MIC ECON Lec 16 – International Finance



LEARNING OBJECTIVE The goal of this topic is to derive the financial aspect of international trade on all countries. This is apparent in the balance of payments.

The processes of adjustment of the balance of payments are different in the flexible and fixed exchange rate systems.

Each system has its detrimental economic effects which countries may want to avoid. This, in turn, explains the history of international monetary systems.

BALANCE OF PAYMENTS The balance of payments of a country is a statement of all the transactions of that country with other countries over the period of a year.

The transactions include flows of merchandise, services, unilateral monetary transfers, monetary flows (short or long term), as well as government transfers of official reserves.

There are several measurements of the balance of payments depending on which of these flows are included.

The balance of payments is made of many different flows. For instance, in 1981, the merchandise trade balance of the United States (that is, the exports minus imports) showed a negative $28 billions. The same year, the balance on goods and services was a positive $13 billions.

BALANCE OF PAYMENTS When imports exceed exports a deficit exists in the balance of payments. When exports exceed imports a surplus is present. (The balance of payments would normally also include net monetary flows). Neither deficit nor surplus may continue over a long period of time without some economic adjustment taking place, most often in the exchange rate.

Between 1982 and 1988 a sizable trade deficit was experienced by the United States in its trade with Japan. During that period of time the value of the yen increased by 50% (from 250 yens to the dollar, to 125 yens to the dollar).

FLEXIBLE EXCHANGE RATES Flexible (or freely floating) exchange rates exist when exchange rates are allowed to adjust in response to a deficit or surplus without any intervention of any country.

If a country experiences a surplus, the demand for its currency exceeds the supply and the value of that currency (or exchange rate) will rise. If a country has a deficit, the opposite will take place: the value of that currency will decrease.

The exchange rates between the dollar, the yen, the British pound and the German mark, are allowed to change according to the needs of buyers and sellers of these currencies. This is a flexible exchange rate system. It has been (more or less) in effect since 1971.

FLEXIBLE EXCHANGE RATES DETERMINANTS The determinants of flexible exchange rates are the demand for and supply of a currency, which are mostly attributable to merchandise and monetary flows.

Changes in the merchandise flows (and therefore, exchange rates) are caused by changes in relative prices, relative income levels, tastes and relative inflation rates in two countries.

Flexible exchange rates are also affected by speculation.

The yen increased in value between 1982 and 1988 because there were more buyers of yen (to pay for imports from Japan such as cars and electronic products) than sellers of yen (from proceeds of exports to Japan, such as airplanes and agricultural products). One of the reasons for the larger American imports from Japan is the consumption desire of the American society.

FLEXIBLE EXCHANGE RATES DISADVANTAGES The major disadvantages of flexible exchange rates are that – uncertainty about future changes in exchange rates may reduce international trade, and – export and import-competing industries are subject to instability and structural unemployment.

International transactions take a long time because of distance, numerous formalities, need for custom inspection, bank credit, and so on. Between the day the sale price is agreed upon and the day the merchandise is received 6 months may easily pass. During that time, the exchange rate may change and either the importer has to make a larger payment or the exporter must accept a smaller one.This potential loss discourages international trade.

FIXED EXCHANGE RATES Fixed exchange rates exist anytime a country attempts to prevent the exchange rates from changing as a result of balance of payments deficit or surplus.

Such intervention in the exchange markets must be accompanied by other measures in order to be effective.

Many currencies are tied to other currencies. For instance, the Mexican peso is tied to the U.S. dollar.

FIXED EXCHANGE RATES When a country is committed to maintain its exchange rate at a certain value, intervention in foreign exchange markets must usually be accompanied by

– macroeconomic adjustments (to reduce income spent on imports), – protective tariffs (to reduce imports).
In addition, exchange controls are sometimes imposed; these are restrictions on the purchase of foreign currencies.

To maintain the official parity between the Mexican peso and the U.S. dollar, the Mexican government must discourage excessive purchases of American products. It does that by requiring an import license for any import. It also uses various macroeconomic policy tools.

FIXED EXCHANGE RATES DISADVANTAGES The major disadvantage of fixed exchange rates is the international transmission of economic instability.

Countries are subject to inflation and unemployment transmitted through trade and monetary flows from other countries.

In addition, sufficient reserves must be available to permit intervention in foreign exchange markets.

Finally, various trade restrictions and exchange controls are often present.

The economic slowdown in the United States in 1930 quickly spread to many countries of the world. For instance, the decrease of American purchasers of British products, caused the British economy to slowdown. Had the exchange rate between the dollar and the pound been flexible, the trade deficit would have been absorbed by a change in exchange rate. But the exchange rate was fixed.

GOLD STANDARD The gold standard is one of the forms of a fixed exchange rates system because all currencies have a set equivalent in gold (mint parity).

The system was abandoned in 1934, in part, because of the worldwide transmission of the great depression.

The gold standard also required flows of gold from one country to another.

The official price of gold in the U.K. prior to 1934 was 4.25 British pounds per ounce of gold. The official price of gold in the United States during that time was $20.67 per ounce of gold. These two mint parities required that the exchange rate between the two currencies be: 4.86 dollars per British pound.

FIXED EXCHANGE RATES SYSTEM From 1944 to 1971, a system of pegged exchange rates was used.

Exchange rates were allowed to be flexible within certain pegs, but not beyond: thus, this constituted a fixed exchange rates system.

The system was agreed upon in 1944 at the Bretton Woods Accord, which also created the IMF.

After World War II, the official price of gold in the United States was $35.00 per ounce of gold.The British pound could no longer (since 1934) be converted directly into gold, but it could be exchanged at the rate of $2.40 per pound and the dollars could be converted into gold. This was the gold exchange standard which lasted until 1971.

INTERNATIONAL MONETARY FUND The International Monetary Fund (IMF) was created in 1944 by the Bretton Woods Accord for the purpose of providing reserves to countries which needed them to maintain their fixed exchange rates.

The IMF lends reserves to countries with balance of payments deficit.

The IMF has made loans to many countries which had difficulties in maintaining the value of their currencies. Recently such loans have been made to Mexico and Brazil.

INTERNATIONAL MONETARY SYSTEM An international monetary system must be agreed to by the major nations of the world because the actions of country to maintain its exchange rate may well be frustrated by actions of other countries; thus cooperation is necessary.

This was illustrated in the various fixed exchange rates systems.

At present, the system is neither fixed nor flexible; it is sometimes referred to as managed or dirty float because countries occasionally intervene.

The official announcements of the meetings between the 7 major monetary powers of the world (U.S., Great Britain, Japan, Germany, Canada, France and Italy) often state that these governments want to maintain the value of certain currencies (e.g. the U.S. dollar). This shows that the current International monetary system is not entirely free and flexible.



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