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Monetarysystem2019
1.
A.Definevalueofmoney?
Thetermvalueofmoneymeansthepurchasingpowerofmoneyreferstothe
numberofgoodsandservicesthatcanbeboughtbyaunitofmoney.The
lowerthepriceleveltheicardishallbethevalueofmoneythepricelevelthe
lowershallbethevalueofmoney.Hencethereisinverserelationship
betweenthevalueofmoneythepricelevelVM=1/p.

B.WhatdoyouunderstandbyGresham'slaw?
Gresham’slawisamonetaryprincipalstatingthe“badmoneydrivesoutgood”forexa
mpleiftherearetwoformsofcommoditymoneyincirculationwhich
areacceptedbylawashavingsimilarfacevaluethemorevaluablecommodity
willgraduallydisappearedfromcirculation.

C.Whatdoyoumeanbydevaluation?
Currencydevaluationisadeliberatedownwardadjustmentofthevalueofa
country'scurrencyagainstanothercurrency.Devaluationisatoolusedby
monetaryauthoritiestoimprovethecountry’stradebalancebyboosting
exportsatmomentswhenthetradedeficitmaybecomeaproblemforthe economy.

D.Differentiatebetweensoftmoneyandnearmoney.

E.Whatdoyoumeanbymonometallism?
itreferstothemoneyinwhichthemonetaryunitismadeupofconvertible
onlyonemetal,undermonometallism standardcoinsorfull-bodiedlegal
tenderandtheirvalueisequaltotheirintrinsicmetallicstandardmaybeof twotypes.

F.Whatdoyoumeanbygoldparitystandard?
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ThissystemhasemergedwiththeestablishmentofIMFin1946;itdoesnot
possessanyfeatureofthevariousgoldstandardExplainabowunderthis
“everycountryhastodeclarethepowervalueofitsmonetaryunitintermsof
afixedquantityofgold’.Itaimsatkeepingtheexchangerateofthecurrency
stableinformofgold.AccordingtoCrowther“thedomesticgoldstandardis
mainlyconcernedwiththevolumeofmoneyandwithitsinfluenceonthe
domesticpricelevel.”

G.Whatiscapitalflight?
Capitalflightisalargescaleexedusoffinancialassetsandcapitalfrom a
nationduetoeventssuchaspoliticaloreconomicinstabilitycurrency
devaluationortheimpositionofcapitalcontrols.

H.Whatdoyoumeanbyeurobonds?
Eurobondsitdeptinstrumentthat'sdenotedinacurrencyotherthanthe
homecurrencyofthecountryormarketinwhichitisissued.Eurobondsare
frequentlygrouptogetherbythecurrencyinwhichtheyaredenominated
suchaseurodollarorEuro-yenbonds.

I.Whatispeggedexchangerate?
Peggedexchangerateisatypeofexchangerateregimeinwhichacurrency
valueisfixedorfeaturedbyamonetaryauthorityagainstthevalueof
anothercurrencyabasketofanothercurrencyoranothermeasureof
valuesuchasgold.

J. Whatissecularequilibriuminbalanceofpayments?

Thisequilibriumreferstoapersistentdeficitorasurplusinthebalanceof
paymentsofacountry.Itisalsoknownasseculardisequilibrium.When
thereisacontinuousincreaseinthestockofgoldandforeignexchange reserves.

Section-B

2.CriticallyevaluatetheIrvingfisher’squantitytheoryofmoney?
Thequantitytheoryofmoneystatesthatthequantityofmoneyisthemain File
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determinantofthepricelevelofthemoney.Anychangeinthequantityof
moneyproducersandexactlyproportionatechangeinthepricelevel.Inthe
wordsIrvingfisher's“otherthingsremainingunchanged,asthequantityof
moneyincirculationincreasesthepricelevelalsoincreasesindirectproportion
andthevalueofmoneydecreasesandviceversa”ifthequantityofmoneyis
doubledthepricelevelwillalsodoubleandthevalueofmoneywillbeonhalf
ontheotherhandifthequantityofmoneyisreflectedbyonehalftheprice
levelwillalsobereducedbyonehalfandthelevelofmoneywillbetwicefisher
asexplainedhistheoryintermsofhisequationofexchangePT=MV+M1V1
WHEREP=PRICELEVEL
M=thetotalquantityoflegaltendermoney
V=thevelocityofcirculationofm
M1=thetotalquantityofcreditmoney
V1=thevelocityofcirculationofM1
T=volumeoftransactionofgoodsandservices

WhenthequantityofmoneyisdoubledtoM2thepricelevelisalsodoubledto
P2furtherwhenthequantityofmoneyisincreasedfourfoldthen4theprice
levelalsoincreasedby4timestoP4thisrelationshipisexpressedbythecurve
p=f(m)fromtheoriginof45degreeinpanelBofthefiguretheinverserelation
betweenthequantityofmoneyandvalueofmoneyisdepictedwherethe
valueofmoneyistakenontheverticalaxiswhenthequantityofmoneyis
youngwonthevalueofmoneyisp.butwiththedoublingofthequantityof
moneytoM2thevalueofmoneybecomesoneofofwhatitwasbeforeP2and
withthequantityofmoneyincreasesby42M4thevalueofmoneyisreduced
byP4thisinverserelationshipbetweenthequantityofmoneyandthevalueof
moneyisshownbydownwardslopingcurvep=f(m).

Criticisesoftheory:-
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1.Thequantitativetheoryofmoneyisbasedonunrealisticassumption
2.Quantitativetheoryoffersalong-termanalysisofmoney
3.Thetheorydoesnottelluppreciouslyhowenhanceinmoneysupplyinfloor
oncethepricelevel
4.Thereisnodirectandproportionalrelationshipbetweenthequantityof
moneyandpricelevel
5.thetheoryisbasedonthewrongassumptionoffullemployment
6.Theoryisnotacomprehensive.

3.StatethecausesforthefailureofBrettonwoodssystem?
DuringtheperiodprecedingWorldwar1almostallthemajorNational
currencieswearonasystemoffixedexchangeratesundertheinternational
goldstandard.Thissystem hastobeabandonedduring Worldwar1there
werefluctuatingexchangeratefromtheendofthewarto1925effortswere
madeonreturntothegoldstandardfrom 1925.InJuly1944theallied
countriesmetatBrettonwoodsintheUSAtoavoidtherigidityofthegold
standardandthechowsofthe1930sininternationaltradeandfinanceandto
encouragefreetradeundertheBrettonWoodssystem exchangerates
betweencountriesweresetorpeggedintermsofgoldortheUSdollars
avoiddollar35perowncyofgold.Thisrelatedtothefixedexchangerateregime
withchangesintheexchangewithinabandorragefrom1%aboveto1%below
theparvalue.
ReserveoutflowswearamatterofconcernundertheBrettonwoodssystem.
SotheIMFinsteadonexpenditurepoliciesandevaluationtocorrecttheBOP
deficit.TemporaryBOPdeficitswerealsometbyborrowingfromthefundfora
periodof3to5years.Acountryborrowsfromthefundsfoundonthebasisof
thesizeofitsquotawithit.
InfactBrettonwouldwasafixedratesystem innameonlyoftwomajor
industrialcountriesonlythe UnitedStatesandJapanhadanchangeinpar
valueduringtheperiod1946to1971ofthe21countries.12devaluedtheir
countriesmorethan30%againstthedollar,fourhadregulationsandfourweer
floatingtheircurrenciesbymind1971whenthissystemcollapsed.

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Thefixedexchangeratesystem collapsealongwithdissoluronofthegold
standard:therearetworelatedreasonsforthecollapseoftheBrettonwoods system.
1.FirstinflationreacheditsuglyheadinUS.Inthemid1960’sJohnson
administrationfinancetheescalatingwarinVietnamanditsequallyexpensive
greatsocietyprogramsineffectprintingmoneyinsteadofrisingtaxes.Asa
resultitwasdifficultfortheUnitedStatestomaintainthepriceofgoldat35
dollarandoncewithoutresortingtothevariousdilatoryfactsreferredto above
2.Thefixedexchangeratesystemcollapsedbecausesomecountriesprimarily
wereGermanyJapanandSwitzerland-refusedtoaccepttheinflationthata
fixedexchangereadwiththedollarwouldhaveimposedonthemfirstofdoes
thedollardepreciatedsharplyrelatedtothecurrenciesofthesethree countries.
ThemainpointsoftheBrettonwoodssystemarea
1.ThenewinstitutiontheIMFwouldbeobtablisbledinWashingtonDC
2.Afterapostwartransitionperiodcurrentcieswheretobecomeconvertible
3.Thefundwouldgetgoldandcurrenciesoflendthroughsubscription
4.Afundmembercouldchangeitsparvaluewithfundapprovalandonlyifthe
country’sbalanceofpaymentwasin“fundamentaldesirablebarium”
BreakdownoftheBrettonwoodssystem
1.Fixedexchangeratesweremaintainedbyofficialinterventionintheforeign
exchangemarketfrom 1947to1971thefundamentaltradebetweenthe
countrieshave expanded especially those ofdeveloped countriesand
demandedconvertibility.
2.Thestabilityofexchangeratesremotestgraindealofuncertaintyfrom
internationaltradeandbusinessestransactionsdoeshelpingtheoranitriesto grow.
3.Thesystemissufferedfromnumberofinheritedstructuralproblems.
a.TherigidapproachadoptedbytheIMFtothebalanceofpaymentsthis
equilibriumsituation
-Lowconditionalityforshorttermfunds
-Iconditionalityforlongtermfunds
b.Lackofinternationalliquidity,crisisofconfidenceandcollapse.
c.Builtininstability(countrieswhererelucatattodevaluetheircurrencies)
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4.StatetheessenceofGresham’slaw.
Whentwokindsofmoneyorincirculationtheproblem beforethe
governmentistokeepthem concurrentlyincirculationwhenthetwo
currencieshavingsamelegalvaluehavedifferentiateintrinsicvalueorreal
valueinthedomesticofforeignmarketthenthemoneyhavingmarketvalueis
saidtobeundervaluedcurrencywhiletheotherissaidtobeovervalued
currencyinsuchasituationthe valuedcurrencywilltendtodriveoutthe
undervaluedcurrencyfromcirculation.Theundervaluedcurrencyiswithdrawn
frommonetaryusemeltedanddivertedtothenon-monetaryusesGerman’s
lawisbasedonthisobservation.Germanwasbynomeansthefirsttotake
statementontheissueoftheovervaluedManidrivingawaytheundervalued
money.Germanslowlooseleastratedthroughtheexpression“badmoney
drivesoutgoodmoneyfromcirculation”Gresham’slawhasbeenwidelycited
andoftenmisunderstoodacorrectstatementofhislaw isfoundinthe
followingpassage.

“Wheretwoormoreformsofmoneyofthesamenominalorfacevaluefor
concurrentincirculationanditoneisrelativelyovervaluedformonetary
purposetheselfinterestofthepublicwillleadthemtodiscriminatebetween
thetwoforms.Theundervaluedform willberetained,andtheovervalued form
willbepassedalongtoothers.Intimetheform ofmoneywhichis
undervaluedformonetarypurposeswilldisappearfrom circulation.Ifthe
communityisinapositiontorefusetoacceptthebadmoney;thegoodmoney
willnotdisappearbutwillcontinuetocirculateandapremium”

Gresham’slawisbasedonthefollowingassumption

1.Thedifferentmoniesincirculationorfulllegaltenderandthepublicisnot
indifferenttowardsanyofthem.
2.Thetotalquantityofmoneyexceedsthetotalmonetaryrequirementsofthe
publicthatisapartofthetotalmoneysupplyisredundant.
3.Thesupplyoftheovervaluedmoneyissufficienttomeetthemonetary
demandofthecommunity.Ifthiswasnotsotheundervaluedmoneywillnot
altogetherdisappearfromcirculationatapremium.
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factitwilloperateunderbimetallism.Monometallicorpaperstandard
providedovervaluedundervaluedcoincirculatorconcurrently.Abasicprinciple
ofGresham'slawisthattheundervaluedmoneycanremainincirculationat
onlyifitwillcirculateatpremium.Thisconclusionfollowsfromthefactthat
peoplewillnotspendtheundervaluedmoneyathomeonthesamebasisas
theovervaluedmoneywhentheycangetrelativemorefortheundervalued
moneyinforeigncountries.

5.Explainindetailthecausesofthisequilibriuminthebalanceofpayment? -
Tradecycle:
Cyclicalfluctuation theirphasesand amplitude differencesin different
countriesgenerallyproducecyclicalequilibriuminthebalanceofpaymentor
BOP.Duringdepreciationtheincomesofthepeopleinforeigncountriesfollow
asaresulttheexportofthesecountriestendstodeclinewhichinturn
producesthisequilibriuminthehomecountryBOP.
-Heavyinvestmentsontheimportofcapitalgoods:
InvestmentonmachinerytechnologyknowhowetcbydevelopingNations -
Hugedevelopmentandinvestmentprogrammes:
Hugedevelopmentandinvestmentprogramsindevelopingeconomicsforthe
rootcausesofthedisequilibriumintheBOPthesecountriestheirpropensityto
improvegoesonincreasingforwhatofcapital.
-Populationgrowth:
HighpopulationgrowthonpopulationalsohadadvestryasteredBOPposition.
Itiseasytoseethatanincreaseinpopulationleadstoanincreaseinneedsof
peoplewearbycountriesimportincreasesanddecreasesthecapacityto export.
-Inflation:owningtorapideconomicdevelopmenttheresultingincomeand
priceeffectswilladverselyaffecttheBOPpositionofadevelopingcountrywith
anincomethemarginalpropensityofimportbeinghighinthiscountryistheir
demandforimportantarticleswillrisesincemarginalpropensitytoconsumeis
alsohighinthiscountry’s.
-Fallindemand:fallindemandforunderdevelopedaswellasdeveloping
countriesduetoinnovation,technology,changeindemandtasteandhabitsof
customersorbarriers

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-Developmentschemes:disequilibriummayarisebecauseofrapidincreasein
importsforvariousdevelopmentprogrammewasadevelopingcountrymay
openeduponthedevelopedcountriesforthesupplyofmachinerytechnology
knownhowrawmaterialsetc.
-Appreciationofexchangerate
-Importrestrictionsofadvancedcountries
-Demonstrationeffect
-Compulsoryexports
-Hugeexternalborrowing

6. Describetheevaluationofinternationalmonetarysystem?

1.Bimetallismbefore1875

2.Classicalgoldstandard1876to1913

3.Interwarperiod1914to1944

4.BrettonWoodssystem1945to1973

5.Flexibleexchangerateregimesince1973

1.Bimetallismbefore1875:

Priortothe1870’smoneycountrieshadbimetallism thatisadouble
standardinthatfreecoinagewasmaintainedforbothgoldandsilverin greatBritain.

Countriesthatwhereinthebimetallismstandardof10experiencethewell
knownphenomenareferredtoasGermanslawsincetheexchangeratio
betweenthetwometalswasfixedefficiallyonlytheabundantmetalwas
usedofmoneyduringmoresquaremetaloutofcirculation.ThisisGermans
lawaccordingtowhich'bad'moneyserviceout“good”moneyexample
whengoldfromnewlydiscoveredminesinCaliforniaandAustraliapoured
intothemarketin1850sthevalueofgoldbecamedepressedcasing
evaluationofgoldundertheFrenchofficialradiothisectatedagoldFrance
effectivelybecameagoldcurrency.

2.Classicalgoldstandard:

Fundamentalprinciplewasearncountryshouldsetaparvalueforits File
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currencycouldbeconvertedtotheweightofgolditisdeterminedbytheir
goldcommentmankind’sfondnessforgoldasastorageofwealthandmeans
ofexchangedatesBankantiquityandwassharedwidelybydivercivilizations
“ChristopherColumbusoncesaid,“goldconstitutetreasureandpossesses
itasallheneedsinthisworldthefirstfreefledgedgoldstandardhowever
wasnotestablisheduntil1821ingreatBritain.Whennotesfromthebankof
Englandweremadefullyredeemableforgold.

3.interwarperiod:WorldwarfirstendedtheclassicalgoldAndradein
August1914asmajorcountrysearchesgreatBritainFranceandRussia
suspendedredemptionofaBanknotesingoldmanycountries.Especially
GermanyAustraliaPolandandRussiasufferedbyhypeinflationtheGerman
experienceprovidesaclassicalexampleofperinflationbytheendof1923
thewholesalepriceindexinGermanywasmorethan1trilliontimesashigh
astheprewarlevel.

Freedomfromwartimepiggingexchangerateamongcurrencieswhere
fluctuatingintheearly1980duringthisperiodcountryiswidelyused “predatory”
depreciation oftheircurrencies as a means ofgaining
advantagesintheWorldexportmarket.

4.BrettonWoodssystem:Brettonwoodsestablishedsystem ofpayments
basedonthedollarwhichdefinedallcurrenciesinrelationtothedollaritself
convertibleintogoldandall“asgoodasgold”fortradeUScurrencywasnow
iftheworldcurrencythestandardtowhicheveryothercurrencywaspegged.

5Flexibleexchangerateregimesince:Inviewofthecollapsepurposeofthe
Brettonwoodssystemofexchangerate.TheboardofgovernorsoftheIMF
appointedcommitteeof22suggestguidelinesforevolvingonexchangerate system
thatcould be accepted to the membercountries.The report
suggestedvariousoptionsthatwerediscussedatrambowelletinNovember
 1978andapprovedattheJamaicameetonJanuary1876.Theywereformal
formallyincorporatedintothetreatofsecondamendmenttothearticlesof
agreementthatsameintoforcefromApril1978theboardoptionsunderthe
newexchangerateregiment.

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7. Explainthefactorscontributedtothegrowthofeurocurrencymarket?

ThemoneymarketinwhichEurocurrencycurrencyheldinbanksoutsideof
thecountrywhereitislegaltenderisborrowedandlentbybanksinEurope.
TheEurocurrencymarketallowsformoreconvenientborrowingswhich
improvestheinternationalflowofcapitalfortradebetweencountriesand companies.

Factorsthatcontributedtothegrowth(eurodollarmarket)

-TheSuezcrisis:therestrictionsplaceduponsterlingcreditfacilitiesfor
financingtradewhichdidnottouchtheBritishshowsduringtheSuezcrisisin
1957providedastimulusforthegrowthoftheEurodollarmarkettheBritish
banksinsearchofanalternativewaytomeetthedemandforcreditonthe
partofthetradersinthissphereeasilyfindagoodsubstituteindollarthere
wasalreadyavailableforallofUSdollars.
-Relaxationofexchangecontrolsandresumptionofcurrencyconvertibility:
thegeneralrelaxationofexchangecontrolthesuitabilityIndiaexchange
marketandthefreedomsessionofcurrencyconvertibilityinwesternEuropein
1958providedonaddedadvantagetothegrowthoftheeurodollarmarket.In
aconvertiblecurrencysystemsomecountrieshasarulesurplusandothersin deficit.
-Thepoliticalfactors:thecoldwarbetweentheUSandthecommunist
countriesalsocontributedtothegrowthofeuromarket.
-BalanceofpaymentdeficitoftheUS:thelargeandpersistentdeficitisthe
topoftheUSmintandincreasingflooroftheUSdollartothosecountries
whichartsupplieswithUS.
-Innovativebanking:Theadventofnontivebankingspearheadedbythe
AmericanbanksinEuropeandthewillingnessofthebanksinthemarketto
operateonthenarrow ”spread”alsoencouragedthegrowthofeuromarket.
-Supplyofpetrodollars:theflowofpetrodollarfacilitewhydidterminant
increaseintheepicsofoilrevenueflowingthelikeIntheoilpricessince1973,
hasbeenasignificantsourcesofgrowthoftheeurodollarmarket(the
organisationofthepetroleumexportingcountries)
-Theregulation'Q':aceilingwasimportedontheinterestratepayableon
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autoallondepositsupto30days.ThisencouragedtheUSbanktoopen
branchesinEuropeandattachdollardeposittobeusedforfinancing
internationaltradeithappenedin1968and1969andagainfrom 1979 onwards.
Regulation-Q capitalloaninterestrateontimedepositsboththeUS citizens and
foreigners howing dollars in excess oftheirtransaction
requirementstransferredtheminEuropebanksbecausetheypaidinterestrate
thanUSbanks.ThiswasthereasonoffirstgrowthofEDM.

Section-C

8.CriticallyexaminetherecentdevelopmentsinForexmarkets.
Foreignexchange(Forex)Market: DevelopingforeignexchangeMarketor
Forexmarketisaplacewhereinternationalcurrenciesaretraded.Ithas
emergedtobethelargestanddecentralizedfinancialmarketoperating
globally.Itdoesnothaveanycentralauthorityandhenceitiscalledan“Over
theCounter”(OTC)market.Itallowsthetraderstobuy,sellexchangeand
speculateoncurrencies.Themajordeterminantoftheexchangerateisthe
monetaryvalueofthecurrency.
ForexMarket-AGlobalEntity:itisafterbreakdownofBrettonWoods’ssystem
in1971andmostoftheeconomiesshiftingtomanagedexchangearethe
regime,whentheForexmarketstartedoperatinggloballyinamajorway.The
decadeof1990’switnessedmajorpolicychangestherebyre-orientingmarkets
whichreflectedarapidexpansionofForexmarketintermsof:

∙Increasednumberofparticipant

∙Increasedtransactionvolumes

∙Declineintransactioncosts
∙Efficientmechanismsofrisktransfer
ForexMarketParticipants:TheForexmarketisdifferentfromstockmarketin
thesensethattheformerfollowsahierarchicalorderinitslevelofaccess.At
theapexistheInter-Bankmarket,consistingofcommercialbanksandsecurity
dealers.Theyaccountfor53%ofalltransactions.FollowingInter-Banksarethe
SmallerBanks,thentheMulti-NationalCorporations,largeHedgeFundsand
someRetailForexmarketmakers.Hence,themainparticipantsare:

∙Banks,ForexfixingandCentralbanks

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∙RetailForextraders

∙Commercialcompanies

∙Hedgefundsasspeculator

∙Non-bankingforexcompanies

∙Investmentmanagementfilms

∙Moneytransfer/Remittancecompanies
AstheforexmarketfollowsOTCnatureofmarket,theexchangerates(prices)
ofdifferentcurrenciesarenotfixed.Thepriceofacurrencydependsonthe
tradingbanksormarketmarkers.Thequotedpriceofanycurrencyreflects
London’smarketprice,asitthemaintradingcentreintheworld.
FactorsInfluencingForexMarket:
ForeignExchangerate(Forexrate)isoneofthemostimportantmeansthrough
whichacountry’srelativelevelofeconomichealthisdetermined.Acountry’s
exchangerateprovidesawindowtoitseconomicstability,whichiswhyitis
constantlywatchedandanalyzed.Ifyouarethinkingofsendingorreceiving
moneyfromoverseas,youneedtokeepakeeneyeonthecurrencyexchange
rates.Theexchangerateisdefinedas“therateatwhichonecountry’s
currencymaybeconvertedintoanother.”Itmayfluctuatedailywiththe
changingmarketforcesofsupplyanddemandofcurrenciesfromonecountry to
another.For these reasons; when sending or receiving money
internationally,itisimportanttounderstandwhatdeterminesexchangesrates.
1.InflatingRates:Changesinmarketinflationcausechangesincurrency
exchangerates.Acountrywithalowerinflationratethananother’swillseean
appreciationinthevalueofitscurrency.Thepricesofgoodsandservices
increaseataslowerratewheretheinflationislow.Acountrywitha
consistentlylowerinflationrateexhibitsarisingcurrencyvaluewhileacountry
withhigherinflationtypicallyseesdepreciationinitscurrencyandisusually
accompaniedbyhigherinterestrates.
2.InterestRates:Changesininterestrateaffectcurrencyvalueanddollar
exchangerate.Forexrates,interestrates,andinflationareallcorrelated.
Increasesininterestratescauseacountry’scurrencytoappreciatebecause
higherinterestratesprovidehigherratestolenders,therebyattractingmore
foreigncapital,whichcausesariseinexchangerates.
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accountreflectsbalanceoftradeandearningsonforeigninvestment.It
consistsoftotalnumberoftransactionsincludingitsexports,imports,debt,etc.
Adeficitincurrentaccountduetospendingmoreofitscurrencyonimporting
productsthanitisearningthroughsaleofexportscausesdepreciation.Balance
ofpaymentfluctuatesexchangerateofitsdomesticcurrency.
4.GovernmentDebt:Governmentdebtispublicdebtornationaldebtowedby
thecentralgovernment.Acountrywithgovernmentdebtislesslikelyto
acquireforeigncapital,leadingtoinflation.Foreigninvestorswillselltheir
bondsintheopenmarketifthemarketpredictsgovernmentdebtwithina
certaincountry.Asaresult,adecreaseinthevalueofitsexchangeratewill follow.
5.TermsofTrade:Relatedtocurrentaccountsandbalanceofpayments,the
termsoftradeistheratioofexportpricestoimportprices.Acountry’sterms
oftradeimprovesifitsexportspricesriseatagreaterratethanitsimports
prices.Thisresultsinhigherrevenue,whichcausesahigherdemandforthe
country’scurrencyandanincreaseinitscurrency’svalue.Thisresultsinan
appreciationofexchangerate.
6.PoliticalStability&Performance:Acountry’spoliticalstateandeconomic
performancecanaffectitscurrencystrength.Acountrywithlessriskfor
 politicalturmoilismoreattractivetoforeigninvestors,asaresult,drawing
investmentawayfrom othercountrieswithmorepoliticalandeconomic
stability.Increaseinforeigncapital,inturn,leadstoanappreciationinthe
valueofitsdomesticcurrency.Acountrywithsoundfinancialandtradepolicy
doesnotgiveanyroomforuncertaintyinvalueofitscurrency.But,acountry
pronetopoliticalconfusionsmayseedepreciationinexchangerates.
7.Recession:Whenacountryexperiencesarecession,itsinterestratesare
likelytofall,decreasingitschancestoacquireforeigncapital.Asaresult,its
currencyweakensincomparisontothatofothercountries,thereforelowering
theexchangerate.
8.Speculation:Ifacountry’scurrencyvalueisexpectedtorise,investorswill
demandmoreofthatcurrencyinordertomakeaprofitinthenearfuture.Asa
result,thevalueofthecurrencywillriseduetotheincreaseindemand.With
thisincreaseincurrencyvaluecomesariseintheexchangerateaswell.

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9.Whatdoyoumeanbythecircularflowofmoney?Explainthecircularflow
ofmoneyinaneconomy.Usediagramtoillustrateyouranswer. Circularflow
ofmoneyreferstoprocesswherebymoneypaymentsand
receiptsofaneconomyflowinacircularmannercontinuouslythroughtime.
Thevariouscomponentsofmoneypaymentsand receiptsaresavings,
investments,taxation,loans,governmentpurchases,exports,imports.
CIRCULARFLOWOFMONEYINECONOMY:
Thecircularflowofincomedescibestheflowofmoneyamongthefivemain
sectorsofaneconomy.ASindividualsandfirmsbuyandsellgoodsand
services,moneyflowsamongthedifferentsectorsofaneconomy.From a
simpleversionofthecircularflow,welearnthat-asamatterofaccounting
GrossDomesticProduct(GDP)=income=production=spending
Thisrelationshipliesattheheartofmacroeconomic analysis.Therearetwo
sidestoeverytransaction.correspondingtotheflowofmoneyinthecircular
flow,thereareflowsofgoodsandservicesamongthesesectors.For
example,thewageincomereceivedbycustomersisthereturnforlabour servicesthatflow
from householdstofirms.Theconsumptionspendingof
householdsisinreturnforthegoodsandservicesthatflowfrom firmsto
households.Acompleteversionofthecircularflowispresentedinfigure16.10.
ThestateoftheEconomy”containsadiscussionofasimplerversionofthe
circlarflowwithonlytwosectors;householdsandfirms

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Thecompletecircularflow hasfivesectors;ahouseholdsector,a
governmentsector,aforeignsectorandafinancialsector.Different
chaptersofthebookemphasizesdifferentpiecesofthecircular
flow,andfigure16.10showsushow everythingfitstogether.Inthe
followingsubsections,welookattheflowsintoandfromeachsectorin
turn.Ineachcase,thebalanceoftheflowsintoandfromeachsector
areunderliesausefuleconomicrelationship.

10.“Balanceofpaymentalwaysbalances”.Comment.
Equilibrium intheBOP:TheBopalwaysdebitbalancemustequalto
creditbalance,iftheentriespassesarecorrect.Thustherecanbeno
disequilibrium in theBopsasawhole.However,whileanations
internationalaccountsmustalwaysbalance,italwaysneednotbein
equilibrium,sayifacountry’sBopsshowsadebitbalanceinmerchandise
andservicesaccount(oncurrentaccountside)mustbesufficientlylarge
sothattotaldebitsequaltototalcredits.Thatistosay,whenacountry
hasadebitbalanceoncurrentaccount,itiseitherimportingcapitalona
longorshorttermoritisexportinggoldoritisreceivingdonationsfrom
foreignersandtherebyitscreditinthecurrentaccountisextendedtoan
extentofdebitinthecurrentaccount.Inafunctionalsense,thusthere
maybedisequilibriumintheBopsofacountry;operationallyacountryat
atimemaybereceivingmorepaymentfromabroadthanwhatithasto
make.Thuswhentotalreceiptexceedtotalpayment,thereisasurplus
bops.Itisregardedas“afavourablebal”;sometimesacountryhasto
makemorepaymentsinabroadthanwhatitreceives.Then,thereisa
deficitinitbops,itisregardedasan“unfavourablebal”.Hence,theusual
analyticalapproachtotheBopsistoconsideritasthedifferencebetween
receiptsfromandpaymenttoforeignersbytheresidentsofthecountry.
Symbolically,thustheBopsmaybedefined:-B=R-PwhereB:Bops,R:
receiptsfromforeigners,P:paymentsmadetoforeigners.WhenR–P>0,
itimpliesreceiptsaremorethanpaymentsandthereisasurplusinBOP
andviceversa(R–P<0).Clearlythus,whenBiszero,thebopscanbe
regardedasequilibriumbops,thatistosayacountry’sbopsmaybesaid
tobeinequilibriumwhenitsreceiptsareequaltoitpaymentsonaccount
ofitstransactionswithothercountriesoftheworld.Suchacountrywith
equilibriumbopsisoftencalledacountryin“externalbal”.However,a
country’sbopsissaidtobe“favourable”orin“surplus”whenthetotal

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receiptsfromtherestoftheworldexceedthetotalpaymenttotherest
oftheworld.SymbolicallywhenBispositive,itiscalledafavourableBops.
Symbolically,whenBisnegative,itiscalledanunfavourableorindeficit
BOP.AcountrywholeBopsareinsurplusweoftenreferredtoasa
“surplus”country.Similarly,whenit’sBopsisindeficitoradverse,itis
calleda“deficitcountry”.
Ifnetforeignlendingandinvestmentabroadaretaken,aflexible
exchangeratecreatesanexcessofexportsoverimports.Thedomestic
currencydepreciatesintermsofothers.Theexportsbecomecheaper
relativelytoimports.Itcanbeshowninanequationformas:X+B=M+I
(WhereX:exports,B:foreignborrowing,I:investment,M:imports)orX– M =I–
B,thatis(X–M)–(I–B)=0.Theequationshowsthebopin
equilibrium.Anypositivebalanceincurrentaccountisexactlyoffsetbya
negativebalanceofitscapitalaccountandviceversa.Intheaccounting
sense,thebopalwaysbalances.Thiscanbeshownwiththehelpofthe
followingequation.C+S+T=C+I+G+(X–M),Y=C+I+G+(X–M)
WhereCisofconsumptionexpenditure,Sdomesticsavings,Ttaxreceipts,
IInvestmentexpenditures,G governmentexpenditure,Xexportsof
goodsandservices,M importsofgoodsandservices;Intheaccounting
sense,totaldomesticexpenditure(C+I+G)mustequalcurrentincome
 (C+S+T)thatisA=Y.domesticsavingsmustequaltodomestic
investment,similarly,anexportsurplusoncurrentaccount(X>M)must
beoffsetbyanexcessofdomesticsavingsoverinvestment(S>I).Thus
balanceofpaymentsisalwaysinequilibriumintheaccountingsense.

11. WriteareviewoftherecentdevelopmentsinForeignCapitalFlows.

CircularFlowofMoneywiththeForeignSector:

Sofarthecircularflowofincomeandexpenditurehasbeenshowninthe
caseofaclosedeconomy.Buttheactualeconomyisanopenonewhere
foreigntradeplaysanimportantrole.Exportsareaninjectionorinflowsinto
theeconomy.Theycreateincomesforthedomesticfirms.Whenforeigners
buygoodsandservicesproducedbydomesticfirms,theyareexportsinthe
circularflowofincome.Ontheotherhand,importsareleakagesfrom the
circularflow.Theyareexpendituresincurredbythehouseholdsectorto
purchasegoodsfrom foreigncountries.Theseexportsandimportsinthe
circularflowareshowninFigure.
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Taketheinflowsandoutflowsofthehousehold,businessandgovernment
sectorsinrelationtotheforeignsector.Thehouseholdsectorbuysgoods imported
from abroad and makespaymentforthem ofmoney.The
householdermayreceivetransferpaymentsfrom theforeignsectorforthe
servicesrenderedbythem inforeigncountries.Ontheotherhand,the
businesssectorexportsgoodstoforeigncountriesanditsreceiptsarean
injectioninthecircularflow.Similarly,therearemanyservicesrenderedby
businessfirmstoforeigncountriessuchasshipping,insurance,banking,etc.,
forwhichtheyreceivepaymentsfrom abroad.Theyalsoreceiveroyalties,
interests,dividends,profits,etc.,forinvestmentsmadeinforeigncountries.On
theotherhand,thebusinesssectormakespaymentstotheforeignsectorfor
importsofcapitalgoods,machinery,raw materials,consumergoods,and
servicesfromabroad.Thesearetheleakagesfromthecircularflow.Likethe
businesssector,moderngovernmentsalso,exportandimportgoodsand
services,andlendtoandborrowfrom foreigncountries.Forallexportsof goods,the
governmentreceivespaymentsfrom abroad.Similarly,the
 governmentreceivespaymentsfromforeignerswhentheyvisitsthecountryin
touristsandforreceivingeducation,etc.,andalsowhenthegovernment
providesshipping,insuranceandbankingservicestoforeignersthroughthe state-
ownedagencies.Italsoreceivesroyalties,interest,dividendsetc.,for
investmentsmadeabroad.Theseareinjectionsintothecircularflow.Onother
hand,theleakagesarepaymentsmadeforthepurchaseofgoodsandservices
toforeigners.

Figureshowsthecircularflowofthefour-sectoropeneconomywithsaving,
taxesandimportsshownasleakagesfromthecircularflowontherighthand
sideofthefigure,andinvestment,governmentpurchasesandexportsas
injectionsintothecircularflowontheleftsideofthefigure.Further,imports,
exportsandtransferpaymentshavebeenshowntoarisefrom thethree
domesticsector—thehousehold,thebusinessandthegovernment.These
outflowsandinflowspassthroughtheforeignsectorwhichisalsocalledthe
“balanceofmoneyreceiptsandpaymentsamongthebusinesssectorthe
householdsector,thegovernmentsectorandtheforeignsectorincurrents andcross-
currents.

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12. WhatisSDR?HowdoSDRssolvetheproblemofInternationalLiquidity?

SDR(SpecialDrawingRights)thisisakindofreserveofforeignexchange
assetscomprisingleadingcurrenciesgloballyandcreatedbytheinternational
monetaryfundintheyear1969.

ForSDRstobeamedium ofexchange,theywouldhavetobeacceptedin
privatemarkets,buttheywereonlybalancesincentralbanks.IftheIMFhad
thepowertobeaworldcentralbank,itwouldunderminetheabilityof
nationalcentralbankstocreatetheirownseigniorageandconducttheirown
monetarypolicy.PoliticalpressuresfromthoseintheUnitedStateswhofear
thattheSDRcoulddisplacethedollarasaninternationalreservelimitedSDR
interestratesto1.5%.Thecentralbanksofmanycountriesrespond,asa
matterofpolicy,todemandsforforeignexchange(demandforexports,usually)
bysimplycreatingmoremoney.Japan,bydoingthisonlyinmoderation,was
 forcedtodealwiththeconsequencesofan"expensive"yen:reduceddemand
foritsexportsandcheaperimportsavailableforJapaneseconsumers.Ina
flexibleeconomy,deflationwouldcorrecttheeffectsofacurrencygrown
relativelystronginworldtrade,butcontractsforwages,materials,etc.infixed
numbersofyenmakesdeflationslow.Theshort-term consequencesare
unemploymentandeconomicrecessioninresponsetothedecreasedforeign demand
forthe overpriced goods.The inflationary practicesofmany
governmentshaveledtotheadoptionofAmericandollarsasadefacto
monetarystandardinmanycountries.Russiahasmoredollarsincirculation
thananycountryoutsidetheUS.Seventypercentofthecurrencyactuallyused
incommerceinPeru&Boliviaisindollars.Panama&Liberiahaveuseddollars
astheofficialcurrencyformanyyears,andEcuadorwasforcedtosubstitute
dollarsforitsowncurrency,thesucre,inearlyyear2000.Widespreaduseof
thedollarasaglobalcurrencybothexpandsthepoweroftheFedandallows
theUSgovernmenttoexportpaper(dollars)inexchangeforrealgoodsand
servicesfrom abroad.AlthoughtheIMFfailedtobecometheworldcentral
bankasintendedbyBrettonWoods,ithasbecomeasugardaddyforforeign
governmentsthatmismanagetheireconomies— therebyencouragingsuch
practices.One-fifthofIMFfundsusedforbailoutloanscomesfromtheUnited
States.Ratherthanallowingthenaturaldisciplineofeconomicfailureto
provokereform,theIMFeffectivelyunderwritesthesefailureswhilecreating File
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indebtednesstotheIMF.Asanexample,inthe1990s,Thailand,Indonesia,
SouthKoreaandanumberofotherAsiancountriesrapidlyexpandedtheir
moneysupplieswhiletheircentralbanksloweredinterestrates.Localstock
marketssoaredinthisillusoryprosperity,butin1998theUSDollarroseover 100%
againsttheThaiBahtand500% againsttheIndonesianruppiah.To
preventcurrencycollapsethelocalcentralbankstightenedinterestrates—
precipitatingthe"Asiancrisis",blamedoncurrencyspeculators(afavorite
scapegoatofgovernments).IndonesiaacceptedmoneyfromtheIMF,signing
agreementswhichitviolated,andcontinueditspoliciesofcronycapitalism
whiletheIMFcontinuedtodemonstrate"considerableflexibility".Evenwhere
IMFrequirementshavebeenobservedtheeffectisoftendetrimental,since
theIMFsooftendemandstaxincreases.InthecaseofArgentina,increased
taxeshaveactuallyaccompaniedreducedtaxrevenues,andhaveprobably
stifledeconomicgrowth.Inexchangeforbailoutfunds,theIMFgenerally
demandslocalcentralbanksthatcanbe"harmonized"withtheUSFed.Cynics
mightarguethattheIMFisactingsoastoexpandtheglobaldollar-reserve
system.Thisisnotsimplyanissueofpower-politics,however,becausemost
peoplesincerelybelievethatgovernmentregulatedmoney& bankingis
superiortoafreemarketsystem—andthattheUSFed"knowsbest".

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