Chap 7 : The International Monetary System and the Balance of Payments

special drawing rights (SDRs

- created in 1967 - IMF members can use SDRs to settle official transactions at the IMF - sometimes called "paper gold - An SDR's value is currently calculated daily as a weighted average of the market value of four major currencies 1) —U.S. dollar, 2) euro, 3) Japanese yen, and 4) British pound sterling—with the weights revised every five years. As of July 2013, the SDR was worth $1.50 in U.S. dollars.

The most recently created regional development bank

- is the European Bank for Reconstruction and Development. It was established by the Western countries to assist in the reconstruction of Central Europe and Eastern Europe after the regions' communist regimes collapse

Avoiding a currency war and ensuring that the international monetary system functions efficiently to promote world commerce

is thus of great importance to world leaders, central bankers, and business people. - The international monetary system exists because most countries have their own currencies.

Memebrs of IMF

- As of 2013, 188 countries were members. - To join, a country must pay a deposit, called a quota, partly in gold and partly in the country's own currency - The quota's size primarily reflects the global importance of the country's economy, although political considerations may also have some effect

Under a flexible (or floating) exchange rate system,

- supply and demand for a currency determine its price in the world market - Since 1973, exchange rates among many currencies have been established primarily by the interaction of supply and demand - We use the qualifier primarily because central banks sometimes try to affect exchange rates by buying or selling currencies on the foreign-exchange market. Thus, the current arrangements are often called a managed float (or, more poetically, a dirty float) because exchange rates are not determined purely by private sector market forces

The 1930s

- were marked by similar economic conflicts. - Many international economists believe that the manipulation of their currencies' values by the United States, the United Kingdom, France, Switzerland, and Belgium deepened and elongated the Great Depression of that decade -

The size of a quota is important for several reasons:

1) A country's quota determines its voting power within the IMF. * usa controls 16.8% of the vote in the IMF *Japan 6.2%, Germany 5.8%, france and UK 4.3%, Canada 2.6%, Russia 2.4%, 2) A country's quota serves as part of its official reserves 3) The quota determines the country's borrowing power from the IMF. * each member borrow up to 25% of its quota from IMF 4) IMF policy allows additional borrowings contingent on the member country's agreeing to IMF-imposed restrictions—called IMF conditionality—on its economic policies

The gold standard effectively created a fixed exchange rate system.

1) An exchange rate is the price of one currency in terms of a second currency. 2) Under a fixed exchange rate system, the price of a given currency does not change relative to each other currency. 3)The gold standard created a fixed exchange rate system because each country tied, or pegged, the value of its currency to gold 4) The United Kingdom, for example, pledged to buy or sell an ounce of gold for 4.247 pounds sterling, thereby establishing the pound's par value, or official price in terms of gold. The United States agreed to buy or sell an ounce of gold for a par value of $20.67. The two currencies could be freely exchanged for the stated amount of gold, making £4.247 = 1 ounce of gold = $20.67. 5) This implied a fixed exchange rate between the pound and the dollar of £1 = $4.867, or $20.67/£4.247.

The Gold Standard

1) 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 2) Under 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, in contrast to mercantilism's hoarding of gold, to allow the free export of gold bullion and coins. 3) In 1821 the United Kingdom: 1st to adopt adopt the gold standard. During the 19 century, Russia, Austria-Hungary, France, Germany, and the United States ( most other important trading countries) did the same.

The Bretton Woods Era

1) Inflation, unemployment, and the costs of rebuilding war-torn economies created political instability that enabled fascist and communist dictators to seize control of their respective governments 2)They also agreed to the creation of two new international organizations that would assist in rebuilding the world economy and the international monetary system: - the International Bank for Reconstruction and Development and the International Monetary Fund.

The World Bank established the International Development Association (IDA) in 1960.

1) The IDA offers soft loans, loans that bear some significant risk of not being repaid. 2) IDA loans carry low or zero interest rates, although the IDA may collect a small service charge (currently 0.75 percent) from borrowers. 3) The loans also have long maturities (normally 35 to 40 years), and borrowers are often granted a 10-year grace period before they need to begin repaying their loans. 4) The IDA's lending efforts focus on the least-developed countries. - A typical loan is the $25 million provided to Guinea to reduce water pollution and lessen waterborne diseases. 5) The IDA obtains resources from the initial subscriptions its members make when joining it, from transferred World Bank profits, and from periodic replenishments contributed by richer countries. 6) In 2012, the IDA made new loan commitments amounting to $14.8 billion.

The Collapse of the Gold Standard

1) The economic pressures of war caused country after country to suspend their pledges to buy or sell gold at their currencies' par values 2) 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 3) Most countries, including the United States, the United Kingdom, and France, readopted the gold standard in the 1920s despite the high levels of inflation, unemployment, and political instability that were wracking Europe 4) The resuscitation of the gold standard proved to be short-lived, however, as a result of the economic stresses triggered by the worldwide Great Depression

THE INTERNATIONAL MONETARY FUND

1) To ensure that the post-World War II monetary system would promote international commerce, the Bretton Woods Agreement 2) to oversee the functioning of the international monetary system

Article I of the IMF's Articles of Agreement lays out the organization's objectives:

1) To promote international monetary cooperation 2) To facilitate the expansion and balanced growth of international trade 3)To promote exchange stability, to maintain orderly exchange arrangements among members, and to avoid competitive exchange depreciation 4)To assist in the establishment of a multilateral system of payments 5) To give confidence to members by making the general resources of the IMF temporarily available to them and to correct maladjustments in their balance of payments 6) To shorten the duration and lessen the degree of disequilibrium in the international balance of payments of members

European Monetary System (EMS)

1) created In 1979 by the EU members 2) to manage currency relationships among themselves. 3) Most EMS members chose to participate in the EU's exchange rate mechanism (ERM) to pledged to maintain fixed exchange rates among their currencies within a narrow range of ±2.25 percent of par value and a floating rate against the U.S. dollar and other currencies

The International Finance Corporation (IFC),

1) created in 1956, is charged with promoting the development of the private sector in developing countries. 2) Acting like an investment banker, the IFC, in collaboration with private investors, provides debt and equity capital for promising commercial activities. - For example, the IFC provided Bangladesh's Lafarge Surma Cement Ltd. with $10 million in equity and $35 million in loans to help it build a $60-million plant capable of producing 1.2 million tons of cement annually. 3) The IFC is also interested in helping small entrepreneurs. In total the IFC provided $15.5 billion of financing in 2012.

According to the resulting Jamaica Agreement,

1) each country was free to adopt whatever exchange rate system best met its own requirements 2) The United States adopted a floating exchange rate. 3) Other countries adopted a fixed exchange rate by pegging their currencies to the dollar, the French franc, or some other currency 4) Still others used crawling pegs, allowing the peg to change gradually over time.

The international monetary system

1) establishes the rules by which countries value and exchange their currencies. 2) It also provides a mechanism for correcting imbalances between a country's international payments and its receipts. 3) the cost of converting foreign money into a firm's home currency—a variable critical to the profitability of international operations— depends on the smooth functioning of the international monetary system.

THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

1) is the official name of the World Bank. 2) Established in 1945, the World Bank's initial goal was to help finance reconstruction of the war-torn European economies. 3)With the assistance of the Marshall Plan, the World Bank accomplished this task by the mid-1950s 4) It then adopted a new mission - to build the economies of the world's developing countries. 5) As its mission has expanded over time, the World Bank has created three affiliated organizations: 1. The International Development Association 2. The International Finance Corporation 3. The Multilateral Investment Guarantee Agency 6) Together with the World Bank, these constitute the World Bank Group. The World Bank, which currently has $134 billion in loans outstanding, is owned by its 188 member countries 7) In reaching its decisions, the World Bank uses a weighted voting system that reflects the economic power and contributions of its members. - The United States currently controls the largest bloc of votes (15.0 percent), - followed by Japan (8.8 percent), - Germany (4.7 percent), * the United Kingdom (4.2 percent), - France (4.2 percent), -China (3.2 percent). 8) To finance its lending operations, the World Bank borrows money in its own name from international capital markets - The World Bank made $20.6 billion in new loan commitments in 2012.

The World Bank

1) may lend only for "productive purposes" that will stimulate economic growth within the recipient country. - An example of such a loan is the $200 million provided to Indonesia to modernize its national highways and improve traffic safety 2) cannot finance a trade deficit, but it can finance an infrastructure project, such as a new railroad or harbor facility, that will bolster a country's economy 3) the World Bank must follow a hard loan policy; that is, - it may make a loan only if there is a reasonable expectation that the loan will be repaid. 3) the World Bank established the International Development Association (IDA) in 1960. - The IDA offers soft loans, loans that bear some significant risk of not being repaid

The balance of payments (BOP) accounting system records

1) records international transactions and supplies vital information about the health of a national economy and likely changes in its fiscal and monetary policies. 2) BOP statistics can be used to detect signs of trouble that could eventually lead to - governmental trade restrictions, - higher interest rates, - accelerated inflation, -reduced aggregate demand, and general changes in the cost of doing business in any given country.

The Louvre Accord

1) signaled the commitment of these five countries to stabilizing the dollar's value

Paralleling the efforts of the World Bank are the regional development banks,

1) such as the African Development Bank, the Asian Development Bank, and the Inter-American Development Bank. 2) These organizations promote the economic development of the poorer countries in their MULTILATERAL INVESTMENT GUARANTEE AGENCY Provides political risk insurance: $2.7 billion of new insurance in 2012 215 respective regions.

The other World Bank affiliate, the Multilateral Investment Guarantee Agency (MIGA),

1) was set up in 1988 to overcome private sector reluctance to invest in developing countries because of perceived political riskiness—a topic covered in Chapter 3. 2) MIGA encourages direct investment in developing countries by offering private investors insurance against noncommercial risks. - For example, MIGA issued $18 million of political risk insurance to Société Nationale de Télécommunications du Sénégal to protect its investment in Ikatel SA, a Mali telephone company, and $115 million in support of the Bujagali hydropower plant in Uganda. 3) In 2012, MIGA underwrote a total of $2.7 billion in political risk insurance

The Bank of England, the United Kingdom's central bank

1) 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 for gold at par value. 2) After the United Kingdom abandoned the gold standard, - a "sterling area" emerged as some countries, primarily members of the British Commonwealth, pegged their currencies to the pound and relied on sterling balances held in London as their international reserves.

History of the International Monetary System

1)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. 2) Silver, for example, was used in trade among India, Babylon, and Phoenicia 2as early as the seventh century b.c.e 3) As the modern nation-states of Europe took form in the sixteenth and seventeenth centuries, their coins were traded on the basis of their relative gold and silver content.

From 1821 until the end of World War I in 1918

1)the most important currency in international commerce was the British pound sterling, a reflection of the United Kingdom's emergence from the Napoleonic Wars as Europe's dominant economic and military power. 2) Most firms worldwide were willing to accept either gold or British pounds in settlement of transactions. As a result, the international monetary system during this period is often called a sterling-based gold standard. 3) The pound's role in world commerce was reinforced by the expansion of the British Empire. The Union Jack flew over so many lands - for example, present-day Canada, Australia, New Zealand, Hong Kong, Singapore, India, Pakistan, Bangladesh, Kenya, Zimbabwe, South Africa, Gibraltar, Bermuda, and Belize—that the claim was made that "the sun never sets on the British Empire.