#1. Introduction: International Financial Markets

1. #1. Introduction: International Financial Markets • 1. History of International Financial System • 2. Exchange Rates since 1973 • Reading: • International Monetary System (Eun and Resnick Chapters 1 and 2)

2. 1. History of International Financial System • Bimetallism: Before 1875 • Classical Gold Standard: 1875-1914 • Interwar Period: 1915-1944 • Bretton Woods System: 1945-1972 • The Flexible Exchange Rate Regime: 1973-Present

3. Bimetallism: Before 1875 • A “double standard” in the sense that both gold and silver were used as money. • Some countries were on the gold standard, some on the silver standard, some on both. • Both gold and silver were used as international means of payment and the exchange rates among currencies were determined by either their gold or silver contents. • Gresham’s Law implied that it would be the least valuable metal that would tend to circulate.

4. Gresham’s Law • Suppose Gold and Silver were both used, when the conversion rate is one ounce of gold = 15.5 ounces of silver. • Suddenly, discovery of new gold mines causes huge influx of gold into the market. Gold becomes much cheaper to produce than silver is. • Producer will produce lots of gold, and everyone will use gold. • Bad money (gold) drives out good money (Silver).

5. Classical Gold Standard: 1875-1914 • During this period in most major countries: • Gold alone was assured of unrestricted coinage • There was two-way convertibility between gold and national currencies at a stable ratio. • Gold could be freely exported or imported. • The exchange rate between two country’s currencies would be determined by their relative gold contents.

6. Classical Gold Standard: 1875-1914 For example, if the dollar is pegged to gold at U.S.$30 = 1 ounce of gold, and the British pound is pegged to gold at £6 = 1 ounce of gold, it must be the case that the exchange rate is determined by the relative gold contents: $30 = £6 $5 = £1

7. Classical Gold Standard: 1875-1914 • Highly stable exchange rates under the classical gold standard provided an environment that was conducive to international trade and investment. • Misalignment of exchange rates and international imbalances of payment were automatically corrected by the price-specie-flow mechanism.

8. Price-Specie-Flow Mechanism • Suppose Great Britain exported more to France than Great Britain imported from France. • This cannot persist under a gold standard. • Net export of goods from Great Britain to France will be accompanied by a net flow of gold from France to Great Britain. • This flow of gold will lead to a lower price level in France and, at the same time, a higher price level in Britain. • The resultant change in relative price levels will slow exports from Great Britain and encourage exports from France. • Question: Guess whether inflation rate was high or low during the gold standard…

9. Cumulative consumer price index

10. Bretton Woods System: 1945-1972 • During the interwar period from 1914 to 1945, exchange rates fluctuated wildly. • Bretton Woods system was named after a 1944 meeting of 44 nations at Bretton Woods, New Hampshire. • The purpose was to design a postwar international monetary system. The goal was exchange rate stability without the gold standard. • In the same meeting, the IMF and the World Bank were created.

11. Bretton Woods System: 1945-1972 • Under the Bretton Woods system, the U.S. dollar was pegged to gold at $35 per ounce and other currencies were pegged to the U.S. dollar. • Each country was responsible for maintaining its exchange rate within ±1% of the adopted par value by buying or selling foreign reserves as necessary. • The Bretton Woods system was a dollar-based gold exchange standard.

12. German mark British pound French franc Par Value Par Value Par Value Bretton Woods System: 1945-1972 U.S. dollar Pegged at $35/oz. Gold

13. 2. Exchange Rates since 1973

14. Exchange Rate Classifications ( Source: Stanley Fisher, “Mundell-Fleming Lecture …”, IMF conference 2007 )

15. Example of a Crawling Peg Bekaert and Hodrick 2008

16. An Example of a Peg with Horizon Band (Target Zone) Bekaert and Hodrick 2008

21. Course • This course is distinct from: • open economy macroeconomics • international trade • economic development • International corporate finance • Most class materials (lecture notes, problems) from Professors Urban Jermann and Amir Yaron.

22. Timing issues • The schedule may change as the semester goes along. • We may spend more time on some topics and introduce relevant news and research into discussions. • Exam 1: February 22 (6-8pm) • Exam 2: April 12 (6-8pm)

23. Guessing Game and Group Formation • Which exchange rate series’ are Indonesia’s, Argentina’s, Canada’s & Brazil’s? • We use the exchange rate definition of the price of foreign currency in dollars: • S($/FC) • Analogous to price of shoes: P($/shoe)

24. Indonesia, Argentina, Canada & Brazil

25. Measuring Exchange Rate Movements • A decline in a currency’s value is referred to as depreciation, while an increase is referred to as appreciation. • % D in foreign currency value = (S - St-1) / St-1 • A positive % D represents appreciation of the foreign currency, while a negative % D represents depreciation.

26. Which currency?

27. Our email Professor David Ng (davidng@wharton.upenn.edu) Teaching Assistants: Jennifer Grossman: jennifrg@wharton.upenn.edu FlorianHagenbuch: hflorian@wharton.upenn.edu Qi Liu:  qiliu@wharton.upenn.edu

28. Administrative Details • No class next Monday (Martin Luther King day observed in Penn) • Textbooks • Eun and Resnick • Office Hours • Webcafe under FNCE 219 • Groups

29. A bit about myself... • My Background • My Research Interest .