ARBA MINCH UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ECONOMICS

COURSE MATERIAL: INTERNATIONAL ECONOMICS II (Econ 3082)

BY: MIHRETU TESFAYE (MA)

FEBRUARY, 2023

ARBA MINCH, ETHIOPIA

AMU: International Economics II Mihretu .T(MA)

Table of Contents
CHAPTER ONE ........................................................................................................................................... 4
FOREIGN EXCHANGE MARKET ............................................................................................................ 4
1.1. Foreign Exchange Market ................................................................................................................. 4
1.2. Characteristics of foreign exchange market and its participant ........................................................ 4
1.3. The functions of foreign exchange market........................................................................................ 6
1.3.1. Scope of the foreign exchange market ...................................................................................... 7
1.3.2. Exchange rate ............................................................................................................................ 7
1.3.3. Determinants of foreign exchange rate ..................................................................................... 8
1.4. The demand for and the supply of foreign exchange ...................................................................... 11
1.5. Exchange Rate Systems (regimes) .................................................................................................. 15
CHAPTER TWO ........................................................................................................................................ 27
THEORY OF EXCHANGE RATE DETERMINATION (MONEY INTEREST RATE & EXCHANGE
RATE) ......................................................................................................................................................... 27
2. Definition of Money ........................................................................................................................... 27
2.1. Functions of Money ........................................................................................................................ 27
2.2. Demand for Money ......................................................................................................................... 28
2.3. Equilibrium in the money market ................................................................................................... 31
2.4. Price Levels and Exchange Rates in the Long run .......................................................................... 38
2.5. Purchasing Power Parity (PPP) ....................................................................................................... 39
2.5.1. A Long-run Exchange Rate Model Based on PPP .................................................................. 42
2.6. Measurement Problems with PPP ................................................................................................... 44
CHAPTER THREE .................................................................................................................................... 48
BALANCE OF PAYMENT ....................................................................................................................... 48
3.1. Definition of Balance of payments(BOP) ....................................................................................... 48
3.2. Balance of Payment Accounting ..................................................................................................... 49
3.3. The Components of BOPs............................................................................................................... 50
3.4. The Trade balance ........................................................................................................................... 51
3.5. BOP Equilibrium and Disequilibrium (Surplus or Deficit) ............................................................ 55
3.6. Approaches to Balance of Payments ............................................................................................... 60
3.6.1 Elasticities Approach ..................................................................................................................... 61
3.6.2. Multiplier Approach................................................................................................................ 66

AMU: International Economics II Mihretu .T(MA)

3.6.3. Absorption Approach .................................................................................................................. 67
3.6.4. Monetary Approach ................................................................................................................ 72
CHAPTER FOUR....................................................................................................................................... 83
MACROECONOMIC POLICY IN AN OPEN ECONOMY ..................................................................... 83
4.1. Open Economy and Macroeconomic Policy ................................................................................... 83
4.2. Macroeconomic Policy Goals in an Open Economy ...................................................................... 83
4.3. Stabilization Policy Instruments ..................................................................................................... 92
4.3.1 Internal and External Balance under fixed exchange rate .............................................................. 94
4.3.2. Internal and External Balance Under Floating Exchange Rate ............................................... 95
4.3.3. A SMALL OPEN ECONOMY WITH PREFECT CAPITAL MOBILITY ........................... 98
4.4. International Macroeconomic Policy Coordination ...................................................................... 102
CHAPTER FIVE ...................................................................................................................................... 105
INTERNATIONAL MONETARY SYSTEM AND KEY INTERNATIONAL FINANCIAL
INSTITUTIONS ....................................................................................................................................... 105
5. What is the International Monetary System (IMS)? ......................................................................... 105
5.1. Criteria for Evaluating an International Monetary System ................................................................ 105
5.2. The Evolution of an IMS .............................................................................................................. 106
5.3. Key International Financial Institutions ........................................................................................ 109
5.4. International Capital Flows and Multinational Corporations ........................................................ 109
5.5. The concept of Dutch Disease ...................................................................................................... 111

AMU: International Economics II Mihretu .T(MA)

 CHAPTER ONE

FOREIGN EXCHANGE MARKET

Learning Objectives

– Meaning of foreign exchange market

– Learn who participates in foreign exchange markets and why
– Discussing exchange rate regime
– Defining purchasing power parity

1.1. Foreign Exchange Market

What is foreign exchange market?

Foreign exchange is the trading of currencies. The foreign exchange market is not a single
place like the NY Stock Exchange (NYSE). Instead, the foreign exchange market refers to the
activities of major international banks that engage in currency trading. These banks act as
intermediaries between the true buyers and sellers of currencies (i.e., government, business, and
individuals). These banks will hold foreign currency deposits and stand ready to exchange these
for domestic currency upon demand. It is a widely decentralized 24-hour-a-day market, made up
of banks and traders communicating electronically. The retail market is b/n individuals,
nonfinancial companies, nonbank financial institutions includes investment banks, mortgage
lenders, money market funds, insurance companies, etc, and other customers of banks. The
wholesale or interbank market is the trading between banks. This accounts for 60% or more of
the total trading. The foreign exchange market is thus the market in w/c individuals, firms and
banks buy and sell foreign currency.

1.2. Characteristics of foreign exchange market and its participant

The following points highlight the top seven characteristics of foreign exchange market. the
characteristics are: 1. most liquid market in the world 2. most dynamic market in the world
3. twenty-four hour market 4. market transparency, 5. international network of dealers 6.
most widely traded currency is the dollar 7. ―over-the-counter‖ market with an ―exchange-
traded‖ segment.

1. Most liquid market in the world

Currency spot trading is the most popular FX instrument around the world, comprising more
than 1/3 of the total activity. It is estimated that spot FX trading generates about $1.5 trillion

AMU: International Economics II Mihretu .T(MA)

a day in volume, making it the largest most liquid market in the world. Liquidity has its
advantages, the primary one being no manipulation of the market. Thin stock and futures
markets can easily be pushed up or down by specialists, market makers, commercials, and
locals. Spot FX on the other hand takes real buying/selling by banks and institutions to
move the market. Any attempted manipulation of the spot FX market usually becomes an
exercise in futility.
2. Most dynamic market
Foreign exchange market is the most dynamic market in the world regardless of which
instrument you are trading like stocks, government bonds, Ethiopian government treasuries,
foreign exchange , or any of the countless others the attributes that determi ne the viability of
a market as an investment opportunity remain the same.
3. It is a twenty-four hour market
The twenty-four hour market means that exchanges rates and market conditions can change
at any time in response to developments that can take place at any time. It also means that
trades and other market participants must be alert to the possibility that a sharp move in an
exchange rate can occur during an off hour, elsewhere in the world.
4. Market transparency
Price transparency is very high in the FX market and the evolution of online foreign
exchange trading continues to improve this, to the benefit of traders. One of the biggest
advantages of trading foreign exchange online is the ability to trade directly with the market
maker. A reputable forex broker will provide traders with streaming, executable prices. It is
important to make a distinction between indicative prices and executable prices.

5. International Network of Dealers

The market is made up of an international network of dealers. The market cons ists of a
limited number of major dealer institutions that are particularly active in foreign exchange,
trading with customers and (more often) with each other. Most, but not all, are commercial
banks and investment banks. These dealer institutions are geographically dispersed, located
in numerous financial centers around the world. Wherever located, these institutions are
linked to, and in close communication with, each other through telephones, computers, and
other electronic means.

AMU: International Economics II Mihretu .T(MA)

 6. Most widely traded currency is the Dollar

The dollar is by far the most widely traded currency. According to the 1998 survey, the dollar
was one of the two currencies involved in an estimated 87 percent of global foreign exchange
transactions, equal to about $1.3 trillion a day. In part, the widespread use of the dollar reflects
its substantial international role as – ―investment‖ currency in many capital markets, ―reserve‖
currency held by many central banks, ―transaction‖ currency in many international commodity
markets, ―invoice‖ currency in many contracts, and ―intervention‖ currency employed by
monetary authorities in market operations to influence their own exchange rates.

Examples of currencies used by different

Country Currency Symbol ISO Code

US Dollar $ USD

UK Pound £ GBP

Canada Dollar C$ CAD

Germany Deutsche Mark DM DEM

France Franc FF FRF

Mexico Peso Ps MXP

Japan Yen ¥ JPY

Euro zone Euro €

Ethiopia Birr Br

1.3. The functions of foreign exchange market

The following are the main functions of foreign exchange market, which are actually the
outcomes of its working;

 To facilitate currency conversion

 Provide instruments to manage foreign exchange risk such as foreign exchange
 Allow investors to speculate in the market for profit

AMU: International Economics II Mihretu .T(MA)

  It transfer funds or purchasing power from one nation & currency to another

1.3.1. Scope of the foreign exchange market

About half of the daily foreign exchange trading is done b/n banks in London and New York. In
2001, the trading volume was about $1.2 trillion per day. (The NYSE turned over about $42
billion per day.) Most of the trading involves U.S. currency. Sometimes the intent is to trade one
foreign currency for another, & the U.S. currency is only involved as an intermediate step. When
this is done, the dollar is called a vehicle currency.

1.3.2. Exchange rate

The exchange rate is the price of one country‘s money in terms of another country‘s money.
The exchange rate can be given as the price of the foreign currency in terms of the domestic
currency—this is the usual way, & the way we‘ll use in this course— (domestic
currency/foreign currency) or as the price of the domestic currency in terms of the price of the
foreign currency (Foreign currency/domestic currency).

The ―spot” exchange rate is the price for immediate exchange. (Immediate usually means
within two working days.) This amounts to about 33% of all trading. The ―forward‖ exchange
rate is the price for exchange to take place at some specific time in the future, often 30, 90, 180
days. This amounts to about 11% of all trading.

A ―swap‖ is a ―package trade‖ that includes both a spot exchange of two currencies & a
contract to the reverse forward exchange a short time later. This is useful when the parties to the
swap have only a short-term need for the currency. This amounts to about 56% of all trading.

Nominal effective exchange rate (NEER) –is an unadjusted weighted average rate at w/c one
country‘s currency exchanges for a basket of multiple foreign currencies. It is the amount of
domestic currency needed to purchase foreign currency. It is exchange rate without adjusting for
inflation. Example: the nominal effective exchange rate of the euro for France is a weighted
mean (with the weighting being specific to France) of the exchange rates of the euro against the
currencies of the computing countries in a given zone,.i.e euro zone

The real effective exchange rate (REER) is the weighted average of a country‘s currency in r/n
to an index or basket of other major currencies. The weights are determined by comparing the

AMU: International Economics II Mihretu .T(MA)

relative trade balance of a country's currency against that of each country in the index. REER is
determined by taking the average of the bilateral exchange rates b/n one nation & its trading
partners & then weighting it to take into account the trade allocation of each partner. Example
let's say the U.S. had a foreign trading relationship with only three parties: the euro zone, Great
Britain, and Australia. That means the U.S. dollar has a trading relationship with the euro, the
British pound, and the Australian dollar. The real effective exchange rate of the euro for France
includes the exchange rate but also the ratio of France‘s export prices to those of competing
countries in the zone under consideration. Which indicates it is adjusted for inflation.

1.3.3. Determinants of foreign exchange rate

There are so many factors that influence exchange rates. But five factors are considered most
important in influencing foreign exchange rates. These are;

 Changing inflation: A country with a lower inflation rate has greater purchasing power
against other currencies and so displays rising currency value. Higher rate of inflation
obviously lowers currency value. However, a currency may sometimes strengthen when
inflation rises because of expectations that the central bank will raise short-term interest
rates to combat rising inflation.
 Changing interest rate: Inflation, interest rates and exchange rates are closely related to
each other. Central banks forge interest rates to influence exchange rates and inflation
which directly affect the inflation and forex rates. Higher interest rates benefit investors
to attract more foreign investors. This results in an increase in a foreign capital with the
country and increased foreign exchange rates.
 Relative income levels: The third factor influencing the exchange rate is relative income
level because income level affects the amount of import demanded and the exchange rate.
Let, between the US and UK, UK income level increases and US income level remains
unchanged. As a result demand curve will shift upward because of the increase in UK
income and increased demand for US goods. But the supply schedule is not expected to
change. For this reason, there is an increase in the equilibrium exchange rate.
 Government Controls and change in expectations: Government can control
equilibrium exchange rates by many ways. There are so many factors, such as foreign
exchange barriers, foreign trade barriers, Intervening transactions etc., in the foreign

AMU: International Economics II Mihretu .T(MA)

 exchange market that government can impose to affect the exchange rate (Madura,
2010). The last factor that influences the exchange rate is expectations of future exchange
rates. Like all financial markets, foreign exchange markets react to the news that can
create future effects. The effective can either increase or decrease the exchange rate
(Eitrman, 2013). Let news spreads in the US that inflation will increase in the recent
future. It will make traders sell US dollars and supply will increase. But, demand will
have no impact. As a result, supply will be decreased and this will result in a decreased
exchange rate. But if news spread that there will be deflation in the US, traders will buy
US dollars as they will try to purchase all the US dollars from the market, increasing US
dollar demand. But there will be no change in supply. This will increase equilibrium
exchange rate.

Why exchange rate?

It has strong influence on current account & other macroeconomic variables. As it is the price
one currency in terms the other, it governs the asset price. Facilitate the flow of asset from one
place to another. It allows comparing the price of goods & services produced at d/t
places/countries.

Types of Exchange rate markets

Foreign exchange market is broadly divided into: spot exchange market & forward exchange
market.
 Spot Market Transaction
The spot market transaction determines the spot exchange rate(S). This indicates the prices of
currencies for immediate transaction. It may take 1-2 days to settle the payment. The term spot is
used here to imply short time period only. Example: British firm buys a U.S. product from a
U.S. firm, which requires payment in U.S. dollars ($). The British firm contacts its bank, gets a
quote on the dollar-pound exchange rate, and approves it. The British firm instructs its bank to
take pounds from its checking account, convert these to dollars, & transfer the amount to the
U.S. producer. The British bank instructs its ―correspondent‖ bank in New York to take U.S.
dollars from its account and pay the U.S. producer by transferring them to the producer‘s bank.

AMU: International Economics II Mihretu .T(MA)

  Forward Exchange Market
The forward exchange market refers to the foreign exchange deal /contractual agreement / for
sale and purchase of foreign currency at some future date. Forward rate, (F), is that rate
negotiated today at which foreign exchange can be bought and sold for delivery sometime in the
future. The most popularly traded forward contract has a maturity of 90 days and contracts
beyond 1 year are relatively scarce. Forward contracts are generally negotiated between an
individual – for example, a private customer or commercial organization –and a bank & the
individual has to take delivery of the contract on the specified date. It is one way of hedging
against exchange rate risk. Example: suppose that a US company buys radio from the Japan
Sony company expecting a shipment of the Radio in a month, for which it needs to pay yen.
Could the company wait until the shipment to buy the yen to pay Sony? But it does not know
what will happen to value of that yen in meantime. If yen appreciates a lot, the $ price US
Company has to pay to get the radio could change a lot. i.e.... the US company need to pay more
dollars per yen. To avoid this risk, the company can arrange for currency trade ahead of time to
be executed later at a set exchange rate.
Automated systems in foreign exchange market
SWIFT (the Society for Worldwide Interbank Financial Telecommunications) it is Electronic
System with over 2,000 member banks in almost 200 countries. About 4 million transactions per
day.
CHIPS (the Clearing House International Payments System) clears dollar transfers among
member banks, includes all major, internationally-active banks the ease of us of CHIPS makes
the dollar convenient as a vehicle currency clears over $1 trillion dollars per day.

Interbank Trading: Conducted by brokers and traders. Traders work in trading rooms with
computer terminals & telephones. Traders get to know their counterparts at other banks very well

Interbank ―rates‖ are quoted for amounts of $1 million or more, & a trader may handle millions
of dollars of foreign exchange in a matter of minutes. The volumes are so large, that they often
refer to $1 million of exchange as ―one dollar‖.

AMU: International Economics II Mihretu .T(MA)

1.4. The demand for and the supply of foreign exchange
The exchange rate of the foreign exchange (dollar) will be determined by the intersection of the
supply & demand for dollar on the foreign exchange market in the world financial markets. The
Demand for foreign exchange; the demand for currency in the foreign exchange market is a
derived demand. It is derived from the demand for US product. i.e..., dollar is not demanded
because it has intrinsic value by itself, but rather because of what it can buy. Example; to derive
hypothetical demand for dollar let us assume that US is exporting country and Ethiopia being
importer.

Table 1.2. Demand for dollar

Price of US Export Exchange Price of US Quantity of US Demand for
good in USD(1) rate(2) export in birr export (4) USD(5)=(1)(4)
(3)(1x2)
10 9.20 birr 92 1500 15000
10 9.30 93 1300 13000
10 9.40 94 1100 11000
10 9.50 95 900 9000
10 9.60 96 700 7000
10 9.80 98 500 5000
10 10.00 100 300 3000

If dollar appreciate against birr, the price of the US export increase and this leads to a lower
quantity of US exports thus reduce demand for dollar.

Fig. 1.1. Demand for dollar

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Note that any factor that affects the demand for US export affects the demand for dollar. Such
as: change in ETH income, change in the price of ETH goods (which can substitute imports from
US) change in ETH tastes in favor of US goods .All the above factors cause shift in demand for
dollar.

Supply of foreign exchange: If dollar appreciates, the US export become expensive to the
Ethiopian importers, on the other hand, Ethiopian export becomes cheap to the US residents.
This leads to increase in demand for Birr, leading to rise in supply of USD. This show an
upward sloping supply schedule for USD. Consider the following table.

Table 1.3. The Supply of dollar

Price of ETH Exchange Price of ETH Quantity of Demand for Supply of

export goods rate export in ETH export birr (5) USD (6) = )
in birr (1) birr/USD (2) USD (3) ) (4) (1)x(4)
100 9.20 10.9 300 30000 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 94770 9975.79
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

Supply curve of foreign exchange slope upwards due to positive relationship between supply for
foreign exchange and foreign exchange rate. In Fig. 1.2, supply of foreign exchange (US
Dollar) and rate of foreign exchange have been shown on the X-axis and Y-axis respectively.

AMU: International Economics II Mihretu .T(MA)

The Supply of and Demand for Dollar

 Supply of foreign currency is created by: Ethiopian. Exports of goods and services and
its capital inflows for Ethiopia.
 Demand for foreign currency is created by: Ethiopian. Imports of goods and services and
which is capital outflows for Ethiopia
 Supply of U.S. dollars is created by U.S. imports of goods and services and there are
capital outflows from U.S.
 Demand for U.S. dollars is created by U.S. exports of goods and services which results
capital inflow to U.S.

Causes of shift in demand for dollar

GDP changes: When a country‘s income falls, the demand for imports falls. Then demand for
foreign currency to buy those imports falls.

Price level changes (inflation): If the U.S. has more inflation than other countries, foreign
goods will become cheaper. U.S. demand for foreign currencies will tend to increase, and
foreign demand for dollars will tend to decrease.

Interest rate changes: A rise in U.S. interest rates relative to those abroad will increase
demand for U.S. assets. The demand for dollars will increase. The forward discount or premium
is usually expressed as a percentage of the spot exchange rate. That is,

AMU: International Economics II Mihretu .T(MA)

Where F- is forward exchange rate quotation, S – is the spot exchange rate quotation. The
presence of arbitrage ensures that the covered interest parity (CIP) condition holds
continuously.

Covered interest rate parity refers to a theoretical condition in which the relationship
between interest rates and the spot and forward currency values of two countries are in
equilibrium. The covered interest rate parity situation means there is no opportunity for
arbitrage using forward contracts, which often exists between countries with different interest
rates. CIP is the formula used by banks to calculate their exchange quotation and is given by:

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.

AMU: International Economics II Mihretu .T(MA)

 Fig.1.4.2. Supply for Dollar
Fig.1.4.1. Demand for Dollar

1.5. Exchange Rate Systems (regimes)

There are three types of exchange rate regimes:
Fixed (or pegged) exchange rate system – the gov‘t chooses an exchange rate & offers to buy &
sell currencies to keep the exchange rate within a narrow band. The ―official rate‖ is call the par
value. It is called a pegged exchange rate, in which a currency‘s value is fixed or pegged by a
monetary authority against the value of another currency or gold. Under a floating-rate system
the fall in the market price (exchange rate) of the currency is depreciation and the rise in the
market price (exchange rate) of the currency is appreciation

Flexible (floating) exchange rate system – determination of exchange rates is left totally up to
the market, and is determined entirely by supply and demand. The major trading countries have
been on this system since 1973. Under a fixed-rate system the official lowering of the par value
of a currency is devaluation and official rising of the par value of a currency is revaluation.

Partially flexible (dirty or managed float) exchange rate system– the government sometimes
affects the exchange rate & sometimes leaves it to the market.

The effects of changes in exchange rate on Import/ Export

When a country‘s currency depreciates or is devalued: Foreigners find its exports are cheaper, &
the volume of exports rises. Residents find that imports are more expensive, and the volume of
import falls. Hence, net exports rise & GDP rises.

AMU: International Economics II Mihretu .T(MA)

When a country‘s currency appreciates or is revalued (upward): Foreigners pay more for its
exports, & the volume of exports falls. Residents pay less for imports, and the volume of imports
rises. Hence, net exports fall and GDP falls.

Direct intervention of authorities on foreign exchange rate

If the exchange rate is floating no authority intervention is required. Because the market will
automatically adjust the exchange rate fluctuation based on the demand and supply forces.
Basically, it is based on the trade balance. i.e. if trade balance shows surplus, exchange rate will
appreciates. If balance shows deficit, exchange rate will depreciates.

Fixed exchange rate: To maintain a given fixed exchange rate, a country must stand ready to
intervene in the foreign exchange market, buying or selling (support or defend) its currency to
maintain the official par value. A country can maintain a fixed exchange rate only as long as it
has the official reserves (foreign currencies) to maintain this constant rate.

Intervention to control revaluation

Once it runs out of official reserves, it will be unable to intervene, and then must either borrow or
devalue its currency.

Fig.1.5. Fixed exchange rate: intervention to control revaluation

In the above figure, the increased demand for dollar forced the dollar to be revalued. However,
the authority needs to control dollar from revaluation. Thus, intervene in FORX, by selling
Q1Q2 amount of dollar to purchase home currency.

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This action increases dollar supply from S1 to S2, which eliminates the excess demand for
dollar. So that the exchange rate will remain fixed at 9.5B/$.

Intervention to control devaluation

Increased demand for Ethiopian export will increase supply of dollar, this will in turn rise
demand for birr. As result forces the birr to revalue/ dollar to devalue/ shifts supply of USD from
S1 to S2. But the authority is not willing to revalue birr. Thus, it will intervene in FORX to
collect the excess supply of dollar through selling Birr for dollar. This action raises the foreign
reserve and birr in circulation.

Fig. 1.6. Fixed exchange rate: intervention to control devaluation

To maintain the fixed exchange rate, Q1Q2 amount of dollar has to be purchased. This action
eliminates the excess demand for birr & maintain the exchange rate fixed at 9.5b/$.

Transaction in forward exchange market: There are three kinds of players and three kinds of
transaction in the forward exchange rate market: Arbitrage: Hedging and Speculation.

A. Arbitrage

Because of the foreign exchange market is so large and decentralized, tiny discrepancies/
difference between exchange rates and cross-rates may briefly arise. Arbitrage is the process of
simultaneously buying and selling of currencies to take advantage of such discrepancies. i.e. to
make profit.

Importance of arbitrage; it is nearly riskless; it ensures that rates in different locations are
essentially the same, and it ensures that rates and cross-rates are consistent. It transfers foreign

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exchange from where it is cheap to where it is expensive. It works as stabilizing factor in foreign
exchange market.

Weakness: It is possible only when there is no exchange rate control. Otherwise, it is

impossible.

Types of Arbitrage

We said that arbitrage is exploitation of price differential in the exchange rate. There are two
types: financial - center arbitrage and cross-currency arbitrage

Assumption of arbitrage

 Transaction costs are zero (negligible)

 There is only single exchange rate quotation

Financial center arbitrage: this ensures birr –dollar exchange rate quoted in New York will be
same as that quoted in Addis Ababa is one the financial center. If exchange rate is birr 9.22 /$ in
A.A but birr 9.20 /$ in NY it would be profitable for banks to buy birr in A.A and sell in NY for
a guaranteed profit of 0.02cents such buying of currency from where they are cheap and selling it
at higher rate is called financial center arbitrage.

Cross–currency arbitrage: this arbitrage involves three currency units. Suppose that the
exchange rate of birr is 9.20/$ and the exchange rate of dollar against Euro is 1.5$/euro.
Currency arbitrage implies that the exchange rate against Euro is 13.8birr/euro = (1.5*9.2) If the
actual Birr/Euro =14, then the US dealer wanting birr would do better to first obtain Euro with
13.8Birr/euro(1.5*9.2), then sell birr 14, making 0.2cents per each Euro. If you arbitrage through
three exchange rates, this is called triangular arbitrage.

The discrepancies b/n exchange rates, is known 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 (positive). A currency is said to be at
forward discount if its forward exchange rate quotation shows depreciations ( negative). The
forward discount or premium is usually expressed as a percentage of the spot exchange rate. That
is,

AMU: International Economics II Mihretu .T(MA)

Where F- is forward exchange rate quotation, S is the spot exchange rate quotation.

The presence of arbitrage ensures that the covered interest parity (CIP) condition holds
continuously.

Covered interest rate parity refers to a theoretical condition in which the relationship between
interest rates and the spot and forward currency values of two countries are in equilibrium.
The covered interest rate parity situation means there is no opportunity for arbitrage using
forward contracts, which often exists between countries with different interest rates.

Covered interest parity (CIP) is the formula used by banks to calculate their exchange quotation
and is given by;

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.

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/euro. The one year forward exchange rate can be calculated as:

Forward discount/premium =

This shows that the one year forward rate of euro is at an annual forward discount of 2%.

For example birr 10.1/Euro. In this instance an Ethiopian investor with birr 1000 could base on
the above example earn 1050 birr at the end of the year(1.05x1000), but by buying Euro spot at
birr 10 per euro, and simultaneously selling forward at birr 10.10 at spot exchange 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). This
process continues until arbitrage possibility eliminates. With a spot rate of birr10/Euro, only the

AMU: International Economics II Mihretu .T(MA)

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 risk-less arbitrage profits to be made.

If the country interest rate is higher than the foreign interest rate, then the currency be at forward
premium by equivalent percentage. If the domestic interest rate is lower than the foreign interest
rate, the currency will be at forward discount by an equivalent percentage. For example, if
interest rate on birr 3% & euro interest rate 5% per annual indicates an annual forward discount
on euro of 2% => birr will depreciate by nearly 2% against euro.

Other kinds of Trades

Traders may engage in hedging (they may hedge) to reduce or eliminate exposure to exchange
risk, by eliminating a net asset or net liability position in the foreign currency.

Forex hedge is a transaction implemented to protect an existing or anticipated position from an

unwanted move in exchange rates. Forex hedges are used by a broad range of market
participants, including investors, traders and businesses. By using a forex hedge properly, an
individual who is long a foreign currency pair or expecting to be in the future via a
transaction can be protected from downside risk. Alternatively, a trader or investor who is short
a foreign currency pair can protect against upside risk using a forex hedge.

Speculating is the act of taking a long position or a short position in some currency or related
asset in hopes of making a short-term profit. It is purely a gamble, & is not motivated by any
import/export activity.

B. Hedging

A forward exchange contract is an agreement to exchange one currency for another at some
specified future date at an exchange rate set now (the forward exchange rate). The exchange rate
that actually eventuates is called the future spot rate.

Hedging involves acquiring an asset in the foreign currency to offset a net liability in another, or
vice versa. It effectively sets the exchange rate for a future exchange transaction now, removing
the exchange rate risk. If 100% of the risk is removed, it is called a perfect hedge. For example,

AMU: International Economics II Mihretu .T(MA)

a U.S. firm makes a sale to a company in another country for $10 million worth of merchandise
for delivery in 30 days and payment 60 days thereafter in the foreign currency. Rather than risk
the exchange rate changing unfavorably, the U.S. firm enters into a forward exchange contract
with a bank, guaranteeing that the bank will exchange the foreign currency for U.S. dollars at the
current rate upon receipt of the payment in 90 days. In payment for this contract, the bank
receives a forward premium. This is something like buying an insurance policy, guaranteeing the
exchange rate at which the exchange will be made.

Suppose US radio importer imports radio from Japan Sony Company. But the importer knows
that in 30 days it must pay yen to the Sony Company for shipment of radios arriving then. The
importer can sell each radio for $100 &must pay its supplier yen 9000/radio, its profit depends
on the dollar/yen exchange rate. At the current spot exchange rate of $0.0105/yen. The radio
importer firm would pay $0.0105/yen X 9,000 yen = $94.50 per radio; Profit = $100-$94.50 =
$5.50/radio But the importer may not have the fund to pay to the supplier until the radio arrives
& are sold. If on the next 30 days dollar unexpectedly depreciated to $0.0115/yen. The importer
firm will have to pay $0.0115/yen*9000 = $103.50/ radio. Profit = $100-$103.50 = -$3.50 lose
incurred duet to appreciation in yen.

To avoid such risk of lose, the importing firm can make 30 days forward exchange deal with a
Bank of America. If the Bank of America agrees to sell yen to importer in 30 days at the rate of
$0.0107/yen, then the importer is ensured of paying $0.0107/yen*9000 =$96.30, Profit =$100-
$96.30= $3.70.

C. Speculation

Speculation is a deliberate act of assuming risk to make profit from the fluctuation in exchange
rate. The profit from speculation depends on the speculator‘s expectation about the future. There
are pessimistic/bears/ speculators: expect exchange rate to decline, thus sell their currency
holding to avoid loss. Optimistic /bulls/ speculator’s: expect exchange rate to increase, they
buy foreign currency with a view to selling it when exchange rate increase in future. Speculative
transaction has both stabilizing and destabilizing impact on the exchange rate. If a speculator
buy a currency when it is cheap and sell when it is dearer, it has a stabilizing effect on exchange
rate(Bulls).

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If speculators sell when a currency is weak in the expectation that it will be weaker, or buying it
when it rises in prices believing that it will be still more stronger /Bears/. Has destabilizing effect
on exchange rate

In general, if speculators buy when a currency is weak and sell when it is strong, the speculation
is stabilizing. And vice versa. Examples: A trader purchases a currency—i.e., takes a long
position. If the exchange rate moves in favor of that currency viz a viz another currency, the
trader sells the currency (“closes out the long position”) at a profit (in the other currency).

A trader sells a currency that he/she does not own—i.e, takes a short position. The trader takes
the proceeds from the sale and holds it in his/her account. If the exchange rate moves lower, the
trader buys back the currency at a lower price, and keeps the leftover money (profit).

Example: Suppose that the dollar exchange rate for the British pound is $2.00. You believe
(know?) that the exchange rate in 90 days will be $1.50. And you offer a forward contract,
agreeing to provide £10,000,000 for $5,000,000 in 90 days. In 90 days, the exchange rate is
$1.50. You buy $5,000,000 with £7,500,000 and keep £2,500,000 as profit.

Covered and Uncovered Investments

A covered international investment is one for w/c the foreign exchange is fully hedged. An
uncovered international investment is one for w/c the foreign exchange is not hedged. The
covered interest differential (CD) in favor of a UK investment (―in favor of London‖) is:
CD = (1 + rUK)F /S – (1 + r*US)
where F is the forward exchange rate, S is the spot exchange rate, r*UK and rUS are the interest
rates in the U.K. and the U.S., respective.
Interest Differentials
The forward premium (or discount, if negative) is the proportionate difference b/n the current
forward exchange rate & the current spot value; that is,
Forward premium = (F – S )/S
Thus, approximately,
CD = F + (rUK – r*US)

Covered return, UK Return, US

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Returns on foreign investments are always the sum of the foreign exchange gain/loss and the
local return on the investment.
Covered Intersect arbitrage
Covered interest arbitrage is buying a country‘s currency in the spot market and selling it
forward, while making a net profit off: the combination of higher interest rate in the country and
any forward premium on its currency.

Covered interest parity

John Maynard Keynes argued that opportunities for arbitrage profits should be self-eliminating.
Because the forward exchange rate would adjust so that the covered interest differential returned
to zero. After Keynes, we refer to CD = 0 as covered interest parity, specifically, Covered
interest parity: any interest rate differential between countries should be offset exactly by the
forward premium or discount on its exchange rate. That is, the forward premium should be
approximately equal to the difference in interest rates. Covered interest parity helps explain
differences b/n spot and forward exchange rates.

Evidence on covered interest parity: One study examined CDs b/n short-term financial assets
in the U.S. and those in Germany, Japan, and France. For Germany and Japan, the covered
interest differential is consistently very close to zero (within the bounds of transactions costs)
from about 1985 on. For France this is true from about 1987. Earlier years showed discrepancies
explainable by capital controls that limited the ability of investors to move currencies in or out of
the countries in question. Thus, covered interest parity seems to hold.

Uncovered Investment

If the future exchange rate is not ―guaranteed‖ by a forward contract, then the investor must
make the decision to invest based upon the future expected spot rate, and the expected uncovered
interest differential (EUD) is:

EUD = (1 + rUK)Se/S – (1 + r*US)

If this is positive, then the expected overall return favors investing abroad; if negative, investing
at home.

AMU: International Economics II Mihretu .T(MA)

Uncovered interest parity

Uncovered interest rate parity (UIP) theory states that the difference in interest rates between two
countries will equal the relative change in currency foreign exchange rates over the same period.
It is one form of interest rate parity (IRP) used alongside covered interest rate parity. The market
will drive rates until there is no incentive for shifts in investments—when the expected
uncovered differential equals zero, at least for the average investor. If true, then EUD = 0, called
uncovered interest parity. Equivalently, the expected rate of appreciation of the spot exchange
rate of a currency should (approximately) equal the difference in interest rates.

Evidence on uncovered interest parity: This is harder to test because one must know what
market participants ―expected‖. Based on survey data, panel studies of the U.S. versus Germany
and Japan suggest that market participants often expected large uncovered differentials. This
suggests that uncovered interest parity does not hold very well.

Other studies suggest that uncovered interest parity applies roughly, with important deviations.
Exchange rate risk may matter—investors may not feel that they will be adequately paid for
accepting risk.

Forward predict future spots: Expectations of market participants about future spot prices appear
to be biased. Implications:-The market may not be efficient and market participants learn slowly;
that is, their expectations will ultimately be unbiased, but until they have fully absorbed all
information, they will appear biased.

There may be problems in the forward rate that prevent it from being an unbiased predictor of
the future spot rate & the forward rate is not a particularly accurate predictor, either.

Currency Futures: are future contract for currencies that specify the price of exchanging one
currency for another at future date. Currency futures are used to hedge the risk of receiving
payments in a foreign currency. Currency futures are contracts traded on organized exchanges,
like the Chicago Mercantile Exchange or the NY Futures Exchange (NYFE). The futures
contract is a standardized contract, and is a tradable security. It is standardized according to
amount, terms, and delivery date, and cannot be customized to the specific buyer.

AMU: International Economics II Mihretu .T(MA)

When you enter into a futures contract, the exchange requires you to put up a specific margin
(down payment) in cash. Forward contracts may not require this. Profits &losses accrue to you
daily with a futures contract:-it is ―marked to market daily‖& losses may require you to put up
more margins. Forwards profits or losses do not generally accrue until the maturity date. Anyone
can enter into a futures contract, not just money center banks dealing in large sums of money.
Even ―small guy‖ can get into futures.

Currency options

A currency option (also known as a forex option) is a contract that gives the buyer the right,
but not the obligation, to buy or sell a certain currency at a specified exchange rate on or before
a specified date. For this right, a premium is paid to the seller. Currency options are one of the
most common ways for corporations, individuals or financial institutions to hedge against
adverse movements in exchange rates.

A currency option gives the buyer or holder of the option the right, but not the obligation, to
buy (a call option) or sell (a put option) foreign currency at some time in the future at a price set
today. The price at which the buyer has the right to buy or sell is called the strike price or
exercise price. For this right, the buyer pays the seller a premium.

Currency Swaps

A currency swap, sometimes referred to as a cross-currency swap, involves the exchange of

interest and sometimes of principal in one currency for the same in another currency. Interest
payments are exchanged at fixed dates through the life of the contract. It is considered to be a
foreign exchange transaction and is not required by law to be shown on a company's balance
sheet.

In a currency swap, two parties agree to exchange flows of d/t currencies during a specified
period of time. It is basically a set of spot and forward exchanges packaged together in a single
contract. It generates lower transactions costs than an array of equivalent spot and forward
contracts, and also may lower risk.

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Review Questions

1. The function of the foreign exchange market is to (A) transfer funds from one nation to
another, (B) provide short-term credits to finance trade, (C) provide the facilities for
hedging, (D) all of the above.
2. If $3.60 is needed to purchase £2, exchange rate is (A) $3.60 = £2, (B) $1.80 = £1, (C)
£0.50 = $1, (D) £0.40 = $1.
3. When the Ethiopian demand for dollar increase under a flexible exchange rate system,
(A) The birr depreciates, (B) the dollar depreciates, (C) the birr appreciates, (D) none of
the above
4. Hedging refers to (A) the acceptance of a foreign exchange risk, (B) the covering of a
foreign exchange risk, (C) foreign exchange speculation, (D) foreign exchange arbitrage.
5. Covered interest arbitrage involves, (A) the transfer of liquid funds from one monetary
center and currency into another to take advantage of higher interest rate in the latter, (B)
hedging of currency, (C), earning extra interest in a riskless way. (D) all of the above.
6. What are the determinants for demand for foreign currency?
7. Suppose the dollar exchange rates of the euro and the yen are equally variable. The euro,
however, tends to depreciate unexpectedly against the dollar when the return on the rest
of your wealth is unexpectedly high, while the yen tends to appreciate unexpectedly in
the same circumstances. As a U.S. resident, which currency, the euro or the yen, would
you consider riskier?
8. Suppose the one-year forward $/€ exchange rate is $1.26 per euro and the spot exchange
rate is $1.2 per euro. What is the forward premium on euro (the forward discount on
dollars)? What is the difference between the interest rate on one-year dollar deposits and
that on one-year euro deposits (assuming no political risk)?

AMU: International Economics II Mihretu .T(MA)

 CHAPTER TWO
THEORY OF EXCHANGE RATE DETERMINATION (MONEY
INTEREST RATE & EXCHANGE RATE)
Chapter Objective

- Defining money, functions of money

- Examine demand for and supply of money
- Interest rate, exchange rate, and price level
- Money supply in short-run and long-run its effect on real variables

2. Definition of Money
What is money?

As the word money is used in everyday conversation, it can mean many things, but to
economists, it has a very specific meaning.

Money is defined as anything that is generally accepted in payment for goods & services or in
the repayment of debts. Defining money merely as currency is too much narrow for economists.
Because recently payments are settled not only in paper or coin currency, checks and saving
deposits as payment for purchases, these accounts in effect function as money if they can be
quickly & easily converted into currency or checking account deposits. Today the credit cards,
Smart cards & ATM help liquidating the saving account deposits. So, the term money is
sometimes referring to money supply.

2.1. Functions of Money

Money has the following functions

As a medium of exchange: serve as a medium of exchange, a generally Accepted means of

payment. Example, consider the barter trade the trade of goods or services for other goods or
services.

Unit of account: serve as a widely recognized measure of value. Prices of goods, services, and
assets are typically expressed in terms of money. Exchange rates allow us to translate d/t
countries ‗money prices in to comparable terms. The convention of quoting prices in money

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terms simplifies economic calculations by making it easy to compare the prices of different
commodities

As store of value: because money can be used to transfer purchasing power from the present
into the future, it is also an asset or a store of value and also no one would be willing to accept it
in payment if its value in terms of goods & services evaporated immediately.

2.2. Demand for Money

By individuals: what are the factors that determine the amount of money an individual desires to
hold? The demand for money by Individuals is based on their demand for an asset on three
characteristics:

1. The expected return the asset offers compared with the returns offered by other assets.
2. The riskiness of the asset's expected return,
3. The asset's liquidity.

How the three considerations listed above influence money demand in the economy's households
and firms? Let‘s consider each of them.

Expected return: Currency pays no interest. Checking deposits often do pay some interest, but
they offer a rate of return that usually fails to keep pace with the higher return offered by less
liquid forms of wealth. When you hold money, you therefore sacrifice the higher interest rate
you could earn by holding your wealth in a gov‘t bond, a large time deposit, or some other
relatively non-liquid asset.

Suppose, for example, that the interest rate you could earn from a U.S. Treasury bill is 10% per
year. If you use $10,000 of your wealth to buy a Treasury bill, you will be paid $11,000=((1.1
x1000) at the end of a year. But if you choose instead to keep the $10,000 as cash in a safe-
deposit box, you give up the $1000 interest you could have earned by buying the Treasury bill.
You thus sacrifice a 10% rate of return by holding your $10,000 as money.

The expected return theory states that, other things equal, people prefer assets offering higher
expected returns. An increase in the interest rate implies arise in the rate of return on less liquid
assets relative to the rate of return on money. Thus, individuals will want to hold more of their
wealth in non-money assets that pay the market interest rate & less of their wealth in the form of

AMU: International Economics II Mihretu .T(MA)

money if the interest rate rises. Therefore, all else equal, arise in the interest rate causes the
demand for money to fall.

Riskiness: It is risky to hold money b/c an unexpected increase in the prices of goods & services
could reduce the value of your money in terms of the commodities you consume. Since interest-
paying assets such as gov‘t bonds have face values fixed in terms of money, the same
unexpected increase in prices would reduce the real value of those assets by the same percentage.
Therefore, changes in the risk of holding money need not cause individuals to reduce their
demand for money & increase their demand for interest-paying assets.

Liquidity: Households & firms hold money b/c it is the easiest way of financing their everyday
purchases. That is, to finance a continuing stream of smaller expenditures at various times & for
various amounts, households & firms have to hold some money. An individual's need for
liquidity rises when the average daily value of his transactions rises. In general, a rise in the
average value of transactions carried out by a household or firm cause its demand for money to
rise.

Aggregate Demand for Money

Aggregate demand: The total demand for money by all households & firms in the economy.
Aggregate money demand is just the sum of all the economy's individual money demands.
Three main factors determine aggregate money demand:

1. The interest rate: A rise in the interest rate causes each individual in the economy to
reduce her demand for money. All else equal, aggregate money demand therefore falls
when the interest rate rises.
2. The price level: The economy's price level is the price of abroad reference basket of
goods & services in terms of currency. If the price level rises, individual households &
firms must spend more money than before to purchase their usual weekly baskets of
goods & services. To maintain the same level of liquidity as before the price level
increase, they will therefore have to hold more money.
3. Real national income: When real national income (GNP) rises, more goods & services
are being sold in the economy. This increase in the real value of transactions raises the
demand for money, given the price level.

AMU: International Economics II Mihretu .T(MA)

If P is the price level, R is the interest rate, and Y is real GNP, the aggregate demand for money,
, can be expressed as

Where the value of L(R,Y) falls when R rises, and rises when Y rises.

If all prices doubled but the interest rate and real income remained unchanged. The money value
of each individual‘s average daily transactions would then simply double, as would the amount
of money each wished to hold.

This way of expressing money demand shows that the aggregate demand for liquidity, L(R,Y),is
not a demand for a certain number of currency units but is instead a demand to hold a certain
amount of purchasing in liquid form. For a given level of real GNP, changes in interest rates
cause movements along the L(R,Y) schedule. Changes in real GNP, however, cause the schedule
itself to shift.

Fig2.1.: Aggregate money demand and interest rate.

AMU: International Economics II Mihretu .T(MA)

Fig.2.2. Effects of rise in income on aggregate money demand

2.3. Equilibrium in the money market

If is the money supply, the condition for equilibrium in the money is: . After
dividing both sides of this equality by the price level, we can express the money market

equilibrium condition in terms of aggregate real money demand as: . Given the

price level O, and output Y, the equilibrium interest rate is the one at which aggregate real
money demand equals the real money supply.

The market always moves toward an interest rate at w/c the real money supply equals aggregate
real money demand. If there is initially an excess supply of money, the interest rate falls, & if
there is initially an excess demand, it rises.

£ Interest rate and money supply: An increase in the money supply lowers the interest
rate, while a fall in the money supply raises the interest rate, given the price level and
output.

AMU: International Economics II Mihretu .T(MA)

Fig.2.3. Effects of increased money supply on interest rate

Fig.2.4. Determination of equilibrium interest rate.

£ The money supply and exchange rate in the short run

In previous chapter, we learned about the interest parity condition, which predicts how interest
rate movements influence the exchange rate, given expectations about the exchange rate‘s future
level. How shifts in a country‘s money supply affect the interest rate on non-money assets
denominated in its currency, & how monetary changes affect the exchange rate? We will
discover that an increase in a country‘s money supply causes its currency to depreciate in the
foreign exchange market, while a reduction in the money supply causes its currency to
appreciate.

Linking Money, the Interest Rate, and the Exchange Rate

To analyze the relationship between money & the exchange rate in the short run, let‘s combine
money market and exchange market equilibriums. Let‘s assume once again that we are looking
at the dollar/euro exchange rate, i.e., the price of euros in terms of dollars.

The equilibrium in the foreign exchange market shows how exchange rate is determined given
interest rates & expectations about future exchange rates. While equilibrium in the money
market reveals how the dollar interest rate is determined in the money market.

£ Combination of equilibrium in two markets,.i.e., money market and foreign

exchange market.

AMU: International Economics II Mihretu .T(MA)

Fig.2.5. Simultaneous Equilibrium in the U.S. Money Market and the Foreign Exchange market

The top figure reveals the equilibrium in foreign exchange market and how exchange rate is
determined given interest rate and expectations about future exchange rates. The downward-
sloping curve shows the expected return on euro deposits, measured in dollars. It is downward
sloping because of the effect of current exchange rate changes on expectations of future
depreciation.

Strengthening of dollar today (a fall in ⁄ ) relative to its given expected future level makes
euro deposits more attractive by leading people to anticipate a sharper dollar depreciation in the
future. At the intersection of the two schedules (point 1), the expected rates of return on dollar
and euro deposits are equal, and therefore interest parity holds, ⁄ is the equilibrium exchange
rate. While the bottom figure depicts equilibrium in the money market and how the dollar
interest rate is determined in the money market.

Money market is at equilibrium at point 1, where the dollar interest rate induces the demand
and supply for real balances are equal. The U.S money market determines the dollar interest rate,
which in turn affects the exchange rate that maintains interest parity. The same is true for
European money supply.

Given the price levels and national incomes of the two countries equilibrium in national money
markets leads to the dollar and euro interest rates and . These interest rate feed into the
foreign exchange market, where, given expectations about the future dollar/ euro exchange rate,
the current rate is determined by the interest parity condition.

AMU: International Economics II Mihretu .T(MA)

Link between Money and Exchange rate

How the dollar/euro exchange rate changes when the federal reserve changes the U.S. money
supply? The effect of this change in money supply is summarized in the following figure.

Fig. 2.7. effect on the dollar/euro exchange rate and dollar interest rate of an increase in the U.S
money supply.

At the initial money supply , the money market is in equilibrium at point 1 with an interest
rate . Given the euro interest rate and the expected future exchange rate, a dollar interest rate
of implies that foreign exchange market equilibrium occurs at point, with an exchange rate
equal to ⁄ .

What happens when the Federal Reserves, perhaps fearing the onset of a recession, raises the U.S
money supply to ?. This increases sets in motion the following sequence of events:

1) At the initial interest rate, there is an excess supply of money in the U.S. money market ,
so the dollar interest rate falls to as the money market reaches its new equilibrium
position (point 2).
2) Given the initial exchange rate ⁄ and the new lower interest rate on dollars , the
expected return on euro deposits is greater than that on dollar deposits. Holders of dollar
deposits therefore try to sell them for euro deposits, which are momentarily more
attractive.

AMU: International Economics II Mihretu .T(MA)

 3) The dollar depreciates to ⁄ as holders of dollar deposits bid for euro deposits.
The foreign exchange market is once again in equilibrium at point 2‘ b/c the exchange
rate‘s move to ⁄ causes a fall in the dollar‘s expected future depreciation rate
sufficient to offset the fall in the dollar interest rate.

All in all an increase in a country‘s money supply causes its currency to depreciate in the foreign
exchange market. And a reduction in a country‘s money supply causes its currency to appreciate
in the foreign exchange market. What do you think the effect of the change in money supply of
European on the return on dollar?

£ Money, the Price Level, & the Exchange Rate in the Long Run

How monetary factors affect a country‘s price level in the long run? Long-run equilibrium is the
position an economy would eventually reach if no new economic shocks occurred during the
adjustment to full employment. The long-run equilibrium that would occur if prices were
perfectly flexible & always adjusted immediately to preserve full employment, we need to
examine how such changes shift the economy‘s long-run equilibrium. Using the theory of
aggregate money demand.

If the price and output are fixed in short run, the condition for money market equilibrium,
determines the domestic interest rate, R

By rearranging, we can determine the long-run price level, when the interest rate and output are
at their long-run level that is at levels consistent with full employment.

This shows how the price level depends on the interest rate, real output, and the domestic money
supply. When money market is in equilibrium & all factors of production are fully employed,
then the price level will remain steady if the money supply, the aggregate money demand
function, and

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the long-run values of R and Y remain steady.

The predictions of the above equation for P from the relationship between a country‘s price level
and its money supply, in general is : All else equal, an increase in a country‘s money supply
causes a proportional increase in its price level. For example, if the money supply doubles (2Ms)
but Y and R do not change, the price level must also double (to2P) to maintain equilibrium in
the money market. That is, demand for real balance is independent of change in money supply
that leaves R and Y. If aggregate real money demand is independent of money supply, then
money market equilibrium will be maintained is the rise in money supply is totally absorbed by
the rise in price level.

£ The Long-Run Effects of Money Supply Changes

We have seen that money supply affects the price level but not interest rate & output, which can't
explain how money supply changes affect the price level in the long run. To understand the long-
run effects of money supply on the interest rate and output, consider a currency reform, where
government redefines the national currency unit. For example, if the government of Ethiopia
reformed birr to each new birr equals 1000 old birr, this effect is simply to affect the number of
money in circulation and prices but no effect on real variables. An increase in the supply of a
country‘s currency has the same effect in the long run as a currency reform.

That is, doubling of the money supply, for example, has the same long-run effect as a currency
reform in which each unit of currency is replaced by two units of ―new‖ currency. If the
economy is initially fully employed, every money price in the economy eventually doubles, but
real GNP, the interest rate, and all relative prices return to their long-run or full-employment
levels.

 Why change in money supply is similar with a currency reform in its effects on the
economy’s long-run equilibrium?

The full-employment output level is determined by the economy‘s endowments of labor and
capital, i.e. long run, real output is independent of money supply.

AMU: International Economics II Mihretu .T(MA)

If money supply and all prices double permanently, there is no reason why people previously
willing to exchange $1 today for $1.10 a year from now will not be willing to exchange $2 today
for $2.20 a year from now, so the interest rate will remain at 10% per annum.

Relative prices also remain the same if all money prices double, since relative prices are just
ratios of money prices. Similarly, the interest rate is independent of the money supply in the long
run. That is, changes in money supply don‘t change the long-run allocation of resources. but the
absolute level of money prices changes.

A permanent increase in the money supply causes a proportional increase in the price level‘s
long-run value. In particular, if the economy is initially at full employment, a permanent increase
in the money supply eventually will be followed by a proportional increase in the price level.

£ Money and the Exchange rate in the Long run

The domestic currency price of foreign currency is one of the many prices in the economy that
rise in the long run after a permanent increase in the money supply. Suppose, for example, that
the U.S. government replaced every pair of ―old‖ dollars with one ―new‖ dollar. Then if the
dollar/euro exchange rate had been 1.20 old dollars per euro before the reform, it would change
to 0.60 new dollars per euro immediately after the reform. That is, halving of the U.S. money
supply would eventually lead the dollar to appreciate from an exchange rate of 1.20 dollars/euro
to one of 0.60 dollars/euro.

Since the dollar prices of all U.S. goods & services would also decrease by half, this 50 %
appreciation of the dollar leaves the relative prices of all U.S. & foreign goods & services
unchanged.

Generally, all else equal, a permanent increase in a country‘s money supply causes a proportional
long-run depreciation of its currency against foreign currencies. Similarly, a permanent decrease
in a country‘s money supply causes a proportional long-run appreciation of its currency against
foreign currencies.

AMU: International Economics II Mihretu .T(MA)

 £ Exchange rate Overshooting

In its initial depreciation after a money supply rise, the exchange rate jumps from ⁄ up to

⁄ , a depreciation greater than its long-run depreciation from ⁄ to ⁄ as indicated in

the figure below. The exchange rate is said to overshoot when its immediate response to a
disturbance is greater than its long-run response.

Fig. 2.8. Exchange rate overshooting

Exchange rate overshooting is an important phenomenon because it helps explain why

exchange rates move so sharply from day to day. Investors can react rationally to news in such a
way as to drive the exchange rate past what they know to be it into ultimate long-run equilibrium
rate, and then slowly back to that rate later on. That is, in the short run, the exchange rate
actually overshoots its long-run value and then reverts back toward it.

2.4. Price Levels and Exchange Rates in the Long run

 What economic forces lie behind such dramatic long-term movements in exchange
rates?

We have seen that exchange rates are determined by interest rates and expectations about the
future, which are, in turn, influenced by conditions in national money markets. To understand
fully long-term exchange rate movements, we have to extend our model in two directions.

First, we must complete our account of the linkages among monetary policies, inflation, interest
rates, and exchange rates.

Second, we must examine factors other than money supplies & demands, for example, demand
shifts in markets for goods and services—that also can have sustained effects on exchange rates.

AMU: International Economics II Mihretu .T(MA)

2.5. Purchasing Power Parity (PPP)
The theory of purchasing power parity states that the exchange rate between two countries
‗currencies equals the ratio of the countries price levels. The domestic purchasing power of a
country's currency is reflected in the country's price level, the money price of a reference basket
of goods and services. The PPP theory therefore predicts that a fall in a currency's domestic
purchasing power (as indicated by an increase in the domestic price level) will be associated with
a proportional currency depreciation in the foreign exchange market. Symmetrically, PPP
predicts that an increase in the currency‘s domestic purchasing power will be associated with a
proportional currency appreciation. Symbolically, PPP can be expressed as :

⁄ ⁄

Where ⁄ -exchange rate of dollar per euro, Pus-price of U.S., PE-price of European.

Example, if the reference commodity basket costs $200 in U.S and 160 in Europe. Thus, PPP
predicts as ⁄ exchange rate = $200/ =$1.25/ . If the U.S price level is tripled, so would
the dollar price of a euro. PPP = ⁄ =3*1.25.

The dollar price of the reference basket when purchased in Europe ( ⁄ ). This is true
if the PPP holds. PPP thus, asserts that all countries price levels are equal when measured in
terms of the same currencies. Therefore, PPP holds when, at going exchange rate every
currency‘s domestic purchasing power is always the same as its foreign purchasing power.

£ The PPP theory and the Law of One Price

To understand the market forces that might give rise to the results predicted by the purchasing
power parity theory, we discuss first a related but distinct proposition known as the Law of one
price.

Law of one price: states that in competitive markets, free of transportation costs & official
barriers to trade(such as tariffs), identical goods sold in d/t countries must sell for the same price
when their prices are expressed in terms of the same currency. When trade is open & costless,
identical goods must trade at the same relative prices regardless of where they are sold. For

AMU: International Economics II Mihretu .T(MA)

example, suppose that the dollar/pound exchange rate is $1.50 and the price of sweater is $45 in
New York while the same sweater costs £30 in London. The dollar price of the sweater when
sold in London is then ($1.50/£ pound) X (£30/ sweater)= $45/ sweater, the same as its price in
New York.

To see whether the law of one price holds or not, let us further consider the effect of change in
exchange rate on the relative prices of the sweater in both markets. If pound depreciated from
$1.50/£ to $1.45/£, now a sweater costs $43.50 in London (=$1.45/£ X £30). If the same sweater
were selling for $45 in New York, U.S. importers & British exporters would have an incentive to
buy sweaters in London & ship them to N.Y, pushing the London price up and the N.Y price
down until prices were equal in the two locations and vice versa.

From the above example we can see that the law of one price provides link between the domestic
prices of goods and exchange rates.

The law of one price can formally be stated as follows; Let be the dollar price of good I
when sold in the U.S., the corresponding euro price in Europe. Then the law of one price
implies that the dollar price of good i, is the same wherever it is sold, ⁄ . The
dollar/euro exchange rate is the ratio of the price of good i, in U.S. and European money prices is

⁄ ⁄ , law of one price looks like the PPP. However, there is clear difference

between PPP and law of one price. These are:

1. The law of one price applies to individual commodity, while PPP applies to the general
price level, which is composite of the prices of all the commodities that enter into the
reference baskets.
2. If the law of one price holds for every commodities PPP must automatically holds as long
as the reference baskets used to reckon different countries price level are the same.

The proponents of PPP argue that its validity as a long run theory does not require the law of one
price to hold exactly. Example, if the goods & services become temporarily expensive in one
country than in others, the demand for its currency & its products fall pushing exchange rate
(depreciation) & domestic prices back in line with PPP. The opposite situation of relatively

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cheap domestic products leads, to currency appreciation and price level inflation. Thus, PPP,
asserts that even when the law of one price is not literally true, the economic forces behind it
will help eventually to equalize a currency's purchasing power in all countries.

£ Absolute PPP and Relative PPP

The statement that exchange rates equal relative prices level in (the previous equation ) is
sometimes referred to as absolute PPP. Absolute PPP implies relative PPP, Which states that the
% change in the exchange rate b/n two currencies over any period equals the difference b/n the
% changes in national price levels.

Relative PPP thus translates absolute PPP from a statement about price & exchange rate levels
into one about price and exchange rate changes. It asserts that prices and exchange rates change
in a way that preserves the ratio of each currency‘s domestic & foreign purchasing powers. If for
example, the U.S. price level rises by 10 % over a year while price level of Europe‘s rises by
only 5%, the relative PPP predicts a 5 % depreciation of the dollar against the euro.

The dollar‘s 5% depreciation against the euro just cancels the 5% by which U.S. inflation
exceeds European inflation, leaving the relative domestic & foreign purchasing powers of both
currencies unchanged. More formally, relative PPP between the United States & Europe would
be written as:

⁄ ⁄ ⁄( ⁄ )

Where denotes an inflation rate (that is ⁄ , the percentage change in a

price level between dates t and t-1.

Unlike absolute PPP, relative PPP can be defined only with respect to the interval over which
price levels and the exchange rate change. The notion of relative PPP thus convenient when we
have to rely on gov‘t price level statistics to evaluate PPP.

As it makes sense to compare % exchange rate changes to inflation differences, when countries
base their price level estimates on product baskets that differ in coverage & composition.

AMU: International Economics II Mihretu .T(MA)

Relative PPP is important also b/c it may be valid even when absolute PPP is not. if the factors
causing deviations from absolute PPP are more or less stable over time, % changes in relative
price levels can still approximate % changes in exchange rates.

2.5.1. A Long-run Exchange Rate Model Based on PPP

The theory of PPP leads to a useful theory of how exchange rates & monetary factors interact in
the long run. It is known as the monetary approach to the exchange rate.

The monetary approach is considered as a long-run theory b/c it does not allow for the price
rigidities rather it assumes that as if prices can adjust right away to maintain full employment as
well as PPP. This implies that in the long run prices are perfectly flexible to equilibrate the
variability in output & factor market prices. To develop the monetary approach’s predictions
for the $/euro exchange rate, let us assume in the long run, the foreign exchange market sets the

rate so that PPP holds: ⁄ ⁄ .

This equation would hold if there are no market rigidities to prevent the exchange rate & other
prices from adjusting immediately to levels consistent with full employment.

At the beginning of this unit we expressed domestic price levels in terms of domestic money
demands and supplies. For instance in the United States, , while in
Europe, . The money supply and aggregate decreases when the
interest rate rises and increases when real output rises.

According to the statement of PPP, the dollar price of a euro is simply the dollar price of U.S.
output divided by the euro price of European output. These two price levels, in turn, are
determined completely by the supply and demand for each currency area‘s money.

The monetary approach therefore makes the general prediction that the exchange rate, w/c is the
relative price of American & European money, is fully determined in the long run by the relative
supplies of those monies and the relative real demands for them. Shifts in interest rates & output
levels affect the exchange rate only through their influences on money demand.

In addition, the monetary approach makes a number of specific predictions about the long-run
effects on the exchange rate of changes in money supplies, interest rates, and output levels:

AMU: International Economics II Mihretu .T(MA)

Money supplies: other things equal, a permanent rise in the U.S. money supply causes a
proportional increase in the long-run U.S. price level . If the U.S money supply rises by 10
percent, the price in U.S. and ⁄ both eventually rise by 10 percent as well. Thus, an increase in
the U.S money supply causes a proportional long-run depreciation of the dollar against the euro.
Conversely, permanent increase in the European money supply causes a proportional income in
the long-run European price level. Under PPP, this price level rise implies as proportional long-
run appreciation of the dollar against the euro (which is the same as a proportional depreciation
deprecation of the euro against the dollar).

Interest Rate: a rise in the interest rate in dollar-denominated assets lowers real U.S. money
demand the long run U.S. price level rises, and under PPP the dollar must depreciate
against the euro in proportion to this U.S. price level increase. A rise in the interest rate on
euro-denominated assets has the reverse long-run exchange rate effect. Because real European
money demand falls, Europe‘s price level rises. i.e. PPP, reveals dollar appreciate against the
euro in proportion to increase Europe‘s price level.

Output levels: A rise in U.S. output raises real U.S. money demand leading to a fall in the long-
run U.S. price level. Under PPP, shows appreciation of the dollar against the euro. Similarly, a
rise in European output raises & causes a fall in Europe‘s long-run price level. PPP predicts the
dollar depreciate against the euro.

According to the monetary approach, the U.S. price level drops immediately to bring about a
market-clearing increase in the supply of real balances. PPP implies that this instantaneous
American price deflation is accompanied by an instantaneous dollar appreciation on the foreign
exchanges. The monetary approach leads to the long-run foreign exchange value of a country‘s
currency moves in proportion to its money supply. The theory also rises what seems to be a
paradox. We always found that a currency appreciates when the interest rate it offers rises
relative to foreign interest rates.

How a rise in a country’s interest rate depreciates its currency by lowering the real demand for
its money?

AMU: International Economics II Mihretu .T(MA)

2.6. Measurement Problems with PPP
Many researchers have tried to test whether PPP can be used to predict exchange rate or not.
Their 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, most 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.

1. Transport costs & restrictions on trade certainly do exist. These trade barriers may be
high enough to prevent some goods & services from being traded b/n countries.
Moreover some goods are non-traded
2. Existence of Imperfect competition: in goods markets may interact with transport costs &
other trade barriers to weaken further the link b/n the prices of similar goods sold in d/t
countries.
3. Because the inflation data reported in different countries are based on different
commodity baskets, there is no reason for exchange rate changes to offset official
measures of inflation differences, even when there are no barriers to trade and all
products are tradable.
4. Difference between Capital and Goods Market: Purchasing power parity is based on the
concept of goods arbitrage and has nothing to say about the role of capital movement.

According to Rudiger D. (1976) in a world where capital market are highly integrated & goods
markets exhibit slow price adjustment. There can be substantial (significant) & prolonged
deviation of the exchange rate from PPP.

That is, in 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(extended).

AMU: International Economics II Mihretu .T(MA)

Productivity Differentials: when prices of similar basket of both traded & non-traded goods are
converted into a common currency, the aggregate price indices tend to be higher in rich countries
than in poor countries. The overall higher price in rich countries is mainly due to the fact that
non-tradable goods prices are higher in developed than in developing countries.

The lower relative price of non-tradable in poor countries is due to their lower labor
productivity b/n developing & 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.

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 & 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 w/c are susceptible(easily) to international competition. Here
belongs most manufacturing goods like Automobile, Electronics products and fuels and the like.

Non traded goods:- are those that cannot be traded internationally at a profit. Their price will
not be affected by the international competition. These includes different goods and services like,
Hair cut (hair dressing), Restaurant food service, Houses, E.t.c.

The distinction b/n them is due to the fact that the price of traded goods tends to be in line with
the international competition, while the price of non-traded goods will be determined
predominantly by domestic supply & demand considerations. For instance if a car costs 15,000
£ in the UK & $ 30,000 in US arbitrage will tend to keep the pound-dollar rates at 2 $/£.
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 $10 in US and the exchange rate is birr 10/$. No one in the U.S will
travel to Ethiopia for a haircut knowing that they can save $9 because of the time and transport
costs involved.

When aggregate price indice is determined both by tradable and non-tradable are considered.
Assuming that PPP holds for tradable we have the following locations.

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 .

Where - price of traded goods in the domestic country measured in terms of the domestic
currency, the price of traded goods in the foreign country measured in-terms of 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 ( ) and non-tradable goods ( ) priced in the domestic currency. We
have,

Where, is the proportion of non-traded goods in the domestic price index.

Where, is the proportion of non-traded goods in the foreign price index. Dividing equation (1)
and (2) we obtain

If we divide the numerator by and the denominator by , which because of the

assumption of PPP for tradable goods are equivalent expression, we obtain;

( )

This can be rearranged , to give the solution for the exchange rate as

[ ]
( )

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. Furthermore, the equation suggests that the relative price of non-tradable relative to
tradable will influence the exchange rate. Testing the PPP using price indices on tradable goods

AMU: International Economics II Mihretu .T(MA)

prices is likely to lead to better results than when using aggregate price indices made up of both
types of goods.

Review Questions

1. In short run, a permanent increase in the domestic money supply causes?

A. An upward shift in the demand curve, which is greater than that caused by an equal
but transitory increases
B. A downward shift in aggregate demand curve, which is greater than that caused by an
equal but transitory increase.
C. An upward shift in the aggregate demand curve, which is smaller than that caused by
an equal but transitory increase.
D. A downward shift in the aggregate demand curve, which is smaller than that caused
by an equal but transitory increase.
E. An upward shift in the AA curve, which is greater than that caused by an equal but
transitory increase.
2. Explain how an increase money supply affect exchange rate and price level of that a
given nation in the long-run?
3. What are the principal functions of foreign exchange market?
4. If the exchange rate between the birr and the dollar changes from 52 birr =$1 to 63 birr
=$1, what does this mean for the birr? And what does for dollar?
5. Explain the exchange rate overshooting of the dollar that is likely to result from reduction
in the rate of interest in the U.S. relative to that in the U.K?

AMU: International Economics II Mihretu .T(MA)

 CHAPTER THREE
BALANCE OF PAYMENT
Chapter Objective

- Define balance of payment, components of BOP,

- Balance of payment disequilibrium
- Link between exchange rate and balance of payment
- Approaches to balance of payment, monetary approach, absorption approach, elasticity
approach

3.1. Definition of Balance of payments(BOP)

What is Balance of Payment?

The BOP is the statistical record of a country‘s international transactions over a certain period of
time presented in the form of double-entry bookkeeping.

N.B. when we say “a country’s balance of payments” we are referring to the transactions of its
citizens & gov’t.

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. It reveals how many
goods & services the country has been exporting & importing & whether the country has been
borrowing or lending money to the rest of the world. For the purpose of BOP reporting, a
multinationals are treated as being residents in the country in w/c 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 & 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.

£ Why balance of payment (BOP)?

The BOP serves a very useful purpose as it yields necessary information for the future monetary
policy, fiscal policy and foreign trade policies formulation.

AMU: International Economics II Mihretu .T(MA)

The major uses of the BOP are as follows

1. It provides extremely useful data for economic analysis of country‘s weakness and
strength as a partner in international trade. The economic position of a country can be
determined. If BOP shows improvement or deterioration, necessary correction measures
may be adopted.
2. It reveals the changes in the composition and magnitude of foreign capital movements.
The changes that are deterrent to economic well-being of the country and lead to
deterioration in the BOP of the country warrant necessary action by the government.
3. It provides indications of future repercussions (consequence) of a country‘s past trade
performance. If BOP shows a continuous and large deficits over time, it shows growing
international indebtedness which may lead to financial bankruptcy, persistent large scale
deficit in BOP if its magnitude exceeds the absorption capacity of the country, causes
inflation
4. Detailed BOP account reveals weak and strong points in the country‘s foreign trade
relations and thereby forewarns the government for necessary corrective measures
especially against the weak points.
£ Collection, Reporting of the BOP

The BOP statistics record all of the transaction between domestic and foreign residents, 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 and outflow is obtained from banks,
pension funds, multinationals and investments Agency. The responses from different sources are
compiled by government statistical agencies.

3.2. Balance of Payment Accounting

The BOP accounts are those that record all transactions b/n the residents of a country and
residents of all foreign nations. In an accounting sense they always balance. This is because they
are based up on the principle of double-entry book-keeping. Each transaction b/n domestic &
foreign residents has two sides: a receipt & payment, where, both sides are recorded in the BOP
statistics. Each receipt of currency from residents of the rest of the world is recorded as a credit

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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).

3.3. The Components of BOPs

The following were the elements (components) of balance of payments. It composed of the
following accounts; the current account, capital account, the balance for official financing (the
official reserves account) and statistical discrepancy or difference.

Current account refers to income flows. Includes all imports and exports of goods and services
(invisible trade) and unilateral transfers of foreign aid. If the debits exceed the credits, then a
country is running a trade deficit. If the credits exceed the debits, then a country is running a
trade surplus. It is thought that the CA responds to changes in income and the exchange rate.

Capital account (K): The capital account records change in the assets and liabilities. The capital
account measures the difference between domestic sales of assets to foreigners and domestic
purchases of foreign assets.

The Official Reserve Account: It is a subdivision of the capital account, is the foreign currency
and securities held by government, usually by its central bank, and is used to BOP from year to
year. Official reserves assets include gold, foreign currencies, special drawing rights (SDRs), and
reserve positions in the IMF. The official reserves increases when there is a trade surplus and
decreases when there is a deficit. The balance for official financing shows the net increase or
decrease in a country‘s holdings of foreign currency reserves: A decrease in the official reserves
is reported as a credit item (+) and an increase is reported as a debit item (-).

Statistical Discrepancy: There‘s going to be some omissions and misreported transactions, so

we use a ―plug‖ figure to get things to balance.

The BOP must always balance since the accounts are constructed such that this must be true by
definition However, there can be measurement error & unreported borrowing from abroad &
there illegal activities The discrepancy represents a combination of unrecorded current & capital
account transactions This requires the inclusion of what is referred to as a balancing item, to
ensure the accounts balance in practice.

AMU: International Economics II Mihretu .T(MA)

 3.4. 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 BOP, while the payment for import is
recorded as a debit. When the trade balance is in surplus this meant that a country has earned
more from its exports of goods than in has paid for its imports of goods.

£ THE CURRENT ACCOUNT BALANCE

The CA balance is the sum of visible trade balance & the invisible balance. The invisible balance
shows the difference between revenue received from export of services & payment made for
imports of services such as Shopping, Tourism, Insurance and Banking and Transport. In
addition receipts & 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.

£ 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, increases in foreign assets in the
nation and investment in the country by foreigners. These items are referred to as capital inflows
and are recorded as credit items in the BOP. Capital Inflow-lead to payments from foreigners.

Capital outflows are a decrease in the country‘s holding of foreign assets or increase in liabilities
of to foreigners. Usually capital outflows are recorded as debit in the BOP- it presents some
confusion to many readers. Capital outflow- lead to payments to foreigners, assets such as stock,
bonds, treasury bills.

The easiest way to minimize this problem is that to think of investment by foreigners as export of
equity or bonds & sales of foreign investment as an export of those investments to foreigners.

Financial inflows: can take either of two forms: an increase in foreign assets in the nation or a
reduction in the nation‘s assets abroad. For example, when a U.K. resident purchases Ethiopian

AMU: International Economics II Mihretu .T(MA)

stock, foreign assets in Ethiopia increase. This is a capital inflow to Ethiopia and is recorded as a
credit in Ethiopia‘s BOP because it involves the receipt of a payment from a foreigner.

A capital inflow can also take the form of a reduction in the nation‘s assets abroad. For example,
when an Ethiopian sells a foreign stock, Ethiopian assets abroad decrease. This is a capital
inflow to Ethiopia (reversing the capital outflow that occurred when the Ethiopian purchased the
foreign stock) and is recorded as a credit in Ethiopian BOP because it too involves the receipt of
a payment from foreigners.

Financial Outflows: can take the form of either an increase in the nation‘s assets abroad or a
reduction in foreign assets in the nation because both involve a payment to foreigners. For
example, the purchase of a U.K. treasury bill by an Ethiopians increases Ethiopia‘s assets abroad
and is a debit because it involves a payment to foreigners.

Similarly, the sale of subsidiary by a Turkey firm reduces foreign assets in Ethiopia and is also a
debit because it involves a payment to foreigners.

Table.3.1. Annual balance of payment (BOP): Current Account Balance

Current Account Balance

1. Export of goods +150

2. Import of goods - 200

3. Trade balance - 50 (1+2)

4. Export of services + 120

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)

AMU: International Economics II Mihretu .T(MA)

Table.3.2. Annual Balance of payment (BOP)

Capital Account Balance

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)

RECORD OF TRANSACTIONS IN THE BOP

To understand exactly why the sum of credits and debits in the BOP should sum to zero we
consider some examples of economic transections 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 return for a financial asset.

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 II. An exchange of goods/services in return for other goods/ services

III. An exchange of a financial item in return for a financial item

IV. A Transfer of goods or services with no corresponding transaction (aid (food or military)

V. A unilateral transfer of financial asset with no corresponding transaction.

AMU: International Economics II Mihretu .T(MA)

 3.5. BOP Equilibrium and Disequilibrium (Surplus or Deficit)
BOP 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 BOP is necessarily in
balance. For instance the current account can be in surplus while the capital account is in deficit.

£ Surplus Vs. deficit in BOP

The CA surplus and deficit is important economic indicator because a surplus means the
country is earning more than its spending against the rest of the world(ROW), hence increasing
its stock of claims on the ROW. Whereas deficit means the country is reducing its net claims on
the ROW. The surplus in the current account will be offset by deficit in the capital account &
vice versa. The total receipts and total payments arising out of transfer of goods and services and
long term capital movement.

All the transactions are regrouped under two different categories: a) autonomous transaction b)
induced transaction or accommodating capital flows. Surplus in the BOP is defined as excess of
autonomous receipts over autonomous payment.

AMU: International Economics II Mihretu .T(MA)

The deficit is an excess of autonomous payment over autonomous receipts. That is, autonomous
receipts greater than autonomous payment which results BOP surplus while autonomous receipts
less than autonomous payment which results BOP deficit.

The autonomous transactions: that takes place independently of the BOPs. Such transactions
take place for the sake of their own. i.e. on the account of people‘s desire to consume or to earn
profit. Example, export and import of goods and services change in current account elements.
Export and imports take place irrespective of other transactions entered in the BOP account. If
export = import in value, there will be no other transaction. If export ≠ import, it leads to short-
run capital movement, e. g, international borrowing or lending, these capital movements are not
taking place for their own sake but for the sake of making payment for the deficit in the BOP.

Other autonomous elements on the current account are gifts and donations. They are voluntary
and deliberate. On the capital account, the export & import of long-term capital are autonomous
transactions; short-term capital movements motivated by the desire to invest abroad for higher
return are also autonomous

Accommodating capital/induced/ transaction: those transactions which finance any difference

between autonomous receipts or payment. These involve accommodating capital flows. Short
term capital movements, gold movements and accommodating capital movements on account of
autonomous transaction are induced transactions. These transactions lead to reduction in the gold
and foreign exchange reserves of the country.

The total receipts and payments resulting from the autonomous transactions determine the deficit
or surplus in the BOP. If receipts & payment are imbalance, BOP disequilibrium will be realized.
If total payment exceeds total receipts BOP shows deficit. If a receipt from autonomous
transaction exceeds payments for the autonomous transactions, BOP shows surplus. If both
equals no disequilibrium

Depletion of gold & foreign exchange reserves are indicators of BOP running into deficit, which
calls for government concern. If reserves are plentiful and government adopt a deliberate policy
to run it down, deficit in BOP is not taken as unhealthy sign of the economy. Disequilibrium
Surplus is also not a serious problem unless it causes inflationary condition. However,

AMU: International Economics II Mihretu .T(MA)

accumulation of large surplus of foreign currency does often cause inflation, then it become a
serious concern.

Determinants of autonomous transactions are: International demand for foreign goods &
services, income –elasticity of demand for imports, the price of imports and domestic substitutes,
price elasticity of demand for imported goods and people‘s preference for foreign goods.

£ Kinds and causes of BOP disequilibrium

The first and foremost cause of the disequilibrium in BOP is the change in price level. Price
changes may be inflationary or deflationary. Deflation causes BOP surplus. BOP surplus does
not cause serious concern from the country‘s surplus point of view unless it leads to wasteful
expenditure and mal-allocation of resources.

Inflationary conditions create deficit in BOP. A deficit in BOP results in increased indebtedness,
depletion of gold reserves, loss of employment, distortions in the domestic economy and cause
serious problem in the deficit country.

1. Fundamental Disequilibrium: inflation causes the relative change in prices of imports

and exports. Exchange rate remains the same, inflation causes increase in imports as
domestic prices become relatively higher than the import prices. On the other hand
inflation causes export to decrease because of decrease in foreign demand for domestic
goods due to increase in domestic prices. The increase in import also depends on price
elasticity of demand for imports in the home market and decrease in export depends on
the price elasticity of the foreign demand for domestic goods. If price elasticities are not
equal to zero, the gap b/n imports –exports widen rapidly. As a result there will be deficit
in the BOP. When inflationary condition perpetuates, it produces long run disequilibrium.
If the size of deficit is large & disequilibrium is obdurate (persistent) it is called as a
fundamental disequilibrium.
2. Cyclical disequilibrium: if price fluctuation takes the form of business cycle, most
countries face depression and inflation almost simultaneously. But since the economic
size of nations differ, their imports are affected in varying degrees. Deficit and surplus
varies from moderate to large. The country with higher marginal propensity to
import(MPI) accumulates larger deficits during inflationary phase of the trade cycle and

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 moderate deficit or even surplus, during the depression. Such disequilibrium are known
as cyclical disequilibria. However knowing MPI is difficult.
3. Structural Disequilibrium: this is another cause of BOP disequilibrium resulting from
internal and external factors to the economy. Structural changes refers to the changes w/c
results from such factors as depletion of cheap natural resources, changes in technology,
change in industrial structure, and change in consumers tastes and fashion, etc. Such
changes incapacitates exporting country & find it difficult to face the competition in the
international market, due to either too high cost of production or lack of foreign
demand If the size of foreign trade is fairly large, the BOPs are adversely affected by
structural disequilibrium. Structural disequilibrium may also originate from the discovery
of new resources w/c may invite foreign capital in large measure. Large scale capital
outflow may turn the BOP position into deficit.
£ Other Factors for temporal disequilibria

In addition to the above factors, the followings are also important:

1. Seasonal disturbances of crop failure, particularly in the primary products.

2. Rapid growth in population leading to large scale imports of food items
3. Ambitious development projects requiring heavy imports of technological know-how,
machineries and equipment
4. Demonstration effect of advanced countries on the consumption pattern of the developing
economies.

Financing BOP deficits: members with BOPs deficits may borrow money in foreign
currencies, which they must repay with interest, by purchasing with their own currencies the
foreign currencies held by the IMF. Each member may immediately borrow up to 25% of its
quota in this way. Countries financed their deficits both by commercial borrowing and by
borrowing from official agencies such as the IMF.

£ Exchange rates and Balance of Payment

For the most part, we have been discussing a system of flexible (floating) exchange rates.
Flexible exchange rate is rate determined by the forces of demand and supply without

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government intervention. The rate varies according to the demand and supply of the currency in
the forex market.
In the table below the floating FER is an exchange rate determined by the market forces. Eo =
Initial equilibrium. When Dd for US goods (M↑), Dd for USD↑ (Do to D1), USD ↑ and Birr↓.
Vice Versa. This floating FER regime creates: economic instability, currency speculation, High
risks for exporters and importers in the long run.

Assume that the economy is at Eo = Initial equilibrium. When Ethiopian ↑M from US, Dd for
USD↑ (Do to D1); US BOP surplus by EoE1; USD↑; US exports more expensive; Dd for US
goods drops from E1 to E2. In contrast, Birr↓ and Ethiopia goods cheaper; US ↑M for Ethiopia
goods, ↑Ss of USD from Eo to E2. New Eq.= E2. Thus, Ethiopia and US BOPs are always in
equilibrium between Eo and E2.

Fixed exchange rate is rate of exchange between currencies pegged and maintained by the central
bank‘s on going purchases and sales of currencies. An exchange rate determined by the gov‘t
through buying/selling of currencies. Initial fixed exchange rate is at equilibrium at point E. If
the Ethiopian Government sees this rate is not suitable, new rate can be as follows: 1) Birr less

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valued which equal Birr has less market value which indicated Birr depreciation. To encourage
exports and discourage imports – Birr depreciation makes Ethiopian products relatively cheaper
than foreign goods. 2. Birr over valued = Birr > market value = Birr appreciation To discourage
speculation on Birr (buying and selling Birr for profit).

Fixed FER would not achieve equilibrium BOP. At USD1=Birr3.50: Ss of USD>Dd for USD
(X>M for Ethiopia). To fix this rate, the Government uses Birr reserve to buy USD. To achieve,
equilibrium, USD should ↓. In contrast, to remain at USD1=Birr2.50, the Government sell USD
reserve to finance the BOP deficit (imports).

3.6. Approaches to Balance of Payments

There are three basic models that investigate the impact of exchange rate change on the current
account position of the economy. These are commonly known as the elasticity approach, the
absorption approach & monetary approach.

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 £ 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 cannot be
relied upon to ensure adjustment of the current account.

3.6.1 Elasticities Approach

This approach provides an analysis of what happens to the current account balance when the
country devaluates its currency. The model makes some simplifying assumption; it focuses on
demand condition and assumes that:- The elasticity supply of the domestic export good &
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. This approach also
assumes that capital flows occur only as a means of financing current account transactions.

The central 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. The
current account balance (CA) when expressed in terms of the domestic currency.

CA=PX-SP*M …………… (3.1)

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 (3.1) becomes.

CA=X-SM …………….………(3.2)

By deviating the equation 3.1 we have

AMU: International Economics II Mihretu .T(MA)

Determining the marginal change due to small change in exchange rate is obtained by dividing
3.3.

Now let us introduce the concept of price elasticity demand for export and import, respectively.

Price Elasticity of Demand for Export: Price elasticity of demand for export (Ex) is percentage
change in export over the percentage change in price as represented by percentage change in
exchange rate.

⁄
⁄ …………….…(3.5)
⁄

Price Elasticity of Demand for Import: Price elasticity of demand for import (Em) is
percentage change in import over the percentage change in price as represented by percentage
change in exchange rate.

⁄
⁄ …………..(3.6)
⁄

By substituting equation 3.5 and 3.6 in to 3.4 we have:

But at initial equilibrium condition ⁄ then . This

equation is known as the Marshall-Learner condition & says that starting from equilibrium

position in CA, devaluation improve the CA that is , only if the sum of the foreign

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elasticity of demand for export & the home country elasticity of demand for import is greater
than unity. That is . If sum of these two elasticity is less than unity then a
devaluation will lead to a deterioration of the CA.

The Role of Elasticity: The elasticities of the supply and demand for foreign exchange are
fundamental determinants of adjustment to a BOPs deficit.

The Marshall-Lerner Condition: The Marshall-Lerner condition specifies the necessary

condition for a positive effect of devaluation of domestic currency on the BOPs. The elasticities
approach centers on changes in the prices of goods and services as the determinant of a country‘s
BOP and the exchange value of its currency.

£ Two effects devaluation

1. The Price Effect: – This effect arises b/c 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 between more
expensive after devaluation. These price effects clearly contribute to a worsening of the
current account.

The net effect depends up on w/c effect dominates. If the increase in export volume is not
sufficient to out weight a decrease in price, then less will be received from export in the
foreign currency unit.

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
CA moves from balance to deficit.

2. The Volume Effect: it 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 (MLC) is that devaluation may be a cure for
some countries BOP deficit but not for others. There are enormous problems involved in
estimating the elasticity of demand for import and export. A general consensus accepted by most

AMU: International Economics II Mihretu .T(MA)

economist is that elasticity are lower in the short-run than in the log-run in which case the
Marshall-Lerner condition (MLC) may only hold in the medium than the long run.

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 fails to sum to unit
while the long- run elasticity almost always sum to greater than unity.

The possibility that devaluation may lead to a worsening rather than improvement in the BOP led
to many 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 dep‘t upon
imports so that their elasticity of demand for imports is likely to be very low. These effect of the
devaluation led to the J-curve effect.

£ Definition of 'J Curve'

A theory stating that a country's trade deficit will worsen initially after the devaluation of its
currency because higher prices on foreign imports will be greater than the reduced volume of
imports. The effects of the change in the price of exports compared to imports will eventually
induce an expansion of exports and a cut in imports which, in turn, will improve the BOPs.

£ J-Curve Effect

A devaluation of the domestic currency is unlikely to immediately improve a country‘s BOPs

deficit. It is even possible that the devaluation could cause a country‘s BOP to worsen before it
improves.

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Why CA response is slow?

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.

1. A time lag in the consumers 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 countries.
2. 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 & such contracts are not
readily cancelled in the short-run. Factories will be reluctant to cancel orders for vital inputs
and raw materials.
3. Imperfect Competition: - penetrating the foreign market & building market share in the
foreign market is not an easy operation & is a time –consuming & costly business. Due to
this fact foreign exporters may be reluctant to loss their market share in the developing
countries & 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

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 devaluation. Similarly, foreign importers 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. 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 & so
would unable to reduce their price. In addition to the above effect it is unlikely that the price
of exports as measured in the domestic price will remain fixed.
4. 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.

3.6.2. Multiplier Approach

The multiplier approach is a modified & extended version of the elasticity analysis. The
exchange rate is assumed fixed. The theory is suitable to analyze the adjustment process under a
pegged regime. The only possibility for BP adjustment in this model is by changes in national
income. Assumptions, underemployed resources; Rigidity of all prices; Absence of capital
mobility; All exports are made out of current output.

National Income:

, ,G , ,

Thus:

An expansionary fiscal policy (a rise in G0), an expansionary monetary policy (a rise in I0

resulting from lower interest rates), or added exports (a rise in X0) can increase national income.

dY dY dY 1
   0
dG0 dI 0 dX 0 1  c  m
While a contractionary fiscal policy, a contractionary monetary policy or reduced exports will
decrease national income. An expansionary fiscal policy or an expansionary monetary policy can
worsen a country‘s CA (and then its BOPs).

dCA 1 c
 0
dX 0 1  c  m

AMU: International Economics II Mihretu .T(MA)

In conclusion, when an economy has underemployed resources, fiscal policy, monetary policy &
trade policies can be used for adjusting its BOPs.

– Contractionary fiscal or monetary policy can improve the balance of

payments but at the cost of a decrease in national output.

– Added exports resulting from export-encouraging policies will improve the

balance of payments & meanwhile, increase national income.

3.6.3. Absorption Approach

The elasticity approach discussed previously 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 & import volumes will have implication for national income
& consequently income effect need to be incorporated in a more comprehensive analysis of the
effects of devaluation.

The absorption approach assumes that prices remain constant & emphasizes changes in real
domestic income. Hence, the absorption approach is a real-income theory of the BOP. The
analysis of such evaluation was given by Alexander (1952). His analysis was focusing on the fact
that a CA imbalance can be viewed as the d/c b/n domestic output & domestic spending.

Domestic spending like (C+G+I) are called Absorption. Consider the national income identity.

Y=C+I+G+X-M

Absorption: A = C+I+G

National Income: Y= C+I+G+(X-M)

Current Account: CA = X-M CA = Y-A. Thus,

It shows whether a currency devaluation can improve the current account (then the BOPs)
depends on its effect on national income & on domestic absorption. The above equation can be
interpreted as CA, represents the d/c b/n domestic output & domestic absorption.

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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,
CA =Y-A, the effect of devaluation on the CA 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 & absorption is the fundamental concept of this topic.

Absorption has two parts, these are; a rise in income w/c will lead to an increase in absorption &
this is determined by marginal propensity to absorb (a) and a direct effect on absorption w/c is all
the other effects on absorption resulting from devaluation & this is denoted by - A.

Change in total absorption is a sum of change in income that affects absorption (a. dY) & change
in direct effect dA.

Change in current account can be shown as

dCA= dY-dA

dCA =dY−(adY+dA ) and this can be rearranged as

dCA = (1-a) dY - dA

This Equation 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.

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 £ THE EFFECT OF DEVALUATION ON NATIONAL INCOME

That is clear 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 current account.
Whereas, if income were to fall this would raise the absorption-to income ration 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 MLC 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 MLC 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, &
can be expressed algebraically as, TT = /( )

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 & if
this is not matched by a corresponding rise in export price the terms of trade deteriorate.
Deterioration in the terms of trade represents a loss of real national income b/c 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.

Even if income rises overall, it is still not clear what the implication of such a rise are for the CA,
this will depend up on the value of the marginal propensity to absorb. If marginal propensity to

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absorb is less than unity then an increase in income leads to an improvement in the current
account b/c 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.

£ 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, , Where, K represents some constant & is an

aggregate price index w/c is given by,

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.

Example, Suppose that the price of the domestic good is birr 10 while the price of the foreign
good is $2, & the pre-devaluation exchange rate is birr 10/1 USD. The domestic consumers
spend 60% of their income on domestic goods so that σ=0.6. Then the average price level can be
determined as;

If the birr is devaluated to say birr 12/1USD, then the average price level will be changed as,

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This means, a 20 percent devaluation of birr will raise the average price index facing Ethiopia
consumers, by approximately 11.23 percent. Given an exchange, money stock & the assumption
that economic agents aim to maintain a given amount of real money balance as; . The

devaluation of domestic currency means that economic agents have to maintain their real
balance by cutting down on direct absorption. Economic agents will attempt to increase their
money balance by selling bonds, w/c 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.

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. 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 & 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 dep‘t on their expectations about the
future. If their expectation is favorable then the devaluation & 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.

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 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.

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 b/c they suffer money
illusion. If money illusion is the case, consumers are actually spending more on direct absorption
than before. However, the money illusion effect may work in reverse way. This is b/c, consumers
due to price rises, may actually decide to cut back direct absorption by more than the proportion
to the price rise, so that direct absorption falls.

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 BOPs. However, it can be argued that
inflationary expectation may reduce investment which may rather lower direct absorption.

Laursen-Metzler Effect:- 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
arise in absorption and vise versa, hence, the effect of devaluation on direct absorption are a
ambiguous.

3.6.4. Monetary Approach

The analysis of BOP using a monetary approach is based on the following assumptions such as
there exist a stable money demand function, the aggregate supply is fixed or vertical and PPP
largely work among nations, involved in international trade.

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  Stable Money Demand Function

The monetarists use the quantity theory of money to explain stable money demand function.
This is presented as:

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, b/c as price goes up
money is needed to buy the same quantity of goods & 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 1 we can depict the aggregate demand for a simple a monetary model.
From equation (1) we held fixed money demand & assume that the parameter k is also fixed. We
further assume that money supply is also fixed.

From this figure we can observe that an increase in real income(Y) fromY1 to say, Y2 require
equi-proportionate fall in the price level from P1 to P2. Hence P1Y1= P2Y2 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) & this leads to increase in aggregate demand fromY1 to

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Y2. An increase in the money supply will shift the aggregate demand to the right fromAD1 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 constant at the level
that equates the supply & demand for labor. Moreover, a rise in the domestic price level
does not lead to an increase in domestic output b/c 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.

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) will
hold among economies. The theory of PPP is explained in chapter 2. However, let‘s revisit
some basic concepts.

According to this theory the exchange rate adjusts so as to keep the following relationship:

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Thus, PPP shows the relationship b/n domestic price & foreign price level. In other words, it
shows combination of the domestic price level & exchange rate w/c are compatible with PPP
given the foreign price level P*.

PPP curve has a slope given by P*& implies that X% rise in the domestic price level requires an
X% 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, whereas points to
the right represent undervaluation in relation to PPP.

Using these three assumptions of the monetary model & some accounting identities, we can
develop a theory of BOP. The domestic money supply is composed of two components, namely
domestic bond holdings & the foreign currency reserve valued in the domestic currency. This
can be:

Where, Ms is the domestic money base; D is the domestic bond holding of the monetary
authority; R is the foreign reserve holdings.

Accordingly, 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 NBE. This increases NBE‘s liabilities but increases its asset of domestic
bond holdings as represented by D.

The authority may conduct foreign exchange operation (FXO) w/c is a purchase of foreign
currency asset (money or foreign bond) held by private agents by NBE. These again increase the
NBE‘s monetary liabilities but increase its asset of foreign bonds & are represented as R.

AMU: International Economics II Mihretu .T(MA)

Equation 2, state that any change in the domestic money supply (monetary base) can be caused
by the change either in an OMO or by the change in FXO of the monetary authority.

Fig.3.5. the relationship between money supply and reserve.

In the above figure when bond holdings D is fixed at D1all 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
increase in domestic monetary base from D1 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, expansion of the money supply due to the purchase of foreign currency
through FXO, increases a country‘s foreign exchange reserve from R1 to 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.

£ A Monetary Exchange Rate Equations

Before analyzing the effect of d/t shock under fixed & floating exchange rate let‘s how the
exchange rate is determined in the simple monetary model. The demand for money in the
home country is given by: . The demand for money in foreign economy is given

by: ; where = foreign money demand; = foreign nominal income

AMU: International Economics II Mihretu .T(MA)

elasticity of demand for money; the foreign price level & real foreign income. The

exchange rate determined by PPP & is shown by .

In equilibrium money demand is equal to the money supply in each country & can be shown as:
The relative money supply function can be expressed as:

From PPP; the above equation can be reduced to:

⁄
Solving for exchange rate we have:
⁄

The above last equation says that the exchange rate is determined by the relative supply &
demand for the d/t national money stock & 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 an increase in domestic income leads to an increased transactions demand

for domestic currency  appreciation. Based on this model of exchange rate determination,
we can analyze the effect of money supply, income changes & changes in foreign price level.

£ A MONEY SUPPLY EXPANSION UNDER FIXED EXCHANGE RATES

When the exchange rate of a country‘s currency is fixed, the monetary authorities have to buy
the currency when it is in excess supply & sell it when it is in excess demand in the private
market to avoid a currency devaluation or Revaluation.

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 open market operation (OMO) under
a fixed exchange rate w/c raise the money supply by a central bank purchase of domestic

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Treasury bond. The effect of such an expansionary open market operation(OMO) is depicted in
figure below.

Fig.3.6. A monetary expansion under fixed exchange rate

An expansionary OMO Shifts the money supply curve from Ms1 to Ms2 & increases the
domestic money supply from M1to 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 w/c 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 raise fromP1 to P2. At P2 & 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 BOP into deficit.

To prevent a devaluation of the currency the authorities have to intervene to purchase the
domestic currency & the authorities‘ reserves start to decline below R1. The purchase back of
the domestic money supply starts to reduce the excess money balance & at the same time
aggregate demand starts to shift back fromAD2 to words AD1. As the excess money balance are
reduced & this puts down word pressure on the domestic price level w/c falls back to its original
level P1 so as to arrive back at PPP.

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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 R1to 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 BOPs deficits resulting from the expansion in the money stock to be a temporary &
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 that eventually eliminates the excess supply of the
currency.

Two conditions under which a BOP deficit or surplus can become more than a temporary feature.
The first 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 monetary bases by conducting a further OMO by
purchase of bonds from the public. But such OMO cause a BOP deficit, which requires a further
foreign exchange intervention. Hence, sterilization policy can cause a prolonged BOPs deficit,
and the pursuit of such operation will be limited by the extent of a country‘s reserves.

Second condition that can lead to continuous deficit would be when the surplus countries were
prepared to purchase the deficit country‘s currency & hold it in their reserve.

In such circumstances the deficit country will have its exchange rate fixed by foreign central
bank intervention, & such a process can continue so long as foreign central banks are prepared to
accumulate the home country‘s currency in their reserves. Although in this case reserve changes
are zero, the deficit is reflected as an increase in liabilities to foreign authorities.

£ A Money Supply Expansion Under Floating Exchange Rates

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 Under floating exchange rates the monetary approach maintains that there is no as such BOP
deficit or surplus & the monetary authorities do not have to intervene to purchase or sell the
domestic currency in order to maintain its exchange rate. As it was shown by
∆𝐵𝑂 =∆ +∆ −∆ =0 change in reserve is zero & any CA deficit or surplus will be offset
by a net capital inflow (out flow) of the amount.

As it shown in the above figure an expansionary OMO leads to arise in the money stock from
M1 to M2 & creates excess money balance. As a result of increase in money stock the aggregate
demand shifts from AD1 to AD2 with demand of Y2 which exceed domestic output. The excess
demand for goods results in increase in expenditure on foreign goods & 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 Md1 to Md2. When the domestic price rises demand for
money will increase & this lead to a contraction of aggregate demand along the AD2 curve & the
equilibrium price P2 is restored.

In the long-run, the effect of an x% increase in the money stock is depreciation of exchange rate
by x%, & increase the domestic price level by the same x%. 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 of exchange rate, we have seen variables like Ms*, Ky, & K*y* are
all fixed, & 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

AMU: International Economics II Mihretu .T(MA)

expansionary OMO leads to a disequilibrium in the money market. This is solved by adjustment
in the BOP & reserves held by the monetary authorities.

Under floating exchange rates an expansion in the monetary base leads to a depreciation of the
exchange rate & a rise in domestic price. Moreover, the authorities can determine the amount of
money supply, & money market equilibrium is restored by changes in money demand caused by
change in the domestic price level & exchange rates.

In fixed exchange rates the monetary authority cannot conduct independent monetary policy like
that of floating exchange rates where the authorities are free to expand & control the money
supply to their desired level.

£ CRITICISMS OF THE MONETARY APPROACH

1. 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 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.
2. As to these groups of economists, the assumptions made by this approach are empirically
open to question. There is ample evidence that money demand functions can be highly
unstable, economies are rarely at full employment, and PPP is useless as a guide to
exchange rate movements.
3. 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 CA 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 BOPs. 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 BOP is unnecessary.

AMU: International Economics II Mihretu .T(MA)

Review Questions

1. Define the balance of payments account and describe its significances? What are the
major components of the balance of payments?
2. How are the following transactions entered into the U.S balance of payment? (a) the U.S
gives $200 cash aid to the government of Ethiopia. (b) Ethiopia uses the cash aid to
import $200 worth of machinery from the U.S.
3. Describe the approaches of balance of payment? What do elasticities of imports and
exports mean? What do elastic and inelastic imports or exports imply Vis a Vis deficits
and surpluses?
4. How does the absorptive approach define determination of or changes in exchange rates?
5. Which of the three approaches can be used to influence balance of payments in Ethiopia?

AMU: International Economics II Mihretu .T(MA)

 CHAPTER FOUR
MACROECONOMIC POLICY IN AN OPEN ECONOMY
Chapter Objectives

- Explain Open economy and macroeconomic policy

- Discuss goals of Open economy macroeconomic objectives
- Internal and external balance
- Different macroeconomics policy instruments
- International macroeconomics policy coordination

4.1. Open Economy and Macroeconomic Policy

In this chapter we will examine how both exchange-rate changes & macroeconomic policies
impact upon an open economy. An economy is said to be open if it engages in unrestricted trade
and commerce with other economies worldwide .,i.e. export & import.

Open economy is one that interacts freely with other economies around the world. It interacts
with other countries in two ways. It buys and sells goods and services in world product markets.
And also it buys and sells capital assets in world financial markets.

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 BOP is
an important additional dimension for consideration in the formulation of economic policy in an
open economy.

4.2. Macroeconomic Policy Goals in an Open Economy

These important macroeconomic goals objectives were: Internal balance:- means (1) full
employment, (2) low inflation, and (3) high economic growth. External balance: is the
achievement of neither BOP deficits nor BOP surpluses.,i.e., ensuring a sustainable BOPs
position over time.

AMU: International Economics II Mihretu .T(MA)

 £ 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 & 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 and a stable level of price level.

Achieving a full employment with a stable price level is called internal balance. Even if the
gov‘ts were generally committed to achieve full employment, it is widely believed & recognized
that expanding output in an open economy will have impact on the BOP. For instance, expanding
output & employment will result in greater expenditure on imports & 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 BOP, that is, balance in the supply & demand for their currency.

The objective of having balance or equilibrium in the balance of payment is called external
balance. Changes in fiscal & monetary policies w/c 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 b/n domestic & 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 & external balance. In fact the policy problem of achieving
both internal & external balance was first conceptualized by Treuor Swan (1955) in a diagram
called Swan diagram.

In the swan diagram below, 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 devaluation
which implies improved international competitiveness. The horizontal axis is the amount of real

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domestic absorption which represents the sum of consumption, investment and government
expenditure

Fig.4.1. Swan 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 revaluation of real exchange rate
will reduce export and increase imports. Thus, to maintain full employment it is necessary to
increase domestic expenditure

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 devaluation of
the exchange rate will increase export and reduces imports. So to prevent the CA moving into
surplus requires increased in domestic expenditure to induce an offsetting increase in imports.

To the right of the EB schedule domestic expenditure is greater than that required for CA
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, and Zone 4-
Represents a surplus and inflationary pressure.

AMU: International Economics II Mihretu .T(MA)

The economy is in both internal & 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 & try to reduce the CA deficit by cutting back real domestic expenditure they move the
economy towards point C. 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.

The important lesson obtained from this simple model is that, the use of one instrument, be it
fiscal policy 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 combined with devaluation will
control inflation and improves the current account so that the two objectives can be met. The
idea that a country generally requires as many instruments as it has targets was elaborated by
Noble prize winning Dutch economist known as Jan Tinbergen (1952)., and is known as
Tinbergen’s Instruments –targets rule.

£ Criticisms of Swan Diagram

The Swan diagram provides a useful conceptual frame-work for economic policy discussion but:

1) it is simplistic so that the underlying economic relationships are not explicitly defined.
2) There is no role for international capital movements that were an increasingly important
feature of the post-world war II international economy.
3) No distinction is made b/n monetary & fiscal policies as means of influencing aggregate
demand & output in the economy.

The Mundell -Fleming model, however, will integrate such feature into a formal open economy
macroeconomics model.

£ Mundell- Fleming Model

This Model has its own origin to paper published by James Fleming (1962) and Robert Mundel
(1962-1963). Their major contribution was incorporating international capital movements into
formal macroeconomic models based on the Keynesian IS-LM frame work.

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Derivation of IS schedule for an open economy

IS schedule for an open economy shows various combinations of output & interest rate that
result in equilibrium in goods market or that makes leakages equal to injections. Where
leakage=S+M, Injections=I+G+X

Goods market is at equilibrium when quantity of goods & services demanded are equal to
quantity supplied or injections in the system equals to leakages in the system. In open economy
we have the following identity called open economy identity

…………..…..1
We know that S=Y-C therefore equation 1 can be restated in terms of leakages and injections

……………….. 2

For simplicity the following linear r/ships are assumed

……………3

……….4

Investment is assumed to be Inverse function of interest. Thus,

In the diagram below, Quadrants I presents the relationship between leakages and nations
income. It is upward because increase in income leads to increase in saving and imports. The
resulting volume of leakages is transferred to quadrant II which has 45 degree line that converts
any distance along the vertical to an equivalent distance into equivalent of injections(In),

Injection schedule is depicted in quadrant (III) which shows the given price level and state of
expectations the rate of interest that leads to level of injections In1,if the interest rate is r1. This
means that at Y1 leakages is L1 & Injection is In1, and this occurs at interest rate r1.

AMU: International Economics II Mihretu .T(MA)

Fig.4.2. Derivation of IS model

In quadrant(4), we can depict a point on IS curve for an open economy because interest rate r1
and income level Y1, we know that leakages are equal to injections. We repeat the same process
for income level Y2 to obtain the rate of interest rate r2 for which leakages are equal to
injections.

Derivation of LM Schedule

LM-curve show various combination of the level of income & interest rate for w/c money market
is at equilibrium (Md=Ms). It is assumed money is demanded for

I . Transaction Purpose—+ve function of income

II. Speculative purpose— -Ve function of interest rate

Equilibrium in money market is : money demand equals money supply

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Fig. 4.3.Derivation of LM Schedule

Quadrant 1 shows the positive relationship b/n income and demand for money for transaction
purpose. Quadrant 2 shows the distribution of the fixed money supply between transaction and
speculative balance. Quadrant 3 ,show the negative relationship between interest rate and
speculative demand. Quadrant 4 shows interest rate and income combination that can maintain
the equilibrium of the money market.

The LM schedule is up ward sloping from left to right because high income levels imply
relatively larger transaction demand, which for a given money supply can only be drawn out of
speculative demand by relatively high interest rate. This is so, most of the time transaction
demand for money outweigh the speculative demand for money. Regardless the level of interest
rate.

£ Derivation of BP Schedule

BP schedule shows different combinations of interest rate and income that keep BOP at
equilibrium.

1. Current Account: X-

2.Capital Account:

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Net capital flow (K) is a positive function of domestic interest rate. Equilibrium in BP is:
. This assumes position of reserve is regulated by market forces, thus the ∆R = o.
This implies that if there is a current account deficit there should be an offsetting surplus in
capital account to have equilibrium in BP and vice versa.

Fig.4.4. Derivation of Balance of payment

Quadrant 1 shows the negative relationship between CA and national income. Which implies that
higher income causes the CA to deteriorate? Quadrant 2 transfers the CA position into an equal
capital flow of opposite sign. With CA surplus CA1 there is a required capital outflow K1 to
ensure BP equilibrium. Whereas deficit CA2, requires a capital inflow of K2. Quadrant 3 the
interest rate that is required for a given capital flow. The capital flow schedule is down ward
sloping b/c high domestic interest rate encourages net capital inflow and low interest rate
encourage net capital out flow. Quadrant 4 the BP schedule is upward sloping. This is because
higher level of income causes deterioration in the CA and this necessitates reduced capital
outflow or higher capital inflow which requires higher interest rate. Thus ever point of the BP
shows a combinations of domestic income and interest rate for w/c the overall BP is in
equilibrium.

At points to the left of the BP schedule BP is in surplus because for a given amount of capital
flows the CA is better that that required for equilibrium as the level of income is lower. To the

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right of BP the BP shows deficit as income is higher than that compatible with overall
equilibrium.

Note that the slope of BP is determined by the relative degree of international capital mobility.

If international capital mobility is very high BP will be flatter or the slope will be smaller. This is
because increase in income leads to a deterioration of CA, 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. If capital is perfectly immobile internationally then rise in the domestic interest rate
will fail to attract capital inflows making the BP schedule vertical. Therefore between these two
extremes, we have an upward sloping BP schedule where capital mobility is imperfect.

Equilibrium of the Model-General equilibrium of an open economy: Equilibrium occurs when IS

, LM and BP schedules intersect each other at common point.

Fig.4.5. General equilibrium of an open economy

Equilibrium is achieved at interest rate r1 and income Y1, the income is less than full
employment(Yf), implying that there is some unemployment in the economy.

AMU: International Economics II Mihretu .T(MA)

The reason why IS-LM schedules do not intersect at the full level of income(Yf), is that Yf is
that planned leakages (S+m) would exceed planned injections(I+G+X). This would imply a
buildup of stock of unsold goods leading producers to reduce output. Only at output level Y1 do
planned leakages equal to planned injections so that changes in stocks are avoided.

£ Factors shifting the IS-LM-BP schedules

Change in fiscal and monetary policies will affect the equilibrium, as change in these policies
influence both income level & interest rate. Expansion in investment, government spending and
export shift the IS schedule. Resulting in higher interest rate which is not compatible with the
equilibrium in BP and LM. Autonomous fall in leakages (saving + imports) shift IS outwards.

Shifting Factors for LM Schedule: Increase or decrease in domestic money supply, which will
have opposite effect on equilibrium interest rate and income. Depreciation of exchange rate will
lead to rise in domestic price index. This implies rise in the price of imported goods this in turn
reduces real money balance that can only be eliminated by reducing the transaction demand for
money. This implies a lower income and leftward shift of the LM schedule.

Shifting factors for BP: Autonomous increase in export or decrease import. This improves the
CA, requires right ward shift in BP. This rises domestic income at each level of interest rate.
Devaluation/revaluation, devaluation if MLC is satisfied will improve the CA hence shift the BP
to the right. As it increases national income Since revaluation mostly cause deterioration in the
current account it shifts the BP to the left. Reduces national income

4.3. Stabilization Policy Instruments

Swan diagram revealed that use of both expenditure-switching and Expenditure changing
policies by the authorities can lead to achievement of internal and external balance. But they did
not distinguish fiscal and monetary policies which are quite independent and different type of
expenditure changing policies. But this model distinguishes fiscal & monetary policy.

The Question is whether or not it is possible /feasible to achieve the twin objectives (internal
and external balance) by combining fiscal and monetary policy without the need to adjust the
exchange rate?

AMU: International Economics II Mihretu .T(MA)

 I. Monetary Policy

Expansionary Monetary Policy: When the authorities conduct an this 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 BOPs
is concerned, the increase in income leads to a deterioration of the CA and lower interest rate
will lead to increase in capital outflow so that the BOP moves into deficit.

Contactionary Monetary Policy: Conversely, this policy involves the authorities selling bonds,
this pushes down the price of bonds and leads to a rise in the domestic interest rate, w/c leads to
less investment and a fall in output. The BOP position will improve as imports fall & the higher
interest rate attracts capital inflow.

II. Fiscal Policy

Expansionary 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 BOP is indeterminate b/c while the
expansion of output will worsen the CA , the rise in interest rate will improve the capital
account. The fiscal policy will not affect the money supply /demand in the hands of the private
sector. The money raised from bond sales is re-injected into the economy, through increased
gov‘t expenditure. Contractionary Fiscal Policy: converse is true

£ Sterilized intervention & non sterilized intervention

Another issue we need to distinguish is sterilized & non sterilized intervention in foreign
exchange market.

a. Sterilized intervention: with such intervention authorities will offset the money base
through exchange market intervention to ensure that reserve changes due to intervention
do not affect domestic money base.
b. Non sterilized intervention: In such intervention authorities allow the reserve changes to
affect monetary base.

AMU: International Economics II Mihretu .T(MA)

Fig. 4.7. Change in liquidity of money (LM)

Example: Non Sterilization: Purchasing of bonds shifts LM curve from LM1 to LM2 . To
maintain fixed exchange rate, authorities will purchase domestic currency by fox. This reduces
reserves and domestic money supply. This reduction in domestic currency is exactly offset by
further expansion of money supply so that LM remains at LM2. Sterilization: Purchasing of
bonds shifts LM curve from LM1 to LM2 to maintain exchange rate fixed, authorities will
purchase domestic currency by fox. This shifts LM curve back to original LM1.

4.3.1 Internal and External Balance under fixed exchange rate

Assume economy is at A with interest rate r1 and income level Y1 which is below full
employment (level of income Yf). Government attempts to eradicate unemployment through
fiscal expansion (by selling bonds). This shifts IS curve from IS1 to IS2 which then increases
output from y1 to y2 and internal equilibrium can be achieved at the expanse of BOP balance.
So authorities forced to purchase home currency in foreign exchange market by purchasing
foreign exchange which shifts LM curve from LM1 to LM2 (contractionary monetary policy)

AMU: International Economics II Mihretu .T(MA)

Fig. 4.9. Internal and external balance under a fixed exchange rate

Conclusion: So we can conclude that by combining expansionary fiscal and contractionary

monetary policy internal & external balance can be achieved simultaneously.

4.3.2. Internal and External Balance Under Floating Exchange Rate

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. Let us
see separately fiscal and monetary expansion under floating exchange rates.

a. Monetary expansion under floating exchange rates

Fig.4.9. monetary expansion under floating exchange rates

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Assume economy is at Y1 ( less than full employment) with interest rate r1.let‘s assume now
government adopts expansionary monetary policy and shifts LM curve from LM1 to LM2 w/c
increases income and reduce interest rate and then deficit at point B. Exchange rate is allowed to
depreciate and then this shifts IS to IS2 and BP from BP1 to BP2 .However it also leads to
leftward shifts of LM curve LM2 to LM3 until all three schedules intersect each other at
common point C with new income level Y2 and interest rate r2

Conclusion: Under floating regime it is possible to achieve increase in real output to the full
employment level and achieve external balance by using expansionary monetary policy with
changes in exchange rate.

b. Fiscal Expansion Under floating Exchange Rate

The effect of fiscal expansion on the exchange rate under floating exchange rate depends on
slope of BP schedule relative to 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 and reverse is true for the flatter BP schedule. So we shall consider two cases,
in the first case the balance of payment- BP schedule is steeper than the LM schedule , while in
case two the reverse is true.

Fig. 4.10. Case 1: A fiscal expansion under floating exchange rates

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Case I: Where BP schedule is steeper than the LM Schedule. An expansionary fiscal policy
shifts the IS schedule from IS1 to IS2 which induce the rise of the domestic interest rate and
domestic income. Increase in interest rate & income has opposing effects on the BOPs. That is
the expansion of real output leads to a deterioration of the CA, the increase in interest rate
improves the Capital account. However, since capital flows are relatively less mobile the former
effect outweighs the later, as a result the BOP 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. 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.

Fig. 4.11. Case 2: A fiscal expansion under floating exchange rates

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 & the BP schedule is less steeper than the
LM schedule. The shift in IS schedule will raise both interest rate & domestic income. The
increase in interest rate will increase the capital inflow which is more than offsets the
deterioration in the CA due to the increase in income and the BOPs moves into surplus. This
surplus induce an appreciation of the exchange rate which moves the LM schedule to the right

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from LM1 to LM2 and the IS carve to the left from IS2 to IS3. Equilibrium is obtained at higher
level of output, higher interest rate and an exchange rate appreciation.

4.3.3. A SMALL OPEN ECONOMY WITH PREFECT CAPITAL MOBILITY

One of the legacies of the post WWII 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.

A. FIXED EXCHANGE RATES AND PERFECT CAPITAL MOBILITY

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 leads to a massive capital outflow as international investors
seek higher world interest rate. Such massive bond sale means that bond prices fall & 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.

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Fig. 4.12. a. fixed exchange rates and perfect capital mobility

In the figure, the initial level of income is Y1 where IS-LM curves intersect, which is below the
full employment level of income Yf. 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
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 cannot be pursued. Therefore, with perfect capital mobility and fixed exchange rates,
monetary policy is ineffective in influencing output.

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Fig. 4.12. 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 w/c 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 instruments-
target rule, although monetary policy does have to passively adjust to maintain the fixed
exchange rate.

B. FLOATING EXCHANGE RATES AND PERFECT CAPITAL MOBILITY.

Suppose the economy is initially 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, w/c in turn leads to capital outflow and a
depreciation of the exchange rate.

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 Fig.4.13. floating exchange rates and perfect capital mobility.

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 authority could obtain both internal & external balance by
monetary policy alone.

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

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 which leads to a massive capital inflow & 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.

4.4. International Macroeconomic Policy Coordination

What is meant by International Macroeconomic (economic-policy) Policy Coordination?

International economic-policy coordination:-is the attempt to significantly modify national

policies; monetary policy, fiscal policy, exchange-rate policy in recognition of international
economic interdependence. Policy coordination does not necessarily imply that nations give
precedence to international over domestic concerns. Since the policies of one nation can spill
over to influence the objectifies of others; nations should therefore communicate with one
another & attempt to coordinate their policies.

There are many examples of international economic-policy coordination. The Smithsonian

Agreement of 1971 was a coordination attempt by the major industrial nations to realign the
exchange values of their currencies using currency devaluations & revaluations. The 1978 Bonn
Summit resulted in the enactment by Germany & Japan of expansionary fiscal & monetary
policies to stimulate their demand for U.S. goods & reduce the U.S. trade deficit; in return, the
U.S raised its price of oil to the world level.

Why does the need for international Macroeconomic arise?

If economic policies in each of two nations affect the other, then the case for policy coordination
would appear to be obvious. Policy coordination is considered important in the modern world
because economic disruptions are transmitted from one nation to another. Without policy

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coordination, national economic policies can destabilize other economies. Example: suppose the
world consists of just two nations, Germany & Japan. Although these nations freely trade goods
with each other, they desire to pursue their own domestic economic priorities. Germany wants to
avoid trade deficits with Japan, while achieving full employment for its economy; Japan desires
full employment for its economy while avoiding trade deficits with Germany.

Assume that both nations achieve balanced trade with each other, but each nation‘s economy
operates below full employment. Both nations contemplate enacting expansionary government
spending policies that would stimulate demand, output, and employment.

Potential Benefits of Policy Coordination: Policy coordination permits each nation to achieve
full employment and balance of trade. In the real world however, policy coordination generally
involves may countries & many diverse objectives, such as low inflation, high employment,
economic growth, & trade balance.

Potential Impediments to Policy Coordination: Several obstacles hinder successful policy

coordination. Even if national economic objectives are harmonious, there is no guarantee that
governments can design and implement coordinated policies.

Policy makers in the real world do not always have sufficient information to understand the
nature of the economic problem or how their policies will affect economies.

Policy coordination is also complicated by different national starting points: different economic
objectives, different national institutions, different national political climates, and different phase
in the business cycle.

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Review Questions

1. Describe the internal and external balances that policy makers seek to maintain? Why
need internal and external balances?
2. What should governments do when an undesirable change occurs that distort the
equilibrium for an open economy? Do all economies adopt the same policy measures?
3. Suppose that an open economy with fixed exchange rate system is in equilibrium. A
sudden fall in the tastes of consumers for domestic products falls. What type of policy is
effective in restoring equilibrium?
4. What are some of the most important policy instruments or tools that a nation can employ
to achieve important economic objectives or targets of nations? How many policy
instruments or tools does a nation need to reach its objectives?
5. Suppose again that an open economy with managed floating exchange rate policy is in
equilibrium. Consumptive demand for output abruptly rises. What type of policy can
policy makers use to attain equilibrium?

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 CHAPTER FIVE

INTERNATIONAL MONETARY SYSTEM AND KEY INTERNATIONAL

FINANCIAL INSTITUTIONS

Chapter Objectives

- Define International Monetary system

- Evolution of International monetary system
- International financial institutions

5. What is the International Monetary System (IMS)?

The international monetary system refers to the operating system of the financial environment,
which consists of financial institutions, multinational corporations, and investors. The IMS
provides the institutional framework for determining the rules & procedures for international
payments, determination of exchange rates, and movement of capital.

An IMS is a set of internationally agreed rules, conventions & supporting institutions that
facilitate international trade, cross border investment and generally the reallocation of capital
between states that have different currencies.

5.1. Criteria for Evaluating an International Monetary System

IMS are usually classified by two criteria (or along two dimensions): the role of the exchange
rate, and the nature of the reserve asset(s).

The role of exchange rate: The need for converting one country‘s currency into those of others
gives the exchange rate regime a prominent place in the IMS. The degree of flexibility of the
exchange rate is one basis of classifying IMS. We are already familiar with the permanently
fixed & absolutely flexible exchange rates.

Sometimes nations stand ready to change the fixed par value of their currencies, needed to
correct fundamental disequilibrium in the BOPs, this system is known as the adjustable peg. A
managed float exchange rate regime is one in w/c there are no fixed par values, but the monetary
authority does intervene in the foreign exchange market, so as to prevent the exchange rate from

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moving far away from its long term trend. The target zone approach-it involves the setting up of
a set of mutually consistence targets for (trade-weighted) real exchange rates by major
economies (such as U.S, Germany, & Japan). With targets given, the participating countries
remain committed to keep the exchange rate within a band (or zone) of 10 per cent on either side
of the targets.

The nature of the reserve asset(s): A second way of characterizing the IMS is in terms of the
nature of the reserve asset(s). There are two major types of international reserve assets. These
are: Commodity reserves, and fiduciary (or fiat) reserves

The essential difference between the two lies in the intrinsic value of the relevant reserve asset.
While the commodity reserves (like gold) have some intrinsic value (other than their value as
money) fiduciary reserves (such as special Drawing Rights, and national currencies which are
not convertible into commodity reserves) have none. On the basis of the nature of reserves held
by the monetary authority, a threefold classification of the IMS is possible.

1. Pure Commodity Standards : where all reserves consist of commodity reserves (as in
the case of gold standard).
2. Pure Fiduciary Standards: in which the entire reserve consists of fiduciary reserves
(e.g. the inconvertible paper standard).
3. Mixed Standards: in which the entire reserves are partly commodity reserves and partly
fiduciary reserves(e.g. the gold exchange standard)

5.2. The Evolution of an IMS

The IMS has gone through four stages in its evolution: The gold standard (1870-1914), the gold-
exchange standard (1925-1933), the Bretton Woods system (1944-1971), the floating/hybrid
exchange rate system (1976-present).

Gold Standard:-under this standard each country fixes the price of its currency in terms of gold
by standing ready to trade domestic currency for gold whenever necessary to defend the official
price. Because countries tie their currencies to gold under a gold standard, official international
reserves take the form of gold. Gold standard rules also require each country to allow unhindered
imports & exports of gold across its borders. Under these arrangements, a gold standard, like a

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reserve currency system, results in fixed exchange rates b/n all currencies. Example. if the dollar
price of gold is pegged at $35 per ounce by the Federal Reserve while the pound price of gold is
pegged at 14.58 pound per ounce by Britain‘s central bank, the bank of England, the
dollar/pound exchange rate must be constant at ($35 per ounce)÷ (£14.58 𝑝 ) =$2.40 per
pound.

£ Benefits and Drawbacks of the Gold Standard

Benefits: A gold standard places automatic limits on the extent to which central banks can cause
increases in national price levels through expansionary monetary policies, this limits make the
real values of national monies more stable and predictable, it enhancing the transaction
economies arising from the use of money.

Drawbacks: The gold standard places undesirable constraints on the use of monetary policy to
fight unemployment, typing currency values to gold ensures a stable overall price level only if
the relative price of gold and other goods and Services is stable, an IMS based on gold is
problematic because central banks can‘t increase their holdings of international reserves as their
economic grow unless there are continual new gold discoveries.

£ The Gold Exchange Standard

Halfway between the gold standard and a pure reserve currency standard is the gold exchange
standard. Under a gold exchange standard central banks' reserves consist of gold and currencies
whose prices in terms of gold are fixed, and each central bank fixes its exchange rate to a
currency with a fixed gold price. A gold exchange standard can operate like a gold standard in
restraining excessive monetary growth throughout the world, but it allows more flexibility in the
growth of international reserves, which can consist of assets besides gold. A gold exchange
standard is, however, subject to the other limitations of a gold standard listed above. The post-
world war II reserve currency system centered on the dollar was, in fact, originally setup as a
gold exchange standard.

£ The Bretton Woods System as a Gold Exchange Standard

The Bretton Woods Agreement was reached in a 1944 summit held in New Hampshire, USA on
a site by the same name. A Bretton wood is a system under which the currencies are pegged with

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dollar whereas under the gold standard the currencies are pegged to gold. The agreement was
reached by 730 delegates, who were the representatives of the 44 allied nations that attended the
summit. The delegates, within the agreement, used the gold standard to create a fixed currency
exchange rate. The Bretton Woods System is a set of unified rules & policies that provided the
framework necessary to create fixed international currency exchange rates.

Essentially, the agreement called for the newly created IMF to determine the fixed rate of
exchange for currencies around the world. Every represented country assumed the responsibility
of upholding the exchange rate, with incredibly narrow margins above and below. Countries
struggling to stay within the window of the fixed exchange rate could petition the IMF for a rate
adjustment, w/c all allied countries would then be responsible for following. The Bretton woods
system collapsed in August 1971 when U.S President Nixon suspended the gold convertibility of
the dollar. This system of fixed exchange rates had two main features: (1) Parity, as the currency
of each member country was determined in terms of gold or the dollar, and (2) the price of gold
was also fixed in terms of the dollar, which was convertible into gold.

£ The Current System: Managed Float / Hybrid System

Managed Floating exchange rate system: It is an exchange rate system that allows a nation‘s
central bank to intervene regularly in foreign exchange markets to change the direction of the
currency‘s float and/ or reduce the amount of currency volatility. This exchange rate is also
known as a ―dirty float‖. Central bank might attempt to bring currency depreciation to: improve
the balance of trade or improve the CA by making exports more prices competitive, reduce the
risk of a deflationary recession- a lower currency increases export demand & increases the
domestic price level by making imports more expensive, rebalance the economy away from
consumption towards higher exports & capital investment or to bring about an appreciation of
the currency, to curb demand-pull inflationary pressures and to reduce the prices of imported
capital & technology or essential inputs to enhance long run growth potential.

Limits to central bank intervention to manage a currency’s value: Requires large scale
foreign exchange reserves- many smaller and relatively poorer countries do not have these,
Central banks intervening on their own may have little or no market power against the
sheer(thin) weight of speculative buying and selling in global currency markets (turnover > $6

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trillion a day), and Changing interest rates to influence a currency might conflict against other
macroeconomic objectives - raising interest rates to support a currency might stifle(hold back)
growth.

5.3. Key International Financial Institutions

An international financial institution (IFI) is a financial institution that has been established by
more than one country, and hence is subject to international law. IFIs were established after
WWII to assist in the reconstruction of Europe and provide mechanisms for international
cooperation in managing the global financial system. Its owners or shareholders are generally
national governments, although other international institutions and other organizations
occasionally figure as shareholders. The most prominent IFIs are creations of multiple nations,
bilateral financial institutions exist and are technically IFIs.

What does the IMF do?

The IMF monitors the international monetary system & global economic developments to
identify risks & recommend policies for growth & financial stability. The Fund also undertakes a
regular health check of the economic & financial policies of its 190 member countries.

What does the WB do?

The World Bank is an international financial institution that provides loans & grants to the gov‘ts
of low- & middle-income countries for the purpose of pursuing capital projects. Their
approaches to achieving this shared goal are complementary: the IMF focuses on
macroeconomic & financial stability while the WB concentrates on long-term economic
development and poverty reduction.

5.4. International Capital Flows and Multinational Corporations

Multinational corporations leverage their financial position and access to global markets to
raise capital in a cost-effective and efficient manner. This gives these companies an advantage
over small domestic operators that do not have the same level of credit or cash, but there are
risks associated with international finance. The capital structure multinationals use directly
impacts profitability, growth and sustainability.

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Invested Capital: A multinational‘s capital structure comprises the sources of money used to
finance operations, expand production or purchase assets. Companies acquire capital through the
sale of securities in financial markets such as the New York Stock Exchange or the London
Stock Exchange. Debt and equity are the two forms of capital that multinationals have to choose
from, and each form has its advantages and disadvantages. The cost of raising capital is an
important component of financing decision.

Debt Financing: Acquiring debt capital is a process that is contingent on the availability of
funds in the global credit markets, interest rates and a corporation‘s existing debt obligations. If
credit markets are experiencing a contraction, it may be difficult for the corporation to sell
corporate bonds at favorable rates. In particular, it may be challenging to get high advance rates
for asset-backed securities. If a firm becomes over-leveraged, it may be unable to pay its debt
obligations leading to insolvency. However, debt costs less to acquire than other forms of
financing.

Equity Financing: Preferred stock, common stock and components of retained earnings are
considered equity capital. It is important for a multinational to carefully analyze its equity cash
flows and mitigate the risk associated with currency fluctuations. Otherwise, it may lose equity
due to changes in exchange rates. Also, the issuance of new shares may cause stock prices to fall
because investors no longer feel company shares are worth their pre-issuance price. Offering
stock in global financial markets costs multinationals more than acquiring debt, but it may be the
right financing option if a corporation is already highly leveraged.

Tax Considerations: Multinationals have the option to shift income to jurisdictions where the
tax treatment is the most advantageous. As a result, debt and equity financing decisions are
different relevant to solely domestic companies. If income is reported in the United States, it may
be beneficial to obtain debt financing, because the interest is tax-deductible. When making
capital structure decisions, multinationals must evaluate their tax planning strategies to minimize
their tax liabilities.

AMU: International Economics II Mihretu .T(MA)

 5.5. The concept of Dutch Disease
What is Dutch Disease?

Dutch disease is a concept that describes an economic phenomenon where the rapid development
of one sector of the economy (particularly natural resources) precipitates a decline in other
sectors. It is also often characterized by a substantial appreciation of the domestic currency.
Dutch disease is a paradoxical situation where good news for one sector of the economy, such as
the discovery of natural resources, results in a negative impact on the country‘s overall economy.

£ Breaking Down the Dutch Disease Phenomenon

The Dutch disease term was first introduced in The Economist magazine in 1977 to analyze the
economic situation in the Netherlands (hence the name) after the discovery of large natural gas
fields in 1959. Although the Dutch economy increased its revenues from the export of natural
gas, the significant appreciation of the national currency from the large capital influx into the
sector resulted in a higher unemployment rate in the country, as well as a decline in the
manufacturing industry.

The phenomenon of Dutch disease commonly occurs in countries whose economies rely heavily
on the export of natural resources. The paradox contradicts the concept of comparative
advantage. According to the comparative advantage model, each country should specialize in the
industry in which it possesses a comparative advantage over other countries.

However, it does not work well with countries that primarily export natural resources. For
example, the volatility of commodity prices cannot sustain a country‘s economy for long time
periods. Also, the overdependence on the export of natural resources leads to the
underdevelopment of other sectors of the economy, such as manufacturing and agriculture.

£ The Workings of Dutch Disease

The negative influence of Dutch disease on the economy can be explained by some features
attributable to the sectors that are related to natural resources. For example, mining industries
generally require heavy capital investments, but they are not labor-intensive. Therefore,
multinational corporations and foreign countries that have capital are often interested in investing
in such ventures.

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Foreign investment may lead to higher demand for the country‘s domestic currency, and it will
start appreciating. The appreciation of the domestic currency will make the country‘s exports in
other industries more expensive while imports will become cheaper.

Subsequently, domestic producers will face lower demand for their products abroad, as well as
greater competition from foreign producers. Thus, the lagging sectors of the economy will face
further troubles.

How to Avoid Dutch Disease?

The two primary strategies that can help solve Dutch disease are listed below:

1. Deceleration of domestic currency appreciation: The deceleration of currency

appreciation is an easier and more viable strategy to prevent the adverse effects of Dutch
disease. It can sometimes be achieved by smoothing the spending of revenues earned
from the export of natural resources. One of the most common methods to do so is the
creation of a sovereign wealth fund. Many developed and developing countries, including
Australia, Canada, Norway, and Russia, manage large sovereign wealth funds. Sovereign
wealth funds aim to stabilize the inflows of capital into the economy to prevent it from
overheating and causing significant currency appreciation. Excess revenues can be spent
on education or infrastructure that will help to diversify the economy.
2. Diversification of the economy: The diversification of the economy is a strategy that can
almost eliminate the negative impact of Dutch disease on the economy. Economic
diversification can be achieved by subsidizing lagging sectors of the economy or
establishing tariffs to support domestic producers.

Review Questions

1. Explain Bretton Woods System of exchange rate? How it was set up and maintained?

AMU: International Economics II Mihretu .T(MA)

 2. What was decided by the group of ten under the Smithsonian Agreement in December
1971?
3. What was the main cause of Dutch disease? How do you explain it?
4. What is special drawing right (SDR)? How do nations apply SDRs?

AMU: International Economics II Mihretu .T(MA)