ECON1020 Tutorial 11: The International Financial

System
Question 1 [Current exchange rate systems, Bretton Woods]
a) What exchange rate system does Australia have?
b) What are the other two aspects of the current exchange rate system?
What advantages and disadvantages does each currency approach have?
c) Provide an overview of the Bretton Woods system and the Gold Standard
that preceded it.
d) What problems did Bretton Woods have? Are there any parallels to todays
exchange rates?
Q1 Answers
a) Australia has a managed float. The exchange rate is determined by supply
and demand, with occasional intervention by the RBA.
b) Most countries in Western Europe have adopted a single currency, the
euro. An advantage is that this facilitates trade between neighbouring
countries. Disadvantages are that individual countries are unable to
conduct independent monetary policy and that individual countries cant
depreciate their countries to be more competitive.
Many developing countries have pegged their currency (ie have a fixed
exchange rate) against another major currency like the USD. Advantages
include: fewer currency fluctuations, which makes business planning
easier; reduced fluctuations in import prices; and fixed foreign debt levels
and repayments. Similar to the Eurozone, countries lose the ability to
conduct independent monetary policy or to adjust the value of their
currency to be more competitive. A central bank may also need to borrow
money from overseas to support their domestic currency value.
c) Under the Gold Standard, the currency of a country could be redeemed in
gold. Exchange rates were determined by the quantity of gold in each
currency. The Gold Standard was abandoned during the 1930s (around the
time of the Great Depression) because countries could not conduct
monetary policy with it.
The Bretton Woods System ran from 1944 to 1971 and saw countries
essentially fixing their currencies against the USD. Under certain
circumstances, countries were allowed to revalue their currencies (a
limited form of monetary policy).
d) Two problems emerged:
a. The value of USD held by foreign banks was more than the gold
reserves in the US (Bretton Woods meant that USD were meant to
be exchangeable for gold)
b. Some countries with undervalued currencies refused to revalue
them (eg West Germany)
Looser capital controls made it easier to speculate on a currencys
value. This put pressure on the exchange rates in the Bretton Woods
System and contributed to the systems collapse.

A parallel that could be drawn to todays exchange rate system is the

competitive nature of currency value. Low exchange rates help a
countrys exports, at the expense of other countries exports.

Question 2 [PPP, limitations, TWI]

a)
b)
c)
d)

What is Purchasing Power Parity (PPP) and what is the reasoning behind it?
What factors prevent PPP from holding perfectly?
What determines exchange rates in the long run?
What does the Trade Weighted Index measure? Why might it be more
useful that a simple exchange rate?

Q2 Answers
a) PPP is the theory that in the long run exchange rates move to equalise the
purchasing power of different currencies. The reasoning behind this is that
if one currency could purchase more goods and services than another
currency, then everyone would convert their money to the first currency
with the higher purchasing power. This would push up the exchange rate
until the purchasing power of the two currencies is equal.
b) 1. Not all products can be traded internationally
2. Products and consumer preferences are different across countries
3. Countries impose barriers to trade (eg Tariffs and quotas)
The Big Mac Index is a light-hearted way of looking at PPP. The above
factors help explain why the prices of Big Macs dont explain exchange
rates perfectly: it is hard to internationally trade cooked Big Macs, Big
Macs may be more or less popular in some countries, and there are
probably restrictions on trading cooked Big Macs.
c) Relative price levels exchange rates will adjust so that the same goods
cost the same amount in different currencies, adjusting for the price
levels.
Relative rates of productivity growth: productivity growth tends to lower
prices, which increases demand for a countrys goods and thus demand
for its currency.
Preferences for domestic and foreign goods: preferences for a countrys
exports increase demand for its currency.
Tariffs and quotas: import tariffs and quotas reduce demand for foreign
goods and thus the supply of domestic currency for foreign currency. With
less supply, exchange rates tend to be higher.
d) A trade weighted index (TWI) measures the value of a currency against a
basket of other currencies of a countrys main trading partners. A TWI
gives a better idea of the relative expensiveness of a countrys imports
and exports compared to its trading partners.
Question 3 [Currency Peg, Speculation]
A fictional kingdom called Macrostan maintains a currency peg to improve
domestic stability. Its currency is called the Macro. Assume that the initial
currency peg is at US$2.50/Macro while the equilibrium level is US$2.00/Macro.

a) Show the supply and demand for Macros. Carefully identify the equilibrium
and show where the peg is in relation to the equilibrium. (Hint: when
drawing the graph, remember the Quantity currency is the one on the
bottom of the currency ratio)
b) Domestic economic conditions deteriorate such that fewer businesses
want to invest in Macrostan. Show what happens to the supply and
demand graph and comment on what happens to the exchange rate.
c) Suppose that currency speculators further believe that the government of
Macrostan will be unable to maintain the currency peg. Show what will
happen to the supply and demand graph.
d) What do you think will happen in the long run?

Q3 Answers

Peg
Equilibriu
m value

a)

2.00

b)

Because the currency is pegged, the exchange rate is still at US$2.50 /

Macro. However, there is now a bigger gap between the quantity of money
willing to be supplied at this price and the demand.

c)
Demand shifts further to the left, to D2. At this point, there is an even
larger gap between the quantity of US$ supplied and the demand for US$.
d) In the long run, it seems unlikely that the central bank would be able to
sustain the currency peg. To do so, it would need to keep selling US$ in
exchange for Macros. Before long, it would run out of reserves. If that
happens, the exchange rate will converge to the new (lower) equilibrium
rate.
Question 4 [China, current topics]
"They keep devaluing their currency until they get it right. They're doing a big
cut in the yuan, and that's going to be devastating for us [the United States]."
Donald Trump, 11 August 2015.
a) What economic basis is there for Mr Trumps statement?
b) Assume that the equilibrium market exchange rate is US$0.30/Yuan but
the current rate is $0.15/Yuan. Show this on a supply and demand graph
for Yuan.
c) If the above information is correct, what must Chinas central bank do to
maintain the peg?
d) You do some research and realise that China has actually pegged the yuan
against a basket of currencies since 2005. Explain what would happen if
the currencies in this basket appreciate, and show on the graph. Assume
the demand and supply fundamentals for the US$ remain unchanged.
Q4 Answers
a) If countries compete in exports (ie they both sell exports to similar
countries) then, if one of the exporting countries devalues their exchange
rate, exports from that country will become cheaper. In reality, the US and
China tend to export different types of goods so this statement may not
hold in reality.

b)
c) If the peg is below the market rate, then there is more demand for the
Yuan than supply. This means the central bank must sell extra Yuan in
exchange for Dollars, otherwise the currency would appreciate.
d) If the basket of currencies appreciates, the central bank would seek to
increase the value of the peg. Note that we assume the other drivers of
demand and supply do not change. Notice that now that the pegged value
is closer to equilibrium there is a smaller gap between quantity demanded
and supplied.