international finance fina 5331 lecture 4: balance of payments a history of monetary arrangements

International FinanceFINA 5331

Lecture 4: Balance of Payments

A History of Monetary Arrangements

Read: Chapters 2&3Aaron Smallwood Ph.D.

The Current Account

• Includes all imports and exports of goods and services (invisible trade).

• Includes unilateral transfers of foreign aid.• If the debits exceed the credits, then a

country is running a trade deficit.• If the credits exceed the debits, then a

country is running a trade surplus.• It is thought that the CA responds to changes

in income and the exchange rate.

The Current Account

• Consists of the following:– Merchandise trade– Services– Unilateral transfers– Investment income

Classifying transactions

• For the current account, we credit transactions that:– We naturally think of as exports or that cause

foreign currency to flow into a country

• For the financial account, we debit transactions that:– We naturally think of as imports or that cause

foreign currency to flow out of a country

The Financial Account

• The financial account measures the difference between U.S. sales of assets to foreigners and U.S. purchases of foreign assets.

• The financial account is composed of Foreign Direct Investment (FDI), portfolio investments and other investments.

The Financial Account

• When a domestic entity (firm or individual) sells an asset to a foreign resident, there will be a credit recorded on the financial account.

• When a domestic resident buys an asset from a foreign entity, there will be a debit recorded on the financial account.

• Note – income earned on these assets is recorded on the current account, not the financial account.

Balance of payments

• Financial account– Includes portfolio investment: Sales of

purchases of financial assets– Foreign direct investment: Implies investment

where ownership is made by a foreign party– Other investment: Transactions in currency,

bank deposits, and so on.

• Positive entries (credits) increase liabilities or decrease assets

The Balance of Payments Identity

BCA + BFA + BRA = 0whereBCA = balance on current accountBFA = balance on financial accountBRA = balance on the reserves account

• Note: When a country experiences a currency crisis, we typically see BRA>0 (and HUGE)

Under a pure flexible exchange rate regime, BCA + BFA = 0

Because BRA = 0

Balance of Payments Trends

• Since 1982 the U.S. has experienced continuous deficits on the current account and continuous surpluses on the financial account.

• During the same period, China has experienced the opposite.

China BOP

Japan BOP

USA BOP

Balances on the Current (BCA) and Financial (BKA) Accounts of United Kingdom

1981 1986 1991 1996 2001 2006 2011-100

-80

-60

-40

-20

0

20

40

60

80United Kingdom

Bala

nces

in B

illion

s of

US

dolla

rs

Current Account Balance

Financial Account Balance

Official reserves

• In the US official reserve assets include gold, foreign currency, and special drawing rights (issued by the IMF).

• The official settlements balance is BCA+BFA

• When BCA+BFA≠0, the central bank must acquire or deplete holdings of official reserves.

Examples

• Example 3.1: Boeing (US) exports a 747 to Japan Airlines for $50 million. Japan Airlines pays from its dollar account at Chase.

• Example 3.3: Ford acquires Jaguar, a British car manufacturer for $750 million paid from deposits at Barclay’s.

• Example: In an intervention move, the Federal Reserve sells RMB10,000,000 in the open market. The RMB are used by a trader to purchase manufactured goods from China.

Balance of Payments and National Income Accounting

• GNP = Y = C + I + G + X – M• Y = C + S + T• X – M = (S- I) + (T- G)• If a developing economy experiences large

trade deficits (X-M <0), the remedies are:1. Savings must increase, S↑2. Investment must fall, I↓3. Government spending must fall, G↓4. Taxes must rise, T↑

International Monetary Arrangements

• International Monetary Arrangements in Theory and Practice– The International Gold Standard, 1879-1913– Bretton Woods Agreement, 1945-1971– Smithsonian Agreement 1971-1973– The Floating-Rate Dollar Standard, 1973-1984

• Jamaica Agreement 1976

– The Plaza-Louvre Intervention Accords (1985 and 1987) and the Floating-Rate Dollar Standard, 1985-1999

Additionally

• What exchange rate systems exist today?– The choice between a fixed system and a flexible

system.• How does another country’s exchange rate

system affect you? How does China’s changing exchange rate system affect you?

• What are currency crises and how can they impact your business?

• What is the euro? Will the euro-zone expand? How does expansion of the euro-zone affect you?

The International Gold Standard, 1879-1913

• Countries unilaterally elected to follow the rules of the gold standard system, which lasted until the outbreak of World War I in 1914, when European governments ceased to allow their currencies to be convertible either into gold or other currencies.

Fix an official gold price or “mint parity” and allow free convertibility between domestic money and gold at that price.

For example, during the gold standard, the dollar is pegged to gold at :

U.S.$20.67 = 1 ounce of gold

The British pound is pegged at :

£4.2474 = 1 ounce of gold.

The exchange rate is determined by the relative gold contents:


$20.67 = £4.2474

$4.866 = £1

• 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.


Price-Specie-Flow Mechanism

• Suppose Great Britain experienced a balance of payments imbalance associated with an official settlements surplus.

• 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.


• With stable exchange rates and a common monetary policy, prices of tradable commodities were much equalized across countries.

• Real rates of interest also tended toward equality across a broad range of countries.

• On the other hand, the workings of the internal economy were subservient to balance in the external economy.

• There are shortcomings:– The supply of newly minted gold is so restricted that the

growth of world trade and investment can be hampered for the lack of sufficient monetary reserves.

– Even if the world returned to a gold standard, any national government could abandon the standard.

– Countries with large gold holdings may be able to exert an inordinate influence on the global economy.

– Prices are stable only to the extent that the relative price of gold to goods and services is stable.


The Relationship Between Money and Growth

• Money is needed to facilitate economic transactions.• MV=PY →The equation of exchange.• Assuming velocity (V) is relatively stable, the quantity

of money (M) determines the level of spending (PY) in the economy.

• If sufficient money is not available, say because gold supplies are fixed, it may restrain the level of economic transactions.

• If income (Y) grows but money (M) is constant, either velocity (V) must increase or prices (P) must fall. If the latter occurs it creates a deflationary trap.

• Deflationary episodes were common in the U.S. during the Gold Standard.

Interwar Period: 1918-1941

• Exchange rates fluctuated as countries widely used “predatory” depreciations of their currencies as a means of gaining advantage in the world export market.

• Attempts were made to restore the gold standard, but participants lacked the political will to “follow the rules of the game”.

• The result for international trade and investment was profoundly detrimental.

• Smoot-Hawley tariffs• Great Depression

Economic Performance and Degree of Exchange Rate Depreciation During the Great Depression

Bretton Woods System: 1945-1971

• Named for 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.

• The result was the creation of the IMF and the World Bank.


• 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 U.S. was only responsible for maintaining the gold parity.

• Under Bretton Woods, the IMF and World Bank were created.

• The Bretton Woods is also known as an adjustable peg system. When facing serious balance of payments problems, countries could re-value their exchange rate. The US and Japan are the only countries to never re-value.

The Fixed-Rate Dollar Standard, 1945-1971

• In practice, the Bretton Woods system evolved into a fixed-rate dollar standard.Industrial countries other than the United States : Fix an official par value for domestic currency in terms of the US$, and keep the exchange rate within 1% of this par value indefinitely.

United States : Remain passive in the foreign change market; practice free trade without a balance of payments or exchange rate target.


German markBritish

pound

French franc

U.S. dollar

Gold

Pegged at $35/oz.

Par Value

Par ValuePar

Value

Purpose of the IMF

The IMF was created to facilitate the orderly adjustment of Balance of Payments among member countries by:

• encouraging stability of exchange rates,

• avoidance of competitive devaluations, and

• providing short-term liquidity through loan facilities to member countries

Composition of SDR(Special Drawing Right)

Today: The SDR

• $/SDR: 1.54576– Number of dollars: 0.66

• $ equivalent: 0.66 (42.7%)

– Number of euros:0.423• $ equivalent: 0.555568 (35.9%)

– Number of pounds: 0.111• $ equivalent: 0.179620 (11.6%)

– Number of yen: 12.1• $ equivalent: 0.150572 (9.74%)

Collapse of Bretton Woods

• Triffin paradox – world demand for $ requires U.S. to run persistent balance-of-payments deficits that ultimately leads to loss of confidence in the $.

• SDR was created to relieve the $ shortage.• Throughout the 1960s countries with large $ reserves

began buying gold from the U.S. in increasing quantities threatening the gold reserves of the U.S.

• Large U.S. budget deficits and high money growth created exchange rate imbalances that could not be sustained, i.e. the $ was overvalued and the DM and £ were undervalued.

• Several attempts were made at re-alignment but eventually the run on U.S. gold supplies prompted the suspension of convertibility in September 1971.

• Smithsonian Agreement – December 1971

The Floating-Rate Dollar Standard, 1973-1984

• Without an agreement on who would set the common monetary policy and how it would be set, a floating exchange rate system provided the only alternative to the Bretton Woods system.

The Floating-Rate Dollar Standard, 1973-1984

Industrial countries other than the United States : Smooth short-term variability in the dollar exchange rate, but do not commit to an official par value or to long-term exchange rate stability.

United States : Remain passive in the foreign exchange market; practice free trade without a balance of payments or exchange rate target. No need for sizable official foreign exchange reserves.

The Plaza-Louvre Intervention Accords and the Floating-Rate Dollar Standard, 1985-1999

• Plaza Accord (1985):– Allow the dollar to depreciate following

massive appreciation…announced that intervention may be used.

• Louvre Accord (1987) and “Managed Floating”– G-7 countries will cooperate to achieve

exchange rate stability.– G-7 countries agree to meet and closely

monitor macroeconomic policies.

Value of $ since 1973

IMF Classification of Exchange Rate Regimes

• Independent floating• Managed floating• Exchange rate systems with crawling bands• Crawling peg systems• Pegged exchange rate systems within horizontal

bands• Conventional pegs• Currency board• Exchange rate systems with no separate legal tender

international finance fina 5331 lecture 4: balance of payments a history of monetary arrangements

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