🪅Global Monetary Economics Unit 9 – Global Monetary System & Balance of Payments

Key Concepts and Definitions

• Global monetary system encompasses the set of rules, institutions, and mechanisms that govern international monetary and financial transactions
• Exchange rate is the price of one currency in terms of another, determined by market forces or government intervention
• Balance of payments (BOP) is a statement that summarizes a country's economic transactions with the rest of the world over a specific period
  • Consists of current account (trade in goods and services), capital account (financial transactions), and financial account (changes in international investment position)
• Foreign exchange reserves are assets held by central banks in foreign currencies, used to influence exchange rates and ensure financial stability
• Special Drawing Rights (SDRs) are international reserve assets created by the International Monetary Fund (IMF) to supplement member countries' official reserves
• Currency convertibility refers to the ease with which a currency can be exchanged for another currency or gold
• Purchasing Power Parity (PPP) is an economic theory that states exchange rates between currencies are in equilibrium when their purchasing power is the same in each country
• Impossible Trinity or Trilemma suggests that a country cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy

Historical Evolution of the Global Monetary System

• Gold Standard (1870s-1914) was a system where countries fixed the value of their currencies to a specified amount of gold, allowing for stable exchange rates and free capital flows
• Bretton Woods System (1944-1971) established a fixed exchange rate system based on the U.S. dollar, which was convertible to gold at $35 per ounce
  • Created the International Monetary Fund (IMF) and the World Bank to promote international monetary cooperation and economic development
• Collapse of Bretton Woods (1971) occurred when the U.S. suspended the convertibility of the dollar to gold, leading to the adoption of floating exchange rates by major economies
• Smithsonian Agreement (1971) was an attempt to maintain fixed exchange rates by devaluing the U.S. dollar and allowing other currencies to fluctuate within a wider band
• Plaza Accord (1985) was an agreement among G-5 countries to intervene in currency markets to depreciate the U.S. dollar against the Japanese yen and German Deutsche Mark
• Louvre Accord (1987) aimed to stabilize exchange rates and halt the depreciation of the U.S. dollar through coordinated central bank intervention
• European Monetary System (EMS) and the creation of the euro (1999) marked a significant step towards monetary integration in Europe, with the euro becoming a major global currency

Current Structure of the International Monetary System

• Hybrid system combines elements of fixed and floating exchange rates, with countries adopting different exchange rate regimes based on their economic priorities
• U.S. dollar remains the dominant global reserve currency, followed by the euro, Japanese yen, and British pound sterling
• Multilateral institutions such as the IMF, World Bank, and World Trade Organization (WTO) play crucial roles in promoting international monetary and financial stability
• Increasing importance of emerging market economies, particularly China, in the global monetary system
  • China's Renminbi (RMB) has been included in the IMF's Special Drawing Rights (SDR) basket since 2016
• Rise of digital currencies and their potential impact on the global monetary system
  • Central Bank Digital Currencies (CBDCs) are being explored by many countries as a means to enhance financial inclusion and monetary policy transmission
• Growing influence of regional monetary arrangements, such as the Chiang Mai Initiative Multilateralization (CMIM) in East Asia and the Eurasian Economic Union (EAEU)
• Increasing role of private sector actors, such as multinational corporations and institutional investors, in shaping global financial flows and exchange rates

Exchange Rate Regimes and Mechanisms

• Fixed exchange rate regime involves pegging a country's currency to another currency or a basket of currencies, with the central bank intervening to maintain the peg
  • Examples include the Hong Kong dollar's peg to the U.S. dollar and the Danish krone's peg to the euro
• Floating exchange rate regime allows the currency's value to be determined by market forces of supply and demand, with limited central bank intervention
  • Major currencies such as the U.S. dollar, euro, and Japanese yen operate under floating exchange rate regimes
• Managed float or dirty float is a hybrid system where the exchange rate is largely determined by market forces, but the central bank occasionally intervenes to influence the rate
  • Many emerging market economies, such as Brazil and India, adopt managed float regimes
• Currency board is a strict form of fixed exchange rate regime where the domestic currency is backed by a foreign reserve currency at a fixed rate, with the central bank obliged to maintain the peg
  • Examples include the Bulgarian lev's peg to the euro and the Brunei dollar's peg to the Singapore dollar
• Crawling peg is a system where the exchange rate is adjusted periodically in small increments, often in response to changes in macroeconomic indicators such as inflation or trade balances
  • Historically, countries like Chile and Colombia have used crawling peg systems to manage their exchange rates
• Dual or multiple exchange rate systems involve the use of different exchange rates for different types of transactions, such as a fixed rate for essential imports and a floating rate for other transactions
  • Venezuela and Argentina have used dual exchange rate systems in the past to manage foreign exchange shortages and capital flows

Balance of Payments: Components and Analysis

• Current account records a country's trade in goods and services, primary income (investment income and compensation of employees), and secondary income (transfers)
  • A current account surplus indicates that a country is a net lender to the rest of the world, while a deficit suggests that it is a net borrower
• Capital account records capital transfers and the acquisition or disposal of non-produced, non-financial assets (such as patents and copyrights)
• Financial account records transactions involving financial assets and liabilities between residents and non-residents
  • Includes direct investment, portfolio investment, financial derivatives, and reserve assets
• Errors and omissions is a balancing item that accounts for statistical discrepancies and measurement errors in the BOP
• BOP analysis helps policymakers assess a country's external vulnerabilities, such as excessive current account deficits or reliance on short-term capital inflows
  • Persistent current account deficits may indicate a lack of competitiveness or an unsustainable consumption pattern
• BOP crises occur when a country faces a sudden stop or reversal of capital inflows, leading to a sharp depreciation of the currency and a contraction in economic activity
  • Examples include the Latin American debt crisis in the 1980s and the Asian financial crisis in 1997-1998
• Macroeconomic policies, such as fiscal and monetary policies, can be used to address BOP imbalances and promote external stability
  • For example, a country with a large current account deficit may adopt contractionary fiscal policy to reduce domestic demand and import growth

International Financial Institutions and Their Roles

• International Monetary Fund (IMF) promotes international monetary cooperation, exchange rate stability, and orderly BOP arrangements
  • Provides financial assistance to member countries facing BOP difficulties, subject to conditionality (policy reforms)
  • Conducts surveillance of member countries' economic policies and provides technical assistance
• World Bank Group promotes long-term economic development and poverty reduction through loans, grants, and technical assistance
  • Consists of five institutions: International Bank for Reconstruction and Development (IBRD), International Development Association (IDA), International Finance Corporation (IFC), Multilateral Investment Guarantee Agency (MIGA), and International Centre for Settlement of Investment Disputes (ICSID)
• Regional development banks, such as the African Development Bank (AfDB), Asian Development Bank (ADB), and Inter-American Development Bank (IDB), provide financing and technical assistance for regional development projects
• Bank for International Settlements (BIS) serves as a bank for central banks and promotes international monetary and financial cooperation
  • Hosts the Basel Committee on Banking Supervision, which sets global standards for bank regulation and supervision
• Financial Stability Board (FSB) coordinates the work of national financial authorities and international standard-setting bodies to promote global financial stability
  • Monitors and assesses vulnerabilities in the global financial system and develops regulatory and supervisory policies to address them
• Paris Club is an informal group of official creditors that coordinates the restructuring of bilateral government loans to developing countries facing debt difficulties
• London Club is an informal group of commercial banks that coordinates the restructuring of commercial bank loans to developing countries facing debt difficulties

Global Financial Crises and Their Impacts

• Great Depression (1929-1939) was a severe economic downturn characterized by sharp declines in output, employment, and prices, with widespread bank failures and a collapse in international trade
  • Led to the abandonment of the gold standard and the adoption of protectionist trade policies
• Latin American Debt Crisis (1980s) occurred when many Latin American countries defaulted on their external debts following a sharp rise in global interest rates and a decline in commodity prices
  • Resulted in a "lost decade" of economic growth and high inflation in the region, with many countries adopting IMF-supported structural adjustment programs
• Asian Financial Crisis (1997-1998) was triggered by a series of currency devaluations and capital outflows in East and Southeast Asian economies, leading to sharp economic contractions and financial sector distress
  • Exposed the vulnerabilities of fixed exchange rate regimes and the risks of excessive short-term foreign borrowing
• Global Financial Crisis (2007-2009) originated in the U.S. subprime mortgage market and spread to the global financial system through complex financial instruments and interconnected financial institutions
  • Led to a severe recession in many advanced economies and a sharp slowdown in emerging market economies, with governments and central banks implementing unprecedented fiscal and monetary stimulus measures
• Eurozone Debt Crisis (2010-2012) was triggered by concerns over the sustainability of public debt in several peripheral European countries, such as Greece, Ireland, and Portugal
  • Exposed the structural weaknesses of the European Monetary Union, such as the lack of a fiscal union and the divergence in economic performance among member states
• Financial crises can have long-lasting effects on economic growth, employment, and social welfare, with disproportionate impacts on vulnerable groups such as low-income households and small businesses
  • Policymakers face the challenge of balancing short-term crisis management with long-term reforms to enhance financial stability and resilience

Future Trends and Challenges in Global Finance

• Increasing digitalization of financial services, with the rise of fintech (financial technology) and the adoption of digital currencies and payment systems
  • Presents opportunities for financial inclusion and efficiency gains, but also raises concerns over data privacy, cybersecurity, and the stability of the financial system
• Growing importance of sustainable finance and environmental, social, and governance (ESG) considerations in investment and lending decisions
  • Reflects the increasing awareness of the financial risks posed by climate change and the role of the financial sector in supporting the transition to a low-carbon economy
• Demographic shifts, such as population aging in advanced economies and the rise of the middle class in emerging markets, will have significant implications for global savings, investment, and capital flows
• Geopolitical tensions and trade conflicts, such as the U.S.-China trade war and the impact of Brexit on the European financial system, may disrupt global financial flows and increase market volatility
• Need for international cooperation and policy coordination to address global challenges, such as climate change, pandemics, and cross-border financial stability risks
  • Requires a strengthening of the multilateral framework for global economic governance and the adaptation of international financial institutions to the changing global landscape
• Potential for a multi-polar global monetary system, with the rise of new reserve currencies and the increasing use of regional and local currencies in international transactions
  • May reduce the dominance of the U.S. dollar and increase the resilience of the global financial system to shocks emanating from a single country or region
• Importance of promoting financial literacy and consumer protection, particularly in the context of increasing financial innovation and the growing complexity of financial products and services