CP

(National Geographic (Little) Kids) #1
554 CHAPTER 15 Multinational Financial Management

exports to Great Britain, there would be a greater demand for pounds than for dollars,
and this would drive up the price of the pound relative to that of the dollar. In terms of
Table 15-1, the dollar cost of a pound might rise from $1.4338 to $2.0000. The U.S.
dollar would be said to be depreciating,because a dollar would now be worth fewer
pounds, whereas the pound would be appreciating.In this example, the root cause of
the change would be the U.S. trade deficitwith Great Britain. Of course, if U.S. ex-
ports to Great Britain were greater than U.S. imports from Great Britain, Great
Britain would have a trade deficit with the United States.^2
Changes in the demand for a currency, and the resulting exchange rate fluctua-
tions, also depend on capital movements. For example, suppose interest rates in Great
Britain were higher than those in the United States. To take advantage of the high
British interest rates, U.S. banks, corporations, and sophisticated individuals would
buy pounds with dollars and then use those pounds to purchase high-yielding British
securities. This buying of pounds would tend to drive up their price.^3
Before August 1971, exchange rate fluctuations were kept within a narrow 1 per-
cent limit by regular intervention of the British government in the market. When the
value of the pound was falling, the Bank of England would step in and buy pounds to
push up their price, offering gold or foreign currencies in exchange. Conversely, when
the pound rate was too high, the Bank of England would sell pounds. The central
banks of other countries operated similarly.
Devaluationsand revaluationsoccurred only rarely before 1971. They were usu-
ally accompanied by severe international financial repercussions, partly because
nations tended to postpone needed measures until economic pressures had built up to
explosive proportions. For this and other reasons, the old international monetary sys-
tem came to a dramatic end in the early 1970s, when the U.S. dollar, the foundation
upon which all other currencies were anchored, was cut loose from the gold standard
and, in effect, allowed to “float.”
The United States and other major trading nations currently operate under a sys-
tem of floating exchange rates,whereby currency prices are allowed to seek their
own levels without much governmental intervention. However, the central bank of
each country does intervene to some extent, buying and selling its currency to smooth
out exchange rate fluctuations.
Each central bank would like to keep its average exchange rate at a level deemed de-
sirable by its government’s economic policy. This is important, because exchange rates
have a profound effect on the levels of imports and exports, which influence the

(^2) If the dollar value of the pound moved up from $1.43 to $2.00, this increase in the value of the pound would
mean that British goods would now be more expensive in the United States. For example, a box of candy cost-
ing £1 in England would rise in price in the United States from about $1.43 to $2.00. Conversely, U.S. goods
would become cheaper in England. For example, the British could now buy goods worth $2.00 for £1,
whereas before the exchange rate change £1 would buy merchandise worth only $1.43. These price changes
would, of course, tend to reduceBritish exports and increaseimports, and this, in turn, would lower the ex-
change rate, because people in the United States would be buying fewer pounds to pay for English goods.
(^3) Such capital inflows would also tend to drive down British interest rates. If British rates were high in the
first place because of efforts by the British monetary authorities to curb inflation, these international cur-
rency flows would tend to thwart that effort. This is one of the reasons domestic and international
economies are so closely linked.
A good example of this occurred during the summer of 1981. In an effort to curb inflation, the Federal
Reserve Board pushed U.S. interest rates to record levels. This, in turn, caused a flow of capital from Euro-
pean nations to the United States. The Europeans were suffering from a severe recession and wanted to
keep interest rates down in order to stimulate investment, but U.S. policy made this difficult because of in-
ternational capital flows. Just the opposite occurred in 1992, when the Fed drove short-term rates down to
record lows in the United States to promote growth, while Germany and most other European countries
pushed their rates higher to combat the inflationary pressures of reunification. Thus, investment in the
United States was dampened as investors moved their money overseas to capture higher interest rates.


548 Multinational Financial Management
Free download pdf