Foreign Exchange and the International Monetary System - Essay Example

Running Head: FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM Foreign Exchange and the International Monetary System Name Institution Date Foreign Exchange and the International Monetary System Introduction Foreign exchange explains the process of changing domestic currency into global banknotes. It can also be referred as the exchange of a given nation’s currency into another currency. Apart from offering a forum to implement currency transactions, foreign exchange markets are the leading measurements of economic activity. Government officials normally monitor foreign exchange markets to effectively develop policies and management for domestic commercial activity (Brown 2009). International monetary systems are procedures and policies that various countries normally employ in exchanging their currencies in the world trade. The systems are important in defining a common standards and values for the world’s currencies. They normally offer means of payment that is acceptable among buyers and sellers of various nationalities, incorporating deferred payment. For the systems to work well, they are expected to inspire confidence, offer enough liquidity for fluctuating levels of trade and offer ways by which international imbalances can be rectified. The systems are able to grow organically as a collective outcome of several individual agreements among international economic participants spread over some decades. The system can also grow from one architectural vision (Eichengreen 2008). The role of foreign exchange in a country’s economy Foreign exchange market is a network of businesses, monetary exchanges, private persons and government entities that offer platforms for trading global currencies among nations. Consumers normally enter the markets to obtain international banknotes so that he or she can be able to purchase goods and services from a broad. Businesses on the other hand trade within foreign exchange markets to exchange the revenue from abroad back into domestic currency. Therefore, foreign exchange, through foreign exchange markets, enables the consumers to easily acquire foreign goods and the businesses to easily convert their sales abroad to local currencies (Owen 2009). Apart from making and obtaining payments, foreign exchange, through foreign exchange markets, offers investment opportunities. According to Brown (2009), foreign exchange also enables investors to diversify their total monetary portfolios and to increase their total returns. It normally quotes the rates of currency, which function as a measure of political and economic climates of different countries. Foreign exchange rates usually determine the amount of a given country’s currency that need to be exchanged with a unit of another currency. The country’s strong foreign exchange rates are always due to its developing economy and political stability. The strong foreign exchange rate in a given country normally makes foreign investors to long for that country’s properties and to transact with its currency. Weak foreign exchange rates are normally associated with economic downturn and political instability. Foreign exchange transactions include the whole lot from the exchanging of local currency to foreign currency by a traveler at a kiosk in the airport to billion-dollar payments made by governments and corporate giants for commodities bought abroad. Globalization enhancement in current decades has resulted to a huge enhance in the number of foreign exchange transactions. International foreign exchange market is so far the largest monetary market, with average daily volumes in trillions of dollars. Effects of foreign exchange in a country’s economy Owen (2009) argues that Governments are the largest participants in the foreign exchange markets since they have exceptionally huge resources. Politicians normally create foreign exchange reserves that can enable them to make official payments to other nations and also to control their respective domestic economies. On national level, exports are normally favored by lower exchange rates. Lower exchange rates makes exported goods cheaper to foreign buyers. The country’s economy therefore develops with a decrease in exchange rates since more goods will be exported as compared to those imported. High exchange rates on the other hand are also important since they stabilize domestic prices. This will therefore enables the consumers to purchase a lot of imported goods and services because of their improved purchasing power. According to Owen (2009), Treasury managers can spend home currency on foreign exchange to affect global exchange rates. In April 2010, China maintained $ 900 billion worth of United States treasuries in its foreign exchange reserves. The holdings made the Chinese Yuan to loose value relative to United States dollar. This helped the China’s export economy to grow. Foreign exchange markets on the other hand have introduced contagion risks. Contagion explains the capability of a given localized economic affair to transition into international collapse. For the past quarter century, neglected debt defaults in Russia, Argentina, Thailand, Greece and Mexico have changed into global and regional panic for instance, the debt default of Mexican government caused Peso to lose important value. The problems caused by foreign exchange can be easily solved through currency derivatives. Employment of currency derivatives always permits easy management of risks in the foreign exchange markets. Currency derivatives significantly lock in prearranged exchange rates for the periods that have been set. Rules and procedures of international monetary system Public finance officials from different countries have developed and modified rules and procedures such as exchange rate policies and physical institutions such as international monetary fund that oversee the global monetary system. Exchange rate policies In July 1944, forty five representative countries gathered in Bretton woods, New Hampshire to talk about Europe’s recovery from the Second World War and to resolve global trade and fiscal issues. The resulting Bretton Woods accord established global bank for reconstruction and growth, that is, the World Bank. The bank offered long-term loans to help Europe in recovery. International monetary fund was established to control the global monetary system of fixed exchanged rates. The system was also created at the conference (Engel 2009). The current monetary system introduced more exchange rates that are more stable than those of 1930s, a decade known by restrictive trade policies. In Bretton woods accord, IMF member countries a greed on a system of exchange rates that pegged the dollar value to gold price and pegged the rest of the currencies to a dollar. The system remains in place up to 1972. In the same year, Bretton woods system of pegged exchange rates collapsed forever and was later replaced by the managed floating exchange rates system that is operating currently. The Bretton woods collapsed because the dynamics of demand, price and supply in a country influenced the real value of its currency regardless of pegging policies or fixed rate plans. When the dynamics are not shown in currency’s foreign exchange value, the currency might become overvalued or undervalued in relation to other currencies. Its price, whether fixed or otherwise, might become too low or too high, given the nation’s economic fundamentals and the supply’s, prices’ and demand’s dynamics. When this happens, the international’s trade flows and payments normally get distorted. In 1960s, the increasing costs in the United States caused its exports to be uncompetitive. Similarly, Japan and Western Europe came out from the wreckage of the Second World War to become productive economies thus they managed to compete with United States of America. This therefore caused the United States dollar to be overvalued under the fixed exchange rate system. It later resulted to a drain on the gold supply in United States since foreigners preferred to keep rather than the dollar that is overvalued. In 1970, the gold reserves in United States reduced to around ten billion dollars, a decline of more than fifty percent from the peak of twenty four billion dollars in 1949 (Vreeland 2007). A nation normally controls its currency’s value by purchasing or selling it in the foreign exchange market. In case the central bank of a given country purchases its currency, the currency’s supply normally decreases and the supply of other country’s currencies enhances relative to it thus its currency’s value later increases. If a country’s central bank on the other hand sells its currency, that currency’s supply in the market enhances and other currencies’ supply reduces relative to it thus its currency’s value decreases. The international monetary fund normally plays a significant role in operations that assist a country to control its currency’s value. International monetary fund International monetary fund can be taken as the central bank of the world. IMF headquarter is in Washington D.C. It has one hundred and eighty four member countries and closely works with the World Bank. IMF has a board of directors consisting of a single representative from each member country. The board of directors normally elects a twenty-member executive board to perform regular operations. The aims of IMF are always to promote international trade, steady exchange rates and orderly rectification of balance of payments crisis. This normally prevents a situation in which a country may decide to devalue its currency in order to purely promote its exports. Currency devaluation of this kind is always considered as unfair way of competition if the underlying issues such as bad fiscal and monetary policies have not been addressed by the country (Vreeland 2007). Member countries normally maintain cash inform of currency reserve units. The funds are referred as Special Drawing Rights. The SDRs are similar to federal funds that commercial banks in United States keep on deposit with the Federal Reserve. The value of SDRs had always been based on the currencies of the sixteen leading trading countries since 1974 to 1980. Later between 1990 and 2000, SDRs were based on currencies of five largest exporting countries. SDRs’ value is usually reassigned after every five years. SDRs are held in IMF nations’ accounts in proportion to the country’s contribution to the fund. United States as the biggest contributor, account for approximately twenty five percent of the IMF fund (Vreeland 2007). As away of settling global accounts, Involving countries agreed to take SDRs in exchange for reserve currencies, that is, foreign exchange currencies. Every IMF accounting is performed in SDRs and the commercial banks normally accept the SDR-denominated deposits. The IMF normally simplifies its own and its member country’s payment and accounting processes. Apart from maintaining SDRs’ system and international liquidity promotion, IMF monitors global economic developments and offers policy advice, technical assistance and loans to member countries. For example: After the Soviet Union collapsed, the IMF assisted Russia, the Baltic nations and other former soviet nations in setting up treasury systems that can help them in moving away from planned to market-based economies. The IMF assisted Korea to strengthen its reserves during financial crisis that hit Asia in 1997 and 1998. The IMF also pledged twenty one billion dollars to assist Korea in reforming its economy, reorganizing its corporate and financial sectors and to recover from recession. In the year 2000, the executive board of IMF urged the government of Japanese to stimulate development by maintaining low interests rates, supporting bank restructuring and deregulation promotion. The IMF confirmed a fifty two million dollar loan for Kenya in October 2000. The loan was meant to assist Kenya in dealing with severe drought. This was a section of a three-year one hundred and ninety three million dollar loan IMF lending plan for low income countries. Many economists consider the new international monetary system as a success. It allows market forces and the economic performance of the nation to determine the foreign currencies’ value. It also enables countries to maintain arranged foreign exchange markets. Conclusion From our discussion, it is quite clear that foreign exchange and international monetary system are employed to promote international trade. Foreign exchange has various roles that are helpful in a country’s economy. It enables consumers to easily acquire foreign goods and services. Businesses can easily transact across the boarder. Foreign exchange creates investment opportunities. It allows investors to easily diversify in their total fiscal portfolios and in enhancing their returns. Rules and procedures of international monetary system such as foreign exchange rate policies and physical institution are normally employed to oversee international trade. Exchange rates policies have been in effect since 1944. Nations have been considering exchange rates policies that are stable. Physical institutions such as international monetary fund normally operate as if they are the central bank of the world. References Eichengreen J.B. (2008). Globalizing capital: a history of the international monetary system. New York: Princeton University Press. Brown G. H. (2009). Foreign Exchange: A Study of the Exchange Mechanism of Commerce. New York: BiblioBazaar. Owen L.R. (2009). Foreign Exchange. New York: BiblioBazaar. Vreeland R. J. (2007). The International Monetary Fund: politics of conditional lending. New York: Taylor & Francis. Engel C. (2009). Exchange Rate Policies: A Federal Reserve Bank of Dallas Staff Paper. New York: DIANE Publishing Read More