Question 1
Most developing countries have large balance of payment deficit that have accumulated over the years. This has been caused by the high level of dependence by developing countries on the outside world which is evidenced by the large proportion of imports relative to exports. There various measures can be used by developing countries to correct balance of payment deficits.
First, a country can devalue its currency. Devaluation of a nation’s currency will result in downward shift in the value of the domestic currency relative to foreign currencies. Devaluation of the domestic currency will reduce the prices of exports while increasing the prices of imports. This will in turn make imports more expensive while increasing the competitiveness of exports. The effectiveness of this policy in correcting a deficit depends on the price elasticity of demand and supply.
Another policy that can be adopted by developing countries to correct balance of payment deficit is to reduce the aggregate import bill for foreign goods and services by quantitative restrictions. This measure can be combined with foreign exchange control to ensure only a given quantity of particular goods and services are imported. This policy is effective in cutting down imports. It can also be used selectively to restrict import of consumer goods while allowing import of capital goods intermediate goods required for the attainment of macro-economic development goals.
Lastly, developing countries can use taxes, tariffs and custom duties to correct balance of payment deficits. Increasing taxes, tariffs and custom duties has an effect of increasing cost of importing goods and services. The increase in costs is passed on to domestic consumers in form of higher prices. Domestic consumers will substitute imports for domestically produced goods which are relatively cheaper. The reduction in demand for imports holding exports constant will correct balance of payment deficits.
Question 2
Service trade Balance = Current account balance + merchandise trade surplus +current transfer surplus
Service trade Balance = -4000+5000+3000 =$4000
Question 3
After World War II, leading countries agreed to establish an international monetary system to facilitate growth of world trade. At a conference in Bretton Woods, the agreed to adopt a fixed exchange rate that is adjustable and the United States dollar as the standard value. The price of the US dollar was pegged at $35 per ounce of gold. However, the Bretton Woods agreement failed in 1973. They also agreed to establish the World Bank and International Monetary Fund to support the new international monetary system. This resulted into the Bretton Woods Agreement that eventually collapsed in 1973.
The success of the Bretton Woods agreement largely depended on the stability of the price of US dollar in relation to gold. This is because the Bretton Woods agreement was based on a fixed exchange rate that was adjustable while the value of the United States dollar was not expected to change. However, in the late 1940s, the US faced a series of large balance of payment deficits. The balance of payment persisted until early 1970s. These chronic deficits caused an out flow of gold from the US and a loss of the world’s confidence in the ability of the United States to supply gold to dollar holders for all claims in future that resulted in mounting demands to convert dollars into gold. This forced the US to suspend convertibility of the dollar into gold and allowed the dollar to float in relation to other world currencies thus leading to the collapse of the Bretton Woods agreement .Several attempts to repair the Bretton Woods systems of were futile and the system of fixed exchange rates was finally abandoned in 1973.
Question 4
A common currency is a single currency that is used as a medium of exchange to replace domestic currencies of member countries. A good example is the Euro which is the official currency of the Eurozone and is used by 17 member countries of the European Union. There are several advantages associated with using a common currency as discussed below.
First, transaction costs associated with trading between member countries are eliminated. Member countries will not incur any costs of buying and selling of foreign currencies to facilitate exchange of goods and services. In addition importers and exporters will have lower costs due to savings made on currency conversion costs. These reductions in costs may be passed to consumers in form of lower prices. Another advantage is price transparency. Households and firm find it hard to make accurate comparisons between the prices of goods and services from different countries due to distortionary effect of differences in exchange rates discouraging trade. A common currency eliminates the distortionary effect of exchange rates on prices.
A common currency eliminates uncertainties resulting from fluctuations in the currency exchange rates. Most investors are anxious when they invest in countries with a different currency due to exchange rate risk. A common currency eliminates exchange risk thus increasing cross border investments and trade. Businesses will eliminate foreign exchange losses thus increasing their profitability .Similarly; firms will no longer need to make provisions for unrealized foreign exchange losses and gains. Lastly, a common currency will improve efficiency and effectiveness of trade between member countries. Less time will be spend transacting since no time is spend on converting currencies and expressing prices and cost in the various currencies.
References
Kim, S. H., & Kim, S. H. (2006). Global corporate finance: text and cases (6, illustrated ed.). New York: John Wiley & Sons.
Stonehill, A. I., & Eiteman, D. K. (2008). Finance: an international perspective (revised ed.). California: Irwin.
Vishwanath, S. R. (2007). Corporate Finance: Theory and Practice (2, illustrated ed.). New York: SAGE.
