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Global Finance

I.  The Global Financial System (GFS)

A financial system refers to a set of components and mechanisms, such as monetary policies, insurance and banks, that allows economic transactions to occur. There are many types of financial systems that exist on different levels of society, ranging from those used to operate transactions within a company to those that facilitate international financial transactions. Without these systems, many normal activities would become difficult, if not impossible, such as trading and investing.

Money, credit cards and checks are examples of the types of components that may exist in a financial system. An accounting method, an auditing service and financing procedures are examples of mechanisms that facilitate the operation of these systems. The absence of a financial system would produce drastic changes because people may not have access to credit, there would be no monetary products to exchange for goods and there would be no policies regulating complex transactions.

Since the dawn of creation, people have engaged in financial transactions of some sort. Today, financial transactions often take place on an international level within the global financial system. This system allows markets to exchange information and financially impact each other around the clock. The technical definition for a global financial system, however, is a system composed of financial institutions and regulators that act on an international level. As globalization evolves, the system becomes more influential in many individual country’s economies.

The global financial system is responsible for providing core economic functions. The system facilitates trades, provides a mechanism for the pooling of resources, manages financial risks, provides price information, and provides ways for countries to transfer economic resources across borders and among different industries with ease. The financial system is a complex system that functions and changes with the economic and political climate. Despite differences in cultural, political and historical backgrounds, countries come and work together in the global system.

 

Global Financial Stability Report

Global Financial Development Data Base (World Bank)

Future of the Global Financial System (World Economic Forum)

II. International Economic Actors

Each of the core economic functions - consumption, production and investment - have become highly globalized in recent decades. While consumers increasingly import foreign goods or purchase domestic goods produced with foreign inputs, businesses continue to expand production internationally to meet an increasingly globalized consumption in the world economy. International financial integration among nations has afforded investors the opportunity to diversify their asset portfolios by investing abroad. Consumers, multinational corporations, individual and institutional investors, and financial intermediaries (such as banks) are the key economic actors within the global financial system. Central banks (such as the European Central Bank or the US Federal Reserve System) undertake open market operations in their efforts to realize monetary policy goals. International financial institutions such as the Bretton Woods institutions, multilateral development banks and other development finance institutions provide emergency financing to countries in crisis, provide risk mitigation tools to prospective foreign investors, and assemble capital for development finance and poverty reduction initiatives. Trade organizations such as the World Trade Organization, Institute of International Finance, and the World Federation of Exchanges attempt to ease trade, facilitate trade disputes and address economic affairs, promote standards, and sponsor research and statistics publications.

WTO: Let’s Talk Rules-based Trade (2:46)

III.  International Financial Institutions

International financial institutions (IFIs) are organizations that were created by the national governments of different nations. Their owners or shareholders are generally national governments, although other international institutions and other organizations occasionally figure as shareholders. The World Bank, the International Monetary Fund (IMF), and the African Development Bank (AfDB) are all international financial institutions. Some institutions, such as the World Bank, provide lending services to nations around the world. Others focus on working with governments and humanitarian organizations within one particular area. International financial institutions attempt to foster economic development and improve economic relations between nations. There are several types of IFIs.

A. Multilateral Development Banks

A multilateral development bank (MDB) is an institution, created by a group of countries, that provides financing and professional advising for the purpose of development. MDBs have large memberships including both developed donor countries and developing borrower countries. MDBs finance projects in the form of long-term loans at market rates, very-long-term loans (also known as credits) below market rates and through grants.

The following are usually classified as MDBs.

o   World Bank

o   International Fund for Agricultural Development (IFAD)

o   European Investment Bank(EIB)

o   Islamic Development Bank (IsDB)

o   Asian Development Bank (ADB)

o   European Bank for Reconstruction and Development (EBRD)

o   CAF: Development Bank of Latin America (CAF)

o   Inter-American Development Bank Group (IDB, IADB)

o   African Development Bank (AfDB)

o   Asian Infrastructure Investment Bank (AIIB)

There are also several "sub-regional" multilateral development banks. Their membership typically includes only borrowing nations. The banks lend to their members, borrowing from the international capital markets. Because there is effectively shared responsibility for repayment, the banks can often borrow more cheaply than could any one member nation. These banks include the following.

o   Caribbean Development Bank (CDB)

o   Central American Bank for Economic Integration (CABEI)

o   East African Development Bank (EADB)

o   West African Development Bank (BOAD)

o   Black Sea Trade and Development Bank (BSTDB)

o   Economic Cooperation Organization Trade and Development Bank (ETDB)

o   Eurasian Development Bank (EDB)

o   New Development Bank (NDB)

There are also several multilateral financial institutions (MFIs). MFIs are similar to MDBs but they are sometimes separated since they have more limited memberships and often focus on financing only certain types of projects.

o   European Commission (EC)

o   International Finance Facility for Immunization (IFFIm)

o   International Fund for Agricultural Development (IFAD)

o   Nordic Investment Bank (NIB)

o   OPEC Fund for International Development (OPEC Fund)

o   Nederlandse Financieringsmaatschappij voor Ontwikkelingslanden NV (FMO)

o   International Investment Bank (IIB)

o   The Arab Bank for Economic Development in Africa (BADEA)

B. Bretton Woods Institutions

The best-known IFIs were established after World War II to assist in the reconstruction of Europe and provide mechanisms for international cooperation in managing the global financial system. They include the World Bank, the IMF and the International Finance Corporation. Today the largest IFI in the world is the European Investment Bank.

C. Regional Development Banks

The regional development banks consist of several regional institutions that have functions similar to the World Bank group's activities, but with particular focus on a specific region. Shareholders usually consist of the regional countries plus the major donor countries. The best-known of these regional banks cover regions that roughly correspond to United Nations regional groupings, including the Inter-American Development Bank, the Asian Development Bank; the African Development Bank; the Central American Bank for Economic Integration; and the European Bank for Reconstruction and Development. The Islamic Development Bank is among the leading multilateral development banks. IsDB is the only multilateral development bank after the World Bank that is global in terms of its membership. 56 member countries of IsDB are spread over Asia, Africa, Europe and Latin America.

D. Bilateral Development Banks and Agencies

A bilateral development bank is a financial institution set up by one individual country to finance development projects in a developing country and its emerging market, hence the term bilateral, as opposed to multilateral. Examples include:

o   the Netherlands Development Finance Company FMO, headquarters in The Hague, one of the largest bilateral development banks worldwide

o   the DEG German Investment Corporation or Deutsche Investitions und Entwicklungsgesellschaft, headquartered in Köln, Germany

o   the French Development Agency or Agence Française de Développement, and Caisse des Dépôts, founded 1816, both headquartered in Paris, France

E. Other Regional Financial Institutions

Financial institutions of neighboring countries establish themselves internationally to pursue and finance activities in areas of mutual interest. Most of them are central banks, followed by development and investment banks. The table below lists some of them in chronological order of when they were founded or listed as functioning as a legal entity. Some institutions were conceived and started working informally 2 decades before their legal inception (e.g. the South East Asian Central Banks Centre).

IV.  Examples of International Financial Institutions

A. International Monetary Fund (IMF)

The International Monetary Fund (IMF) is an international organization headquartered in the United States which promotes the maintenance of a healthy global economy. There are 185 member nations in the IMF, which means that almost every country in the world is in the IMF, and the handful of countries which do not belong are usually represented indirectly. In the course of its daily operations, the IMF works closely with the International Bank for Reconstruction and Development, more commonly known as the World Bank.

Groundwork for the establishment of the IMF was laid at the Bretton Woods conference in 1944. The nations at the conference agreed that a rapid plan needed to be put into action to promote economic recovery in the wake of the Second World War. The goal was to make funds readily available for reconstruction and the rebuilding of key economies which had been devastated by the war by establishing an international monetary exchange rate system. From there, the IMF naturally expanded to an organization with international scope.

One of the key roles of the IMF in the global economy is as a lender to nations which are struggling economically. The IMF acts as a lender of last resort for members in financial distress, e.g., currency crisis, problems meeting balance of payment when in deficit and debt default, etc. The IMF makes loans with funds invested by its member nations. The Fund also facilitates the smooth exchange of currency worldwide, and promotes international trade while keeping an eye on the health of the international economy and holding regular meetings for its member nations to discuss issues of importance.

Each member nation in the IMF is given a quota based on factors like the strength of its economy and the stability of its government. The quota determines the clout the member nation has in the IMF, and the amount of money which the nation may borrow. Each country is also assigned a number of Special Drawing Rights (SDRs) on the basis of its quota. SDRs allow member nations to draw on the IMF's currency reserve, and they are routinely used in international accounting. In fact, SDRs sometimes come very close to an international currency.

The work of the IMF is sometimes criticized by people who are concerned about developing nations. IMF loans usually come with terms known as conditionalities, which some people feel are exploitative or unproductive. Conditionalities may place what is perceived as an unfair burden on the beneficiaries of IMF loans, or they may dictate national policy in a way which does not always benefit the population. Most notably, the IMF usually mandates Structural Adjustment programs which force its beneficiaries to open to free trade, sometimes at terms which are not very favorable.

The IMF attempts to stabilize global financial markets by encouraging member nations to work closely together and to implement laws that encourage economic development and international trade. IMF member nations can borrow money from the fund, and during recessionary periods some nations heavily rely on these loans to combat the danger of economic collapse. The Fund works by controlling and monitoring exchange rates and serving as a liaison for countries to enter into transactions with each other. The International Monetary Fund is credited for preventing a number of crises in the global financial system.

B. World Bank Group

Another prominent player in the global system is the World Bank, whose main purpose is to provide loans to developing countries. The World Bank was created by the United Nations in an effort to eradicate poverty in poor countries. In addition to financial resources, the World Bank also lends technical expertise to help countries progress in areas of education, infrastructure, communications and health. The World Bank aims to provide funding, take up credit risk or offer favorable terms to development projects mostly in developing countries that couldn't be obtained by the private sector.

The organizations that make up the World Bank Group are owned by the governments of ITS 189 member nations, which have the ultimate decision-making power within the organizations on all matters, including policy, financial or membership issues. Member countries govern the World Bank Group through the Board of Governors and Boards of Directors. These bodies make all major decisions for the organizations. To become a member of the Bank, under the IBRD Articles of Agreement, a country must first join the International Monetary Fund (IMF). Membership in the World Bank Group's International Development Association, International Finance Corporation and Multilateral Investment Guarantee Agency are conditional on membership in the IBRD.

The World Bank was founded in 1944 with the intention of reducing poverty around the world. In the aftermath of World War II, the World Bank, with funding from nations including the United States and the United Kingdom, began to write loans to war-ravaged nations. Since its inception, the World Bank has shifted its attention to tackling poverty by providing loans to developing nations. The United States has been the primary international power behind the bank and nominates the president of the bank, who has been a United States citizen since the organization's start.

The initial goal of the World Bank was to free the world of poverty. After many years in existence, the World Bank has undergone criticism for its inability to eliminate the massive poverty that still rages in many countries. Critics of the World Bank say that the loans it makes to poor countries result in indebtedness and reliance on foreign aid. One of the strongest criticisms of the World Bank has been the way in which it is governed. While the World Bank represents 188 countries, it is run by a small number of economically powerful countries. These countries (which also provide most of the institution's funding) choose the leadership and senior management of the World Bank, and so their interests dominate the bank.

Organizational Charts:

The World Bank (IBRD & IDA) (PDF)

International Finance Corporation (PDF)

Multilateral Investment Guarantee Agency (PDF)

C. African Development Bank (AfDB)

The AfDB is a multilateral development finance institution that was founded in 1964 in order to facilitate the economic development of African nations. The AfDB’s mission is to fight poverty and improve living conditions on the continent through promoting the investment of public and private capital in projects and programs that are likely to contribute to the economic and social development of the region. National governments can obtain low cost loans from the AfDB to finance projects such as the implementation of new communication systems, improved sanitation and roads. Although it was founded as an African entity, the bank now allows non-African nations to join. The United States, China and Japan are among the non-African member states that have a role in the AfDB. The AfDB is controlled by a Board of Executive Directors, made up of representatives of its member countries. The voting power on the Board is split according to the size of each member's share, currently 60%-40% between African (or regional) countries and non-regional member countries (donors). The largest African Development Bank shareholder is Nigeria with nearly 9% of the vote. All member countries of the AfDB are represented on the AfDB Board of Executive Directors. Day-to-day decisions about which loans and grants should be approved and what policies should guide the AfDB’s work are made by the Board. There has been progress at all levels with regard to democracy, growth and restoring the macro-economic balances in Africa over the past fifteen years, but half of sub-Saharan Africa still lives on less than one dollar a day, and AIDS is threatening the social fabric of the continent.

D. European Investment Bank (EIB)

The European Investment Bank (EIB) is the European Union's nonprofit long-term lending institution established in 1958 under the Treaty of Rome. As a "policy-driven bank" whose shareholders are the member states of the EU, the EIB uses its financing operations to bring about European integration and social cohesion. Today, the EIB is the world's largest IFI. It is among the most politically powerful international financial institutions in existence. An investment bank is a financial firm which specializes in the sale and management of securities such as stocks and bonds, rather than just handling cash funds like a traditional bank. Most investment banks handle securities from multiple nations, and are used by governments, individuals and institutions. Member nations can obtain loans from the EIB, but its primary objective is to provide economic support for the EU's political objectives. Within Europe the bank primarily focuses on fostering cohesion between member nations, but outside Europe the bank helps to encourage economic reform and energy conservation. The EIB is a publicly owned international financial institution and its shareholders are the EU member states. The member states set the bank's broad policy goals and oversee the two independent decision-making bodies — the board of governors and the board of directors.

There are a few projects financed by or under the appraisal procedure of the EIB that have raised objections from local communities as well as international and national NGOs. Such projects include the M10 motorway in Russia, the Gazela Bridge in Serbia, the Raĉa Bridge in Croatia, the D1 motorway in the Slovakia, Šoštanj Power Plant in Slovenia, the Bujagali Hydroelectric Power Station in Uganda and the mining sector in Zambia. The Transparency Policy of the EIB has been heavily criticized by NGOs in the past. In 2004, Article 19 issued a memorandum in which it accused the EIB of failing to meet international (including EU) standards on openness. However, NGOs acknowledge important improvements in the EIB's transparency since 2004, and the new transparency policy adopted in 2010 is widely considered to be up to standards reflecting international best practice.

E, World Trade Organization (WTO)

The World Trade Organization also plays a crucial role in the global financial system. The organization was created to establish and enforce rules of trade between nations. The World Trade Organization settles trade disputes and negotiates international trade agreements in its rounds of talks. Among the various functions of the WTO, these are regarded by analysts as the most important: It oversees the implementation, administration and operation of the covered agreements and provides a forum for negotiations and for settling disputes. The WTO deals with regulation of trade between participating countries by providing a framework for negotiating trade agreements and a dispute resolution process aimed at enforcing participants' adherence to WTO agreements, which are signed by representatives of member governments and ratified by their parliaments. Additionally, it is the WTO's duty to review and propagate the national trade policies, and to ensure the coherence and transparency of trade policies through surveillance in global economic policy-making. Another priority of the WTO is the assistance of developing, least-developed and low-income countries in transition to adjust to WTO rules and disciplines through technical cooperation and training.

The WTO has 161 members and 23 observer governments. The highest decision-making body of the WTO is the Ministerial Conference, which usually meets every two years. It brings together all members of the WTO, all of which are countries or customs unions. The Ministerial Conference can make decisions on all matters under any of the multilateral trade agreements. The WTO establishes a framework for trade policies; it does not define or specify outcomes. That is, it is concerned with setting the rules of the trade policy games. Five principles of particular importance are non-discrimination, reciprocity, binding and enforceable commitments, transparency, and safety valves.

The stated aim of the World Trade Organization is to "ensure that trade flows as smoothly, predictably and freely as possible." However, it is important to note that the WTO does not claim to be a "free market" organization. According to the WTO, it is "sometimes described as a 'free trade' institution, but that is not entirely accurate. The system does allow tariffs and, in limited circumstances, other forms of protection. More accurately, it is a system of rules dedicated to open, fair and undistorted competition." This compatibility to a certain degree of protection is proved, for example, by the fact that cartels like the OPEC have never been involved in trade disputes with the WTO despite the evident contrast between their objectives. The actions and methods of the World Trade Organization evoke strong antipathies. Among other things, the WTO is accused of widening the social gap between rich and poor it claims to be fixing. UNCTAD estimates that the market distortions cost the developing countries $700 billion annually in lost export revenue.

The World Bank (WB) and The International Monetary Fund (IMF) (3:17)

Global Economy Definitions

 

How do the WTO, World Bank and IMF work? (7:01)

International Financial Institutions (Center for Global Development)

International Financial Institutions (International Trade Union Confederation)

IMF Data Portal Bulk Download Tutorial (2:40)

Did You Know? Asian Development Bank (4:03)

Portrait of a Bank: the Inter-American Development Bank (3:31)

Learn about WTO (World Trade Organisation) (9:56)

The World Trade Organization (WTO) Explained With Maps (5:49)

The World Trade Organization: Definition, History, Purpose & Members (5:57)

Making Sense of SDRs (1:37)

V. Financial Markets within the Global Financial System

7. spot markets: assets are traded for immediate delivery (usually within one or two business days)

8. futures or forward markets: trade contracts calling for the future delivery of financial instruments

9. option markets: contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date

International Financial Markets: Basic Concepts (Intro, 1.1, 1.2 Intro)

The Globalization of International Financial Markets: What Can History Teach Us?

VI.  Functions of the Global Financial System

1. generates and allocates savings

2. stimulates the accumulation of wealth

3. provides liquidity for spending

4. provides a mechanism for making payments

5. supplies credit to aid in the purchase of goods and services

6. manages financial risks

7. supplies a channel for government policy in helping achieve economic goals

8. facilitates trades

9. provides a mechanism for the pooling of resources

10. provides price information

11. provides ways for countries to transfer economic resources across borders and among different industries with ease

VII. Implications of Globalized Capital

A. Balance of Payments

The balance of payments of a country is the record of all economic transactions between the residents of the country and the rest of the world in a particular period (over a quarter of a year or more commonly over a year). It summarizes payments made to or received from foreign countries. The balance of payments is a function of three components: the current account (transactions involving export or import of goods and services), the financial account (transactions involving purchase or sale of financial assets) and the capital account (transactions involving unconventional transfers of wealth). The current account summarizes three variables: the trade balance, net factor income from abroad and net unilateral transfers. The financial account summarizes the value of exports versus imports of assets. The capital account summarizes the net value of asset transfers received and given. The capital account also includes the official reserve transaction account, which summarizes central banks' purchases and sales of domestic currency, foreign exchange, gold and SDRs for purposes of maintaining or utilizing bank reserves … i.e. the net amount of international reserves that shift among central banks to settle international transactions.

Because the balance of payments sums to zero, a current account surplus indicates a deficit in the asset accounts and vice versa. A current account surplus or deficit indicates the extent to which a country is relying on foreign capital to finance its consumption and investments, and whether it is living beyond its means. For example, assuming a capital account balance of zero (thus no asset transfers available for financing), a current account deficit of $1 billion implies a financial account surplus (or net asset exports) of $1 billion. A net exporter of financial assets is known as a borrower, exchanging future payments for current consumption. Further, a net export of financial assets indicates growth in a country's debt. From this perspective, the balance of payments links a nation's income to its spending by indicating the degree to which current account imbalances are financed with domestic or foreign financial capital, which illuminates how a nation's wealth is shaped over time. A healthy balance of payments position is important for economic growth. If countries experiencing a growth in demand have trouble sustaining a healthy balance of payments, demand can slow, leading to: unused or excess supply, discouraged foreign investment and less attractive exports which can further reinforce a negative cycle that intensifies payments imbalances.

A country's external wealth is measured by the value of its foreign assets net of its foreign liabilities. A current account surplus (and corresponding financial account deficit) indicates an increase in external wealth while a deficit indicates a decrease. Aside from current account indications of whether a country is a net buyer or net seller of assets, shifts in a nation's external wealth are influenced by capital gains and capital losses on foreign investments. Having positive external wealth means a country is a net lender (or creditor) in the world economy, while negative external wealth indicates a net borrower (or debtor).

B. Financial instability is the 'dark side' of international finance. It may consist of:

1. excess volatility of exchange rates (especially among major currencies) which can be disruptive for trade and financial flows

2. excess volatility in stock and bond markets, which makes it difficult to evaluate investments

3. excess instability of financial flows, which can move from one country to another massively and with extreme rapidity giving rise to bubbles or financial crises having real economic consequences

C. Unique Financial Risks

Nations and international businesses face an array of financial risks unique to foreign investment activity.

1. Political risk is the potential for losses from a foreign country's political instability or otherwise unfavorable developments, which manifests in different forms.

2. Transfer risk emphasizes uncertainties surrounding a country's capital controls and balance of payments.

3. Operational risk characterizes concerns over a country's regulatory policies and their impact on normal business operations.

4. Control risk is born from uncertainties surrounding property and decision rights in the local operation of foreign direct investments.

5. Credit risk implies lenders may face an absent or unfavorable regulatory framework that affords little or no legal protection of foreign investments. For example, foreign governments may commit to a sovereign default or otherwise repudiate their debt obligations to international investors without any legal consequence or recourse. Governments may decide to expropriate or nationalize foreign-held assets or enact contrived policy changes following an investor's decision to acquire assets in the host country.

6. Country risk encompasses both political risk and credit risk, and represents the potential for unanticipated developments in a host country to threaten its capacity for debt repayment and repatriation of gains from interest and dividends.

The Future of Global Finance

Bitcoin 101: How to Make a Digital Currency (18:46)

The Future of International Financial Institutions

Development Economics: How Improving Financial Systems Can Help Fight Global Poverty (3:13)

 

Test Yourself: Global Finance

Exchange Rates

I. A World of Currencies

1. When dealing with the GFS one has to face the problem of having different currencies and how to exchange one for another through exchange rates. Exchange rates determine the rate of change in the market of a currency with another (or with gold). The US $/euro exchange rate is the number of $ units that are needed to get 1 euro. When left to market forces exchange rates may vary considerably and even abruptly. Most countries define their exchange rate in ‘direct terms’, that is ‘units of national currency against 1unit of a foreign currency’ (UK is an exception). This is sometimes called ‘uncertain for certain’. One has always to make sure of what is the currency at the numerator and which one at the denominator

2. The number of national currencies remains very high notwithstanding 17 national currencies have disappeared with the introduction of the euro.

3. Not only money and bank deposits but also financial assets are denominated in a national currency.

4. Reserve currencies are those mostly used in international transactions (US $, Euro, yen, at one time the British pound).

5. The US$ is still used to price oil.

6. Central banks normally hold relevant quantities of reserve currencies to use in the money and exchange markets for their operations in addition to gold.

7. Gold still represents an important share of international reserves. Most gold is held by central banks and the IMF but private institutions like investment funds also have gold in their asset portfolios. The US and most European countries hold more than 70% of their foreign reserves in gold bars. Why is gold so important? Gold still represents an important store of value. Albeit its price changes daily on a market basis, its value does not depend on ‘trust’ like in the case of currencies.

8. The IMF Special Drawing Rights (SDR) is an international currency albeit it is not physical but only serves as an accounting unit.

9. The US$ still accounts for 60% of all international reserves.

II. Exchange Rate Terminology

1. Exchange rate regime: the type of criterion that a country chooses to set the value of its exchange rate, whether flexible (i.e. determined by market forces) or fixed or any other form between these two extremes

2. Exchange rate system: an agreement by which some countries, in a region or at the global level, set their (reciprocal) exchange rates according to a given mechanism (e.g. the Bretton Woods System of exchange rates 1944-1973)

3. Devaluation/Revaluation: a fixed exchange rate that is devalued/revalued by the country’s authorities (the exchange rate parity is revised)

4. Depreciation/Appreciation: a flexible exchange rate that registers a depreciation/appreciation on the foreign exchange market

III. Determining Foreign Exchange Rates: A foreign exchange rate is the price of foreign currency in terms of domestic currency. If the foreign exchange rate for Japanese yen is 1 cent, one yen costs 1 cent. The exchange rate between yen and dollars is determined by the demand for and supply of yen and dollars in the foreign exchange market.

1. Demand for and Supply of Foreign Currency: Flexible or floating exchange rates fluctuate in the foreign exchange market in response to changes in supply and demand conditions. Every US transaction concerning the importation of foreign goods constitutes a supply of dollars and a demand for some foreign currency in the foreign exchange market and vice versa for export transactions.

2. Market Determinants of Exchange Rates:

1. Changes in Real Interest Rates: If the US interest rate increases relative to the rest of the world, international investors will increase their demand for dollar-denominated assets, thereby, increasing the demand for dollars.

2. Changes in Productivity: When a country’s productivity increases relative to others, the former will become more competitive, demand for its exports will increase, and so will the demand for its currency.

3. Changes in Consumer Preferences: If other countries change their preferences to US goods, this will increase the derived demand for US dollars in foreign exchange markets.

4. Perceptions of Economic Stability: If the US looks economically and politically stable relative to other countries, more foreigners will want to put their savings into US assets. The demand for dollars will increase.

THE MARKET FOR FOREIGN CURRENCY

When people in one country demand products from firms in another country, they must enter into another market first, to buy that nation’s currency. For example, if you were employed as the merchandise buyer for a retail consumer electronics firm and wanted to buy Sony CD players to sell to your customers, you would not simply send a check to Sony in the amount of American dollars. Firms want to deal in their own currencies. As a result, you would have to go into the foreign exchange market to buy yen, which you could then use to pay Sony for the CD players.

In the same way that supply and demand for products shifts to change the prices of those products, the constant shifts in the supply and demand for foreign currency result in changing prices of currency. As a result, the price of money changes as demand for foreign currencies changes. We call this price of foreign currency, in terms of US currency, the foreign exchange rate. It simply tells you how many American dollars it will cost you to purchase a unit of foreign currency. This floating foreign exchange rate changes daily with the international supply and demand for currency.

That means exchange rates vary between countries based on the supply of and demand for a country's currency. If there's more demand for than supply of a currency, its value goes up … and vice versa.

A number of factors can increase demand for a foreign currency. If the other nation’s products sell at a lower price than domestic products, consumers will increase their demand for imports. If domestic incomes rise or domestic inflation rates are higher than those in other nations, demand for imports will rise, as well. In capital markets, if another nation’s interest rate (return on investment) is higher than the domestic interest rate, some people will choose to invest in the other nation’s securities. When consumers import more products from a country or invest in that country’s securities, their demand for that currency increases. This increase in demand pushes the price of the currency higher, so their currency appreciates (rises in value).

       THE MARKET FOR US CURRENCY

Because consumers use US dollars to buy foreign currency, when the demand for foreign currency increases, the international supply of US dollars increases proportionately. As the supply of dollars increases, the price of US dollars falls, causing the dollar to depreciate (fall in value).

In the international market today, the supply and demand for currencies and the resulting relative values of currencies can affect the demand for imports and exports. For example, if we have a strong dollar, the dollar is very valuable compared to other currencies; other currencies appear very inexpensive to us. Because we can buy the currency more cheaply, the prices of the country’s products appear lower to us. And at lower prices, quantity demanded rises. So when the US has a strong dollar, we buy more imports from foreign countries. This helps US importers, such as electronics outlets, grocery stores and gas stations, because when they can buy goods at a lower cost, they can offer those goods to their customers at lower prices, increasing the quantity demanded for their products and potentially increasing their profits.

An important negative effect of the strong dollar, however, exists for American exporters. When we have a strong dollar, buyers from other countries see our currency as being very expensive; they must give up more of their currency to buy dollars. As a result, the prices of our products appear more expensive to them. Therefore, the quantity demanded of our exports falls. This harms US exporters, such as computer companies, auto manufacturers and farmers, because they must lower their prices to try to attract demand for their products, resulting in lower profits and possibly forcing some firms out of business completely. The resulting impact of a strong dollar is a trade deficit. Imports rise, while exports fall.

The interesting thing about this entire phenomenon of changing exchange rates is that they can be self-correcting over time. For example, when we have a strong dollar, we demand more pesos to buy more Mexican products. But the very act of demanding more pesos causes the peso to appreciate, so Mexican imports appear to be more and more expensive over time. At the same time, the supply of US dollars in the international market is growing, so their value falls as the dollar depreciates. Over time, imports are not as attractive, but our exports become more attractive to other countries, because their currency has become stronger. At that point, the US would have a weak dollar – a condition, in which US dollars are not very valuable compared to other currencies. Such a situation helps US exporters, but hurts US importers. This rise in exports and fall in imports results in a trade surplus. But over time, the situation can again reverse itself, as the increased foreign demand for US exports forces up the prices of American goods internationally, so the quantity demanded by foreign countries again begins to fall.

In the cycle of international trade, changes in relative incomes, inflation rates, product prices and interest rates can affect the international value of currencies. And at the same time, changes in the international value of currencies can affect the demand for products and securities in the international marketplace.

As supply and demand for currencies change, the values of those currencies change. When the US dollar is strong, imports seem less expensive, leading to increased demand for imported products and the currency needed to purchase them. In addition, when interest rates in another nation are higher than those in the US, demand for the foreign currency rises, as people buy the currency in order to invest in the other nation’s securities. At the same time, a stronger dollar decreases exports, because they appear more expensive to foreign consumers. Therefore, a trade deficit develops as the result of a strong dollar. The opposite effects result from a weak US dollar. While importers prefer a strong dollar, exporters prefer a weak dollar.

The differences in currency values can affect our ability to buy imports or sell exports, affecting our standard of living. Therefore, the effects of currency crises in other nations are not limited to those nations – they can affect our economy and our lives in important ways.

C.    Market Mechanisms to Establish Exchange Rates

There are primarily five market mechanisms to establish exchange rates with each having its share of merits and demerits. All countries like to have economic stability and prefer a stable exchange rate, however fixing exchange rates often leads to currency crises if the monetary policy is inconsistent with it. Countries are less vulnerable to economic shocks if they allow their currency to float freely but that may exhibit excessive volatility which hurts trade and economic growth. The trade-off between different mechanisms depends on the importance of the underlying benefits and trade-offs associated with them.

1. Free float: Free market exchange rates are determined by the interaction of currency supply and demand, which is in turn influenced by price level changes, interest differential and economic growth. The exchange rate fluctuates randomly as market participants react to new information - for example, government policies or acts of God and nature. This is also called clean float as the exchange rates are free flowing without any manipulation. Proponents of the system said it would reduce economic volatility, facilitate free trade and offset the differences in inflation rates. High inflation countries would have their currencies depreciate, allowing their firms to stay competitive without having to affect wages and unemployment.

2. Managed float:  Intervention by governments in the foreign change market reduces the economic uncertainty associated with a free float. This is triggered by the fear of a sudden change in the currency's value. Central banks intervene to smooth out exchange rate fluctuations and determine the rate. That is why it is called a managed or dirty float.

3. Target zone arrangement: Under this system, countries adjust their national economic policies to maintain their exchange rates within a specific margin. Members of the arrangement adjust their national economic policies to maintain the target range.

4. Fixed rate system: Bretton Woods was a fixed rate mechanism. In this type of regime, governments are committed to maintain a target exchange rate. Central banks buy and sell currency actively if the exchange rate is threatened. For this system to work, all member nations must accept the group's joint rate as its own.

5. Hybrid system: This currency system is one where major currencies float on a managed basis. Some currencies are freely floating while other currencies follow various types of pegged exchange rates - for example, use another currency as legal tender (Ecuador, El Salvador, the US dollar), peg against a single currency (Malaysia, Maldives, Nepal, Iraq, Jordan)

Exchange Rates

A History of Exchange Rates Infographic

IV. The Gold Standard and the International Monetary Fund

The Gold Standard: An international monetary system in which nations fix their exchange rates in terms of gold. Thus, all currencies are fixed in terms of each other. Any balance of payment problems could be made up by shipments of gold. There is a relationship between the balance of payments and changes in domestic money supplies. When a nation had a deficit in its balance of payments, more gold was flowing out than in. Because the domestic money supply was also based on gold, an outflow of gold to foreigners caused an automatic reduction in the domestic money supply. Interest rates rose attracting foreign capital and improving the balance of payments and national output and prices fell. Imports were discouraged and exports were encouraged improving the balance of payments. Bretton Woods and the International Monetary Fund: The Bretton Woods Agreement Act of 1945 set up the International Monetary Fund (IMF) to lend to member countries with a balance-of-payments deficit. Member governments were obligated to maintain the values of their currencies in foreign exchange markets within 1% of the declared par value (the legally established value of the monetary unit). The US was obligated to maintain gold prices within 1% of the official value of $35 an ounce. In 1971 President Nixon suspended the convertibility of dollars into gold. In 1973 the finance ministers of the European Economic Community announced they would let their currencies float against the dollar. Since 1973 the US and most other important trading countries have either had flexible exchange rates or managed (dirty) floating exchange rates.

The IMF, World Bank, and G20 for Forex Traders (4:46)

IMF Data and Statistics

 

V. Fixed Versus Floating Exchange Rates

1. Fixing the Exchange Rate: Central banks can keep exchange rates fixed as long as they have enough foreign exchange reserves available to deal with potentially long-lasting changes in the demand or supply of their nation’s currency.

2. Pros and Cons of a Fixed Exchange Rate:

1. Foreign Exchange Risk: Limiting foreign exchange risk is one major argument for fixed exchange rates. The possibility that changes in the value of a nation’s currency will result in variations in market values of assets. Hedging can also offset this type of risk.

2. The Exchange Rate as a Shock Absorber: If residents of a country are relatively immobile, then exchange rate movements can reduce the shock of a decrease in demand for a country’s products by having the exchange rate fall thus increasing the quantity demanded along the new demand curve. The unemployment effects of the decrease in demand for the country’s exports will be smaller.

3. Splitting the Difference: Dirty Floats and Target Zones:

A Dirty Float: A system of managed exchange rates in between flexible and fixed exchange rates in which central banks occasionally enter foreign exchange markets to “smooth out” rate fluctuations. Crawling Pegs: An exchange rate arrangement in which a country pegs the value of its currency to the exchange rate of another nation’s currency, but allows the par value to change at regular intervals.

3. Target Zones: A range of permitted exchange rate variations between upper and lower exchange rate bands that a central bank defends by buying or selling foreign exchange reserves.

 

Not Really 'Made in China': The iPhone's Complex Supply Chain Highlights Problems with Trade Statistics

An Example of Floating vs Fixed Rates: The Chinese Yuan

Currency value is as much a part of the price of a product made in another country as is the price of raw materials like plastic and cardboard. And Beijing historically has intervened in global markets to make sure the yuan remains cheap compared with other currencies. A cheap yuan provides world consumers cheap imports, which they like. But it also takes away millions of domestic manufacturing jobs, which they don’t like. And it affects China’s consumers as well, by making imports in China more expensive and feeding Chinese inflation. However, a cheap yuan also keeps Chinese exports cheap, and that helps Chinese firms make money and keeps China's export-driven factories humming. A cheap yuan also means political stability in a nation where tens of millions of Chinese peasants need jobs. In the late 1990s (the period just prior to that shown on the chart above), the yuan was fixed, pegged to the US dollar at about 8.28 to 1. The problems started around 2001 when the US dollar weakened and took the yuan with it. The US and other trading partners watched with concern as China's trade surplus grew and its foreign-exchange reserves ballooned. Developed countries rightfully argued that the yuan’s too-low exchange rate gave Chinese companies an artificially low price advantage. Plus, the resulting unbalanced trade created large trade deficits in the developed countries and significant currency flows into China. In 2005, after years of pressure, China unpegged its currency from the dollar and allowed it to float within a range determined in relation to a basket of currencies.  From then until 2008, the yuan gained more than 20% against the dollar. Despite allowing the value of the yuan to float (according to Beijing), China's central bank has decisive ability to control its value with relationship to other currencies. Ideally, market forces determine the value (or price) of currencies but China's currency markets are not free or completely open. China's central bank intervenes in its currency market to control the value of the yuan. Here's how it works: Chinese exporters accumulate US dollars or other currencies from foreign customers. However, they need to pay their Chinese employees and suppliers in yuan. Too, China requires that all Chinese companies exchange the dollars they obtain from trade with the US for yuan at state-owned Chinese banks where the exchange takes place at rates established by the authorities. So, Chinese exporters go to China's currency market to swap their dollars for yuan. With thousands of firms doing this, the demand for yuan is high. In a free currency market, this would push up the price of the yuan as demand outpaces supply. To prevent that from happening, China's central bank increases the market supply of yuan. It prints and sells as many extra yuan as the market wants, thus increasing supply and pushing down the price of the yuan. In 2008, when a global economic downturn hit, China returned to a de facto peg to the US dollar in order to protect its exporters and ensure economic stability amid the tough global conditions. The international community was outraged and threatened retaliation. In mid-2010, China announced that it would let its currency float more freely against the dollar. But, while appearing to let the yuan float, China actually increased its currency intervention by amassing record amounts of foreign exchange reserves to prevent meaningful appreciation of the yuan. Specifically, China purchased huge amounts of world currencies, mainly the dollar, increasing its foreign currency reserves to a total of $3 trillion by the end of the first quarter of 2011. There is a complex relationship between China's balance of trade, inflation, measured by the consumer price index and the value of its currency. Despite allowing the value of the yuan to float, China's central bank has decisive ability to control its value with relationship to other currencies.

China: Awakening Giant (PDF, slow to load)

Currency Appreciation and Depreciation (7:47): and see the Q&A below the video

The relationship between the Current Account Balance and the Exchange Rate (16:15)

How Does China Manipulate Its Currency? (3:27)

 

Test Yourself: Exchange Rates