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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