Transcript Industrial countries other than the United States

International Finance
FINA 5331
Lecture 4: Balance of Payments
A History of Monetary Arrangements
Aaron Smallwood Ph.D.
The Current Account
• Includes all imports and exports of goods and
services (invisible trade).
• Includes unilateral transfers of foreign aid.
• If the debits exceed the credits, then a
country is running a trade deficit.
• If the credits exceed the debits, then a
country is running a trade surplus.
• It is thought that the CA responds to changes
in income and the exchange rate.
The Current Account
• Consists of the following:
– Merchandise trade
– Services
– Unilateral transfers
– Investment income
Classifying transactions
• For the current account, we credit
transactions that:
– We naturally think of as exports or that cause
foreign currency to flow into a country
• For the financial account, we debit
transactions that:
– We naturally think of as imports or that cause
foreign currency to flow out of a country
The Financial Account
• The financial account measures the difference
between U.S. sales of assets to foreigners and
U.S. purchases of foreign assets.
• The financial account is composed of Foreign
Direct Investment (FDI), portfolio investments
and other investments.
The Financial Account
• When a domestic entity (firm or individual)
sells an asset to a foreign resident, there will
be a credit recorded on the financial account.
• When a domestic resident buys an asset from
a foreign entity, there will be a debit recorded
on the financial account.
• Note – income earned on these assets is
recorded on the current account, not the
financial account.
Balance of payments
• Financial account
– Includes portfolio investment: Sales of
purchases of financial assets
– Foreign direct investment: Implies investment
where ownership is made by a foreign party
– Other investment: Transactions in currency,
bank deposits, and so on.
• Positive entries (credits) increase liabilities
or decrease assets
The Balance of Payments Identity
BCA + BFA + BRA = 0
where
BCA = balance on current account
BFA = balance on financial account
BRA = balance on the reserves account
• Note: When a country experiences a currency
crisis, we typically see BRA>0 (and HUGE)
Under a pure flexible exchange rate regime,
BCA + BFA = 0
Because BRA = 0
Balance of Payments Trends
• Since 1982 the U.S. has experienced
continuous deficits on the current account
and continuous surpluses on the financial
account.
• During the same period, China has
experienced the opposite.
China BOP
Japan BOP
USA BOP
Balances on the Current (BCA) and Financial (BKA)
Accounts of United Kingdom
United Kingdom
80
Balances in Billions of US dollars
60
Current Account Balance
Financial Account Balance
40
20
0
-20
-40
-60
-80
-100
1981
1986
1991
1996
2001
2006
2011
Official reserves
• In the US official reserve assets include gold,
foreign currency, and special drawing rights
(issued by the IMF).
• The official settlements balance is BCA+BFA
• When BCA+BFA≠0, the central bank must
acquire or deplete holdings of official reserves.
Examples
• Example 3.1: Boeing (US) exports a 747 to Japan
Airlines for $50 million. Japan Airlines pays from its
dollar account at Chase.
• Example 3.3: Ford acquires Jaguar, a British car
manufacturer for $750 million paid from deposits at
Barclay’s.
• Example: In an intervention move, the Federal Reserve
sells RMB10,000,000 in the open market. The RMB are
used by a trader to purchase manufactured goods from
China.
Balance of Payments and National Income
Accounting
•
•
•
•
1.
2.
3.
4.
GNP = Y = C + I + G + X – M
Y=C+S+T
X – M = (S- I) + (T- G)
If a developing economy experiences large
trade deficits (X-M <0), the remedies are:
Savings must increase, S↑
Investment must fall, I↓
Government spending must fall, G↓
Taxes must rise, T↑
International Monetary Arrangements
• International Monetary Arrangements
in Theory and Practice
– The International Gold Standard, 1879-1913
– Bretton Woods Agreement, 1945-1971
– Smithsonian Agreement 1971-1973
– The Floating-Rate Dollar Standard, 19731984
• Jamaica Agreement 1976
– The Plaza-Louvre Intervention Accords (1985
and 1987) and the Floating-Rate Dollar
Standard, 1985-1999
Additionally
• What exchange rate systems exist today?
– The choice between a fixed system and a flexible
system.
• How does another country’s exchange rate
system affect you? How does China’s changing
exchange rate system affect you?
• What are currency crises and how can they
impact your business?
• What is the euro? Will the euro-zone expand?
How does expansion of the euro-zone affect
you?
The International Gold Standard, 1879-1913
Fix an official gold price or “mint parity”
and allow free convertibility between
domestic money and gold at that price.
• Countries unilaterally elected to follow the rules of
the gold standard system, which lasted until the
outbreak of World War I in 1914, when European
governments ceased to allow their currencies to be
convertible either into gold or other currencies.
The International Gold Standard, 1879-1913
For example, during the gold standard,
the dollar is pegged to gold at :
U.S.$20.67 = 1 ounce of gold
The British pound is pegged at :
£4.2474 = 1 ounce of gold.
The exchange rate is determined by the
relative gold contents: $20.67 = £4.2474
$4.866 = £1
The International Gold Standard, 1879-1913
• Highly stable exchange rates under the
classical gold standard provided an
environment that was conducive to
international trade and investment.
• Misalignment of exchange rates and
international imbalances of payment were
automatically corrected by the pricespecie-flow mechanism.
Price-Specie-Flow Mechanism
• Suppose Great Britain experienced a balance
of payments imbalance associated with an
official settlements surplus.
• This cannot persist under a gold standard.
– Net export of goods from Great Britain to France will be
accompanied by a net flow of gold from France to Great
Britain.
– This flow of gold will lead to a lower price level in France and,
at the same time, a higher price level in Britain.
• The resultant change in relative price levels
will slow exports from Great Britain and
encourage exports from France.
The International Gold Standard, 1879-1913
• With stable exchange rates and a
common monetary policy, prices of
tradable commodities were much
equalized across countries.
• Real rates of interest also tended toward
equality across a broad range of
countries.
• On the other hand, the workings of the
internal economy were subservient to
balance in the external economy.
The International Gold Standard, 1879-1913
• There are shortcomings:
– The supply of newly minted gold is so restricted that the
growth of world trade and investment can be hampered for
the lack of sufficient monetary reserves.
– Even if the world returned to a gold standard, any national
government could abandon the standard.
– Countries with large gold holdings may be able to exert an
inordinate influence on the global economy.
– Prices are stable only to the extent that the relative price of
gold to goods and services is stable.
The Relationship Between Money and Growth
• Money is needed to facilitate economic transactions.
• MV=PY →The equation of exchange.
• Assuming velocity (V) is relatively stable, the
quantity of money (M) determines the level of
spending (PY) in the economy.
• If sufficient money is not available, say because gold
supplies are fixed, it may restrain the level of
economic transactions.
• If income (Y) grows but money (M) is constant, either
velocity (V) must increase or prices (P) must fall. If
the latter occurs it creates a deflationary trap.
• Deflationary episodes were common in the U.S.
during the Gold Standard.
Interwar Period: 1914-1945
• Exchange rates fluctuated as countries widely used
“predatory” depreciations of their currencies as a means
of gaining advantage in the world export market.
• Attempts were made to restore the gold standard, but
participants lacked the political will to “follow the rules of
the game”.
• The result for international trade and investment was
profoundly detrimental.
• Smoot-Hawley tariffs
• Great Depression
• Under the Great Depression, Bernanke and Jones shows
countries that stayed on the gold standard longer, tended
to suffer the most.
Bretton Woods System: 1945-1973
• Named for a 1944 meeting of 44
nations at Bretton Woods, New
Hampshire.
• The purpose was to design a postwar
international monetary system.
• The goal was exchange rate stability
without the gold standard.
• The result was the creation of the IMF
and the World Bank.
Bretton Woods System: 1945-1973
• Under the Bretton Woods system, the U.S. dollar
was pegged to gold at $35 per ounce and other
currencies were pegged to the U.S. dollar.
• Each country was responsible for maintaining its
exchange rate within ±1% of the adopted par value
by buying or selling foreign reserves as necessary.
• The U.S. was only responsible for maintaining the
gold parity.
• Under Bretton Woods, the IMF and World Bank were
created.
• The Bretton Woods is also known as an adjustable
peg system. When facing serious balance of
payments problems, countries could re-value their
exchange rate. The US and Japan are the only
countries to never re-value.
The Fixed-Rate Dollar Standard, 1945-1973
• In practice, the Bretton Woods system
evolved into a fixed-rate dollar standard.
Industrial countries other than the United States :
Fix an official par value for domestic currency in terms
of the US$, and keep the exchange rate within 1% of
this par value indefinitely.
United States : Remain passive in the foreign change
market; practice free trade without a balance of
payments or exchange rate target.
Bretton Woods System: 1945-1973
British
pound
German
mark
French
franc
Par
Value
U.S. dollar
Pegged at $35/oz.
Gold
Purpose of the IMF
The IMF was created to facilitate the
orderly adjustment of Balance of
Payments among member countries by:
• encouraging stability of exchange rates,
• avoidance of competitive devaluations,
and
• providing short-term liquidity through loan
facilities to member countries
Composition of SDR
(Special Drawing Right)
Today: The SDR
• $/SDR: 1.54576
– Number of dollars: 0.66
• $ equivalent: 0.66 (44.0%)
– Number of euros:
0.423
• $ equivalent: 0.548208 (36.6%)
– Number of pounds: 0.111
• $ equivalent: 0.169319 (11.3%)
– Number of yen: 12.1
• $ equivalent: 0.121352 (8.1%)
Collapse of Bretton Woods
• Triffin paradox – world demand for $ requires U.S. to
run persistent balance-of-payments deficits that
ultimately leads to loss of confidence in the $.
• SDR was created to relieve the $ shortage.
• Throughout the 1960s countries with large $ reserves
began buying gold from the U.S. in increasing
quantities threatening the gold reserves of the U.S.
• Large U.S. budget deficits and high money growth
created exchange rate imbalances that could not be
sustained, i.e. the $ was overvalued and the DM and
£ were undervalued.
• Several attempts were made at re-alignment but
eventually the run on U.S. gold supplies prompted
the suspension of convertibility in September 1971.
• Smithsonian Agreement – December 1971
The Floating-Rate Dollar Standard, 1973-1984
• Without an agreement on who would set
the common monetary policy and how it
would be set, a floating exchange rate
system provided the only alternative to
the Bretton Woods system.
The Floating-Rate Dollar Standard, 1973-1984
Industrial countries other than the United States :
Smooth short-term variability in the dollar exchange rate,
but do not commit to an official par value or to long-term
exchange rate stability.
United States : Remain passive in the foreign exchange
market; practice free trade without a balance of
payments or exchange rate target. No need for sizable
official foreign exchange reserves.
The Plaza-Louvre Intervention Accords and
the Floating-Rate Dollar Standard, 1985-1999
• Plaza Accord (1985):
– Allow the dollar to depreciate following
massive appreciation…announced that
intervention may be used.
• Louvre Accord (1987) and “Managed
Floating”
– G-7 countries will cooperate to achieve
exchange rate stability.
– G-7 countries agree to meet and closely
monitor macroeconomic policies.
Value of $ since 1973
IMF Classification of Exchange Rate
Regimes
•
•
•
•
•
Independent floating
Managed floating
Exchange rate systems with crawling bands
Crawling peg systems
Pegged exchange rate systems within horizontal
bands
• Conventional pegs
• Currency board
• Exchange rate systems with no separate legal tender