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CHAPTER 7
The International Monetary
System and the Balance of Payments
Chapter Objectives
After studying this chapter, students should be able to:
1. Discuss the role of the international monetary system in promoting
international trade and investment.
2. Explain the evolution and functioning of the gold standard.
3. Summarize the role of the World Bank Group and the International
4. Explain the evolution of the flexible exchange rate system.
5. Describe the function and structure of the balance of payments
accounting system.
6. Differentiate among the various definitions of a balance of payments
surplus and deficit.
LECTURE OUTLINE
OPENING CASE: Will the Stars Shine on Astra Again?
PT Astra is one of the oldest and largest conglomerates in Asia, at one point having
employed 125,000 people. After borrowing in dollars from foreign banks, Astra’s fortunes
plummeted with the collapse of the Indonesian rupiah. A new president installed in
1998, Rini Soewandi, did much to turn the company around until her ouster in 2000.
Now, with deals struck with the Indonesian Bank Restructuring Agency (IBRA) and the
International Monetary Fund (IMF), Indonesia and Astra may again have reason to be
optimistic.
Key Points
• Astra was a domestically oriented firm.
• Even so, it was not impervious to international competitive issues, such as changes
in the value of the Indonesian rupiah.
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• As global competition increases, domestically protected companies face greater and
greater challenges internally and outside of their country.
CHAPTER SUMMARY
Chapter Seven explores the international monetary system and the balance of
payments. The chapter traces the history of the international monetary system
beginning with the gold standard and ending with the current system of a managed float.
It then goes on to examine the different accounts and balances in the balance of
payments.
HISTORY OF THE INTERNATIONAL MONETARY SYSTEM
• The international monetary system establishes the rules by which countries value
and exchange their currencies. It also provides a mechanism for correcting
imbalances between a country’s international payments and its receipts.
• The accounting system that governs the international monetary system is the
balance of payments (BOP). The BOP records international transactions and
supplies vital information about the health of a national economy and likely changes
in its fiscal and monetary policies.
Teaching Note:
Students may find it helpful to use a timeline when discussing the
different exchange-rate systems that have taken place over the last
century.
The Gold Standard
• The gold standard, under which countries agreed to buy and sell their paper
currencies in exchange for gold on the request of any individual or firm, was the
international monetary system in place in the nineteenth century.
• The gold standard had the effect of creating a fixed exchange rate system because
each country tied or pegged the value of its currency to gold. An exchange rate is
the price of one currency in terms of a second currency. The par value of a
currency is its official price in terms of gold.
The Collapse of the Gold Standard
• As countries suffered through the economic chaos of World War I, the sterling-based
gold standard came unraveled; however, it was readopted in the 1920s.
• In spite of its resuscitation, the gold standard ended in 1931 when Britain, under
pressure to honor guarantees made under the system, allowed its currency to float
(the pound’s value was determined by the forces of supply and demand).
• While some countries, primarily those in the British Commonwealth, pegged their
currencies to the pound after the gold standard was abandoned, others linked their
currencies to the U.S. dollar or the French franc. In addition, many countries
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• In 1944, representatives of 44 countries met to construct a postwar international
monetary system that would create an environment of worldwide peace and
prosperity. The representatives agreed to renew the gold standard on a modified
basis, and they created two new international organizations, the International Bank
for Reconstruction and Development and the International Monetary Fund, to assist
the rebuilding of the world economy and monetary system.
• The International Bank for Reconstruction and Development, also known as the
World Bank, was established in 1945 to finance reconstruction of war-torn European
economies, and when this was completed, focused on building the economies of
lesser-developed nations.
• The World Bank has created three affiliated organizations: the International
Development Association, the International Finance Corporation, and the Multilateral
Guarantee Agency, which together comprise the World Bank Group. See Figure
7.2 here.
• The World Bank lends only for “productive purposes” and follows a hard loan policy
(it makes loans only if there is a reasonable expectation that they will be repaid).
• The International Development Association (IDA) was established in response to
criticism from poorer countries that World Bank policies favored countries well along
EMERGING OPPORTUNITIES
Frog Ranching in Peru
This section describes the World Bank Group’s attempt to help poor Peruvian
campesinos (subsistence farmers) improve their livelihood. It financed a new
Peruvian company, Forests and Frogs, which will raise and export poison-dart frogs.
Poor peasants are being trained to gather and nurture the amphibians’ eggs.
Forests and Frogs believes it can double the peasants’ income once the project is
underway.
• The International Monetary Fund. The International Monetary Fund’s (IMF) primary
responsibility is to oversee the functioning of the international monetary system.
• To join the IMF, countries must pay a deposit, called a quota. Quotas are important
• A country is allowed to borrow up to 25 percent of its quota from the IMF. Additional
borrowings require that countries agree to IMF conditionality.
• A Dollar-Based Gold Standard. Under the international monetary system
established at Bretton Woods, all countries agreed to peg the value of their
currencies to gold (the dollar was pegged to gold at a value of $35 per ounce).
Thus, the agreement was a fixed exchange rate system. In addition, the United
States agreed to redeem the dollar for gold at the request of foreign central banks.
In this way, the dollar played a key role in the Bretton Woods system.
The End of the Bretton Woods System
• The reliance on the U.S. dollar eventually led to the downfall of the Bretton Woods
system. Since the supply of gold did not expand in the short term, the dollar became
• The IMF attempted to alleviate the situation by creating an additional source of
international liquidity, the special drawing right (SDR). The SDR, a weighted
average of the market value of five major currencies, is used by IMF members to
settle official transactions at the IMF.
• The SDR did not have the desired effect of reducing the glut of dollars held by
foreigners, and by 1971, it became clear that the United States did not have enough
Performance of the International Monetary System since 1971
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central bank will intervene and affect exchange rates leading to the term “managed
float” or dirty float. See Table 7.2 for a list of today’s most important central banks.
BRINGING THE WORLD INTO FOCUS
Fixed Versus Flexible Exchange Rates
This box discusses how the fixed and flexible exchange rate systems each reach
equilibrium – the fixed system through the purchase and sale of gold, the flexible
system through changes in supply and demand (and therefore value) for a country’s
currency.
• Under the Jamaica Agreement, established in 1976, each country was free to adopt
whatever exchange rate system best met its requirements. Some countries (i.e., the
United States) chose a floating exchange rate, while others opted for a fixed
exchange rate system by pegging their currencies to another.
• The European Monetary System (EMS) was established by EU members in 1979
to manage currency relationships among themselves. Most EMS members
• While the EMS has been helpful in curbing inflation and in promoting intra-EU
investment, it has also been adjusted 39 times because of differences in the
monetary policies of EU members.
• The current international monetary system is based on flexible exchange rates,
although some countries (i.e., the EU) have chosen to maintain fixed exchange-rate
1985), resulted in an agreement to let the dollar’s value fall. Table 7.1 can again be
used here.
• A second meeting, the Louvre Accord, was called in 1987 to stabilize the dollar.
Discuss Figure 7.3 here, showing the changing value of the dollar against the
Japanese yen, Euro and the Deutsche Mark, 1960-2010.
• Because a depreciation in a firm’s home currency makes it easier for the firm to
export and defends it from the threat of imports, exchange rates are very important to
firms.
BRINGING THE WORLD INTO FOCUS
Should Bretton Woods Be Restored?
This box is basically a discussion of the trade-offs between a fixed exchange rate
system (such as Bretton Woods) and the floating exchange rate system prevalent
today. A fixed system eliminates uncertainty for business, but a floating system
allows more flexibility to governments in managing their economies.
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• The International Debt Crisis. The international debt crisis grew out of events that
occurred shortly after the flexible exchange rate system of 1973 began, when Arab
nations quadrupled the price of oil. Banks recycled the petrodollar in the form of
loans to countries that were damaged by the rise in oil prices. However, many
countries borrowed more than they could repay.
• Various efforts were made to resolve the crisis. The 1985 Baker Plan stressed the
importance of debt rescheduling, tight IMF-imposed controls over domestic fiscal and
monetary policies, and continued lending to debtor countries in hope that economic
THE BALANCE OF PAYMENTS ACCOUNTING SYSTEM
• The balance of payments (BOP) accounting system is a double-entry bookkeeping
system designed to measure and record all economic transactions between
residents of one country and residents of all other countries during a particular time
period.
• There are several reasons why international business people should pay attention to
the BOP. First, BOP statistics help identify emerging markets for goods and services.
Second, they can warn of possible new policies that may alter a country’s business
climate, thereby affecting the profitability of a firm’s operations in that country. Third,
they can indicate reductions in a country’s foreign reserves, which may mean that a
country’s currency will depreciate in the future. Fourth, they can signal increased
riskiness of lending to particular countries.
The Major Components of the BOP Accounting System
The BOP accounting system can be divided into four major accounts: the current
account; the capital account; the official reserves account; and the errors and
omissions account.
Current Account
• The current account records exports and imports of merchandise and services,
investment income, and gifts. Table 7.3 summarizes the debit and credit entries
for transactions involving the current account.
• To Germany, a sale of a Mercedes-Benz automobile to a doctor in Marseilles is a
merchandise export, and the purchase by a German resident of Dom Perignon
champagne from France is a merchandise import. The difference between a
country’s exports and imports of goods is called the balance on merchandise
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trade. The United States has a merchandise trade deficit because it has been
importing more than it exports, while Japan has a merchandise trade surplus
because it has been exporting more than it imports.
• The sale of a service (i.e., consulting services) to a resident of another country is
a service export, while the purchase of a service by a resident of another
country is a service import. The term trade in invisibles is also used to
describe trade in services. The difference between a country’s export of services
Capital Account
• The capital account records capital transactions – purchases and sales of
assets – between residents of one country and those of other countries. Capital
account transactions can be divided into foreign direct investment (FDI) and
portfolio investment. The former is any investment made for the purpose of
controlling the organization in which the investment is made, while the latter is
any investment made for purposes other than control. Both types of investment
are discussed in Chapter One. Discuss Table 7.4 here.
• Short-term portfolio investments are financial instruments with maturities of
one year or less. Long-term portfolio investments are stocks, bonds, and
other financial instruments issued by private and public organizations that have
maturities greater than one year and that are held for purposes other than
Official Reserves Account
• The official reserves account records holdings of the official reserves held by a
national government including gold, convertible currencies (currencies that are
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freely exchangeable in world currency markets), SDRs, and reserve positions at
the IMF.
Errors and Omissions
• The errors and omissions account is used to make the BOP balance in
accordance with the following equation: Current Account + Capital Account +
Errors and Omissions + Official Reserves = 0.
• A large portion of the errors and omissions account is probably due to
underreporting of capital account transactions. It is becoming more and more
BRINGING THE WORLD INTO FOCUS
Ben Franklin, World Traveler
This box examines the process of determining how much U.S. currency is held
by foreigners. The box notes that current estimates are that 49 percent of U.S.
currency in circulation is held by foreigners. These foreign holdings act as
interest-free loans to the United States.
• Other errors and omissions are related to the current account, particularly
merchandise exports and trade in services.
The U.S. Balance of Payments in 2010
• U.S. merchandise exports were $1,288.7 billion in 2010 (see Figure 7.4 for a
detailed breakdown). Automobiles and auto parts were the largest component of
U.S. merchandise exports. Table 7.6 and Figure 7.4 give a more detailed
breakdown of imports and exports by industry. Discuss the tables here.
Discuss Figure 7.5 here.
• The capital account (use Table 7.6 here) shows that in 2010, U.S. FDI outflows
were $351.4 billion, while FDI inflows were $236.2 billion. New U.S. long-term
international portfolio investments were $147.2 billion in 2010, while new foreign
Defining Balance of Payments Surpluses and Deficits PP 7-46
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• When people talk about a balance of payments surplus or deficit, they are talking
about a subset of BOP accounts. For example, a merchandise trade surplus occurs
when a country exports more than it imports. Other balances that are often
mentioned include the balance on services, the balance on goods and services, the
current account balance, and the basic balance (the sum of the current account and
net long-term capital investment).
• The official settlements balance reflects changes in a country’s official reserves; it
essentially records the net impact of the central bank’s interventions in the foreign
exchange market in support of the local currency.
• Which BOP concept to use depends on the issue confronting the international
businessperson or policy maker. There is no single measure of a country’s global
CHAPTER REVIEW
1. What is the function of the international monetary system?
The international monetary system establishes the rules by which countries value and
2. Why is the gold standard a type of fixed exchange rate system?
The gold standard is a type of fixed exchange rate system because under the system, each
country pegged the value of its currency to gold. Currencies are then exchanged using the
3. What were the key accomplishments of the Bretton Woods conference?
The key accomplishments of the Bretton Woods conference included an agreement to
4. Why was the IFC established by the World Bank?
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5. Why are quotas important to IMF members?
6. Why did the Bretton Woods system collapse in 1971?
A key part of the Bretton Woods system was the agreement by the United States to
exchange its currency for gold. During the 1950s and 1960s, foreigners happily held onto
7. Describe the differences between a fixed exchange rate system and a flexible exchange
rate system.
8. List the four major accounts of the BOP accounting system and their components.
The four major accounts of the BOP accounting system are the current account, the capital
account, the official reserves account, and the errors and omissions account. The capital
account summarizes merchandise exports and imports, service exports and imports,
9. What factors cause measurement errors in the BOP accounts?
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Various factors contribute to measurement errors in the BOP accounts. It is believed that a
large portion of the account is a result of the underreporting of capital account transactions.
10. Identify the different types of balance of payments surpluses and deficits.
The merchandise trade balance, which summarizes a country’s trade position in goods, is
the most commonly referred to balance. Other balances include the balance on services,
which records a country’s trade in services, the balance on goods and services which
QUESTIONS FOR DISCUSSION
1. What parallels exist between the role of the British pound in the nineteenth-century
international monetary system and that of the U.S. dollar since 1945?
In the nineteenth century, the British pound was the most important currency in international
business. The pound gained this status because the United Kingdom emerged at the end of
the Napoleonic Wars as the dominant economic and military power in Europe. The British
pound (or gold) was accepted by most companies in the settlement of transactions.
2. Did the key role that the dollar played in the Bretton Woods system benefit or hurt the United
States?
It can be argued that the key role the dollar played in the Bretton Woods system benefited
the United States because it helped the country to gain the status of a force to be reckoned
3. Under what conditions might a country devalue its currency today?
A country might devalue its currency in an effort to help the international competitiveness of
its exporters. A devalued dollar, for example, has the effect of making U.S. exports cheaper
4. Are there any circumstances under which a country might want to increase its currency’s
value?
Countries may try to increase the value of their currencies in certain circumstances. For
example, major trading partners met at the Louvre Accord in an effort to halt the decline of
5. Can international businesses operate more easily in a fixed exchange rate system or in a
flexible exchange rate system?
6. What connections exist between the current account and the capital account?
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BUILDING GLOBAL SKILLS
Essence of the exercise
This exercise is designed to allow students to better understand the BOP concept by actually
accounting for various “transactions.” The exercise provides three examples of how the BOP
double-entry system works, and then asks students to record another set of transactions.
Answers to the follow-up questions:
How will the following transactions be recorded in the U.S. BOP accounts?
1. An American entrepreneur seeking to sell souvenirs at the 2012 summer Olympics in
London pays British Airways, a U.K. carrier, $1,500 for a Los Angeles – London round-trip
ticket.
The credit entry in this transaction affects the short-term portfolio account in the amount of
2. The American entrepreneur instead pays United Airlines (an American airline) $1,500 for a
Los Angeles – London round-trip ticket.
This transaction will not affect the U.S. BOP because the airline is an American carrier being
3. Ford Motor Company (U.S.) pays $2.5 billion for all the common stock of the Jaguar Motor
Co. (U.K.).
Ford is buying a long-term asset (the Jaguar Motor Co.) for purposes of control, and the
4. The U.S. government gives Rwanda $500 million worth of food to feed starving refugees.
The U.S. BOP would reflect a debit in the unilateral transfer account for the amount of $500
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CLOSING CASE
Recent U.S. BOP Performance: Is the Sky Falling?
The closing case provides two divergent views as to how the U.S. BOP should be interpreted.
One perspective looks at the last decade’s BOP favorably, while the other perspective does not.
Key Points:
• Over the last decade, the U.S. BOP has reflected a large annual deficit in the current
account, a large annual surplus in the capital account, and relatively small changes
in the official reserves account.
• This BOP can be interpreted in two ways. First, that U.S. firms are uncompetitive in
• Both views are consistent with the data.
• Those who favor the first argument believe that the United States must reduce its
BOP deficit by following policies to make U.S. firms more competitive in foreign
markets and by following policies to keep imported goods out.
• People who believe the second argument is true feel that the country should strive to
do anything possible to become more attractive to foreign investors.
• It is important for companies to understand BOP statistics because they are the key
to the type of international trade policy the United States will pursue.
Case Questions
1. What is more important to the U.S. economy – exports or foreign capital inflows?
The answer to this question depends on whether one takes the view that the last
decade’s BOP indicates that the United States is becoming uncompetitive in foreign
markets, or the view that the BOP indicates that the United States is in a good
2. What is the connection between the U.S. current account deficit and capital account
surplus?
3. Which of the following groups is likely to endorse the “sky is falling” view of the U.S.
BOP?
• Import-threatened firms such as textile producers
• Textile workers
• A cash-starved California biotechnology company
• Merrill Lynch
• Boeing Aircraft, one of the country’s largest exporters
• Consumers
Import-threatened firms such as textile producers, and textile workers are likely to
endorse the “sky is falling” perspective of the United States. A cash-starved biotech
firm is likely to view foreign investment favorably, as is Merrill Lynch. Consumers
Additional Case Application
Instructors may wish to raise the issue of whether the BOP should be considered
an accurate measure of economic performance for the United States or other
service-oriented economies. The class can be divided into two groups. One