intern

ation

al bu

siness, 5

th edition

chapter 7the international monetary system and the balance of payments

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Chapter Objectives 1

• 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 2

• 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

International Bank forReconstruction and Development

InternationalDevelopmentAssociation

InternationalFinance

Corporation

MultilateralInvestmentGuarantee

Agency

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Objectives of the International Monetary Fund 1

• 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 2

• 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

• 184 member countries as of April 2006

• Membership requires payment of a quota

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The IMF plays a key role in stabilizing the world’s monetary system.

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The Bretton Woods System

• 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

• Bretton Woods system ended August 15, 1971

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Post-Bretton Woods System

• 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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Table 7.1 The Groups of Five, Seven, and Ten

Group of 5 Group of 7 Group of 10

United States United States United States

Japan Japan Japan

Germany Germany Germany

United Kingdom United Kingdom United Kingdom

France France France

Italy Italy

Canada Canada

Netherlands

Switzerland

Belgium

Sweden

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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 7.2 Key Central Banks

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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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 The Brady Plan

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Figure 7.4 The Asian Contagion

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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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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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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

PortfolioInvestment

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Table 7.4 Capital Account Transactions

Maturity Motivation Typical Investments

Portfolio (short-term)

One year or less Investment in or facilitation of international commerce

Checking account balances

Time deposits

Commercial paper

Bank loans

Portfolio (long-term)

More than one year

Investment income

Government bills, notes, bonds

Corporate stocks, bonds

Foreign Direct Investment

Indeterminate Active control of organization

Foreign subsidiaries

Foreign factories

Joint ventures

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Table 7.5 BOP Entries, Capital Account

Debt (Outflow) Credit (Inflow)

Portfolio (short-term) Receiving a payment from a foreigner

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

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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

Assets

Gold

ConvertiblesecuritiesSDRs

Reservepositions

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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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Figure 7.7 The U.S. BOPAccording to Various Reporting Measures