BALANCE OF PAYMENT

AND EXCHANGE RATE

GOLD STANDARD, BRETTON
WOODS AND FLOATING
SYSTEM

What is Balance of Payment?

BOP : statement of systematic record of
all economic transaction between one
country and the rest of the world during a
given period of time.
Difference between the total value of
goods and services imported and exported
over a given period of time.

Cont..
BOP account records both debits and
credits.
BOP includes both visible and invisible
goods.
Economic transaction : merchandise
trade, services such as transportation,
insurance, banking and others.

Balance of Payment, cont..

Debit (-) : any transaction that supplies
the countrys currency in the foreign
exchange market. (money outflow)
Credit (+) : any transaction that creates
demand for the countrys currency in the
foreign exchange market. (money inflow)

Structure of Malaysian BOP

2. Capital Account
There are two types of transaction in the
capital account namely private and official.
Private transaction: includes all types of
investment: direct, portfolio and short term
Official or government transaction:
loans to and from foreign official agencies

3. Official Reserve Account

IMF is an international organization created to
oversee the international monetary system.
IMF holds currency reserves for member
countries and makes loans to central banks.
SDR is an international money mechanism
created by IMF in the form of bookkeeping entries
that can be used by countries to settle their
international accounts.

Errors and Omissions

Balancing item in which the credits and debits
must be equal.
In all economic transactions, such as exporting
goods, importing goods, the buying of land in
foreign countries should balance according to
accounting bookkeeping concepts.
However, there may be some missing
information.
Thus, BOP accountant uses error and omission
to balance the account.

Disequilibrium in BOP
Occurs when there is a deficit or surplus
in BOP.
A surplus or deficit shows a countrys
strength or weakness in relation to its
external capital position as measured by the
balance of its external assets to liabilities.

How to Correct
Disequilibrium in BOP?
Export promotion develop quality
products with lower prices and improve
marketing strategies
Discourage imports imposing high
tariffs rates or quotas for imported products
Control inflation (deficit BOP) impose
tight monetary policy or tight fiscal policies
or both to control

How to Correct
Disequilibrium in BOP?
Using the governments reserves in
the form of gold and foreign currencies to
balance deficit in BOP but only can be
used for short period continuous payment
from gov reserves will reduce its amount in
long run.

How to Correct
Disequilibrium in BOP?
Devaluation Governments policy of
lowering the par value of the countrys
currency compared to the currencies of
other countries by an official announcement
reduce value of home currency increase
value of foreign currencies stimulate
exports reduce imports from foreign
countries

Exchange Rate
Exchange Rate: Price of one currency in
terms of another currency
Buyers of imported goods or investors
who want to invest in other countries should
convert their domestic currency into the
currency of the nation that they are going to
deal with.

Cont..
Example : An importer in Malaysia who
wants to buy digital cameras from Japan will
need to convert Malaysian Ringgit to
Japanese Yen to carry out business with
Japanese firms.

Gold Standard
Prior to 1930s, gold standard was major
system of the exchange rate determination.
Values of all currencies were fixed
according to gold value.
Example, if US defines $20 in terms of
one ounce of gold and Britain defines 4 for
one ounce of gold, then the exchange rate
between dollars and pounds will be $5 to 1.

Features of Gold Standard

Each country defines its monetary value
in terms of quantity of gold
There must be freedom in export and
import of gold
Each country maintains a fixed
relationship between its stock of gold and its
money supply.

Bretton Woods System

In 1944, after Great Depression and
Second World War, representatives from
industrial countries held an international
conference at Bretton Woods to create a
new monetary system to replace the gold
standard.

Cont
Modified the fixed exchange rate system
(Gold Standard) and was known as
adjustable-peg system or Bretton Woods
System.
Under this system, countries have to peg
their currencies to US Dollar instead to gold.
Then, US Dollar was pegged directly to
gold that was worth $35 per ounce of gold.

Flexible Exchange Rate System

After 1973, Bretton Woods system of
fixed exchange rate was replaced by the
flexible exchange rate system or floating
system.
Under this system, major currencies are
free to float to their equilibrium market level.

Cont..
Most trading countries will allow their
exchange rates to move up or down in order
to stabilize excess supply or demand based
on supply and demand in the foreign
exchange market.
This system will considerably more
volatile than Bretton Woods System.

Demand Curve for US Dollar

Supply Curve for US Dollar

Determination of Exchange Rate