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Group X
SUBMITTED BY: JEENAL KARANI (16) MAYURI MODI (29) SWA NIL ARIK! ("6) REETI RAT!I (#$) KAUTIK S!A! (#6) ROBIN S!A! (#9)

Bretton Woods System

THE PRE BRETTON WOODS PERIOD
Most major internationalized nations of the world and their trading partners operated under Gold Standard: Each nation defined its currency in terms of gold Dollar=1/20 of ounce of gold, ound=!/20 of ounce of an ounce gold "ence, #1=$! Each nation agreed to con%ert its paper money into gold on demand and there was no restriction of shipment of gold from one country to other& 'old (tandard (ystem )ccounts *etween countries settled *y e+change of gold,E+port of a country - .mport lead to gold /low out&

A reduction in Gold reserves due to deficit of BOP

Ccontraction of money supply

Exchange Rate Fluctuations & Balance of Trade

Price decline Export goes up import goes down

BOP conditions restored

0hus, a*o%e process leads to an automatic correction in 12 through changes in the monetary gold reser%es of the nations& 1efore 3orld 3ar 1 nation a*ided *y the golden rule of gold standards and e%en after 3orld 3ar 1 *ut during the great depressions many countries suspended gold standards and ne%er re%i%ing it&

THE BRETTON WOODS SYSTEM ost 3orld 3ar 2 the 4nited 5ations Monetary and /inancial 6onference held at 1retton woods and proposed the esta*lishment of 0he .nternational Monetary /und 7.M/8 to achie%e e+change rate sta*ility and to help mem*er countries finance short term 12 deficits& 0he international *an9 of reconstruction and de%elopment 7.1:D8, now world *an9 to assist in the post war reconstruction and de%elopment of mem*er countries .nternational trade organization 7.028, to achie%e cooperation among trade mem*ers

0he 1retton wood rested on 2 illars 0he maintenance of sta*le e+change rates ) multilateral credit mechanism institutionalized in the .M/ and super%ised *y it& 0he 1retton woods (ystem was considered as good as gold The Par value system or pegged exchange rate system (1947 1971! 0his system ena*led each country define its currency in terms of gold or 4( Dollars 7owing to financial dominance of 4(, 4(D acted as the inter%ention currency to sta*ilize e+change rates in the mar9et8 and to maintain 7to peg8 the mar9et %alue of its currency within ; 1 percent of the defined 7par8 %alue& 0he %alue of the 4( dollar was set at 1/<! of an ounce of gold and the 4nited (tates promised that all 4( dollars in the hands of central *an9s would *e redeemed in gold, upon demand, at the fi+ed price of $<! per ounce& E%ery other nation then defined its currency in terms of the dollar and/or gold& )t the end of the 3orld 3ar .., the 4nited (tates held o%er =>? of the worlds monetary gold stoc9 and accounted for a*out half of the world@s real '5 & )n important reason for this was that *ecause of the financial dominance of the 4nited (tates, it was ine%ita*le that other countries came to regard the 4( dollar as international money& )s a result, they accumulated dollars in official reser%es and used it as an inter%ention currency to sta*ilize e+change rates in the mar9et& 0he failure of gold, a 9ey source of reser%e in the 1retton 3oods system, to pro%ide a steady and sufficient increase in international liAuidity o%er time also contri*uted to this trend& 0he dollar was not merely as good as gold, it was *etter than gold *ecause 7as reser%es8 earned interest while gold did not&
Exchange Rate Fluctuations & Balance of Trade

0he designers of the par %alue system realized that the e+change rate *etween two currencies would not hold constant fore%er, *ut they hoped that changes would *e infreAuent and would *e made for %alid reasons, under controlled conditions& 1retton woods (ystems, pro%ided a steady and sufficient increase in international liAuidity& 0he .M/ pro%ided credit facilities to mem*er countries suffering from payment pro*lems& 0he credit facilities which a mem*er could a%ail of normally depended on its Auota i&e& the mem*er@s contri*ution to the fund, imports, ratio of e+ports to income and %aria*ility of imports& Breakdown of the Bretton Woods System and emergence of managed !oat "#ost $%&$' 0he sta*ilization process under this system reAuired reser%e assets, just as it did under the gold system& 0he difference was that nations 9ept their reser%es not only in gold *ut also in dollars& )n e+pansion in trade, howe%er, reAuired an increase in international liAuidity& (ince major part of the gold and dollars, the international reser%es, were in the 4(), growth could come only from an outflow of gold and dollars from there& .n the early period 71B!0@s8 the supply of dollars outside came from the Marshall plan and other )merican aid programmed, contri*ution to the 3orld 1an9, multinational in%estments and )merican defense e+penditure a*road& 0he small deficits in the )merican 12 in 1B!0@s were welcome *ecause they appeared that the 1retton 3oods system *y permitting the e+pansion of world monetary reser%es at a much faster rate than a system restricted *y supply of gold, sol%ed one of the major pro*lems of the gold standard *ut had many defects 0he 3orld@s supply of gold did not increase adeAuately to meet the reAuirements of rapidly e+panding international trade and finance, the dollar increasingly *ecame the world currency in which international reser%es were 9ept *y %arious countries& 1ut, the 4( had a large deficit in 12 during 1BC0@s& 0o meet these deficits, the 4( used its gold reser%e for ma9ing payments to other countries 7'ermany and Dapan8& 0his could not continue fore%er *ecause its gold reser%es would ha%e e%entually run out& 0he 4( official gold stoc9 dropped from a*out $2! *illion in 1B>B to around $10 *illion in 1B=1& Due to surplus 12 'ermany and Dapan acAuired not only gold *ut a large Auantity of the dollars from the 4( which they 9ept as reser%es& "ad countries holding dollars tried to e+change them for gold, it would ha%e hurt .nternational trade& .n %iew of large and persistent deficit in 12 , the 4( go%t& withdrew its con%erti*ility of dollar into gold at $<!/ounce& 0he lin9 *etween gold and international %alue of the

Exchange Rate Fluctuations & Balance of Trade

dollar ended and conseAuently dollar was floated, permitted its e+change rate with other countries to *e determined *y mar9et forces& Sm"thson"an #greement: , )n agreement for the realignment of e+change rate to correct the prior o%er,%aluation of the dollar& 0he dollar price of the gold was increased from $<! and $<E an ounce and further $>2&2 an ounce& 6urrencies were allowed to fluctuate within a wider 2&!? range on either side of the newly fi+ed rates called the central rates& E%en this agreement reAuired 6entral *an9 sta*ilization efforts *ut it allowed more fluctuation of rate& 0he collapse of the (mithsonian )greement leads to floating e+change rate system& Monetary authorities ha%e not allowed their currency %alues to *e determined solely *y demand and supply, *ut ha%e *een inter%ening time to time to 9eep the e+change rates while pro%iding sharp fluctuations in rates& The $ama"ca #greementF 0he agreement recognized that although e+change rates should reflect the *asic forces of demand and supply, go%ernments ha%e the right to maintain their own sta*ilization policies to inter%ene in the foreign e+change mar9et& )ll go%t& should pursue the goal of international sta*ility and growth& .t also eliminated the official price of gold& 0he .M/ sold 1/Cth of its gold reser%es and used proceeds to help GD6 7least de%eloped countries8 (earn)ng from the Bretton woods System %n&lat"on, 0he classical gold standard had the lowest rate of inflation, and the interwar period displayed mild deflation& 0he rate of inflation during the 1retton 3oods period was on a%erage, and for e%ery country e+cept Dapan, lower than during the su*seAuent floating e+change rate period& 'eal per (ap"ta G)%, 'enerally, the 1retton 3oods period e+hi*ited the most rapid growth of any monetary regime, especially the con%erti*le period& 1ut, *ecause of higher %aria*ility in the precon%erti*le period, the 1retton 3oods system as a whole was more %aria*le than the floating period& )om"nal and 'eal *xchange 'ates, 0he lowest mean rates of change of the nominal e+change rate and the least di%ergence *etween rates of change occurred during the 1retton 3oods con%erti*le and the gold standard period&
Exchange Rate Fluctuations & Balance of Trade

Managed !oat System )n Ind)a .ndia has a fle+i*le or floating e+change rate system& Garge appreciation or depreciation of e+change rate ad%ersely affects the economy, especially 12 & .n order to pre%ent this, :1. often inter%enes to ensure that e+change rate should remain within reasona*le limits& 3hen the rupee is depreciating too much, :1. inter%enes and sells dollars from its reser%es of foreign e+change& 0his increases the supply of dollars in the mar9et and pre%ents the depreciation of the rupee& 0hough the inter%ention *y :1., e+change rate system is not allowed to change *eyond certain limits& 0herefore, such a system that has *een adopted *y .ndia is not completely fle+i*le or floating e+change rate system& 0herefore, it is called managed float system&

Su+m"tted By: reeti :athi 7>08

References %nternat"onal ,acro *conomy Pol"cy +y Paul -rugman *conom"cs *nv"ronment o& Bus"ness +y S (hand The Bretton Woods %nternat"onal ,onetary System: # ."stor"cal /verv"e0 +y ,"cheal 1 Bordo

Exchange Rate Fluctuations & Balance of Trade

Ty#es of ore)gn E*change Rates

/oreign E+change :ates can *e classified into the following categories, 5ominal, :eal, /i+ed and /le+i*le E+change ratesF

The Nom)na! E*change Rate

.t is the Hrelat"ve pr"ce o& the currenc"es2 of two countries& 5ominal e+change rates are esta*lished on currency financial mar9ets called I/ore+ mar9etsI, which are similar to stoc9 e+change mar9ets& /or e+ampleF if the e+change rate *etween the 4&( dollar and the Dapanese yen is 120 yen per dollar, then a dollar can *e e+changed for 120 yen in the world mar9ets for foreign currency& Dapanese who wants to o*tain dollars would pay 120 yen for each dollar he *ought& )n )merican who wants to o*tain yen would get 120 yen for each dollar he paid& 3hen people refer to Hthe e+change rateJ *etween two countries, they usually mean the 5ominal E+change :ate& (uppose the e+change rate on a particular day of 11!&C2 yen per dollar was up from 11>&B2 yen per dollar on the day prior to that particular day, such a rise in the e+change rate is called an appreciation of the dollar& 2n the contrary, if the rate comes down to 11<&E!, it will imply depreciation of the dollar& 0he rule goes that, when the domestic currency

appreciates, it *uys more of the foreign currencyK when it depreciates it *uys less& )n appreciation is sometimes called a (trengthening of the currency and depreciation is called a 3ea9ening of the currency&
Exchange Rate Fluctuations & Balance of Trade

"

The Rea! E*change Rate

.t is the Hrelat"ve pr"ce o& the goods2 of two countries& 0he real e+change rate tells us the rate at which we can trade the goods of one country for the goods of another& 0he real e+change rate is sometimes called the Hterms of tradeJ& 0o see the relation *etween real and nominal e+change rates, we consider a single good produced in many countriesF 6ars& (uppose an )merican car costs $10,000 and a similar Dapanese car costs 2,>00,000 yen& 0o compare the prices of the two cars, we must con%ert them into a common currency& .f a dollar is worth 120 yen, the then the )merican car costs 1,200,000 yen& 6omparing the price of the )merican 6ar 71,200,000 yen8 and the price of the Dapanese car 72,>00,000 yen8, we conclude that )merican car costs on,half of what the Dapanese car costs& 0hat is at the current price we can e+change 2 )merican cars for a Dapanese car& 0herefore, :eal E+change :ate is = 5ominal E+change :ate L rice of Domestic 'ood rice of /oreign 'ood .f the real e+change rate is high, foreign goods are relati%ely cheap, and domestic goods are relati%ely e+pensi%e and %ice,%ersa&

)*ed "Sta+!e' ore)gn E*change Rate

Exchange Rate Fluctuations & Balance of Trade

4nder the system of fi+ed e+change rates, a 6entral 1ac9 stands a ready to *uy or sell the domestic currency for foreign currencies at a predetermined price& ) fi+ed e+change rate dedicates a country@s monetary policy to the single goal of 9eeping the e+change rate at the announced le%el& .n other words, the essence of a fi+ed e+change rate system is the commitment of the 6entral *an9 to allow the money supply to adjust to whate%er le%el will ensure that the eAuili*rium e+change rate in the mar9et for foreign currency e+change eAuals the announced e+change rate& Moreo%er, as long as the central *an9 stands ready to *uy or sell foreign currency at the fi+ed e+change rates, the money supply adjusts automatically to the necessary le%el& /or e+ampleF suppose the /ed is going to announce that it was going to fi+ the

e+change rate at 100 Men per Dollar& .t would then stand ready to gi%e $1& 0o carry out this policy, the /ed would need a reser%e of dollars 7which it can print8 and a reser%e of yen 7which it must ha%e purchased pre%iously8&

!oat)ng E*change Rate

4nder a floating e+change rate system, the e+change rate is set *y mar9et forces and is allowed to fluctuate in response to changing economic conditions& .n this case, the e+change rate e adjustments to achie%e simultaneous eAuili*rium in the goods mar9et and the money mar9et& 3hen something happens to change that eAuili*rium, the e+change rate is allowed to mo%e to a new eAuili*rium %alue&
Exchange Rate Fluctuations & Balance of Trade

actors that affect e*change rate f!,ct,at)ons

0here are %arious reasons which may cause fluctuations in e+change rates in an economy which are as followsF

Pol"t"cal Sta+"l"ty: ) 9ey factors which impacts demand .( olitical sta*ility& E%en with a large supply, and no glo*al demand, the currency of a country de%alues say, *ecause of a ci%il war& .n%estors e+change speculati%e currencies for Hsafe ha%enJ currencies, in the e%ent that there are political insta*ilities across the world& )lso, the change in the country go%ernment,
Exchange Rate Fluctuations & Balance of Trade

go%ernment policies cause a change in the e+change rate&

*conom"c Sta+"l"tyF )n economic factor li9e .nterest rate generally determines the fluctuation of e+change rate& 3hen an economy is ailing and the *usiness sector might *e doing its *est to reco%er losses do the *est they can to sol%e the pro*lem lest which they would enter *an9ruptcy, it implies that the economy is unsta*le and the interest rates are mo%ing down continuously&& 0he interest rate change affects the e+change rates which in turn lead to inflation 7which generally depends on e+pectations8 in an economy&

1emand and Supply: E+change rate fluctuations may also happen due to the demand or supply conditions of a particular currency& 0he changes in demand and generally happen due to changes in price of currencies&

1&

Exchange Rate Fluctuations & Balance of Trade

3re4uency o& trade: 0he freAuency of *uying and selling of currencies also impact the prices of the currencies which has a direct impact on the e+change rates of the same&

)atural (alam"t"es: .f an economy has faced any natural calamity, it gets affected and thus the entire economic system also gets affected which causes a change in the demand and supply of goods and ser%ices which also impacts the prices of these imports and e+ports thus impacting the e+change rates of currencies& Su+m"tted By: Mayuri Modi 72B8 References ,acroeconom"cs +y )5Gregory ,an6"0 ,acroeconom"cs (*conom"c Gro0th7 3luctuat"ons7 and Pol"cy! +y 'o+ert *5 .all and 1av"d .5 Papell

11

Exchange Rate Fluctuations & Balance of Trade

Inter-ent)on
Introd,ct)on
6entral 1an9 inter%enes in currency mar9et or /oreign e+change mar9et when there is huge num*er of *uying or selling of currency leading to depreciation/appreciation of currency *eyond a prescri*ed limit& .n .ndia, currency rate was earlier decided *y :1., thus foreign e+change currency rates were fully under control of :1.& /rom 1BB<, :1. has made it made it mar9et dri%en& 0hus, inter%ention comes into picture when /loating e+change rate system is implemented&

Necess)ty of Inter-ent)on

.n floating rate system, the currency rate is determined *y mar9et forces 7demand and supply8& "ence, if proper monitoring of currency in not done then there would *e a huge change in home currency rates leading to e+change losses&

)ote: There are only t0o ma8or sources o& earn"ng &ore"gn currency: *xport and Borro0"ngs

/oreign 6urrency is a scarce resource, hence it is %ery necessary that 6entral *an9 inter%enes and maintains currency for future reAuirement 7unforeseen circumstances8&
Exchange Rate Fluctuations & Balance of Trade

0hus, we can conclude that, .nter%ention of 6entral 1an9 is to protect mar9et failure, :edistri*ution of income and to achie%e other noneconomic o*jecti%es& .nter%ention can *e done through different ways depending on the decisions made of Ministry of /inance and counties economic condition&

12

o!!ow)ng are the fo,r ma.or ty#es of Inter-ent)on $a0+on"ng

.t is one of the cheapest and easiest methods of inter%ention& "ere, Ministry of /inance or :epresentati%es of 6entral 1an9 tal9s a*out the future currency rates in the mar9et in order to persuade the pu*lic to *uy or purchase and hence control prices& 0his method doesn@t in%ol%e usage of foreign e+change reser%e for application of policy&

(oncerted
.n this type of inter%ention nations unify and discuss a*out a particular currency that is fluctuating too much& 0his method is successful if the num*er of nations in%ol%ed is in large num*ers& "ere they decide to appreciate or depreciate a particular currency in terms of other currency&

/perat"onal %ntervent"on
)s the name suggests the actual currency *uying or selling is done as per the reAuirement& .t is one of the most directly effecti%e method as the result will *e seen fast& )lso the countries inter%ening %ery often cannot use this 9ind of method which might lead to depletion of foreign reser%es&

Exchange Rate Fluctuations & Balance of Trade

9nster"l":ed and Ster"l":ed %ntervent"on

4nsterilized inter%ention means when central *an9 sells the foreign currency in the mar9et and purchases domestic currency which reduces money supply in the economy& 0his effect of decreased money supply can *e sterilized *y purchases of 'o%ernment securities from the mar9et leading to infusing domestic currency& 0hus (terilized .nter%ention is all a*out offsetting the money supply or 9eeping the monetary *ase constant&

13

3or example
2n Dune 1=, 1BBE the /ederal :eser%e 1an9 of 5ew Mor9 *ought $E<< Million worth of yen 7D M8 at the direction of the 4&(& 0reasury and the /ederal 2pen Mar9et 6ommittee& .n the a*sence of offsetting transactions, this transaction would ha%e increased the 4&(& monetary *ase *y $E<< million, which would tend to temporarily lower interest rates and ultimately raise 4&(& prices, depressing the %alue of the dollar& )s is customary with 4&( inter%ention, howe%er, the /ederal :eser%e 1an9 of 5ew Mor9 also sold an appropriate amount of 4&(& 0reasury securities to a*sor* the liAuidity and maintain desired conditions in the inter*an9 loan mar9et& (imilarly, to pre%ent any change in Dapanese money mar9et conditions, the 1an9 of Dapan would also conduct appropriate transactions to offset the rise in demand for Dapanese securities caused *y the $E<< million /ederal :eser%e purchase& 0he net effect of these transactions would *e to increase the relati%e supply of 4&(& go%ernment securities %ersus Dapanese securities held *y the pu*lic *ut to lea%e the 4&(& and Dapanese money supplies unchanged&

o!!ow)ng are the -ar)o,s Ster)!)/at)on )nstr,ments ,sed +y 0entra! Banks1

1& GiAuidity )djustment /acility/ :epurchase agreementsF 2& 2pen Mar9et 2perations <& 1alances of 'o%ernment of .ndia with :eser%e 1an9 of .ndiaF >& 'o%ernment of .ndia *alances with the :eser%e 1an9 !& /2:EN (waps C& 6ash :eser%e :eAuirementsF
Exchange Rate Fluctuations & Balance of Trade

0hus, (terilization should *e done ta9ing into consideration e+change rate policy, le%el of reser%es, interest rate policy along with considerations related to domestic liAuidity, financial mar9et conditions as a whole, and degree of openness of the economy& 0he only thing that is necessary to understand that (terilized .nter%ention is different from monetary policy and hence it should not affect the o*jecti%es of monetary policy&

Ster)!)/ed and 2nster)!)/ed Inter-ent)on 0om#ar)son

.nter%ention *y central *an9 is done only after it has measured the inflow and the outflow of the capital account in long term as well as short term&

4nsterilized .nter%ention can *e preferred as it helps in alignment of Domestic .nterest rates with .nternational .nterest rates& .n short run, it leads to asset price %olatility, imprudent lending etc&

(terilization is a temporary measure to as it helps in temporary inflows and Auic9 implementation& (terilization is preferred as it 9eeps money supply and money *ase unchanged& "owe%er, in future there can *e pressure *uild up in on interest rates&

0onc!,s)on1 %ntervent"on &rom (entral Ban6 "s never d"sclosed to anyone5 %t "s one o& the most con&"dent"al operat"ons7 as reveal"ng the operat"on 0ould lead to un atta"nment o& the o+8ect"ve +eh"nd conduct"ng any part"cular type o& "ntervent"on5

Su+m"tted By: Deenal Oarani 71C8 'e&erences

Exchange Rate Fluctuations & Balance of Trade

0in*ergen .nstitute Discussion aperF 0he .mpact of 6entral 1an9 /N .nter%entions on 6urrency 6omponents :eport of the 3or9ing 'roup on .nstruments of (terilization

1!

E*change Rate mo-ements and Trade !,ct,at)ons

Introd,ct)on
2nce the 1retton 3oods system came to an end there was a de*ate in the academic circles a*out whether the real e+change rate were fle+i*le enough to support trade adjustments& 0here was another de*ate at that point of time into the academic circles that whether or not the demand for international goods was sensiti%e to foreign currency changes& 0he *est way to understand the direct effect of fluctuation in e+change rate causes a change in the *alance of trade of a country can *e seen *y the following e+ample& 3e can ta9e the case of trade *etween the .ndia and 4()& .f there is a situation in which, there is a depreciation of the dollar %is,P,%is the rupee& 0hen this ma9es 4&( produced goods cheaper to .ndian consumers/ importers& 0his in turn will *oost the price competiti%eness of 4&(& firm@s %is,P,%is the .ndian firms& /or e+ample if there is a mo%ement from one dollar for :s& >0 to :s& <0 per dollar and assume that 4&(& e+porters charge a set price in dollars, say $10, for each unit sold& 0he price in paid *y consumer decreases from >00 :s& to <00 :s& 0hus this will lead to an increase in the e+ports of 4( and a sharp decrease in the e+ports of .ndian 'oods&

1"

Exchange Rate Fluctuations & Balance of Trade

/urther if an .ndian importer needs some raw materials for producing his goods which he is supplying in the domestic mar9et he will ha%e no choice *ut to increase the price of his products in the .ndian mar9et& 0his effect is called as the pass through effect in economic literature wherein the fluctuation in e+change rate simply affects the cost of production in a country which is then 3#assed thro,gh to the f)na! reta)! #r)ce of the #rod,ct45

E*#end)t,re Sw)tch)ng Effect

)lso if 4&(&,made goods are su*stitutes for .ndian,made goods, .ndian consumers will switch their consumption, increasing their demand for 4&(& produced goods and reducing their demand for .ndian ones& ) similar mechanism would *e triggered in the 4nited (tates, where the dollar price of .ndian good for which the e+porters charge increases& 0his effect of responsi%eness of an economy to the changes in the e+change is e+plained through the e*#end)t,re5sw)tch)ng effect&

3e should remem*er that and there is relationship that e+ists *etween the real e+change rate and the imports and e+ports in a country& 3hen the real e+change rate is high, the relati%e price of goods at home is higher than the relati%e price of goods a*road& .n our e+ample the increase in the cost of .ndian products and also the decrease in price of 4( products 7induced through depreciation of 4( currency8 will lead the .ndian consumer to *uy more of 4( goods than the .ndian goods leading of worsening terms of trade and greater deficit in the *alance of
Exchange Rate Fluctuations & Balance of Trade

payments account of .ndia& 0he model of this e+penditure switching effect is used *y policy ma9ers in many countries to sta*ilize their economy which is facing ad%erse rise in prices due to supply shoc9s& /or e+ample an increase in the relati%e price of a home made goods resulted from an ad%erse home output shoc9 raises the cost of li%ing of home households and there*y it reduces home consumption& 4nder the fle+i*le e+change rate system the policy ma9ers are a*le to increase money supply and depreciate the e+change rate in foreign currency to induce agents across the world to switch to relati%ely cheap home produced= good, stimulating e+ports and home production and increasing home income and consumption&

1#

E!)m)nat)on of R)sk )n ore)gn E*change Market

0hus the ris9 in%ol%ed in foreign trade induced *y its fluctuation persists in this glo*alized world& .n order to minimize this ris9 the traders in%ol%e in foreign currency hedging& "edging is the *est way to translate the %olatility in the currency mar9et and minimize the losses arising out during foreign rate fluctuation *etween the date of the transaction and the date of the actual receipt or payment&

ore)gn 0,rrency Hedg)ng Strateg)es

0here are %arious internal and e+ternal ways of hedging foreign trade ris9s& 0he internal ways are as followsF, 15 ;ead"ng and ;agg"ng %ncome and *xpend"tures: ) trader can lead 7pay in ad%ance8 or lag 7pay late8 his foreign currency payments, depending on whether he e+pects the foreign currency to appreciate or depreciate, in the near future& 0he idea is that foreign currency depreciation 7home currency appreciation8 translates into lower receipts and higher payments, respecti%ely& .n foreign trade, for e+ample, if a manufacturer has to pay $1 million on a certain date for imported material and recei%es an e+port order for $1 million, it might try either to delay the payment for imports or to press for an early
Exchange Rate Fluctuations & Balance of Trade

payment *y the *uyer, or *oth, so that the cash inflow from e+port is used as cash outflow for imports& .t will thus try to escape de%aluation ris9 in import,payment and default ris9 in e+port,receipt *y juggling two cash flows&

<5 )ett"ng 'ece"pts and PaymentsF 0he idea of netting in%ol%es matching 7or clu**ing8 the receipts and payments in a currency, so that any losses in receipts are compensated *y the gains in payments and %ice %ersa& Su+m"tted By: = :o*in (hah 7>B8

1$

'e&erences Introd,ct)on 1& 0he .nternational :ole of the Dollar and 0rade 1alance )djustment *y Ginda 'old*erg Q 6Rdric 0ille E*#end)t,re Sw)tch)ng 2& .mpact of 0rade 2penness on the E+penditure (witching effect of E+change :ate S *y 'eun Mee )hn S 6hung "an Oim 7Dune 200=8 <& E+penditure 6hanging and E+penditure (witching policies *y "iro .to 7 ortland (tate 4ni%ersity8 Hedg)ng httpF//www&*uzzle&com and )rticle on "edging *y (ayali 1ede9ar atil

1%

Exchange Rate Fluctuations & Balance of Trade

6 0,r-e Theory
Def)n)t)on of 76 0,r-e8
)s per the D 6ur%e theory, a countryTs trade deficit will worsen in the initial stage after the de%aluation of its currency *ecause the amount *y which prices of foreign imports has risen will *e greater than the reduced %olume of imports& 0he term $ curve is used in se%eral different fields to refer to a %ariety of unrelated D,shaped diagrams where a cur%e initially falls, *ut then rises to higher than the starting point& "istorically, the D,6ur%e effect has *een more noticea*le in the 4nited (tates of )merica, where pri%ate eAuity firms tend to carry their in%estments at the lower of mar9et %alue or in%estment cost and ha%e *een more aggressi%e in writing down in%estments than in writing up in%estments& )s a result, the carrying %alue of any in%estment that is underperforming will *e written down *ut the carrying %alue of in%estments that are performing well tend to *e recognized only when there is some 9ind of e%ent that forces the pri%ate eAuity firm to mar9 up the in%estment& $ (urve : Balance o& Trade along 0"th the 3ore"gn *xchange rate

2&

Exchange Rate Fluctuations & Balance of Trade

.n economics, the TD cur%eT refers to the trend of a country@s trade *alance following a de%aluation or depreciation under a certain set of assumptions& ) de%alued currency means imports are more e+pensi%e than e+ports, and it is assumed that the %olume of imports and e+ports change little immediately, this causes a depreciation of the current account 7a *igger deficit or smaller surplus8& )fter some time, e%en though the %olume of e+ports starts to rise *ecause of their lower and more competiti%e prices to foreign *uyers, on the other end domestic consumers may *uy fewer of the costlier imports& E%entually, if a*o%e scenario ta9es place, the trade *alance may impro%e which declined at t the time of de%aluation of domestic currency& .f there is a currency re%aluation or appreciation the same reasoning leads to an in%erted D,cur%e& .mmediately following the depreciation or de%aluation of the currency, the %olume of imports and e+ports may remain largely unchanged due in part to pre,e+isting trade contracts that ha%e to *e honoured& Moreo%er, in the short run, demand of more e+pensi%e imports 7and demand for e+ports, which are cheaper to foreign *uyers using foreign currencies8 remains price inelastic& 0his is due to time lags in the consumerTs search for accepta*le, cheaper alternati%es 7which might not e+ist8 2%er the longer term depreciation in the e+change rate can ha%e the desired effect of impro%ing the current account *alance& Domestic consumers might switch their
Exchange Rate Fluctuations & Balance of Trade

e+penditure to domestic products and away from e+pensi%e imported goods and ser%ices, assuming eAui%alent domestic alternati%es e+ist& EAually, many foreign consumers may switch to purchasing the products *eing e+ported into their country, which are now cheaper in the foreign currency, instead of their own domestically produced goods and ser%ices& Empirical in%estigations of the D,cur%e ha%e sometimes focused on the effect of e+change rate changes on the trade ratio, i&e& e+ports di%ided *y imports, rather than the trade *alance, e+ports minus imports& 4nli9e the trade *alance, the trade ratio can *e logged regardless of whether a trade deficit or trade surplus e+ists

21

(ountry status model ( re&: $ (urve Boo6 +y Bremmer!

)nother TD,6ur%eT refers to the correlation *etween sta*ility and openness& 0his theory was suggested initially *y the author .an 1remmer, in his *oo9 0he D 6ur%eF ) 5ew 3ay to 4nderstand 3hy 5ations :ise and fall& 0he +,a+is of the political D,6ur%e graph measures the TopennessT of the economy in Auestion and the y,a+is measures the sta*ility of that same country& .t suggests that those countries that are TclosedT/undemocratic/unfree 7such as the 6ommunist dictatorships of 5orth Oorea and 6u*a8 are %ery sta*leK howe%er, as one progresses right, along the +,a+is, it is e%ident that sta*ility 7for relati%ely short period of
Exchange Rate Fluctuations & Balance of Trade

time in the lengthy life of nations8 decreases, creating a dip in the graph, until *eginning to pic9 up again as the TopennessT of a county increases )t the other end of the graph to closed countries are the open countries of the 3est, such as the 4nited (tates of )merica or the 4nited Oingdom& 0hus, a D,shaped cur%e is formed& 6ountry can tra%el *oth forward 7right8 and *ac9wards 7left8 along this D,cur%e, and so sta*ility and openness are ne%er secure& 0he D is steeper on the left hand side, as it is easier for a leader in a failed state to create sta*ility *y closing the country than to *uild a ci%il society and esta*lish accounta*le institutionsK the cur%e is higher on the far right than left *ecause states

22

that pre%ail in opening their societies 7Eastern Europe, for e+ample8 ultimately *ecome more sta*le than authoritarian regimes& 1remmerTs entire cur%e can shift up or down depending on economic resources a%aila*le to the go%ernment in Auestion& (o (audi )ra*iaTs relati%e sta*ility at e%ery point along the cur%e rises or falls depending on the price of oilK 6hinaTs cur%e analogously depends on the countryTs economic growth&

Su+m"tted By: (wapnil ari9h7<C8

References 1evaluat"on: http:>>en50"6"ped"a5org>0"6">1evaluat"on $ (urve and Sta+"l"ty o& 3ore"gn *xchange ,ar6et %nternat"onal 3"nance 1"scuss"on Paper $ (urve Boo6 +y %an Bremmer

23

Exchange Rate Fluctuations & Balance of Trade

The Em#)r)ca! E*am#!e1 The 9s)an )nanc)a! 0r)s)s

9n O-er-)ew
/or Auite an e+tensi%e period *efore 1BB=, )sian countries li9e .ndonesia, Oorea, Malaysia and 0hailand had a sta*le growth, E,12? 'D , and their economic data such as inflation, fiscal position, and increase in e+port attracted the foreign in%estors& .t attracted almost !0? of capital inflow into de%eloping nation& 0his achie%ement was acclaimed *y financial institutions including 3orld 1an9 and .M/ which ga%e name to this e%ent as H)sian Economic MiracleJ& /irstly, lac9 of transparency which made in%estors as well as financial institutions to assume that )sian countries are ha%ing sta*le growth &(econdly, mislead structural and economic policies which did not e%en attempt to cur* deficits in *alance of payments and de*t are the two main factors which were ta9ing place *efore the crisis of 1BB=,1BBE and *ecame main reason for the catastrophic financial crisis& 0he )sian financial crisis too9 place in 1BB= in 0hailand while other )sian countries li9e Oorea, Malaysia, and .ndonesia su*seAuently followed& 0here was a rapid increase in de*t in these countries due to shorter payment dead line& 0he international de*t of 5orth Oorea increased from <1&CBB million dollars in 1BB0 to 1C>&<>! million at the end of 1BBC& 0hailand increased from 2E&0EE million dollar de*t to B0&C22 million in the same period& 0he short,de*t represented <1? of the total de*t in 1BB0 for (outh Oorea, yet in 1BBC it represented C=? 73orld 1an9 report8& Most parts of this de*t were in%ol%ed in the pri%ate sector& Major economists namely Gawrence, Gincoln, /urman and (tiglitz agreed that short term de*t was one of the main factors of crisis& (hort term de*t was %ery high, it occurred *ecause of following reasonsF )sian pri%ate entities offered a high short term interest rate which attracted in%estors to in%est in such institution due to high return& /i+ed e+change rate system was *een used *y these countries which meant that in%estors won@t lose any money while con%erting from one currency to other when they
Exchange Rate Fluctuations & Balance of Trade

withdraw their funds from the institutions, which led to deficit *alance in *an9s as there was high payouts to the in%estors and not enough assets to ma9e accounts *alance& (ta*ilization agencies were unaware of the situation faced *y *an9 which led to increase in magnitude of the crisis& Measures ta9en *y central *an9 of the affected countries to cur* this crisis situation were to increase the interest rate of long term in%estment and decrease the interest rate of short term in%estments& 1ut the strategy failed and didn@t *ring the e+pected results& 0his was *ecause when there is change in interest rate it also affects e+change rate, money supply and e+ports as well& Moreo%er when interest rates go up the mar9et will suspect a wea9ening in financial system which in turn will represent as a signal of lac9 of confidence&

0a,ses of de+ac!e 0he causes of de*acle are many and disputed& (ome of them areF
Exchange Rate Fluctuations & Balance of Trade

(hort term capital flow was e+pensi%e and often highly conditioned for Auic9 profit& De%elopment money went in the hands of people who were not particularly the *est suited or most efficient, *ut those closest to the centres of power& 0hese countries *ecame e+cessi%ely dependent upon e+ports for their economy& 4&( reco%ered from 'reat depression of 1BB0@s and /ederal :eser%e 1an9 increased the interest rates which attracted in%estors and in%estment destination changed from )sia to 4&( which raised the %alue of dollar&

0hese countries had currencies pegged to the 4&( dollars hence higher the %alue of dollar caused their own e+ports e+pensi%e and less competiti%e in glo*al mar9et& 0hese countries e+port growth rate slowed down in 1BBC which deteriorated their current account position&

2!

Pr)mary Effects of the de+ac!e :esulting large Auantities of credit that *ecame a%aila*le generated a highly le%eraged economic climate and pushed the asset prices up to an unsustaina*le le%el& )sset prices e%entually *ean to collapse, causing indi%iduals and companies to default on de*t o*ligations& 0his created panic situation among lenders which resulted in large amount of withdrawal from crisis countries causing credit crunch and *an9ruptcies& )s large amount of foreign in%estors started withdrawing money from crisis countries, it resulted in depreciation of their currencies& Measures ta9en *y central *an9 and go%ernment as specified a*o%e didn@t sustain for long& 0he authorities allowed their currencies to float instead of fi+ed e+change rates& 0he resulting depreciated %alue of those currencies resulted increase in foreign currency,denominated lia*ilities than that of domestic currency terms, causing more *an9ruptcies and further deepening the crisis&

Ma.or 0onse:,ences
0he crisis had significant macroeconomic,le%el effects, including sharp reductions in %alues of currencies, stoc9 mar9ets, and other asset prices of se%eral )sian countries& 0he nominal 4&(& dollar 'D of )(E)5 fell *y 4($B&2 *illion in 1BB= and $21E&2 *illion 7<1&=?8 in 1BBE& .n (outh Oorea, the $1=0&B *illion fall in 1BBE was eAual to <<&1? of the 1BB= 'D & Many *usinesses collapsed, and as a conseAuence, millions of people fell *elow the po%erty line in 1BB=S1BBE&
Exchange Rate Fluctuations & Balance of Trade

.ndonesia, (outh Oorea and 0hailand were the country@s most affected *y the crisis& 0he economic crisis also led to a political uphea%al, most nota*ly culminating in the resignations of resident (uharto in .ndonesia and rime Minister 'eneral 6ha%alit Mongchaiyudh in

0hailand& 0here was a general rise in anti,3estern sentiment, with 'eorge (oros and the .M/ in particular singled out as targets of criticisms& "ea%y 4&(& in%estment in 0hailand ended, replaced *y mostly European in%estment, though Dapanese in%estment was sustained& .slamic and other separatist mo%ements intensified in (outheast )sia as central authorities wea9ened&

2"

*xchange (per 9S?1! (urrency Dune

rate (hange (ountry

G)P (9S?1 +"ll"on! Dune Duly 1BBE 1BB= 0hailand 1=0 102 >0&0? (hange

Duly 1BBE 1BB= 0hai *aht .ndonesian 2,<E0 rupiah hilippine 2C&< peso Malaysian 2&! ringgit (outh (outh Oorean E!0 won 1,2B0 <>&1? >&1 <B&0? >2 <=&>? 1>,1!0 E<&2? .ndonesia 2>&! >1 >0&2?

20!

<>

E<&>?

hilippines

=!

>=

<=&<?

Malaysia B0

!!

<E&B?

><0 Oorea

2E<

<>&2?

Resc,e Meas,res
0he scope and se%erity of the collapses reAuired outside inter%ention& (ince large amount of money was at sta9e any response to the crisis was welcomed and was li9ely to *e cooperati%e
Exchange Rate Fluctuations & Balance of Trade

and international& .nternational Monetary /und 7.M/8 created series of *ailouts for the most affected economies to ena*le affected nations to a%oid defaults& 0he rescue pac9ages were gi%en putting forward some conditions 9nown as H(tructural )djustment ac9age 7() 8J& 0he () s called on crisis,struc9 nations to reduce go%ernment spending and deficits, allow insol%ent *an9s and financial institutions to fail, and aggressi%ely raise interest rates& 0he reasoning was that these steps would restore confidence in the nationsT fiscal sol%ency, penalize insol%ent companies, and protect currency %alues& 0he restrictions on foreign ownership were greatly reduced in some affected countries& 0here were to *e adeAuate go%ernment controls set up to

2#

super%ise all financial acti%ities& /inancial system were to *ecome 0ransparent and pro%ide with relia*le financial information which would help to ma9e sound financial decisions&

Pre-ent)ng f,t,re 0r)s)s

(ome proposals gi%en *y famous economist to the policy ma9ers to pre%ent crisis areF 0a+ for outflow of short,term capital& ) fi+ed spread for the financial institutions that will apply only in the short term& ) dirty e+change rate that will apply only the short term&
Exchange Rate Fluctuations & Balance of Trade

)n impro%ement of financial transparency&

Su+m"tted By: Oauti9 (hah 7>C8

References Paul Krugman, Currency Crises, January 2000

2$

Eshan Karunatilleka, The Asian Economic Crisis, ECONOMIC POLICY AND STATISTICS SECTION, FEBRUARY 1999

Warwick J. McKibbin and Waranya Pim Chanthapun , Exchange Rate Regimes in the AsiaPacific Region and the Global Financial Crisis ,October 2009.

Ila Patnaik , Ajay Shah , Anmol Sethy , Vimal Balasubramaniam , The exchange rate regime in Asia: From crisis to crisis

http://html.rincondelvago.com/asian-financial-crisis.html

http://en.wikipedia.org/wiki/1997_Asian_financial_crisis

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Exchange Rate Fluctuations & Balance of Trade