International Finance Exam Solutions

International Finance Theory and Policy
INTRODUCTION
When studying open economy that trade with other countries, there is a major difference in
the transactions between domestic and foreign residents as compared to those between
residents of the same country. One of the features of international trade is the involvement of
foreign currencies. The subject called International Finance as a part of International
Economics is concerned with monetary and macroeconomics relations among different
countries. International Finance is dynamically evolving discipline and deals with real issues
in business environment related to financing transactions among different nations.
This teaching material, therefore, presents some basic theory and principles of International
Finance that are essential for a better understanding of the subject International Economics.
Such an understanding of the theories and principles would enable students to evaluate and
suggest solutions to improve international economic problems and issues facing the global
economy. Students are expected to appreciate those issues by extending their analysis to
individual countries. The basic knowledge gained from this teaching material will enable
readers to assess the policy implication of the issues and problems.
This teaching material is organized in such a way that, the first two chapters provide basic
knowledge about market for foreign exchange, introduces the major participants in the
foreign exchange market, and types of exchange markets. It also addresses concepts and
issues related to determination of floating exchange rates. It starts by reviewing the basic and
early concepts of purchasing power parity and the law of one price. Version of PPP and
problems associated with PPP in using to determine exchange rate would be explained at the
end of the chapter.
The next three chapters deal broadly with the concept of balance of payment. In these
chapters, the meanings of balance of payment, components of balance of payment and basic
concepts of deficit and surplus of the balance of payment would be explained closely. The
two approaches, the elasticity approach and the absorption approach are dealt is some detail
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Adama University, Faculty of Business and Economics, Department of Economics

in chapter four of the teaching material. The monetary approach to the balance of payment is
analyzed in some detail in one full chapter-chapter five.
Open economy and Macroeconomic policy, particularly the problem of internal and external
balance and the Mundell -Fleming model is revisited in the subsequent chapter chapter six.
Finally, the international monetary system is presented briefly in the last part of the material chapter seven.
For better understanding of the subject, readers are advised to refer additional materials and
revise basic concepts of Macroeconomics, International Trade and other related literatures in
International Economics.
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CHAPTER I
EXCHANGE RATES AND FOREIGN EXCHANGE MARKET
NTRODUCTION
This chapter will attempt to examine different participants in the foreign exchange market
and explains the basic forces that operate in the market. The concept of exchange rate and the
determination of exchange rate would also be examined in some details. The basic
operational differences between fixed exchange rates and floating exchange rates regime will
be explained as well. The basic concepts of spot exchange rates and forward exchange rate
and the relationship between spot and forward exchange rate will finally be presented.
CHAPTER CONTAINT
1.0. Objective
1.1. Exchange Rates and The Foreign Exchange Market
1.2. Characteristics And Participants of The Foreign
Exchange Market
1.3. The spot and Forward Exchange Rates
1.4. Summary
1.5. Review Question
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1.0. OBJECTIVE
At the end of this chapter readers will be able to
Explain exchange rate
Understand characteristics of foreign exchange market
Know major participants of the foreign exchange market.
Explain the concept of arbitrage in foreign exchange market
Understand the essence and difference between spot and forward exchange rates
Explain how exchange rates are determined.
1.1. EXCHANGE RATE AND THE FOREIGN EXCHANGE MARKET

In an open economy that trade with different countries, there is a major difference in the
transaction of goods and services between domestic and foreign residents as compared to
those between residents of the some country. One of the facture of international trade is the
involvement of foreign currencies.
The Ethiopian importer will generally have to pay to the Japanese exporter in yen, to US
exporter in USD and to Germen exporter in Euro. For these reasons, the Ethiopian importers
will have to buy these currencies with birr in foreign exchange market.
The foreign exchange market is not a single physical place rather it is defined as. a market
where the various national currencies are bought and sold.
In this chapter, we will try to look at some of the basic issues like, the participants in the
foreign exchange market and the basic force that operate in the market. We will also try to
examine the basic determinant of exchange behavior. The spot and forward exchange rates
will also be discussion in some brief way.
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What is exchange rate?

People in different countries use different currencies as well as different languages. The
translator between different currencies is the exchange rate, the price of one country money
in unit of another countrys money.
Generally, exchange rate is simply the price of one currency in terms of another. There are
two methods of expressing the price of one countrys currency. These are,.
Domestic currency unit per unit of foreign exchange. For instance, taking birr as the
domestic currency, on February 15, 2008 there was approximately 9.22 birr required
to purchase one US dollar. Thus, Exchange rate between birr & US dollar (USD) is
9.22 to 1 USD.
Foreign currency units per unit of the domestic currency. That is, how much USD can
one Ethiopian birr buy? For example, again taking Ethiopian birr as domestic
currency, on February 15, 2008, One Eth. Birr can only buy 0.11 USD.
We can easily observe that the second method is just the reciprocal of the former. It is not as
such important which method of expressing the exchange rate is employed. What important
is to be careful when talking about a rise or fall in the exchange rate. This is because the
meaning will be very different depending up on which definition is used.
A rise in the Eth birr per dollar exchange rate, say from 9.22 to 9.30 means that more birr
have to be given up in order to obtain a dollar. This means that the birr has depreciated in
value or equivalently the dollar has appreciated in value.
Where as if the second definition is employed, a rise in the exchange rate from USD 0.11/ 1
birr to say 0.12 / birr would mean that more dollars are obtained per birr, so that the birr has
appreciated or equivalently the dollar has deprecated.
To avoid unnecessary confusion the rest of this material will refer to exchange rate as the
price of the foreign currency in terms of domestic currency. That is the price paid in the
home currency for a unit of foreign currency.
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1.2. CHARACTERISTICS AND PARTICIPANTS OF THE FOREIGN

EXCHANGE MARKET
The foreign market is the market in which individuals, firms and banks buy and Sell foreign
currency. The foreign exchange market is a world wide market and is made up of primarily
of commercial banks, foreign exchange brokers and other authorized agents trading in most
of the currencies of the world.
These groups are kept in close and continuous contact with one another through the available
means of communications like, telephone, on line computers, telex and fax and video
conference and the like. The current development in Information Communication
Technology has further made easy the communication among different foreign exchange
participant and economic agents
Among the most important foreign exchange centers are London, New York, Tokyo,
Singapore and Frankfurt.
The most widely traded currency is the US dollar which is knows as a vehicle currencybecause it is widely used to denominate international transaction. Oil and many other
important primary products such as tin, coffee and gold all are priced in dollars However,
since its existence Euro( European currency unit) is becoming attractive and getting wider
range of acceptability as well.
Participants in the Foreign Exchange Market

The main participants in the foreign exchange market can be categorized as follows.
Retail Clients: - These are made up of business investors, multi-national corporations and so
on. These need foreign exchange for the purpose of operating their business. Commonly they
do not directly purchase or sell foreign currency themselves; rather they operate by placing
buy/sell orders with the commercial banks.
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Commercial Banks: The commercial banks carry out buy/sell orders from their retail
clients and buy/sell currencies on their own account so as to alter the structure of their assets
and liabilities in different currencies. Banks may deal either directly with other banks or
through foreign exchange brokers.
Foreign exchange brokers: - Commonly banks do not trade directly with one another, rather
they offer to buy and sell currencies via foreign exchange brokers. Brokers intermediate the
exchange currencies between different clients. The benefits of brokers is that, they collect,
buy and sell order for most currencies from different banks around the world thereby the
most favorable quotation can be obtained quickly and at lower cost.
A small brokerage fee is paid when banks are dealing through a broker which can be avoided
in a straight bank to bank deal. Each financial center has just a few authorized brokers
through which commercial banks conduct their exchange.
Central banks (monetary authority):- The monetary authority of a country can not be
indifferent to change in the external value of its currency, even if exchange rates of the major
industrial nations have been left to fluctuate freely since 1973.
Central banks frequently intervene by buying /selling their currencies to influence the rate at
which their currency is traded. Under a fixed exchange rate system the authorities are obliged
to purchase their currencies when there is excess supply and sell the currency when there is
excess demand.
Bulls, And Bears in the Foreign Exchange Market

Speculators are usually classified as bulls and bears to their views on a particular currency. If
a speculator expects a currency, for example dollar (spot or forward) to appreciate in the
future he is said to be bullish about the currency. Under this condition, it pays the speculator
to take a long-position on the dollar. That is, to buy the dollar spot or forward at cheap price
today in the hope that he can sell it at a higher price in the future.
But if the speculator expects the dollar (spot or forward) to depreciate in the future he is said
to be bearish about the currency in which case it would be better for the speculator to take
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short position on the currency. That is, to sell the dollar at what he believed to be a relatively
high price today in the hope of buying it back at a cheap rate sometimes in the future.
Speculation is the opposite of hedging and it is the act of taking a net asset position (long
position) or a net liability position (short position) in a foreign currency. Speculation means
committing one self to uncertain future value of ones net worth in terms of home currency.
Most of these commitments are based on conscious, expectations about the future prices of
the foreign currency.
Arbitrage in the foreign Exchange market

Arbitrage is the exploitation of price differentials for risk less guaranteed profit. There are
two types of arbitrage, financial center and cross currency arbitrage. To explain these two
forms of arbitrage let us assume that transaction costs are negligible and that there is only a
single exchange rate quotation ignoring the bid off spread.
Financial center arbitrage:- This type of arbitrage ensure that the birr dollar exchange
rate quoted in New York will be the some as that quoted in Addis and other financial centers
(assuming that birr is freely traded currency and Addis is one of the finical centers).
This is because if exchange rate is birr 9.22 in Addis but only birr 9.20 in New- York, it
would be profitable for banks to buy birr in New York and simultaneously sell them in Addis
and make a guarantied profit of 2 cents on every dollar sold and bought. Such process of
buying birr in New York and selling it in Addis continues until the rate quoted in the two
centre concedes to equal level . Such action of buying a currency from a financial center
that offers it at lower rate and selling it at higher rate in other financial centers is called
financial center arbitrage.
Cross Currency arbitrage:- This form of arbitrage can be better explained with the help
of simple and hypothetical example. Suppose the exchange rate of birr is 9.20 birr/1 USD.
And the exchange rate of dollar against Euro is 1.5 USD/1Euro. Currency arbitrage implies
that the exchange rate of birr against Euro will be 13.8 birr/ Euro (1.5 x 9.2). If this were not
the case and the actual exchange rate was for example, 14 birr /Euro, then the US dealer
wanting birr would do better to first obtain Euro with 13.8 birr/Euro (1.5x9.2) which will
then buy birr 14, making 0.2 cents per each Euro sold.
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The increase in demand for Euro would quickly appreciate its rate against the Euro to 1.5217
USD/Euro level at which level the advantage to the US dealer in buying Euro first to then
convert into birr disappears.
1.3. THE SPOT AND FORWARD EXCHANGE RATES.

The exchange rate can be of two types depending on the form of delivery takes place. These
are spot and forward exchange rate.
The Spot Exchange Rate

The spot exchange rate is the quotation between two currencies for immediate delivery. In
other words, the spot exchange rate is the current exchange rates of two currencies vis--vis
each other. In practice, there is normally a two-day lag between a spot purchase or sale and
the actual exchange of currencies to allow for verification, paper work and clearing of
payments. In the spot transaction, the seller of the currency has to deliver the currency he has
sold on the spot, usually with in two days.
The Forward Exchange Rate

Another important market for foreign exchange is the forward market. It is also possible for
economic agents to agree today to exchange currencies at some specified time in the future.
In forward market, the contract is signed and the seller agrees to sell a certain amount of
foreign currency to deliver at future date at a price agreed up on in advance. Analogously, a
buyer agrees to buy a certain amount of a foreign currencies at a future date and at a
predetermine price. The most common forward contracts are 1 month (30 day), 3 months (90
days), and 6 months (180 days). The rate of exchange at which such a purchase or sale can be
made is known as the forward exchange rate.
Why economic agents may engage in forward exchange transaction and how the forward
exchange rate is determined will be discussed below.
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Simple Model of the Determination of the Spot Rate

Since the adoption of floating exchange rate in 1973, there has developed new set of theories
attempting to explain exchange rate behavior, know as the modern asset market approach to
the exchange rate determination
However, in this chapter we will look at a simple model of exchange rate determination
which was widely used prior to the development of these new theories. Despite its short
coming, the model serves as a useful introduction to exchange rate determination and is some
how a prerequisite for understanding of this chapter.
The underlining assumption of the model is that the exchange rate (the price) of a currency
can be analyzed like any other price of commodities with the help of supply and demand
frame work. That is, the exchange rate of the birr will be determined by the intersection of
the supply and demand for birr on the foreign exchange market(if birr was freely traded
currency in major financial markets). Let us briefly look at each of the market forces turn by
turn.
The Demand for Foreign Exchange

The demand for currency in the foreign exchange market is a derived demand. Since we are
not sure that birr is freely traded in foreign exchange market, let us use dollar in stead of birr
for discussion purposes.
Restating the above statement, the demand for dollar is a derived demand It is derived from
the demand for US product. That is, dollar is not demanded because it has intrinsic valve by
itself, but rather because of what it can buy. To derive hypothetical demand for dollar let us
assume that US is exporting country and Ethiopia being importer. Table 1.1 presents the
derivation of a hypothetical demand for dollar schedule with respect to change in the
exchange rate.
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Table 1.1 Demand for dollar
Price of US Export Exchange

rate (2)
good in USD (1)
10
10
10
10
10
10
10
9.20 birr
9.30
9.40
9.50
9.60
9.80
10.00
Price of Us Quantity of Demand

for
export in birr US expert (4) USD(5)=(1) (4)
(3)(1x2)
92
1500
15000
93
1300
13000
94
1100
11000
95
900
9000
96
700
7000
98
500
5000
100
300
3000
As dollar appreciate against birr, that is when it moves from 9.20 to 10 birr, the price of the
US export to Ethiopian importers increase and this leads to a lower quantity of exports and
with it a reduced demand for dollar. Hence, the demand curve for dollar which is shown in
figure 1.1 . slops dawn wards from left to right.
Birr/USD
10
9.5
9.20
D
3000
9000
15000
Quantity US export
Figure 1.1 The demand curve for dollar

In this simple model the demand for dollar depends upon the demand for US export product.
Any factor which results in increase in demand for US exports will result in an increased
demand for dollars and a shift to the right of the demand curve for dollars. Some of the
factors that result in such a shift are
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a change in ETH income
a change in the price of ETH goods (Which can substitute imports from US)
a change in ETH tastes in favor of US goods
All these factors result in an increase or decrease demand for us export and hence dollar and
a shift of the demand schedule either to the right or left.
The Supply of Foreign Exchange

The supply of dollars is similar to ETH or other countries demand for dollars. Table 1.2
presents hypothetical supply of dollar schedule.
As the dollar appreciates the cost of US exports will be higher to Ethiopian importers and
cost of ETH exports becomes cheaper for US residents (Ethiopian products will be come
cheaper to US consumers). As such, they demand more Ethiopias exports (say Coffee ) and
this results in an increased demand for birr which are purchased by increasing the amount of
dollar supplied in the foreign exchange market. This yields an up ward slopping supply of
dollar curve as shown in figure 1.2.
Table 1.2 The supply of dollar.

Price of
ETH export
goods in
birr(1)
Exchange
rate birr
/USD
(2)
Price of ETH export

in USD
(1)
(3)=
(2)
Quantity of
ETH
export
(4)
Demand for
birr (5)
(1)x(4)
Supply of
USD (6)
(5)
100
9.20
10.9
300
30000
(2)
3260.90
100
9.30
10.75
500
50000
5376.34
100
9.40
10.64
700
70000
7446.80
100
9.50
10.53
947.7
947.70
9000.00
100
9.60
10.42
1200
120000
12500.00
100
9.80
10.21
1350
135000
13775.50
100
10.00
10
1500
150000
15000.00
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The supply curve for dollar is depicted using the supply schedule of demand as shown in
table 1.2.
Exchange rate
9.8
9.6
9.5
9.4
9.3
9.2
300
900 9473.7
1500
Quantity of dollar
Figure 1.2 The Supply curve of dollar
The supply of dollar depends up on the US demand for Ethiopian good (in the above
example) .
The supply curve can shift to the right or to the left depending on factors like.
Change in US in come
Change in tastes of US residents
Change in prices of US goods (Which are substitutes or complementary to
Ethiopian export commodities)

All the above factors change may increase or decrease demand for Ethiopian goods and birr
which is reflected in an increased supply of dollar.
Since the exchange market brings together those people that whish to buy currency (which
represents the demand) with those that wish to sell their currency (which represent the
supply) then the spot exchange rate can easily be considered as being determined by the
intersection of the supply and demand for the currency. The following figure (Fig..1.3)
presents the determination of the birr-dollar exchange rates. The equilibrium exchange rate is
represented by the intersection of the supply and demand curve and this yields a birr- dollar
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exchange rate of 9.5 USD. When the exchange rate is made to float freely, it is determined by
the intersection of the supply and demand curve as shown below.
Birr/dollar
9.5
D
Quantity of dollar
9000
Figure 1.3 Determination of birr-dollar sport exchange rate (spot)
Fixed Vs Floating Exchange Rate

At the Breton Wood conference of 1948 the major nations of the western world agreed to a
pegged exchange rate system. Each country fixes its exchange rate against the US dollar with
a small margin of fluctuation around the par value. In 1973 the Breton Woods system broke
down and the major currencies were left to be determined by market forces in a floating
exchange rate world. The basic difference between the two systems can be explained using
the supply and demand frame work.
Floating Exchange- Rate Regime
Under the floating exchange rate regime the authority do not intervene to buy or sell their
currency in the foreign exchange, market rather, they allow the value of their currency to
change due to fluctuations in the supply and demand of the currency, and this is illustrated in
figure below.
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In figure 1.4 ( a) shows how the exchange rate is initially determined by the equality of
demand (D1) and supply (S1) of dollar at the exchange rate of 9.50 birr per dollar.
birr /$
S1
Birr/ $
S1
S2
9.70
. 9.5
D2
D1
Q1 Q2
(a)
QUSD
Q1 Q2
Q USD
(b)
Figure 1.4 floating exchange rate regimes (a) in crease in demand and (b) increase in
supply
If there is an increase in the demand for US exports, there will be a shift in the demand curve
for dollar from D1 to D2 , this increase in demand for dollar will lead to an appreciation of
the dollar from 9.5 say, to 9.70 or depreciation of birr Figure 1.4 (b) shows the impact of
increase in supply of dollar due to an increase demand for Ethiopian export and thus for birr.
The increased supply of dollar shifts the supply curve S1 to the right to S2 , resulting in a
depreciation of dollar from 9.50 to 9.40 .or appreciation of birr In general, the essence of a
floating exchange rate is that the exchange rate adjusts in response to any changes in the
supply and demand for currency.
Fixed Exchange Rate Regime

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In fixed exchange rate regime, exchange rate is fixed by the authorities and can not adjust in
response to the change in supply and demand for currency. Figure 1.5 illustrates the
mechanism of fixing exchange rate.
In figure 1.5 (a) the exchange rate is assumed to be fixed by monetary authorities at the point
where demand intersect the supply curve at birr 9.50. If there is an increased demand for
dollar which shifts the demand curve from D1 to D2, there is a resulting pressure for the
dollar to be revaluated. To control the appreciation of dollar, the National Bank of Ethiopia
will sell Q1 Q2 amount of dollar to purchase birr with dollars in the foreign exchange market.
This save of dollar by National Bank of Ethiopia shifts the supply curve of dollar from S1 to
S2. Such intervention eliminate the excess demand for dollar so that exchange rate will
remain fixed at birr 9.5. This intervention will decrease the amount of birr in circulation and
decreases the National Banks dollar reserve.
Similarly figure 1.5 (b) presents a situation where the exchange rate is pegged by the
National Bank at the point where S1 intersects D1 at birr 9.50 per dollar.
Birr/USD
Birr/ USD
S1
S1
S2
9.5
S2
9.5
D2
D1D2
(a)
Q1 Q2
QUSD
D1
Q1
(b)
Q2 QUSD
Figure 1.5 Fixed exchange rate regime (a) increase in demand (b) increase in supply
If there is an increase in demand for Ethiopian export, there will be an increased demand for
birr and increased supply of dollar which shifts the supply curve to S2. That is excess supply
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of dollar at the prevailing exchange rates and there will be a pressure on the dollar to be
devaluated or domestic currency to be revalued . To avoid this the National (Central) Bank
of Ethiopia has to intervene in the foreign exchange market by purchasing Q1 Q2 amount of
dollar to keep the exchange rate fixed at birr 9.50 per dollar. This intervention is shown by a
right ward shit of the demand curve from D1 to D2 . Such intervention removes the excess
supply of dollar so that the exchange rate remain pegged at birr 9.50 per pound and it leads to
an increase in the Ethiopian National Banks reserves of dollar and in the amount of birr in
circulation.
Forward Exchange Rate and its Determination

The forward exchange-market is a market where buyers and sellers agree to exchange
currencies at some specified date in the future. For example, Ethiopian importer who has to
pay $10,000 to his US supplier at the end of August, may decide on June 1 to buy $ 10,000
for delivery on August 31 of the same year at a forward exchange rate of say birr 9.40 per
dollar. The question that commonly arises is that, why should any one wish to agree today to
exchange currencies at some future date?
To answer this question we need to look at different participants in the forward exchange
market. Traditionally, economic agents involved in the forward exchange market are divided
into three groups based on their motives for participation in the foreign exchange market.
These are
Hedgers
Speculators
Arbitrageurs
Hedger: These are agents (usually firms) that enter the forward exchange market to protect
themselves against exchange rate fluctuation, which entail exchange rate risk.
Exchange risk is the risk of loss due to adverse exchange rate movements. We will explain
why a firm may engage in a forward exchange rate transaction using the following
illustrative example.
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Consider the Ethiopian importer who is going to pay for goods imported from the US to the
value of US $ 10,000 in one year time. Suppose the spot exchange rate is 9.5 birr while the
one year forward exchange rate is birr 9.4. By buying dollars forward at this rate the importer
can be sure that he only has to pay birr 94000. If he does not buy forward today, he might run
the risk that in one years time the spot exchange rate may be higher that birr 9.4 such as birr
9.50 which would mean he has to pay birr 95000. Of course, the spot exchange rate in one
years time may be changed in favor of the importer and may be birr 9.20 in which case he
would only has to pay birr 92000. But by engaging in a forward exchange contract the
importer can be sure of the amount of birr he have to pay for the imports, and therefore can
protect himself against the risk of exchange rate fluctuation.
One may ask why the importer does not immediately by US $10,000 at spot at birr 9.40 and
hold for 1 year. One reason is that he may not at present have the necessary funds for such a
spot purchase and is reluctant to borrow the money, knowing that he will have the funds in
one years time from sales of goods. By engaging in a forward contract he can be sure of
getting the dollars he requires at known exchange rate even though he does not yet have the
necessary birr.
In effect, hedgers avoid exchange risk by matching their asset and liability in the foreign
currency. In the above example, the Ethiopian importer buys 10,000 USD forward (his asset)
and will have to pay 10,000 for imported goods (his liability).
Arbitrageurs:- These are agents (usually banks) that aim to make a risk less profit out of
discrepancies between exchange rates differences and what is know as the forward discount
or forward premium.
A currency is said to be at a forward premium if its forward exchange rates represents an
appreciation as compared to the spot rate quotation. On the other hand a currency is said to
be at forward discount if its forward exchange rate quotation shows depreciations as
compared to its spot- rate quotation.
The forward discount or premium is usually expressed as a percentage of the spot exchange
rate. That is,
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F S
Forward discount/Premium = S
X100
Where F is the forward exchange rate quotation and S is the spot exchange rate quotation.
The presence of arbitrageurs ensures that the covered interest parity (CIP) condition holds
continuously.
CIP is the formula used by banks to calculate their exchange quotation and is given by the
following
(r*r)s
F = (1+r)
+s
Where,
F is the one - year forward exchange rate quotation in domestic currency per unit of
foreign currency,
S is the spot exchange rate quotation in domestic currency, per unit of foreign
currency, r is the one year foreign interest rate and
r* is the one year domestic interest rate
The above formula has to be amended by dividing the three months interest rate by 4 to
determine the three month forward exchange rate quotation and dividing by 2 to calculate
the six moth forward exchange rate.
As an illustrative example of the determination of the forward exchange rate, suppose that
the Euro interest rate is 5%, and the birr interest rate is 3%, and the spot rate birr against Euro
is birr 10 per euro. The one year forward exchange rate can be calculate as follows.
F=
(0.030.05)10
(1+0.05
0.2
+10 => F = 1.05
+10 = 9.81
Forward discount/premium =
9.8110
10
x100=0.019X100 which is nearly 0.02.
The one
year forward rate of euro is at an annual forward discount of 2%.

To understand why covered interest parity (CIP) must be used to determine the forward
exchange rate, consider what would happen if the forward rate was different from that of
calculated in the above example, for example birr 10.1/Euro. In this instance an Ethiopian
investor with birr 1000 could earn 1050 birr at the end of the year, but by buying Euro spot at
birr 10 per euro, and simultaneously selling pounds forward at birr 10.10 at spot exchange
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rate he would buy 100 Euro (1000/10) and will earn 105 at the end of the year at 5% Euro
interest rate (1.05x100=105). Selling 105 at forward rate of 10.1 giving him birr 1060.5
(105x10.1).
Clearly, it pays Ethiopian investor to buy Euro at spot and sell Euro forward. With sufficient
numbers of investors doing this, the forward rate would gradually depreciate until such
arbitrage possibilities were eliminated. With a spot rate of investors doing this, the forward
rate would gradually depreciate until such arbitrage possibilities were eliminated. With a spot
rate of birr 10/Euro, only the forward rate is at 9.81 birr will yield in Ethiopia and in
European Union time deposit be identical (since 105x9.81=1030). Only at this forward rate
there is no risk-less arbitrage profits to be made.
Since the denominator in the above equation is very close to one (unity), the equation can be
modified to yield an approximate expression for forward premium /discount
F =
T hus,
(r* r )s
(1 + r )
F S
5
+ s
= r
(r* r ) S + S 5
S
This approximate version of CLP says that, if the country interest rate is higher than the
foreign interest rate, then its currency be at forward premium by equivalent percentage ;
while if the domestic interest rate is lower than the foreign interest rate, the currency will be
at forward discount by an equivalent parentage. In our example, the Ethiopian, interest rate of
3% less than Euro interest rate of 5% indicate an annual forward discount on Euro of 2%,
which is an approximation to the actual 1.9 percent discount obtained using the full CLP
formula.
Speculators: - speculators are agents that hope to make a profit by accepting exchange rate
risk. They engage in the forward exchange market because they believe that the future spot
rate corresponding to the date of the quoted forward exchange rate will be different from the
quoted forward rate
Consider the situation where the one year forward rate is quoted at birr 9.40/ USD and a
speculator fells that the dollar will be rather birr 9.20 /USD in one years time. In this case he
20
may sell $1000 forward at birr 9.40 so as to obtain birr 9400 one year and hope to change
them back into dollar in one years time at birr 9.20 /USD, and so obtain US $1021.74
making $21.74 profit.
In fact the speculators may be wrong in his expectation and find that in one years time spot
exchange rate is rather above 9.40, say birr 9.50 /USD, in which case his 9400 birr are worth
only 989.47 USD implying a loss of USD 10.53
Generally, speculator hops to make money by taking and open position in the foreign
currency. In our example, he has a forward asset in Birr which is not matched by a
corresponding liability of equivalent value.
The Relation Between Spot and Future Exchange Rate

Why spot and forward exchange rate are different in most cases?
The answer is that, the spot and forward exchange rate should differ by about as much as
interest rate differs in the two countries currencies as explained earlier.
Here is an explanation for difference between spot and forward rates. A country with one
percent higher interest rate will tend to have a one percent forward discount (short fall of the
forward rate below the spot rate) on its currency. In fact, Euro did have a forward discount in
our previous example (and this is a forward premium to birr).
The relationship between spot and forward rate is thus, dictated by the international interest
rate gap. As long as this gap stays the same, the spot and forward rates will keep differing by
the same percentage, and whatever moves the spot rate up and down will do the same to the
forward rate.
Interest rate parity :- The forward exchange value of a currency will tend to exceed its spot
value by as much (in percent) as its interest rate are lower than the foreign interest rate.
For our better understanding how interest rate parity condition works let us have one more
example.
i.
We can convert present dollar into future birr by selling them at the spot
exchange rate (rs, measures birr per dollar) and investing those birr at the
Ethiopian interest rate. In the case future birr per present dollar = rs .(1 + ia) Or
21
ii.
We can convert present dollar into future birr by investing the dollar in US at
the interest rate ib and selling the later earnings right now at the forward
exchange rate rf again measured in birr per dollar.
In this case future birr value per present dollar = (1 + ib).rf
If you can get from present dollar to future birr in either of the two ways, you will take the
more profitable way. But every body thinks the same way. Since investor have choices, the
exchange rates and interest rates will adjust so that the two future dollar values are equal.
That is.
rs .(1 + ia) = (1 + ib).rf or
rf
= (1 + ia ) /(1 + ib )
rs
This is called the interest rate parity condition.
1.4. SUMMARY
As trade among counties (international trade) increases the need the need for foreign
exchange market becomes very important activity of economic agents. Trade with financial
assets always involves the exchange of different national currencies. If the world economy
had a single currency then a foreign exchange market would not exist. The modern foreign
exchange market is truly a global market and is characterized by a large volume of daily
transactions.
Most topics in international finance focuses on the forces that determine exchange rate
movement, and the implication of these movement for trade and economic growth and the
development of the world economy.
Conducting Economic analysis of the effect of
exchange- rate changes, require making distinction between the real and nominal exchange
rate and between bilateral and effective exchange rates depending on the purpose of the
particular analysis being undertaken.
Even if exchange rate may change significantly at time, this is not necessary disruptive to the
international trade as traders can protect themselves against exchange risk by hedging in the
forward exchange market.
For many countries the depreciation / devaluation of their

22
currencies is an important mechanism for maintaining their international competitiveness and

trade volume.
1.5. REVIEW QUESTIONS

1. How do you understand Exchange- rates?
2. What are the major participants of foreign Exchange market and explain their
characteristics?
3. What do you understand by Bulls and Bears in the foreign exchange market ?
4. Explain the difference between the act of speculation and Hedging in the foreign
exchange market ?
5. Explain the difference between financial center and cross-currency arbitrage.
6. What do you understand by spot exchange rate?
7. Explain the essence of determination 7 spot exchange- rate.
8. What is for-ward exchange Rate?
9. What are factors affecting demand for foreign exchange ?
10. What are factors affecting supply of foreign exchange?
11. What are the economic agents participating in the foreign exchange market?
12. Explain the relationship between spot and future exchange rate.
13. Suppose you are a speculator in the foreign exchange market and suppose that Euro can
be purchased sold to day at a for ward rate of 15 birr/ Euro in one Years time and you
expect the spot rate to be 14.5 birr/Euro after one year. If you have 10,000 Euro at hand
today, how can you earn benefit from it?
How would your answer change if the expected spot rate after one year were birr
16/Euro?
CHAPTER II
DETERMINATION OF FLOATING EXCHANGE RATE
23
INTRODUCTION
This chapter presents one of the earliest and simplest models of exchange rate determination
know as purchasing power party (PPP) theory. Common understanding of PPP is essential to
the study of international finance.
In fact this theory has been advocated as an appreciate model of exchange rate determination
for the long-run exchange rate theories. The concept of Purchasing power parity (PPP) is
linked to what we call it the law of one price The purchasing power parity, has its original
date back to nine teeth century by David Ricardo. The basic concept underlying PPP
theory is that arbitrary forces will lead to the equalization of goods prices internationally
once the price of goods are measured in the same currency. As such this chapter presents the
theory of PPP and the application of the law of one price . It also summarizes some of the
problems associated with the concept and with the measurements of PPP.
CHAPTER CONTENT
2.0. Objective
2.1. The law of one price and purchasing power parity
2.1.1. Absolute purchasing power parity
24
2.1.2. Relative purchasing power parity

2.2. The Generalized version of purchasing power parity
2.3. Measurement problems and poor performance of the
theory of PPP.
2.4. Summary
2.5.
Review Question
2.0. OBJECTIVE
At the end of this chapter the reader will be able to.
Explain the law of one price and the concept of purchasing power parity.
Explain the difference between the absolute and relative purchasing power
parities.
Understand generalized version of the purchasing power parity.
Explain the reason why the theory of purchasing power parities perform poorly in
the real world condition
2.1
Explain the problem of measuring purchasing power parity
THE LAW OF ONE PRICE
The law of one price state that in the presence of a competitive market structure and the
absence of transport costs and other barriers to trade, identical products which are sold in
different markets will be sold at the same price when expressed in terms of a common
currency . The law of one price is based up on the idea of perfect goods arbitrage.
Arbitrage occurs when economic agents exploit price differences to provide a risk less profit.
Examples
If a car costs $20,000 in US and the identical model costs birr 180,000 in Ethiopia, then
according to the law of one price the exchange rat should be 180,000/ 20,000, which is birr
9/USD.
25
Suppose the actual exchange rate were higher than this at birr 9.20 /USD, then it would pay
US citizens to buy a car in Ethiopia, because with 19565 USD he can buy a car
(1800,000/9.20) by doing so he will save 435 USD compared to purchasing the car in the US
market.
According to the law of one price, US residents will exploit this arbitrage possibility and start
purchasing birr and selling dollars. Such a process will continue until the birr appreciates to
birr 9/USD at which point arbitrage profit opportunities are eliminated.
Conversely, if the exchange rate is birr 8.50/USD then US car cost the Ethiopian residents
21176 USD if he purchases the car in Ethiopia. But if he purchases in US the Ethiopian
resident may save 1176 USD. Thus, Ethiopian residents will purchase dollar and sell birr
until the dollar appreciates and exchange rate becomes 9 birr/USD.
The proponents of PPP argue that the exchange rate must adjust to ensure that the law of one
price which applies, to individual good, also holds internationally for identical bundles of
goods.
Purchasing power parity (PPP) theory comes in two forms on the basis of strict interpretation
of the law of one price
Absolute purchasing parity
Relative purchasing power parity
2.1.1. ABSOLUTE PURCHASING POWER PARITY (PPP)

This is a strict form of interpretation of the law of one price. In this approach, if one takes a
bundle of goods in one country and compares the price of that bundle with an identical
bundle of goods sold in a foreign country converted by the exchange into a common currency
measurement, then the price will be equal.
26
For example, if a bundle of goods costs birr 20 in Ethiopian and the same bundle costs $2 in
the US, then the exchange rate defined as birr per dollar will be 20 birr/2 USD = birr
10/USD . Algebraically, the absolute version of PPP can expressed as
S= p
p*
Where,
S represents the exchange rate defined by domestic currency units (birr) per unit of
foreign Currency (USD)
P is the price of bundles of goods expressed in the domestic currency ( price in

birr)
P*- is the price of identical bundle of goods expressed in the foreign currency (USD).
According to the absolute PPP a rise in the home price level relative to the foreign price
level will lead to a proportional depreciation of the home currency against the foreign
currency.
In the above example, if the price of Ethiopian bundle of goods rise say to 21 birr while the
price of the same bundle remain unchanged , that is $ 2 then the birr will depreciate to birr
10.5 / USD ( 21/2).
2.1.2. RELATIVE PURCHASING POWER PARITY (PPP)

Many economist are some how skeptical as to the application of the absolute version of PPP,
According to them the absolute version of PPP is unlikely to hold precisely because of the
existence of transportation cost, imperfect information and the distorting effect of tariffs and
other forms of protectionism.
However, it is argued that a weaker form of PPP known as relative PPP can hold even in the
presents of such distortions
In other words, the relative version of the theory of PPP argues that the exchange rate will
adjust by the amount of the inflation differentials between two economies. This can be
expressed as follows
%S = %p p *
27
Where,
% s The percentage change in the exchange rate
% p The percentage change in the domestic inflation rates

*
% P The percentage change in the foreign inflation rate
According to the relative version of PPP, if the inflation rate in the US is 10 percent that of
Ethiopia is 5 percent, the birr per dollar exchange rate should be expected to appreciate by
the approximately 5 percent .
The absolute version of PPP does not have to hold for this to be the case. For example, the
exchange rate may be birr 10/ USD while the Ethiopia bundle of goods costs birr 120 and the
US bundle of identical goods cost, USC 10 so that absolute PPP to hold it would require
(
120
= 12 / US ) . But if Eth price goes up 10 percent to birr 132 and the US bundle of goods
10
goes up 5 Percent to 10.5 USD, the relative version of PPP predicts the birr will deprecate by
5% to birr 10.5 /USD.
2.2. THE GENERALIZED VERSION OF PPP

One of the major problems with PPP is that it is supposed to hold for all types of goods.
However, a more generalized version of PPP provides some useful insights and makes
distinction among goods traded. According to general version of PPP goods can be
categorized into traded goods and non-traded goods.
Traded goods:- These are goods which are susceptible to international competition. Here
belongs most manufacturing goods like.
Automobile
Electronics products and fuels and the like
Non traded goods:- are those that can not be traded internationally at a profit. Their price
will not be affected by the international competition. These includes different goods and
services like
28
Hair cut (hair dressing)
Restaurant food service
Houses
Etc
The distinction between them is due to the fact that the price of traded goods will tend to be
kept in line with the international competition, while the price of non-traded goods will be
determined predominantly by domestic supply and demand considerations.
For instant, if a car costs 15,000 Pound in the UK and $ 30,000 in US arbitrage will tend to
keep the pound-dollar rates at 2 USD/Pound.
However, arbitrage forces do not play a role in the case of house trade. Similarly, if a hair-cut
cost birr 10 in Ethiopia but $10 in US and the exchange rate is birr 10/USD,
No one in the US will travel to the Ethiopia for a haircut knowing that they can save $9
because of the time and transport costs involved.
When aggregate price-indices is determined both tradable and non-tradable are considered.
Assuming that PPP holds for tradable we have the following locations.
pT = spT *
Where,
pT price of traded goods in the domestic country measured in terms of the domestic
currency
pT * the price of traded goods in the foreign country measured in-terms of the foreign
currency.
S - The exchange rate defined as domestic currency units per unit of foreign
currency.
The aggregate price index ( pI ) for the domestic economy is made up of a weighted average
of the price of both tradable ( pT ) and non-tradable goods ( PN ), priced in the domestic
currency. Likewise, the foreign aggregate price index ( ( pI *), is made up of a weighted
average of the prices on tradable ( PN * ) priced in the foreign currency. This is shown as
p I = P N + (1 ) p T ............... (1)
Where, is the proportion of non-traded goods in the domestic price index
29
pI * = PN * + (1 ) PT * .........(2)
Where, is the proportion of non-traded goods in the foreign price index.
Dividing equation (1) and (2) we obtain
PI
PN + (1 ) PT
=
PI * PN * + (1 ) PT *
If we divide the numerator by
pT and the denominator by SPT *
which because of the
assumption of PPP for tradable goods are equivalent expression, we obtain

( PN / PT ) + (1 )
PI
=S
......(3)
PI *
( PN * / PT * ) + (1 )
This can be rearranged, to give the solution for the exchange rate as
S=
PI
( PN * / PI * ) + (1 )
........(4)
PI * ( P / P ) + (1
N
T
The above equation is an important modification to the initial PPP equation. This is because
PPP no longer necessary holds in terms of aggregate price indices due to the terms on the
right hand side. Further more, the equation suggests that the relative price of non tradable
relative to tradable will influence the exchange-rate.
Testing for PPP using price indices based on tradable goods prices is likely to lead to better
results than when using aggregate price indices made up of both types of goods.
2.3. MEASUREMENT PROBLEMS AND POOR PERFORMANCE OF

THE THEORY OF PPP
Many of the proponents of PPP argued prior the adoption of floating exchange rate changes
would be in line with those predicted by the theory of PPP.
30
However, there are problems faced when it is applied practically. One of such problems is
that, whether the theory is applicable to both traded and non-traded goods.
At the beginning PPP seems readily applicable to traded goods. However, some people
argued that the distinction between tradable and non tradable is fuzzy, because in most cases
they are linked to each other. Moreover tradable goods are used as input into the production
of non-tradable goods.
Money researchers have tried to test whether PPP can be used to predict exchange rate or not.
They used graphical evidence, simplistic data analysis and more sophisticated econometric
evidences and the results are summarized as follows.
PPP performs better for countries that are geographically close to one another
and where trade linkages are high
Exchange rates have been much volatile than the corresponding national prices
level. This is against the PPP hypothesis in which exchange rates are only
expected to be as volatile as relative price.
PPP holds better in the long-run than in the short-run.
The currencies of countries with very high inflation rates relative to their trading
partners, mostly likely would experience depreciation reflecting their high
inflation rate. This suggests that PPP is the dominant force in determining their
exchange rate.
Overall , PPP holds better for traded goods than non-traded goods
Strikingly, it was observed that the price of non-traded goods tends to be more
expensive in rich countries than in poor countries once they are converted into a
common currency.
There have been many explanation put forward to explain the reasons for poor performance
of the theory of purchasing power parity. Some of these reasons are,
Statistical Problem,
Transport Costs and Trade Impediment
Imperfect competition
Difference Between capital and goods markets.

31
Productivity Differentials.
Statistical Problems
The theory PPP is based on the concept of comparing identical baskets of goods in two
economies. The problem facing researchers is that different countries usually attach different
weight to various categories of goods and services when constructing their price indices. This
factor is very significant when testing for PPP between developing and developed nations.
People in developing countries usually spend a high proportion of their income on basic
goods like food and clothing, while these take up a much smaller proportion of peoples
expenditure in developed economies.
Transportation Cost and Trade Impediments

Studies by Frenkel (1981) showed that PPP holds better when the countries are
geographically close and trade linkage are high, can partly be explained by transport costs
and the existence of other trade barrier such as tariff.
For example, if a bundle of good costs birr 100 in Ethiopia and $ 10 in US then the PPP
suggests that the exchange rate would be birr 10/USD. If transport costs are birr 20 then the
exchange rate would be between birr 12/USD and birr 8/USD. Without bringing arbitrage
forces in to play. However, since transportation costs and trade barriers do not change
dramatically over time they are not sufficient reason for the failure of the relative version of
PPP .
Imperfect Competition
The main idea behind PPP is that there is sufficient international competition to prevent
major departure of the prices of goods among countries. However, it is know that there are
considerable variations in the degree of competition internationally. In fact these conditions
are necessary for successful price determination.
Difference between Capital and Goods Market
32
Purchasing power parity is based on the concept of goods arbitrage and has nothing to say
about the role of capital movement. Rudiger D. (1976) hypothesized that in a world where
capital market are highly integrated and goods markets exhibit slow price adjustment., there
can be substantial prolonged deviation of the exchange rate from PPP.
The basic idea is that in the short-run good price in both home and foreign country can be
considered as fixed , while the exchange rate adjusts quickly to new information and change
in economic policy , This is the case being exchange rate changes represent deviation from
PPP which can be quite substantial and prolonged .
Productivity Differentials
The other striking result obtained is that when prices of similar basket of both traded and
non-traded goods are converted in to a common currency, the aggregate price indices tend to
be higher in rich countries than in poor countries. In other words, a dollar buys more goods in
say, Ethiopia than in US. The over all higher prices in rich countries is mainly due to the fact
that non-tradable goods prices are higher in developed than in developing countries.
An explanation for the lower relative price of non-tradable in poor countries is due to their
lower labor productivity between developing and developed countries. In other words higher
price of non-traded goods in developed countries is mainly due to their higher labor
productivity in the traded sector as compared to developing countries.
2.4. SUMMARY
When major country abandon fixed exchange rate regime and adopt floating exchange rate, it
was widely believed that the exchange rate would adjust in line with change in national price
levels as provided by PPP theory.
The basic concept underlying PPP theory is that arbitrage forces will lead to the equalization
of goods prices internationally once the price of goods are measured in the same currency.
33
As such the theory represents the application of the law of one price. According to this law in
the presence of a competitive market structure and the absence of transport costs and other
barrier to trade, identical products which are sold in different market will be sold at the same
price when expressed in terms of a common currency.
Purchasing Power Parity theory comes in two forms, relative and absolute PPP. Absolute
purchasing power parity holds that if one takes a bundle of goods in one country and
compare the price of that bundle with an identical bundle of goods sold in a foreign country
and converted into common currency, then the price will be the same (equal) Relative PPP
which is a weaker form of PPP state that the exchange rate will adjust by the amount of the
inflation differential between two counties.
One of the major problems with PPP theory is that it is suggested to hold for all types of
goods. However, the more general version of PPP makes distinction between traded and nontradable goods. By considering these two types of goods the generalized version. suggests to
use the aggregate price index to estimate the exchange rate, tend to be higher in rich
countries than in poor countries. In other words, a dollar buys more goods say, in Ethiopia
than in US. The over all higher prices index in rich countries is mainly due to the fact that
non-tradable goods prices are higher in developed than in developing countries. An
explanation for the lower relative price of non-tradable goods in poor countries is due to their
labor productivity between developing and developed countries.
In other words higher price of non-traded goods in developed countries is mainly due to their
higher labor productivity in the traded sector compared to developing countries

1. Explain the concept of the law of one price.
2. Explain the essence of Absolute purchasing power parity using appropriate example.
3. Suppose one kilogram of coffee costs birr 10 in Ethiopia, 40 shillings in Kenya,
determine the exchange rate defined as birr per Kenyan shelling using Absolute
purchasing power approach .
4. Explain how Relative purchasing power parity differs from Absolute purchasing power
34
Parity!
5. What are traded goods?
6. Explain the importance of traded goods in determining exchange rate.
7. What are problems faced when purchasing power party theory is applied practically.
8. List some of the empirical test results concerning the applicability of PPP to predict
exchange rates.
9. The poor performance of purchasing power parity in predicting exchange rate has been
explained by many factors. Explain them.
CHAPTER III
BALANCE
OF
PAYMENT
AND
NATIONAL
INCOME
ACCOUNT
35
INTRODUCTION
The Balance of payment accounts are an integral part of the national income account for an
open economy. Balance of payment is one of the most important economic indicators for
policy-makers in the open economy. The balance of payment (BP) records all transactions
among residents of different counties are broadly interpreted as all individuals, business, and
governments and their agencies, international organizations are also included as well.
What is happening to a countrys balance of payment often captures the news headlines and
can become the focus of attention particularly in most industrialized countries. A good or a
best set of figures can have an effect on the exchange rate and can lead policy-makers to
change their economic policy. BP deficit may lead to the government raising interest rater or
reducing public expenditure to reduce expenditure on imports. Deficit may also lead to
protectionism against foreign imports or capital controls to defend the exchange rate.
Before, considering various policy options to deal with the perceived problems in the balance
of payments, we need to consider what the balance of payment figure are and what is meant
by the notion of a surplus or deficit. This chapter will try to look at the components of
balance of payment, how they are compiled and interpretation of different statistical figures.
CHAPTER CONTENT
3.0. Objective
3.1. What is Balance of Payment?
3.2. Balance of payment Account
3.2.1. The Current Account Balance
36
3.2.2. The Capital Account Balance

3.2.3. The Official account Balance
3.3. Record of Transactions in the Balance of payment
3.4. What is a Balance of Payment Surplus or Deficit?
3.5. Alternative Concept of Surplus and Deficit
3.6. The Link between Current Account and the National Income
Account, (Open Economy Identity)
3.7. Summary
3.8. Review Question.
3.0. OBJECTIVE
At the end of the chapter students will be able to
Define balance of payment
Explain the balance of payment account
Differentiate the components of the balance of Payment
Understand the basic operations of balance of payment
Understand the meanings of balance of payment surplus and deficit
Explain the link between the current account and the national income account
3.1. WHAT IS BALANCE OF PAYMENT?

The Meaning of Balance of Payment
Balance of payment is a statistical record of all the economic transactions between the
residents of the reporting country and residents of the rest of the world during a several time
period. The usually reporting period for all the statistics included in the account is a year.
However, some of the statistics are published more regularly on monthly or quarterly basis.
37
The balance of payment is one of the most important statistical statements for any country. It
reveals how many goods and services the country has been exporting and importing and
whether the country has been borrowing or lending money to the rest of the world. In
addition, whether or not, the monetary authority ( National Bank ) has added to or reduced
its reserves of foreign currency is reported in the statistics. It is important to note that
citizenship and residency are not necessarily the same from the view point of the balance of
payments statistics.
Thus, a key definition that needs to be resolved at the outset is that a domestic and foreign
residents.
The term residents refers to individuals, house holds, firms and the public authorities. The
problem arising from the definition of residents is those multinational corporations are by
definition resident in more than one country.
For the purpose of balance of payment reporting, the subsidiaries of a multinationals are
treated as being residents in the country in which they are located even if their share are
actually owned by foreign residents. Another distinction regarding the treatment of
international organizations such us, the International Monetary Fund, the World Bank,
United Nations and the like, these institutions are treated as being foreign residents even
though they may actually be located in the reporting country. Tourists are regarded as being
foreign residents if they are in the reporting country for at less than a year.
Collection, Reporting of the Balance of Payment

The balance of payments statistics record all of the transaction between domestic and foreign
residents, be they purchases or sales of goods, services or of financial assets such as bonds,
equities and banking transactions.
Reporting figures are usually in terms of the domestic currency of the reporting country. The
authorities collect their information from the custom authorities, survey of tourist numbers
and expenditure, and data on capital in-flow outflow is obtained from banks, pension funds,
38
multinationals and investments houses. The responses from different sources are compiled by
government statistical agencies.
3.2. BALANCE OF PAYMENT ACCOUNTING

An important point about balance of payment statistics is that in an accounting sense they
always balance. This is because they are based up on the principle of double-entry bookkeeping. Each transaction between domestic and foreign residents has two sides to it, a
receipt and payment, and both these sides are recorded in the balance of payment statistics.
Each receipt of currency from residents of the rest of the world is recorded as a credit item
(carries a plus in the account) while each payment to residents of the rest of the world is
recorded as a debt item (carries a minus in the accounts).
Components of Balance of Payment

Before considering some examples of how different types of economic translations between
domestic and foreign residents get recorded in the balance of payment, we need to consider
the various sub-accounts (components) that make up the balance of payment.
Traditionally, the statistics are divided into two main sections, the current account and the
capital account. Each of them can be further subdivided. The explanation for division into
these two main parts is that the current account refers to income flows, while the capital
account records change in the assets and liabilities.
Example of a simplified annual balance of payment for Europe as a whole is presented in
table 3.1
Table 3.1. Balance of payment of Euro land
Current Account
1. Export of goods
+150
2. Import of goods
- 200
3. Trade balance
- 50
4. Export of services
+ 120
(1+2)
39
5. Import of services
- 160
6. Interest, profit and Dividend received
+ 10
7. Interest, profit and dividend paid
-10
8. Unilateral receipts
+30
9. Unilateral payment
-20
10. Current Account balance
-70 (sum 3-9)
Capital Account
11. Investment abroad
-30
12. Short term lending
-60
13. Medium and long term lending
-80
14. Repayment of borrowing than Row
-70
15. Inward foreign investment
+170
16. Short-term borrowing
+40
17. Medium and long-term borrowing
+30
18. Repayment on loans received from Rest of the world
+50
19. Capital Account Balance
+50 (sum (11-18)
20. Statistical Error
+5 (zero minus (10+19+24)
21. Official settlement balance
-15 (10 + 19+ 20)
22. Change in reserves rise (-) fall (+)
-10
23. IMF borrowing from (+) repayment to (-)
-5
24. Official financial balance
+15 (22+23)
The Trade balance

The trade balance some time referred to as the visible balance because it represents the
difference between receipts from export of goods and expenditure on imports of goods which
can be visibly seen crossing frontiers.
The receipts for exports are recorded as a credit in the balance of payment, while the
payment for import is recorded as a debit. When the trade balance is in surplus this meant
40
that a country has earned more from its exports of goods than in has paid for its imports of
goods.
3.2.1 THE CURRENT ACCOUNT BALANCE

The current account balance is the sum of visible trade balance and the invisible balance. The
invisible balance shows the difference between revenue received from export of services and
payment made for imports of services such as
Shopping,
Tourism
Insurance and Banking
Transport
In addition receipts and payments of interest, dividends and profits are recorded in the
invisible balance as they represent the rewards for investment in overseas companies, bonds
and equities. Payment represents the reward to foreign residents for their investment in the
domestic economy.
From table 3.1 we can observe an item called unilateral transfers included in the invisible
balance. These are payment or receipts for which there is no corresponding transaction or
activity. Examples of such transactions are migrant workers remittances to their family back
home, the payment of pensions to foreign residents, and foreign aid. Such receipts and
payments represent a redistribution of income between domestic and foreign residents. A
unilateral payment can be considered as a fall in domestic income due to payment to
foreigners and so are recorded as a debit, while unilateral receipts can be viewed as an
increase in income due to receipts from foreigner and consequently are recorded as credit .
3.2.2. THE CAPITAL ACCOUNT BALANCE
The capital account records transactions concerning the movement of financial capital into
and out of the country. Capital comes into the country by borrowing, sales of foreign assets
41
and investment in the country by foreigners. These items are referred to as capital in flows
and are recorded as credit items in the balance of payment.
Capital inflows are a decrease in the countrys holding of foreign assets or increase in
liabilities of to foreigners. Usually capital inflows are recorded as credit in the balance of
payment - it presents some confusion to many readers.
The easiest way to minimize this problem is that to think of investment by foreigners as
export of equity or bonds and sales of foreign investment as an export of those investments to
foreigners.
Capital leaves the country due to lending, buying of overseas asset, and purchase of domestic
assets owned by foreign residents. These items are recorded as debits as they are represent
the purchase of foreign bonds or equities, and the purchase of investment in the foreign
country.
Items in the capital account are normally classified on the basis of their origin as private or
public sector. On the basis of the time period the capital account items are classified as
short-term or long-term capital items. The summation of the capital inflows and outflows are
recorded in the capital account gives the capital account balance.
3.2.3 OFFICIAL SETTLEMENTS BALANCE

Due to huge statistical problems involved in compiling the balance of payment statistics,
there will be a discrepancy between the sums of all the items recorded in the account. To
ensure that the credits and debits are equal, it is necessary to incorporate a statistical
discrepancy for any difference between the sum of credit and debits.
42
There are different sources of such error. One of the most important is that it is impossible to
keep record of all the transactions between domestic and foreign residents, many of the
reported statistics are based on sample estimate derived from separate sources; as a result
some errors are unavoidable. Another problem is that due to the desire to avoid taxes some of
the transactions in the capital account are under reported. Moreover, some dishonest firms
may deliberately under invoice their exports and over invoice their imports to artificially
deflate their profit.
The balance of payments records receipts and payments for a transaction between domestic
and foreign countries, but most of the time goods are imported but the payment delayed.
Since the import is recorded by the customs authority and the payment by banks, the time
discrepancy may mean that the two sides of the transaction are not recorded in the same set
of figure.
The summation of the current balance, capital account balance, and the statistical discrepancy
gives the official settlements balance. The balance on this account is important because it
shows the money available for adding to the countrys official reserves or paying off the
countrys official borrowing. The central bank normally holds a stock of reserves made up of
foreign currency assets like different government Treasury-Bills (T-bills).
Such reserves are held primarily to enable the central bank to purchase its currency in order
to prevent the depreciation of its currency.
Any official settlements deficit has to be covered by the authorities drawing on their reserves,
or borrowing money from foreign central banks or from the IMF (recorded as plus in the
account).
If, on the other hand, there is an official settlement surplus then this can be reflected by the
government increasing official reserves or repaying debts to the IMF or other sources (a
minus since money leaves the country).
Reserve increases are recorded as a minus, while reserve fall are recorded as a plus in the
balance of payment statistics. Such recording is a source of confusion for many students. For
better understanding we can think that reserves increase when the authorities purchase
foreign currency.
43
3.3. RECORD OF TRANSACTIONS IN THE BALANCE OF PAYMENT

To understand exactly why the sum of credits and debits in the balance of payment should
sum to zero we consider some examples of economic trisections between domestic and
foreign countries
There are basically five types of such transactions that can take place. These are
i.
Exchange of goods/services in reform for a financial asset.
ii.
An exchange of goods/services in return for other goods/ services
iii.
An exchange of a financial item in reform for a financial item
iv.
A Transfer of goods or services with no corresponding transaction (aid (frod or

military) )
v.
A unilateral transfer of financial asset with no corresponding transaction.
Let us look at how each transaction is recorded twice once as a credit and once as a debit.
Consider the case of different types of trisections between two countries, USA and UK
residents and table 3.2 shows how each transaction is recorded in each of the two countries
balance of payment. The exchange rate between these two countries at the time of transaction
was $ 1.60 /pound. Since each credit in the accounts has a corresponding debit elsewhere, the
sum of all items should be equal to zero.
This by itself raises the question as to what is means by a balance of payments deficit or
surplus.
Table 3.2 Example of balance of payment account as provided by Pilbeam (1998)

US balance of payment
UK balance of payment
Current Account
Current Account
Export of goods
+ 80 m
Import of goods -50m
Capital Account
Reduced US bank liability 80 m
44
Example 2 :- The US exports $ 1000 of goods to the UK in exchange for $1000 of services
US Balance of payment
UK Balance of payment
Current account
Current Account
Export of goods
+$ 1000
Import of goods - 625
Import of services
-$ 1000
Export of services + 625
Example 3:- A US investor decides to buy 500 of UK T- bills and to pay for them by
debiting his US bank account and crediting the account of the UK T-bill held
in New York
Capital Account
Capital Account
Increase in UK T-bills holding - $ 800
- Increase UK liability + 500 US
Increase in US liability
resident
+$ 800
- Increase in US T-bill holdings - 500

Example 4- The US makes gift of $ 1.6 million of goods to a UK charitable organization
US Current Account
UK Current Account
Export + $ 1.6 million
Import - 1 million
Unilateral Transfer -$1.6 million
Unilateral receipt + 1 million
Example 5:- The US pays interest, profit and dividend to UK investor of $ 80 million by
debiting US bank account which are then credited to UK resident bank

account held in US
UK current account
Current Account
Current Account
Interest, profit, dividend
Interest, profit, dividend
Paid -$ 80 m
receipts + 50m
45
US Capital account
UK Capital account
Increased US bank liability + 80 m
Increased US bank deposit - 50m
3.4. WHAT IS A BALANCE OF PAYMENT SURPLUS OR DEFICIT?

As we have seen in table 3.2, the balance of payment always balances, since each credit in
the account has a corresponding debit. However, this does not mean that each of the
individual accounts that make-up the balance of payment is necessarily in balance. For
instance the current account can be in surplus while the capital account is in deficit.
Economist make a distinction between autonomous (above line item) and accommodating
(below the line) items. The autonomous items are transactions that take place independently
of the balance of payments. While accommodating items are those transactions which
finance any difference between autonomous receipts or payment.
Surplus in the balance of payment is defined as excess of autonomous receipts over
autonomous payment. The deficit is an excess of autonomous payment over autonomous
receipts. That is,
Autonomous receipts > Autonomous payment = Surplus
Autonomous receipts < autonomous payment = Deficit
The major issues raised here is that which items are categorized in autonomous and which
one in a commendation items. There is no agreement among economists as to the
classification of items in to autonomous and accommodating category. Disagreement on
which items qualify as autonomous and which are not leads to alternative views on what
constitute a balance of payment surplus or deficit. Here under some of the most important of
these concepts are reviewed.
3.5. ALTERNATIVE CONCEPTS OF SURPLUS AND DEFICIT
46
The Trade Account and the Current Account

The trade account and the current accounts are very important indicators and their estimates
are published on a monthly basis by most developed countries. Since the current account
balance is concerned with visible and invisible (services), it is generally considered to be
more important of the two accounts. The current account surplus and deficit is important
economic indicator because a surplus means that the country as a whole is earning more than
its spending against the rest of the world and hence increasing its stock of claims on the rest
of the world where as deficit means that the country is reducing its net claims on the rest of
the world.
Furthermore, the current account can readily be incorporated into economic analysis of an
open economy. Generally the current account is likely to quickly pickup changes than any
other economic variables such as changes in the real exchange rate domestic and foreign
economic growth and price inflation
The Basic Balance

The basic balance is the current account balance plus the net balance on long-term capital
flow. It was argued that any significant change in the basic balance must be a sign of a
fundamental change in the direction of the balance of payments. The more volatile elements
such as short-term capital flows and changes in official reserves were regarded as below the
line items.
Although a worsening of the basic balance is considered as a sign of a deteriorating
economic situation, having an overall basic balance deficit is not necessary bad thing
For Example, a country may have a basic balance deficit that is caused by a large long -term
capital out flow so that the basic balance is in a large deficit. However, the capital outflow
will yield future profits, dividends and interest receipts that will help to generate future
surplus on the current account
47
Conversely, a surplus in the basic balance is not necessarily a good thing. A current account
deficit which is covered by a net capital inflow so that the basic account is in surplus could
be open to two interpretations.
It might be argued that because the country could borrow long-run there is nothing
i.
to worry about since it is regarded as viable by those foreigners who are prepared to
lend it money in the long-run.
ii.
It could be argued that the basic balance surplus is a problem because the long-run
borrowing will lead to future interest, profits and dividend payment which will
worsen the current account deficit.
Apart from interpretation, the principal problem with the basic balance concerns the
classification of short-term and long-term capital flows. The usual way of classifying longterm loans on borrowing is that they should be at least 12 months of maturity.
However, many long-term capital flows can be easily covered in to short term flows if need
be. For example purchase of a five year US treasurer bond by a UK investor could be
classified as a long-term capital outflow in the UK balance of payment and long-tern capital
in flaw in the US balance of payment. However, the UK investor could very easily sell the
bond back to US investors any time before its maturity date. Similarly many short-term items
which is less than 12 months can get renewed and it will become long-term asset.
The official Settlement Balance

The Official settlement balance focuses on the operations that the monetary authorities have
to finance any in balance in the current and capital accounts. With the settlement concept, the
autonomous items are all the current and capital account transactions including the statistical
error, while the accommodating items are those transactions that the monetary authorities
have undertaken as indicated by the balance of official financing. The current account and
capital account items are all regarded as being induced by independent, households, and
48
firms, central and local government and are regarded as the autonomous items. If the sum of
the current and capital account is negative the country can be regarded as being in deficit as
this has to be financed by the authorities drawing on their resources of foreign currency,
borrowing from foreign monetary authorities or from the IMF.
The Official settlement concept of a surplus or deficit is not as relevant to countries that have
floating exchange rate as those countries with fixed exchange rates. This is because if
exchange rates are left to float freely the official settlement balance will tend be zero because
the central authorities neither purchase nor sell their currency, and so there will be no
changes in their reserves. If the sales of a currency exceed the purchases then the currency
will depreciate. If the sales are less than the purchase the currency appreciates.
The settlement concept is, very important under fixed exchange rates because it shows the
amount of pressure on the authorities to devalue or revalue their currencies. Under fixed a
exchange-rate system a country that is running an official settlement deficit will find that
sales of its currency exceed purchases and to avert a devaluation of the currency authorities
have to sell reserves of foreign currency to purchase the home currency. On the other hand,
under floating exchange rate and no intervention of the official settlement balance
automatically tends to be zero as the authorities do not buy or sell the home currency since it
is left to appreciate or depreciate.
Even in a fixed exchangerate regime the settlement concept ignores the fact that the
authorities have other instruments available with which to defend the exchange rate, such as
capital controls and interest rates. Also it does not reveal the real threat to the domestic
currency and official reserves represented by the liquid liability held by foreign residents
who might switch suddenly out of the currency.
Although in 1973 major industrialized countries changed their exchange rate system to
floating exchange-rate system, many developing countries continue to peg their currency to
the US dollar and consequently attach much significance to the settlement balance.
Industrialized countries also continue to intervene in the foreign exchange market to
49
influence the value of their currencies; the settlement retains some significance and news
about changes in the reserves of the authorities give a valuable information to foreign
exchange dealers
The IMF provides an annual summary of the balance of payments statistics using these
alternative concepts of balance of payment disequilibrium. The summary of key concepts of
balance of payment is presented in table 3.3
Table 3.3 Summery of key concepts of balance of payment as provided by IMF
Trade Balance
+
Export goods
Impart goods
Trade balance
Current Account Balance

50
Trade balance
+
Export of servile
Interest, dividend, and profit received
Unilateral & receipts
Imp of services
Interest, dividend and profit paid
Unilateral payment abroad
Current Account balance
Basic Balance
Current Account Balance

+
Balance of Long-term capital account
Basic Balance
Official Settlements Balance

Basic Balance
+
Balance on short-term capital account
Statistical error
Official Settlement Balance.
3.6. THE LINK BETWEEN CURRENT ACCOUNT AND THE

NATIONAL INCOME ACCOUNT (OPEN-ECONOMY IDENTITY)
So far we have tried to look at the balance of payment statistics. We now proceed to
analyze how the current account is an integral part of the national income accounts.
51
In an open economy the Gross Domestic product (GDP) is different from that GDP of closed
economy. This is because in an open economy there is an additional injection -export which
represents foreign expenditure on domestic goods and services. There is also an additional
leakage called expenditure on imported goods and services. The identify of an open economy
is given by
Y=C+I+G+X-M .. (3.1)
Where,
Y is national income (GDP),
C is domestic consumption,
I is domestic investment,
G is government expenditure,
X is export and
M import expenditure
If we deduct taxation from the national income we get disposable income which is given by
Yd= C+I+G+X-M-T . (3.2)
Where,
Yd is disposable income and
T is tax payment
If we denote private savings as

S= Yd-C .... (3.3)
S = Yd C
Rearranging equation 3.2 we obtain the following relations,
Yd-C-I+T-G= (X-M) . (3.4)
This can be further rearranged as,
(X-M)
(S-I)
(T-G) ... (3.5)
Current
Net saving/
Government fiscal
Account
dis-saving of private sector
deficit /surplus
Where S=Yd - C
52
Equation 3-5 is an important identity of an open economy. It says that a current account
deficit has a counterpart in either private dis-saving that is private investment exceeding
private saving and /or in government deficits that is government expenditure exceeding
government taxation revenue .The equation is merely an identity and says nothing about
causation.
However, it is often argued that the current account deficit is due to the lack of private
savings and/or the government budget deficit. But it is also possible that it can be interpreted
the other way round. That is, the current account deficit can be responsible for the lack of
private saving or budget deficit. Equation 3.5 can also be rearranged as follows.
I+G+X = S+T+M . (3.6)
This shows that the equilibrium level of national income is determined where injunction (the
variables on the left had side) are equal to leakages (the variable on the right and side) of
equation (3.6) .
Injunctions are all those factors that work to raise national income, where as leakages are
those factors that work to lower it.
Open Economy Multiplier

The use of multiplier analysis was first developed by John Maynard Keynes in his work
called the general theory of employment, interest rate and money. In his work he has tried to
examine the effect of change in government expenditure and investment on output and
employment.
However, his work was only confined to a closed economy. Nonetheless the idea of Keynes
was applied to the analysis of open economy. The underlying assumptions in the analysis are:
Domestic price and the exchange rates are fixed
The economy is operating at less than full employment so that increases in

demand result in an expansion of output.
The authorities adjust the money supply to changes in money demand by pegging
the domestic interest rate. This assumption is important, because increases in
output that lead to a rise in money demand with a fixed money supply would lead
53
to a rise in the domestic interest rate. This assumption implies that the authorities
passively expand the money stock to meet any increase in money demand so that
interest rates do not have to change. There is no inflation resulting from the
money supply expansion because it is a response to the increase in money demand
The starting point for analysis is the identity of equation (3.1) given below as (3.7)
Y=C+I+G+X-M (3.7)
Government expenditure and exports are assumed to be exogenous. Government expenditure
is determined independently by political decision where as export is determined by foreign
expenditure decision and the level of foreign income. This is algebraically given by,
C=Ca+cY...(3.8)
Where,
Ca represents autonomous consumption and
- is the marginal propensity to consume, i.e., the fraction of any increase in
income that is spent on consumption (
dc
)
dy
In other words marginal propensity to consume tell us by how much proportion consumption
increases/decreases when income increase/ decrease. In this simple model consumption is
assumed to be a linear function of income.
An increase in consumer income induces an increase in their consumption. Import
expenditure is assumed to be partly autonomous and partly a positive function of the level of
domestic income.
M=Ma+mY ..(3.9)
Where,
Ma is autonomous import and
m is the marginal propensity to import, that is, the fraction of any increase in
income that is spent on import (
dM
)
dY
54
In this simple formulation import expenditure is assumed to be a positive linear function of

income. Import expenditure and income are positive related for reasons that increased in
income increases demand for imported good and also increased domestic production
normally requires more import of intermediate goods.
Since we have assumed that domestic prices are fixed , this means that income, Y represents
real income. If we substitute equation (3.8) and (3.9) in to equation (3.7) we obtain,
Y = Ca + cY + I + G + X Ma mY this can be rearrangedas
Y CY + mY = Ca + I + G + X Ma
Y (1 c + m) = Ca + I + G + X Ma.............................(3.10)
.
The term (1-c) is equal to the marginal propensity to save s , that is fraction of any increase
in income that is saved, then we obtain.
Ca + I + G + X ma
1
=
(Ca + I + G + X Ma )
s + m.
s+m
1
Thus, Y =
(Ca + I + G + X Ma )....................(3.11)
s+m
Y=
The Effect of Government Expenditure (G) on income (Y)

From equation (3.11) we can derive the multiplier of government expenditure (G). This is,
just like determining change in income (Y) due to small change in government expenditure .
This is given by
y
1
=
> 0...............................................(3.12)
G s + m
From equation (3.12) we can learn that an increase in government expenditure will have an
expansionary effect on national income. The size of this effect depends up on the marginal
55
propensity to save and to import. Since the sum of these is less than one, an increase in
government expenditure will result in a greater increase in national income.
3.1. Example
Suppose the marginal propensity to save in Eth is 0.2 and the marginal propensity to import
is 0.3. The effect of an increase in government expenditure of birr 100 on the national income
can be seen as
Given,
G = 100 bill
S= 0.2
M=0.3
Y
1
=
G s + m
1
Y = (
)G
s+m
1
Y = (
)100 nill
0.2 + 0.3
Y = 2 x100 bill
birr 200 bill
An increase in government expenditure of birr 100 billion will raise eventually the national
income by 200 billion birr.
The Effect of Export on National Income

Using the same simple model we can also determine the foreign trade multipliers or export
multiplier to see the effect of change in export on the countrys national income.
We can easily see that the multiplier effect of an increase in exports is identical to that of an
increase in government expenditure as is given by y = 1
( s + m)
x
56
In practice the government expenditure is more biased to domestic output than private
consumption expenditure, implying that the value of m is smaller in the case of the
government expenditure multiplier than in the case of export multiplier. This means an
increase in government expenditure will have a more expansionary effect on domestic output
than an equivalent increase in export.
Example 3.2
Assume that the marginal propensity to save is 0.2 and marginal propensity to import is 0.3.
The effect of increase in export of birr 100 bill on national income is given by,
y 1
1
=
y = (
) x100 bill = 2 x100 bill
+
s
m
(
)
x
0.2 + 0.3
y = 200 bill.
The effect of change in either government expenditure or increase in export is graphically

shown in figure 3.1 below. On the vertical axis are injection /leakages, and on the horizontal
axis is national income (y). The saving plus import expenditure are assumed to increase as
income increases - reflected by the upwards slope of the injection schedule. Since, the sum of
the marginal propensity to save and import is less than one, this schedule has a slope less
than one. Injections are assumed to be exogenous of the level of income; its schedule is a
horizontal line.
S+m
(s+m)2
(s+m)
s+m
(G+I+X)2
(G+I+X)1
57

Income
0
Y1
Y2
The equilibrium level of national income is determined by the equality of injection (G+I+X)
and leakage (STM) , which is initially at income level Y1. An increase in either government
expenditure, investment or export result in an upward shift of the injection schedule from
shift of the injection schedule from (G+I+X)1 to (G+I+X) 2 , and this rise in income induces
more saving and import expenditure but over all the increase in income from Y1 and Y2 is
greater than the initial increase in injection.
Note that the lower are the marginal propensity to save and import, the less steeper will be
the leakage schedule and the greater will be the increate in income.
The Current Account Multipliers (The Effect of Change in the Economic

Variable on the Current Account)
The effect of an increase /decreases in government expenditure and export on the current
account balance can be obtained by rearranging the equation of the initial open economy
identity, i.e.
Y C I G + M X = 0
Substituting equation (3.8) and 3.9) yields

Y-cY+mY- Ca+Ma-I-G-X=0
This can be written as ,
Y(1-c+m)-Ca+Ma-I-G-X= 0
Since Y (1-c+m)=Y(s+m) Hence, 1-C is marginal propensity to consume S=(1-C).

Then we have the equation
Y(s+m)-Ca+Ma-I-G-X=0
58
Multiplying both side by m/s+m yields,
s+m
(Ca Ma + I + G + X = 0
If we add both right and left hand side Ma and X, recalling that M=Ma+mY , and rearranging
we obtain the following equation.
X- M = X-Ma- m
stm
(Ca Ma + I + G + x)........(3 13)
We know that X-M = CA

Thus,
CA = X - Ma-
M
(Ca Ma + I + G + X )..........(3.14)
s+m
Using equation (3.14) we can derive the effect of change in the government expenditure on
the current account balance, which is given by,
CA m
=
s+m
G
, and this is less than zero
This can be interpreted as an increase in government spending leads to a deterioration of the

current account balance which is some fraction of the initial increase in government
expenditure. This is because economic agents spend part of the increase in income on
imports. In other words, an increase in government purchases increases national income, and
the increase in income leads to high import demand as there is a positive relation between
import demand and national income.
Example 3.3
Suppose that the marginal propensity to save is 0.2, and the marginal propensity to import is
0.3. The effect of an increase in government expenditure of $100 bill birr on the current
account balance can be determined as follows.
59
CA M
=
G s + m
and change in CA is then CA =
M
G.
s+m
0.3
CA =
x100 bill
0.5
CA = 0.6 x100 = 60 bill.birr

An increase in government expenditure leads to an eventual decrease in the current account
by 60 mill birr. The reason is that the increased government expenditure of birr 100 billion
because of the open economy multiplier increased national income by birr 200 billion. Since
the marginal propensity to import (m) is 0.3, the birr 200 bill increase in income leads to a
0.3x200 bill = 60 billon increase in imports which corresponds to the deterioration in the
current account balance.
The other variable that affects the current account is the change in exports. The effect of
export on the current account can be determined from the same equation (3.14) and is given
by
CA
m
= 1
, Which is greater than zero. This can be simplified as
x
s+m
CA
S
=
>0
x s+m
Since
S
is positive but less then one, an increase in export leads to an improvement in
s+m
the current account balance by a magnitude less than the initial rise in export. The
explanation for this is that part of the increase in income resulting from the additional exports
is offset by increase expenditure on import.
Example 3.4
Assume that the marginal propensity to save is 0.2 and the marginal propensity to import is
0.3. The effect of an increase in exports of birr 100 billion can be obtained.
60
S
xX
s+m
0.2
x100 bill
CA =
0.5
CA = 40 billion
CA =
The birr 100 billion increases in export initially improve the current account by birr 40
billion. However, it also generates an eventual increase of national income by birr 200 billion
which induces an increase in import of 60 billion, so the net improvement in the current
account is limited to birr 40 billion.
The simple multiplier analysis discussed in this part shows the Keynesian income effects are
an essential part of balance of payments analysis and that the current account part of the
balance of payment is an integral part of macroeconomic equilibrium for an open economy.
An important point here is that an analysis of macroeconomic fluctuation for an open
economy requires consideration of what is happening in foreign economies ; increase foreign
income raise the exports and income of the home economy.
3.7. SUMMARY
In this chapter we have seen different concepts of balance of payments. The very important
fact is that there is no single agreed- upon definition (concept) of balance of payment. The
choice of which concept is most relevant depends up on the exchange rate regime and the
particular purpose of the analysis being undertaken.
Each of the concepts has different information content and taken together they provide an
important indicator about the macro-performance of an open economy.
In the short-run, the trade and current account balance capture the attention of policy makers
as they are published so frequently. An important thing that we need to know is that it is
necessary to bring in a time dimension when we analyze the balance of payment statistics.
A deficit is not necessarily a bad thing if it is likely to be followed by future surpluses. It can
be argued that it is necessary to look at the composition of goods that a country is importing.
If the imported goods are predominantly consumers goods like cars, and consumers
61
electronics, then it can be viewed that the deficit is worrying than when the imports are plant
and machineries that could be important in generating future export.
Another important point that has to be considered is that weather the current account surplus
or deficit is significant problem or not, weather the country concerned is a net creditor or
debtor against the rest of the world. A current account deficit means that the country is
increasing its indebtedness or reducing it claim on the rest of the world. If the country is a net
creditor it can usually afford to do this. Where as if the country is a net debtor the deficit may
be regarded as a more serious problem. In the balance of payment analysis we need also to
look at the potential causes of the current account deficit or surplus. If the country has a large
deficit due to a large government budget deficit, then the remedy may be reducing
government expenditure and/or raising taxes. If the deficit is due to high investment then
there is a good chance that future export growth will reduce the deficit and corrective policy
action may not be necessary.
Finally, when analyzing a balance of payments statistics and assessing whether the country is
facing or is likely to face problems in the near future, it is important to remember that
whatever concept of the balance of payment disequilibrium is used, it gives only a partial
view of the economy.
If a country has a current account deficit, high inflation, and low economic growth then the
balance of payment problem is more worrying than if the deficit is accompanied by high
economic growth and low inflation
3.8. REVIEW QUESTION

1. What is meant by balance of payment? What purpose does it serve?
2. Which of the following transaction would contribute to Ethiopia current account balance
of payment ;
62
a. Ethiopia borrows $100 million long-term from Sudan buy $ 100 million of Sudan
oil.
b. The Ethiopia sells a birr 100 mill coffee for the same amount in bank deposit
c. The Ethiopian government in the form of deposit
3. What are the possible interpretations of surplus in basic balance?.
4. Explain the meanings of official settlement balance!
5. What do we mean by the balance of payment disequilibrium/equilibrium?
6. How do we know whether a countrys balance of payment is in equilibrium or not ?
7. Show the links between current account and the national income!
8. Suppose that the marginal propensity to save is 0.15 and marginal propensity to import is
0.3 what is the effect of increase in export by birr 50 billion on national income?
CHAPTER IV
THE THEORY OF BALANCE OF PAYMENT

63
INTRODUCTION
In the previous chapter we have introduced the exchange rate and the balance of payment. In
this chapter we will try to look at their relationship. In particular we shall be studying two
models that investigate the impact of exchange rate change on the current account position of
the country. These are commonly know as the elasticity approach and the absorption
approach.
Both models were designed to tackle one of the most important questions in international
economics. This is, will a devaluation of the exchange rate lead to a reduction of a current
account deficit? The answer to this question is very important because if an exchange rate
change can not be relied upon to ensure adjustment of the current account, then policy
makers will have to rely on other instrument to improve the position.
CHAPTER CONTENT
4.0. Objective
4.1. The Elasticity approach to the Balance of Payment
64
4.2. The Absorption Approach to the Balance of the Balance of

payment
4.2.1. The Effect of Devaluation on the National Income
4.2.2. The Effect of Devaluation on Direct Absorption
4.3. Summary
4.0. OBJECTIVE OF THE CHAPTER

At the end of these chapter students will be able to
Understand the relationship between balance of payment and exchange rate
Explain the impact of exchange rate change on the current account balance
Understand elasticity approach to balance of payment
Understand absorption approach to balance of payment
4.1. THE ELASTICITY APPROACH TO THE BALANCE OF PAYMENT

This approach provides an analysis of what happens to the current account balance when the
country devaluates its currency. This analysis was initially provided by a number of authors
and Lerner and later extended by Joan Robinson (1937). The model makes some simplifying
assumption; it focuses on demand condition and assumes that
The supply elasticity of the domestic export good and foreign import good are
perfectly elastic so that the changes in demand volumes have no effect on price.
This assumption implies that domestic and foreign prices are fixed as a result any
changes in relative price are caused by change in nominal exchange rate.
The gist idea of the elasticity approach is that there are two direct effects of devaluation on
the current balance. One of which works to reduce a deficit, whilst the other contributes to
worsen the current account deficit than before. Let us consider these two effects closely.
65
The current account balance (CA) when expressed in terms of the domestic currency.
CA=PX-SP*M .. (4.1)
Where,
P is domestic price level,
X is the volume of domestic exports,
S is the exchange rate.
P* is foreign price level and
M is the volume of import
In other words Current Account (CA) equals export minus import For the sake of simplicity
we shall set the domestic and foreign price level at unit. The value of domestic exports (PX)
will be X, while the foreign currency value of import (P*M) will be M. using these
simplification equation (4.1) becomes.
CA=X-SM .(4.2)
In differential form (4.2) can be expressed as
CA = X S M M S ..................(4.3)
Determining marginal change in current account due to small change in exchange rate is
obtained by dividing equation (4.3) by the change in the exchange rate ( s). This is
CA X
M
S
=
S
M
...........(4.4)
S
S
S
S
Now let us introduce price elasticity of demand for export and price elasticity of demand for
import
Price Elasticity of Demand for Export
66
Price elasticity of demand for export is the percentage change in export over the percentage
change in price as represented by the percentage change in the exchange rate. It is given by
Ex =
x
s
This implies dx = Ex
s
x..(4.5)
s
Price Elasticity of Demand for Import

Price elasticity of import (Em) is the percentage change in import over the percentage change
in their price represented by the percent change in the exchange rate.
Em =
M
S
S
This implies Mx
S
M ...(4.6)
S
Substituting (4-5) and (4-6) in to (4.4) we obtain
CA Ex X
=
+ Em M M
S
S
Dividing by M
CA 1 Ex X
=
+ Em 1...............(4.7)
S M SM
Assuming that we initially have balanced trade, i.e, X = SM ,we have
= 1, andrearranginequation(4.7) yieds.
SM
CA
= M ( Ex + Em 1) ............(4.8)
S
x
Equation (4.8) is known as the Marshall learner condition and says that starting from
equilibrium position in the current account; devaluation will improve the current account.
That is , CA
> 0, only if the sum of the foreign elasticity of demand for export and the
home country elasticity of demand for import is greater than unity. That is,
E X + Em > 1......................(4.8)
67
If sum of these two elasticity is less than unity then a devaluation will lead to a deterioration
of the current account.
Two effects occur once a countys currency devaluate and these are,
i. The Price Effect: This effect arises because export become cheaper measured in
foreign currency. For example if coffee costs $ 1 USD when exchange rate was 10
birr /USD, it costs only 0.5 when birr devaluate to 20/1, USD. On the other hand
import becomes more expensive after devaluation.
This price effect clearly
contribute to a worsening of the current account

iii. The Volume Effect: - This effect arises due to the fact that when export becomes
cheaper, more will be exported. In other words cheaper export encourage an increased
volume of exports, and the effect that imports become more expensive should lead to
a decrease volume of imports The volume effect clearly contributes to improving the
current account.
The net effect depends up on which effect dominates. If the increase in export volume not
sufficient to out weight a decrease in price, then less will be received form export in the
foreign currency. Similarly, if the decrease in import volume is not sufficient to out weight
the increase in import price, then more will be paid for imports in the domestic currency.
The result is that current account moves from balance to deficit
The possibility that devaluation may lead to a worsening rather than improvement the
balance of payment led to money researchers to find empirical evidence of the elasticity of
demand for export and imports.
In fact economists are divided into two groups called elasticity optimist who believed that the
sum of these two elasticity tends to exceed unit. The other group called elasticity pessimists
who believed that the sum of these two elasticity tends to be less than unit.
Generally, it was argued that devaluation may work better for industrialized countries than
the developing countries. The justification is that many developing countries are heavily
dependent upon imports so that their elasticity of demand for imports is likely to be very low.
68
The volume effect is much greater than the price effect. For the industrialized countries that
have to face competitive export market, the price elasticity of demand for their export may be
quite elastic. The implication of the Marshal - Lerner conditions is that devaluation may be a
cure for some countries balance of payment deficit but not for others. There are enormous
problems involved in estimating the elasticity of demand for import and export.
Gylfason (1987) has tried to estimate the elasticity of import and export for some selected
countries and the summary of it is presented in table 4.2
According to this study the Marshall Lerner condition is fulfilled for all of the 15
industrialized countries and for developing countries surveyed. The result clearly support that
devaluation will improve the current account.
In deed, a study by Artus and Knight (1984) has shown that up to a period of six months,
estimated price elasticity are so low that the Marshall-Lerner conditions are not fulfilled.
A general consensus accepted by most economist is that elasticity are lower in the short-run
than in the log-run in which case the Marshall-Lerner condition may only hold in the medium
than the long run.
Goldstein and Kahn (1985) in their empirical literature, concluded that in general the long
run elasticity are approximately twice as much as short-run elasticity
Accordingly, they considered long-run as a time period greater than two years where as
short-run as a time period less than 6 months. Further, the short-run elasticity generally fail to
sum to unit while the long- run elasticity almost always sum to greater than unity.
Table 4.2 The elasticity of demand for export and imports of 15 industrial and 9
developing countries.
Elasticity of export Elasticity of import Sun
Country
demand
demand
Industrialized country
Australia
1.02
1.23
2.25
Belgium
1.12
1.27
2.39
Canada
0.68
1.28
1.96
Denmark
1.04
0.91
1.95
69
France
Germany
Iceland
Italy
Japan
Netherlands
Norway
Sweden
Swat Zealand
United Kink dam
United state
Average
Argentina
Brazil
India
Kenya
Korea
Morocco
Pakistan
Philippines
Turkey
Average
1.28
0.93
1.02
0.79
0.83
0.87
1.26
0.78
1.40
0.95
1.46
0.74
0.92
1.19
1.58
0.88
1.03
1.13
0.86
0.65
1.19
1.24
1.11
0.99
Developing countries
0.6
0.9
0.4
1.7
0.5
2.2
1.0
0.8
2.5
0.8
0.7
1.0
1.8
0.8
0.9
2.7
1.4
2.7
1.1
1.5
2.21
1.81
1.7
2.04
2.35
2.2
2.11
2.46
2.16
1.51
2.43
2.10
1.5
2.1
2.7
1.8
3.3
1.7
2.6
3.6
4.1
2.6
The possibilities that in the short-run the Marshall - Lerner conditions may not be fulfilled
though it may hold in the long-run leads to a phenomenon called J-curve effect.
J-Curve Effect:- According to this effect in the short run export volumes and import
volume, do not change much, as a result the price effect out weight the volume effect and
this lead to a deterioration in the current account balance. However, after a time lag export
volume start to increase and import volume start to decline. This leads to gradual
improvement of current account balance and eventually moves to surplus. The issue is
whether the initial deterioration in the current account is greater than the future improvement
so that overall devaluation can be said to work
There are different explanation as to the low responsiveness, of export and import volume in
the short-run and why the response is greater in the long-run. Some of the most important
explanations are of the following.
70
A time lag in the consumes response:- It takes time for consumers in both the devaluating
country and the rest of the world to respond to the changed competitive situation. Switching
away from foreign imported goods to domestically produced goods takes some time because
consumers will be worried about issues other than the price change such as reliability and
reputation of domestic goods as compared to the foreign import, while foreign consumers
may be reluctant to switch away from domestically produced goods towards the exports of
the developing country.
A time lag in producer, response: - Even if devaluation improves the competitive position
of exports , it will take time for domestic producers to expand production of exportable
goods. Moreover, orders for imports are made well in advance and such contracts are not
readily cancelled in the short-run. Factories will be reluctant to cancel orders for vital inputs
and raw materials.
For example a waiting list for a Boeing Aero-plane can be over five years, and it is most
unlikely that Ethiopian airlines will cancel the order just because the birr has been
devaluated. The payments for many imports will have been hedged against exchange risk in
the forward market and so will be left unaffected by the devaluation.
Imperfect Competition: - penetrating the foreign market and building market share in the
foreign market is not an easy operation and is a time consuming and costly business. Due to
this fact foreign exporters may be reluctant to loss their market share in the developing
countries and might respond to the loss in their competitiveness by reducing their selling
price, to the extent that they do this in the face of the rise in the cost of import caused by the
devaluation.
Similarly, foreign import competitors may react to the threat of increased export by the
devaluating country by reducing prices in their home markets, limiting the amount of
additional export by the devaluating country.
71
The existence of imperfect competition gives foreign firms some excess profit margin
enabling them to reduce their price. If foreign firms were in a high competitive environment
they would only be making normal price and so would unable to reduce their price.
In addition to the above effect it is un likely that the price of exports as measured in the
domestic price will remain fixed. Many imports are used as inputs for exporting industries,
and the increased price of imports may lead to higher wage costs as workers seek
compensation for higher import prices; this will to some extent lead to a rise in the export
price reducing the competitive advantage of devaluation.
Figure 4.2 , called J-curve, and shows the effect of devaluation on the response of different
economic agents in the devaluating country ?.
Current Account Surplus
Time
Deficit
Figure 4.1. The J-Curve
4.2. THE ABSORPTION APPROACH

The elasticity approach discussed above was on the basis of the assumption that all other
things are equal. This assumption was considered as one of the weakness of the elasticity
approach. In fact, changes in export and import volumes will have implication for national
72
income and consequently income effect need to be incorporated in a more comprehensive

analysis of the effects of devaluation. The analysis of such evaluation was given by
Alexander (1952). His analysis was focusing on the fact that a current account imbalance can
be viewed as the difference between domestic output and domestic spending. Domestic
spending like (C+G+I) are called Absorption.
Take the national income identity.
Y=C+I+G+X+M ....(4.9)
Define domestic Absorption as A= C+I+G, equation 4.9 can be rearranged as
CA = X-M=Y-A ..(4.10)
Equation (4.10) can be interpreted as current Account (CA), represents the difference
between domestic output and domestic absorption. A current account surplus means that
domestic output exceeds domestic spending where as a current account deficit implies that
domestic spending is larger than the domestic output.
Since, current account CA =Y-A, the effect of devaluation on the current account will depend
up on how the devaluation affects national income relative to domestic absorption. If
devaluation raises domestic income, relative to domestic absorption, the current account
improves. If devaluation rather increased domestic absorption relative to domestic income
the current account deteriorates. Thus, understanding how devaluation affects both income
and absorption is the fundamental concept of the absorption approach to the balance of
payment Analysis.
Absorption has two parts, these are
A rise in income which will lead to an increase in absorption and this is

determined by marginal propensity to absorb (a)
A direct effect on absorption which is all the other effects on absorption resulting
from devaluation and this is denoted by - Ad.
Thus, the change in total absorption, A, is given by
A = a Y + A d .........................( 4 1 1)
73
Change in total absorption is a summation of change in income that affects absorption (a Y )

and change in direct effect Ad .
Change in current account can be shown as
CA = Y A................(4.12)
Substituting equation (4.11) in to (4.12.) we obtain
CA = Y (aY + Ad ) and this can be rearranged as

and this can be rearranged as
CA = (1 a )Y Ad .....................(4.14)
Hence =
Equation (4.13) tells us the fact that three factors need to be considered when analyzing the
effect of devaluation. These are,
Is the marginal propensity to absorb greater or less than unity?
Does devaluation raise or lower direct absorption?
Does Revaluation raise or lower direct absorption?
The condition for devaluation to improve the current account is that (1-a) Y > Ad . That is,
any change in income not spent on absorption must exceed any change in direct absorption.
To look at whether the above condition will be full filled it is worth to analyze by separating
the set of economy into below full employment so that income may raise, and full
employment so that income may not rise.
4.2.1. THE EFFECT OF DEVALUATION ON NATIONAL INCOME

What is clear is that if the economy is at less than full employment devaluation most likely
either rises or lowers the national income. If the marginal propensity to absorption is less
than one, then the rise in income will raise the income to absorption ratio and so improve the
74
current account. Where as, if income were to fall this would raise the absorption-to income
ration (as absorption would fall by less than income) which would worsen the current
account. There are two important effects on income that need to be examined. These are
employment effect and the term of trade effect.
Employment effect: - If the economy is at less than full employment, the Marshall Lerner
condition is fulfilled and there will be an increase in net export following a devaluation
which will lead to an increase in national income and employment through foreign trade
multiplier. However, if the Marshall-Learner condition is not fulfilled then net exports would
fall, implying that national income falls. Hence, it is not clear whether the employment effect
will raise or lower national income.
Terms of trade effect:- Terms of trade are the price of export divided by the price of import,
and can be expressed algebraically as,
price of exp ort

=
Pr iceofimport
P
SP *
Where,
P is the domestic price index,
P* is the foreign price index, and
S is the exchange rate (domestic currency per unit of foreign currency).
Devaluation (a rise in S) tends to make imports more expensive in domestic currency terms
and this is not matched by a corresponding rise in export price. This means that the terms of
trade deteriorate. Deterioration in the terms of trade represents a loss of real national income
because more units of exports have to be given up to obtain a unit of import. Hence, the
terms of trade effect lowers national income.
Overall, the effect of devaluation on the income of the devaluating country is ambiguous.
Even if there is increase in net export earnings, the negative terms of trade work to reduce
national income.
75
Even if income rises overall, it is still not clear what the implication of such a rise are for the
current account- this will depend up on the value of the marginal propensity to absorb. If this
is less than unity then an increase in income leads to an improvement in the current account
because income rises by more than absorption. However, if the marginal propensity to absorb
is greater than unity then the increased income would lead to an even bigger rise in
absorption resulting in a worsening of the current account
4.2.2. THE EFFECT OF DEVALUATION ON DIRECT ABSORPTION

Let us assume that the net effect of devaluation on the national income is zero. If devaluation
reduces direct absorption then it will lead to an improvement in the current account. Whereas
if direct absorption increase then the current account deteriorate
Now let us consider possible ways in which devaluation can be expected to have impact on
direct absorption.
Real balance effect:- A simple formulation of demand for money is a demand for real
money balance. If price doubles then agents will demand twice as much money as before
The money demand function can be shown as,
M
P1
=K
..............................(3.14)
Where ,
K represents some constant and,
PI is an aggregate price index which is given by,
PI = P + (1 ) Sp *......................(3.15)
Where,
- the percentage of expenditure on domestic goods,
P - the price of domestic goods,
P*- the price of imported goods, and
S - the exchange rate defined as domestic currency per unit of foreign currency.
76
Example
Suppose that the price of the domestic good is birr 10 while the price of the foreign good is
$2, and the pre-devaluation exchange rate is birr 10/1 USD. The domestic consumers spend
60 percent of their income on domestic goods so that =0.6. Then the average price level
can be determined as
PI= 0.6x10+ (1-0.6) x10x2
PI= 6+(0.4x10x2)
PI= 6+8
PI=14 birr
If the birr is devaluated to say birr 12/l USD, then the average price level will be changed as.
PI= 0.6x10+0.4x2x12
PI=6+9.6
PI=15.6
This means, a 20 percent devaluation of birr will raise the average price index facing
Ethiopian consumers, by approximately 11.23 percent.
Given an exchange money stock and the assumption that economic agents aim to maintain a
given amount of real money balance as shown in equation (3.15) The devaluation of
domestic currency means that economic agents have to maintain their real balances by
cutting down on direct absorption. Economic agents will attempt to increase their money
balance by selling bonds, which pushes down the prices of bonds raising the domestic
interest rate. The rise in interest rate will reduce investment and consumption, so reducing
direct absorption.
For the real balance effect to work the authorities must not accommodate the increase in
money demand by a corresponding increase in the money supply. If the money supply
increases, it will leave the ratio M/PI constant so that the real balance effect will not be
effective.
77
Income Redistribution Effect:- This effect arise due to the fact that devaluation
of
domestic currency may increase general price index, and this most likely have a number of
effects on income distribution. To the extent that it redistributes income from those with a
low marginal propensity to absorb to those with a high marginal propensity to absorb, this
will increase direct absorption. There are some scenarios with this respect. These are:
a) Increase in the general price index will tend to reduce the real income of those with fixed
incomes. But if overall income is unchanged then those with variable income will gain. It
is believed that the groups on fixed incomes are poor who have a higher propensity to
absorb. Income is redistributed from those with fixed income to those with variable
incomes; this income redistribution effect will tend to reduce direct absorption.
b) Devaluation commonly leads to an improvement of company profits through increased
sales in export and increased sale of import competing industries. The effect on direct
absorption of this redistribution is not clear: while firms may have a tendency to lower
absorption than workers this will be very much dependent on their expectations about the
future. If their expectation is favorable then the devaluation and profit rise may stimulate
investment and even raise direct absorption.
c) There may be considerable income adjustment within groups of companies and workers.
Some companies profits will benefit from devaluation as export sales rise. However,
some firms that are dependent on imported inputs may find their cost increased and
reducing their profit margin. The overall effect on direct absorption will then depend up
on the companies that gain has a higher propensity to absorb than those that lose.
In general, it is very difficult to say whether the income redistribution effect will raise or
lower direct absorption.
Money illusion effect:- It is also argued that even if prices are increased due to devaluation
of domestic currency, Consumers may exactly consume the some quantity because they
suffer money illusion. If money illusion is the case consumers are actually spending more on
direct absorption than before.
78
However, the money illusion effect may work in reverse way. This is because, consumers
because of price rises, may actually decide to cut back direct absorption by more than the
proportion to the price rise, so that direct absorption falls. Whatever, way the money illusion
effect works it is unlikely to be insignificant and is most likely only a temporary rather than
permanent factor.
Expectation Effect: - It is possible that economic agents regarded the increase in price due
to devaluation of domestic currency may spark further price rises. Such expectation may lead
to an increase in direct absorptions which would worsen the balance of payments. However,
it can be argued that inflationary expectation may reduce investment which may rather
lowers direct absorption.
Laursen-Metzler Effect:- This effect is named after Laursen- Metzler who has raised this
effect in 1950. According to this effect the deterioration in the terms of trade following
devaluation of domestic currency will have two effects on absorption. These are income and
substitution effect.
Income effect:- The deterioration in the terms of trade lower national income and
thereby income related absorption .

Substitution effect:-
This effect arises due to the fact that devaluation makes
domestic products relatively cheaper than imported goods, which

results in a substitution of domestic goods for imported goods.
If the positive substitution effect out weight the negative income effect, devaluation will lead
to a rise in absorption and vise versa, hence, the effect of devaluation on direct absorption are
a ambiguous.
From all the above discussion we observe that only the real money balance effect works to
lower direct absorption, all the other effects are not Cleary determined. Since we do not
know if the marginal propensity to absorb is greater or less than one, if income rises or falls,
or if direct absorption rises or falls, the effect of devaluation are indeterminate
79
However, the absorption approach has some important lesson for policy makers. Its central
message is that raising domestic income relative to domestic absorption will improve the
current balance. In this respect devaluation is more likely to succeed if it is accompanied by
economic policy measure that concentrate on raising income while constraining absorption.
Previously it was believed that the absorption approach was an alternative to the elasticity
approach. The elasticity approach concentrate on price effect while the absorption. approach
focus on income effect. Later on some authors such as Tsiang (1961) and Alexander (1959)
showed that the two models are not substitute rather they are complements.
4.3. SUMMERY
This chapter has tried to address the question that how economic agents respond to the
change in relative price induced by devaluation of domestic currency. To answer this
question two approaches were discussed. These two approaches are not substitute rather they
are complement to each other. Even though the two approaches are static in nature, they
point out the importance of dynamic forces and the time dimension to the ultimate outcome.
Demand elasticity are higher in the long-run than in the short-run, leading to a possible Jcurve effect, and the effect of devaluation on income and absorption will be spread over time.
In this simple model it is seen that there are a verity of forces to work. Moreover, greater
ambiguity would emerge as a result of time lag, wealth effect and an explicitly treatment of
expectation.
Despite their simplistic assumptions, ambiguous conclusion and deficiencies that the two
approaches have, they remain influential because they contain clear and useful message for
policy makers. A devaluation is more likely to succeed when elasticity of demand for import
and export are high and when it is accompanied by measures such as fiscal and monetary
restriction that boost income relative to domestic spending.
It should also be noted that both approaches assume that foreign countries do not react to the
competitive advantage gained by the country devaluating its currency. To the extent that they
80
react by devaluating their currencies this will undermine the effectiveness of a devaluation
policy.

1. Briefly explain the main ideas of elasticity approach.
2. What do you understand the Marshall Lerner condition.
3. According to elasticity approach to the Balance of payment when a country
devaluate its currency two effects would occur. What are these and explain each
of them!
4. It was generally argued that devaluation may work better for industrialized nation
than the developing countries. Justify this statement
5. Explain the J. curve effect!
6. Compare and contrast the employment effect and terms of trade Effects
devaluation on national income.
7. What do you understand by income redistribution effect
8. Explain the following concepts
A. Money illusion effect
B. Expectation effect
C. Laursen-Metzler effect
CHAPTER V
THE MONETARY APPROACH TO THE BALANCE OF

PAYMENT
81
INTRODUCTION
Monetary approach is one of the policy analyses of balance of payment. It has been raised as
a policy tool by monetary economists like M. Whitman (1977), J. Franle and H. Johnson
(1996).
Proponents of this approach argue that the balance of payment is a monetary phenomenon
and require a monetary approach to analyze it. Balance of payment is
not only a
measurement of monetary flow but also the flow can only be explained by disequilibrium in
the stock, demand and supply of money. In deed there are a number of variants of the
monetary approach though they may not agree each other on the assumption used in the
analysis.
In this chapter few of a simple model that explain the basic idea of the monetary approach to
the balance of payment within the context of monetary model, this chapter shall examine
how devaluation will affect the balance of payment.
CHAPTER CONTENT
5.0. Chapter Objective

5.1. A Simple Monetary Model
5.2. The Monetary Concepts of Balance of Payments
disequilibrium
82
5.3. The Effect of Devaluation

5.4. A Monetary Exchange Rate Equation
5.5. A Money Supply Expansion Under Fixed Exchange Rates
5.6. A Money Supply Expansion Under Fixed Exchange Rates
5.7. The Implication of The Monetary Approach
5.8. Criticism of The Monetary Approach
5.9. Summary
5.0. OBJECTIVE
At the end of this copter students will be able to
5.1
Define the money demand function
Explain aggregate supply
Revise the purchasing power parity co nap
The effect of devaluation on balance of payment.
A SIMPLE MONETARY MODEL
The analysis of balance of payment using a monetary approach is largely based on the
following assumption which are subsequently explained in brief.
There exist a stable money demand function
The aggregate supply is fixed or vertical.
PPP largely work among nations, involved in international trade. Let us see each
of these assumptions closely.
Stable Money Demand Function

83
The fundamental concept of the monetary approach is based on the assumption that there is a
stable money demand function which is made up of few variables. The monetarists use the
quantity theory of money to explain demand function. This is presented as,
Md = kPy(5.1)
Where,
Md is the demand for nominal money balance,
P is domestic price level ,
Y is real domestic income, and
K is a parameter that measures the sensitivity of money demand to change in nominal

income
The demand for money is positively related to the domestic price level, because as price goes
up money is needed to buy the some quantity of goods and services. Moreover a rise in the
domestic price level will reduce the real money balance.
The real money balance is money stock over price level, i.e., M/P. The fall in real money
balance will lead to an equi-proportionate increase in the demand for money. The demand for
money is also positively related to real domestic income. The increase in real income will
lead to increase in the transaction demand for money.
On the basis of equation 5.1 we can depict the aggregate demand for a simple a monetary
model. From equation (5.1) we held fixed money demand and assume that the parameter k is
also fixed. We further assume that money supply is also fixed.
Price level
P1
84
AD2
P2
AD1
Y1
Y2
Real income
Figure 5.1 Aggregate demand
From figure 5.1 we can observe that an increase in real income (Y) from Y1 to say , Y2
require equi-proportionate fall in the price level from P1 to P2 . Hence P1Y1 = P2 Y2 since the
parameter K is fixed by assumption.
A fall in the price level from P1 to P2 given a fixed money supply will increase the real
money balance (M/P) and this leads to increase in aggregate demand from Y1 to Y2. An
increase in the money supply will shift the aggregate demand to the right from AD1 to AD2
Vertical Aggregate Supply curve

The simple monetary model assumes that the economy is always at full employment as the
labor market is sufficiently flexible. Wage rate are flexible that they are constantly at the
level that equates the supply and demand for labor. Moreover, a rise in the domestic price
level does not lead to an increase in domestic output because wage adjust immediately to the
higher price level so that there is no advantage for domestic producers to take on more labor.
This means that the aggregate supply is vertical at full employment level of output as shown
in figure (5.2).
Price level
AS1
AS2
85
Y1
Y2 Real income
Figure 5-2 Aggregate Supply
Even if the aggregate supply is fixed at full employment level Y1, it does not mean that
output is always will be fixed. The aggregate supply may shift to the right say to AS2 if there
is an improvement in productivity due to technological progress.
Purchasing power parity (PPP)

One of the assumptions of the monetary model is that the purchasing Power Parity (PPP).
The theory of PPP is explained in chapte1. However, we can revisit some basic concepts.
According to this theory the exchange rate adjusts so as to keep the following relationship
which was explained in chapter1.
S=p
p*
that is
P = SP *
Thus, PPP shows the relationship between domestic price and foreign price level. In other
words it shows combination of the domestic price level and exchange rate which are
compatible with PPP given the foreign price level P*. This can be shown graphically as
depicted in figure 5-3
Price level
PPP
P1
overvaluation
Undervaluation
Exchange rate
86

Figure 5.3 Purchasing power parity
The above figure depicts the PPP relationship between the domestic price and exchange rate.
It shows the combination of the domestic price level and exchange rate which is compatible
with the purchasing power parity for a given foreign price level. It has a slope given by P*
and implies that X percent rise in the domestic price level requires an X percent depreciation
of the home currency to maintain PPP. Points to the left of PPP curve represents an over
valuation of the domestic currency in relation to PPP, where as points to the right represent
undervaluation in relation to PPP.
Using these three assumptions, the simple monetary model and using some accounting
identities we develop a theory of balance of payment. The domestic money supply is
composed of two components, namely domestic bond holdings and the foreign currency
reserve valued in the domestic currency. This can be presented as,
Ms= D+R ... (5-2)
Where,
M is the domestic money base,
D the domestic bond holding, of the monetary authority, and
R the reserve of foreign currencies valued in the domestic currency.
According to the equation (5.2), the domestic monetary base comes into circulation in either
of the following ways.
The monetary authority may conduct an open market operation (OMO) to purchase
bonds held by private agents by the Central Bank. This increases a central banks
liabilities but increases its asset of domestic bond holdings which is the domestic
component of the monetary base as represented by D.
The authority may conduct foreign exchange operation (FOX) which is a purchase of
foreign currency asset (money or foreign bond) held by private agents by a central
87
bank. This again increase the central banks monetary liabilities but increase its asset
of foreign bonds and is represented as R
Equation (5.2) state that any change in the domestic money supply (monetary base) can be
caused by the change either in an open market operation (OMO) or by the change in foreign
exchange operation (FXO) of the monetary authority. The relationship between the money
supply and reserves is graphically shown in figure 5.4
Ms2
Money supply
C
M2
M1
Ms1
D2
D1
R1
R2
Reserve
Figure 5.4 The relationship between money supply and reserve
In the above figure when bond holdings D is fixed at D1 all the domestic money supply is
made up of entirely of the domestic component since reserves are zero at this point. For the
sake of simplicity we set the exchange rate of domestic to foreign currency equals to unity.
Under this condition an increase of 1 unit of foreign currency leads to an increase in the
domestic money supply by 1 unit, so that when reserves are R1 the money supply is M1 that
is, D1+R1
The OMO will have the effect of shifting the MS schedule by the amount of the increase in
the central banks domestic bond holdings. The increase in domestic monetary base from D1
88
to D2 due to an OMO will shift the money supply from MS1 to MS2; as a result the total
money supply rises from M1 to M2. On the other hand an expansion of the money supply due
to the purchase of foreign currency thorough FXO, increases a countrys foreign exchange
reserve from R1 and R2. This also will have an effect of increasing the money stock from
point A to point B or monetary base from M1 to M2.
5.2
THE MONETARY CONCEPTS OF A BALANCE OF PAYMENTS

DISEQUILIBRIUM
The monetary view of balance of payment surplus and deficit as monetary flow is due to
stock disequilibrium in the money market. A deficit in the balance of payment is because of
an excess of money supply against money demand. A surplus in balance of payment is due to
an execs of demand for money against the stock of money supply.
Thus, the balance of payment disequilibrium is a reflection of disequilibrium in the monetary
market. In this sense the monetary flow, are the autonomous items in the balance of payment,
while the purchase and sales of goods/serves and investment are viewed as the
accommodating items.
This is completely the opposite of the Keynesian approach which viewed the current account
items as autonomous items. And capital account and reserve changes as the accommodating
items.
Monetarists observe that the overall balance of payment can be thought of as consisting of
the current account balance, the capital account balance, and change in the authorities
reserve. This can be shown as,
BP = CA + K + R = 0..........................(5.3)
This can be rewritten as

CA+K=- R (5.4)
Where,
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CA refers to current account,
K is capital account and
R is change in the authorities reserves.
If the recorded R in the balance of payment account is positive, it means that the
compound current account and capital account are in deficit. This implies that reserves have
fallen as the authorities have purchased the domestic currency with foreign currency
reserves.
Thus, equation (5.4) presents different way of looking in the balance of payment. Increase in
reserves due to purchase of foreign currencies represents a surplus in the balance of
payments, while falls in reserve resulting from purchases of the domestic currency represents
a deficit in the balance of payment.
According to the monetarist view, if the currency is left to float, that is if the authorities do
not intervene in the foreign exchange market, then reserves do not change at all, and the
balance of payment is in equilibrium.
With this concept of a balance of payment surplus /deficit we can analyze the effect of
various shocks under both fixed and floating exchange rate.
The model is said to be at equilibrium when aggregate supply is equal to aggregate demand
so that there is no excess demand for goods. This condition is presented in figure 5.5.
Equilibrium occurs at point of intersection of the aggregate demand and aggregate supply at
price Pl and output level Yl as shown in figure 5.5(b). The PPP holds in the foreign exchange
market so that at price level Pl and exogenous foreign price level P* and the exchange rate
compatible with PPP is given by S1 and is presented in figure 5.5 (a).
Price
Price
AS
PPP
P1
MS
P1
M1
Md
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Exchange rate
Real income
Reserve
AD
S1
Y1
(a)
R1
(b)
(c)
Figure 5.5 Equilibrium in goods, moneys and exchange market
The money market is in equilibrium, with the money supply M1 (made up of the domestic
component D1 and reserve R1) equal to money demand. The money supply, MS curve cuts
the Md curve at equilibrium point.
The exact position of money demand curve is determined by the domestic price level and
domestic income level. Equilibrium in the money market also implies equilibrium in the
balance of payment. With this information we can examine the effect of different shocks
within the context of the monetary approach to the balance of payment.
5.3
THE EFFECT OF DEVALUATION
According to the monetary approach devaluation can only have an effect on the balance of
payment by influencing the demand for money in relation to the supply of money. This effect
is depicted in figure 5.6.
Price level
Price
AS
Money Supply
PPP
P2
P1
Ms1
P2
A
AD2
P1
AD1
S1 S2 exchange rates
Y1
Real .Income
Md2
M2
M1
Md1
D1
R1
R2 reserves
91
(a)
(b)
(c)
Figure 5.6 The effect of devaluation
Figure 5.6 represents the effect of devaluation on the balance of payment. This effect can be
observed in the short - run as well as in the long-run. The immediate effect of a devaluation
of the exchange rate from S1 to S2 will make domestic goods relatively less expensive and
hence competitive in relation to PPP at point A in the figure 5.6 (a).
As domestic goods
become more competitive as compared to foreign goods there is an increase in the demand
for the domestic currency which is represented by a shift of the money demand curve from
md1 to md2 figure 5-6(c).
This means that money demand M2 exceeds the money supply
(M1). The competitive advantage of devaluation means that the balance of payments moves
into surplus as domestic residents demand less foreign goods and service, while foreigners
demand more domestic goods and services.
To prevent the appreciating of domestic currency, the monetary authorities have to purchase
the foreign currency with new domestic money base. This increases the reserves and leads to
an expansion of the domestic money supply which in turn raises aggregate demand for
domestically produced good and services. The aggregate demand curve shifts to the right
from AD1 to AD2 (Figure 5-6 (b) ) and start pushing up domestic price until PPP is restored
at price P2
Once the domestic price level is at P2 and the money supply has increased to M2 real money
balances will be at their equilibrium level (M1/P1=M2/P2) and the competitive advantage of
the devaluation has been off set. The balance of payment will be back in equilibrium as the
money supply is once again equal to the money demand. In the long run the effect of say an x
percent devaluation will lead to an equal percentage rise in the domestic price level, and an
equal percentage increase in the domestic money stock.
In general, the surplus resulting from devaluation is merely a transitory phenomenon. The
monetary approach emphasizes that devaluation will have a transitory beneficial effect on the
balance of payment only so long as the authorities do not simultaneously engage in an
expansionary OMO.
92
If the authorities immediately increase the money stock to M2 through OMO, there will be an
immediate rise in aggregate demand and domestic price to P2 so that the competitive
advantage conferred by a devaluation is eliminated.
The important point derived from the monetary model concerning the effect of devaluation is
that exchange rate changes are viewed as incapable of bringing about a lasting change in the
balance of payment.
A devaluation or revaluation operates strictly by causing disequilibrium in the money market,
causing a deficit or surplus in the balance of payment, which continues only until equilibrium
is restored in the money market through reserve changes.
5.4
A MONETARY EXCHANGE RATE EQUATIONS
Before analyzing the effect of different shock under fixed and floating exchange rate we need
to consider how the exchange rate is determined in the simple monetary model.
As we have seen in the early stage in this chapter, the demand for money in the home country
is given by
Md= kPy .(5.5)
Similarly the demand for money in the foreign economy is given by
Md*=K*P*Y* (5.6)
Where,
Md* represents foreign money demand
K* foreign nominal income elastically of demand for money.
P* the foreign price level, and
Y* real foreign income.
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The exchange rate is determined by PPP and is shown by

S=
p
.......................................(5.7)
p*
In equilibrium money demand is equal to the money supply in each country and can be
shown as.
Ms=Md and Ms* = Md* (5.8)
With this conditions the relative money supply function as equation (5.5) replacing Md and
Md* with Ms and Ms* from equation (5.8)
Ms
kpy
=
.......................(5.9)
Ms * k * p * y *
Since P/P* = S , because of PPP, then we can rewrite equation (5.9) as
Ms
sky
=
.......................(5.10)
Ms * k * y *
And solving the above equation for the exchange rate yields,
S=
Ms Ms *
ky / k * y *
.......................(5.11)
The above equation (5.11) says that the exchange rate is determined by the relative supply
and demand for the different national money stock an increase in foreign income relative to
domestic income will lead to a depreciation (rise) of the domestic currency, while an
increase in domestic income relative to foreign income leads to an appreciation (fall) in the
exchange rate.
This is because of the fact that an increase in domestic income leads to an increased
transactions demand for domestic currency which leads to an appreciation. With this simple
model of exchange rate determination we can analyze the effect of money supply, income
changes and changes in the foreign price level.
5.5
A MONEY SUPPLY EXPANSION UNDER FIXED EXCHANGE

RATES
94
When the exchange rate of a countrys currency is fixed, the monetary authorities have to
buy the currency when it is in excess supply and sell it when it is in excess demand in the
private market to avoid a currency devaluation or appreciation. Selling of the domestic
currency be monetary authorities lead to a rise in their reserves of foreign currency. If the
authorities buy the domestic currency, this lead to the fall of the foreign reserve
Let us look at what will happen if there is an expansionary OMO under a fixed exchange rate
which raise the money supply by a central bank purchase of domestic treasury bond. The
effect of such an expansionary open market operation is depicted in figure (5.7) below
Price level
Money supply
Price level
PPP
AS
Ms2
P2
P1
P1
S1 Exchange rates
(a)
Ms1
Ms1
M2
P2
AD2
M1
AD1
D2
D1
Y1 Real income
(b)
Md1
R1
R2 Reserve
(c)
Figure 5.7 A monetary expansion under fixed exchange rate
An expansionary OMO Shifts the money supply curve from Ms1 to Ms2 (figure 5.7 (c ) ) and
increases the domestic money supply from M1 to M2. And this increase the domestic
component of monetary base from D1 to D2 .
The immediate effect is that domestic residents have excess real money balance
(M2/P1>M1/P1). That is, the money supply M2 exceeds money demand M1. To reduce their
excess real balance residents increase aggregate demand for goods which is given by a shift
of the aggregate demand curve from ADl to AD2 and this puts upward pressure on prices of
domestic goods whose prices rise from P1 to P2 .
95
At P2 and fixed exchange rate S1, the domestic economy is not competitive in relation to
PPP as it finds itself to the left of the PPP curve
The uncompetitive nature of the economy moves the balance of payment into deficit. To
prevent a devaluation of the currency the authorities have to intervene to purchase the
domestic currency and the authorities reserves start to decline below R1.
The purchase
back of the domestic money supply starts to reduce the excess money balance and at the
same time aggregate demand starts to shift back from AD2 to words AD1. As the excess
money balance are reduced and this puts down word pressure on the domestic price level
which falls back to its original level P1 so as to arrive back at PPP.
Once the money supply returns to M1 along the MS2 curve the excess supply of money is
eliminated and the economy is restored to equilibrium. In other words in the long-run the
price level, output level, and money stock return to their initial levels.
Thus, an increase in the domestic components of the monetary base from D1 to D2 will lead
to an equivalent fall in the reserves from R1 and R2 . The decrease in reserve due to purchase
of the home currency leads to a return of the money stock to its original level.
The monetary approach regards the balance of payments deficits resulting from the
expansion in the money stock to be a temporary and self-correcting phenomenon. An
expansion of the money supply causes a temporary excess supply of money and a combined
current and capital account deficit, which to maintain the fixed exchange rate requires
intervention in the foreign exchange market which eventually eliminates the excess supply of
the currency.
Actually there are two conditions under which a balance of payment deficit or surplus can
become more than a temporary feature.
One condition is when the authorities practice sterilization of their foreign exchange
operations. When monetary authority intervenes to purchase their currency to prevent its
being devaluated there is a reduction of the monetary base. The authorities could try to offset
these monitory bases by conducting a further OMO by purchase of bonds from the public.
96
But such open market operations cause a balance of payment deficit, which requires a further
foreign exchange intervention. Hence, sterilization policy can cause a prolonged balance of
payments deficit, and the pursuit of such operation will be limited by the extent of a
countrys reserves.
Second conditions that can lead to continuous deficit would be when the surplus countries
were prepared to purchase the deficit countrys currency and hold it in their reserve. In such
circumstances the deficit country will have its exchange rate fixed by foreign central bank
intervention, and such a process can continue so long as foreign central banks are prepared to
accumulate the home countrys currency in their reserves. Although in this case reserve
changes are zero, the deficit is reflected as an increase in liabilities to foreign authorities.
5.6
A MONEY SUPPLY
EXCHANGE RATES
EXPANSION
UNDER
FLOATING
Under floating exchange rates the monetary approach maintains that there is no as such
balance-of- payment deficit or surplus and the monetary authorities do not have to intervene
to purchase or sell the domestic currency in order to maintain its exchange rate. In floating
exchange rate regime there is no balance of payments surplus or deficit as there is no changes
in international reserves.
As it was shown by equation 5.4 the change in reserve is zero and any current account deficit
or surplus will be offset by a net capital inflow (out flow) of the same amount.
Price level
Price level
Money Supply
AS
MS2
PPP
P2
P2
P1
P1
S1
S2 Exchange
MS1
M2
M1
AD2 D2
AD1 D1
Y1 Y2
Real income
R1
Reserve
97
Rate
(a)
(b)
Figure 5.8 A Monetary expansion under floating exchange rate.
(c
As it shown in figure (5.8) an expansionary Open Market Operation (OMO) leads to a rise in
the money stock from M1 to M2 and creates excess money balance. As a result of increase in
money stock the aggregate demand shifts from AD1 to AD2 (figure 5.8.(b)) with demand of
Y2 which exceed domestic output (aggregate supply).
The excess demand for goods results in to increase in expenditure on foreign goods and
foreign investment. This leads to a deprecation of the exchange rate. As a result of the
excess demand for goods the domestic price will raise leading to an increase in money
demand as reflected by an upward shift of the money demand curve from Mdl to Md2.
When the domestic price rises demand for money will increase and this lead to a contraction
of aggregate demand along the AD2 curve and the equilibrium price P2 is restored.
In the long-run , the effect of an x percent increase in the money stock is depreciation of
exchange rate by the same percent (x percent), and an increase the domestic price level by
the same x percent. The increase in the price level induces a rise in the demand for money so
that the excess money balance created by the OMO is eliminated.
From equation (5.1) we can see variables like Ms*, Ky, and K*y* are all fixed, and any rise
in Ms leads to a rise in the exchange rate S for the equation to holds true .
If we compare the two exchange rate regimes (fixed and floating.) under fixed exchange rates
an expansionary OMO leads to a disequilibrium in the money market. This is solved by
adjustment in the balance of payment and reserves held by the monetary authorities .
Under floating exchange rates an expansion in the monetary base leads to a depreciation of
the exchange rate and a rise in domestic price. Moreover the authorities can determine the
amount of money supply, and money market equilibrium is restored by changes in money
demand caused by change in the domestic price level and exchange rates.
98
In fixed exchange rates the monetary authority can not conduct in dependent monetary
polices like that of floating exchange rates where the authorities are free to expand and
control the money supply to their desired level.
5.7. THE IMPLICATION OF THE MONETARY APPROACH

The important feature of the monetary approach is that, money market disequilibrium is
considered as an important factor that provoke balance of payment disequilibrium. With real
output fixed, aggregate expenditure is considered as a function of real money balance rather
than income.
In the monetary model agents decide on the amount of money balance they whish to hold and
then spend accordingly, and not the other way round. In this senses it is money decision that
matter but not the expenditures.
The central idea of the monetary approach is that the demand for a stable and predictable
money function is a stable and predictable function of relatively few variables. The demand
for money is a demand for real money balance and excess money balance raise aggregate
demand.
One of the implications of the monetary approach is that in a fixed exchange rate regime, the
authorities have to accept a loss of control over their domestic monetary policy as the price
of fixing the exchange rate. Any attempt to expand the domestic money supply under fixed
exchange rates leads to a balance of payment deficit and the need to purchase back the
currency on the foreign exchange market. If foreign prices rise, then so does the domestic
money supply and domestic price level too. Under the fixed exchange rates the authorities
lose the ability to pursue an independent monetary policy.
The only thing that the authorities can do is to control the composition of the monetary base
between its domestic and foreign components. Moreover an increase in the domestic
components of the monetary base leads to an equivalent fall in the foreign component.
99
Another implication of the monetary approach is that from the point of view of balance of
payment it is irrelevant whether the change in the money supply result from an OMO or a
foreign exchange operation (FXO). According to monetarist both operations can bring about
disequilibrium in the money market.
An expansion of the domestic monetary base under fixed exchange rate regime causes an
excess of real money balance. The result is a balance of payment deficit which requires the
authorities to intervene to support their currency. As monetary authorities intervene to
support their currency, the reserves decline until the money supply is brought back to its
original level and excess balances are eliminated. Under fixed exchange rate monetary policy
is endogenously determined by the need to peg the exchange rate where as under floating
exchange rate the country can exogenously determine its money supply because it is the
exchange rate that restore equilibrium but not monetary change.
There is difference in monetarist camp as to the desirability of fixed over floating exchange
rate. One group of monetarist argue that since balance of payments deficit or surplus are
transitory and self correcting, countries should agree to permanently fix their exchange rates
and enjoy the benefits of their stability.
On the other hand some monetarist including Milton Friedman advocates that authorities
should allow their currency exchange rate to float so that countries are left free to determine
their own rates of inflation and monetary policy independently of other countries.
5.8. CRITICISMS OF THE MONETARY APPROACH.

The monetary approach to the balance of payment is not with full agreement with even all
monetarists. There are different views which can be categories as follows.
According to some economists an increase in the domestic money supply may not be
reflected exclusively in the equivalent fall in the reserves under fixed exchange rates. For
example, if there is unemployment (not full employment), all expansionary monetary policy
100
may lead to some increase in output which result in increase in money demand. This may
lead to slow down of the devaluation process on the home currency. In this case reserve
would not need to fall in exact proportion to the initial rise in the money supply as some of
the expansion would be willingly held as transaction balance.
Some critics argued that to regard the balance of payment as a monetary phenomenon is true
only if the balance of payments measure monetary flow between domestic and foreign
residence. They argue that it is quite wrong to regard balance of payment deficit and surplus
as exclusively due to the monetary decision because the question of causation is not clear yet.
If economic agents decide to spend more on foreign goods and foreign investment, under
fixed exchange rate system, there will be a transitory deficit in the balance of payment. The
deficit then forces the authorities to buy the domestic money in the foreign exchange market.
The cause of the deficit is the expenditure decision but not the decrease in money demand
which then leads to excess real money balance and a balance of payments deficit. In other
words, causation can easily lead from expenditure decision to change in money demand,
rather than changes in money demand including changes in expenditure behavior.
As to these groups of economists, the assumptions made by this approach is empirically open
to question.. There is ample evidence that money demand functions can be highly unstable,
economies are rarely at full employment, and purchasing power parity is useless as a guide to
exchange rate movements.
Even if these assumptions hold in the long run they are very rarely fulfilled in the short-run.
The empirical violation of this assumption must bring into question the policy relevance of
the monetary approach.
Another criticism of the monetary approach is that no attention is paid to the composition of
a deficit and surplus. If there is a large deficit in the current account which is financed by an
offsetting surplus in the capital account, the monetarists argue that this means there is no
need for any policy concern with regard to the balance of payments. Since any surplus or
deficit is a transitory feature representing a stock disequilibrium in the money market which
is necessarily self correcting, a policy with regard to the balance of payment is unnecessary.
101
Such an approach ignores the dangers of increasing indebtedness due to current account
deficits being financed by capital inflows.
In the real world it is the increase in such indebtedness, such as the third world debt crisis in
1980, and Asian financial crisis 1997/8 that causes much concern for policy makers of the
countries concerned.
5.9 SUMMARY
The monetary approach to the balance of payment provided a clear analysis of the effect of
devaluation and monetary expansion on the balance of payment.
Its emphasis on
disequilibrium in the balance of payment being a flow response to stock disequilibrium in the
money market represent an important contribution to the research on international
economies.
Another significant contribution of the monetary approach is that it provides a rich set of
policy recommendations. A country that opts to fix its exchange rate will loss its monetary
autonomy, a monetary expansion can lead to temporary balance of payment deficit. Where as
a country that allows its currency to float will have monetary autonomy but a monetary
expansion then leads to a depreciation of its currency. Hence, it provides a warning to policy
makers that uncontrolled monetary expansion can lead to balance of payment problems under
fixed exchange rate, or a currency problem under floating exchange rates.
With regard to the deficit of devaluation of a currency, starting from a position of
equilibrium, the monetary approach suggests that there will be an unambiguous transitory
surplus in the balance of payment. This stands in contrast to the elasticity and absorption
approach which suggests the effects are rather ambiguous.
The monetary approach, however, does not specify precisely how temporary the resulting
surplus is, presumably this is on a country- by- country basis.
5.10 REVIEW QUESTION

102
1. The analysis of balance- of payment using a monetary approach is based on some basic
assumptions what are they ? Explain briefly each of these assumptions. !
2. What are the components of domestic money supply?
3. Explain how the domestic monetary base comes into circulation!
4. What does increase in the reserve due to purchase of foreign currency indicates about the
balance of payment.
5. Explain the effect of devaluation on the balance of payment using graph according to the
monetarist approach .
6
In floating exchange rate regime there is no balance of payment surplus or deficit.

Explain why?
What the differences among monetarists are as to the desirability of fixed over floating
exchange rate?
Explain the major criticism against the monetary approach !
CHAPTER VI
MACRO ECONOMIC POLICY IN AN OPEN ECONOMY
INTRODUCTION
103
In previous chapter we have seen the basic identity for an open economy and considered the
possible effect of devaluation on current account. It has been noticed that the ultimate impact
of devaluation will depend up on the economic policies that accompany the devaluation.
In this chapter we will examine how both exchange-rate changes and macroeconomic polices
impact upon an open economy. A fundamental difference between an open economy and a
closed economy is that overtime a country has to ensure that there is balance in its current
account.
The need for economic policy makers to pay attention to the implication of changes in
monetary and fiscal policy on the balance of payment is an important additional dimension
for consideration in the formulation of economic policy in an open economy. Ensuring a
sustainable balance of- payments position over time is an important economic objective to go
along with high economic growth, low unemployment and low inflation.
CHAPTER CONTENT
6.0. Objective
6.1. The problem of Internal and external Balance
6.2. The Mundell - Fleming Model
6.2.1. The Derivation of IS schedule for an open economy
6.2.2. The Derivation of the LM Schedule for an open economy
6.2.3
The Derivation of the BP Schedule.

104
6.3. Equilibrium of the model.

6.4. Factors shifting the IS-LM-BP schedule
6.5. Policy instrument to maintain Internal and external
balance
6.6. Internal and external Balance under fixed exchange rate
6.7. Internal and external Balance under floating exchange
rate.
6.7.1. Fiscal extortion under floating exchange ratr
6.8 A Small Open Economy with Perfect Capital Mobility

6.8.1. Fixed Exchange Rates and capital Mobility
6.8.2. Floating Exchange Rates and Perfect Capital
Mobility
6.9. Limitations of the Mendel Fleming Model
6.9
Summary
6.10 Review Question
6.0. OBJECTIVE OF THE CHAPTER

At the end of this chapter students will be able to
Explain the meanings of internal and external balance
Understand the problems of internal and external balance
Explain IS and define it for an open economy and identify factors afacting it
Explain the meaning of LM and derive it for an open economy
Explain the meaning of BP and derive it
Identify appropriate policy to maintain internal and external balance
Distinguish the internal and external balance in fixed and floating exchange rates
105
Explain the limitation of the Mendel -Fleming model
6.1. THE PROBLEM OF INTERNAL AND EXTERNAL BALANCE

Between the years 1948 and 1973 the international monetary system was that of fixed
exchange rate with the major currencies being pegged to the US dollar. Only if there are
fundamental disequilibrium that authorities were allowed to devaluate or revaluate their
currency. This implies that there was considerable interest in the relative effectiveness of
fiscal and monetary policies as a means of influencing the economy.
Though economic policy makers generally have many macroeconomics objectives, the focus
in the 1950, and 1960 , was primarily concerned with two objectives, these are
Achieving full employment for the labor force
A stable level of price
Achieving a full employment with a stable level of price is called internal balance. Even if
the governments were generally committed to achieve full employment, it is widely believed
and recognized that expanding output in on open economy will have impact on the balance of
payment. For instance, expanding output and employment will result in greater expenditure
on importers and consequently will lead to a deterioration of the current account. When
authorities decided to maintain fixed exchange rate, then they were interested in running
equilibrium in the balance of payment, that is, balance in the supply and demand for their
currency.
The objective of having balance or equilibrium in the balance of payment is called external
balance. Changes in fiscal and monetary policies which aim to influence the level of
aggregate demand in the economy is called expenditure changing policies. Whereas polices
such as devaluation or revaluation of the exchange rate in order to influence the composition
of spending between domestic and foreign goods are called expenditure switching policies.
Many literatures, in the 1950, and 1960, were concerned with how the authorities might
simultaneously achieve both internal and external balance. In fact the policy problem of
106
achieving both internal and external balance was first conceptualized by Treuor Swan (1955)
in a diagram called Swan diagram.
The swan diagram is depicted in figure 6.1. The vertical axis represents the real exchange
rate, defined as domestic currency units per unit of foreign currency so that a rise represents a
real depreciation which implies improved international competitiveness. The horizontal axis
is the amount of real domestic absorption which represents the sum of consumption,
investment and government expenditure.
Real exchange
Rate
Depreciation
Appreciation
EB
(4)
Inflation
Surplus
(3)
A
Unemployment
Surplus C
(2)
Unemployment
Deficit
(1)
Inflation deficit
B
IB
Domestic absorption (C+I+G)
Figure 6.1 The Suan diagram
The Internal Balance (IB) schedule represents combinations of the real exchange rate and
domestic absorption for which the economy is in internal balance; that is, full employment
with stable prices. The IB is downward sloping. This is because an appreciation of real
exchange rate will reduce export and increase imports. Thus, to maintain full employment it
is necessary for there to be an increase in domestic expenditure. To the right of the IB
schedule there are inflationary pressure in the economy because for a given exchange rate
domestic expenditure is greater than that required to produce full employment, while to the
left there are deflationary pressure because expenditure is short of that required to maintain
full employment,
107
The external Balance (EB) schedule shows combinations of the real exchange rate and
domestic absorption for which the economy is in external balance that is, equilibrium in the
current account. The EB schedule is upward sloping from left to right. This is because a
deprecation of the exchange rate will increase export and reduces imports so to prevent the
current account moving into surplus requires increased in domestic expenditure to induce an
offsetting increase in imports. To the right the EB schedule domestic expenditure is greater
than that required for current account equilibrium so that the result is a current account
deficit, while to the left there is current account surplus.
The swan diagram is divided into four zones representing different possible states for the
economy.
Zone 1- Represents a deficit and inflationary pressure
Zone 2- Represents a deficit and deflationary pressure
Zone 3- Represents a surplus and deflationary pressure
Zone 4- Represents a surplus and inflationary pressure.
The economy is in both internal and external balance only at point A where IB and EB
schedule intersects. Suppose that the economy is initially at point B in Zone 1, experiencing
both inflationary pressure and a current account deficit. If the authorities maintain a fixed
exchange rate and try to reduce the current account deficit by cutting back real domestic
expenditure they move the economy towards point C.
Trying to achieve external balance by adopting a policy that reduces expenditure alone would
require a cut back in absorption and the economy is pushed into recession with resulting
unemployment. Alternatively, authorities may try to tackle the deficit by devaluating the
exchange rate, this has the effect of moving the economy towards point D on the EB
schedule.
While the devaluation has the effect of reducing the current account deficit it does so at the
expense of adding further inflationary pressure to the economy. This is shown by the fact
that the economy moves further away from the internal balance schedule.
108
The important lesson obtained from this simple model is that, the use of one instrument, be it
fiscal expansion or devaluation to achieve two goals- internal and external balance, may not
be successful. To move from point B to point A, the authorities need to deflate the economy
and undertake devaluation by appropriate amount. The deflation will control inflation and
the devaluation improves the current account so that the two objectives can be met.
While the Swan diagram provides a useful conceptual frame-work for economic policy
discussion it is rather simplistic in that the underlying economic relationships are not
explicitly defined.
Further more; there is no role for international capital movements that
were an increasingly important feature of the post second world war international economy.
Moreover, there is no distinction made between monetary and fiscal policies as means of
influencing aggregate demand and output in the economy. The Mundell -Fleming model,
however, will integrate such feature into a formal open economy macroeconomics model.
6.2. THE MUNDELL FLEMING MODEL

This model has its origin to a paper published by James Fleming (1962) and Robert Mundell
(1962, 1963). Their major contribution was to incorporate international capital movements
into formal macroeconomics models based on the Keynesian IS-LM frame work.
Their
paper led to dramatic implications concerning the effectiveness of fiscal and monetary policy
to achieve internal and external balance.
We shall now examine the main implication of the Keynesian model and the results of
Flemings and Mendels paper by using the so called IS-LM-BP analysis.
6.2.1 THE DERIVATION OF THE IS SCHEDULE FOR AN OPEN

ECONOMY.
The IS curve is a curve or schedule for an open economy that shows various combinations of
the level of output. (national income) and interest rate that makes leakage equals to injection
109
Leakage refers to savings and import expenditure, where as injection refers to investment,
government expenditure and export, I.e.,
Leakage = Injection
S+M = I+G+X
In an open economy we have the following identity called open economy identity,
Y=C+I+G+X-M ..(6.1)
Where,
Y is national income,
C domestic consumption,
G is government expenditure,
I is domestic in vestment,
X is export expenditure, and
M is import expenditure.
The above open economy identity can be restated in terms of equality between leakages and
injections. We know that S =Y-C
Where, S represent saving and the equation (6.1) can be written as ,
S+M= I+G+X .(6.2)
For simplicity the following linear relation ship between saving and national income is
assumed.
S = Sa+sY (6.3)
Equation (6.3) state that saving, are equal to autonomous savings (Sa) plus induced savings
sY which are a positive function of income, where s is the marginal propensity to save. That
means saving has two parts, one is autonomous which is not related to the level of income
and the other is a part which is directly related to the level of income.
Similarly import has two parts, one is autonomous and is not affected by the level of income
and the other is the amount which is directly related to income and is indicated as
110
M = Ma+mY....(6.4)
Equation (6.4) state that imports are equal to autonomous imports (Ma) plus imports which
are a positive function of income, where m is the marginal propensity to import. Investment
is assumed to be an inverse function of the rate of interest and is given by
I = I( r ) .(6.5)
Where r is interest rate and
I
<0
r
As far as government expenditure and exports are concerned both are considered to be
exogenous with respect to rate of interest and level of national income.
The following relationships are depicted in figure 6.2 which includes four quadrants.
Quadrant (1) presents the relationship between leakage and national income,
and this
relationship is upward sloping line because increase in income lead to increased in savings
and imports, and the slope of the line is given by
( s + m)
At income level Y1, the corresponding level of leakage is given by L1, similarly at income
level y2, the corresponding level of leakage is given by L2 .
The resulting volume of leakages is transferred to quadrant (2) which has a 45o line that
converts any distance along the vertical axis to an equivalent distance on the horizontal axis
which measures injection. Hence, the leakage L1 are converted into an equivalent of injection
(In),
The injection schedule is depicted in quadrant ( 3) which shows that given the price level and
state of expectations, the rate of interest that leads to a level of injections (In) is given by r1.
The injection schedule is down ward sloping. This is because investment is inversely related
to the rate of interest while the level of government expenditure and exports are assumed to
be independent of the rate of interest.
111
S+M
(1)
S+M
L2
L2
L1
L1
Y1
Y2
Income
(2)
45o
In1
In2
Injection (I+G+X)
(3)
(4)
r1
r1
r2
r2
IS
Y1
Y2
In
In1
Income
In2
Injection
Figure 6.2 the derivation of IS curve in an open economy.
We now see that the income level Y1 generates leakage L1 which will be equal to injection
In1, if the interest is r1. This means that at Y1, leakage is L1 and injection is In1, and this
occurs when interest rate is r1 .That is given Y1 level of out put , equilibrium condition
requires r1 lese of output. If this is the case in quadrant (4) we can depict a point on the IS
curve for an open economy because at interest rate r1 and income level Y1 we know that
leakages are equal to injection. We can repeat the same process for the income level Y2 to
obtain the rate of interest r2 for which leakages are equal to injections. By joining such
different points of income and interest rate at which leakages will be equal to injections we
get a down-ward slopping curve called IS curve or schedule.
112
The IS curve is downward sloping because higher level of income generates higher level of
leakage which require a fall in the interest rate to generate increased investment to maintain
equality of injections and leakages .
6.2.2. THE DERIVATION OF THE LM SCHEDULE FOR AN OPEN

ECONOMY
The LM curve shows the relationship between the interest rate and national income at which
the money market is at equilibrium. In other words the LM schedule shows various
combinations of the level of income and rate of interest for which money demand equals
money supply.
In the simplest model we assume that money is demanded only for two reasons. These are,
For transaction purpose
For speculative purpose
Transaction motive of money demand:- With this motive people hold money because
there is no a perfect synchronization between their receipt and expenditure of money. In

general it is assumed that when income of a consumer increases their demand for money for
transaction purpose will increase as well. This is due to the fact that increased income
induces higher consumption of goods and services and this leads individual to hold more
money for transaction purpose. Hence, the transactions demand for money is assumed to be
a positive function of income and is expressed as follows
Mt=mt(Y) ..(6.)
Where, mt represents transaction demand for money.
Demand for money for speculative motive:- Another reason for holding money is a
speculative, motive. It is assumed that any money balances held in excess of those required
for transaction purpose are speculative balance. Speculative demand for money is related to
the level of rate of interest. When interest rate increases the opportunity cost of holding
113
money will also increase as a result individuals will hold less amount of money and hence
demand for money will fall.
For example, if the interest rate is 3% annually, the opportunity cost of holding birr 1000 is
birr 30 per year. But if the annual interest rate increases to 10% the opportunity cost increase
to 100 per year, as a result the demand to hold speculative balance will fall as the rate of
interest increases.
Generally, the relationship between demand for speculative purpose and interest rate is
inverse and is presented algebraically a follows
Msp = Msp ( r ) .. (6.7)
Where Msp is the speculative demand for money
In equilibrium, money demand (Md) which is the sum of transaction and speculative
balances is equal to the money supply (Ms).
The money market equilibrium is given by,
Md = Msp+M t=Ms .(6.8)
With the above money market equilibrium in mind, the derivation of LM is depicted in figure
(6.3). In the figure quadrant (1 ) depicts the transaction demand for money as a positive
function of income.
When in come rises from Y1 to Y2 the demand for transaction balance rise from Mt1 to Mt2 .
(1)
Mt
(2)
Mt
a
Mt 2
Mt2
Mt 1
Mt1
114
0
Y1
Y2
Income
(4)
Msp2 Msp1
Msp
(3)
LM
r2
r2
r1
r1
Msp
Y1
Y2
Income
Msp1
Msp2
Figure 6.3. Derivation of LM curve
The transaction balance figure is transferred to quadrant (2) which shows the distribution of
the fixed money supply between transaction and speculative balance.
The distance Oa represents the total money supply. It shows that, say, if mt1 is held for
transaction purposes then Msp1 is held as a speculative balance (Oa-OMt1=Msp1).
Quadrant (3) shows the speculative demand for money which is down ward sloping . This is
because the demand for speculative balance is inversely related to the rate of interest. The
schedule reveals that speculative balances Msp1 are willingly held at interest rate r1.
Now we have sufficient information to derive the LM curve which represents the
combination of income and interest rate at which money market is at equilibrium. Quadrant
(4) shows that at interest rate r1 and income level Y1 the demand for speculative and
transaction balances is equal to the money supply. By taking another income level Y2 by
115
similar process we can find a rate of interest r2 which is compatible with money market
equilibrium. By joining all such paints we obtain a curve called LM.
The LM schedule is up ward sloping from left to right because high income levels imply
relatively larger transaction balances, which for a given money supply can only be drawn out
of speculative balances by a relatively high interest rate.
6.2.3. THE DERIVATION OF THE BP SCHEDULE FOR AN OPEN

ECONOMY
The balance of payment (BP) schedule shows different combination of rates of interest and
income that are compatible with equilibrium in the balance of payment. When referring to
the balance of payment we divide it in to two sections. These are, the current account and
capital account. Exports are assumed to be independent of the level of national in come and
the rate of interest, but imports are assumed to be positively related to income, and is
expressed algebraically as,
M=Ma+mY. ....... ( 4.9)
Total import (M) is a function of autonomous import (Ma) and the level of income, where m
is the marginal propensity of import.
We now need to remind ourselves the essential part of the balance of payments. As we have
seen it in the previous chapter, the overall balance of payment is made up of there major
components and these are
The current Account ( CA)
The Capital Account (K)
The change in Reserve (R)
Maintaining balances in the supply and demand for currency, means that maintaining the
external balance and this mean that there is no need for the authorities to have to change their
holdings of foreign exchange reserve( (R = 0). Thus, BP equilibrium is achieved when
116
CA+K=0 This implies that if there is a current account deficit there should be an off setting
surplus in capital account to have equilibrium in balance of payment. Conversely, if there is
a current account surplus there need to be an offsetting deficit in the capital account to have
equilibrium in the balance of payment.
Since exports are determined exogenously and imports are a positive function of income,
when the national income raises the current account surplus will fall or the current account
deficit widened.
The net capital flow (K) is a positive function of the domestic interest rate. Assume the
interest rate in the rest of the world (r*) is fixed, the higher the domestic interest rate ( r ) the
higher will be the capital inflow into the country or the capital outflow will be lower. This
relationship is expressed as.
K= K(r-r*)..(6.10)
Since the balance of payment schedule shows different combinations of level of income and
the rate of interest for which the balance of payment in equilibrium,
X-M+K=0 .(6.11)
Where, X-M= CA
A positive K indicates a net inflow of fund, where as a negative K indicates a net outflow of
funds. Having this in mind the derivation of the BP schedule is depicted in figure (6.4)
Current account
CA
CA1
0
Current account
(1)
(2)
CA1
0
CA2
450
117
0
Y1
Y2
Income
K2
K1 Capital account
Outflow (-)
Inflow (+)
BP
r
(3)
r2
(4)
r1
r2
r1
K
Y1
Y2
Income
Inflow
L2
Capital Account
Outflow (-)
Figure 6.4. The derivation of BP Schedule
Quadrant (1) shows the relationship between the current account and level of national
income. The current balance schedule slopes downwards as increase in income leads to a
deterioration of the current account. At income level Y1 there is a current account surplus of
CA1. The current account surplus or deficit is transferred to quadrant (2) where the 450 line
convert the current account position to an equal capital flow of the opposite sign. With a
current account surplus CA1 there is a required capital outflow K1 to ensure balance of
payment equilibrium. Where as a current account deficit CA2 require a capital inflow K2.
Quadrant ( 3 ) shows the rate of interest rate that is required for a given capital flow. The
capital flow schedule is downward sloping from left of right. This is because high interest
rate encourages a net capital inflow, where as low interest encourage a net capital outflow.
To get a capital outflow of K1 requires the interest rate to be r1, while a capital inflow of K2
requires a higher i-rate of r2 .
Since income level Y1 is associated with a balance of payment surplus, there has to be an
offsetting capital outflow K1 which requires an interest rate r1; these coordinates give a point
on the BP schedule that is depicted in quadrant (4) . The BP schedule is upward sloping.
This is because higher level of income causes deterioration is the current account, and this
118
necessitates reduced capital outflow or higher capital inflow which requires a higher interest
rate. Every point on BP schedule shows a combination of domestic income and rate of
interest for which the overall balance of payment is in equilibrium. At point to the left of the
BP schedule the overall balance of payments is in surplus because for a given amount of
capital flows the current account is better than that required for equilibrium as the level of
income is lower. Conversely, to the right of the BP the over all balance of payment is in
deficit as the income level is higher than that compatible with overall equilibrium.
An important point is that the slope of the BP schedule is determined by the degree of
international capital mobility. If the international capital mobility is very high the balance of
payment schedule will be flatter or the slope will be smaller. This is due to the fact that
increase in income leads to a deterioration of the current account, higher degree of capital
mobility and interest rate required to rise by smaller amount to attract sufficient capital
inflow to ensure overall equilibrium.
When capital is perfectly mobile, a small rise in the domestic interest rate above the world
interest rate leads to a massive capital inflow making the BP schedule horizontal at the world
interest rate. At the other extreme if capital is perfectly immobile internationally then a rise
in the domestic interest rate will fail to attract capital inflows making the BP current
account balance. Between these two extremes, that is when we have an upward sloping BP
schedule, we say the capital is imperfectly mobile.
6.3. EQUILIBRIUM OF THE MODEL

Equilibrium occurs when all three schedules intersect. At the point of intersection, the level
of rate of interest and income level represents equilibrium income and rate of interest.
Figure 6.5 represents all the three schedules intersecting at point A. Changing the slope of
any one of these curves can lead to somewhat different policy prescription All the three
curves passes through a common point A which corresponds to the domestic interest rate r1
and income level Y1. The Income level Y1 is seen to be less than that of the full employment
119
level of income Yf, implying that there is some unemployment in the economy. Although the
economy is not in internal equilibrium, the balance of payment is in equilibrium because the
IS and LM curves intersect at a point on the BP curve
BP
LM
A
r1
IS
Y1
Yf
Figure 4.5. Equilibrium of the model
The explanation as to why the IS-LM schedule do not intersect at the full employment level
of income Yf is that at Yf planned leakage (saving and import) would exceed planned
injection (government expenditure, export and investment). This would imply a build up of
inventory stock, of unsold goods leading producers to reduce output. Only at output level y1
do planned leakage equal planned injection so that changes in inventory stocks are avoided.
6.4. FACTORS SHIFTING THE IS-LM-BP SCHEDULES ( CURVES )

The change in monetary and fiscal policy will affect the schedule of these three
variables.
A policy that affects the IS schedule, will also affect the equilibrium interest rate and income
level. In this part let us look at factors affecting each of these schedules.
120
Factors Shifting the IS Schedule

If there is an increase in investment, government expenditure or export, the IS curve will
shift to the right. In other words any policy intended to increase either export, government
expenditure or investment will shift the IS curve to the right leading to higher rate of interest
and expansion of level of national income ( if LM and BP remain unchanged). This is
because of the fact that an increase in these injections requires a higher level of national
income to induce a matching increase in leakage in the form of increased savings and
imports.
An autonomous fall in savings or imports will also lead to a rightward shift of the IS
schedule because a higher level of income is required to induce more savings and imports
expenditure
so
as
to
maintain
equality
of
leakages
and
injections.
Another important factor that causes a right ward shift of the IS schedule is a depreciation or
devaluation of the exchange rate, provided that the Marshall Lerner condition holds; this is
because deprecation of the exchange rate leads to a reduction of import expenditure and an
increase in export sales, so that injections then exceed leakages requiring an increased level
of income to bring them back into equality.
Factors Shifting the LM Schedule

The LM schedule will shift to the right, if there is an increase in the domestic money supply
because for a given rate of interest the increased supply will only be willingly held if there is
an increase in income which leads to a rise in transaction demand.
A depreciation of exchange rate will lead to a rise in the aggregate price index, that is an
index made up of a weighted basket of domestic and foreign imported goods which implies
a rise in the price of imports. This means that real money balances will be reduced and there
will be a resulting excess demand for money that can only be eliminated by reducing the
121
transaction demand for money implying a lower level of income and leftward shift of the LM
schedule.
Factors Shifting the BP Schedule

An autonomous increase in exports or an autonomous decrease in imports will lead to an
improvement in the current account requiring a rightward shift of the BP curve / schedule to
induce a sufficient increase in imports to maintain balance of payments equilibrium. In other
words, an autonomous increase in exports (injection or an autonomous decrease in imports
(leakage) raises equilibrium income at each lever of interest rate, which implies a right ward
shift in BP schedule
Another factor that can cause a right ward shift of the BP schedule is a depreciation/
devaluation of the exchange rate, provided that Marshall-Lerner condition holds, the value of
the export sales will rise and the value of import expenditure decline. Hence, the only way to
ensure overall balance- of- payments equilibrium is a rise in the level of domestic income.
6.5. POLICY
INSTRUMENTS
TO
MAINTAIN
INTERNAL
AND
EXTERNAL BALANCE
So far we have tried to look at some of the possible facts that shifts the three
schedules/curves. In this section we will try to see how the knowledge of these factors are
important in the application of open economy macroeconomic policy.
The swan diagram showed that authorities generally need as many instruments as they have
targets and revealed that the use of both expenditure-switching and expenditure-changing
policies can lead to the attainment of internal and external balance. However, it was not
possible to distinguish between the fact that fiscal and monetary policies are quite different
and independent types of expenditure-changing polices.
122
This raise question like whether or not it is feasible to achieve the twin objective of internal
and external balance by combining fiscal and monetary policies without the need to adjust
the exchange rate?
Before addressing the issue we need to consider how monetary and fiscal policy may be used
as policy instrument for achieving internal and external balance , and we need to consider
how the two polices influence economic activities.
Monetary Policy
When the authorities conduct an expansionary monetary policy, they purchase bonds from
the public, this pushes up the price of bonds and leads to a fall in the domestic interest rate,
which in turn stimulates investment and leads to a rise in output. As far as the balance of
payments is concerned, the increase in income leads to a deterioration of the current account
and lower interest rate will lead to in crease in capital outflow so that the balance of payment
moves into deficit.
Conversely, a concretionary monetary policy involves the authorities selling bonds, this
pushes down the price of bonds and leads to a rise in the domestic interest rate, which leads
to less investment and a fall in output. The balance of payment position will improve as
imports fall and the higher interest rate attracts capital inflow.
Fiscal Policy
With an expansionary fiscal policy the government increases its expenditure. Government
with pure fiscal policy finances its expenditure by selling bonds. The increase in government
expenditure will shift the IS curve to the right. However, the bond sales will depress the
price of bonds, there by rising domestic interest rate which will offset expansion in output.
The price effect of the fiscal expansion on the balance of payment is indeterminate because
while the expansion of output will worsen the current account, the rise in interest rate will
improve the capital account. The fiscal policy will not affect the money supply /demand in
123
the hands of the private sector. The money raised from bond sales is re-injected into the
economy, through increased government expenditure.
Sterilized and Non-Sterilized Intervention

Another policy which we need to clarify is the distinction between sterilized and nonsterilized intervention, in the foreign exchange markets.
Sterilized Intervention:- With such intervention authorities will offset the money base
implication of their exchange market intervention to ensure that the reserve changes due to
intervention do not affect the domestic money base.
Non-Sterilized Intervention:- With such intervention the authorities allow the reserve
changes resulting from their intervention to affect the monetary base.

Let us illustrate the difference between these two interventions with the help of graph which
is depicted in figure 6.7 below,
BP
LM1
r1
r2
LM2
124
IS
Y1
Y2
Figure 4.7. Monetary expansion under fixed exchange rate
Suppose the authority takes measure that leads to a monetary expansion. This monetary
expansion shifts the LM curve from LM1 to LM2. This causes a fall in interest rate to r2 and
a rise in domestic income to Y2 which will lead to a deficit in the balance of payment as both
current and capital account deteriorates.
The deficit in the balance of payment means there is an excess supply of the domestic
currency or excess demand for foreign exchange on the foreign exchange market. To
maintain a fixed exchange rate the authorities have to purchase the home currency with their
foreign reserve. The purchase of the home currency by the authorities would start to shift the
LM schedule back to LM1. This is an example of nonsterilized intervention, that is, the
authorities allow their intervention in the foreign exchange market to influence the money
supply.
On the other hand if the authorities follow a policy of sterilization, the reserve fall which
reduce the money supply are exactly offset by a further expansion of the money supply so
that the LM schedule remains at point LM2. A problem with sterilization policy is that by
remaining at LM2 with interest rate r2 and income level Y2, the authority will suffer
continuous balance of payment deficit and a continuous fall in reserve. Such sterilization
policy is only feasible in the short-run because in the long-run reserves would eventually run
out making devaluation inevitable.
6.6. INTERNAL AND EXTERNAL BALANCE UNDER FIXED

EXCHANGE RATES
125
In this section we will try to examine how fiscal and monetary policy and exchange-rate
policy can be combined in various combinations to simultaneously achieve internal and
external balance.
The situation of fixed exchange rate and unemployment is depicted in figure 6.8.
BP
LM2
C
r3
r2
LM1
B
r1
IS2
IS1
Y1 Yf
Y2
Figure 6.8 Internal and External balance under fixed exchange rate.
Suppose initially the economy is at point A with interest rate r1 and income level Y1, which
means that while the economy is in external balance the income level is below the full
employment level of income Yf.
The government attempts to eradicate the unemployment through a bond-financed fiscal
expansion which leads the IS curve to shift to the right from IS1, to IS2.
As a result
domestic output expands from Y1 to Y2 and the economy would be at point B with interest
rate r2. When the level of output increases beyond the full employment we find that the
induced increase in imports moves the current account into deficit. Even if the rise in the
interest rate attracts some capital inflow the balance of payment is in overall deficit since the
economy is to the right of the BP schedule.
126
To solve the problem authorities will be forced to purchase the home currency in a foreign
exchange market, but as they follow a sterilization policy the LM schedule remain at LM1.
Thus, using only a single policy instrument, in this case fiscal policy, the government can
temporarily achieve its internal balance at the expense of or by specifying the external
balance.
Ideally, authorities would like to achieve both internal and external balance. This is possible
if the authorities combine the expansionary fiscal policy-shift of IS1, to IS2-with a
concretionary monetary policy which shifts the LM Schedule from LM1 to LM2 where it
passes through point C on the BP curve. The restrictive monetary policy raises interest rates
further than in the case of a solely fiscal expansion to r3, thereby attracts additional capital
inflows so as to restore the balance of payment back to equilibrium
Therefore, by combining an expansionary fiscal policy with concretionary monetary policy

the authorities can achieve both internal and external balance. What is important to notice is
that both internal and external balances can be achieved without the need to change the
exchange rate; this is because the authorities have two independent instruments available,
monetary and fiscal policy and two targets.
6.7. INTERNAL AND EXTERNAL BALANCE UNDER FLOATING

EXCHANGE RATES
According to our analysis of the Swan diagram, by combining an exchange rate change with
expenditure changing policy, it is possible to achieve both internal and external balance.
Figure 6.9 illustrates the case of monetary expansion under floating exchange rates.
Suppose the country is initially at equilibrium at point A with interest rate r1 and output level
Y1. When the authorities, adopt an expansionary monetary policy which shifts the LM
schedule from LM1 to LM2. The combination of a fall in the interest rate and increase in
income leads to a balance of payments deficit at point B.
127
However, the exchange rate is allowed to depreciate and this leads to a rightward shift of the
IS schedule from IS1 to IS2 and a rightward shift of the BP schedule from BP1 to BP2. It also
leads to a left ward shift of the LM schedule until all three schedules intersect at a common
point such as C with new income level Y2 and interest rate r2.
BP1
r
LM1
r1
A
C
BP2
LM3
r2
LM2
B
IS1
Y1
Y2
Figure 6.9 Monetary expansions under floating exchange rate
Thus, by using monetary policy in conjunction with exchange rate change , it is possible to
raise output to the full employment level and achieve external balance simultaneously .Over
all, money supply expansion results in an exchange rate depreciation, a fall in the domestic
interest rate, and an increase in income.
The lower interest rate implies a lower capital inflow or higher capital outflow than before
the money supply expansion, while the increases in income worsen the current account.
Overall however, the current account improves due to the exchange rate depreciation. It
128
must improve because the capital account has deteriorated due to the fall in the domestic
interest rates.
6.7.1 FISCAL EXPANSION UNDER FLOATING EXCHANGE RATES

To look at the effect of fiscal expansion under floating exchange rates we shall consider two
cases, in the fist case the balance of payment- BP schedule is steeper than the LM schedule ,
while in case two the reverse is true
Figure 6.10 depicted the case where BP schedule is steeper than the LM Schedule. Steeper
BP schedule means capital flows are relatively insensitive to interest-rate changes, while
money demand is fairly elastic with respect to the interest rate. An expansionary fiscal
policy shifts the IS schedule from IS1 to IS2 which induce the rise of the domestic interest
rate and domestic income. In crease in interest rate and income has opposing effects on the
balance of payments. That is the expansion of real output leads to a deterioration of the
current account, the increase in interest rate improves the capital account .
However, since capital flows are relatively less mobile the former effect out weighs the
lather,
as
result
the
balance
of
payment
moves
into
deficit.
The deficit in the BP leads to a deprecation of the exchange rate and this has the effect of
shifting the BP schedule to the right from BP1 to BP2 and the LM schedule to the left from
LM 1 to LM2 and the IS schedule even further to the right from IS2 to IS3
.
BP1
BP2
LM2
129
LM1
r2
B
A
r1
IS3
IS2
IS1
Y1
Y2
Figure 6.10, Case 1, fiscal expansion under floating exchange rate
In the above figure (fig.6.10), final Equilibrium is obtained at point C with interest rate r2 and
income level Y2. Hence, the deterioration in the balance of payment resulting from the rise
in real income is offset by a combination of a higher interest rate and exchange rate
depreciation
The effect of fiscal expansion under case 2, is presented in figure 6.11. An expansionary
fiscal policy shifts the IS schedule from IS1 to IS2. Under this case, capital flows are more
responsive to change in interest rate and the BP schedule is less steep than the LM schedule.
The shift in IS schedule will raise both interest rate and domestic income. The increase in
interest rate will increase the capital inflow which is more than offsets the deterioration in the
current account due to the increase in income and the balance of payments moves into
surplus. This surplus induce an appreciation of the exchange rate which moves the LM
schedule to the right from LM1 to LM2 and the IS carve to the left from IS2 to IS3.
Equilibrium is obtained at higher level of output, higher level of output, higher interest rate
and an exchange rate appreciation.
LM1
LM2
130
B
BP2
r2
BP1
A
r1
IS1
Y1
IS3
IS2
Y2
Figure 6.11, case 2 fiscal expansion under floating exchange rate
Generally, a fiscal expansion can, according to the degree of international capital mobility,
leads to either exchange rate depreciation or an exchange rate appreciation.
6.8 A SMALL OPEN ECONOMY WITH PREFECT CAPITAL MOBILITY

One of the legacies of the post-second world war is the increase in integration of
international monetary system and international capital market. The desirability of capital
flows and how they might endanger the ability of authorities to conduct effective economic
policy has been widely discussed.
Mundell and Fleming (1962) sought to examine the implication of high capital mobility for a
small country that had no ability to influence world interest rates. Their paper showed that
for such a country, the choice of exchange-rate regime would have radical implications
concerning the effectiveness of monetary and fiscal policy in influencing the level of
economic activity.
6.8.1. FIXED EXCHANGE RATES AND PERFECT CAPITAL MOBILITY
131
The model assumes a small country facing perfect capital mobility. Any attempt to raise the
domestic interest rate leads to a massive capital inflow to purchase domestic bonds pushing
up the price of bonds until the interest rate returns to the world interest rate. Similarly, any
attempt to lower the domestic interest rate lead to a massive capital outflow as international
investors seek higher world interest rate. . Such massive bond sale means that bond prices
fall and the domestic interest rate immediately returns to the world interest rate in order to
stop the capital outflow. The implication of perfect capital mobility is that the BP schedule
for a small open economy becomes a horizontal straight line at the domestic interest rate
which is equal to the world interest rate.
Figure 6.12 . depicts a small open economy with a fixed exchange rate.
r
LM1
LM2
r1
BP
IS2
IS1
Y1
6.12. Fixed exchange rates and perfect Capital mobility
In the above figure, the initial level of income is Y1 where IS-LM curves intersect, which
is below the full employment level of income Y1. If the authorities attempt to raise output by
a monetary expansion, the LM curve shifts from LM1 to LM2 , and there is a down ward
pressure on the domestic interest rate and this results in a massive capital outflow. The
capital outflow means, there is pressure for devaluation of the currency. To prevent the
devaluation authorities must intervene in the foreign exchange market to purchase the home
132
currency with reserves. Such purchase result in a reduction of the money supply in the bond
of private a gents, and the purchase have to continue until LM curve shifts back to its original
position at LM 1 where the domestic interest rate is restored to the world interest rate. With
perfect capital mobility, any attempt to pursue a sterilization policy leads to such large
reserve loss that it can not be pursued.
Therefore, with perfect capital mobility and fixed exchange rates, monetary policy is in
effective in influencing output.
By contrast, if there is a fiscal expansion, the IS schedule will shift to the right from IS1 to
IS2. This shift puts up-ward pressure on the domestic interest rate which leads to a capital
inflow.(increase in supply of FOE)
To prevent appreciation of domestic currency the
authorities have to purchase the foreign currency with domestic currency, This mean that the
amount of domestic currency held by private agents increase. The increase in the money
stock continues until the LM schedule passes through the IS2 schedule at the initial interest
rate.
Thus, under fixed exchange rates and perfect capital mobility an active fiscal policy has the
ability to achieve both internal and external balance. This is an exception to the instrumentstarget rule, although monetary policy does have to passively adjust to maintain the fixed
exchange rate.
6.8.2.
FLOATING
EXCHANGE
RATES
AND
PERFECT
CAPITAL
MOBILITY.
Figure 6.13 depicts the situation under floating exchange rate with perfect capital mobility.
Suppose the economy is initial in equilibrium at income level Y1 where the IS1 schedules
intersect the LM1 schedule. A monetary expansion shifts the LM schedule from LM1 to LM2
leading to downward pressure on the interest rate, which in turn leads to capital outflow and
a depreciation of the exchange rate. The depreciation leads to an increase in exports and
reduction in imports. This will shift the IS curve to the right and the LM curve to the left so
that final equilibrium is obtained at higher level of income say Y2. This implies that with an
133
appropriate initial monetary expansion the authority could obtain both internal and external
balance by monetary policy alone.
r
LM1
LM3
r1
IS1
Y1
Y2
IS2
Y
Figure 10.13. Floating exchange rate and perfect capital mobility
Suppose the authorities attempt to expand output by an expansionary fiscal policy. The
increased government expenditure shifts the IS schedule from IS1 to IS2. The increase in the
sale of government bond (to finance the fiscal expansion) leads to increase in the interest rate
which leads to a massive capital inflow and an appreciation of the exchange rate. The
appreciation of the exchange rate result in a reduction of export and increase in import, and
this forces the IS schedule to shift back to its original position.
Thus, with perfect capital mobility and a floating exchange rate, fiscal policy is ineffective in
influencing output.
In summary, fiscal policy is very effective in influencing output under fixed exchange rate
and monetary policy is very effective under floating exchange rate with perfect capital
mobility. This is relevant to economic policy design. Under fixed rates, policy makers will
pay more attention to fiscal policy than under floating rates when more emphasis will be
placed on monetary policy.
134
The degree of capital mobility and the exchange rate regime both demonstrate that
appropriate economic policy instrument in an open economy is very different from that in a
closed economy context.
6.9. LIMITATIONS OF THE Mundell FLEMING MODEL

For economic policy formulation for an open economy the Mundell.- Fleming model- ISLM-BP model has been so far one of the major policy model for the last three decades.
However, the model has been criticized by different authors on different grounds. The
limitations of the model are enumerated as follows.
The marshal-Lerner condition:- The model assumes that the Marshal- Lerner condition
holds even though it is a short- term model which is the time scale under which the MarshalLerner conditions are least likely to be met. That is , though the mundell - Fleming model is
a short term model, it assumes that the marshal Lerner condition holds.
Interaction of stocks and flows: - The model ignores the problem of the interaction that
may exist between stock and flow. According to the model a current account deficit can be
financed by a capital inflow. Such a policy can be feasible in the short run. However, capital
inflow overtime increases the stock of foreign liabilities owed by the country to the rest of
the world, and this leads to a worsening of the future current account as interest is paid
abroad. Clearly, a country can not go on financing a current account deficit indefinitely as the
country becomes an ever-increasing debtor to the rest of the world.
Neglect long- run budget Constraint:-
According to Frenkel and Razin (1987), One of
the major deficiencies of the model is that it fails to take account of long-run constraints that
govern both the private and public sector. In the long-run private sector spending has to be
equal to its disposable income, while in the absence of money creation government
expenditure (including its debt service repayment) has to equal its revenue from taxation.
This means, in the long run the current account has to be in balance. One implication of
these budget constraints is that a forward-looking private sector would realize that increase in
government expenditure will imply higher taxation for them in the future, and this will
135
induce increase private sector savings today that will undermine the effectiveness of fiscal
policy.
Wealth effect: - The model does not allow for wealth effects that may help in the process of
restoring long-run equilibrium. A decrease in wealth resulting from a fall in the foreign asset
associated with a current account deficit will lead to a reduction in import expenditure.
which should help to reduce the current account deficit. Such an omission of wealth effects
on the import expenditure function may be justified as being of small significance in the
short-run However, the omission again emphasizes the essentially short-run nature of the
model.
Neglect of supply-side factors:- another limitation of the model is that it concentrates on the
demand side of the economy and neglects the supply side. There is an implicit assumption
that supply adjusts in accordance with changes in demand. Moreover, since the aggregate
demand do not lead to changes in the domestic price level, rather they are reflected solely by
increase in real output.
The Model assumes a continuous Capital flows :-
The model assumes that a rise in the
domestic interest rate leads to a continuous capital inflow from abroad. However, to expect
such flows to continue indefinitely is unrealistic because after some points international
investors will have to rearrange the stocks of their international portfolios to their desired
content and once this happens the net capital inflows in to the country will cease. The only
way that the country could continue to attract capital inflow would be a further rise in its
interest rate until once again international portfolios are restored to their desired content
A Country that needs a continuous capital inflow to finance its current account deficit has to
continuously raise its interest rate. That means, capital inflows are a function of the change
in interest differential not the differential itself.
The model ignores the role of Exchange-rate expectation:- A major problem with the
model is the treatment of exchange rate expectation. The model does not explicitly consider
these and implicitly assumes that the expected change is zero. This is known as static
136
exchange rate expectation. This may not be an unreasonable under fixed exchange rate. But
it is less reasonable under floating exchange rate.
According to the model a monetary expansion leads to a depreciation of the currency under
floating exchange rate. In such condition it seems unreasonable to assume that economic
agents do not expect depreciation as well. If economic agents expect depreciation, this may
require a rise in the domestic interest rate to encourage them to continue to hold the currency
which will have an adverse effect on domestic investment. This implies a weaker
expansionary effect of monetary policy than is suggested by the model.
Flexibility of policy instrument: - Another criticism is that the analysis is of a comparative
static nature and assumes that adjusting monetary and fiscal policy is a fairly simple matter.
In the real world the political process means that the degree of flexibility to adjust economic
policy, especially fiscal policy is hard to achieve.
6.10. SUMMARY
This chapter has tried to illustrate important aspects of the conduct of economic policy in an
open economy. Fiscal and monetary policy are useful in achieving full employment even
though they have an important implications for the balance of payment and exchange rate.
The change in balance of payment and exchange rate induced by fiscal and monetary policy
will also have feedback effects on the domestic economy.
The economic policy formulation in an open economy has to take into account many
important additional considerations compared to a simple closed economy. The most
important lessons for economic policy makers are that they generally need as many
independent policy instruments as they have targets. Any attempt by authorities to use only a
single policy instruments such as monetary policy instruments alone to achieve all the targets
of economic policy is highly doubtful.
137
Policy makers, still have a major policy problem in deciding which instruments to use to a
particular objective (target). Since the structures of economies differ from country to country,
no general rules exist to solve this problem. Theory remind us the fact that the choice and
application of incorrect policy instrument may provoke in stability in the economy .
In real world, however, achieving internal and external balance is difficult than our
theoretical analysis has suggested. Policy makers
usually face uncertainty in assigning a
particular policy instrument to a particular target. Such uncertainty is due to factors like,
Time lag problem
The authorities are in the passion of only limited information about an economy
Economies are continually being subjected to new shocks as well as adjusting to

previous shocks.
In the chapter we have seen that, though Mundell -Fleming model has many limitations, it
also calls attention on the difficulties and dilemmas facing policy makers in an open
economy. The most significant Contribution to international economics is that it focuses on
the important role that international capital flow can play in determining the effectiveness of
macroeconomic policies under alternative exchange rate regimes.

1. Explain the function of interest rate in an open economy?
2. Describe those factors affecting IS schedule in an open economy.
3. Which of the following factors causes the LM curve to shift or rotate and
Explain why and how!
a. Money supply change
b. Business and consumers confidence (expectation)
c. Interest rate
d. Price level
4. What is BP schedule?
5 In open economy with floating exchange rate system, monetary policy is said to be
138
effective instrument to maintain external balance. Explain why!

6. In an open small economy with perfect capital mobility and fixed exchange rates,
monetary policy is said to be ineffective to change the level of income. Explain why?
7.
xplain the fact that fiscal policy alone can be an effective instrument to bring internal as
well as external balance in a small economy with perfect capital mobility and fixed
exchange rate.
8.
Explain how monetary policy alone is effective to bring about change in output. Change
for a small open economy with perfect capital mobility and with floating exchange rate.
9.
Explain the difference between internal and external balance in the economy.
10. Explain the following statements.

a. The balance of payment schedule has positive slope.
b.
A point above the balance of payment schedule shows a surplus and below it
shows deficit in the balance of payment.
11. List and explain the limitations of the Mundell Fleming model.
139
CHAPTER VII
INTERNATIONAL MONETARY SYSTEM
INTRODUCTION
The international monetary is system referred to as the set of conventions, rules, procedures
and institutions that govern the conduct of financial relations between nations. In this chapter
we will try to briefly address some of the development of the post-second world war
international monetary system. Understandings of the historical institutional and economical
developments that have occurred since the 2nd world war was an essential background to the
study of international economics in general and to the study of international finance in
particular. There are many facts of the post - war system that deserve attention and are
shortly presented in this chapter. Some of the topics addressed are Breton-Woods system
and its eventual break-down, the setting up of European monetary system and economic
policy divergences of the 1980.
140
CONTENT
7.0. Objectives of the chapter
7.1 The Breton Woods system
7.2 The Break-down of the Breton-Woods system
7.3 Alternative Interpretation of the Demise of Breton-Wood
system
7.4 The European Currency and the Eurobond Market
7.5 The European Monetary System.
7.6 Euro- the European Currency
7.7 International Debt Crisis
7.8 Summary
7.0. THE OBJECTIVE OF THE CHAPTER

At the end of the chapter readers will be able to
Describe the Internal monetary system
Explain the evolution of Interaction monetary system
Under-stand the historical back ground of the Breton-Woods system
Learn how the Breton-Wood system broken down
Explain the International Debt crisis and LDCs.
7.1. THE BRETON-WOOD SYSTEM

The first talks on reconstruction of a post war international monetary system started between
the United State and United Kingdom as early as 1941. Given the US economic and political
dominance at the end of the war, it is not surprising that the eventual system reflected more
141
the US interest and proposals. The system that emerged was ratified at an international
monetary conference held at Breton-Woods, New Hampshire which was attended by some
44countries.
The motivation behind creating a new international monetary order was to avoid the
breakdown in international monetary relations that had occurred in the 1930s. In the 1920s
Germany faced with hyperinflation and the US stock market collapse of 1929 indicated a
worldwide recession. 1920s were marked by major trade imbalances which lead to the
adoption of widespread protectionism, the adoption of deflationary polices, competitive
devaluations and the abandonment of the gold exchange standard.
7.1.1. FEATURES OF THE BRETON- WOOD SYSTEM

There were several important features of this system, some of them are
a fixed but adjustable exchange rates
The setting up of two new international organization
The International monetary fund and.
The International Bank for Reconstruction and Development ( IBRD)

Commonly known as World Bank
Fixed but adjustable exchange rates

The Breton Woods system established a system of fixed but adjustable exchange rates. Each
currency was assigned a central parity against the US dollar and was allowed to fluctuate by
plus or minus one percent either side of this parity. The dollar itself was fixed to the price of
gold at $ 35 per ounce.
The idea of fixing the dollar to the price of gold was to provide confidence in the system. In
1945 the US authority held approximately 70 per cent of the worlds gold reserve. This is
because of the fact that foreign central banks would be more willing to hold dollars in their
reserve since dollar could be converted in to gold, and the US authority made a commitment
142
to keep the dollar convertibly into gold at $ 35 per ounce. This commitment was in effect a
pledge on the part of the US to preserve to purchasing power of dollars making the dollar as
good as gold.
A country was expected to preserve the par value of its currency with dollar, but in the case
of fundamental disequilibrium in its balance of payment it could devaluate or revaluate its
currency. Providing the proposed change was less than 10 percent the IMF could not object,
but larger realignments required the permission of the fund. The ability of a country to alter
its par rate as a last resort was seen as an essential part of the system. It offered countries an
ultimate alternative to deflation or import controls as a means of correcting persistent balance
of payment imbalance..
Under the agreement of the IMF, the member governments committed themselves to make
their currencies convertible for current account transactions as far as feasible. Convertibility
for such transactions means that while, governments could still employ capital control, they
could not prevent their residents or those of others countries from buying or selling their
currency for current account transaction. Such a commitment, however, to convertibility was
not required with respect to capital account transaction.
This omission reflected the
widespread suspicion that capital movement were potentially destabilizing.
The IMF and Credit Facilities

International Monetary Fund- IMF was set up with the objective to oversee (supervise) and
promote international monetary cooperation and the growth of world trade. One of the tasks
of the fund was to ensure the smooth functioning of the fixed exchange rate system.
The IMF would organize the system, consult with member countries about exchange rate
changes, and create international liquidly when needed. It also attempts to minimize the need
for devaluate and revolve the member countries currencies by providing them with credit
facilities with which to finance temporary balance of payments imbalance.
143
One of the major problems observed with the fixed exchange rates system was that countries
facing a temporary balance of payment deficit would be forced to deflate their economy if
they wish to maintain their exchange rate parity. The fund also sets up a credit mechanism to
provide support for countries facing transitory balance of payment problem.
Under the credit facility, each member of the IMF was allocated quota the size of which
related to its economic importance as reflected in the size of its contribution to the fund. A
country had to place a quarter of its quota in reserve assets (manly gold), and the remaining,
three quarters in its own currency with the fund. This gives the IMF a stock of fund which
could be lent to countries facing balance of payment difficulties. A country having difficulty
was entitled to the fist 25% of its quota, known as its gold trenches, automatically and a
further four trenches of 25% known as credit trenches could be drawn providing the country
agreed to conditions set by the IMF which became increasingly austere with each trenches
drawn.
Thus, in total a country can draw a maximum of 125% of its quota. The condition attached
to the latter trenches have called IMF conditionally and generally constitute a set of measures
designed to improve a countries balance of payments.
The IMF commenced its operation in March 1947 with the total initial quotas available at
US$8.8 billion. When a member country draws the IMF resources it would purchase reserve
assets (usually dollars) in exchange for further deposited of its currency. The fund decides
what assets and currencies the drawing country reserves as the basis of the composition of its
own resources. As a rule any borrowing from the fund has to be repaid over a period of three
to five years, and when repaying the fund a country buys back its currency with foreign
reserve.
7.2. THE BREAK DOWN OF THE BRETON WOOD

The Breton woods system operated with reasonable success with occasional realignments
from 1947 to 1971. The system has broken down in 1971 due to two reasons liquidity
problem and lack of an adequate adjustment Mechanism.
144
Liquidity Problem:- Before the break down of the Breton Wood system, Triffin (1960)
has predicted an eventual loss of confidence in the system. He argued that there was an
inherent contradiction in the gold-dollar standard. The Breton Wood system function
successfully as long as confidence on US dollar maintained. In other words for successful
functioning of the system, Central banks of member countries should be confident that the
dollar could be converted in to gold at $ 35 per ounce and hence willingly hold dollars in
their reserve.
Triffin pointed out that as international trade grew, demand for international reserve for US
dollar would grow as well. To meet the demand for these reserve the Breton Wood system is
dependent on US. the US would run deficit, while other countries running surplus and
purchasing dollars to prevent their currencies appreciating. As a result, the ratio of US dollar
liabilities to gold held by the US Federal Reserve would deteriorate until eventually the
convertibility of dollars in to gold at $35 per ounce would become impossible.
Under this situation the US authorities most likely unable to fulfill their convertibility
commitment. Triffin predicted that central banks would begin to anticipate a devaluation of
the dollar rate against gold. With this expectation central banks would start to convert their
dollar reserve into gold and stop pegging their currencies against the dollar leading to
inevitable break-down of the system.
The Breton woods system worked well in the 1950, but the confidence in the system slowly
deteriorated in the 1960s when the US faces a liquidity problem between 1968 to 1972 which
corresponds to the collapse of the system
Lack of an adjustment Mechanism:- The Breton-Woods system permitted a realignment
of exchange rate parities as a last resort in case of fundamental disequilibrium of members

balance of payment. However, in practice countries found to reluctant to either devalue or
revalue their currencies or undertake other economic policies.
145
The US could not devalue the dollar in terms of gold as it would undermine confidences in
the whole system. Moreover, a dollar devaluation against gold would not improve US
competitiveness if other countries maintained their exchange-rate parties against the dollar .
As such, the US was expected to pursue appropriate deflationary any policies at home to
keep the size of it balance-of payments deficit under control.
In practice the US was
reluctant to deflate its economy to regulate its deficits.

In mid-1960s US financed its involvement in Vietnam and a series of domestic social
programs through inflationary money supply increases rather than through higher taxation.
The expansionary US monetary policy resulted in higher US inflation and a significant
widening of its balance- of- payments deficit.
Other countries suffering persistent current account deficits could have resorted to
devaluation. In practice, deficit countries also proved to be extremely reluctant to devaluate
their currencies as such action was viewed as a sign of governmental and national weakness.
The deficit countries were equally reluctant to adopt deflationary policies which could cure
the deficits since most had committed themselves to the objective of achieving full
employment. With deficit countries reluctant to adjust, it was then necessary that surplus
countries take action to reduce their surpluses.
The surplus countries, Germany, Japan and Switzerland were also reluctant to revalue their
currencies. This was because the undervaluation of their currencies had enabled them to
experience strong export growth and biased their economies towards the production of
tradable goods. These countries believed that to revaluate their currencies would risk ending
exports growth and lead to unemployment in their economy as their tradable industries would
be forced to contract..
With neither deficit nor surplus countries being prepared to adjust their economies or
exchange rates, the question of how to maintain fixed exchange - rate parities in the face of
persistent balance of payment imbalances required an answer. In order to prevent exchange
rate realignment, the surplus countries supplied the deficit counties central banks with
reserves on a credit basis to enable them to prevent devaluations of their currencies.
146
Packages were arranged to support the Italian lira in 1964 and Sterling in 1965. However, it
was proved that such packages were only a means for delaying fixed exchange rate regime
rather than real solution to the problem in the monetary system.
7.3. ALTERNATIVE INTERPRETATION OF THE DEMISE OF

BRETON WOODS (SEE BACKS)
Although the Triffin dilemma seems to fit the facts quite well, and is commonly held as a
major cause of the breakdown of the Breton Woods system, Jurg Niehans (1984) and Paul De
Grauwe (1989) have suggested some what different interpretation of events. Their
interpretation is based on an application of what is known as Greshams law.
Thomas Gresham (1529-79) argued that when there is a discrepancy between official rate of
exchange between two assets and their private market rate of exchange, the asset that is
undervalued at the official rate will disappear from circulation. When this law applied to the
monetary field this means that bad money derives out good money
Greshams law can provide an insight into the collapse of the Breton Wood system. In this
case the two assets to be considered are gold and the US dollar. Under the Breton Woods
system the official rate of exchange of these two assets was at $ 35 per ounce. The US
authorities were committed to buy and sell gold with foreign monetary authorities at this
price. When US price increased by some 40 percent between 1959 and 1969 , the price of
gold should have risen by a similar amount. Indeed, in the private market there was a
persistent upward pressure on the price of gold leading to the setting up of the gold pool.
However, these gold sales become so significant the loss of gold led central banks to disband
the gold pool in 1968. A two-tier market for gold led to the private market price of gold
rising above the official rate.
Once the official price of gold become undervalued compared to the private rate, central
banks could easily have caused a major run on the dollar by converting their dollar reserves
147
into gold and then selling the gold on the private market at a profit. In a bid to preserve the
fixed exchange banks want to convert their dollar reserves into gold or to sell gold to private
market.
In effect, the dollar was de facto no longer convertible into gold. In the end, following a
further deterioration of the US balance of payments in 1970 and 1971, President Nixon
announced, the de jury suspension of dollar convertibility into gold. Dollars had driven out
gold in accordance with Greshams law.
7.4. THE EUROPEAN CURRENCY AND THE EUROBOND MARKET

In this part we look at two important markets that had a great deal of influence on the
international financial system, particularly after the collapse of the Breton Wood system.
These are the Eurocurrency market and Eurobond market. Eurocurrency market are defined
banking markets which involve short-term borrowing and lending conducted outside of the
legal jurisdiction of the authorities of the currency that is used; fore example, Eurodollar
deposits are dollar deposits held in London and Paris. The Eurocurrency market has two
sides ot it- the receipts of deposits and the loaning out of those deposits. By far the most
important Eurocurrency was the Eurodollar which currently accounts for approximately 6570% of all Eurocurrency activity.
Since the 1960s until the introduction of European Currency (euro) there has been an
astonishing rate of growth of the Eurocurrency market. In 1963 the gross total value of Euro
bank assets (a similar figure applies to deposit liabilities) was approximately $12.4 billion,
but by the end of 1995 the Eurodollar market stood at $8034 billion which works out at an
average growth rate of 22.5 per cent per annum over the 32 years! Measuring the actual size
of the Eurocurrency market presents some difficulty because a distinction needs to be made
between the gross and net size of the market. The gross measure includes both non Eurobank and inter-bank deposits, while the net measure excludes inter-bank deposits.
The Eurocurrency market is part of the international money market since it involves lending
and borrowing for a period of less than a year. By contrast, the Eurobond market is part of
148
the international capital market and involves lending and borrowing for periods of more than
a year.
A Eurobond is a bond that is sold by a governmental institution or company in a currency
that is different from the country where the bond is issued. For example, a dollar bond sold in
London is a dollar Eurobond and a sterling bond so1d in Germany is a sterling Eurobond.
Both the Eurocurrency and Eurobond markets arc in many ways a phenomenon of the
increasingly open world trading system. There is no reason why borrowing and lending in a
given currency needs to he carried out exclusively in the particular country that issues the
currency.
Participants in the Eurocurrency and Eurobond Markets

Before looking at the Eurocurrency and Eurobond markets it is worth examining the
participants that use these markets and their motivations. The participants in the international
money and capital markets include national governments, local authorities, financial
institutions such as banks, multinational firms, companies and international institutions such
as the World Bank and European Investment Bank, as well as private investors. Most
Industrialized countries participants act as both lenders and borrowers of funds, while many
developing countries used the markets almost exclusively for borrowing purposes.
The Origins and Development of the Eurocurrency Market

The origins of the Eurocurrency market can be traced back to 1957. The Russians having
acquired US dollars through their exports of raw materials were, given the strong anticommunist sentiment prevailing in the US and the cold war, reluctant to hold these funds
with US banks. Instead, they were held in an account with a French bank in Paris, the cable
address of which was EURO-BANK. Also in 1957, the Bank of England introduced
restrictions on UK banks ability to lend sterling to foreigners, and foreigners ability to
borrow sterling. This induced UK banks to turn to the US dollar as a means of retaining
Londons leading role in the financing of world trade. In 1958 the abolition of the European
Payments Union and restoration of convertibility of European currencies meant that
European banks could now hold US dollars without being forced to convert these dollar
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holdings with their central banks for domestic currencies.

An important drive for the rapid growth of the Eurodollar market came from the increased
regulation of domestic banking activities by the US authorities. In 1963 the US government
introduced Regulation which imposed a 5.25 per cent ceiling on the rate of interest that US
banks could pay on savings and time deposit accounts (the idea being to prevent US banks
pushing up interest rates in a competition for depositors funds, which might then be lent to
risky lending policies). Since the regulation did not apply to offshore banks this encouraged
many US banks to set up subsidiaries abroad in centers such as London.
In the same year, the US authorities concerned about the impact of capital outflows on the
US balance of payments introduced the Interest Equalization Tax (IET). The lET raised the
cost to foreigners of borrowing dollars in New York, but this then led them to borrow funds
on the Eurodollar market (the IET was abolished in 1974). A further measure that restricted
lending to foreigners by US banks was the Voluntary Foreign Credit Restraint Guidelines
which were issued in 1965 and made compulsory in 1968.
This increased regulation of US domestic banks gave a boost to the development of Eurobanking activities to avoid the effects of these controls. Many US hanks decided to set up
foreign branches and subsidiaries to escape the banking regulations. Indeed, since US
banking law severely restricted US banks ability to operate in more than one state, setting up
subsidiaries abroad was an important means of expansion for many US banks. More
importantly, the regulations conferred a competitive edge to Euro-banks which were not
subject to such regulations.
Following the hike in oil prices in 1973/74, the Oil Petroleum Export Countries (OPEC)
deposited large amounts of surplus dollars on the Euromarkets. The Euro-banks then lent
much of the funds to oil importing countries that faced balance-of-payments problems. As
such the Euro-.banks played an important intermediary role in recycling funds from the
surplus OPEC countries to the deficit oil importing countries. A similar role was performed
by the Euro-banks following the second oil price shock at the end of 1978, although on a
lesser scale. The large majority of loans made by the Euro-banks to the developing countries
in the 1970s and early 1980s were made by syndicates of Euro-banks. A syndicate is
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normally led by a lead or managing bank with other banks that wish to participate in a loan
contributing to its funding. Such syndicated loans are useful from the perspective of
individual Euro-banks because they reduce the exposure of a Euro-bank to a given borrower,
and by participating in a wide range of syndicated loans a Euro-bank can diversify and
reduce its loan risks far more than by engaging in a limited number of large individual loans.
A final factor behind the growth of Euro-banking activity has been the rapid growth of world
trade; this means that more companies have excess working balances in a foreign currency on
which they seek high rates of return, while others require short-term borrowing facilities at
competitive rates of interest.
In December 1981 the Federal Reserve, recognizing that many US Banks had set up offshore
branches to avoid US regulations in exotic locations such as the Bahamas and Cayman
Islands, decided to legalize so-called International Banking Facilities (IBFs). IBFs essentially
permit US banks to conduct Euro-banking business free of US regulations in the United
States by maintaining a separate set of books for this business. IBFs are not subject to reserve
requirements, interest-rate regulations or deposit insurance premiums, but they can only
accept deposits and make loans to non US residents. In addition, IBF business is maintained
on a separate book to the parent bank. IBFs have proved to be popular since their inception
and much business that was previously carried out in offshore offices has been relocated back
to the US. Following the success of IBFs, in 1986 the Japanese government permitted the
setting up of a Japanese Onshore Market (JOM) which likewise permits Japanese banks to
take on Euro-yen deposits in Tokyo.
The Characteristics of the Eurodollar Market

The major centers for Euro-bank activity are London, Paris, New York, Tokyo and
Luxembourg. Offshore banking centers in Bahrain, Bahamas, and Cayman Islands, Hong
Kong, Panama, Netherlands Antilles and Singapore account for most of the remaining
business.
Euro banks are generally free of government regulation, and more specifically they do not
face compulsory reserve requirements, interest ceilings or deposit insurance. The main users
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of the Eurocurrency market facilities are the Euro-banks themselves, non-Euro-bank

financial institutions, multinational corporations, international institutions and central and
local government. Multinationals are attracted by the relatively high interest rates paid on
their surplus corporate funds and the competitive borrowing rates. International
organizations such as the World Bank frequently borrow funds from Euro-banks for lending
to developing countries. A large proportion of Eurocurrency transactions are between Eurobanks themselves, those with surplus funds loaning to Euro-banks that have lending
possibilities but are short of funds.
The pivotal rate of interest for the Eurocurrency markets is the London Inter-Bank Offer Rate
(LlBOR) which is the rate of interest that London clearing banks will charge for loans
between themselves on the London inter-bank market. Non-bank borrowers then pay a
spread above LIBOR depending on their credit rating and the lending hanks transaction
costs, while non-hank depositors typically receive a rate of interest on their deposits below
LIBOR. In the early days of the Euro-market, the interest paid on deposits and charged loans
was usually fixed for the whole period of the depositor loan.
Increasingly, however, floating interest rates based on LIBOR have become the norm for
medium to long term (above six months) deposits and loans. With floating rates, the interest
charged on a medium to long-term loan is adjusted every three or six months to stay a fixed
spread above LIBOR. In effect, many long-term loans are a succession of short-term loans
that are automatically rolled over, but at interest rates that vary in line with changes in
LIBOR. There are usually penalties to be paid if deposits are withdrawn before maturity. One
of the interesting characteristics of the structure of Euro-banks assets (loans) and liabilities
(deposits) is that they are predominately of a short-term nature with some deposits being as
short as one day (overnight deposit), and the vast majority under six months. Furthermore,
there is a close matching of the maturity structure of deposits and liabilities; typically if
money is taken in for three (six) months, then it will be loaned out for three (six) months.
This is because Euro-banks have to be wary of sudden large withdrawals of short-term funds.
(Another motivation behind the close matching of Assets and liabilities is that it reduces the
risks to the banks due to interest fluctuations. This close matching of assets and liabilities
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stands in contrast to the balance sheets of domestic banks which usually accept short-term
demand and time deposits and then engage in medium- to long-term lending. It should be
noted that since 1982 the existence of Eurodollar futures markets in Chicago, New York and
London has enabled Euro-banks to protect themselves against interest fluctuations without
matching their assets and liabilities.
The Competitive Advantage of Euro-banks

The main reason for the continuing success of Euro-banking despite the relaxation of
regulations on US banks is that they are able to offer higher deposit rates and lower loan rates
than US banks. It is this competitive edge which is the fundamental reason for their
continued popularity and growth.
The Euro-banks are generally able to pay a higher rate on deposits and charge a lower rate for
loans than US banks can for similar facilities. This implies that the interest rate spread that
is, the difference between the rates paid on deposits and charged for loans is lower for the
Euro-banks than US banks. The lower Euro-interest spread can be accounted for by a number
of factors:
Euro-banks, unlike domestic banks, are free 0f regulatory control and in particular
they are not required to hold reserve assets. This gives them a competitive advantage
over domestic banks which are required to hold part of their assets in zero or low
interest liquid assets to meet official reserve requirements. Since Euro-banks are not
subject to reserve requirements they are able to hold less money in the form of low
interest reserves enabling them to pay a higher interest rate on deposits and charge a
lower rate on loans..
Euro-banks benefit from economies of scale; the average size of Euro-bank deposit
and loans (usually hundreds of thousands and millions of dollars) is considerably
greater than those of domestic banks (usually tens, hundreds and thousands of
dollars). This means the average operating cost associated with each dollar deposit
and loan transaction is much lower for Euro-banks.
Euro-banks avoid much of the personnel, administration costs and delays associated
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with complying with domestic banking regulations. They do not have to maintain a
large branch network for their business, as does the domestic banking sector. In
addition, domestic banks need extensive internal control mechanisms and large costly
legal departments whereas Euro-banks have far less need for these.
The Euro-banking business is highly competitive internationally with relatively easy

entrance requirements as compared to domestic banking activity; this encourages
greater efficiency and more competitive pricing on the part of Euro-banks.
Euro-banks do not have to pay deposit insurance whereas US banks have to insure
their deposit base with the Federal Deposit Insurance Corporation (FDIC).
Euro-bank lending is almost exclusively to high quality customers with a virtually

negligible default rate; in contrasts with the relatively high default rate in domestic
banking where banks have to charge an appropriate default risk premium in the form
of higher lending and lower deposit rates.
The Creation of Eurodollar Deposits and Loans

Euro-banks are basically financial intermediaries whose function is channeling funds from a
non-bank lender to a non-bank borrower. Between the deposit and the lending there may be a
series of inter-bank transactions. To enhance the understanding of Eurocurrency markets we
consider a hypothetical example of how Eurocurrency deposits and loans are created.
Assume that a US multinational SUPER Corp. starts the process of by transferring $50
million from its US bank account into a Eurodollar deposit account with Euro-bank A. Eurobank A may not have an immediate use for these funds but Euro-bank B has a client, MINI
Corp., who wishes to borrow $50 million hut Euro-hank B is in short of the necessary funds.
In this instance, Euro-bank B borrows the $50 million from Euro-bank A and then loans the
funds to the ultimate borrower MINI Corp. From these transactions we can see that what has
basically occurred is that SUPER Corp. has switched a dollar deposit from a US bank to
Euro-bank A. Euro-bank A has a new deposit liability to SUPER Corp. but also now holds
increased funds which it can utilize for lending purposes.
As far as the US banking system is concerned, the amount of deposits held by the non-bank
public has fallen; however, these funds have been switched into the Euro-banking arena. The
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transfer of funds from Euro-bank A to Euro-bank B constitutes an inter-bank transaction, the

effect of which is to raise the total of Eurodollar deposits from $50 million to $100 million.
We can now distinguish between the effect on the net size of the Eurodollar market the
original $50 million deposit and the gross size of $100 million which includes the inter-bank
transaction. With the loan to MINI: Corp. the funds that were initially deposited by SUPER
Corp. have been given an ultimate use.
The Euro-banks are in effect acting as financial intermediaries ensuring that surplus funds
from one organization (SUPER Corp.) are transferred to other organizations with borrowing
requirements (MINI Corp.). When MINI Corp. starts to spend money, then the dollars have
ultimately been derived from the US banking system not from the Euro-banks. Only the US
banking system creates dollars, the Euro-banks create deposits which are not a means of
payment. Euro-banks are essentially financial intermediaries who accept deposits and then
loan out these funds.
The real question which now arises is what MINI Corp. does with its borrowed funds. If it
were to just redeposit them with another Euro-bank then the whole process could be
restarted; however, this is most unlikely to be the case. More likely, MINI Corp. will use the
funds to pay various bills due or to finance a project, and only a small fraction of its $50
million will eventually end back in the Euro-banking system which can then be used to create
further credit.
This is a highly simplified example of the way the Euro-banking system creates credit, and
there are some obvious limits to the amount of credit it can create. In the first instance, Eurobank A and Euro-bank B are unlikely to lend out instantly all the deposits they received, and
then MINI Corp. is likely to redeposit only a fraction of its money with the Euro-banking
system. It is quite likely that most of the money received by MINI Corp. will eventually be
re-injected into the American economy and thereby returned to the US banking system, from
which there may be some limited leakage back to the Eurocurrency markets.
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The International Capital Market and the Eurobond Market

The international capital market is longer-term than the Eurocurrency market in which
borrowers and lenders from different countries are brought together to ~~change funds, and it
comprises (i). the domestic bond market, (ii) the foreign bond market, and (iii) the Eurobond
market. A domestic bond is a bond issued in the currency of the country of issue by a
domestic entity for example, a US dollar treasury bond issued by the US Treasury or a dollar
corporate bond issued by a us corporation in the United States. A foreign bond is a bond
issued by a foreign entity in the domestic currency of the country of issue; an example might
be a British company that issues a dollar bond in the us market such a foreign bond is
known as a Yankee, and other foreign bonds have names symbolizing the country whose
currency is being borrowed such as bulldogs for sterling bonds, samurais for Yen bonds and
matadors for peseta bonds. A Eurobond is a bond that is sold by a governmental institution or
company in a currency that is different from the country where the bond is issued. For
example, a dollar bond sold in London is a dollar Eurobond and a sterling bond sold in
Germany is a sterling Eurobond
Since the early 1965, the international capital market has grown at an astonishing pace both
in terms of the funds transferred and the number of participants in the market .The Eurobond
market has grown from its origins in the mid-196o to such an extent that the outstanding
value of dollar Eurobonds issued significantly exceeds the issue of domestic US corporate
bonds
These days there is no need for securities markets to be restricted to national boundaries.
Economic agents may seek to raise funds in either the domestic or a foreign currency and in
doing so at the cheapest possible cost they may seek the assistance 0f foreign financial
institutions and foreign financial centers which in turn can attract both domestic and foreign
investors. In the following section we pay particular attention to the Eurobond market which
has become a particularly significant source of funds.
The Origins and Development of the Eurobond Market

The first Eurobond was issued in 1963 and since then the market has grown enormously,
particularly during the 1980s and 1990s. The Eurobond market dates back to the imposition
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of the Interest Equalization Tax (IET) by the US authorities on US citizens that held dollar
bonds issued by foreign entities in the United States. The US authorities imposed the tax
because of concern about the long-term outflow of capital on the US balance of payments.
By reducing the attractiveness to US investors of investing in foreign bonds, the tax provided
a stimulus for foreign entities to issue US dollar bonds outside of the United States. A further
incentive for the development of the Eurobond market was that the US authorities also
imposed withholding taxes on foreign citizens that held US bonds, and this meant that those
citizens had a clear incentive to hold Eurobonds that were not subject to US taxation.
Although the IET was abolished in 1974, and withholding taxes removed in 1984, the
Eurobond market continued to prosper. Its growth in the 1980s was partly stimulated by the
fact that corporations found banks increasingly reluctant to lend funds due to problems
stemming from the Third World debt.
Furthermore, many corporations realized that they could exploit their credit ratings which
were often as good if not better than some of the banks that they had traditionally borrowed
funds from, especially as they increasingly deemed the rates of interest and security
requirements of banks to be excessive. In addition, many corporations found that banks were
reluctant to lend at fixed rates of interest at the longer time horizons that corporations were
interested in. The major advantage of a Eurobond issue over domestic and foreign bond
issues is that there are less stringent regulatory and disclosure requirements on the corporate
issuer, and a greater variety or different bond types can be issued. In sum, the Eurobond
market generally means lower-cost finance for well-known companies than borrowing
directly from banks or the domestic bond market.
Control and Regulation of the Eurobond Market

.
Eurobonds are generally exempt from the rules and regulations that govern the issue of
foreign bonds in the country. However, Eurobond issues and trading do have to meet certain
regulatory requirements and a self-regulatory body known as the Association of International
Bond Dealers sets rules and standards.
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Despite the fact that the Eurobond market is by definition outside of the legal jurisdiction of
the country of the currency of issue, this does not mean
that the national authorities of the
currency in question are unable to exert significant influence on the Eurobond market.
National governments have always exerted control on national capital markets for a number
of reasons; the most important is that they are usually huge borrowers themselves, they are
also keen to encourage scarce domestic capital to be invested in domestic bond issues, and
they are also concerned about possible tax avoidance and the impact of outflows of capital on
the value of their currency. Governments still have a number of means of controlling the
issue of Eurobonds in their national currencies. Firstly, most clearance of funds raised in
Eurobond issues is done through the clearing system of the domestic banking system of the
currency in question, giving the central bank of that currency the ability to prohibit issues if it
so wishes. Secondly, governments can exert pressure on both domestic investment banks and
foreign investment banks not to participate in Eurobond issues with the implicit threat of
losing government business and ultimately their license to operate in their country. The Swiss
authorities have effectively prevented Eurobond issues in Swiss francs by requiring all Swiss
franc issues to be done in Switzerland, and the Japanese have managed to exert strong control
over Eurobond issues in yen.
The US authorities have generally had a concerned but tolerant attitude to the Eurobond
market. The main concern has been that because Eurobonds are issued in bearer form, then
the possibility of tax avoidance is high. Another is that the US government is itself a large
borrower of funds and to some extent finds itself in competition with the attractive rates of
interest offered on dollar Eurobonds.
The US authorities also claim that they wish to protect US investors from investment risk due
to the looser regulatory and disclosure requirements, and for these reasons they prohibit the
sale of Eurobonds by investment banks to US citizens with the Stock Exchange Commission
requiring US investment banks to take measures reasonably designed to preclude
distribution or redistribution of the securities, within, or to nationals of, the United states.
However, there is currently no law preventing US citizens purchasing Eurobonds on their
own initiative, although they would clearly be expected to reveal any coupon earnings in
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their tax declaration. The private placements rule 144A permits sophisticated US financial
institutions to hold Eurobonds in their investment portfolios so long as they are clearly held
for investment purposes.
Innovations in the Eurobond Market

The first Eurobond issues were in the form of straights, thats borrowing at a fixed rate of
interest, but the market has since developed so that many Eurobond issues now have
innovative features. These days a good proportion (around a quarter) of Eurobond issues is
floating rate notes, and another major innovation is that many recent issues are denominated
in the euro.
Other innovations noted earlier include the issue of convertible Eurobonds whereby the
investor has the right to convert the bond into shares in the company at a predetermined
price. Some Eurobonds are issued with warrants attached which can be traded separately
giving the holder the right to buy shares at a predetermined price. Many Eurobond issues also
have a call-back feature which enables the issuer to buy back the issue should it wish to do
so (a particularly useful feature if the borrowers cash flow turns out to be better than
expected, or if interest rates decline sufficiently). More recently, in some Eurobond issues the
principal to be returned to the investor is linked to movements in a broad equity market index
such as the Nikkei.. Another recent innovation is asset-backed Eurobonds; with these, illiquid
assets such as the outstanding loans of a bank are sold in the form of a Eurobond promising
to pay a given coupon based on the income from the outstanding loans. Such bonds can still
have a AAA rating because the bond will typically be over-collaterized that is, backed up
by loans with a face value considerably higher than that of the bond so even if allowance is
made for default on some of the outstanding loans the Eurobond investor can expect to
receive full payment.
In recent years the Eurobond market has been opened up to governments from the so-called
emerging markets such as Argentina, Mexico, Venezuela, South Africa, China, Poland and
South Korea. Some of the high-risk countries such as Argentina and Mexico may need to pay
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as much as 500 basis points above the equivalent US Treasury bond rates, while other
emerging countries such as China, Poland and South Africa can get away with borrowing at a
spread of ISO basis points or less. In many ways the Eurobond market has the potential to
provide a valuable source of funding for emerging-market governments, although such
borrowers are of a higher risk than traditional Eurobond borrowers.
All of these innovative features, as well as the fact that interest is paid once a year and the
lower liquidity of Eurobonds compared to Treasury bonds, make it quite difficult to compare
the yields on Eurobonds with that of standard Treasury and corporate bonds. Nonetheless, a
typical Eurobond offers a premium over the standard Treasury bond of between 30 to 150 :1
basis points depending on the credit rating of the issuer.
7.5 THE EUROPEAN MONETARY SYSTEM.

The Long-term goal of the European Community was the establishment of European
Monetary Union (EMU). The original target date for EMU was set at 1980, but because of
the accession of Demark and the United Kingdom in 1973 delayed any steps towards
implementing the original plan and the disturbances that followed the break-down of the
Breton-woods system. In addition differential inflation rates among the EC countries and the
break-up of the exchange rate mechanism in 1992 have meant that EMU seemed some how
unlikely to be achieved as it was originally planned.
The European Monetary union has two main elements:
Members should fix (not peg) their exchange rate to one another and ultimately there
should be one currency in the union.
There should be complete integration of the capital market in the member countries.
This actually has several implications for other policies.
The monetary union was based on a scheme aimed at reducing the fluctuations between the
currencies of the EC members. The original version of the scheme known as the snake in the
tunnel, required that the members restrict fluctuations between their own currencies to +
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1.125 percent of their par value, but subject to the constraint each was allowed to fluctuate
against the dollar by the full + 2.25 per cent allowed by the Smithsonian Agreement.
The tunnel was abandoned when the members decide to float against the dollar, the system
then being known as the snake. The snake did not have a happy or along life, with various
countries withdrawing, and numerous currency realignment, and effectively came to an end
in 1979.
Later in1978 at the Bremen conference decision were made to establish the European
monetary system (EMS). The communities policy makers were concerned with the
increasing divergence between the members and the growth of free trade within the
community.
The EMS begins its operation in March 1979 It has four main features. These are
The exchange rate mechanism (ERM)
The European currency Unit (ECC)
Financing facilities
European Monetary Fund (EMF)
All member of the EC are members but not all participants in the ERM .
The exchange Rate Mechanism: - The essence of the exchange rate mechanism (ERM) is
that each participant has an allowed range within which its currency may fluctuate against the
others. The norm is + 2.25 percent, but initially, Italy, Spain and UK are permitted a
boundary of + 6 percent fluctuation. Intervention to keep a currency within the prescribed
range may be in terms of either members currency of the dollar. If a boundary is reached
then the two members concerned are obliged either to intervene in the foreign exchange
markets or to take other policy action. Any change in the grid of central rates requires
mutual agreement.
The European Currency Unit (ECU) :- The ECU is a weighted basket of the various EMS
currencies, and is used as an indicator of divergence. The basic idea is to avert any dispute
about which of the two members involved should be expected to act when a boundary is
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reached. That is, should the country whose currency is at the bottom of the range be required
to intervene in the exchange market and /or change in polices, or should that be the
responsibility of the country whose currency is at top of the range? Under the ECU based
system a divergence between a countrys currency and the ECU that exceeds the specified
boundaries lead to the presumption (but not the requirement) that the country will take
remedial action. ECU members have access to credit facilities intended to help deficit
countries to manage transitory problems and defend their exchange-rate parities.
These facilities, which come under three headings, namely, covering very-short term, short
term, and medium term requirement are operated by the central bank of the members. The
credit facilities to half countries having problem was provided from the union fund called
European Monetary Fund.
The EMS is intended to reduce the volatility of nominal exchange rate among its members.
There is evidence that the EMS has bean successful both in this and in reducing the volatility
of real effective exchange rates as well.
A further benefit of ERM was that high inflation members would find it easier to reduce
inflation both by influencing private expectations and behavior and by giving the authorities
an incentive to bring inflation under control. For some countries membership of the EMS has
effectively meant pegging their currencies to the Deutschmark, which has been the lowestinflation currency among the members. They are essentially trying to borrow some of the
Bunds banks renowned credibility.
The EMS bears a strong resemblance to the Breton woods system. Currencies are paged to
one another, but exchange rates are not fixed. Germany plays a role that is in some ways
similar to that undertaken by the United State under Breton-Woods. The essential difference
is that the members of EMS may run a collective surplus or deficit with the rest of the world
rather than passively accepting the outcome of the policies of the other countries, as the
United States did for so long. The EMS finally successfully led to the creation of a monetary
union by adopting single currency called Euro.
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7.6. THE EURO-EUROPEAN UNION CURRENCY

The euro with currency sign: and banking code: EUR, is the official currency of the
European Union (EU). Currently euro is used by 15 member states known collectively as the
Euro-zone. The euro-zone countries are Austria, Belgium, Cyprus, Finland, France,
Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia,
and Spain.
It is also used in 9 other countries around the world, 7 of those being in Europe. Hence it is
the single currency for over 320 million Europeans. Including areas using currencies pegged
to the euro, the euro directly affects close to 500 million Europeans. European including
areas using currencies pegged to the euro, the euro directly affects close to 500 million
people worldwide. With more than 610 billion in circulation as of December 2006 equivalent
to US$ 802 billion at the exchange rates at the time, the euro is the currency with the highest
combined value of cash in circulation in the world, having surpassed the U.S. dollar.
The euro was introduced to world financial markets as an accounting currency in 1999 and
launched as physical coins and banknotes on 1 January 2002. It replaced the former
European Currency Unit (ECU) at a ratio of 1 to 1.
The euro is managed and administered by the Frankfurt-based European Central Bank (ECB)
and the Euro-system composed of the central banks of the euro zone countries.
As an independent central bank, the ECB has sole authority to set monetary policy. The
Euro-system participates in the printing and distribution of notes and coins in all member
states, and the operation of the Euro-zone payment systems.
While all European Union (EU) member states are eligible to join if they comply with certain
monetary requirements, not all EU members have chosen to adopt the currency. All nations
that have joined the EU since the 1993 implementation of the Maastricht Treaty have pledged
to adopt the euro in due course. Maastricht obliged current members to join the euro;
however, the United Kingdom and Denmark negotiated exemptions from that requirement
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for themselves. Sweden turned down the euro in a 2003 referendum, and has circumvented
the requirement to join the euro area by not meeting the membership criteria. In addition,
three European microstates, namely Vatican City, Monaco, and San Marino, although not EU
members, have adopted the euro due to currency unions with member states. Andorra,
Montenegro, and Kosovo have adopted the euro unilaterally, while not being EU members
either.
7.7. THE INTERNATIONAL DEBT CRISIS
The international capital market has become increasingly liberalized and integrated,
particularly with the abandonment of exchange controls and the development of new
technologies for processing, transmitting and storing information. Policy makers in the major
developed nations view this development as being largely beneficial.
Those in less-developed countries (LDCs), however, do not necessarily share that view. The
debt crisis of recent years has forced many LDCs , particularly those in the middle income
group to take costly policy measures that they would have preferred to avoid.
LDCs may borrow privately, from banks and similar institution for a Varity of reasons, some
economists suggested the following classification of such borrowing.
Borrowing for Consumption
Borrowing for adjustment and
Borrowing for investment
Borrowing for consumption is undertaken to smooth the path of consumption overtime. This
is mainly considered by countries such as primary commodity exporters that face instability
in their export revenue. Borrowing for adjustment is undertaken to permit the gradual
introduction of policy measures that may be required as a consequence of change in
economic conditions. Borrowing for investment is, if rational, concerned with obtaining
fund from foreign sources at real rates of interest that are lower than the real rates of return
on the projects that are to be financed. Such borrowing is said to be self financing.
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Countries that borrow prudently should not experience difficulty in servicing their debt (i.e.,
making interest payments and repaying the principal). However, it has been argued that most
LDCs particularly some Latin American countries, did not in practice borrow prudently.
This is usually linked with another argument that such countries did not use appropriate
economic policies. The source of the problem was often found to be political instability and
/or political will, usually manifested in the form of budgetary and balance of payments
deficit, high inflation and overvalued exchange rates.
Imprudent borrowers should not however be able to obtain loans from prudent lenders.
Analysis of the operation of loan market suggests the fact that prudent lending may be
difficult to achieve. Lenders rarely have full information on the intention of the borrowers,
and are also exposed to the risk that the borrower will default on the loan. Most of the loan
to LDC however were either made to governments or were guaranteed by them, and lenders
are inclined to believe that governments would not repudiate those debts.
Private lending to LDCs, expanded significantly in the 1970s. The first OPEC oil-price hike
of 1973 drove many LDCs, into balance of payment difficulties, both trough the direct effect
on their import bill and through the reduction in their export revenues as a result to the
recession in the developed countries. This created a potential demand for foreign borrowing.
At the same time the OPEC centuries, unable to absorb all the increase in their revenue,
placed large volume of petrodollars on the London and New York money markets. Real
interest rate, were low (even negative) in the developed countries as a consequence of the
inflation and recession induced by the oil-price hike. Bankers seem to have taken the view
that Latin American countries had good growth prospective, and so the petrodollars were
recycled through heavy lending to these countries in particular, and to LDC,s in general.
The loans were made at variable rates of interest, which meant that the risk of interest rate
increase was carried proximately by the borrowers, but ultimately by lenders unable to
extract debt service.
The second price hike of 1979 triggered another series of balance of payments deficits and
increased borrowing by oil importing countries. The already indebted LDC,s might however,
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have been able to cope with this new shock had the reaction of the developed countries been
the same as in 1973. Unfortunately for the LDCs the developed countries reacted to the new
situation by using restrictive monetary policies in an attempt to deal with the inflationary
impact of the rise in oil prices. The consequence was a sharp increase in nominal and real
interest rate (particularly in the United State, where the budget deficit increased
significantly). The increase in both nominal and real interest rates drove up the cost to the
LDC,s of servicing their existing debt and raised the cost of new borrowing.
At the
sometime, LDCs export earnings on trade with the developed countries fell sharply. The
LDCs, continued to increase their borrowing, nearly doubling their international indebtedness
between 1979 to 1982
The breaking of the debt crisis is usually dated to Mexicos announcement in August 1982 of
a moratorium on its debt repayments until new arrangement had been negotiated with its
creditors.
Since the Mexican difficulties were not unique, this triggered a fear in the
international banking community that other heavily- in debited countries would follow suit.
Many banks, particularly in the United State, had very exposure to LDCs lending and there
was a fear that a loan default by any of the major borrowers such as, Argentina, Brazil,
Mexico and Venezuela, would trigger a run of banking failures in the developed countries.
The banks have attempted to deal with the debt-crisis on an individual basis, usually by
extending the maturity of their loans (rescheduling), and have been generally reluctant to
make new loans. At the same time governments in the developed countries have put pressure
on the LDCs to at least maintain their interest payments, in order to avert a banking crisis.
The IMF has offered loans to the heavily-indebted countries under stringent conditionality
requirements.
166
7.8. SUMMARY
After the Second World War, the international monetary system has moved from the Breton
Wood system, which represented a cooperative venture between the major industrialized
countries with the dollar at its heart, in to a far more diversified system. To some extent this
reflects the fact that the world economy has evolved from one which was dominated by that
of the US, to one in which economic power is increasingly shared between an integrated
Europe, Japan, and the US and other emerging regions such as South-East Asia and Latin
America. The dollar still remains the major reserve currency and this role has to date only
been infringed upon at the margin by the EMU. In fact there is no doubt that the new
European currency (the euro) is increasingly becoming the dominant currency not only in
Europe but also in many countries out-side the euro-zone.
A grated sharing of economic power has been accompanied by a larger degree of
interdependence between economies with respect to both trade and capital flows, and the
international monetary system has been constantly evolving to cop with these changes.
The current monetary system permits countries to adopt whatever exchange-rate policy they
wish providing that they do not peg their currencies to the value of gold. In practice there
exists a wide range of exchange rate polices from completely free floating to various pegging
arrangements
167

1.
What do you understand by international monetary system ?
2.
Explain the factor that motivated the creation of a new international monetary order in
the post second world War!
3.
What are features of Breton Wood System?
4. What are the two major reasons for breaking down of the Breton woods system ?
5. Explain how the liquidity problem explains the break down of Breton woods system as
explained by
6. One of the causes of the demise of Breton-Wood system is lock of adjustment
mechanism. Explain it?
7. Explain Gresham law and how it could it could explain the break down of the Breton
woods system!
8. Explain the essence of European monetary system.
9. What are the elements of European Monetary system?
168
REFERENCES
Alixander. S . (1959). Effect of Devaluation. A simplified synthesis of Elastic ties
and Absorption Approach, American Economic Review. Vol. 49 , PP 22-42.
Alexanider (1952):The effect of Devaluation on trade Balance IMF stat paper pp, 263-78
Artus and knight (1984). Issues in the assessment of the exchange Rate Industrial
countries, IMF occasional paper No 29
Artus, J.R. and Young, J.H (1979) Fixed and Flexible Exchange Rates a Renewal of the
Debate; IMF stat papers, Vol. 26,pp, 654-698.
Bo Sodersten and Geoffry.R (1994) : International Economics 3rd edition ,UK.
Cumby, R.E and obstfeld . M. (1984).
International Interest Rate and price level
Linkages under Flexible exchange Rates; a Review of Recent Evidence, in

J.F.O. Bilson and R.C Marston (eds), Exchange Rate theory and practice,
university of Chicago press, Chicago
De Gravwe, P. (1989). International Money, Clarendon Press, oxford
Fleming. J.M. 91962): Domestic Financial Policies under fixed and floating exchangeRates, IMF stat paper, Vol9, PP 369-80
Frenkel, J.A. (1963).
And Razin, A. (1987); The Mundell-Fleming Model a Quarter
Century Later. A Unified Exposition, IMF Stat paper, Vol , 34 PP. 567-620
Frenkel. J.A. and Mussa, M. (1981) , The collapse of Purchasing power parity during the
1970s, European Economic review, Vol. . 16,PP.145-65
Grobb.J.O.(1986). International Financial Market, Elsevier, New York
Johnson, H.G. (1977). The Monetary Approaches to to the Balance- of- Payment a Nontechnical Guide , Journal of International Economics vol 7,pp 251-268
Kemp, D.S (1987). Balance of payment
Concepts- what do They Aedly mean ? . in
Reading in International Finance, Federal Reserve Bank of Chicago, Chicago.

Kenen, P.B (1988), managing exchange Rates, Rout ledge, London
Kenen. P.B, et al (1994), The international Monetary system, Cambridge University Press,
Cambridge
Lindert H.P. (1991), International Economics, 9th edition, Irwin, USA.
169
Mundell R.A. (1963). Capital Mobility and stabilization policy under Fixed and Flexible
Exchange. Rate , In Canadian Journal of Economics and Political
Science, Vol 29, PP, 475-485
Mundell R.A (1968). International Economics, Macmillan, London.
Manzur, M , (1990). An International Comparison of Price and Exchange Rates New test of
purchasing power parity, Journal of International Money and Finance.
Vol.9,pp, 75-91
Mckinnon, R.I. (1988) , Monetary and Exchange Rates polices for International Financial
stability , a proposal, In journal of Economic perspectives, Vol 2, PP
83-103
Pilbeam , K. (1998), International Finance, 2nd edition, Macmillan London
Rabin , A and Yeager.L. (1982), Monetary Approach to The Balance of payment and
Exchange Rates, Princeton Essays in Intonation Finance No. 148.
Triffin (1960), Gold and the Dollar crisis , New Heven, Conn,: Yale University
Walmsley, J, (1996) International Monetary and foreign exchange markets, Wiley, New
York
170
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International Finance Theory and Policy

International Finance Theory and Policy

International Finance Theory and Policy

EXCHANGE RATES AND FOREIGN EXCHANGE MARKET

International Finance Theory and Policy

Explain exchange rate

Understand characteristics of foreign exchange market

Know major participants of the foreign exchange market.

Explain the concept of arbitrage in foreign exchange market

Explain how exchange rates are determined.

1.1. EXCHANGE RATE AND THE FOREIGN EXCHANGE MARKET

International Finance Theory and Policy

What is exchange rate?

International Finance Theory and Policy

1.2. CHARACTERISTICS AND PARTICIPANTS OF THE FOREIGN

Participants in the Foreign Exchange Market

International Finance Theory and Policy

Bulls, And Bears in the Foreign Exchange Market

International Finance Theory and Policy

Arbitrage in the foreign Exchange market

International Finance Theory and Policy

1.3. THE SPOT AND FORWARD EXCHANGE RATES.

The Spot Exchange Rate

The Forward Exchange Rate

International Finance Theory and Policy

Simple Model of the Determination of the Spot Rate

The Demand for Foreign Exchange

International Finance Theory and Policy

Table 1.1 Demand for dollar

Price of US Export Exchange

Price of Us Quantity of Demand

Figure 1.1 The demand curve for dollar

International Finance Theory and Policy

a change in ETH income

a change in ETH tastes in favor of US goods

The Supply of Foreign Exchange

Table 1.2 The supply of dollar.

Price of ETH export

International Finance Theory and Policy

Figure 1.2 The Supply curve of dollar

Ethiopian export commodities)

International Finance Theory and Policy

Figure 1.3 Determination of birr-dollar sport exchange rate (spot)

Fixed Vs Floating Exchange Rate

Floating Exchange- Rate Regime

International Finance Theory and Policy

Fixed Exchange Rate Regime

International Finance Theory and Policy

International Finance Theory and Policy

Forward Exchange Rate and its Determination

International Finance Theory and Policy

International Finance Theory and Policy

r* is the one year domestic interest rate

x100=0.019X100 which is nearly 0.02.

year forward rate of euro is at an annual forward discount of 2%.

International Finance Theory and Policy

International Finance Theory and Policy

The Relation Between Spot and Future Exchange Rate

Adama University, Faculty of Business and Economics, Department of Economics

International Finance Theory and Policy

rs .(1 + ia) = (1 + ib).rf or

Conducting Economic analysis of the effect of

For many countries the depreciation / devaluation of their

Adama University, Faculty of Business and Economics, Department of Economics