CHAPTER 2

THE INTERNATIONAL MONETARY SYSTEM

2. Defending a Fixed Exchange Rate. What did it mean under the gold standard to
‘defend a fixed exchange rate’, and what did this imply about a country's money
supply?

Under the gold standard a country’s central bank was responsible for preserving the
exchange value of the country’s currency by being willing and able to exchange its
currency for gold reserves upon the demand by a foreign central bank. This required
the country to restrict the rate of growth in its money supply to a rate which would
prevent inflationary forces from undermining the country’s own currency value.

5. Fixed Exchange Rate. Why do many emerging market economies prefer to adopt a
fixed exchange rate?

Many emerging economies resort to pegging their domestic currencies against major
currencies. In emerging nations that are dependent on imports, a floating rate can
cause inflation if import prices rise. Further, if their currencies depreciate, these
nations may not benefit if there is low international demand for their exports. Under a
floating system, speculation on the currencies of these nations can be damaging and
destabilizing for the economy, causing uncertainty for investors.

9. The Impossible Trinity. With reference to the impossible trinity, what are the
possible policy mixes that a nation could have?

The impossible trinity states that a nation cannot have all of the following three
policies: fixed exchange rate, no capital controls, and an independent monetary
policy. The following are the possible policy combinations that nations can have:
  13. SDRs. What are the advantages and disadvantages of Special Drawing Rights
(SDRs)?

Special Drawing Rights (SDRs) were created by the IMF in 1969 when the supply of
two key reserve assets (the US dollar and gold) proved inadequate for supporting the
expansion of international trade. SDRs are potential claims on the convertible
currencies of IMF members. SDRs can be used in exchanges between trade partners.
Their main advantage to members with weak external positions is that the IMF can
designate more developed nations to purchase SDRs from these financially weaker
countries. Another major advantage is that the SDR is relatively stable. It is also used
as the unit of account by the IMF and other international institutions. Moreover,
commercial banks accept deposits and make loans in SDRs, and sometimes use SDRs
to price some international transactions.

The main disadvantage is that the IMF quota system results in the developed
countries holding most of the SDRs. Developing countries complain that this hurts
their economies since it is in their interest to hold relatively stable foreign reserves.
Another disadvantage is that since SDRs are valued according to an average of a
basket of five currencies, SDRs become less valuable than the strongest reserve
currency. Thus, SDRs would be among the first reserves to go when a country sells
reserves.
15. Fixed Exchange Rates in Emerging Market Economies. What are the methods
available to an emerging market economy if it elects to adopt a pegged exchange rate
system? What is the ideal system if it needs to manage inflation and economic
growth?

In regard to the exchange system, emerging market economies have three

alternatives: float their currencies, adopt a managed float system, or totally peg their
currency. In the case of managed floats, the domestic currency is left to float freely,
but the central bank of the nation regularly intervenes if the currency moves outside a
given band. The pegged foreign exchange system can be implemented through
official pegs against a single currency or a basket of major currencies. The least
extreme system is the one where parallel exchange rates are also adopted along the
fixed rate. The extreme methods of pegged exchange rate regimes are implemented
through currency boards or dollarization. In both cases, the central bank does not
have the discretion to conduct monetary policy, and hence becomes unable to fix
macroeconomic imbalances such as inflation and unemployment. Further, the
economy is vulnerable to fluctuations of foreign currency, increasing risks to
investors.
16. Globalizing the Yuan. What are the major changes and developments that must
occur for the Chinese yuan to be considered ‘globalized'?

First, the yuan must become readily accessible for trade transaction purposes. This is
the fundamental and historical use of currency. Secondly, it then needs to mature
towards a currency easily and openly useable for international investment purposes.
The third and final stage of currency globalization is when the currency itself takes on
 a role as a reserve currency, currency held by central banks of other countries as a
store of value and a medium of exchange for their own currencies.

CHAPTER 3

THE BALANCE OF PAYMENTS

6. Balance. If the BOP always “balances,” then how do countries run a BOP deficit or
surplus?

The cumulative international economic transactions of the BOP should balance. These
include the three main component accounts: current account, capital account, and
financial account, in addition to the statistical discrepancies and official reserves. But
each of the three component accounts can either show a deficit or a surplus. Countries
run BOP deficits when their outflows are higher than their inflows and vice versa. A
BOP deficit can be supported by drawing on reserve holdings or by borrowing from
abroad. Conversely, an overall BOP surplus is absorbed by adding to the central
bank’s reserve holdings or by making foreign loans.

7. BOP Accounting. If the BOP were viewed as an accounting statement, would it be a

balance sheet of the country’s wealth, an income statement of the country’s earnings,
or a funds flow statement of money into and out of the country?

A country’s balance of payments is similar to a corporation’s funds flow statement in that

the balance of payments records events that cause the receipt (earnings) and
disbursement (expenditures) of into and out of the country.

8. Current Account Surpluses. Explain the main causes behind the current account
surpluses that Asian emerging economies have maintained during the last two
decades.

Asian emerging economies have maintained a current account surpluses for the last two
or three decades. This is mainly due to the fact that their economic growth strategies
are dependent on export-oriented policies. These policies include a devaluated
domestic currency that provides more competitiveness for local industries and
restricts imports. At the same time, the relatively closed nature of Asian emerging
markets hampers foreigners’ exports. These protectionist policies have created a
continuous current account surplus. But it may not be favorable to maintain in the
long-run since they will eventually lead to exchange rate appreciation and
deterioration in the terms of trade.

11. Negative Net International Investment Position. What does a country’s consistent
negative net international investment position indicate?

The net international investment position (NIIP) is the difference between the
accumulated stock of the country’s claims on foreigners and the accumulated stock of
 foreign claims on domestic residents. The NIIP can be thought of as a nation’s
international balance sheet. The accumulated stock and liabilities include assets such
as shares, bonds, private assets, direct investment (such as subsidiaries and branches
in foreign countries), bank loans, trade credits, official reserve assets, and government
assets (such as foreign treasury bills).

When claims of foreigners on the country are greater than domestic claims on foreigners,
this represents the net foreign indebtedness of the country. One reason for this deficit
is foreign borrowings, mainly to service debts or to finance current account deficits.
Another reason could be that domestic investors prefer to include foreign financial
instruments in their portfolio because of higher rates of return on assets held abroad in
comparison to domestic rates of return. Negative NIIP could be the result of
fluctuations in asset prices and/or exchange rates.

12. The Financial Account. What are the primary sub-components of the financial
account? Analytically, what would cause net deficits or surpluses in these individual
components?

The main components and possible examples are:

Direct investment.

Debit: Ford Motor Company builds a factory in Australia.

Credit: Ford Motor Company sells its factory in Britain to British investors.
Portfolio investment.

Debit: An American buys shares of stock of a European food chain on the

Frankfurt Stock Exchange.

Credit: The government of Korea buys United States treasury bills to hold as part
of its foreign exchange reserves.

Net financial derivatives.

Debit: A U.S. firm purchases a financial derivative like a currency swap in

London

Credit: A U.S. firm sells a financial derivatives like a forward contract on the
dollar versus the pound to a London buyer

Other investment.

Debit: A U.S. firm deposits $1 million in a bank balance in London.

Credit: A U.S. firm generates an account receivable for exports to Canada.

13. Classifying Transactions. Classify the following as a transaction reported in a sub-
component of the current account or the capital and financial accounts of the two
countries involved:

a. A U.S. food chain imports wine from Chile. Debit to U.S. goods part of current
account, credit to Chilean goods part of current account.

b. A U.S. resident purchases a euro-denominated bond from a German company.

Debit to U.S. portfolio part of financial account; credit to German portfolio of
financial account.

c. Singaporean parents pay for their daughter to study at a U.S. university. Credit to
U.S. current transfers in current account; debit to Singapore current transfers in
current account.

d. A U.S. university gives a tuition grant to a foreign student from Singapore. If the
student is already in the United States, no entry will appear in the balance of
payments because payment is between U.S. residents. (A student already in the
U.S. becomes a resident for balance of payments purposes.)

e. A British Company imports Spanish oranges, paying with eurodollars on deposit

in London. A debit to the goods part of Britain’s current account; a credit to the
goods part of Spain’s current account.

f. The Spanish orchard deposits half the proceeds in a Eurodollar account in

London. No recording in the U.S. balance of payments, as the transaction was
between foreigners using dollars already deposited abroad. A debit to the income
receipts/payments of the British current account; a credit to the income
receipts/payments of the Spanish current account.

g. A London-based insurance company buys U.S. corporate bonds for its investment
portfolio. A debit to the portfolio investment section of the British financial
accounts; a credit to the portfolio investment section of the U.S. balance of
payments.

h. An American multinational enterprise buys insurance from a London insurance

broker. A debit to the services part of the U.S. current account; a credit to the
services part of the British current account.

i. A London insurance firm pays for losses incurred in the United States because of
an international terrorist attack. A debit to the services part of the British current
account; a credit to the services part of the U.S. current account.

j. Cathay Pacific Airlines buys jet fuel at Los Angeles International Airport so it can
fly the return segment of a flight back to Hong Kong. Hong Kong keeps its
balance of payments separate from those of the People’s Republic of China.
Hence a debit to the goods part of Hong Kong’s current account; a credit to the
goods part of the U.S. current account.
k. A California-based mutual fund buys shares of stock on the Tokyo and London
stock exchanges. A debit to the portfolio investment section of the U.S. financial
account; a credit to the portfolio investment section of the Japanese and British
financial accounts.

l. The U.S. army buys food for its troops in South Asia from vendors in Thailand. A
debit to the goods part of the U.S. current account; a credit to the goods part of the
Thai current account.

m. A Yale graduate gets a job with the International Committee of the Red Cross
working in Bosnia and is paid in Swiss francs. A debit to the income part of the
Swiss current account; a credit to the income part of the Bosnia current account.
This assumes the Yale graduate spends her earnings within Bosnia; should she
deposit the sum in the United States then the credit would be to the income part of
the U.S. current account.

n. The Russian government hires a Dutch salvage firm to raise a sunken submarine.
A debit to the service part of Russia’s current account; a credit to the service part
of the Netherlands’s current account.

o. A Colombian drug cartel smuggles cocaine into the United States, receives a
suitcase of cash, and flies back to Colombia with that cash. This would not get
captured in the goods part of the U.S. or the Colombian current accounts.
Assuming the cash was “laundered” appropriately, from the point of view of the
smugglers, bank accounts in the U.S. or somewhere else (probably not Colombia,
possibly Switzerland) would be credited. This imbalance would end up in the
errors and omissions part of the U.S. balance of payments.

p. The U.S. government pays the salary of a Foreign Service Officer working in the
U.S. embassy in Beirut. Diplomats serving in a foreign country are regarded as
residents of their home country, so this payment would not be recorded in any
balance of payments accounts. If or when the diplomat spent the money in Beirut,
at that time a debit should be incurred in the goods or services part of the U.S.
current account and a contrary entry in the Lebanon balance of payments. It is
doubtful that the goods or services transaction would get reported or recorded,
although on a net basis changes in bank balances would reflect half of the
transaction.

q. A Norwegian shipping firm pays U.S. dollars to the Egyptian government for
passage of a ship through the Suez Canal. If the Norwegian firm paid with dollar
balances held in the U.S. and the Suez Canal Authority of Egypt redeposited the
proceeds in the U.S. no entry would appear in the U.S. balance of payments.
Norway would debit a purchase of services, and Egypt would credit a sale of
services.

r. A German automobile firm pays the salary of its executive working for a
subsidiary in Detroit. Germany would record a debit in the income
 payments/receipts in its current account; the U.S. would record a credit in the
income payments/receipts in its current account.

s. An American tourist pays for a hotel in Paris with his American Express card. A
debit would be recorded in the services part of the U.S. current account; a credit
would be recorded in the services part of the French current account.

t. A French tourist from the provinces pays for a hotel in Paris with his American
Express card. A French resident most likely has a French-issued credit card,
issued by the French subsidiary of American Express. In this instance, no entry
would appear in either country’s balance of payments. If, later, the French
subsidiary of American Express paid a dividend back to the U.S., that would be
recorded in the income part of the current accounts.

u. A U.S. professor goes abroad for a year and lives on a Fulbright grant. The current
transfers section of the U.S. current account would be debited for the salary paid
to a foreign resident. (Even though an American, the professor is a foreign
resident during the time he lives abroad.) The current transfers section of the host
country’s current account would be credited..