International Monetary System & Trade

Chapter 4: International Monetary System and the Balance of Payments

• Having a weaker currency helps manufacturers domestically because it improves the relative of U.S. exports abroad and make foreign imports to the U.S. more expensive

International Monetary Terminology

• To conduct international business or trade, a well-organized system must exist to settle transactions
• This system must accommodate any changes in patterns, directions, volumes, and nature of financial flows
• This is broadly termed as the International Monetary System (IMS)
• International trade has occurred for thousands of years, monetary settlement is recent
• Barter was the first trading mechanism, this became formalized with systems relying on gold for settlement
• Transactions can be easy when trade is domestic as the country's currency is acceptable to all
• More than one currency creates a need for an internationally accepted basis to settle transactions

Hard Currencies

• A requirement for setting up an IMS is having an international agreement establishing the basis to settle transactions
• The basis makes valuing one country's currency against others necessary
• A currency that forms the basis of settlement has to be accepted by everyone
• Currencies of certain countries have a fairly wide acceptance for settling obligations, these are hard currencies
• U.S. dollar, British pound, Japanese yen, and euro are examples of hard currencies
• Hard currencies can be used by two countries even if it is not the home currency of either
• Trade transactions between Canada and Mexico can be settled in U.S. dollars, acceptable to both, even though it is not their home currency
• An important feature of hard currencies is that there is usually a free and active market for them
• These currencies can be easily acquired and disposed of internationally in large quantities, if necessary
• There are usually few restrictions on the transfer of such currencies in and out of their home countries
• Constructing an international monetary system relies on hard currencies

Soft Currencies

• Soft currencies are not widely accepted as a medium for settling international funancial transactions
• There is usually not a free maket or foreign exchange available for them
• They are not easy to aquire and disposal is more difficult
• Restrictions by monetary or governmental authorites often apply to their transfer in and out of their countries
• Examples include Zimbabwe dollar, North Korean won, and Cuban peso

Convertibility

• The concept of convertibility is linked to hard and soft currencies
• Convertibility is where one currency can be freely converted into another
• Some countries restrict currencies so they cannot be freely converted into others
• This typically occurs in countries with centrally controlled economies where transactions outside the country require official approval
• Covertibility means there is a free and active market for a currency
• A currency that may be unrestricted by governmental regulations for conversion can lack adequate demand outside the country
• These currencies are said to be lacking in convertibility
• Hard currencies possess convertibility, and soft currrencies do not
• Restricting full convertibility of a currency can result in a black market
• The black market is a free market that parallels the official market and provides local currency conversion, but at a substantial premium over the rate
• In developing countries, this market operates around parks, international hotels, or transportation stations
• The inconvertible Zimbabwe dollar has an official exchange rate, but the actual market rate is higher relative to the foreign currency

Exchange Rate

• When the currency of any one country is used to settle an international transaction, its value has to be fixed vis-a-vis the currency of the other country
• This can be directly or in terms of a third currency
• A price for the value of one currency in terms of another country is know as the determination of the exchange rate
• The exchange rate indicates how many units of one currency can be exchanged for one unit of the other currency or vice versa
• Exchange rates are not usually fixed permanently, a currency value may change upward or downward due to a variety of factors
• The the frequency with which the currency value changes depends on the type of exchange-rate arrangement of a currency
• Fundamentally, the movement of the value of a currency can be either up or down

Appreciation

• When the value of a currency is revised or changes upward, it is appreciating
• Appreciation means it has become more expensive in terms of other currencies
• More units of other countries will be needed to purchase the same amount of this currency
• Fewer units of the appreciated currency will buy the same amount of other currency
• If the exchange rate of the pound sterling and U.S. dollar is £1 = US$2 and the pound appreciates by 50%, then £1 = US$3
• More U.S. dollars can be purchased by the same amount of currency, that is £1
• In this example, before appreciation US$2 purchased £1, but after £1 requires US$3

Depreciation

• When the price of a currency is changed downward, it is depreciating
• Upon depreciation, it becomes less expensive in terms of another currency
• Fewer units of the other currency can be purchased with the same amount of the currency after its devaluation
• More units of the depreciated currency are needed to purchase the same amount of foreign currency
• If US$1 buys DKr6 and after a hypothetical depreciation of the dollar, US$1 becomes equal to DKr4
• In effect, after depreciation, US$1 now can buy only DKr4, whereas previously it took US$1.50 to buy DKr6

A Brief History of the International Monetary System

• The first form of an international monetary system emerged in the late nineteenth century
• In 1865, four European countries founded the Latin Monetary Union, it rested on the bimetallic currencies usage that had international acceptability, such as gold and silver

The Gold Standard

• Replaced the bimetallic standard as a system with wide international acceptance
• Lasted from its introduction in 1880 until World War 1 in 1914
• Central feature of the gold standards was that exchange rates of different countries were fixed, values were set in relation to gold

The Gold Specie Standard

• A pure gold standard
• The primary role of gold was an internationally accepted means of settlement with corresponding debits and credits between different nations
• Gold was in the form of coins, being the primary means of settling domestic transactions
• Therefore, the gold specie standard required that gold should be available through monetary authorities at fixed prices in unlimited quantities
• There could be no restraints on the import or export of gold
• Anyone could have coins struck at the mint with the amount of gold required
• Face value of gold coins matched exact intrinsic value
• The amount of coins that a country could issue would be limited to the amount of gold

The Gold Bullion Standard

• The direct link between gold and actual currency that a country could issue was eliminated
• Currency could be in the form of either gold or paper, but the issuing authority of the currency would guarantee to redeem the currency issued in gold on demand at fixed price
• Gold thus backs the issue, but the requirement to maintain exact proportions is eliminated
• The authority could expect that not all the paper currency would come up for redemption at same time
• There was need to maintain a link, but a certain proportion of gold backup had to be maintained to honor redemption
• Widely adopted in the late nineteenth century, the gold bullion standard allowed international transactions to settle fairly easily because each country had defined the value of its currency in terms of gold
• A country with a balance of payments deficit had to lose some of its gold to pay debts to the country with the surplus, leading to a reduction in the money supply and prices
• Because exports increased and imports declined, the balance of payments moved away from the deficit and moved toward equilibrium
• The opposite effect is the surplus, which moved to a balance of payments equilibrium position
• A flaw of the gold standard was that it tended to exacerbate economic conditions between successful and unsuccessful countries
• If Britain purchased goods from France, for example, then gold went France and Britain under the gold standard
• The continual outflow of gold led to fewer reserves, an increase of interest rates, a contraction of loans, a weakening of prices, and cutbacks in output and employment
• In France, the influx of gold would raise reserves, loans, prices, and employment
• Depression resulted in Britain, with France facing speculation
• Exchange rates were fixed under the gold standard and not beyond the upper and lower limits, known as the upper and lower gold points
• Slight fluctuation occurred because of the costs involved in physical movement of equilibrating gold flows from the deficit to the surplus country
• If exchange rates went beyond the gold points, the physical transfer of gold would become remunerative and push the price back within the points
• The gold standard worked well from 1880 to 1914, with the supply of gold steady and the world economy growing steadily
• The British Empire was at its zenith, and London was the center of international trade and finance
• The United Kingdom and the Bank of England inspired confidence in the system
• The outbreak of World War I changed it and pressures on the United Kingdom shook popular confidence
• During the war years, no universal system prevailed, most major currencies were floating freely, and the war effort was financed by the creation of large amounts of money that was not backed gold

The Interwar Years 1918-1939

• After WI the IMS was in disarray
• Currencies had undergone fluctuations, and economies were damaged
• Primarily motivated by Great Britain, returning to the gold standard was attempted
• Great Britain announced a prewar exchange parity linked to gold which was too high
• The exchange rate was unrealistic and overvalued, forcing Great Britain to redeem currency in gold
• While Great Britain tried to maintained a strong currency redeemable in gold, other countries improved their competitive position begun currency devaluations without formal agreement, resulting to a devaluation race
• Arbitrary descions determined the currencies value
• The Great Depression, Germany facing financing reparations, collapsing Austraining bank system and introducing exchange controls, restricted currency convertibility and was symptomatic with international monetary chaos in the 1930's
• United States had become the world's leading economic power, maintaining a relatively undervalued exchange rate with huge balance of payments surpluses
• United States exerted pressure on the economically beleaguered nations of Europe by acquiring substantial quantities of gold, which it financed
• Countries established exchange controls , like Great Britain and France to ensure the availability of foreign exchange for essential imports and currency blocs like dollar area blocs

The Bretton Woods System 1944–1973

• World War 2 recognised that arbitrary, antagonistic exchange-rate and monetary policies for the major industrialized countries were futile
• These policies resulted in lower trade and empolyment levels in countries, a misallocation of resources that retarted their utilization
• United States and Great Britain created a stable monetary system that was internationally acceptable and agreed on after negotiations
• The Bretton Wood agreements adopted a gold exchange standard along proposals that were made, Harry Dexter White made it gold back in the system and revived fixe exchange rates
• Difficulties in rigid exchange rates were recongized and provisions for flexibility were made Participants agreed to stipulate a par value, currencies were linked to the gold content of the U.S. dollar, and limited fluctuations either side
• Par values could not be changed exect with concurence of the International Monetary Fund (IMF)

International Monetary Fund (IMF)

Aims

• Administers the exchange rate arrangements
• Secures orderly monetary conditions
• Promotes international cooperation
• Facilitates growth of internatinal trade
• Promotes exchange rate stability
• To reduce imbalances it makes resources available
• Three goals of the IMF were to administer exchange rate arrangements, correct payments imbalances with financial resoucrse, and provide aforum

Membership

• The IMF had 44 members originally and now has 184, growth was rapid in the 1960s
• Most countries aree now members, with some isolationist nations not members
• Membership is based on a quota, members quota determines their voting power, their subscription determined acces to resources
• Quotas are adjusted to reflect changes, a formula is used to compute quotas
• Trade and variability are cruteria

structure

• The higest decision making body is the board of govenors, whichconsits ministers of Finance
• Day to day operations are overseen by an execotive board the largest quota holders appoint directos
• United States largest quota, followed by Germany, France, Japan, Saudi Arabia

Forms of IMF Assistance

• Offers assistance by making resources available through a range of sources loans are to correct for balane of payment imbalances through four trancheds that equal its quota fund
• The Credit Tranche drawing has loans that are short term

Extended funcility facility

• 1974 provisioned to be of periods to correct structural and policy distortions
• To allow correction without shocks

Compensatory Financing facility

• Primarily established to provide less deveoped countries
• Assistance is provide under specific corrective programs that are spread ver a period of three yrs

IMF Conditionallity

• Impliies policies that members who receive financila sistance from IMF are expectd to follow within economies
• Generate an ability to keep all accounts balanced
• The IMF requires Conditionallity because lending has to be addressed that can generate borrowed capcity -There are four conditions for lending, achievement with realistic exchange trades, tariff, trade and exchange restrictions

special drawing rights

using special drawing rights

• rights represents rights to access resources of equal value
• originated to crisis