Exchange Rates, International Balances, and International Finance

Open economies cannot conduct economic policies as though they were closed to international trade and capital movements. What the rest of the world does affects the economy of a country.

The money of one country is exchanged for the money of another country in foreign exchange markets. These markets are needed in international trade because people wish to be paid in the money of their own country.

The intersection of the demand curve and the supply curve in the foreign exchange market indicates the equilibrium foreign exchange value of a nation's money. Purchasing power parity exists when the buying power of a country's money for traded goods and services is the same at home as abroad. Transactions on the capital account involve the concept of rate-of-return parity, where the rate of return on a dollar invested at home is the same as it would be if that dollar were exchanged for the foreign money and invested there.

Countries may try to raise the exchange value of their money by using their gold and foreign exchange reserves to supplement the demand for their money. They may lower its exchange value by selling their own money in the foreign exchange market.

The argument for flexible exchange rates is that they do a more efficient job of pricing goods and allocating resources than do government- controlled rates. Moreover, government attempts to control rates often break down and cause serious problems.

The argument for fixed exchange rates is that they reduce uncertainty and thus help international trade and investment. Moreover, since governments usually influence exchange rates anyway, it is better that it be done openly. 

Under the gold standard, monies are linked to each other because each is guaranteed to be ex changeable for a stated amount of gold. Under this system, gold and trade flows tend to force the price levels in gold-standard countries into fixed relationships, corresponding inversely to the gold backing of their monies. The gold-standard system collapsed in the unstable economic conditions following World War 1.

The International Monetary Fund was set up near the end of World War 11 to make loans to countries to help them hold the exchange value of their monies in line with fixed exchange rates ap proved by the IMF directors. This fixed-exchange-rate system broke down in 19 71 when the United States refused to continue to exchange gold for dollars, thus letting the reserve money itself float in foreign exchange value. 

Eurocurrencies are deposits of a country's money in banks in a foreign country. These deposits are free from their issuing government's controls over reserve ratios, interest rates, and the quality of loans. The advantages of this freedom from control have led to a great expansion of Eurocurrency accounts.

Balance of payments accounts record transactions that involve demands (credit entries) and supplies (debit entries) for a nation': money in international payments. Widely recognized concepts of balance are (a) the balance of trade, (b) the balance on investment income, (c) the balance on current account, (d) the balance on capital account, and (e) the official settlements balance of payments.

If the sum of a country's current and capital accounts is positive, the country's balance of payments is in surplus. If the sum is negative, its balance of payments is in deficit.

It is sometimes suggested that countries move through several balance of payments stages in the course of economic development. They start as immature debtors and end as mature creditors, living off dividends and interest from previous investments abroad.

Following mercantilist views, a positive payments balance usually is considered favorable and a negative balance is unfavorable. However, in terms of macroeconomic policy, these judgments depend on whether the goal is to expand the economy or to fight inflation.

A country has a primary payments problem if its international reserves of gold and convertible foreign monies are low and its balance of payments is usually negative. 

A country has a secondary payments problem (1) if its current account is in deficit but its payments are balanced by undesired capital imports, or (2) if its capital account deficit, or capital flight, is absorbing a large portion of the export surplus the country had hoped to use for other purposes.

Remedies for payments problems, either primary or secondary, include price deflation-the so-called "classical medicine" of laissez faire-currency devaluation or depreciation, international aid or lending, trade protection, exchange controls, and countertrade.