Chapter 4: The Monetary System in the International
Arena
International Transactions
Trillions of dollars' worth of goods and services are
traded across international borders each year. Buying goods,
services, or assets from foreign countries is complicated by the
fact that countries use different monetary systems. In order for
these transactions to take place, there must be some way to
change domestic into foreign money.
Balance of Payments
The balance of payments is a summary statement of all
transactions that take place between a country and the rest of the
world during a given period of time. One of the main uses of the
account is to provide information regarding the demand and
supply of foreign exchange. Transactions are recorded as debits
and credits. Examples of debit transactions are:
 Imports of goods and services
 Transfers to foreign residents (also known as remittances)
 Acquisition of long-term assets or reduction of a long-
term liability (i.e., stocks, bonds, real capital)
 Acquisition of a short-term asset or reduction of a short-
term liability (i.e., bank deposits, cash or short-term bonds
such as treasury bills).
A credit (+) transaction is a flow for which the home country is
paid and increases the demand for the home currency by foreign
residents. Examples of credit transactions are:
 Exports of goods and services
 Transfers from foreign residents
 Sale of a long-term asset or increase of a long-term liability
 Sale of a short-term asset or increase of a short-term
liability.
Credit includes all transactions that give rise to foreign
exchange inflows and debit includes those that cause foreign
exchange outflows. International transactions are not limited to
the exchange of goods and services but also include flows of
capital for lending or investment purposes.
Current and Capital Accounts
If a country has a current account surplus, then there
must be a corresponding capital account deficit. The purchase of
home country assets by foreign residents is known as inward
investment or capital inflow. Items like trade credit (i.e., the
settlement of debts at a future date) and lending by banks are
also included.
Balance of Payments Disequilibrium
A deficit or a surplus in the balance of payments is an
economic and not an accounting concept. From an economic
point of view, the existence of deficits or surpluses is a frequent
phenomenon. Autonomous transactions include exports, imports,
transfers, public transactions, and net capital movements. For
example, suppose a country’s autonomous transactions are the
following:
• Exports: $40 billion
• Imports: $50 billion
• Transfer receipts: $4 billion
• Foreign aid receipts: $2 billion
• Net capital inflow: $2 billion.
A deficit is financed by either an increase in the holdings of US
dollars by foreign governments or a reduction in the United
States' foreign exchange reserves.
The Foreign Exchange Market
 The average of the bid and ask rates (sometimes also
known as fixing) gives a single exchange rate. A small spread
indicates the absence of relative risk (i.e., the exchange rate is not
expected to fluctuate) while the opposite holds true in case of a
large spread.
Exchange Rates in the Business Context
As a general rule, a lower exchange rate for the dollar
increases American exports. American importers of European
goods will have to pay European suppliers in euros. A low
exchange rate will attract European investors because they can
now buy larger quantity of assets with the same amount of euros.
More European tourists will visit the United States if the exchange
rate is low.
Demand and Supply of Foreign Exchange
In a free market, exchange rates are set by the forces of
demand and supply. American suppliers require payment in
dollars and, consequently, Europeans must acquire them in
exchange for (a supply of) euros. A low exchange rate will
encourage American exports to Europe. A rise in the dollar's value
makes European goods, services, and assets in the United States
cheaper and increases the demand for them.
Exchange Rate Determination
A change in some or all of these factors can cause the
demand curve and/or the supply curve of a currency to shift.
Relative National Incomes. The demand for a country's imports is
directly related to the country's income. From the standpoint of
the U.S., when income falls, as a result of a recession, the demand
for imports declines. As Americans demand less imports, the
supply of dollars falls (i.e., the supply curve of dollars shifts to the
left) When incomes abroad rise, there is an increased demand for
US goods.
Relative Price Levels. Inflation in the United States and foreign
demand for US exports will affect the dollar supply and demand
for dollars. If inflation is higher, exporting becomes more difficult
as foreign goods become comparatively cheap. The fall in exports
will cause the demand curve for dollars to shift leftward while the
rise in imports will cause a rightward shift in the supply curve.
Interest Rates. Capital markets today are global. If the U.S.
provides higher yields than comparable securities in, say, Europe,
investors will sell their assets denominated in euros and buy dollar
assets. Conversely, if European interest rates are higher than US
interest rates, the demand for dollars will fall and the supply of
dollars will increase.
Expectations. Expectations about changes in the future value of a
currency also exert a significant influence on exchange rates.
Americans believe that the euro will appreciate relative to the
dollar at a future date. As a result, expectations about a future
appreciation cause the current exchange rate to rise.
Purchasing Power Parity
The purchasing power parity (PPP) theory holds that
exchange rates between two currencies adjust to reflect
differences in the price levels between the two countries. PPP
theory is based on the "law of one price". In the absence of
transportation costs, exchange rates should adjust so that the
same product costs the same whether it is measured in dollars,
euros, yen, or any other currency. Basically, two versions of PPP
are used:
 • Absolute PPP, which is based on the law of one price and refers
to the price levels between two countries.
• Relative PPP, whereby changes in exchange rates reflect
differences in relative price levels, that is inflation rates
Absolute PPP and the "law of one price" do not hold well in
practice because of the presence of significant barriers to trade
(tariffs, quotas, etc.). Relative PPP theory seems to be a rather
good determinant of exchange rates in the long run, but not in
the short run. A relationship consistent with PPP is clear: the
currencies of high-inflation countries tend to depreciate while low
inflation countries have appreciating currencies.
Exchange Rate Regimes
Exchange rate variability has given rise to a vast
international literature on the relative merits of different
exchange rate systems. Three basic exchange rate regimes have
operated during the twentieth century: fixed exchange rates,
flexible exchange rates, and managed exchange rates.
Fixed Exchange Rates
A fixed exchange rate is pegged at a certain level by the
national monetary authorities and can only be changed by a
government decision. In this case, there is an excess supply of
dollars that is balance of payments deficit as a result of
appreciation of the dollar. The monetary authorities will have to
sell dollars in order to keep the dollar from appreciating.
Flexible Exchange Rates
Under a flexible or freely floating exchange rate system the
monetary authorities do not intervene in the foreign exchange
market. The price of a currency is allowed to rise or fall according
to prevailing demand and supply conditions. Balance of payments
equilibrium is achieved automatically as payments to foreign
residents are exactly equal to receipts from them.
Managed Exchange Rates
An intermediate system, sometimes referred to as a “dirty float,”
may be, and has been, used whereby the monetary authorities
intervene in varying degrees in order to influence the exchange
rate in the desired direction by the purchase and sale of foreign
currencies
Fixed or Flexible Exchange Rates?
In the real world the choice between alternative exchange rate
systems is less extreme as there are varying degrees of
government intervention in the foreign exchange markets.
The Adjustment Mechanism
One of the main objectives of macroeconomic policy is the
achievement of balance of payments equilibrium. Under freely
determined exchange rates, the dollar will depreciate, as there will
be a greater supply of dollars than demanded. For a devaluation
to be effective, the Marshall–Lerner condition must hold so that
domestic consumers respond to increased prices of imports and
reduce their expenditure on them.
Advantages and Disadvantages of Fixed and Flexible
Exchange Rates
The debate on the relative merits of the two exchange rate
systems focuses primarily on the following issues:
• International monetary stability
• Economic policy independence.
International Monetary Stability. Fixed exchange rates facilitate
international trade. Pricing is easier and the cost of foreign
exchange transactions is very low. Since rates are fixed, there is
no scope for speculation. Expectations of exchange rate changes
provoke speculative flows, forcing monetary authorities to
abandon fixed exchange rates. Problems arise when a country is
about to run out of foreign exchange.
Economic Policy Independence. A high inflation country has
much to gain by pegging its currency because it provides
necessary discipline to bring inflation down. Lowering interest
rates can also have important implications on capital flows
through the interest rate parity condition. Domestic
macroeconomic policy itself also influences the exchange rate as
lower interest rates will cause a capital outflow, leading to a
depreciation in the foreign exchange rate.
The International Monetary System
The international monetary system can be seen as a
network effecting international payments through institutions,
rules, and regulations. In order to fulfill its role effectively, an
international monetary system should possess certain
characteristics:
 A time element regarding the elimination of balance of
payments disequilibrium among countries, that is countries
must be allowed sufficient time to adjust without severe
recessions or high inflation but, at the same time, should not
be allowed to avoid adjustment at the expense of other
countries.
 The choice of the unit of account that is the agreed measure
of the value of currencies.
 International cooperation with respect to adjustment
methods, concerted intervention, and reserve assets.
 Promotion of free international trade so that productive
resources are optimally allocated.
We can now briefly examine the different systems that have
prevailed throughout modern economic history.
The Gold Standard
The gold standard is the only example in history of
exchange rates being truly fixed. It was a system whereby the
values of currencies were fixed relative to the value of gold. Since
the money supply was directly tied to gold, the government could
not pursue an independent monetary policy. The gold standard
was suspended in 1914, just before World War I, and finally
collapsed following the Great Depression and World War II.
The Bretton Woods System
Bretton Woods was essentially an agreement for a return
to fixed exchange rates. The agreement also provided for the
establishment of the IMF to oversee and manage the new
international economic order. Restrictions on payments of goods
were not allowed; countries could resort to foreign exchange
controls.
The Present “Nonsystem”
Most industrial countries' exchange rates are allowed to
fluctuate although monetary authorities intervene in the foreign
exchange market. After the breakdown of the Bretton Woods
system, the United States switched to managed exchange rates.
Since 1998, 12 member countries of the European Union adopted
irreversible fixed exchange rates among their currencies.