Pakistanis employed in the United Kingdom who need to send money to their families. They earn sterling, but their families want rupees. If there are people in Pakistan with rupees who want sterling in the United Kingdom, the possibilities for an informal exchange system become apparent. Participants in the system gather sterling from the workers in the London, and promise to deliver rupees to their families in Karachi. The rupees of those desiring to get money out of Pakistan are used to pay the families, and the sterling gathered in London becomes available to them for whatever use they prefer. All that is required is a communications route making it possible for those in Karachi to know which families are to be paid how many rupees. That might be done in coded form by phone, email, or courier. If the communications mechanism can be kept confidential and the exchange process in London and Karachi informal, there is no obvious way for the Pakistani or the British government to know what is going on. Hawala banking is not only a way to evade exchange controls, but is widely believed to be used by criminal enterprises and by terrorists to move funds from the Middle East and South Asia to indus- trialized countries. September 11 greatly increased the attention given to hawala banking by the US and European governments, and a few such operations have reportedly been closed. The attractions of a regulated exchange market for a developing country facing payments deficits are obvious, but the record of such control systems is poor. Enforcement is difficult and frequently produces a decline in respect for law. Increasing volumes of export receipts (particularly from remittances and tourism) are diverted to an illegal market, so the avail- ability of foreign exchange for important purposes stagnates or declines. Economics is about how rational economic agents maximize their self-interest, which means that it is about avarice and ingenuity. Few situations bring out the unattractive aspects of such maximizing behavior more quickly than a system of foreign exchange market controls that denies people the opportunity to purchase foreign exchange legally, thereby driving them to illegal alternatives. Such systems almost guarantee widespread lawbreaking and thereby undermine respect for the legal system. Despite the arguments of economists and a poor historical record, these systems of exchange market controls remain common in the developing world. It ought to be noted that not just hawala banking, but all of the techniques for evading foreign exchange controls discussed above, are useful for criminals or terrorists seeking to move funds in forms that are difficult to trace in order to finance their activities. Since September 11, 2001 law enforcement agencies in many countries have become far more interested in finding ways to trace, and to stop, such transfers. This will not be an easy task. Exchange market intervention with floating exchange rates In theory, a flexible exchange rate system means that no central bank intervenes in the exchange market and that rates are determined the way prices of common stocks are settled: through shifts in supply and demand without official stabilization. In a clean or pure float, the exchange rate rises and falls with shifts in international payments flows, and these exchange rate movements keep the balance of payments in constant equilibrium (i.e. the official reserve transactions balance = 0). If the balance of payments and the exchange market were in equilibrium when a large surge of imports occurred, the local currency would depreciate to a level at which offsetting transactions were encouraged and the market again cleared, which is analogous to what happens to the price of General Motors stock if a sudden wave of selling hits the market. The price falls until enough buyers are attracted to clear the market. In a clean float, the exchange market operates in the same way, but countries do not 13 – Markets for foreign exchange 299 maintain clean floats. Large or rapid exchange rate movements are seen as so disruptive that central banks instead operate dirty or managed flexible exchange rates. There is no defense of a fixed parity, but instead discretionary intervention takes place whenever the market is moving in a direction or at a speed that the central bank or government wishes to avoid. If, for example, the yen were depreciating beyond the wishes of Tokyo, the Bank of Japan would purchase yen and sell foreign currencies in an attempt to slow that movement. Such purchases might be coordinated with similar actions by central banks in Europe and North America, creating a stronger effect on the market. Since the mid- 1980s such intervention has increased, and more of it is being coordinated among the central banks of the major industrialized countries. Many economists remain skeptical that such intervention can have more than temporary effects on exchange rates unless it is accompanied by changes in national monetary policies. Purchases of yen by the Bank of Japan may temporarily slow a depreciation, but a reduction in the total yen money supply, that is, a tighter Japanese monetary policy, would have a more lasting impact. Despite such doubts among economists, the central banks of countries with flexible exchange rates have become more active in exchange markets in recent years. The result seems to be some reduction in exchange rate volatility. 4 Exchange market institutions The foreign exchange market is maintained by major commercial banks in financial centers such as New York, London, Frankfurt, Singapore, and Tokyo. It is not like the New York Stock Exchange where trading occurs at a single location, but instead it is a “telephone market” in which traders are located in the various banks and trade electronically. Although trading occurs in other cities, the vast majority of the US market is in New York, where it includes New York banks, foreign banks with US subsidiaries or branches, and banks from other states that are allowed to do only international banking in New York. The banks typically maintain trading rooms that are staffed by at least one trader for each major currency. 5 Orders come to the traders from large businesses that have established ties to that bank and from smaller banks around the country that have a correspondent banking relationship with that institution. The banks maintain inventories of each of the currencies which they trade in the form of deposits at foreign banks. If, for example, Citibank purchases yen from a customer, those funds will be placed in its account in Tokyo, and sales of yen by Citibank will come out of that account. Because these inventories rise and fall as trading proceeds, the banks take risks by frequently having net exposures in various currencies. If, for example, Citibank has sold yen heavily and consequently retains yen assets that are less than yen liabilities, the bank will have a short position in yen, and will lose if the yen appreciates and gain if it falls. Some banks try to impose strict limitations on such exposure by buying currencies to offset any emerging short or long positions, whereas others view such exposure as a way to seek speculative profits. Currencies such as the Canadian dollar or the euro would normally be quoted in hundredths of a cent or basis points, with bid-asked spreads usually being about five basis points or one-twentieth of a cent for large transactions. The Canadian dollar, for example, might be quoted at 64.42–47 US cents, meaning that the banks are prepared to purchase it for 64.42 cents or sell it for 64.47 cents. Before the advent of flexible exchange rates in the early 1970s, bid-asked spreads were narrower, because exchange rate volatility and risk were smaller. The spreads widened to about ten basis points in the 1970s and narrowed to 300 International economics the current range of about five points in the 1980s. Spreads are sometimes narrower for sets of currencies that are very heavily traded and for which the bilateral exchange rate has been particularly stable. These narrow spreads are for very large transactions for banks’ best customers, and they widen when that circumstance does not prevail. When tourists exchange money at airport banks or similar institutions, the spreads are much wider because the institutions need to cover their costs and make a profit on small transactions. 6 The spread of about five basis points also operates in what is known as the “interbank market,” in which the banks trade among themselves. If, for example, Chase Manhattan had bought a large volume of Canadian dollars over a period of a few minutes and the traders became uncomfortable with the resulting long position, they would sell the excess Canadian funds in the interbank market, perhaps using a broker as an intermediary or perhaps dealing directly with another bank to save a brokerage fee. Information on interbank rates and spreads is provided electronically, primarily by Reuters, which supplies television monitors with the current rates for the major currencies. Reuters gathers information on current trades and on the willingness of banks to trade various currencies. The resulting spreads appear on its screens both in the major banks and in major industrial firms that have extensive international business dealings. As a result, everyone in the market should have the same information as to what rates are available. Bank traders have said, however, that Reuters and competing services can sometimes lag the market by 30 to 45 seconds when trading is particularly active, and that trading with customers at “screen rates” can therefore become risky. In such situations, traders are often in direct phone contact with other trading rooms to try to find out what the most current rates are. Reduced cost and increased speed for international communications mean that during overlapping business hours, the European and New York markets are really a single market. Early in the day, New York banks can trade as easily in London or Frankfurt as in New York. Thus differences in exchange rates among these cities are arbitraged away almost instantly. Chicago and San Francisco continue trading after New York, and then Tokyo and Hong Kong open for business, so trading is going on somewhere in the world around the clock. Some New York banks are reportedly maintaining two shifts of traders, with one group arriving at 3 a.m. when London and Frankfurt open and the other group trading very late at night until Tokyo opens. The large New York banks have branches or subsidiaries in Tokyo, Frankfurt, and London; therefore these banks are trading somewhere all the time during business days. Foreign exchange transactions in the spot market are typically completed or cleared with a 2-day lag, so that transactions agreed to on Monday will result in payments being made on Wednesday. This lag is partially the result of differences in time zones and is required to allow paperwork to be completed. Canadian/US dollar business is normally cleared in 1 day because New York and Toronto are in the same time zone. Payment is made by electronic transfer through a “cable transfer,” which is simply an electronic message to a bank instructing it to transfer funds from one account to another. If, for example, General Motors bought DM 2 million from Chase Manhattan on Tuesday, Chase would send such a cable transfer to its subsidiary or branch instructing it to transfer the funds from its account to that of General Motors on Thursday, and General Motors would transfer the required amount of dollars from its US account to Chase Manhattan. The transaction that had been arranged on Tuesday would then be complete. For the major industrialized countries, the cable transfers are handled through a system known as the Society for Worldwide Interbank Financial Telecommunications (SWIFT), which began 13 – Markets for foreign exchange 301 operations in 1987. The electronic system through which foreign exchange transfers are made in New York is known as the Clearing House International Payments System (CHIPS), which was reportedly handling over $600 billion per day in the late 1990s, much of which was for trades made outside the United States. Worldwide foreign exchange trading was about $1,200 billion per day in 2002, with well in excess of 90 percent of the trading being for capital rather than current account transactions. Although most foreign exchange trading involves the dollar, London remains the largest foreign exchange market at about $500 billion per day, followed by New York ($250 billion), Tokyo ($150 billion), and Singapore ($140 billion). The revolution that the Internet has introduced to common stock trading in the United States is beginning to extend to the foreign exchange market. Internet trading in foreign exchange has begun, and is expected to grow rapidly at the expense of the trading rooms in the large commercial banks. Internet and other electronic trading systems are particularly attractive for relatively small transactions, where bid/asked spreads are wider than those described above for large transactions. Some market participants expect 50 percent of foreign exchange transactions to be done without the involvement of a commercial bank trading room within a few years. The major commercial banks have recently created a new transactions clearing system which will reduce or eliminate default risks in the case of a bank failure. This problem can arise because European banks are operating 6 hours ahead of US banks, so a transaction may be completed in Europe before New York is open for business. This means that a few hours have existed in which one half of the transaction is complete and the other is not. When a German bank, Herstatt, failed in 1974, a number of other commercial banks absorbed losses on transactions with Herstatt which were only half completed. The new system, operating under the name CLS (Continuous Linked Settlement) Bank first nets out trans- actions in the opposite between pairs of banks, so that only one net payment is made. It then schedules such payments during hours when both banks are open for the booking of trans- actions. The netting out of opposite transactions greatly reduces the volume of payments to be made. For one day in October 2002, for example, the gross transactions were $395 billion, but only $17 billion in net payments had to be made. Alternative definitions of exchange rates In the past, exchange rates were measured only bilaterally and as the local price of foreign money. The US exchange rate in terms of sterling might be $1.65 or whatever. This practice had two disadvantages: (1) it did not provide any way of measuring the average exchange rate for a currency relative to a number of its major trading partners; and (2) it meant that if a currency fell in value or depreciated, its exchange rate would rise. A decline of the dollar would mean an increased US cost of purchasing sterling and an increase in the US exchange rate. Because this practice was found to be confusing, informal usage has now changed. An exchange rate now means the foreign price of the currency in question, or the number of foreign currency units required to purchase the currency in question. The exchange rate for the US dollar in terms of sterling might be 0.6042. That is, just over one-half of a pound is required to purchase a dollar. The newspaper table shown in Exhibit 13.1 presents bilateral exchange rates in both forms. With the new usage, reading that the exchange rate for the dollar fell tells us that the dollar declined in value relative to foreign currencies. Thus less foreign money is required to purchase a dollar, but more US money is needed to buy foreign currencies. 302 International economics The nominal effective exchange rate We still have to resolve the problem of how to measure the exchange rate for the dollar relative to the currencies of a number of countries with which the United States trades extensively. The nominal effective exchange rate is an index number of the weighted average of bilateral exchange rates for a number of countries, where trade shares are typically used as the weights. An effective exchange rate might be calculated for the dollar, for example, using January 1973 as the base, by calculating how much the dollar had risen or fallen since that time relative to the currencies of a number of other countries, as can be seen in Figure 13.2. If 20 percent of US trade with that group was carried on with Canada, the Canadian dollar would get a 20 percent weight in that average; if 8 percent of that trade was with the UK, then sterling would get an 8 percent weight. Either US or world trade shares could be used as weights, and published indices sometimes appear in both forms. US trade shares would give the Canadian dollar the largest weight, whereas world trade shares would put the euro or the yen in that position. 13 – Markets for foreign exchange 303 EXHIBIT 13.1 EXCHANGE RATES Source: The Wall Street Journal. Republished by permission of Dow Jones, Inc. via Copyright Clearance Center, Inc. © 2003 Effective exchange rate indices can sometimes give an incomplete image of a currency’s behavior if too few foreign currencies are included. Some of the early effective exchange rate indices for the dollar, for example, only included nine currencies of major industrialized countries. Although the majority of US trade is still with those countries, the role of a number of developing countries, particularly the NICs, has grown rapidly. A moderately representative index for the dollar would now have to include the currencies of China, South Korea, Taiwan, Hong Kong, Mexico, and Brazil, and an ideal index would include every country with which the United States has significant trade. The real effective exchange rate In the latter part of the twentieth century a new exchange rate index was developed which was designed to measure changes in a country’s cost or price competitiveness in world markets. Such an index would begin with the nominal effective exchange rate but would be adjusted for inflation in the domestic economy and in the rest of the world. If, for example, a country’s local rate of inflation was 8 percent whereas its trading partners had only 3 percent inflation, a fixed nominal effective exchange rate would imply a 5 percent real appreciation of its currency and a deterioration of its competitive position in world markets of that amount. If the currency depreciated by 5 percent in nominal terms, just offsetting the difference in rates of inflation, the competitive position of the country would remain unchanged. The index of the real effective exchange rate is constructed as follows: XR n ϫ P dom XR r = P row where XR r is the real effective exchange rate; XR n is the nominal effective exchange rate, measured as the foreign price of local money; P dom is the domestic price level, usually 304 International economics 160 150 140 130 120 110 100 90 1970 75 80 85 90 95 2000 index, 1990 = 100 2003 Figure 13.2 Nominal effective exchange rate for the dollar (1970–2003). The dollar experienced an enormous appreciation between 1981 and early 1985, followed by a slightly larger depreciation in the 1985–7 period. It traded in a narrow range through the early 1990s, and appreciated modestly late in the decade and at the beginning of the next decade, before declining moderately during 2002. Source: Morgan Guaranty Trust Company of New York and the IMF, International Financial Statistics. EXHIBIT 13.2 REAL EFFECTIVE EXCHANGE RATE INDICES Source: IMF, International Financial Statistics Yearbook (Washington, DC: IMF). measured as consumer or wholesale prices. Unit labor costs may be used as an alternative to wholesale prices; P row is the price level for the rest of the world, using the country’s major trading partners as a proxy. Trade shares are used as weights. Unit labor costs may be used as an alternative to the price level. If the real exchange rate (XR r ) rises, the country’s cost-competitive position has deterio- rated because it has experienced more inflation than its trading partners after allowance for changes in the nominal exchange rate. Such a deterioration implies greater difficulty in selling exports and an increased volume of imports. Real exchange rate indices, calculated using prices and unit labor costs, can be found in the IMF, International Financial Statistics Yearbook. (See Exhibit 13.2.) 306 International economics Box 13.1 The Big Mac index An amusing but insightful attempt to determine the extent to which market exchange rates misvalue currencies has been provided by The Economist magazine in the form of its Big Mac index. A problem in determining misvaluation has always been to find a basket of the same goods and services that are consumed in both, or all, countries through which to make the purchasing power parity comparison. The Economist begins by assuming that McDonald’s sees to it that its Big Mac sandwich is exactly the same in all countries in which it is sold, and then allows the Big Mac to be its universal good for the purposes of determining under- or overvaluations of currencies relative to the dollar. It is important that the raw materials and labor used for producing a Big Mac are locally produced, making a Big Mac a nontradable good. If the product being used for price comparison were a tradable, prices would be much more likely to be the same, or at least close to the same, in various countries despite many currencies being over or undervalued. Using a nontradable good for the comparison means that The Economist really is comparing the relative costs of doing business in each country through current exchange rates. Translating local currency prices of a Big Mac into dollars at the market exchange rate and comparing them to the average price of a Big Mac in the United States leads to the conclusion that, as of the end of 2002, most currencies were undervalued relative to the dollar, that is, that the dollar was overvalued. (See The Economist, January 18, 2003, p. 98.) A few currencies, however, were overvalued, relative to the dollar. The Swiss franc was the most overvalued, at 72 percent, followed by Sweden (31 percent, the United Kingdom (20 percent), and the euro area (8 percent). More currencies were undervalued, including Argentina (55 percent), all of the 1997–9 Asian debt crisis countries except South Korea, Russia (52 percent), China (55 percent), and Japan (16 percent). In the past The Economist has suggested that the Big Mac index has produced useful information as to how exchange rates are likely to move in the short- to medium-term future, with undervalued currencies rising relative to the dollar, and overvalued currencies falling, but no data were provided to support this conclusion. The dollar, which The Economist said was badly overvalued in early 2002 according to this index, did depreciate from spring 2002 to the end of the year and during the first half of 2003. An alternative definition of the real effective exchange rate is the ratio of the domestic price of nontradable goods and services to the domestic price of tradables; that is: P NT P T These two definitions of the real effective exchange rate look entirely different, but the second can be derived from the first with a few assumptions. 7 The common sense of the second definition of the real exchange rate is that when this ratio is too high domestic firms are encouraged to produce nontradables rather than tradables, whereas domestic consumers are encouraged to consume tradables rather than nontradables, thereby generating a trade deficit. Different elements within the consumer price index are sometimes used as proxies for the prices of nontradables and tradables for the purpose of estimating the real effective exchange rate; services are used for non-tradables and goods are used for tradables. The wage rate might be used as the price of non-tradables, or an index of unit labor costs might be even better. Unit labor cost over the price of goods provides a clear index of the competitiveness of this economy as a place to produce for international markets; if that index rises, the country becomes an increasingly unattractive location for manufacturing, and vice versa. Alternative views of equilibrium nominal exchange rates Economists have had a variety of opinions as to how nominal exchange rates are determined, and the oldest of those views is implicit in the index of a real exchange rate. The purchasing power parity (PPP) view is that nominal rates should move to just offset differing rates of inflation, that is, that the real exchange rate ought to be constant. 8 In a regime of floating exchange rates it was widely expected that the workings of the exchange market would produce that result, in that nominal exchange rates would naturally follow differences in rates of inflation. That has not been the case since 1973, and changes in real exchange rates were quite large during the 1980s but were somewhat smaller in the 1990s. 9 The US dollar appreciated by approximately 40 percent in real terms between 1981 and 1985, and then depreciated by a similar amount in the following four years. Some developing countries have had modest success with a “purchasing power parity crawl” in that they have adjusted otherwise fixed exchange rates by small amounts every month or so to offset the difference between local and foreign inflation. If, for example, Brazil was experiencing 40 percent inflation when the rest of the world had 4 percent inflation, a 3 percent devaluation of the real per month would maintain the ability of Brazilian firms to compete in world markets. The purchasing power parity view of equilibrium exchange rates is entirely tied to international trade in that it makes no allowance for capital account transactions as determinants of the exchange rate. In recent years exchange rates for the industrialized countries have frequently been modeled in an “asset market” context. 10 Since capital flow transactions have increasingly dominated the exchange markets in such countries, the equilibrium exchange rate is that which allows international markets for financial assets to clear. Borrowers and lenders are assumed to operate in both domestic and local markets, and therefore to move funds through the exchange market. The exchange rate then becomes an element in supply and demand functions for such assets, and the equilibrium exchange rate is determined by the clearing of these financial markets. This approach has the problem of 13 – Markets for foreign exchange 307 ignoring trade. Although a majority of exchange market transactions is for capital accounts, it does seem a bit extreme to determine an equilibrium exchange rate without reference to differing rates of inflation or other factors affecting trade flows. Finally, there is the somewhat tautological view that the equilibrium exchange rate is that which produces a zero official reserve transactions account balance. It is therefore the rate that would be observed in a regime of clean floating exchange rates. Such a view implies little permanence and instead a great deal of volatility. Large swings in short-term capital flows, in part driven by speculation, have produced large and frequently reversed changes in exchange rates during recent years. This approach therefore implies that the equilibrium exchange rate is likely to change from one month to another for reasons as ephemeral as speculative moods. As will be seen in Chapter 20, econometric attempts to explain short- to medium-term movements of floating exchange rates on the basis of economic or financial fundamentals, including purchasing power parity, have met with a decided lack of success. Summary of key concepts 1 Minus transactions in a country’s balance of payments accounts generate a domestic demand for foreign exchange, and vice versa. The exchange market is the institutional arrangement in which these supplies and demands are accommodated. 2 If private transactions are out of balance, the exchange market can clear only through official intervention, which is normally carried out by the central bank. A payments deficit requires that the central bank sell foreign exchange, thereby reducing its foreign exchange reserves, and buy its own currency in the exchange market. 3 Many developing countries try to protect scarce foreign exchange reserves from losses through such intervention by maintaining systems of exchange market control, particularly seeking to prohibit capital outflows from the country. Such control systems seldom succeed for long, because there are numerous ways to cheat on them, transfer pricing perhaps being the most important. 4 Although theoretically unnecessary, official intervention is quite common for countries that maintain floating exchange rates, with such intervention typically intended to produce a less volatile exchange rate than would otherwise exist. 5 The nominal effective exchange rate is a trade-weighted average of bilateral rates. The real effective exchange rate is the nominal effective rate, adjusted for inflation in the home country and abroad. It is therefore an index of this country’s price and cost competitiveness in world markets. 308 International economics [...]... points, see Leland Yeager, International Monetary Relations: Theory and Policy, 2nd edn (New York: Harper and Row, 1 976 ), pp 20–1 and 3 17 18 2 An extensive discussion of the Bretton Woods intervention system can be found in Yeager, op cit., chs 20 and 21 See also Robert Solomon, The International Monetary System: 1945–1 976 : An Insider’s View (New York: Harper and Row, 1 977 ), chs 5 7, for a discussion of... “Puzzles in International Financial Markets,” in G Grossman and K Rogoff, eds, Handbook of International Economics, Vol III (Amsterdam: Elsevier), 1995, pp 1913 72 • Stokes, H and H Neuberger, “Interest Arbitrage, Speculation, and the Determination of the Forward Exchange Rate,” Columbia Journal of World Business, Winter 1 979 • Study Group, Recent Innovations in International Banking, Basle: Bank for International. .. Rate Determination, and Market Efficiency,” in R Jones and P Kenen, eds, Handbook of International Economics, Vol II (Amsterdam: North-Holland, 1985), ch 19 See also J Frankel and A Rose, “Empirical Research on Nominal Exchange Rates,” in Grossman and Rogoff, eds, Handbook of International Economics, Vol III, ch 33 14 International derivatives Foreign exchange forwards, futures, and options Learning... to 3 cents? 328 International economics Suggested further reading • Aliber, Robert, The New International Money Game, 6th edn, Chicago: University of Chicago Press, 2002 • Fieleke, N., “The Rise of the Foreign Exchange Futures Market,” New England Economic Review, March 1985 • Froot, K., and R Thaler, “Anomalies: Foreign Exchange,” Journal of Economic Perspectives, Summer 1990, pp 179 –92 • Giddy, I.,... ed., Cases in International Finance, New York: John Wiley & Sons, 1993 • Study Group, Recent Innovations in International Banking, Basle: Bank for International Settlements, 1986 • Walmsley, J., The Foreign Exchange and Money Markets Guide, New York: John Wiley & Sons, 1992 • Weismeiller, Rudi, Managing a Foreign Exchange Department, Cambridge, UK: WoodheadFaulkner, 1985 310 International economics Notes... Heath, 1994), ch 8 See also Study Group, Recent Innovations in International Banking (Basle: Bank for International Settlements, 1986), chs 1–4 Data on the volume of trading and the notional value of contracts outstanding in the international derivatives market can be found in the Bank for International Settlements, Annual Report (Basle: Bank for International Settlements, 1998), p 156 15 Alternative models... Exchange Market Intervention Work? (Washington, DC: Institute for International Economics, 1993) See also R Dunn, Jr., “The Many Disappointments of Flexible Exchange Rates,” Princeton Essays in International Finance, no 154, December 1983, pp 13–15 5 The institutional arrangements through which foreign exchange is traded are covered in M Melvin, International Money and Finance (New York: Harper and Row, 1989),... despite the fact that the 330 International economics United States and many other countries maintain floating exchange rates This ordering has been chosen both for pedagogical reasons and because many countries still maintain parities rather than having independent floating exchange rates With regard to the pedagogical argument, the experience of teaching international economics has led to the conclusion... resources to be used later, but such assets are also subject to the effects of inflation The US price level more than tripled between 19 67 and 19 87, and during many of those years ex post real interest rates on US government securities were negative Foreign 334 International economics governments that held foreign exchange reserves in the form of dollar assets during that period did not do well Balance-of-payments... pound The writer or seller of the option is in the mirror-image situation, facing a loss that rises as sterling falls below $1. 571 0 and a profit that is at a maximum of 2.90 cents per pound if spot sterling never falls below $1.60 before the option expires 324 International economics Profit US¢/pound Buyer 1.50 $1.600 Spot £ 0 $1.6150 1.50 Seller Loss US¢/pound Figure 14.3 Profits and losses from a call . level, usually 304 International economics 160 150 140 130 120 110 100 90 1 970 75 80 85 90 95 2000 index, 1990 = 100 2003 Figure 13.2 Nominal effective exchange rate for the dollar (1 970 –2003). The. op. cit., chs 20 and 21. See also Robert Solomon, The International Monetary System: 1945–1 976 : An Insider’s View (New York: Harper and Row, 1 977 ), chs 5 7, for a discussion of the problems which the. and cost competitiveness in world markets. 308 International economics Suggested further reading • Aliber, Robert, The New International Money Game, 6th edn, Chicago: University of Chicago Press,