EAE 308 International Economics II 2011 31.5.2012 PDF
EAE 308 International Economics II 2011 31.5.2012 PDF
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Copyright © Kenyatta University, 2012
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KENYATTA UNIVERSITY PRESS
MODULE
2
EAE308: INTERNATIONAL ECONOMICS II MODULE
TABLE OF CONTENTS
Introduction to the course 4
Lesson one 5
1.0 Evolution of Money 5
Lesson Two 14
2.0 Markets for Curencies 14
Lesson Three 23
3.0 The Foreign Exchange Market 23
Lesson Four 37
4.0 The Link Between Foreign Exchange Markets and Financial Markets 37
Lesson Five 48
5.0 The Demand for and Supply of Foreign Exchange 48
Lesson Six 75
6.0 Balance of Payments 75
Lesson Seven 88
7.0 National Income Equilibrium in an Open Economy 88
Lesson Eight 112
8.0 The Money Market and National Income Analysis 112
Lesson Nine 132
9.0 The Balance of Payments Policy Instruments 132
Lesson Ten 143
10.0 The International Monetary System 143
Lesson Eleven 155
11.0 The Bretton Woods Institutions 155
Lesson Twelve 169
12.0 Regional Economic Integration 169
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Bibliography 179
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B. Objective of the course
The objective of the course is to expose students to the economic concepts and
theories of international finance and how a country’s bilateral and multilateral
relations with other countries affect international financial transactions. The course
will also equip students with tools of economic analysis to handle issues and
problems related to international finance and regional integration.
LESSON ONE
In this lesson we are going to look at the historic background of money, what constitutes
money, and its use in international trade. We shall also look at nominal and real prices.
Objectives
5
1.2 Money and Its Use in International Trade.
When specialization takes root as a mode of production in society, the logical sequel
is to barter and trade the surplus of the specialized output with other products made
by other people who have also specialized in their arts and trades.
In an unsophisticated society with least exposure to outside influences, the barter
system of trade is adequate to meet the exchange needs of society’s members.
However, the barter system of exchange has limitations in the absence of what
Stanley W. Jevons called a “double coincidence” of wants (Jevons, 1892).
With the absence of a “double coincidence” of wants, each person must make a
multiplicity of exchanges before acquiring the required goods and services.
The problem encountered by lack of “double coincidence” of wants can be overcome
when, through practice and custom, certain items of trade are accepted by the
majority of participants in trade as intermediate items or medium of exchange.
When this happens, these intermediate items or medium of exchange are called
commodity money.
In Kenya, cattle, camels, sheep and goats have played the role of commodity money
from time immemorial to date.
Each country in the world has at one time of its history used commodity money in its
trade transactions (Einzig, 1966).
6
However, for over 4000 years, the dominant intermediate item that has served as
commodity money is a group of precious metals, mostly silver, gold and, to a lesser
extent, copper. (Gary Smith, 1991)
7
Coins made of precious metals and paper money that is fully backed by metal, are
called “hard money.”
On the other hand, “soft money” usually refers to token coins and paper money that
are not backed by precious metal e.g. Kenya’s currency in circulation.
One big advantage of soft money is that, by Gresham’s law, there is little or no
incentive to hoard it and is kept in circulation to fulfill its other two functions as a
medium of exchange and as a unit of account.
8
Later, students of economics discovered that an increase in the rate of
circulation of money had the same effect on price as an increase in the
volume of money.
More recently, scholars have stressed that the course of prices is also influenced
by the rate at which people use their free balances for present (current)
consumption as opposed to investment (development) expenditure.
Sixteenth century contemporaries realized that price level rises (inflation)
favored debtors and penalised creditors.
It was clear to all that debtors had to produce less goods than before to
meet their money obligations
Debtors therefore got more money per unit of what they produced
Creditors were being repaid in terms of money, which bought only a
fraction of the goods it could have bought previously.
For manufacturers, they kept wages low despite the high prices of goods
As a result their revenues were very high, causing profit inflation.
On the demand side of specie, it was during the mercantilists period (1500-1750), that
the demand for precious metals (specie) reached feverish peak.
During this period, accumulation of specie became an obsessions of merchants
who were eager to become wealthy and powerful.
For those countries, which did not posses mines of precious metals, or colonies
with mines of precious metals, the easiest option available to their merchants to
accumulate specie was through foreign trade of goods and services.
During the mercantilist era, the general belief was that specie (money in form of gold
and silver) was a source of wealth and power.
The pursuit of specie-accumulation was considered both an individual merchant’s
goal and a national duty.
Thus, during this period, national policy was geared towards encouraging specie
inflow (through promotion of exports), while specie outflow was discouraged by
restricting imports.
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For hundreds of years merchants from all countries pursued this specie-accumulation
policy despite the fact that one country’s exports are by definition another country’s
imports.
It was left to David Hume, Adam Smith and David Ricardo to come up with
theories and sound economic arguments to justify free trade.
In 1752, David Hume came up with his specie-flow mechanism argument that
questioned the rationale behind mercantilists’ obsession with specie accumulation and
restrictions of specie outflow.
Hume’s specie-flow mechanisms demonstrated that the automatic adjustment
mechanism would come into play once one country accumulated too much specie at
the expense of others.
He argued that the success of one country in accumulating a lot of specie would be
short-lived because the bulged money stock in that country would raise the prices of
domestic products, making them unattractive to foreigners.
On the home front, the high prices of domestic products would trigger an increase in
the demand for cheaper import substitutes.
In the long run the outflow of specie, triggered by cheaper imports, would lead to the
elimination of accumulated specie surpluses in the home country.
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1.5.2 What does money consist of or what constitutes money?
Money comes in various forms, viz:
i. As metallic coins and paper currency notes
ii. As bank money (current and time deposits) used to effect payment for trade
transactions.
iii. As travelers cheques
iv. As plastic money: debit and credit cards (such as ATMs, visa and master
cards) for electronic use
v. As financial assets (paper claims which include long term bank deposits,
bonds/securities, equities/shares/stocks etc)
vi. As units of Special Drawing Rights (SDR) – an international paper asset
created by the International Monetary Fund (IMF) to be used by member
countries to purchase foreign currency (more on this later in section 8.1).
In economics, it is the first four forms of money (coins and paper money, bank
money, traveler’s cheques and plastic money), which are known as currency because
they are used directly as means of payment for goods and services in daily exchange
transactions.
Non-currency assets like stocks/shares, bonds, certificates of deposits, saving
deposits, gold and diamonds also represent purchasing power to their owners, but
they cannot be used directly as a means of payment in day-to-day exchange
transactions.
Why do some assets serve as money while others do not?
An asset serves as money if it is generally accepted in exchange transactions and can
be used to acquire other assets.
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Before we start discussing prices of goods and services in different currencies, we
should understand the relationship between relative (real) prices and money
(nominal) prices in one country, say Kenya.
Money prices represent the number of units of domestic currency (Kenya shillings)
that must be foregone in order to acquire one unit of a good or a service.
It is therefore important that money prices reflect relative prices or the opportunity
cost, so that firms which produce or individuals who buy goods and services can
make rational decisions based on information at their disposal, regarding
comparative advantage or economic efficiency.
Suppose the money price of a 2 kg packet of Unga’s wheat flour, EXE (call it good
X) costs Ksh. 100/=, and a 2 kg packet of Unga’s maize flour, Jogoo (call it good Y)
costs Ksh. 50/=.
Then the ratio of the money prices of the two Unga products (EXE and Jogoo)
represents the opportunity cost or relative price of the respective goods.
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Adam Smith, in his Wealth of Nations (1776), observed that the instinct to barter and
exchange is inherent in man and is driven by man’s desire for self-improvement.
Therefore so long as man continues to exist there will be exchange, including
exchange across national borders.
Since a substantial proportion of exchange involves cross-border trade, and since
almost each of the 194 countries of the world, recognized by the United Nations, has
got its own currency, it is necessary to study the mechanisms of currency markets
and their role in facilitating cross-border trade.
ACTIVITY
SUMMARY
Yarbrough, B.V. and Yarbrough, R.M. (1988), The World Economy: Trade and
Finance; The Dryden Press, Chicago.
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LESSON TWO
In this lesson we are going to look at how the exchange rate between two different currencies
are determined; the Law of One Price (LOP) and how the purchasing power parity (PPP)
concept provided the basis for the oldest theory of exchange rates.
Objectives
15
The goods and services involved in the transactions cross borders.
The transactions normally involve the use of more than one currency.
Except in cases where a country’s economic problems are so deep that residents
have no confidence in the domestic currency,(like was the case in Uganda in the late
1970s during the last years of Idi Amin’s rule), in which case foreign currency is
used for domestic transactions, earnings from foreign trade transactions should be
converted into local currency for use domestically.
80,000/= with a Dell computer, imported from the US at a price of US$ 1,000?
It is necessary to know the exchange rate between the American dollar (US$) and
We define the exchange rate e as the number of Kenyan shillings required to buy
one unit of a foreign currency – in this case, one US$ i.e. the price of one currency
e = 80/1
(Note: e is not the irrational number which is equal to 2.7182818284…)
It is also possible, in the case of an American tourist visiting Kenya, to define the
exchange rate as the number of units of a foreign currency required to buy one
unit of a local currency (Ksh), viz:
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e` = US$/Ksh. = 1/e = 1/80.
In this second definition, the exchange rate is the reciprocal or the inverse of the
first definition.
The first definition of e is referred to as the “Kenya terms”, while the second
Since both of these definitions are used by different authors, to avoid confusion,
students must form a habit of first establishing which definition is in use when
reading about exchange rates.
If the American dollar exchanges for Ksh 80, and if as in our example above, a
locally assembled Mecer computer costs Ksh. 80,000/=, then Kenyans will be
indifferent between buying a Mecer computer and an imported Dell computer
(ignoring differences in quality and Kenyans’ taste for foreign goods).
This is because for a Kenyan resident to obtain US$1,000 to buy an imported Dell
computer, he will have to forego Ksh 80,000/= (ignoring transaction and other
costs) in order to buy the Dell computer.
If e is greater than Ksh.80, Kenyans residents will have the incentive to buy the
locally assembled Mecer computer.
However, if e is less than Ksh 80 Kenyan residents will have the incentive to
import the Dell computer, ceteris paribus.
If we assume that the decisions concerning purchase of domestic and foreign
products are made on the basis of comparative advantage or efficiency, then:
When e is greater than Ksh 80/=, there will be an incentive to buy locally
made goods because the dollars required to buy imported substitutes will be
too expensive in “Kenya terms”
If Kenyan residents are still eager to buy imported goods, the competition to
buy the dollars will result in a future rise in the price or exchange rate of the
dollar.
17
Any change in the exchange rate e, between the Ksh. and the US $ changes
all foreign prices relative to the domestic prices.
If exchange rates of various currencies never changed (like conversion of miles into
kilometers: 5miles = 8kilometers vice versa) there would be no need to study the
effects of using different currencies in international trade.
However, because currency exchange rates keep changing (today, it is Ksh 72 per
US$, tomorrow it is different), we need a theory to explain them.
These factors: domestic prices, foreign prices and exchange rates are linked through
what is called the law of one price.
By linking domestic price, foreign prices and exchange rates, the law of one price
(LOP) requires that the domestic price of a foreign item should equal the domestic
price of a comparable domestic substitute i.e.
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where:
The Kenya price of the foreign item = (1+0.10) epf …………………. (2.2)
Assuming that the imported Dell and locally assembled Mecer computers are
homogeneous (very similar), the logic behind the law of one price implies that the
Kenyan price of the Mecer computer cannot exceed this price, because if it does,
Kenyan residents will prefer Dell computers i.e.
19
Assuming again that the Dell and Mecer computers are homogeneous, the logic of the
law of one price implies that the foreign price of the Mecer computer cannot be
greater than the foreign price of the Dell computer.
It should be pointed out that, in international trade, many goods and services are
said to be non-traded goods because import and export transport costs are
prohibitively expensive for them to be traded.
A good example is sand in the Arabian peninsular which is very cheap, but
transporting that sand to Kenya as an export is infeasible due to the high
transportation costs.
However, the law of one price is very relevant to trade transactions involving raw
materials and financial assets, such as treasury bills and bonds.
Many raw materials and financial assets are good substitute for one another.
It is because internationally traded financial assets are good substitutes which are
traded inexpensively (electronically) that has led to the development of huge
transfers of traded financial assets on the international money markets.
Finally, it should be noted that the bulk of international trade transactions are not
in export and import of goods, but in financial assets transactions by banks,
insurance companies and pension funds, with managers of banks, insurance
companies and pension funds trading currencies on behalf of their clients.
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e = pd /pf ……………………………………………. (2.6)
where now:
cent increase in USA’s price level implies a 13 per cent depreciation of the Ksh
relative to the US$.
This means that Kenya residents will need 13 per cent more Ksh in order to buy
the same limitations of inflation rate, transport and other transaction costs as the
law of one price concept is.
Thus, equations 2.1 (pd = epf) and 2.4 (pf < or = 1+0.8 x 1/e x pd) help us
to remember the relationship between domestic prices, foreign prices and exchange
rates.
21
According to equation 2.1, an increase in e implies a depreciation of the Ksh. such
that the Kenya shilling price of imports rise, (and the foreign prices of Kenyan
goods fall).
This makes Kenyan goods attractive (and foreign goods expensive) to Kenya
residents.
The concept of purchasing power parity is an important and recurrent concept in
equilibrium.
The theory argues that the exchange rate between two currencies should, in the long
run, move towards the rate that equalizes the prices of identical bundle of traded
goods and services in two trading countries.
Since in the real world, the frictionless price does not exist, it is the relative version
of the PPP theory that states that the change in the exchange rate is proportional to
the change in the ratio of the two countries’ price levels, that is more relevant.
That is to say, so long as there are no changes in transport costs, no barriers to trade
and no structural changes in the two economies, a change in exchange rates should
be proportional to a change in the ratio of the two countries’ general level of prices.
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ACTIVITY
SUMMARY
FURTHER READINGS
1. Smith, G. (1991), Money, Banking and financial Intermediation; D.C Heath and
Company, Massachusetts.
2. Hallwood, C.P. and MacDonald, R. (1994), International Money and Finance;
Blackwell Publishers, Oxford.
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LECTURE THREE
3.0: THE FOREIGN EXCHANGE MARKET FOR CURRENCIES
3.1 Introduction
In this lesson we are going to look at the functions of the foreign currency and futures
(commodities) foreign exchange markets.
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Objectives
By the end of this lesson, you should be able to know the participants in,
And the three main functions of, the foreign exchange market: Clearing;
hedging; and speculation. We should also have learnt about the
operations of the futures foreign exchange market
Unlike trading in commodities (like the Mombasa tea and coffee auctions in Kenya
and the Chicago Commodities Exchange in the USA) or trading in shares/equities
(like the Nairobi Stock Exchange in Kenya and the New York Stock Exchange in the
USA), the foreign exchange market is not a single physical location in which
traders/brokers meet face to face.
The foreign exchange market (FEM), is a worldwide network of markets and
institutions that deal in buying and selling foreign currencies.
Because there are over 180 different currencies, there are literally thousands of
exchange rates, since each currency has a relative price in terms of every other
currency.
Traders in the FEM are scattered throughout the world in different FEM centers (like
New York, London, Paris, Frankfurt, Zurich, Singapore, Hong Kong, Tokyo etc).
They are connected with one another electronically by telephone cables (e.g. the
proposed East African Submarine Cable System -EASSy), and computer terminals to
form a single FEM.
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Among the traders in the FEM are individuals, banks and foreign exchange
brokers who participate in the FEM as:
Importers who need foreign currency to pay for imports of goods and services,
Exporters who want to convert the foreign currency they have earned from
their exported products into the domestic currency,
Investors who desire to acquire short term investments abroad,
Hedgers who do business internationally and want to protect themselves
against the uncertainty of changes in exchange rates and unforeseen
fluctuations in the prices of foreign goods and services,
Speculators who take the deliberate risky positions through trading in
currencies in order to benefit from the existence of different exchange rates
for the same currency in the different FEMs.
Money launderers who would like to sanitise the money they acquire through
illegal economic activities, like drug trafficking.
Although in theory all the over 180 world currencies are supposed to be traded in the
FEMs, in practice, the currencies of small economies are rarely traded.
Currently(2007), there are about 40 most traded currencies which are
listed on large FEMs like the Wall Street in the New York and the London Exchange
in Britain.
The Central Bank of Kenya (CBK) currently trades in 18 foreign
currencies whose exchange rates it posts to its clients daily on working days.
These are the US dollar, sterling pound, Euro, South African rand, Uganda
shilling, Tanzanian shilling, United Arab Emirates dirham, Canadian dollar,
Swiss franc, Japanese yen, Swedish kroner, Danish kroner, Norwegian kroner,
Indian rupee, Hong Kong dollars, Singapore dollar, Sandi riyal and Australian
dollar.
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Similarly, commercial banks, foreign exchange bureaus and other financial
institutions use the CBK’s daily posted rate as a benchmark to determine their own
daily exchange rates of the currencies they regularly trade in.
Most of the FEM transactions involve exchange of bank deposits denominated in
different currencies.
Just as the domestic money supply of each country is dominated by demand deposits,
rather than cash, the FEM is also dominated by demand deposits denominated in
various foreign currencies.
However, there are separate and much smaller markets for the exchange of actual
cash or bank notes to facilitate daily small transactions such as tourism, education,
medical expenses, and incidental purchases by residents traveling abroad.
Foreign exchange in cash-form is more expensive to buy because of the transaction
and security risk cost of handling cash.
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and when residents want to remit part of their incomes and send gifts and
donations abroad.
All these demands for foreign currencies are effected by exchanging the domestic
currency (Ksh) for the required foreign exchange through a foreign exchange dealer.
On the other hand the home country’s supply of foreign currency results from:
expenditures of foreign tourists visiting the country;
export earnings;
foreign investments in the country;
remittances by Kenyans in Diaspora, gifts and donations from abroad.
One may add another source of supply (which is illegal, but occasionally exists
in a big way in Kenya and some countries) that is, money laundering.
A country’s commercial banks act as clearing houses for the foreign exchange
demanded and supplied in the course of foreign transactions by the country’s
residents with the rest of the world.
When some commercial banks find themselves with excess foreign currencies
resulting from the transactions they handled, they sell the excess foreign currencies
(through inter bank wholesaling or through the intermediary of foreign exchange
brokers) to other commercial banks with foreign currency shortages.
If, in the course of its foreign transactions, the country’s total demand for foreign
currency exceeds its total foreign exchange supply, the exchange rates at which the
foreign currencies are traded with local ones have to change so that there is an
equilibrium between total demanded and total supplied.
As we shall see later, such adjustment in the exchange rates is automatic if the
country is operating a flexible or a floating exchange rate regime.
However, if the country is operating a fixed exchange rate regime, the country’s
commercial banks must borrow from the central bank, which acts as a ‘lender of last
resort ’ by drawing on its foreign exchange reserves.
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On the other hand, if in the course of foreign transactions the country’s foreign
exchange earnings exceed its demand, and the country is operating a fixed exchange
regime, the excess foreign currency must be sold to the central bank in exchange for
local currency.
In the process, the country’s foreign exchange reserve will increase.
The second function of foreign exchange markets is the credit function.
Businesses usually need credit facilities when their goods are in transit and to allow
them time to sell their imports before payment.
It is common for exporters to give the importer a 90-day grace period before
payment.
However, the exporter usually uses the letter of credit with his bank to discount the
importer’s obligation to pay after 90 days, and gets paid right away.
After 90 days, the bank receives full payment from the importer.
The third function of foreign exchange markets is to provide facilities for the hedging
and speculation functions of the FEM.
Today, these two functions (hedging and speculation) account for the largest part of
foreign exchange trading in the foreign exchange markets.
According to the Economist Magazine of November 25th 2006, the London FEM is
now the world leader in the trading of foreign exchange and over the-the-counter(off-
exchange) derivatives.
3.3 Participants in the Foreign Exchange Market
There are four categories of participants in the foreign exchange market, viz:
The first level participants are the immediate users of foreign currency
such as tourists, importers, exporters and investors.
The second level participants are commercial bank which act as clearing
houses between users and earners of foreign exchange.
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The third level participants are the foreign exchange brokers who facilitate
buying and selling of foreign currencies between commercial banks ( the
inter-bank or wholesale market).
The fourth and the highest level of participant is the country’s central bank
which acts as the seller or buyer of last resort when the country’s total
foreign exchange earnings and expenditures are in deficit or surplus
respectively.
In the case of the fourth category above, the central bank either draws on its foreign
exchange reserves or adds to them.
We can now turn to the constituent parts of the foreign exchange market, namely, the
spot, the forward and the futures markets for foreign exchange.
3.4 The Spot Market for Foreign Exchange
The largest market for foreign exchange is the spot market where currencies of
different countries are traded for immediate delivery, usually within two
working days.
The three main functions of the spot market are:
i. Clearing
ii. Hedging
iii. Speculation
The clearing and hedging functions are related to foreign trade transactions while the
speculating functions involves trade in currencies as an end in itself.
One of the main reasons for transacting business in the spot market for foreign
exchange is the clearing function.
When individuals and firms make orders for goods and services from abroad that
must be paid for before delivery , they enter the spot market where, with their local
currency, they buy the foreign currency required for the transaction.
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Once the necessary currency has been purchased, it must be telegraphically or
electronically remitted abroad within two business working days.
This transaction of remitting currency abroad in the spot exchange market is known
as the clearing function of the foreign exchange market.
The two business working days during which the transaction is cleared provides
commercial banks with opportunities to indulge in arbitrage.
Arbitrage in foreign exchange is a process where banks seek to make a profit by
taking advantage of differences in prices of currencies prevailing simultaneously
in different markets (countries).
The arbitrageur (usually a foreign exchange dealer of a commercial bank) buys a
currency in a monetary center ( say the New York FEM) where it is cheaper.
He then resells it immediately (in a matter of minutes) in another monetary center
(say the London FEM) where it is more expensive, in order to make profit.
For example if the dollar price of British sterling pounds in the New York FEM is
eNY = US dollar per sterling pound = US $ 1.79 and the foreign exchange rate in the
London FEM is eL = US Dollar per sterling pound = US$ 1.81, the arbitrageur will
buy the cheaper pounds in New York at US$ 1.79 and immediately resell them in
London for US$=1.81, and make a profit of US$ 0.02 per sterling pound.
The whole exercise is conducted by telephone and , or electronic transfer in a matter
of minutes.
If the transaction involves one million British pounds, the profit will be US$ 20,000,
minus the transaction costs (cost of telephone calls and or electronic transfer charges
etc.) which are very small.
Commercial bank arbitrageurs have access to billions of clients’ funds paid through
the banking system, which they use in this function.
As hundreds of arbitrage activities take place during the course of the day, where
currencies are transferred from the cheaper monetary center (New York FEM) to the
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expensive monetary center ( London FEM), the exchange rate between the two
currencies being traded tends to be equalized in the two monetary centers.
This is because the increased demand for British sterling pounds in the cheaper
monetary center (New York) exerts an upwards pressure on the dollar price of pounds.
On the other hand, the transfer of funds from New York to London (the expensive
monetary center) to take advantage of the expensive sterling pound, exerts
downward pressure on the dollar price of sterling pounds in London.
Arbitrage activities continue until the dollar price of sterling pound in the New York
and London foreign exchange markets (eNY and eL) are equalized.
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At the end of the 100 days, he enters the spot foreign exchange market to buy
the US$ 100,000 at the existing spot exchange rate
If the Kenyan importer chooses the first option, he is hedging.
That is, he is protecting himself from the risk associated with changes in the
exchange rate of the dollar during the 100-days waiting period.
He is therefore said to be holding a balanced or closed position in dollars.
Hedgers are said to be risk averse.
On the other hand, if he chooses the second option above, the exchange rate may rise
requiring him to pay more shillings to buy the required US$ 100,000.
During the 100 days period of waiting under the second option, the Kenyan importer is
said to be holding a short position in dollars.
This means he is short of (or has not yet bought) dollars required for the transaction at
the end of the 100-days waiting period.
The other way of putting it is that the importer is taking an uncovered or open
position.
If at the beginning of the transaction the Kenyan importer had suspected or believed
that the dollar would be cheaper in terms of Kenya Shillings at the end of the 100-
days waiting period, he might choose to speculate rather than to hedge.
3.4.3 Speculating in the Foreign Exchange Market
The third reason for making transactions on the spot FEM is speculation.
Speculation is the taking of a deliberate risky position to an uncertain future by:
Purchasing foreign currency now (taking a long position) in the hope
that the price of the currency you have bought will rise in future and thus
allow you to sell it at a profit.
Waiting to purchase foreign currency you will need in future ( taking a short
position) in the hope that the price of the currency you are keen to acquire later
will fall so that you buy more of it with the same amount of local currency at
33
your disposal, or in the hope that you will pay less local currency for the same
amount of foreign currency you require in future.
For a speculator, changes in the price of foreign currency affect his income.
If the changes in the price of foreign currency are in consonance with his
expectations, he makes a profit.
If the changes are a negation of his expectations, he makes losses on investments in
speculative bids.
A speculator is known as a risk-taker.
A 1986 survey by the USA Federal Reserve Board ( USA’s central bank) established
that total currency traded daily worldwide exceeded US$ 200 billion.
This was 25 times the daily volume of exports of goods and services worldwide.
According to Heath (2007) the average daily market turnover in the foreign exchange
market has since grown to US$ 3.2 trillion ( 1 trillion = 1000 billion) worth of
currencies in 2007.
The world largest foreign currency trading centers are London,
New York, Tokyo, Frankfurt, Singapore and Hong Kong (Smith, 1991,p72).
**For a more detailed discussion of this Section see, Appleyard and Field, 1992, p500)
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The percentage difference between the 30, 60, 90 or 180 days forward rate on a
currency and the spot rate is known as the forward premium, if positive, or the
forward discount, if negative.
Thus, if today’s spot rate for the dollar is Ksh.72.15 and the today’s forward rate for
delivery in 90 days is Ksh 83.00, the forward premium is 15 per cent .
Similarly, if today’s spot rate is Ksh 72.15 and the forward rate for delivery in 90
days is Ksh 61.327, then the forward discount is 15 per cent (Ksh83.00 - 72.15 /
72.15 x100 = 15%).
As already pointed out, every international commercial transaction which does not
occur instantaneously, is a potential foreign exchange risk for one of the parties.
The existence of a forward market in foreign exchange allows these risks to be
transferred.
In the process, the forward market in foreign exchange provides an additional
opportunity for currency speculation.
For instance, if a Kenyan importer orders US$ 100,000 worth of Dell computers
from the USA and payment is to be effected in 100 days time, the three options the
importer has at his disposal, if he suspects that the dollar price in Ksh may rise in the
100-days waiting period, are:
a) He could decide to hold a balanced (or closed) position by buying dollars now at
the current spot exchange rate; or
b) He could avoid the risk of an unfavorable change in the exchange rate by
buying dollars in the 90 day forward market for foreign exchange; or
c) He could hold a short position by waiting until when the 100 days are
approaching and then buy dollars in the FEM at the then spot market rate.
The option the importer will choose will depend on:
The current spot exchange rate
The forward exchange rate
35
The short-term interest rates available on assets denominated in Kenya
shillings (say the CBK’s T-Bill rate) and dollars (say USA T-Bills rate).
The spot rate that the importer expects to prevail in 90 days time (the
future spot rate)
The importers disposition towards risk-taking - that is to say whether the
importer is a risk-taker or is risk averse.
If the importer chooses the first option (a) above - that is, he buys dollars in the spot
market, the attractiveness of this option will be determined by the current spot rate
and the interest rate he can earn on dollar-denominated assets that he can invest in
USA for 90 days.
If he chooses the second option (b)- that is, buy dollars in the forward market, the
attractiveness of this option will depend on forward exchange rate and the interest
rate on Kenya shilling-denominated assets.
Finally, if he chooses the third option (c )- that is, he takes a short positions and waits
to buy dollars on the spot markets at the expiry of the 100-days contract period, the
attractiveness of the option will depend on the interest rate on Kenya shilling –
denominated assets and the future spot rate that the importer expects at the end of
the contract period.
The last option is a risky or speculative strategy based on the importer’s
expectations of the future spot rate and his capacity to take risks.
36
This commodities market provides an opportunity for foreign exchange brokers to
make money by negotiating contracts in foreign currency.
The opportunities available to trade in foreign currency are:
a) Buying or selling major currencies only in the foreign currency futures
market (a futures contract).
b) Buying an option on the futures market (a foreign currency option).
37
By contrast forward contracts can be made for specified time intervals
(usually 30, 60,90 and 180 days) from any trading day.
Although the futures market is more expensive to its customers, it not only provides
competition to the forward market, but it is also more centralized and standardized and
caters for the needs of smaller customers than the forward market.
**(For a detailed treatment of the subject, see Fieleke, 1985).
How are the concepts of the law of one price (LOP) and purchasing
power parity (PPP) used as the basis of the oldest theory of foreign
exchange equilibrium? Do the assignment in your groups. Note
that the assignment relates to Lesson Two.
SUMMARY
In this lesson we have learnt about the functions of the currency
and futures foreign exchange markets; how the two markets
facilitate trade in goods and financial services, immediately and
over time.
FURTHER READINGS
39
LESSON FOUR
4.0 THE LINK BETWEEN FOREIGN EXCHANGE MARKETS
AND FINANCIAL MARKETS
4.1 Introduction
In this lesson we are going to look at the link between foreign exchange markets and
financial markets. We shall learn about covered and uncovered interest arbitrage, and how the
activities of arbitrageurs bring markets in different trading centres into equilibrium.
Objectives
By the end of this lesson, you should be able to know the concepts of
covered and uncovered arbitrage; the link between the foreign
exchange market and the financial market; and how the activities
of arbitrageurs bring the two markets into equilibrium;
40
Although we have discussed the spot, forward and futures foreign exchange
markets individually, in practice exchange rates in the three markets are determined
simultaneously in conjunction with interest rates.
We observed in section 3.0 that among the participants in the foreign exchange market
are the investors who want to acquire short-term investments abroad.
The demand for foreign exchange for purposes of investing in short-term assets,
denominated in foreign currency, will depend not only on the interest rates in the two
countries but also on the exchange rate that the investor expects at the end of the
investment period.
Two factors will influence the decisions of the investors in short term assets
denominated in foreign currency, namely:
The rate of interest earned on the short-term assets
The additional income earned due to the appreciation of the foreign currency
over the investment period.
The risks associated with the change in exchange rate can be hedged in the forward
market, if the investor is risk averse and does not wish to stay uncovered.
The covered investment position will then include interest earned on the foreign
investment plus the cost of hedging in the forward market.
If the financial markets are working normally, that is if they are in equilibrium, the risk
averse short-term investor should be indifferent between the domestic and the foreign
investment.
Similarly, in equilibrium the risk-averse importer should be indifferent between
hedging using the short-term foreign investment and by using the forward market.
Thus, the link between the spot, forward, and money markets that generates the equality
conditions is achieved through covered interest arbitrage.
41
There are two types of interest arbitrage activities.
These are:
Uncovered interest arbitrage
Covered interest arbitrage
Both of them seek to take advantage of differences in short-term interest rates on
similar assets denominated in foreign currencies at a particular point in time.
One type of interest arbitrage activity is speculative, in that the investor does not use
the forward exchange market to hedge against foreign exchange risk.
This type of arbitrage is known as uncovered interest arbitrage.
That is, the investor is not “covered” against the risk of spot rate fluctuations.
The second type of arbitrage activity utilizes the forward market of foreign exchange to
hedge against the risk involved in the transactions.
This type of arbitrage is called covered interest arbitrage.
That is, the investor is covered against the risk of possible spot rate fluctuation.
a) The spot rate between the Kenya Shilling and the dollar is e = Ksh / $ = Ksh80;
b) The 90-days interest rate on CBK Treasury bill rates is 1.8 per cent.
c) The 90-days interest rate on US Treasury Bills is 2 per cent;
What would be the Kenyan investor’s options?
One, he could invest his Ksh 1.6million in CBK Treasury Bills at 1.8 per cent interest
rate and get a return of Ksh 28800/= at the end of the 90-days maturity period.
Two, he could buy US dollars at Ksh 80/= per dollar and get US$ 20,000.
42
Then, through electronic transfer, he could invest in 90-day US Treasury Bills at 2%
and get a return of US$ 400 at the expiry of the 90 day period.
Finally, he would convert the $400 back into Kenya shillings.
If the investor chose the second option, his return on the investment in
terms of Kenya shillings will depend on the spot exchange rate at the maturity of the
investment.
If the spot rate did not change, (e = Ksh/$ = 80/=) over the 90 day period, he could get
43
where:
ee is the expected future spot rate at the expiry of the investment period
e is the current spot rate
Numerical example, if:
{(8.68% -1.8%) = 6.88%} < {(Ksh 83/$ -Ksh 72/$)/(Ksh 72/$) = 15.28%}, invest in
dollars
The term on the left hand side {iksh-i$} in equation 4.1 is the interest differential.
The term on the right-hand side {(ee-e)/e} is the expected increase (if positive) or
decrease (if negative) in the value of the foreign currency (dollars) against Kenya
shilling expressed in percentage terms.
In the numerical example above, the expected loss in the value (depreciation) of the
Kenyan shilling from Ksh 72/= per US$ to Ksh 83/= per US$ more than off-sets the
interest differential in favor of the Kenyan shilling denominated assets.
This makes the investor to opt to invest in dollars.
On the other hand, if:
In this case the interest differential {iKsh -i$} in favor of Ksh - denominated assets is
large enough to compensate for the expected loss in reconverting dollars into Ksh.
From the rules of Equations 4.1 and 4.2, there will be no incentive for the Kenyan
investor to switch investments from the Kenya shilling denominated assets to the
44
foreign currency denominated asset if the interest differential is equal to the expected
cost of the foreign exchange transactions, since the two will be in equilibrium.
This equilibrium condition is known as uncovered interest parity (UIP) viz:
Numerical example:
{( 8.4%-4.4%) = 4%} = {(Ksh 77/$-Ksh74/$)/(Ksh74/$) = 4%}
Uncovered interest parity (UIP) holds when the interest differential just equals the
foreign currency (US$), the foreign currency is said to be at a premium whenever the
forward rate is higher than the spot rate.
If the forward rate is less than the spot rate, the foreign currency is said to be at a
discount.
(ee-e)/e
UIP
iKsh i$ e ee
45
I
iKsh i$ e ee
II
45
0 iksh-i$
In figure 4.1, the equilibrium condition is satisfied along the uncovered interest parity
(UIP) line.
Below to the right of the line, the interest differential exceeds the expected change in
the values of dollars relative to Kenya shillings.
In such a situation, investment funds will flow into Kenya.
Above and to the left of the UIP line, the expected change in the value of dollars
relative to Kenya shillings exceeds the interest differential on Kenya Shillings.
In this case, funds flow out of Kenya to the USA.
The arrows in Fig. 4.1 showing changes in interest rates, and exchange rates represent
the effects of the adjustment through arbitrage in restoring uncovered interest parity.
The condition described in equation 4.1 holds at point I in figure 4.1 above.
In this case the interest rate on Kenya shilling-denominated assets exceed that on dollar
Ksh
denominated assets {(i -i$) >0}, but by less than the percentage by which the
e
dollar is expected to gain value {(e -e)/e}.
The Kenyan investor will therefore prefer to purchase and hold on to dollar
denominated assets leading to investment funds to flow out of Kenya to the USA.
This will lower interest rates in USA (the recipient of fund flows) and raise interest
rates in Kenya (the country subject to funds outflow).
46
It will also raise current spot rate of dollars in Kenya and lower expected future spot
rate of dollars for the Kenya investor.
These adjustments in interest rate and spot rate cause a movement from point I in Fig.
4.1 above to a point on the UIP line.
A similar explanation holds for interest arbitrage activities that cause a movement from
point II to a point on the UIP line.
For example, if {iKsh - i$} > {(ef - e)/e}, invest in Kenya shillings… (4.5)
47
Numerical example, if:
{(3% - 4%) = -1%} > {(Ksh 64/$-Ksh 84/$)/(Ksh 84/$) = -23.8%}, invest
in Kenya shillings
In summary, both the interest differential and the forward premium or discount on
foreign exchange must be taken into account in making investment decisions under
covered interest arbitrage.
When individuals and banks in an economy make their investment based on the
relationship in equations 4.4 and 4.5, the resulting equilibrium condition is known as
Covered Interest Parity (CIP).
This can be presented algebraically as:
(ef-e)/e
CIP
iKsh i$ e ef
48
iKsh-i$
II
iksh i$ e ef
45
0
Covered interest parity holds when the forward premium or discount on foreign
exchange just equals the interest rate differential.
In Fig. 4.2, area I to the left of the CIP line, the interest differential in favour of Ksh
denominated assets is less than the forward premium on dollars as in Equation 4.4.
In such a case, Kenyan investors move funds out of Kenya to USA.
The process lowers interest rates in USA (where inflows from abroad increase invest
able funds), but raise interest rates in Kenya (where funds have been depleted).
The process also raises the spot rate of dollars and lowers the forward price of dollars.
This causes a movement back to the CIP line.
In the area II to the right of the CIP, the interest differential in favor of Ksh
denominated assets exceeds the forward premium on dollars.
Investors respond by investing in Kenya to take advantage of the interest differential,
and exchange rates making interest rates to adjust back to the equilibrium CIP line.
49
ACTIVITY
SUMMARY
In this lesson we have learnt the concepts of covered and
uncovered arbitrage. We have also learnt how, in their
endeavours to make profit, the activities of arbitrageurs under
covered and uncovered conditions link the two markets and
bring them into equilibrium.
FURTHER READINGS
Yarbrough, B.V. and Yarbrough, R.M. (1988), The World Economy: Trade and
Finance; The Dryden Press, Chicago.
50
LESSON FIVE
5.0 THE DEMAND FOR AND SUPPLY OF FOREIGN EXCHANGE
5.1 Introduction
In this lesson we are going to look at why there is demand for foreign exchange and the
sources of supply to satisfy that demand. We shall also look at the four main foreign
exchange regimes that are operated by different countries in their cross border trade
transactions.
51
Objectives
We now turn to the question that needs to be asked and answered: “what determines
spot exchange rates?”
Under a liberalized economic regime, where market forces are left to operate with
minimal state intervention, the demand for and supply of foreign exchange determine
the price (exchange rate) of currencies just as is the case with other goods or services.
This means that the demand curve for foreign exchange shows how many units of a
foreign currency will be demanded in the spot market at various prices (exchange
rates). See Figure 5.1 below.
On the other hand, the supply curve of foreign exchange shows how many units of a
foreign currency can be supplied at various exchange rates. See Figure 5.2 below.
In order to introduce the mechanisms or operations of market forces in determining the
exchange rates, we shall introduce simple demand and supply models of foreign
exchange.
These demand and supply models are partial-equilibrium models, which are subject to
limitations.
One main limitation is that the models ignore many of the interconnections among
variables that influence the determinants of exchange rates.
52
To purchase foreign made goods and services to be paid for in foreign
currency.
To purchase securities or bonds denominated in foreign currency.
To invest directly in foreign countries either by buying shares in foreign
companies or by building production facilities in foreign countries.
To speculate in the foreign exchange market for purposes of making a profit.
Each of these four sources of demand involves a negative relationship between the
quantity of foreign currency demanded and the exchange rate.
A high exchange rate means that many units of domestic currency are required to buy
one unit of a foreign currency.
This implies that a local currency is weak.
A high exchange rate therefore makes foreign goods and services, bonds, shares or
machinery more expensive relative to their domestic substitutes.
Since foreign currency is demanded for purposes of purchasing foreign goods and
services, bonds, shares etc fewer units of foreign currency will be demanded when the
exchange rate is high.
Graphically, such scenario is represented by point 1 in figure 5.1 below:
Fig. 5.1 Effects of changes in Exchange Rate on Quantity Demanded
Exchange rate
Ksh/ $
e1 1
e2 2
D
Quantity of dollars
(Foreign Exchange)
53
0 D$1 D$2
At point 1, where the exchange rate is e1, dollars are expensive in terms of Kenya
Shillings.
That is why the quantity of dollars demanded is only D$1.
At point 2, with the exchange rate having dropped to e2 the Kenya shilling price of
dollars is low, resulting in the purchase of relatively large quantity of dollars D$2.
At point 2, Kenyan residents will be eager to buy foreign goods and invest in foreign
securities and shares.
Just like in other markets, the price of foreign exchange is only one of the several
determinants of quantity demanded of foreign exchange in the foreign exchange
market.
Other important determinants include:
a) Relative prices of domestic versus foreign made products
b) Relative interest rates
c) Relative profit rate or rate of return on investments
d) Incomes of participants in trade
e) Expectations of speculators about the future value of the exchange rate.
As individuals and firms decide on how to allocate their spending between domestic
and foreign made products, relative prices are an important consideration.
The higher the prices of foreign made products vis a vis domestic products (pf/pd) the
fewer the foreign products and therefore dollars demanded by Kenyan residents.
Relative interest rates help to determine the allocation of portfolio investment funds used to
purchase securities (treasury bills and bonds) between two trading countries.
When the ratio of foreign interest rate to those of Kenya rise, on assets with similar risks
$ Ksh
i.e. (i /i ), with exchange rates unchanged, investible funds will flow out of Kenya.
This will create in Kenya conditions for an increase in the demand for dollars.
As a result, the demand curve for dollars will shift to the right.
Conversely, a fall in the (i$/iKsh) ratio causes funds to flow from abroad into Kenya.
This increased supply of dollars lowers the demand for dollars in Kenya.
54
Relative rates of profit, i.e. ( foreign/Kenya), determine the allocation of direct
investment funds between two countries.
Direct investment in a country can take the form of buying shares in a company or
building new plants and other production facilities.
Because investors make investment decision using the profit-maximization criterion,
relative profit rates determine the geographical distribution of new investments.
Currently (2012), the most popular countries in attracting foreign direct investment
(FDI) are the Peoples’ Republic China and Vietnam (both of them, communist
countries), with very rapidly growing domestic markets.
A rise in the rate of profit (say in China) over that in Kenya, { china/ Kenya} increases
foreign direct investment in China by Kenyan firms.
Since these FDI by Kenyan firms must be financed in foreign currency, the demand for
dollars in Kenya (used to invest in China) increases.
This was the case in 2006 when Kenya Airways set up an office in Hong Kong, China
to promote tourists inflow from China.
A fall in the profits made in China relative to those in Kenya lowers the demand for
foreign currency in Kenya to invest in China.
In this case, the demand curve will shift to the left.
As incomes (Ys) within a country rise, residents tend to consume more foreign goods.
For example, a rise in Chinese incomes relative to those in Kenya (YChina/YKenya) raises
the demand for Kenyan exports to China (tourism, coffee, tea etc).
This causes demand for foreign currency (dollars) in China to rise.
A fall in china’s income relative to Kenya’s income has the opposite effect i.e. increases
demand for foreign currency in Kenya in order to buy the relatively cheaper Chinese
products.
Finally, expectations of speculators concerning the future value of the exchange rate,
e
(e ) affects the speculative demand for foreign currency.
If the future value of the foreign currency is expected to rise in the foreign exchange
market, an incentive is created to purchase that currency in the spot market.
It is then held until the expected price rise occurs and sold for a financial gain.
55
When potential speculators expect a rise in the exchange rate, the demand curve for
foreign currency shifts to the right.
The opposite happens if the speculators expect a fall in the exchange rate.
As the exchange rate (e = Ksh/$) rises, more units of foreign currency flow into the
country.
This means that the quantity demanded of Kenya’s exports, local securities, FDI in
Kenya, and local currency for speculative purposes by foreign residents rise.
56
The resultant increase in supply of foreign exchange will in turn lead to a fall in the
exchange rate, e.
Similarly, a rise in the interest rates in Kenya will make foreign residents relocate their
investible funds to Kenya to take advantage of the higher interest rates.
As a result, the demand for local currency by foreigners rises as they supply more
foreign currency to Kenya.
Thus, a rise in interest rates in Kenya will lead to increased inflow of foreign currency
to take advantage of the interest rate differential.
On the other hand, a rise in the profitability of investment in Kenya will lead to
relocation of foreign direct investment into Kenya.
This will lead to an increase in the supply of foreign currency to Kenya, which in turn
Figure 5.2: Effects of Exchange Rate on the Quantity supplied of Foreign Exchange
Exchange rate
(Ksh/$) S$
e1
1
e2 2
57
Quantity of foreign exchange
0 Q$2 Q$1 (dollars)
At point 1, with the exchange rate e1, the exchange rate is high.
This means that a non-resident with foreign currency can exchange and get more units
of Kenya shilling, while at point 2, with exchange rate e2, the same person will get
fewer units of Kenya shillings for the same amount of foreign currency.
In the same vein, ceteris paribus, Kenyan goods and services become cheaper to the
58
Today (2012), most governments have abandoned currency controls and fixed exchange
rates in favour of flexible or floating exchange rates operating under free market forces.
However, some countries, like South Africa, still control foreign exchange outflow
from their countries.
Although the IMF had for a long time been advocating for global currency decontrol, it
was only when the then British Prime Minister, Margaret Thatcher, decided to free the
pound sterling from government controls in mid-1980s that the floodgates of currency
decontrol opened far and wide.
Kenya started in earnest the process of currency decontrol in 1992 when, under
pressure from the IMF and the World Bank, liberalization policies were introduced.
The process of liberalization in the financial sector was completed in 1996 when the
Foreign Exchange Control Act was finally repealed.
Thus, until 1970s, governments in each country determined the type of policy to follow
regarding exchange rates.
The basic policy adopted to determine exchange rates was referred to as the exchange
rate regime.
There were four main exchange rate regimes, viz:
a) Flexible or Floating Exchange rate regime
b) The Managed or Dirty Float Exchange Rate regime
c) The Foreign Exchange Controls Exchange Rate regime
In addition to these four, there were a number of mixed or intermediate exchange
regimes, which could not fit the description of the above basic four.
59
Under this regime, the market for foreign exchange works in the same way as the free market for any other
good or service.
Under this regime, the foreign exchange market is assumed to operate under perfect
competion conditions applicable to other goods and services in a free market, viz:
Millions of individuals and firms participate in the market for foreign
exchange, such that each one is too small to influence the market-
determined price.
Foreign exchange, in form of internationally traded convertible currencies,
is a homogeneous commodity i.e. all units of currencies being traded in
the foreign exchange market are identical.
Information is good and readily available to participants in the market for
foreign exchange.
Entry and exit into the foreign exchange market is unrestricted to all
participants.
Decision-making is guided by rationality.
Figure 5.3: Equilibrium in the foreign exchange Market Under a flexible Exchange
Rate Regime
Exchange rate S$
Ksh/$
B C
e1
A
e0
e2 D E
D$
60
0
Quantity of foreign exchange (dollars)
In figure 5.3 the equilibrium exchange rate is eo, where at point A demand for and
supply of foreign exchange are equated.
However, if market forces of demand and supply cause the exchange rate to rise from
On the other hand, if the market forces cause the exchange rate to fall from e0 to
In the same Figure 5.3, a change in the exchange rate from eo to e2 is a depreciation of
the dollar or equivalently an appreciation of the Kenya shilling.
That is to say one needs fewer Kenya shillings to buy a dollar and therefore, the Ksh
has gained in value or strengthened, while the dollar has lost value or weakened.
It should be noted that when referring to an appreciation or depreciation, it is always
necessary to specify the two currencies involved because a change in the exchange rate
always involves an appreciation of one currency and a depreciation of the other.
For simplicity purposes, we have dealt with only two currencies: the Kenya shillings
and the US dollar.
In reality, there are numerous exchange rates.
As recounted earlier, the Central Bank of Kenya (CBK) trades in eighteen foreign
currencies, whose exchange rates it posts daily on working days.
61
Thus in addition to the exchange rates between the Kenyan shilling and the US dollar,
there are 17 other currencies whose exchange rates with the Kenya shilling are given.
Once the exchange rate between the Kenya shilling, the dollar and any other currency is
given, then exchange rates between the other currencies (cross rates) can easily be
determined.
For example, if e = Ksh/US$ = 80 and Ksh/Euro = 90, then the exchange rate
62
iv. A flexible exchange rate also offers the advantage of low administrative costs
since the intervention activities required under a fixed exchange rate regime can
be quite costly in three ways:
a) Policy makers spend a lot of time in meetings to make decisions.
b) Administrative costs and policy implementation costs are avoided.
c) High cost of maintaining foreign exchange reserves that facilitate
intervention is avoided.
63
As economies grew and international transactions increased, paper money was
introduced as a substitute of specie.
Each unit of paper money stood for a unit of specie held by the issuer of paper notes.
This meant that paper money was convertible into specie on demand and vice versa.
This was the origin of the Gold Standard. (See Lesson 9)
Although at that time there were no specific international agreements about exchange
rates, the major trading economies (United Kingdom, Holland, Spain, Portugal, USA,
Germany, Italy etc) were operating under some form of gold standard until the
international gold standard was set up in 1880.
At that time, the basic rule that governed the International Gold Standard (IGS) was
that each government defined the value of a unit of its currency in terms of gold.
For example, in 1834 the official price of gold in the USA was adjusted from US$19.39
to US$ 20.67 per ounce of gold.
When the IGS was established in 1880, the USA retained the 1834 rate such that the
USA government committed itself to buy and sell gold at the 1834-fixed price.
The British, on the other hand, bought and sold gold at the fixed price of 4.34 sterling
pounds notes per ounce of gold.
If an ounce of gold could be freely traded for US$ 20.67 or 4.34 sterling pounds, then
US$ 20.67 had the same value as Britain’s 4.34 sterling pounds.
Thus one British Sterling Pound was worth US$20.67/4.34 = US$ 4.76.
Thus, US$ 4.76 was the fixed exchange rate at which the British pound was exchanged
for US dollar under the IGS.
In a similar way, exchange rates among all the other currencies issued by signatories of
the gold standard agreement of 1880 were determined.
The enforcement of these fixed exchange rates came from the option of converting one
currency into gold and then back into another currency.
However, the International Gold Standard collapsed due to the effects of two world
wars (1914-1917 and 1939-1945) and the Great World Depression of 1929-1933.
By 1936, every country, except the USA, had completely abandoned the gold standard.
In 1934 the USA had raised the gold price from US$ 20.67 to US$ 35 per ounce.
64
At the Bretton Woods Conference in 1944, a new-international monetary system was
agreed upon to replace the Gold Standard.
This agreement restored the fixed exchange rate under a new exchange rate regime
known as the Gold –Exchange Standard, or the Gold-Dollar Standard.
This meant that the key currency –the dollar- was to play the central role.
Non-dollar currencies were convertible at fixed rates into dollars, which in turn were
convertible into gold at US$ 35 per ounce of gold.
Much as the exchange rate of each currency was fixed, the Bretton Woods Agreement
allowed each rate to fluctuate in a band of one percent around the fixed or pegged rate.
That is why the new system’s other name was the adjustable-peg system.
Under the Bretton Woods Agreement, each central bank was allowed to fix its exchange
rate to the dollar, but adjustable by one per cent either way when need arose.
Under the fixed or pegged exchange rate regime, which operated in most countries
during the post World War II till 1973, the forces of demand for and supply of foreign
exchange were still in play, but were not allowed to determine the price (rate of
exchange) of a currency, as is the case under the flexible exchange rate regime.
Under the fixed exchange rate regime, the Central bank must stand ready to absorb any
excess demand for and supply of its currency in order to maintain the pegged rate.
To be able to do this, Central banks had to control the outflow of local currency and at
the same time try to ensure that all foreign currency inflows pass through its hands.
Figures 5.4 and 5.5 show how a fixed exchange regime operates.
5.4: Fixed Exchange Rate Between the Kenya shilling and the American Dollar,
above the Equilibrium rate.
Exchange rate S$
Ksh/$
e1B C
65
D$
0
$D $S Qty of foreign
Exchange (dollars)
Suppose the central bank of Kenya decided to fix or peg the exchange rate between the
Kenya shilling and the US dollar at e1.
At that point e1, the quantity of dollars supplied exceeds the quantity demanded by BC.
The artificially high exchange rate of the dollar (in terms of Ksh.) makes the dollar very
expensive to Kenyans.
Similarly, foreign goods will be expensive to Kenyan residents.
But Kenyan goods and services will be relatively cheap to foreigners, since they can get
more Kenyan shillings in exchange for dollars to acquire them.
This makes the Kenyan shilling and Kenyan goods and services attractive to the
foreigners who can now buy more Kenyan goods and services.
By so doing, they supply dollars in large quantities to Kenya.
The surplus dollars in the foreign exchange market exerts pressure on the exchange rate
to fall towards the equilibrium price.
However, for the exchange rate, which was fixed by the Central Bank of Kenya (CBK)
at e1 to be held at that point, the CBK must intervene in the market and buy up the
surplus dollars (BC).
This policy is known as government intervention in the foreign exchange market.
But the government must use some local currency to purchase the surplus dollars.
In this case, it must use its reserves of Kenyan shilling to buy the surplus dollars.
If the government decides to keep the artificially high exchange rate at e1, for a long
time, it will eventually run out of its Ksh reserves with which to buy excess dollars.
If this happens, the government will be forced to either:
a) Allow market forces of demand and supply to bring the exchange rate down to the
equilibrium level P, or
66
b) Re-set the pegged exchange rate to a level nearer to the equilibrium rate.
c) If the Central Bank of Kenya chooses to adjust the pegged exchange rate
downwards form e1, the policy is called revaluation of the Kenya shilling, against
the dollar, i.e. one will now need fewer Kenyan shilling to buy the dollar.
A revaluation of a currency under a fixed exchange rate regime is analogous (similar)
to an appreciation of a currency under a flexible exchange rate regime.
Both “revaluation” and “appreciation” of a currency refer to an increase in the value of
a currency relative to another currency.
Figure 5.5 A Fixed Exchange Rate Below the Equilibrium Rate
S$
Exchang
erate
Ksh/$
e2 C D
D$
0
Quantity of foreign
$S $D exchange (dollars)
Suppose the Kenyan government through the CBK, decided to fix the exchange rate at
67
Kenya residents will need fewer Kenya shillings to buy dollars for importation
purposes, while foreigners who want to visit Kenya as tourists, will receive very few
Kenya shillings in exchange for their dollars.
The forces of demand and supply in the foreign exchange market will put pressure on
the shilling price of dollars to go up towards the equilibrium point P.
If the government insists on maintaining the fixed exchange rate at e2, the CBK must
intervene in the foreign exchange market to supply enough dollars to make up for the
difference (CD) between the supply and demand quantities for dollars.
The CBK does this by buying Kenya shilling from the market using its reserve of
dollars.
In the process, the CBK’s Ksh reserves will accumulate, if the desired goal is to reduce
liquidity of local currency in circulation and off-load foreign currency into the market.
However, if the CBK does not want to reduce liquidity of the local currency in
circulation, then it must re-set (re-fix or re-peg) the exchange rate to a level nearer to
the equilibrium point P.
Alternatively, it could allow the exchange rate to become flexible.
If the CBK decides to re-set the exchange rate at a level higher than e2, then the policy
decision is called the devaluation of the Kenya shilling against the dollar i.e. you need
more Kenya shillings to purchase the dollar.
A devaluation of currency under the fixed exchange rate regimes is analogous to a
depreciation of a currency under a flexible exchange rate regime.
Both “devaluation” and “depreciation” of a currency refer to a decrease in the value of
one currency relative to another currency.
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However, experience in developing countries, does not support the discipline argument.
In fact, evidence shows that during the pre-liberalisation period, many central banks in
developing countries engaged in expansionary monetary policies in spite of, or because
of operating a fixed exchange rate regime.
The uncertainty argument is the more credible one, but this also depends on whether the
central bank plays by the rules and has the necessary stock of reserves of currency to be
used for intervention purposes.
A fixed exchange rate builds confidence among business actors only when there is
stability in exchange rates resulting from strict adherence and correct or timely
application of adjustment policy instruments.
5.4.2.2 Arguments Against a fixed Exchange Regime
One of the frequently advanced arguments against a fixed exchange rate system is
that it subordinates internal economic objectives (like maintaining high
employment, price stability and rapid economic growth) to the external objective
of maintaining balance of payments equilibrium.
For example, maintaining reserves for intervention purposes is not only
expensive, but the reserves are maintained at the expense of financing
growth and development, in particular, of the export sector.
If the misalignment of the fixed exchange rate with the equilibrium rate lasts
a long time, the government will run out of reserves to intervene with,
making it difficult to sustain the regime.
The second argument against a fixed exchange rate regime flows from the first,
and that is, it is very expensive to maintain:
The central bank has to maintain a very large foreign exchange department
to control inflows and outflow of foreign currency.
The large bureaucratic procedures required to control inflows and outflows
of foreign currency breed corrupt practices.
Time consumed at meetings to make decisions, like licensing exports and
imports, could be spent on other more productive economic decisions.
Decisions on when to intervene or not can be wrong and take long to correct
when a lot of harm has been done on the economy.
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The third argument against fixed exchange rate is that during prolonged periods of
inflation, the monetary authorities will not cope with the support of the local
currency through intervention, nor is resort to periodic devaluation an attractive
option, since it defeats the very purpose of having a fixed exchange rate regime.
5.4.3 A Managed Float Exchange Regime
The managed float (sometimes referred to as the dirty float) regime policy, attempts
to combine market-determined exchange rates with some foreign exchange market
intervention in order to try and capture the best aspects of both the fixed and flexible
exchange rate regimes.
Since 1973, most countries in the world have operated the managed float exchange rate
regime rather than freely floating exchange rate regime (Salvatore, 1990, p 601-602).
The fundamental idea behind the managed float is to use intervention to avoid day-to-
day fluctuations in the exchange rates that contribute to the uncertainty that is
characteristic of the flexible exchange rate regime.
Under a managed float regime, the monetary authorities (the Treasury and Central
bank) usually do not allow full depreciation required to eliminate the balance of
payments deficit, as would be the case under the flexible exchange rate regime.
Under this regime, erratic exchange rate fluctuations can be avoided by government
intervention.
By contrast, long-term intervention is avoided so that long-run movements in exchange
rates are determined by the market forces of supply of and demand for various
currencies.
The ideal working of a managed float exchange rate regime is illustrated in
figure 5.6(a) and (b) below:
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Figure 5.6 (a) Permanent Increase in Demand Foreign Exchange (for dollars)
e1
e0
D$1=D$2
$
D0
Quantity of foreign
exchange (dollars)
Figure 5.6 (b) Temporary Increase in Demand Foreign Exchange (for dollars)
S$
Exchange rate
Ksh/$
e1
e0
D$1
D$0=D$2
Quantity of foreign
0 exchange (dollars)
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Source: Adapted from Beth Yarbrough and Robert Yarbrough, 1988, The World Economy, p.
601
Both Fig. 5.6(a) and 5.6(b) show the demand for and supply of dollars in the foreign
exchange market.
Initially, D$0 and S$ give the demand for and supply of dollars, respectively.
Without the Central Bank of Kenya’s intervention, the exchange rate for the dollar
would settle at e0.
At that rate, the quantity of dollars demanded is in equilibrium with the quantity
supplied.
In Fig. 5.6(a), the market for dollars is disturbed by a permanent increase in demand for
dollars leading to a shift to a new demand curve D$1.
A number of events could cause such a permanent increase e.g. the explosive increase
in the demand for cell phones by Kenyan residents in the mid-2000s.
Once the demand for dollars shifts from D$0 to D$1, the old equilibrium exchange rate e0
is no longer an equilibrium rate, since at that rate the quantity of dollars demanded
exceeds the quantity supplied.
Under a managed float exchange regime, how should the central bank react?
The two basic choices available are:
i. Allow the exchange rate to float in response to the market forces of demand and
supply, resulting in a movement of the exchange rate from e0 to the higher Kenya
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Using intervention in an attempt to hold the exchange rate at e0 will require a fall in
Kenya’s domestic currency money stock, relative to foreign currency, in order to
eliminate the payments imbalance.
This makes the second option an undesirable policy outcome.
Figure 5.6(b), represents the case of a short-term or temporary increase in the demand
for dollars.
In this case, demand shifts upwards from D$0 to D$1 and then back down to D$0.
This can happen, for example, when there is serious drought requiring massive
importation of foodstuffs that triggers a sudden increase in the demand for dollars.
If the exchange rate is floating, the Kenya shilling price of dollars will temporarily
move upwards form e0 to e1 and, then back again down to e0 after the emergency
response to the drought is over.
This type of short-term volatility in exchange rates is viewed as one of the primary
drawbacks of the flexible exchange rate regime.
It causes uncertainty about profitability of international trade and financial transactions.
This is so because the future value of the exchange rate is important in determining
profitability.
Proponents of intervention argue that uncertainty about exchange rates discourages
specialization and trade, thus reducing the efficiency of the world economy.
Under the ideal managed float regime, the response to the temporary disturbance would
be a temporary intervention to hold the exchange rate at its underlying equilibrium level
of e0 until the drought is over and then allow market forces to operate.
This would require the central bank to sell dollars or purchase Kenya shilling, but only
for the brief period during which demand is at D$1.
As soon as the disturbance is over, demand returns to D$0 = D$2, when no further
intervention is required.
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This is done to achieve certainty, which is one of the proclaimed virtues of a fixed
exchange rate.
At the same time, the managed float regime allows market forces to determine
exchange rates, thus, facilitating the link between the balance of payments and the
money stock, and preventing chronic balance of payments disequilibria.
By so doing, the managed float regime achieves two virtues of a flexible exchange rate
regime - that is, market forces-determined exchange rates, and minimized problems of
balance of payment.
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Through laws, rules, regulations and price manipulations, exchange controls endeavor
to influence who buys and sells currencies, in what quantities, at what price and for
what purpose.
The simplest and most common form of foreign exchange control involves government
monopoly of receipt and ownership of all foreign currencies that flow into the country.
Under this regime, foreign currencies can be bought or sold, only through a government
agency, usually the foreign exchange department of the central bank. There is no legal
private foreign exchange market.
However, illegal or black markets for foreign exchange thrive under this regime.
This regime authorizes the government to decide which international transaction to
permit.
For example, travel abroad is restricted to people with permits issued under its
authority, and certain imports may be prohibited.
Most often, the countries that adopt this regime, face chronic shortages of foreign
exchange or balance of payments problems.
It is this chronic shortage of foreign exchange, which provides the rationale for
government to allocate the scarce resource – foreign exchange.
However, experience had shown that government monopoly of foreign exchange is
usually unsuccessful in dealing with the basic problem of balance of payment deficits.
Since under this regime government also fixes the exchange rate, there is a tendency of
fixing the rate below the equilibrium rate.
In practice, this means that the demand always exceeds supply of foreign currency.
When foreign currencies are unavailable through legitimate channels, there is a large
economic incentive for illegal or black markets to emerge to cover the gap.
In some countries that operate this regime, the volume of transactions flowing through
the black market for currencies, is far greater than that through official channels.
The second method by which government effects control under this regime is through
instituting multiple exchange rates whereby foreign exchange is sold at various prices
depending on purpose or use.
Developing countries usually institute such a system, by setting a low price for foreign
exchange to be used to import essential goods and services (machinery, books,
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medicines) and a high price of foreign exchange to be used to import non-essential or
luxury goods and services (alcohol, cigarettes, private saloon cars).
Once again, multiple exchange rates create an incentive for the emergence of black
markets for foreign exchange, and promotion of corruption, where luxury goods and
services are imported under the official guise of necessities (e.g. four-wheel drive
station wagons vehicles are imported for “projects” or for official up-country travel by
government officials).
The most common system of multiple exchange rates is the dual exchange rate
system.
In the dual exchange rate system, commercial transactions involving trade in goods and
services are made at a fixed exchange rate called the commercial rate.
On the other hand, capital transactions for short-term capital flows in response to
interest rate differentials are made at a floating rate called the financial rate.
The aim of adopting a commercial rate, which is fixed, is to establish a stable
exchange rate, that encourages trade in goods and services and to insulate the
commercial rate from volatility caused by short-term capital flows.
Experience in Latin America and Africa where exchange controls and multiple
exchange rates were most common, showed that not only were they inefficient but also
involved very high administrative costs.
76
ACTIVITY
Use the supply and demand model of the foreign exchange market to
analyze the effects of a rise in the price level of the USA relative to
that of Kenya:
a) Under a fixed exchange rate regime
b) Under a flexible exchange rate regime.
SUMMARY
In this lesson we have learnt about the factors that influence the
demand for and supply of foreign exchange. We have also
covered the four main exchange rate regimes operated by most
countries in their cross border trade transactions.
FURTHER READINGS
77
LESSON SIX
6.0 BALANCE OF PAYMENTS
6.1 Introduction
In this lesson we are going to look at the meaning of the concept of balance of payments
(BoP); the three accounts that constitute the BoP and how the three accounts relate to each
other. Finally, we shall delve into the concepts of the BoP deficits and surpluses.
Objectives
By the end of this lesson, you should have grasped the concept of BoP
and should be able to:
Compile a BoP account under its three main constituent components
Explain the concepts of BoP deficits and surpluses.
In the preceding chapter, we showed that the foreign exchange market is a mechanism
that brings together buyers and sellers of different currencies.
We now focus on how countries record their international economic transactions.
The international economic transactions of any country involve payments (outflows
spent by residents on imports, gifts, and investments abroad) and receipts (inflows
received by residents for exports, gifts and investment from abroad).
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All economic transactions of a country’s residents, firms and governments with their
counterparts in the rest of the world are summarized in a set of accounts known as
balance of payments (BoP)
Balance of payment is in principle, a summary of all transactions undertaken by
residents of one country, with the rest of the world, recorded during a specified period
of time, usually one calendar or budgetary year.
Since a country’s transactions with the rest of the world are literally in millions, they
cannot appear individually, but in a summary form in the balance of payments (BoP).
The main purpose in the BoP is to provide the government with information that helps
it in the formulation of monetary, fiscal and commercial policies.
The information provided by the BoP is also useful to banks, businesses, academicians
and individuals who are directly or indirectly involved in international trade and
finance activities.
6.2 Components of Balance of Payments (BoP)
To keep track of a given year’s international economic transactions, the BoP account
employs various arbitrary procedures, which we shall not delve into, because our
purpose is to have a working knowledge of the BoP accounts, for purposes of
interpreting and understanding broad economic trends, events and policies.
The more advanced a country’s economy is, the more complex its BoP accounts are.
We shall content ourselves with simplified classification of components of a BoP into
three basic accounts, viz:
The current account
The capital account
The official settlements account
As a general rule, each item on the BoP account has a debit and a credit side.
The debit side items of the BoP are transactions that involve payments or outflows
from the home country.
These items include; imports, gifts sent out of the country, repatriated earnings of
foreign investments in the home country and investments made in foreign countries by
residents of the home country.
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Credit items on the other hand, involve transactions that result in receipts or inflows of
foreign currency to the home country.
These items include: income from exports, gifts form abroad to residents of the home
country, incomes to residents from their investments abroad and inflows of foreign
investments into the home country.
By convention, debit items on the BoP are recorded with a minus (-) sign, while credit
items in the BoP are recorded with a plus (+) sign.
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This is also known as an unfavorable trade balance or a trade deficit.
However, if the sum of the items on the credit side exceeds the sum on the debit side,
the current account balance is said to be in surplus.
This is also known as favourable trade balance or trade surplus (see listing below).
Debits (-)
Imports of goods: payments for computers, vehicles, and aircrafts imported into
Kenya.
Imports of services: Payments for consultancy, banking and insurance services
offered to Kenyan residents by foreign firms; payments for education and health
services abroad.
Investment income: payments of interest, dividends and other forms of income
due to foreigners accruing from their investments in Kenya.
Military Transactions: payments by the Kenya government to foreign firms for
military supplies to Kenya’s security services; payments for duty free supplies to
the military canteens and shops e.t.c.
Travel and Transportation: payments by Kenya residents for air travel on
foreign airlines; payments for shipments of Kenya exports and imports on foreign
vessels.
Unilateral Transfers: gifts sent by Kenya residents to foreigners; pensions to
retired expatriates staff now living abroad, expatriate workers’ remittances to their
home countries.
Credits (+)
Exports of goods: receipts by Kenya residents for coffee, tea, and horticultural
produce exported abroad.
Export of services: receipts by Kenyans offering consultancy services in
Namibia, South Africa and Botswana; receipts for hotel accommodation from
tourists; receipts for game viewing by tourists in game reserves e.t.c.
Investment income: receipts by Kenyan residents of interest, dividends and other
forms of incomes accruing from their investments abroad.
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Military Transactions: receipts by Kenya for sale of ammunition from Eldoret
factory to neighboring countries; receipts by Kenya for supply of personnel to UN
peacekeeping missions at various world trouble spots.
Travel and Transportation: receipts by Kenya airways, railways and local tour
firms for transporting foreigners in or outside Kenya.
Unilateral Transfers: Gifts received from abroad by Kenyan residents;
remittances by Kenyans in Diaspora to their home relatives and friends.
NB: According to the World Bank Report: Global Economic prospects, 2006, over
one million Kenyans in Diaspora remitted to Kenya US$ 700 million in 2005.
The Central Bank of Kenya (CBK) Quarterly Review (April,2012) reported
that in 2011, remittances from Kenyans in Diaspora were Ksh 74.8 billion
(US$891 million). For the year 2011, remittances from Kenyans abroad made this
item the country’s fourth largest foreign exchange earner, after horticulture, tea
and tourism.
Current account balance: If the sum of the current account payments exceeds
the sum of the current account receipts, then the current account balance is in
deficit.
The current account balance is in surplus if the reverse is true.
The assets could be securities (treasury bills or bonds) issued by foreign central banks
or physical assets like houses, factories and real estate or shares/stocks in foreign
companies.
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Capital outflows represent increases in Kenya residents’ ownership of foreign assets.
When foreigners purchase Kenyan assets (CBK’s treasury bills and bonds, factories or
shares in Kenyan companies) the purchases result in capital inflows into Kenya and are
recorded as credits.
The transactions are recorded as credits in Kenya’s capital account of the BoP.
Capital inflows into Kenya represent increases in foreigners’ ownership of Kenyan
assets.
The difference between capital outflows and capital inflows is a capital account
balance.
As was the case with the current account, a capital account is said to be in surplus if
the inflows (credits) exceed outflows (debits) and, in deficit if the outflows exceed the
inflows.
For Kenya, a surplus capital account represents a decline in the net ownership of
foreign assets by Kenya residents, while a deficit on the capital account denotes an
increase in the ownership of foreign assets by Kenya residents.
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Foreign exchange reserves of other foreign banks held by a local central bank
(Central Bank of Kenya) are also recorded on the official settlements account.
Foreign exchange reserves held by the country’s commercial banks for their
day today transactions.
All intervention activities by the central bank in the foreign exchange market are
transacted within the official settlements account.
Increases in the level of a country’s reserves or decreases in the level of reserves held
by foreign central banks in the country’s central bank are recorded as debits in the
official settlements accounts.
On the other hand, decreases in a country’s reserves or increases in the foreign reserves
held in the country’s central bank are recorded as credits.
The official settlements balance gives the net change in the country’s stock of foreign
reserves and official government borrowing.
The transactions on the official settlements account are used to compensate for any
differences between total payments and total receipts in the other two accounts
(current and capital accounts).
For example, if the combined balance on the current account and the capital account is
in deficit, there must be an offsetting credit balance in the official settlements account.
Similarly, if there is a surplus in the combined current and capital accounts, the official
settlements account must be in deficit.
As a result, in the BoP account, the sum of the current account balance, the capital
account balance and the official settlements account balance must be equal to zero.
Equation 6.1 below gives a summary presentation of balance of payment.
However, when actual data is collected by the data collection agency (in Kenya it is the
Central Bureau of Statistics – CBS) for use in calculating the balance of payment,
many transactions are either missed or go unreported.
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This occurs for a variety of reasons, including:
Money laundering: e.g. The National Bureau of Statistics and the CBK
could not explain a massive Ksh 164billion (US$ 2.16 billion) of foreign
currency that found its way into Kenya’s economy during the 2009/10
calendar year, reflected as errors and omissions in CBK’s official BoP
statistics of May 2010. (Question: Where does Somali pirates’ ransom
money go?). Note that this money is more than the combined tea,
horticulture and coffee export earnings for that year.
Smugglers who purposely avoid paying tax do not report their import
transactions to the authorities causing them to be unrecorded.
Unscrupulous businessmen divert non-taxed goods destined for export into
the local market, yet records show they have been exported.
Tourism and many import items that tourists bring into the country (like
video cameras e.t.c.) are not closely monitored for record purposes.
These imperfections in data collection are reflected in an item known as statistical
discrepancy.
This is the amount by which the sum of the current, capital and official settlements
balances, as actually calculated, fail to sum up to zero.
Equation 6.1 of the balance of payment above has to be modified to incorporate the
new item “statistical discrepancy” to become:
Depending on the country, the value of the statistical discrepancy can be very large.
For example, in the USA, for each of the years from 1979 to 1982, the statistical
discrepancy was larger than the current account balance (Yarbrough, 1988, p 405).
It should be noted that the statistical discrepancy mismeasurement is associated only
with current and capital accounts categories of BoP.
85
The question that arises now is: if the components of the balance of payments always
sum up to zero, why do Economics text books still talk about balance of payments
surplus or deficit?
To explain this apparent contradiction, we use the concept of autonomous transactions
(or items above the line) and the concept of accommodating transactions (or items
below the line) to explain the concepts of balance of payments surplus and deficits in
the next section.
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This deficit must be settled with an equal net credit from the “items below the line”
otherwise known as the official settlements account.
Another name for transactions in the official settlement account is the accommodating
transactions, or “ items below the line” because they are required to balance deficits
or surpluses in the “items above the line”.
These accommodating transactions are official government transactions specifically
undertaken to sort out BoP problems.
This means the monetary authority draws down the country’s foreign currency reserves
or officially borrows (say from the IMF) for balance of payment support.
A close look at equations 6.2 and 6.3 above shows that there is a relationship between
the official settlements balance and the BoP.
If one rearranges equation 6.2 one gets:
Further, if one combines equation 6.3 and 6.4 one ends up with:
Balance on Balance on
Autonomous = - Accommodating ……… 6.6
Transactions Transactions
OR
Balance on Balance on
Autonomous + Accommodating = 0 ……… 6.7
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Transactions Transactions
Note that both equations 6.1 and 6.7 yield the same result where the sum of the
components of the balance of payments are equal to zero.
Thus, a deficit in the balance of payments can be measured either by the excess of
total debits over total credits in the current and capital accounts (items above the line),
or by excess of total credits over total debits in the official settlements account (items
below the line).
On the other hand, a country is said to have a surplus in the balance of payments if its
total credits exceed its total debits in the current and capital accounts.
An equal debit balance in the official settlements account settles the net credit surplus.
In this case, the country will augment its stock of foreign reserves.
Finally, it should be noted that the concepts of deficit or surplus in the balance of payment
and the method of measuring them as explained above are strictly speaking correct only
when a country is operating under fixed and managed float exchange rate regimes.
ACTIVITY independence in 1963. Explain why this is the case and how it has
managed to fulfill its international obligations.
88
SUMMARY
In this lesson we have learnt the concept of BoP and its three
main components. We have also learnt that:
The three components should sum up to zero
However, when dealing with only items above the
line, one can encounter BoP deficit or surplus.
FURTHER READINGS
Yarbrough, B.V. and Yarbrough, R.M. (1988), The World Economy: Trade and
Finance; The Dryden Press, Chicago.
Rivera-Batiz, F. L & Rivera-Batiz, L. (1994) International Finance and Open
Economy Macroeconomics; Macmillan, New York.
LESSON SEVEN
89
7.0 NATIONAL INCOME EQUILIBRIUM IN AN OPEN ECONOMY
7.1 Introduction
In this lesson we are going to use the simple Keynesian Income Model to analyse national
income accounts and the balance of payments.
Objectives
By the end of this lesson, we should be able to use the simple Keynesian
model to:
Explain the effects of changes in national income, consumption and investment, on exports
and imports, that is, balance of payments.
Use of concept of the Keynesian autonomous spending multiplier to explain the effects of
changes in autonomous spending on consumption, investment and exports on national
income equilibrium.
The relationship between the external sector of an economy and the national
income is a two-way relationship:
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The same can be said of other items of the balance of payments
We now look at the theoretical linkage between the external sector of an economy
We shall use the simple Keynesian Income Model to analyse the macroeconomic
activities of an open economy.
Keynesian income with the desired expenditures being spent on goods and
services.
The Keynesian income Model assumes:
Prices are constant, thus focusing on real income movement not price
changes
The economy is not at full employment, partly due to trade union activities
which mitigate against decrease in wages to absorb more labour
There is no government sector ( i.e no government expenditure and taxes)
These assumptions are relaxed later when we look at the effects of government
policy.
Thus:
E=C+I+X-M --------------------------------------- (7.1)
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Keynes hypothesized that aggregate C is determined by the level of income of an
economy i.e.
C = f(Y) ---------------------------------------------------- (7.2)
The precise way of writing equation (7.2) which is the standard Keynesian
consumption function is
C = a + bY ------------------------------------------------ (7.3)
where:
a is autonomous or exogenous consumption expenditure which depends on
other things other than income, i.e consumption expenditure, which is
independent of income.
bY is the consumption expenditure which depends on income and is
known as induced consumption spending
b is known as the marginal propensity to consume ( MPC)
Suppose we put numerical content to equation (7.3), it becomes
C = 100 + 0.75Y
Let us assume that Kenya’s national income in 2011 is US $ 30,000 million, then
consumption expenditure is:
C = $ 100 million + 0.75 ($ 30, 000 million)
= $ 22,600 million
If national income increases from US $ 30,000 million to US $35,000, then
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In any economy, it is assumed that any income that is not spent on consumption is
saved.
Thus, we also have the marginal propensity to save (MPS) defined as the change
in savings ( S) divided by the change in income ( Y) i.e the proportion of any
additional income that is saved in an economy:
Y=C+S
Y = a + bY + S
S = Y - (a - bY)
S = -a + (1 - b)Y
S = - a + sY --------------------------------- (7.7)
where s = (1- b) is the marginal propensity to save.
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Figure 7.1: Keynesian Consumption Function
Consumption
0.75
Income
S = -100 + 0.25Y
0.25
94
0
-100 Income (Y)
Ī =560 Ī = 560
Income (Y)
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This means that investment spending is determined by other factors such as
interest rate, wage rates and expectations of firms concerning the future.
When investment is assumed to be independent of current income, it is written as:
For exports (X) the Keynesian income model assumes them (exports) also to be
autonomous or exogenous or independent of the country’s current income.
Thus the export equation is
EXPORTS
(X)
X =350 X =350
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Income Y
Thus, if the export level in the country is US$3500million, these are independent of
the country’s level of income since they depend on other countries income levels-
the buying power of other countries.
In addition , home exports depend on such non-income factors as relative prices of
domestic goods vis a vis other countries’ goods, the exchange rate, innovation of
home industries and foreign tastes and preferences.
If any of these factors change, such that more domestic exports are demanded, then
the export function will shift vertically in parallel fashion.
The opposite will happen if demand for exports falls.
In the Keynesian income model, imports (M) depends on the importing country’s
income
Thus the import function is:
Or M = M + mY ------------------------------------------------- (7.11)
where
M = autonomous imports, the amount of spending that is independent of
income, but dependent on such factors as taste and preference for
foreign goods.
mY = induced imports, or spending on imports that depends on the level of
income
Suppose M = 40 + 0.15Y, this would mean that the value of autonomous imports in
Kenya is US $40 million and the value of induced imports is 0.15 times the income
level.
The figure 0.15 that stands for m in equation (7.11) is the marginal propensity to
import (MPM).
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MPM is defined as the change (Δ) in imports (M) divided by the change in income:
Students should note that the MPM is distinguished from the average propensity to
import ( APM), which is total spending on imports divided by total income:
It is at this juncture that we introduce the term income elasticity of demand for imports
(YEM) , which is defined as the percentage change (%Δ) in the demand for imports
divided by the percentage change in income i.e the percentage growth in imports that
will occur as the national income grows over time. Thus
YEM = (%ΔM)/(%ΔY)
= (ΔM/M)/(ΔY/Y)
= (ΔM/ΔY)/(M/Y)
= MPM/APM ……………………. (7.14)
Thus, if a country’s MPM exceeds its APM, imports relative to income will rise as the
country’s income grows ( YEM is elastic).
If MPM is less than APM the YEM is inelastic and imports will fall as a proportion of
income as income rises.
If MPM = APM, the YEM is unit-elastic and imports as a proportion of national
income remains the same as income rises.
Since 2003 when the country’s economy was growing at a faster rate than in the
1990s, Kenya’s GDP grew from around US $ 20,000 million to about US $ 30,000
million.
Imports (Cars, TVs, Fridges, Cell phones) increased both in quantity, variety and
quality during the period 2003 and 2007.
This suggests that Kenya’s income elasticity of demand for imports (YEM) was
elastic since imports increases as the national income grew from US $ 20 billion to $
30 billion.
98
The import function, namely M = 40 + 0.15Y is shown in Figure 7.6
Imports
(M)
M = 40 + 0.15Y
0.15
M = 40
Income (Y)
99
The intercept of the import function is located at the value of autonomous
imports M
The slope of the import function is the MPM = 0.15Y.
The equilibrium income level is the level at which there is no tendency for the
income level to rise or fall – the economy is at rest.
This level of income occurs when desired expenditure matches the production
level of the economy.
In an economy, when the income level matches the production level, this is
represented by a 450 line from the origin of right angled graph as in graph 1.7.
The 450 line has the property that each point on it is equidistant from the
vertical axis (Expenditure) and the horizontal axis (Production or income).
If expenditure exceeds production (or income), this means the country’s firms
have not produced enough output to meet domestic demand.
The resultant increase in the price level induces firms to increase output
towards the equilibrium level.
On the other hand, if production exceeds expenditure there will be surplus
output and the resultant drop in the price will force firms to cut output towards
the equilibrium level.
Graphically, this can be demonstrated in Figure 7.7 below.
Desired 45◦
Spending
C+I+X-M B C+I+X-M=E
100
MPC-MPM=b-m
F e A
aI X M G
0 Y1 Ye Y2 Income (Y)
The components C, I, and X are added together while imports M are subtracted
to yield C + I + X - M line, whose intercept is at a + I X M and slope b , m or
MPC – MPM.
The C + I + X - M line gives total desired expenditure on domestic goods in
relation to income.
The equilibrium level of income Ye is where income level matches production
level at point e.
At lower income level Y1, expenditure is Y1F which is greater than production
0Y1 =Y1G.
The gap GF is covered by imports or induces local firms to increase output to
reach equilibrium point e.
At income beyond OYe, say at Y2, expenditure Y0A is less than production 0Y2 =
Y2B
The surplus AB is exported or local firms cut production towards equilibrium
point e.
The equilibrium level of income can also be determined algebraically.
Using our examples equations, suppose the figures were in US $ s billion:
C = 100 + 0.75 Y
Ī = 560
X = 350
M = 40 + 0.15Y
101
The expenditure E components C + I + X – M add to total production or income, Y.
Hence
Y=E=C+I+X-M
Y = (100 + 0.75Y) + 560 + 350 - (40 + 0.15Y)
Y = 970 + 0.6Y
Y - 0.6Y = 970
0.4Y = 970
Y = 970/0.4 = 2,425
The alternative way of determining the equilibrium level of income is to represent the
equilibrium income level as:
In this approach, savings and imports are considered as leakages from the spending
stream i.e they reduce spending on domestic products.
Investment and exports are considered as injections into the spending stream i.e they
increase domestic production and domestic consumption.
If the leakages (Savings + Imports) exceed injections (Investment + exports) then
there is downward pressure on spending and hence income.
If the injections exceed leakages, there is pressure for expansion in the economy
This approach can be illustrated in figure 7.8.
S+M
I+X
S+M
MPS+MP
102
Y1 e I+X
0 Ye Y
Y2
Figure 7.8 shows saving and import function combined into an S + M function with a
slope of MPS plus MPM, and the autonomous investment and export schedules
combined into an I + X schedule.
The equilibrium level of income is situated immediately below point e where the two
schedules intersect, at income level 0Ye.
This 0Ye is the same as the 0Ye in figure 7.7
If the economy is at income level below 0Ye, say at 0Y 1, then (I + X) exceeds (S +
M).
What this implies is that the economy will expand due to injections (of investment
and export earnings) being in excess of leakages (of savings and imports).
Expansion or growth of the economy will lead to a movement towards the
equilibrium income level 0Ye.
At income level 0Y2 the opposite will happen
Again , with the leakage/injection approach, one can determine the equilibrium
income level algebraically.
If we use our earlier example of figures in US$ billion:
C = 100 + 0.75Y
S = -100 + 0.25Y
M = 40 + 0.15Y
Ī = 560
X = 350
S+M=I+X
103
(-100+0.25Y) + (40+0.15Y) = 560+350
-60+0.4Y = 910
0.4Y = 970
Y = 970/0.4 = 2,425
I +X.
S-I
Ye
0 Y
e
104 X-M
The upward-sloping line S-I is derived by subtracting the fixed amount of
investment I from the saving function.
Thus, with S = -100+0.25Y and I = 560, the S-I is :
The good thing about this second alternative approach is that it illustrates
the current account balance for the economy when it (the economy) is in
equilibrium.
105
In our numerical example, the current account balance that occurs when
income is in equilibrium is
106
In our numerical example, suppose the autonomous investment rises from US$
560 million to $660 million, what will be the ΔY?
The best way to understand the multiplier concept is to think of rounds of
spending in the multiplier process.
The autonomous increase of US$100 million in investment will generate
production (hence income) worth $ 100 million for the investors and their
employees.
Due to the MPC, some of the income will be spent on domestic goods and
some on imports.
In our numerical example, the MPC = 0.75, MPS = 0.25 and MPM = 0.15
Therefore, the $ 100 million income generated, $ 75 million will be spend on
consumption and $ 25 million will be saved.
However, of the $75 million spend in the second round on consumption , $15
million will be spent on imports ( $100 million x 0.15 = $15 million)
This means that the induced consumption of domestic goods and services is
( $75 million - $15 million) $ 60 million.
The domestic producer (investors and their employees) who received the $ 60
million income will indulge in the second round of investing since the $ 60
million creates new demand for goods and services.
The $60 million will be invested in the second round to produce the increased
demand of goods and services worth $ 60 million.
O the $60 million of new income, 0.75 will be consumed and 0.25 will be
saved i.e $ 45 million and $15 million respectively.
Of the $60 million, 0.15 will be spent on imports, equivalent to 9 million ($60
million X 0.15 = $9 million).
Thus the amount spent domestically is 45 million - $9 million =$36 million
The $36 million of income will be spent in the third round and so on
Theoretically, this process goes on through an infinite number of rounds
Therefore, there is geometric series of increases in income, with 0.75 as the
MPC and 0.15 as the MPM.
107
The total change in income ( total ΔY) after all periods have occurred is the
sum (Σ) of this series:
Thus, the initial increase in autonomous investment of $100 million has led to a
total change in income of $250 million.
An initial change in autonomous consumption or export spending of $100
million would have had the same $250 million impact as the change in
autonomous investment did.
The multiplier is simply the total change in income divided by the initial change
in autonomous spending , viz,
1
K0 =
1 ( MPC MPM )
1
Or K0 =
1 MPC MPM
1
Or K0 = --------------------- (7.17)
MPS MPM
108
For a closed economy, there would be no imports, hence the MPM = 0, since
there would be no leakage of spending in the economy
The closed economy multiplier KC would simply be:
1
KC =
(1 MPC )
1
Or KC = ------------------------------- (7.18)
MPS
ΔY/ΔM = -K0
1
=- ---------------- (7.19)
MPS MPM
This conclusion appears to contract what trade theory had asserted in AEC 306
and EAE 504 that free trade which leads to increase in imports ( allowing choice
of more goods and services available to consumers) has a positive effect on
national welfare ( see welfare effects of free trade).
109
However, it should be recalled that trade theory assumed that the country was
always at full employment and operated on its production-possibilities frontier
(PPF) both before and after change in imports.
This is one of the main points of departure between Keynesian and classical
economic theory
Most of the Keynesian macro-economic models do not assume full employment
In fact Keynes asserted that a country’s economy could attain equilibrium at less
than full employment.
Two points should be made about the simultaneous coexistence of a current
account deficit with national income equilibrium as shown in figure 7.9 earlier.
Through contractionary macro-economic policy that reduces imports (that also
reduce national income) it is possible to eliminate the current account deficit.
By how much would national income have to be reduced in order to eliminate the
current account deficit?
In our numerical example, there is a deficit of $ -53.75 million
This means the country’s income must contract enough for imports to fall by
$53.75 million.
Remembering MPM concept, this means that income must fall enough so that the
change in income (ΔY) multiplied by the MPM equals - $ 53.75 million.
Hence if the ΔM target is -53.75 mill ion.
ΔM = MPM. (ΔY)
-$358.33 million = ΔY
Therefore the level of income must fall by -$358.33 million in order to reduce
the current account deficit of $ 53.75 million and restore balance in the current
account.
110
The first point that is brought out by this analysis is that if they economy is at
less than full employment i.e there is plenty of unemployment as is the case in
Kenya, the contraction of an economy to that magnitude will cause more
unemployment and other economic social problems than what the goal of
eliminating the current account deficit will achieve.
Thus the conflict between an internal economic goal: create jobs and external
goal: bring balance in the current account cannot be restored using this tool of
reducing the level of national income.
Can expanding exports (for example, by depreciating the local currency to make
the country’s exports cheaper) be used to eliminate the current account deficit?
If exports increase by $ 53.75 million, will this eliminate the current account
deficit?
The answer is No; why?
If exports increase by $ 53.75 million, the open economy multiplier of 2.5 is
applied to this autonomous increase in exports.
This means that the level of income will increase by:
The increase in income level (ΔY) by $ 134.38 million will induce imports by
the MPM =(0.15)($134.38 million)=$20.157 million
Thus, the expansion of exports by $ 53.75 million has cut the deficit by $53.75
million -$20.157 million = $33.6 million
This has not eliminated the current account deficit which is -$53.75 million
By how much must the exports increase in order to eliminate the current
account deficit of $53.38 million?
Recall that (S - I) = (X - M) is in equilibrium in equation (7.15)
If the economy moves to a new equilibrium level, the new (S - I) must again
equal the new (X - M)
Thus to eliminate the current account deficit, the export increase necessary to
eliminate this deficit is:
111
(ΔS - ΔI) = (ΔX - ΔM) as the country moves from the old to the new
equilibrium
ΔS – 0 = $53.75 million
Or MPS.(ΔY) = $53.75 million
(0.25)(ΔY) = $53.75 million
(ΔY) = $ 215 million
If change in income associated with the new equilibrium is $215 million, what
amount of export change (ΔX) is necessary to provide this $215 million change in
income?
Since a change in exports has the open-economy multiplier of 2.5 in our example,
then:
112
1.3 REVIEW QUESTIONS
ACTIVITY 2. By how much must the exports increase in order to eliminate the
current
If in account deficit
2010 Kenya of $53.38
recorded million?
a current account deficit of over US $ 6
billion, could expanding exports by depreciating the Kenya
shilling from Ksh 83 / US $ to Ksh 107 / US $ be sufficient to
eliminate the trade deficit? Use the open economy multiplier to
explain your answer.
SUMMARY
In this lesson we have learnt how to use the simple Keynesian
Income Model to analyse national income accounts and the
balance of payments. We have also learnt how to use the
concept of the Keynesian autonomous spending multiplier to
explain the effects of changes in autonomous spending on
consumption, investment and exports on national income
equilibrium.
FURTHER READINGS
8.1 Introduction
In this lesson we are going to learn about the money market and national income analysis.
We shall learn how to use the LM and IS curves tools to analyse the general equilibrium in
the money market and the real (goods) sector, respectively. Finally, we shall learn about the
simultaneous use of the LM, IS and balance of payments curves to analyse the equilibrium in
an open economy.
Objectives
115
8.2 Demand for Money balances
L= hY (8.2)
where,
116
h = a constant term reflecting a stable relationship, such that if incomes
rise, more money is demanded; if incomes fall, less money is
demanded.
The influence of interest rate i on the demand for money is negative, such
that as i rises, the demand for money falls; if I falls, the demand for money
rises.
What this means is that money held in currency (cash) and current account
would be invested in other financial instruments (e.g. treasury bills) to take
advantage of the increase in i.
Thus when interest rates rise people move out of money balances into
more risky assets in search of higher returns.
The asset demand for money curve is downward sloping.
Interest
Rate
i
L = f(i)
117
Money
The income level Y and the interest rate i are thought to be the two major
The other two variables W and O in equation 2.1 are said to have a positive
influence on the demand for money.
As the wealth level rises, the holding of all kinds of assets, including demand for
money increases.
People who receive their pay envelopes weekly, on average hold less money
balances than those who receive monthly pay.
Another institutional feature is the use of credit cards for daily transactions – the
greater the use of credit cards, the less need to hold cash for transactions.
In the short run, the wealth level and institutional features are not thought to vary
much, especially during the short-run periods – thus, their less influence on the
demand for money balances than the income level and interest rates.
We start by assuming that the supply of money under the control of the monetary
authority at any given point in time is fixed.
118
Figure 8.2 Equilibrium in the Money Market
Ms
Interest
rate i
A
i1 B
e
ie
i2 A’ L
B’
Money
Increases (decreases) in the supply of money would shift the vertical line Ms to
the right (left) respectively.
The demand (L) and supply (Ms) of money jointly determine the equilibrium
interest rate at ie.
Increases (decreases) in the supply of money would shift the vertical line Ms to
the right (left) respectively.
For those of you who have done business courses, you know that there is an
inverse relationship between the interest rate and bond prices.
Since bonds pay a fixed money amount, say Kshs. 5,000/= per year in a bond for
an investment of Ksh. 50,000/=, the price of the bond determines the yield on the
interest rate that the holder of the bound is earning, in this case 10%.
119
This interest rate, due to competition for funds in the money market, will be in
line with other interest rates in the economy.
If the market price of the bond you hold is Kshs. 50,000/=, then your receipt of
Kshs. 5,000 per year of interest is a 10 percent return (Kshs. 5,000/ Kshs. 50, 000
= 10%).
However, if the market price of the bond rises to Kshs. 80,000/=, then the interest
rate of the return of Ksh 5,000 you received on the bond has fallen to 6.25 (from
10%) percent (Kshs. 5,000/Kshs. 80,000 = 6.25%).
Similarly, if the bond price falls to Kshs. 40,000, then interest rate increases to
12.5 percent (Kshs. 5,000/Kshs. 40,000 = 12.5%)
This inverse relationship between the bond price and interest rates is useful in
understanding the portfolio adjustment process for attaining equilibrium.
Thus in figure 8.2 above, at interest rate i 1, the amount of money demanded
represented by the horizontal distance i1A is less than the money supplied i1B.
The excess supply AB indicates that people hold more of their wealth in form of
money i1B than they would under normal circumstances wish to hold ( i 1A) at this
relatively high interest rate.
As a result, money holders will purchase other assets, such as bonds, with their
excess cash balances.
These asset purchases will drive up the price of bonds, and therefore drive down
interest rates.
The process will continue until the interest rate has dropped to the levels at which
the existing money supply is willingly held at the equilibrium interest rate, ie.
If the monetary authority (the CBK in Kenya) increases the money supply, the
Ms shifts to the right to Ms 2 resulting in excess supply of money at the old
equilibrium interest rate ie in figure 8.3 (a).
This will cause the interest rate to fall to i 2, the level corresponding to the
intersection of demand curve L with the new money supply line, Ms 2 as in fig.
8.3 (a)
The converse will happen if the CBK reduced the money supply Ms to Ms 1 as
in fig 8.3 (b)
120
Fig. 8.3 (a) Increase in Ms Fig 8.3 (b) Decrease in Money
Supply
MS MS2
MS1 M
i1
i i2
i
i2
L
(a) (b)
When we obtained the interest rate equilibrium in figures 8.2 and 8.3, the interest
rate was the only explicit determinant of the demand for money.
What was implicit was that the level of income remained constant – that is why
Y was not shown in the graph
Suppose the level of income changes, this is what we discuss in the next section.
Up to now we have concentrated on the interest rate and the equilibrium between
the demand and supply of money.
The other main determinant of the demand for money is the level of income in the
economy
When we obtained the equilibrium interest rate in figure 8.2 in section 8.3 the
interest rate was the only explicit determinant of the demand for money.
121
What was implicit in the discussion was that the level of income was being held
constant.
Suppose that the level of income Y in the economy was not constant - it rose
instead.
You will recall in section 2.1 and equation 2.2 we stated that the level of income
is positively associated with the demand for money, such that:
L = hY
Fig 8.4 shows the L curve we have been using.
It shows that the L curve is associated with the level of income, shown in
parenthesis.
Figure 8.4: Relationship Between Income Level, Demand for Money and Interest
Rate.
MS
Interest
Rate (i)
i1 L’(Y1
ie )
L (Y0)
i2
L”( Y2)
Income
The level of income which is associated with the equilibrium rate i 0 and
equilibrium demand for money L is (Y0) in parenthesis.
Figure 8.4 shows the different equilibrium interest rates when income levels
change:
When income level rises from (Y0) to (Y1), the demand curve also rises
from L to L’ and equilibrium interest rate rises from i0 to i1
Conversely when income level drops from (Y0) to ( Y2), the demand curve
also drops from L to L” and equilibrium interest rate drops form i0 to i2
122
This discussion of the relationship between income level, interest rate and money
market equilibrium leads to a graphical construct known as the LM curve, first
developed by John R. Hicks in his famous seminal paper “Mr. Keynes and the
‘Classics’” of 1937, which is extensively used in macroeconomics.
The LM curve shows the various combinations of income and interest rates that
produce equilibrium in the money market.
Interest LM
rate
i1
V
i0 R0
i2 T
Income (Y)
Y2 Y0 Y1
At each point on the LM curve, for the particular income level on the horizontal
axis, the associated interest rate on the vertical axis is the interest rate that makes
the demand for money equal to the fixed supply of money Ms .
Thus at point R0 on the LM curve, the income level Y 0 and interest rate i0 together
give the equilibrium in the money supply market when the fixed money supply is
Ms .
To the right of the LM curve, say at point T, there is an excess demand for money
As shown in fig. 8.4, when the income level rises from Y 0 to Y1, this generates or
causes an increase in the demand for money for transactions ,such that the
demand curve L shifts upwards to L’
123
Simultaneously, the interest rate in the money marks rises from i0 to i1.
Once the interest rate rises from i0 to i1, the excess demand for money is
eliminated and the money market is again in equilibrium.
From the analysis above, it can now be seen that any point to the right of the LM
curve (e.g. at T) is associated with excess demand for money for transactions.
At point T, the interest rate in the money market is too low for the income level.
On the other hand, any point to the left of the LM curve (e.g point V) is associated
with excess supply of money due to the high interest rate above the equilibrium.
Lastly, increases in the demand for money due to other influences besides a rise in
income or decrease in the supply of money will shift the LM curve to the left.
In either situation, the interest rate rises for any given level income.
This is analogous to saying that the income level must fall in order to maintain the
same interest rate (Kenya’s experience in 1970s when interest rates were
maintained at a fixed 5% per annum for over a decade is a case in point).
The reverse is true: decease in demand for money due to other influences besides
a fall in income level and increases in the supply of money will shift the LM
curve to the right.
In figure 7.8 (section 7.3) we demonstrated that when the level of income is in
equilibrium, the leakages of savings and imports (S + M) are equal to injections
of investment and exports (I + X).
We did so without taking into consideration what happens in the money market,
which means we assumed that interest rates were constant
In fig. 8.6 we introduce interest rate (in parentheses) to show that the interest rate
is being held constant when the income level is in equilibrium.
The interest rate in parenthesis( i0) indicates that the interest rate is held constant
when we consider the [I (i0) + X] line
124
With this interest rate, the equilibrium level of income is Y0
If the interest rate is reduced, investors will borrow more to invest due to the
lower cost of borrowing. (Remember investment refers to plant and equipment
spending by firms not purchase of financial instruments).
Because of the sensitivity of investment to the interest rate, a lower interest rate
will be associated with higher investment and higher export line.
I +X
S+M S+M
I+X
I+X
I’(i1)+ X
I(i0)+X
I(i2)+X
0
Y2 Y1 Y
Y0
Thus when interest rates are reduced from i0 to i1 the investment line [I(i0) + X]
shifts vertically upwards to [I’(i1) + X].
This upward shift results in an intersection with the S+M line at a higher
equilibrium level of income Y1.
125
The relationship between the interest rate (i) ,investment (I) and the resulting
equilibrium level of income gives us the information necessary to generate the IS
curve.
The IS curve shows the various combinations of income and the interest rate that
produce the equilibrium in the real ( goods and services) sector of the economy.
In the Keynesian income model, the IS curve shows the combination of income
and interest rate that make investment plus exports (I + X) equal to saving plus
imports (S + M).
IS
S+M i
I+X
S+M i1
I’(i1) + X
R
i1
i0
I(i0) + X
i0 U
I”(i2) + X IS
i2
i2
Y
0
Y2 Y0 Y1 Y
Y2 Y0 Y1
Figure 2.6
Figure 2.7
126
What this means is that the income level is too high for the associated interest
rate, since high income levels results in high savings and high imports.
Thus I 0
i
Alternatively, for the income level associated with R, the interest rate is too high
resulting in lack of investments.
To the left of the IS (say at point U) investment plus exports exceed saving plus
imports.
For the interest rate associated with point U on the left of the IS, income is too
low to generate enough savings and imports to match investment plus exports.
127
Figure 8.8: Simultaneous Equilibrium in the Real and Monetary sectors.
i LM
e F IS
ie
Ye Income (Y)
The income and interest rate equilibrium occurs where the IS curve intersects the
LM curve at point e in fig. 8.8
At point e, the equilibrium income Y e and the equilibrium interest rate ie combine
to give the equilibrium in both sector of the economy.
If the economy has not settled at Y e and ie, market forces (contractionary pressure
on the income level and upward pressure on interest rate) will be set in motion to
move to this equilibrium (See arrows in Figure 2.8 above).
For example, if the economy is at point F, because this point is to the right of the
IS curve, then (S + M) is greater than (I + M)
Since point F is also on the right hand side of the LM curve, the demand for
money exceeds the supply of money; this will bring about upward pressures on
the interest rate to rise.
These forces (contractionary pressure on the income level and upward pressure on
interest rate) will eventually move the economy towards the equilibrium point e.
128
The analytical tool, the balance of payments (BP) curve, shows the various
combinations of income and interest rate that produce equilibrium in the balance
of payments.
In this context, we are no longer speaking of only the current account of the BP as
was the case in the simple Keynesian income model.
We now include international financial capital flows that exclude official reserve
short -term capital flows.
To obtain the BP curve, we ask the question as to how the income level and the
interest rate affect a country’s balance of payments
A rise in income induces demand for more imports (MPM times ΔY)
Interest rate, on the other hand, is assumed to have its primary influence on the
capital account, particularly on short term private capital flows.
If the interest rate rises, liquid short-term financial capital from abroad
flows into the home country to take advantage of the high interest rate.
Interest
rate (i)
BP
r
129
i2 Y1 Income
Q1
i1
I N’
Q0
i0 N
Q2
Y2 Y0
The BP curve shows the various combinations of income and the interest rate that
produce balance of payment equilibrium – the Q points along the BP curve in
Figure 8.9.
Suppose the income and interest rate have interacted to produce the BP
equilibrium at Q0 and then the income level rises with no change in interest rate:
This will move the economy horizontally to the right of Q0, say to N.
The BP will move into deficit because the higher income level will have
induced higher demand for imports
If interest rate is moved from i0 to i1, this will eliminate the BP deficit by
achieving a new BP equilibrium at Q1.
This is because a rise in interest rate will generate net short-term capital
in-flows from abroad to take advantage of the higher interest rate
Thus, at point Q1, income level Y1 and interest rate i1, combine to produce
BP equilibrium at Q1.
130
The opposite effect will happen on the BP if the income level fell from Y0 to Y2:
This will trigger a reduction in the interest rate from i 0 to i2, causing short-
term capital out-flows to seek higher interest rates abroad.
Short-term capital outflows will off-set the surplus in the current account
Thus, if the economy is located to the right of the BP curve, then there is BP
deficit
This is because of high income that will induce higher demand for imports, but
low interest rate will trigger short term capital outflows, resulting in the deficit of
both the current account (CA) and the capital account (KA) .
If the economy is located to the left of the BP curve, there is a BP surplus in the
economy.
This is attributed to high interest rate that attracts short term capital inflows
leading to KA surplus
Finally , if we remember that the BP curve is drawn for a fixed exchange rate,
then the simple rule is :
8.9 Equilibrium in the Open Economy: The Simultaneous Use of LM, IS and BP
Curves
As a final step in preparation for the discussion of macroeconomic policy in an
open economy, we bring together the concepts behind the LM, IS and BP curves.
131
Figure 8.10 shows the simultaneous equilibrium in the money market (LM) the
real sector (IS) and the balance of payments (BP) at point e, where all the three
schedules
Figure 8.10: Simultaneous Equilibrium in the Real and Monetary Sectors and in the
Balance of Payments.
Interes
t rate LM
BP
e
ie
IS
Ye Income (Y)
The income level associated with the three way equilibrium is Y e, and the interest
rate is ie.
As we shall see later, this equilibrium position may not be optimal in terms of a
country’s economic objectives
We are now ready to bring in the monetary approach to BP, the monetary
approach to the exchange rate, the asset market approach to BP and exchange rate,
and exchange rate overshooting phenomenon.
132
ACTIVITY
“In the Keynesian income model, the IS curve shows the combination
SUMMARY
In this lesson we have learnt about the money market and national
FURTHER READINGS
effects of changes in the exchange rate on domestic prices and terms of trade. Finally, we
134
shall learn about the Marshall – Lerner condition
INTRODUCTORY LESSON ON INTERNATIONAL TRADE
Objectives
9.3 Balance of Payments Correction under Flexible and Fixed Exchange Rates
135
Regimes
Two methods are used to correct BoP disequilibria:
Automatic adjustment mechanism
Interventionist or adjustment policies
Automatic adjustment mechanism method is one that is activated
by BoP disequilibrium itself, without any government action, and is usually
associated with a flexible exchange rate regime.
On the other hand, interventionist policies are specific measures
invoked by the government with the primary objective of correcting the BoP
disequilibrium and are associated with a fixed exchange rate regime.
Automatic adjustment mechanisms are triggered immediately a
BoP disequilibrium arises and continue to operate until the disequilibrium is
eliminated, ceteris paribus.
Interventionist’s policies, on the other hand, involve a time lag, in
that it takes time for the government to recognize the existence of a BoP
disequilibrium, and then when it acts, it takes time for the policies to work.
S$*
E* S$
136
80
E
74 C F
72 A Deficit B D$
D$*
0
8 10 12 Q$ (millions)
137
Thus, it is important to know how elastic Kenya’s demand and supply curves for
dollars are in order to decide on the level of intervention.
Sometimes the shape of the deficit country’s demand and supply curves for
foreign exchange is such that a devaluation or depreciation actually increases,
instead of reducing or eliminating, the deficit in its BoP.
Figure 9.2 below shows the effect of a shift in the daily demand for foreign
exchange on the balance of payments and how government is expected to respond
under different exchange regimes.
Figure 9.2: Balance of Payment Disequilibrium Under Fixed and Flexible Exchange
Regimes.
S$
e=Ksh/$
77.25 E1
75 M F
72.60 E R
D1$
D$
Millions if
0 $ per day
3 4.5 5.4 6.5 8
Figure 9.2 shows hypothetical daily demand and supply curves of US dollars on the
Kenyan foreign exchange market.
D$ represents Kenya residents’ daily demand curve for dollars.
138
This demand arises from the residents’ demand for imports of goods and services from
the rest of the world; from residents’ unilateral transfers to friends and relatives abroad;
and from residents who are desirous of investing abroad.
These autonomous debit transactions of Kenya residents involve payments to the rest of
the world.
On the other hand, S $ represents the supply curve of dollars.
Supply of dollars arises from residents’ export of goods and services to the rest of the
world; receipts of income from investments abroad; unilateral transfers received from
abroad by Kenya residents; and foreigners’ investments in Kenya.
These are the autonomous credit transactions that involve receipts of foreign
currency by Kenya residents.
In figure 9.2, with the demand curve D$ and supply curve S$, the equilibrium exchange
rate at point E is e = Ksh/$ =72.60 with the quantities of dollars supplied and
demanded equal at $3.0 million per day.
Suppose for some reason (such as political uncertainty that increases the incentive for
Kenya’s business community to repatriate funds abroad) Kenya’s autonomous demand
curve for dollars shifts from D$ to D1$.
If Kenya is operating a fixed exchange rate regime and the central bank wants to
maintain the exchange rate at e = Ksh/$ = 72.60, it will have to intervene in the foreign
exchange market and supply, from its official reserves, the excess demand (ER) of $5
million ($8m-$3m), per day in order to prevent the depreciation of the Kenya shilling
to the new equilibrium point E1, where e=Ksh/$=77.25 and demand and supply are
equal at $5.4 million per day.
The $5 million drawn from the reserves in the official settlements account will
constitute the net credit of accommodating transactions to take care of the balance of
payments disequilibrium, caused by excess demand (excess total debit over total
credits) of the autonomous transactions.
However, if Kenya operated a flexible or a floating exchange rate regime, a shift of
the autonomous transactions demand curve from D$ to D1$, would make the market
forces of demand and supply to put pressure on the exchange rate to move upwards.
139
In the process, the Kenya shilling will depreciate to e = Ksh/$ = 77.25, where a new
equilibrium point is automatically established at E1, without recourse to intervention
using accommodating transactions.
In other words, a flexible exchange rate system contains an automatic adjustment
mechanism that, in the long run, minimizes balance of payments deficits or
surpluses.
On the other had, if Kenya operated a managed float exchange rate regime, and the
CBK wished to limit the depreciation of the Kenya shilling to e = Ksh/$ =75 .0
(instead of 77.25), it would have to intervene in the foreign exchange market and off-
load $ 2 million ($ 6.5m - $4.5m) per day from its official reserves, to cover the gap
(MF) of excess demand (excess total debit over total credit) of items above the line.
Just like was the case with a fixed exchange rate regime, the action of intervention in
the foreign exchange market under the managed float exchange rate regime is to tackle
the problem of disequilibrium in the balance of payments caused by excess demand in
the items above the line.
9.5 Effects of Exchange Rate changes on Domestic Prices and Terms of trade.
A devaluation or depreciation of the Kenya shilling visa vis the dollar has
important effects on domestic (Kenyan) prices:
Devaluation or depreciation of the shilling stimulates the domestic
production of import substitutes and exports.
Devaluation or depreciation of the shilling also leads to rise in prices of
goods and services, since imports will be more expensive i.e. the effect is
inflationary.
The greater the devaluation or depreciation of the shilling, the greater its
inflationary effect on Kenya’s economy and therefore the less feasible it is
to use the exchange rate increase as a method of correcting the BoP deficit
in Kenya.
Devaluation or depreciation of the shilling is also likely to affect Kenya’s terms
of trade (defined as the ratio of the price of a country’s exports to the price of its
imports).
140
Exports and import prices must both be measured in terms of either the
domestic or the foreign currency.
Since the price of both exports and imports of a country rise in terms of the
domestic currency as a result of a depreciation/devaluation, Kenya’s terms of
trade can rise, fall or remain same depending on whether the price of exports
rises by more than, by less than, or by the same percentages as the price of
imports.
141
If it were possible to know the shape of the demand and supply curves (elastic or
inelastic) of foreign exchange in the real world, it would be easy to determine the
size of the depreciation/devaluation required to correct a BoP deficit.
Since this is not the case, we can only deduce the elasticity of the demand and
supply curves for foreign exchange from the actual demand for and supply of the
country’s imports and exports.
The elasticity of any demand curve is defined as the percentage change in
quantity demanded resulting from a percentage change in the price.
In the Marshall-Lerner condition case, if the country’s demand and supply
curves for foreign exchange are elastic, then the country’s BoP deficit will
improve with a devaluation/depreciation, since the increase in the domestic price
of imports (due to devaluation) leads to a reduction in the total expenditure on
imports, and the reduced price of exports (in terms of foreign currency) leads to
an increase in the demand for the country’s exports.
However, if the domestic demand and supply curves of foreign exchange are
inelastic, the impact of depreciation/devaluation is uncertain, since it is difficult to
know how the partners in trade will respond to the devaluation /depreciation.
If due to devaluation/depreciation, the increase in domestic expenditure on
imports is greater than the increase in expenditure on home country exports by the
trading partners, the BoP deficit will worsen with depreciation/devaluation,
leading to the foreign exchange market being unstable.
Thus, the Marshall-Lerner condition indicates a stable foreign exchange market
if the sum of the price elasticities of the demand for imports (Dm) and the price
elasticities of demand for exports (Dx) is greater than one, in absolute terms i.e.
If [(Dm +Dx) >1], the foreign exchange market is stable.
Where:
Represents price elasticity;
Dm represents demand for imports;
Dx represents demand for exports.
When the Marshall-Lerner condition of a stable foreign exchange market
exists, devaluation will yield positive results in the BoP
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However, if the sum of the price elasticities of demand for imports and price
elasticities of demand for exports is less than one, in absolute terms, i.e. [(Dm
+Dx) <1], the foreign exchange market is unstable.
Thus, when the foreign exchange market is unstable, a devaluation of a domestic
currency will not have a positive effect on a country’s BoP.
Finally, if the sum of the two demand price elasticities is equal to one, in absolute
terms, i.e. [(Dm +Dx) =1], a devaluation/depreciation of a domestic currency
will leave the BoP deficit unchanged.
It should be noted that the general formulation of the Marshall-Lerner condition
is very complex and is best presented algebraically.
For those students who are keen to expand their knowledge of the concept of the
Marshall-Lerner condition, and its derivation, they should turn to Appleyard
and Field, 1992, pages 551-553 or Salvatore, 1990, pages 482-484 or Sodersten,
1992, Ch. 25.
SUMMARY
condition
FURTHER READINGS
145
INTRODUCTORY LESSON ON INTERNATIONAL TRADE
In this lesson we are going to look at the historical development of the international monetary
system, from the Gold Standard in the 1870s to the present (2012) system currently in
operation.
Objectives
146
Governments of each of these nations committed themselves to buy and sell gold at the
legally defined weights and fixed prices.
For example, Britain defined its sterling pound gold coin as containing 113.0016
grains of pure gold, while the price of gold was fixed at 4.248 sterling pounds per
ounce (oz) of gold (480 grains/113.0016 grains = 4.248).
For the USA, one dollar gold coin was originally defined in 1781 as containing 23.22
grains of pure gold
Since there were 480 grains of gold per ounce, equating 23.22 to the dollar established
the price of gold at $20.67 per ounce (oz) of gold (480 grains/23.22grains = 20.67).
This meant that the mint parity between one sterling pound gold coin and one dollar
gold coin was, grains 113.0016/23.22 = 4.87 grains.
Similarly, the exchange rate between the sterling pound and the dollar was
$20.67/4.248 sterling pounds = $4.87.
This became the fixed exchange rate at which the sterling pound was traded with the
USA dollar under the gold standard.
Note that in the imperial weights measures, 16 ounces (ozs) = 1pound (lb, and, for
conversion into metric weights measures, 2.2 pounds = 1kg.
The same principle was used to arrive at fixed exchange rates among all the currencies
issued by gold-standard nations, namely: ……“an international gold standard fixes
the currency exchange rates for all participating nations” (Gary smith, 1991, p.61)
Under the gold standard, all currencies were convertible into gold.
There was no reserve currency, although the British sterling pound was a dominant
currency in international trade, due to Britain’s imperial (Pax Britannica) dominance
during that period.
Amazingly, during the period when the gold standard was in operation, there were no
institutions or written agreements or law to enforce the fixed exchange rates.
The system was enforced through the option of converting one currency into gold and
then back into another currency.
This was possible because gold was traded freely and each participating country had
committed itself to buy and sell gold at fixed prices.
147
Arbitrage activities of individual arbitrageurs kept the day-to-day exchange rate around
the fixed rate.
For example, suppose an importer in USA wanted to exchange dollars for sterling
pounds, in order to buy British goods, what steps would he take to get pounds?
He would go to a local currency dealer to effect the transaction.
If a local currency dealer demanded $5 per sterling pound, and the USA importer
considered this price too expensive, he had the option of using his dollars to buy gold
from the USA government at $20.67 per ounce.
He would then ship the gold to Britain, and sell it to the Bank of England at 4.24
sterling pounds per ounce.
Since the shipping and other transactional costs ranged between $0.02 and $0.03 per
ounce of gold, the American importer would by-pass the currency dealer, if the
currency dealer’s price was more than $4.905 ($4.875+0.03) per ounce of gold.
It should be noted that in addition to purchasing British goods, the importer had the
option of exchanging the sterling pounds, earned from the sale of gold in Britain, at the
official price of $4.875 per sterling pound.
If the USA currency dealer’s dollar price of the sterling pound remained at $5 per
pound, arbitrageurs would find it profitable to buy gold in the USA at the official rate of
$20.67, ship the gold to Britain and sell it to the Bank of England at the official price of
4.24 sterling pounds per ounce, and exchange the pounds for (4.24 x 5.00) = $21.20 in
the USA foreign exchange market.
The arbitrageur would earn a gross profit of $21.20 - $20.67 = $0.53 on each ounce of
gold.
If you subtract the transportation and other transactional costs of $0.03 per ounce, the
arbitrageur is left with a net profit of $0.5 per ounce.
The arbitrage process raised the demand for dollars in the USA foreign exchange
market, resulting in lowering the market exchange rate back towards the mint rate of
exchange of $4.875.
Thus, arbitrage activities would keep the market exchange rate within a band around
the mint exchange rate determined by the shipping and other transactional costs of
gold.
148
As an international monetary system, the gold standard worked very well until the
outbreak of World War I in 1914, when most aspects of the international economy were
disrupted.
During the war, most large economies except the USA, abandoned the convertibility of
the currencies into gold.
This is because countries involved in the war printed large quantities of their currencies,
which were not backed by gold, to finance their participation in the war.
After the war, some countries such as Germany and Austria experienced hyper-
inflation, which made it difficult for them to return to the pre-World War I currency
rates for gold.
In the mean time meetings were held by gold-standard nations, to discuss as to when
to re-establish the gold standard and how to choose the new rate at which each
currency could be converted into gold.
Throughout the first half of the 1920s, Britain’s Chancellor of the Exchequer (minister
of finance), Winston Churchill, worked tirelessly to introduce deflation measures so
that his country could lead others to return to the gold standard.
In 1925, Churchill’s efforts bore fruit when the gold standard was re-established, but
the implied exchange rates were, in some cases, inappropriate.
This gave rise to unofficial exchange rates, as some governments were hard pressed to
meet the needs of the currency transactions at the official exchange rates.
Churchill’s efforts were, however, to come to naught with the advent of the Great
Depression of 1929.
Beginning in 1931 the brief return to the gold standard collapsed in the midst of the
Great Depression that lasted from August 1929 to March 1933.
However, notwithstanding the fate of Churchill’s effort to prop up the gold standard in
Europe, the USA was the only major economy among the gold-standard nations,
whose currency remained convertible into gold, when the fixed mint exchange rates of
the gold standard era finally ceased to operate in 1931.
In 1934, the USA government nationalized all USA gold and raised the price of gold
from $20.67 to $35 per ounce of gold.
The 1934 Gold Reserve Act forbade private citizens in USA from holding gold except for “legitimate”
non-monetary uses. However, since 1975 private citizens in the USA are now free to hold gold and
149
This led to the rush of gold pouring into the USA, to the extent that the dollar worth of
US Treasury’s gold stocks swelled six-fold from $4 billion in 1934 to $23 billion in
1941
The Second World War, which broke out in 1939, injected more chaos in the already
unstable international monetary system.
During the war, concerted efforts were made to engineer a replacement of the gold
standard.
These efforts, which began in 1941, culminated in the holding of the Bretton Woods
Conference of 1944 that produced a modified version of the gold standard.
speculate on it.
150
The difference was that under this new system, non-dollar currencies could not be
converted directly into gold.
They had first to be converted at a fixed rate into dollars, which in turn were converted
into gold at a fixed price of US$ 35 per ounce (Oz) of gold.
Second, the architects of the new monetary regime recognized the need to adjust the
exchange rate from time to time, as different economies went through the recovery
process from the destructive effects of the Second World War.
A provision was therefore made for each exchange rate to fluctuate in a band of one
per cent around the pegged rate.
Adjustments larger than one per cent were only allowed with the unanimous consent of
the rest of the group of 44 countries.
Thus the new system was appropriately termed as the Adjustable Peg.
Third, the Bretton Woods System, unlike the pre World War II gold standard, was a
product of international negotiations of the representatives of 44 countries, not
withstanding the dominant role played by Britain and the USA.
As a result, a major international organization, the International Monetary Fund
(IMF), was created as a multilateral consultative and administrative body to oversee the
successful operation of the new system.
Until the late 1950s, and early 1960s, when other currencies became fully convertible,
the US dollar was the only intervention currency.
That is why the new system was also known as the Gold-Dollar Standard.
.
10.4 The Mechanisms of the Gold Exchange Standard, or the Gold-
Dollar Standard Under the Bretton Woods Agreement.
Since the USA dollar was the key reserve currency in the Bretton Woods’ gold
exchange standard system, the implication was that there was a distinction between
the monetary policies to be pursued by the USA and those to be followed by the other
countries, viz:
It was the primary responsibility of the USA government to ensure that the
US dollar, as the key reserve currency, maintained convertibility into gold,
at all times, at the fixed price of US$ 35 per ounce of gold.
151
Fulfillment of this responsibility required that the USA government was:
to stand ready to buy or sell gold in exchange for dollars at US$ 35
per ounce of gold
not to create more dollars than could be backed by the large but
finite stock of gold stored at its secure location at Long Knox vaults
to provide sufficient dollars for interventionist purposes by member
countries in support of the fixed exchange rates of their currencies
Other central banks had the responsibility to buy and sell dollars for intervention
purposes, thereby keeping the dollar values of their respective currencies at the pegged
rates that were agreed upon as per Bretton Woods Agreement.
152
Alternatively, a country would buy dollars using its own currency (adding to its
foreign reserves) to prevent an appreciation of its currency by more than one per cent
from the agreed fixed exchange rate with the dollar.
However, if economic circumstances changed drastically, such that the pegged rate was
too far away from the equilibrium, the Adjustable Peg was an inadequate tool.
Instead, intervention of a fundamental nature was to be undertaken under the
guidance of the IMF to arrive at an exchange rate that corresponded closely to the new
equilibrium level.
In theory, therefore, the Adjustable Peg was supposed to allow flexibility in action to
stem crises that fixed exchange rates, under the gold standard, became a victim of.
In practice, governments under the Bretton Woods system were often less willing to
adjust exchange rates even when the observed disequilibria were quite fundamental.
For some reason, an over valued currency was not only sought after, but was
associated with preservation of sovereignty by many political leaders.
As a result, the delay or failure to deploy in time the Adjustable Peg tool made the tool
less effective in achieving the goal desired by the framers of the Bretton Woods System.
153
It later transpired that because of the large quantities of dollars required for intervention
by foreign central banks, the USA’s fulfillment of one of the requirements would
inevitably lead to the contravention of the other.
As a result, by 1964, the dollar liabilities to foreign central banks surpassed the USA’s
stock of monetary gold at Long Knox vaults.
This put a question mark on USA’s ability to maintain convertibility at the official rate
of $35 per ounce of gold.
Second, macroeconomic policies pursued by the USA and other governments conflicted
with the 1944 Agreement’s requirements.
For example, the USA, in order to finance the Korean War (1950-1953), the Vietnam
War (1959-1975) and the Cold War (1946-1990) pursued excessively expansionary
monetary policies, as domestic taxation for those programmes was unpopular.
As a result, first, the USA’s expansionist monetary policies severely weakened the
value of the dollar.
This was not helped by the fact that USA’s gold stocks at Long Knox vaults were
rapidly being depleted by balance of payment deficits resulting from the
aforementioned wars.
Third, under the Bretton woods Agreement, foreign central banks were obliged to
purchase excess dollars in the foreign exchange market, which they added to their
foreign exchange reserves.
Since foreign exchange reserves are a component of the monetary base of a country,
this led to rapid monetary growth, which was responsible for the serious global
inflationary spiral experienced during the 1960s and 1970s.
Fourth, there was the adjustment problem when it came to operating the adjustable peg.
Many countries did not adjust their exchange rates in time when balance of payments
problems arose.
Instead, they directed their monetary and fiscal policies towards internal targets.
For example, the USA, which had serious BoP deficits, was more concerned about the
slow rate of economic growth and unemployment at home than its responsibilities to
the Bretton Woods Agreement.
154
As a result, it did not institute measures to reduce money supply as expected of a deficit
country.
Germany on the other hand, was so fearful of inflation due to the1920’s experience that
it did not, as expected, expand its money supply in order to adjust its BoP surplus.
Fifth, central banks of many countries could not adequately compensate for USA
government’s failures to implement the 1944 Agreement.
For example, when in mid-1960s central banks realized that the dollar liabilities to
foreign central banks surpassed the USA’s monetary stock of gold, they were reluctant
to accumulate dollars at the rate at which dollars were being created by USA.
The inflationary impact of USA’s monetary policies on foreign economies caused a lot
of resentment to those countries that were faithful to the provisions of the Bretton
Woods Agreement.
By the end of 1970, the problems that plagued the Bretton Woods system due to USA’s
macroeconomic polices had graduated into an international monetary crisis.
In 1971, a devaluation of the dollar (a rise in the dollar price of gold) was anticipated.
This made central banks to rush to exchange their dollar reserve holdings for gold
before the devaluation was effected.
After a number of informal and formal attempts to end the crises failed, convertibility
of the dollar ended on 15th August, 1971 when president Richard Nixon of the USA
unilaterally declared that the USA government would no longer buy or sell gold at the
fixed rate of US$ 35 per ounce of gold.
The other countries were left with no other option but to float their currencies.
From August 1971, the international monetary system was in a state of confusion until
March 1973 when the flexible exchange regime was officially recognized by the IMF
and its member countries.
Since then,the flexible exchange regime is now the dominant regime operated by the
majority of countries involved in international trade.
In the meantime, the gold price in the open market rose sharply from the official price
of $35 to over $500 per ounce of gold at the height of the inflationary spiral in the mid-
1970s.
In January 1980, it reached an all time high of $850 per ounce of gold.
155
1.3 REVIEW QUESTIONS
ACTIVITY
SUMMARY
In this lesson we have learnt about:
The Gold Standard international monetary system and its
operations from 1870s up to its collapse in the 1930s.
The Bretton Woods international monetary system that replaced
it.
The collapse of the Bretton Woods monetary system that gave
birth to the current liberalized global monetary system.
156
FURTHER READINGS
LESSON ELEVEN
11.0 THE BRETTON WOODS INSTITUTIONS
11.1 Introduction
In this lesson we are going to look at the three international organizations that were created at
the Bretton Woods Conference.
157
Objectives
Towards the end of World War II, the leading victorious countries, Britain and USA,
started plans to establish new structures under which the world economy would operate.
Finally, at a conference of Bretton Woods, New Hampshire in 1944, it was agreed on
organizing the world economy around three institutions, viz: the International Monetary
Fund (IMF), the International Bank for Reconstruction and Development (IBRD) and
the International Trade Organization (ITO).
158
The value of the bancor would be fixed in gold.
The clearing union would create bancors just as a national central bank creates money
domestically.
In essence, the Keynes plan provided for an international central bank.
Under the Keynes plan, only gold and the bancor could be used for
international payments.
A country could acquire the bancor in two ways:
One, it could do so by selling gold.
Two, it could use its credit facilities with the clearing union to
acquire bancors.
The plan provided for the exchange of gold and the bancor to be one way only, i.e.
gold could be used to acquire bancors but not the other way round.
In practical terms, the clearing union would perform the functions of a World Central
Bank.
The plan was built on the premise that deficits and surpluses in the BoP change in
cyclical fashion and are temporary.
Since each member country would be allocated a quota based on the country’s exports
and imports, a deficit country would access credit facilities from the clearing union
based on its quota.
If a country borrowed more than 25 per cent but less than 50 per cent of its quota, it
would pay an annual rate of interest of one percent.
If it used more than 50 per cent of its quota, it would pay two per cent of interest per
annum.
Keynes plan also provided for a surplus country to pay a penalty charge.
If a country accumulated more than 50 per cent of its quota in excess foreign exchange
reserves, it would pay one per cent per annum interest charge as a penalty (Bo
Sodersten, 1970, Ch. 28).
The Keynes plan, as earlier pointed out, was not adopted.
What was adopted was the Harry D. White’s plan, which gave birth to the gold-dollar
standard as outlined in section 7.2 above.
159
The institution that was created to oversee the new system of fixed but adjustable
exchange rates was the IMF.
The IMF charter empowered it to ensure that each country followed a set of agreed
upon rules of conduct in international trade and finance to avoid the wide fluctuations,
the competitive depreciations, the shrinkage in trade and the general instability of the
world economy experienced during the 1917-1939 inter-war period.
The second role assigned to the IMF was to work for harmony between a member
country’s external goals (such as adjustments in BoP imbalance) with national goals
(such as economic growth and jobs creation) in macroeconomic policy formulation.
The third role of the IMF was to provide credit to member countries experiencing
temporary BoP problems.
The architects of the new International Monetary System were of the view that once
deficit countries had access to IMF short-term loans to finance trade, they would have
no incentive to impose trade barriers, for purposes of conserving foreign exchange
reserves.
The IMF started operations in March 1947, with 33 members on board.
By 2006, membership had risen to 184 countries, with Switzerland as the only major
Western (capitalist) economy that is not a member of the IMF.
A country joins the IMF by contributing a sum called a “Quota”.
The quota consists of 25 per cent gold and or some other internationally accepted hard
currency.
The rest (75 per cent) is composed of a country’s own currency.
The size of each country’s quota is determined by its economic size and the country’s
volume of trade.
For example, in 1991 Kenya was assigned a quota of 0.2 percent, which was equivalent
to $190.4 million while the USA was assigned a quota equivalent to
$ 24.03 billion (Appleyard et al, 1992).
Voting rights within the IMF are proportioned according to the country’s quota.
For example, the USA, which has always had the largest quota, was assigned a quota of
36 per cent of total in 1944, but has by June 2011 been reduced to 16.8 percent,
followed by Japan, 6.25percent, Germany, 5.83 percent , France, 4.3 percent, Britain,
160
4.3 percent, China, 3.92 percent, Italy 3.17 percent, Saudi Arabia 2.81 percent and
Russia, 2.4 percent.
It will be noted that China’s quota is about half that of Japan, despite China having
officially surpassed Japan in January 2011 to become second only to the USA as the
largest economy in the world. It is sixth in the IMF pecking order of the quota or
voting rights.
The IMF members’ quotas were revised in 1999, when the total quota was increased by
45 percent from $212 billion to $ 308billion.
A country’s quota determines it’s drawing or borrowing rights from the IMF.
In 1970 the IMF decided to expand its reserve base so that it did not have to depend on
members’ contributions only.
It did this by introducing a paper asset (sometimes called “paper gold”), known as the
Special Drawing Rights (SDRs).
On January 1st, 1970, the IMF simply entered on the books of all participating members
a total of $ 3.5 billion worth of SDRs.
In the same year (1970), the SDR was defined as equal to 1/35 of an ounce of gold,
and thus equal to one dollar.
The $3.5 billion worth of SDRs was divided amongst member countries in proportion
to each country’s quota share of the total IMF quotas.
Since 1970, SDRs have been created on several occasions.
The total SDR quota at the end of March 2006, was SDR 213 billion (about US$ 318.4
billion).
Today, the value of the SDR is determined by a weighted average of a basket of sixteen
major currencies.
On 24th May 2006, one SDR was valued at US$ 1.4947.
161
so by making the necessary arrangements with the IMF to swap her (Kenya’s) SDRs
with another country, say Britain, which has yens it wants to dispose off.
Alternatively, Japan’s 75 per cent quota contributions in yens to the IMF can be
swapped with Kenya’s SDR holdings to settle Kenya’s loan obligation to Japan.
This will solve Kenya’s liquidity problem, and at the same time increase Japan’s
international reserves.
According to the IMF rules, a country can obtain annual loans of up to 125 per cent of
its IMF quota to sort out its BoP problems, but cannot go beyond 300 per cent
cumulatively.
Only under exceptional circumstances can access to funds be higher.
The 125 per cent of a country’s quota is divided into tranches, viz:
The first tranche of 25 per cent is called the gold or reserve tranche.
The next 100 per cent is divided into four equal tranches namely: first,
second, third and fourth credit tranches.
Under the IMF regulations, a country can automatically use its gold tranche without
any questions being asked.
Thereafter, each credit tranche drawn must be negotiated and approved by the IMF
according to its conditionalities.
These conditionalities become more stringent as the country moves towards the fourth
credit tranche.
For example, payment of interest is on an increasing scale as one borrows beyond the
gold tranche.
Once a country reaches the fourth credit tranche, it becomes a candidate for structural
adjustment programme (SAP), with very stringent IMF conditionalities.
162
In Kenya, the IMF conditionality was to impose a freeze on the recruitment of teachers
and nurses at the time the government was implementing the free primary education
and the HIV/Aids programmes.
Sometimes the programmes supported by the IMF and World Bank prevent countries
from accepting external grants to fund programmes which are in the developing
countries’ priority sectors like HIV/Aids (see IMF, 2006, http://www.imf.org/)
The second major criticism of the IMF is that the IMF- supported programmes favour
commercial banks, foreign direct investment and the investments of the elite in society.
In Kenya, this was clearly demonstrated when, in the second half of 2004 the
government gave in to the pressure from the visiting IMF mission, to facilitate a hike in
the interest rates on 90-day Treasury bills from about 4 per cent to over 8 per cent.
The IMF did this by lifting its own imposed ceiling on the Kenya government’s
borrowing from Ksh 20 billion to Ksh 30 billion.
According to the then minister of finance, David Mwiraria, the Treasury
was surprised that the IMF visiting team advised the government to borrow in excess of
the IMF’s own set budgetary borrowing ceiling.
It was not lost to observers that over 50 per cent of the government borrowing through
Treasury Bills is from commercial banks and the bulk of the rest is borrowed from
firms controlled by a small clique of elites in business circles.
As of September 2006, commercial banks held Ksh 52.9 billion of the possible Ksh
98.6 billion of government Treasury Bills.
The third major criticism is that the IMF has one kit cure for all economic problems for
its disparate member countries, neither is it comprehensible to developing countries
when IMF assumes and acts as though all countries benefit from globalization with
equal measure.
This view of the IMF is strengthened by the fact that the IMF does little to help
developing countries, which have been adversely affected by globalization through loss
of both jobs and domestic market due to the flooding of cheap manufactured goods
from the industrialized world.
The other criticisms of the IMF include:
163
The IMF is dominated by the group of seven (G-7) industrialized nations,
especially so the USA Treasury.
The IMF is not accountable to its members, especially the economically
weak developing countries.
The IMF forces developing countries to open up their markets to imported
manufactured products from industrialized countries but does little to
make industrialized countries to open up their markets to third world
countries’ exports, or reduce subsidies to their farmers who compete
unfairly with farmers from developing countries.
The SDR – quota formulas generally benefit small, open economies but
penalize large, fast growing countries.
For example, China’s economy as of March 2006 is double the size of
Belgium and the Netherlands combined, yet, each of these two European
countries have a bigger IMF quota than China.
The IMF’s 24-member executive board, which oversees the daily running
of the fund, is dominated by Europe, which has 8 seats, Africa 2, Middle
East 3, America 4 and one each for USA and Russia
11.4 The World Bank.
Another institution that was set up by the Bretton Woods Conference is the
International Bank for Reconstruction and Development (IBRD), more commonly
known as The World Bank.
It began in 1944 with 38 member countries, but by March 31st 2006, its membership
had increased to 184.
Originally, the World Bank was established specifically to provide long-term loans for
the reconstruction of Europe, which was recovering from the destructive effects of
World War II.
However, Europe’s reconstruction took a shorter time than anticipated.
As a result, the World Bank diverted its attention to raising capital from the developed
industrialized countries, to finance development projects in developing countries.
164
The World Bank has four affiliates, which play different but supportive roles in the
World Bank’s mission of reducing poverty, promoting economic growth, and improving
the quality of life of the poor people in developing countries.
While the IBRD focuses on middle income and credit-worthy countries of the third
World, its affiliate, the International Development Association (IDA), which was
established in 1960, provides long-term loans on concessionary terms to the poorer
group of developing countries.
The second affiliate of the IBRD is the International Finance Corporation, which was
established in 1956, to help private investors in developing countries to access funding
from local and external sources.
The other affiliates of the World Bank are: the Multilateral Investment Guarantee
Agency, and the International Center for Settlement of Investment Disputes.
Currently, the World Bank is the largest source of long-term funding for developing
countries.
It employs 10,000 workers, 7000 of whom are based at its headquarters in Washington,
and another 3000 are based in more than 100 offices around the world.
165
Instead of member countries bargaining bilaterally on trade matters, GATT was to
facilitate joint negotiations of trade terms and trade policy that would make
international trade flow smoothly.
Membership of GATT grew from the original number of 22 countries in 1947 to over
100 by 1994 when GATT was wound up.
GATT member countries observed the so-called “most-favored-nation” (MFN) clause
under which member countries agreed on the principle of non-discrimination – that is,
they agreed not to give better treatment to any single country as far as trade policy was
concerned.
The only exception to this principle was made in cases of economic integration (to be
discussed in the next section), such as customs union and in the case of trade between a
country and its former colonies.
GATT was also to work for elimination of non-tariff barriers to trade such as quotas
except for agricultural products and for nations in BoP difficulties.
Member countries of GATT also agreed on consultations among themselves in solving
trade disputes within the GATT framework.
Between 1947 and 1962, GATT did not record much success, partly because tariffs
negotiations were conducted on product-by-product basis, but mainly because of the
protectionist devices the USA Congress imposed in the Trade Agreement Act.
The protectionist devices in the USA Trade Agreement Act were:
Peril-point provision: this provision prevented the president of USA from
negotiating any tariff reduction that would cause serious damage to domestic
(USA) industry.
The escape clause: this clause allowed any domestic industry that claimed
injury from imports to petition the US Tariff Commission, which could then
recommend to the president to revoke any negotiated tariff reduction.
The national security clause: this clause prevented implementation of tariff
reductions (even if already negotiated) if they would hurt industries
considered important to USA’s national security.
From 1947, the USA has persistently used the “escape clause” to provide protection to
her industries from global competition.
166
Since most tariff reduction proposals by GATT would hurt those industries with
comparative disadvantage in USA, but which industries enjoyed comparative
advantage in developing countries (like textile and apparel industries), the use of the
“escape clause” by the USA has always hurt developing countries most.
After 1962, GATT recorded substantial progress in the reduction of trade barriers in
three sequential rounds of negotiations, viz:
a) The Kennedy round (1962-1967) which reduced tariff by 40 per cent.
b) The Tokyo round (1973-1979) which reduced tariff by 30 percent.
c) The Uruguay Round (1986-1994), which not only cut tariffs by a further
40 percent, but it also tackled non-tariff issues such as intellectual property
and /or patents.
However, most developing countries complained against GATT’s unsympathetic
handling of their development concerns.
They argued that they needed tariffs to protect their infant industries from established
competitors from the advanced industrialized countries.
The infant industry argument is a centuries old argument ably presented by Alexander
Hamilton (1757-1804) in his famous Report on Manufactures (1791) in defence of
USA manufacturing industry, and German scholar, Friedrich List (1789-1846) in his
famous Das Nationale System DER politschen Okonomic…(1841) in defence of
German manufacturing industry.
GATT responded positively by approving a provision known as Generalized System of
Preferences (GSP) for developing countries exports.
The GSP was a preferential treatment by advanced industrialized countries of
developing countries’ exports.
Under the GSP, a quota of imports from developing countries to an advanced
industrialized country, were exempted from tariffs.
In addition, developing countries were exempted from GATT’s provision of
reciprocity, that is, developing countries were not to provide reciprocal trade
liberalizing concessions to advanced industrialized countries.
Critics of GSP argue that a long list of trade items were ineligible for consideration
under the GSP, such as textiles, apparel and foot ware.
167
Yet, these were the trade items in which developing countries had a comparative
advantage to produce.
The other criticism of GATT was that the GSP applied only to tariffs and not other non-
tariff trade barriers, which were commonly used by advanced industrialized countries
against developing countries’ product.
The Uruguay Round of negotiations ended in 1994 with the launch at Rabat, Morocco,
of the World Trade Organization (WTO), which took over all roles performed by
GATT.
The key difference between GATT and WTO is in dispute settlement procedures.
Although GATT performed same roles as WTO, international law did not recognize
GATT as a legal organization, but only as a treaty.
Thus compliance with GATT rulings in disputes was not mandatory, while compliance
with the WTO rulings, is mandatory.
Article VI of the General Agreement on Tariffs and Trade of 1994, which deals with
issues of anti-dumping, gives countries the freedom to export to foreign markets as long
as they are not engaged in unfair practices.
The rules give individual countries the powers to apply anti-dumping measures after
investigations determine that an imported product is dumped, and that the dumped
imports are causing material injuries to a domestic industry producing the same
product.
Investigation procedure:
Investigate to establish that there is dumping under the WTO
definition
Government should make an official complaint to the WTO about the
country dumping. (Note that under WTO rules only governments can launch
official complaints)
By December 2005, WTO member countries had reached 149.
Viet Nam became the 150th member in January 2007, and by November 2009,
membership had increased to 153.
The functions of WTO are given as:
Administering WTO trade agreements
168
Acting as a forum for trade negotiations
Handling trade disputes between member countries
Providing technical assistance and training for developing countries
Cooperating with other international organizations to facilitate smooth
international trade flows.
While WTO mission is to liberalize trade, in some circumstances, its rules support
maintaining trade barriers.
For example, it has provisions for protection of infant industries, protection of
consumers and prevention of the spread of disease.
The WTO launched its own trade round of negations known as the Doha Development
Round in November 2001.
When the 144 WTO member countries met in Doha, Qatar, in November 2001 they
agreed to start to negotiate the reduction of European and USA excessive farm
subsidies to their farmers under the Doha Development Round.
In 1999 the Seattle Conference was scuttled by poor countries’ opposition to
protectionism by the developed countries of their agricultural sector, while the latter put
pressure on poor countries to open their borders to the developed countries’
manufactured goods and services.
In 2001 the World Bank estimated that the developed countries’ subsidies distorted
trade to the tune of US$ 3000 billion per annum.
The USA’s “Farm Security and Rural Investment Act of 2002, which provides about
80% of extra subsidies to US farmers has been challenged the Cairns Group of
countries: Australia, Brazil, South Africa, Argentina, Bolivia, Colombia, Costa Rica,
Fiji, Guatemala, Indonesia, Malaysia, New Zealand, Paraguay, Philippines, Thailand
and Uruguay.
According to the Oxfam Report of April 2003, The Rigged Rules and Double
Standards, it is estimated that poor countries, which depend on agriculture, but cannot
afford to subsidize their farmers due to poverty, were shortchanged US$ 100 billion per
annum due to the current lopsided trade dispensation in favour of the developed
countries.
169
The Doha Development Round of negotiations collapsed in June 2006 due to USA’s
and European Union’s reluctance to reduce subsidies on agriculture to the satisfaction
of developing countries.
By June 2012 the Doha Development Round of negotiations had not been concluded.
ACTIVITY
In your groups, discuss the function of the IMF, the World Bank
and World Trade Organization; How they operate; and The
criticisms labled ot their operations.
170
SUMMARY
FURTHER READINGS
LECTURE TWELVE
In this lesson we are going to look at the economics of regional economic integration.
171
Objectives
172
transformed England into a larger economic entity that dominated the less
industrialized and disunited German states.
List, therefore, came up with his proposal of the Zollverein as a counter-weight to the
classical economists’ advocacy of free trade.
List exhorted all German states to come together under the Zollverein to form one large
free trade area, by pulling down customs barriers against each other, while at the same
time maintaining trade barriers against the rest of the world.
According to List, the following guidelines should be adhered to when establishing a
Zollverein:
Free trade as advocated by classical economist should only be extended to
members of the Zollverein since they were at a similar level of economic
development.
To protect the infant industries of members of the Zollverein, customs tariffs
should be imposed on all imports from outside the Zollverein.
Member countries of the Zollverein would take advantage of access to a larger
international market created by the Zollverein.
The long-term objective of the members of the Zollverein should be to achieve
political union of a larger and stronger country that would be able to compete with
the more advanced industrialized economies.
By 1834, the Zollverein had been established and practically all German states, except
Austria, had come under a single trade area, inside which free trade offered a larger
market to German industry (Roll, 1992).
Since then, List’s idea of a Zollverein/customs union, has been adopted by other
countries neighboring each other with similar level of development.
These include; Belgium, the Netherlands and Luxembourg in 1921, European
Economic Community in 1958, the East African Community in 1967 and the common
Markets for East and Southern Africa. (COMESA), in 1994.
173
a) Preferential Trade Area (PTA): Under PTA, member countries agree to lower
trade barriers against each other, but retain high barriers against non-member
countries.
This was the case with the Eastern and Southern African countries when
the Heads of State signed the PTA treaty in 1981 at Lusaka.
b) Free Trade Area (FTA): A free Trade area is a form of economic integration
where all trade barriers against member countries were eliminated, but with each
member country being allowed the freedom to maintain individually determined
trade barriers against non-members.
The best example of a FTA was the European Free Trade Association
(EFTA), formed in 1960 by Britain, Austria, Denmark, Norway, Portugal,
Sweden and Switzerland, with Finland as an associate member.
c) Customs Union (CU): with the customs union, member countries eliminate all
tariffs and other trade barriers between themselves, and harmonize trade policies
such as establishing a common external tariff against non-members.
This is what the East African Community was, before its collapse in 1977.
d) Common Market (CM): with a common market, free trade is extended to factors
of production such that labor and capital movements are unrestricted between
member countries.
In addition, individual common market members are much less free to
initiate trade policy.
The best example of a common market was the European Economic
Community (EEC), which was established in 1957.
e) Economic Union (EU): With the economic union, member countries are obliged
to jointly make economic policy and must operate a common currency.
An economic union is very difficult to achieve because it requires member
countries to agree on very wide range of issues including micro and
macroeconomic issues.
The European Union, which was established by the Maastricht Treaty that
became effective in November 1993 with a current membership of 25
countries, is currently the closest organization to the economic union
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although one of the most important members, Britain, is yet to adopt the
common currency, the Euro.
12.4 Theory of Economic Integration
12.4.1 Static Effects of Economic Integration.
The incentive towards economic integration for neighbouring countries with similar
level of economic development is the desire to create a larger domestic market, and
provide the necessary economic size when facing the world competition.
However, the net effect of economic integration is not uniform to all member countries.
The reason for the ambiguity in outcome is a result of the fact that economic integration
serves both policy objectives of protection (against non-member countries) and a move
towards free trade (with member countries).
Therefore, in order to determine the effect of economic integration, it is necessary to
analyze the effect on individual countries on a case-by-case basis.
If Friedrich List provided the conceptual framework for economic integration, it was
Jacob Viner (1950), who pioneered the development of the theory of customs union,
by highlighting the production effect of trade creation, under the customs union.
James E. Meade (1955) improved on Viner’s theory by extending the analysis to the
consumption effect of trade creation.
Harry G. Johnson (1958) completed the theoretical formulation by adding total
welfare gains from trade under economic integration.
According to Viner (1950), there are two immediate outcomes or static effects of
economic integration, namely: trade-creation and trade-diversion.
Trade-creation, according to Viner, occurs whenever economic integration leads to a
shift in product origin from a higher-resource-cost domestic producer to a lower-
resource-cost member producer of the union.
This shift should represent a movement in the direction of free trade allocation of
resources within the union.
Thus, on the free trade front, trade creation involves the elimination of protection
among member countries of the union.
This allows them to specialize and trade on the basis of comparative advantage.
175
Trade diversion, on the other hand, takes place whenever there is a shift in product
origin, from a lower-resource-cost non-union producer to a higher –resource-cost
producer of a union member country.
Such a shift represents a movement away from free trade allocation of resources.
Thus, on the protectionist front, trade diversion involves the re-routing of trade from
the more efficient non-member countries, to the less efficient union member countries,
as a result of preferential treatment accorded to member countries, inherent in economic
integration.
176
Figure 10.1: Welfare Effects of Economic Integration in a Small Country
PX
S
E
SM+t
P0X G C SNM+t
P1X a J b c d H SM
e SNM
F T R
D
0
X3 X1 X0 X2 X
177
Residents of the country under study consume X0 units of good X, at the price of P0X.
Of those X goods consumed, X1 are produced domestically and (X0 - X1) are imported
from countries that, if integration occurred, would be non-members.
No good X is imported from would-be members because non-member countries supply
good X at a lower price than would-be members of the economic union.
Graphically, this scenario is reflected by the fact that SNM lies below SM , or SNM + t lies
below SM + t.
The area of triangle POX EC gives the consumer surplus, and the domestic producer’s
surplus is given by FP0X G.
The government collects revenue (import tariff) equivalent to the area of rectangle
TGCR.
After the formation of a free trade area, the relevant supply curves are D, SM, (because
imports from member countries are no longer subject to the local tariff), and SNM + t
(because the imports from non-member countries are still subject to the tariff).
The new equilibrium is at point H, where X2 units of good X are consumed at price
P1X, and X3 units are produced domestically.
The consumer surplus rises by (a + b + c + d) and domestic producers surplus declines
by the area of a trapezium a.
The government no longer collects import tariff revenue, since all imports are from
member countries, which enjoy duty-free status.
Area c, which previously went to government in form of tariff revenue, now goes to
the consumers inform of reduced prices for good X.
Area b is a net gain from increased efficiency.
The units of good X between X3 and X1 were previously produced domestically, at a
relatively high cost, represented by the height of the domestic supply curve.
These are now imported at lower price to the consumer represented by the height of SM.
This efficiency gain is one part of the trade-creation effect of economic integration.
The other trade- creation effect is denoted by area d.
As lower-cost imports become available, consumption increases from X0 to X2.
178
For each additional unit of consumption, the value to consumers (represented by the
height of the demand curve) exceeds the opportunity cost of production (represented by
the height of SM).
The total trade-creating effect of the elimination of the tariff on imports from member
countries equals the sum of triangle areas b and d.
179
1.3 REVIEW QUESTIONS
SUMMARY
180
FURTHER READINGS
181
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