The Monetary System in
the International Arena
Balance Of Payments
The balance of payments provides a record of transactions between domestic and foreign residents. While payments within a country are made in the same currency, payments between residents of different countries involve different currencies.
The balance of payments accounts are compiled through the use of double-entry bookkeeping with credit and debit entries; credit items include all transactions that give rise to foreign exchange inflows whereas debit items include all transactions causing foreign exchange outflows.
Sections:
1.Current account dealing with trade in goods and services
- Capital account dealing with investment flows and transactions in assets
- Official reserves accounts, which equates the overall balance of payments
Exchange Rate
The foreign exchange market sets the exchange rates between different currencies.
The exchange rate is the price of one nation’s currency in terms of anothers.
The demand for a currency arises from its exports and all credit items in the balance of payments accounts while the supply of a currency arises from its imports and all debit items.
Factors That Influence S&D of currencies
Incomes at home and abroad
Relative Inflation
Interest Rates
PPP theory states that inflation and currency depreciation should balance so that the prices of any given product in different countries are equal.
Expectation
Flexible Exchange Rate System
Monetary authorities do not intervene in the foreign exchange market by buying or selling their currencies and let exchange rates be determined in free markets by the laws of demand and supply.
A currency appreciates if its value rises whereas a currency depreciates if its value falls.
Fixed Exchange Rate
A fixed exchange rate is pegged at a certain level, or within a band, by the national monetary authorities and can only be changed by a government decision.
They facilitate trade by providing monetary stability and that they impose discipline on the conduct of macroeconomic policy
However, the correction of balance of payments deficits depends on the adequacy of foreign exchange reserves and that the country is susceptible to destabilizing speculation when it is about to run out of reserves
Exchange rate adjustments are made in an orderly fashion without excessive fluctuations since any deficits or surpluses are eliminated by appropriate exchange rate adjustments.
Allow independence in the conduct of domestic monetary and fiscal policies, which is, in effect, the reverse of the discipline argument for fixed exchange rates
Gold Standard
The gold standard was a system of fixed exchange rates whereby the value of each currency was fixed in terms of gold.
Problems rose because countries could not control domestic money supply.
The Bretton Woods system replaced the gold standard after World War II. Exchange rates were fixed in terms of US dollars and the dollar was fixed in terms of gold.
The system came to end in 1971 as the dollar became overvalued and the United States was running chronic balance of payments deficit.
Since 1971, the world turned into a system of managed exchange rates in which diversity was so great that it is referred to as a nonsystem.