A Comparison between International and Domestic Liquidity
' Liquidity', in an economic context, refers to the means of payment for goods (see Fig. 9.6). Cash is the most liquid of all assets because it is generally accepted as a form of purchasing power; other means of payment have varying degrees of liquidity. International liquidity is more complicated than domestic liquidity because there are so many different currencies. International trade is sometimes described as triangular, but in the more precise language, it is multi-lateral. Bilateral trade (a direct swap agreement) still occasionally takes place, but it has all the disadvantages inherent in a barter economy. Let us try to understand this using an example, if there still remains some confusion availing economics homework help might be useful. After the Second World War, the USSR traded wheat and tinned crab for UK tractors and trawlers, but this type of trade must be limited to a few commodities, and it is difficult to decide how much wheat should be exchanged for how many tractors, without any currency transactions.
Over a given period (say, a year), the UK might have a surplus of Deutschmarks, West Germany might gain a surplus of dollars, and the USA might obtain a surplus of pounds sterling. So long as the currencies involved are allowed to be freely exchanged, i.e., there is free convertibility, a country may make payments to a second country by arranging for a debt owed to be transferred to a third country. So long as the second country can convert into its currency the currency of the third country, the arrangements will prove satisfactory to all three parties. As West German manufacturers, workers, exporters, etc., wish to have Deutschmarks to use within their own country, there is an advantageous opportunity for foreign currency exchange, and the main point at issue is how the rates of exchange should be determined. It would appear, a priori, that exchange rates should be governed by the Purchasing Power Parity theory, as defined by Professor Cassel. According to this theory, the rate of exchange between two currencies depends on the relative price levels in the two countries concerned. In simple terms, if a bottle of wine is priced at $4.60 in the USA, a similar bottle of wine should be priced at about £2 in the UK, if the exchange rate were £1 = $2.30. This is an oversimplification, but it enables us to comprehend the basic principles underlying foreign currency transactions under a system of free exchange rates.
The Gold Standard
- If gold came into a country, that country should increase its money supply; this would cause some degree of inflation, raise the price of the country's exports, and tend automatically to correct a balance of payments surplus.
- If a country were losing gold, it should deflate its internal currency: cheaper exports sell more easily and the balance of payments deficit would tend to be eliminated. The USA and France, ignoring the 'golden' rules, hoarded gold without allowing it to adjust correctly the cash basis of their money supply, and in the end the Gold Standard collapsed-probably forever. Gold now accounts for only about 20 percent of the total international reserves, and its rate of growth in recent years has been the slowest of any of the reserve components.
Free exchange rates
- To promote exchange stability and discourage multiple exchange rates. (Countries are more likely to engage in trade if they know where they stand and if there is no discrimination against certain countries or in favour of others.)
- To establish a code of good monetary conduct among trading countries.
- To encourage countries to cooperate on international monetary problems.
- To maintain orderly foreign exchange arrangements.
- To avoid competitive exchange depreciation.
- To discourage a country from the devaluation of its currency without previous consultation.
- To provide short-term credit for countries in temporary balance of payments difficulties. (The UK has been the greatest user of the Fund, especially in this respect).
|Rate of Exchange
|$4.03 = £1
|$2.80 = £1
|$2.40 = £1
|$ 2.60 = £1
|$1.50 = 1 (floating £)
European Monetary System(EMS)
- A European currency unit (ECU),
- An exchange rate and intervention mechanism.
- A credit mechanism.
- Measures designed to strengthen the less prosperous states in the EMS.
Special drawing rights
- Gold radicals contend that the world should return to the system of using gold as the only medium of exchange for international trade.
- Banking radicals favor the creation of a new international currency.
- Modifiers believe that the liquidity shortage problem can be solved by increasing the scope and flexibility of present foreign exchange arrangements.
- Central bankers' reluctance to change the status quo.
- Reforms would bring benefits to some countries and disadvantages to others in different relative magnitudes.
- Agreement in principle (that more flexibility and larger reserves are essential) breaks down over questions of detail.