You are on page 1of 34


CHAPTER 1 ...................................................................................................................... 2
1.1 International Finance ................................................................................................ 2
1.2 Globalization ............................................................................................................ 4
Globalization on enterprises ....................................................................................... 4
Globalization on finance ................................................................................................. 7
CHAPTER II ...................................................................................................................... 8
2.1 International Monetary System. Exchange rate regimes ........................................... 8
2.2 Exchange rate regimes............................................................................................. 9
2.3 The European Monetary Union and the Euro ......................................................... 11
2.4 The euro crisis ........................................................................................................ 14
2.5 History of the international monetary system .......................................................... 15
Adjust the imbalances in the balance of payments under the gold standard ............. 16
2.6 The Interwar Period (1918-1939) ............................................................................ 17
2.7 Bretton Woods System (1944-1971)....................................................................... 19
2.8 Fixed versus flexible exchange rates ...................................................................... 22
Fixed Exchange Rates .............................................................................................. 22
Floating Exchange Rates .......................................................................................... 23
CHAPTER III ................................................................................................................... 24
3.1 BALANCE OF PAYMENTS .................................................................................... 24
ACCOUNTING BALANCE OF PAYMENTS .............................................................. 24
CHAPTER IV ................................................................................................................... 29
4.1 Equilibrium exchange rate ...................................................................................... 29
4.2 Currency Offer ........................................................................................................ 30
4.3 Capital account and Exchange rate ........................................................................ 30
4.5 Efficacy of the devaluation ...................................................................................... 32
BIBLIOGRAPHY .............................................................................................................. 34


1.1 International Finance

The purpose of this part is to acknowledge how to properly finance our projects, by

knowing the great/wide portfolio financial market offers us, there are many debt

instruments that could be used to optimize our assets and add value to our companies.

There are two sides that need to be understood as we enter into the financial framework;

International economy and corporate finance, which combined lead us to international

corporate finance.


International Economy International corporative finances

- International Monetary system - International finance markets

- Currency regimes - World-scale operations

- Process of adjustment to the imbalances of - Evaluation and management of exchange rate

the balance of payments. risk.

- Conditions of parity - International finance

- Factors that determine the exchange rate - Investment in international portfolio

Source: kozikowski, 2013

To understand how it works the international financial market we got to get that each point

of both international economy and corporate finance and its changes affect in great measure

the international financial market.

Here are some of the financial market functions:

Transfer risk; at the moment a company issues a bond that has a face value, is also issuing

risk and by giving it to the primary market and then the secondary market we could say the

company is transferring risk (as an example)

· Supply & demand; the process of pricing debt instruments is being developed at

every second, at the moment something (anything) happens in a country, it will affect

somehow prices in the international financial market

· Provides liquidity; the issuer receives liquidity by selling its debt instrument and the

buyer receives a promise of payment at a determined time

· Make money out of money; this happens within the primary and secondary market

both mixed up, the first buys the debt, sell it to the secondary market as loans, in the

secondary market the prices are renegotiated and sold again, until comes the maturity time

To get a better look on the last point (make money out of money) we will illustrate an


A financial Institution, from now FI, receives a deposit of USD 500,000 on January 1st, this

deposit will be returned to the original owner 120 days after the deposit has been made. If

the FI pays an interest rate of 6% it will have to look for 4 borrowers to lend that money at

a higher interest rate (in total), let’s suppose 2% each, the first borrower begins the same

date and pays the 30th day, then the second one starts the 30th day and pays the 60th day,

and so on until pays the 4th borrower, the sum is 8% from the lend minus 6% from the

deposit, which leaves us with a 2% profit.

International finance allows us to make proper decisions based on facts, by measuring the

risk and profits both at the same time, this will determine the cost of capital that we might

to give up if we assess two or more projects, which will give us a greater return? In what

time? At what risk? Always looking for liquidity also, there are some other issues that need

and some other political issues that might encourage a rough decrease in the companies’ cash flows. that might be represented through taxes. offshores some of its activities to other countries for a huge . there are three types in terms of globalization. 1. International Finance allows and enables the flow of cash from surplus agents to deficit agents. International. on its side. later to find the Net Present value. First of all an International enterprise is involved in exports as in imports. and the reason is that who runs a company tries to increase the value of its company and this value is represented by the total of future values (expected to receive) from a period and added to a risk rate that is the capital cost. knowledge on finance has been increasing the last 20 years and this due to globalization regardless of the disadvantages that some attribute as the wealth gap. wealth accumulation is part of the whole-package knowledge of it. from now NPV. Now adding the International part. leaving aside for a moment local enterprises which are be in our minds to finance a project. This matter generates opportunities in the International market. Multinational and transnational. even though the market is not perfect. The Multinational. The three quoted are.2 Globalization Globalization on enterprises According to the definition on types of enterprises by professor kozikowski. which will be mentioned later as well as the advantages. medium and large. from some company/people that has excess of money to someone who requires an amount of money to launch a project on something on that matter. For This matter. the risk rate is also related to the country risk. laws. small.

which basically says that the gap between rich and poor is getting wider . but by increasing the supply levels. in other to take the finances (for interest rates or risk rates). not entirely for company purposes. for the same reason. it could affect the economy of other countries · Deflationary tendencies. · And finally one issue that is being at the scope of every country. it might be better on a country to assemble parts (production). enterprises competitively relies on excessive capacity. but on the financial matter: · Prices volatility (difficult to measure risk exposure) · Infection effect. but there are some detractors to globalization. this of course in terms of costs comes accurate for the firm as are reduced. opportunities and investment) By far there is more to see the full picture. Transnationals. as the firm gets larger and larger. these multiplied by a huge number of companies that do the same. the global distribution gap. And for last but not least. these are by far larger than multinational. according to professor Kozikowski. it should expand its operations to reduces costs and increase on terms of economy of scale. customer services to another and so on. Now to address some of the advantages of globalization and how it works and fits in the International market here are some of it: · Lower costs on production · Larger scope on the market (economy of scale) · Be trend on public eye (to recognize the firm at any place) · Greater portfolio (of risk. if there is a crisis in country that has some presence on the financial market.number of reasons. there operations are so scattered that is nearly too difficult to determine where is the matrix. dropping prices below the surface.

we get a better profitability and use of capital than using the 100% of own capital. investors run away from these kind of economies. Of course both advantages and “disadvantages” makes on to think if it is better to be part of globalization or not. With globalization some jobs are getting useless. technology advances contribute to this indeed. Economies’ integration might get a bit scary for those who fear to have the flu. liabilities are used to leverage the capital performance. how much would last that risk and how much is the capital cost of the debt. According to a financial report “Long-term Financial report” by the World bank group (2016). but the looks of it right now on 2017. large companies in developing countries were the most affected from the financial crisis on 2008. not to mention Venezuela… Closed economies or protectionist measures mostly end up damaging the country’s reliability on foreign investment. this is an example of the previous point on disadvantages “infection”. Let’s just look what is happening to Ecuador. other than try and contribute and resent and globalization on its time will devour it. it seems that there’s no really a choice there. either countries get stronger or they will get ripped off. but nowadays there’s no way to escape from it. however there is a risk that must be assessed and addressed if it is a country risk. reducing the payment on taxes and other stuff as on interest rates. but is a matter of the government to determine what should be the measures to be taken to reduce the poverty for unemployment during these times. As we try to rely on finance externally.and wider due globalization. .

According to some financial analysts it is very preoccupying that financial activity shoot up without any proportion related to real economy (Kozikowski). so if there is financial crisis in one of those countries it will definitely affect somehow the international financial market. markets operate simultaneously in too many countries.Globalization on finance Globalization has made our world more open and connected. but not quite. at least not just that. financial markets and money markets are not different from this. it blows just like a bubble. as if the industry has not sustainable basis on its projections and how is it planned to grow on a period of time. then begins to increase roughly until. providing the necessary financial resources from surplus agents (who exceeds from money) to deficit agents (who lack of money). there’s also opportunities. as Kozikowski says on his book “International Finance”. . there is a delicate matter called speculation which starts slowly by the growth of a certain industry. it is obviously that the most of this transactions has little to do with international commerce and obeys to speculative and hedging matters. needless to say there are some figures that need to be discussed. Hedging wouldn’t be “bad” for this speculative matters if the finance goes to an industry that really needs it. as we’ve mentioned above about risk. at a given time. countries that are related with financial markets add their own country risk. note that it is said “somehow” because where there’s crisis. actually financial markets are no longer used to provide liquidity or to entirely look for finance . then finance would just be wasted when there are truly needs on other projects. At this moment globalization has been integrating financial and money market all around the world.

which increases the need for institutions to regulate and facilitate them. CHAPTER II 2. services and capital. Exchange rate regimes The international monetary system is the institutional framework established for making payments International flows of capital. a high degree of cooperation is required between governments of major countries. and to determine the exchange rates between the different currencies. The monetary system has evolved over time and continues to adapt to new realities. mechanisms. It is a set of international agreements. rules and policies necessary for the global economy to function. Globalization intensifies international flows of goods. institutions.1 International Monetary System. For the international monetary system to function. It is necessary to sacrifice part of the sovereignty National and subordinate some of the nationalist interests for the common good. .

the most known case is Hong Kong. 4. Hungary and Tonga. This group already includes more than 41 countries (including Australia. The coins of 30 Countries are affixed to a single currency. Romania. Japan. Council examples against the euro: Bulgaria. Honduras. with the difference that the role of gold is currently played by a hard currency. 6. National currency stuck to a coin or a basket of coins. to a strong currency. Independent float. Bermuda. 40 countries have such a monetary arrangement. Brazil. Costa Rica. Egypt. at a fixed rato. Israel. Cyprus. United States. The country uses as a means of payment the currency of another country like the dollar (Ecuador.2. Examples of the Monetary Council Against the dollar: Hong Kong. Nicaragua and Solomon Islands. Panama). . United Kingdom) and continues to grow. the national currency is convertible. Ten countries have their coins stuck to one basket of coins. Uruguay and Venezuela. 7. Total. Lithuania.2 Exchange rate regimes The International Monetary Fund exchange regimes in eight categories: There is no legal national currency. Crawling peg rate (four countries): Bolivia. 3. but within horizontal bands (five countries): Denmark. Exchange rate within crawling bands (Six countries): Belarus. Cayman Islands. Since Argentina adopted the free float. or the euro (the 23 countries of the Euro Zone). National currency stuck. The Monetary Council remembers the gold standard. Mexico. 2. By law. 1. Bosnia and Herzegovina. 5. Canada. Flotation administered without an announced route (41 countries). Currency board.

The aim of controlling the exchange rate is to have greater room for maneuver in macroeconomic policy. the exchange rate is the most important price in the economy. However. .  The exchange rate is flexible (free floating) if the central bank does not intervene in the market. In an open economy. For most countries. allowing the level of the exchange rate to be established as a result of the free play between supply and demand for foreign exchange. Fixed exchange rates may have strong variations and flexible exchange rates may be relatively stable over time.  The exchange rate is fixed if the central bank establishes its value and then intervenes in the foreign exchange market to maintain it. In general terms we can say that the objective of the authorities is to achieve internal and external balance. The monetary authority allows market forces to determine the long-term exchange rate. The practical operation of a currency regime can be very different from the intentions of its creators. exchange rate policy is related to the objectives of macroeconomic policy. but intervene sporadically to avoid excessive short-term fluctuations. but neither should we forget that not everything that is desirable is at the same time feasible. The key to the fixed exchange rate is the mandatory intervention of the central bank to achieve its desired level. The discussion on the most appropriate regime for the country's economy and for the world economy as a whole is far from complete. It should not surprise the eagerness to control it. The free floating exchange rate does not exclude the possibility of central bank intervention. Another important objective is high and sustained economic growth. this is not mandatory and the central institute has no commitment to any specific level of the exchange rate.

As in open economies. The latter definition may seem a bit vague. External balance means a sustainable current account position.3 The European Monetary Union and the Euro In 1979 the countries of the European Economic Community (EEC) created the European Monetary System (EMS). interest rates. Internal balance is reached when full use of a country's resources coexists with price stability (full employment and low inflation). The external balance can occur in conditions of both the current account balance and a deficit or a surplus in it. In 1991. in Maastricht. A surplus should not result in the unsustainable position of trading partners. trade balance and economic growth. The objectives included:  Create an area of monetary stability in Europe  Coordinate foreign exchange policies with countries outside the EEC and prepare the way for the European Economic Union. unemployment. and the Exchange Rate Mechanism.  The SME had two instruments: an artificial currency. the ECU. 1. and so it is actually. 2.  The system did not work very well because the member countries did not coordinate their macroeconomic policies. A deficit should be easily financed with a corresponding surplus in the capital account. exchange rate policy is at the heart of macroeconomic policy and its direction depends on priorities in variables such as inflation. the 12 members of the EEC signed a treaty establishing a .

18. In January 2002 euro banknotes and coins were introduced and national currencies were withdrawn in July 2002. timetable for the creation of the European Union (EU) with a common currency. Each country committed itself to: Keep the budget deficit below 3% of GDP. During the first two years the euro was used only in interbank payments. the consequences of which are still not well understood. to keep inflation within the Euro Zone below 2%.2. 2. It then started to fall to USD 0. the euro was equivalent to DEM 1 9558 and DEM 6 5559. with the euro becoming the only means of payment in the 12 countries. Maintain public debt below 60% of GDP. 4. In the following years the euro not only regained its value but appreciated.7%. The value of each currency was irreversibly fixed in terms of the euro and from that moment these currencies ceased to be independent.35 level. Currently (2012) the euro returned to its initial level of USD 1. 11 of the 15 EU members adopted a common currency: the euro. as a fundamental criterion of its policy Monetary policy. the value of the euro was USD 1. For example. Achieve low inflation. They renounced their monetary sovereignty but maintained fiscal sovereignty. the euro.6 in 2008 (an appreciation of 93% from its lowest level). reaching the level of USD 1. Maintain the exchange rate within a set range. 3.3 The European Central Bank decided.83 in October 2002: a depreciation of 29. It was a historical event. This means that the FR / FR exchange rate was frozen at the 3. The signatory countries agreed to coordinate their fiscal and monetary policies and established the convergence criteria. According to many experts the euro will continue to depreciate until it reaches 1: 1 parity. . In January 1999. At the time of its launch. and a common central bank.

lowering capital costs for companies and increasing opportunities for investors. Robert Mundell created the concept of optimal currency area. monetary union has more advantages than disadvantages if certain criteria are met. Countries with weak currencies (Greece. the only recourse for the country concerned is deflation and the reduction of wages in nominal terms. 2. 5. Homogenizes and reduces prices. which were estimated at 0. In the EU legal barriers to labor mobility were removed. It promotes the development of a continent capital market. increasing the efficiency and competitiveness of the European economy. 6. Eliminates exchange rate uncertainty. the common currency presents certain disadvantages: 1. It reduces transaction costs. The national governments lose the monetary and exchange sovereignty. The most important of these is the high degree of mobility of capital and labor in the area. but cultural and linguistic barriers impeding adjustment remained. 3. In the case of an asymmetric shock. It contributes to greater political cooperation and peace. Promotes trade and industrial restructuring on the continental scale. 3. Italy and Spain) earned more than countries with strong currencies (Germany and the Netherlands). According to this concept. The euro has many advantages: 1.4% of GDP in the EU. 2. On the other hand. . 4. fostering competition and investment.

no fiscal rules or pensions) contributed to the crisis and had a strong impact on the ability of European leaders to react. the banking system and the economic system in general. Slowly the euro countries move towards greater integration. fears of a sovereign debt crisis began to grow among investors as a result of rising private and public debt levels around the world. The Eurozone structure as a monetary union (ie a currency union) without fiscal union (ie. while a wave of deterioration in the credit rating of Government debt between different European states. as a result of the public bailout of failed banks and government response measures to Economic weakness post bubble. fiscal union and greater cooperation in all aspects. so that concerns about the solvency of European banking systems or the solvency of sovereign debt are reinforced negatively. It has aspects of a sovereign debt crisis. European banks hold considerable amounts of sovereign debt on their property. Steps in this path include: bank union. The author believes not only that the common European currency will survive. The Euro sceptics. is a crisis currently in progress that affects the countries of the euro zone. but that it will emerge stronger from the crisis.2. between countries. private debt arising from a bubble in the price of real estate assets was transferred to sovereign debt. In many of them.4 The euro crisis The crisis of the euro. in the countries affected by the crisis. Since the end of 2007. should remember the following: . perhaps towards a federation of independent nations. also called crisis of the euro zone. The crisis has made it difficult or impossible for some countries in the euro area to refinance their public debt without the assistance of third parties. The causes of the crisis were different according to the country.

a massive flight of capital was avoided. the euro is emerging from the well-off crisis. not justified by productivity. international flows of goods and capital were relatively free. especially if Greece decides to abandon the euro (or it gets expelled). Governments guaranteed the convertibility of notes into metal. It was considered gold as the anonymous monarch. • The European Central Bank maintains its independence from political pressures and provides all the necessary liquidity to avoid a financial collapse. • An inflationary outbreak that normally accompanies an adjustment through devaluation was avoided. The exchange rates between different currencies simply reflected the ratio of the amounts of gold corresponding to each monetary unit. which made it unnecessary to raise interest rates to defend the exchange rate.5 History of the international monetary system The period of the classic gold standard: 1875-1914 During the period of the classical gold standard. In the countries of southern Europe pre-crisis living standards increased unsustainably. • When the contagion effect of the Greek crisis affected Spain and Italy. Its future remains uncertain. given the circumstances. London was the world's financial center. and the pound sterling. . In short. as the power behind the throne.• Although the crisis lowered living standards after 2008. The countries of southern Europe have nothing to complain about since they have a stronger infrastructure and higher standards of living than would have been possible without adopting the euro. Each country established the value of its monetary unit in terms of gold. 2. it did so from high levels thanks to integration.

. Figure 1: Automatic adjustment to the deficit of the balance of payments under the gold standard (in- kind flow-price). but there is controversy about how it worked exactly. The first mechanism. the level of prices and interest rates.Adjustment to the imbalances in the balance of payments under the gold standard Adjust the imbalances in the balance of payments under the gold standard The adjustment mechanism for such imbalances was the subject of intense research. emphasizes the relationship of the balance of payments to the quantity of money in the economy. Everyone agrees that the adjustment mechanism operated automatically. There are two feedback chains that promote equilibrium: one through the interest rate and another through internal prices. proposed by the classical economists.

According to experience. the adjustment process did not seem to work as the theory indicated. above all.6 The Interwar Period (1918-1939) World War I interrupted the relatively effective operation of the gold standard. the adjustment mechanism could not function as described by classical economists. for prices to fall. Reducing prices was rare. reduction of interest rates. The . This causes a gold output. coupled with the reduction of productive capacity in the main countries. etc. In practice. increase in domestic prices. After the war. chaotic conditions prevailed in both trade and international finances. to the low flexibility of the prices downwards. The excessive issuance of banknotes. This was due to the sterilization policies of the monetary authorities and. The international flow of Goods and capital and gold became the only means of external payment. to the extent that foreigners want to convert the country's notes into gold.Suppose that a country suffers a deficit in the balance of payments. In fact. In the short run. using the paper money issue to finance the activities. If prices were not flexible on the downside. the adjustment process would work in the opposite way: gold inflow. the increase in imports. The majority of countries abandoned it. contracting aggregate demand has more impact on production than on prices. increase in the monetary base. contributed to inflationary outbursts and even to the introduction of the "war economy" in the central powers. triggered a process of reduction of economic activity 2. the main culprit of balance of payments problems. In the case of a country with a surplus in the balance of payments. a long period of recession is needed.

In that period the theory of parity of the purchasing power as a method to determine the equilibrium exchange rate. the major nations abandoned the gold standard. many countries used devaluations with the aim of "exporting unemployment" and "impoverishing the neighbor". Germany and some other countries suffered episodes of hyperinflation which had no precedent in history. France in 1928) invariably failed. The problem not solved was: how to establish the exchange rates that reflect the economic realities postwar? Countries that sought to return to the gold standard did not know which parity would ensure external balance.interwar period is the only episode in modern history during which international trade developed at a slower rate average economic growth. The free floating of the . but wants to export more and import less to encourage domestic employment. In Austria. All attempts to return to the gold standard led to recessions and political instability. The policies of impoverishment of the neighbor inevitably provoke reprisals on the part of the affected countries. In order to resolve their internal imbalance problems. Is considered that devaluation is competitive if the country that applies it has no problems with the balance of payments. which in itself was very low. Britain in 1925. In the period 1918-1923. quotas and administrative measures.10 the value of the ounce of gold was set at $ 35. In 1934 the United States Introduced a modified gold standard. Another form of neighbor impoverishment policy consists of a system of restrictions to trade that includes high tariffs. in 1931. During the Great Depression the volume of world trade was halved. Attempts to return to the gold standard United in 1918. "Trade wars" arise that effectively impoverish all participants.

. external capital movements Short-term became destabilizing. East Final form at the Bretton Woods Conference (New Hampshire. The Bretton Woods system aimed to promote global growth Trade and internal and external economic stability. To make matters worse. 3. The following requirements: 2. In order to avoid repeating the Inter-War story. Facilitate the growth of trade. winners made the decision to establish a new world economic order.7 Bretton Woods System (1944-1971) The Second World War caused a clash in the consciousness of the nations followed by a new spirit of cooperation. United States) in July 1944. In view of the emergence of new International finance centers (New York and Paris). thus breaking the relationship between the positions of the balance of payments and the country's money supply. countries gave priority to internal versus external balance and did not follow the rules of the game. Promote international monetary cooperation. Central banks sterilized international movement’s capital and gold. with the participation of 44 countries. In a systematic way. Sterilization effectively neutralizes the adjustment mechanism and makes the imbalances persist in prolonged periods. 2. speculators raised the value of currencies strong and lower the value of weak currencies.main currencies in the exchange markets did not establish the equilibrium parities. The Statutes of Convention to the countries affiliated to the International Monetary Fund (IMF) 1.

6. but virtually flooded the world with dollars. at the beginning of the postwar period. the difference between the purchasing power of the currency and its cost of production. it armed its main allies and built in all the continents an extensive network of expensive military bases. The United States used it in a liberal way to further its strategic objectives. that is. the dollar became the world currency. This reserve contracted quickly as the dollar holders demanded their exchange for gold to Price of $ 35 per ounce. 5. it had stored 75% of all gold in the world. which is the gain of the one who produces money. From 1950 to 1970 it lost 13 mmd of its reserves in gold. Promote the stability of exchange rates. The United States enjoyed the privilege of seignior age. the world's appetite for dollars seemed insatiable. Further. If. the United States was stronger than ever. It seems that the United States abused its advantage. Create a reserve base. In addition to being the currency of international reserves. the United States implemented expansive fiscal and monetary policies to finance the . Since 1950. Establish a multilateral payment system. In the 1960s. the United States has seen an increasing deficit in its balance of payments. during Two decades this country has not only been able to satisfy this hunger by far. which helped rebuild Western Europe. When the Second World War. Until 1957 there was a strong shortage of it. The United States balance of payments problem After World War II.4. while the economies of other countries were in ruins. such as the Marshall Plan.

As a consequence. which depended on international trust in a single Country. In an attempt to save the Bretton Woods system. When some European central banks attempted to convert their reserves of gold dollars. and The system collapsed. The crisis of the monetary system seemed inevitable. in 1973. the costs of adjusting exchange rates between major currencies were very high. since its beginning contained the seed of the convertibility crisis. The collapse of the Bretton Woods system Foreigners had more dollars than they wanted. In practice. . the scarcity of dollars became excessive abundance. the United States suspended the convertibility of the dollar to gold12 and imposed a 10% surcharge on imports. In 1971 the expectations of the devaluation of the dollar caused a great flight of capital of the United States. The gold standard exchange system. confidence in that currency was lost. The main points of the agreement were: o Devalue the dollar (the price of an ounce of gold went from 35 to 38 dollars). the main countries adopted the free floating exchange rate regime.unpopular Vietnam War without raising taxes. 2. the 10 largest countries in the world signed the Smithsonian Agreement (1971). o Suspend the convertibility of the dollar to gold. The dollar remained under strong pressure until. o Revaluate other strong currencies. Among the main causes of the collapse of the Bretton Woods system we can mention the following: 1.

but also other major currencies such as the euro. . it is determined that the value of a single unit of local currency is equal to US$3. This ensures an appropriate money supply. A fixed. 2. the yen or a basket of currencies). If. US expansionary policies created the phenomenon of inflation export. the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged. for example. In order to maintain the local exchange rate. The central bank can also adjust the official exchange rate when necessary. A set price will be determined against a major world currency (usually the U.S. appropriate fluctuations in the market (inflation/deflation) and ultimately. dollar. the exchange rate. the central bank must keep a high level of foreign reserves. the central bank will have to ensure that it can supply the market with those dollars. rate is a rate the government (central bank) sets and maintains as the official exchange rate. This is a reserved amount of foreign currency held by the central bank that it can use to release (or absorb) extra funds into (or out of) the market.8 Fixed versus flexible exchange rates Fixed Exchange Rates There are two ways the price of a currency can be determined against another. and for other countries the only option not to import US inflation was the free flotation of their currencies. In order to maintain the rate. or pegged. 3.

thus making imported goods more expensive and stimulating demand for local goods and services. market pressures can also influence changes in the exchange rate. A floating rate is often termed "self-correcting. Look at this simplified model: if demand for a currency is low. it is less often that the central bank of a floating regime will interfere.Floating Exchange Rates Unlike the fixed rate. A floating exchange rate is constantly changing. A central bank will often then be forced to revalue or devalue the official rate so that the rate is in line with the unofficial one. when a local currency reflects its true value against its pegged currency. a floating exchange rate is determined by the private market through supply and demand. causing an auto-correction in the market. no currency is wholly fixed or floating. In a fixed regime. its value will decrease. This in turn will generate more jobs. thereby halting the activity of the black market. . a "black market" (which is more reflective of actual supply and demand) may develop. Sometimes." as any differences in supply and demand will automatically be corrected in the market. However. In reality. the central bank may also intervene when it is necessary to ensure stability and to avoid inflation. In a floating regime.

CHAPTER III 3. Current account 2. The main objective of this instrument is to inform the government about the country's international position and help it to formulate monetary. · Transactions . strengthening.Debit: . These transactions generate an increase in foreign exchange supply and in turn increases the demand for the national currency.1 BALANCE OF PAYMENTS ACCOUNTING BALANCE OF PAYMENTS The balance of payments of a country is the summary of all its economic transactions with the rest of the world. it generates foreign exchange earnings recorded as income in the balance of payments. Capital account 3.Credit: Are payments by foreigners. over a certain period. fiscal and commercial policies. the main reason why several countries cannot achieve a high and sustainable economic growth. Official reserves account · Transactions . meet the international competitiveness that has a country. identify external imbalances and their causes. It records all income and expenses of foreign exchange. 1. The balance of payments allows to know the expectations about the future. Accounts of the balance of payments.

A transaction is accounted for as debit (-) if it leads to a payment to foreigners. capital and land). Debit transactions are recorded in the balance of payments as expenses. recorded payments for interest. Currencies leave the country. These transactions increase the demand for foreign exchange in the foreign exchange market. income is received by the holders of factor production are city residents and they are invested in . they increase the supply of national currency. and thus contribute to its weakening. The services balance is divided into factor services and non-factor services. The balance of trade is the official term for net exports that makes up the balance of payments. CURRENT ACCOUNT The current account includes: · Balance of trade · Balance of services · Transfers Balance of trade The difference between the value of goods and services exported out of a country and the value of goods and services imported into the country. · Factorial services: Also called factor income. dividends or profits by the factors of production (labor. Balance of services Collects revenue and payments from the sale of services between residents of a country and other residents. Alternatively.

books and music. messaging. plus changes in the reserve account. Assets include: foreign currencies (dollar and euro). being able to circulate in both directions. These transfers are usually of a donation or prize type and can be either public (eg donations between governments) or private (eg. satellite service payments. portfolio and other investments. constitutes a nation's balance of payments. A capital account may also refer to an account showing the net worth of a business at a specific point in time. money that migrants send to their countries of origin CAPITAL ACCOUNT A capital account shows the net change in physical or financial asset ownership for a nation and. The capital account includes foreign direct investment (FDI).foreign. together with the current account. in turn non-factor services include: mail. · Non factor balance: It mainly refers to services related to international trade and international tourism. Transfers The balance of transfers will record the movements of money between residents of the country and residents of the outside. while expenditures is the income city residents not deliver to owners of the factors of production that are invested in our country. OFFICIAL RESERVE ACCOUNTS The official reserves account measures the change in the assets of a country abroad. SDRs and the reserve position in the . phone. gold.

STATISTICAL DISCREPANCY Double-entry accounting should result in equal total credits and debits. less their liabilities in favor of entities other than the IMF DOUBLE ENTRY ACCOUNTING Each international transaction is incorporated as a credit or debit in the balance of payments.IMF. the international reserves are its holdings of gold and freely disposable currencies. . According to the definition of the Bank of Mexico. Each transaction has two records: we sell something and receive a payment. in most cases. Total credits should always be equal to total debits when all three accounts are taken together. Banco de México's reserves consist of deposits with foreign central banks and investments in the money market. have to pay a tariff that is a source of income for the government. in practice this equality is not met due to errors and omissions of registration. we buy something and we must pay for it. which means that the yield they earn is very low. a counterparty credit or debit is also recorded for the same amount in one of the three accounts of the balance. These have to be liquid and safe. imports are registered with greater care than exports because the former. so a line called statistical discrepancy is required to balance the balance of payments. Each time a transaction is entered. Errors and omissions are due to inadequate recording of some entries and exits or failure to register in the double entry system. In general terms.

Spending on financial assets does not represent investment (saving). · Consumption: consumer spending on goods and services (e. the companies can´t sell all their production and have to reduce it. Both are reflected in gross domestic product (GDP). the economy suffers inflationary pressures on the demand side. machinery. In the opposite case (the AD is less than the aggregate supply). which causes a recession.g. car). government buildings. In a closed economy (an economy with no international trade) any goods that are not sold to consumers or the government or used by firms for investment are added to inventories (which are a part of investment) .NATIONAL ACCOUNTING AND BALANCE OF PAYMENTS The economy is in equilibrium if the aggregate demand (AD) is equal to the aggregate supply. schools. computers. and military spending. while aggregate supply is reflected in output and domestic income. · Investment: firm spending on new plants and equipment (e. state. and inventories).g. factory. · Government Spending: spending on goods and services by the federal. Aggregate demand is represented by national spending. This spending includes highway repairs. Transfers payments (social security and unemployment benefits) are not included in G since the governments gets nothing in return. If the AD is greater than the aggregate supply. and local government. Investment adds to a country’s capital stock.

which include both foreign direct investment and portfolio investment. • Remittances from citizens working abroad. it is necessary to understand the factors that affect the supply and demand of foreign exchange. • The interventions of the central bank. The second will include the capital account. We will develop our analysis in two stages. only the factors that affect the current account will be examined. Like all prices. • Net external capital inflows. . To understand changes in the exchange rate. an increase in the supply of foreign exchange causes an appreciation of the national currency: the exchange rate low. the exchange rate is determined by the forces of supply and demand. the impact of the capital account on the exchange rate depends on the degree of openness that the country has to foreign investment. the exchange rate is one of the most important prices in decision making. In the first. While the importance of the current account is the same throughout the world. In an open economy. The main sources of foreign exchange offer include: • Exports of goods and services (X). CHAPTER IV 4. if it sells the currencies in the market.1 Equilibrium exchange rate The exchange rate is the price of the foreign currency in terms of the national currency. If everything else remains constant.

which is equivalent to a surplus in the capital account. can to some extent counteract other elements that push the exchange rate up or down. The intervention of the monetary authorities.4. when it shifts the supply curve to the right. • The interventions of the central bank. the national currency depreciates: the exchange rate rises.2 Currency Offer The demand for foreign exchange comes from: • Imports of goods and services (M). if not impossible. when it buys the currencies. Given the incidence of multiple factors in both supply and demand. to determine the equilibrium exchange rate. • Net capital outflows. are changed by national currency. it is very difficult. The net inflow of capital.3 Capital account and Exchange rate Changes in import and export curves are slow and explain only long-term exchange rate movements. before being able to invest them. Demand for foreign exchange ↑ ⇒ S ↑ If the demand for foreign exchange changes at the same rate as supply. This increases the supply of foreign exchange in the . This is because the currencies entering the country. 4. which include the investment of Mexicans abroad and the reduction of foreign investment in Mexico. tends to appreciate the national currency (low exchange rate). When the demand for foreign exchange increases while the supply remains constant. Daily movements are due to capital flows. by affecting both. the exchange rate remains constant.

foreign exchange market and lowers the price of them. 4. portfolio investment should not exceed 50% of total foreign investment. The outflow of capital always increases the demand for foreign exchange and pushes the exchange rate upwards. • Excessive monetary expansion. the monetary authorities should: 1. Foreign investment strengthens domestic firms by: • Providing access to global markets and new technologies. • Expansion of consumption due to the substitution of internal savings by external ones. 3. In general terms. Improve the environment for business and international competitiveness. Its effect on the economy depends on the causes. foreign portfolio investment can be used for productive purposes if economic and political stability is achieved. maintaining a floating exchange rate. Reform the tax system in order to reward savings and domestic investment and punish current consumption.10 In addition. Prevent the national currency from being overvalued. which can generate inflationary pressures. If it is the investments that domestic companies make abroad. capital inflows. and if the domestic financial system is competitive and efficient. In order to control these negative consequences. 2. Sterilize. However. too rapid entry of large volumes of this type of investment can have negative consequences. such as: • Overvaluation of the national currency. • Reduces the vulnerability of firms to external shocks by diversifying their sources of . the net effect is positive. • Leverages economies of scale and scope. and Accumulation of reserves or amortization of external debt. at least partially.

2. equilibrium in the balance of payments. it has collateral effects. Notice it is said Efficacy and not efficiency because even though it reaches the goal that is to balance the current account. interest rates. some social . 4. 4. An international reserve sufficient to discourage speculation. Capital flight reduces domestic spending on both consumption and investment. 3. In order to avoid capital flight and to encourage the repatriation of these. this means that exports will increase and imports will be reduced due the exchange rate. Physical and legal security. If the cause of the capital account deficit is the flight of capital. the following conditions must be met: 1. if the domestic currency is being devalued then importers will have to pay more on domestic currency to get the foreign currency necessary to make the payment and exporters will receive more on domestic currency.income. An autonomous central bank and a monetary policy that protects the purchasing power of the national currency. causes shortage of loanable funds and increases the cost of credit. stable and positive in real terms). 6. the market economy and the rule of law. Macroeconomic stability (balanced budget.5 Efficacy of the devaluation Devaluation it is a mechanism to aid the current account to get into balance. low inflation. Free flotation of the exchange rate. its economic effects are always disastrous. 5. Political and structural reforms aimed at strengthening democracy.

If the result of the assessment of elasticity throws that is elastic. this is a mechanism. again. then a devaluation might be possible to address. this means that tariffs are low and goods have a low non-tariff barriers 2) sound financial and monetary system 3) Non-existence monopolies or not many 4) Efficiency on production and its competitiveness 5) Strong and diverse export industry . because. then it’s more complicated and it should need some complementary monetary policies to aid the currency devaluation. but if is inelastic. the willing to force and adequate a situation that shouldn’t be other than that. A collateral effects that a rough devaluation might incur into is the loss of international competitiveness.cost has to be paid. This mechanism depends on the elasticity of demand and supply of foreign currency. To get a better picture of the elasticity of devaluation. Professor kozikowski (2013) tells us 5 reasons of it: 1) An open economy.

V. WorldTradeOrganization (2016) retrieved from: https://www.pdf/8139cd44- c760-4a93-ad7d-11c5d347451a 5. de Bank of Canada retrieved from: http://www. (2008).pdf 6. Carney. Finanzas internacionales. The Evolution of the International Monetary System. de ECONLOG Sitio web: . 3. (2013). B. ATkearney (2016) Global cities 2016 retrieved from: https://www. Globalizing international-monetary-system/ 4. Kozikowski. DE C. Eichengreen B. Economic.atkearney. 2013.wto. Caplan. M. Mexico: McGRAW- HILL/INTERAMERICANA EDITORES.econlib. United Kingdom: Library of congress cataloging.BIBLIOGRAPHY 1. (2009). (2008). 2016.