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  • Moffett, M., Stonehill, A., & Eiteman, D. (2012). Fundamentals of multinational finance (4th). Boston, MA: Prentice Hall. ISBN: 9780132138079 (print), 9780132138161 (e-text).

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Chapter 1
Current Multinational
Challenges and the
Global Economy
Current Multinational Financial Challenges
and the Global Economy: Learning
Objectives
• Examine the requirements for the creation of
value
• Consider the basic theory, comparative
advantage, and its requirements for the
explanation and justification for international trade
and commerce
• Discover what is different about international
financial management
1-2
© 2012 Pearson Education, Inc. All rights reserved.
Current Multinational Financial Challenges
and the Global Economy: Learning
Objectives
• Detail which market imperfections give rise to the
multinational enterprise
• Consider how globalization process moves a
business from domestic focus to financial
relationships and composition global in scope
• Examine possible causes to the limitations to
globalization in finance
1-3
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Creating Firm Value in Global
Markets
• Multinational firms (MNEs) are those with
operations in more than one country
• MNEs include for profit, non-profit firms, and
NGOs
• Today, MNEs rely on emerging markets for raw
materials, cheaper labor, and outsourced
manufacturing
• MNEs also rely on emerging markets for sales and
profits
• BRICs – the new world markets of Brazil, Russia,
India, and China
1-4
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Global Finance in Practice 1.1
Global Capital Markets: Entering a New Era
• Global capital markets expanded from 1980 – 2007
to quadruple the size of global GDP
• The 2008 financial crises reduced the value of
global financial assets by $16 trillion
• Looking ahead financial assets are expected to
grow more inline with GDP, government debt will
increase, and GDP will rise faster in emerging
market countries
1-5
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Exhibit 1.1 Global Capital Markets
1-6
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The Global Financial Marketplace
• We may characterize the market place as links
among three items
– Assets – at the heart of the financial asset markets are
government issued debt securities. Several financial
assets derive their value from these underlying financial
instruments. The financial markets depend upon the
health of these government securities
1-7
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The Global Financial Marketplace
– Institutions
• Central banks which control each country’s money
supply
• Commercial banks which take deposits and make
loans
• Other financial institutions created to develop, market,
and trade securities and derivatives
– Linkages – the interbank networks that provide
the actual medium for exchange e.g. LIBOR
1-8
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The Market for Currencies
• Rates quoted in exhibit 1.2 are currency “midrates” because they are midway between the
average bid and offer rates among currency
traders
• Most currency quotes follow a convention asz a
result of some history or tradition
– E.g., euros per dollar and dollars per pound
1-9
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Exhibit 1.2 Global Currency Exchange Rates
1-10
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Exhibit 1.2 Global Currency Exchange Rates (cont.)
1-11
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Eurocurrencies and LIBOR
• Eurocurrencies
– Eurocurrencies are domestic currencies of one country
on deposit in a second country
– Any convertible (exchangeable) currency can exist in
“Euro-” form (do not confuse this term with the European
Euro)
– Eurocurrency markets serve two valuable purposes
• These deposits are an efficient and convenient money
market device for holding excess corporate liquidity
• This market is a major source of short-term bank loans to
finance corporate working capital needs
1-12
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Eurocurrencies and LIBOR
– The modern eurocurrency market was born shortly
after World War II
– Eastern European holders of dollars, including state
trading banks in the Soviet Union, were afraid to
deposit their dollar holdings in the United States
because they felt claims could be made against
these deposits by U.S. residents
– These currency holders then decided to deposit their
dollars in Western Europe
– While economic efficiencies helped spurn the growth
of this market, institutional events were also
important
1-13
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Eurocurrencies and LIBOR
• Eurocurrency Interest Rates: LIBOR
– In the eurocurrency market the reference rate of interest
is LIBOR- The London Interbank Offered Rate
– LIBOR is now the most widely accepted rate of interest
used in standardized quotations, loan agreements or
financial derivatives valuations
– LIBOR is officially defined by the British Bankers
Association
– For example, the U.S. dollar LIBOR is the mean of 16
multinational banks inter bank offered rates as sampled
at 11am London time in London
– Yen LIBOR, EURO LIBOR and all other LIBOR rates are
calculated the same way
1-14
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Exhibit 1.3 U.S. Dollar-Denominated
Interest Rates
1-15
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The Theory of Comparative
Advantage
• The theory of competitive advantage provides a
basis for explaining and justifying international
trade in a model assumed to enjoy
– Free trade
– Perfect competition
– No uncertainty
– Costless information
– No government interference
1-16
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The Theory of Comparative
Advantage
• The features of the theory are as follows;
– Exporters in Country A sell goods or services to unrelated
importers in Country B
– Firms in Country A specialize in making products that can
be produced relatively efficiently, given Country A’s
endowment of factors of production (land, labor, capital,
and technology)
– Country B does the same with different products (based
on different factors of production)
1-17
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The Theory of Comparative
Advantage
– Because the factors of production cannot be
transported, the benefits of specialization are
realized through international trade
– The terms of trade, the ratio at which quantities
of goods are exchanged, shows the benefits of
excess production
– Neither Country A nor Country B is worse off
than before trade, and typically both are better
off (albeit perhaps unequally)
1-18
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The Theory of Comparative
Advantage
• For and example of the benefits of free trade
based on comparative advantage, assume
Thailand is more efficient than Brazil at producing
both sports shoes and stereo equipment
• With one unit of production (a mix of land, labor,
capital, and technology), efficient Thailand can
produce either 12 shipping containers of shoes or
6 shipping containers of stereo equipment
• Brazil, being less efficient in both, can produce
only 10 containers of shoes or 2 containers of
stereo equipment with one unit of input
1-19
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The Theory of Comparative
Advantage
• A production unit in Thailand has an absolute advantage
over a production unit in Brazil in both shoes and stereo
equipment
• Thailand has a larger relative advantage over Brazil
in producing stereo equipment (6 to 2) than shoes
(12 to 10)
• As long as these ratios are unequal, comparative
advantage exists
• The following exhibit illustrates total world (in this
example) production and consumption if there was no
trade and if each country completely specialized in one
product
1-20
© 2012 Pearson Education, Inc. All rights reserved.
The Theory of Comparative
Advantage
• Clearly the world in total is better off because
there are now 10,000 containers of shoes (instead
of just 6,000), as well as 6,000 containers of
stereo equipment (instead of just 5,600)
• However, the goods are not distributed across
international boundaries!
1-21
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The Theory of Comparative
Advantage
• Trade can resolve that distribution problem
• While total production of goods has increased with
the specialization process, international trade at a
certain range of prices (containers of shoes for a
container of stereo equipment) can be distributed
between the countries
• This exchange ratio will determine how the larger
output is distributed
1-22
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The Theory of Comparative
Advantage: Limitations
• Although international trade might have
approached the comparative advantage model
during the nineteenth century, it certainly does
not today;
– Countries do not appear to specialize only in those
products that could be most efficiently produced by that
country’s particular factors of production
– At least two of the factors of production (capital and
technology) now flow easily between countries (rather
than only indirectly through traded goods and services)
– Modern factors of production are more numerous than
this simple model
– Comparative advantage shifts over time
1-23
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The Theory of Comparative
Advantage
• Comparative advantage is still, however, a
relevant theory to explain why particular countries
are most suitable for exports of goods and
services that support the global supply chain of
both MNEs and domestic firms
• The comparative advantage of the 21st century,
however, is one which is based more on services,
and their cross border facilitation by
telecommunications and the Internet
1-24
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Exhibit 1.4 Global Outsourcing of
Comparative Advantage
1-25
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Exhibit 1.5 What is Different About
International Financial Management?
1-26
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Market Imperfections:
A Rationale for the MNE
• Firms become multinational for one or several of
the following reasons:
– Market seekers – produce in foreign markets either to
satisfy local demand or export to markets other than their
own
– Raw material seekers – search for cheaper or more
raw materials outside their own market
– Production efficiency seekers – produce in countries
where one or more of the factors of production are
cheaper
– Knowledge seekers – gain access to new technologies
or managerial expertise
– Political safety seekers – establish operations in
countries considered unlikely to expropriate or interfere
with private enterprise
1-27
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Exhibit 1.6 Trident Corp: Initiation
of the Globalization Process
1-28
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The Globalization Process
• The globalization process is the structural and
managerial changes and challenges experienced
by a firm as it moves from domestic to global in
operations
• We will examine the case of Trident, a young firm
that manufactures and distributes an array of
telecommunication devices
– Trident’s initial strategy is to develop a sustainable
competitive advantage in the U.S. market
– Trident is currently constrained by its small size, other
competitors, and lack of access to cheap capital
1-29
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The Globalization Process
• In Phase One, Trident is not itself international or
global in its operations
• However, some of its competitors, suppliers or
buyers may be
• This is one of the key drivers pushing Trident into
Phase Two, the first transition of the globalization
process
• This is the Global Transition I: The Domestic
Phase to The International Trade Phase
1-30
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The Globalization Process
• In the International Trade Phase, Trident
responds to globalization factors by importing
inputs from Mexican suppliers and making exports
sales to Canadian buyers
• Exporting and importing products and services
increases the demands of financial management
over and above the traditional requirements of the
domestic-only business
1-31
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The Globalization Process
• First, direct foreign exchange risks are now
borne by the firm
– Pricing and payments may be in different currencies
– The value of these foreign currency receipts and
payments can change, creating a new source of risk
• Second, the evaluation of the credit quality of
foreign buyers and sellers is now more important
than ever; this is known as credit risk
management
– Potential for non-payment of exports and non-delivery of
imports
– Differences in business and legal systems and practices
1-32
© 2012 Pearson Education, Inc. All rights reserved.
The Globalization Process
• If Trident is successful in its international trade
activities, it will soon need to establish foreign
sales and service affiliates
• This step is often followed by establishing
manufacturing operations abroad or by licensing
foreign firms to produce and service Trident’s
products
• This is the Global Transition II:
The International Trade Phase to
The Multinational Phase
1-33
© 2012 Pearson Education, Inc. All rights reserved.
The Globalization Process
• Trident’s continued globalization will require it to
identify the sources of it competitive advantages
• This variety of strategic alternatives available to
Trident is called the foreign direct investment
sequence which include the creation of foreign
sales offices, licensing agreements,
manufacturing, etc.
• Once Trident owns assets and enterprises in
foreign countries it has entered the multinational
phase of globalization
1-34
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Exhibit 1.7 Trident’s Foreign Direct
Investment Sequence
1-35
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The Limits to Financial Globalization
• The growth in the influence and self-enrichment of
corporate insiders
• The next exhibit illustrates the agency problems
1-36
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Exhibit 1.8 The Potential Limits of
Financial Globalization
1-37
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Summary of Learning Objectives
• Financial management is an integral part of a
firm’s strategy. This course analyzes how a firm’s
financial management tasks evolve as it pursues
global strategic opportunities and new constraints
unfold
• The evolution of firms from domestic to
multinational is called the globalization process. A
firm may enter into international trade
transactions, then international contractual
arrangements and ultimately the acquisition of
foreign subsidiaries. This final stage is when a
firm truly becomes a multinational
1-38
© 2012 Pearson Education, Inc. All rights reserved.
Summary of Learning Objectives
• This globalization process results in a firm
becoming increasingly influenced by exchange
rate movements and other global political and
economic forces in general
• The decision whether or not to invest abroad may
require the MNE to enter into global licensing
agreements, joint ventures, acquisitions or
Greenfield investments
1-39
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Summary of Learning Objectives
• The theory of competitive advantage is based on
one country possessing a relative advantage in the
production of goods compared to another country
• Imperfections in national markets for products,
factors of production and financial assets translate
into market opportunities for MNEs
• Strategic motives drive the decision to invest
abroad and become an MNE. Firms could be
seeking new markets, raw materials, production
efficiencies, access to technology or political safety
1-40
© 2012 Pearson Education, Inc. All rights reserved.
Chapter 3
The International
Monetary System
Learning Objectives
• Learn how the international monetary system has
evolved from the days of the gold standard to
today’s eclectic currency arrangement
• Analyze the characteristics of an ideal currency
• Explain the currency regime choices faced by
emerging market countries
• Examine how the euro, a single currency for the
European Union, was created
3-2
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History of the International
Monetary System
• The Gold Standard, 1876-1913
– Countries set par value for their currency in terms of gold
– This came to be known as the gold standard and gained
acceptance in Western Europe in the 1870s
– The US adopted the gold standard in 1879
– The “rules of the game” for the gold standard were simple
• Example: US$ gold rate was $20.67/oz, the British pound
was pegged at £4.2474/oz
• US$/£ rate calculation is $20.67/£4.2472 = $4.8665/£
3-3
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History of the International
Monetary System
• Because governments agreed to buy/sell gold on
demand with anyone at its own fixed parity rate,
the value of each currency in terms of gold, the
exchange rates were therefore fixed
• Countries had to maintain adequate gold reserves
to back its currency’s value in order for regime to
function
• The gold standard worked until the outbreak of
WWI, which interrupted trade flows and free
movement of gold thus forcing major nations to
suspend operation of the gold standard
3-4
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History of the International
Monetary System
• The Inter-War years and WWII, 1914-1944
– During WWI, currencies were allowed to fluctuate over
wide ranges in terms of gold and each other, theoretically,
supply and demand for imports/exports caused moderate
changes in an exchange rate about an equilibrium value
• The gold standard has a similar function
– In 1934, the US devalued its currency to $35/oz from
$20.67/oz prior to WWI
– From 1924 to the end of WWII, exchange rates were
theoretically determined by each currency’s value in
terms of gold.
– During WWII and aftermath, many main currencies lost
their convertibility. The US dollar remained the only
major trading currency that was convertible
3-5
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History of the International
Monetary System
• Bretton Woods and the IMF, 1944
– Allied powers met in Bretton Woods, NH and created a
post-war international monetary system
– The agreement established a US dollar based monetary
system and created the IMF and World Bank
– Under original provisions, all countries fixed their
currencies in terms of gold but were not required to
exchange their currencies
– Only the US dollar remained convertible into gold (at
$35/oz with Central banks, not individuals)
3-6
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History of the International
Monetary System
– Therefore, each country established its
exchange rate vis-à-vis the US dollar and then
calculated the gold par value of their currency
– Participating countries agreed to try to maintain
the currency values within 1% of par by buying
or selling foreign or gold reserves
– Devaluation was not to be used as a
competitive trade policy, but if a currency
became too weak to defend, up to a 10%
devaluation was allowed without formal
approval from the IMF
3-7
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History of the International
Monetary System
– The Special Drawing Right (SDR) is an international
reserve assets created by the IMF to supplement existing
foreign exchange reserves
• It serves as a unit of account for the IMF and is also the
base against which some countries peg their exchange rates
• Defined initially in terms of fixed quantity of gold, the SDR
has been redefined several times
• Currently, it is the weighted average value of currencies of 5
IMF members having the largest exports
• Individual countries hold SDRs in the form of deposits at the
IMF and settle IMF transactions through SDR transfers
3-8
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History of the International
Monetary System
• Fixed exchange rates, 1945-1973
– Bretton Woods and IMF worked well post WWII,
but diverging fiscal and monetary policies and
external shocks caused the system’s demise
• The US dollar remained the key to the web of
exchange rates
– Heavy capital outflows of dollars became
required to meet investors’ and deficit needs
and eventually this overhang of dollars held by
foreigners created a lack of confidence in the
US’ ability to meet its obligations
3-9
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History of the International
Monetary System
– This lack of confidence forced President Nixon to suspend
official purchases or sales of gold on Aug. 15, 1971
– Exchange rates of most leading countries were allowed to
float in relation to the US dollar
– By the end of 1971, most of the major trading currencies
had appreciated vis-à-vis the US dollar; i.e. the dollar
depreciated
– A year and a half later, the dollar came under attack
again and lost 10% of its value
– By early 1973 a fixed rate system no longer seemed
feasible and the dollar, along with the other major
currencies was allowed to float
– By June 1973, the dollar had lost another 10% in value
3-10
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Exhibit 3.1 The IMF’s Exchange Rate
Index of the Dollar
3-11
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Contemporary Currency Regimes
• The IMF today is composed of national currencies,
artificial currencies (such as the SDR), and one
entirely new currency (Euro)
• All of these currencies are linked to one another
via a “smorgasbord” of currency regimes
3-12
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Contemporary Currency Regimes
• IMF Exchange Rate Regime Classifications
– Exchange Arrangements with No Separate Legal
Tender: Currency of another country circulates as sole
legal tender or member belongs to a monetary or
currency union in which same legal tender is shared by
members of the union
– Currency Board Arrangements: Monetary regime
based on implicit national commitment to exchange
domestic currency for a specified foreign currency at a
fixed exchange rate
3-13
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Contemporary Currency Regimes
– Other Conventional Fixed Peg Arrangements:
Country pegs its currency (formal or de facto) at a fixed
rate to a major currency or a basket of currencies where
exchange rate fluctuates within a narrow margin or at
most ± 1% around central rate
– Pegged Exchange Rates w/in Horizontal Bands:
Value of the currency is maintained within margins of
fluctuation around a formal or de facto fixed peg that are
wider than ± 1% around central rate
– Crawling Peg: Currency is adjusted periodically in small
amounts at a fixed, preannounced rate in response to
changes in certain quantitative measures
3-14
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Contemporary Currency Regimes
– Exchange Rates w/in Crawling Peg: Currency is
maintained within certain fluctuation margins around a
central rate that is adjusted periodically
– Managed Floating w/ No Preannounced Path for
Exchange Rate: Monetary authority influences the
movements of the exchange rate through active
intervention in foreign exchange markets without
specifying a pre-announced path for the exchange rate
– Independent Floating: Exchange rate is market
determined, with any foreign exchange intervention
aimed at moderating the rate of change and preventing
undue fluctuations in the exchange rate, rather than at
establishing a level for it
3-15
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Contemporary Currency Regimes
• Fixed Versus Flexible Exchange Rates and why countries
pursue certain exchange rate regimes; based on premise
that all else equal, countries would prefer fixed exchange
rates
– Fixed rates provide stability in international prices for the
conduct of trade
– Fixed exchange rates are inherently anti-inflationary,
requiring the country to follow restrictive monetary and
fiscal policies
– Fixed exchange rates regimes necessitate that central
banks maintain large quantities of international reserves
for use in occasional defense of fixed rate
– Fixed rates, once in place, may be maintained at rates
that are inconsistent with economic fundamentals
3-16
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Exhibit 3.2 World Currency Events
1971 – 2007
3-17
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Exhibit 3.2 World Currency Events
1971 – 2007 (cont.)
3-18
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Exhibit 3.2 World Currency Events
1971 – 2007 (cont.)
3-19
© 2012 Pearson Education, Inc. All rights reserved.
Exhibit 3.2 World Currency Events
1971 – 2007 (cont.)
3-20
© 2012 Pearson Education, Inc. All rights reserved.
Attributes of the “Ideal” Currency
• Exchange rate stability – the value of the currency would
be fixed in relationship to other currencies so traders and
investors could be relatively certain of the foreign exchange
value of each currency in the present and near future
• Full financial integration – complete freedom of monetary
flows would be allowed, so traders and investors could
willingly and easily move funds from one country to another
in response to perceived economic opportunities or risk
• Monetary independence – domestic monetary and interest
rate policies would be set by each individual country to
pursue desired national economic policies, especially as they
might relate to limiting inflation, combating recessions and
fostering prosperity and full employment
3-21
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Exhibit 3.3 The Impossible Trinity
3-22
© 2012 Pearson Education, Inc. All rights reserved.
Attributes of the “Ideal” Currency
• This is referred to as The Impossible Trinity
because a country must give up one of the three
goals described by the sides of the triangle,
monetary independence, exchange rate stability,
or full financial integration. The forces of
economics do not allow the simultaneous
achievement of all three
3-23
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Emerging Markets & Regime Choices
• Currency Boards – exist when a country’s central
bank commits to back its monetary base, money
supply, entirely with foreign reserves at all times
– This means that a unit of the domestic currency cannot
be introduced into the economy without an additional unit
of foreign exchange reserves being obtained first
• Example is Argentina in 1991 when it fixed the Argentinean
Peso to the US Dollar
3-24
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Emerging Markets & Regime Choices
• Dollarization – the use of the US dollar as the official
currency of the country
• Arguments for dollarization include
– Country removes possibility of currency volatility
– Theoretically eliminate possibility of future currency crises
– Greater economic integration with the US and other dollar
based markets
• Arguments against dollarization include
– Loss of sovereignty over monetary policy
– Loss of power of seignorage, the ability to profit from its
ability to print its own money
– The central bank of the country no longer can serve as
lender of last resort
• Examples include Panama circa 1907 and Ecuador circa 2000
3-25
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Exhibit 3.4 The Ecuadorian Sucre Exchange
Rate, November 1998-March 2000
3-26
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Exhibit 3.5 The Currency Regime
Choices for Emerging Markets
3-27
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The Birth of a Currency: The Euro
• 15 Member nations of the European Union are also
members of the European Monetary System (EMS)
– Maastricht Treaty specified timetable and plan for
replacing currencies for a full economic and monetary
union
– Convergence criteria called for countries’ monetary and
fiscal policies to be integrated and coordinated
• Nominal inflation should be no more than 1.5% above average for
the three members of the EU with lowest inflation rates during
previous year
• Long-term interest rates should be no more than 2% above average
for the three members of the EU with lowest interest rates
• Fiscal deficit should be no more than 3% of GDP
• Government debt should be no more than 60% of GDP
– European Central Bank (ECB) was established to promote
price stability within the EU
3-28
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The Euro & Monetary Unification
• The euro, €, was launched on Jan. 4, 1999 with 11
member states
• Effects for countries using the euro currency
include
– Cheaper transaction costs,
– Currency risks and costs related to exchange rate
uncertainty are reduced,
– All consumers and businesses, both inside and outside of
the euro zone enjoy price transparency and increased
price-based competition
3-29
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The Euro & Monetary Unification
• Successful unification of

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