Download Brief answers to problems and questions for review

Brief answers to problems and questions for review
1.
From our discussion of the factor-proportions theory in Chapter 4, we know that the
developed countries are capital abundant and the developing countries are capital
scarce. This sets up the situation where the return to capital is higher in the developing
countries than it is in the developed countries. As we saw in Chapter 7, capital would
tend to flow from the developed countries to developing countries. For the developed
countries, this would show up in the balance of payments as an outflow in the
financial account. For the developing countries, it would show up as an inflow in the
financial account.
2.
Debt is the situation where the borrower must repay all or part of the loan plus interest
at certain points in time. Equity is a situation where the lender is also an owner in the
company or project being financed. The most important distinction between the two is
the timing of the repayment. Debt payments must be made at certain points in time
irrespective of the economic condition of the borrower. Payments to equity can be
made in a more flexible way when the borrower is in a position to repay. Owners of
equity normally do not have a right to fixed payments in the form of a stream of
income. Rather, they have a claim on all or part of the firm's assets.
3.
The total external debt of the developing countries is approximately $2.7 trillion. Of
this total, $2 trillion is long-term debt. The recent flow of capital into the developing
countries was $276 billion. Of this total, $147 billion is in the form of FDI. The
balance is portfolio capital flows in the form of bonds and equity.
4.
An unfortunate characteristic of debt is that payments have to be made at specific
points in time. For a country with debt to foreign entities, this means that the country
must have an adequate amount of foreign exchange to repay the debt. This foreign
exchange must come from previously accumulated foreign exchange or from current
foreign exchange earnings from exports. Foreign reserves is the term used for the
stock of foreign exchange that a country has accumulated. The debt/export ratio
expresses the amount of current debt payments in relation to current earnings of
foreign exchange. The ability of a country to repay its debt is positively related to the
amount of foreign reserves and inversely related to the debt/export ratio.
5.
In the graph below, the exchange rate is depicted on the vertical axis and the quantity
of foreign exchange is on the horizontal axis. The equilibrium exchange rate (XR) is
shown at point A where the demand and supply of foreign exchange intersect. An
exchange rate shock is shown as a leftward shift in the supply of foreign exchange
from S to S'. The equilibrium is now at point B with a new exchange rate of XR'.
© 2015 W. Charles Sawyer and Richard L. Sprinkle
Exchange rate
(XR)
S'
S
XR'
B
XR
A
D
FX
FX'
Foreign exchange (FX)
This sudden depreciation of the exchange rate will cause a supply shock to the
economy. In the graph below, the equilibrium price level (P) and real GDP (Y) are
shown at point A. A supply shock would shift the AS curve to the left from AS to
AS'. The new equilibrium is at point B. The price level has increased to P' and real
GDP has declined to Y'. The result of the exchange rate shock is a higher price level
coupled with a lower real GDP.
© 2015 W. Charles Sawyer and Richard L. Sprinkle
Price level
(P)
AS'
P'
AS
B
P
A
AD
Y'
6.
Y
Real GDP (Y)
The prices of primary commodities in international markets can be volatile. If the
demand and supply are both inelastic, any significant change in either one can cause
substantial changes in the price. For example, an increase in the supply of a primary
commodity could cause the price of the product to drop. In this case, the supply of
foreign exchange for a country exporting this commodity could likewise drop. This
would be indicated in the graph above by a depreciation of the currency from XR to
XR'.
© 2015 W. Charles Sawyer and Richard L. Sprinkle
Exchange rate
(XR)
S'
S
XR'
B
XR
A
D
FX
Price level
(P)
FX'
Foreign exchange (FX)
AS'
AS
P'
P
AD
Y'
Y
Real GDP (Y)
Such a depreciation of the currency could be large enough to cause an exchange rate
shock. This is shown below as a leftward shift in the AS curve from AS to AS'. This
shift would increase the price level in the economy from P to P' and depress real GDP
to Y' from Y.
© 2015 W. Charles Sawyer and Richard L. Sprinkle
The prices of primary commodities can also rise. In this case, the situation described
above is just the reverse. A rise in the price of primary commodities could cause the
exchange rate to appreciate. This appreciation could cause a rightward shift in the AS
curve. This type of shift would tend to lower the price level and raise the level of real
GDP.
7.
Countries borrow to intervene in the foreign exchange market in order to fix the
exchange rate. In the graph below, the equilibrium in the foreign exchange market
without intervention is shown at point A. In this case, intervention increases the
supply of foreign exchange and establishes a lower exchange rate at point B. If the
foreign exchange necessary for the intervention is not available, then the exchange
rate would depreciate from XR' to XR.
Exchange rate
(XR)
S
S'
XR
A
XR'
B
D
FX
FX'
Foreign exchange (FX)
The inability to continue intervention has caused an exchange-rate shock. In the graph
below, this moves the AS curve from AS to AS'. This movement causes the price
level to increase from P to P' and real GDP to fall from Y to Y'.
© 2015 W. Charles Sawyer and Richard L. Sprinkle
Price level
(P)
AS'
AS
P'
P
AD
Y'
8.
Y
Real GDP (Y)
In a fixed exchange rate system, the IMF made loans to countries with temporary
balance of payments problems. A typical situation is shown in the graph below. The
country's exchange rate is fixed at XR. In this case, assume the demand for foreign
exchange is not consistent with this exchange rate and a balance of payments deficit
of AB exists at the fixed exchange rate. The IMF would loan the country money for
intervention in the foreign exchange market. This would shift the supply of foreign
exchange from S to S' and make the fixed exchange rate sustainable.
© 2015 W. Charles Sawyer and Richard L. Sprinkle
Exchange rate
(XR)
S
S'
XR
A
B
D
FX
FX'
Foreign exchange (FX)
However, this exchange rate is not sustainable in the long run. The demand for
foreign exchange needs to be reduced to allow the fixed exchange rate to be
sustainable. In most cases, this will mean the government taking steps to reduce
aggregate demand in the economy. In turn this will reduce the demand for imports
and foreign exchange. Knowing this, the IMF imposes conditions on borrowing to
encourage the government to pursue macroeconomic policies consistent with the fixed
exchange rate.
9.
The IMF was originally set up to manage a global system of fixed exchange rates.
However, the system was based on the US dollar and not gold. When the US floated
the dollar in 1971, the global system of fixed exchange rates collapsed. Since this
collapse, it has not been entirely clear what the mission of the IMF is. During the
1970s and 1980s, the IMF has loaned money to middle-income countries that were
attempting to maintain fixed exchange rates. This lending rarely accomplished its
purpose and put the IMF in the unenviable position of imposing strict conditionality
on relatively poor countries. These activities have made the IMF both controversial in
general and deeply unpopular in the developing countries.
10.
Since the breakup of the Bretton Woods system of fixed exchange rates in the early
1970s, the IMF has been primarily involved in making loans to developing countries.
The original intent of IMF lending was short-run balance of payments support for
countries whose macroeconomic policies were inconsistent with a fixed exchange
rate. However, much of the IMFs lending is now to developing countries with chronic
balance of payments problems that may not be related to macroeconomic policy. The
balance of payments problems of developing countries may be more related to such
© 2015 W. Charles Sawyer and Richard L. Sprinkle
issues as oil shocks, primary commodities shocks, and the adjustment from import
substitution to export promotion development strategies. IMF lending to cope with
these problems is becoming more long run in nature. Since the World Bank has
always made long-term loans for development projects, the maturity structure of the
lending of the two institutions is becoming more similar over time.
11.
Governments in developing countries quite properly spend money on infrastructure
projects with long expected lifetimes. However, in order to pay for these investments
foreign exchange is frequently necessary as capital and expertise must sometimes be
bought from OECD countries. In these cases, it makes sense for governments to
borrow in foreign exchange and as a side benefit, this type of borrowing may carry
lower interest rates than those available domestically.
12.
Debt is the borrowing by countries in the form of bonds and bank loans. The interest
on these instruments must be paid irrespective of economic conditions in the country.
Equity is borrowing in the form of FDI or stocks. The owners of equity usually do not
have any fixed claim to a return on the investment. It is this timing that makes debt
risky.
13.
The total external debt of the developing countries is $2.7 trillion. Of this about $1.3
trillion is public debt and $786 billion is private. The middle income countries hold
the lion’s share of the debt at $2.3 trillion.
14.
The debt/export ratio is 1.4 for the low-income countries and 0.82 for the middleincome countries.
15.
See recent economist.com.
16.
See recent economist.com.
17.
If a country has a large quantity of oil to export, then the exchange rate may become
extremely overvalued relative to what it would be if there were no oil exports. In this
case it becomes very difficult to develop other industries. Both import competing and
export industries will be laboring under a very large handicap. In turn this may distort
the structure of the economy so badly that oil exports inhibit the overall growth
prospects of the economy.
18.
Moral hazard is the situation where market participants engage in risky behavior
because they feel that they will not have to bear all of the costs of engaging in this
behavior. The term has been applied to the IMF. Commercial banks have made large
loans to developing countries. Some of the borrowing countries have experienced
difficulties in repaying these loans. In spite of this, in some cases banks have
continued to make loans to these countries. The reason may be the presence of the
IMF and the thought that this presence may make the loans less risky.
19.
This is an example of financial contagion. In some cases a country-specific problem
may become a regional problem. Once international investors decide to withdraw
from a particular country, they may also withdraw from an entire region such as Asia
or Latin America. In this case, a well-managed country might suffer an exchange rate
shock simply because they are in the wrong part of the world at the wrong time.
© 2015 W. Charles Sawyer and Richard L. Sprinkle
20.
In addition to regular IMF lending there are at least 11 other programs under which
members may obtain loans from the IMF.
© 2015 W. Charles Sawyer and Richard L. Sprinkle