Download International Monetary System

The International
Monetary System
and the Balance
of Payments
Griffin & Pustay
7-1
Copyright 2010 Pearson Education, Inc. publishing as Prentice Hall
International Business, 6th Edition
chapter 7
Chapter Objectives
• Discuss the role of the international
monetary system in promoting
international trade and investment
• Explain the evolution and functioning of
the gold standard
• Summarize the role of the World Bank
Group and the International Monetary
Fund in the post-World War II international
monetary system established at Bretton
Woods
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Chapter Objectives (continued)
• Explain the evolution of the flexible
exchange rate system
• Describe the function and structure of the
balance of payments accounting system
• Differentiate among the various
definitions of a balance of payments
surplus and deficit
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International Monetary System
The international monetary system
establishes the rules by which
countries value and exchange their
currencies and provides a mechanism for
correcting imbalances between a
country’s international payments and
receipts.
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Balance of Payments
The Balance of Payments (BOP)
Accounting System records
international transactions and
supplies vital information about the
health of a national economy and
likely changes in its fiscal and
monetary policies.
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History of the International
Monetary System
• The Gold Standard
• The Sterling-Gold Standard
• The Collapse of the Gold Standard
• The Bretton Woods Era
• The End of the Bretton Woods Era
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The Gold Standard
Countries agree to buy or sell their
paper currencies in exchange for gold
on the request of any individual or firm
and to allow the free export of gold
bullion and coins.
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Fixed Exchange Rate System
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Sterling-Based Gold Standard
• British pound sterling was the most
important currency from 1821 to
1918.
• Most firms would accept either gold
or British pounds.
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Map 7.1 The British Empire, 1913
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The Collapse of the Gold
Standard
• Economic pressures of WWI
• Countries suspended pledges to buy or
sell gold at currencies’ par values
• Gold standard readopted in 1920s
• Dropped during Great Depression
• British pound allowed to float in 1931
– Float: value determined by supply and
demand
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Figure 7.1 The Contraction of
World Trade, 1929-1933
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The Bretton Woods Era
• 44 countries met in Bretton Woods, New
Hampshire, in 1944
• Goal: to create a postwar economic
environment to promote worldwide
peace and prosperity
• Renewed gold standard on modified
basis (dollar-based)
• Created International Bank for
Reconstruction and Development and
International Monetary Fund
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International Bank for Reconstruction and
Development (the World Bank)
• Goal 1: to help finance
reconstruction of European
economies
– Accomplished in mid-1950s
• Goal 2: to build economies of the
world’s developing countries
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Figure 7.2 Organization of the
World Bank Group
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Objectives of the
International Monetary Fund
• To promote international monetary
cooperation
• To facilitate the expansion and balanced
growth of international trade
• To promote exchange stability, to
maintain orderly exchange arrangements
among members, and to avoid
competitive exchange depreciation
• To assist in the establishment of a
multilateral system of payments
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Objectives of the
International Monetary Fund
(continued)
• To give confidence to members by
making the general resources of the IMF
temporarily available to them and to
correct maladjustments in their balances
of payments
• To shorten the duration and lessen the
degree of disequilibrium in the
international balances of payments of
members
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Membership in the IMF
• Open to any country willing to agree
to rules and regulations
• 185 member countries as of 2008
• Membership requires payment of a
quota
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A Dollar-Based Gold Standard
• Countries agreed to peg the value of
currencies to gold
• U.S. $ keystone of system
• Fixed exchange rate system
• Adjustable peg
• Functioned well in times of economic
prosperity
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The End of the Bretton Woods System
• Susceptible to speculative “runs on the
bank”
• U.S. $ became only source of liquidity
necessary to expand international trade
• People questioned the ability of U.S. to
meet obligations (Triffin Paradox)
• IMF created special drawing rights
(SDRs) – paper gold
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• Bretton Woods system ended August 15,
1971
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These runs on the British and French central banks
were a precursor to a run on the most important
bank in the Bretton Woods system—the U.S.
Federal Reserve Bank. Because the supply of gold
did not expand in the short run, the only source of
the liquidity needed to expand international trade
was the U.S. dollar. Under the Bretton Woods
system, the expansion of international liquidity
depended on foreigners’ willingness to continually
increase their holdings of dollars. Foreigners were
perfectly happy to hold dollars as long as they
trusted the integrity of the U.S. currency, and during
the 1950s and 1960s the number of dollars held by
foreigners rose steadily.
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7-22
As foreign dollar holdings increased, however,
people began to question the ability of the United
States to live up to its Bretton Woods obligation.
This led to the Triffin paradox: foreigners
needed to increase their holdings of dollars to
finance expansion of international trade, but the
more dollars they owned, the less faith they had
in the ability of the United States to redeem those
dollars for gold. The less faith foreigners had in
the United States, the more they wanted to rid
themselves of dollars and get gold in return. If
they did this, however, international trade and the
international monetary system might collapse
because the United States did not have enough
gold to redeem all the dollars held by foreigners.
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The End of the Bretton Woods System
• As a means of injecting more liquidity into
the international monetary system while
reducing the demands placed on the
dollar as a reserve currency, IMF
members agreed in 1967 to create
special drawing rights (SDRs). IMF
members can use SDRs to settle official
transactions at the IMF. Thus, SDRs are
sometimes called “paper gold.”
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Performance of the International Monetary
System since 1971
• Most currencies began to float
• Value of U.S. $ fell relative to most major
currencies
• Group of Ten agreed to restore fixed
exchange rate system with restructured
rates of exchange
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International Monetary System
since 1971
• Development of floating exchange rate
system
– Supply and demand for a currency determine
its price in the world market
– Managed float – central banks can affect
supply and demand
• Legitimized in 1976 with the Jamaica
Agreement
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Table 7.1 The Groups of
Five, Seven, and Ten
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Table 7.2 Key Central Banks
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Country
Bank
Canada
Bank of Canada
European Union
European Central Bank
Japan
Bank of Japan
United Kingdom
Bank of England
United States
Federal Reserve Bank
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European Union
• Believed flexible system would hinder
ability to create integrated economy
• Created European Monetary System to
manage currency relationships
• ERM participants maintained fixed
exchange rates among their currencies
• Facilitated creation and adoption of euro
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Map 7.2 Exchange Rate Arrangements as
of 2007
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Figure 7.3 Exchange Rates of Dollar vs. Yen,
the Euro, and the Deutsche Mark, 1970-2005
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International Debt Crisis
• OPEC quadrupled world oil prices
– Resulted in inflationary pressures in
oil-importing countries
– Exchange rates adjusted
– Transfer of wealth
• Countries borrowed more than they could
repay
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Approaches to Resolve the
International Debt Crisis
The Baker Plan
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The Brady Plan
1985 Baker Plan (named after then U.S. Treasury
Secretary James Baker) stressed the importance of
debt rescheduling, tight IMF-imposed controls over
domestic monetary and fiscal policies, and continued
lending to debtor countries in hopes that economic
growth would allow them to repay their creditors. In
Mexico’s case, the IMF agreed to provide a loan
package only if private foreign banks holding
Mexican debt agreed to reschedule their loans and
provide Mexico with additional financing. However,
the debtor nations made little progress in repaying
their loans. Debtors and creditors alike agreed that a
new approach was needed.
• The 1989 Brady Plan (named after the first
Bush administration’s treasury secretary
Nicholas Brady) focused on the need to
reduce the debts of the troubled countries
by writing off parts of the debts or by
providing the countries with funds to buy
back their loan notes at below face value.
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The Balance of Payments
Accounting System
The BOP accounting system is a
double-entry bookkeeping system
designed to measure and record all
economic transactions between
residents of one country and residents of
all other countries during a particular
time period.
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Figure 7.4
The Asian Contagion
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Balance of Payments (BOP)
Accounting System
• Measures and records all economic
transactions between residents of one
country and residents of all other
countries during specified time period
• Provides understanding of performance
of each country’s economy in
international markets
• Signals fundamental changes in country
competitiveness
• Assists policy makers in designing
appropriate public policies
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Four Important Aspects of the
BOP Accounting System
• Records international transactions made in
some time period
• Records only economic transactions
• Records transactions between residents of
one country and all other countries
– Residents include individuals, businesses,
government agencies, nonprofit organizations
• Uses a double-entry system
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Major Components of the BOP
Accounting System
Current Account
Capital Account
Official Reserves
Errors and Omissions
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Types of Current Account
Transactions
• Exports and imports of goods
• Exports and imports of services
• Investment income
• Gifts
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Capital Account
Foreign Direct
Investment
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Portfolio
Investment
Table 7.4 Capital Account Transactions
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Table 7.5 BOP Entries, Capital Account
Debt (Outflow)
Portfolio (short-term)
Portfolio (long-term)
Foreign direct
investment
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Credit (Inflow)
Receiving a payment from a
foreigner
Making a payment to a
foreigner
Buying a short-term foreign
asset
Selling a domestic shortterm asset to a foreigner
Buying back a short-term
domestic asset from its
foreign owner
Selling a short-term
foreign asset acquired
previously
Buying back a long-term
domestic asset from its
foreign owner
Selling a domestic longterm asset to a foreigner
Buying a foreign asset for
purposes of control
Selling a long-term
foreign asset previously
acquired
Buying back from its foreign
owner a domestic asset
Selling a domestic asset
to a foreigner
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Official Reserves Account
• Records level of official reserves
• Four types of assets
– Gold
– Convertible currencies
– SDRs
– Reserve positions at the IMF
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Official Reserves Account
Reserve
positions
Gold
Assets
SDRs
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Convertible
securities
Errors and Omissions
• BOP must balance
• Current Account + Capital Account
+ Official Reserves Account = 0
• Current Account + Capital Account
+ Official Reserves Account +
Errors and Omissions = 0
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Table 7.6. U.S. Balance of Payments in 2007
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Figure 7.5a. Leading U.S. Merchandise
Exports, 2007
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Figure 7.5b. Leading U.S. Merchandise
Imports, 2007
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Figure 7.6. Trade Between the U.S. and its
Major Trading Partners, 2007
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Defining BOPs Surpluses and Deficits
Official Settlements Balance reflects
changes in a country’s official
reserves; essentially, it records the
net impact of the Central Bank’s
intervention in the foreign-exchange
market in support of the local
currency
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Figure 7.7 The U.S. BOP
According to Various Reporting Measures
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