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Chapter 4

The International Monetary System and the Balance of Payments

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

Chapter Objectives (continued)


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

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 countrys international payments and receipts.

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.

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

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.

Fixed Exchange Rate System

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.

The British Empire, 1913

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

The Contraction of World Trade, 1929-1933

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

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 worlds developing countries

Figure 7.2 Organization of the World Bank Group

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

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

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

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

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 Bretton Woods system ended August 15, 1971

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

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

PLEASE READ FIXED VERSUS FLEXIBLE EXCHANGE RATES, PP.217.

The Groups of Five, Seven, and Ten

Key Central Banks


Country
Canada European Union Japan United Kingdom

Bank
Bank of Canada European Central Bank Bank of Japan Bank of England

United States

Federal Reserve Bank

Copyright 2010 Pearson Education, Inc. publishing as Prentice Hall

Exchange Rate Arrangements as of 2007

Copyright 2010 Pearson Education, Inc. publishing as Prentice Hall

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.

The Asian Contagion

Copyright 2010 Pearson Education, Inc. publishing as Prentice Hall

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 countrys economy in international markets

Balance of Payments (BOP) Accounting System


Signals fundamental changes in country

competitiveness Assists policy makers in designing appropriate public policies

Four Important Aspects of the BOP Accounting System


Records international transactions made in some

time period
Records only economic transactions

Four Important Aspects of the BOP Accounting System


Records transactions between residents of

one country and all other countries


Residents include individuals, businesses, government agencies, nonprofit organizations

Uses a double-entry system (Debit/ Credit)

Major Components of the BOP Accounting System


Current Account Capital Account Official Reserves Errors and Omissions

Types of Current Account Transactions


Exports and imports of goods
Exports and imports of services Investment income Gifts

Capital Account

Foreign Direct Investment

Portfolio Investment

Capital Account Transactions

BOP Entries, Capital Account


Debt (Outflow) Portfolio (short-term) Receiving a payment from a foreigner Credit (Inflow) Making a payment to a foreigner

Buying a short-term foreign asset

Selling a domestic short-term asset to a foreigner

Portfolio (long-term)

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 long-term asset to a foreigner

Foreign direct investment

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

Official Reserves Account


Records level of official reserves
Four types of assets Gold Convertible currencies SDRs Reserve positions at the IMF

Official Reserves Account


Reserve positions Gold

Assets Convertible securities

SDRs

Errors and Omissions


BOP must balance GOOD! But not realistic

Current Account + Capital Account + Official Reserves Account = 0 VERY GOOD! Realistic Current Account + Capital Account + Official Reserves Account + Errors and Omissions = 0

Table 7.6. U.S. Balance of Payments in 2007

Defining BOPs Surpluses and Deficits


Official Settlements Balance reflects changes in a countrys official reserves; essentially, it records the net impact of the Central Banks intervention in the foreignexchange market in support of the local currency

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