BALANCE OF PAYMENTAND EXCHANGE RATE GOLD STANDARD, BRETTON WOODS AND FLOATING SYSTEM

What is Balance of Payment? BOP : statement of systematic record of all economic transaction between one country and the rest of the world during a given period of time.

Difference between the total value of goods and services imported and exported over a given period of time.

Cont.. BOP account records both debits and credits. BOP includes both visible and invisible goods. Economic transaction : merchandise trade, services such as transportation, insurance, banking and others.

Balance of Payment, cont.. Debit (-) : any transaction that supplies the countrys currency in the foreign exchange market. (money outflow)

Credit (+) : any transaction that creates demand for the countrys currency in the foreign exchange market. (money inflow)

Structure of Malaysian BOP

2. Capital Account There are two types of transaction in the capital account namely private and official. Private transaction: includes all types of investment: direct, portfolio and short term

Official or government transaction: loans to and from foreign official agencies

3. Official Reserve Account IMF is an international organization created to oversee the international monetary system.

IMF holds currency reserves for member countries and makes loans to central banks.

SDR is an international money mechanism created by IMF in the form of bookkeeping entries that can be used by countries to settle their international accounts.

Errors and Omissions Balancing item in which the credits and debits must be equal. In all economic transactions, such as exporting goods, importing goods, the buying of land in foreign countries should balance according to accounting bookkeeping concepts. However, there may be some missing information.Thus, BOP accountant uses error and omission to balance the account.

Disequilibrium in BOP Occurs when there is a deficit or surplus in BOP.

A surplus or deficit shows a countrys strength or weakness in relation to its external capital position as measured by the balance of its external assets to liabilities.

How to Correct Disequilibrium in BOP? Export promotion develop quality products with lower prices and improve marketing strategies Discourage imports imposing high tariffs rates or quotas for imported products Control inflation (deficit BOP) impose tight monetary policy or tight fiscal policies or both to control

How to Correct Disequilibrium in BOP? Using the governments reserves in the form of gold and foreign currencies to balance deficit in BOP but only can be used for short period continuous payment from gov reserves will reduce its amount in long run.

How to Correct Disequilibrium in BOP? Devaluation Governments policy of lowering the par value of the countrys currency compared to the currencies of other countries by an official announcement reduce value of home currency increase value of foreign currencies stimulate exports reduce imports from foreign countries

Exchange Rate Exchange Rate: Price of one currency in terms of another currency Buyers of imported goods or investors who want to invest in other countries should convert their domestic currency into the currency of the nation that they are going to deal with.

Cont..Example : An importer in Malaysia who wants to buy digital cameras from Japan will need to convert Malaysian Ringgit to Japanese Yen to carry out business with Japanese firms.

Gold Standard Prior to 1930s, gold standard was major system of the exchange rate determination. Values of all currencies were fixed according to gold value. Example, if US defines $20 in terms of one ounce of gold and Britain defines 4 for one ounce of gold, then the exchange rate between dollars and pounds will be $5 to 1.

Features of Gold Standard Each country defines its monetary value in terms of quantity of gold There must be freedom in export and import of gold Each country maintains a fixed relationship between its stock of gold and its money supply.

Bretton Woods System In 1944, after Great Depression and Second World War, representatives from industrial countries held an international conference at Bretton Woods to create a new monetary system to replace the gold standard.

Cont Modified the fixed exchange rate system (Gold Standard) and was known as adjustable-peg system or Bretton Woods System. Under this system, countries have to peg their currencies to US Dollar instead to gold. Then, US Dollar was pegged directly to gold that was worth $35 per ounce of gold.

Flexible Exchange Rate System After 1973, Bretton Woods system of fixed exchange rate was replaced by the flexible exchange rate system or floating system. Under this system, major currencies are free to float to their equilibrium market level.

Cont.. Most trading countries will allow their exchange rates to move up or down in order to stabilize excess supply or demand based on supply and demand in the foreign exchange market. This system will considerably more volatile than Bretton Woods System.

Demand Curve for US Dollar

Supply Curve for US Dollar

Determination of Exchange Rate