1. INTERNATIONAL MONETARY SYSTEM AND BALANCE OF PAYMENTS

2. CHAPTER 3: INTERNATIONAL MONETARY SYSTEM AND BALANCE OF PAYMENTS LEARNING OBJECTIVES To discuss the role of international monetary system in promoting international trade To look at the history of international monetary system To summarize the role of the World Bank Group and the International Monetary Fund To understand how fixed and floating exchange rates are established To describe the Balance of Payments and indicate its importance for the MN manager

3. Importance of Price Stability in International Trade Dollar has depreciated – went down – weak dollar What does this mean? Depreciation – from ($2 - £1) to ($3 - £1) To opposite – Appreciation – from ($2 - £1) to ($3 - £1) Winners with depreciation: America´s exporting industries (Cheaper products for foreigners) Tourists going to America English students who study in America… UK in its trading with the USA Losers with depreciation: American importing industries (imports are more expensive) Americans who study abroad, American tourists

4. THE UPS AND DOWNS Companies are affected by the uncertainty of financial risk When government intervene to devalue of the purpose of encouraging exports the financial risk is even greater. Name this guy who is shouting from his grave A--- S---- The world loses from an artificial environment!!!!!!

5. THE GOLD STANDARD (British-based) 1879 - 1934 Each nation defined its monetary units in terms of a certain quantity of gold. E.g. $ was 25 grains of gold and £ was 50 grains. Therefore the pound was worth 2 dollars gold $25gr $50gr £1=$2 Each country was suppose to convert paper money into gold at the stipulated rate upon request Therefore, all countries followed a pegged (fixed) system Also, everybody trusted England and the British pound indirectly replaced gold. Practical and “zero” risk World War I broke up, there was mistrust between two camps, England run deficits and trust was lost. England devalued and the system collapsed. Competitive devaluations were also seen.

6. THE MAGIC OF GOLD Gold inflows and outflows provided the relevant mechanism for macroeconomic adjustments (E.g. USA) – Imports Exports - deficit - gold would flow out of USA - money supply - interest rates Aggregate demand (products) - Unemployment - Prices Low prices would encourage exports and discourage imports American demand for £s and supply of pounds Exchange rate remained fixed and BO was eliminated without government intervention (the magic of gold - Keep in mind that if governments intervened due to their unwillingness to submit their economies to painful macroeconomic adjustments (unemployment, falling incomes) then the system would collapse, like it did

7. Bretton Woods Era (Dollar – Based Gold Standard) (1944 – 1973) New Hampshire, Bretton Woods, 1944: International conference of Allied Nations. Create the International Monetary System (IMF) to develop and oversee the stability of a new monetary system. Committed themselves to a fixed adjustable-peg system (±1) If a nation persistently showed deficit then, under the permission of the IMF, it could devalue even more. Each member had to keep reserves (25% of trade volume in gold and 75% in home currency). Currencies were not required to be exchanged with gold. The only exception was the USA. Upon demand by other countries, it was required to sell or buy gold at a fixed price of $35 per ounce and it should not devalue no matter what.

8. The Collapse of the Dollar – Based Gold Standard Did exchange rates remain stable? USA was doing great just after World War II. Not Japan and Europe, though. They were not exporting. They all depended on USA which even gave them zero interest loans and aid under the “Marshal Plan” By 1960, Europe and Japan rebuilt themselves and were really competing with USA USA was now facing problems… and it was not suppose to devalue Under the fear that the dollar would devalue all countries were giving their dollars to USA asking for gold. The mines could not produce so much Nixon finally closed the gold window and the dollar devalued – the system collapsed Most countries returned to a freely floating system

9. Note: Special Drawing Rights Created by IMF in 1967 and became a unit of account It is value was determined according to a basket of strong currencies (FF, $, BP£, DM, Yen) It was an attempt to add liquidity into the international monetary system when many dollars were out of the USA and the USA did not have enough gold to redeem them Sometimes called “paper gold”

10. Freely Floating System Demand and supply between two currencies establishes new equilibrium prices and governments do not intervene. It is a free competitive market. Demand for a domestic currency depends on foreign demand for the domestic products. Supply of a domestic currency depends on the country´s demand for foreign products.

11. Example: The USA $ Vs the British £ Assume that an equilibrium price is at P (where demand meets supply) Fig. 1 Pound to Dollar Quantity of dollars demanded

12. Demand for dollars is high (since British will be paying in dollars for cheaper imports) shift of demand curve to the right, D1 Supply of dollars, therefore, shift of supply curve to the left (S1). Therefore, a higher equilibrium price will be set at P1. Pound to Dollar Quantity of dollars demanded Inflation seen in England (Prices of British goods go up) Demand 1 Supply 1 Price 1 Therefore, a higher equilibrium price

13. What happens to the British £ ? Assume that an equilibrium price is at P (where demand meets supply) Fig. 1 Pound to Dollar Quality of dollars demanded Demand 1 Supply 1 Price 1 Therefore, a lower equilibrium price

14. Maintaining a Fixed Exchange Rate (Government intervention) What did countries do (under the IMF agreement and even today) to maintain a fixed exchange rate – not devalue? Case A: UK in its trading with the USA Assume a trade deficit for the UK – expensive British goods (Imports are up and Exports are down) Demands of $, and demand of £ Supply of $ and supply of £ Therefore, to increase $s supply and reduce £s supply, the Central Bank of England would step in and buy £s so as to give out $s and gold

15. Maintaining a Fixed Exchange Rate (Government intervention) What did countries do (under the IMF agreement and even today) to maintain a fixed exchange rate – not devalue? Case B: UK in its trading with the USA Assume a trade surplus for the UK – (low –priced British goods) Imports are down and Exports are up) Demands of $, and demand of £ Supply of $ and supply of £ Therefore, to reduce $s supply and increase £s supply, the Central Bank of England would step in and buy $s so as to give out £s and gold

16. ΙΜF-Objectives and Role Today It is main purpose was to oversee the functioning of the international monetary system. (Mainly watch over “dirty” floating). With close to 180 members today, the IMF has a role to play, but not a strong one (especially with advanced, developed countries) It influences policies and decisions of weak ones since they need their help (loans) Each member country can bellow from the IMF and according receives “consultation” on economic decisions.

17. The World Bank Group Organized in 1945 and owned by IMF countries Made up of three major organizations A. International Bank for Reconstruction and Development (Finances countries for their economic infrastructure with low interest rates). Originally know as the World Bank. B. International Development Association (Formed in 1960 to provide support to LDCs on a more liberal basis – 50 years loan with “0” interest – than IBRD. C. International Finance Corporation (Provides loans to private enterprises in developing countries, helps on joint ventures between developing and developed countries and helps in the establishment of efficient stock markets.

18. BALANCE OF PAYMENTS An accounting system measuring the flow of economic transactions between the residents of a country and the residents of the rest of the world during a certain period of time It is a double-entry system where for every transaction we observe a debit and credit entry The BOP is divided into several accounts: Current Account A.Merchandise imports and exports (Balance on Merchandise Trade) B.Service imports and exports (Balance on Services Trade) C.Investment Income D.Unilateral Transfers (Private & Public gifts)…. Current A/c Balance Capital Account (Trade in Ownership) A.Direct Investment, B. Portfolio Investment, C. Short-term Capital Official Reserves Account A.Gold export or import, B. Increase/decrease in foreign exchange, C. SDR Error and Ommissions or Net Statistical Discrepancy (To balance it)

19. Importance of BOP to the MN manager Statistics might help us identify emerging markets of goods/services (in- depth analysis of the balance on merchandise and service) Might warm of possible new policies which might affect our profitability (e.g. too many imports might signal an overheated economy and we might see a “tight” money policy. By limiting money supply, consumption might be reduced as well as inventories of businesses) Too many imports might indicate a reduction in foreign – exchange reserves. As a result of that we might witness a devaluation of the country´s currency. Serious persistent deficits increase the risk of lending money in such countries.