International Monetary Fund (IMF), international economic organization whose purpose is to promote international monetary cooperation to facilitate the expansion of international trade.
The IMF operates as a United Nations specialized agency and is a permanent forum for consideration of issues of international payments, in which member nations are encouraged to maintain an orderly pattern of exchange rates and to avoid restrictive exchange practices.
The IMF was established, along with the International Bank for Reconstruction and Development, at the UN Monetary and Financial Conference held in 1944 at Bretton Woods, New Hampshire. The IMF began operations in 1947.
Membership is open to all independent nations and included 183 countries in 2001.
Friday, May 1, 2009
Exchange Rate Mechanism (ERM
Exchange Rate Mechanism (ERM), central component of the 1979 European Monetary System (EMS) designed to maintain monetary stability among participating members of the European Union (EU).
The specific purpose of the ERM was to limit fluctuations in currency exchange rates among EMS members by linking these rates to the unit of account of the EU, the European Currency Unit (ECU, which became the euro in 1999).
The exchange rates of the participating countries were formally established in relation to the ECU and were allowed to fluctuate only by small amounts. In practice, however, the German currency, the deutsche mark, was the fulcrum of the system as the strongest European currency.
The specific purpose of the ERM was to limit fluctuations in currency exchange rates among EMS members by linking these rates to the unit of account of the EU, the European Currency Unit (ECU, which became the euro in 1999).
The exchange rates of the participating countries were formally established in relation to the ECU and were allowed to fluctuate only by small amounts. In practice, however, the German currency, the deutsche mark, was the fulcrum of the system as the strongest European currency.
The founding members of the EMS
The founding members of the EMS in 1979 were Belgium, Denmark, France, West Germany (reunified with East Germany after 1990 as the Federal Republic of Germany), Ireland, Italy, Luxembourg, The Netherlands, and the United Kingdom. Of these, all but the United Kingdom agreed to participate in the ERM; the United Kingdom joined the ERM in 1990. Spain and Portugal, which became members of the European Community (now the EU) in 1986, joined the ERM in 1989 and 1992, respectively.
The central feature of the ERM
The central feature of the ERM was the commitment by the participating countries to maintain their exchange rates in relation to one another and to the ECU within a margin of fluctuation of 2.25 percent. As an exception, Italy was given a margin of fluctuation of 6 percent, as were Spain and the United Kingdom when they joined. The ERM was not a fixed rate system: The central rates could be altered by negotiation among the participating governments.
The original motive behind the ERM
The original motive behind the ERM was to provide short-term monetary stability, which was seen as important in stimulating trade and investment within the EU. The system survived because the limits on exchange rate fluctuation were not excessively rigid in practice, and currencies were realigned when necessary. There were 11 realignments from 1979 to 1987, in every instance a devaluation of one or more currencies against the deutsche mark.
Exchange rate realignments
Exchange rate realignments became less frequent after 1983, and from 1987 until 1992 they ceased altogether. During this period, the ERM acquired a more ambitious objective—holding down inflation throughout the system.
To accomplish this, the ERM was made more rigid and member currencies were locked to the ECU or, for all intents and purposes, to the strong deutsche mark. This more rigid system enjoyed early success, and inflation rates fell sharply in the member countries of the ERM.
However, the role of the ERM in this drop is questionable, as inflation also fell in industrial countries outside the ERM such as the United States and the United Kingdom. Even so, bringing down inflation was an important motive behind the United Kingdom’s decision to enter the ERM in 1990 and in Italy’s decision in the same year to narrow its band of fluctuation from 6 percent to 2.25 percent.
To accomplish this, the ERM was made more rigid and member currencies were locked to the ECU or, for all intents and purposes, to the strong deutsche mark. This more rigid system enjoyed early success, and inflation rates fell sharply in the member countries of the ERM.
However, the role of the ERM in this drop is questionable, as inflation also fell in industrial countries outside the ERM such as the United States and the United Kingdom. Even so, bringing down inflation was an important motive behind the United Kingdom’s decision to enter the ERM in 1990 and in Italy’s decision in the same year to narrow its band of fluctuation from 6 percent to 2.25 percent.
The main pressure on the system
However, the system’s lack of flexibility soon became a problem. The main pressure on the system came from the 1990 German reunification, which necessitated heavy spending by the German government to aid the weak economy of former East Germany.
Government debt in Germany increased, but monetary policy was tightened to keep inflation low. As a result, German interest rates rose, putting upward pressure on interest rates in the other countries of the ERM. In September 1992 currency traders began to doubt the value of the currencies of some member states, and this led to a major speculative crisis as traders began heavily buying and selling these currencies.
This put severe pressures on the ERM, and its inability to respond by realigning exchange rates led to a weakening of member currencies.
Government debt in Germany increased, but monetary policy was tightened to keep inflation low. As a result, German interest rates rose, putting upward pressure on interest rates in the other countries of the ERM. In September 1992 currency traders began to doubt the value of the currencies of some member states, and this led to a major speculative crisis as traders began heavily buying and selling these currencies.
This put severe pressures on the ERM, and its inability to respond by realigning exchange rates led to a weakening of member currencies.
In the wake of economic damage (EMU)
The crisis also had political causes. Doubts had arisen about the commitment of EU countries to Economic and Monetary Union (EMU) as established in the 1992 Maastricht Treaty that created the EU.
EMU originally met with a great deal of skepticism, and early in 1992 the Danish electorate rejected the Maastricht Treaty in a referendum. The treaty was passed in Denmark in a subsequent referendum and EMU eventually went into effect; however, the uncertainty concerning the future of EMU was an important factor in the speculative attack.
In the wake of economic damage caused by trying to maintain fixed exchange rates during the crisis, Italy and the United Kingdom left the ERM and allowed their currencies to fluctuate freely against those of other states. Other countries retained formal membership in the system, although Spain, Portugal, and Ireland devalued their currencies several times.
There was another speculative crisis in 1993; in response, the margins of fluctuation were widened to 15 percent. Such a wide margin of fluctuation made the ERM essentially useless for regulating currency rates and signaled the collapse of the ERM as an anchor against inflation.
EMU originally met with a great deal of skepticism, and early in 1992 the Danish electorate rejected the Maastricht Treaty in a referendum. The treaty was passed in Denmark in a subsequent referendum and EMU eventually went into effect; however, the uncertainty concerning the future of EMU was an important factor in the speculative attack.
In the wake of economic damage caused by trying to maintain fixed exchange rates during the crisis, Italy and the United Kingdom left the ERM and allowed their currencies to fluctuate freely against those of other states. Other countries retained formal membership in the system, although Spain, Portugal, and Ireland devalued their currencies several times.
There was another speculative crisis in 1993; in response, the margins of fluctuation were widened to 15 percent. Such a wide margin of fluctuation made the ERM essentially useless for regulating currency rates and signaled the collapse of the ERM as an anchor against inflation.
Original ERM
The original ERM ended in 1999 with the establishment of EMU, as set out in the Maastricht Treaty. Currency exchange rates for countries qualifying for EMU were irrevocably fixed, and on January 1, 1999, the euro became the common currency for 11 of the 15 EU member states, replacing the ECU on a one-to-one basis.
A revised ERM structure was drafted as part of the 1997 Amsterdam Treaty. This revised structure was designed to regulate relations between the euro and the national currencies of the non-EMU countries—the United Kingdom, Denmark, Sweden, and Greece. (In 2001, however, Greece became the 12th member of the EU to adopt the euro.) The permissible range of fluctuation was set at 15 percent.
A revised ERM structure was drafted as part of the 1997 Amsterdam Treaty. This revised structure was designed to regulate relations between the euro and the national currencies of the non-EMU countries—the United Kingdom, Denmark, Sweden, and Greece. (In 2001, however, Greece became the 12th member of the EU to adopt the euro.) The permissible range of fluctuation was set at 15 percent.
Gold Standard
Gold Standard, in economics, monetary system wherein all forms of legal tender may be converted, on demand, into fixed quantities of fine gold, as defined by law. Until the 19th century, most countries of the world maintained a bimetallic monetary system.
The widespread adoption of the gold standard during the second half of the 19th century was largely a result of the Industrial Revolution, which brought about a vast increase in the production of goods and widened the basis of world trade.
The countries that adopted the gold standard had three principal aims: to facilitate the settlement of international commercial and financial transactions; to establish stability in foreign exchange rates; and to maintain domestic monetary stability.
They believed these aims could best be accomplished by having a single standard of universal validity and relative stability; hence the gold standard is sometimes called the single gold standard.
The widespread adoption of the gold standard during the second half of the 19th century was largely a result of the Industrial Revolution, which brought about a vast increase in the production of goods and widened the basis of world trade.
The countries that adopted the gold standard had three principal aims: to facilitate the settlement of international commercial and financial transactions; to establish stability in foreign exchange rates; and to maintain domestic monetary stability.
They believed these aims could best be accomplished by having a single standard of universal validity and relative stability; hence the gold standard is sometimes called the single gold standard.
Black Market
Black Market, term designating the illicit sale of commodities in violation of government rationing and price-fixing. The term originated in Europe during World War I, when the introduction of rationing in belligerent countries tempted some persons with access to supplies to enrich themselves by selling unrestricted quantities of rationed items at inflated prices.
Black markets are phenomena of times of crisis. They flourish only when an abnormal scarcity of essential goods may cause a government to impose rationing and price controls as a means of ensuring a more equitable distribution of supplies.
At such times certain consumers will pay abnormally high prices to obtain the scarce items, and some profiteers are prepared to take legal and other risks to obtain and sell these items at high prices. Black markets flourished throughout World War II but disappeared after the war as soon as the production of civilian goods returned to normal and government controls were lifted.
Illicit currency exchanges are also sometimes defined as black market operations. These black markets develop when the official exchange value of a currency is fixed at a rate that does not reflect its real exchange value. Such a situation is an incentive for holders of foreign currencies to engage in extralegal currency exchanges rather than to use the less profitable exchanges at official rates.
Black markets are phenomena of times of crisis. They flourish only when an abnormal scarcity of essential goods may cause a government to impose rationing and price controls as a means of ensuring a more equitable distribution of supplies.
At such times certain consumers will pay abnormally high prices to obtain the scarce items, and some profiteers are prepared to take legal and other risks to obtain and sell these items at high prices. Black markets flourished throughout World War II but disappeared after the war as soon as the production of civilian goods returned to normal and government controls were lifted.
Illicit currency exchanges are also sometimes defined as black market operations. These black markets develop when the official exchange value of a currency is fixed at a rate that does not reflect its real exchange value. Such a situation is an incentive for holders of foreign currencies to engage in extralegal currency exchanges rather than to use the less profitable exchanges at official rates.
Balance of Payments
Balance of Payments, relationship between the amount of money a nation spends abroad and the income it receives from other nations. The balance of payments is officially known as the Statement of International Transactions and includes two main accounts.
The first, the current account, tracks activity in merchandise trade—exporting and importing; income earned from investments abroad; money paid to foreign investors; and transactions on which the government expects no returns.
The second, the capital account, tracks both loans given to foreigners and loans received by citizens. Because the balance of payments is one reflection of a nation's financial stability in the world market, the International Monetary Fund (IMF) uses these accounts to make decisions such as qualifying a country for a loan.
The IMF also provides the information to its members so that they can make informed decisions about investments and trade.
All balance of payments transactions have an offsetting receipt. Although a country might have a deficit in merchandise trade (indicating that it is importing more than it is exporting), it will show a surplus in another area, such as its investment income.
The balance of payments can be used as an indicator of a nation's economic stability. Changes in the balance of payments can affect the exchange rate of a country's currency. For example, a deficit in merchandise trade means that the currency of that nation is flooding the world economy, since it is being used to buy the imports that cause the deficit. Unless government controls are used, the value of the currency will most likely depreciate.
The first, the current account, tracks activity in merchandise trade—exporting and importing; income earned from investments abroad; money paid to foreign investors; and transactions on which the government expects no returns.
The second, the capital account, tracks both loans given to foreigners and loans received by citizens. Because the balance of payments is one reflection of a nation's financial stability in the world market, the International Monetary Fund (IMF) uses these accounts to make decisions such as qualifying a country for a loan.
The IMF also provides the information to its members so that they can make informed decisions about investments and trade.
All balance of payments transactions have an offsetting receipt. Although a country might have a deficit in merchandise trade (indicating that it is importing more than it is exporting), it will show a surplus in another area, such as its investment income.
The balance of payments can be used as an indicator of a nation's economic stability. Changes in the balance of payments can affect the exchange rate of a country's currency. For example, a deficit in merchandise trade means that the currency of that nation is flooding the world economy, since it is being used to buy the imports that cause the deficit. Unless government controls are used, the value of the currency will most likely depreciate.
Price Fluctuation
Foreign exchange is a commodity, and its price fluctuates in accordance with supply and demand; exchange rates are published daily in the principal newspapers of the world and on the World Wide Web.
By international agreement fixed exchange rates with a narrow margin of fluctuation existed until 1973, when floating rates were adopted that fluctuate as supply and demand dictate. Foreigners need dollar exchange to pay for goods imported from the United States, for services supplied by Americans, for interest and dividends earned by American capital invested abroad, for the purchase of securities in the United States, and for other types of transactions.
Americans buy foreign exchange for similar reasons. Payments for services that must be made by one nation to another include freight charges, insurance premiums, commissions, and travel expenses.
New York City merchants importing goods from the United Kingdom buy drafts on London from their banks. These drafts, or bills of exchange, create a supply of dollars and a demand for pounds. At the same time, other American merchants sell goods to persons in the United Kingdom and receive drafts payable in pounds that they desire to convert into dollars. The foreign exchange banker buys the pounds from the American exporters and sells them to the importers who need pounds in exchange for their dollars.
Ordinarily, and without government restrictions, the rate of exchange, or the price of the currency of one country in terms of that of another, will depend on overall supply and demand and on the relative purchasing power of the two currencies—that is, on the competitive position of the two countries in world markets. At times, speculation in foreign exchange by dealers, brokers, or others becomes a major influence on exchange rates.
By international agreement fixed exchange rates with a narrow margin of fluctuation existed until 1973, when floating rates were adopted that fluctuate as supply and demand dictate. Foreigners need dollar exchange to pay for goods imported from the United States, for services supplied by Americans, for interest and dividends earned by American capital invested abroad, for the purchase of securities in the United States, and for other types of transactions.
Americans buy foreign exchange for similar reasons. Payments for services that must be made by one nation to another include freight charges, insurance premiums, commissions, and travel expenses.
New York City merchants importing goods from the United Kingdom buy drafts on London from their banks. These drafts, or bills of exchange, create a supply of dollars and a demand for pounds. At the same time, other American merchants sell goods to persons in the United Kingdom and receive drafts payable in pounds that they desire to convert into dollars. The foreign exchange banker buys the pounds from the American exporters and sells them to the importers who need pounds in exchange for their dollars.
Ordinarily, and without government restrictions, the rate of exchange, or the price of the currency of one country in terms of that of another, will depend on overall supply and demand and on the relative purchasing power of the two currencies—that is, on the competitive position of the two countries in world markets. At times, speculation in foreign exchange by dealers, brokers, or others becomes a major influence on exchange rates.
Inflation and Deflation
Inflation is the pervasive and sustained rise in the aggregate level of prices measured by an index of the cost of various goods and services. Repetitive price increases erode the purchasing power of money and other financial assets with fixed values, creating serious economic distortions and uncertainty.
Inflation results when actual economic pressures and anticipation of future developments cause the demand for goods and services to exceed the supply available at existing prices or when available output is restricted by faltering productivity and marketplace constraints. Sustained price increases were historically directly linked to wars, poor harvests, political upheavals, or other unique events.
Deflation involves a sustained decline in the aggregate level of prices, such as occurred during the Great Depression of the 1930s; it is usually associated with a prolonged erosion of economic activity and high unemployment. Widespread price declines have become rare, however, and inflation is now the dominant variable affecting public and private economic planning.
Inflation results when actual economic pressures and anticipation of future developments cause the demand for goods and services to exceed the supply available at existing prices or when available output is restricted by faltering productivity and marketplace constraints. Sustained price increases were historically directly linked to wars, poor harvests, political upheavals, or other unique events.
Deflation involves a sustained decline in the aggregate level of prices, such as occurred during the Great Depression of the 1930s; it is usually associated with a prolonged erosion of economic activity and high unemployment. Widespread price declines have become rare, however, and inflation is now the dominant variable affecting public and private economic planning.
Effects of Devaluation
Currency devaluation primarily affects a nation's trade balance, which is the difference between the value of its exports and that of its imports. Devaluation reduces the value of a nation's currency in terms of other currencies; thus, following a devaluation, a nation will have to exchange more of its own currency in order to obtain a given amount of foreign currency.
This causes the price of imports to rise and makes domestic products more attractive to consumers at home. Because it takes less foreign currency to buy a given amount of a devalued currency, the price of the nation's exports declines, making them more desirable to foreign consumers.
Depending on consumer and producer responsiveness to price changes (known as supply and demand elasticities), an effective devaluation should reduce a nation's imports and raise world demand for its exports. Improvement in a country's balance of trade will cause an increase in the new inflow of foreign currency; this, in turn, may help strengthen a country's overall balance of payments account.
The total effect of a currency devaluation depends on the actual elasticities of the supply and demand for traded goods. The more elastic the demand for imports and exports, the greater the effect of the devaluation will be on the country's trade deficits and, therefore, on its balance of payments; the less elastic the demand, the greater the necessary devaluation will be to eliminate a given imbalance.
Devaluation often is criticized as an inflationary monetary policy because it raises the domestic price of imports. The underlying cause of inflation is not devaluation, however, but rather excess money creation. Nonetheless, devaluation is an unpopular policy, especially in small countries that are extremely dependent on imports as a source of food and other necessities.
This causes the price of imports to rise and makes domestic products more attractive to consumers at home. Because it takes less foreign currency to buy a given amount of a devalued currency, the price of the nation's exports declines, making them more desirable to foreign consumers.
Depending on consumer and producer responsiveness to price changes (known as supply and demand elasticities), an effective devaluation should reduce a nation's imports and raise world demand for its exports. Improvement in a country's balance of trade will cause an increase in the new inflow of foreign currency; this, in turn, may help strengthen a country's overall balance of payments account.
The total effect of a currency devaluation depends on the actual elasticities of the supply and demand for traded goods. The more elastic the demand for imports and exports, the greater the effect of the devaluation will be on the country's trade deficits and, therefore, on its balance of payments; the less elastic the demand, the greater the necessary devaluation will be to eliminate a given imbalance.
Devaluation often is criticized as an inflationary monetary policy because it raises the domestic price of imports. The underlying cause of inflation is not devaluation, however, but rather excess money creation. Nonetheless, devaluation is an unpopular policy, especially in small countries that are extremely dependent on imports as a source of food and other necessities.
Causes of Devaluation
The free-market value of a national currency is determined by the interaction of supply and demand. If the quantity of the currency demanded is greater than the quantity supplied, a nation's currency will appreciate, or increase in value. A nation's currency will depreciate, or decrease in value, when the quantity of currency supplied is greater than that demanded.
The demand for a nation's currency depends on the amount of its exports, domestic investments, and assets held in domestic currency. A nation's currency supply on world markets depends partly on the amount of imports, investments abroad, and assets held in foreign countries. Ultimately, the supply of a currency depends on national monetary policy; if a country prints too much money, causing inflation domestically, a balance of payments deficit results.
Under a system of fixed exchange rates a country can adjust its exchange rate by trading its national currency for foreign currency or gold. If a balance of trade surplus persists, the government may decide to buy more foreign currency or gold in order to move back into equilibrium. Conversely, if a deficit exists, the government may sell some of its reserves of foreign currency or gold in order to bolster the value of its own currency.
Because a nation's reserves of other currencies and gold are limited, the government may choose to correct an imbalance by officially readjusting the value of its currency. Such a devaluation will usually be achieved through a legislative or administrative order. Under a flexible exchange-rate system, alterations in the exchange rate can be made to help a nation achieve equilibrium in its balance of payments.
The demand for a nation's currency depends on the amount of its exports, domestic investments, and assets held in domestic currency. A nation's currency supply on world markets depends partly on the amount of imports, investments abroad, and assets held in foreign countries. Ultimately, the supply of a currency depends on national monetary policy; if a country prints too much money, causing inflation domestically, a balance of payments deficit results.
Under a system of fixed exchange rates a country can adjust its exchange rate by trading its national currency for foreign currency or gold. If a balance of trade surplus persists, the government may decide to buy more foreign currency or gold in order to move back into equilibrium. Conversely, if a deficit exists, the government may sell some of its reserves of foreign currency or gold in order to bolster the value of its own currency.
Because a nation's reserves of other currencies and gold are limited, the government may choose to correct an imbalance by officially readjusting the value of its currency. Such a devaluation will usually be achieved through a legislative or administrative order. Under a flexible exchange-rate system, alterations in the exchange rate can be made to help a nation achieve equilibrium in its balance of payments.
Devaluation
Devaluation, in economics, official act reducing the rate at which one currency is exchanged for another in international currency markets. A government may choose to devalue its currency when a chronic imbalance exists in its balance of trade, part of its overall balance of payments. Such a trade imbalance weakens the international acceptance of the currency as legal tender.
Devaluation occurs when a country has been maintaining a fixed exchange rate relative to other major foreign currencies. When a flexible exchange rate is maintained—that is, currency values are not fixed but are set by market forces—a decline in a currency's value is known as a depreciation.
Devaluation occurs when a country has been maintaining a fixed exchange rate relative to other major foreign currencies. When a flexible exchange rate is maintained—that is, currency values are not fixed but are set by market forces—a decline in a currency's value is known as a depreciation.
Subscribe to:
Posts (Atom)
