©1989 & 2002 John Petroff.
The goal of this topic is to derive the financial aspect of
international trade on all countries. This is apparent in the
balance of payments. The processes of adjustment of the balance
of payments are different in the flexible and fixed exchange
rate systems. Each system has its detrimental economic effects
which countries may want to avoid. This, in turn, explains the
history of international monetary systems.
BALANCE OF PAYMENTS
The balance of payments of a country is a statement of all the
transactions of that country with other countries over the
period of a year. The transactions include flows of merchandise,
services, unilateral monetary transfers, monetary flows (short
or long term), as well as government transfers of official
reserves. There are several measurements of the balance of
payments depending on which of these flows are included.
The balance of payments is made of many different flows. For
instance, in 1981, the merchandise trade balance of the United
States (that is, the exports minus imports) showed a negative
$28 billions. The same year, the balance on goods and services
was a positive $13 billions.
BALANCE OF PAYMENTS
When imports exceed exports a deficit exists in the balance of
payments. When exports exceed imports a surplus is present.
(The balance of payments would normally also include net
monetary flows). Neither deficit nor surplus may continue over a
long period of time without some economic adjustment taking
place, most often in the exchange rate.
Between 1982 and 1988 a sizable trade deficit was experienced
by the United States in its trade with Japan. During that period
of time the value of the yen increased by 50% (from 250 yens to
the dollar, to 125 yens to the dollar).
FLEXIBLE EXCHANGE RATES
Flexible (or freely floating) exchange rates exist when exchange
rates are allowed to adjust in response to a deficit or surplus
without any intervention of any country. If a country
experiences a surplus, the demand for its currency exceeds the
supply and the value of that currency (or exchange rate) will
rise. If a country has a deficit, the opposite will take place:
the value of that currency will decrease.
The exchange rates between the dollar, the yen, the British pound
and the German mark, are allowed to change according to the needs
of buyers and sellers of these currencies. This is a flexible
exchange rate system. It has been (more or less) in effect since
FLEXIBLE EXCHANGE RATES DETERMINANTS
The determinants of flexible exchange rates are the demand for
and supply of a currency, which are mostly attributable to
merchandise and monetary flows. Changes in the merchandise flows
(and therefore, exchange rates) are caused by changes in relative
prices, relative income levels, tastes and relative inflation
rates in two countries. Flexible exchange rates are also affected
The yen increased in value between 1982 and 1988 because there
were more buyers of yen (to pay for imports from Japan such as
cars and electronic products) than sellers of yen (from proceeds
of exports to Japan, such as airplanes and agricultural
products). One of the reasons for the larger American imports
from Japan is the consumption desire of the American society.
FLEXIBLE EXCHANGE RATES DISADVANTAGES
The major disadvantages of flexible exchange rates are that
- uncertainty about future changes in exchange rates may reduce
international trade, and
- export and import-competing industries are subject to
instability and structural unemployment.
International transactions take a long time because of distance,
numerous formalities, need for custom inspection, bank credit,
and so on. Between the day the sale price is agreed upon and the
day the merchandise is received 6 months may easily pass. During
that time, the exchange rate may change and either the importer
has to make a larger payment or the exporter must accept a
smaller one. This potential loss discourages international
FIXED EXCHANGE RATES
Fixed exchange rates exist anytime a country attempts to prevent
the exchange rates from changing as a result of balance of
payments deficit or surplus. Such intervention in the exchange
markets must be accompanied by other measures in order to be
Many currencies are tied to other currencies. For instance, the
Mexican peso is tied to the U.S. dollar.
FIXED EXCHANGE RATES
When a country is committed to maintain its exchange rate at a
certain value, intervention in foreign exchange markets must
usually be accompanied by
- macroeconomic adjustments (to reduce income spent on imports),
- protective tariffs (to reduce imports).
In addition, exchange controls are sometimes imposed; these are
restrictions on the purchase of foreign currencies.
To maintain the official parity between the Mexican peso and
U.S. dollar, the Mexican government must discourage excessive
purchases of American products. It does that by requiring an
import license for any import. It also uses various macroeconomic
FIXED EXCHANGE RATES DISADVANTAGES
The major disadvantage of fixed exchange rates is the
international transmission of economic instability. Countries
are subject to inflation and unemployment transmitted through
trade and monetary flows from other countries. In addition,
sufficient reserves must be available to permit intervention in
foreign exchange markets. Finally, various trade restrictions
and exchange controls are often present.
The economic slowdown in the United States in 1930 quickly spread
to many countries of the world. For instance, the decrease of
American purchasers of British products, caused the British
economy to slowdown. Had the exchange rate between the dollar and
the pound been flexible, the trade deficit would have been
absorbed by a change in exchange rate. But the exchange rate was
The gold standard is one of the forms of a fixed exchange rates
system because all currencies have a set equivalent in gold
(mint parity). The system was abandoned in 1934, in part,
because of the worldwide transmission of the great depression.
The gold standard also required flows of gold from one country to
The official price of gold in the U.K. prior to 1934 was 4.25
British pounds per ounce of gold. The official price of gold in
the United States during that time was $20.67 per ounce of gold.
These two mint parities required that the exchange rate between
the two currencies be: 4.86 dollars per British pound.
FIXED EXCHANGE RATES SYSTEM
From 1944 to 1971, a system of pegged exchange rates was used.
Exchange rates were allowed to be flexible within certain pegs,
but not beyond: thus, this constituted a fixed exchange rates
system. The system was agreed upon in 1944 at the Bretton Woods
Accord, which also created the IMF.
After World War II, the official price of gold in the United
States was $35.00 per ounce of gold. The British pound could
no longer (since 1934) be converted directly into gold, but
it could be exchanged at the rate of $2.40 per pound and the
dollars could be converted into gold. This was the gold
exchange standard which lasted until 1971.
INTERNATIONAL MONETARY FUND
The International Monetary Fund (IMF) was created in 1944 by the
Bretton Woods Accord for the purpose of providing reserves to
countries which needed them to maintain their fixed exchange
rates. The IMF lends reserves to countries with balance of
The IMF has made loans to many countries which had difficulties
in maintaining the value of their currencies. Recently such
loans have been made to Mexico and Brazil.
INTERNATIONAL MONETARY SYSTEM
An international monetary system must be agreed to by the major
nations of the world because the actions of country to maintain
its exchange rate may well be frustrated by actions of other
countries; thus cooperation is necessary. This was illustrated
in the various fixed exchange rates systems. At present, the
system is neither fixed nor flexible; it is sometimes referred
to as managed or dirty float because countries occasionally
The official announcements of the meetings between the 7 major
monetary powers of the world (U.S., Great Britain, Japan,
Germany, Canada, France and Italy) often state that these
governments want to maintain the value of certain currencies
(e.g. the U.S. dollar). This shows that the current international
monetary system is not entirely free and flexible.
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