and credits held with IMF.

o Confidence
 Confidence in a financial system underpins its stability.
 Central banks and governments need assurance that all members will abide by rules and be consistent with their pledges rather than pursue self-interest when it is economically or politically convenient.
 Deficit countries need to be assured there is a ‘lender of last resort’ when the private foreign capital inflows used to finance deficits begin to slow or stop.
 Holders of reserve currencies will need to be confident that the reserve currency countries will not pursue policies that sharply alter the value of the currencies they hold in their reserves.