International Economics II-1

Department of Economics, Gambella University, Ethiopia
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International Economics II (3082)
Chapter 1: THE FOREIGN EXCHANGE MARKET
What is a Foreign Exchange Market?

The foreign exchange market is a market for buying and selling foreign currencies. It is a global online network
where currencies of different countries are bought and sold. The foreign exchange market determines the exchange rate
for currencies around the world. This market is also termed as Currency, FX, or forex market. Its structure comprises of
individuals, firms, commercial banks, the central banks, importers and exporters, investors, brokers, immigrants, tourists.
The foreign exchange market is a system and does not have any physical location.
This market operates 24 hours a day from 5 p.m. EST on Sunday to 4 p.m. EST on Friday. It is the world’s most
liquid financial market. The trading of currencies in the foreign exchange market always takes place in pairs so that the
value of one of the currencies in that pair is relative to the value of others. This global market has two tiers. The first one
is known as the interbank market and the second one is known as the over-the-counter market. The interbank market is
the one where bigger banks trade and exchange currencies with each other. Over the counter market is the one where
individuals and companies trade and has become a very popular market as now there are several companies that provide
online trading platforms
Characteristics and Participants of the Foreign Exchange Market

Characteristics of such market are:
 Dollar most widely traded: The dollar is the most dominant currency in the foreign exchange market. This
currency is paired with every country’s currency being traded in the forex market. In a major proportion of
transactions every day, the dollar is one of the two currencies being traded.
 Lower trading cost: The forex market has a very low trading cost. In these markets, there are no commissions
like in case of any other investments. Any difference between buying and selling prices of currencies is the only
cost of trading in the forex market. As there are low costs then the possibility of incurring losses is also minimum
thereby making it possible for small investors to make good profit from trading.
 Operates 24 hours: Foreign exchange markets function 24 hours a day. It provides a platform where currencies
can be traded anytime by traders. It provides a convenient time to all necessary adjustments when and wherever
needed.
 Dynamic market: The foreign exchange market is a dynamic market. In these markets, currency values change
every second and hour. These values changes in accordance with changing forces of demand and supply which
also helps in determining the exchange rates. Due to its fast-changing character, this market is termed as the
perfect market to trade.
 Market transparency: Trader in the foreign exchange market has full access to all market data and information.
They can easily monitor different countries’ currencies price fluctuations through real-time portfolio and account
tracking without the need of a broker. All this information helps in making better trading decisions and control
over investments.
 High liquidity: The foreign exchange market is the most liquid financial market in the world. It involves the
trading of various currencies across the globe. All traders in this market are free to buy or sell currencies anytime
as per their choice. They are free to exchange currencies without prices of currencies being traded getting
affected. Currencies prices remain the same both at the time of order placed and executed thereby enabling to
earn the expected prices.
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Participants in Foreign exchange market can be categorized into five major groups, viz.; commercial banks, Foreign
exchange brokers, Central bank, MNCs and Individuals and Small businesses.
 Commercial Banks: The major participants in the foreign exchange market are the large Commercial banks who
provide the core of market. As many as 100 to 200 banks across the globe actively “make the market” in the
foreign exchange. These banks serve their retail clients, the bank customers, in conducting foreign commerce or
making international investment in financial assets that require foreign exchange.
 Foreign Exchange Brokers: Foreign exchange brokers also operate in the international currency market. They
act as agents who facilitate trading between dealers. Unlike the banks, brokers serve merely as matchmakers and
do not put their own money at risk. They actively and constantly monitor exchange rates offered by the major
international banks through computerized systems such as Reuters and are able to find quickly an opposite party
for a client without revealing the identity of either party until a transaction has been agreed upon. This is why
inter-bank traders use a broker primarily to disseminate as quickly as possible a currency quote to many other
dealers.
 Central banks: Another important player in the foreign market is Central bank of the various countries. Central
banks frequently intervene in the market to maintain the exchange rates of their currencies within a desired range
and to smooth fluctuations within that range. The level of the bank’s intervention will depend upon the exchange
rate regime flowed by the given country’s Central bank.
 MNCs: MNCs are the major non-bank participants in the forward market as they exchange cash flows associated
with their multinational operations. MNCs often contract to either pay or receive fixed amounts in foreign
currencies at future dates, so they are exposed to foreign currency risk. This is why they often hedge these future
cash flows through the inter-bank forward exchange market.
 Individuals and Small Businesses: Individuals and small businesses also use foreign exchange market to
facilitate execution of commercial or investment transactions. The foreign needs of these players are usually
small and account for only a fraction of all foreign exchange transactions. Even then they are very important
participants in the market. Some of these participants use the market to hedge foreign exchange risk.
The Functions of Foreign Exchange Markets

The foreign exchange market is commonly known as FOREX, a worldwide network, that enables the exchanges
around the globe. The following are the main functions of foreign exchange market, which are actually the outcome of its
working:
 Transfer Function: The basic and the most visible function of foreign exchange market is the transfer of funds
(foreign currency) from one country to another for the settlement of payments. It basically includes the
conversion of one currency to another, wherein the role of FOREX is to transfer the purchasing power from one
country to another.
 Credit Function: FOREX provides a short-term credit to the importers so as to facilitate the smooth flow of
goods and services from country to country. An importer can use credit to finance the foreign purchases. Such as
an Indian company wants to purchase the machinery from the USA, can pay for the purchase by issuing a bill of
exchange in the foreign exchange market, essentially with a three-month maturity.
 Hedging Function: The third function of a foreign exchange market is to hedge foreign exchange risks. The
parties to the foreign exchange are often afraid of the fluctuations in the exchange rates, i.e., the price of one
currency in terms of another. The change in the exchange rate may result in a gain or loss to the party concerned.
Thus, due to this reason the FOREX provides the services for hedging the anticipated or actual claims/liabilities
in exchange for the forward contracts. A forward contract is usually a three-month contract to buy or sell the
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foreign exchange for another currency at a fixed date in the future at a price agreed upon today. Thus, no money
is exchanged at the time of the contract.
There are several dealers in the foreign exchange markets, the most important amongst them are the banks. The
banks have their branches in different countries through which the foreign exchange is facilitated, such service of a bank
are called as Exchange Banks.
The Demand for and the Supply of Foreign Exchange

A foreign exchange market is where one currency is traded for another. There is a demand for each currency and
a supply of each currency. In these markets, one currency is bought using another. The price of one currency in terms of
another (for example, how many dollars it costs to buy one Mexican peso) is called the exchange rate.
Foreign currencies are demanded by domestic households, firms, and governments who wish to purchase goods,
services, or financial assets that are denominated in the currency of another economy. For example, if a US auto importer
wants to buy a German car, it must buy euros. The law of demand holds: as the price of a foreign currency increases, the
quantity of that currency demanded will decrease. Foreign currencies are supplied by foreign households, firms, and
governments that wish to purchase goods, services, or financial assets denominated in the domestic currency. For
example, if a Canadian bank wants to buy a US government bond, it must sell Canadian dollars. As the price of a foreign
currency increases, the quantity supplied of that currency increases.
Exchange rates are determined just like other prices: by the interaction of supply and demand. At the equilibrium
exchange rate, the supply and demand for a currency are equal. Shifts in the supply or demand for a currency lead to
changes in the exchange rate. Because one currency is exchanged for another in a foreign exchange market, the demand
for one currency entails the supply of another. Thus the dollar market for euros (where the price is dollars per euro and
the quantity is euros) is the mirror image of the euro market for dollars (where the price is euros per dollar and the
quantity is dollars).
To be concrete, consider the demand for and supply of euros. The supply of euros comes from the following:
 European households and firms that wish to buy goods and services from non-euro countries
 European investors who wish to buy assets (government debt, stocks, bonds, etc.) that are denominated in
currencies other than the euro
The demand for euros comes from the following:
 Households and firms in non-euro countries that wish to buy goods and services from Europe
 Investors in non-euro countries that wish to buy assets (government debt, stocks, bonds, etc.) that are
denominated in euros
Figure 1 "The Foreign Exchange Market" shows the dollar market for euros. On the horizontal axis is the quantity
of euros traded. On the vertical axis is the price in terms of dollars. The intersection of the supply and demand curves
determines the equilibrium exchange rate.
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The foreign exchange market can be used as a basis for comparative statics exercises. We can study how changes
in an economy affect the exchange rate. For example, suppose there is an increase in the level of economic activity in the
United States. This will lead to an increase in the demand for European goods and services. To make these purchases, US
households and firms will demand more euros. This will cause an outward shift in the demand curve and an increase in
the dollar price of euros. When the dollar price of a euro increases, we say that the dollar has depreciated relative to the
euro. From the perspective of the euro, the depreciation of the dollar represents an appreciation of the euro.
The Foreign Exchange Rate

Foreign Exchange Rate is defined as the price of the domestic currency with respect to another currency. The
purpose of foreign exchange is to compare one currency with another for showing their relative values. Foreign exchange
rate can also be said to be the rate at which one currency is exchanged with another or it can be said as the price of one
currency that is stated in terms of another currency. Exchange rates of a currency can be either fixed or floating. Fixed
exchange rate is determined by the central bank of the country while the floating rate is determined by the dynamics of
market demand and supply.
Definition of Exchange Rate

An exchange rate is a rate at which one currency will be exchanged for another currency and affects trade and the
movement of money between countries. The exchange rate between two currencies is commonly determined by the
economic activity, market interest rates, gross domestic product, and unemployment rate in each of the countries.
Commonly called market exchange rates, they are set in the global financial marketplace, where banks and other financial
institutions trade currencies around the clock based on these factors. Changes in rates can occur hourly or daily with small
changes or in large incremental shifts.
Spot and Forward Exchange Rates

There are two types of foreign exchange rates, namely the spot rate and forward rates ruling in the foreign
exchange market. The spot rate of exchange refers to the rate or price in terms of home currency payable for spot delivery
of a specified type of foreign exchange. The forward rate of exchange refers to the price at which a transaction will be
consummated at some specified time in future.
Nominal, Real and Effective Exchange Rates

The real effective exchange rate (REER) is the weighted average of a country's currency in relation to an index or
basket of other major currencies. The weights are determined by comparing the relative trade balance of a country's
currency against that of each country in the index. An increase in a nation's REER is an indication that its exports are
becoming more expensive and its imports are becoming cheaper. It is losing its trade competitiveness.
The effective exchange rate is an index that describes the strength of a currency relative to a basket of other
currencies. A real effective exchange rate (REER) adjusts NEER by the appropriate foreign price level and deflates by the
home country price level.
The Determinants of Exchange Rates

 Inflation Rates: Changes in market inflation cause changes in currency exchange rates. A country with a lower
inflation rate than another's will see an appreciation in the value of its currency. The prices of goods and services
increase at a slower rate where the inflation is low. A country with a consistently lower inflation rate exhibits a
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rising currency value while a country with higher inflation typically sees depreciation in its currency and is
usually accompanied by higher interest rates
 Interest Rates: Changes in interest rate affect currency value and dollar exchange rate. Forex rates, interest rates,
and inflation are all correlated. Increases in interest rates cause a country's currency to appreciate because higher
interest rates provide higher rates to lenders, thereby attracting more foreign capital, which causes a rise in
exchange rates.
 Country's Current Account / Balance of Payments: A country's current account reflects balance of trade and
earnings on foreign investment. It consists of total number of transactions including its exports, imports, debt, etc.
A deficit in current account due to spending more of its currency on importing products than it is earning through
sale of exports causes depreciation. Balance of payments fluctuates exchange rate of its domestic currency.
 Government Debt: Government debt is public debt or national debt owned by the central government. A country
with government debt is less likely to acquire foreign capital, leading to inflation. Foreign investors will sell their
bonds in the open market if the market predicts government debt within a certain country. As a result, a decrease
in the value of its exchange rate will follow.
 Terms of Trade: A trade deficit also can cause exchange rates to change. Related to current accounts and
balance of payments, the terms of trade are the ratio of export prices to import prices. A country's terms of trade
improve if its exports prices rise at a greater rate than its imports prices. This results in higher revenue, which
causes a higher demand for the country's currency and an increase in its currency's value. This results in an
appreciation of exchange rate.
 Political Stability & Performance: A country's political state and economic performance can affect its currency
strength. A country with less risk for political turmoil is more attractive to foreign investors, as a result, drawing
investment away from other countries with more political and economic stability. Increase in foreign capital, in
turn, leads to an appreciation in the value of its domestic currency. A country with sound financial and trade
policy does not give any room for uncertainty in value of its currency. But, a country prone to political confusions
may see a depreciation in exchange rates.
 Recession: When a country experiences a recession, its interest rates are likely to fall, decreasing its chances to
acquire foreign capital. As a result, its currency weakens in comparison to that of other countries, therefore
lowering the exchange rate.
 Speculation: If a country's currency value is expected to rise, investors will demand more of that currency in
order to make a profit in the near future. As a result, the value of the currency will rise due to the increase in
demand. With this increase in currency value comes a rise in the exchange rate as well.
Exchange Rate Regimes

Fixed Exchange Rate
The pegged exchange rate or the fixed exchange rate system is referred to as the system where the weaker
currency of the two currencies in question is pegged or tied to the stronger currency. Fixed exchange rate is determined
by the government of the country or central bank and is not dependent on market forces. To maintain the stability in the
currency rate, there is purchasing of foreign exchange by the central bank or government when the rate of foreign
currency increases and selling foreign currency when the rates fall. This process is known as pegging and that’s why the
fixed exchange rate system is also referred to as the pegged exchange rate system.
Following are some of the advantages of fixed exchange rate system
 It ensures stability in foreign exchange that encourages foreign trade.
 There is a stability in the value of currency which protects it from market fluctuations.
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 It promotes foreign investment for the country.
 It helps in maintaining stable inflation rates in an economy.
Following are some of the disadvantages of the fixed exchange rate system
 There is a constant need for maintaining foreign reserves in order to stabilise the economy.
 The government may lack the flexibility that is required to bounce back in case an economic shock engulfs the
economy.
Freely Floating / Flexible Exchange Rate

Flexible exchange rate system is also known as the floating exchange rate system as it is dependent on the market
forces of supply and demand. There is no intervention of the central banks or the government in the floating exchange
rate system.
Following are the advantages of the floating exchange rate system
 There is no need to maintain foreign reserves in this exchange system.
 Any deficiencies or surplus in Balance of Payment is automatically corrected in this system.
Following are some of the disadvantages of the floating exchange rate system
 It encourages speculation that may lead to fluctuations in the exchange rate of currencies in the market.
 If the fluctuations in exchange rates are too much it can cause issues with movement of capital between countries
and also impact foreign trade.
 It will discourage any type of international trade and foreign investment.
Managed Float / Hybrid System

Managed floating exchange rate system is the combination of the fixed (managed) and floating exchange rate
systems. Under this system the central banks intervene or participate in the purchase or selling of the foreign currencies.
The Interaction of Hedgers, Arbitrageurs, and Speculators

Hedging would mean the reduction of risk. An investor who is looking at reducing his risk is known as a Hedger.
A Hedger would typically look at reducing his asset exposure to price volatility and in a derivative market, would usually
take up a position that is opposite to the risk he is otherwise exposed to. Hedgers primarily look at limiting their exposure
risk. This is done by using derivative tools and “insuring” limited losses in case of unfavourable movements in the
underlying asset. That brings us to the next group of derivative market participants – the Speculators. Hedging is the
simultaneous purchase and sale of two assets in the expectation of a gain from different subsequent movements in the
price of those assets. Usually the two assets are equivalent in all respects except maturity.
Arbitrage is the simultaneous purchase and sale of equivalent assets at prices which guarantee a fixed profit at the
time of the transactions, although the life of the assets and, hence, the consummation of the profit may be delayed until
some future date. The key element in the definition is that the amount of profit be determined with certainty. It
specifically excludes transactions which guarantee a minimum rate of return but which also offer an option for increased
profits.
In the pursuit of these profits, arbitrageurs tend to force prices in all markets toward equality. The arbitrageur’s
transactions tend to raise prices in the cheap market and depress prices in the expensive one. Because of transaction costs
and transportation costs, literal equality will not be achieved. But neglecting the former costs, completely effective
arbitrage would eliminate the incentive to shop among markets. To the extent that arbitrageurs, through specialization,
can seek out market imperfections more efficiently than other market participants can, they will increase social welfare.
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Speculation is the purchase or sale of an asset in the expectation of a gain from changes in the price of that asset.
For speculators as a group actually to earn a profit requires that merchants be willing to sell for future delivery at prices
lower than those they expect in the future. One reason why they might do so is that by hedging, they eliminate risk; and
the difference between the price at which they sell and the price they expect in the future is the risk premium—somewhat
analogous to the premium one pays for insurance (over and above the actuarial value of the risk).
Appreciation / Revaluation and Depreciation / Devaluation of Currencies

The exchange rate for any currency usually fluctuates. When the value of the currency goes up as compared to
other currency it is known as appreciation. When the value of currency falls as compared to other currency it is known as
depreciation. Devaluation is when the price of the currency is officially decreased in a fixed exchange rate system.
Revaluation is the official increase in the price of the currency within a fixed exchange rate system.
The meaning of revaluation and devaluation of a currency is when the government issuing a currency changes its
value in relation to a foreign currency that it has been fixed to. Revaluation of a currency occurs when the value of a
currency is increased relative to another currency in a fixed exchange rate regime. Devaluation of a currency occurs when
the value of the currency is decreased relative to another currency in a fixed exchange rate regime. Revaluation and
devaluation are terms that only apply under a fixed exchange rate regime and not under a floating exchange rate regime.
Chapter 2: THEORIES OF EXCHANGE RATE DETERMINATION
The Purchasing Power Parity Theory

Purchasing Power Parity (PPP) is a measurement that economists use to compare the spending power between
two or more nations. This is done through a basket of commonly bought goods which measures the difference in price
between two nations. For example, a Big Mac in the US may cost $8 and £5 in the UK. Purchasing Power Parity (PPP)
calculates the exchange rate by which both countries would see ‘parity’. In other words, the Purchasing Power Parity
(PPP) exchange rate would be 1.6 as that is the ratio between a Big Mac in the UK at £5 and the US at $8.
Purchasing Power Parity (PPP) takes a basket of commonly purchased goods such as milk, televisions, motor
vehicles, and phones, among others. It then calculates the price of these, thereby working out the total cost of these goods
in local currency. Purchasing Power Parity measures the exchange rate by which two nations would achieve absolute
parity in the number of goods they could buy. For example, many tourists will go away on cheap holidays knowing they
can buy a meal at half the price they do at home. Hotels are cheaper, food is cheaper, and excursions are cheaper. This is
because there is not purchasing power parity between the two nations – meaning one currency is undervalued, and
another overvalued.
There are three main assumptions which define Purchasing Power Parity (PPP). First of all, there are no
transaction costs. In other words, it doesn’t cost businesses significantly more to ship or manufacture goods. Second of
all, there are no trade barriers that would enhance the price of the basket of goods. And third of all, it ignores regional
differences. For example, you get less for your money in California than you do in Alabama. In its very basic form,
Purchasing Power Parity (PPP) calculates the average basket of goods in one country and compares to another in that
local currency. The PPP is then calculated by converting the value in one currency, to the value in the other. So how
much of Currency A is needed to buy exactly the same quantity of goods with Currency B.
Purchasing Power Parity = Total cost of a basket of goods in Country A/ Total cost of a basket of goods in Country B
In economic theory, there are two types of purchasing power parity: Absolute Parity and Relative Parity.
 Absolute Parity: Absolute parity is the core theory of PPP. It is the theory that a basket of goods in one country
is worth exactly that in another. As long as the product is similar, it doesn’t matter which country produces it, the
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price will remain the same. In other words, consumers in the US can buy exactly the same number of Big Mac’s
as those in Germany. To put it another way, absolute parity is where the exchange rate is equal to the ratio
between prices in two countries. For example, a meal at KFC in the US may cost $10, whilst in the UK it costs
£5. So the absolute parity would be where money in either country can be exchanged for an equal number of
goods. The main issue with absolute parity is that it doesn’t consider other factors such as inflation. It’s not very
dynamic and is a static form of measurement.
 Relative Parity: By contrast to absolute parity, relative parity includes everything stated in absolute parity, but
considers inflation. It is an economic theory that states exchange rates and price levels will equal each other over
the long-term. That means that fluctuations due to factors such as inflation will bring the actual exchange rate out
of PPP alignment. However, over the long-term, the exchange rate will equal PPP. For example, an iPhone may
cost $999 in the US and £799 in the UK. That would state that the PPP would be $999 / £799 = 1.25. However,
the rate of inflation may increase the cost in the US to $1,099. This would bring it out of line with the PPP
exchange rate of 1.25. In the long-term, inflation in both the US and UK is likely to fluctuate. Relative parity
would suggest that these fluctuations will even out over the course of many years, and bring it in line with PPP
over a set period of time.
Money, Interest rate and Exchange rate

A Brief Review of the Money Market
The money market refers to trading in very short-term debt investments. At the wholesale level, it involves large-
volume trades between institutions and traders. At the retail level, it includes money market mutual funds bought by
individual investors and money market accounts opened by bank customers. In all of these cases, the money market is
characterized by a high degree of safety and relatively low rates of return. The money market is one of the pillars of the
global financial system. It involves overnight swaps of vast amounts of money between banks and the U.S. government.
The majority of money market transactions are wholesale transactions that take place between financial institutions and
companies.
Institutions that participate in the money market include banks that lend to one another and to large companies in
the eurocurrency and time deposit markets; companies that raise money by selling commercial paper into the market,
which can be bought by other companies or funds; and investors who purchase bank CDs as a safe place to park money in
the short term. Some of those wholesale transactions eventually make their way into the hands of consumers as
components of money market mutual funds and other investments.
The Definition of Money

Money is anything that serves as a medium of exchange. A medium of exchange is anything that is widely
accepted as a means of payment. In Romania under Communist Party rule in the 1980s, for example, Kent cigarettes
served as a medium of exchange; the fact that they could be exchanged for other goods and services made them money.
The Functions of Money

Money serves three basic functions. By definition, it is a medium of exchange. It also serves as a unit of account
and as a store of value.
 Money as a Medium of Exchange: A medium of exchange is an asset that can be used in a transaction to
exchange goods and services. Gold and other precious metals have been used as a medium of exchange before
money itself, or alongside it.
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 Money as a Standard of Deferred Payment: The above function is somehow related to the first, as it creates
credit and allows transactions to be settled in the future. To be a standard of deferred payment, money must be an
accepted way to value and settle a debt in the future.
 Money as a Store of Wealth: As services can’t be stored and a lot of goods are perishable, society requires more
effective ways of storing wealth. Money can be easily stored, retrieved, and used at a later time, and, at least in
times of low inflation, it’s able to maintain most of its value.
 Money as a Measure of Value: Money can be used as a universal unit of account to measure the value of all the
goods and services exchanged in an economy. In a money-based economy, prices can be indicated using only one
measure of value, simplifying transactions and people’s understanding of how much a good or service is worth.
Conversely, in a barter economy, the prices for a good or service should be established based on all the other
goods or services produced and exchanged.
The Supply of and the Demand for Money

 Supply of Money:
Supply of money conforms to the ‘stock’ concept and not the ‘flow’ concept. Just as the demand for money is the
demand for money to hold, similarly, the supply of money means the supply of money to hold. Money must always be
held by someone, otherwise it cannot exist. Hence, the supply of money means the sum total of all the forms of money
which are held by a community at any given moment. The stock of money, which constitutes the supply of it, consists of
(a) metallic money or coins, (b) currency notes issued by the currency authority of the country whether the Central bank
or the government, and (chequable bank deposits. In old times, the coins formed the bulk of money supply of the country.
Later, the currency notes eclipsed the metallic currency and now the bank deposits in current account withdraw-able by
cheques have overwhelmed all other forms of money. Thus, money supply means total volume of monetary media of
exchange available to the community for use in connection with the economic activity of the country. Broadly speaking,
money supply in a country is composed of two main elements, viz., (a) currency with the public; and (b) deposit money
with the public.
In order to arrive at the total amount of currency with the public, we add: (i) currency notes in circulation; (ii)
circulation of rupee notes and coins; and (iii) circulation of small coins; and from the total deduct- ‘Cash in hand with
banks’ The bulk of the currency with the public (over 95 per cent) is in the form of currency notes issued by the Reserve
Bank of India. Next in importance are the rupee notes issued by the Government of India. Besides currency, money
supply with the public includes the deposit money, i.e., the bank balances held in current accounts of the banks. In
underdeveloped countries, the currency, and not the bank deposits, occupies a dominant position, because in such
countries the bulk of commercial dealings are done through cash as a medium of exchange and not through cheques as in
advanced countries. Deposit money with the public in India consists of two items, viz., net demand deposits of bank and
‘other deposits’ with the Reserve Bank of India.
By adding total currency with the public and the total demand deposits, we get the total money supply with the
public. It is also worth nothing here that in India the deposit money with the public has now come to exceed, albeit
slightly, the total currency money with the public. Compare with it the position in 1950-51, when deposit money with the
public was not even one-half of the currency in circulation among the public. This shows that the banking habit has
steadily been growing in the country and the time will not be far off when deposit money will far outstrip the currency
money. The total amount of bank deposits in the country is determined by the monetary policy of the central bank of the
country. When the central bank wants to give a boost to the economy of the country, it follows a cheap money policy,
lowers the bank rate, which is followed by lower rates of interest charged by the commercial banks, thus helping credit
creation by the banks. There are times, however, when in the interest of economic stability, the central bank follows a
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policy of credit squeeze by raising the bank rate and purchasing securi ties through open market operations and adopting
other credit control measures.
 Demand for Money:

The old idea about the demand for money was that money was demanded for completing the business
transactions. In other words, the demand for money depended on the volume of trade or transactions. As such the demand
for money increased during boom period or when the trade was brisk and it decreased during depression or slackening of
trade. According to Keynes, the demand for money, or liquidity preference as he called it, means the demand for money
to hold. Broadly speaking, there are three main motives on account of which money is wanted by the people by the
people, viz.: Transactions motive, Precautionary motive, and Speculative motive
o Transactions Motive:
This motive can be looked at: (a) From the point of consumers who want income to meet the household
expenditure which may be termed the income motive, and (b) From the point of view of the businessmen, who require
money and want to hold it in order to carry on their business, i.e., the business motive.
 Income Motive: The transactions motive relates to the demand for money or the need for cash for the current
transactions of individual and business exchanges. Individuals hold cash in order “to bridge the interval between
the receipt of income and its expenditure.” This is called the income Motive’. Most of the people receive their
incomes by the week or the month, while the expenditure goes on day by day. A certain amount of ready money,
therefore, is kept in hand to make current payments. This amount will depend upon the size of the individual’s
income, the interval at which the income is received and the methods of payments current in the locality.
 Business Motive: The businessmen and the entrepreneurs also have to keep a proportion of their resources in
ready cash in order to meet current needs of various kinds. They need money all the time in order to pay for raw
materials and transport, to pay wages and salaries and to meet all other current expenses incurred by any business
of exchange. Keynes calls it the ‘Business Motive’ for keeping money. It is clear that the amount of money held,
under this business motive, will depend to a very large extent on the turnover (i.e., the volume of trade of the firm
in question). The larger the turnover, the larger in general, will be the amount of money needed to cover current
expenses.
 Precautionary Motive: Precautionary motive for holding money refers to the desire of the people to hold cash
balances for unforeseen contingencies People hold a certain amount of money to provide tor the risk of
unemployment, sickness, accidents and other more uncertain perils. The amount of money held under this motive
will depend on the nature of the individual and on the conditions in which he lives.
 Speculative Motive: The speculative motive relates to the desire to hold one’s resources in liquid form in order
to take advantage of market movements regarding the future changes in the rate of interest (or bond-prices). The
notion of holding money for speculative motive is a new typically Keynesian idea. Money held under the
speculative motive serves as a store of value as money held under the precautionary motive does. But it is a store
of money meant for a different purpose.
The Demand for Foreign Currency Assets

The demand (or outflow) of foreign exchange comes from those people who need it to make payment in foreign
currency. It is demanded by the domestic residents for the following reasons:
o Imports of Goods and Services: Foreign Exchange is demanded to make the payment for imports of goods and
services.
o Tourism: Foreign exchange is needed to meet expenditure incurred in foreign tours.
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o Unilateral Transfers sent abroad: Foreign exchange is required for making unilateral transfers like sending
gifts to other countries.
o Purchase of Assets in Foreign Countries: It is demanded to make payment for purchase of assets, like land,
shares, bonds, etc. in the foreign countries.
o Speculation: Demand for foreign exchange arises when people want to make gains -from appreciation of
currency.
The demand for foreign currency rises in the following situations:
o When price of a foreign currency falls, imports from that foreign country become cheaper. So, imports increase
and hence, the demand for foreign currency rises. For example, if price of 1 US dollar falls from Rs 50 to Rs 45,
then imports from USA will increase as American goods will become relatively cheaper. It will raise the demand
for US dollars.
o When a foreign currency becomes cheaper in terms of the domestic currency, it promotes tourism to that country.
As a result, demand for foreign currency rises.
o When price of a foreign currency falls, its demand rises as more people want to make gains from speculative
activities.
Demand curve of foreign exchange slope downwards due to inverse relationship between demand for foreign
exchange and foreign exchange rate.
In Fig. 11.1, demand for foreign exchange (US dollar) and rate of foreign exchange are shown on the X- axis and
Y-axis respectively. The negatively sloped demand curve (DD) shows that more foreign exchange (OQ 1) is demanded at a
low rate of exchange (OR1), whereas, demand for US dollars falls to OQ 2 when the exchange rate rises to OR2.
Interest Parity Condition and Rate of Return

Interest rate parity (IRP) is a theory according to which the interest rate differential between two countries is
equal to the differential between the forward exchange rate and the spot exchange rate. Interest rate parity (IRP) plays an
essential role in foreign exchange markets by connecting interest rates, spot exchange rates, and foreign exchange rates.
IRP is the fundamental equation that governs the relationship between interest rates and currency exchange rates. The
basic premise of Interest rate parity is that hedged returns from investing in different currencies should be the same,
regardless of their interest rates.
Interest rate parity is the concept of no-arbitrage in the foreign exchange markets (the simultaneous purchase and
sale of an asset to profit from a difference in the price). Investors cannot lock in the current exchange rate in one currency
for a lower price and then purchase another currency from a country offering a higher interest rate.
Return on investment (ROI) is the key measure of the profit derived from any investment. It is a ratio that
compares the gain or loss from an investment relative to its cost. It is useful in evaluating the current or potential return
on an investment, whether you are evaluating your stock portfolio's performance, considering a business investment, or
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deciding whether to undertake a new project. In business analysis, ROI and other cash flow measures—such as internal
rate of return (IRR) and net present value (NPV)—are key metrics that are used to evaluate and rank the attractiveness of
a number of different investment alternatives.
The monetary model of exchange rate determination

There are four main types of exchange rate regimes: freely floating, fixed, pegged (also known as adjustable peg,
crawling peg, basket peg, or target zone or bands), and managed float. Monetary models to exchange rate determination
are basically stock models that derived from the IS/LM/Phillip Curve model. So, monetary approach maintains that
exchange rate is determined predominantly by shifts in the demand for and supply of money.
Chapter 3: BALANCE OF PAYMENTS
Definition and Purposes of Balance of Payments

Balance of Payment (BOP) is a statement that records all the monetary transactions made between residents of a
country and the rest of the world during any given period. This statement includes all the transactions made by/to
individuals, corporates and the government and helps in monitoring the flow of funds to develop the economy. When all
the elements are correctly included in the BOP, it should be zero in a perfect scenario. This means the inflows and
outflows of funds should balance out. However, this does not ideally happen in most cases.
A BOP statement of a country indicates whether the country has a surplus or a deficit of funds, i.e. when a
country’s export is more than its import, its BOP is said to be in surplus. On the other hand, the BOP deficit indicates that
its imports are more than its exports. The formula for calculating the balance of payments is current account + capital
account + financial account + balancing item = 0.
A country’s BOP is vital for the following reasons:
o The BOP of a country reveals its financial and economic status.
o A BOP statement can be used to determine whether the country’s currency value is appreciating or depreciating.
o The BOP statement helps the government to decide on fiscal and trade policies.
o It provides important information to analyse and understand the economic dealings with other countries.
Balance of Payments Accounting Principle

Balance of payments is systematic statement that systematically summarizes, for a specified period of time, the
monetary transactions of an economy with the rest of the world. Put in simple words, the balance of payments of a
country is a systematic record of all transactions between the ‘residents’ of a country and the rest of the world. Three
main elements of actual process of measuring international economic activity are:
o Identifying what is/is not an international economic transaction,
o Understanding how the flow of goods, services, assets, money create debits and credits, and
o Understanding the bookkeeping procedures for BoP accounting.
Each transaction is recorded in accordance with the principles of double-entry book keeping. That is every
transaction is recorded based on accounting principle. One of these entries is a credit and the other entry is debit. In
principle, the sum of all credit entries is identical to the sum of all debit entries, and the net balance of all entries in the
statement is zero. Exports decreases in foreign financial assets (or increases in foreign financial liabilities) are recorded as
credits, while imports increases in foreign financial assets (or decreases in foreign financial liabilities) are recorded as
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debits. In other words, with regard to assets, whether real or financial, decreases in holdings are recorded as credits, while
increases in holdings are recorded as debits. On the other hand, increases in liabilities are recorded as credits, while
decreases in liabilities are recorded as debits. In practice, the figures rarely balance to the point where they cancel each
other out. This is the result of errors or missions in the compilation of statements. A separate balancing item is used to
offset the credit or debit.
However, there is no book-keeping requirement that the sums of the two sides of a selected number of balance of
payments accounts should be the same, and it happens that the balances shown by certain combinations of accounts are of
considerable interest to analysts and government officials. It is these balances that are often referred to as “surpluses” or
“deficits” in the balance of payments. The following some simple rules of thumb help to the reader to understand the
application of accounting principles for balance of payments accounting.
Any individual or corporate transaction that leads to increase in demand for foreign currency (exchange) is to be
recorded as debit, because if is cash outflow, while a transaction which results in increase the supply of foreign currency
(exchange) is to be recorded as a credit entry. All transactions, which result an immediate or prospective payment from
the rest of the world to the country should be recorded as credit entry. On the other hand, the transactions, which result in
an actual or prospective payment from the country to the rest of the world should be recorded as debits.
Credit Debit
1. Exports of goods and services 1. Imports of goods and services
2. Income receivable from abroad 2. Income payable to abroad
3. Transfers from abroad 3. Transfers to abroad
4. Increases in external liabilities 4. Decreases in external liabilities
5. Decreases in external assets 5. Increases in external assets
Thus balance of payments credits denote a reduction in foreign assets or an increase in foreign liabilities, while
debits denote an increase in foreign assets or a reduction of foreign liabilities. In balance of payments accounting the
principle of accrual accounting governs the time of recording of transactions. Therefore, transactions are recorded when
economic value is created, transformed, exchanged, transferred, or extinguished. Claims and liabilities arise when there is
a change in ownership. Put in simple words, balance of payments is usually prepared for a year but may be divided into
quarters as well.
The Components of Balance of Payments

There are three components of the balance of payment viz. current account, capital account, and financial
account. The total of the current account must balance with the total of capital and financial accounts in ideal situations.
o Current Account
The current account monitors the inflow and outflow of goods and services between countries. This account
covers all the receipts and payments made with respect to raw materials and manufactured goods. It also includes receipts
from engineering, tourism, transportation, business services, stocks, and royalties from patents and copyrights. When all
the goods and services are combined, they make up a country’s Balance of Trade (BOT). There are various categories of
trade and transfers which happen across countries. It could be visible or invisible trading, unilateral transfers or other
payments/receipts. Trading in goods between countries is referred to as visible items, and import/export of services
(banking, information technology etc.) are referred to as invisible items. Unilateral transfers refer to money sent as gifts
or donations to residents of foreign countries. This can also be personal transfers like – money sent by relatives to their
family located in another country.
o Capital Account
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All capital transactions between the countries are monitored through the capital account. Capital transactions
include purchasing and selling assets (non-financial) like land and properties. The capital account also includes the flow
of taxes, purchase and sale of fixed assets etc., by migrants moving out/into a different country. The deficit or surplus in
the current account is managed through the finance from the capital account and vice versa. There are three major
elements of a capital account:
 Loans and borrowings – It includes all types of loans from the private and public sectors located in foreign
countries.
 Investments – These are funds invested in corporate stocks by non-residents.
 Foreign exchange reserves – Foreign exchange reserves held by the country’s central bank to monitor and
control the exchange rate do impact the capital account.
o Financial Account
The flow of funds from and to foreign countries through various investments in real estate, business ventures,
foreign direct investments etc., is monitored through the financial account. This account measures the changes in the
foreign ownership of domestic assets and domestic ownership of foreign assets. Analysing these changes can be
understood if the country is selling or acquiring more assets (like gold, stocks, equity, etc.).
Balance of Trade and Balance of Payments

o Definition of Balance of Trade
Trade refers to buying and selling of goods, but when it comes to buying and selling of goods globally, then it is
known as import and export. The Balance of Trade is the balance of the imports and exports of commodities made to/by a
country during a particular year. It is the most important part of the current account of the country’s Balance of Payment.
It keeps records of tangible items only.
Balance of Trade shows the variability in the imports and exports of merchandise made by a country with the rest
of the world over a period. If the imports and exports made to/by the country tallies, then this situation is known as Trade
Equilibrium, but if imports exceed exports, then the condition is unfavourable as it states that the economic status of the
country is not good, and so this situation is termed as Trade Deficit. Now, if the value of exports is greater than the value
of imports, this is a favourable situation because it indicates the good economic position of the country, thus known as
trade surplus.
o Definition of Balance of Payments

The Balance of Payments is a set of accounts that recognises all the commercial transactions performed by the
country in a particular period with the remaining countries of the world. It keeps the record of all the monetary
transactions done globally by the country on commodities, services and income during the year. It combines all the
public-private investments to know the inflow and outflow of money in the economy over a period. If the BOP is equal to
zero, then it means that both the debits and credits are equal, but if the debit is more than credit, then it is a sign of deficit
while if the credit exceeds debit, then it shows a surplus. The Balance of Payment has been divided into the following sets
of accounts:
 Current Account: The account that keeps the record of both tangible and intangible items. Tangible items
include goods while the intangible items are services and income.
 Capital Account: The account keeps a record of all the capital expenditure made and income generated
collectively by the public and private sector. Foreign Direct Investment, External Commercial Borrowing,
Government loan to Foreign Government, etc. are included in Capital Account.
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 Errors and Omissions: If in case the receipts and payments do not match with each other than balance amount
will be shown as errors and omissions.
Comparison Chart
BASIS FOR BALANCE OF TRADE BALANCE OF PAYMENT
COMPARISON
Meaning Balance of Trade is a statement that Balance of Payment is a statement that keeps
captures the country's export and track of all economic transactions done by the
import of goods with the remaining country with the remaining world.
world.
Records Transactions related to goods only. Transactions related to both goods and services
are recorded.
Capital Transfers Are not included in the Balance of Are included in Balance of Payment.
Trade
Which is better? It gives a partial view of the It gives a clear view of the economic position of
country's economic status. the country.
Result It can be Favourable, Unfavourable Both the receipts and payment sides tallies.
or balanced.
Components It is a component of Current Current Account and Capital Account.
Account of Balance of Payment.
The following are the major differences between the balance of trade and balance of payments:
 A statement recording the imports and exports done in goods by/from the country with the other countries, during
a particular period is known as the Balance of Trade. The Balance of Payment captures all the monetary
transaction performed internationally by the country during a course of time.
 The Balance of Trade accounts for, only physical items, whereas Balance of Payment keeps track of physical as
well as non-physical items.
 The Balance of Payments records capital receipts or payments, but Balance of Trade does not include it.
 The Balance of Trade can show a surplus, deficit or it can be balanced too. On the other hand, Balance of
Payments is always balanced.
 The Balance of Trade is a major segment of Balance of Payment.
 The Balance of Trade provides the only half picture of the country’s economic position. Conversely, Balance of
Payment gives a complete view of the country’s economic position.
Every country of the world keeps the record of inflow and outflow of money in the economy with the help of a
Balance of Trade and Balance of Payments. They reflect the actual position of the whole economy. With the help of BOT
and BOP, analysis and comparisons can also be made that how much trade has increased or decreased, since the last
period.
Balance of Payments Disequilibria

A balance of payments deficit means the nation imports more commodities, capital and services than it exports. It
must take from other nations to pay for their imports. The nation could use its reserves of foreign exchange in order to
balance any shortfall in its BoP:
o When the foreign exchange is being sold by the reserve bank when there is a deficit, it is known as official
reserve sale.
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o The decrease or increase in official reserves is known as the overall balance of payments deficit or surplus.
o The fundamental hypothesis is that the monetary authorities are the final financiers of any deficit in the BoP(or
the recipients of any surplus.
o Official reserve transactions are relevant under the reign of the fixed exchange rates than when exchange rates are
floating.
o There are many factors that may lead to a BOP deficit or surplus:
Reasons of balance of payment disequilibrium

 Temporary Changes (or Disequilibrium): There may be a temporary disequilibrium caused by random
variations in trade, seasonal fluctuations, the effects of weather on agricultural production, etc. Deficits or
surpluses arising from such temporary causes are expected to correct themselves within a short time.
 Fundamental Disequilibrium: Fundamental disequilibrium refers to a persistent and long-run BOP
disequilibrium of a country. It is a chronic BOP deficit, according to IMF. It is caused by such dynamic factors
as:
 Changes in consumer tastes within the country or abroad which reduce the country’s exports and increase
its imports.
 Continuous fall in the country’s foreign exchange reserves due to supply in-elasticities of exports and
excessive demand for foreign goods and services.
 Excessive capital outflows due to massive imports of capital goods, raw materials, essential consumer
goods, technology and external indebtedness.
 Low competitive strength in world markets which adversely affects exports.
 Inflationary pressures within the economy which make exports dearer.
 Structural Changes (or Disequilibrium): Structural changes bring about disequilibrium in BOP over the long
run. They may result from the following factors:
 Technological changes in methods of production of products in domestic industries or in the industries of
other countries. They lead to changes in costs, prices and quality of products.
 Import restrictions of all kinds bring about disequilibrium in BOP.
 Deficit in BOP also arises when a country suffers from deficiency of resources which it is required to
import from other countries.
 Disequilibrium in BOP may also be caused by changes in the supply or direction of long-term capital
flows. More and regular flow of long-term capital may lead to BOP surplus, while an irregular and short
supply of capital brings BOP deficit.
 Changes in Exchange Rates: Changes in foreign exchange rate in the form of overvaluation or undervaluation
of foreign currency lead to BOP disequilibrium. When the value of currency is higher in relation to other
currencies, it is said to be overvalued. Opposite is the case of an undervalued currency. Overvaluation of the
domestic currency makes foreign goods cheaper and exports dearer in foreign countries. As a result, the country
imports more and exports less of goods. There is also outflow of capital. This leads to unfavourable BOP. On the
contrary, undervaluation of the currency makes BOP favourable for the country by encouraging exports and
inflow of capital and reducing imports.
 Cyclical Fluctuations (or Disequilibrium): Cyclical fluctuations in business activity also lead to BOP
disequilibrium. When there is depression in a country, volumes of both exports and imports fall drastically in
relation to other countries. But the fall in exports may be more than that of imports due to decline in domestic
production. Therefore, there is an adverse BOP situation. On the other hand, when there is boom in a country in
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relation to other countries, both exports and imports may increase. But there can be either a surplus or deficit in
BOP situation depending upon whether the country exports more than imports or imports more than exports. In
both the cases, there will be disequilibrium in BOP.
 Changes in National Income: Another cause is the change in the country’s national income. If the national
income of a country increases, it will lead to an increase in imports thereby creating a deficit in its balance of
payments, other things remaining the same. If the country is already at full employment level, an increase in
income will lead to inflationary rise in prices which may increase its imports and thus bring disequilibrium in the
balance of payments.
 Price Changes: Inflation or deflation is another cause of disequilibrium in the balance of payments. If there is
inflation in the country, prices of exports increase. As a result, exports fall. At the same time, the demand for
imports increase. Thus increase in export prices leading to decline in exports and rise in imports results in adverse
balance of payments.
 Stage of Economic Development: A country’s balance of payments also depends on its stage of economic
development. If a country is developing it will have a deficit in its balance of payments because it imports raw
materials, machinery, capital equipment, and services associated with the development process and exports
primary products. The country has to pay more for costly imports and gets less for its cheap exports. This leads to
disequilibrium in its balance of payments.
 Capital Movements: Borrowings and lending’s or movements of capital by countries also result in
disequilibrium in BOP. A country which gives loans and grants on a large scale to other countries has a deficit in
its BOP on capital account. If it is also importing more, as is the case with the USA, it will have chronic deficit.
On the other hand, a developing country borrowing large funds from other countries and international institutions
may have a favourable BOP. But such a possibility is remote because these countries usually import huge
quantity of food, raw materials, capital goods, etc. and export primary products. Such borrowings simply help in
reducing BOP deficit.
 Political Conditions: Political condition of a country is another cause of disequilibrium in BOP. Political
instability in a country creates uncertainty among foreign investors which leads to the outflow of capital and
retards its inflow. This causes disequilibrium in BOP of the country. Disequilibrium in BOP also occurs in the
event of war or fear of war with some other country.
 How is balance of payment deficit measured?

Meaning Balance of Payment deficit is a situation when autonomous receipts are less than autonomous payments.
of deficit [Current A/c + Capital A/c Receipts] < [Current A/c + Capital A/c Payments]
in BOP Autonomous transactions are those transactions which are carried out with economic motive irrespective
of the present position of the BOP.
This situation arises only on account of autonomous transactions.
Correctio To correct the deficit i.e. Adverse BOP position government will:
n of BOP (a) Withdraw the required amount from its Foreign Exchange Reserves or
deficit (b) If required, it can borrow from the IMF.
These are the accommodating transactions of the government made only to bring equilibrium in the
Balance of Payment.
 How is balance of payment surplus measured?

Meaning of surplus in BOP Balance of Payment Surplus is a situation when autonomous receipts are more than
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autonomous payments.
[Current A/c + Capital A/c Receipts] > [Current A/c + Capital A/c Payments]
Autonomous transactions are those transactions which are carried out with economic
motive irrespective of the present position of the Balance of Payment.
This situation arises only on account of autonomous transactions.
Correction of BOP surplus To remove the surplus government will:
Deposit the excess foreign exchange in its Foreign Exchange Reserves.
This is an accommodating transaction of the government made only to bring
equilibrium in the Balance of Payment.
 What are the causes of deficit in BOP?

Economic (a) Fast Economic Development
factors o For fast development, developing countries import machines, technology, and other equipment.
o This leads to a high level of outflows of foreign exchange that can result in a deficit in the BOP
account.
(b) Inflation
o Inflation i.e. continuous rise in prices in a country makes foreign goods relatively cheaper.
o It increases imports which cause a deficit in the Balance of Payment.
Political (a) Political Instability
factors o Due to uncertainty, there may be large capital outflows and lesser inflows of foreign funds. It can
create an adverse position in the Balance of Payment.
(b) Political disturbances
o Frequent changes in government, unstable tax structure, etc. result in loss of trust of foreign
investors and discourage inflows of capital.
o Domestic investors also prefer to invest outside the economy. As a result, an adverse position
created in the balance of Payment.
Social (a) Changes in taste, preferences, fashion, and style, etc.
factors o A favourable change for imported goods increases the demand for imported goods and lead to a
deficit in the balance of payment.
(b) Demonstration effect
o Most of the developing countries get influenced by developed nations and start adopting the
foreign pattern of consumption.
o This results in a sharp rise in imports leading to a deficit in the Balance of Payment.
(c) Population explosion
o Population explosion in underdeveloped nations, also generally, results in large scale imports and
causes a deficit in the Balance of Payment.
Measures to Correct Deficit Balance of Payments

o Adjustment through Exchange Depreciation (Price Effect):
Under flexible exchange rates, the disequilibrium in the balance of payments is automatically solved by the forces
of demand and supply for foreign exchange. An exchange rate is the price of a currency which is determined, like any
other commodity, by demand and supply. “The exchange rate varies with varying supply and demand conditions, but it is
always possible to find an equilibrium exchange rate which clears the foreign exchange market and creates external
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equilibrium.” This is automatically achieved by depreciation of a country’s currency in case of deficit in its balance of
payments. Depreciation of a currency means that its relative value decreases. Depreciation has the effect of encouraging
exports and discouraging imports.
When exchange depreciation takes place, foreign prices are translated into domestic prices. Suppose the dollar
depreciates in relation to the pound. It means, that the price of dollar falls in relation to the pound in the foreign exchange
market. This leads to the lowering of the prices of U.S. exports in Britain and raising of the prices of British imports in the
U.S. When import prices are higher in the U.S., the Americans will purchase less goods from the Britishers. On the other
hand, lower prices of U.S. exports will increase exports and diminish imports, thereby bringing equilibrium in the balance
of payments.
o Devaluation or Expenditure-Switching Policy:
Devaluation raises the domestic price of imports and reduces the foreign price of exports of a country devaluing
its currency in relation to the currency of another country. Devaluation is referred to as expenditure switching policy
because it switches expenditure from imported to domestic goods and services. When a country devalues its currency, the
price of foreign currency increases which makes imports dearer and exports cheaper. This causes expenditures to be
switched from foreign to domestic goods as the country’s exports rise and the country produces more to meet the
domestic and foreign demand for goods with reduction in imports. Consequently, the balance of payments deficit is
eliminated.
o Direct Controls:
To correct disequilibrium in the balance of payments, government also adopts direct controls which aim at
limiting the volume of imports. The government restricts the import of undesirable or unimportant items by levying heavy
import duties, fixation of quotas, etc. At the same time, it may allow imports of essential goods duty free or at lower
import duties, or fix liberal import quotas for them. For instance, the government may allow free entry of capital goods,
but impose heavy import duties on luxuries. Import quotas are also fixed and the importers are required to take licenses
from the authorities in order to import certain essential commodities in fixed quantities.
In these ways, imports are reduced in order to correct an adverse balance of payments. The government also
imposes exchange controls. Exchange controls have a dual purpose. They restrict imports and also control and regulate
the foreign exchange. With reduction in imports and control of foreign exchange, visible and invisible imports are
reduced. Consequently, an adverse balance of payment is corrected.
o Adjustment through Capital Movements:
A country can use capital imports to correct a deficit in its balance of payments. A deficit can be financed by
capital inflows. When capital is perfectly mobile within countries, a small rise in the domestic rate of interest brings a
large inflow of capital. The balance of payments is said to be in equilibrium when the domestic interest rate equals the
world rate. If the domestic interest rate is higher than the world rate, there will be capital inflows and the balance of
payments deficit is corrected.
o Adjustment through Income Changes:
Given the foreign exchange rate and prices in a country, an increase in the value of exports, causes an increase in
the incomes of all persons associated with the export industries. These, in turn, create demand for other goods and
services within the country. This will raise the incomes of persons engaged in the latter industries and services. This
process will continue and the national income increases by the value of the multiplier.
o Stimulation of Exports and Import Substitutes:
A deficit in the balance of payments can also be corrected by encouraging exports. Exports can be encouraged by
producing quality products, by increasing exports through increased production and productivity, and by better marketing.
They can also be increased by a policy of import substitution. It means that the country produces those goods which it
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imports. In the beginning imports are reduced but in the long run exports of such goods start. An increase in exports cause
the national income to rise by many times through the operation of the foreign trade multiplier. The foreign trade
multiplier expresses the change in income caused by a change in exports. Ultimately, the deficit in the balance of
payments is removed when exports rise faster than imports.
o Expenditure-Reducing Policies:
A deficit in the balance of payments implies an excess of expenditure over income. To correct it, expenditure and
income should be brought into equality. For this expenditure reducing monetary and fiscal policies are used. A
contractionary or tight monetary policy relates to increase in interest rates to reduce money supply and a contractionary
fiscal policy relates to reduction in government expenditure and or increase in taxes. Thus expenditure reducing policies
reduce aggregate demand through higher taxes and interest rates, thereby reducing expenditure and output. The reduction
in expenditure and output, in turn, reduces the domestic price level. This gives rise to switching of expenditure from
foreign to domestic goods. Consequently, the country’s imports are reduced and the balance of payments deficit is
corrected.
3.6. Approaches to Balance of Payments

3.6.1. Elasticity Approach to Balance of Payments
The elasticity approach to BOP is associated with the Marshall-Lerner condition which was worked out
independently by these two economists. It studies the conditions under which exchange rate changes restore equilibrium
in BOP by devaluing a country’s currency. This approach is related to the price effect of devaluation. When a country
devalues its currency, the domestic prices of its imports are raised and the foreign prices of its exports are reduced. Thus
devaluation helps to improve BOP deficit of a country by increasing its exports and reducing its imports.
But the extent to which it will succeed depends on the country’s price elasticities of domestic demand for imports and
foreign demand for exports. This is what the Marshall -Lerner condition states: when the sum of price elasticities of
demand for exports and imports in absolute terms is greater than unity, devaluation will improve the country’s balance of
payments, i.e. ex + em > 1
Where ex is the demand elasticity of exports and Em is the demand elasticity for imports. On the contrary, if the
sum of price elasticities of demand for exports and imports in absolute terms, is less unity, e x + em > 1, devaluation will
worsen (increase the deficit) the BOP. If the sum of these elasticities in absolute terms is equal to unity, e x + em = 1,
devaluation has no effect on the BOP situation which will remain unchanged.
The following is the process through which the Marshall-Lerner condition operates in removing BOP deficit of a
devaluing country. Devaluation reduces the domestic prices of exports in terms of the foreign currency. With low prices,
exports increase. The extent to which they increase depends on the demand elasticity for exports. It also depends on the
nature of goods exported and the market conditions. If the country is the sole supplier and exports raw materials or
perishable goods, the demand elasticity for its exports will be low. If it exports machinery, tools and industrial products in
competition with other countries, the elasticity of demand for its products will be high, and devaluation will be successful
in correcting a deficit.
Devaluation has also the effect of increasing the domestic price of imports which will reduce the import of goods.
By how much the volume of imports will decline depends on the demand elasticity of imports. The demand elasticity of
imports, in turn, depends on the nature of goods imported by the devaluing country. If it imports consumer goods, raw
materials and inputs for industries, its elasticity of demand for imports will be low. It is only when the import elasticity of
demand for products is high that devaluation will help in correcting a deficit in the balance of payments. Thus it is only
when the sum of the elasticity of demand for exports and the elasticity of demand for imports is greater than one that
devaluation will improve the balance of payments of a country devaluing its currency.
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Absorption Approach to Balance of Payments

The absorption approach to balance of payments is general equilibrium in nature and is based on the Keynesian
national income relationships. It is, therefore, also known as the Keynesian approach. It runs through the income effect of
devaluation as against the price effect to the elasticity approach. The theory states that if a country has a deficit in its
balance of payments, it means that people are ‘absorbing’ more than they produce. Domestic expenditure on consumption
and investment is greater than national income.
If they have a surplus in the balance of payments, they are absorbing less. Expenditure on consumption and
investment is less than national income. Here the BOP is defined as the difference between national income and domestic
expenditure. This approach was developed by Sydney Alexander. The analysis can be explained in the following form
Y = C + Id + G + X-M …………(1)
Where Y is national income, C is consumption expenditure, Id total domestic investment, G is autonomous
government expenditure, X represents exports and M imports. The sum of (C + Id + G) is the total absorption designated
as A, and the balance of payments (X – M) is designated as B. Thus Equation (1) becomes
Y=A+B
Or B = Y-A ……………….(2)
Which means that BOP on current account is the difference between national income (Y) and total absorption
(A). BOP can be improved by either increasing domestic income or reducing the absorption. For this purpose, Alexander
advocates devaluation because it acts both ways.
First, devaluation increases exports and reduces imports, thereby increasing the national income. The additional
income so generated will further increase income via the multiplier effect. This will lead to an increase in domestic
consumption. Thus the net effect of the increase in national income on the balance of payments is the difference between
the total increase in income and the induced increase in absorption, i.e.,
∆B = ∆Y – ∆A ……………(3)
Total absorption (∆A) depends on the marginal propensity to absorb when there is devaluation. This is expressed
as a. Devaluation also directly affects absorption through the change in income which we write as D. Thus
∆A = a∆Y + ∆D ……………(4)
Substituting equation (4) in (3), we get
∆B = ∆Y – a∆Y – ∆D
or ∆B = (1 -a) ∆Y-∆D ………………(5)
The equation points toward three factors which explain the effects of devaluation on BOP. They are: (i) the
marginal propensity to absorb (a), (ii) change in income (∆T), and (Hi) change in direct absorption (∆D). It may be noted
that since a is the marginal propensity (MP) to absorb, (1 – a) is the propensity to hoard or save. These factors, in turn, are
influenced by the existence of unemployed or idle resources and fully employed resources in the devaluing country.
Monetary Approach to Balance of Payments

The monetary approach to the balance of payments is an explanation of the overall balance of payments. It
explains changes in balance of payments in terms of the demand for and supply of money. According to this approach, “a
balance of payments deficit is always and everywhere a monetary phenomenon.” Therefore, it can only be corrected by
monetary measures.
The monetary approach can be expressed in the form of the following relationship between the demand for and
supply of money: The demand for money (MD) is a stable function of income (Y), prices (P) and rate of interest (i)
MD = f (Y, P, i) ………………(1)
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The money supply (Ms) is a multiple of monetary base (m) which consists of domestic money (credit) (D) and
country’s foreign exchange reserves (R). Ignoring m for simplicity which is a constant,
MS = D + R ……………… (2)
Since in equilibrium the demand for money equals the money supply,
MD = Ms .. (3)
or MD = D + R [MS = D + R] …………(4)
A balance of payments deficit or surplus is represented by changes in the country’s foreign exchange reserves. Thus
∆R = ∆MD – ∆D ………………….. (5)
Or ∆R = B … ( 6)
Where B represents balance of payments which is equal to the difference between change in the demand for
money (∆MD) and change in domestic credit (∆D). A balance of payments deficit means a negative B which reduces R
and the money supply. On the other hand, a surplus means a positive B which increases R and the money supply. When B
= O, it means bop equilibrium or no disequilibrium of BOP. The automatic adjustment mechanism in the monetary
approaches is explained under both the fixed and flexible exchange rate systems.
Chapter 4: MACROECONOMIC POLICY IN AN OPEN ECONOMY
What is Open – Economy Macroeconomics?

An open economy is one which deals with other countries through distinct methods. An open economy is a type
of economy where not only domestic factors but also entities in other countries engage in trade of products (goods and
services). Trade can take the form of managerial exchange, technology transfers, and all kinds of goods and services.
Certain exceptions exist that cannot be exchanged; the railway services of a country, for example, cannot be traded with
another country to avail the service. In fact, most of the modern economies are open. There are three ways in which these
connections can be determined.
o Output Market: An economy can deal and trade in commodities and services with other nations. This broadens
the preferences in the sense that the customers and manufacturers can pick between domestic and foreign
commodities
o Financial Market: Often, an economy can purchase financial assets from other nations. This furnishes investors
the opportunity to pick between domestic and foreign assets
o Labour Market: Enterprises can pick where to locate manufacturing plant and workers to pick where to work.
There are several immigration laws which constraint the movement of labour between nations
Macroeconomic Policy Goals in an Open Economy

Macroeconomics refers to the study of the overall performance of the economy. While microeconomics studies
how individual people make decisions, macroeconomics deals with the overall aggregate effect of microeconomics.
Macroeconomics is crucial for the government to understand and predict the long-term consequences of their decisions.
The overarching goals of macroeconomics are to maximize the standard of living and achieve stable economic growth.
The goals are supported by objectives such as minimizing unemployment, increasing productivity, controlling inflation,
and more. The macroeconomic of a country is affected by many forces, and as such, economic indicators are invaluable to
assessing different aspects of performance.
o Economic Indicators
 Gross Domestic Product (GDP)
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Often used as the primary indicator of macroeconomics, absolute GDP represents the economy’s size at a point in
time. GDP is usually calculated and released by the government on a quarterly or annual basis. As a rule of thumb,
spending stimulates growth. Individual consumer consumption drives businesses, business investments promote growth,
and government spending maintains social welfare. Net exports, as calculated by (exports – imports), measures trade.
Positive net exports represent a trade surplus, while negative net exports represent a trade deficit. Economic growth can
be calculated by comparing GDP over time, such as year-over-year increases.
 Inflation
Inflation is the increase of overall price levels and consequently the decrease in purchasing power. It occurs
primarily due to increased demand for products and services, which, in turn, raises prices. Inflation, therefore, represents
growth. However, too much inflation is also harmful if purchasing power decreases much more than inflated prices,
decreasing overall spending and devaluing the currency. The target inflation rate is usually around 1% to 3%.
 Unemployment
Unemployment accounts for individuals who are jobless and are actively seeking one. Individuals who are retired
or disabled are not included as unemployed. Unemployment is a natural occurrence and cannot be completely eliminated.
The sum of frictional and structural is called natural unemployment. It arises from everyday events, such as individuals
changing jobs or industries shrinking from a decline in demand. The sum of natural unemployment and cyclical
unemployment represents the actual unemployment. Naturally, in recessions, employees are laid off, and in times of
prosperity, employment rates skyrocket. Since employment is directly related to economic output, it is a good indicator of
economic conditions. Actual unemployment is useful to gauge the economy’s short-term conditions, while natural
unemployment can identify trends in the long term.
 Interest Rates
Interest rates are the return the borrower pays from lending. They are set by the central bank – the Federal
Reserve in the U.S. and the Bank of Canada in Canada. Because interest rates influence consumer decisions, it is a very
useful tool for influencing economic activity. When interest rates are high, borrowing becomes more expensive, so
consumers are incentivized to reduce spending. Conversely, when interest rates are low, it is cheaper to borrow, so
consumers will be incentivized to spend more.
Stabilization Policies
Fiscal Policy
Fiscal policy refers to the use of government spending and tax policies to influence economic conditions,
especially macroeconomic conditions. These include aggregate demand for goods and services, employment, inflation,
and economic growth. During a recession, the government may lower tax rates or increase spending to encourage demand
and spur economic activity. Conversely, to combat inflation, it may raise rates or cut spending to cool down the economy.
Fiscal policy is often contrasted with monetary policy, which is enacted by central bankers and not elected government
officials.
U.S. fiscal policy is largely based on the ideas of British economist John Maynard Keynes (1883-1946). He
argued that economic recessions are due to a deficiency in the consumer spending and business investment components of
aggregate demand. Keynes believed that governments could stabilize the business cycle and regulate economic output by
adjusting spending and tax policies to make up for the shortfalls of the private sector. His theories were developed in
response to the Great Depression, which defied classical economics' assumptions that economic swings were self-
correcting. Keynes' ideas were highly influential and led to the New Deal in the U.S., which involved massive spending
on public works projects and social welfare programs.
 Tools of Fiscal Policy
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A government has two tools at its disposal under the fiscal policy – taxation and public spending. Taxation
includes taxes on income, property, sales, and investments. On the one hand, more taxes mean more income for the
government, but it also results in less income in the hand of the people. Public spending includes subsidies, and transfer
payments, like salaries to government employees, welfare programs, and public works projects. Those who get the funds
have more money to spend.
 Types of Fiscal Policy: There are two types of fiscal policy – expansionary and contractionary fiscal policy.
o Expansionary Fiscal Policy: A government uses this type of policy to stimulate economic growth by increasing
spending or lowering taxes, or both. The objective of this policy is to ensure more money in the hands of the
citizens so that they spend more. More spending, in turn, leads to more income and more job creation. There have
been debates over which is more effective – tax cuts or spending. Some say that spending in the form of public
projects ensures that the money reaches the consumers. Those in favour of the tax argue that tax cuts allow
businesses to hire more staff. Though there is no consensus on which of the two is better, the government uses a
combination of both tools to boost economic growth.
o Contractionary Fiscal Policy: A government rarely uses this policy as it aims to slow economic growth. You
must be thinking about why any government will want to do that. The answer is to curtail inflation. Too much
inflation has the potential to damage the economy in the long term. So, the government has to step in to control
inflation. Here also, the government has the same tools at its disposal – spending and tax cuts. But, they are used
differently – taxes are raised while the spending is reduced. One can easily imagine how unpopular such
measures will be among the voters.
o A Balanced Approach: A government always faces a risk that more spending and lower tax rates could fuel
inflation. This happens because more money in the economy pushes the consumer demand up, eventually leading
to a fall in the value of money. This means it now takes more money to buy a product or service whose value is
not changed. So, it is very important for a government to monitor its fiscal policy constantly. And, if there are any
signs of inflation going out of control, the government must address it accordingly.
Monetary Policy: Tools of Monetary Policy

Monetary policy is a set of tools used by a nation's central bank to control the overall money supply and promote
economic growth and employ strategies such as revising interest rates and changing bank reserve requirements. In the
United States, the Federal Reserve Bank implements monetary policy through a dual mandate to achieve maximum
employment while keeping inflation in check.
Monetary policy is the control of the quantity of money available in an economy and the channels by which new
money is supplied. Economic statistics such as gross domestic product (GDP), the rate of inflation, and industry and
sector-specific growth rates influence monetary policy strategy. A central bank may revise the interest rates it charges to
loan money to the nation's banks. As rates rise or fall, financial institutions adjust rates for their customers such as
businesses or home buyers. Additionally, it may buy or sell government bonds, target foreign exchange rates, and revise
the amount of cash that the banks are required to maintain as reserves.
 Tools of Monetary Policy
o Open Market Operations: In open market operations (OMO), the Federal Reserve Bank buys bonds from
investors or sells additional bonds to investors to change the number of outstanding government securities and
money available to the economy as a whole. The objective of OMOs is to adjust the level of reserve balances to
manipulate the short-term interest rates and that affect other interest rates.
o Interest Rates: The central bank may change the interest rates or the required collateral that it demands. In the
U.S., this rate is known as the discount rate. Banks will loan more or less freely depending on this interest rate.
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o Reserve Requirements: Authorities can manipulate the reserve requirements, the funds that banks must retain as
a proportion of the deposits made by their customers to ensure that they can meet their liabilities. Lowering this
reserve requirement releases more capital for the banks to offer loans or buy other assets. Increasing the
requirement curtails bank lending and slows growth.
 Types of Monetary Policy
Monetary policies are seen as either expansionary or contractionary depending on the level of growth or
stagnation within the economy.
o Contractionary: A contractionary policy increases interest rates and limits the outstanding money supply to slow
growth and decrease inflation, where the prices of goods and services in an economy rise and reduce the
purchasing power of money.
o Expansionary: During times of slowdown or a recession, an expansionary policy grows economic activity. By
lowering interest rates, saving becomes less attractive, and consumer spending and borrowing increase.
Chapter 5: INTERNATIONAL MONETARY SYSTEM AND KEY INTERNATIONAL FINANCIAL

INSTITUTIONS
What is the International Monetary System?

International Monetary System (IMS) is a well-designed system that regulates the valuations and exchange of
money across countries. It is a well-governed system looking after the cross-border payments, exchange rates, and
mobility of capital. This system has rules and regulations which help in computing the exchange rate and terms of
international payments. In other words, International Monetary System mobilizes the capital from one nation to another
by felicitating trade. There are many participants like MNCs (Multinational Corporations), Investors, Financial
Institutions, etc., in the International Monetary System.
The main purpose of the International Monetary System today is to enhance high growth in the world with stable
price levels. Earlier the scope was only up to exchange rates. Now the system has a broader scope by taking financial
stability into consideration. International Monetary System has established International Monetary Fund (IMF) and the
World Bank in the year 1944. International Monetary System is also known as “International Monetary and Financial
System” and also “International Financial Architecture.”
Criteria for Evaluating an International Monetary System

Over the past 75 years, the International Monetary System has been modified according to the prevailing
conditions. The scope has evolved over the years, but the purpose of the system has remained constant. The evolution of
the International Financial Architecture is as follows: -
o Classic Gold Standard
The first phase of the International Monetary System was the Classic Gold Standard from 1816 to 1914. Only a
few countries adopted this standard in the initial years of the Gold Standard. Later almost all countries accepted it.
Usually, coins and billions of gold were useful during this standard. This gold standard gave birth to a fixed exchange rate
system with minimal fluctuations. Because of the most fixed exchange rate, International trade saw a boost during this
time. Gold Standard also made all countries of the world abide by strict monetary policy. This standard was helpful in
correcting trade imbalances in the country. The other name of Classic Gold Standard is International Gold Standard.
After the end of World War 1, the Classic Gold Standard collapsed. During World War, many countries printed
more money in order to finance their military requirements. As a result of this, the money in circulation exceeded the gold
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reserves of the country, and so those countries have to give up on Classic Gold Standard. The only United States of
America didn’t give up on Classic Gold Standards.
o Interwar Period
The period between World War 1 and World War 2 is known as the Interwar Period. This was the next episode of
the International Monetary System from 1915 to 1944. During this time, Britain was replaced by the United States of
America as the dominant financial powerhouse across the globe. During this period, all the economies had gone into a
depression with a higher inflation rate. The fixed exchange rate system collapsed with a higher supply of money. Almost
all countries started focussing on domestic revamping and not on international trade.
o Bretton Woods System
The period after World War 2 gave birth to Bretton Woods System. This monetary system was in existence from
1945 to 1972. Representatives from 44 countries, in the year 1944, met at Bretton Woods of the United States and came
up with a new International Monetary System. The focus of the Bretton Woods Agreement was to establish a uniform and
liberal International Financial Architecture with independence on domestic policies. This agreement gave birth to the US
Dollar-based Monetary System or Gold-Exchange Standard. This system gave birth to the pegging of domestic currency
in terms of US Dollars. A price of $35 was set for 1 ounce of gold—the countries, rather than linking their currency to the
gold-linked it to US Dollars.
All the member countries of Bretton Woods had to maintain their currencies value within 1% upward or
downward variations in comparison to Fixed Exchange Rate. This agreement also allowed the Governments of the
country to convert their gold into the US Dollar at any point in time. Eventually, countries and businesses have started
ignoring the link between US Dollar and Gold and have started considering exchange rates directly. If the situation
prevailed, then Bretton Woods Agreement allowed the country to devalue its currency by more than 10% straight.
Although, it didn’t allow countries to use this mechanism to benefit from imports and exports of the country.
Post-World War situation, the supply of US Dollars suddenly increased in the world economy. As a result of it,
many countries started questioning the quantum of gold reserves of the US Government with the supply of the US Dollar.
By 1973, many countries started losing confidence in the US Dollar and started searching for some other reliable sources.
o Current International Monetary System
After the downfall of the Bretton Woods System, there has not been any formal International Monetary System in
place. The present-day International Financial Architecture is a managed float system. All the currencies of all the
countries can freely float against one another in an open market under the managed float system. The government
intervenes only when the currency needs to be stabilized. Managed Float System has been in place since 1976 with the
Jamaica Agreement. Later in 1980, the International Financial Architecture was regulated by G-5 countries. This G-5
group has currently turned into G-20, with a group of 20 countries managing the exchange rate on managed float system.
Advantages of Current International Monetary System

Following are a few advantages of the International Monetary Market
o IMS enhances financial stability and maintains the price level on a global scale. It also boosts global growth.
o International Monetary System mobilizes money across countries and determines the exchange rate.
o This system encourages the governments of respective countries to manage their Balance of Payment by reducing
the trade deficit.
o IMS is a well-regulated system that makes the whole process of international trading smooth.
o This system relocates the capital from one country to another by enhancing cross-border investments.
o International Financial Architecture provides liquidity to the countries of the world.
o This system tries and avoids any short or long-run disruptions in the world economy.
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Key International Financial Institutions

The International Monetary Fund
The International Monetary Fund (IMF) is an international organization that promotes global economic growth
and financial stability, encourages international trade, and reduces poverty. Quotas of member countries are a key
determinant of the voting power in IMF decisions. Votes comprise one vote per 100,000 special drawing rights (SDR) of
quota plus basic votes. SDRs are an international type of monetary reserve currency created by the IMF as a supplement
to the existing money reserves of member countries.
The International Monetary Fund (IMF) is based in Washington, D.C. The organization is currently composed of
190 member countries, each of which has representation on the IMF's executive board in proportion to its financial
importance. Quotas are a key determinant of the voting power in IMF decisions. Votes comprise one vote per
SDR100,000 of quota plus basic votes (same for all members). The IMF's website describes its mission as "to foster
global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and
sustainable economic growth, and reduce poverty around the world."
o History of the IMF
The IMF was originally created in 1945 as part of the Bretton Woods Agreement, which attempted to encourage
international financial cooperation by introducing a system of convertible currencies at fixed exchange rates. The dollar
was redeemable for gold at $35 per ounce at the time. The IMF also acted as a gatekeeper: Countries were not eligible for
membership in the International Bank for Reconstruction and Development (IBRD)—a World Bank forerunner that the
Bretton Woods agreement created in order to fund the reconstruction of Europe after World War II—unless they were
members of the IMF. Since the Bretton Woods system collapsed in the 1970s, the IMF has promoted the system of
floating exchange rates, meaning that market forces determine the value of currencies relative to one another. This system
remains in place today.
o IMF Activities
The IMF's primary methods for achieving these goals are monitoring capacity building and lending.
 Surveillance: The IMF collects massive amounts of data on national economies, international trade, and the
global economy in aggregate. The organization also provides regularly updated economic forecasts at the national
and international levels. These forecasts, published in the World Economic Outlook, are accompanied by lengthy
discussions on the effect of fiscal, monetary, and trade policies on growth prospects and financial stability.
 Capacity Building: The IMF provides technical assistance, training, and policy advice to member countries
through its capacity-building programs. These programs include training in data collection and analysis, which
feed into the IMF's project of monitoring national and global economies.
 Lending: The IMF makes loans to countries that are experiencing economic distress to prevent or mitigate
financial crises. Members contribute the funds for this lending to a pool based on a quota system. In 2019, loan
resources in the amount of SDR 11.4 billion (SDR 0.4 billion above target) were secured to support the IMF’s
concessional lending activities into the next decade. IMF funds are often conditional on recipients making
reforms to increase their growth potential and financial stability. Structural adjustment programs, as these
conditional loans are known, have attracted criticism for exacerbating poverty and reproducing the colonialist
structures.
o Where Does the IMF Get Its Money?
The IMF gets its money through quotas and subscriptions from its member countries. These contributions are
based on the size of the country's economy, making the U.S., with the world's largest economy, the largest contributor.
o How Much Are the IMF Grants?
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IMF grants are given to charities in Washington D.C. and member countries. The grants are meant to foster
economic independence through education and economic development." The average grant size is $15,000
o What Is the Difference Between the International Monetary Fund and the World Bank?
The International Monetary Fund is primarily focused on the stability of the global monetary system and
monitoring the currencies of the world. The aim of the World Bank is to reduce poverty across the world and strengthen
the low- to middle-class populations.
o The Bottom Line
The IMF works to help reduce poverty, encourage trade, and promote financial stability and economic growth
around the world. It accomplishes this by monitoring capacity building and providing loans. While the IMF is currently
working on these goals with its 190 member nations, the organization has still faced criticism for the possible negative
impacts of its structural adjustment programs.
The World Bank (WB)

The World Bank is an international organization dedicated to providing financing, advice, and research to
developing nations to aid their economic advancement. The bank predominantly acts as an organization that attempts to
fight poverty by offering developmental assistance to middle- and low-income countries. The World Bank is a provider of
financial and technical assistance to individual countries around the globe. The bank considers itself a unique financial
institution that sets up partnerships to reduce poverty and support economic development.
The World Bank supplies qualifying governments with low-interest loans, zero-interest credits, and grants, all to
support the development of individual economies. Debt borrowings and cash infusions help with global education,
healthcare, public administration, infrastructure, and private-sector development. The World Bank also shares information
with various entities through policy advice, research and analysis, and technical assistance. It offers advice and training
for both the public and private sectors World Bank provides financing, advice, and other resources to developing
countries in the areas of education, public safety, health, and other areas of need. Often, nations, organizations, and other
institutions partner with the World Bank to sponsor development projects.
o World Bank Financials
The World Bank is an organization, rather than a bank. Therefore, its financials are not comparable to traditional
financial institutions. Within the organization operates different sectors: International Bank of Reconstruction and
Development (IBRD), the International Development Association (IDA), the International Finance Corporation (IFC),
and the Multilateral Investment Guarantee Agency (MIGA)
 International Bank of Reconstruction and Development (IBRD): It is a development bank administered by the
World Bank. The IBRD offers financial products and policy advice to countries aiming to reduce poverty and
promote sustainable development. The International Bank of Reconstruction and Development is a cooperative
owned by 189 member countries. The International Bank of Reconstruction and Development (IBRD) is one of
the two major institutions that make up the World Bank, with the other being the International Development
Association (IDA). The IDA is a financial institution dedicated to making developmental loans to the world’s
poorest countries. The IBRD was founded in 1944 with the goal of helping war-torn European countries rebuild
their infrastructure and their economies.
 International Development Association (IDA): The International Development Association (IDA) is the part of
the World Bank that helps the world’s poorest countries. Established in 1960, IDA aims to reduce poverty by
providing zero to low-interest loans (called “credits”) and grants for programs that boost economic growth,
reduce inequalities, and improve people’s living conditions. IDA complements the World Bank’s original lending
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arm—the International Bank for Reconstruction and Development (IBRD). IDA supports a range of development
activities that pave the way toward equality, economic growth, job creation, higher incomes, and better living
conditions. IDA is one of the largest sources of assistance for the world’s 74 poorest countries and is the single
largest source of donor funds for basic social services in these countries. IDA lends money on concessional terms.
This means that IDA credits have a zero or very low interest charge and repayments are stretched over 30 to 40
years. More than half of IDA countries receive all, or half, of their IDA resources on grant terms, which carry no
repayments at all. These grants are targeted to the low-income countries at higher risk of debt distress.
 International Finance Corporation (IFC): It provides financing of private-enterprise investment in developing
countries around the world, through both loans and direct investments. Affiliated with the World Bank, it also
provides advisory services to encourage the development of private enterprise in nations that might be lacking the
necessary infrastructure or liquidity for businesses to secure financing. The IFC was established in 1956 as a
member of the World Bank Group, focused on investing in economic development. It claims to be the largest
global development institution focused on the private sector in developing countries. The IFC says it also seeks to
ensure that private enterprises in developing nations have access to markets and financing. The IFC's most recent
stated goals include the development of sustainable agriculture, expanding small businesses' access to
microfinance, supporting infrastructure improvements, as well as promoting climate, health, and education
policies. The IFC is governed by its 184 member countries and is headquartered in Washington, D.C.
 Multilateral Investment Guarantee Agency (MIGA): It is an international institution that promotes investment
in developing countries by offering political and economic risk insurance. By promoting foreign direct
investment into developing countries, the agency aims to support economic growth, reduce poverty, and improve
people’s lives. The Multilateral Investment Guarantee Agency (MIGA) is a member of the World Bank Group
and is headquartered in Washington, D.C. As of March 2020, 181 member governments make up MIGA—156
developing nations and another 25 industrialized countries. The agency was created to complement both public
and private investment insurance sources against non-commercial risks in developing countries. Its multilateral
character and sponsorship by advanced and developing nations were seen as bolstering confidence among people
going across borders to invest their money. In September 1985, the World Bank endorsed the idea of a
multilateral political risk insurance provider and established MIGA in April 1988. The agency started out with $1
billion worth of capital among its initial 29 member states.
International Capital Flows

International capital flows are the financial side of international trade. When someone imports a good or service,
the buyer (the importer) gives the seller (the exporter) a monetary payment, just as in domestic transactions. If total
exports were equal to total imports, these monetary transactions would balance at net zero: people in the country would
receive as much in financial flows as they paid out in financial flows. But generally the trade balance is not zero. The
most general description of a country’s balance of trade, covering its trade in goods and services, income receipts, and
transfers, is called its current account balance. If the country has a surplus or deficit on its current account, there is an
offsetting net financial flow consisting of currency, securities, or other real property ownership claims. This net financial
flow is called its capital account balance.
When a country’s imports exceed its exports, it has a current account deficit. Its foreign trading partners who hold
net monetary claims can continue to hold their claims as monetary deposits or currency, or they can use the money to buy
other financial assets, real property, or equities (stocks) in the trade-deficit country. Net capital flows comprise the sum of
these monetary, financial, real property, and equity claims. Capital flows move in the opposite direction to the goods and
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services trade claims that give rise to them. Thus, a country with a current account deficit necessarily has a capital
account surplus.
Multinational Corporations
A multinational corporation (MNC) is a company that operates in its home country, as well as in other countries
around the world. It maintains a central office located in one country, which coordinates the management of all its other
offices, such as administrative branches or factories.
The following are the different models of multinational corporations:
 Centralized: In the centralized model, companies put up an executive headquarters in their home country and
then build various manufacturing plants and production facilities in other countries. Its most important advantage
is being able to avoid tariffs and import quotas and take advantage of lower production costs.
 Regional: The regionalized model states that a company keeps its headquarters in one country that supervises a
collection of offices that are located in other countries. Unlike the centralized model, the regionalized model
includes subsidiaries and affiliates that all report to the headquarters.
 Multinational: In the multinational model, a parent company operates in the home country and puts up
subsidiaries in different countries. The difference is that the subsidiaries and affiliates are more independent in
their operations.
The following are the common characteristics of multinational corporations:
The following are the common characteristics of multinational corporations:
 Very high assets and turnover: To become a multinational corporation, the business must be large and must
own a huge amount of assets, both physical and financial. The company’s targets are high, and they are able to
generate substantial profits.
 Network of branches: Multinational companies maintain production and marketing operations in different
countries. In each country, the business may oversee multiple offices that function through several branches and
subsidiaries.
 Control: In relation to the previous point, the management of offices in other countries is controlled by one head
office located in the home country. Therefore, the source of command is found in the home country.
 Continued growth: Multinational corporations keep growing. Even as they operate in other countries, they strive
to grow their economic size by constantly upgrading and by conducting mergers and acquisitions.
 Sophisticated technology: When a company goes global, they need to make sure that their investment will grow
substantially. In order to achieve substantial growth, they need to make use of capital-intensive technology,
especially in their production and marketing activities.
 Right skills: Multinational companies aim to employ only the best managers, those who are capable of handling
large amounts of funds, using advanced technology, managing workers, and running a huge business entity.
 Forceful marketing and advertising: One of the most effective survival strategies of multinational corporations
is spending a great deal of money on marketing and advertising. This is how they are able to sell every product or
brand they make.
 Good quality products: Because they use capital-intensive technology, they are able to produce top-of-the-line
products.
The Concept of Dutch Disease

Dutch disease is an economic term for the negative consequences that can arise from a spike in the value of a
nation’s currency. It is primarily associated with the new discovery or exploitation of a valuable natural resource and the
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unexpected repercussions that such a discovery can have on the overall economy of a nation. Dutch disease exhibits the
following two chief economic effects: (a) It decreases the price competitiveness of exports of the affected country's
manufactured goods, and (b) It increases imports. Both phenomena result from a higher local currency. In the long run,
these factors can contribute to unemployment, as manufacturing jobs move to lower-cost countries. Meanwhile, non-
resource-based industries suffer due to the increased wealth generated by resource-based industries.
The term Dutch disease was coined by The Economist magazine in 1977 when the publication analysed a crisis
that occurred in The Netherlands after the discovery of vast natural gas deposits in the North Sea in 1959. The newfound
wealth and massive exports of oil caused the value of the Dutch guilder to rise sharply, making Dutch exports of all non-
oil products less competitive on the world market. Unemployment rose from 1.1% to 5.1%, and capital investment in the
country dropped. Dutch disease became widely used in economic circles as a shorthand way of describing the paradoxical
situation in which seemingly good news, such as the discovery of large oil reserves, negatively impacts a country's
broader economy.
In the 1970s, Dutch Disease hit Great Britain when the price of oil quadrupled, making it economically viable to
drill for North Sea Oil off the coast of Scotland. By the late 1970s, Britain had become a net exporter of oil, though it had
previously been a net importer. Although the value of the pound skyrocketed, the country fell into recession as British
workers demanded higher wages and Britain's other exports became uncompetitive. In 2014, economists in Canada
reported that the influx of foreign capital related to exploitation of the country's oil sands may have led to an overvalued
currency and a decreased competitiveness in the manufacturing sector. Simultaneously, the Russian ruble greatly
appreciated for similar reasons. In 2016, the price of oil dropped significantly, and both the Canadian dollar and the ruble
returned to lower levels, easing the concerns of Dutch disease in both countries
Issues on Foreign Aid and International Debt Crises

Foreign aid is the international transfer of capital, goods, or services from a country or international organization
for the benefit of the recipient country or its population. Aid can be economic, military, or emergency humanitarian (e.g.,
aid given following natural disasters).
 Types and purposes
Foreign aid can involve a transfer of financial resources or commodities (e.g., food or military equipment) or
technical advice and training. The resources can take the form of grants or concessional credits (e.g., export credits). The
most common type of foreign aid is official development assistance (ODA), which is assistance given to promote
development and to combat poverty. The primary source of ODA—which for some countries represents only a small
portion of their assistance—is bilateral grants from one country to another, though some of the aid is in the form of loans,
and sometimes the aid is channeled through international organizations and nongovernmental organizations (NGOs). For
example, the International Monetary Fund (IMF), the World Bank, and the United Nations Children’s Fund (UNICEF)
have provided significant amounts of aid to countries and to NGOs involved in assistance activities.
Countries often provide foreign aid to enhance their own security. Thus, economic assistance may be used to
prevent friendly governments from falling under the influence of unfriendly ones or as payment for the right to establish
or use military bases on foreign soil. Foreign aid also may be used to achieve a country’s diplomatic goals, enabling it to
gain diplomatic recognition, to garner support for its positions in international organizations, or to increase its diplomats’
access to foreign officials. Other purposes of foreign aid include promoting a country’s exports (e.g., through programs
that require the recipient country to use the aid to purchase the donor country’s agricultural products or manufactured
goods) and spreading its language, culture, or religion. Countries also provide aid to relieve suffering caused by natural or
man-made disasters such as famine, disease, and war, to promote economic development, to help establish or strengthen
political institutions, and to address a variety of transnational problems including disease, terrorism and other crimes, and
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destruction of the environment. Because most foreign aid programs are designed to serve several of these purposes
simultaneously, it is difficult to identify any one of them as most important.
 International Debt Crises

Debt crisis is a situation in which a country is unable to pay back its government debt. A country can enter into a
debt crisis when the tax revenues of its government are less than its expenditures for a prolonged period. In any country,
the government finances its expenditures primarily by raising money through taxation. When tax revenues are
insufficient, the government can make up the difference by issuing debt. That is done primarily by selling government
treasury bills in the open market to investors.
A government with a good reputation and little debt or an established track record of paying back what it has
borrowed usually does not face much difficulty in finding investors who are willing to lend to it. However, if the debt
load of a government becomes too large, investors begin to worry about its ability to pay back, and they start demanding
higher interest rates to compensate for the higher risk. That results in an increase in the cost of borrowing for that
government. As investor confidence deteriorates further over time, pushing the cost of borrowing to higher levels, the
government may find it more and more difficult to roll over its existing debt and may eventually default and enter into a
debt crisis.
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International Economics II-1

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Department of Economics, Gambella University, Ethiopia

Chapter 1: THE FOREIGN EXCHANGE MARKET

What is a Foreign Exchange Market?

Characteristics and Participants of the Foreign Exchange Market

The Functions of Foreign Exchange Markets

The Demand for and the Supply of Foreign Exchange

The Foreign Exchange Rate

Definition of Exchange Rate

Spot and Forward Exchange Rates

Nominal, Real and Effective Exchange Rates

The Determinants of Exchange Rates

Exchange Rate Regimes

Freely Floating / Flexible Exchange Rate

Managed Float / Hybrid System

The Interaction of Hedgers, Arbitrageurs, and Speculators

Appreciation / Revaluation and Depreciation / Devaluation of Currencies

Chapter 2: THEORIES OF EXCHANGE RATE DETERMINATION

The Purchasing Power Parity Theory

Money, Interest rate and Exchange rate

The Definition of Money

The Functions of Money

The Supply of and the Demand for Money

 Demand for Money:

The Demand for Foreign Currency Assets

Interest Parity Condition and Rate of Return

The monetary model of exchange rate determination

Chapter 3: BALANCE OF PAYMENTS

Definition and Purposes of Balance of Payments

Balance of Payments Accounting Principle

The Components of Balance of Payments

Balance of Trade and Balance of Payments

o Definition of Balance of Payments

Balance of Payments Disequilibria

Reasons of balance of payment disequilibrium

 How is balance of payment deficit measured?

 How is balance of payment surplus measured?

 What are the causes of deficit in BOP?

Measures to Correct Deficit Balance of Payments

3.6. Approaches to Balance of Payments

Absorption Approach to Balance of Payments

Monetary Approach to Balance of Payments

Chapter 4: MACROECONOMIC POLICY IN AN OPEN ECONOMY

What is Open – Economy Macroeconomics?

Macroeconomic Policy Goals in an Open Economy

Monetary Policy: Tools of Monetary Policy

Chapter 5: INTERNATIONAL MONETARY SYSTEM AND KEY INTERNATIONAL FINANCIAL

What is the International Monetary System?

Criteria for Evaluating an International Monetary System

Advantages of Current International Monetary System

Key International Financial Institutions

The World Bank (WB)

International Capital Flows

The Concept of Dutch Disease

Issues on Foreign Aid and International Debt Crises

 International Debt Crises

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