Jin ce- \fter ta& rrket yin rajor
T3:* Es:rerffiaticnal M3*ffi*effiry SysCcr::
The price of every thing rises and falls from time to time anrl place to place; and with every such change the purchasing pou,er of money changes so .far us tlzat thing goes. -Alfred Marshall.
s= L:AR Fi i FJ il * F.i E {r”i” r V E 5 @ Learn how the international monetary system has evoiled from the days of the gold
standard to today’s eclectic currency arrangement.
& Analyze the characteristics of an ideal currency. @ Explain the currency regime choices faced by emerging markel countries.
& Examine how the euro, a single currency for the European Union, was created.
This chapter begins with a brief historv of the international monetary system from the days of the classical gold standard to the present time. The next section describes contemporary cur- rency regimes, fixed versus flexible exchange rates. and the attributes of the ideal currency. The next section analyzes emerging markets and regime choices, including currency boards and dollarization. The following section describes the birth of the euro and the path toward monetary unification, including the expansion of the European Union on May 1,2004.The final section analyzes the trade-offs betrveen exchange rate regimes based on rules, discre- tion, cooperation, and independence. The chapter concludes with the Mini-Case, First Steps in the Globelization of the Yuan, which details the evolution of the Chinese yuan from a purely domestic to an increasingly giobal currencv.
F-$ist*e”y cfl the XerCer”p:aticnal fo{cnetary Systenei Over the ages currencies have been defined in terrns of gold and other items of value, and the international monetary system has been subject to a variety of international agreements. A review of these systems provides a useful perspective against which to understand today’s system and to evaiuate weaknesses and proposed changes in the present system.
Ti*e Gsld $t*n”s*ard. T*76*1S”!3 Since the days of the pharaohs (about 3000 e.c.), goid has served as a medium of exchange and a store of value. The Greeks and Romans used gold coins and passed on this tradition through the mercantile era to the nineteenth century. The great increase in trade during the free-trade period of the late nineteenth century led to a need for a more formalized system tor settling international trade balances. One countrv after another set a par value for its currency in terms of gold and then tried to adhere to the so-called rules of the game.
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i *!
;. t; I .l :.::
i;, i :1,
f ii
t, ii 1ii
i:r ,?.
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59
60 i:,;r :; l. : Global Financial Environment
This larer came to be known as the classical gold standard. The gotd standard as an inter- :iarional monetary system gained acceptance in Western Europe-in the 1870s. The Unitecl States rr,’as something of a latecomer to the system, not officially aclopting the standard urrit 1979.
Ilnder the gold standard, the “rules of the game” were ciear and simple. Each country set the rate at which its currency unit (paper or coin) could be converteci to a iveight of gold. The United States, for example, declared the doliar to be convertibie to gold at a rate of $20.67 per ounce (a rate in effect until the beginning of World War i). The gdtish pound was pegged at f’ 4’2474 per ounce of gold. As long as both currencies rvere freely converiible into gotolTne dollar/pouncl exchang” ,it” *u,
$20.67lounce of sold f4.ur4lt”r,r” rf e”ld
– $4’8665/f
Because the government of each country on the gold standard agreed to buy or sell gold on demand with anyone at its own fixed parity rate. the vaiue of each individuai currency in terms of gold, and therefore exchange rates between currencies, was fixed. Maintaining ade- quate reserves of gold to back its currency’s value was very important for a country
“under
this system. The system also had the effect tf implicitly limiting tire rate at which any individ- ual country could expand its money suppiy. Any growth in the amount of money was limited to the rate at which offrcial authorities couid acquire additional goid.
The gold standard worked adequately until the outbreak of WorlO War I interrupted trade flows and the free movement of gold. This event caused the main trading nations to sus- pend operation of the gold standard.
‘ii-:* Ji:i*rir.*r Y+*l* ,=;’:rJ “‘#*rl* yrj*r lF, !:*.!.+–,,*44 During World War I and the early 792}s,currencies were allowed to fluctuate over fairly wide ranges in terms of gold and in relation to each other. Theoretically, supply ancl demand for a country’s exports and imports causecl moderate changes in an exchang” iut” about a central equilibrium vaiue. This was the same function that gold had performld under the previous gold standard. Unfortunately, such flexible exchange rates did not rvork in an equiiibrating manner. On the contrary: international speculators sold the rveak currencies short, causing them to fall further in value than warranted by real economic factors. Selling shart is a specu- lation technique in which an individual speculator sells an asset such u, u
“uir”n.y to another
party for deliverv at a future date. The speculator. horvever, does not yet own the asset, ancl expects the price of the asset to fall by the date r.r’hen the asset must be purchased in the open market by the speculator for delivery.
The reverse happened with strong currencies. Fiuctuations in currency values could not be offset by the relatively iltiquid forward exchange market except at exorbitant cost. The net result was that the voiume of world trade dicl not grow in the 1920s in proportion to world gross domestic product but instead declined to a very low level with the;dvent of the Great Depression in the 1930s.
The United States adopted a modified gold standar d in 1934 when the U.S. dollar was devalued to $:S per ounce of goid from the $20.67 per ounce price in effect prior to World War I. Contrary to previous practice. the U.S. Treasury traded gold only with foreign cen- tral banks, not private citizens. From 1934 to the end of World War II, exchange ratJs were theoreticaliy determined by each currency’s value in terms of gold. During frorld War II and its chaotic aftermath, however, many of the main trading cuirencies lost their convert- ibiiity into other currencies. The dollar was the only major traCing currency that continued to be convertible.
F{ar*n: at Bretr
The gove tating imtr sive polic represent 1944 (Jul United N purpose \ tem. lt w€ points wa
Althc the leadin and the I John Mal weight.” 1 be decide used befc War l, iha ate pressL
a country) economie:
needs tha The I
U.S. Trea White, anc thau, Jr. T rates) but although tl of the Allie cies shoul should ocr of governn
On tl postwar si was suffici
PARI I Global Financial Environment
purchases and payments between a country and all other countries. It does not add up the value of al1 assers and liabilities of a country on a specific date like a balance sheet does for
an indir,idual firm. T\1,o tvpes of business transactions dominate the balance of payments:
1. Exchange of real assets. The exchange of goods (e.g., automobiles, computets, watches, and texiiles) and services (e.g., banking, consulting, and travel services) for other goods
and services (barter) or for moneY
2. Exchange of financial assets. The exchange of financial claims (e.g., stocks, bonds, loans, and purchases or sales of companies) for other financial ciaims or money
Although assets can be identified as real or financial, it is often easier simply to think of
all assets as goods that can be bought and sold. The purchase of a hand-woven area rug in a
shop in nangtot by a U.S. tourist is not all that different from a Wall Street banker buying a British government bond for investment purposes’
S*F &ce*Lrnling The measurement of all internationai transactions in and out of a country over a year is a
daunting task. Mistakes, errors, and statistical discrepancies will occur. The primary problem
is that double-entry bookkeeping is employed in theory, but not in practice. Individual pur-
cfrase and salb fraRsac-fi’ons sftor:r’ltd-lTr ffreorr’-r€scr’rrf irr .lita.t:r’rrg €rTJ”,;9s;’T .tL€ ba]a’rce ‘e’f payments that match. In reality, the entries are recorded independently’ Currelnt, financial’
and capital account entries are recorded independently of one another, not together as double-
entry bookkeeping would prescribe. Thus. there rvill be serious discrepancies (to use a nice
term for it) between debits and credits.
“t’he Aceslrants sf {he ffialatlce *f Xiaym:enfs The balance of payments is composed of three primary subaccounts: the current account, the ‘
financial account, and the capital account. In addilion, the official reserves account tracks gov-
ernment currency transactions, and a fifth statistical subaccount,the net errors and omissions
accoLtnt,is produced to preserve the balance in the BOP. The international economic rela-
tionships between countries, however, continue to evolve, as the recent revision of the major
u.”orni, within the BOP discussed in the follorving sections indicates.
TFre e urrerlt Ace€qint The current accountincludes all international economic transactions with income or payment
flows occurring within the year, the current period. The current account Consists of four sub-
categories:
1. Goods trade. The export and import of goods is known as the goods trade’ Merchandise trade is the oldest and most tradiiional form of iniernational economic activity. Although
many countries depend on imports of goods (as they should, according to the theory of
comparatiYe advantage), they also normally work to preserve either a balance of goods
trade or even a surPlus.
2. Services trade. The export and import of services is known as the services trade’ Com-
mon international services are financial services provided by banks to foreign importers
and exporters. travel services of airlines, and construction services of domestic firms in
other countries. Fbr the major industrial countries, this subaccount has shown the fastest
growth in the Past decade.
3′ Income’ This is predominantly current incomeassociated with investments that weremade in previous periods’ tt a “u.s. firm created a subsidiary in South Korea to producemetal parts in a previous year’ the proportion of net income that is paid back to ihe par-ent company in the current yeat line aividend) consd;;;; current investment income. f:”T:t:;t'”
wases and salaries puto to ,ro,rr.ria”,rl’;;;k”,., are arso included in rhis 4′ current transfers’ The financial settlements associated with the change in ownership ofreal resources or financial items are called current ounri”.r.’any transfer between coun-tries that is one-way-a gift or grant-is termed u rurr”n’rronsJ.er.Forexample, fundsprovided by the u’s’ governmen”t to aid in the devei”t-“;; of a ress-developed nationwould be a current transfer’ Tiansfers associated witi the transfer of fixed assets areincluded in a separate account, the capital account.
All countries possess some amount of trade, most of which is merchandise. Many smalier ff”0j,””‘#l?;**:1ffi;::ffiJ* in ,r,” way of ,”,ui.”-*0., or irems tr,ut iiri u,,a”.
T}re current account -is
typically dominated by the first component described, the exporrand import of merchandise.’For this reason, the barance oy trair(BoT), which is so widelyquoted in the business press in most countries, r”r”., to th”‘auiil””of exports and imports ofgoods trade oniy’ rf the-country h u rutg”;i.rdustrialized .ourrt.v, irorever, the Bor is some_whalmllJeading, in that service rrade is “rt i;;lrl;;*vs
vvq’lrr, r Exhibit 4’2 summarizes the
‘u,r”ni u..oun_t_1nd its components for the united Statesfor the 20a21009 period. Ar illrJ;;;j, ,rr” u.s. gooo, riJ” barance has been consis_ ;””ijtJ”:.”trrive,
but has been purtiutty oirret by rhe continuing surprus in services rrade
Ga*** Trs#* ‘Exhibit 4’3 places the current account values^of Exhibit 4.2 in perspective over time by divid-ing the current account into its ,.’. *”:*lomponents; 1) giods’trade and z) services tradeand investment income.The first *Jri”r, ,rriking -.rrugZ i, ,i” magnitude of the goods
CHAPTEn 4 TheBalanceof payments
The United States Current Account, 2l}2_2lXg(billions of U.S. dollars)
i:i
t; .i !:
,i.:
tt F:.E:
i :9.
& l”!j
+.,}’i$ t1′, :.:J
;a $: :i
l:. .];:
-1 t:
il. :, 1:
Goods exports Goods imporls
Goods trade balance (BOT) Services trade credits Services trade debiis
Services trade balance lncome receipts lncome payments
lncome balance Current transfers, credits Current iransfers, debits
Net transfers
Current Account Balance
?0-.02 2003 2OO4 686 717 Bl I
-t191.-1264 *1477*1t11 – Eta+u, _ccd _ tj66 2Bg 30j 350 ?91_ ,250 -2s1 58 51 Se
281 320 414 – 254 .-275 _347
27 45 6,7 12 jS 20_77 _87 _tOb
-ob – 72 _84 _461 _s23 _62s
2005 2006 BeB roio
=lQgz :tBQg -783 -844 385 432
-314 _stg72 83 535 682
-463 *634 t2 48 t9 26
-109 -117-90 -91 -729 -804
2007 2008 2009 1164 1309 1073
– I g,B5-, ,?-1 41 , 1977
-82O -832 _5A4 484 530 498
=g6Q _s97 _369 1 18 133 12g 830 797 5BB
-739 -64.5 _467 100 152 121 24 2a c1
*140 -146 _146 -116 -122 _125 – 718 _669 _378
Source; Derived from lnternationat Financiat Statistics,lMF,org, December 20j0.
I Global Financial Environmenl
U.S. Trade Balances on Goods and Services, 1985-2009 (billions of U’S. dollars)
$200
$1 o0
$o
-$100
-$200
-$300
-$400
-$500
$600
-$700
-$Boo
-$900
d e.t ed
rrrrfffffffffffIr
e.. atq a.”.”f s&a+ “”+ e# e-” frd e”. fr”- “””” “.$ “”& “.& “”.- “.e “”.” “”$ .p..
“””” J #akr”tronolt!’iLt*”
rtii -.:F{i
.
r”!
$, llt
:’
ir
f fatFntU’otiGfldt” source: lnternational Monetary Fund, lnternatianat Financial statislics, lN,4F.org, December
2010
trade deficit in the period shown (a continuation of a position created in the early 1980s)’ The
balance on services and income, aithough not large in comparison to net goods trade, has with
few exceptions run a surplus over the past two decades’ The deficits in the BbT of the pasi decade have been an area of considerable concern for
the united States, in both the public and private sectors. Merchandise trade is the original
core of international trade. The manufacturing of goods was the basis of the industrial revo-
iution and the focus of the theory of comparative advantage in international trade. Manufac-
turing is traditionally the sector of the economy that employs most of a country’s workers’
The loods trade deiicit of the 1980s saw the decline of traditional heavy industries in the
unitJo States, industries that through history employed many U.S. workers’ Declines in the
BOT in areas such as steel, automoliles, automoiive parts, textiles, and shoe manufacturing
caused massive economic and social disruption’ LJnderstanding merchandise import and export performance is much like understanding
the market for any silgle product. The demand factors that drive both are income, the eco-
nomic growth rate of ttr”e Ouyer, and price of the product in the eyes of the consumer after pass-
ing thr6ugh an exchange ,ui”. io, example, U.S. merchandise imports reflect the income level of u.s. consumers and’growth of industry. As income rises, so does the demand for imports’
Exports follow th’e same principles, but in the reverse. U.S. manufacturing exports Oepend not on the incomes of U.S. residents, but on the incomes of buyers of U’S’ products
in
ail other countries around the world. When these economies are growing, the demand for
U.S. products rises.
!lllAl’tl,: li 4 TheBalanceof Payments 89
or ral /o-
tc- )rs.
he he ng
rng
lo- SS-
vel
he
th
,rtS
iin for
The service component of the U.S. current account is a mystery to many. As illustrated in
Exhibits 4.2 and 4.3,the United States has consistently achieved a surplus in services trade income. The major categories of services include travel and passenger fares; transportation services; expenditures by U.S. students abroad and foreign students pursuing studies in the United States; telecommunications services; and financial services.
The {-apilal an{l Finalrciill Acctlttnts The capital and financial accounts of the balance of payments measure all international eco- nomic transactions of financial assets.
* The capital account. The capital account is made up of transfers of financial assets and the acquisition and disposal of nonproduced/nonfinancial assets.This account has been intro- duced as a separate component in the IMF’s balance of payments only recently. The mag-
nitude of capital transactions covered is relatively minor, and we will include it in principle in all of the following discussion of the financial account.
t The financial account. The financial account consists of three components: direct invest- ment, portfolio investment,and other asset investment.Financial assets can be classified in a number of different ways, including by the length of the life of the asset (its maturity) and the nature of the ownership (public or private). The financial account, however, uses a third method, the degree of control over assets or operations, as in portfulio investment, where the investor has no control, or direct investment, where the investor exerts some explicit degree of control over the assets.
Direct lnvestment. This investment measure is the net balance of capital dispersed from and into
the United States for the purpose of exerting control over assets. If a U.S. firm builds a new auto- motive parts facility in another country or actually purchases a company in another country this
is a rlirect investment in the U.S. balance of payments accounts, When the capital flows out of the
United States, it enters the balance of payments as a negative cash flow. Il however, a foreign firm purchases a firm in the United States, it is a capital inflow and enters the balance of pay- ments positively.Whenever 10o/o or more of the voting shares in a U.S. company are held by for-
eign investors, the company is classified as the U.S. affiliate of a foreign company, an d as a foreign direct investmenr. Similarly, if U.S. investors hold 10o/o or more of the control in a company out- side the United States, that company is considered the foreign affiliate of a U.S. company’
The 1980s boom in foreign investment into the United States, or foreign resident pur- chases of assets in the United States, was extremely controversial.The source of concern over
foreign investment in any country, including the United States, focuses on two topics: control and profit. Some countries place restrictions on what foreigners may own in their country. This rule is based on the premise that domestic land, assets, and industry in general should be
owned by residents of the country. On the other hand, the United States has traditionally had few restrictions on what foreign residents or firms can own or control; most restrictions remaining today relate to national security concerns. Unlike the case in the traditional debates over whether international trade should be free, there is no consensus that interna- tional investment should necessarily be free. This question is still very much a domestic polit- ical concern first, and an international economic issue second.
The second major source of concern over foreign direct investment is who receives the profits from the enterprise. Foreign companies owning firms in the United States will ultimately profit from the activities of the firms, or put another way, from the efforts of
tliirr:rt i *l lc,i i:*l:;:i:i:iatr *****r;t *al;*rl*c *+:i ;rti*l: sh i #r
Exhibit4.6illustratesthecurrentandfinancialaccountbalancesfortheUnitedStatesover recenr years.The “”hi;i;.;;;”on”
ot th” b;;;;nomic and accountins relationships of the
balance of payments,”ti’inrirr” relation between the ct+rrent
anrl finincial accounts’This
inverse relationship o not u..iO”nral.The *J;il;;t “i ‘ft3
balance of payments’ double-
entrv bookkeeping i”;l;”;y’ “quires ‘rt”‘ ‘i-‘” “.””‘li u”o financial accounts be offsetting’
unliss thecountry,s “#’;;;^#1, ;”*s lrliir ry;toulated
or controlled bv governmen-
tal authoriti “r. CnAo,lfinalnce in fractrcl^!idescribei
one very high profile case in which
government policy has thwarted “”ono*i”rlrt ” ,*in surpluses of china’ countrles expell-
o.nins larse cuilent account deficits “tirrun.”lllnese puichases through equally large
sur-
oi”t”3rt ifi” financial account’ and vice versa’
NetErrorsandomissions.Aspreviouslynoted,becausecurrentandfinancialaccount entries are collected-J;’r””oro”o
,”purut”ty];;;;;-;t statistical discrepancies will occur’
Tlte net errors and omissions account”n””””thut the BOP actually
balances”
oflicialReservesAccount.TheofficialReservesAccountisthetotalreselvesheldbyofficial monetary authorities?,rri” ”
*r”,ry. These reserves are normally composed of the major
currencies used in tr;;il;riiua,uno i#r*t;nru”tion, (so-.att”i “hard currencies”
like rhe U.S. douar, il;;;;; “rro, and Jrp;;;;;;;;eora;-o ‘p””iur
drawing rights’ SDRs)’
rhesignirica”‘”‘l'”J’i'”*;;;;;”‘#ffi “*””*;t:::i::T:r?;HT#J:'”‘?::}
r,*:Jtr’i{*”-“”:r;i’s:xfi’.;?,oi’f,’;:!’;15Jfi#iii;il;v;;;nve*ibrein’lo a fixed amount of some orher
currency ;#’}e;;;i”, ,rt” cn*”‘” y’un was fixed to the
Giobal Financiat Environmenl
currentandcombinedFinancial/capitalAccountBalancesfortheunitedstates’ tnnr-r0On (billions of U’S’ dollars)
w s5g;:
@ffi .:*::
5a:j:
i;rl –
$5:
$1 ,o0o
$800
q.ffffrfflfllll -$600
-s800
-$1’000 i995 1996 1997 1998 1999 2000 2001 2oo2 20ffi 2004
1992 1993 1ev’,
I| Current Account ; FinanciauCapital Accounl
Source: lnternational Monetaty Fund’ lnternationat Financial
statisllcs’ lMF org’ December 2o10
lfr _ji_
20a5 2006 2007 2008 2009
r, I i l\ lj 1 i:: ll ;1 The Balance o{ Payments 93
China’s Ywin SurPluses
Exhibit A illustrates the current and flnancial account balances
for China over recent years’ China’s surpluses in both the cur
rent and financial accounts-termedlhe Double Surp/us in the
business press, is highly unusual. Ordinarily, for example, in the
cases of the United States, Germany, and Great Britain’ a
country will demonstrate an inverse relationship beht/een the
two accounts. This inverse relationship is not accidenial, and
typically illustrates that most large, mature, industrial countries
“finance” their current account deficits through equally large
surpluses in the financial accounl’ For some countries like
Japan, it is the inverse; a cunent account surplus is matched
against a inancial account deficit’
China, however, has experienced a massive current account surplus and a marginal financial account surplus
simultaneously. This is highly unusual, and an indicator of iust
how exceptional the growth of the Chinese economy is’
Although current account surpluses of this magnhude would
ordinarily always create a financial accouni deficit’ the posi-
tive prospects of the Chinese economy have drawn such
massive capital inflows into China in recent years, that the
financial account ioo is in surplus’ lt will be interesting to
watch how these balances perlorm in the coming years’
4.1
China’s Twin Surplus, 1998-2009 (billions of U’S’ Dollars)
$450
$400
$350
$300
$2s0
$200
$ 150
$1 00
$50 I JTIilIL 2002 2003
$oI q4n
r ooa
rl
1 99S 2000 2001 2AO4 2005 2006 2007 2008 2009
ll Current Account I Financial/Capital Account
Source: lrtternalional Monetary Fun d, tnternationat Financiat Statistics,IMF statistics.org, December 2O1O
U.S. dollar for many years. It was the Chinese government’s responsibility to maintain this fixed rate, also called parity rate.If for some reason there was an excess supply of Chinese yuan on the currency market, to prevent the value of the yuan from falling, the Chinese gov-
ernment would have to support the yuan’s value by purchasing yuan on the open market (by spending its hard currency reserves, its official reserves) until the excess supply was eliminated. Under a floating rate system, the Chinese government possesses no such respon-
sibility and the role of official reserves is diminished. But as discussed in Global Finance in
Practice 4.2,the Chinese government’s foreign exchange reserves are now the largest in the
world, and if need be, it probabiy possesses sufficient reserves to manage the yuan’s value for years to come.
Global Financial Environment
such as India (software and cail centers), China, Eastern Europe, Mexico, and the Philippines. This pattern has caused a loss of some lvhite-collar jobs in the United States and Western Europe and a corresponding increase elsewhere.
The **F asld Hxshfing* Fet*S A country’s BOP can have a significant impact on the level of its exchange rate and vice versa, depending on that country’s exchange rate regime. The relationship between the BOP and exchange rates can be illustrated by using a simplified equation that summarizes BOP data:
JI :!:.
.it,:i’ .* ‘*] -‘#i’ iifi
#s i
,*,’
:,1!
t, :.4.1
il: :+1
$ *: It ,f ril
ti t:f :li1 .ri
r t:l.
:ij. :l:. r1:
a:.
+ 1: .lu
!’t; r1′
rii
.; ::.: ,.ti
ltl .i.
.1F
,..*
Current account baiance
(x-M) +
Capital account balance
(cr-co)
Financial account balance
+ (Fr- FO)
Reserve Balance of balance payments
+ FXB BOP
X : exports of goods and services M : tmports of goods and services CI : capiLal inflows
CO : capital outflows F1 : financial infloq,s
FO – financial outflorvs FXB : official monetary reserves such as foreign exchange and goid The effect of an imbalance in the BOP of a country works somewhat differentiy depend-
ing on whether that country has fixed exchange rates. floating exchange rates, or a managed exchange rate system.
Fixed Exchange Rate Gountries. Under a fixed exchange rate system, the government bears the responsibility to ensure that the BOP is flear zero.If the sum of the current and capital accounts do not approximate zero,lhe government is expected to intervene in the foreign exchange mar- ket by buying or selling officiai foreign exchange reserves. If the sum of the first two accounts is greater than zeto, a surplus demand for the domestic currency exists in the worid. To ptese ve the fixed exchange rate, the government musl then interrrene in the foreign exchange market and sell domestic currency for foreign currencies or gold so as to bring the BOP back near zero.
If the sum of the current and capital accounts is negative, an excess suppiy of the domestic currency exists in world markets. Then the government must intervene by buying the domestic currency with its reserves of foreign currencies and gold. It is obviously impor- tant for a government to maintain significant foreign exchange reserve balanceq sufficient to allow it to intervene effectiveiy. If the country runs out of foreign exchange reserves, it will be unable to buy back its domestic currency and will be forced to devalue.
Floating Exchange Rate Gountries. Under a floating exchange rate system, the government of a country has no responsibility to peg its foreign exchange rate. The fact that the current and capital account balances do not sum to zero wili automatically (in theory) alter the exchange rate in the direction necessary to obtain a BOP near zero. For example, a country running a sizable current account deficit, with a capital and financial accounts balance of zero will have a net BOP deficit. An excess suppiy of the domestic currency will appear on world markets. Like ail goods in excess supply, the market wili rid itself of the imbalance by lower- ing the price. Thus, the domestic currency will fall in value, and the BOP will move back toward zero. Exchange rate markets do not always follow this theory, particularly in the short to intermediate term. This delay is known as Ihe J-curve effect (see the next section “Tiade
,-Il
li’ p.
,i:
;;. a ;i:t if ?! .#.
.5.
+ .:4.
f;
I
CHA,PTER 4 TheBalanceof Payments 99
res.
)rn
:sa,
nd rta:
Balances and Exchange Rates”). The deficit gets worse in the short run, but moves back
toward equilibriurn in the long run’
Managed Floats. Atthough still relying on market conditions for day-to-day exchange rate
determination, countri;s;;erating witl managed floats often find.it necessary to take action
to maintain their desired exchange rate values]Therefore, they seek.to alter the market’s val-
uation of a specific exchange rate by influencing the motivatiottt df market activity’ rather
than through direct interv”itiott in the foreign eichange markets’ ) The primary action taken by such governments is to change reiative
interest rates, thus
influencing the economic fundamentais of exchange rate determination’ In the context of
the equation discussed, a change in domestic interest rates is an attempt to alter the term
(CI – CO),especially tlre short-Jerm portfolio component of these capital flows, in order to
restore an imbalance caused by the deficit in the current account’ The power of interest
rate changes on international capital and exchange rate movements can be substantial’
A country with a managed float that wishes to defend its currency may choose to raise
domestic interest rates tJ alftactadditional capital from abroad’ This step will alter market
forces and create additional market demand ftr the domestic currency’ In this process’ the
government signals to exchange market participants that it intends to take measures to
preserve the currency’s value Viithin certain ,urrg”r. The process also raises the cost of locai
borrowing for businesses, howevef, so the policy is seidom without domestic critics’
The **F *nd lnte.r’est Rate* Apart from the use of interest lates to intervene in the foreign exchange market’
the overall
level of a country’s interest rates compared to other countries has an impact on the financial
account of the balance of payments. Relatively low real inte-rest rates should normally stimu-
late an outflow of capital t””ting higher interest rates in other country currencies’.However’ in the case of the United States,lhelpposite effect has occurred’ Despite relatively
low real
interest rates and iarge BOP deficits on current account’ the U’S’ BOP financial account has
experienced offsetting financial inflows .due to relatively attractive U’S’ growth rate
prospects, high levels o”f ptoOu”tiue innovation, and perceived political safety’ Thus’ the finan-
cial account inflows have helped the united States to maintain its lower interest rates and to
finance its exceptionally largi fiscai deficit. However, it is beginning to appear that the favor-
able inflow on the financial”account is diminishing rvhiie the U’S’ balance on cullent account
.is w’orsening.
Th* 8*F ai’!d l*fgtrtisil Rates Imports have the potential to lower a country’s inflation rate’ In particular, imports of lor’ver-
priced goods and iervices place a limit on what domestic competitors charge for comparable
loods ind services. Thus, foreign competition substitutes for domestic competition to main-
lain a lower rate of inflation than might have been the case without imports’
On the other hancl, to the exteni that lower-priced imports substitute for domestic pro-
duction and employment, gross domestic product wiil be lower and the balance on current
account will be more negative.
Sr.aeie BaE*nees and txeErange Kates A country’s import and export of goods and services is affected by changes in exchange,tates’
The transmission mechanism is in principle quite simple: changes in exchange rates change
relative prices of imports and exports, and changing prices in-turn result in changes in
quantities demanded through the price elasticity of demand’ Although the theoretical eco-
nomics appear straightforwird, the reality of global business is more complex.
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