KENYATTA UNIVERSITY

INSTITUTE OF OPEN DISTANCE & e-LEARNING

IN COLLABORATION WITH
SCHOOL OF ECONOMICS
DEPARTMENT 0F APPLIED ECONOMICS

EAE 308: INTERNATIONAL ECONOMICS II

WRITTEN BY:

PATRICK MASETTE KUUYA

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Copyright © Kenyatta University, 2012
All Rights Reserved
Published By:
KENYATTA UNIVERSITY PRESS

MODULE

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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

EAE 308: INTERNATIONAL ECONOMICS II MODULE

INTRODUCTION TO THE COURSE

A. Background to the Course
 The EAE 308: International Economics II course assumes that students have
already done EAEC 307: International Economics I (International Trade) course.
 The EAE 307 course should have introduced them to concepts and theories of
international trade and the tools of analysis used to handle them.
 In the EAE 307 course, students examined decisions individuals, firms and
government make concerning the production of goods and services, their
consumption and how they are traded.
 Students will recall that in the EAE 307 course, individuals and firms use relative
prices to make the decisions concerning production, consumption and trade.
 However, in everyday economic and business activities, relative prices are hardly
used except in those economic activities where exchange is still based on the barter
system.
 In EAE 308: International Economics II course, we shall concentrate on
international finance, where, instead of relative prices, money (or nominal) prices are
the basis of decision-making.
 The course covers the basic theory underlying international finance transactions, with
particular focus on exchange rates, foreign exchange markets, global capital flows,
balance of payment and how a country’s bilateral and multilateral relations with other
countries affect international financial transactions.

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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

1.0 : EVOLUTION OF MONEY

1.1 Introduction

INTRODUCTORY LESSON ON INTERNATIONAL TRADE

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

By the end of this lesson, you should be able to:

Explain why money is used in international trade.
Explain the difference between nominal and real prices.

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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).

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 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)

1.3 Precious Metals versus Paper Money

 Precious metals have many characteristics that are desired in commodity money.
 They are intrinsically useful, convenient to carry, divisible and durable.
 Their one major drawback is that, without expertise and technology, precious metals
are not easily verifiable for weight and purity.
 To minimize the problem of debasing metal money by clipping, shaving or filing bits
of metal from the coins, governments passed legislation that defined the metal content
of a designated pure or full-bodied coin of gold, silver or copper.
 Full-bodied coins are currency coins made of pure currency metal, the size and
weight of which are defined by the monetary authority e.g a sterling pound gold coin
in Britain, a dollar gold coin in USA or the 1960s East African five shilling silver
coin.
 Before this legislative measure, the existence of coins of varying authenticity led to
Gresham’s law of 1558 which states: Bad money drives out good.
 What this law meant in real life was that merchants hoarded pure quality coins or
full-bodied coins while they released into circulation lower quality coins.
 In most cases, full-bodied coins were hoarded for purposes of performing the other
important role of money, viz: as a store of value.
 To avoid the problems of debasing or hoarding full-bodied coins, use of difficult- to –
counterfeit paper money was printed as substitutes to coins.
 The paper money had to be fully backed by precious metals held by the printer of the
paper money.
 This meant that any holder of paper money had a right to its equivalent in precious
metals on demand.

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 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.

1.4 Demand for and Supply of Precious Metals (Specie)

 Just like any other economic good, the supply and demand for precious metals
determine their price.
 On the supply side of specie, in the sixteenth century, the flooding of precious metals
from the New Lands (the Americas) to Spain as a result of Christopher Columbus’
navigation adventure caused the first recorded continent-wide inflation in Europe.
 The resultant quintupling of prices in Spain during this period was quickly
transmitted to all Europe through trade because Madrid, the capital of Spain, was
the center of international trade at the time.
 Similarly, the California gold rush in the first half of the nineteenth century
caused inflation in north America in the 1850’s.
 The first recorded inflation throughout Europe in the 16th century caused social
tensions:
 Prices of goods and services in Europe rose dramatically
 Prices of labour (wages) did not rise in tandem with those of goods.
 Jean Bodin in his reply to the paradoxes of M. Malestroit came up with the
first fundamental principles of the quantity theory of money in 1568, which
states:
“If the quantity of money in circulation is increased without a comparable
increase in the supply of goods, prices tend to react upwards.”

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  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.

1.5 International Moneys

1.5.1 What is money?
 By now we already know the three main functions of money, viz: as a unit of
exchange; as a unit of account; and as a store of value.
 In the EAE 308 course, we shall add a fourth: money as a commodity that can be
bought or sold at a price in a foreign exchange market.
 Currencies are traded in a foreign exchange market just like company shares and
commodities are traded on their respective markets, except that money markets do not
have physical trading centers like the other two.

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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.

1.5.3 Nominal versus Real Prices

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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.

 That is to say: Px/Py = 100/50 = 2

 What this means is that one must forego 2 units of good Y in order to get one unit of
good X.

 Conversely: Py/Px = 50/100 = 0.5

 Similarly, one has to forego 0.5 units of good x in order to get one unit of y.
 The relative price of a good is sometimes referred to as its real price.
 In our case above, the price of a good X or Y is measured in real units of the other
good rather than in money (nominal) units such as Kenyan shillings.
 In the real world, economic data is recorded in money (nominal) prices.
 However, it should be noted that people work and are paid a nominal wage.
 The money earned as wages is used to buy goods and services for enjoyment.
 Therefore, people care about the real value of money, that is, what money can buy.
 To put it in another way, people care about the purchasing power (PP) of money.

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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.

1.3 REVIEW QUESTIONS

1. Define the following terms: full-bodied coins, specie, hard money,

soft money, nominal price and real price.
2. List the six types of money used in trade transactions.

ACTIVITY

“If the quantity of money in circulation is increased without a

comparable increase in the supply of goods, prices tend to react
upwards.” Discuss this statement in your groups in relation to the
concept of nominal prices and real price.

SUMMARY

In this lesson we have learnt the role of money in international

trade, the types of money used in trade transactions, Gresham’s
law and Bodin’s first principle that formed the basis of the first
quantity theory of money. We have also learnt :
 Paper money is used in trade more than metallic money
 The difference between nominal and real prices.
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FURTHER READINGS

Appleyard, D.R. and Field, A. J. (1992), International Economics; Irwin, Boston.

Yarbrough, B.V. and Yarbrough, R.M. (1988), The World Economy: Trade and
Finance; The Dryden Press, Chicago.

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 LESSON TWO

2.0: MARKETS FOR CURRENCIES VERSUS MARKETS FOR

GOODS AND SERVICES
2.1 Introduction.

INTRODUCTORY LESSON ON INTERNATIONAL TRADE

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

By the end of this lesson, you should be able to:

Explain how exchange rates between different currencies are determined
Explain the concepts of the law of one price and the purchasing power parity are used to
explain changes in exchange rates.

 International trade can be distinguished from domestic trade by two basic

characteristics, viz:

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  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.

2.2 Prices or Exchange Rates of Different Currencies

 Section 1.4.3 above has explained the relationship between relative and money

prices in one country.

 We now move a step further to compare prices of goods and services across

countries with different currencies.

 How can we compare a locally assembled Mecer computer, costing Ksh.

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

the Kenya shilling (Ksh).

 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

in terms of another, viz: e = KSH/US$

 If at a material time you require Ksh 80/= to buy one US$, then:

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

definition of e` is referred to as the “American terms”.

 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.

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  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.

2.3 The Law of One Price

 In section 1.4.1, it was pointed out that money, like any other good, carries a price
when the exchange or conversion takes place.
 Section 2.2 showed that exchange rates are important because they determine the
domestic price of foreign goods.
 In our example of computers, the imported Dell computer, which costs US $ 1,000
in the USA will, ceteris paribus, carry a price tag of Ksh 80,000/= in Kenya, if the
exchange rate remains at Ksh 80/= for each US $.
 As a general rule, therefore, the domestic price of a foreign item is equal to the
exchange rate multiplied by the foreign price of a good/service. i.e.

Domestic price of = Domestic currency x Foreign price of a

a foreign item Foreign currency foreign item
pd e x pf

 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.

pd = epf ………………………………………………………. 2.1

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 where:

pd = domestic price of a domestic item

pf = foreign price of a foreign item
e= exchange rate (domestic currency /foreign currency)
f
 In our example, e = Ksh 80/= per US$; P = US $ 1,000.
d
 Thus, the law of one price implies that the domestic price of a foreign good P is =
epf = (Ksh 80) (US$ 1,000) = Ksh. 80,000/=
 The law of one price does not hold precisely, at least in the short run, because of
many factors, including inflation in one country, transport costs, tariffs, cost of
money if goods are offered on credit, profit margin of the trader e.t.c.
 Therefore, the Kenya price of foreign goods is not strictly speaking just
Pd = epf , which is known as frictionless price.
 To this frictionless price must be added transport and other transaction costs.
 If these added costs raise the Kenyan price of the Dell computer by 10 percent, this
means that:

 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.

Pd must be < or = (1+0.10) epf ………………………. (2.3 )

 Similarly, if transactional costs raise foreign prices of Kenyan goods by 8 percent

then we divide by the exchange rate to convert Ksh into foreign currency i.e.

 The foreign price of a Kenyan item = (1+0.08) 1/e .pd .

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  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.

 Thus, Pf < or = (1+0.08) 1/e .pd …………………………… (2.4 )

 A combination of equations 2.3 and 2.4 yields :

1/(1+0.08) < or = pd/epf < or = (1+0.10) ………… (2.5)

 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.

2.4 Purchasing Power Parity (PPP)

 The law of one price is sometimes applied to the overall price levels of two
trading countries to determine the implied value of the exchange rate.

 We can rewrite equation 2.1 i.e. ( Pd = epf ) as :

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 e = pd /pf ……………………………………………. (2.6)

where now:

Pd = overall level of domestic prices

Pf = overall level of foreign prices

e = exchange rate (domestic currency/foreign currency)

 According to the theory of purchasing power parity (PPP), the percentage change

in the exchange rate between two currencies is approximately equal to the

difference in their respective countries’ rate of inflation.

 Thus: %e = %pd - %pf

 If, for example, Kenya’s overall price level rises faster than America’s overall price
level, then the Kenyan shilling must depreciate (lose value) vis a vis the US$ in
order for Kenya’s goods and services to remain competitive.
 Specifically, a 15 per cent increase in Kenya’s overall price level and a 2 per

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

one US$ i.e. % e = 15% - 2% =13%

 Since the concept of PPP is derived from the law of one price, PPP is subject to

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.

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  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

international finance, which is used in one way or other in a number of theories of

exchange rate and balance of payments (Hallwood and MacDonald, 2000).
 The purchasing power parity concept is used to argue that the relative prices of

goods and services between countries drive exchange rates.

 In fact, the PPP concept provided the basis of oldest theory of foreign exchange

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.

1.3 REVIEW QUESTIONS

1. Define the exchange rate e in Kenya terms.

2. What is a frictionless price?
3. How is the law of one price used to explain the concept of
purchasing power parity?

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ACTIVITY

“The law of one price is very relevant to trade trans actions

involving raw materials and financial assets, such as treasury bills
and bonds ”. Discuss this statement in your groups and show why
it is less relevant to trade in manufactured goods.

SUMMARY

In this lesson we have learnt how exchange rates are

determined; how the concepts of the law of one price
and purchasing power parity are used to explain the
changes in exchange rates. We have also learnt that the
PPP concept forms the basis of the oldest theory of
exchange rates.

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

INTRODUCTORY LESSON ON INTERNATIONAL TRADE

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.

25
 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.

26
 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.

3.2 Functions of the Foreign Exchange Market

 The main function of the foreign exchange market is to facilitate the transfer of
funds from one country to another.
 This is done either by wired telegraphic (telex) and telephone transfer or by electronic
transfer, when local banks instruct their correspondent banks in foreign (countries)
monetary centers to pay specified amounts of the local currency of those foreign
countries to designated persons, firms or accounts.
 The demand for foreign currency in the home country (Kenya) arises when:
 residents want to visit other countries as tourists, for business, for medical
treatment, for education etc.;
 local firms want to import inputs, machinery, consultancy services from other
countries;
 individual residents, firms and government agencies want to invest abroad.

27
  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.

28
 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.

29
  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.

3.4.1 The Clearing Function in the Foreign Exchange Market

 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.

30
 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

31
 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.

3.4.2 Hedging in the Foreign Exchange Market

 The second reason for transacting business in the spot foreign exchange market is
hedging.
 Hedging is an activity undertaken by an individual (or firm) to protect oneself from
the inherent risk of changes in the price of currencies in the foreign exchange market.
 Suppose you are a Kenyan importer who has ordered for 100 computers from the
USA at a price of US$ 1,000 each.
 The total payment of US$ 100,000 is due in 100 days time after all the
computers have been delivered in Kenya.
 Since the contract is written in dollars, there is a possibility of a change in the
Ksh exchange rate during the period.
 The Kenyan importer faces at least two options:
 One, he can enter the spot foreign exchange market now and buy the
required US$ 100,000 at the current spot exchange rate and invest the
dollars in USA to earn interest until payment is due at the end of 100 days
period.
 Two, he can hold on to his Kenyan Shilling worth US$ 100,000 and
invest them in CBK’s 91-day Treasury Bills to earn interest.

32
 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)

3.5 The Forward Market for Foreign Exchange

 The other major market for foreign exchange is the forward market.
 This is a market where foreign exchange deals are agreed upon now, but the
deliveries of the foreign currency are effected at some specified future dates
(usually 30, 60, 90 or 180 days).
 Thus a 90-day forward rate for dollars to be delivered in 90 day’s time is the Kenya
shilling price of the dollar agreed upon today.
 The link between the spot rate and the forward rate is normally expressed in terms of
a premium or discount.

34
 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.

3.6 The Futures (Commodities) Market for Foreign Exchange

 In addition to the forward market for foreign exchange, two additional avenues are
available to participants in the foreign exchange market to buy and sell foreign
currency.
 The futures market deals in commodities (bushels of wheat, barrels of crude oil), which
are bought (paid for) today but are delivered to the buyer at an agreed future date.
 The Chicago Commodities exchange is the world’s largest market for commodities.

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).

3.6.1 A Futures Contract.

 A futures contract is in many ways similar to a contract in the forward market for
foreign exchange.
 It is an agreement to buy or sell a specified quantity of foreign currency for
delivery at a future date, at a given exchange rate.
 Although they appear similar, a futures contract differs from a forward contract in
several ways:
 In a futures market, the contractor is represented by a foreign exchange
broker who negotiates the contract for a specified amount of foreign
exchange at the best rate possible.
 Once the contract is signed by the broker, the International Monetary
Market (IMM), which is part of the Chicago Mercantile Exchange based in
Chicago, Illinois, USA, guarantees that the foreign currency will be
delivered and paid on schedule.
 A margin deposit, usually a fixed percentage of the contract value, is
required as the transaction cost;
 The futures contract is resalable any time up to the time of its maturity,
which is not the case with a forward contract.
 The futures contract is available only on four specific dates, namely the
third Wednesdays of March, June, September and December.

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).

3.6.2 The Foreign Currency Option

 Another way of participating in the futures market is by participating in foreign
currency options.
 A foreign currency option is a contract that gives the holder the right to buy or sell a
foreign currency at a specified exchange rate at some future point.
 Unlike the forward and futures contracts, the holder of an option is not obliged to
exercise the option contract, if he chooses not to.
 A European option is a contract that can be effected only on the expiry date, while an
American option is a contract that can be exercised any time up to the expiry date.
 To participate in this market, one must either buy or sell an option contract.
 The option buyer (holder) acquires the right to exchange foreign currency with the
option seller (writer) for a fee or premium.
 This fee represents the maximum loss the buyer would experience should the option be
exercised.
 The completion of the option contract involves the actual exchange of the foreign
exchange currencies involved in the transaction.
**(For a detailed discussion of option contracts, see Gendreau, 1984)

1.3 REVIEW QUESTIONS

Define and explain the functions of the following terms: Clearing;

hedging; and speculation in the foreign exchange market.
38
ACTIVITY

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

Rivera-Batiz, F. L & Rivera-Batiz, L. (1994) International Finance and Open

EconomyMacroeconomics; Macmillan, New York.
Gandolfo, G. (1987), International Economics II: International Monetary Theory
And Open Economy Macroeconomics;
Springer – Verlag, Berlin

39
 LESSON FOUR
4.0 THE LINK BETWEEN FOREIGN EXCHANGE MARKETS
AND FINANCIAL MARKETS
4.1 Introduction

INTRODUCTORY LESSON ON INTERNATIONAL TRADE

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.

4.2 Covered and Uncovered 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.

4.2.1 Uncovered Interest Arbitrage

 The theory of uncovered interest arbitrage states that the differences between the
current spot exchange rate and the expected future spot rate of two currencies reflects
differences in the interest rate on short-term assets denominated in the two currencies.
 For example, suppose a Kenyan investor had Ksh 1.6 million to invest, and the
following business information was accessible to him:

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

($400x80/=) Ksh 32000/=.

 However, if after 90 days the spot rate dropped to Ksh70/= per dollar, the Kenyan
investor would be able to get back only ($400 x Ksh70/=) Ksh 28000/=.
 It is clear from the above analysis that the incentive to invest in dollar-denominated
assets depends not only on the interest rates of the two currencies but also on what the
investor expects to happen to the future spot rate at the expiry of the investment period.
 There is no way the investor can know for certain in advance what the expected future
spot rate will be in 90-days time.
 His view of the expected future spot rate will at best be speculative.
 If his expectations turns out to be correct, he makes a profit on his investment.
 If his expectation are incorrect, he makes a loss.
 When all individuals and firms in the economy make their decisions concerning
investments in Kenya shillings and US dollar denominated assets as described above ,
the result is a relationship among interest rates, the current spot rate and the
expected future spot rate.
 As long as the interest differential in favour of the Kenya shillings denominated assets
is less than the expected increase in the value of the foreign (dollar) denominated asset
over the investment period, there is an incentive to invest in foreign currency.
 Algebraically, if:

{iksh – i$} < {(ee-e)/e} , invest in dollar denominated assets………..(4.1)

43
 where:

 iKsh is the interest rate on short-term Kenya shilling denominated assets

 i$ is the interest rate on short-term foreign(dollar) denominated assets

 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:

{iKsh -i$} > { (ee-e)/e} invest in Kenya shilling denominated assets…….(4.2)

 Numerical example, if:
{(8.42% -1.11%) = 7.3%} > {(Ksh 78/$ -Ksh 74/$) / (Ksh 74/$)= 5.4%}, invest in
Kenya shilling denominated assets.

 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:

{ iKsh - i$} = {(ee - e) / e} is the equilibrium condition of UIP…….. (4.3)

Numerical example:
{( 8.4%-4.4%) = 4%} = {(Ksh 77/$-Ksh74/$)/(Ksh74/$) = 4%}
 Uncovered interest parity (UIP) holds when the interest differential just equals the

expected premium, if positive, or discount, if negative, on foreign exchange.

 The relationship in equation 4.3 is known as the equilibrium condition, because when
this condition does not hold, the Kenyan investor will arbitrage by relocating his
investment funds between the Kenya shilling and the US dollars to make a profit.
 The link between the spot rate and the forward rate is often discussed in terms of

premium and discount.

 When the exchange rate is stated in terms of domestic currency units (Kshs) per unit of

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.

 Thus: p = (eforward/ e) – 1 or ( eforward/ e = p + 1)

 Where p is the percentage premium which is positive when the foreign currency is at

a “ premium” and negative when the foreign currency is at a “discount”.

 Figure 4.1 shows graphically UIP relationship.

Figure 4.1: Uncovered Interest Parity (UIP) Relationship

(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.

4.2.2 Covered Interest Arbitrage

 Undertaking a transaction in the forward market for foreign exchange at the same time
that the investment is made can cover the foreign exchange risk inherent in interest
arbitrage.
 A Kenyan resident investing in US treasury bills (dollar denominated assets) would buy
Kenya shillings or sell dollars in the forward market in order to avoid the risk of
adverse changes in the exchange rate during the investment period.
 For an investor engaged in covered interest arbitrage, the relevant information is the
comparison of the interest rate differential and the forward premium or discount on
foreign exchange, i.e. the percentage difference between the forward and the spot
exchange rates.
f
 If e represents the forward rate, this can be represented algebraically as:
Ksh
If {i - i$} < {(ef - e)/e} invest in dollars………………….(4.4)
Numerical example, if:
{(4% - 5%) = -1%} < {(Ksh 83/ $ - Ksh 82/ $) / (Ksh 82/ $) = 1.2%} invest in dollars.
 In this case, the interest differential does not off-set the loss involved in converting
Kenya shillings into dollars in the spot market and reconverting dollars into shillings in
the forward market.
 Although the interest differential in this case is negative, this does not necessarily rule
out a decision to invest in shillings.
 A sufficient rise in the value of the Kenya shillings over the investment period can
offset the negative interest differential.

 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:

{iKsh-I$} = {(ef-e)/e} is the equilibrium condition of CIP… (4.6)

Numerical example:
{(2% - 4%) = -2%} = {(Ksh/$ -Ksh79.63/$) / Ksh 79.63/$ = -2%}
 Whenever covered interest parity does not hold, there are opportunities to make risk-
less profit through interest arbitrage of the type described in equations 4.1 and 4.5.
 As individuals and banks engage in this type of arbitrage this results in the equilibrium
condition in equation 4.6.
 The result can be represented graphically as in Figure 4.2 below, where the covered
interest parity (CIP) represents the equilibrium condition from equation 4.6.
 Figure 4.2 shows graphically covered interest parity.

Figure 4.2: Covered Interest Parity (CIP)

(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.

1.3 REVIEW QUESTIONS

1. Define the following terms: covered interest arbitrage; uncovered

interest arbitrage.
2. When does covered interest parity hold?

49
ACTIVITY

“Whenever covered interest parity does not hold, there are

opportunities to make risk- less profit through interest arbitrage”.
Discuss this statement in relation to the activities of arbitrageurs
in bringing the foreign exchange and financial markets into
equilibrium.

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

INTRODUCTORY LESSON ON INTERNATIONAL TRADE

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

By the end of this lesson, you should be able to:

Know the reasons why foreign currences are demanded
Know the purposes for which foreign echange is supplied
Know the four most widely adopted foreign exchange regimes the countries of the world
operate under in crosss border trade transactions.

 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.

5.2 The Demand for Foreign Exchange

 Residents of any country demand foreign currency in the foreign exchange markets
because of four main reasons, viz:

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.

5.3 The Supply of Foreign Currency

 Foreign residents supply dollars in order to purchase Kenya shillings in the foreign
exchange market for purposes of:
a) Purchasing Kenya made goods and services
b) Investing in local currency denominated securities (T-bills and T-bonds)
c) Investing directly in Kenya
d) Speculating on the future value of the local currency if they want to trade in it.
 Each of these sources of supply of foreign exchange involves a positive relationship
between the exchange rate and the quantity of foreign exchange supplied.

 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.

 The opposite is also true if (e = Ksh/$) falls.

 Like was the case with the demand for foreign currency, factors other than the exchange
rate affect the quantity supplied of a foreign currency.
 The main factors affecting the supply of foreign currency include:
a) Domestic prices relative to foreign prices
b) Interest rates
c) Profit rates, or rate of return on investments
d) Changes in incomes of the residents
e) Speculator’s expectations about the exchange rate.
 For example, if Kenya prices fall relative to foreign prices of goods and services,
foreign residents will switch their demand to Kenyan goods and services e.g. tourism.
 This will increase demand for Ksh, in order to buy the Kenyan goods and services.

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

results in a fall in the exchange rate, e.

 A rise in the foreigner’s incomes will lead them to demand more Kenyan goods and
services e.g. tourism, horticultural products, e.t.c.
 This will lead to an increase in the supply of foreign currency to Kenya.
 Finally, expectations of a rise in the future (expected) exchange rate of foreign currency
will lead to holding on foreign currency now in order to off-load it later on the foreign
exchange market to make a profit.

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

foreigner when e is at point 1, and more expensive when e is at point 2.

 Thus at point 1, more tourists will visit Kenya because their foreign currency will get
them more Kenyan shillings to spend on their holiday.
 Therefore, at point 1, more foreign currency will be supplied to Kenya as foreigners
consume more Kenyan goods and services.
 At point 2, Kenyan goods and services become more expensive to the foreigners as
they receive fewer Kenyan shillings in exchange for their currency.
 Since they will need more of their currency to get enough shillings to buy Kenyan
goods, they will demand fewer Kenyan goods and services.
 Consequently, the inflow or supply of foreign currency will be less.

5.4 Exchange Rate Determination: Different Exchange Rate Regimes

 The demand and supply curves discussed in sections 5.1 and 5.2 assumed that market
forces of demand and supply freely determined the price or value of exchange rates.
 In reality, at least until recently, governments in each country used to determine the type
of policy to follow regarding determination of exchange rates.
 Before the current global trend of adopting liberalization economic policies,
governments all over the world controlled their countries’ foreign exchange rates as per
the 1944 Bretton Woods agreement. (See detailed discussion in Lesson 10).
 Under the 1944 Agreement, the USA was the guarantor of the global fixed exchange
rate regime that was operated by all countries affiliated to the International Monetary
Fund.

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.

5.4.1 Flexible or Floating Exchange Rate Regime

 The popularity and worldwide use of the flexible exchange rate regime has its origins
in the early 1970s when the USA abandoned the fixed exchange regime that was put in
place as a result of protracted negotiations at Bretton Woods Conference (details later).
 Under the flexible exchange rate regime, the demand for and supply of each currency in
the foreign exchange market are allowed to determine the exchange rate.
 This means that the price (exchange rate) of a currency is free to move to the level that
equates the quantity demanded of a currency to the quantity supplied.

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

e0 to e1, there will be a surplus of foreign exchange equal to BC.

 The availability in the market of this BC foreign exchange surplus exerts pressure on
the exchange rate to fall towards e0, as shown by the arrow pointing downwards.

 On the other hand, if the market forces cause the exchange rate to fall from e0 to

e2, there will be a shortage of foreign exchange to the tune of DE.

 As a result, market forces pressure will be exerted to push up the exchange rate from

e2, to e0, as shown by the arrow pointing upwards.

 Under the flexible exchange regime, a rise in the market-determined rate from eo

to e1 is referred to as a depreciation of the Ksh and an appreciation of the dollar.

 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

between the Euro and the US dollar is e = Euro/US$= 90/80 = 1.125.

 Since over time a currency can depreciate against some currencies and appreciate
against others, an effective exchange rate has to be calculated.
 This is done using a weighted average of exchange rates between the domestic (Kenya)
currency and the country’s most important trade partners’ currencies.
 The weights are given by the relative importance of the country’s trade with each of
these trade partners.
 For Kenya, the most important trade partners are Uganda, the COMESA trade block,
Japan, USA, and China, all of whose trade is denominated in US$, European
Community countries that use the Euro and Britain which uses the sterling pound.
 It should be noted that, to date, there has been no real world experience with truly
flexible exchange rates (Salvatore, 1990, p605).

5.4.1.1 Arguments For Flexible Exchange Rate Regime

 The main argument for adopting a flexible exchange rate regime is the same as one
given for market determined prices in an economy, namely, smooth, automatic and
continuous adjustment to equate quantity demanded with quantity supplied.
 Under this regime, appreciation and depreciation of a country’s currency is automatic.
 Such automatic adjustment under this regime has advantages, which include:
i. Large balance of payment deficits and surpluses are minimised, since exchange
rates move in response to any tendency for either deficits or surpluses to develop.
ii. Policy decisions are unnecessary, thus avoiding the potential for policy errors
(like fixing the exchange rate above or below the equilibrium rate).
iii. Bureaucratic delays in decision-making are avoided.

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.

5.4.1.2 Arguments Against Flexible Exchange Rate Regime

 Paradoxically, the automatic adjustment attribute, which is associated with the flexible
exchange rate regime in positive terms, is the same attribute that is used as an argument
against the flexible exchange rate regime.
 This time, on the ground that it makes the exchange rates volatile.
 Volatility introduces uncertainty that negatively affects business decisions and plans.
 The flexible exchange rate regime also denies the monetary authority a tool to use for
intervention in case the automatic mechanism of market forces fail.
 For example, when the exchange rate settles at a rate that hurts domestic producers of
exports, but favors importers, intervention in exchange market is precluded.

5.4.2 Fixed or Pegged Exchange Rate Regime

 Historically, exchange rates have not been flexible.
 In fact, flexible exchange rates were rare until early 1970s.
 It was central banks, which fixed the exchange rates of their countries’ currencies.
 The use of fixed exchange rates dates back many centuries when specie (gold and
silver) was minted into coins of specified weight.
 The minted coins were full-bodied, with the value and quantity of specie they
contained being certified by the government or sovereign.
 The gold, silver or even copper content of the full-bodied coins was usually
determined by law and was called the gold, silver or copper parity.

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.

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 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

e2, well below the equilibrium price.

 This could be the case if the government wants to encourage the import of critical
inputs in its industrialization program.
 At e2, the quantity of foreign exchange demanded exceeds, by CD, the quantity
supplied.
 This will make imported goods and services cheaper to Kenyan residents, but Kenyan
goods will be expensive to the foreigners.

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.

5.4.2.1 Arguments for a Fixed Exchange Rate Regime

 Two main arguments, are advanced by proponents of a fixed exchange rate regime:
 Fixed exchange rate regime imposes discipline by preventing monetary authorities
from engaging in expansionary or inflationary monetary policies.
 They (fixed exchange rates) reduce uncertainty over the future value of the
exchange rate, thereby encouraging or facilitating business decision-making.

68
 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.

69
  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:

70
Figure 5.6 (a) Permanent Increase in Demand Foreign Exchange (for dollars)

Exchange rate Ksh/$

S$

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)

71
 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

shilling price of the dollar at e1.

 In this case the new demand curve D$1 becomes permanent D$2.
ii. Intervention by the central bank by selling dollars / buying Kenya shillings in the
open market in order to maintain the exchange rate at e0.
 Under a managed float regime, the proper response to the permanent increase in the
demand for dollars is to adopt the first option that allows the exchange rate to move to a
new equilibrium at e1.

72
  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.

5.4.3.1 Arguments for a Managed Float Exchange Regime

 A managed float regime aims at limiting foreign exchange rate uncertainty by using
government intervention in foreign exchange markets to eliminate short-term
fluctuations in exchange rates.

73
 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.

5.4.3.2 Arguments Against a Managed Float Regime

 The main criticism of managed float system is practical, rather than theoretical.
 Fig. 5.6 (a and b) shows clearly what the correct policy response should be when there
is a permanent or temporary disturbance in the exchange rate.
 However, in practice, disturbances in the world economy do not give clear signals
revealing the precise nature and time duration of the disturbance.
 Operating a managed float regime does not change the basic rule that to correct a
balance of payment imbalance requires either:
i. A change in the exchange rate, or
ii. A change in the money stock, or
iii. A change in both the exchange rate and the money stock.
 When central banks that operate a managed float regime ignore this rule, crises occur.
 For example, any advantage that may accrue from a fixed exchange regime is
eliminated if the economy experiences chronic balance of payment deficits.
 Thus, under a managed float regime, fixed exchange rates generate confidence in
stability only if the chosen rates are near the equilibrium or are sustainable through
intervention.
5.4.4 The Foreign Exchange Control Regime
 The exchange regime that was until recently very widely used, especially so by
developing countries, is the foreign exchange controls regime.
 Exchange controls refer to a number of laws, rules, regulations and practices by which
governments seek to control purchase and sales of currencies by individuals and firms.

74
 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,

75
 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.

1.3 REVIEW QUESTIONS

1. Define the following terms: Depreciation; appreciation; devaluation;

revaluation
2. What is the current dominant exchange regime operated worldwide
and why?

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

1. Sodersten, B. and Reed, G.V. (1994), International Economics; Macmillan,

London.
2. Rivera-Batiz, F. L & Rivera-Batiz, L. (1994) International Finance and Open
Economy Macroeconomics; Macmillan, New York.
3. Pilbleam, K. (1992), International Finance; Macmillan Press LTD, London

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 LESSON SIX
6.0 BALANCE OF PAYMENTS
6.1 Introduction

INTRODUCTORY LESSON ON INTERNATIONAL TRADE

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).

78
 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.

79
 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.

6.2.1 The Current Account of Balance of Payments

 The current account within the balance of payment records values of current outflows
(payments) and inflows (receipts) between residents of the home country (Kenya) and
the rest of the world.
 The major categories of transactions within the current account are:
 Payments and receipts for imports and exports of goods
 Payment and receipts for imports and exports of services
 Payment and receipt of current income earned on foreign investments,
owned by residents of the home country (Kenya), which do not include new
investments, but only the current income from investments already made.
 Payment and receipts from current transactions undertaken by the military:
these are listed separately, although they include imports and exports of
merchandise and services (e.g. duty free merchandise for military canteens).
 Payments and receipts from travel and transport economic activities
 Unilateral transfers: these include expatriate workers’ remittances to their
home countries and gifts sent and received from abroad e.t.c.
 Each of the above categories of the current account involves both payments by
residents of the home country (Kenya) to the rest of the world (known as debits) and
receipts from the rest of the world by Kenya residents (known as credits).
 Finally, the sum of the debits, net the sum of the credits of the above six current
account components yield the home country’s current account balance.
 If the sum of the items on the debit side exceeds the sum of the items on the credit side,
then the current account balance is in deficit.

80
 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.

81
  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.

6.2.2 The Capital Account of Balance of Payments

 The capital account of the balance of payments records international lending and
borrowing and purchases and sales of assets by individuals, firms and government
agencies.
 When Kenya residents purchase foreign assets, or advance loans to foreigners, these
transactions are entered as debits in Kenya’s capital account and are known as capital
outflows.

 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.

6.2.3 Official Settlements Account of Balance of Payments

 All transactions within the official settlement account of the balance of payments are
conducted by authorized government agencies, usually the country’s monetary
authorities.
 In Kenya, these are the Treasury and the Central Bank of Kenya (CBK).
 Components of the official reserve assets, which are recorded on the official
settlements account include:
 The Gold holdings of the country’s monetary authorities
 Special Drawing Rights (SDR or “paper gold”) created on the books of the
International Monetary Fund (IMF) for use by member countries.
 A country’s foreign exchange reserve holdings kept by the IMF in the US
Treasury.
 Official holdings of foreign currency reserve by a country’s monetary
authorities.

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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.

Current Capital Official

Account + Account + Settlements = 0 …………. 6.1
Balance Balance Balance

 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.

84
 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:

Current Capital Statistical Official

Account + Account + Discrepancy + Settlements = 0 ……. 6.2
Balance Balance Balance

 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.

6 .3 Balance of Payments Deficit and Surplus Concepts

 All transactions on the current and capital accounts of the balance of payments account
are known as autonomous transactions.
 These are transactions undertaken by participants in the foreign exchange market
without them (participants) being conscious of their transactions’effects on the balance
of payment.
 The individuals, firms and government agencies, who transact business under items on
these accounts, do so for profit or social motives without regard to what will happen to
the balance of payments.
 Autonomous transactions items are sometimes referred to as “items above the line”.
 Another way of putting it is that the sum of the current account balance, the capital
account balance and the statistical discrepancy constitute the balance on autonomous
transactions.
 The sum of these autonomous transactions constitutes the BoP, in that:

Current Capital Statistical “The’ Balance of

Account + Account + Discrepancy = Payments” ……… 6.3
Balance Balance
 Thus, a surplus balance of payments is said to exist if total autonomous receipts
(credits) exceed the total autonomous payments to the rest of the world.
 On the other hand, in the “items above the line”, the net debit balance of
autonomous transactions measures the deficit in the country’s balance of payments.

86
 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:

Current Capital Statistical Offficial

Account + Account + Discrepancy = - Settlement Account ……6.4
Balance Balance Balance

 Further, if one combines equation 6.3 and 6.4 one ends up with:

Balance of payments = - Official settlements Account Balance …… 6.5

 Another way of presenting equation 6.5 is by writing it as an explicit relationship

between autonomous and accommodating transactions:

Balance on Balance on
Autonomous = - Accommodating ……… 6.6
Transactions Transactions

OR

Balance on Balance on
Autonomous + Accommodating = 0 ……… 6.7

87
 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.

1.3 REVIEW QUESTIONS

1. Define the following terms: unilateral transfers; debits; credits; items

above the line; accommodating transactions.
2. If the sum of the current, capital and official settlements accounts
equal zero, why do economists talk of a deficit or surplus balance of
payments?

Kenya has never recorded a positive balance of trade since

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

Appleyard, D.R. and Field, A. J. (1992), International Economics; Irwin, Boston.

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

INTRODUCTORY LESSON ON INTERNATIONAL TRADE

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.

7.2 The Simple Keynesian Income Model

 The relationship between the external sector of an economy and the national
income is a two-way relationship:

 Income is earned by residents when they export goods and services

 Income is spent by residents on imports, causing an outflow of income

90
 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

and the country’s macroeconomic activities.

 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.

 In the simple open economy Keynesian Model, desired expenditure E during a

time period consists of:

 Consumption spending by households on goods and services C

 Investment spending on product goods I
 Export earnings by residents X
 Expenditures on imports by residents M

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

consumption expenditure rises to:

C = $100million + 0.75 ($35,000 million)
= $ 26,350 million

 The marginal propensity to consume (MPC) is defined as the change (Δ) in

consumption divided by the change (Δ) in income ( Y), i.e the proportion of
additional income spent on consumption:

MPC = ΔC/ Δ Y --------------------------------------------- (7.4)

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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:

MPS = ΔS/ ΔY ------------------------------- (7.5)

 Since any change in (ΔY) can be allocated to consumption and savings, it

follows that

MPC + MPS = 1.0 --------------------------- (7.6)

 In equation 7.3 of the consumption, we designated 0.75 as the MPC,

meaning that the MPS must equal 0.25.

 This means that the consumption function C = a + bY also gives us the

saving function of an economy.
 Thus, if by definition, national income can only be allocated to
consumption and saving, then the saving function can be obtained by:

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.

 The consumption and saving function can be illustrated graphically as in figures

7.1 and 7.2 below.

93
Figure 7.1: Keynesian Consumption Function

Consumption

(C) C = 100 + 0.75 Y

0.75

Income

Figure 7.2: Keynesian Saving Function

Saving
(S)

S = -100 + 0.25Y

0.25

94
 0
-100 Income (Y)

Figure 7.3: Keynesian Investment Function

Investment
(I)

Ī =560 Ī = 560

Income (Y)

 An increase in the amount of autonomous investment spending in the country

would result in a parallel upward shift of the investment schedule from say $560
million to $ 660 million.
 In the Keynesian income model, Investment (I) is assumed to be entirely
autonomous or exogenous or independent of current income in the economy.

(In the real world this is a very unrealistic assumption).

95
  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:

I=Ī ………………………………… (7.8)

where Ī with the bar means that the level of investment is fixed at a given
amount for all levels of income.
 Thus if investment levels in Kenya is US $560 million i.e (I= $560
million), this would mean that the expenditure on investment in Kenya is US $
560 million irrespective of the level of income in the economy.

 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

X=X ------------------------------------------ (7.9)

where X represents autonomous exports.

Figure 7.4: Keynesian Export Function

EXPORTS

(X)

X =350 X =350

96
 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:

M = f(Y) ----------------------------------------------- (7.10)

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).

97
 MPM is defined as the change (Δ) in imports (M) divided by the change in income:

MPM = ΔM/ΔY ------------------------------------------ (7.12)

 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:

APM = M/Y ---------------------------------------------- (7.13)

 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

Figure 7.6: The Keynesian Import Function

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.

7.3 Equilibrium Level of National Income

 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.

Figure 7.7 Equilibrium level of National Income

Desired 45◦
Spending

C+I+X-M B C+I+X-M=E

100
 MPC-MPM=b-m
F e A

aI 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

 Therefore the equilibrium level of income is US$ 2,425 billion

 The alternative way of determining the equilibrium level of income is to represent the
equilibrium income level as:

Desired savings and imports by households = Investment plus exports by firms.

 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.

Fig 7.8 Alternative Representation of Equilibrium Level of National Income

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

 Thus, the equilibrium income level is again US$ 2,425 billion

 Another alternative presentation of the equilibrium level of income focuses on the
current account balance of the economy
 In the Keynesian model, X - M represents all exports and imports of goods and
services
 Since there are no unilateral transfers in the Keynesian model, X - M represent the
current account balance.
 In this approach we take our earlier equilibrium condition:

Y = E = C + I + X – M and rearrange it to get

(Y- C) – I = X - M ………………………………… (7.15)
Or
S–I=X-M …………………………………… (7.16)
 We then use this to get a new figure 7.9 similar to the one representing S+M
and

I +X.

Figure 7.9 The Second Alternative Representation of Equilibrium Income Level.

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 :

S - I = (-100 + 0.25Y) - 560

S - I = - 660 + 025Y
 The X-M downward-sloping line is obtained in the same way as the S - I
line i.e it subtracts the import function from the fixed amount of exports M

 With the fixed X = 350 and M = 40 + 0.15Y, the X - M line is

X - M = 350 - (40 + 0.15Y)

X – M = 310 - 0.15Y

 Therefore the equilibrium level of income is :

(-660 + 0.25Y) = 310 - 0.15Y

0.25Y + 0.15Y = 310 + 660
0.4Y = 970
Y = 970/0.4 = 2,425

 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

X - M = 350 – (40 + 0.15Y)

X - M = 350 - (40 + 0.15(2,425)
= 350 - 403.75
= -53.75 = Current account deficits
 The important conclusion one can draw from this example is that, even though the
economy is in income equilibrium, it is not necessary that the current account
balance be zero i.e the economy can be in equilibrium simultaneously with a
negative current account balance.
 In figure 7.9, the existence of the current account deficit when the economy is at its
equilibrium income is shown by the fact that the equilibrium point e is below the
horizontal axis, 0Y.
 If e occurs at a point above the horizontal axis, there would be a current account
surplus.
 If e lies on the horizontal axis, then X = M, which indicates a balance in the current
account.

7.4 The Keynesian Autonomous Spending Multiplier

 A concept, which is familiar to the Keynesian income models, is the

autonomous spending multiplier.
 This autonomous spending multiplier is used to answer the following
question:

If autonomous spending on C or I or X is changed, by how much will

equilibrium income be changed?

 Graphically, as in figure 1.&, this question is simply, if (C + I + X - M) shifts

in parallel fashion, what will be the ΔY as the economy responds to the
changes in autonomous spending?

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:

ΔY = 100 + (0.75 - 0.15)(100) + ( 0.75 - 0.15)(60) + (0.75 - 0.15)(36) +……

=100 + (0.6)(100) + (0.6)2(100) + (0.6)3100 + …………………
which, mathematically, can be shown to add up to:
ΔY= [1/(1-0.6)][100]
= [1/0.4][100]
= 250

 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,

$250 million/$100 million = 2.5 = multiplier

 Formula for calculating the autonomous spending multiplier in an open

economy:

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

 Autonomous imports M constitute another type of autonomous spending in an

open economy.
 What would happen if M increases?
 If the demand for imports increase autonomously ( like was the case in Kenya
since liberalization policies were introduced in 1992) this is equivalent to
autonomous decrease in the demand for domestic goods and services ( landline
telephone vis mobile telephone)
 Therefore in the national income models, and autonomous increase in imports
will lead to a decrease in the level of income, since this leads to reduced
consumption of domestic goods – in general, it is a loss of income by local
producers.
 The multiplier process for autonomous increase in imports operates in the
downward direction , viz:

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)

-$53.75 million = 0.15 (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:

($53.75 million)(2.5)=$134.38 million to $2,559.38 million

 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

 In our numerical example, (ΔX-ΔM) must be $53.75 million in order to

eliminate the current account deficit.
 Since investment will remain unchanged ( only the currency will be depreciated
and it is independent of income, then (ΔS-ΔI)= $53.75 million, and hence

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:

ΔX.(2.5) = 215 million

(ΔX) = $86 million

 Therefore, an increase in autonomous exports of $86 million will yield an increase in

income of $215 million.
 It will be noted that you will require a very large devaluation of the domestic currency
in order to induce such a large increase in exports.
 This might not be politically and socially feasible
 Therefore the economic (monetary) policy too of devaluation to induce exports might
be theoretically appealing, but practically difficult for policy makers to adopt,
especially in a developing economy with undeveloped money and financial markets.

112
 1.3 REVIEW QUESTIONS

1. Define the following terms: Marginal propensity to consume;

marginal propensity to import; and the Keynesian autonomous
spending multiplier.

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

Appleyard, D.R. and Field, A. J. (1992), International Economics; Irwin, Boston.

Sodersten, B. and Reed, G.V. (1994), International Economics; Macmillan,

London.
113
114
 LECTURE EIGHT

THE MONEY MARKET AND NATIONAL INCOME ANALYSIS

8.1 Introduction

INTRODUCTORY LESSON ON INTERNATIONAL TRADE

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

By the end of this lesson, you should be able to:

Use the LM / IS curves tools to analyse the general equilibrium in the money market and
real sector, respectively.
Simultaneously use the LM, IS and BoP curves to analyse the equilibrium in an open
economy.

115
8.2 Demand for Money balances

 Up to this point we have been concerned with consumption, investment, exports

and imports of goods and services of the real sector economy.
 We now bring in the money sector by considering demand and supply of money.
 In this course, the demand for money refers to the desire to hold wealth in form of
money balances, (currency plus check or current account) rather than in form of
shares (stocks), bonds, or other financial instruments like treasury bills.
 Economists define the demand for money function as

L = f(Y, i, W, 0) ……………………… (8.1)

where,
L = Demand for money
Y = Income
i = Interest rate
W = Level of wealth
O = Other things that influence residents to hold money
 The level of income Y has a positive relationship with or is positively influences
the demand for money; that is, it refers to the transactions demand for money (L)
 As one’s income rises, one wants to spend more because one’s marginal propensity
to consume, which rises with income, induces one to consume more.
 Thus, as one’s income rises, the more money balances have to be held in order to
finance the increased transaction needs.
 This positive relationship is specified as:

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.

(Note that: most current accounts in banks do not attract interest).

 Conversely, a fall in i will induce residents to hold their wealth in form of
money to buy real goods.

 The relationship of interest rate i to demand for money balances is often

called asset demand for money.

 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.

Fig. 8.1 The Asset Demand for Money

Interest
Rate
i

L = f(i)

117
Money
  The income level Y and the interest rate i are thought to be the two major

influences upon the demand for money.

 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.

 The variable O (other influences) reflects such institutional features of the

economy like the frequency with which people receive their salaries and wages.

 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.

8.3 The Supply of Money

 We start by assuming that the supply of money under the control of the monetary
authority at any given point in time is fixed.

 The specification of a fixed money supply Ms is shown as a vertical line in

Figure 8.2

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.

8.4 General Equilibrium in the Money Market: the LM Curve

 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

 We now introduce the role of income in the money market equilibrium.

 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.

Figure 8.5 illustrates an LM curve, representing Income and Interest Rate.

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

 Why does the LM curve slope upwards?

 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.

8 5 General Equilibrium in the Real Sector: The IS-Curve

 The graphical construct known as the IS-curve is used to depict economic

activity in the real sector, which is in the goods and services sector, just as the
LM-curve is used to explain the relationships in the money sector.

 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).

 Empirical evidence suggests that borrowing for construction and spending on

plant and equipment are very sensitive to interest rate changes.

 Because of the sensitivity of investment to the interest rate, a lower interest rate
will be associated with higher investment and higher export line.

Figure 8.6 Equilibrium level of Income Incorporating Interest Rate.

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.

 Similarly, a rise in interest rate from i 0 to i2 will cause a drop in investment,

shifting the investment line vertically downwards to [I” (i2) + X]

 Thus i2 is associated with a lower level of income Y2

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).

Fig 2.7 (derived from fig. 2.6) The IS Curve

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

 If the economy is situated to the right of the IS curve ( such as at point R) in

Figure 8.7, then the disequilibrium exists because saving plus imports exceed
investment plus exports: (S + M) > (I + X)

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.

 It will be recalled that m = f(Y); and S = f(Y)

 It will also be recalled that X = X ; and that I = f(i)

Thus I 0

i
 Alternatively, for the income level associated with R, the interest rate is too high
resulting in lack of investments.

 As a result income levels will fall through cutbacks in production to reduce

inventory accumulation at the higher levels of income.

 To the left of the IS (say at point U) investment plus exports exceed saving plus
imports.

 This exerts expansionary pressure due to depletion of inventory.

 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.

8.5 What causes shifts in the IS curve?

 Any change in autonomous investment, exports, savings or imports will cause
shifts in the IS-curve

 An increase in autonomous investment ( due to something other than a fall in the

interest rate) and autonomous exports or an autonomous decrease in savings and
imports will shift the IS curve to the right

 On the other hand, an autonomous decrease in I or X or an autonomous increase

in S and M will shift the IS curve to the left.

8.6 Simultaneous Equilibrium in the Monetary and Real sectors

 The simultaneous determination of income and interest rate when both the
monetary and real sectors of the economy are considered involves plotting the IS
curve and the LM curve on the same diagram, as in figure 8.8

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)

 When (S + M) is greater than (I + M) contractionary pressures are brought to bear

on the level of income.

 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.

8.7 Equilibrium in the Balance of Payments: The BP Curve

 Since we are dealing with an open economy, we need to introduce a further
construct to describe the balance of payments.

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

 It should be noted that the BP curve is constructed under the assumption of a

fixed exchange regime.

 In this analysis, income is assumed to primarily influence the current account

through its (the income) impact on imports.

 A rise in income induces demand for more imports (MPM times ΔY)

 With exports being independent of income, a rise in imports leads to a

deficit in the current account

 By contrast, a fall in income will produce the opposite effects on the

current account

 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.

 (For example, during President Moi’s regime when TB interest

rates were over 20%, hot money flowed into Kenya and domestic
capital flight was reduced to the minimum. Kenyans who had
stashed their loot abroad brought it back to take advantage of the
high interest rate on treasury bills)

 If interest rates fall, the opposite responses will occur.

Figure 8.9 Income and Interest Rate: the BP curve

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.

8.8 Why does the BP curve slope upwards?

 The BP curve slopes upwards because high interest rate and income are required
for there to be equilibrium in the external market.

 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

 The current account deficit is off-set by the short-term capital inflows on

the capital account.

 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:

 Demand for imports will fall

 The economy will move horizontally to the left to N’

 There will be improvement on the current account into the surplus.

 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

 The BP will settle at Q2 in a new equilibrium where income level Y 2 is in

equilibrium with the interest rate i2.

 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 :

 A devaluation of the home currency against foreign currencies shifts the

BP curve to the right

 An overvaluation of the home currency against foreign currencies shifts

the BP curve to the left.

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.

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  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

 In such a situation, there is a role for macroeconomic policy.

 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.

1.3 REVIEW QUESTIONS

1. Define the following terms: The LM curve; the IS curve

2. What are the LM and IS curves used for?

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ACTIVITY

“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)”.

Discuss this statement in relation to the information necessary in

order to draw the IS curve

SUMMARY
In this lesson we have learnt about the money market and national

income analysis. We have also learnt 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.

FURTHER READINGS

Appleyard, D.R. and Field, A. J. (1992), International Economics; Irwin, Boston.

Sodersten, B. and Reed, G.V. (1994), International Economics; Macmillan,

London.
133
 LESSON NINE
9.0 THE BALANCE OF PAYMENTS POLICY INSTRUMENTS
9.1In this lesson we are going to learn how to use the policy instruments, tools and knowledge
Introduction
we have acquired to correct the balance of payments disequilibria. We shall also look the

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

By the end of this lesson, we should be able to know what policy

instruments to use to correct the balance of payments under:
The flexible exchange rate regime.
The fixed exchange rate regime
We should also be able know what happens to domestic prices and terms of trade when there
are changes in exchange rate. One of the effects is the Dutch Disease phenomenon.

9.2 Correction of Balance of Payments Disequilibrium

 In discussing correction of balance of payments (BoP) disequilibria, this section
will concentrate on ways of correcting BoP deficit since correction of BoP surplus
generally requires the opposite techniques.
 For simplicity, BoP deficit will be defined as the excess of debits over credits in
the current account which is not balanced by autonomous capital inflows but require
some accommodating transactions from a country’s international reserves, official
borrowing or the depreciation/devaluation of a domestic currency.

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.

9.4 Correcting Balance of Payments Deficit Using Exchange Rate Changes.

 Balance of payments can be corrected by depreciation or devaluation of a
country’s currency.
 Since the effects of depreciation and devaluation are generally the same, they will
be discussed together in figure 9.1 below.

Figure 9.1: Balance of Payments Adjustment Using Exchange Rate Changes.

R = Ksh/$

S$*
E* S$

136
 80

E
74 C F

72 A Deficit B D$

D$*

0
8 10 12 Q$ (millions)

 In figure 9.1, it is assumed that:

 Kenya and the USA are the only two countries trading,
 There are no international capital flows,
 And that Kenya’s demand and supply curves for dollars reflect only trade
in goods and services.
 The figure shows that at the exchange rate of Ksh 72/$, the quantity of dollars
demanded by Kenya residents is $12 million while the supply is $8million.
 As a result, Kenya has BoP deficit of $4 millions represented by AB.
 If Kenya’s demand and supply curves for dollars are given as D$ and S$, a 2.777
per cent devaluation or depreciation of the Kenya shilling from Ksh 72/$ to Ksh
74/$ would completely eliminate the deficit since demand and supply will
equilibrate at $10 millions (point E).
 However, if the demand and supply curves were more inelastic (steeper), as
indicated in figure 6.1 by S$* and D$*, the same 2.777 per cent would only
reduce Kenya’s deficit by $ 3 million (CF), but an 11.11 per cent devaluation or
depreciation from Ksh72/$ to Ksh 80/$ would be required to achieve the
equilibrium point E* and eliminate the deficit in BoP.

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.

7.6 The Dutch Disease Phenomenon

 An interesting situation arises when a country starts to exploit a domestic
natural resource that it previously imported (e.g. if Kenya discovers oil and
starts to exploit the crude oil deposits).
 A good example was the case of Great Britain when it started to exploit its
North Sea Oil deposits in 1976 during the oil crisis triggered by the Israeli-Arab
war of 1973.
 As a result of this action, exchange rate of Great Britain’s currency, the sterling
pound, appreciated so much that the country’s traditional exports in the
industrial sector lost international competitiveness.
 This phenomenon is known as the Dutch Disease – a name derived from
Holland when in the early 1970s the country’s traditional exports from the
industrial sector lost international competitiveness as a result of the appreciation
of the Dutch Florin after Holland started to exploit her natural gas deposits in
the late 1960s.

9.7 The Marshall – Lerner Condition.

 The Marshall-Lerner condition states that the sum of the elasticities of demand for
a country’s exports and of its demand for imports has to be greater than unity for a
devaluation to have a positive effect on a country’s BoP.

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

142
  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.

7.8 Required further readings for Lesson Nine

Students should read on their own to familiarize themselves with the following:
 The J-curve effect
 The Pass-through Effect
 The Specie-flow Mechanism
 Different measures of the spot rate:
 Effective exchange rate (EER)
 Real effective exchange rate (REER)

1.3 REVIEW QUESTIONS

1. Define the following terms: balance of payments; Dutch Disease

phenomenon; demand elasticity; price elasticity.
2. How does the BoP disequilibrium manifest its self in an economy?
143
ACTIVITY

1. In your groups, discuss what the effects of a devaluation of a local

currency are on the terms of trade with the rest of the world?
2. With the recent discovery of oil deposits in Turkana County, what
steps would you advise the government of Kenya to take to avoid the
emergence of the Dutch Disease phenomenon in Kenya’s economy?

SUMMARY

In this lesson we have learnt how to use the policy instruments,

tools and knowledge we have acquired to correct the balance of

payments disequilibria. We have also learnt about the effects of

changes in the exchange rate on domestic prices and terms

of trade. Finally, we have learnt about the Marshall – Lerner

condition

FURTHER READINGS

Appleyard, D.R. and Field, A. J. (1992), International Economics; Irwin, Boston.

Sodersten, B. and Reed, G.V. (1994), International Economics; Macmillan,

London.
144
 LESSON TEN
10.0 THE INTERNATIONAL MONETARY SYSTEM
10.1 Introduction

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

By the end of this lesson, we should 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 system.

10.2 The Gold Standard

 Before the late 1870s, most countries operating a money economy had adopted a
bimetallic standard with fixed prices for gold and silver (specie).
 However, by 1880 countries that were involved in international trade had agreed on a
currency exchange system known as the international gold standard.
 Under this arrangement, each one of the gold-standard nations defined the value of its
unit of currency in terms of gold.
 The weight of gold was measured in terms of grains and ounces, with 480 grains
making up one ounce (Oz) of gold.

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.

10 3 The Bretton Woods International Monetary system

 In July 1944, more than 700 delegates from 44 countries, held a conference at the
Mount Washington Hotel in Bretton Woods, Hampshire, to discuss final draft proposals
for a new international monetary system that would replace the pre-world war two gold
standard.
 The draft proposals had been worked out by experts and accepted by the principal
architects form Britain, John Maynard Keynes and Assistant Secretary of the USA
Treasury, Harry D White.
 The system that was agreed upon was subsequently referred to as the Bretton Woods
Agreement International Monetary System, or simply the Bretton Woods System.
 This new system attempted to restore fixed exchange rates without the domestic
disruptions caused by the gold standard that was re-introduced in 1925.
 The 1944 fixed exchange rate system was known as the gold-exchange standard or the
gold-dollar standard.
 It contained four major features, which distinguished it from the classic gold standard
of pre-World War I.
 First, the US dollar was the key reserve currency in foreign exchange transactions.
 In this role, it replaced the British sterling pound, which was the dominant currency
before World War I.

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.

10.4.1: The Adjustable Peg

 After World War II, the major economies were confronted with divergent economic
problem needing equally divergent solutions.
 As a result, countries pursued diverse economic policies.
 While some economies were recovering very fast from the effects of the war, others
were struggling to recover.
 Except for the USA, the rest of the major economies were confronted with balance of
payments problems, which required devaluation intervention.
 The architects of the Bretton Woods Agreements had anticipated these problems and
made provision for them to be tackled through the IMF framework and machinery, to
avoid the destructive competitive devaluations that had occurred during the Great
Depression of 1929-1933.
 One of the provisions in the Agreement, which was designed to tackle balance of
payments problems, was the Adjustable Peg.
 Under this provision, central banks were allowed to intervene to keep the exchange rate
within one percent band of the fixed rate, by buying and selling dollars whenever
short-term disturbances caused disequilibrium at the pegged rates.
 A country would do this by drawing down its dollar reserves to purchase its own
currency in order to prevent it from depreciating by more than 1 per cent from the
agreed fixed exchange rate with the dollar.

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 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.

10.4.2 Problems with the Bretton Woods System

 The Bretton woods System encountered implementation problems, some of which were
not anticipated.
 These became a source of the system’s collapse three decades later.
 As pointed out earlier, the USA government took up specific responsibilities to ensure
the smooth functioning of the new system.
 However, some of the USA government’ s responsibilities to the 1944 Agreement
conflicted with each other.
 First, one of USA’s responsibilities limited the creation of dollars to the quantity of
USA’s monetary gold stocks stored safely at Long Knox vaults.
 Yet at the same time, the USA was required by the Agreement to ensure that, since the
US dollar was a reserve currency, there were sufficient dollars for foreign banks to use
in their interventionist activities in support of the fixed exchange rates as per the
Adjustable Peg requirement.

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 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.

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 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.

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1.3 REVIEW QUESTIONS

1. 1. Define the following terms: money mint; gold standard, adjustable

peg; reserve currency, gold-dollar standard
2. How did the gold standard system work in practice?

ACTIVITY

1. In your groups, discuss what caused the collapse of the gold

standard, and why efforts to resurrect it were unsuccessful.
2. Discuss what system replaced the gold standard and what were the
main features that differentiated the operations of the two systems.
3. Finally, discuss why the Bretton Woods system of exchange
regime collapse.

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.

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 FURTHER READINGS

Appleyard, D.R. and Field, A. J. (1992), International Economics; Irwin, Boston.

Sodersten, B. (1970), International Economics; Macmillan Press LTD. London

Sodersten, B.(1992), International Economics; (2nd Edition) Macmillan, London.
Sodersten, B. and Reed, G.V. (1994), International Economics; Macmillan,
London.

LESSON ELEVEN
11.0 THE BRETTON WOODS INSTITUTIONS
11.1 Introduction

INTRODUCTORY LESSON ON INTERNATIONAL TRADE

In this lesson we are going to look at the three international organizations that were created at
the Bretton Woods Conference.

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 Objectives

By the end of this lesson, we should be able to know:

How the IMF, the World Bank and the World Trade Organisation were founded, for what
purpose and how they operate
Their mandate, and
Criticisms of the three institutions

11.2 Historical Background

 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).

11.3 The International Monetary Fund (IMF)

 The IMF is the key institution that was set up to facilitate the smooth functioning of the
new international monetary system established by the 1944 Bretton Woods Agreement.
 The new international monetary system adopted the American plan, presented by the
US Treasury Assistant Secretary, Harry D. White, rather than the British plan,
presented by John Maynard Keynes.
 The Keynes plan called for the establishment of a Clearing Union that would create
international liquidity based on a new unit of account called the bancor.

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 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.

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 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,

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 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.

11.3.1 How the SDR is used

 A country that receives SDRs from the IMF adds them to its stock of foreign exchange
reserves for use in settling international transactions.
 For example, if Kenya is short of hard currency and needs Japanese yen to settle this
year’s yen loan obligation by the East African Portland Cement Company Ltd, it can do

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 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.

11.3.2 Criticisms of the IMF

 Many criticisms have been labeled against the IMF.
 One of the major criticisms of the IMF is that it imposes excessively rigid austerity
programmes on developing countries experiencing BoP problems.
 For example, the IMF imposes programmes that constrain spending on priority sectors
like education and health in developing countries with IMF programmes.

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 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:

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  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.

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  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.

11.5 The World Trade Organization

 The third institution that was set up as a result of the Bretton Woods Agreement was the
International Trade Organization (ITO).
 The ITO was meant to work towards achieving free trade, which at that time, just as
today, was unpopular with some powerful forces in USA business and politics.
 The ITO soon collapsed when the USA senate refused to ratify the treaty establishing it.
 In its stead, the General Agreement on Tariffs and Trade (GATT) was created in 1947
with less ambitious goals than the ITO.
 The GATT, which was based in Geneva, was to serve as a “clearing house” on trade
matters between member countries.

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 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.

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 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.

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 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

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  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.

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 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.

1.3 REVIEW QUESTIONS

1. Who were the architects of the Bretton Woods system?

2. How does a country become a member of IMF and how does it
benefit from its membership?
3. What is Special Drawing Rights (SDR) facility and how do member
countries of the IMF use it?

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.

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SUMMARY

In this lesson we have learnt about:

 How the IMF, the World Bank and the World Trade
Organisation were founded, for what purpose and how they
operate
 Their mandate, and
 The criticisms labeled against the three institutions

FURTHER READINGS

Appleyard, D.R. and Field, A. J. (1992), International Economics; Irwin, Boston.

Sodersten, B. (1970), International Economics; Macmillan Press LTD. London

Sodersten, B.(1992), International Economics; (2nd Edition) Macmillan, London.
Sodersten, B. and Reed, G.V. (1994), International Economics; Macmillan,
London.

LECTURE TWELVE

12.0 REGIONAL ECONOMIC INTEGRATION.

12.1 Introduction

INTRODUCTORY LESSON ON INTERNATIONAL TRADE

In this lesson we are going to look at the economics of regional economic integration.

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 Objectives

By the end of this lesson, we should have learnt:

About the historical background of regional economic integration
The stages of regional economic integration
The theory of regional economic integration, and
The welfare effects of economic integration

12.2 Historical Background

 The German philosopher, Friedrich List (1789-1846) provided economics with the
conceptual framework for regional economic integration with his advocacy of a
Zollverein (customs union).
 At the height of the Industrialization Revolution, the German people were split into
numerous independent states, which erected strict customs barriers against each other,
yet they could not offer any resistance to the highly competitive British manufactured
products (Roll, 1992).
 List’s German nationalism led him to dismiss laissez-faire (free trade), advocated by
Adam Smith and other classical economists, as unsuitable to the German aspirations.
 He argued that England was not only industrially more advanced, but it was imperative
that the Acts of Union of 1536, 1707, and 1800 that united Wales, Scotland, and
Ireland, respectively, with England to form the United Kingdom of Great Britain,

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 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.

12.3 Stages of Economic Integration.

 Modern economic integration takes the form of five stages each of which represents a
higher degree of integration, viz:

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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.

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 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.

12.4.2 Welfare Effects of Economic Integration.

 If in the process of economic integration, the outcomes /effects of trade-creation are
greater than those of trade-diversion, then the economic integration has led to an
increase in welfare of residents.
 However, if the outcomes of trade-diversion dominate those of trade- creation, then the
welfare of residents in that particular participating country is reduced.
 Figure 10.1 below shows trade-creating and trade-diverting welfare effects of
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

Source: B.V and R.M. Yarbrough, 1988, Op cit, p. 331.

 In figure 10.1, a group of small countries form a free trade area under economic
integration.
 Let us assume that each of the member countries eliminates trade barriers on good X.
 Then, D and S represent a country’s domestic demand for and supply of good X
respectively.
 SM represents the supply of good X from the other member countries of the free trade
area.
 SNM is the supply of X by countries that are non-members of the free trade area of the
economic union.
 Before economic integration, imports of good X from all countries are subject to a tariff
of t per unit; thus, the effective supply curves of imports from the two possible sources
are given by SM + t and SNM + t.
 The initial equilibrium is at point C.

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.

 The trade-diverting effect of integration is shown by area e.

 It will be noted that before economic integration, all imports came from non-member
countries, which were low cost producers of good X.
 After integration, all imports come from higher –cost member country producers.
 This switch from low-cost to high-cost sources of imports is the basis of trade-
diversion.
 Before integration, area e was a portion of the tariff revenue, going to the domestic
government.
 After integration, area e becomes the dead-weight loss to the country.
 Each unit of imports between X1 and X0 is now being produced at an opportunity cost
represented by the height of SM, rather than the lower opportunity cost represented by
the height of SNM.
 The overall effect on welfare is determined by comparing the trade-creation and trade-
diversion effects.
 If trade-creation effects dominate, the formation of a free trade area will enhance the
welfare of residents.
 However, if trade-diversion effects exceed trade-creation effects, then the welfare of
residents will have been reduced.
 If one uses the example of the European Community (EC), most analysts have come to
the conclusion that trade-creation effects outweigh trade-diversion effects.
 Estimates suggest that European Community trade-creating effects have been four
times those of its trade-diverting effects (Yarbrough, 1988, op cit, P.332).

179
1.3 REVIEW QUESTIONS

1. Define the following terms: Zollverein; preferential trade area; free

trade area; customs union; common market; economic union; trade
creation; and trade diversion.
2. What are the four main guidelines used to establish a customs
union?

customs union; common market; economic union; trade creation; trade

diversion.
What are the four main guidelines used to establish a customs union?
ACTIVITY

1. In your groups, use sketch graphs to show the welfare effects of

economic integration in a small country.
2. Use a graph to show trade diverting and trade creating effects of
economic integration for a small country.

SUMMARY

In this lesson we have learnt:

 About the historical background of regional economic
integration
 The stages of regional economic integration
 The theory of economic integration, and
 The welfare effects of economic integration

180
FURTHER READINGS

Appleyard, D.R. and Field, A. J. (1992), International Economics; Irwin, Boston.

Hazelwood, A. (1975), Economic Integration: The East African Experience;

Heinemann, Nairobi
Lipsey, R. G. (1960), “The Theory of Customs Union: A General Survey”,
Economic Journal 70, pp 496-513.
Meade, J.E. (1955) The Theory of Customs Union; Amsterdam: North Holland.
Ogunkola, E. O. (1998) “ An Empirical Evaluation of Trade Potential in the
Economic Community of West African States;
AERC Research Paper 84.

181
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