FINANCIAL MARKETS

A financial market is a market in which people trade financial securities, commodities, and
other fungible items of value at low transaction costs and at prices that reflect supply and
demand. Securities include stocks and bonds, and commodities include precious metals or
agricultural products.

In economics, typically, the term market means the aggregate of possible buyers and sellers of a
certain good or service and the transactions between them.

The term "market" is sometimes used for what are more strictly exchanges, organizations that
facilitate the trade in financial securities, e.g., a stock exchange or commodity exchange. This
may be a physical location nse. Much trading of stocks takes place on an exchange; still,
corporate actions (merger, spinoff) are outside an exchange, while any two companies or people,
for whatever reason, may agree to sell stock from the one to the other without using an exchange.

Trading of currencies and bonds is largely on a bilateral basis, although some bonds trade on a
stock exchange, and people are building electronic systems for these as well, similar to stock
exchanges.

Types of financial markets

Within the financial sector, the term "financial markets" is often used to refer just to the markets
that are used to raise finance: for long term finance, the Capital markets; for short term finance,
the Money markets. Another common use of the term is as a catchall for all the markets in the
financial sector, as per examples in the breakdown below.

Capital markets which to consist of:

o Stock markets, which provide financing through the issuance of shares or

common stock, and enable the subsequent trading thereof.

o Bond markets, which provide financing through the issuance of bonds, and enable
the subsequent trading thereof.

Commodity markets, which facilitate the trading of commodities.

Money markets, which provide short term debt financing and investment.

Derivatives markets, which provide instruments for the management of financial risk.[1]

Futures markets, which provide standardized forward contracts for trading products at
some future date; see also forward market.
 Foreign exchange markets, which facilitate the trading of foreign exchange.

Spot market

Interbank lending market

The capital markets may also be divided into primary markets and secondary markets. Newly
formed (issued) securities are bought or sold in primary markets, such as during initial public
offerings. Secondary markets allow investors to buy and sell existing securities. The transactions
in primary markets exist between issuers and investors, while secondary market transactions
exist among investors.

Liquidity is a crucial aspect of securities that are traded in secondary markets. Liquidity refers to
the ease with which a security can be sold without a loss of value. Securities with an active
secondary market mean that there are many buyers and sellers at a given point in time. Investors
benefit from liquid securities because they can sell their assets whenever they want; an illiquid
security may force the seller to get rid of their asset at a large discount.

Raising capital
Financial markets attract funds from investors and channel them to corporationsthey thus
allow corporations to finance their operations and achieve growth. Money markets allow firms to
borrow funds on a short term basis, while capital markets allow corporations to gain long-term
funding to support expansion (known as maturity transformation).

Without financial markets, borrowers would have difficulty finding lenders themselves.
Intermediaries such as banks, Investment Banks, and Boutique Investment Banks can help in this
process. Banks take deposits from those who have money to save. They can then lend money
from this pool of deposited money to those who seek to borrow. Banks popularly lend money in
the form of loans and mortgages.

More complex transactions than a simple bank deposit require markets where lenders and their
agents can meet borrowers and their agents, and where existing borrowing or lending
commitments can be sold on to other parties. A good example of a financial market is a stock
exchange. A company can raise money by selling shares to investors and its existing shares can
be bought or sold.

The following table illustrates where financial markets fit in the relationship between lenders and
borrowers:

Relationship between lenders and borrowers

Lenders Financial Intermediaries Financial Markets Borrowers

 Interbank Individuals
Banks
Stock Exchange Companies
Individuals Insurance Companies
Money Market Central Government
Companies Pension Funds
Bond Market Municipalities
Mutual Funds
Foreign Exchange Public Corporations

Lenders

The lender temporarily gives money to somebody else, on the condition of getting back the
principal amount together with some interest/profit or charge.

Individuals & Doubles

Many individuals are not aware that they are lenders, but almost everybody does lend money in
many ways. A person lends money when he or she:

Puts money in a savings account at a bank

Contributes to a pension plan

Pays premiums to an insurance company

Invests in government bonds

Companies

Companies tend to be lenders of capital. When companies have surplus cash that is not needed
for a short period of time, they may seek to make money from their cash surplus by lending it via
short term markets called money markets. Alternatively, such companies may decide to return
the cash surplus to their shareholders (e.g. via a share repurchase or dividend payment).

Borrowers

Individuals borrow money via bankers' loans for short term needs or longer term
mortgages to help finance a house purchase.

Companies borrow money to aid short term or long term cash flows. They also borrow to
fund modernization or future business expansion.

Governments often find their spending requirements exceed their tax revenues. To make
up this difference, they need to borrow. Governments also borrow on behalf of
nationalized industries, municipalities, local authorities and other public sector bodies. In
 the UK, the total borrowing requirement is often referred to as the Public sector net cash
requirement (PSNCR).

Governments borrow by issuing bonds. In the UK, the government also borrows from
individuals by offering bank accounts and Premium Bonds. Government debt seems to be
permanent. Indeed, the debt seemingly expands rather than being paid off. One strategy used by
governments to reduce the value of the debt is to influence inflation.

Municipalities and local authorities may borrow in their own name as well as receiving funding
from national governments. In the UK, this would cover an authority like Hampshire County
Council.

Public Corporations typically include nationalized industries. These may include the postal
services, railway companies and utility companies.

Many borrowers have difficulty raising money locally. They need to borrow internationally with
the aid of Foreign exchange markets.

Borrowers having similar needs can form into a group of borrowers. They can also take an
organizational form like Mutual Funds. They can provide mortgage on weight basis. The main
advantage is that this lowers the cost of their borrowings.

Derivative products
During the 1980s and 1990s, a major growth sector in financial markets was the trade in so
called derivative products, or derivatives for short.

In the financial markets, stock prices, bond prices, currency rates, interest rates and dividends go
up and down, creating risk. Derivative products are financial products which are used to control
risk or paradoxically exploit risk.[2] It is also called financial economics.

Derivative products or instruments help the issuers to gain an unusual profit from issuing the
instruments. For using the help of these products a contract has to be made. Derivative contracts
are mainly 4 types:[3]

1. Future

2. Forward

3. Option

4. Swap

Seemingly, the most obvious buyers and sellers of currency are importers and exporters of goods.
While this may have been true in the distant past,[when?] when international trade created the
demand for currency markets, importers and exporters now represent only 1/32 of foreign
exchange dealing, according to the Bank for International Settlements.[4]

The picture of foreign currency transactions today shows:

Banks/Institutions

Speculators

Government spending (for example, military bases abroad)

Importers/Exporters

Tourists

Analysis of financial markets

Much effort has gone into the study of financial markets and how prices vary with time. Charles
Dow, one of the founders of Dow Jones & Company and The Wall Street Journal, enunciated a
set of ideas on the subject which are now called Dow theory. This is the basis of the so-called
technical analysis method of attempting to predict future changes. One of the tenets of "technical
analysis" is that market trends give an indication of the future, at least in the short term. The
claims of the technical analysts are disputed by many academics, who claim that the evidence
points rather to the random walk hypothesis, which states that the next change is not correlated to
the last change. The role of human psychology in price variations also plays a significant factor.
Large amounts of volatility often indicate the presence of strong emotional factors playing into
the price. Fear can cause excessive drops in price and greed can create bubbles. In recent years
the rise of algorithmic and high-frequency program trading has seen the adoption of momentum,
ultra-short term moving average and other similar strategies which are based on technical as
opposed to fundamental or theoretical concepts of market Behaviour.

The scale of changes in price over some unit of time is called the volatility. It was discovered by
Benot Mandelbrot that changes in prices do not follow a Gaussian distribution, but are rather
modeled better by Lvy stable distributions. The scale of change, or volatility, depends on the
length of the time unit to a power a bit more than 1/2. Large changes up or down are more likely
than what one would calculate using a Gaussian distribution with an estimated standard
deviation.

Financial market slang

Poison pill, when a company issues more shares to prevent being bought out by another
company, thereby increasing the number of outstanding shares to be bought by the hostile
company making the bid to establish majority.
 Bips, meaning "bps" or basis points. A basis point is a financial unit of measurement used
to describe the magnitude of percent change in a variable. One basis point is the
equivalent of one hundredth of a percent. For example, if a stock price were to rise
100bit/s, it means it would increase 1%.

Quant, a quantitative analyst with advanced training in mathematics and statistical

methods.

Rocket scientist, a financial consultant at the zenith of mathematical and computer

programming skill. They are able to invent derivatives of high complexity and construct
sophisticated pricing models. They generally handle the most advanced computing
techniques adopted by the financial markets since the early 1980s. Typically, they are
physicists and engineers by training.

IPO, stands for initial public offering, which is the process a new private company goes
through to "go public" or become a publicly traded company on some index.

White Knight, a friendly party in a takeover bid. Used to describe a party that buys the
shares of one organization to help prevent against a hostile takeover of that organization
by another party.

Round-tripping

Smurfing, a deliberate structuring of payments or transactions to conceal it from

regulators or other parties, a type of money laundering that is often illegal.

Spread, the difference between the highest bid and the lowest offer.

Pip, smallest price move that a given exchange rate makes based on market convention.
[5]

Pegging, when a country wants to obtain price stability, it can use pegging to fix their
exchange rate relative to another currency. [6]

Role in the economy

One of the important sustainability requisite for the accelerated development of an economy is
the existence of a dynamic financial market. A financial market helps the economy in the
following manner.
 Saving mobilization: Obtaining funds from the savers or surplus units such as household
individuals, business firms, public sector units, central government, state governments
etc. is an important role played by financial markets.

Investment: Financial markets play a crucial role in arranging to invest funds thus
collected in those units which are in need of the same.

National Growth: An important role played by financial market is that, they contribute
to a nation's growth by ensuring unfettered flow of surplus funds to deficit units. Flow of
funds for productive purposes is also made possible.

Entrepreneurship growth: Financial market contribute to the development of the

entrepreneurial claw by making available the necessary financial resources.

Industrial development: The different components of financial markets help an

accelerated growth of industrial and economic development of a country, thus
contributing to raising the standard of living and the society of well-being.

Functions of financial markets

Intermediary functions: The intermediary functions of financial markets include the
following:

o Transfer of resources: Financial markets facilitate the transfer of real economic

resources from lenders to ultimate borrowers.

o Enhancing income: Financial markets allow lenders to earn interest or dividend

on their surplus invisible funds, thus contributing to the enhancement of the
individual and the national income.

o Productive usage: Financial markets allow for the productive use of the funds
borrowed. The enhancing the income and the gross national production.

o Capital formation: Financial markets provide a channel through which new

savings flow to aid capital formation of a country.

o Price determination: Financial markets allow for the determination of price of

the traded financial assets through the interaction of buyers and sellers. They
provide a sign for the allocation of funds in the economy based on the demand
and to the supply through the mechanism called price discovery process.

o Sale mechanism: Financial markets provide a mechanism for selling of a

financial asset by an investor so as to offer the benefit of marketability and
liquidity of such assets.
 o Information: The activities of the participants in the financial market result in the
generation and the consequent dissemination of information to the various
segments of the market. So as to reduce the cost of transaction of financial assets.

Financial Functions

o Providing the borrower with funds so as to enable them to carry out their
investment plans.

o Providing the lenders with earning assets so as to enable them to earn wealth by
deploying the assets in production debentures.

o Providing liquidity in the market so as to facilitate trading of funds.

o Providing liquidity to commercial bank

o Facilitating credit creation

o Promoting savings

o Promoting investment

o Facilitating balanced economic growth

o Improving trading floors

Components of financial market

Based on market levels

Primary market: Primary market is a market for new issues or new financial claims.
Hence its also called new issue market. The primary market deals with those securities
which are issued to the public for the first time.

Secondary market: Its a market for secondary sale of securities. In other words,
securities which have already passed through the new issue market are traded in this
market. Generally, such securities are quoted in the stock exchange and it provides a
continuous and regular market for buying and selling of securities.
Simply put, primary market is the market where the newly started company issued shares to the
public for the first time through IPO (initial public offering). Secondary market is the market
where the second hand securities are sold (securitCommodity Marketies).

Based on security types

Money market: Money market is a market for dealing with financial assets and
securities which have a maturity period of up to one year. In other words, its a market for
purely short term funds.

Capital market: A capital market is a market for financial assets which have a long or
indefinite maturity. Generally it deals with long term securities which have a maturity
period of above one year. Capital market may be further divided into: (a) industrial
securities market (b) Govt. securities market and (c) long term loans market.

o Equity markets: A market where ownership of securities are issued and

subscribed is known as equity market. An example of a secondary equity market
for shares is the Bombay stock exchange.

o Debt market: The market where funds are borrowed and lent is known as debt
market. Arrangements are made in such a way that the borrowers agree to pay the
lender the original amount of the loan plus some specified amount of interest.

Derivative markets: A market where financial instruments are derived and traded based
on an underlying asset such as commodities or stocks.

Financial service market: A market that comprises participants such as commercial

banks that provide various financial services like ATM. Credit cards. Credit rating, stock
broking etc. is known as financial service market. Individuals and firms use financial
services markets, to purchase services that enhance the working of debt and equity
markets.

Depository markets: A depository market consists of depository institutions that accept

deposit from individuals and firms and uses these funds to participate in the debt market,
by giving loans or purchasing other debt instruments such as treasure bills.

Non-depository market: Non-depository market carry out various functions in financial

markets ranging from financial intermediary to selling, insurance etc. The various
constituency in non-depositary markets are mutual funds, insurance companies, pension
funds, brokerage firms etc.
 BALANCE OF PAYMENTS
The balance of payments, also known as balance of international payments and abbreviated
B.O.P., of a country is the record of all economic transactions between the residents of the
country and the rest of the world in a particular period (over a quarter of a year or more
commonly over a year). These transactions are made by individuals, firms and government
bodies. Thus the balance of payments includes all external visible and non-visible transactions of
a country. It is an important issue to be studied, especially in international financial management
field, for a few reasons. First, the balance of payments provides detailed information concerning
the demand and supply of a country's currency. For example, if the United States imports more
than it exports, then this means that the supply of dollars is likely to exceed the demand in the
foreign exchanging market, ceteris paribus. One can thus infer that the U.S. dollar would be
under pressure to depreciate against other currencies. On the other hand, if the United States
exports more than it imports, then the dollar would be likely to appreciate. Second, a country's
balance-of-payment data may signal its potential as a business partner for the rest of the world. If
a country is grappling with a major balance-of-payment difficulty, it may not be able to expand
imports from the outside world. Instead, the country may be tempted to impose measures to
restrict imports and discourage capital outflows in order to improve the balance-of-payment
situation. On the other hand, a country experiencing a significant balance-of payment surplus
would be more likely to expand imports, offering marketing opportunities for foreign enterprises,
and less likely to impose foreign exchange restrictions. Third, balance-of-payments data can be
used to evaluate the performance of the country in international economic competition. Suppose
a country is experiencing trade deficits year after year. This trade data may then signal that the
country's domestic industries lack international competitiveness. To interpret balance-of-
payments data properly, it is necessary to understand how the balance of payments account is
constructed.[1][2] These transactions include payments for the country's exports and imports of
goods, services, financial capital, and financial transfers. It is prepared in a single currency,
typically the domestic currency for the country concerned. Sources of funds for a nation, such as
exports or the receipts of loans and investments, are recorded as positive or surplus items. Uses
of funds, such as for imports or to invest in foreign countries, are recorded as negative or deficit
items.

When all components of the BoP accounts are included they must sum to zero with no overall
surplus or deficit. For example, if a country is importing more than it exports, its trade balance
will be in deficit, but the shortfall will have to be counterbalanced in other ways such as by
funds earned from its foreign investments, by running down currency reserves or by receiving
loans from other countries.

While the overall BoP accounts will always balance when all types of payments are included,
imbalances are possible on individual elements of the BoP, such as the current account, the
capital account excluding the central bank's reserve account, or the sum of the two. Imbalances
in the latter sum can result in surplus countries accumulating wealth, while deficit nations
become increasingly indebted. The term balance of payments often refers to this sum: a
country's balance of payments is said to be in surplus (equivalently, the balance of payments is
positive) by a specific amount if sources of funds (such as export goods sold and bonds sold)
exceed uses of funds (such as paying for imported goods and paying for foreign bonds
purchased) by that amount. There is said to be a balance of payments deficit (the balance of
payments is said to be negative) if the former are less than the latter. A BoP surplus (or deficit) is
accompanied by an accumulation (or decumulation) of foreign exchange reserves by the central
bank.

Under a fixed exchange rate system, the central bank accommodates those flows by buying up
any net inflow of funds into the country or by providing foreign currency funds to the foreign
exchange market to match any international outflow of funds, thus preventing the funds flows
from affecting the exchange rate between the country's currency and other currencies. Then the
net change per year in the central bank's foreign exchange reserves is sometimes called the
balance of payments surplus or deficit. Alternatives to a fixed exchange rate system include a
managed float where some changes of exchange rates are allowed, or at the other extreme a
purely floating exchange rate (also known as a purely flexible exchange rate). With a pure float
the central bank does not intervene at all to protect or devalue its currency, allowing the rate to
be set by the market, and the central bank's foreign exchange reserves do not change, and the
balance of payments is always zero.

Components

The current account shows the net amount a country is earning if it is in surplus, or spending if it
is in deficit. It is the sum of the balance of trade (net earnings on exports minus payments for
imports), factor income (earnings on foreign investments minus payments made to foreign
investors) and cash transfers. It is called the current account as it covers transactions in the "here
and now" those that don't give rise to future claims.[3]

The capital account records the net change in ownership of foreign assets. It includes the reserve
account (the foreign exchange market operations of a nation's central bank), along with loans and
investments between the country and the rest of world (but not the future interest payments and
dividends that the loans and investments yield; those are earnings and will be recorded in the
current account). If a country purchases more foreign assets for cash than the assets it sells for
cash to other countries, the capital account is said to be negative or in deficit.

The term "capital account" is also used in the narrower sense that excludes central bank foreign
exchange market operations: Sometimes the reserve account is classified as "below the line" and
so not reported as part of the capital account.[4]
Expressed with the broader meaning for the capital account, the BoP identity states that any
current account surplus will be balanced by a capital account deficit of equal size or
alternatively a current account deficit will be balanced by a corresponding capital account
surplus:

The balancing item, which may be positive or negative, is simply an amount that accounts for
any statistical errors and assures that the current and capital accounts sum to zero. By the
principles of double entry accounting, an entry in the current account gives rise to an entry in the
capital account, and in aggregate the two accounts automatically balance. A balance isn't always
reflected in reported figures for the current and capital accounts, which might, for example,
report a surplus for both accounts, but when this happens it always means something has been
missed most commonly, the operations of the country's central bank and what has been
missed is recorded in the statistical discrepancy term (the balancing item).[4]

An actual balance sheet will typically have numerous sub headings under the principal divisions.
For example, entries under Current account might include:

Trade buying and selling of goods and services

o Exports a credit entry

o Imports a debit entry

Trade balance the sum of Exports and Imports

Factor income repayments and dividends from loans and investments

o Factor earnings a credit entry

o Factor payments a debit entry

Factor income balance the sum of earnings and payments.

Especially in older balance sheets, a common division was between visible and invisible entries.
Visible trade recorded imports and exports of physical goods (entries for trade in physical goods
excluding services is now often called the merchandise balance). Invisible trade would record
international buying and selling of services, and sometimes would be grouped with transfer and
factor income as invisible earnings.[2]

The term "balance of payments surplus" (or deficit a deficit is simply a negative surplus) refers
to the sum of the surpluses in the current account and the narrowly defined capital account
(excluding changes in central bank reserves). Denoting the balance of payments surplus as BoP
surplus, the relevant identity is
Variations in the use of term "balance of payments"

Economics writer J. Orlin Grabbe warns the term balance of payments can be a source of
misunderstanding due to divergent expectations about what the term denotes. Grabbe says the
term is sometimes misused by people who aren't aware of the accepted meaning, not only in
general conversation but in financial publications and the economic literature.[4]

A common source of confusion arises from whether or not the reserve account entry, part of the
capital account, is included in the BoP accounts. The reserve account records the activity of the
nation's central bank. If it is excluded, the BoP can be in surplus (which implies the central bank
is building up foreign exchange reserves) or in deficit (which implies the central bank is running
down its reserves or borrowing from abroad).[2][4]

Another cause of confusion is the different naming conventions in use.[5] Before 1973 there was
no standard way to break down the BoP sheet, with the separation into invisible and visible
payments sometimes being the principal divisions. The IMF have their own standards for BoP
accounting which is equivalent to the standard definition but uses different nomenclature, in
particular with respect to the meaning given to the term capital account.

The IMF definition of Balance of Payment

The International Monetary Fund (IMF) use a particular set of definitions for the BoP accounts,
which is also used by the Organisation for Economic Co-operation and Development (OECD),
and the United Nations System of National Accounts (SNA).[6]

The main difference in the IMF's terminology is that it uses the term "financial account" to
capture transactions that would under alternative definitions be recorded in the capital account.
The IMF uses the term capital account to designate a subset of transactions that, according to
other usage, previously formed a small part of the overall current account.[7] The IMF separates
these transactions out to form an additional top level division of the BoP accounts. Expressed
with the IMF definition, the BoP identity can be written:

The IMF uses the term current account with the same meaning as that used by other
organizations, although it has its own names for its three leading sub-divisions, which are:

The goods and services account (the overall trade balance)

The primary income account (factor income such as from loans and
investments)

The secondary income account (transfer payments)

balance of payments are also known as "balance of international trade"

Imbalances

While the BoP has to balance overall,[8] surpluses or deficits on its individual elements can lead
to imbalances between countries. In general there is concern over deficits in the current account.
[9]
Countries with deficits in their current accounts will build up increasing debt or see increased
foreign ownership of their assets. The types of deficits that typically raise concern are[2]

A visible trade deficit where a nation is importing more physical goods than it
exports (even if this is balanced by the other components of the current
account.)

An overall current account deficit.

A basic deficit which is the current account plus foreign direct investment
(but excluding other elements of the capital account like short terms loans
and the reserve account.)

As discussed in the history section below, the Washington Consensus period saw a swing of
opinion towards the view that there is no need to worry about imbalances. Opinion swung back
in the opposite direction in the wake of financial crisis of 20072009. Mainstream opinion
expressed by the leading financial press and economists, international bodies like the IMF as
well as leaders of surplus and deficit countries has returned to the view that large current
account imbalances do matter.[10] Some economists do, however, remain relatively unconcerned
about imbalances[11] and there have been assertions, such as by Michael P. Dooley, David
Folkerts-Landau and Peter Garber, that nations need to avoid temptation to switch to
protectionism as a means to correct imbalances.[12]

Current account surpluses are facing current account deficits of other countries, the indebtedness
of which towards abroad therefore increases. According to Balances Mechanics by Wolfgang
Sttzel this is described as surplus of expenses over the revenues. Increasing imbalances in
foreign trade are critically discussed as a possible cause of the financial crisis since 2007.[13]

Causes of BoP imbalances

There are conflicting views as to the primary cause of BoP imbalances, with much attention on
the US which currently has by far the biggest deficit. The conventional view is that current
account factors are the primary cause[17] these include the exchange rate, the government's
fiscal deficit, business competitiveness, and private behaviour such as the willingness of
consumers to go into debt to finance extra consumption.[18] An alternative view, argued at length
in a 2005 paper by Ben Bernanke, is that the primary driver is the capital account, where a global
savings glut caused by savers in surplus countries, runs ahead of the available investment
opportunities, and is pushed into the US resulting in excess consumption and asset price
inflation.[19]
Reserve asset

The US dollar has been the leading reserve asset since the end of the gold standard.

In the context of BoP and international monetary systems, the reserve asset is the currency or
other store of value that is primarily used by nations for their foreign reserves.[20] BoP imbalances
tend to manifest as hoards of the reserve asset being amassed by surplus countries, with deficit
countries building debts denominated in the reserve asset or at least depleting their supply. Under
a gold standard, the reserve asset for all members of the standard is gold. In the Bretton Woods
system, either gold or the U.S. dollar could serve as the reserve asset, though its smooth
operation depended on countries apart from the US choosing to keep most of their holdings in
dollars.

Balance of payments crisis

A BoP crisis, also called a currency crisis, occurs when a nation is unable to pay for essential
imports or service its debt repayments. Typically, this is accompanied by a rapid decline in the
value of the affected nation's currency. Crises are generally preceded by large capital inflows,
which are associated at first with rapid economic growth.[30] However a point is reached where
overseas investors become concerned about the level of debt their inbound capital is generating,
and decide to pull out their funds.[31] The resulting outbound capital flows are associated with a
rapid drop in the value of the affected nation's currency. This causes issues for firms of the
affected nation who have received the inbound investments and loans, as the revenue of those
firms is typically mostly derived domestically but their debts are often denominated in a reserve
currency. Once the nation's government has exhausted its foreign reserves trying to support the
value of the domestic currency, its policy options are very limited. It can raise its interest rates to
try to prevent further declines in the value of its currency, but while this can help those with
debts denominated in foreign currencies, it generally further depresses the local economy.

Balancing mechanisms

One of the three fundamental functions of an international monetary system is to provide

mechanisms to correct imbalances.

Broadly speaking, there are three possible methods to correct BoP imbalances, though in practice
a mixture including some degree of at least the first two methods tends to be used. These
methods are adjustments of exchange rates; adjustment of a nations internal prices along with its
levels of demand; and rules based adjustment. Improving productivity and hence competitiveness
can also help, as can increasing the desirability of exports through other means, though it is
generally assumed a nation is always trying to develop and sell its products to the best of its
abilities.
Rebalancing by changing the exchange rate

An upwards shift in the value of a nation's currency relative to others will make a nation's
exports less competitive and make imports cheaper and so will tend to correct a current account
surplus. It also tends to make investment flows into the capital account less attractive so will help
with a surplus there too. Conversely a downward shift in the value of a nation's currency makes
it more expensive for its citizens to buy imports and increases the competitiveness of their
exports, thus helping to correct a deficit (though the solution often doesn't have a positive impact
immediately due to the MarshallLerner condition).[37]

Exchange rates can be adjusted by government[38] in a rules based or managed currency regime,
and when left to float freely in the market they also tend to change in the direction that will
restore balance. When a country is selling more than it imports, the demand for its currency will
tend to increase as other countries ultimately[39] need the selling country's currency to make
payments for the exports. The extra demand tends to cause a rise of the currency's price relative
to others. When a country is importing more than it exports, the supply of its own currency on
the international market tends to increase as it tries to exchange it for foreign currency to pay for
its imports, and this extra supply tends to cause the price to fall. BoP effects are not the only
market influence on exchange rates however, they are also influenced by differences in national
interest rates and by speculation.

Rebalancing by adjusting internal prices and demand

When exchange rates are fixed by a rigid gold standard,[40] or when imbalances exist between
members of a currency union such as the Eurozone, the standard approach to correct imbalances
is by making changes to the domestic economy. To a large degree, the change is optional for the
surplus country, but compulsory for the deficit country. In the case of a gold standard, the
mechanism is largely automatic. When a country has a favourable trade balance, as a
consequence of selling more than it buys it will experience a net inflow of gold. The natural
effect of this will be to increase the money supply, which leads to inflation and an increase in
prices, which then tends to make its goods less competitive and so will decrease its trade surplus.
However the nation has the option of taking the gold out of economy (sterilising the inflationary
effect) thus building up a hoard of gold and retaining its favourable balance of payments. On the
other hand, if a country has an adverse BoP it will experience a net loss of gold, which will
automatically have a deflationary effect, unless it chooses to leave the gold standard. Prices will
be reduced, making its exports more competitive, and thus correcting the imbalance. While the
gold standard is generally considered to have been successful[41] up until 1914, correction by
deflation to the degree required by the large imbalances that arose after WWI proved painful,
with deflationary policies contributing to prolonged unemployment but not re-establishing
balance. Apart from the US most former members had left the gold standard by the mid-1930s.
A possible method for surplus countries such as Germany to contribute to re-balancing efforts
when exchange rate adjustment is not suitable, is to increase its level of internal demand (i.e. its
spending on goods). While a current account surplus is commonly understood as the excess of
earnings over spending, an alternative expression is that it is the excess of savings over
investment.[42] That is:

where CA = current account, NS = national savings (private plus government sector), NI =

national investment.

If a nation is earning more than it spends the net effect will be to build up savings, except to the
extent that those savings are being used for investment. If consumers can be encouraged to spend
more instead of saving; or if the government runs a fiscal deficit to offset private savings; or if
the corporate sector divert more of their profits to investment, then any current account surplus
will tend to be reduced. However, in 2009 Germany amended its constitution to prohibit running
a deficit greater than 0.35% of its GDP[43] and calls to reduce its surplus by increasing demand
have not been welcome by officials,[44] adding to fears that the 2010s will not be an easy decade
for the eurozone.[45] In their April 2010 world economic outlook report, the IMF presented a
study showing how with the right choice of policy options governments can shift away from a
sustained current account surplus with no negative effect on growth and with a positive impact
on unemployment.[46]

Rules based rebalancing mechanisms

Nations can agree to fix their exchange rates against each other, and then correct any imbalances
that arise by rules based and negotiated exchange rate changes and other methods. The Bretton
Woods system of fixed but adjustable exchange rates was an example of a rules based system.
John Maynard Keynes, one of the architects of the Bretton Woods system had wanted additional
rules to encourage surplus countries to share the burden of rebalancing, as he argued that they
were in a stronger position to do so and as he regarded their surpluses as negative externalities
imposed on the global economy.[47] Keynes suggested that traditional balancing mechanisms
should be supplemented by the threat of confiscation of a portion of excess revenue if the surplus
country did not choose to spend it on additional imports. However his ideas were not accepted by
the Americans at the time. In 2008 and 2009, American economist Paul Davidson had been
promoting his revamped form of Keynes's plan as a possible solution to global imbalances which
in his opinion would expand growth all round without the downside risk of other rebalancing
methods.[37][48][49]