(ii) Supply = the supply of FE derives from the credit items in the BP. There is a direct relationship with price.
For example, if Bank of England announces that the par value of £
= $2.00 and supports British pound at 2% below the par or supports $ at 2%
above the par, they have to get rid of the excess supply or demand at these
prices using their international reserve assets. During the Bretton Woods
era, a country's international reserve assets included gold and other foreign
currencies. (See for instance, Japan's
international reserves (copy)). Since 1973,
they included SDRs and foreign currencies. While gold can be held by the
private sector as well as public institutions, gold is no longer used as
a means to settle international payments. In countries where gold is held
as a reserve asset, its market value is listed, but gold cannot be directly
used to settle payments between central banks.
(i) US buys £, this ⇒ increases £ reserve in US (For example, because of its low dollar peg of RMB, China is buying dollars, about $200 billion a year. China accumulated about $1.4 trillion as of November 2007. China is considering selling dollars ⇒ As $ ↓, the value of China's reserve asset declines. )
(ii) UK buys £ (sell $), this ⇒ decreases $ reserve in UK.
Figure 2
(i) US sells £ (£ reserve falls in the US)
(ii) UK sells £ ($ reserve increases in UK). China sells RMB and $ reserve increase in China.
Fixed Rates: the government announces an exchange rate, called the parity rate and defends it.
X%
Example: Mexico's arrangement during the early 1990s provides a good example of a crawling peg. Mexico pegged the peso to the US dollar. However, the inflation rates of the two countries diverged considerably, which necessitated a gradual depreciation of the peso. In this case, it is better to adopt a crawling peg than to devalue the peso drastically once in a while. Similarly, Nicaragua pegged the value of its currency to the US dollar. US inflationa averaged about 2 to 3 %, but inflation in Nicaragua remained between 10 to 20% a year. Because of this large difference in inflation rates, there would be a tendency for the córdoba to depreciate against the US dollar. Thus, Nicaragua adopted a crawling peg. (Daniels and van Hoose, 2002).
Currency Baskets
While it is efficient to peg one's currency to a stable currency, relying
on a single currency might be risky. For this reason, a nation might peg
its currency to a basket of foreign currencies. A basket of currencies is
likely to be less variable than a single currency.
If all other currencies were included in the basket, the resulting peg would be most stable. However, managing such a peg can be quite cumbersome. Moreover, not all currencies are equally important, and weights should be assigned to each currency in accordance with the economic power of the nations included in the basket. For this reason, the currency baskets often include a small number of major currencies. For instance, the Czech Republic pegged its currency koruna to a basket of currencies including 0.0125 USD and 0.0329 DM, equivalent to 1 koruna (Kc 1).
Currency Boards do not engage in discretionary monetary policy. Many small countries have currency boards: Estonia, Hong Kong, Lithuania, and Argentina.
Recently, Lithuania abadoned its currency board because in 1997 a rise in the value of USD resulted in an appreciation of lit against the currencies of its major trading partners and a huge trade deficit.
Some countries use the currencies of another nation as their legal tender.
Other nations may also abandon their domestic currencies. This practice
is called dollarization, i.e., the use of any other currency (dollar or
not) as the legal tender.
Zimbabwe gives in to US dollar, New York Times, February 9, 2009
Euroization
Some European countries now consider euroization, namely to use euro as a legal tender in their countries unilaterally without consulting European Union. The new member states are expected to use euro as legal tender sooner or later. There is as yet no movement to use euro as legal tender in other European countries.
Flexible (Floating) Rates: The government does not announce a parity rate.
dirty (managed) float: occasional monetary intervention designed to smooth out fluctuations
Current Account
Services = transportation, insurance, travel, investment services (interest income, dividends, profits), royalties and other services
Unilateral transfers = gifts to foreigners
private transfers = expenditures for missionary, charitable and educational
organizations + personal remittances (of immigrants to their families and
relatives)
government transfers = tax receipts from nonresidents, nonmilitary grants, but the largest is government aid toward developing countries (net military transactions)
Capital Account
Capital inflow occurs when residents' financial liabilities increase, e.g. selling bonds to foreigners
Capital outflow occurs when residents' financial claims on foreigners increase (or liabilities decrease)
Direct Investment = long term capital outflow. This includes only foreign branches + subsidiaries effectively controlled. (US residents control 50% or more of the voting stock)
Portfolio Investment = long term capital outflow that do not give effective control over investments. covers all international financial transactions with maturity exceeding one year.
Short term capital flows = transactions of international assets with maturity of one year or less. short term borrowing from foreign banks/short term deposits in foreign banks. Most volatile component/ errors & Omissions
Official Reserve Account
records transactions of central bank (Federal Reserve system, Treasury, exchange stabilization agency).
These transactions of the central bank are carried out in order to postpone or delay a change in exchange rate. Except in emergencies, these changes are evidence of either defending a weak currency or manipulating the currency peg to maintain a country's exports or trade surplus.
This balance measures only exports and imports of merchandise by putting them above the line, i.e., treating them as autonomous decisions. Available monthly, and hence popular.
Xg - Mg
X - M.
It is more difficult to keep track of service transactions.
This measure covers all transactions that are current,
X - M - T
If surplus, it represents the amount of international lending and
corresponds to net foreign investment.
Large current account deficits do not necessarily imply there is a problem
in the economy.
The basic balance is the sum of the current account balance and the net movement of long term capital (direct and portfolio investments).
X - M - T - LTC
LTC = long term capital outflow
This balance measures the liquidity position of the US,
X - M - T - LTC - STCUS.
STCUS = short term US capital outflow
In case of trouble, STCUS cannot be mobilized, but STCforeign can be quickly retrieved from the US. Appropriate measure in a crisis, but not in a steady state. If the liquidity balance is large and negative, the country faces the risk of a temporary depreciation.
This balance puts the transactions of monetary authorities below the line, and all others above the line. X - M - T - LTC - STCprivate. If the monetary authorities engage in no transactions to manipulate exchange rates, the official reserve transactions are zero by definition. This balance measures the extent of actions by monetary authorities to delay a change in exchange rates.
BP Accounting under Flexible Exchange Rate
Since 1978 the US decided not to intervene in the FE market, except in emergency. However, several countries have intervened in the FE markets occasionally, when a currency appreciated or depreciated too much relative to other currencies (e.g., Plaza accord in 1985). Accordingly, BP accounts are prepared in a different way. In a country with a clean float, no reserve transactions occur, so the official reserve transactions account is zero by definition.
If there are no reserve movements, then the current account and capital account must total zero.
If there is a shock in the payments system, the adjustment is made through exchange rates, i.e., a change in the foreign price of a domestic currency. If clean floats were in operation, then payments accounts would include only current and capital accounts.
However, the US and many industrial countries maintain dirty or managed floats.
Since 1977, BP accounts have been published in a different format which reflects the nonintervention policy of the Federal Reserve Bank. (No reseve transactions)
Current Account
Exports of goods, services, and income
Merchandise export
service export
income receipts on US assets abroad
Imports of goods, services, and income
merchandise import
service import
income payments on foreign assets in US
Unilateral transfers
Capital Account
US Assets Abroad
US official reserve asset (gold, SDR, reserve position
in the IMF)
US government assets
US private assets
Foreign Assets in the US
Foreign official assets in the US
other foreign assets
Statistical discrepancy