International Financial System, E/R and Balance of

Payments
The domestic and the foreign markets are connected via the exchange rate
(e/r) which we defined as the price of foreign money: How many units of
domestic money do we have to give up to get a unit of foreign money. This is
nothing else but the classic demand and supply framework that you are
familiar with and you could work with, except it is for currencies.

Lets take a closer look a the Demand for foreign currencies- call these the
uses and the Supply of foreign currencies -call these the sources.

Countries demand foreign currencies to buy goods and services (IMPORTS) ,

to make gifts to other countries and to their citizens and to invest in other
countries (both financial and real investments). To buy these foreign
currencies they have to make payments using either their own currencies or
the currencies of other countries

Countries supply foreign currencies that they have received from other
countries either through (EXPORTS), through investments by foreigners or
through loans from other countries

It is therefor the intersection of the Demand and Supply curves that will
determine the price of the foreign currency; the exchange rate

If the demand for foreign currencies by a country increases the value of its
currency would fall and the opposite would hold ( assuming the supply does
not change)

If the e/r is constant of at least you have an idea about its value, it is easy to
facilitate trade and other transactions. If the e/r is however fluctuating wildly
it make it difficult to engage in trade and commerce. Countries, especially
smaller ones have always paid attention to the value of their currency

There are many different exchange rate schemes among countries and
among regions –(look at the back page of your textbook) for various reasons;
some countries fixed the value of their currencies while other let it be
determined by the market place . There is on going debate regarding the pros
and cons of the fixed rate of exchange as compared to the pros and cons of a
flexible exchange rare
This debate is framed well in the Impossible Trinity Concept that you will
read in your textbook

The key issues for you to concentrate on as you read Chapter 2 is the
following

1. Why and how did the global financial system evolve to its current
status?
2. What are the factors that propelled the system forward and what are
the milestones
3. Why were the various global institutions developed? What is their
scope?
4. What does the future hold for the global financial system and the global
economy

Comments on the Balance of Payments

The various trade and other financial activities between nations have to be
recorded and have to be settled

Here is a simple framework to simplify things for you

Goods and services flow from Country A to country B; country B has to

generate a payment from B to A , which gives rise to financial flows; all of
these flows are obviously better if there is information flows between
countries

The countries record these flows under various accounts to be a in a better

position to measure and to manage them since they impact their underlying
economic structures

Your first task is to be become familiar with the definition of the Balance of
Payments and the recording of the entries to the various accounts and the
balances that are created from these accounts

Your next task ( key) is to be able to interpret what the accounts mean and
how the various accounts are interconnected. Remember that you need to
assess these holistically and not on an individual basis. Furthermore you
need to consider the accounts on a multilateral and not a bilateral basis

Task three; be in a good position to make prediction and assess policy

based on the accounts