The International Monetary System 555domestic employment. For example, if a country is having a problem with un-
employment, its central bank might try to lower interest rates, which would cause capi-
tal to flee the country to find higher rates, which would lead to the sale of the currency,
which would cause a declinein the value of the currency. This would cause its goods to be
cheaper in world markets and thus stimulate exports, production, and domestic em-
ployment. Conversely, the central bank of a country that is operating at full capacity and
experiencing inflation might try to raise the value of its currency to reduce exports and
increase imports. Under the current floating rate system, however, such intervention
can affect the situation only temporarily, because market forces will prevail in the long
run. In the case of the euro, each of the EMU currencies was fixed relative to the euro;
however, the value of the euro still fluctuated. The 11 EMU countries turned over con-
trol of their monetary policy to the European Central Bank. In 2002, the national cur-
rencies of the countries in the EMU began to be phased out, and only the euro will exist.
Exchange rate fluctuations can have a profound impact on international monetary
transactions. For example, in 1985 it cost Honda Motors 2,380,000 yen to build a par-
ticular model in Japan and ship it to the United States. The model carried a U.S.
sticker price of $12,000. Since the $12,000 sales price was the equivalent of (238 yen
per dollar)($12,000) 2,856,000 yen, which was 20 percent above the 2,380,000 yen
cost, the automaker had built a 20 percent markup into the U.S. sales price. However,
three years later the dollar had depreciated to 128 yen. Now if the model still sold for
$12,000, the yen return to Honda would be only (128 yen per dollar)($12,000)
1,536,000 yen, and the automaker would be losing about 35 percent on each auto sold.
Therefore, the depreciation of the dollar against the yen turned a healthy profit into a
huge loss. In fact, for Honda to maintain its 20 percent markup, the model would have
to sell in the United States for 2,856,000 yen/128 yen per dollar $22,312.50. This
situation, which grew even worse, led Honda to build its most popular model, the Ac-
cord, in Marysville, Ohio.
The inherent volatility of exchange rates under a floating system increases the
uncertainty of the cash flows for a multinational corporation. Because its cash flows are
generated in many parts of the world, they are denominated in many different
currencies. Since exchange rates can change, the dollar-equivalent value of the com-
pany’s consolidated cash flows can also fluctuate. For example, Toyota estimates that each
one-yen drop in the dollar reduces the company’s annual net income by about 10
billion yen. This is known as exchange rate risk,and it is a major factor differentiating a
global company from a purely domestic one.
Concerns about exchange rate risk have led to attempts to stabilize currency move-
ments. Indeed, this concern was one of the motivating factors behind the European
consolidation. As we indicated above, each participating country’s currency is now
pegged relative to the euro. Countries with pegged exchange ratesestablish a fixed
exchange rate with some major currency, and then the values of the pegged currencies
move together over time. Other countries have chosen to peg their currency to the U.S.
dollar. For example, Venezuela pegs its currency to the U.S. dollar at a rate of 0.00116
dollar per Bolivar. Its reason for pegging its currency to the dollar is that a large portion
of its revenues are linked to its oil exports, which are typically traded in dollars, and its
trading partners feel more comfortable dealing with contracts that can, in essence, be
stated in dollar terms. Similarly, Kuwait pegs its currency to a composite of currencies
that roughly represents the mix of currencies used by its trading partners to purchase its
oil. In other instances, currencies are pegged because of traditional ties—for example,
Chad, a former French colony, still pegs its currency to the French franc.^4(^4) The International Monetary Fund reports each year a full listing of exchange rate arrangements in its
Annual Report on Exchange Arrangements and Exchange Restrictions.