Session 5.

The International Monetary

System, The Balance of Payments, and
Foreign Exchange Market

SULISTYANDARI – FEB UNSOED

 Objectives

1. Understanding the role of the international monetary

system in promoting international trade and investment
2. Explaining the evolution and functioning of the gold
standard
3. Summarize the role of the world bank group and the IMF in
the post-World War II international monetary system
established at Bretton Woods
4. Explain the evolution of the flexible exchange rate system
5. Describe the function and structure of the BOPst accounting
system
6. Differentiate among various definitions of a BOPs surplus
and deficit
 History of the International Monetary System

 Today’s international monetary system can trace its

roots to the ancient allure of gold and silver, both of
which served as media of exchange in early trade
between tribes and in later trade between city-states
 As the modern nation-states of Europe took form in
the siixteenth and seventeenth centuries, their coins
were traded on the basis of their relative gold and
silver content.
 The Gold Standard

 Ancient reliance on gold coins as an international

medium of exchange led to the adoption of an
international monetary system known as the gold
standard
 Under the gold standard, countries agree to buy or
sell their paper currencies in exchange for gold on
the request of any individua or firm and, in contrast
to mercantilism’s hoarding of gold, to allow the free
export of gold bullion and coins.
 The gold standard effectively created a fixed
exchange rate system.
 An exchange rate is the price of one currency in
terms of a second currency
 Under a fixed exchange rate system the price of a
given currency does not change relative to each other
currency
 The gold standard created a fixed exchange rate
system because eac country tied, or pegged, the value
of its currency to gold
 Example :

 The UK pledged to buy or sell an ounce of gold for

4.247 poundsterling, thereby establishing the
pound’s par value, or official price in terms of gold.
 The US agreed to buy or sell an ounce of gold for a
par value of $20.67
 The two currencies could be freely exchange for the
stated amount of gold, making 4.247
poundsterling=1 ounce of gold = $20.67
 This implied a fixed exchange rate between the
pound and the dollar of 1 poundsterling=$4.867, or
$20.67/4.247
 The collapse of the Gold Standard

 During WW II, the sterling-based gold standard

unraveled. With the outbreak of war, normal commercial
transactions between the allies (France, Rusia, and the
UK) and the central powers (Austria-Hungary, Germany,
and the Ottoman Empire) ceased.
 The economic pressures of war caused country after
country to suspend their pledges to buy or sell gold at
their currencies’ par values.
 After the war, conferences at Brussels (1920) and Genoa
(1922) yielded general agreements among the major
economic powers to return to the prewar gold standard.
 Most countires, including US, UK and France,
readopted the gold standard in the 1920s despite the
high levels of inflation, unemployment, and political
instability that were wracking Europe.
 The resuscitation of the gold standard proved to be
short-lived, however, due to the economic stresses
triggered by the world wide great depression. The
Bank of England, the UK’s central bank, was unable
to honor its pledge to maintain the value of the
pound.
 On September 21, 1931 it allowed the pound to float,
meaning that the pound’s value would be determined
by the forces of supply and demand and the bank of
England would no longer redeem British paper
currency of gold at par value
 After the UK abandoned the gold standard, a sterling
area emerged as some countries, primarily members
of the
 THE BALANCE OF
PAYMENTS

SULISTYANDARI, SE., M.SI. (FE UNSOED)

 Subtopics

 Balance of Payments Accounting

 The Current Account
 The Capital Account
 The Official Reserve Account
 Double-Entry Bookkeeping
 Statistical Discrepancy
 Measuring the Deficit or the Surplus, or Official
Intervention
 Balance of Payments Accounting

 A Nation’s Balance of Payments is a summary

statement of all its economics transactions with the
rest ot the world during a given year.
 Main components are the :
1. Current Account
2.Capital Account
3.Official Reserve Account
 Continue…..

 Each transaction is entered in the balance of

payments as a credit or a debit.
 A credit transaction is one that leads to the receipt of
a payment from foreigners
 A debit transaction leads to a payment to foreigners
 The Current Account

 Current Account includes trade in goods an services

and unilateral transfers
 Service transactions are travel and transportation,
receipts and payments on foreign investments, and
military transactions
 Unilateral transfers refers to gifts made by
individuals and the government to foreigners, and
gifts received from foreigners.
 Continue…

 The exports of goods and services and the receipt of

unilateral transfers are entered in the current
account as credits (+) because they lead to the
receipt of payment from foreigners.
 On the other hand, the import of goods and services
and the granting of unilateral transfers are entered
as debits (-) because they lead to payments to
foreigners
 The Capital Account

 Capital account shows the change in the nation’s

assets abroad and foreign assets in the nation.
 It includes :
1. Direct investments (building of a foreign plant)
2.Purchase or sale of foreign securities (stocks,
bonds, treasury bills)
3.Change in the nation’s non bank and bank claims
on
4. Liabilities to foreigners during the year
 Continue….

 Increases in the nation’s assets abroad and

reductions in foreign assets in the nation (other than
official reserve assets) are capital outflows or debits
(-) in the nation’s capital account because they lead
to payments to foreigners.
 Decreases in the nation’s assets abroad and increases
in foreign assets in the nation are capital inflows or
credits (+) because they lead to the receipt of
payments from foreigners
 The Official Reserve Account

 The official reserve account measures the change in a

nation’s official reserve assets and the change in
foreign official assets in the nation during the year.
 Include :
1. Gold holdings of the nation’s monetary
authorities,
2. Special drawing rights (SDRs)
3. Nation’s reserve position in the IMF
 Double-Entry Bookkeeping

 D-E Bookkeeping refers to the accounting procedure

whereby whenever a credit or debit transaction is
entered in a nation’s balance of payments, an
offsetting debit or credit, respectively, of a equal
amount is also entered.
 Thus, total credits should always equal total debits
when the three accounts are taken together.
 Reason for Double-entry Bookkeeping

 Every transaction has two sides.

 We sell something, and we receive payment for it
 We buy something, and we must pay for it
 Statistical Discrepancy

 Theoretically, D-E Bookkeeping should result in total

credits beeing equal to total debits when all three
accounts of the balance of payments are taken
together.
 However, because of recording errors and
ommissions, this equality does not usually hold.
 Thus, a special entry called statistical discrepancy is
necessary tp “balance” the nation’s balance of
payments statements
 Measuring the Deficit or the Surplus, or Official
Intervention

 Deficit in the BOP if total debits exceed total credits

in the current and capital account (including
statistical discrepancy), there are net debit balance
 It is also equal to the net credit balance in the
nation’s official reserve account
 continue…..

 The opposite is a surplus in the BOP

 The exceess of total credits over total debits in the
current and capital accounts (including the
allocation of SDRs and the statistical discrepancy)
 It is also equal to the net debit balance in the nation’s
official reserve account
 Continue….

 This measure of the deficit or surplus in the BOP (as

well as the concept itself) is strictly correct only
under a fixed exchange rate system
 Type of Disequilibrium

 Seasonal Disequilibrium
Holiday, summer-winter,
 Cyclical Disequilibrium
change of price, employment rate overcome by fiscal or monetary
policy
 Structural Disequilibrium
change on demand and supply as the production change by
technology, etc overcome by long rung policy
 Speculation Disequilibrium
speculative action, solution: remove the speculation element by
doing the credible policy
FOREIGN EXCHANGE
MARKETS

SULISTYANDARI, SE., M.SI. (FE UNSOED)

 This chapter discuss about:

 Definition and Functions

 The Foreign Exchange Rates
 The equilibrium Foreign Exchange Rate
 Hedging
 Speculation
 Covered Interest Arbitrage
 Exchange Rate Dynamics
 The Eurocurrency Markets
 Definition and Functions

 The Foreign exchange market is the organizational

framework within which individuals, firms and
banks buy and sell foreign currencies and foreign
exchange.
 The foreign exchange market for any currency, say
the Dollar, is composed of all the locations, such as
London, Zurich, Paris, Frankfurt, Singapore,
Hongkong, Tokyo, as well as New York, where
Dollars are bought and sold for other currencies
 Functions of Foreign Exchange Markets

 Transfer of fund
 Purchasing power from one nation and currency to
another
 Provide short-term credits to finance trade and
 Facilities for avoiding foreign exchange risks or
hedging
 The Foreign Exchange Rates

 Foreign exchange rates is the domestic currency

price of the foreign currency.
 This exchange rate is kept the same in all parts of the
market by arbitrage.
 Foreign exchange arbitrage refers to the purchasing
of a foreign currency where is price is low and selling
it where the price is high
 A rise in the exchange rate refers to a depreciation or
a reduction in the value of the domestic currency in
relation to the foreign currency
 A fall in the exchange rate refers to an appreciation
or an increase in the value of the domestic currency
 The Equilibrium Foreign Exchange Rate

 Foreign exchange rate is determined by the

intersection of the market demand curve for and the
market supply curve of the foreign currency
 The demand for foreign exchange arises primarily in
the course of importing goods and services from
abroad and making foreign investments and loans
 The supply of foreign exchange arises in the course
of exporting goods and services and receiving foreign
investment and loans
See Figure 7.1
 Hedging

 Hedging refers to the act of avoiding or covering a

foreign exchange risk
 Need for hedging arises because (spot) exchange
rates fluctuate continuously through time
 Hedging can take place in the spot market, exp: a US
importer who anticipates making a future payment
in pounds, and who worries that the spot rate of the
pound will rise in the future (so that she will need
more dollars than presently to buy the pounds she
needs)
 Continue….

 Can buy the pounds she needs in the spot market

today at today’s spot rate and leave them on deposit
(and earn interest) in London bank until needed to
make the payments
 Continue….

 Hedging usually takes place in the forward market

because it is simpler and at the same time, it does
not tie up the individual’s or firm’s capital or funds.
 Exp: the above US importer, by purchasing pounds
today and holding them until the payment is due , in
effect, paying cash for her imports (the interest she
receives on her pound deposiys could be earned in
the form of a price discount from the exporter by
paying cash)
 Speculation

 Speculation refers to taking of a foreign exchange

risk or an open position in hopes of making a profit
 Opposite of hedging
 If speculatorcorrectly predicts the market, he or she
makes a profit. Otherwise, the speculator incurs a
loss.
 Usually occurs in the forward exchange market
 Covered Interest Arbitrage

 Interest arbitrage refers to the transfer of liquid

funds from one monetary center and currency to
another to take advantage of higher rates of returns
(interest)
 Spatial Arbitrage

 Seek to profit from differences exchange rates for

same currency at different bank
 Triangular Arbitrage

 Converting one currency to another a third currency

, finally converting back into original currency with a
short time span.
 Exchange Rate Dynamics

 Refers to the exchange rate volatility (variability) and

over-shooting
 Over-shooting refers to the tendency of exchange
rate to immediately depreciate or appreciate by more
than required for long-run equilibrium and then to
partially reverse their movement as they move
toward their new long-run equilibrium level.
 The Eurocurrency Markets

 EM are the markets where Eurocurrencies are

bought and sold.
 Eurocurrencies refers to commercial bank deposits
outside the country of issue of the currency
 Exp: a deposit denominated in US dollars in a British
commercial bank (or even in a british branch of a US
banks) is called a Eurodollar.
 Continue…..

 Similarly, a poundsterling deposit outside the UK is

called a Eurosterling, and so on

 The eurocurrency market consists mostly of short-

term funds with maturity of less than six months