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IB 2-1 Tasks 1 & 2 Week 1 Literature Summary Lindert, Peter H., Pugel, Thomas A.. (1996). International Economics, tenth edition. Boston: Irwin/McGraw-Hill Task 1: 1. 2. 3. Explain the graphs! What are “mixing regulations”? – When you import goods you also have to buy them in a certain quantity locally. What are direct trade restrictions or exchange controls? (direct: quota; indirect: tariffs) Task 2: 1. What’s the theory of “comparative advantage”? Chapter 1 – International Economics is different - sovereign nations can be more indifferent to the interests of others than any other body areas of interest: exchange rates, fiscal policies & factor mobility Chapter 2 – The basic theory of international trade 4 questions about trade: 1. 2. 3. 4. Why do countries trade? What determines which products are exported/imported? o trade begins as someone conducts arbitrage How does trade affect production and consumption in each country? o price changes to free-trade equilibrium price and thus quantities produced and consumed adjust to this price How does trade affect the economic well being of each country? Gains/losses? o gains are proportional to the change in the price; in all positive How does trade affect the distribution of economic well-being or income among various groups within the country? Groups that gain/lose because of int. trade? o gainers: consumers of imported goods and producers of exportable goods; loosers: producers of importcompeting goods and consumers of exportable goods Demand and Supply – Review Demand - demand is driven by utility (reach highest possible satisfaction with limited resources) ! determinants are taste, income and price of the product and prices of other products normal good = demand increases as income increases (usual case) inferior good = demand decreases (stays the same) as income increases demand curve slops downwards, anything besides price and quantity is assumed constant, otherwise the curve shifts price elasticity of demand = percent change in quantity demanded resulting from a 1% increase in price (above 1 elastic, below inelastic – actually a negative number) Supply - supply is driven by profits – a company supplies more products as long as marginal cost are less than the price it gets supply curve slopes upwards, other things influencing supply are constant price elasticity of supply = percent increase in quantity supplied resulting from a 1% increase in market price (above 1 elastic, below 1 inelastic) Surplusses IB 2.1 – International Economics and Trade by Boris Nissen Page 1 IB 2-1 Tasks 1 & 2 Week 1 - consumer surplus = net gain form the increase in the economic well-being of consumers who are able to buy the product at a market price lower than the highest price thy are willing/able to pay ! area below demand curve and above price line - producer surplus = net gain (difference between revenues received and costs incurred)from the increase in the economic well-being of producers who are able to sell the product at a market price higher than the lowest price that would have drawn out their supply ! area above supply curve and below price line ! in a national market without trade the equilibrium price results in positive amounts for both consumer and producer surplus 2 National Markets and the Opening of Trade - arbitrage = buying something in one market and reselling the same thing in another market to profit from a price difference Free trade equilibrium - free-trade equilibrium ! called the international or world price – no transport costs or other frictions are regarded ! balances total world demand and supply demand for imports represents excess demand (quantity demanded – quantity supplied); export supply is excess supply (quantity supplied – quantity demanded) at the free-trade equilibrium found by equalizing supply of exports and demand for imports Effects in the Importing Country - consumers: lower prices result in more consumer surplus producers (entrepreneurs, workers & other input suppliers): hurt by lower prices and shrinking production – less producer surplus net national gains: as one usual cannot compare welfare effects on different groups without imposing subjective weights to the economic stakes of each group, we use the one-dollar, one-vote yardstick o one-dollar, one-vote yardstick: One shall value any dollar of gain or loss equally, regardless of who experiences it. ! Distribution of well-being thus has to be handled in other ways than trade and we can simply judge trade and trade policies in terms of aggregate gains and losses. Effects in Exporting Country - producers gain and consumers loose, but in all there is a gain Gains - trade is a positive-sum activity, but gains are generally not equal, the country that experiences the larger price change has a larger value of the net gains from trade “The gains from operating trade are divided in direct proportion to the price changes that trade brings to the two sides. If a nation’s price ratio changes x percent (as a percentage of the free-trade price) and the price in the rest of the world changes y percent, then Nation’s gain / Rest of world’s gains = x / y, The side with the less elastic (steeper) trade curve (import demand curve or export supply curve) gains more.” Chapter 3 – Why everybody trades - we always use a simplified scenario with only 2 products and 2 countries Mercantilism: national well-being is measured in gold and silver – export more than you import to increase belongings Adam Smith’s Theory of Absolute Advantage - - Theory: Countries gain by trading and specializing according to their absolute advantages, but we don’t know how much as the theory discards the demand side ! we only know that the resulting prices will be somewhere in between the ratios of the 2 countries absolute advantage = one country can produce at an absolutely lower labor cost than the rest of the world (labor was assumed to be the driving cost factor) with no international trade, each nation has its separate price ratio, dictated by the conditions in that respective country (ratios are expressed in terms of the goods, a world of barter is assumed, transportation costs are 0), through trade mutual ratios are found IB 2.1 – International Economics and Trade by Boris Nissen Page 2 IB 2-1 Tasks 1 & 2 Week 1 Ricardo’s Theory of Comparative Advantage - - Theory: Two countries gain by trading with each other and with third ones as long as their (dis)advantages in making different goods are different; a country can even gain from trade if it is worse or better at everything. ! the resulting prices will be somewhere in between the ratios of the 2 countries comparative advantage = a relative advantage of one country over the other – the absolute labor costs are irrelevant to the fact that countries gain from trade, what matters are the different price ratios before trade the direction of trade and the gains from trade arise form differences in opportunity costs opportunity costs = the amount of the other good you give up to get more of this good Assumptions of the Theories of specialization: (Repetition from 1-2) 1. Full employment ! made by both theories, but not valid. Unemployed countries might even seek to employ idle resources even if employment is inefficient 2. Economic efficiency objective ! goals may not be limited to economic efficiency (specialization increases vulnerability, culture) 3. Divisions of gains ! division of increased output not clear; trading partners might prefer to forgo absolute gains for themselves in order to prevent relative losses 4. Two countries, two commodities ! made by both, but also valid for more 5. Transport costs ! not considered, but resources for transportation needed. As long as the diversion reduces output by less than what is gained from specialization there are gains from trade. 6. Mobility ! resources are neither as mobile domestically and inbetween different jobs nor as immobile internationally as the theories assume. 7. Services ! both deal with commodities rather than services, but are still valid IB 2.1 – International Economics and Trade by Boris Nissen Page 3 IB 2-1 Tasks 3 & 4 Week 1 Task 3: 1. 2. 3. What are the different slopes of the PPC and what does influence them? How can the gains form trade be analyzed using the PPC? How do the indifference curves help complete the picture? Task 4: 1. 2. 3. What are the Hecksher-Ohlin theory, the Stolper-Samuelson Theorem, the specialized-factor pattern and the factor-price equalization theorem? Who benefits from trade and why (in the short- / in the long run) What’s the surprising result Leontief discovered? Chapter 3 – Why Everybody Trades Ricardo’s Constant Costs and the Production-Possibility Curve (PPC) - - PPC (Production-Possibility Curve) = shows all combinations of outputs of different goods that an economy can produce with full employment of resources and maximum productivity; the slope is the marginal cost Ricardo’s comparative advantage can also be show within the PPC diagram ! o without trade consumption is limited to the PPC line, but with trade and specialization of both countries on the products they have a comparative advantage in they can consume along the trade line that is always above the PPC o trade line: crosses x or y axis at the maximum output of the product to specialize on, the slope is the free-trade price o distractors: marginal costs are assumed to be constant, but in the real world most often one encounters increasing marginal costs ! this leads to assumption of total specialization (only production of the good to specialize on – countries need to be similar in size for this to work) which cannot be observed in real life Increasing Marginal Costs - increasing marginal costs: as one industry expands at the expense of others, increasing amounts of the other goods must be given up to get each extra unit of the expanding output (more realistic assumption) o the slope are the rising opportunity costs for producing o they are very likely to occur, as different products use factor inputs in different proportions, this variations can set up an increasing-cost PPC even if constant returns to scale exist (see page 40); also the relative factor endowments differ o the product combination actually chosen is the point of tangency of the price line to the PPC and the value of national production cannot be increased anymore Community Indifference Curves - - indifference curve = shows all the consumption points at which utility equals some constant o individuals try to be on the highest possible indifference curve of their infinite set of i. curves o actual consumption chosen by the individual depends on the budget constraint facing the person community indifference curves = show how the economic well-being of a whole group depends on the whole group’s consumption (but it is not clear how to add up individual’s indifference curves and the national welfare is not defined) o higher national welfare as shown by community indifference curves does not mean that each person is actually better off Production and Consumption Together - without trade: community maximizes will-being at the point where one of the indifference curves is tangent to the PPC – the slope at that point shows the no-trade equilibrium relative price with trade: trade results in an equilibrium international price ratio at which im- and exports equal each other, the new consumption point can now be along the line that is tangent to the PPC with the slope of the international price ratio (as the products can be traded for that ratio) and the point chosen will be that one where this line is tangent to an indifference curve IB 2.1 – International Economics and Trade by Boris Nissen Page 4 IB 2-1 o o Tasks 3 & 4 Week 1 the export-import quantities in each country can be summarized by the “trading triangles” (rectangular rectangle beneath the 2 points of tangency) that show these quantities and are of the same size general assumption that there is only one free-trade equilibrium international price ratio for a given set of supply and demand conditions Demand and Supply Curves Again - demand curves can be derived form the PPC and the community indifference curves: make price lines tangent to the PPC and plot their points of tangency with the indifference curves The Gains form Trade - gains can be shown by the fact that the consumption point lies beyond the PPC and by the achivement of a higher indifference curve (but fact that some groups might loose is concealed) how much each country gains depends on the international price ration in the ongoing international trade equilibrium ! o terms of trade: price of the export good(s) of a country / price of the import good(s) for it o when the terms of trade are higher, the country gains more (can reach a higher indifference curve) Trade Affects Production and Consumption - - output in each country is expanded for the product it has a comparative advantage in, using resources from the other industry in the country; although production shifts, they do not necessarily specialize completely (increasing marginal costs) shift to trade results in a more efficient world altering the quantities consumed of each good (amount of importable product consumed increases, real income rises, exportable product consumption may decrease, increase or stay the same (depending of the pressures of negative substitution effect and income effect) What Determines the Trade Pattern - the basis for trade is that relative prices differ; that can be because of differing consumption and production conditions production-possibility curves can differ because of 2 reasons: o different production technologies or resources productivities (assumed in this chapter to be the same) o Hecksher-Ohlin theory based on (1) differences across countries in availability of factor resources and (2) differences across products in the use of these factors in producing the products The Heckscher-Ohlin (H-O) Theory: actor Proportions Are Key - H-O theory: Countries export the products that use their abundant factors intensively and import the products using their scarce factors intensively. ! the key to comparative costs lies in factor proportions labor-abundant: a country is relatively labor-abundant if it has a higher ratio of labor to other factors than does the rest of the world labor-intensive: a product is relatively labor-intensive if labor costs are a greater share of its value than they are of the value of other products Chapter 4 – Who gains and who loses from trade Who Gains and Who Loses within a Country Short-Run Effects of Opening Trade - the prices respond to trade, but the inputs are still tied to the current lines of production ! all groups tied to rising sectors gain, all groups tied to declining sectors lose Long-Run Factor-Price Response - as the production responds to the new prices, the factor demands change, and factor prices need to respond resulting in making some people absolutely better off and others absolutely wore off in each of the trading countries, the losers are those who own the scarce resource, but overall net gains are for both countries positive ! effects in the long run are different from those in the short run IB 2.1 – International Economics and Trade by Boris Nissen Page 5 IB 2-1 Tasks 3 & 4 Week 1 Three Implications of the H-O Theory for factor incomes The Stolper-Samuelson Theorem - 4 assumptions: 2 countries, 2 products, 2 productions factors, one good is land the other labor intensive; factors are mobile between sectors and fully employed; competition prevails; technology involves constant returns to scale - Theorem: Predicts rising real returns to the factor used intensively in the rising-price industry and declining real returns to the factor used intensively in the falling-price industry in the long run, regardless of which goods the sellers of the two factors prefer to consume. ! Opening trade must enable one of the two factors to buy more of either good and will make the other factor poorer in its ability to buy either good. o A factor more closely associated with the rising-price sector will have its market reward rise even faster than the product price rise, a factor more closely associated with the falling-price sector will have its real purchasing power cut ! only follows principle that price must equal marginal cost under competition before and after trade The Specialized-Factor Pattern “The more a factor is specialized, or concentrated, into the production of exports, the more it stands to gain from trade. Conversly, the more a factor is concentrated into the production of the importable good, the more it stands to lose from trade.” More general (more factors & commodities possible) than Stolper-Samuelson Theorem o pattern is valid in the short and the long run (more valid for goods that can only be used for production of one thing) The Factor-Price Equalization Theorem - - Theorem: ”Given certain conditions and assumptions, free trade will equalize not only commodity prices but also the prices of individual factors between the two countries, so that all laborers will earn the same wage rate and all units of land will earn the same rental return in both countries even if factors cannot migrate between countries.” o factors cannot migrate, but end up being implicitly shipped between countries in commodity form Do Factor Prices Equalize Internationally? o the strong form of the equalization of factor prices is certainly wrong, as there are barriers to free trade and the technology (as assumed) is not exactly the same everywhere, but a tendency toward international factor-price equalization can be observed Does Heckscher-Ohlin Explain Actual Trade Patterns? - the Heckscher-Ohlin approach provides important insights in theory about the gains from and the effects of trade on production and consumption and well as on incomes of production factors, but does it help explain the real world? ! look at factor endowments and trade patterns o trade pattern fit the H-O theory reasonably well, but not perfectly (better for US and Japan than for Europe) What are the Export-Oriented and Import-Competing Factors? - H-O theory suggests also the effects of trade on factor groups’ incomes and purchasing power, about which policymakers need to know to plan ahead to compensate the losers US pattern: export-oriented: skilled labor and farmland; import-competing: low skilled labor and capital Canadian pattern: export-oriented: capital, farmland, mineral rights; import-competing: labor oil-exporting countries pattern: export-oriented: mineral rights, capital; import-competing: all others oil-importing developing countries: export: unskilled labor, agricultural land, minerals; import: capital, skilled labor, oil Blue Boxes: - factor-ratio paradox: trade makes the land/labor ratio fall/rise in both industries in both countries, but the ratio stays the same for the country as a whole - Leontief Paradox: tested the Heckscher-Ohlin theory using capital and labor for the US and its trading partners and discovered that US was importing capital intensive products, having capital as its abundant resource at the same time ! no real paradox as only more factors have to be considered - US jobs and foreign trade: Restrictions on imports will usually reduce exports on a dollar by dollar basis, when the exported goods need more labor than the imported goods, jobs will be lost. IB 2.1 – International Economics and Trade by Boris Nissen Page 6 IB 2-1 Tasks 7 & 8 Week 2 Task 5: 1. 2. 3. How does growth in a given industry affect a country’s trade patterns? How do the terms of trade affect welfare? What is the willingness to trade and how does it relate to welfare? Task 6: 1. 2. 3. 4. How does limited competition affect trade? What is the effect of economies of scale on trade? What are alternative trade theories? Why do countries trade similar goods with each other? Chapter 5 – Growth and Trade - - economic growth = production-side changes – 2 fundamental sources o increases in countries’ endowments of production factors o improvements in production technologies H-O theory makes predictions of a certain moment in time, but it can also be used to show the effects of changes over time Balanced versus biased growth - - growth shifts the country’s PPC outward balanced growth = the ppc shifts out proportionately so that its relative shape is the same ! same proportionate increase in production of all products if prices remain the same o occurs because of increases in factor endowments by the same proportion or technology improvements of similar magnitude in both industries biased growth = the ppc’s shift is skewed toward the faster-growing product (other product can be increasing by proportionally less, staying the same or declining) ! if relative product prices stay the same, production quantities do not change proportionally o factor endowments grow at different rates, or improvements in production technology are larger in one industry Growth in only one factor - - Rybczynski theorem = In a two-good world, and assuming that product prices are constant, growth in the country’s endowment of one factor of production, with the other factor unchanged, results in an increase in the output of the good that uses the growing factor intensively, and a decrease in the output of the other good. o the decrease is due to the fact, that the industry using the growing factor also needs for the increase in output some of the other factor that is not growing again setting more of the growing factor free ! the proportionate expansion of the industry using the growing factor intensively is larger than the proportion by which the factor endowment grows Dutch disease = development of a new sector in the field of natural resources bids resources away from the industrial sector and imports are increasing (very likely side effect) Changes in the Country’s Willingness to Trade - growth alters a country’s capabilities in supplying products, but also alters its demand for products, e.g. by changing the income available when production and consumption change, a country’s willingness or interest in engaging in trade can change, even if relative prices stay constant ! o willingness to trade – can be shown be the size of the trade triangle, growth can alter its size Effects on the country’s terms of trade - if a country’s willingness to trade changes and its size is large enough to have an impact on the relative international price ratio, its terms of trade can be affected and thus also its welfare small country = one whose trade does not affect the international price ratio (it’s a price-taker in world markets) – in every case, it gains from its growth by reaching a higher c. indifference curve large country = one whose trade can have an impact on relative international price ratio o growth reduces willingness to trade ! relative price of the import good is reduced, that of the export good rises ! country benefits twofold form growth IB 2.1 – International Economics and Trade by Boris Nissen Page 7 IB 2-1 o Tasks 7 & 8 Week 2 "# production benefit form the ppc shift outward "# benefit from the improved terms of trade (more for exports, less for imports) growth increases willingness to trade ! demand for imports increases the relative price of the import good; increase in supply of exports reduces the relative price of the export good ! decline in the terms of trade ! effect on the well-being is not clear Immiserizing growth - - immiserizing growth: growth that expands the country’s willingness to trade can result in such a large decline in the country’s terms of trade that the country is worse off. ! 3 conditions for it to occur o growth must be strongly biased toward expanding the supply of exports and be large enough to have a noticeable impact on world prices o demand for the exports must be price inelastic (expansion leads to large drop in prices) o country must be heavily engaged in trade countries with a diversified selection of export goods do not seem to be at much risk even if expansion makes a nation worse of, it is individuals who undertake the investment and they might profit any effect of growth in the national economy on the terms of trade affects the returns form encouraging that growth ! a country can reap greater benefits if its expansion of import-competing capabilities causes a drop in the price of imports – so a large country has reason to favor import-replacing industries over export industries Technology and Trade - over time, a technology-based comparative advantage can arise as technological change occurs at different rates in different sectors and countries technology differences can become an important cause of the pattern of trade, and this explanation is an alternative that competes with the H-O theory, but technology differences can also be consistent with the HO view o most improvements come form organized efforts (R&D) in the high technology sector (those industries that need high skilled labor) o national location of production of goods using a new technology is not clear cut – technology can spread internationally (diffusion) ! H-O theory suggest that the suitable location fits the factor proportions of production using the new technology to the factor endowments of the national locations Individual Products and the Product Cycle - product cycle hypothesis = both R&D and initial production are likely to occur in an advanced developed country, then as production technology becomes more standardized and familiar, factor intensity shifts from skilled to unskilled labor and production locations and thus also trade shifts (limitations: MNCs, unpredictable evolution of a product) Technology and Convergence among Developed Countries - - a process of convergence since WW2 resulted in the fact that no one developed country has general predominance, but competition in the high technology industries and other skilled-labor-intensive or capitalintensive industries is severe to some extent the convergence reflects the fact that differences in the relative abundance of endowments of physical capital and skilled labor have narrowed/disappeared Chapter 6 – Alternative Theories of Modern Trade - chapter tries to explain the aspects that are not consistent with the standard theory Modern Trade Facts in Search of Better Theory - comparative advantage theory suggests that industrialized countries (are similar in production-side capabilities) should trade little with each other, but fact is that ¾ of exports of industrialized countries goes to other industrialized countries The Rise of Intra-industry trade IB 2.1 – International Economics and Trade by Boris Nissen Page 8 IB 2-1 - - - Tasks 7 & 8 Week 2 intra-industry trade = two-way trade of the same or very similar goods a country’s trade in an industry’ products can be divided into: o net trade = difference between the exports - imports for the industry (H-O can explain this part) o intra-industry trade = the part that is matched exports and imports the importance of intra-industry trade in a country’s overall trade can be calculated as an index (in total or for class of industries) ! o Intra-industry trade (ITT) share = 1 – ((sum of |X – M|) / (sum of X + M)) o for most developed countries, ITT constitutes for more than 50% of their overall trade (exception is Japan) ITT is more prevalent when trade barriers and transport costs are low Reasons for ITT: o Product differentiation = consumers perceive products of an industry as close but not perfect substitutes and as income growth so does demand toward luxuries, variety is demanded o But demand effects do not fully explain ITT, on the supply side full customization is not achieved reducing the variety in order to achieve economies of scale Global Industries Dominated by a Few Large Firms - another fact that challenges the standard theory is the departure form the assumption of highly competitive international markets one key departure is the importance of scale economies Economies of Scale - standard theory assumed constant returns to scale – the major alternative theory uses economies of scale as a major departure economies of scale = increasing returns to scale exist if increasing expenditure on all inputs increases the output quantity by a larger percentage so that the average cost of producing each unit declines o internal scale economies = if expansion of the size of the firm itself is the basis for the decline in its average costs o external scale economies = relate to the size of the entire industry within a specific geographic area ! explain clustering of some industries (e.g. Silicon Valley) o if scale economies are modest ! monopolistic competition = large number of firms competing vigorously, product differentiation gives the firms some control over its product’s price o substantial scale economies over a large range of output ! oligopoly = few large firms dominate the global industry who can if they do not compete too aggressively earn economic (pure) profit o monopoly = only one firm dominates the world industry, a price setter Monopolistic Competition and Trade - before trade: firm engaged in monopolistic competition finds production volume setting marginal cost and marginal revenue equal (like a monopolist), after a short while, indirect competition (threat of new entry, etc.) drives the firm’s pure profits to zero and finally at the quantity found matching marginal revenue and marginal cost, the demand curve is tangent to the average cost curve (see page 101) - this market is now opened to trade ! 2 things happen o exports are made o additional competition from imports arise ! transition to a new long-run equilibrium as on the national level, but situation has changed in that demand curve is different, presumable there are now more different models and the demand will be more elastic, resulting in lower prices and higher output - but exports are not due to the fact of scale economies, as presumably all competitors will also have similar downward-sloping average cost curves (thus there is no comparative advantage) ! the basis is rather product differentiation - role of scale economies is that each country specializes on certain variations of the product leading to a larger number of different product on the world market but using economies of scale in production of the individual variations ! intra-industry trade - in addition to IIT, an industry may also have some net trade, whose basis can be a comparative advantage, but also differences in marketing capabilities or shifts in consumer tastes Gains from Trade - sources of national gains form trade o increase in variety o lower prices of domestic varieties IB 2.1 – International Economics and Trade by Boris Nissen Page 9 IB 2-1 - Tasks 7 & 8 Week 2 opening of trade has little impact on the domestic distribution of factor income if the trade is intra-industry (export++ imports++) ! all groups gain from additional variety if losses in factor income result form interindustry shifts in production that do occur the variety can offset them Oligopoly and International Trade - firms in an oligopoly are caught in a prisoners’ dilemma – if both restrain their competition they both can make pure profits, but if only one restrains his competition the other one can even make more, but if both compete aggressively they drive their pure profits to zero - - pattern of trade: if substantial scale economies exist, production is concentrated in few countries to take advantage of them ! those countries then are net exporters location for the production usually evolved by historical matters production location even when another country has a comparative advantage is hard to change, as production would have to start at a very high level at the new location to be competitive, for a competitor to enter the business is also difficult as his production has capture a large market-share right away welfare effects: pure profits arise form exporting ! country’s terms of trade are enhanced (national governments try to attract such production) External Scale Economies and Trade - - case: external scale economies + perfectly competitive industry before trade: the entire industry produces at a price level where average costs equal the price opening of trade: the opening of trade now increases the demand as products are exported, in the standard case with constant returns to scale, the supply curve would not change, but there would be merely a shift along the supply curve, in the case of external economies scale, the increase output also leads to lower marginal and thus also lower average costs, increasing the supply – this then can results contrary to standard theory also in the exporting country to lower prices welfare effects: only the producers in the importing country loose, all others gain now pattern of trade: production tends to be concentrated in a small number of locations, whose locations are attributable to historical luck or a push form governmental policy IB 2.1 – International Economics and Trade by Boris Nissen Page 10 IB 2-1 Tasks 7 & 8 Week 2 Task 7 1. 2. 3. Which area represents the cost of the tariffs to consumes? How much are those costs and what is the effect of the tariff on producers? What would happen in the example if a 10% tariff were put on imported cars? What are different tariffs and how do they affect producers, consumers and governments? Would jobs actually be created? Task 8 1. 2. Why are quotas often preferred over tariffs? Why do the effects of a quota depend on the market structure? What are different welfare effects of voluntary export restraints and import quotas? Chapter 7 – The Basic Analysis of a Tariff - tariff = a tax on importing a good or service into a country, usually collected by customs at place of entry o specific tariff = tariff stipulated as a money amount per physical unit of import o ad valorem (on the value) tariff = percentage of the estimated market value of the goods when they reach the importing country Preview of Conclusions - - a tariff almost always lowers world well-being a tariff usually lowers the well-being of each nation, including the nation imposing the tariff general rule: whatever a tariff can do for the nation, something else can do better exceptions to the case of free trade: o “nationally optimal” tariff – when a nation can affect the prices at which it trades with foreigners, it can gain form its own tariff, but the world as a whole loses o when other incurable distortions exists in the economy, tariff may be better than nothing o in a narrow range of cases with distortions specific to international trade itself, a tariff can be better than any other policy a tariff absolutely helps groups tied closely to the production of import substitutes The effect of a tariff on consumers - we observe the effects in a small-country case (nation is a competitive price taker) we can quantify what consumers gain form being able to buy any of the good and how much a tariff would cut their gains ! o the consumer surplus area (below domestic demand curve and above price line) is a measure of what consumers gain o a tariff raises the price, less people buy the product and more is manufactured locally o the consumer surplus shrinks (consumer pays more for imported and domestically produced goods) o if slope of demand curve is not know, we can still approximate the loss "# underestimation: tariff gap * number purchased with tariff "# overestimation: tariff gap * number purchased with free trade The effect of a tariff on producers - domestic suppliers gain from extra sales and higher prices – the producer surplus rises the part lying above the marginal cost curve and within the total-revenue area represents profits above (variable) costs – this area increases gain for domestic producers is smaller than the loss for domestic consumers, as the producers gain only on the domestic output, while consumers loose on both domestic products and imports The effective rate of protection - incomes of workers and others in an industry are counted in the “value added” in that industry effective rate of protection (of an individual industry) = percentage by which the entire set of a nation’s trade barriers raises the industry’s value added per unit of output = (old value added – new value added) / new value added) IB 2.1 – International Economics and Trade by Boris Nissen Page 11 IB 2-1 - Tasks 7 & 8 Week 2 a given industry’s incomes (or value added) will be affected by trade barriers on its inputs as well as trade barriers on its output – the effective rate of protection will be greater than the nominal rate when the industry’s output is protected by a higher duty than the tariff duties on its inputs The tariff as government revenue - as long as a tariff does not prohibit all imports, it brings revenue to the government – as it accrues to someone within the country, it counts as an element of national gain revenue equals the unit amount of the tariff times volume of imports with tariff The net national loss form a tariff - by combining effects on consumers, producers and the government, we arrive at the conclusion that there is a net loss to the country using the one-dollar-one-vote welfare measure (key assumption) one-dollar-one-vote welfare measure: every dollar of gain or loss is just as important as every other dollar of gain or loss regardless who the gainers or losers are the loss can be show in the demand and supply diagram, and also under the market demand curve for imports (there it is the triangle with tariff as height and total cut in imports as width) the information needed is only the height of the tariff itself and the estimated volumes by which a tariff reduces imports (usually percent elasticity) ! you don’t need to know domestic demand and supply curves! Gains from trade lost by tariffs come in 2 forms: o Consumption effect: loss to consumers in the importing nations corresponding to their being induced to cut total consumption – what was consumer surplus before, no one gains (deadweight loss) o Production effect: welfare loss tied to fact that some demand is shifted form imports to more expensive domestic production – it is the cost of drawing domestic resources away form other uses exceeding the savings from not paying foreigners to sell us the extra units (deadweight loss) The terms-of-trade effect and nationally optimal tariff (see page 129) - - - - if a nation has a large enough share of the world market for one of its imports to be able to affect the world price unilaterally (monopsony power) it can exploit this advantage with a tariff on imports that leads to a lower world market price a lower world market price arises from the decreasing world demand terms-of-trade effect (terms of trade = export prices / import prices): a tariff imposed by a large country can increase world price of a good increasing the terms-of trade for the country imposing the tariff the net effect for the country then can be positive, as long as the gains form continuing most of the previous imports at a lower world market price outweigh the costs that arise from the domestic price increase due to the tariff ! the foreign producers pay part of the tariff optimal tariff rate: calculated as a fraction of the price paid to foreigners, equals the reciprocal of the price elasticity of foreign supply of our imports o the lower foreign supply elasticity, the higher the optimum tariff rate (if supply elasticity is infinite (small country) the optimal tariff is zero) however on a world view any tariff results in a net loss, as foreigners lose more than we gain from the tariff even if foreign suppliers cannot fight back, their governments can!!! Chapter 8 – Nontariff barriers to imports - not only tariffs hurt to world as a whole and probably also the importing nation, but also nontariff barriers do the same GATT – Tariff success versus the rising nontariff challenge - GATT (General agreement on tariffs and trade): signed 1947 by major industrial nations, expanded to more than 120 nations till now – 1994 name change into “World Trade Organization”; headquartered in Geneva Agreement based on 3 principles: o Liberalized trade o Nondiscrimination o No unfair encouragement for exports IB 2.1 – International Economics and Trade by Boris Nissen Page 12 IB 2-1 - - Tasks 7 & 8 Week 2 GATT succeeded to lower tariffs worldwide form around 40% (1940) to about 3% (when Uruguay round results come into effect) in 8 rounds of multilateral negotiations, but some areas of protectionism have been left largely intact (e.g. agricultural production) GATT had less success in lowering nontariff barriers (import quotas, quality standards, domestic content requirements, state monopolies on foreign trade, buy-at-home rules for government purchases, administrative red-tape, complicated exchange controls…) as the protective effects of nontariff barriers are harder to measure and thus it is harder to get to an agreement on what constitutes an exchange of comparable reductions ! protectionism has increasingly taken refuge behind nontariff barriers The import quota - import quota = limit on the total quantity of imports allowed in into a country ! cuts the quantity imported and also drives the price of the good up above the world market price ! similar to the import tariff Reasons for quotas - insurance against further increases in import competition and import spending give government officials greater administrative flexibility and power in dealing with domestic firms (e.g. lobbying, bribes) Quote versus Tariff with competition - - comparing an import quota with an equivalent tariff – assuming a small-country case – domestic buyers face with a quota a supply curve that is the domestic supply curve plus the fixed quota at all prices above the world price welfare effects are equivalent to those of a tariff under competitive conditions ! under competitive conditions, a quota is no better or worse than the equivalent tariff, but it looks worse than the tariff under 2 sets of conditions: o if the quota creates monopoly powers: as long as a firm faces a non-prohibitive tariff, it faces elastic competing import supply, but a quota gives it a better chance of facing a sloping demand curve and it thus can reap monopoly profits (see Appendix E) o if the licenses to import are allocated inefficiently Ways to Allocate Import Licenses - - whoever gets the rights without paying for them captures the gains the government would earn if it used tariffs import-license auctions = selling off import licenses on a competitive basis (publicly or under the table) o public auctions are likely to yield a price equal to the difference between foreign price and highest home price – this is the best and cheapest way fixed favoritism = fixed shares are simply assigned to firms without competition, applications or negotiations (most arbitrary way) resource-using application procedures = people compete for the licenses in a non-price way leading to lobbying and other activities whose cost will approximate the amount of potential economic rents fought for resulting in a loss of that area – most costly way to society Voluntary Export restraints (VERs) ! see table on page 144 - - - voluntary export restraints (VERs) = arrangements by which the government of an importing country coerces foreign exporters to agree “voluntarily” among themselves on how to restrict their exports into that country (importing country gives foreigners monopoly power!) VER are used by large, powerful countries as a rear-guard action to protect their industries having trouble ot compete VERs versus import quotas: o An import quota keeps the price markup revenues (and if there is an effect on world market prices also some terms-of trade gains) within the country that sets up the quota o An VER, results in the exporters having a pure gain in terms of the increased price they can sell their exports for in the importing country (with quotas they sell at world market prices) o For the world as a whole the net loss is equal to a quota VERs versus free trade o For the importing country the VER is very expenses, it loses the triangle on prevented imports and the price markup o VERs effects on exporters can be bad, good or neutral relative to free trade, if their export supply curve is flat, they surely gain IB 2.1 – International Economics and Trade by Boris Nissen Page 13 IB 2-1 Tasks 7 & 8 Week 2 Other Nontariff Barriers - - - quality standards = restrictive laws pertaining to product quality (e.g. health, sanitation, safety, environment) o do not raise revenues for importing country, but use up government resources to enforce o make it easy to disguise costly protectionism domestic content requirements (or mixing requirements) = stipulate that the importer must buy a certain percentage of the final product locally (gains are captured by the protected sellers of the product, world as a whole suffers) “Section 301 of the Trade Act of 1974” of the US: gives the US president power to impose barriers against imports form a country using “unfair trade practices” to shout out imports for the US and other countries ! if used as a threat and it works it is a gain, but if it is used for retaliation, it results in losses How big are the Costs of Protection As percentage of GDP - the partial equilibrium analysis look only at a single market without exploring economy-wide effect of a trade barrier ! underestimated costs by far (formula see page 148) computable general equilibrium methods come up with a larger but still very small percentage (less than 10%), the largest gains came when barriers were high and removed completely, but still the number is underestimated because: o foreign retaliation: import barriers provoke retaliation that increase the costs o enforcement costs: enforcement of trade-barriers can be costly (revenues collected by governments by tariffs are not all redistributed) o new barriers cost much more than existing ones: the calculations are based on the already low trade barriers, but new trade barriers are quite high and you can see that: "# net loss = ½ * (% tariff)² * (import-demand elasticity) "# thus the tariff has a squared effect, doubling a tariff quadruples its cost As a share of the protection given - - taken a different perspective, the costs of import barriers look larger, especially when seen on a cost for each dollar of protection given (see example page 149) ! even a 0.1% GDP loss with a 10% tariff with the total import of that commodity accounting for 10% of GDP results in a protection cots of 10 cents per dollar even small shares of the GDP can equal billions of dollars in a study covering selected products (1990) it turned out that the US as a whole losses 49 cents for every dollar of protected income with 26 cents being a deadweight loss tariff protection in the US seems to cost less, it actually brings a net gain (terms-of-trade gains!), but tariff protection has shifted towards quotas and VERs IB 2.1 – International Economics and Trade by Boris Nissen Page 14 IB 2-1 Tasks 9 & 10 Week 3 Chapter 9 – Arguments for and against protection - - conclusion: There are valid “second-best” arguments for protection, yet some other policy is usually better than barriers to imports in the second-best cases. Valid arguments for protection are quite different form its usual defenses. We shift our focus away form that of a perfect world towards one where economic incentives are already distorted and look where import barriers start look goods for the nation and the world The Troubled World of Second Best - to locate the boundaries to the free-trade argument, we must go beyond assuming that any demand or supply curve does double duty, representing both private and social benefits or costs Distortions - - - - distortions = gaps between the private and social benefits or costs of any activity perfect world – all 5 marginal values are equal o Price (P) = buyers’ private marginal benefit (M) = social marginal benefit (SMB) = sellers’ private marginal cost (MC) = social marginal cost (SMC) “second-best” world = one riddled with gaps between private and social benefits or costs ! private actions will not lead to a social optimum (see Figure 9.1 on page 156) o externalities (spillover effects) = net effects on parties other than those agreeing to buy and sell in a marketplace how should a society try to fix its distortions ! 2 approaches o tax-or-subsidy approach (optimistic) = spot distortions and have the government eliminate them with taxes or subsidies "# e.g. if SMC > MC = P = MB = SMB ! tax of SMC – SMB brings all five in line "# e.g. if SMB > MB = P = MC = SMC ! subsidy of SMB – SMC so that everyone gets full social returns o property-rights approach (pessimistic) = creating new private-property can solve the problems idea of the chapter is to explore the tax-or-subsidies approach in the best possible cases for government interference with trade, without assuming that these are the most likely real-world outcomes The Specificity Rule - every case is different and there is no cure-all prescription for trade policy, but a rough rule serves well for policy making in a distortion-riddled economy specificity rule: Intervene at the source of the problem. It is usually more efficient to use those policy tools that are closest to the sources of the distortions separating private and social benefits or costs. it tends to cut against import barriers and shows that some other policy instrument is usually more efficient A Tariff to Promote Domestic Production - - - most popular second-best arguments for protection can be viewed as variations on the theme of favoring a particular import-competing industry ! each stating that there are social benefits to domestic production when one draws a downward sloping marginal social side benefits curve, a tariff increasing local production also enlarges the area below the marginal social side benefit curve, but as the area is hard to estimate, a tariff might prove to be better or worse than doing nothing other policy tools: specificity rule demands for concentration of the problem, which is domestic production and not imports ! subsidies can do the same for an industry as a tariff, but they do not have a consumption effect thus the only loss is due to the production effect (see page 160) a subsidy only enables domestic firms to capture part of the same total consumption form foreign competition The Infant Industry Argument - infant industry argument = asserts that a temporary tariff is justified because it cuts down on imports while the infant domestic industry learns how to produce at low enough costs to compete without the help of a tariff o claims the tariff will help the nation as well as the world in the long-run IB 2.1 – International Economics and Trade by Boris Nissen Page 15 IB 2-1 - - Tasks 9 & 10 Week 3 o protection is only needed for a while 3 conclusions: 1. There can be a case for some sort of government encouragement. 2. A tariff may or may not help. 3. Some other form of help is a better infant industry policy than the tariff. - if infant industry concerns call for encouraging current domestic production ! subsidies are better - if extra benefits will arise through learning by doing ! best way is to let the industry borrow against its own future profits if protection needed is truly temporary ! tariffs should also not be used because it is hard to remove them a tariff is especially inferior to direct subsidies to production, training and research in technologically complex industries (e.g. computers) where many of the gains in knowledge occur in the consuming industries The Dying Industry Argument and Adjustment Assistance - - same issues and results that arise in the infant industry case, also arise in debates about saving dying industries form import competition (again production subsidy/retraining/loans are better than a tariff) first-best world assumes that production factors are fully mobile, but in reality resources do not have some other equally profitable use they can easily turn to leaving an industry can be costly, when incorporating the marginal social side benefit of continuing, one has once again to compare the area that would be lost with tariffs and the one that would be kept below the marginal social side benefit curve adjustment assistance = government financial aid to relocate and retrain workers for reemployment in other sectors whose jobs were lost do to import competition ! often given to forestall more protectionist policies that otherwise would be lobbied for o also problematic is the “social insurance dilemma”, it could actually encourage firms or workers to start in an import competing industry, knowing they are cushioned The Infant Government (Public Revenue) Argument - a tariff as a source of revenue in less developed countries may be beneficial and even better than any alternative policy both for the nation and for the world as a whole (given it is used to fund socially worthy investments) o with low living standards the most serious domestic distortions my relate to the government’s inability to provide and adequate supply of public goods o many low-income countries receive ¼ - 3/5 of their government revenue form customs duties Other arguments - other leading arguments relate to the national pursuit of “noneconomic goals” national price: nations desire symbols and thus there is a case for policy intervention o if price is generated by production itself ! subsidies; if generated by self-sufficiency ! tariff income redistribution: question is whether it is not better to directly address the inequity national defense: argument states that import barriers would help the nation accumulate more stockpiles or capacity to produce goods that would be important in a future military emergency o tariffs might increase capacity, but only by as much as needed and not to emergency levels o stockpiles are not encouraged and if storage is inexpensive why not buy from foreigners in peace time Chapter 10 – Pushing Exports - controversy over export behavior and export policy has begun to rival the fights over import barriers industrial targeting = having the government and industry agree far in advance on just which industrial lines need the most encouragement and subsidy, grooming them as future export specialties Dumping - dumping = international price discrimination in which an exporting firm sells at a lower price in a foreign market than it charges in other (usually its home-country) markets (definition used most often) - predatory dumping = when a firm temporarily discriminates in favor of some foreign buyers with the purpose of eliminating competitors and of later raising its price after competition is dead (puropose: reap monopoly gains) IB 2.1 – International Economics and Trade by Boris Nissen Page 16 IB 2-1 - Tasks 9 & 10 Week 3 seasonal dumping (or cyclical dumping) = occurs if the firm has special reasons to want to hold prices more stable in one market than in the other persistent dumping = continuous dumping Why do some firms charge foreign buyers less? o Firms will maximize profits by charging a lower price to foreign buyers if it has greater monopoly power in its home market (facing a steeper demand curve) and if buyers in the home country cannot avoid the high home prices by buying the good abroad Retaliation against Dumping: What should a Dumpee do? - GATT allows dumpees to levy antidumping tariffs against foreign exporters, but who gains and who loses form an antidumping tariff is a question with a subtle answer o An antidumping duty is likely to lower world welfare o It can raise or lower the net national welfare of the importing country, whose government is retaliating. A small antidumping tariff can bring national gains, but a large tariff is bad for the nation as well as the world. o Other costs arise: easy to get antidumping actions against firms actually not dumping, cost of arguing the cases, many cases are withdrawn because the aggressor agrees to supply only a limited share of the market with higher prices (collusion) Export Subsidies - - exports are subsidized more often than they are taxed ! 2 curiosities o why would a country want to discriminate in favor of selling exports instead of giving just as good a bargain to its own residents o export-subsidizing countries often restrict imports, not noticing that subsidizing exports implicitly subsidizes imports GATT proscribes export subsidies as “unfair competition” and allows importing countries to retaliate as they are bad from a world point of view actually benefit the importing countries, are bad for the countries that use them Countervailing Duties - should a country being the target of subsidized exports enjoy the bargain or impose countervailing import duties to protect the domestic industry ! question of politics o officials lobbied by the industry ! retaliate o officials sensitive to consumers ! enjoy - with free trade and no subsidy, the world gains from trade are maximized as the marginal value of each unit represented by the height of the demand curve just matches the price, which represents the marginal resource cost of supplying that extra unit - if the product is subsidized, the supply curve is lowered, creating too much trade and wastes resources - the importing country however gains what the exporting countries puts as subsidy into its industry - a countervailing duty restoring the price and quantity to free-trade no subsidy levels eliminates the world loss due to resource waste, but that amount is deducted from what the importer gains, but he is still better off ! export subsidies are bad fro the world as a whole and retaliating against them is good for the whole world – but there are 2 clouds: o difficulty of knowing whether a government is really guilty of subsidizing exports o usual analysis may be wrong in assuming competitive supply and demand Strategic Export Subsidies Could Be Good - if there is very limited competition (e.g. just 2 giants), export subsidy can be either good or bad fro the exporting country and the world - good export subsidy: if economies of scale exist and it is only profitable for one producer to produce a new good (to capture those economies of scale) there is an incentive for national governments to subsidize those firms as they might decide not to undertake the investment, if only one country subsidizes one of the giants, word’s consumers certainly gain and possibly also the exporting country - bad: if both countries would subsidize their giant this would make world’s consumers gain, but then if most of the consumers are outside both countries they might give up or decide never to subsidize or produce in first place and the world looses ! export subsidy might be a good thing, but the case for giving the subsidy is very fragile and depens on too many conditions to be a reliable policy IB 2.1 – International Economics and Trade by Boris Nissen Page 17 IB 2-1 Tasks 9 & 10 Week 3 What role has government played with the rising exporters? - question is whether government export promotion, for better or worse, actually had the effect of raising exports enough to explain the big changes in international competition that have occurred over the past quarter century ! did they succeed (gained more market share), did government assistance play a key role ! See Figure 10.6!!! Does Japan Really Push Exports - Japan does not push exports in the sense of giving greater subsidies and other government help to exportoriented sectors, it does not even have a coherent industrial targeting policy of favoring futuristic industries, on the contrary it gives greatest help to those sectors that are in the most trouble ! Japan did and does not practice industrial targeting (back the winners), but Korea did IB 2.1 – International Economics and Trade by Boris Nissen Page 18 IB 2-1 Tasks 11 & 12 Week 3 Task 11: 1. 2. Why are the EU and former communist countries so interested in the partnership? Positive/negative effects of an economic/customs union? Task 12: 1. 2. 3. 4. How should the Netherlands respond? How does trade affect the environment What are the general guidelines for problems related to international externalities? Why does it depend on whether or not a country is able to gain international co-operation to solve the problem? Chapter 11 – Trade Blocs and Trade Blocks - past chapters looked at equal-opportunity import/export barriers, but some are meant to discriminate ! effects of trade blocs Types of Economic Blocs - free-trade area = members remove trade barriers among themselves, but keep their separate national barriers against trade with the outside world customs union = all internal trade barriers are removed and a common set of external barriers adopted common market = members allow full freedom of factor flows (goods, services, labor, capital) among themselves in addition to a customs union economic union = common market + member countries unify all their economic policies (monetary, fiscal, welfare,…) trade blocs = customs union and common market, as they only focus on trade Is Trade Discrimination Good or Bad? - - compared to free-trade, new barriers discriminating against imports from some country is generally bad compared to the real world with lost of restrictions ! what are the gains and losses from removing barriers only between certain countries o Side 1: it is a step to free-trade and thus brings economic gains o Side 2: it is bad because it generates trade diversion and international friction GATT is using the most favored nation (MFN) principle (any concession given to any foreign nation must be given to all nations having MFN status) and thus is opposed to trade discrimination, but granted lots of exceptions The Basic Theory of Customs Unions: Trade Creation and Trade Diversion - trade creation = the net volume of new trade created by forming the trade bloc – results in a welfare gain trade diversion = the volume of trade diverted from low-cost outside exporters to higher-cost bloc-partner exporters – results in a welfare loss ! The gains from a customs union are tied to trade creation and the losses are tied to trade diversion; the net welfare effect, trade-creation minus trade-diversion can be positive or negative ! see page 205 - 3 tendencies that make for greater gains from a customs union o the greater the difference between home-country and partner-country costs, the greater the gains o the smaller the difference between partner-country and outside world costs, the greater the gains o the more elastic the import demand the greater the gains The EU Experience - empirical judgment on gains/losses form the creation of the EU are threefold: o on manufactured goods, the EU has brought enough trade creation to suggest small positive net welfare gains o static gains on manufactures have probably been smaller than the losses on the Common Agricultural Policy o net judgment still depends on what we believe about the unmeasured dynamic gains from economies of scale and productivity stimuli (increased competition) IB 2.1 – International Economics and Trade by Boris Nissen Page 19 IB 2-1 Tasks 11 & 12 Week 3 North America Becomes a Bloc - - - - US and Canada form free-trade area in 1988 economists tend to expect greater absolute effects on Canada, reasoning that the absolute net national gains should be distributed in proportion to the two nations’ price changes caused by the opening of new trade (as Canada’s import-demand and export-supply curves are less elastic new trade should shift Canadian prices more) Canada could raise its GDP by 8-10%, especially important have been the economies of scale it could reach due to the better access to the US market North American Free Trade Area (NAFTA): was founded in 1993 and calls for a phased removal of barriers to trade and investment among the three North American nations, along with new safety and environmental standards plus other harmonization of national laws (dos not call for free human migration) effects of NAFTA ! all three countries will be slight gainers and the rest of the world will if at all only suffer negligible damage; but in all countries there will be losers in the import-competing groups and trade diversion is likely to draw some production especially form Asia to Mexico) in percent Mexico is to gain the most, Canada second most (although in absolute terms it gains the least) Prospects for other Trade Blocs Free-trade areas among developing countries - - using the infant industry argument, one can imaging that forming a customs union/free trade area could give the union a market large enough to support a large-scale producer in each modern manufacturing sector without letting in manufacturers form the highly industrialized countries ! economies of scale and learning by doing could make them internationally competitive problem: life expectancy of average Third World trade blocs has been short as usually the gains are not shared equally ! most experts became skeptical, but there is some hope after the success of MERCOSUR The break-up of the socialist trade bloc - - - the countries of the former socialist bloc have spent the early 90th trying to determine their comparative advantage between 1949 and 1989, socialist countries discriminated strongly against trade with capitalist economies, trying to favor trade among themselves, but actually trade of CMEA countries (Council for Mutual Economic Assistance) was only 50-60% of that of comparable capitalist nations to see who gains more form the expansion of East-West trade, we again have to rely on the simple formula o Gains form opening trade are divided in direct proportion to the price changes that trade brings to the two sides. If a nation’s price ratio changes x percent (as percentage of free-trade price) and the price in the rest of the world changes y percent, then: Nation’s gains / Rest of world’s gains = x / y as the East-West trade has little effect on Western prices, the East is likely to gain more, but the sharp price changes also lead to great resentment form those who lose in the country that has a net national gain Trade Embargoes - - sanction = refers to either discriminatory restrictions or to complete bans on economic exchange embargo / boycott = complete bans on ordinary trade or the trade in services or assets US practices such economic warfare more readily than any other nation (54 out of 89 major embargoes) Effects of banning economic exchange: hurts both countries economically and creates opportunities for third countries ! see page 217 o the embargoed country finds importable goods more scarce, the local price rises and nonembargo countries supply more at the higher price ! the embargoed country looses consumer surplus and the nonembargo countries gain part of that from the higher prices o the embargoing countries loose from a reduction in the world-price, but their action implies that they are willing to sacrifice for other goals embargos fail due to 2 reasons o political failure of an embargo = occurs when the target country’s national decision makers have so much stake in the policy that provoked the embargoes that they will stick with that policy even if the economic cost to their nation becomes extreme o economic failure of an embargo = the embargo inflicts little damage on the target country, but possibly even great damage on the imposing country ! 2 scenarios IB 2.1 – International Economics and Trade by Boris Nissen Page 20 IB 2-1 Tasks 11 & 12 Week 3 "# as embargo that backfires: if the embargoing country itself has a low elasticity of export supply and the embargoed country on the other hand has a very elastic import demand curve, the loss for the embargoing country is much larger than the damage it causes "# a virtually irrelevant embargo: when both the export supply curve as well as the import demand curve are elastic, and the supply curve of competing supplies is also elastic, the embargo does very little harm ! economic sanctions apply stronger pressure when the embargoing country(ies) have high elasticities and the target countries have low ones (! big countries pick small ones; sanctions have more success if they are extreme and sudden; they must result in political pressure) Chapter 12 – Trade and the environment - focuses on the proper role of international trade policy in attacking environmental problems high-income industrial countries (North) are sending out 2 different signals to the lower-income developing countries: 1. encourage free trade and lower government interference; 2. tighter government control to defend the environment Treaties and Tensions - throughout the 20th century, diplomats have gradually increased their efforts at international environmental cooperation even GATT concedes that environmental concerns might conceivably justify trade barriers, but at the same time suspicions that it is a good excuse for protectionism treaties have fallen short to protect all species and far short of guaranteeing clean air and water, primarily because of he human population growth effect of income growth on the environment is not clear – a richer country has better sanitation and less soot but more solid waste and more greenhouse-gas emissions (environmental concern is a luxury) – and so is the effect of more international trade on pollution Earth is a “Second-Best” World - environmental effects such as pollution and resource depletion call for special policies or institutional changes only if they are externalities externalities = exist whenever somebody’s activity brings direct costs or benefits to anybody with whom they are not bargaining in a marketplace distortion = gap between private and social benefits-minus-cost of a private activity Two ways to attack externalities: - use of government taxes and subsidies changing property rights so as to make all relevant resources somebody’s private property neither is clearly better than the other, sometimes only one of them is more practical than the other, but they always lead to the same “optimal amount” of e.g. pollution Example (international pollution): - - the tax-subsidy approach asks for subsidizing a company not to dump waste up to that point where the marginal benefits for the company are equal to the marginal social costs the property-rights approach asks for assigning property rights to the e.g. river and then the owner will sell “licenses for pollution” upto that point where the marginal costs to him are equal to the marginal benefit for the company that buy the license (which is the same point as with the tax-subsidy approach) problematic in an international context is that neither the tax-subsidy approach works as the polluting country has no incentive to restrict its industry when the country suffers, nor the property-rights approach works as there is no supreme court that can enforce a property claim ! any of several arrangements could give us the efficient compromise solution, but the 2 sides would probably not reach that efficient compromise ! result is costly rampant pollution if the polluting agents do as they please The specificity rule - has implications for the relationship of international trade to environmental issues: o international trade policies are efficient only when the externality is specific to trade between nations (rather than to production or consumption) IB 2.1 – International Economics and Trade by Boris Nissen Page 21 IB 2-1 o o Tasks 11 & 12 Week 3 there are gains to getting international agreements that internalize an externality in the sense of bringing it within the jurisdiction of cooperating governments in disputes about the use of some resource that produces a wide range of products for a wide range of countries, it is inefficient to try to tax or subsidize any one product or discriminate against any one country A Preview of Policy Prescriptions - - - general guidelines for solutions to international externalities ! see figure 12.3 page 233 often we cannot hit the exact target, the externality itself ! workable choices are policies toward some economic flow near the target – production, consumption, trade in products related to the externality if nations would cooperate, there would be no need for international trade policy – the recommended policies are one step away from taxing pollution itself; if one nation must act alone, trade barriers can be appropriate second-best solutions o taxing imports of products made by a polluting process o taxing exports of products that generate pollution when consumed why taxing consumption is better than taxing imports: if all consumption is taxed, domestic producers still must compete with importers for sales at the world price, if a tariff is imposed, that competition would fade and the nation would lose welfare as it used domestic factors inefficiently ! the net effect of an import tariff is not as positive as the effect of reducing pollution with the consumption tax trade taxes only look like a best policy when we are forced to act as a single nation and our nation experiences pollutions from foreign nations we trade with Applications - - - - - if international pollution is highly localized ! addressable with unilateral actions or with bilateral agreements if it originates in many countries and has global effects ! multilateral agreement CFCs and Ozone: as evidence suggested that CFCs depleted the ozone-layer, the Montral Protocol was signed and called for outright bans and other quantitative limits (not taxes as the social-cost curve is steeply rising) NAFTA: though critics tried to prevent creation due to environmental concerns, in the end it became a means by which the US could pressure Mexico to accelerate its environmental reform program Dolphins and Tuna: the US started to impose tariffs on tuna from Mexico as dolphin unsafe catching methods were largely employed there, but GATT rule against the US, specificity rule also suggests that a policy against total imports even of only dolphin-unsafe tuna does no good, an exercise tax or ban on US consumption of any dolphin-unsafe tuna or a global multilateral treaty would be a lot more useful Elephants and Ivory: the CITES (Convention on International trade in Endangered Species of Wild Fauna and Flora) calls for strict regulation of trade in products related to species threatened with extinction – the total ban on ivory trade translated into a total stop of all consumption as it is not produced in the consuming countries Brazilian Rain Forests: what kind of policy would maximize the outside conservationists’s chances of slowing the Brazilian deforestation? – direct control of the land, but the power of the Brazilian government stands in the way Greenhouse Gases and Energy Taxes: (1) the scientific facts are in doubt; (2) three palatable solutions will fall short of arresting the CO2 buildup; (3) international trade is not the cause or the cure ! either we do nothing, or we levy a tax on consumption or production of fossil fuels on a near-global scale IB 2.1 – International Economics and Trade by Boris Nissen Page 22 IB 2-1 Task 14 Week 4 Task 14: 1. 2. 3. 4. Look up the different balances? Draw a diagram showing the relationships between the various balances? What’s the structure of the balance of payments? What’s the relation between the single balances and the balance of payments? Chapter 15 – Payments Among Nations - many international transactions are trades in financial assets & nearly all international transactions involve the exchange of money for something else balance of payments = set of accounts recording all flows of value between a nation’s residents and the residents of the rest of the world during a period of time Two Sides to Any International Exchange - an exchange between a country and the rest of the world involves 2 flows of value: o credit (+) = flow for which the country is paid (e.g. export) o debit (-) = flow for which the country must pay (e.g. import) - main kinds of flows in the balance-of-payments accounts: o Merchandise trade flows (flows of goods) o Service flows (e.g. travel, transportation, insurance, fees, royalties, payments for the services of foreign capital) o Unilateral transfers (e.g. government foreign aid grants and private gifts and remittances) o Private capital (asset) flows (e.g. FDI, portfolio investments, changes in bank deposits…) o Official asset flows (refers to official moneylike assets, e.g. gold and foreign exchange assets) "# Official international reserves = moneylike assets that are generally recognized as official assets - Capital inflows are credits (+): They take the form of either an increase in a nation’s liabilities to foreign residents or a decrease in assets previously obtained from other countries. Each of these is a flow for which the nation must be given payment right now, so each is a credit entry. - Capital outflows are debits (-): They take the form of either an increase in a nation’s assets obtained from other countries or a decrease in its liabilities to other countries. Each of these is a flow for which the nation must give up payment right now, so each is a debit entry. ! as every transaction has 2 equal sides the total credits must always equal total debits Putting the accounts together - to highlight changes to wealth and reserves and currency markets, flow categories are summed into 5 special net balances, each defined so that a surplus is positive and a deficit is negative: o merchandise trade balance (or just trade balance)= net exports (merchandise exports – merchandise imports) o goods and services balance = net exports of both goods and services o current account balance = net flow of goods, services and gifts; it also equals the change in the nation’s foreign assets minus foreign liabilities (net foreign investment) "# if positive the nation earns that much in extra assets or reduced liabilities in dealings with other countries o capital account balance = net flows of financial assets and similar claims + statistical discrepancy (excluding official assets) "# the nation is a net private borrower (or capital importer) if the balance is in surplus "# values reported are for the principal amounts of assets traded, any flows of earnings on foreign assets are reported in the services account "# direct investments = any flow of lending to, or purchases of ownership in, a foreign enterprise that is largely owned by residents of the investing country "# statistical discrepancy: in theory the entire set of balances should balance, but there is a tendency to underreport merchandise imports, service exports and capital exports ! accountants add the discrepancy to make them balance and warn us that something was missed o overall balance (or official settlements balance) = current account balance + private capital account balance IB 2.1 – International Economics and Trade by Boris Nissen Page 23 IB 2-1 Task 14 Week 4 "# if it is in surplus, it is counterbalanced by an accumulation of official net assets, if in deficit, it is counterbalanced by an accumulation of official net liabilities "# the term official refers to monetary-type officials, not all government (other government assets are included in the private category ! purpose is to focus on the monetary task of regulating currency values "# official reserve assets: gold, foreign exchange assets, claims on the IMF, holdings of Special Drawings Rights (SDR) The Macro Meaning of the Current Account Balance - - - current account surplus = net foreign investment = national saving not invested at home = difference between national product and national expenditure (CA = X (exports) – M (imports) = If (foreign investment) = S (savings) – Id (domestic investment) = Y (national product) – E (national expenditure)) o as credits must equal all debits, then the surplus on goods, services and gifts must be the net accumulation of foreign assets minus foreign liabilities o net foreign investment = the amount by which all national income or product exceeds what the nation is spending for all purposes including domestic capital formation from the identities, we see what must be changed if the current account balance is to be changed: o improvement in CA must be accompanied by an increase in the value of national product (Y) relative to the value of national expenditure (E) o if national production cannot expand much, national spending must fall in order to decrease imports or to permit more local production to be exported when drawing the current account and the trade balance (as percentages of GDP) against each other, much of the gap can be explained by payment of interest and profits on past borrowings The Macro Meaning of the Overall Balance - the overall balance should indicate whether a country’s balance of payments has achieved an overall pattern that is sustainable over time – the official settlements balance measures the sum of the current account balance plus the private capital account balance ( B = CA + KA) - any imbalances in the official settlements balance must be financed through official reserve transactions (B + OR = 0) o if B is in surplus: equals an accumulation of the country’s official reserve assets or a decrease in foreign official reserve holdings of the country’s assets o if B is in deficit: equals a decrease in the country’s holdings of official reserve assets or an accumulation of foreign official reserve holdings of the country’s assets ! the changes in official reserve holdings show the macroeconomic meaning of the official settlements balance - most of the transactions by countries’ monetary authorities that result in changes in official reserve holdings are official intervention by these authorities in the foreign exchange markets The international investment position - - international investment position = statement of the stocks of a nation’s international assets and foreign liabilities at a point in time (completes the balance of payments account) ! any imbalance in the current account contributes to the change in the nation’s net foreign assets during a time period o a nation is a lender or borrower depending on whether its current account is in surplus or deficit during a time period ! refers to flows over time o a nation is a creditor or debtors depending on whether its net stock of foreign assets is positive or negative ! refers to stock or holdings at a point in time US has come full circle in its international investment position, form net debtor, to net creditor back to net debtor in the early 1980th IB 2.1 – International Economics and Trade by Boris Nissen Page 24 IB 2-1 Task 15, 16 Week 4 Chapter 16 – The foreign exchange market - the exchange rate is determined by competition – the forces of demand and supply – and the assumption of competitive conditions does even hold better than in most markets usually thought of as competitive The Basics of Currency Trading - - - foreign exchange = the act of trading different nations’ money (also refers to holdings of foreign currencies) exchange rate = price of one nation’s money in terms of another nation’s money o spot exchange rate = price for “immediate” exchange (usually in 2 working days, US$, Ca. $ and peso – 1 working day) o forward exchange rate = price for an exchange that will take place in the future (usually 30, 90 or 180 days) book refers to exchange rate as the price of the foreign currency (other is just the reciprocal) banks and traders make up the foreign exchange market that is active 24 hours a day (London, NY, Tokyo) o retail part of the market: trading done with customers – small amount with individuals, large part with nonfinacial companies, financial institution and others o interbank part of the market: trading done between the banks most of foreign exchange trading involves the exchange of US dollars (80-90%) vehicle currency = a currency used as a step in between changing two other currencies (e.g. dollar) Using the foreign exchange market - the retail part of the spot foreign exchange market provides clearing services – it permits payments to flow between individuals, businesses and other organizations that prefer to use different moneys SWIFT (Society for Worldwide Interbank Financial Telecommunications): used to transmit instructions from one member bank to another CHIPS (Clearing House International Payments System): clears dollar transfers between its member banks; payments are totaled at the end of each day and only the differences are settled up by actual flows of dollar funds among the banks Interbank foreign exchange trading - - 90% or more of foreign exchange trading is interbank trading either directly between banks or through brokers which has several functions o provides banks with a continuous stream of information on conditions o allows a bank to readjust its own position quickly and at low cost when it separately conducts a large trade with a customer o permits banks to take on positions in foreign currencies to speculate what is actually traded are demand deposits denominated in different currencies in amounts of $ 1m or more Demand and Supply for Foreign Exchange - - the interaction of demand and supply is the determinant of the equilibrium price and quantity – what forces lie behind the demand and supply curves? o exports of goods and services will create a supply of foreign currency (unless exporters are happy to hold the foreign currency or the importer has large reserves of the exporters currency) o imports of goods and services create a demand for foreign currency o capital outflows create a demand for foreign currency o capital inflows create a supply of foreign currency supply and demand determine the exchange rate, with constraints imposed by the nature of the foreign exchange system under which the country operates o floating exchange rate system = without intervention by governments or central banks, the spot price is market-driven "# demand curve slopes downward, as long as a lower exchange rate raises the quantity demanded (usually because business level then is higher) "# supply curve slopes upward "# the demand and supply curves shift due to a variety of changes in the economy (many demand-side forces relate to the balance-of-payments) and thus the equilibrium price changes IB 2.1 – International Economics and Trade by Boris Nissen Page 25 IB 2-1 Task 15, 16 Week 4 fixed exchange rate system = officials strive to keep the exchange rate virtually fixed (or pegged) even if the rate chosen differs form the equilibrium rate; usually a narrow “band” is defined and if the exchanger rate hits its boundaries, the officials must intervene "# buy their own currency to shorten supply and raise the equilibrium "# sell their own currency to expand supply and lower the equilibrium depreciation / appreciation = fall / raise in the market price in a floating exchange rate system devaluation / revaluation = fall / raise in the market price in a fixed exchange rate system o - Arbitrage within the Spot Exchange Market - arbitrage = process of buying and selling to make a riskless pure profit – ensures that rates in different locations are essentially the same and that rates and cross-rates are related and consistent among themselves triangular arbitrage = occurs when the profit cannot be made by exchanging the same two currencies in two locations, but where a third one and its cross rate come into play to permit for pure profits Chapter 17 – Forward Exchange Exchange Rate Risk Exposure - exchange rates change over time only partly predictably – even in a fixed exchange rate system when the government fails to support the currency, large changes can and sometimes do occur exchange rate risk = an entity is exposed to exchange rate risk if the value of it’s income, wealth or net worth changes when exchange rates change unpredictably in the future people respond to the risk in 2 ways: o risk averse: Hedging a position exposed to rate risk, here foreign-currency or exchange rate risk, is the act of reducing or eliminating a net asset or net liability position in the foreign currency. o gambling: Speculating is the act of taking a net asset position (long) or a net liability position (short) in some asset class, here foreign currency. The Market Basics of Forward Foreign Exchange - there are a number of ways to hedge an exposure to exchange rate risk or to take on additional exposure forward foreign exchange contract = agreement to exchange one currency for another on some date in the future at a price set now (the forward exchange rate) ! for larger transaction Hedging using forward foreign exchange - - hedging involves aquiring an asset in a foreign currency to offset a net liability position already held in the foreign currency or acquiring a liability in a foreign currency to offset a net asset position already held hedging means avoiding both kinds of “open” position in a foreign currency – both “long” positions (holding net assets in the foreign currency) and “short” positions (owing more of the foreign currency than one holds for many types of exposure a forward exchange contract is a direct way of hedging – the liability can be matched by the asset position through the forward contract creating a “perfect hedge” Speculating using forward foreign exchange - - speculating = committing oneself to an uncertain future value of one’s net worth in terms of home currency there are a number of ways to establish speculative foreign currency positions – one direct way is a forward foreign exchange contract (the speculator can even, if the bank believes in ability to honor contract, enter the contract without having the money on hand) speculators’ pressures on supply and demand should drive the forward exchange rate to equal the average expected value of the future spot exchange rate (e.g. increased supply of currency forward puts downward pressure on the forward exchange rate value) Futures, Options, Swaps - currency futures = contracts that are traded on organized exchanges, looking in the price at which you buy or sell a foreign currency at a set date in the future o differs from futures contract in: standard contract and thus tradable; putting up a margin is required; profits and losses accrue to you daily; anyone can enter into a futures contract IB 2.1 – International Economics and Trade by Boris Nissen Page 26 IB 2-1 - - Task 15, 16 Week 4 currency option = gives the buyer (or holder) of the option the right, but not the obligation, to buy (a call option) or to sell (a put option) foreign currency at some time in the future at a price (the exercise or strike price) set today currency swap = a set of spot and forward foreign exchanges packaged into one contract ! lower transaction costs + decrease in risk exposure size of “over the counter products” is much larger than the exchange-traded foreign-currency futures and options The Difference that Forward Cover Makes - decisions about international investments, including decisions about whether to hedge the exposure to exchange rate risk, are based upon the returns and risks of available investment alternatives o covered international investment: an investment hedged against exchange rate risk o uncovered international investment: unhedged investment ! speculative element Covering an International Financial Investment - a domestic investment and a covered international investment can be compared by the “lake diagram” ! see figure 17.1 on page 346 using: sport rate = rs; forward rate= rf and interest rate ius and iuk the choice of the more profitable of the 2 possible routes always depends on the comparison of 2 expressions o covered interest differential (in favor of covered international investment): CD = (1 + iuk)* rf / rs – (1+ ius) o shows a difference between 2 ways of getting form one currency to the same currency with the investor fully hedged or covered against exchange rate risk o forward premium/discount = proportionate difference between the current forward exchange rate value and the current spot value ! F = (rf – rs)/ rs o the CD formula can be simplified by an approximation to: CD = F + (iuk – ius) ! the differential is approximately equal to the difference between the overall coved return to investing in pounddenominated assets and the return to investing in dollar-denominated assets (or stated differently, how the forward premium on the pound compares with the difference between interest rates) Covered interest arbitrage - covered interest arbitrage = buying a country’s currency spot and selling it forward, while making a net profit off the combination of higher interest rates in that country and any forward premium on its currency ! is essentially riskless, though it ties up some assets Covered interest parity - covered interest parity = a currency is at a forward premium (discount) by as much as its interest rate is lower (higher) than the interest rate in the other country (CD = 0) o provides an explanation for differences between current spot and current forward exchange rates o links current forward and current spot exchange rate as well as both interest rates o current spot and current forward rates are highly positively correlated over time International Investment without Cover - - - uncovered international financial investment involves investing in a financial asset denominated in a foreign currency without hedging or veering the future proceeds of the investment into one’s own currency expected uncovered interest differential (in favor of uncovered international investment): EUD = (1 + iuk)* rfe / rs – (1+ ius) o same formula as for the covered investment, only that not the forward rate, but the expected future spot rate is used (rfe ) which brings in the risk o it can be approximated by EUD = Expected appreciation + (iuk – ius) investment without cover has 2 components – risk and return o for investors who add the exchange rate risk to their portfolio, the contribution might actually lower the overall risk of the portfolio uncovered interest parity = a currency is expected to appreciate (depreciate) by as much as its interest rate is lower (higher) than the interest rate in the other country o when it holds, the four rates - current spot rate, expected future spot rates and the interest rates in the 2 countries – are linked together IB 2.1 – International Economics and Trade by Boris Nissen Page 27 IB 2-1 Task 15, 16 Week 4 Does Interest Parity Really Hold? Empirical Evidence Evidence on covered interest parity - covered interest parity states that the forward premium should be approximately equal to the difference in interest rates - basic test is to examine financial assets offered by the same institution but differing in their currencies; a more stringent test involves closely comparable assets issued by different institutions in separate national financial markets ! covered interest parity is an important and empirically useful concept, it applies almost perfectly in the Eurocurrency market and it applies to a growing number of countries that have liberalized or eliminated their capital controls on international movements of moneys Evidence on uncovered interest parity - uncovered interest parity states that the expected rate of appreciation of the spot exchange rate value of a currency should approximately equal the difference in interest rates - one approach is to survey knowledgeable market particiapants about their exchange rate expectations ! often expect large uncovered interest differentials - second approach is to examine actual returns on uncovered international investments; if expected uncovered returns are typically at parity, then over a large number of investments the actual uncovered differentials should be random and on average approximately equal to zero o studies show that it applies roughly, but there also appear deviation of some importance (especially over certain periods) o studies show that the uncovered interest differential is often larger than the risk premium to compensate for this risk ! expectations are biased (if consistently biased, then the market is inefficient) ! uncovered interest parity is useful at least as a rough approximation empirically, but it also appears to apply imperfectly to actual rates Evidence on forward exchange rates and expected future spot exchange rates - if substantial speculation using the forward exchange market takes place, the forward rate should equal the average market expectation of the future spot exchange rate o same as testing uncovered interest parity – for currencies for which covered interest parity holds conclusions about the forward rate are the same as those about uncovered interest parity Eurocurrencies - eurocurrency deposit = a bank deposit that is not subject to the usual regulations imposed by the country of the currency in which the deposit is denominated (actually subject to very little or no government regulation at all, e.g. no reserves have to be kept for eurocurrency deposits enabling banks to pay higher interest/lend at lower interest) o problem might be that they are not part of the narrowly defined money supply and could thus foster inflation, but has not empirically been proven to be right IB 2.1 – International Economics and Trade by Boris Nissen Page 28 IB 2-1 Task 17, 18 Week 5 Task 17 1. 2. 3. 4. Explain the purchasing power parity hypothesis. Why does the PPP predict exchange rates in some situations better than in others? What’s the relationship between the domestic money supply and the exchange rate? What determines exchanger rates in the long run? Task18 1. 2. 3. What determines exchange rates in the short run? What is exchange rate overshooting and its cause? ! last paragraph from problem task? Chapter 18 – What Determines Exchange Rates in the Long Run? - first step in understanding exchange rates is supply and demand, the second is to find out what underlying forces cause supply and demand to change in foreign exchange we can observe long trends, medium-term trends (periods of several years) and substantial variability in the short term we can observe large changes in the values of floating exchange rates and need to know their sources as exchange rate movements set off many macroeconomic effects, of which some are negative 2 approaches to explain the long run trends: o purchasing power parity o monetary approach to exchange rates: emphasizes the importance of money supplies and demands as key to understand the determinants of exchange rates Purchasing Power Parity (PPP) - purchasing power parity hypothesis: international trade irons out differences in the prices of traded goods o o people can buy goods and services from one country or another and base their decision on the price; after a run long enough fro market equilibrium to be restored after major shocks, products that are substitutes for each other in international trade should have similar prices in all countries when measured in the same currency it links national currency prices to exchange rates: P = rs * Pf ! rs = P / Pf (rs = spot rate of foreign currency; P = price level of home country; P = price level in the foreign country denominated in its own currency) General evidence on PPP - PPP predicts well at the level of one heavily traded commodity o law of one price = a single commodity will have the same price everywhere, one the prices at different places are expressed in the same currency – holds only for highly traded, standardized commodities with low transportation costs (e.g. wheat) - PPP predicts only moderately well at the level of all traded goods, as technical difficulties of comparing index numbers - transport costs, official trade barriers, etc. hinder an equalization of prices - PPP predicts least well at the level of all products in the economy, the broadest kind of price level is the GDP price deflator which includes many prices that fail to equalize between countries o worst behave prices for nontraded products as housing and local services - at any level of aggregation ! PPP predicts better over the long run than in the short run ! for all its limitations, PPP theory has its uses: o implies that countries’ currencies with low inflation tend to appreciate; strict application implies that each percentage point more of domestic inflation per year tends to be related to a 1% faster rate of depreciation PPP: Recent experience - empirical evidence proves the PPP theory for the long run to be true, the relationship on the long run between the inflation differential and the rate of exchange is very close to the one-to-one relationship but it takes about 4 years on average for a deviation form PPP to be reduced by half Price Gaps and International Income Comparisons - United Nations International Comparisons Project (ICP): measures the price levels in different countries and thus providing a way to efficiently and realistically compare values of GDP per capita between countries – if the market exchange rate is used, the resulting data is unreliable because the exchange rate is often far from the P/Pf ratio IB 2.1 – International Economics and Trade by Boris Nissen Page 29 IB 2-1 o Task 17, 18 Week 5 Usual comparisons with exchange rates overstate the real income gaps between rich and poor nations Money, Price Levels and Inflation - economists believe that the money supply determines the price level (its growth the inflation rate) – thus national price levels and inflation rates are closely linked to exchange rates in the long run - the relationship between money and the national price level follows from the relationship between money supply and money demand ! the demand can be well proxied by the level of the GDP, the supply is assumed to be dictated by monetary policy alone - quantity theory equation: Ms = k * P * Y (money supply = proportional relationship between money holdings and GDP * price level * constant-price domestic products) ! combining the quantity equations for 2 countries leads to ! rs = P / Pf = (Ms/Msf) * (kf/k) * (Yf/Y) Money and PPP Combined - exchange rate can now be related to just the money supplies, the ks and the GDPs ! o a foreign nation has a rising currency if it has slower money supply growth, faster growth in real output and/or a rise in the ratio kf/k o a nation with fast money growth and a stagnant real economy is likely to have a depreciating currency o if the ratio (kf/k) stays the same: rs rises by 1% for each 1% rise in the domestic money supply (Ms), or each 1% drop in the foreign money supply (Msf) or each 1% drop in domestic real GDP (Y) or each 1% rise in the foreign real GDP (Yf) o an exchange rate will be unaffected by balanced growth The impact of money supplies on the exchange rate - a 10% cut in money supply makes it harder to borrow and consume, GDP would be temporarily lowered but in the long run prices should be 10% lower making the exchange rate rise by 10% (for the foreign country) a 10% increase eventually leads to 10% higher prices, making the exchange rate fall by 10% The effect of real incomes on an exchange rate - an income growth by 10% due to supply-side reasons results with assumed constant money supply in a decline of 10% in the price level and thus a 10% increase in exchange rate if the real income growth is due to aggregate-demand shifts, the increase might not strengthen the currency since the effects of aggregate demand shifts tend to dominate in the short run, while supply shifts dominate in the long run, the quantity theory yields the long-run result, the case in which higher production or income means a higher value of the same country’s currency Explaining Exchange rates in the long run - to forecast exchange rates, we need forecasts of the fundamentals themselves (M, Y, k or P), if we can develop good predictors, we have fair predictions for long-run movements in exchange rates Tracking the Exchange Rate Value of a Currency - nominal bilateral exchange rates = exchange rates quoted in the foreign exchange markets nominal effective exchange rate= weighted-average exchange rate value of a country’s currency real exchange rate (RER): shows the deviation form PPP of the actual exchange rates (0 indicates that the values are those of a base year) ! RER = ((Pf/Pf0)*(rs/rs0))/(P/P0) * 100 o real bilateral exchange rate – relative to one other specific country o real effective exchange rate –as a weighted average relative to a number of other countries Chapter 19 – What Determines Exchange Rates in the Short Run? - economists believe that exchange rates (in the short run) can be best understood in terms of the demands and supplies of assets denominated in different currencies ! asset market approach to exchange rates conclusions: the exchanger rate value of a foreign currency rs is raised in the short run by: o a rise in the foreign interest rate relative to our interest rate (if – i) o a rise in the expected future spot exchange rate IB 2.1 – International Economics and Trade by Boris Nissen Page 30 IB 2-1 - Task 17, 18 Week 5 but there is much that we don’t know! Asset Markets and International Financial Investment ! see figure 19.1 page 382 - - to understand exchange rates in the short run we have to focus on actions of international financial investors, as rather little of the foreign exchange trading is related to international trade in goods and services as financial assets denominated in different currencies shift around, the shifts place pressures on the exchange rates among the currencies ! see uncovered international investment uncovered interest parity links domestic interest rate, foreign interest rate and the current and expected future spot exchange rate ! if one changes, adjustments in at least one of the others have to occur The role of interest rates - what matters is the interest rate differential i – if, if the interest rate differential increases, the return differential shifts in favor for domestic-currency bonds and rs tends to decrease (the domestic currency appreciates), if it decreases, rs tends to increase (always given that res remains constant) The role of the expected future spot exchange rate - - - increases in the expected future spot rate alters the return differential in favor of foreign-currencydenominated bonds, increasing demand in the foreign currency and thus increasing the current spot rate (the foreign currency appreciates the repositioning because of an expected change in the future spot rate can actually then be the cause for the expected event what determines expectations: o bandwagon = expectations are based on the extrapolation of recent trend information "# can be destabilizing in that actions can move the exchange rate away for ma long-run equilibrium consistent with the fundamental economic influences (self-perpetuating) o based on the belief that exchange rates eventually return to values consistent with the PPP ! such expectations are considered stabilizing o based on various kinds of news, for example "# increasing demand for foreign currency as part of the process of paying for the excess of imports over imports tends to appreciate the foreign currency and depreciate the domestic currency a change of both interest rates and expected future spot exchange rate o if nominal interest rate changes due to expected higher inflation (real interest remains constant), then if investors base their expectations of the future spot rates on the PPP value, they will expect the currency to depreciate more, offsetting the effect of the higher nominal interest rate o if real interest rate rises, the future spot exchange rate expectations can rise/remain the same and the country’s currency appreciates quickly Exchange Rate Overshooting - exchange rate overshoot = it changes more than seems necessary in reaction to changes in government policies or to important economic or political news - the long-run predictions by the PPP and monetary approach and the view of exchange rates being determined in the short run by investors relate to each other in that in the short run the exchange rate actually overshoots its long-run value and then reverts back toward it o e.g. if domestic money supply is unexpectedly expended by 10%, at the initial spot exchange rate, the overall return differential favors foreign-currency assets for 2 reasons: "# domestic interest rate has decreased due to the sticky prices "# foreign currency is expected to appreciate by the 10% o the desire of investors to reposition results in a quick appreciation of the foreign currency that rises above the future expected spot rate (which is expected to be 10% higher) – so the foreign currency is expected to depreciate slowly back toward the new expected rate and uncovered interest parity is kept (after the current spot rate overshoots, the overall return on foreign investments becomes lower) o tests suggest 12.3% for a 10% expansion; even PPP theory suggests the overshooting ! extreme exchange rate movements can be part of an understandable process and it can be difficult to identify clearly cases of destabilizing speculation IB 2.1 – International Economics and Trade by Boris Nissen Page 31 IB 2-1 Task 17, 18 Week 5 How Well can we Predict Exchange Rates in the Short Run? - there is general agreement that economic structural models are of little use in predicting exchange rates in the short run (periods of up to 1 year) ! difficult because of 2 reasons o strong reactions are towards unexpected news, which cannot be incorporated into predictions (actually they react also to changes in probabilities) o exchange rate expectations can be formed without much reference to economic fundamentals "# speculative bubble = if a resulting movement in the exchange rate appears to be simply inconsistent with any form of economic fundamentals (expectations act self-confirming) ! there is some economic inefficiency in foreign exchange markets Hope for Forecasting? A Modified Monetary Model - question is how quickly the predictive power of the monetary approach asserts itself ! recognition of the fact that actual exchange rate is different from long-run equilibrium rate assumption that long-run equilibrium exchange rate = rs* = (Ms/Msf)*(Yf/Y) the sport rate at some time in the future is based on both the current and the long-run equilibrium value: rsp = rs * (rs */ rs)b the coefficient b shows the adjustment – how much of the deviation is predicted to be eliminated over the time period of prediction (b=1 all of the deviation is predicted to disappear) for longer forecasts (1 year or more) it seems to give better forecasts than using the current spot rate IB 2.1 – International Economics and Trade by Boris Nissen Page 32 IB 2-1 Task 19, 20 Week 5 Chapter 20 – Government Policies toward the foreign exchange market - governments often have different policies toward foreign exchange, among the objectives are reducing variability, encouraging exports, promoting imports and various non-economic goals 2 Aspects: Rate Flexibility and Restrictions on Use - policies directly applied to the exchange rate itself ! government tires to influence quantity policies directly state who may use the foreign exchange market and for what purpose ! directed at the price (the exchange rate) o exchange control = the country’s government places some restrictions on use of the foreign exchange market (most extreme form is that all foreign exchange proceeds have to be turned over to the country’s monetary authority) o capital controls = the extent to which the foreign exchange market can be used for financial activities is restricted Floating Exchange Rate - clean (or pure) float = government policy lets the market determine the exchange rate – market supply and demand are solely private managed float (optimistic view – pessimistic view: dirty float) = the exchange rate is generally floating but with the government willing to intervene (buying or selling foreign currency) to attempt to influence the market rate ! actual effectiveness is controversial Fixed Exchange Rate - - - fixed exchange rate: government sets the exchange rate it wants, often with the flexibility to float around the par (or central) value within a band what to fix to? ! the exchange rate can be fixed by a commodity standard, some other currency or be tied to a basket of other currencies of the major trading partners (advantage: extremes average out) o special drawing right (SDR) o European Currency Unit (ECU) When to change the fixed rate? ! governments may insist they never change the rate, but the credibility for such a commitment is not clear – the government has the capability to alter its policy o pegged exchange rate = used in place of fixed exchange rate in recognition that the government has some ability to move the peg o adjustable peg = only in the face of a substantial disequilibrium the government may change the pegged rate o crawling peg = exchange rate is changed often according to a set of indicators or the judgment of the government monetary authority (e.g. inflation, holdings of reserves, money supply, actual rate) o the choice of the width of the allowable band is closely related to the issue when to change the peg o polar cases of clean float and permanently fixed exchange rate are useful in order to contrast the implication of the choices, but in reality there is more of a continuum between the two How to defend a fixed exchange rate? ! when the pressure of private supply and demand drive the exchange rate to values not permissible within the band, government has 4 (5) non mutually exclusive ways to intervene: o Intervene in the foreign exchange market, buying or selling foreign currency o Impose exchange controls to constricting demand and supply o Alter domestic interest rates to influence short-term capital flows o Adjust the country’s macroeconomic position o Surrender and alter the fixed rate or switch to a floating exchange rate Defense through Official Intervention - a country’s first line of defense is usually official intervention in the foreign exchange market Defending against depreciation: IB 2.1 – International Economics and Trade by Boris Nissen Page 33 IB 2-1 - - - Task 19, 20 Week 5 private supply and demand are attempting to drive the exchange rate above the top of its allowable band ! usually the strong demand for the foreign currency is related to strong demand for foreign goods, services and financial assets which results in an official settlements balance deficits if the country intervenes and sells the foreign country’s currency and buys its own country can sell its own official international reserves (if it has a reserve position at the IMF it can request to obtain e.g. dollars; if it holds SDR, they act as a line of credit permitting the country to borrow e.g. dollars) or it can borrow the foreign currency (some countries maintain arrangements – swap lines) with each other to facilitate this type of borrowing) from official or private sources o reserve currency = when a country’s currency is readily held by the monetary authorities of other countries the country can effectively borrow through official channels by issuing assets that will be held as reserves by buying its own currency, the authority removes domestic currency from the market o sterilized intervention = authority buys its own currency but restores it back into the rest of the economy o if the country just reduces the supply, the change is likely to alter domestic interest rates and thus the entire macroeconomy of the country Defending against appreciation: - - if market forces are attempting to drive the exchange rate below the bottom of its allowable band (the country’s currency tends toward appreciation), the government has to intervene by buying foreign and selling domestic currency ! results in an official settlements balance surplus, allows foreigners to buy more form the country than they are selling to the country by selling its own currency the domestic money supply is expanded unless separate action is taken to remove it, if this is not the case, interest rates and the entire macroeconomy are likely to be affected Temporary disequilibrium - major issues for the use of an intervention is the length of time for which it must continue (how long the imbalance in the official settlements balance persists) when the imbalance is clearly temporary defending the fixed exchange rate can work and make sense, but some stringent conditions must be met: o private potential speculators are not able to see or cannot take advantage of the temporary imbalances (they would drive the exchange rate to the desired value) o officials must correctly predict the future demand and supply as well as what would be an equilibrium path for the exchange rate without their intervention Disequilibrium that is not temporary - if the disequilibrium is not temporary, the country trying to intervene is continually losing reserves if the imbalance in the official settlements balance is a deficit, or it is accumulating reserves if the imbalance is a surplus o deficit: the country runs lower and lower on reserves and eventually has to devaluate and it turns out that they have to buy back the reserves at a higher price o surplus: the country accumulates large international reserves which usually give it low return and by revaluating its own currency their value will decline ! fundamental disequilibrium calls for adjustment, not merely financing – another way to maintain the rate (or retreat) has to be added Exchange control - - - for defending a fixed exchange rate, exchange controls are socially inferior to the others (despite they are widely used) exchange controls are closely analogous to quantitative restrictions on imports (quotas) ! we can apply the same analysis that gives the result that they are at least as damaging as a uniform tax on all foreign transactions and probably are worse an analysis viewing demand and supply curves as marginal benefit and cost curves shows the welfare loss on society as a whole, but that actually underestimates the loss as: o in best case government would auction foreign currency, but in reality it is hardly ever done o administrative costs are significant o efforts to evade exchange controls are costly to society (second foreign exchange market) Why impose controls? o To reduce uncertainty ! but uncertainty rises if entities are in doubt whether they are allowed to obtain foreign exchange IB 2.1 – International Economics and Trade by Boris Nissen Page 34 IB 2-1 o Task 19, 20 Week 5 To achieve social goals trough government planning? ! increases personal power of officials International Currency Experience The gold standard era (1870-1914) - - - the gold standard has been widely accepted to have been a success, that emerged in 1870 with the help of historical accidents centering on Britain (which linked the pound to gold instead of silver) gold standard: each country’s government fixed its currency to a specified quantity of gold, individuals were freely permitted exchange domestic money or currency for gold and to export and import gold ! through arbitrage the exchange rates remained within a band reflection the transaction costs; changes in the gold holdings were linked to changes in the country’s money supply (thus price level, inflation, etc.) actually research found that the central banks offset (sterilized) external reserve flows in the majority of cases, the balance of payments was kept in line because Britain (and also Germany) had much command over short-term capital and their liquid IOUs were readily accepted (though they were not backed) the gold standard was successful, partly because it was not put to a test, partly because public opinion did not make the bankers responsible for unemployment, etc. in some cases countries gained some experience with flexible exchange rates; they abandoned fixed rates in a context of growing payments deficits and reserve outflows (leading to a sharp drop in the value of their national currency) Interwar instability - - in the interwar period, payment balances and exchange rates gyrated chaotically in response to 2 great shocks: WW1 and the Great Depression WW1 brought inflation and political instability to Europe, making the US the new financial leader o Britain restored the pound to gold standard value, but this caused unemployment, stagnation and a loss of international competitiveness o Italy, France and Germany experienced inflation devaluations, tariffs and other trade restrictions to boost domestic employment (beggar-thy-neighbor policy) were in the 1930th widespread and added to the worldwide depression conclusions were drawn that the interwar experience showed that instability of flexible exchange rates, but subsequent studies have proven that actually the interwar experience shows the futility of trying to keep exchange rates fixed in the face of severe shock and the necessity of turning to flexible rates to cushion some of the international shocks The Bretton Woods Era (1944-71, adjustable pegged rates) - - - in 1944 the world’s monetary leaders met in New Hempshire to design a new system, 2 expert economists envisioned a system with fully fixed exchange rates and a world central bank, but in the end they created the so called Bretton Woods System Bretton Woods System = central feature is an adjustable peg which calls for a fixed exchange rate and temporary financing out of international reserves until a country’s balance of payments is seen to be in “fundamental disequilibrium” o international reserves are augmented by the International Monetary Fund (IMF) the growth climate made the Bretton Woods System work successfully for 2 decades One-Way speculative gamble - - one-way speculative gamble = pegged, but adjustable exchange rates spurred speculators to attack currencies that were “in trouble” because the only thing that could happen was a one way change (depending on the situation) in a floating system, speculators face a 2-way gamble and thus are more cautious, but the one-way speculation is not necessarily destabilizing, as can speed up the process of adjustment (but overshooting!) The dollar crisis - - under the Bretton Woods Agreement, all other countries effectively pegged their currencies to the US dollar, that was backed with 35$/ouce in gold (gold-exchange standard), and in the late 60th, it became questionable whether the dollar was worth as much gold as the official gold price implied instead of a devaluation, in 1968 the US tried to change the system, creating 2 markets for gold, that for private use and that for government transactions, but this approach failed and in 1971 Nixon suspended convertibility of dollars into gold and imposing high import tariffs after effectively devaluation the dollar by IB 2.1 – International Economics and Trade by Boris Nissen Page 35 IB 2-1 Task 19, 20 Week 5 10% (other currencies were revaluated), in March 1973 most major currencies shifted to floating against the dollar The Current System: Limited Anarchy - - - - the international monetary system in place since 1973 is actually a nonsystem – countries can choose almost any exchange rate policy(ies) they want ! free floating, pegged to a single currency or a basket, a crawling peg or a managed float under a heavily managed float the monetary authority of the country changes its exchange rate target using its judgment and a range of indicators – under a crawling peg, the authority changes the pegged exchange rate more or less automatically ! in practice difficult to distinguish EMS (European Monetary System) = a cooperative arrangement to maintain pegged exchange rates amont the members and float as a block against outside currencies; worked well from 1979 to 1990th, after a predecessor “setting up a snake within a tunnel” had failed (see page 425) official desire for fixed exchange rates has remained strong, but they are hard to maintain and can be very costly – even partly managing an exchange rate is economists are debating whether the post-1971 experience shows the stability or instability of floating exchange rates o stability: mastered shocks (oil crisis) better than fixed rates could have o instability: float itself contributed to inflation and instability freeing national officials form price discipline imposed by fixed exchange rates Chapter 21 – How does the open macroeconomy work - addresses the problem of macroeconomic performance – the behavior of national output, jobs and prices in the face of changing world conditions The Performance of a National Economy - we judge a country’s macroeconomic performance against a number of broad objectives that can be divided into 2 categories o internal balance = consists of 2 objectives "# keeping actual national production up to the economies capabilities, so that full employment is achieved and production grows over time "# achieving price stability o external balance = achievement of a reasonable and sustainable makeup of a country’s balance of payments with the rest of the world ! specifying a precise goal is difficult (e.g. current + capital account = 0), but we focus on a sustainable position in the value of the current account balance that can readily be financed by international capital flows (surpluses or deficits should not bee too large) A Framework for Macroeconomic Analysis - for the analysis we need a picture of how the economy functions – but macroeconomists do not fully agree on the correct way ! we use a synthesis approach o short run (<=1 year): Keynesian approach ! prices are sticky thus the price level is not immediately responsive to aggregate supply and demand conditions o long run: more monetarist or classical approach ! price level does respond to demand and supply, inflation depends on growth rate of the money supply and the entire economy tends towards full employment National Production Depends on Aggregate Demand - an economies production potential is determined by supply-side capabilities (factor resources and intangible influences) we assume real GDP = real national income in the short run Y (national production) = AD (aggregate demand) = C (household consumption) + Id (domestic investment) + G (government spending) + (X – M) (net exports) IB 2.1 – International Economics and Trade by Boris Nissen Page 36 IB 2-1 - Task 19, 20 Week 5 national expenditures on goods and services: E = C + Id + G we summarize the major determinant of consumption as income (taxes have to be paid out of income before consumer spending is done): C = C(Y) ! other influences are seen as shocks to keep the model simple real domestic investment spending is negatively related to the level of interest rate (i) in the economy: Id = Id (i) ! other influences are seen as shocks to keep the model simple fiscal policy ! one major part of a government’s policy is government spending on goods and services which is a political decision Trade Depends on Income - - volume of a nation’s imports depends positively on the level of real national income or production ! 2 explanations o imports are used as inputs into production o imports respond to the total real spending in the economy marginal propensitiy to import (m) = estimated amount by which imports increase when the income goes up by one dollar volume of exports might also depend on income (income rises, exports decline), but analysis will assume them independent (nevertheless do they depend on the income in the foreign countries) Equilibrium GDP and Spending Multipliers - assumptions: all prices and pricelike variables (incl. Interest rate) are constant Equilibrium GDP - the condition is that real GDP must equal desired aggregate demand ! Y = AD (Y) = E(Y) + X – M(Y) matching aggregate demand with the national product, we get the equilibrium real GDP at the point of intersection of the aggregate demand line with the 45° line to show how the nation’s foreign trade and investment relate to the process of achieving an equilibrium, it is to notice that: S (national savings) = Id (domestic investment) + If (foreign investment) ! If = X–M = Y–E a current account deficit results in a negative net foreign investment The spending multiplier in a small, open economy - - - when national spending rises in an economy with production initially below its supply side potential, it sets of a multiplier process – whether or not the country is involved in int. trade affects the size of the multiplier the multiplier depends on (small country case) o marginal propensity to save (s) o marginal propensity to import (m) o who both represent leakages to the multiplication process spending multiplier (in a small, open economy) = 1 / (s + m) ! the final change in extra spending equals the initial rise in spending plus the extra demand for the nation’s product that was stimulated by the rise in income results of the multiplier can be reexpressed in a diagram plotting savings and investment over Y, the increased (government) spending being portrayed by a downward shift of the S - Id curve Foreign Income Repercussions - - regarding the marginal propensity to import as a leakage is not fully correct – the more our country’s imports affect foreign incomes, the more the true spending multiplier exceeds the simple formula 1/(s+m) as part of the import leakage returns in form of exports existence of such foreign-income repercussions helps account for the parallelism in business cycles that can be observed among major industrial economies the basic pattern that emerges from estimates is that the bigger the country is, the more does its spending affect other countries How aggregate demand and supply can affect the trade balance - raising our imports as a consequence of a rise in domestic aggregate demand worsens the trade balance and either the deficit increases or the exchange value of the currency has to drop but it is not true that whatever raises national income worsens the balance of trade: o if income is raised by increases in domestic spending ! probably worsens o if income is raised by an international demand shift from foreign to home-country goods and services ! clearly improves IB 2.1 – International Economics and Trade by Boris Nissen Page 37 IB 2-1 o Task 19, 20 Week 5 if income is raised by improvements in supply capabilities ! probably improve (extra ability to supply and compete wins more exports and substitutes imports) A more Complete Framework: Three Markets - - by focusing on the 3 markets, we gain further insight: o national product market o national money market o foreign exchange market first 2 directly determine Y (GDP) and i (the interest rate) – now assumed to be variable both have a major impact on the foreign exchange market all 3 markets can be affected by different kinds of exogenous forces – representing shocks or disturbances that create pressures for macroeconomic changes The national product market - - aggregate demand does not only depend on Y, but also on i ! again the equilibrium between income and production has to be kept ! or stated differently: S (positively linked to Y) = Id (negatively linked to i)+ If (negatively linked to i) IS curve (investment-saving) = shows all combination of national product or income levels and interest rates for which the national product market is in equilibrium o is sloping downwards and because of the spending multiplier, the increase in national product is larger than the increase in real domestic investment resulting directly form the lower interest rate) o changes in any influence other than interest rates that can directly affect aggregate demand causes a shift in the IS curve The money market - - - monetary policy = set of centralbank policies, institutions and bank behavioral patterns governing the availability of bank checking deposits and currency in circulation ! is the top influence on money supply the larger the national product during a time period, the greater the amount of money balances entities will want to keep on hand, but the opportunity costs of money (foregone interest) also affects the willingness to hold money the demand for (nominal) money is positively related to nominal GDP (P = price level) and negatively related to the level of interests available on other financial assets – again the equilibrium of supply and demand has to be kept: Ms = L(PY,i) LM curve (liquidity-money) = shows all combinations of income levels and interest rates for which the money market is in equilibrium, given the money supply, the price level P and the money demand function o slopes upwards o changes in any of the given factors represent exogenous forces that shift the entire LM curve For any given set of basic economic conditions (fiscal policy, business mood, consumer sentiment, foreign demand for the country’s exports, monetary policy…) the 2 markets, product and money, simultaneously determine the level of national product and the level of interest rate in the economy – the intersection of the IS and LM curves show the levels of Y and i that represent equilibrium in both markets. The foreign exchange market (or balance of payments) - - - the 3rd market is where the availability of foreign currency is balanced against the demand for it ! can be either called the foreign exchange market (exchange rate in mind) or the balance of payments (reflecting the nonofficial trading between our and foreign currency) B (official settlements balance) = CA (current account balance) + KA (capital account balance) o CA represents the trade flow effects and is negatively related to the national product (Y) o KA represents financial flow effects and is positively related to interest rates (i) – but only in the short run, in the long run this effect stops (portfolios have adjusted at some time; higher interest rates have to be paid back) the dependence of the balance of payments on income and interest rates can be reexpressed as: B = CA(Y) + KA(i) FE curve = shows the set of all interest-and-income combinations in our country that result in a zero value for the country’s official settlements balance for a given set of other basic economic conditions o slopes upward – the more sensitive capital flows are towards changes in the interest rate, the flatter the curve IB 2.1 – International Economics and Trade by Boris Nissen Page 38 IB 2-1 o o Task 19, 20 Week 5 perfect capital mobility = if capital flows are extremely sensitive to interest rates, the FE curve is essentially completely flat when exogenous forces change, the curve shifts 3 markets together - - by bringing the 3 markets together we get a determination of the level of Y, i and B ! with the economy gravitating towards a simultaneous equilibrium in the first 2 markets, we know the state of the balance of payments o B in surplus: IS-LM equilibrium is to the left of the FE curve o B in deficit: IS-LM equilibrium is to the right of the FE curve the way we use the framework depends on the type of exchange rate policy the country we analyze has adopted ! e.g. shows any divergence between IS-LM intersection and FE curve in a fixed rate environment the need of official intervention to defend the rate; in a clean float environment, all 3 curves have to intersect at one point The Price Level Does Change - - in the development of the framework, the price level (P) has assumed to be constant for the short run ! it can actually change due to 3 reasons: o ongoing inflation (can be anticipated and built into the expectations) o strong or weak aggregate demand can put pressure on the price level, if the price level is sluggish, the effect will not be felt in the immediate short run o shocks can occasionally cause large changes in the price level in the short run (e.g. oil crisis) for subsequent analysis the effect of strong and weak aggregate demand on the price level will be of major interest a change in price level also changes money demand – if increased demand is not met with increased supply, the LM curve will shift over time Trade Also Depends on Price Competitiveness - domestic demand for imports depends not only on our income, but also on the price of our products relative to imports ! M = M (Y, Pfr/P) – volume of imports tends to be higher if our income is higher, but lower if imports are relatively expensive - foreign demand for our exports depends not only on foreign income, but also on the price our products exported relative to the prices of their comparable local products ! X = X(Yf, Pfr/P) – volume of exports tends to be higher if foreign income is higher or if foreign substitute products are relatively expensive ! net exports tend to be higher if price competitiveness of our products is higher; the general indicator of international price competitiveness is the ratio (Pfr)/P (the real exchange rate) - changes in international price competitiveness can be incorporate into the IS-LM-FE framework, they are one of the other economic conditions that cause shifts in the curves, specifically the FE and the IS curve IB 2.1 – International Economics and Trade by Boris Nissen Page 39 IB 2-1 Task 21 Week 6 Chapter 22 – Internal and External balance with fixed exchange rates - still a substantial number of countries do fix their exchange rates and others intervene heavily – general discussions about returning to a system of fixed rates are also continuing ! we need to understand how a fixed exchange rate affects both the behavior of the country’s economy and the use of government policies to affect the economy’s performance From the balance of payments to the money supply - - - first line in defending a fixed exchange rate is official intervention ! holdings of official reserves change and the money supply may change central banking and money supply background: o money supply consists mainly of currency and various types of deposits o fractional reserve banking = banks have to hold a certain fraction of the deposits that he bank owes to its customers; by changing the percentage o with fractional reserve banking, the central bank has 2 ways to control the money supply: (1) control its own balance sheet (assets: bonds, debt securities; liabilities: currency and deposits at domestic banks); (2) setting reserve requirements o money multiplier process = with fractional reserve banking, each dollar of extra bank reserves can back up several dollars of deposits – multiple expansion of money supply official settlements surplus ! buy foreign currency ! increases official international reserve holdings (R) and liabilities in the form that domestic currency is added to the economy ! money supply can increase by a multiple of the intervention (money multiplier process) official settlements deficit ! sell foreign currency ! decrease in official international reserve holdings (R) and the liabilities as domestic currency is taken out of the economy ! money supply can shrink by a multiple of the intervention From the Money Supply Back to the Balance of Payments - - - implications of official interventions on balance of payments and macroeconomic performance in general surplus: by selling domestic currency, the money supply increases ! interest rates drop ! in short run capital flows out and real spending, production and income rise worsening current account balance (in the long run the price level increases deteriorating price competitiveness) ! overall payments balance worsens o worsens = results in a smaller surplus or a larger deficit o increasing the money supply sets of adjustments that tend to reduce its size ! can be pictured using an IS-LM-FE diagram with LM curve being to the left of the intersection (if price level does not change the point of full adjustment is the triple intersection) deficit: by buying domestic currency, money supply decreases ! interest rates drop ! in short run capital flows in and real spending, production and income are lowered (in long run price level decreases increasing price competitiveness ! overall payments balance improves o IS-LM intersection is initially to the right of the FE curve, LM curve shifts to the left (or up) 2 possible problems: o loss or accumulation of official foreign reserves may be seen as undesirable "# may be overcome by accepting that money supply has to change and instead affecting it by open market policies (e.g. buy back gov. bonds to increase money supply; sell gov. bonds to decrease money supply) ! "# open market policies can also be used complementary to achieve external balance more quickly o adjustment toward external balance may not be consistent with internal balance "# increase in money supply can lead to inflation; decrease to recession (with unemployment) Sterilization - - rather than allowing the automatic adjustment in money supply proceed, monetary authority may want to resist, if it perceives it would tend to create an internal imbalance or if the imbalance is believed to be only temporary sterilization = practice of taking an action to reverse the effect of official intervention on the domestic money supply – stabilizing the exchange rate, but no adjustment toward external balance occurs o surplus: selling national currency + open market policy (e.g. sell domestic government bonds) IB 2.1 – International Economics and Trade by Boris Nissen Page 40 IB 2-1 o o o Task 21 Week 6 deficit: buying national currency + open market policy (e.g. buying back dom. gov. bonds) the change in official reserve assets is thus equalized by a counterbalancing change in the holdings of domestic assets is a wait-and-see or wait-and-hope strategy (LM curve does not change!) that is limited by ability to buy/sell domestic currency and by complaints of other countries about the imbalance Monetary Policy with Fixed Exchange Rates - fixed exchange rates greatly constrain a country’s ability to pursue an independent monetary policy, as it must be consistent with maintaining the value of the fixed rate even if an official settlements balance of 0 is the starting point, if internal balance is perceived not to be established, the ability to change the money supply is limited, and eventually stops because of the feedback form the balance of payments and the need to defend the rate Fiscal Policy with Fixed Exchange Rates - fiscal policy = changing government spending and taxes expansionary fiscal policy ! budget deficits ! interest rates rise which attract capital inflows and capital account improves (in the short run) + real spending, production and income rise (in long run price level increases and current account balance worsens) o overall effect depends on the responsiveness (and timing) of international capital flows to interest rate changes o responsive capital flows: overall payments balance goes into surplus and official intervention (if effect is not postponed by sterilization) will increase domestic money supply and lower interest supporting a further expansion in national product o unresponsive capital flows: overall payments balance goes into deficit and official intervention will decrease domestic money supply and further rise interest rates and thus reversing some of the increase in real national product originating from the fiscal policy Perfect Capital Mobility - perfect capital mobility = a practically unlimited amount of international capital flows in response to the slightest change in one country’s interest rates (good basis to analyze countries whose capital markets are open and whose political and economic situation is stable) - this extreme case alters the effectiveness of monetary and fiscal policies under fixed rates - in small country thus interest rate = interest rate in the larger global capital market - if perfect capital mobility exists, the country’s money supply is dictated by the international capital flows and sterilization is nearly impossible ! LM and FE curves are horizontal lines at the global market interest rate, the balance of payments rules the money supply o monetary policy is ineffective as it cannot influence the interest rate or the money supply o fiscal policy’s control is enhanced in the short run as it does not raise interest and thus does not crowd out investment, but it may be a poor substitute (determined by political process) ! monetary policy is subordinated to the defense of the fixed exchange rate and fiscal policy can be powerful Shocks to the Economy - we analyze shocks to an economy with a fixed exchange rate – assuming it has first achieved external balance before the shock Internal shocks - - domestic monetary shock = alters the equilibrium relationship between money supply and money demand (either money supply changes or demand changes) ! causes a shift in the LM curve, but the shift tends as seen to reverse itself as the central bank intervenes ! major effect is on the official reserve assets domestic spending shock = alters domestic real expenditure through an exogenous force that alters one of its components ! discussion of fiscal policy provides an example of the analysis of this type of shock Internal capital-flow shocks (external shock) - international capital-flow shock = unpredictable shifting of internationally mobile funds in response to such events as rumors about political changes or new restrictions on international asset holdings government is expected to devaluate its currency (assumption of external balance) ! capital flight and overall balance shifts into deficit as the FE curve shifts left ! downward pressure on the exchange rate IB 2.1 – International Economics and Trade by Boris Nissen Page 41 IB 2-1 Task 21 Week 6 make intervention necessary (buying domestic currency) ! money supply shrinks as does national product, interest rates rise (sterilization can be used imbalance is perceived to be temporary) International trade shocks (external shock) - international trade shock = shift in a country’s exports or imports that arise form causes other than changes in real income of the country (variability is largest for countries specializing on commodity exports) a shift of int. trade away from a country’s products causes the FE and IS curves to shift to the left, payments balances goes into deficit and the necessary intervention even makes national product to decline more international trade shocks can have a powerful effect on the country’s internal balance and the intervention tends to magnify the effect of the shock on domestic production Imbalances and Policy Responses - achieving internal and external balance is the actual goal, but in many situations countries have imbalances in both as results of shocks or poor previous government policies Internal and external imbalances - - high unemployment + surplus ! expansionary policy rapid inflation + deficit ! contractionary policy o both rules nevertheless might be tricky because balance in one dimension might be achieved whil part of the imbalance in the other remains other cases (high unemployment + deficit; rapid inflation + surplus) are not so clear cut, high unemployment + deficit country faces a dilemma as fighting unemployment with expansionary policy results in worsening the trade balance rapid inflation + surplus country faces dilemma as restraining aggregate demand improves current account 3 basic choices for countries facing either dilemma o abandon goal of external balance ! abandon fixed exchange rate o abandon goal of internal balance (at least in short run) o find more policy tools or more creative ways to use the available tools (e.g. for first dilemma: enhance supply capabilities, but difficult) A short run solution: monetary-fiscal mix - monetary and fiscal policies have different relative impacts on internal and external balance ! difference can be the basis for a creative solution buying time by serving both internal and external goals while staying on fixed exchange rates o monetary and fiscal policies can be mixed so as to achieve any combination of national product and overall payments balance in the short run o assignment rule (Robert Mundell) = assign to fiscal policy the task of stabilizing the domestic economy only and assign to monetary policy the task of stabilizing the balance of payments only (there are some exceptions, but following the rule does nothing worse than make the economy follow a less direct route) ! see table on page 486 "# is very handy as it reduces need for perfect communication between fiscal and monetary officials (might or might not work in practice; e.g. due to capital flows, monetary policy largely run to accommodate fiscal policy, etc. "# the mix also influences the composition of domestic spending and level of foreign debt Surrender: Changing the Exchange Rate - - - if a country’s overall balance of payments is in fundamental disequilibrium, it may be unwilling to change domestic policies by enough to eliminate the imbalance and chooses to surrender the fixed exchange rate, in the hope that the exchange rate change can adjust the external imbalance without excessive disruption to the domestic economy nevertheless do exchange rate changes affect aggregate demand, national production, unemployment and inflation whose effects sometimes need to be offset by other policy changes, but in some situations (especially the 2 dilemmas described earlier they can be very helpful) devaluation ! improves international price competitiveness ! current account tends to improve, effect on capital account is not clear cut, but overall payments balance should improve ! changes increase aggregate demand (increase in exports, reduction in imports) ! upward pressure on price level, but unlikely if high unemployment persisted ! a strategy to attack high unemployment + deficit IB 2.1 – International Economics and Trade by Boris Nissen Page 42 IB 2-1 Task 21 Week 6 fails if: low responsiveness of export and imports exists; capital flees resulting in capital account deficits o key is how other government policies are used with the devaluation, if investors perceive that the policies will limit price level increases, they are less likely to fear another devaluation revaluation ! can lower surplus while reducing inflation pressure by decreasing demand and lowering local-currency prices of imports o - How Well Does the Trade Balance Respond to Changes in the Exchange Rate? - a change in the nominal exchange rate (r) should alter net exports as long as it alters international price competitiveness, but the effect on the current account is not so clear, as also prices change CA = Px (in foreign currency) * X – Pm (in foreign currency) * M o Devaluation: Px ↓ or → ; X ↑ or → ; Pm ↓ or →; M ↓ or → "# Net effect of export side is unclear, net effect of import side is likely to be negative ! outcome is not clear as long as we don’t know more about underlying price elasticities How the response could be unstable - in the case of perfectly inelastic demand curves for exports and imports – the trade balance worsens and the devaluation backfires completely as quantities do not change, looking at prices denominated in the foreign currency, you loose because your exports earn less in terms of the foreign exchange; looking at prices denominated in home currency, you loose because the import’s price in the home currency rises Why the response is probably stable - - - a drop in value of the home currency improves the current account balance especially in the long run, as export and import elasticities are sufficiently high in reality ! if they were not the case a country could revaluate its currency and by that cut its trade deficit and at the same time buy imports more cheaply small country case: with infinite elasticity, the prices in terms of the foreign currency stay the same and, in case of a devaluation, exports go up and imports down, thus both sides work to move the current account in the same direction devaluation is more likely to improve the trade balance the longer the span of elapsed time, as the adaptions in quantities need time J curve = schematic diagram of what economists think is a typical response of the current account balance to a drop in the home currency ! value of the current account at first deteriorates to return where it started after about 18 month and then moves above its initial value ! it takes some time for a large decrease in the exchange rate value to have a positive impact on the current account IMF - IMF gives loans to member countries, to give them time to correct payment imbalances Conditionally = when lending money, the IMF requires a borrowing country to commit to and enact changes in its policies to correct the payments imbalance with quantified performance criteria stated in the agreement – the policies should promise to achieve external balance within a reasonable time IB 2.1 – International Economics and Trade by Boris Nissen Page 43 IB 2-1 Task 22 & 23 Week 6 Chapter 23 – Floating Exchange Rates and Internal Balance - - when letting the exchange rate float freely, it automatically adjusts to achieve external balance, but still leaves the problem of achieving internal balance and affects the behavior of the economy and the effectiveness of monetary and fiscal policies directed at achieving that balance analysis of how a country with floating exchange rate responds to a policy change or any type of economic shock follows 3 steps: o effects at the initial value of the exchange rates (does it push the official settlements balance away from zero) o what change is needed to move back to a zero balance o what are the additional effects on the country’s macroeconomy of this change in exchange rate Monetary Policy with Floating Exchange Rates - - expansion of money supply ! interest rate drops ! real spending, production & income rise (worsen current account) + capital flows out + (long run: price level increases) ! currency depreciatons ! current account balance improves as depreciation increases ex- and decreases imports ! allows real product and income to rise more however can depreciation also enhance the effects of monetary policy on the price level and inflation rate as well with floating exchange rates, monetary policy is powerful in its effects on internal balance ! induced change in the exchange rate reinforces the standard domestic effects o general conclusion holds whatever the degree of capital mobility, the degree of expanding money supply causes a depreciation, and this further expanding aggregate demand o perfect capital mobility ! uncovered interest parity holds and any monetary expansion reducing the domestic interest rate immediately leads to an overshooting of depreciation as capital flows out; this overshooting largely improves price competitiveness in the short and medium runs o effects can be analyzed by the IS-LM-FE diagram: the LM curve shifts from the triple intersection with increased money supply to the right, the balance of payments deficit and the following depreciation shift the FE and the IS curve also right ! real GDP increase (but in the long run purchasing power parity holds and the increase in real GDP is exactly offset) Fiscal Policy with Floating Exchange Rates - fiscal policy can affect exchange rates in either direction increased government spending/lower taxation ! interest rates rise and capital flows in (forces for appreciation) + real spending, production and income rise thus worsens current account (forces for depreciation) ! currency may appreciate first (due to the high capital mobility), but eventually it probably depreciates ! first expansionary effects are reduced (international crowding out), but then there is a tradebased stimulus to domestic production (but if capital flows are unresponsive the expansionary effect is not reduced at all) o effects can be analyzed by the IS-LM-FE diagram for both cases: first the IS curve is shifted right then in case of responsive capital flows, the overall settlements balance goes into surplus and FE and IS curves shift left; in case of unresponsive capital flows the currency does not appreciate as there is a deficit and FE as well as IS curve shift right Shocks to the Economy Internal shocks - - affect relationship between money supply and money demand ! if monetary shock tends to expand the economy, the currency tends to depreciate further increasing national product (or put upward pressure on prices); if it tends to contract the economy, the currency tends to appreciate, decreasing national product example: change in fiscal policy – effect depends on what is changed more: capital flows or current account International capital-flow shocks - occur because of changes in investors’ perceptions of economic and political conditions if shift leads to capital outflow ! downward pressure on exchange rate (as FE curve shifts left) ! depreciation increases price competitiveness (FE curve and IS curve is shifted to the right) IB 2.1 – International Economics and Trade by Boris Nissen Page 44 IB 2-1 - Task 22 & 23 Week 6 under floating exchange rates external capital-flow shocks can have effects on internal balance, but it is risky to conclude that an adverse capital-flow shock is simply good for the country (reason is important and it may disrupt the national financial market) International trade shocks - - cause value of the country’s current account balance to change (e.g. decline in demand for exports, increase in taste for imports, decline in supply for important import) adverse international trade shock ! current account and national product and income worsen (FE and IS curves shift to the left ! depreciation leading to an improvement in current account and thus a rise in national product and income (FE and IS curves shift right) o if nothing else changes (such as international capital flow or price level), then the curves shift back to their original positions with floating exchange rates, effects of international trade shocks on internal balance are mitigated by the effects of the resulting change in the exchange rate Internal Imbalance and Policy Responses - - shocks to the economy alter both international performance and domestic performance – with floating exchange rates a change in the exchange rate takes care of achieving external balance following a shock, but thus affects the internal balance o depreciation: tends to expand country’s economy, welcome in times of recession, but if inflationary pressures are already there it will add to the internal imbalance o appreciation: tends to contract country’s economy, welcome in times of boom, but adds to imbalance in times of recession government monetary or fiscal policy can be used to address any internal imbalances that do arise- size of the change in policy needed to address the imbalance depends on the change in the exchange rate that will occur ! monetary is powerful, effects of fiscal policy are more difficult to predict International Macroeconomic Policy Coordination - - policies adopted by one country have effects on other countries – with floating exchange rates these spillover effects happen in several way including foreign income repercussions as changes in incomes alter demands for imports and changes in international price competitiveness as floating exchanges rates change o danger is that a policy change can harm another country (beggar-thy-neighbor) international macroeconomic policy coordination = joint determination of several countries’ macroeconomic policies to improve joint performance (needs willingness to alter policies to benefit others) o actually this cannot be observed often due to 2 reasons: (1) goals of different countries may not be mutually consistent; (2) benefits of international policy coordination may actually be small in many situations (governments would have followed the policy either way) o major instances of international macroeconomic policy coordination occur infrequently (coordination is more likely if all clearly see and agree to goals and means to achieve them, but then they would either way do it) Sterilized Intervention - sterilized intervention might be effective, in that it acts as a signal influencing expectations Chapter 24 – National and global choices – floating rates and the alternatives - each country must choose a policy towards its exchange rate – the composite of all countries’ choices makes up the global exchange rate system Key issues in the choice of exchange rate policy - we examine the extent of flexibility that is permitted by the various policies, with the extremes being a clean float and a permanently fixed exchange rate analyze the advantages and disadvantages looking separately at the 5 major issues that can influence that can influence the country’s choice: IB 2.1 – International Economics and Trade by Boris Nissen Page 45 IB 2-1 Task 22 & 23 Week 6 Effects of macroeconomic shocks - - a country would favor a policy that reduces the domestic effects of a macroeconomic shock ! effects depend not only on the policy adapted, but also on the type of shock o internal shocks – generally cause less trouble with a fixed rate "# domestic monetary shock: intervention in a fixed exchange rate system tends to reverse the shock, a floating exchange rate would magnify the domestic effect "# domestic spending shock: effects depend on how responsive international flows of financial capital are to interest rates – if capital is not responsive fixed rates are less disruptive, if it is highly responsible the reverse is true o external shocks – generally cause less trouble with a floating rate "# foreign trade shock: in case of a decrease in export demand (increase in import demand in home country), floating rates adjust to improve price competitiveness; fixed rates would reinforce shock !#major way in which business cycles are transmitted – with fixed rates, the business cycles are transmitted through foreign trade and foreign repercussions and the intervention to defend the rate can magnify the transmission; floating rates on the other hand mute transmissions if a country believes that most shocks are external ! floating; if it believes that most are internal ! fixed practical importance is debatable, as discussion e.g. disregards option of sterilized intervention The effectiveness of government policies - - monetary policy: under a fixed exchange rate monetary policy is constrained by the need to defend the fixed exchange rate, wile under a floating exchange rate the resulting changes in the exchange rate reinforce the thrust of the policy change fiscal policy: effectiveness depends on responsiveness of int. capital flows to interest rate changes – if highly mobile, fixed exchange rates are more favorable, as they keep interest rates more stable o if country’s financial market is closely linked to the rest of the world, wanting fiscal policy to be effective in the short run, will want to adopt a fixed exchange rate Differences in macroeconomic goals, priorities and policies - the goals and objectives of macroeconomic policy diverge, especially in priorities, between countries (real economic growth, unemployment, inflation, external balance fixed exchange rates: there needs to be a kind of consistency or coordination between the countries; if policies diverge noticeably, large payments imbalances arise and make the defense of the fixed rate difficult floating exchange rates: tolerant to the diversity in country’s goals, priorities and policies – as long as the country is willing to permit the exchange rate according to market pressure ! policy coordination is possible but not necessary, making the country more independent Controlling inflation - - fixed rate: countries commit to have similar inflation rates over the long run (purchasing power parity) – the nominal exchange rate can be steady only if the difference in inflation rates is zero o fixed rates can create a discipline effect on national tendencies to run high inflation rates o price discipline: fixed-rate system in which most countries participate may also impose discipline to lower the average global rate of price inflation – deficit countries are put under pressure to contract their money supply (may use sterilization in the short run), while surplus countries also have to counteract, but will have enough to use sterilized intervention ! average inflation rate way be somewhat lower then the average each country would have chosen on its own o with fixed rates, a country that prefers to have a lower inflation rate than that of others, especially the lead country in the system, will have difficulty maintaining its low inflation rate floating rate: permit countries to have different inflation rates o proponents ! see it as virtue; there are different beliefs what an acceptable inflation rate is o opponents ! see danger of higher average inflation rate and entanglement in a vicious circle (high inflation ! currency depreciation ! increase in import prices ! inflation) o experience of the 1980th has shown that what really matters in national inflation rates is the discipline and resolve of the national monetary authorities Real effects of exchange rate variability - major concern about flexible exchange rates is their variability, if it leads to discouragement of international activities as trade in goods and services or foreign direct investment IB 2.1 – International Economics and Trade by Boris Nissen Page 46 IB 2-1 Task 22 & 23 Week 6 simple short-run variability has little direct impact, as foreign exchange contracts hedge the risk at low cost o beyond the short run, it can affect real investments that must be made to support export-oriented production (more difficult and expensive to hedge) o studies: rather small effects have been found overshooting ! concern is with the possibility that the dynamics of floating exchange rates sometimes send false price signals or signals that are too strong, resulting in excessive resource reallocations proponents: agree that variability is high, but see that variability as necessary signal of the relative values and represent the ongoing market-based quest for economic efficiency (fixed rates are a form of price control and as such inefficient – sudden changes, one-way speculative gamble…) opponents: believe variability is excessive and is largely affected by speculative bandwagons and bubbles that do not reflect economic fundamentals and also discourage international trade and encourage excessive resource shifts (exchange rate should make transactions between countries as smooth as possible) o - - National Choices - - we can conclude that there are several factors that are likely to be of major importance for most countries: o floating: exchange rates adjust to achieve external balance; monetary policy can be directed to achieve internal balance; permits countries to pursue own goals, priorities and policies; does not need to defend against speculative attacks o fixed: variability is reduced most countries have adopted a floating exchange rate, but not a clean float, but rather use some form of management of the float ! reasonable compromise The European Monetary System - ERM (Exchange Rate Mechanism) = system of fixed exchange rates under the EMS – established in 1979 with bandwidths of 2.25% as an adjustable-peg system o from 1979 to 87, 11 alignments had to be made, then till 1992 the system was stable but then several attacks lead to devaluations and a widening of the band to 15% o generally, all points form the theoretical discussion can be seen: exchange rates have been generally steadier, occasional realignments disturbed the stability, differences between goals (Germany versus others) have led to strains in the systems, monetary policy could not be used, inflation level had to be adjusted to that of the lead country (Germany European Monetary Union – A permanent fix? - - Maastricht treaty = effective since Nov. 1993 – set up process to establish a monetary union and a single unionwide currency monetary union = exchange rates are permanently fixed and a single monetary authority conducts a single unionwide monetary policy European Monetary Union (EMU) = to participate the member countries must fulfill the 5 stability criteria (1.5 inflation difference to 3 best; successful participation in ERM with 2.25%, long term interest rate on government bonds not higher than 2% above those of the best 3 on inflation; government budget deficit <= 3%, gross government debt <= 60%) EMI (European Monetary Institute) was founded in 1994 as a predecessor of the future European Central Bank, whose responsibility conducting the unionwide monetary policy is to achieve price stability gains are based on elimination of all exchange rate concerns (including ending one-way speculation and transaction costs), but the individual countries give up their ability to run independent monetary policies – fiscal policy might not be as effective, as it is limited by the budget constraints and can only be changed with lags created by the political process Chapter 26 – International Lending and the World Debt Crisis - international capital flows usually are flows of financial claims, flows between lenders and borrowers, or flows between owners and the enterprises they own o private lending (or ownership purchases) "# long-term (bonds, stocks, use of patents or copyrights) !#direct investment (lending to, or purchasing ! controlling interest) !#portfolio investment (lending to, or purchasing ! non-controlling interest) IB 2.1 – International Economics and Trade by Boris Nissen Page 47 IB 2-1 Task 22 & 23 Week 6 "# short-term (bills of credit, etc., maturing in a year or less – mostly portfolio investments) governmental lending (or ownership purchases – mostly portfolio, mostly lending, both long and short-term) concentrate on portfolio investments, especially on private lending until 1985, largest lender was US + newly rich oil exporters, but since Japan has become largest lender and US largest net borrower type of lending has changed back to private loans to both government and private borrowers, away from the loans from governments and the direct investments in investor-controlled firms rush of lending to 3rd World ended abruptly in 1982 in a crisis of confidence ! to spot what is wrong, we begin with a view how it should work o - Gains and Losses form Well-Behaved International Lending - - assumption: world is stable and predictable, borrowers fully honor their commitment to repay welfare effects of international lending are exactly parallel to the welfare effects of opening trade o drawing the marginal-product-of capital curves of 2 countries in a diagram (horizontal axis: invested capital and its ownership or wealth/net worth; vertical axis: percentage rates of return) o with international lending, the interest rate in the individual markets is influenced and the world gets a net gain from the new freedom, both the lender and the borrower gain o international freedom benefits the world as a whole and the groups for whom the freedom means opportunity, while it harms the groups for whom the freedom means tougher competition freedom raises world and national products! Taxes on International lending - if a country has power over the international market rate of return, it can exploit it to its own advantage ! nationally optimal tax on foreign lending o as with nationally optimum tariff, country has to see that the triangle it looses from some previously profitable lending activities is smaller than the rectangle it gains in the form of taxes o tax can be either levied by borrower or lender – if both would employ taxes, they are likely to go back to the points of no free capital flows and loose o but analysis does not regard that taxes can be evaded, most commonly device is transfer pricing (lenders and borrowers often trade goods and services at the same time they are agreeing on loans – use off-market price to disguise loan) which brings the international economy back toward efficient market position The world debt crisis: How bad is it? - - at the end of the 1980th the lenders faced the problems of not/late repaying debtors ! reduced lending; the debtors on the other hand, who had borrowed at high interest rates in the 70th (quite high inflation) were hit by the movement to lower inflation rates is the lending crisis an accident of history, or are there more basic defects in int. lending that lead to such crises The surge in int. lending 1974-82 - between the first oil crisis (1973/74) and the climax of the world debt crisis 1982, there was a surge in private international lending to developing countries explanations why the lending surge turned to developing countries: o surge in private bank reserves: newly rich oil exporters lend high amounts in liquid from to US banks and other – increasing reserves to back aggressive lending o investment uncertainty in industrial countries: widespread pessimism about profitability o resistance to direct foreign investment in the 1970th o herd instinct among investors: banks were aggressively sought lending opportunities Over the Cliff in 1982 - in 1982 the supply of international lending capital dropped of and dozens of debtor countries defaulted ! 2 short-run factors: o world depression of 1982: word output and employment were stagnating and inflation cooled down, lifting the interest burden o investor stampede: herding behavior – investors tired to get out, making use of free-riding, leaving it to others to hold the collective arrangements together IB 2.1 – International Economics and Trade by Boris Nissen Page 48 IB 2-1 Task 22 & 23 Week 6 doubtful relevance of oil prices: second oil price shock (1979/80) should have helped at least some countries, but did not forces listed can only explain the timing; basic fact is, that repayment crises are a chronic problem o - The Basic Problem of Sovereign Default - international lending is plagued by defective property rights o borrowers are often sovereign, legally independent – they cannot be legally forced to repay (especially when borrowers are governments themselves) ! have incentive to default on borrowing o helps explain: insistence on higher interest rates, swings in volume of lending o is costly for borrowers too – even if they fully intends to repay, they lack a credible way to convince creditors of that and have to pay the high interest rates When would a sovereign debtor repay? - - how can the property rights problem of sovereign debt be solved wrong answer ! o debtors will repay on time to protect their own future creditworthiness o flawed, as it implies that the debtors will need the extra loans to continue to repay old ones, which can be summarized as steady growth: "# Inflow (>0) = Fresh borrowing – Interest payments (Fresh > Interest) "# Means essentially: growth of accumulated stock of debt > interest o (1) lending to infinity only works because it assumes that an infinite debt is repudiated in the end; (2) creditor countries should have 2nd thought about lending to someone who can only be kept from defaulting by letting loans grow forever correct answer ! o make sure sovereign debtors borrow only up to their collateral (the value of the assets that the creditors could seize if the debtor fell behind on payments) o collateral works well in domestic lending, but is limited in international lending as the hostage assets are being held in the creditor country, but usually not by the creditors themselves o what determines the limits of prudent lending and of borrowers’ incentive to repay? "# Draw in a diagram with horizontal axis stock of debt and vertical axis benefits and costs of not repaying this period !#benefits of not repaying (if principal is paid at end: straight line (1+i)*D) !#debtor’s cost of not repaying (curved line with a fixed cost to making any mention of non-repayment, rises not as fast as the stock of debt itself) "# Intersection between the 2 curves (Dlimit)! to the right, the willingness to repay faithfully disappears (ordinary lending within a country usually operates in the prudent range to the left) "# Dlimit can change due to rotation of the benefit curve, change in costs of not repaying so the level of debt is not within the limit and the debtor has an incentive to default, but also might lending occur beyond the limit o Lending should never be beyond Dlimit, and in the case of an announcement of default, no further lending should occur, as the default indicates that the level of debt is beyond Dlimit already Who Has Repaid Their External Debts? - - in each case we find that the debtor countries that repaid, did it because they had assets the creditor countries could seize in retaliation for default 3rd World debtors actually did, except Mexico, Venezuela and Equador, not repay much of their debts, although due to paper reschedulings, it might look like it North America did repay all (private and most government) loans from before WW1, especially because after WW2 they were in a creditor situation and feared retaliation on their credits + Americans hold many assets abroad East Asia has also a record of relatively faithful repayment of debts, again collateral model seems to apply (heavily dependent on trade) IB 2.1 – International Economics and Trade by Boris Nissen Page 49
