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POLICY GOALS: EXTERNAL BALANCE
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Chapter 1
General Economic Concepts
Chapter 2
What is Policy?
Chapter 3
History of Macroeconomic Policies in the United States
Chapter 4
Policy Goals: Maximum Employment
Chapter 5
Policy Goals: Maximum Production
Chapter 6
Policy Goals: Price Stability
Chapter 7
Policy Goals: External Balance
Chapter 8
Subsidiary Policy Goals
Chapter 9
Conflicting Policy Goals
Chapter 10
The Policy Makers
Chapter 11
The Policy Instruments
Chapter 12
The Decision-Making Processes
Chapter 13
The Policy Indicators
Chapter 14
The General Economic Model
Chapter 15
Monetarist Monetary and Fiscal Policies
Chapter 16
Keynesian Monetary and Fiscal Policies
Chapter 17
Debt Management Policies
Chapter 18
Incomes Policies
Chapter 19
Supply Management Policies
Chapter 20
The Long Wave
Chapter 21
Contemporary Issues
"It can be of no consequence to America, whether the commodities she obteains in return for her own, cost Europeans much, or little labour; all she is interested in, is that they shall cost her less labour by purchasing than by manufacturing them herself."

David Ricardo
British Political Economist and Stock Trader
Note 259 (1820)

  1. Balance-of-Payments Accounts
  2. Importance of the Balance
  3. Foreign Exchange Rates
  4. Foreign Exchange Markets
  5. Mechanics of Foreign Exchange Rate Determination: Supply and Demand
  6. International Monetary Arrangements
  7. Historical Experience with International Monetary Arrangements
  8. Foreign Exchange Rates, Relative Prices, and International Trade
  9. International Trade in a Fixed Exchange Rate System
  10. International Trade in a Flexible (Floating) Exchange Rate System and Hedging
  11. International Finance, Covered Interest Arbitrage, and Speculation
  12. General Causes of International Payments Imbalance
  13. Importance of the Dollar in International Trade and Investment
  14. Current Developments
  15. A Lexicon — Trade Interpretations
  16. International Monetary Adjustment: The J Curve
  17. International Monetary Cooperation
  18. Summary
    Readings
    Websites
top    I. Balance-of-Payments Accounts

The balance-of-payments accounts show the net value of all of the cross-border transactions for a country in a given time period. Balance-of-payments transactions are recorded in two accounts: the current account and the capital account.

The Current Account

The current account shows the net value of all current period income flows. Current account transactions include trade in goods and services and unilateral transfers. Current account flows generate income for the recipient country and are included in Gross National Product.

CURRENT ACCOUNT
    + Exports of merchandise
    - Imports of merchandise Balance on merchandise trade
      = Merchandise Trade Balance
    + Exports of services
    - Imports of services
      = Balance on services
    = Balance of Trade

    +/- Unilateral Transfers (excluding military grants), net

    = Balance on Current Account
CAPITAL ACCOUNT
    +/- Foreign Indirect Investment
      - U.S. bank-reported capital, net
      - U.S. purchases of foreign securities, net
      + Foreign purchases of U.S. Treasury securities, net
      + Foreign purchases of other U.S. securities, net
    +/- Foreign Direct Investment
      - U.S. direct investment abroad
      + Foreign direct investment in the U.S.
      +/- Other private capital flows, net
    = Total private capital flows, net
OFFICIAL RESERVE TRANSACTIONS
    + Change in foreign official assets in the U.S.
    - Change in U. S . government official assets, net
      Holdings of convertible currencies
      Reserve position in IMF
      Gold stock
      Special drawing rights (SDRs)
Statistical discrepancy (errors and omissions)
Balance of Trade The balance of trade shows the net value of all newly produced goods and services traded between the home country and the rest of the world. When the home country sells its goods and services to the rest of the world, the transactions are called exports. When the home country exports goods and services, income and international reserves flow into the home country. When the home country buys its goods and services from the rest of the world, the transactions are called imports. When the home country imports goods and services, income and international reserves flow out of the home country. Together, the transactions are called net exports.

Net exports = Exports - Imports

Merchandise trade consists of trade in newly produced tangible goods.

Services consists of trade in intangibles. Transportation and insurance are examples of services. When foreign goods are transported on the home country's carriers and insured by firms in the home country, these transactions are equivalent to exporting these services abroad. Income, money supply, and international reserves flow into the home country. When the home country's goods are transported on foreign carriers and insured by foreign firms, these transactions are equivalent to importing these services from abroad. Income, money supply, and international reserves flow out of the home country.

Tourism consists of trade in travel. When foreigners travel and spend money in the home country, this transaction is equivalent to exporting these goods and services abroad. Income, money supply, and international reserves flow into the home country. When citizens of the home country travel and spend money in foreign countries, this transaction is equivalent to importing goods and services from abroad. Income, money supply, and international reserves flow out of the home country.

Unilateral transfers consists of one-way transfers of income with no quid pro quo. Interest on government debt, government aid, reparations payments, pension payments, subscriptions to international agencies, grants by charitable foundations, and remittances by immigrants to their former home countries (gifts) are examples of unilateral transfer payments. When domiciles of the home country receive these payments from foreigners, the payments are equivalent to exports. Income, money supply, and international reserves flow into the home country. When domiciles of a foreign country receive these payments from domiciles of the home country, the payments are equivalent to imports. Income, money supply, and international reserves flow out of the home country.

The Capital Account

The capital account shows the net value of all asset transfers. The capital accounts finance current account transactions. Capital account transactions include autonomous transactions and accommodating transactions.

Autonomous Transactions are undertaken for their own sake, for the profit they entail or the satisfaction they yield. They are conducted without respect for the overall balance in the international payments accounts. Autonomous transactions include foreign direct investment and foreign indirect investment (both private and public).
  1. Net Private Capital Flows

    1. Foreign Direct Investment Direct investment connotes ownership: buying real estate, factories, and equipment. When foreigners buy assets of the home country, international reserves are transferred into the home country. However, flows of rental and profit income from ownership of the home country's assets may be appropriated abroad as transfers in subsequent periods. Thus, direct investment in the home country represents a longer-term drain on its international reserves. When domiciles of the home country buy assets in foreign countries, international reserves are transferred out of the home country. However, flows of rental and profit income from ownership of foreign assets may be appropriated from abroad as transfers in subsequent periods. Thus, direct investment in foreign countries represents a longer-term accumulation of the home country's international reserves.

    2. Foreign Indirect Investment Indirect investment connotes lending: making loans and buying corporate debt. When foreigners lend to the home country, international reserves are transferred into the home country. However, flows of interest income from foreign lending to the home country may be appropriated abroad as in subsequent periods. Thus, indirect investment in the home country represents a longer-term drain on its international reserves. When domiciles of the home country lend to foreign countries, international reserves are transferred out of the home country. However, flows of interest income from lending by the home country to foreigners may be appropriated from abroad as transfers in subsequent periods. Thus, indirect investment in foreign countries represents a longer-term accumulation of the home country's international reserves.

  2. Net Governmental Capital Flows (including purchase of government debt) When foreigners lend to the home country's government, international reserves are transferred into the home country. However, flows of interest income from foreign lending to the home country's government may be appropriated abroad as transfers in subsequent periods. Thus, foreign buying of the home country's debt represents a longer-term drain on its international reserves. When domiciles of the home country lend to foreign governments, international reserves are transferred out of the home country. However, flows of interest income from lending by the home country to foreign governments may be appropriated from abroad as transfers in subsequent periods. Thus, buying by the home country of foreign governments' debt represents a longer-term accumulation of the home country's international reserves.
Accommodating Transactions are undertaken to balance the international payments accounts. They are the residual money flows (including flows of official reserves) that occur to fill any gaps left by autonomous transactions. The official reserve account is where settlement of the balance of payments in key currencies, gold, and/or SDRs takes place between central banks. If the inflows from export transactions and/or borrowing exceed the outflows from imports and/or lending, international reserves accumulate in the official reserve account. If the outflows from import transactions and/or lending exceed the inflows from exports and/or borrowing, international reserves are drained from the official reserve account.

top    II. Importance of the Balance

Determines External Balance

Net exporter of capital A country whose current account is in surplus is said to be a "net exporter of capital"; that is, either a recipient of money balances (official flows) or a lender.

Net importer of capital A country whose current account is in deficit is said to be a "net importer of capital" that is, either a payer of money balances (official flows) or a borrower.

Determines Internal Balance

Condition for stability A country with a stable international economic footing has its current account driving its capital (financing) accounts, such that the capital accounts become the means for financing net exports and growth in the country.

Condition for instability A country that is on an unstable international economic footing has its capital accounts driving its current accounts, such that exchange rate determination from capital flows determines the competitiveness of a country's goods and services.

top    III. Foreign Exchange Rates

The Foreign Exchange Rate

A foreign exchange rate is the ratio at which one currency exchanges for another. The price or value of one currency is denominated in terms of another currency and the number of units which are required to purchase a unit of another currency is known as the exchange rate. For example, an exchange rate of ¥100/US$ means that a holder of yen, who wants to buy dollars, must spend 100 yen to buy US$1. A holder of dollars, who wants to buy yen, can purchase 1 yen for US$.01.

Generally currencies are quoted in terms of the U.S. dollars (US$), except for the euro (€), the British pound (£), and, maybe, the Canadian dollar (Can$):

¥/US$ and 元/US$, but US$/€ and US$/£

However, it is always best to use the ratio that best reflects the appreciation and depreciation of the currency that is being analyzed when the ratio rises and falls. See Foreign Exchange Rates Updated Daily; The "Full" Universal Currency Converter.

Changes in the Exchange Rate

Revaluation (appreciation) is the act of raising the value of one currency against another; the act of making a currency more expensive in terms of other currencies. For example, if the exchange rate goes from ¥100/US$1 to ¥200/US$1, dollars become more expensive for Japanese to buy. The dollar has appreciated or been revalued upward, and a holder of yen, who wants to buy dollars, must now spend 200 yen to purchase a dollar. At the same time, yen become cheaper for Americans. The yen has depreciated or been devalued, and a holder of dollars, who wants to buy yen, can purchase a yen for only US$.005.

Devaluation (depreciation) is the act of lowering the value of one currency against another; the act of making a currency cheaper in terms of other currencies. If the exchange rate goes down from ¥200/$1 to ¥100/$1, dollars become cheaper in terms of yen and yen become more expensive in dollar terms. A holder of yen, who wants to buy dollars, must spend only 100 yen for each dollar. Meanwhile, a holder of dollars, who wants to buy yen, must pay $.01 for each yen.

Dollar appreciation Appreciation is an increase in the foreign exchange rate. One currency becomes more expensive in terms of another currency. Dollar appreciation is an increase in the dollar exchange rate. The dollar is becoming stronger. As the dollar strengthens, it buys more units of the foreign currencies, making foreign goods cheaper to Americans and American goods more expensive to foreigners.

Dollar depreciation Depreciation is a decrease in the foreign exchange rate. One currency becomes cheaper in terms of another currency. Dollar depreciation is a decrease in the dollar exchange rate. The dollar is becoming weaker. As the dollar weakens, it buys fewer units of the foreign currencies, making foreign goods more expensive to Americans and American goods cheaper to foreigners.

NOTE: For every appreciation (revaluation) of a currency in terms of another, there must be an equal and offsetting depreciation (devaluation) of the currency of denomination.

top    IV. Foreign Exchange Markets

Purpose of the Foreign Exchange Markets

The foreign exchange markets are markets for the purchase and sale of currencies from countries around the world.

Types of Foreign Exchange Markets

Spot market Spot market transactions involve immediate delivery and payment at the current exchange rate (spot rate).

Futures market Futures market transactions involve future payment and delivery at an agreed exchange rate (future rate). Futures contracts are standardized. They are identical, with fixed amounts, fixed maturity dates, and fixed exchange rates.

Forward market Forward market transactions involve future payment and delivery at an agreed exchange rate (forward rate). Forward contracts are specific (non-standardized). They are tailored to users' specific needs.

Location of the Foreign Exchange Markets

No "physical" markets exist for trading currencies. Rather, most trading in currencies is done electronically between international banks on a 24-hour basis. Much of the buying and selling of currencies is done for importers and exporters who need to convert one currency into another to conduct their trade. But, increasingly, much currency trading is related to international investment, such as when a Japanese investor wants to buy U.S. bonds and needs to convert yen to dollars to do so.

The global foreign exchange (forex) market has become an international behemoth that is woven together by modern telecommunications. As of April 2007, average daily turnover is $3.2 trillion. The bulk of transactions is carried out in London, New York, and Tokyo, but Zurich, Frankfurt, Hong Kong, and Singapore are also centers of trading. The key players are (1) the commercial banks, the principal intermediaries for traditional users, ranging from big importers to individual tourists; (2) central banks, which sometimes engage in trading to influence currency rates; and (3) traders and speculators, seeking to make a profit from differences in prices.

Foreign Exchange Market Participants

Central Banks
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Traditional Users <—————> Commercial Banks <—————> Brokers
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Traders and Speculators
Commercial Banks Commercial banks are the leading players in today's foreign exchange market. They are the main source of currency transactions for traditional users of currency, for central banks when they intervene, and for traders and speculators. Most of their dealings are with other banks as they execute trades for their customers or for their own accounts. Large commercial banks have always been active currency traders, but recently securities firms have increased their participation in the market.

Traditional Users This broad category covers just about anyone engaged in a commercial transaction that crosses a national border, from an auto exporter to an international investment firm to a tourist buying a meal in a restaurant. In the past it has generally included manufacturers, importers, exporters, and trading companies. Today, an increasing role is being played by international investors.

Central Banks Central banks are the official players in the market. Each major government has a central bank to manage its domestic money supply. The central bank can play a key role in the foreign currency market when it "intervenes" to try to influence the value of its currency by buying or selling the currency. Most transactions are handled through commercial banks, but central banks sometimes work directly through brokers.

Brokers Brokers are the most specialized group of foreign exchange market players. These firms arrange large currency deals — $1 million or more — among banks. Brokers operate mainly in the largest markets with London, New York, and Tokyo supporting a group of large firms. The pace at a brokerage house is frantic — in an active market, such as the dollar/mark, prices can change several times a second.

Traders and Speculators This disparate group includes individuals, investment managers, and corporate treasurers, all of whom seek short-term profits by betting on the direction they think currency rates will move.

top    V. Mechanics of Foreign Exchange Rate Determination: Supply and Demand

Foreign exchange rates are currency prices and like other prices they are determined by supply and demand forces in the international currency markets. The supply and demand for currencies, in turn, depends on countries' imports and exports, unilateral transfers, and capital movements. This section presumes that foreign exchange participants are buying and selling U.S. dollars against the euro.

Demand

CHANGING DEMAND FOR THE U.S. DOLLAR

€/US$ changefedemand
The demand curve for the dollar (D0) is derived from the foreign demand to import goods services from the United States (U.S. exports), to buy U.S. assets, and to convert foreign currencies into U.S. dollars to make unilateral payments to Americans. Foreign demand for the dollar represents the ability of the U.S. to export goods and services to other countries and to borrow from them. The demand curve is downward sloping because, at higher rates, the dollar is more expensive to foreigners. Each unit of a foreign currency buys fewer dollars and, as a result, foreigners buy fewer U.S. goods, services, and assets. The ability of the U.S. to export declines as its foreign exchange rate rises. When dollar exchange rate falls, the dollar depreciates. The dollar becomes cheaper to foreigners, who can afford to buy more American goods, services, and assets.

Changes in demand from D0 to D1 (and vice versa) result from differential growth, inflation, interest rates among countries, and unilateral transfers.
  1. As other countries grow faster than the U.S., foreigners will increase their demand for dollars from D0 to D1 to buy more U.S. goods, services, and assets. As growth rates in other countries slow relative to that of the U.S., foreigners will decrease their demand for dollars from D1 to D0 to buy less U.S. goods, services, and assets.

  2. As inflation rates in other countries rise faster than that of the U.S., foreigners will increase their demand for dollars from D0 to D1 to buy more U.S. goods, services, and assets. As inflation rates in other countries slow relative to that of the U.S., foreigners will decrease their demand for dollars from D1 to D0 to buy less U.S. goods, services, and assets.

  3. As interest rates in the U.S. rise relative to the rest of the world, foreign investors will increase their demand for dollars from D0 to D1to buy U.S. assets. As interest rates in the U.S. fall relative to the rest of the world, foreign investors will decrease their demand for dollars from D1 to D0.

  4. Foreigners will increase their demand for dollars if they want to make unilateral transfers to the U.S.
When the demand for the dollar increases from D0 to D1, the value of the dollar rises from €2.0/US$1 to €3.0/US$1. When the demand for the dollar decreases from D1 to D0, the value of the dollar falls from €3.0/US$1 to €2.0/US$1.

Supply

CHANGING SUPPLY OF THE U.S. DOLLAR

€/US$ changefesupply
The supply curve for the dollar (S0) is derived from U.S. demand to import foreign goods and services (foreign exports), to buy more foreign assets, and to convert U.S. dollars into foreign currencies to make unilateral payments to foreigners. It represents the ability of foreigners to export goods and services to the United States and to lend to the U.S. The supply curve is upward sloping because, at higher rates, the dollar is cheaper to Americans. Each dollar buys more units of foreign currencies and, as a result, Americans buy more foreign goods, services, and assets. The ability of the U.S. to import declines as its foreign exchange rate falls. When the dollar exchange rate falls, the dollar depreciates. Foreign currencies become more expensive to Americans, who cannot afford to buy as many foreign goods, services, and assets.

Changes in supply from S0 to S1 (and vice versa) result from government or central bank intervention. The central bank of a country (the Federal Reserve in the U.S.) is primarily responsible for regulating the rate of growth of its country's money supply. In the U.S., when the Federal Reserve increases the U.S. money supply, more dollars become available for international transactions, the supply increases from S0 to S1, the foreign exchange rate falls from €3.0/US$1 to €2.0/US$1, and the dollar depreciates. When the Federal Reserve decreases the U.S. money supply, less dollars are available for international transactions, the supply decreases from S1 to S0, the foreign exchange rate rises from €2.0/US$1 to €3.0/US$1, and the dollar appreciates.

Foreign central banks can also affect the supply of any one country's currency. By buying a currency in the open market and taking it out of circulation, central banks contract the supply of that currency from S1 to S0, and the currency appreciates. When these foreign central banks sell the foreign currency, they put it back into circulation and the supply increases from S0 to S1, and the currency depreciates.

top    VI. International Monetary Arrangements

International monetary arrangements are one of three general varieties: floating or flexible exchange rates, fixed or pegged exchange rates, or a managed or dirty float.

Floating (Flexible) Exchange Rates

A floating exchange rate system is an international financial arrangement, whereby exchange rates vary (float) in response to changes in supply and demand. The central bank does not intervene to offset changes in demand or supply of the country's currency. In an ideal world, with fully flexible exchange rates, imbalances in countries' balance-of-payments accounts would automatically be reflected in the market prices of their currencies.

Mechanics

A FLOATING (FLEXIBLE) DOLLAR
flexiblefe
When the demand for dollars increases from D0 to D1, the foreign exchange value of the dollar increases from 2.0dm/$ to 2.5dm/$. When the demand for dollars decreases from D0 to D2, the foreign exchange value of the dollar decreases from 2.0dm/$ to 1.5dm/$. When the supply of dollars increases from S0 to S1, the foreign exchange value of the dollar decreases from 2.0dm/$ to 1.5dm/$. When the supply of dollars decreases from S0 to S2, the foreign exchange value of the dollar increases from 2.0dm/$ to 2.5dm/$.

Advantages and Disadvantages

Advantages The biggest advantage of flexible exchange rates is that central banks are relatively absent from intervention in the foreign exchange markets. Foreign exchange rates are determined solely by the forces of supply and demand for a country's currency, as reflected in the balance-of-payments accounts of the country. Any excess demand for a country's currency resulting from surpluses will automatically be reflected in an appreciation of the foreign exchange rate for that country's currency. The appreciation will make domestic exports and assets more expensive to foreigners and will make foreign imports and assets cheaper to domestic residents. The appreciation alone should be sufficient to discourage continuous surpluses in the future. By the same token, any excess supply of a country's currency from deficits will automatically be reflected in a depreciation of that country's currency. The depreciation will make foreign imports and assets more expensive to domestic residents and will make domestic exports and assets cheaper to foreigners. The depreciation alone should be sufficient to eliminate subsequent deficits. This automatic adjustment prevents a country from having a net balance owing to other countries. Under a flexible exchange rate system, central banks are free to pursue their own independent monetary policies, as foreign exchange rates adjust passively to differential rates of expansion among trading partners.

Disadvantages The biggest disadvantage of flexible exchange rates is loss of convenience to international traders and investors from uncertainty over future exchange values. This uncertainty creates a foreign exchange rate risk not present in a fixed exchange rate system. Orders placed today for production, delivery, and payment in the future involve an exchange rate risk for either the buyer or seller, depending on the contract currency. Only to the extent that futures or forward contracts are available to international traders and investors can they hedge or protect against some of this risk.

Fixed Exchange Rates

A fixed exchange rate system is an international financial arrangement, whereby exchange rates are pegged at some level for long periods of time. The rates are often established by fixing the amount of "grains fine" of gold to the currency unit. When all currencies were fixed in terms of gold, they were automatically fixed in terms of each other. Central banks act as buyers and sellers of last resort to maintain the fixed rates in the event of any payments imbalances.

A FIXED (PEGGED) DOLLAR
fixedfe
When demand for the dollar increases from D0 to D1, the central bank must sell dollars and increase the supply (S+CB) to stabilize the exchange rate at its fixed value of 2.0dm/$. When demand for the dollar decreases from D0 to D2, the central bank must buy dollars and reduce supply (S-CB) to stabilize the exchange rate at its fixed value of 2.0dm/$. When supply of the dollar increases from S0 to S1, the central bank must buy dollars and reduce supply (S-CB) to stabilize the exchange rate at its fixed value of 2.0dm/$. When supply of the dollar decreases from S0 to S2, the central bank must sell dollars and increase supply (S+CB) to stabilize the exchange rate at its fixed value of 2.0dm/$.

Mechanics

Trade surpluses When a country's balance-of-payments is in surplus, the central bank sells its own currency in exchange for foreign currencies. Such surpluses increase a country's international reserves. If a surplus exists for any extended period of time, the country should revalue its currency upward to reflect the increased demand for its output. Unfortunately, appreciation is merely permissive, not mandatory.

Trade deficits When a country's balance-of-payments is in deficit, the central bank buys its own currency by selling foreign currencies. Such deficits decrease a country's international reserves. Should deficits persist, the country's international reserves will be drained to depletion. That country will no longer be able to engage in foreign trade and investment. When a trade deficit persists, the country is forced to devalue its currency and lower the rate at which it is pegged to other currencies. Unfortunately, depreciations are mandatory, not merely permissive.

Advantages and Disadvantages

Advantages

Certainty over the value of transactions One advantage of fixed exchange rates is the convenience it provides for international traders and investors. Importers and exporters always know the value of each others currencies and, therefore, the relative prices between countries. Relative prices are fixed and constant. Importers and exporters can negotiate orders today for production, delivery, and payment in the future with little or no exchange rate risk. Investors can safely move their funds to places where real interest rates are highest, knowing that the return of principal in the future will maintain purchasing power parity with the domestic currency.

Self-regulating mechanism for internal growth and inflation In addition, fixed exchange rates give countries a measure or tool for internal regulation of growth and inflation. If a country experiences high rates of expansion and inflation relative to its trading partners, foreign demand for its exports will decline and domestic demand for imports will go up. As international reserves flow out of the country to pay for its excess of imports over exports, its own money supply will contract, forcing a slowdown in aggregate demand growth, expansion, and inflation.

Disadvantages

Loss of control over the rate of growth of the domestic money supply The disadvantage of fixed exchange rates is that a country loses control over the growth rate of its money supply as its central bank is obliged to support a fixed currency value in the foreign exchange markets. A country's money supply adjusts passively to international forces.

Loss of trade based on expectations of future devaluations When a country is forced to devalue its currency, the lower rate should make its exports more attractive and imports from abroad less attractive. However, once a country starts to devalue its currency, foreigners will anticipate future devaluations. Rather than buy the country's goods after the first devaluation, foreigners will wait to buy at even lower prices after subsequent devaluations. In the interim, the country's trade deficit gets worse before it gets better.

Unwillingness of countries with trade surpluses to revalue their currencies Unfortunately, countries with trade surpluses are generally loathe to appreciate their currencies, because they perceive the trade surplus as a positive event. This refusal and failure to appreciate the currency by the country with the trade surplus leaves countries with trade deficits no choice but to depreciate their currencies.

Managed Float

A managed float is an international financial arrangement, whereby central banks intervene only periodically, not necessarily to support a country's currency, but rather to stabilize volatile fluctuations in foreign exchange rates. A managed float is some times called a "dirty float" because exchange rates are free to fluctuate, but central banks are committed to intervene under conditions of perceived instability. The central bank steps in to offset only so much of a change in demand or supply to bring the exchange rate back into an acceptable "band" or range of exchange rates.

Mechanics

A MANAGED (DIRTY) FLOAT FOR THE DOLLAR
dirtyfloat
When demand increases from D0 to D1, the exchange rate of the country's currency increases. If it increases above the upper bound of the band, the central bank steps in and sells the country's currency to bring it back down within the band.

When demand decreases from D0 to D2, the exchange rate of the country's currency decreases. If it decreases below the lower bound of the band, the central bank steps in and buys the country's currency to bring it back up within the band.
When supply increases from S0 to S1,the exchange rate of the country's currency decreases. If it decreases below the lower bound of the band, the central bank steps in and buys the country's currency to bring it back up within the band.

When supply decreases from S0 to S2, the exchange rate of the country's currency increases. If it increases above the upper bound of the band, the central bank steps in and sells the country's currency to bring it back down within the band.

Advantages and Disadvantages

Advantage The managed float attempts to combine the advantages of both the fixed and flexible exchange rate systems, depending on the degree of instability. The less instability, the less intervention is necessary by central banks and they can pursue quasi-independent domestic monetary policies to stabilize their own economies. The greater the instability, the more intervention is necessary by central banks and the less free they are to pursue independent domestic monetary policies because they are frequently required to use their money supplies to calm disturbances in the foreign exchange markets.

Disadvantage The big problem with a managed float comes in determining the timing and magnitude of the instability and the necessary intervention. Does a one day drop (rise) in a currency warrant intervention? A week? A month? A year? Five years? Is a 1% drop (rise) in a currency's exchange rate destabilizing? A 2% change? A 5% change? A 10% change? If the central banks are too quick to respond or if the amount of intervention is inappropriate, their actions may be further destabilizing. This increased instability has a tendency to dampen international flows and contract world trade. If they wait too long, permanent damage may be done to some countries' trade and investment balances.

The Second Amendment to the International Monetary Fund's Articles of Agreement, adopted in 1978, allows each nation to choose its own exchange-rate policy, consistent with the structure of its economy and its economic goals, but subject to three principles:
  1. When a nation intervenes in the foreign exchange markets to protect its own currency, it must take into account the interests and welfare of other IMF member countries.

  2. Government intervention in the foreign exchange markets should be carried out to correct disorderly conditions in those markets that are essentially short-term in nature.

  3. No member nation should intervene in the exchange markets to gain an unfair competitive advantage over other IMF nations or to prevent effective adjustments in a nation's balance-of-payments position.
top    VII. Historical Experience with International Monetary Arrangements

Pre-World War II

During the 17th, 18th, and early 19th centuries, trading countries were on a gold standard. Gold coins and bullion could be readily transported, especially among the concentrated trading partners of Western Europe. Each country's currency was defined in terms of so many grains of gold and nations participating in the gold standard agreement consented to exchanging their paper monies and gold coins for gold bullion in unlimited amounts at the fixed or predetermined price per grain. The system provided for the flexibility whereby currencies could be converted directly to other currencies at relatively stable prices, based on the gold content of each currency. The biggest disadvantage in the gold standard was the limited supply of gold. Not only are countries unequally endowed with gold resources, the whole supply of gold could not expand fast enough to accommodate the increasing volume of world trade. Besides transporting gold bullion to and from the New World to settle trade imbalances had become an unnecessary inconvenience.

Post-World War II to Early 1970s

From 1944 to 1971, the United States and most of the world operated under a fixed exchange rate system known as the Bretton Woods System. That system was based on plans that were formulated by a group of representatives from 44 nations that met at Bretton Woods, NH, in July, 1944. Under that system, each country agreed to establish with the International Monetary Fund (IMF) a value for its currency and to maintain the exchange rate of its currency within a specified range. The United States, as lead country, pegged its currency to gold, promising to redeem dollars for gold at an official price of $35 an ounce. All other currencies were tied to the dollar and its gold redemption value. While the value of the dollar was tied strictly to gold at $35 an ounce, other currencies, tied to the dollar, were allowed to vary in a narrow band of 1% around their official rates.

From 1947 until 1958, the U.S. deliberately encouraged an outflow of dollars, and, from 1950 on, the United States ran a balance of payments deficit with the intent of providing liquidity for the international economy. Dollars flowed out through various U.S. aid programs (the Marshall Plan and other generous aid programs) and heavy spending on U.S. troops abroad, particularly in Germany and South Korea. Great quantities of dollars accumulated in central bank vaults overseas. By the summer of 1971, other countries held three times more dollars than the U.S. held in gold. If all foreigners decided to redeem these dollars at once, the U.S. would have had to go into default.

One country, in particular, put pressure on the U.S.: France. At the time, France's President was Charles De Gaulle. De Gaulle did not like the U.S. He detested the fact that the U.S. dollar had become a major world currency. De Gaulle wanted a return to the gold standard. De Gaulle vowed to bury America. De Gaulle was a staunch mercantilist, still believing that the wealth of a nation lay in its stock of precious metals. De Gaulle accumulated dollars to redeem at the U.S. Treasury for gold. He dared other countries to follow France's lead and cash in their dollars for gold. He thought that, if all of the countries cashed in their dollars and the U.S. had no more gold, it would fold. Spain, another major mercantilist country, followed suit.

Money: De Gaulle v. the Dollar, Time, 12 Feb 1965

At first President Nixon devalued the dollar by raising the gold redemption price to $45 per ounce. When that failed to stem the tide of foreign redemptions, he closed the gold window and refused to redeem any dollars for gold. Bretton Woods and the post-WW II fixed exchange rate system collapsed.

In 1973, after the collapse of Bretton Woods, IMF member nations widened the band of float to 2.25%. Unfortunately, the elimination of capital controls and improved telecommunications and computerized fund-transfer techniques allowed speculators to move funds quickly and efficiently around the world in anticipation of fluctuations and intervention, so that even this widened band was difficult to support and eventually suspended.

Current International Monetary Arrangements

The current global exchange system is divided into two parts: floating currencies and pegged currencies. Most of the developed countries are floaters. The value of a floaters' currency is determined by demand and supply forces operating in the marketplace. Some of the floaters, for example, Brazil, Colombia, and Portugal, manage their floats in response to inflation rates. A small number of floaters set currency-value targets based upon the level of growth in their reserve assets. The remaining countries are "peggers." The value of a pegger's currency is tied to another major currency. For example, the Argentine peso and the Korean won are tied to the U.S. dollar, while Madagascar's currency is tied to the French franc and Gambia's monetary unit is tied to the pound sterling. Some countries — Burma, Kenya, Jordan, and Vietnam — have pegged their currency values to the SDR. The current value of the SDR is the trade-weighted value of the four key currencies (the U.S. dollar, the euro, the Japanese yen, and the British pound sterling).

European Monetary System

From its inception in the early 1950s to 1999, the European Economic Community (EEC) under the European Monetary System (EMS) maintained a fixed rate system among the currencies of the member nations. Member nations were required to support their currencies within a 2.25% band, while the basket of EMS currencies floated against other world currencies. Initially, eleven (Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain) of the 15 members of the EEC joined together to adopt a common currency, called the "euro." During the transition phase, between 1999 and 2002, the countries' individual currencies were allowed to float against the euro in a narrow band. Today, 22 countries (the original 11 countries plus Andorra, Cyprus, Greece, Kosovo, Malta, Monaco, Montenegro, San Marino, Slovakia, Slovenia, and Vatican City) use the euro. The euro floats against all other currencies of the world.

Currency Substitution

Currency substitution is the act of replacing the home country's local currency with a foreign currency. This replacement may be unofficial, semiofficial, or official. Unofficial currency substitution occurs when residents of one country hold the currency or bank deposits denominated in the currency of another country, but the government still recognizes its local currency as legal tender for payment of all public and private debts. Semiofficial currency substitution occurs when the home country adopts the foreign currency as legal tender and many bank deposits are denominated in the foreign currency, but the local currency is still used for intra-country transactions and tax payments. Official currency substitution occurs when the home country officially designates the foreign currency as legal tender. The home country issues no currency of its own, all assets and liabilities are denominated in the foreign currency, all contracts are written in the foreign currency, and all payments between private parties and payments by and to the government are made in the foreign currency. If local currency exists, it consists only of coins having small value and plays only a nominal role in all transactions. Currency substitution has all of the advantages of pegged exchange rates, without the threat of devaluation, and all of the disadvantages, plus some others.

Unofficial currency substitution is the most common and has existed for years. The primary benefit of substitution is to protect wealth from inflation in the local currency. Countries that have substituted a foreign currency for the local currency, in part or in whole, generally suffer from high inflation rates, high interest rates, and unstable currencies. High inflation rates mean that local banks must offer high interest rates to attract and keep local currency deposits. High inflation rates also mean that businesses must pay high interest rates to obtain financing for investment. High interest rates deter local investment. To offset high inflation and high interest rates, the governments devalue the local currency. However, continual devaluations retard foreign direct and indirect investment in the country and reduce net capital inflows. To stabilize economy activity and capital flows, these countries pursue a currency partner whose currency is strong, stable and internationally accepted.

Dollarization

Dollarization is a form of currency substitution under which countries replace their local currencies with the U.S. dollar. The local currency ceases to exist, and the dollar acts as the country's unit of account, medium of exchange, store of value, and standard for deferred payment. All local currency is converted into dollar notes, all assets and liabilities are denominated in dollars, all prices are quoted in dollars, and all transactions are conducted in dollars.

The money supply in an officially dollarized economy works similarly to the way it works within the United States. If people want to accumulate dollars, they spend less; if they want to get rid of dollars, they spend more. When a common currency is shared, especially if reinforced by free trade, prices in the adopting country tend to converge to U.S. levels. The commonality of the currency, without capital controls, also causes interest rates in the adopting country to converge to U.S. levels. Market imperfections may cause interest rates and inflation rates to differ between the adopting country and the United States just as they differ between Philadelphia and Los Angeles, but the tendency is toward convergence.

The main difference between a dollarized country and Philadelphia or Los Angeles is that the banks in the dollarized country lack access to the Federal Reserve System as a lender of last resort. The Federal Reserve acts as a lender of last resort only to U.S. banks, not to banks from other countries. However, banks in dollarized countries may borrow in local money markets that are closely linked to world markets through the presence of U.S. and other foreign banks. The head offices of those banks can act as sources of emergency funds for their own branches and for other banks in the dollarized country. It is also possible for a dollarized country to establish an international line of credit, such as Argentina has established for its currency board-like system. So, a dollarized system has or can devise substitutes for a central bank as a lender of last resort.

A dollarized country has no need for exchange controls to support the local currency. Dollars flow in and out of the country from trade, unilateral transfers, and capital exchanges.

Panama has used the US dollar since 1904, although it is called the Balboa for nationalistic reasons. In 2000, Ecuador abandoned its domestic currency and adopted the U.S. dollar as its own currency. It made the decision to dollarize because the local government was unable to demonetize when inflation was high and to remonetize when inflation was low. In both cases, dollarization is expected to reduce the adverse effects of capital flight on domestic financial intermediation. However, the effectiveness of this measure hinges crucially on the public's confidence on the sustainability of the dollarization regime.

top    VIII. Foreign Exchange Rates, Relative Prices, and International Trade

Comparative advantage is the differences in the prices of goods and services that reflect relative scarcity of factor inputs between two countries. If the same quality good or service is available from a foreign country at a lower price, the home country will import the good or service. If the same quality good or service is available from the home country at a lower price, the home country will export the good or service. However, that conclusion only holds under a fixed exchange rate and relative prices may be distorted by changing the foreign exchange rate of the countries' currencies. As a result, whether or not trade takes place, depends not only on the relative prices of the goods or services, but also on the rate at which one currency is exchanged for the other currency to buy the foreign good or service.

  NO TRADE
Exchange Rate Price (U.S. car) Price (German car)
€/US$ US$/€ in US$ in € in € in US$
Original exchange rate
P(US) = P(Ger)
€1.5/US$ US$.67/€ US$30,000 €45,000 €45,000 US$30,000
  When the exchange rate equals the relative price ratio, no trade takes place. The €1.5/US$ ratio is 1.5 and the ratio of the price of the German car in euros to the price of the German car in dollars is €45,000/$30,000 or 1.5. The US$.67/€ ratio is 2/3 and the ratio of the price of the American car in dollars to the price of the American car in euros is US$30,000/€45,000 or 2/3. The American car costs US$30,000 in either the U.S. or Germany and the German car costs €45,000 in either the U.S. or Germany. Americans can either spend US$30,000 for an American car or spend US$30,000 to buy 45,000 euros to buy the German car. Germans can either spend €45,000 to buy the German car or spend 45,000 euros to buy US$30,000 to buy the American car. Because the price of the cars is the same in the U.S. or Germany, the Americans and Germans are indifferent about buying their own cars or trading. Americans and Germans alike find it just as efficient to buy locally as to import and no trade takes place.


  AMERICANS IMPORT GERMAN CARS
Exchange Rate Price (U.S. car) Price (German car)
€/US$ US$/€ in US$ in € in € in US$
US$ appreciates/
€ depreciates
€2.0/US$ US$.50/€ US$30,000 €60,000 €45,000 US$22,500
  When the dollar appreciates from €1.5/US$ to €2.0/US$ and the euro depreciates from US$.67/€ to US$.50/€, trade takes place. When the €/US$ ratio rises from 1.5/1 to 2/1, the ratio of the price of the German car in euros to the price of the German car in dollars rises from €45,000/US$30,000 to €60,000/US$30,000 or 2/1. Similarly, when the US$/€ ratio drops from US$.67/€ to US$.50/€, the ratio of the price of the American car in dollars to the price of the American car in euros rises from US$30,000/€22,500 to US$45,000/€22,500 or 2/1. The German car still costs €45,000 in Germany, but it costs only US$22,500 in the U.S. The American car still costs US$30,000 in the U.S., but its cost rises to €60,000 in Germany. The German car at US$22,500 is now cheaper in the U.S. than is the American car at US$30,000 and the American car at €60,000 in Germany is more expensive than is the German car at €45,000. As a result, Americans import German cars.


  GERMANS IMPORT AMERICAN CARS
Exchange Rate Price (U.S. car) Price (German car)
€/US$ US$/€ in US$ in € in € in US$
US$ depreciates/
€ appreciates
€1.0 US$1.00 US$30,000 €30,000 €45,000 US$45,000
  When the dollar depreciates from €1.5/US$ to €1.0/US$ and the euro appreciates from US$.67/€ to US$1.00/€, trade also takes place, but the trade pattern is reversed. When the €/US$ ratio falls from 1.5/1 to 1/1, the ratio of the price of the German car in euros to the price of the German car in dollars falls from €45,000/US$30,000 to €30,000/US$30,000 or 1/1. Similarly, when the US$/€ ratio rises from 2/3 to 1/1, the ratio of the price of the American car in dollars to the price of the American car in euros rises from US$30,000/€45,000 to US$45,000/€45,000 or 1/1. The German car still costs €45,000 in Germany, but its cost rises to US$45,000 in the U.S. The American car still costs US$30,000 in the U.S., but its cost falls to €30,000 in Germany. The American car at €30,000 is now cheaper in Germany than is the German car at €45,000 and the German car at €45,000 in the U.S. is now more expensive than is the American car at US$30,000. As a result, Germans import American cars.

top    IX. International Trade in a Fixed Exchange Rate System

In a fixed exchange rate system, importers and exporters can negotiate a contract today for delivery and payment in the future, knowing that the rate at which they are exchanging their currencies will be the same tomorrow as it is today.

  FIXED EXCHANGE RATE
Exchange Rate Price (U.S. car) Price (German car)
€/US$ US$/€ in US$ in € in € in US$
US$ appreciates/
€ depreciates
€3.0 US$.333 US$15,000 €45,000 €45,000 US$15,000
  With a fixed exchange rate of €3.0/US$, American importers can negotiate contracts today with German exporters to buy €45,000 cars for US$15,000 and know that they will be paying US$15,000 for 45,000 euros, whether the cars arrive in 3 months or 6 months. It does not matter whether the contract is in euros or dollars. The American importers can then sell the cars for US$16,000 in the U.S. market and earn a US$1,000 per car profit.

top    X. International Trade in a Floating (Flexible) Exchange Rate System and Hedging

In a floating (flexible) exchange rate system, the value of a contract negotiated today may be significantly different tomorrow, depending upon the supply and demand for the currencies. Therefore, the importer or exporter must hedge against adverse movements in the country's currency by buying or selling a forward contract in the forward currency markets.

Hedging is the Act of Avoiding or Covering Risk

The need for hedging arises because (spot) exchange rates fluctuate continuously in a floating (flexible) exchange rate system. As a result, people who expect to make or receive payments in terms of a foreign currency at a future date face the risk that they will have to pay more or will receive less in terms of the domestic currency than they anticipated. Except for foreign exchange speculators, who actually seek foreign exchange risks, everyone else with foreign exchange payables or receivables at a future date should (and usually do) hedge these foreign exchange risks. For example, importers and exporters have enough to think about with respect to their product lines to have to worry also about possible losses resulting from exchange rate fluctuations.

Importers demand foreign currency to settle payments for shipment of goods and services from foreign countries. If they wish to pay at the time of contract, importers enter the spot markets, exchange the domestic currency for the foreign currency and make payment. The more importers in the market, the larger the demand for the foreign currency.

FORWARD MARKETS FOR FOREIGN EXCHANGE
Forward Premium Forward Discount
€/US$ US$/€ €/US$ US$/€
Spot rate €3.00/US$ US$.333/€ €3.00/US$ US$.333/€
3-month forward rate €2.97/US$ US$.336/€ €3.03/US$ US$.330/€
3-month premium/discount .03 premium .003 discount .03 discount .003 premium
3-month percentage premium/discount 1.0% premium 1.0% discount 1.0% discount 1.0% premium
annual percentage premium/discount 4.0% premium 4.0% discount 4.0% discount 4.0% premium
The premium implies that the U.S. dollar will fall against the euro and that the euro will rise against the U.S. dollar. The discount implies that the U.S. dollar will rise against the euro and that the euro will fall against the U.S. dollar.

The American Importer/German Exporter (contracts are in euros)

An American importer negotiates a contract to buy 10,000 cars from a German exporter at €45,000 per car. The total price of the contract is €450,000,000. In 3 months, the American importer must have €450,000,000 to pay the German exporter. If paid today, at the €3.0/US$ rate, the cars would cost the American importer US$15,000 x 10,000 = US$150,000,000. If he can sell the cars for US$16,000, he makes a profit of US$1,000 per car or US$10,000,000.

Paying for the cars today and waiting 3 months for delivery is not the most profitable way of doing business, because the American importer loses the opportunity cost of interest that he could be earning on the US$150,000,000. The American importer may also lose, if, over the next 3 months, while waiting for delivery of the German cars, the dollar depreciates from €3.0/US$ to €2.5/US$.

At €2.5/US$, the American importer must spend US$18,000 per car or US$180,000,000 to buy the same 10,000 German cars. If the American importer can only sell the cars in the U.S. market for US$16,000, his US$1,000 per car profit becomes a US$2,000 per car loss. The American importer can protect himself against this adverse movement in the dollar exchange rate either by buying euros in the spot market and depositing them with a German bank for interest or by selling a forward.

Spot rate 3.00 €/US$
3-month forward rate 2.97 €/US$
Required for payment in 3 months €450,000,000
Spot market An American importer of German cars, who expects to make a future payment of €450,000,000 and fears that the euro will rise (US$ fall), can buy euros today at the spot rate and leave them on deposit with a German bank to earn interest. If the German deposit rate is 12% (1% per month) and the current exchange rate is €3.0/US$, the American importer pays US$145,631,068 for €436,893,204 today (€450,000,000/1.03), puts the euros in a German bank account at 12% per annum (1% per month), and in 3 months the deposit will yield the 450,000,000 euros (€436,893,204 x 1.03) that the American importer needs to pay for the cars. This transaction is also the equivalent of getting a 3% (trade) discount for paying cash and not necessarily the best way to hedge.

Forward market The American importer buys a forward contract at €2.97/US$ and pays US$151,515,152 for the right to receive €450,000,000 in 3 months. Three months later, when the cars arrive, the American importer exercises his contract, receives €450,000,000, pays the German exporter, sells the cars for $16,000 each, and earns an $848 profit on each car or $8,484,900 in total profit. If the euro falls below €2.97/US$ (US$ rises above $.336/€), the American importer is covered against loss. If the euro rises (US$ falls), the American importer loses, because he could have bought euros and the cars more cheaply. However, if the American importer was satisfied with the profit on the original deal ($848 per car), then, he really loses nothing, because he is not in the foreign exchange markets to speculate, only to hedge.

German Importer/American Exporter (contracts are in euros)

A German importer negotiates a contract to buy 10,000 cars from an American exporter at €45,000 per car. The total price of the contract is €450,000,000. In 3 months, the American exporter will receive €450,000,000 that he will need to convert into U.S. dollars to repay the payroll loan he executed to pay his workers to produce the cars. If received today, at the rate of €3.0/US$, the American exporter would be able to convert the €450,000,000 into US$150,000,000. If he produces each car for $14,500, he makes a profit of $500 per car or $5,000,000.

Waiting 3 months to be paid is not the most profitable way of doing business, because the American exporter must borrow to pay his workers to produce the cars today. The American exporter may also lose, if, over the next 3 months, while completing production of the cars, the dollar appreciates from €3.0/US$ to €3.5/US$.

At €3.5/US$, the American exporter will receive only $128,571,429 or $12,857 per car. If each car costs $14,500 to produce, the American exporter's profit turns into a loss of $1,643 per car or $16,430,000. The American exporter can protect himself against this adverse movement in the dollar exchange rate either by borrowing euros in the spot market, exchanging them for dollars today, and repaying the loan when he receives payment for the cars or by buying a forward.

Spot rate €3.00 /US$
3-month forward rate €3.03 /US$
To be received in 3 months €450,000,000
Spot market An American exporter, selling a car to a German importer, expects to receive €450,000,000 in 3 months. If he fears the euro will fall (US$ rise), he can borrow euros in Germany today, exchange them for U.S. dollars at today's rate, pay his workers in U.S. dollars, and repay the loan when he receives the euros from the German importer. If the German borrowing rate is 12% per annum (1% per month) and the current exchange rate is €3.0/US$, the American importer borrows €436,893,204 today and exchanges them for US$145,631,068 (per car profit is $14,563 - $14,500 = $63). In 3 months, when he receives €450,000,000, he repays the loan. This transaction is equivalent to giving the German importer a 3% (trade) discount for cash on the spot and not necessarily the best way to hedge.

Forward market The American exporter can sell a forward contract at €3.03/US$ to deliver €450,000,000 in 3 months and get US$148,514,852. Three months later, when the cars are shipped, the American exporter receives €450,000,000 from the German importer, exercises his contract, and receives US$148,514,852 (per car profit is $14,851 - $14,500 = $351). If the euros falls below €2.97 (US$ rises above $.336), the American exporter is covered. If the euro rises (US$ falls), the American exporter loses, because he could have sold euros for more dollars and raised the revenue and profit on each car. However, if the American exporter was satisfied with the deal in the first place, then, he really loses nothing. He is not in the foreign exchange markets to speculate, only to hedge.

top    XI. International Finance, Covered Interest Arbitrage, and Speculation

The purpose of international financial markets is to facilitate the balancing process by providing financing to prevent the loss of reserves by debtor nations. Their value is in the marginal contribution they make to moving capital around the world. Most of this capital, and the corresponding money flows, take place via covered interest arbitrage transactions.

Interest Arbitrage

Interest arbitrage is the transfer of liquid funds from one monetary center (and currency) to another to take advantage of higher rates of return or interest. In order to make the foreign investment, the national currency must be converted into the foreign currency. Then, when the investment matures or is liquidated, the foreign currency must be reconverted into the national currency. A foreign exchange risk arises because during the period of the investment, the (spot) exchange rate of the foreign currency may fall (so that the investor gets back fewer national currency units than he originally paid). This may wipe out most or all of the extra interest earned on the foreign over the domestic investment and may even lead to an actual loss. Foreign exchange risk can be covered, if at the same time the investor exchanges the national for the foreign currency to make the foreign investment, he also engages in a forward sale of an equal amount of the foreign currency to coincide with the maturity of the investment.

Covered Interest Arbitrage

Covered interest arbitrage is the transfer of liquid funds from one monetary center (and currency) to another to take advantage of higher rates of return or interest, while covering the transaction with a forward currency hedge. Since the foreign currency is likely to be selling at a forward discount, the arbitrager loses on the foreign currency transaction, but gains on the interest rate differential. If the positive interest rate differential in favor of the foreign money center exceeds the forward discount on the foreign currency (when both are expressed in percentage per year), it pays to make the foreign investment.

Covered Interest Arbitrage when American Interest Rates are Higher than Foreign Interest Rates Suppose that the annualized 3-month U.S. T-bill rate is 12% and the annualized 3-month German T-bill rate is 8%. An German earns 4% more per annum on the 3-month U.S. T-bill than he does on his own 3-month German T-bill. Whether the German buys the American or German T-bill depends upon the spot and forward rates on the currency exchange.

  U.S. Germany Spread
Annualized rate on 3-month T-bills 12% 8% 4%
Spot rate €3.00/US$ US$.333/€ 0%
3-month forward rate €2.985/US$ US$.335/€ -2%
If the spot rate today is €3.0/US$ and the spot rate in three months is €2.97/US$, a German buying the 3-month U.S. T-bill will lose .03 euros or 1% on the foreign exchange conversion. The annualized 4% gain from the U.S. T-bill is just offset by the annualized 4% currency loss. The German breaks even and will probably not make the exchange.

If, however, the 3-month forward rate is between €3.0/US$ and €2.97/US$, say, €2.985/US$, the German can cover his foreign exchange conversion risk by buying a forward contract to sell dollars in 3 months in exchange for euros when the T-bill matures. With a 3-month forward rate of €2.985/US$, the German's loss on the foreign currency conversion is:

Foreign currency loss = (3-month forward rate - spot rate)/spot rate

= (€2.985/US$ - €3.0/US$)/€3.0/US$ = -.015/3.0 = -.005 = -0.5%

0.5% for 3 months or 2% per annum. The German's net gain from the 3-month T-bill purchase is 1% for 3 months or 4% per annum. The German nets 0.5% for 3 months or 2% per annum.

  U.S. T-bill German T-bill
3-months maturity value (domestic currency) US$10,000 €30,000
Discounted present value (domestic currency) US$9,709 €29,412
US$s/€ needed to buy U.S. T-bill US$9,709 €29,127
US$s/€ returned in 3 months US$10,000 €29,850
3-month return 2.48%  
Annualized return 10.30%
As long as the interest rate differential is greater than the forward exchange rate differential, the German profits from buying U.S. T-bills and selling forward dollars. In the process, he raises his return from 8% on the German T-bill to 10.30% on the U.S. T-bill plus the foreign currency translation.

As funds are transferred from Germany to the U.S., the supply of funds is reduced in Germany and increased in the US. This tends to put upward pressure on interest rates in Germany and downward pressure on interest rates in the US, so that the positive interest differential of 4% per year will tend to fall toward 2% per year.

At the same time, the increased demand for dollars in the spot market tends to raise the spot rate for dollars and the increased forward supply of dollars tends to push down the forward rate. For both reasons, the forward discount on the dollar will tend to increase, pushing it up to the interest rate differential.

Covered Interest Arbitrage when Foreign Interest Rates are Higher than U.S. Interest Rates Suppose that the annualized 3-month German T-bill rate is 12% and the annualized 3-month U.S. T-bill rate is 8%. An American earns 4% more per annum on the 3-month German T-bill than she does on her own 3-month U.S. T-bill. Whether the American buys the U.S. or German T-bill depends upon the spot and forward rates on the currency exchange.

  U.S. Germany Spread
Annualized rate on 3-month T-bills 8% 12% 4%
Spot rate €3.00/US$ US$.3333/€ 0%
3-month forward rate €3.015/US$ US$.3317/€ -2%
If the spot rate today is US$.333/€ and the spot rate in three months is US$.330/€, an American buying the 3-month German T-bill will lose US$.003 or 1% on the foreign exchange conversion. The annualized 4% gain from the German T-bill is just offset by the annualized 4% currency loss. The American breaks even and will probably not make the exchange.

If, however, the 3-month forward rate is between US$.333/€ and US$.330/€, say, US$.3317/€, the American can cover his foreign exchange conversion risk by buying a forward contract to sell euros in 3 months in exchange for dollars when the T-bill matures. With a 3-month forward rate of US$.3317/€, the American's loss on the foreign currency conversion is:

Foreign currency loss = (3-month forward rate - spot rate)/Spot rate

= (US$.3317/€ - US$.3333/€)/US$.3333/€ = -.0016/.3333 = -.005 = 0.5%

0.5% for 3 months or 2% per annum. The American's net gain from the 3-month T-bill purchase is 1% for 3 months or 4% per annum. The American nets 0.5% for 3 months or 2% per annum.

  U.S. T-bill German T-bill
3-month maturity value (domestic currency) US$10,000 €30,000
Discounted present value (domestic currency) US$9,804 €29,126
US$s/€ needed to buy German T-bill US$9,709 €29,126
US$s/€ returned in 3 months US$9,950 €30,000
3 month return   2.48%
Annualized return 10.30%
As long as the interest rate differential is greater than the forward exchange rate differential, the American profits from buying German T-bills and selling forward dollars. In the process, she raises her return from 8% on the U.S. T-bill to 10.30% on the German T-bill plus the foreign currency translation.

As funds are transferred from the U.S. to Germany, the supply of funds is reduced in the U.S. and increased in the U.S. This tends to put upward pressure on interest rates in the U.S. and downward pressure on interest rates in Germany, so that the positive interest differential of 4% per year will tend to fall toward 2% per year.

At the same time, the increased demand for euros in the spot market tends to raise the spot rate for euros and the increased forward supply of euros tends to push down the forward rate. For both reasons, the forward discount on the euro will tend to increase, pushing it up to the interest rate differential.

Under normal conditions, the relationship between spot and forward rates is determined largely by covered interest arbitrage. If interest rates are higher abroad, covered interest arbitrage tends to keep the foreign currency at a forward discount (and the domestic currency at a forward premium) equal to the positive interest rate differential in favor of the foreign monetary center. If domestic interest rates are higher, covered interest arbitrage tends to keep the foreign currency at a forward premium relative to the spot rate (and the domestic currency at a forward discount) equal to the domestic positive interest rate differential. However, this conclusion may not hold even approximately when covered interest arbitrage is forbidden or with large destabilizing speculation.

Speculation

Foreign exchange speculation is the act of taking a foreign exchange risk or an uncovered position in hopes of marking a profit. It is the opposite of hedging. Speculators influence the demand side of the foreign exchange markets.

A foreign exchange speculator who expects the spot rate of a foreign currency to be higher in three months could purchase the currency in the spot market today at today's spot rate, hold it for three months, and then resell it for the domestic currency in the spot market after three months. If he is right, he will make a profit; otherwise, he will break even or incur a loss. On the other hand, if the speculator expects the spot rate of a foreign currency to be lower in three months, he can borrow the foreign currency and exchange it for the national currency at today's spot rate. After three months, if the spot rate on the foreign currency is sufficiently lower, he can earn a profit by being able to repurchase the foreign currency (to repay the foreign exchange loan) at the lower spot rate. (To make a profit, the new spot rate must be sufficiently lower to overcome the excess interest paid on the foreign currency borrowed for three months, over the interest received on an equal amount of the national currency deposited in a bank for three months.)

Foreign exchange speculation usually takes place in the forward market because it is simpler and, at the same time, involves no borrowing of the foreign currency or tying up of the speculator's funds.

top    XII. General Causes of International Payments Imbalance

Current Account Imbalances

Changes in the Foreign Exchange Rates Changes in the foreign exchange rate between countries alter the relative prices of goods between the countries as well as within each country. Changes in the relative prices of domestic and imported commodities alter the relative attractiveness of these commodities. As a country's currency appreciates, imports become more attractive. At the higher exchange rate, more units of the foreign currency can be obtained, making it more economical to buy foreign goods rather than domestic goods. This same reasoning makes the country's exports less attractive and less affordable. Thus, appreciation of a country's currency tends to worsen its trade balance. As a country's currency depreciates, imports become less attractive. At the lower exchange rate, fewer units of the foreign currency can be obtained, making it more difficult to buy foreign goods rather than domestic goods. This same reasoning makes the country's exports more attractive and more affordable by foreigners. Thus, depreciation of a country's currency tends to improve its trade balance.

Differential Rates of Real Growth or Expansion The faster an economy grows, relative to its trading partners, the more it consumes of both domestic output and imported goods. This increase in imports tends to worsen the trade balance. However, the slower an economy grows, relative to its trading partners, the less it consumes of both domestic output and imported goods. This decrease in imports tends to improve the trade balance.

Differential Rates of Inflation As a rule, rising domestic inflation, relative to that in other countries, will reduce the international competitiveness of that country's exports. The demand for the higher priced commodities in the countries with the highest rates of inflation will fall, thus reducing its exports and worsening the trade balance. Falling domestic inflation (or deflation), relative to that in other countries, will increase the international competitiveness of that country's exports. The demand for the lower priced commodities in the countries with the lowest rates of inflation will rise, thus increasing its exports and improving the trade balance.

Capital Account Imbalances

Differential Real Rates of Interest Generally, financial (indirect) investments are extremely interest-sensitive. As long as there are no restrictions on capital mobility among countries, international funds will flow from those countries with the lowest real rates of interest into those countries with the highest real rate of interest.

Differential Real Rates of Return on Other Assets Other returns include rents and profits. Rents are received from ownership of real estate, while profits are received from the direct ownership and management of production facilities. As long as there are no restrictions on capital mobility among countries, international funds will flow from those countries with the lowest real rates of rent and profit into those countries with the highest real rates of rent and profits.

Balancing the Balance of Payments Accounts International capital flows are generally used to finance current account imbalances. An excess of capital inflows can turn a trade deficit into a balance-of-payments surplus and a deficiency of capital inflows (or, alternatively, an excess of capital outflows) can turn a trade surplus into a balance-of-payments deficit. Any difference is then settled in the official reserve account. Continuous balance-of-payments surpluses increase the international reserves of a country, while continuous deficits drain the international reserves of a country. Global settlement requires that for every surplus there must be an offsetting deficit, and while a country can live with continuous surpluses, its trading partners cannot afford long-term drains. Once international reserves are depleted, trade stops. Therefore, external balance involves the balancing not only of any one country's accounts, but also of all other countries' accounts, such that reserves are shifted in an orderly fashion among countries.

top    XIII. Importance of the Dollar in International Trade and Investment

Dollar Denomination of International Transactions

Except for the euro, England's pound sterling and, perhaps, the Canadian dollar, all other currencies are typically valued in terms of the dollar. Therefore, to know the appropriate exchange rate or parity between two non-dollar currencies is first to know their respective relationship to the dollar. For example, if the Japanese exchange rate is ¥140/US$ and the euro exchange rate is €1.8/US$, then a € = ¥140/€1.8 = ¥77.8/€ or a ¥ = €1.8/¥140 = €.0129.

If this is not the actual market exchange rate, then importers and exporters, investors, and foreign exchange arbitrageurs can profit from this market imperfection by shifting trade and investments from the overvalued currency to the undervalued currency or by buying the undervalued currency and selling short the overvalued currency. From the previous example, if the € = ¥78, the yen would be the overvalued currency and the € would be the undervalued currency. A German importer would buy from Japan and a German exporter would sell to the United States. A Japanese importer would buy from the United States and a Japanese exporter would sell to Germany. A German investor will liquidate any Japanese holdings and transfer the funds to U.S. investments and a Japanese investor will liquidate any U.S. holdings and transfer the funds to German investments. An arbitrageur would buy € and sell short yen. This process would continue until the yen fell to approximately ¥140.045/US$ and the € rose to approximately €1.7955/US$: ¥140.045/€1.7955 = ¥78/€.

International Reserve Currency for Settlement of Foreign Accounts

All international balances can be settled in dollars or dollar-denominated instruments. All central banks hold dollars for settlement of balance-of-payments with other countries. When the dollar appreciates, it is cheaper for foreigners to settle their international balances in dollars because the dollar is worth more in exchange for other currencies. It buys more of the other currencies. When the dollar depreciates, it is more expensive for foreigners to settle their international balances in dollars because the dollar is worth less in exchange for other currencies. It buys less of the other currencies.

The United States is the Largest International Trading Partner for the Rest of the World

Whether it is buying or selling, the volume of international goods and services passing through U.S. ports is the largest in the world. The United States represents the largest market for importation of foreign goods and services as well as the largest production network for exportation of goods and services to the rest of the world. When foreigners buy from the United States, they need dollars. When they sell to the United States, they accumulate dollars.

The United States Is A Politically and Economically Safe Haven for Investment

Central banks and foreign investors hold a significant portion of their reserves and investment portfolios in dollars and dollar-denominated financial and real assets. This is because the United States has a relatively stable political environment. Its economy is also relatively stable. Although the U.S. economy is subject to periodic economic instability (business downturns), its own vast domestic market provides a large cushion to prevent total economic collapse. In addition, it possesses the necessary resources to be economically self-sufficient. While the United States is inextricably linked with other countries in the global markets that expand all countries) production frontiers, the United States could survive if its international ties were severed. This adds to the economic cushion provided by its size and vast domestic market.

Oil Transactions Are In Dollars

The purchase and sale of oil is accomplished in dollars (petrodollars). Since oil is a vital raw material needed by all developing and industrial nations, and the majority of all nations are oil-importers and they require dollars to buy oil.

top    XIV. Current Developments

The United States as a Net Debtor Nation

In 1985, the U.S. became a debtor nation for the first time since World War I. By the end of 1986, U.S. obligations to foreigners exceeded foreign obligations to Americans by more than $200 billion, making the United States the world's largest debtor nation — eclipsing Brazil by almost $100 billion. In 1987, the U.S. annual trade balance deficit reached a peak of $163.9 billion before declining to $22.3 billion in 1991. Since 1991, the U.S. annual trade balance deficit has increased steadily to $760 billion as of 2006. That balance has been almost halved to $400 billion in 2010 as a result of the economic downturn in the U.S. and a growing surplus in the international services account.

The biggest contributor to the U.S. trade deficit is the merchandise trade balance. It reached $839 billion in 2006 and has been slow to recover. The U.S balance on services has been more successful. It reached $90 billion in 1997, retreated to $47 billion in 2003, but has subsequently mushroomed to $136 billion in 2009-2010. (NOTE: To get the annual balance, add the last four quarters.) U.S. Trade Data, BEA; U.S. Trade Data, FRED.

So far, foreigners have been willing to finance these deficits by buying U.S. debt. Questions remain, however, over how much longer this will continue. Unless the U.S. trade position improves, foreigners may sell their debt, forcing a "free fall" in the dollar and an abrupt tightening of monetary policy.

How Did the U.S. Get Into This Predicament?

OPEC oil price increases in 1973 and 1979 drastically altered the international balance of trade. They increased the value of imports for oil-dependent countries and increased the value of exports for oil-producing countries.

Foreign productivity gains have been much more rapid in countries like Japan, South America, and the Pacific Basin countries than in the U.S. After World War II, the Western European nations and Japan, devastated by war, had to rebuild their economies from scratch. They did so with the newest and best capital available. Then, in the 1970s, the desperate push to recycle OPEC's petrodollars led to increased lending to second and third world countries. These loans precipitated their modern industrialization. The increased productive capacity from that investment emerged in the mid-1980s, allowing these countries to flood the U.S. market with cheap imports. Add to this the cheaper price of foreign labor and the combination has made imports from these countries very cheap.

A tight U.S. monetary policy in 1980-81, followed by huge federal budget deficits, increased U.S. interest rates relative to interest rates in other countries. Although real interest rates peaked in the U.S. in 1984, they stayed stubbornly high relative to the other major industrial nations. Since the U.S. is a politically and economically safe haven for investment, the risk-return reward was just too great for foreigners to forego and the U.S. received a large influx of foreign capital. Foreigners increased their demand for dollars to buy U.S. assets (stocks, bonds, and real estate, as well as direct investment in factories, new plant, and equipment). This increased demand for dollars strengthened the dollar exchange rate, making U.S. goods and services more expensive to foreigners and foreign goods and services cheaper for Americans. U.S. goods and services simply became less competitive in world markets.

Explanations for the Persistent Trade Deficit

Americans have a strong sense of brand loyalty. From 1980-85, when the dollar was strong, Americans fell in love with foreign products. They have been reluctant to switch back to domestic products.

Many foreign producers did not pass along full cost savings to U.S. customers when the dollar was rising. Thus, they had a protective cushion to minimize price increases as the dollar was falling.

Foreign producers who rely on dollar-denominated imports for production have seen their costs decline as the dollar has fallen. These producers have been able to keep export prices to the U.S. down without sacrificing profits margins.

Other foreign producers have been willing to lower prices and reduce profit margins in order to remain competitive and to maintain market share at the lower exchange rate. Their goals are long-run growth and market penetration, not short-run profit-maximization.

Some American companies have been very successful operating overseas. Much of their productive capacity is located abroad. Therefore, a cheaper dollar will not have the effect of increasing exports of goods manufactured from the U.S.

Capital costs are lower in many foreign countries, especially Japan and Germany. Lower capital costs allow companies in these countries to hold the line on prices and shave profits margins, while still earning acceptable returns.

The effects of currency adjustment on production and output are not symmetrical for both increases and decreases in a country's currency. Given a 50% rise and then a 50% fall in the dollar, trade flows will not necessarily return to their original point of departure. This is because during the rise in the country's currency, structural changes may have forced domestic producers from the market altogether (e.g. color television sets and VCRs), such that a decline in the country's currency will not necessarily restore domestic capacity and production of these items. These goods may remain imports forever.

Economic growth abroad has been sluggish. Sluggish foreign growth keeps demand for U.S. exports low, despite the lower cost of many American products.

Some economists believe that the continuing trade balance problem stems from the manner in which the dollar's decline was engineered. Instead of cutting the federal budget deficit, the Administration chose to reduce interest rates. This mix of relatively low interest rates and a big public sector deficit perpetuated a consumer spending boom which continues to pull in imports.

Japan and Germany have paid only lip service to changes in their fiscal and monetary policies to stimulate growth. In both countries, the governments and their central banks have been more concerned with preventing inflation than correcting U.S. trade imbalances. The German Bundesbank was totally preoccupied with preventing inflation following its absorption of East Germany and its reconstruction and conversion to a market economy.

Even though the dollar has declined by over 40% against the Japanese yen and the German mark since January 1985, it has not fallen very much against the currencies of other major trading partners. Many of the currencies — the Canadian dollar, the Mexican peso, the Korean won, and the Taiwanese dollar — are tied to the U.S. dollar and their values will tend to move with the U.S. dollar rather than against it. The result might be for U.S. trade deficits with Japan and Germany to be replaced by trade deficits with Canada, Mexico, Korea, and Taiwan.

The trade-weighted value of the dollar may or may not have fallen by any large degree, depending on the index. The trade-weighted value of the dollar, as calculated by the Federal Reserve Board, has fallen four (4) times further than the trade-weighted index calculated by the Federal Reserve Bank of Dallas.

U.S. retailers, who share foreign producers, are able to keep prices low by shifting purchases to lower-wage, cheaper-currency countries, like Taiwan and Korea, if they encounter price increases from countries like Japan, whose currency rose the most against the dollar.

The dollar may have to become even cheaper to compensate for the relative decline in competitiveness of American companies, because of the above structural changes. Yet, because of many of these structural changes, a cheaper dollar, in and of itself, may not be sufficient to produce a more favorable trade balance.

Post-1988

In 1983, the U.S. lost its trade surplus with Europe and has run successively larger trade deficits each year since then. As the European Economic Community moves toward complete integration, the fear emerges that the political demands of unification will force the EEC to oppose the U.S. on key economic issues, including subsidies and protectionist measures in agriculture and services that would deny U.S. companies access to the European market.

As of summer 1988, the U.S. trade balance turned the corner of the J-curve. But the U.S. was still far from reducing that deficit to zero, not only because of the structural changes noted above, but also because of pending factors, not the least of which is the unification of the European community into a single barrier-free market with a common currency, the euro.

During the 1990s, the U.S. economy grew at a faster rate than most foreign countries. While the U.S. economy is operating at or close to full employment, many foreign countries, including Japan, have high unemployment rates and lots of excess capacity. These factors allow foreign companies to produce a lot more to satisfy Americans' seemingly unsatiable appetite for goods at a lower cost than their American counterparts. Consequently, instead of completing the J-curve and achieving a trade surplus, the U.S. trade deficit has continued to worsen with no end in sight.

top    XV. A Lexicon — Trade Interpretations

Putting together new trade legislation has produced jargon that may need some explanation for those who normally do not follow trade closely. Here is a sample:

GATTable

An adjective to describe practices that can be shaped to comply with the international free-trade treaty known as the General Agreement on Tariffs and Trade, or GATT. GATTABLE practices lie somewhere between those that are accepted under the treaty (GATT-legal) and those that are clear violations. For example, paying for worker retraining programs out of money collected from customs duties, as the Senate trade bill would do, may be GATTABLE. Ordering a naval blockade of Japan to prevent it from sending its products to the United States almost certainly would not.

Mandatory Retaliation

What duly enacted laws would require of the President in response to countries that engage in unfair trade practices. Senator Bob Packwood, the ranking Republican on the Senate Finance Committee, has tried to draw a distinction between this approach, which still gives the President some discretion on how to retaliate, and what he calls "compulsory retaliation," provisions that would tie the President's hands completely. In debate, Senator John E. Danforth, Republican of Missouri, conceded that he certainly could not tell mandatory and compulsory retaliation apart. But he said Senator Packwood had spent the last several months in Zen meditation to come up with the distinction in hopes of making the Senate version of such trade legislation palatable to the Reagan Administration.

J-Curve

A mathematical construct that economists use to explain how a decline in the value of the dollar makes the trade deficit worse before it makes it better. (A cheaper dollar automatically raises America's import bill and lowers its profits on exports.) Eventually, price changes are supposed to make Americans buy fewer imported items and make foreigners buy more American goods so that the trade deficit is reduced, but most members of Congress no longer listen to economists who try to explain the J-curve.

Cascading J-Curve

A mathematical construct that economists use to explain why the trade deficit really would have improved after it worsened, but for the continuing fall in the value of the dollar. It seems that a steadily declining dollar produces lots of little J-curves instead of one big one. So just when the trade deficit is starting to improve, a new drop in the value of the dollar sets the whole chain of events off again and makes the deficit worse, before it gets better.

The "C" Word

Shorthand for "Competitiveness," 1986's all-purpose buzzword to describe what the country really needs to get its economy and trade balance back in order. The abbreviated form is favored by lobbyists, trade specialists, and Congressional aides to show their disdain for the device they helped invent, now that everyone else has started using it.

Source: "Trade Interpretations," Susan F. Rasky, New York Times, 13 May 1987: (B)12.

top    XVI. International Monetary Adjustment: The J Curve

What is the J-Curve?

The J-curve is a time path showing the response of a country's trade balance to exchange rate changes. This response has two parts: the "price effect" and the "quantity effect." The price effect is the change in terms of trade (relative prices) that results from an exchange rate change. For a devaluing country, import prices rise and export prices fall. The quantity effect is the change in volume of real goods and services that trade across borders. For a devaluing country, import volume falls and export volume rises.

The J-Curve Effect

Traditonal theory predicts that the quantity effect from a devaluation dominates the price effect and that the adjustment is instantaneous. It explains that a devaluation makes exports less expensive and more attractive to foreigners, while imports become more expensive and less attractive to residents. As foreigners buy more exports and residents buy fewer imports, the trade deficit disappears and turns into a surplus.

In the real world, no adjustment is instantaneous. It takes time for economic participants to adjust to disturbances. Initally, the price effect predominates a devaluation. The country must pay higher prices for its imports while its lower export prices yield less income. Only after some time, as economic participants adjust to the new exchange rate, does the quantity effect predominate. In the meantime, the devaluing country's import bills rise and its export orders and receipts fall. The trade balance worsens before improving in response to the devaluation.

The J-curve effect is the real world lagged response of spending habits and pre-negotiated contracts to a devaluation. Consumers and many businesses using foreign materials or parts continue to buy the old quantity of imports at the new price. That price is effectively higher following the devaluation, because the buyer must spend more of his own currency to pay the bill at the old price in yen, marks, francs, dollars, or whatever. It can take a long time for consumers to change buying habits and for importers to renegotiate foreign contracts or line up domestic sources. This time path results in a downward movement (increase in the trade deficit), followed by an upward movement (decrease in the trade deficit), that resembles the letter "J."

The J-Curve Experience

Postwar history shows that it takes at least three quarters (9 months) to get 75% of the benefit of a major devaluation on the import side. At the same time, the expected gains for exports come even more slowly — at least six quarters (1 1/2 years). Not only do current export contracts have to run out, but a large part of what the U.S. sells abroad is heavy capital that take many months to move from order form to delivery. In the short run, imports rise while exports mark time, and the trade deficit worsens for roughly a year. That is the downward, left leg of the J-curve. Eventually, markets adjust to the new currency values, and the trade balance improves. Spending habits begin to respond to the changes in relative prices, and subsequently, any trade deficit is reversed. That is the right leg.

top    XVII. International Monetary Cooperation

Informal Cooperation

In January, 1985, the value of the dollar peaked and began to weaken and fall. But its decline was nominal and nine months later there were no discernible results. In fact, by September, 1985, the U.S. trade deficit had worsened substantially, as the J-curve theory predicts. The adjustment period, that was expected to be 6-12 months (9-month average), should have been over. But the dollar fell for nine months with no discernible results.

Formal Cooperation

The Plaza Accord The 1985 agreement among the Group of Five (United States, Britain, France, Germany, and Japan) calling for coordinated and concerted effort to lower the value of the dollar. In September, 1985, the G-5 met at the Plaza Hotel in New York City to ratify an initiative to use exchange rates and other macropolicy adjustments as the preferred and necessary means to bring about an orderly decline in the value of the dollar. The agreement, intended to curb increasing U.S. trade imbalances and protectionist action, supported orderly appreciation of the main non-dollar currences against the dollar.

Lourve Accord The 1987 agreement among the G-7 (G-5 plus Canada and Italy) calling for a halt in the dollars decline, re-establish balanced trade, and non-inflationary growth by introducing reference ranges among the G-7 currencies. In February 1987, the G-7 met at Louvre, France, and announced that dollar reached a level consistent with the underlying economic conditions, and that they would intervene only as needed to insure stability. These countries intervene at times, on unannounced basis. Under the Louvre Accord, nations will intervene on behalf of their currencies as needed.

The Case Against Benign Neglect, by Benoît Coeuré and Jean Pisani-Ferry, Finance and Development, IMF, Vol. 36(3), Sep 1999.

top    Summary

Currently, the U.S. economic drama is being played out in the arena of international trade and finance. Central bankers from the industrialized countries have concluded that reducing trade imbalances, without disrupting financial markets, causing inflation in the U.S., or pushing the U.S. and other countries into recession, will be very difficult. In a report released by the International Bank for Settlements in June 1987, the central bankers said that the only way to avoid these pitfalls would be through a high degree of policy coordination among nations. The U.S., West Germany, and Japan will have to speak with one voice and do so more consistently than in the past. They will also have to weigh the risks of taking further fiscal measures — and the inconvenience these measures would imply from a directly domestic point of view — against those that would, without any doubt, arise if private capital flows are insufficient to finance the U.S. trade deficit.

The central bankers said that monetary policy was already doing what it could do to end the external imbalances and that the industrial countries must rely more on fiscal policy. Invoking Keynesian tones, the report said that the time was ripe to revive discussion of fiscal policies to stimulate imports from the U.S. to West Germany and Japan, because money supply growth was already in danger of overextending itself and could spark inflation. While monetary policy coordination can make a significant contribution to the orderly financing of existing imbalances, its effect on their size is unlikely to be significant in the absence of the appropriate fiscal adjustments. It cannot remedy the underlying cause of the present weakness of the dollar. Central bank intervention in the foreign exchange markets is only a fraction of the total volume of foreign exchange transactions on any given day. Therefore, it can be helpful only when it works in tandem with other forces; otherwise, it is powerless against the tide.

top    Readings

A World of Choices: Are we better off with international trade? FRBChi. 28 Jan 2000

Foreign Exchange Operations and the Federal Reserve, J. Alfred Broaddus, Jr., and Marvin Goodfriend, Economic Quarterly (FRBRich). Winter 1996

Bad Standards, Michael F. Bryan, Economic Commentary (FRBClev). 1 Oct 97

The Case Against Benign Neglect, Benoît Coeuré and Jean Pisani-Ferry, Finance and Development (IMF). 36(3) Sep 1999

Balance of Payments, Fedpoint (FRBNY)

Monetary Policy: Domestic Targets and International Constraints, Jacob A. Frenkel, American Economic Review LXXIII(2) May 1983: 48-53

The International Transmission and Effects of Fiscal Policy, Jacob A. Frenkel and Assaf Razin, American Economic Review LXXVI(2) May 1986: 330-35

Markets to the Rescue, Milton Friedman, Wall Street Journal, 13 Oct 1998

International Trade, Investment, and Payments, Gray H. Peter, Houghton Mifflin Co., Boston, 1979: chs. 18-25,27

Understanding Today's International Financial System, Alan Greenspan, The 34th Annual Conference on Bank Structure and Competition of the Federal Reserve Bank of Chicago, Chicago, Illinois, 7 May 1998

Recent U.S. Intervention: Is Less More? Owen F. Humpage, Economic Review (FRBClev). 33(3) 3Q97

Macroeconomics of Stagflation under Flexible Exchange Rates, Pentti J.Kouri, American Economic Review, LXXII(2) May 1982: 390-95

Foreign Exchange Markets in the United States, rev'd ed, Roger M. Kubarych, FRBNY, 1983

Current Accounts and Exchange Rates: A New Look at the Evidence, Greg Leonard and Alan C. Stockman, Research in Progress and Recent Working Papers, May 2000

The Uneasy Case for Greater Exchange Rate Coordination, Jeffrey Sachs, American Economic Review, LXXVI(2) May 1986: 336-41

Strong Dollar, Weak Dollar: Foreign Exchange Rates and the U.S. Economy, FRBChi. 28 Aug 1998

Part 7: British Financial Warfare: 1929; 1931-33 How The City of London Created the Great Depression, Webster G. Tarpley, Surviving the Cataclysm, Dec 1996

Internationally Managed Moneys, George M. Von Furstenberg, American Economic Review, LXXIII(2) May 1983: 54-8

The World Monetary System and External Relations of the EMU - Fasten your safety belts! Norbert Weinrichter, European Integration online Papers (EIoP). 4(10) 17 Jul 2000

U.S. Monetary Policy and World Liquidity, Thomas D. Willett, American Economic Review, LXXIII(2) May 1983: 43-7

top    Websites

Balance of Payments (BOP) and Related Data, BEA, current and historical series
International Developments in Economic Trends (FRBClev), current trends with charts
Exchange Rates, Balance of Payments and Trade Data, FRBStL (FRED), current and historical series
USA Trade Online, Census Bureau, miscellaneous data and info
G-8 Information Centre, Univ. of Toronto

Burgernomics

The Big Mac index, The Economist, 29 Apr 2003
McCurrencies, The Economist, 24 Apr 2003
The Big Mac index, The Economist, 16 Jan 2003
Big MacCurrencies, The Economist, 25 Apr 2002
The Big Mac index, The Economist, 20 Dec 2001
Big Mac Currencies, The Economist, 19 Apr 2001
Burgernomics, The Economist, 11 Jan 2001
Big MacCurrencies, The Economist, 27 Apr 2000
Test-driving a New Model, The Economist, 16 Mar 2000
Big MacCurrencies, The Economist, 1 Apr 1999
Ten years of the Big Mac index, The Economist, 9 Apr 1998
Video Clip, The Economist, 25 Apr 2002


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