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CHAPTER 6
The International Monetary
System and The Balance Of Payments
After studying this chapter, students should be able to:

> Discuss the role of the international monetary system in promoting international
trade and investment.
> Explain the evolution and functioning of the gold standard.
> Summarize the role of the World Bank Group and the International Monetary
Fund in the postwar international monetary system established at Bretton
Woods.
> Explain the evolution of the flexible exchange-rate system.
> Describe the function and structure of the balance of payments accounting
system.
> Differentiate among the various definitions of a balance of payments surplus
and deficit.

LECTURE OUTLINE

OPENING CASE: Will the Stars Shine on Astra Again?

PT Astra is one of the oldest and largest conglomerates in Asia, at one point having
employed 125,000 people. After borrowing in dollars from foreign banks, Astra's
fortunes plummeted with the collapse of the Indonesian rupiah. A new president
installed in 1998, Rini Soewandi, did much to turn the company around until her ouster
in 2000. Now, with deals struck with the Indonesian Bank Restructuring Agency (IBRA)
and the International Monetary Fund (IMF), Indonesia and Astra may again have
reason to be optimistic.

Key Points

• Astra was a domestically oriented firm.

• Even so, it was not impervious to international competitive issues, such as


changes in the value of the Indonesian rupiah.

• As global competition increases, domestically protected companies face greater


and greater challenges internally and outside of their country.
87 > Chapter 6

Case Questions

1. Who wins and who loses from a weak U.S. dollar?

The big winners from a weak U.S. dollar are America’s exporting industries because
a weak dollar makes American products seem cheaper to foreign buyers. U.S.
exporters further benefit from a weak dollar because imports from foreign countries
appear to be more expensive. However, American companies that produce their
products in foreign markets do not benefit from the weak dollar, and all companies
are adversely affected by the uncertainty that is associated with a weak dollar.
American producers are also affected by the increased inward investment from
companies that shift production to the U.S.

2. How do the weak Asian currencies affect producers in the United States?

U.S. corporations are concerned about the Asian crisis on several fronts. Some
companies will be competing against unusually low priced imports, others will find
that their Asian exports have slowed. Still others may find that they will face
increased competition in other markets, such as Latin America, from Asian
exporters. Some companies, particularly those that import raw materials from Asia
do stand to gain from the currency crisis, however.

CHAPTER SUMMARY

Chapter Six explores the international monetary system and the balance of payments.
The chapter traces the history of the international monetary system beginning with the
gold standard and ending with the current system of a managed float. It then goes on
to examine the different accounts and balances in the balance of payments.

I. HISTORY OF THE INTERNATIONAL MONETARY SYSTEM

• The international monetary system establishes the rules by which countries


value and exchange their currencies. It also provides a mechanism for correcting
imbalances between a country’s international payments and its receipts.
• The accounting system that governs the international monetary system is the
balance of payments (BOP). The BOP records international transactions and
supplies vital information about the health of a national economy and likely changes
in its fiscal and monetary policies.

Teaching Note:
Students may find it helpful to use a time line
when discussing the different exchange-rate
systems that have taken place over the last
century.

The Gold Standard

• The gold standard, under which countries agreed to buy and sell their paper
currencies in exchange for gold on the request of any individual or firm, was the
international monetary system in place in the nineteenth century.
The International Monetary System and the Balance of Payments > 88

• The gold standard had the effect of creating a fixed exchange-rate system
because each country tied or pegged the value of its currency to gold. An
exchange rate is the price of one currency in terms of a second currency. The par
value of a currency is its official price in terms of gold.
• For nearly a century (from 1821 until 1918), the most important currency in
international business was the British pound sterling; thus, the international
monetary system was frequently referred to as the sterling-based gold standard
during this time. Show Map 6.1 here.

The Collapse of the Gold Standard

• As countries suffered through the economic chaos of World War I, the sterling-
based gold standard came unraveled; however, it was readopted in the 1920s.
• In spite of its resuscitation, the gold standard ended in 1931 when Britain, under
pressure to honor guarantees made under the system, allowed its currency to float
(the pound’s value was determined by the forces of supply and demand).
• While some countries, primarily those in the British Commonwealth, pegged
their currencies to the pound after the gold standard was abandoned, others linked
their currencies to the U.S. dollar or the French franc. In addition, many countries
engaged in a beggar-thy-neighbor policy, in which nations deliberately devalued
their currencies in the hope of making their goods cheaper in the world
marketplace. Figure 6.1 should be discussed here.

The Bretton Woods Era

• In 1944, representatives of 44 countries met to construct a postwar international


monetary system that would create an environment of worldwide peace and
prosperity. The representatives agreed to renew the gold standard on a modified
basis, and they created two new international organizations, the International Bank
for Reconstruction and Development and the International Monetary Fund, to assist
the rebuilding of the world economy and monetary system.
• The International Bank for Reconstruction and Development, also known as
the World Bank, was established in 1945 to finance reconstruction of war-torn
European economies, and when this was completed, focused on building the
economies of lesser-developed nations.
• The World Bank has created three affiliated organizations: the International
Development Association, the International Finance Corporation and the Multilateral
Guarantee Agency which together comprise the World Bank Group. Show Figure
6.2 here.
• The World Bank lends only for “productive purposes” and follows a hard loan
policy (it makes loans only if there is a reasonable expectation that they will be
repaid).
• The International Development Association (IDA) was established in
response to criticism from poorer countries that World Bank policies favored
countries well along the path to economic development. The IDA offers soft loans
(those that bear significant risk of not being repaid).
• The International Finance Corporation (IFC) is charged with promoting the
development of the private sector in developing countries, while the Multilateral
Investment Guarantee Agency (MIGA) encourages direct investment in
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developing countries by offering private investors insurance against non-commercial


risk.
• Regional development banks parallel the efforts of the World Bank as they
promote the economic development of poorer countries within their regions. The
text provides an example of how the Asian Development Bank and the World Bank
coordinated their efforts to finance a hydroelectric power plant in Nepal.
• The International Monetary Fund. The International Monetary Fund’s (IMF)
primary responsibility is to oversee the functioning of the international monetary
system.
• To join the IMF, countries must pay a deposit, called a quota. Quotas are
important because they determine a country’s voting power within the organization,
serve as part of a nation’s official reserves, and determine a country’s borrowing
power from the IMF.
• A country is allowed to borrow up to 25% of its quota from the IMF. Additional
borrowings require that countries agree to IMF conditionality.
• A Dollar Based Gold Standard. Under the international monetary system
established at Bretton Woods, all countries agreed to peg the value of their
currencies to gold (the dollar was pegged to gold at a value of $35 per ounce).
Thus, the agreement was a fixed exchange rate system. In addition, the U.S.
agreed to redeem the dollar for gold at the request of foreign central banks. In this
way, the dollar played a key role in the Bretton Woods system. Show Figure 6.3
here.
• The Bretton Woods system provided a generally stable environment for
international business because under the agreement each country agreed to
maintain the value of its currency within ±1 percent of its par value.
• An additional feature of the Bretton Woods agreement was an adjustable peg
mechanism that allowed a country to alter the value of its currency in extraordinary
circumstances. The text provides an example of the circumstances that prompted
Great Britain to readjust the pound’s peg value in 1967.

The End of the Bretton Woods System

• The reliance on the U.S. dollar eventually led to the downfall of the Bretton
Woods system. Since the supply of gold did not expand in the short term, the dollar
became the source of additional liquidity to finance expanding international trade.
However, as foreign dollar holdings began to increase, doubt about the ability of the
U.S. to live up to its Bretton Woods’ obligation began to rise.
• The Tiffin paradox arose because foreign banks needed to increase their
holdings of dollars to finance expansion of international trade, but the more dollars
they owned, the less faith they had in the ability of the U.S. to redeem the dollars for
gold.
• The IMF attempted to alleviate the situation by creating an additional source of
international liquidity, the special drawing right (SDR). The SDR, a weighted
average of the market value of five major currencies, is used by IMF members to
settle official transactions at the IMF.
• The SDR did not have the desired effect of reducing the glut of dollars held by
foreigners, and by 1971, it became clear that the U.S. did not have enough gold to
meet the demand of those who wanted to exchange dollars for gold. Nixon officially
ended the system, and currencies began to float against each other.
• The fixed exchange rate system was restored at the Smithsonian Conference in
late 1971. Under the new agreement, the dollar was devalued to $38 per ounce of
The International Monetary System and the Balance of Payments > 90

gold, and the par value of strong currencies was revalued upward. In addition, the
band of fluctuation within which currencies were allowed to fluctuate was widened
to ± 2.25 percent. Discuss Table 6.1 here.

Performance of the International Monetary System since 1971

• The Smithsonian agreement proved to be short-lived as central banks conceded


they could not successfully resist free-market forces. Since 1973, many currencies
have operated under a flexible (or floating) exchange-rate system within which
currency values are determined primarily by supply and demand. Occasionally, a
central bank will intervene and affect exchange rates leading to the term “managed
float” or dirty float. Insert Table 6.2 here.

Discuss Bringing the World into Focus:


Fixed versus Flexible Exchange Rates
This box discusses the how the fixed and flexible exchange rate
systems each reach equilibrium. The fixed system through the
purchase and sale of gold, the flexible system through changes in supply and
demand (and therefore value) for a country's currency.

• Under the Jamaica Agreement, established in 1976, each country was free to
adopt whatever exchange-rate system best met its requirements. Some countries
(i.e., the U.S.) chose a floating exchange rate, while others opted for a fixed
exchange-rate system by pegging their currencies to another.
• The European Monetary System (EMS) was established by EU members in
1979 to manage currency relationships among themselves. Most EMS members
participate in the exchange-rate mechanism, in which participants maintain fixed
exchange rates among their currencies (within a ±2.25 percent band) and a floating
rate against the U.S. dollar and other currencies.
• The EMS members also created a new index currency, the European Currency
Unit, which is a weighted “basket” of the currencies of the EU members that is used
for accounting purposes within the EU. Map 6.2 shows the current status of the
world's exchange rate movements.
• While the EMS has been helpful in curbing inflation and in promoting intra-EU
investment, it has also been adjusted 39 times because of differences in the
monetary policies of EU members.
• The current international monetary system is based on flexible-exchange rates,
although some countries (i.e., the EU) have chosen to maintain fixed exchange-rate
systems.
• Other Postwar Conferences. The world’s central banks meet periodically to iron
out policy conflicts among themselves. One such meeting, the Plaza Accord (held
in 1985), resulted in an agreement to let the dollar’s value fall. Discuss Table 6.1
here.
• A second meeting, the Louvre Accord, was called in 1987 to stabilize the
dollar. Discuss Figure 6.4 here.
• Because a depreciation in a firm’s home currency makes it easier for the firm to
export, and defends it from the threat of imports, exchange rates are very important
to firms. In fact, the text points out that it was an appreciation of the mark against
the dollar that led BMW to invest in the U.S.
91 > Chapter 6

Discuss Bringing the World into Focus:


Should Bretton Woods be Restored?
A debate still brews over the benefits of fixed exchange rate
systems (such as the one developed at Bretton Woods)
compared to the benefits of a flexible, market-driven, system such as we have
today. Fixed rate system proponents are troubled by current volatility in foreign
exchange markets. Flexible system proponents argue that a fixed system does not
avert crises, and that flexible systems allow countries more autonomy in dealing
with internal economic issues.

• The International Debt Crisis. The international debt crisis grew out of events
that occurred shortly after the flexible-exchange rate system of 1973 began, when
Arab nations quadrupled the price of oil. Banks recycled the petrodollar in the form
of loans to countries that were damaged by the rise in oil prices. However, many
countries borrowed more than they could repay.
• Various efforts were made to resolve the crisis. The 1985 Baker Plan stressed
the importance of debt rescheduling, tight IMF-imposed controls over domestic
fiscal and monetary policies, and continued lending to debtor countries in hope that
economic growth would allow them to repay their creditors. The plan had limited
success.
• The 1989 Brady Plan focused on the need to reduce the debts of the troubled
countries by writing off parts of debt or providing countries with funds to buy back
their loan notes at below face value.
• The international monetary system suffered a crisis in July 1997, when investors
began to distrust the abilities of Thai borrowers to repay their debts. Thailand was
forced to unpeg its currency from a dollar denominated basket of currencies,
resulting in a rapid deterioration in the currency’s value. The crisis quickly spread to
neighboring countries setting off a major international currency crisis. Discuss
Figure 6.5 here.

II. THE BALANCE OF PAYMENTS ACCOUNTING SYSTEM

• The balance of payments (BOP) accounting system is a double-entry


bookkeeping system designed to measure and record all economic transactions
between residents of one country and residents of all other countries during a
particular time period.
• There are several reasons why international business people should pay
attention to the BOP. First, BOP statistics help identify emerging markets for goods
and services. Second, they can warn of possible new policies that may alter a
country’s business climate, thereby affecting the profitability of a firm’s operations in
that country. Third, they can indicate reductions in a country’s foreign reserves,
which may mean that a country’s currency will depreciate in the future. Fourth, they
can signal increased riskiness of lending to particular countries.
The International Monetary System and the Balance of Payments > 92

The Major Components of the BOP Accounting System

The BOP accounting system can be divided into four major accounts: the current
account; the capital account; the official reserves account; and the errors and
omissions account.

1. Current Account

• The current account records exports and imports of merchandise and services,
investment income, and gifts. Table 6.3 summarizes the debit and credit entries for
transactions involving the current account.
• To the U.S., a sale of a Ford Escort to a Japanese businessman in Osaka is a
merchandise export, and the purchase of a Sony television from Japan by an
American student is a merchandise import. The difference between a country’s
exports and imports of goods is called the balance on merchandise trade. The
U.S. has a merchandise trade deficit because it has been importing more than it
exports, while Japan has a merchandise trade surplus because it has been
exporting more than it imports.
• The sale of a service (i.e., consulting services) to a resident of another country
is a service export, while the purchase of a service by a resident of another
country is a service import. The term trade in invisibles is also used to describe
trade in services. The difference between a country’s export of services and its
imports of services is called the balance on services trade.
• Income (i.e., interest and dividends) French residents earn from their foreign
investment is viewed as an export of the services of capital by France. Income
earned by foreigners from their investments in France is known as an import of the
services of capital by France.
• Unilateral transfers are gifts between residents of one country and another
country.
• Current account balance measures the net outflow or inflow resulting from
merchandise trade, service trade, investment income and unilateral transfers.

2. Capital Account

• The capital account records capital transactions -- purchases and sales of


assets -- between residents of one country and those of other countries. Capital
account transactions can be divided into foreign direct investment (FDI) and
portfolio investment. The former is any investment made for the purpose of
controlling the organization in which the investment is made, while the latter is any
investment made for purposes other than control. Both types of investment are
discussed in Chapter One. Discuss Table 6.4 here.
• Short-term portfolio investments are financial instruments with maturities of
one year or less. Long-term portfolio investments are stocks, bonds, and other
financial instruments issued by private and public organizations that have maturities
greater than one year and that are held for purposes other than control.
• Current account transactions affect the short-term components of the capital
account because the first entry in the double-entry BOP accounting system involves
the purchase or sale of something, and the second entry typically records the
payment or receipt of payment for the thing bought or sold. (See Building Global
Skills at the end of the chapter for an example of the process.)
93 > Chapter 6

• Capital inflows are credits in the BOP accounting system and occur either when
foreign ownership of assets in a county increases or when ownership of foreign
assets by a country’s residents declines. The text provides examples of both
situations.
• Capital outflows are debits in the BOP accounting system and occur either when
ownership of foreign assets by a country’s residents increases or when foreign
ownership of assets in a country declines. The text provides examples of both
situations. Table 6.5 summarizes the impact of various capital account transactions
on the BOP.

3. Official Reserves Account

• The official reserves account records holdings of the official reserves held by
a national government including gold, convertible currencies (currencies that are
freely exchangeable in world currency markets), SDRs, and reserve positions at the
IMF.

4. Errors and Omissions

• The errors and omissions account is used to make the BOP balance in
accordance with the following equation: Current Account + Capital Account + Errors
and Omissions + Official Reserves = 0.
• A large portion of the errors and omissions account is probably due to
underreporting of capital account transactions. It is becoming more and more
difficult to keep track of legal capital transactions as they become increasingly
sophisticated and grow in volume. Other errors and omissions are deliberate
actions and are frequently illegal. Flight capital, for example, is money sent
abroad by foreign residents seeking a safe haven for their assets, hidden from the
sticky fingers of their home governments.

Discuss Bringing the World into Focus:


Ben Franklin, World Traveler
This Going Global Box examines the process of determining
how much U.S. currency is held by foreigners. The Box notes
that current estimates are that some 49% of U.S. currency in circulation in 1999
was held by foreigners. These foreign holdings act as interest-free loans to the
U.S.

• Other errors and omissions are related to the current account, particularly
merchandise exports and trade in services.

The U.S. Balance of Payments in 1999

• U.S. merchandise exports were $684.3 billion in 1999. Automobiles and auto
parts were the largest component of U.S. merchandise exports. Table 6.6 and
Figure 6.6 give a more detailed breakdown of import and exports by industry.
Discuss Table 6.6 here.
The International Monetary System and the Balance of Payments > 94

• U.S. merchandise imports totaled $1,029.9 billion in 1996. The leading import
was automobiles and auto parts. Insert Figure 6.6 here.
• U.S. exports of services were $271.9 billion in 1999, with travel and tourism
being the largest portion.
• The U.S. tends to import more goods from its major trading partners than it
exports to them, however, it tends to export more services to them that it imports
from them. Figure 6.7 depicts trade in services and should be discussed here.
• The capital account shows that in 1999, U.S. FDI outflows were $150.9 billion,
while FDI inflows were $275.5 billion. New U.S. long-term international portfolio
investments were $128.6 billion in 1999, while new foreign long-term portfolio
investments in the U.S. were $343.6 billion. The capital account balance was
$311.2 billion in 1999, as foreigners bought more U.S. assets than U.S. residents
bought foreign assets.
• The official reserves account transactions were $8.7 billion, and the errors and
omissions account was $11.6 billion.

Defining Balance of Payments Surpluses and Deficits

• When people talk about a balance of payments surplus or deficit, they are
talking about a subset of BOP accounts. For example, a merchandise trade surplus
occurs when a country exports more than it imports. Other balances that are often
mentioned include the balance on services, the balance on goods and services, the
current account balance, and the basic balance (the sum of the current account and
net long-term capital investment).
• The official settlements balance reflects changes in a country’s official
reserves; it essentially records the net impact of the central bank’s interventions in
the foreign exchange market in support of the local currency.
• Which BOP concept to use depends on the issue confronting the international
business person or policy maker. There is no single measure of a country’s global
economic performance. The balance on goods and services reflects the combined
international competitiveness of a country’s manufacturing and service sectors.
The current account balance shows the combined performance of the
manufacturing and service sectors and also reflects the generosity of the country’s
residents as well as income generated by past investments. The basic balance
combines current account transactions with long-term capital investments. The
official settlements balance is a record of supply and demand for a country’s
currency. Discuss Figure 6.8 here.
95 > Chapter 6

CA

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Recent U.S. BOP Performance: Is the Sky Falling?

The closing case provides two divergent views as to how the U.S. BOP should be
interpreted. One perspective looks at the last decade’s BOP favorably, the other
perspective does not.

Key Points:

• Over the last decade the U.S. BOP has reflected a large annual deficit in the
current account, a large annual surplus in the capital account, and relatively small
changes in the official reserves account.

• This BOP can be interpreted in two ways. First, that U.S. firms are
uncompetitive in foreign markets, and foreigners are taking over the country by
buying up valuable U.S. assets. Second, that the U.S. is attracting foreign
investment through foreign country current account surpluses.

• Both views are consistent with the data.

• Those who favor the first argument believe that the U.S. must reduce its BOP
deficit by following policies to make U.S. firms more competitive in foreign markets
and by following policies to keep imported goods out.

• People who believe the second argument is true feel that the country should
strive to do anything possible to become more attractive to foreign investors.

• It is important for companies to understand BOP statistics because they are the
key to the type of international trade policy the U.S. will pursue.

Case Questions

1. What is more important to the U.S. economy--exports or foreign capital inflows?

The answer to this question depends on whether one takes the view that the last
decade’s BOP indicates that the U.S. is becoming uncompetitive in foreign markets,
or the view that the BOP indicates that the U.S. is in a good position relative to
foreign rivals. Those who support the former viewpoint would probably argue that
exports are more important to the U.S. economy, while those who feel that the U.S.
is attracting investment because its prospects are very attractive are likely to believe
that foreign capital inflows are more important.
The International Monetary System and the Balance of Payments > 96

2. What is the connection between the U.S. current account deficit and capital
account surplus?

The connection between the current account deficit and the capital account surplus
is that one cannot exist without the other; the accounts have an inverse
relationship. In a sense then, the means by which the U.S. is able to run a deficit in
its current account (by importing more than it exports) is to finance the deficit with its
capital account.

3. Which of the following groups is likely to endorse the “sky is falling” view of the U.S.
BOP?
• Import-threatened firms such as textile producers
• Textile workers
• A cash-starved California biotechnology company
• Merrill Lynch
• Boeing Aircraft, one of the country’s largest exporters
• Consumers

Import-threatened firms such as textile producers, and textile workers are likely to
endorse the “sky is falling” perspective of the U.S. A cash starved biotech firm is
likely to view foreign investment favorably, as is Merrill Lynch. Consumers probably
do not endorse the “sky is falling” perspective unless they happen to be employed
by a firm that is threatened by imported goods. Finally, export-oriented Boeing
Aircraft is not likely to endorse a “sky is falling” perspective.

Additional Case Application


Instructors may wish to raise the issue of whether the BOP should be
considered an accurate measure of economic performance for the U.S. or other
service-oriented economies. The class can be divided into two groups. One
group can be assigned responsibility for analyzing the position of the U.S. when
service trade is not included in the overall BOP. The second group can analyze
the economic well being of the U.S. when trade in services is incorporated into
its economic measures. The two groups can then present their findings to the
rest of the class.
W

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1. What is the function of the international monetary system?

The international monetary system establishes the rules by which countries value and
exchange their currencies. In addition, the system provides a mechanism to correct
imbalances that may exist between a country’s international payments and its receipts.

2. Why is the gold standard a type of fixed exchange-rate system?

The gold standard is a type of fixed exchange-rate system because under the system each
country pegged the value of its currency to gold. Currencies are then exchanged using the
stated amount of gold. The text provides an example of the process using the U.S. dollar
and the British pound.
97 > Chapter 6

3. What were the key accomplishments of the Bretton Woods conference?

The key accomplishments of the Bretton Woods conference included an agreement to


renew the gold standard on a modified basis, and an agreement to create two international
organizations, the International Bank for Reconstruction and Development and the
International Monetary Fund, to assist in the rebuilding of the world economy and the
international monetary system.

4. Why was the IFC established by the World Bank?

The International Finance Corporation was created in 1956 to promote the development of
the private sector in developing countries. To that end, the IFC (in collaboration with
private investors) serves as an investment banker as it provides debt and equity capital for
commercial activities that show promise.

5. Why are quotas important to IMF members?

Quotas (the deposits countries pay to join the organization) are important to IMF members
for several reasons. First, a country’s quota determines its voting power within the IMF.
Second, a country’s quota serves as part of its official reserves. Third, quotas determine a
country’s borrowing power from the IMF.

6. Why did the Bretton Woods system collapse in 1971?

A key part of the Bretton Woods system was the agreement by the United States to
exchange its currency for gold. During the 1950s and 1960s, foreigners happily held onto
dollars. However, as their holdings increased, they began to question the ability of the
United States to redeem their dollars for gold. After an attempt by the IMF to increase
liquidity in the system using special drawing rights, the Bretton Woods system collapsed in
1971 amid fears that the United States did not have enough gold on hand to meet the
demands of those who wanted to exchange their dollars for gold.

7. Describe the differences between a fixed exchange-rate system and a flexible exchange-
rate system.

Under a fixed exchange-rate system, the price of a given currency does not change relative
to other currencies. Under a flexible exchange-rate system, currencies fluctuate according
to supply and demand.

8. List the four major accounts of the BOP accounting system and their components.

The four major accounts of the BOP accounting system are the current account, the capital
account, the official reserves account, and the errors and omissions account. The capital
account summarizes merchandise exports and imports, service exports and imports,
investment income, and gifts for a given country. The capital account provides a record of
a country’s capital transactions including purchases and sales of assets. The official
reserves account provides a summary of a country’s official reserves including gold,
convertible currencies, SDRs, and reserve positions at the IMF. Finally, the errors and
reserves account provides a mechanism for ensuring that the BOP balances.
The International Monetary System and the Balance of Payments > 98

9. What factors cause measurement errors in the BOP accounts?

Various factors contribute to measurement errors in the BOP accounts. It is believed that a
large portion of the account is a result of the underreporting of capital account transactions.
A portion of this underreporting is due in part to the growing volume of legal short-term
money flowing between countries. Another portion of the account is due to the illegal
activities of drug smuggling, money laundering, and the evasion of government imposed
currency and investment controls. Errors in the current account also affect the errors
and omissions account. The main problems reducing the accuracy of current account
transactions typically involve merchandise exports and trade in services.

10. Differentiate among the different types of balance of payments surpluses and deficits.

The merchandise trade balance, which summarizes a country’s trade position in goods, is
the most commonly referred to balance. Other balances include the balance on services
which records a country’s trade in services, the balance on goods and services combines
the balance on services and the merchandise trade balance, the current account balance
summarizes the activities in the current account (see Review Question 8), the basic
balance sums the current account balance and net long-term capital, and the official
settlements balance reflects changes in a country’s official reserves.

Questions for Discussion

1. What parallels exist between the role of the British pound in the nineteenth-century
international monetary system and that of the U.S. dollar since 1945?

In the nineteenth century, the British pound was the most important currency in
international business. The pound gained this status because the United Kingdom
emerged, at the end of the Napoleonic Wars, as the dominant economic and military power
in Europe. The British pound (or gold) was accepted by most companies in the settlement
of transactions. However, after World War I, when the Great Depression affected
economies worldwide, Britain was unable to meet its pledges under the gold standard, and
the monetary system ended shortly thereafter. The U.S. dollar, like the British pound,
emerged as the dominant currency at the conclusion of World War II, when the U.S. held
the position of a military and economic superpower. Individuals and companies were
happy to settle their transactions with dollars, much as they were with the pound in earlier
times. Under the new international monetary system established at Bretton Woods, the
U.S. pledged to exchange its currency for gold at the rate of $35 per ounce, however,
when the country found itself unable to meet its pledge, it ended the system in 1971.

2. Did the key role that the dollar played in the Bretton Woods system benefit or hurt the
United States?

It can be argued that the key role the dollar played in the Bretton Woods system benefited
the U.S. because it helped the country to gain the status of a force to be reckoned with.
Moreover, the system gave the U.S. veto power on important decisions, and a portion of
each country’s deposits with the IMF were kept in the U.S. On the other hand, it could be
argued that the large depreciation in the value of the dollar that began at the conclusion of
the system and continued into the 1980s helped to create an unstable domestic
environment (although U.S. exporters benefited from the decline in the dollar’s value -- see
opening case question 1).
99 > Chapter 6

3. Under what conditions might a country devalue its currency today?

A country might devalue its currency in an effort to help the international competitiveness of
its exporters. A devalued dollar, for example, has the effect of making U.S. exports
cheaper in foreign markets and foreign imports more expensive to U.S. consumers. U.S.
automakers enjoyed a less competitive domestic environment, for example, in the early
1990s when the U.S. dollar was very weak compared to the Japanese yen. This created a
situation in which Japanese auto exports were not price competitive with domestically
produced vehicles and eventually allowed U.S. producers to recapture a share of the U.S.
market.

4. Are there any circumstances under which a country might want to increase its currency’s
value?

Countries may try to increase the value of their currencies in certain circumstances. For
example, major trading partners met at the Louvre Accord in an effort to halt the decline of
the dollar, which had plummeted almost 46% against the Deutsche mark and 41% against
the yen in just two years. Countries were worried that any further devaluation in the dollar
would disrupt world trade. However, for the most part, countries will be reluctant to
revalue their currencies because a stronger currency makes exports less competitive, and
imports less expensive. The combination of these effects creates a trade deficit.

5. Can international businesses operate more easily in a fixed exchange-rate system or in a


flexible exchange-rate system?

Under a fixed exchange rate system countries peg the value of their currencies to gold.
Under a flexible exchange-rate system supply and demand determine the value of a
country’s currency. Many people would argue that because of the stability and
predictability of exchange rates under a fixed system, that such a system would be
preferred by international businesses. However, others would argue that a flexible
exchange rate system would be preferable to international businesses because their
competitiveness would not be affected by inflation, as it would be offset by a depreciation
in exchange rates.

6. What connections exist between the current account and the capital account?

The current account and the capital account have an inverse relationship as a result of the
BOP double entry accounting system. Thus, if the current account is running a deficit, the
capital account must run a surplus to offset the deficit and bring the BOP into balance. In
the 1990s, the U.S. has experienced a current account deficit and a capital account
surplus, while Japan has experienced just the opposite situation.
The International Monetary System and the Balance of Payments > 100

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This exercise is designed to allow the student to explore the World Bank’s website. It requires
students to assume the role of a manager with a manufacturer of water treatment machinery
and hydroelectric generating technology that is considering locating a sales office in Africa.
Students are required to determine the likelihood that the World Bank will fund projects in the
area in the near future.
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Essence of the exercise
This exercise is designed to allow students to better understand the BOP concept by actually
accounting for various “transactions.” The exercise provides three examples of how the BOP
double entry system works, and then asks students to record another set of transactions.

Answers to the follow-up questions.

How would the following transactions be recorded in the U.S. BOP?

1. A Swiss entrepreneur seeking to sell souvenirs at the 2002 Winter Olympics in Salt Lake
City, Utah, pays Delta, a U.S. airline, $1400 for a Zurich-Salt Lake City round-trip ticket.

The debit entry in this transaction affects the short-term portfolio account in the amount of
$1400. The credit entry in this transaction is a service export of $1400.

2. The Swiss entrepreneur instead pays Swiss Air (a Swiss airline) $1400 for a Zurich-Salt
Lake City round-trip ticket.

This transaction will not affect the U.S. BOP because the airline is a foreign carrier being
used by a foreign national.

3. Ford Motor Company (U.S.) pays $2.5 billion for all the common stock of the Jaguar Motor
Co. (U.K.).

Ford is buying a long-term asset (the Jaguar Motor Co.) for purposes of control, and the
U.K. is buying a short-term asset called “an increase of claims on foreigners or a decrease
of foreign claims on the U.K." The U.S. BOP will reflect a debit of $2.5 billion in the foreign
direct investment account, and a credit of $2.5 billion in the short-term portfolio account.

4. The U.S. government gives Rwanda $500 million worth of food to feed starving refugees.

The U.S. BOP would reflect a debit in the unilateral transfer account for the amount of
$500 million since the money is a gift, and the short-term portfolio account would show a
credit for $500 million.
Other Applications
101 > Chapter 6

Students can take this exercise to the next level by determining how each of the
transactions listed above affects the current account, the capital account and the overall
balance of payments for each country in question.