Exam 9: The International Monetary and Financial Environment

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Many economists believe a persistent trade deficit is harmful to the national economy. When a trade deficit becomes severe or persists for a long time, the nation's central bank may devalue its currency. A devaluation is a government action to reduce the official value of its currency relative to other currencies. It is usually accomplished by the buying and selling of currencies in the foreign exchange market. Devaluation aims to deter the nation's residents from importing from other countries, potentially reducing the trade deficit.
At a broader level, governments must manage their balance of payments, the annual accounting of all economic transactions of a nation with all other nations. The balance of payments is the nation's balance sheet of trade, investment, and transfer payments with the rest of the world. It represents the difference between the total amount of money coming into and going out of a country. Consider a Canadian MNE that builds a factory in China. In the process, money flows from Canada to China, generating a deficit item for Canada and a surplus item for China in their respective balance of payments. The balance of payments is affected by other transactions as well, as when citizens donate money to a foreign charity, when governments provide foreign aid, or when tourists spend money abroad.
The Bretton Woods Agreement was initiated to peg the value of the U.S. dollar to an established value of gold, at a rate of $35 per ounce. The U.S. government agreed to buy and sell unlimited amounts of gold in order to maintain this fixed rate. Each of Bretton Woods' other signatory countries agreed to establish a par value of its currency in terms of the U.S. dollar and to maintain this pegged value through central bank intervention. In this way, the Bretton Woods system kept exchange rates of major currencies fixed at a prescribed level relative to the U.S. dollar and, therefore, to each other.
The demise of the Bretton Woods agreement began in the late 1960s when the U.S. government used deficit spending to finance both the Vietnam War and expensive government programs. Rising government spending stimulated the economy and U.S. citizens began buying more imported goods. This aggravated the U.S. balance of payments, and the United States began to experience trade deficits with Japan, Germany, and other European countries. Over time, demand for U.S. dollars so exceeded supply that the U.S. government could no longer maintain an adequate stock of gold. This situation put pressure on governments in Europe, Japan, and the United States to revalue their currencies. As a result, the link between the U.S. dollar and gold was suspended in 1971, and the promise to exchange gold for U.S. dollars was withdrawn. This action brought an end to the Bretton Woods system.