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International Economics By Robert J. Carbaugh 9th Edition Ch 1 The International Economy Ch 10 International Factor Movements and Multinational Enterprises Ch 2 Foundations of Modern Trade Theory Ch 11 The Balance of Payments Ch 3 International Equilibrium Ch 12 Foreign Exchange Ch 4 Trade Model Extensions and Applications Ch 13 Exchange-Rate Determination Ch 5 Tariffs Ch 14 Balance-of-Payments Adjustments Under Fixed Exchange Rates Ch 6 Nontariff Trade Barriers Ch 15 Exchange-Rate Adjustments and the Balance of Payments Ch 7 Trade Regulations and Industrial Policies Ch 16 Exchange-Rate Systems Ch 8 Trade Policies for the Developing Nations Ch 17 Macroeconomic Policy in an Open Economy Ch 9 Regional Trading Arrangements Ch18 International Banking: Reserves, Debt and Risk International Economics By Robert J. Carbaugh 9th Edition Chapter 1: The International Economy Economic interdependence Elements of interdependence Trade: goods, services, raw materials, energy Finance: foreign debt, foreign investment, exchange rates Business: multinational corporations, global production 4 Economic interdependence Forces driving globalization Technological change: Production Communication & information Transport Liberalization of trade & investment: Tariff, non-tariff barrier reductions Liberalized financial transactions International financial markets 5 Economic interdependence Waves of Globalization 1st wave: 1870-1914 Falling tariff barriers improved transportation 2nd wave: 1945-1980 Agreements to lower barriers again Rich country trade specialization Poor nations left behind 3rd wave: 1980-present Growth of emerging markets international capital movements regain importance 6 Economic interdependence Exports of goods and services as percent of Gross Domestic Product, 2001 Country Netherlands Norway South Korea Canada Germany France United Kingdom Mexico United States Japan Exports (% of GDP) Imports (% of GDP) 68% 48 46 45 35 29 28 28 11 11 62% 30 41 39 34 27 30 30 14 10 7 Economic interdependence Leading trading partners of the United States, 2000 Country Canada Mexico Japan Germany France Italy Netherlands Belgium/Luxembourg Venezuela Australia Value of US exports ($ bill.) $202.4 125.2 98.4 45.2 30.6 16.4 28.9 17.9 9.0 17.9 Value of US imports ($ bill.) $250.1 147.9 165.3 74.3 40.6 31.0 15.0 12.8 19.2 9.7 8 Economic interdependence Interdependence: Impact Overall standard of living is higher Access to raw materials & energy not available at home Access to goods & components made less expensively elsewhere Access to financing and investment not available at home International competition encourages efficiency 9 Economic interdependence Interdependence: Impact (cont’d) Other impacts - good & bad Curtails inflationary pressures at home Limits domestic wage increases Makes economy vulnerable to external disturbances Limits impact of domestic fiscal policy on economy 10 Comparative advantage Comparative advantage means: If the relative cost of making two items is different in two countries, each can gain by specializing in the one it makes most cheaply each has a comparative advantage in that product Even countries that make nothing cheaply can benefit from specialization 11 Economic interdependence Common fallacies of international trade "Trade is zero-sum" - trade can bring benefits to both partners "Imports bad, exports good" - if you buy nothing from other countries, they have no income to buy from you "Tariffs and quotas save jobs" - cutting imports makes it harder to export, so other jobs are lost 12 Comparative advantage Competitiveness & trade Main objective of any nation is to generate high and rising standard of living No nation can efficiently make everything itself International trade allows countries to focus on producing what they make efficiently Inefficient sectors will be squeezed out Sectors open to competition become more efficient and productive 13 Economic interdependence: globalization Ups and downs of globalization Advantages Productivity increases faster when countries produce according to comparative advantage Global competition and cheap imports keep prices low and inflation at bay An open economy encourages technological development and innovation with ideas from abroad Jobs in export industries pay more than those in import-competing industries Free movement of capital gives the US access to foreign investment and keeps interest rates low 14 Economic interdependence: globalization Ups and downs of globalization Disadvantages Millions of US jobs lost to imports or production abroad; those displaced find lower-paying jobs Millions of other Americans fear getting laid off Workers face pressure for wage concessions under threat of having the jobs move abroad Service and white-collar jobs are joining blue-collar ones in being vulnerable to moving overseas US workers can lose their competitiveness when firms build state-of-the-art factories in low-wage countries, making them as productive as plants in the US 15 International Economics By Robert J. Carbaugh 9th Edition Chapter 2: Foundations of Modern Trade Theory Foundations of trade theory Historical development of trade theory Mercantilism Regulation to ensure a positive trade balance Critics: possible only for short term; assumes static world economy Absolute advantage (Adam Smith) Countries benefit from exporting what they make cheaper than anyone else But: nations without absolute advantage do not gain from trade Comparative advantage (David Ricardo) Nations can gain from specialization, even if they lack an absolute advantage 17 Comparative advantage Absolute & Comparative Advantage Absolute advantage: each nation is more efficient in producing one good Output per labor hour Nation Wine Cloth United States United Kingdom 5 bottles 20 yards 15 bottles 10 yards Comparative advantage: the US has an absolute advantage in both goods Output per labor hour Nation Wine Cloth United States United Kingdom 40 bottles 40 yards 20 bottles 10 yards 18 Comparative advantage Ricardo’s Comparative Advantage in money prices Nation Labor Wage US 1 hr UK 1 hr UK 1 hr (at $1.6 = £1) $20/hr £5/hr $8 Cloth (yards) Quant. Price 40 10 10 $0.50 £0.50 $0.80 Wine (bottles) Quant. Price 40 20 20 $0.50 £0.25 $0.40 19 Comparative advantage Production possibilities schedule Generalizes theory to include all factors, not just labor Shows combinations of products that can be made if all factors are used efficiently Slope, or marginal rate of transformation, shows the opportunity cost of making more of one good (how much of one good must be given up to make more of another) 20 Comparative advantage Marginal Rate of Transformation 21 Comparative advantage Production possibilities schedules: constant opportunity costs 22 Comparative advantage Supply schedules: constant opportunity costs 23 Comparative advantage Trading under constant opportunity costs 24 Comparative advantage Production gains from specialization: constant opportunity costs Before Specialization After Specialization Net Gain (Loss) Autos Wheat Autos Wheat Autos Wheat US Canada 40 40 40 80 120 0 0 160 80 -40 -40 80 World 80 120 120 160 40 40 25 Comparative advantage Consumption gains from trade: constant opportunity costs Before Trade After Trade Net Gain (Loss) Autos Wheat Autos Wheat Autos Wheat US Canada 40 40 40 80 60 60 60 100 20 20 20 20 World 80 120 120 160 40 40 26 Comparative advantage Complete specialization under constant opportunity costs 27 Comparative advantage Changing comparative advantage 28 Comparative advantage Trade restrictions and gains from trade 29 Increasing opportunity costs Production possibilities schedule under increasing costs 30 Increasing opportunity costs Supply schedule under increasing costs 31 Increasing opportunity costs Trading under increasing costs: US 32 Increasing opportunity costs Trading under increasing costs: Canada 33 Increasing opportunity costs Production gains from specialization: increasing opportunity costs Before Specialization After Specialization Net Gain (Loss) Autos Wheat Autos Wheat Autos Wheat US Canada 5 17 18 6 12 13 14 13 7 -4 -4 7 World 22 24 25 26 3 3 34 Increasing opportunity costs Consumption gains from trade: increasing opportunity costs Before Trade After Trade Net Gain (Loss) Autos Wheat Autos Wheat Autos Wheat US Canada 5 17 18 6 5 20 21 6 0 3 3 0 World 22 24 25 27 3 3 35 International Economics By Robert J. Carbaugh 9th Edition Chapter 3: International Equilibrium Bringing demand into the model Indifference curves Final pattern of trade depends not just on supply, but also on demand - which is determined by income & individual tastes Tastes can be shown graphically with indifference curves, which show the various combinations of two goods that give a consumer the same total level of satisfaction 37 Bringing demand into the model A consumer’s indifference map 38 Bringing demand into the model Indifference curves (cont’d) Indifference curves have a negative slope Keeping satisfaction constant means giving up some of one good for more of another Indifference curves are convex As the consumer gets more of one good, she is less willing to give up what is left of the other The rate of substituting one good for another is shown by the slope of the curve, the marginal rate of substitution 39 Bringing demand into the model Indifference curves (cont’d) “Higher” indifference curves (those farther from the origin) represent greater levels of satisfaction Individual preferences cannot really be added up into a “community indifference curve” but it is useful to imagine that they can for the purposes of trade theory 40 Bringing demand into the model Indifference curves and int’l. trade 41 Bringing demand into the model Basis for trade, gains from trade 42 International equilibrium Equilibrium terms-of-trade limits 43 International equilibrium Theory of Reciprocal Demand (Mill) Actual trading prices depend on the interaction of trading partners’ demands Final terms of trade will be closer to the domestic price ratio of the nation with stronger demand for the imported good Applies to nations of equal economic size, which will share gains nearly equally Small nations trading with large ones can receive the bulk of the gains from trade 44 International equilibrium Offer curves: supply and demand 45 International equilibrium Offer curves: supply and demand 46 International equilibrium Equilibrium terms of trade 47 International equilibrium Changing equilibrium terms of trade 48 Impact of trade Immiserizing growth 49 International Economics By Robert J. Carbaugh 9th Edition Chapter 4: Trade Model Extensions and Applications Why relative price differentials? Factor endowment theory (Heckscher-Ohlin) Comparative advantage is explained entirely by different national supply conditions, especially resource endowments Nations export products that use inputs which are relatively abundant (cheap) at home, and import products which need inputs which are relatively scarce (expensive) at home 51 Why relative price differentials? Factor endowment theory: assumptions Nations all have the same tastes and preferences (same indifference curves) They use factor inputs which are of uniform quality They all use the same technology 52 Factor endowment model Comparative advantage according to factor endowment theory Autarky equilibrium 53 Factor endowment model Comparative advantage according to factor endowment theory Post-trade equilibrium 54 Factor endowment model Factor endowment theory: implications Factor price equalization The shift within each nation towards use of cheaper factors, and away from expensive ones, leads to more equal factor prices (if factors are mobile) Distribution of income Trade changes domestic distribution of income as demand for different factors changes Tests of factor endowment theory Emphasize the importance of varieties of different factors (such as human capital) and accounting for changes in resource endowment; other explanations are also important 55 Distribution of income Does trade worsen inequality? Trade theory suggests that countries with abundant skilled labor will import goods which are made with unskilled labor Equilibrium wage ratios for skilled/unskilled labor are affected by trade and technology change, immigration, and education & training Evidence suggests that trade contributes relatively little to wage inequality, compared to technological change and other factors; better education and training are potential solutions 56 Bringing theory closer to reality Economies of scale & specialization Economies of scale provide incentives for specialization, since per unit costs go down as production increases Trade provides a larger potential market for products, making higher production levels possible 57 Economies of scale Economies of scale as basis for trade 58 Economies of scale Trade & specialization under decreasing costs 59 Bringing theory closer to reality Other extensions of the theory Overlapping demands Intra-industry trade Product cycles Dynamic comparative advantage industrial policy 60 Bringing theory closer to reality Trade & the environment Environmental regulation can lead to a policy tradeoff Increased costs can reduce comparative advantage of regulated industry Public receives health and environmental benefits Concern that polluting industries would move to poor countries with less regulation But studies indicate that environmental rules have a small role in investment location decisions Polluter-pays principle: incentive to find ways to reduce pollution at least cost 61 Trade & the environment Trade effects of pollution-control regulations 62 Transportation costs Free trade under increasing costs No transportation costs 63 Transportation costs Free trade under increasing costs Transportation costs of $2000 per auto 64 Bringing theory closer to reality Specific factor theory Looks at the income distribution effects of trade in the short run, when some factor inputs are not mobile among sectors Indicates that workers may be better or worse off, depending on preferences Predicts that owners of factors used in export industries gain from trade, while owners of factors used in import-competing industries will lose from trade 65 Bringing theory closer to reality Relative prices and the specific factor model 66 International Economics By Robert J. Carbaugh 9th Edition Chapter 5: Tariffs Tariffs Why restrict trade? Benefits of free trade come in the long term, and are usually spread widely across society Costs of free trade are felt rapidly and are usually concentrated in specific sectors of the economy 68 Tariffs Defining tariffs A tariff is a tax (duty) levied on products as they move between nations Import tariff - levied on imports Export tariff - levied on exported goods as they leave the country Protective tariff - designed to insulate domestic producers from competition Revenue tariff - intended to raise funds for the government budget (no longer important in industrial countries) 69 Tariffs Types of tariff Specific tariff Fixed monetary fee per unit of the product Ad valorem tariff Levied as a percentage of the value of the product Compound tariff A combination of the above, often levied on finished goods whose components are also subject to tariff if imported separately 70 Tariffs Effective rate of protection The impact of a tariff is often different from its stated amount The effective tariff rate measures the total increase in domestic production that the tariff makes possible, compared to free trade Domestic producers may use imported inputs or intermediate goods subject to various tariffs, which affects the calculation 71 Tariffs Effective rate of protection (cont’d) When tariff rates are low on raw materials and components, but high on finished goods, the effective tariff rate on finished goods is actually much higher than it appears from the nominal rate This is referred to as tariff escalation 72 Tariffs Avoiding and postponing tariffs (US) Production sharing and special treatment for foreign assembly using domestic components Bonded warehouses Foreign trade zones 73 Tariffs Tariff welfare effects Consumer surplus The difference between the price buyers would be willing to pay and what they actually pay Producer surplus The revenue producers receive above the minimum amount required to induce them to produce a good 74 Tariffs Consumer and producer surplus 75 Welfare effects of tariffs Tariff trade and welfare effects 76 Welfare effects of tariffs Tariff trade and welfare effects 77 Tariff effects Who pays for import restrictions? Domestic consumers face increased costs Low income consumers are especially hurt by tariffs on low-cost imports Overall net loss for the economy (deadweight loss) Export industries face higher costs for inputs Cost of living increases Other nations may retaliate, further restricting trade 78 Reasons for tariffs Arguments for trade restrictions Job protection Protect against cheap foreign labor Fairness in trade - level playing field Protect domestic standard of living Equalization of production costs Infant-industry protection Political and social reasons 79 Reasons for tariffs Politics of protectionism “Supply” of protectionism (trade policy) depends on: the cost to society of restricting trade the political importance of the importcompeting industries Magnitude of the adjustment costs from free trade Public sympathy for those sectors hurt by free trade 80 Reasons for tariffs Politics of protectionism “Demand” for protectionism depends on: The amount of the import-competing industry’s comparative disadvantage The level of import penetration The level of concentration in the affected sector The degree of export dependence in the sector 81 International Economics By Robert J. Carbaugh 9th Edition Chapter 6: Nontariff Trade Barriers Types of non-tariff barriers Import quotas Quotas are a restriction on the quantity of a good that may be imported in any one period (usually below free-trade levels) Global quotas restrict the total quantity of an import, regardless of origin Selective quotas restrict the quantity of a good coming from a particular country 83 Types of non-tariff barriers Import quota: trade & welfare effects 84 Types of non-tariff barriers Effects of a quota on sugar imports 85 Types of non-tariff barriers Comparing tariffs and quotas 86 Types of non-tariff barriers Tariff-rate quota The tariff-rate quota is a two-tiered tariff A specified number of goods (up to the quota limit) may be imported at one (lower) tariff rate, while imports in excess of the quota face a higher tariff rate 87 Types of non-tariff barriers Tariff-rate quota: trade & welfare effects 88 Types of non-tariff barriers Orderly marketing agreements Market sharing pact signed by trading partners Intended to protect less efficient domestic producers Usually involve voluntary export restraints, or export quotas Recent trade negotiations have restricted the use of these agreements 89 Types of non-tariff barriers Effects of a voluntary export quota 90 Types of non-tariff barriers Domestic content requirements Rules that require a certain percentage of a product’s total value to be produced domestically Often has the effect of forcing lower-priced imports to include higher-cost domestic components or be assembled in a highercost domestic market 91 Types of non-tariff barriers Domestic content: trade & welfare effects 92 Types of non-tariff barriers Subsidies Domestic subsidy Payments made to import-competing producers to raise the price they receive above the market price Export subsidy Payments and incentives offered to export producers intended to raise the volume of exports 93 Types of non-tariff barriers Subsidies: trade & welfare effects 94 Types of non-tariff barriers Subsidies: trade & welfare effects 95 Types of non-tariff barriers Dumping The practice of selling a product at a lower price in export markets than at home (or exporting at prices below production cost) Sporadic dumping - to clear unwanted inventories or cope with excess capacity Predatory dumping - to undermine foreign competitors Persistent dumping - reaping greater profits by engaging in price discrimination 96 Types of non-tariff barriers Other NTBs Government procurement policies Social regulations (health, environmental and safety rules can also restrict trade) Sea transport and freight restrictions 97 International Economics By Robert J. Carbaugh 9th Edition Chapter 7: Trade Regulations and Industrial Policies Trade regulation The US and international trade Smoot-Hawley Tariff Act (1930) High point of US protectionism Reciprocal Trade Agreements Act (1934) Introduced “most favored nation” (MFN) clause (now called “normal trade relations”) General Agreement on Tariffs and Trade [GATT] (1947) World Trade Organization (1995) 99 Trade regulation GATT - Postwar trade liberalization Founded on the principle of nondiscrimination, including: "Normal Trade Relations" treatment National treatment of imported goods Included trade dispute resolution mechanisms Committed signatories to use tariffs rather than quotas 100 Trade regulation GATT - Postwar trade liberalization (2) Started regular negotiations to reduce tariffs and NTBs Exceptions allowed nations to sidestep the rules when they felt threatened, without abandoning the entire process 101 Trade regulation GATT negotiations Early bilateral agreements Kennedy Round (1964-67) - first multilateral negotiations; focus on tariff cuts Tokyo Round (1973-79) - focus on lowering non-tariff barriers Uruguay Round (1986-93) - covered new issue areas (intellectual property, services, agriculture), included developing nations 102 Trade regulation GATT becomes WTO GATT agreement became World Trade Organization in January 1995 WTO members must adhere to all agreements negotiated under GATT (not pick and choose) Covers trade in goods, services, intellectual property and investment WTO strengthens GATT's dispute-settlement mechanisms 103 Trade regulation Controversy over WTO Worries about infringement on national sovereignty Concern about trade liberalization undermining environmental protection WTO became a target for broader opposition to "globalization" 104 Trade regulation US trade remedy laws Escape clause Countervailing duties Anti-dumping duties Unfair trade practices (Section 301) Protection of intellectual property Trade adjustment assistance 105 Trade regulation Effects of dumping, subsidies, and remedies 106 Trade regulation Effects of dumping, subsidies, and remedies 107 Industrial policy US “industrial policy” Broad policies to foster economic growth Aid to targeted sectors Agriculture, ship-building, energy, technology, manufacturing (autos, for example), etc. Tariff protection of declining sectors Export promotion and financing Export-Import Bank Commodity Credit Corporation Knowledge based growth policy 108 Industrial policy Japan’s industrial policy Trade protection and subsidies (especially early on) Assistance to targeted sectors Shipbuilding, steel, autos, machine tools, hightechnology Ministry of International Trade and Industry (MITI) to target aid to promising sectors It is unclear how much of Japan’s success can be attributed to government assistance 109 Industrial policy Strategic trade policy Response to competition in sectors with imperfect competition - small number of producers, each large enough to affect market price Subsidies can give the advantage to domestic manufacturers over foreign ones Critics argue that it is too difficult to determine where assistance makes economic sense 110 Industrial policy Welfare effects of strategic trade policy 111 Trade regulation Economic sanctions Trade sanctions Financial sanctions Success of sanctions depends on: Number of nations imposing sanctions Nature of ties between target and imposing nations Extent of political opposition in target nation Cultural factors in target nation 112 International Economics By Robert J. Carbaugh 9th Edition Chapter 8: Trade Policies for the Developing Nations Developing nations and trade Developing nations’ trade Very dependent on the developed industrial countries as export markets and source of imports Exports are heavily weighted toward primary products (agricultural goods, raw materials, fuels) and labor-intensive manufactures Share of manufactured exports is increasing, but mainly in a small number of newly industrialized nations (such as South Korea, Hong Kong) 114 Developing nations and trade Developing nations: dependence on primary products (2000) Country Nigeria Saudi Arabia Venezuela Burundi Mauritania Zambia Ethiopia Chad Major export product As % of total exports Oil Oil Oil Coffee Iron ore Copper Coffee Cotton 96 86 86 79 56 56 54 40 115 Developing nations and trade Developing nations’ concerns Question whether gains from trade with industrial countries have been fairly distributed Face problems of unstable export markets Concentration on one or a few primary-product exports combined with inelastic supply and demand conditions Argue that they face worsening terms of trade as relative value of primary products has fallen compared to manufactured goods they import Face limited market access for exports because of protectionism Especially for agricultural and labor-intensive goods 116 Developing nations and trade Export price instability for a developing nation 117 Developing nations and trade Remedies for developing nation problems Stabilizing commodity prices - international commodity agreements Production and export controls Buffer stocks Multilateral contracts Generalized system of preferences (GSP) But experience with commodity agreements has been mixed, at best, and application of the GSP is spotty 118 Developing nations and trade Production and export controls 119 Developing nations and trade Buffer stocks: price ceiling and price support 120 Developing nations and trade Cartels Attempt to restrict competition among producers and support higher prices for their product Face obstacles: Incentive to cheat Number of sellers Cost and demand differences Potential competition Economic downturns Substitute goods 121 Developing nations and trade Growth strategies Import substitution Trade barriers protect emerging domestic industries Popular in 1950s and 1960s Export-led growth Focus on export of manufactures as engine of growth Became more common starting in 1970s 122 Growth strategies Import substitution: pros Risk of establishing home import-replacing industry is low because home market already exists Easier for developing nations to protect their own markets than to force industrial nations to open theirs Gives foreign firms an incentive to locate production in developing country, providing jobs 123 Growth strategies Import substitution: cons Trade restrictions shelter home industry from competition, giving no incentive for efficiency Small size of most developing country markets makes it difficult to benefit from economies of scale Protection of import-competing industries draws resources away from all other sectors, including potential exporters 124 Growth strategies Export-led growth: pros Encourages industries in which developing countries are likely to have a comparative advantage - such as labor-intensive manufactures Export markets allow domestic producers to utilize economies of scale Low level of trade restrictions forces domestic firms to remain competitive 125 Growth strategies Export-led growth: cons Main disadvantage to export-led growth is that it depends on the ability and willingness of industrial nations to absorb large quantities of manufactures from developing countries In other words, it is sensitive to economic cycles and protectionist pressures in the export markets 126 Growth strategies Economic performance of developing nations by trade orientation, 1963-92 (World Bank, 1987; OECD, 1998) 127 Growth strategies Growth strategies: case studies Brazil - import substitution in computers Policy backfired, and was abandoned by 1991 East Asian newly industrialized countries - exportled growth Generally very successful, until 1997 crisis High rates of investment and building human capital Problems overlooked: pollution, income distribution Vulnerable to protectionist reactions elsewhere 128 Growth strategies Growth strategies: case studies China - transformation from extreme importsubstitution to focus on exports Dramatic change in China’s role in the world economy has accompanied rapid growth in its domestic economy Heavy state role in economy (legacy of central planning) raises issues of fairness Political issues, lack of enforcement of some agreements (intellectual property) complicate economic relations Accession to the WTO will mean adherence to global trade rules and coping with the dislocations that will involve 129 International Economics By Robert J. Carbaugh 9th Edition Chapter 9: Regional Trading Arrangements Regional trade agreements Types of regional trade arrangements Free trade areas (NAFTA, for example) Customs unions (Benelux) Common markets (EU) Economic/monetary union 131 Regional trade agreements Effects of regional trade agreements Static effects Trade creation effect (consumption effect, production effect) Trade diversion effect Dynamic effects Economies of scale Greater competition Investment stimulus 132 Regional trade agreements Static effects of a customs union 133 Regional trade agreements: case studies The European Union Created by the Treaty of Rome (1957) Policy aims included: Abolition of tariffs, quotas and other restrictions Common external tariff Free movement of capital, labor and business Common policies on transport, agriculture, and competition and business conduct Coordination of monetary and fiscal policies 134 Regional trade agreements: case studies The European Union (cont’d) Lowering of barriers caused within-region trade to grow much more quickly than overall world trade in the 1960s Steps to remove remaining barriers (198592) further increased integration Maastricht Summit (1991) began process of economic and monetary union (EMU) EMU came into full effect in 2002 with the introduction of a common currency, the euro 135 Regional trade agreements: case studies EU Economic & Monetary Union Member nations which met economic criteria by 1999 replaced their national currencies with the euro in 2002 New European Central Bank created to control monetary and exchange rate policy “Convergence criteria” required for membership: Price stability Low long-term interest rates Stable exchange rates Sound public finances 136 Regional trade agreements: case studies Other key EU policies Common agricultural policy (CAP) Support payments to farmers Variable import levies Export subsidies Government procurement policies All EU businesses can bid for larger contracts in any nation 137 Regional trade agreements: case studies CAP: variable levies and export subsidies 138 Regional trade agreements: case studies Opening up government procurement 139 Regional trade agreements: case studies European Union enlargement The EU is negotiating with 12 applicant nations, mostly transition economies in eastern Europe, for EU membership by 2004 Candidate members had to demonstrate their fitness by achieving: Stability of institutions, and guaranteed democracy, rule of law, human rights and protection of minorities A functioning market economy which is ready to compete in the EU market Adherence to the EU’s aims of political, economic and monetary union 140 Regional trade agreements: case studies Costs & benefits of EMU Europe does not meet all the requirements of a theoretical “optimal currency area” Advantages of EMU - real but small: Lower transaction costs Price comparisons easier Exchange rate risk eliminated Stimulates competition 141 Regional trade agreements: case studies Costs & benefits of EMU (cont'd) Disadvantages of EMU: Loss of monetary policy and the exchange rates as economic adjustment tools Use of fiscal policy for adjustment is also constrained Adjustment to shocks therefore depends on wage flexibility and labor mobility, which are both low in Europe 142 Regional trade agreements: case studies North American Free Trade Agmt. (1994) Gradual and comprehensive elimination of trade barriers among US, Mexico and Canada over 15 years: Full, phased elimination of import tariffs Elimination of most NTBs Protection of intellectual property rights Dispute settlement procedures Side agreements on environmental protection and labor law 143 Regional trade agreements: case studies NAFTA's benefits Mexico stood to gain the most, with access to large industrial markets and new inward investment flows Canada maintained its preferences in the US market and hoped for future access to South American markets US stood to gain from access to the Mexican market and cheap labor and parts, access to reliable oil supplies, and less immigration pressure; but the benefits were modest 144 Regional trade agreements: case studies Concerns about NAFTA Main US losers from NAFTA would be importprotected industries competing with Mexican producers, and unskilled workers US industrial workers also worried about lower pay scale in Mexico and plant relocations Concerns Mexico would not enforce environmental protection measures Side agreements on environment and labor law were concluded to address those concerns 145 Regional trade agreements: case studies NAFTA’s impact so far Trilateral trade increased significantly Some US jobs were lost to Mexico, but the numbers were small compared to job creation that came with US growth Changes in investment flows were small (in relation to total US foreign investment) Closer political ties were built among the three nations, and they refrained from building new trade barriers even during recession 146 Regional trade agreements: case studies Special case: economies in transition Nations of eastern Europe and the former Soviet Union have been making a transition from a non-market (planned) economy to a market economy since the early 1990s - which has been very disruptive These nations’ planned economies required them to be largely isolated from world trade instead, set up their own trading bloc, the Council for Mutual Economic Assistance (CMEA) with only limited trade with the West 147 Regional trade agreements: case studies Economies in transition (cont’d) Even after the collapse of the central planning system, the nations remained tied together because of historical trade links inside CMEA and their common legacy as non-market economies There is an ongoing debate over the best pace for economic reform (including trade and financial liberalization) - “shock therapy” vs. gradualism 148 Regional trade agreements: case studies Economies in transition (cont’d) Barriers to trade with the West used to make strategies such as countertrade, co-production agreements, joint R&D agreements, and contract manufacturing agreements very common Gradual elimination of barriers to foreign business in most transition countries has allowed foreign firms to operate in the region more normally in recent years 149 International Economics By Robert J. Carbaugh 9th Edition Chapter 10: International Factor Movements and Multinational Enterprises Factor movements & multinational enterprises Factor movements International movement of factors of production (capital, labor) is a substitute for international trade in goods International capital flows (investment) can substitute for trade in capital-intensive goods Labor mobility can substitute for trade in labor-intensive goods 151 Factor movements & multinational enterprises Multinational enterprises Various business operations in numerous host countries Headquarters often far from operations Stock ownership and management are usually multi-national Frequently employ vertical integration, horizontal integration, conglomerate structure 152 Multinational enterprises Foreign direct investment A foreign or multinational firm can buy a controlling interest in a local firm Buy or build new plants or equipment overseas Shift funds abroad to expand a subsidiary Reinvest the earnings of a foreign subsidiary 153 Multinational enterprises Reasons for foreign direct investment Demand factors Serve different local markets Respond to market competition Cost factors Access to key raw materials Labor costs Transportation costs Government policies 154 Foreign direct investment Choice between export and FDI 155 Foreign direct investment Choice between licensing and FDI 156 Multinational enterprises International joint ventures Two companies can operate a venture in a third country A foreign firm can work with a local company A foreign firm can form a venture with a unit of the local government 157 Multinational enterprises Reasons for international JVs Cost sharing - R&D, capital expenditures (in mining and oil, for example) Avoiding restrictions on foreign ownership of local firms (ensuring local participation) Forestalling pressure for protectionism Problems: divided control means success of JV depends on ability of firms to work together 158 Multinational enterprises Effects of an international JV 159 Multinational enterprises Controversy over multinationals Employment Host country may not gain many jobs, foreign managers often brought in; source country worries about losing jobs Technology transfer MNEs are reluctant to share technology with host nations; source country worries about giving away advantage 160 Multinational enterprises Controversy over multinationals (Cont’d) National sovereignty Host country worries about power of MNE to influence affairs; source country worries about ability to regulate MNE activities elsewhere Balance of payments MNE investments and profits (internal transfers) have impacts on the payments status of both source and host nations 161 Multinational enterprises Controversy over multinationals (Cont’d) Taxation Source countries may have difficulty taxing MNE income stemming from foreign operations Tax rate differences may discourage investment at home Transfer pricing Both host and source governments worry that MNEs may illegally manipulate prices paid between subsidiaries to avoid taxes 162 Multinational enterprises Transfer pricing illustrated Germany Ireland United States (tax rate 48%) (tax rate 4%) (tax rate 34%) Computer produced by parent firm for $2000. Sold to Irish subsidiary for $2000. Irish subsidiary resells the same computer to US subsidiary for $2500, earning $500 profit. US subsidiary sells computer at cost, for $2500. No profit is earned. German tax paid: $0. Irish tax paid: $20. US tax paid: $0. Irish subsidiary then lends money to US subsidiary for expansion 163 International factor movements Migration Tends to equalize wage rates between countries Shifts distribution of income between capital and labor Other concerns: Fiscal drain from immigration Brain drain from developing countries Impact of illegal migration Wider gulf between skilled and unskilled workers 164 International factor movements Effects of labor migration United States Mexico 165 International Economics By Robert J. Carbaugh 9th Edition Chapter 11: The Balance of Payments The Balance of Payments Balance of Payments A record of international transactions between residents of one country and the rest of the world International transactions include exchanges of goods, services or assets “Residents” means businesses, individuals and government agencies, including citizens temporarily living abroad but excluding local subsidiaries of foreign corporations 167 The Balance of Payments Double-entry accounting in the BOP All transactions are either debit or credit transactions Credit transactions result in receipt of payment from abroad Merchandise exports Transportation and travel receipts Income received from investments abroad Gifts received from foreign residents Aid received from foreign governments Local investments by overseas residents 168 The Balance of Payments Double-entry accounting (cont’d) Debit transactions lead to payments to foreigners Merchandise imports Transportation and travel expenditures Income paid on investments of foreigners Gifts to foreign residents Aid given by home government Overseas investments by home country residents Each credit transaction has a balancing debit transaction, and vice versa, so the overall balance of payments is always in balance 169 Structure of the Balance of Payments Current account Goods and services balance Merchandise trade balance Services balance Investment income (net) Unilateral transfers Private transfer payments Governmental transfers 170 Structure of the Balance of Payments Capital and financial account All purchases or sales of assets, including: Direct investment Securities (debt) Bank claims and liabilities Official settlements transactions 171 Current account Current account surplus and deficit Current account and capital & financial account balance each other; when one is in surplus the other must be in deficit Current account surplus means exports of goods and services, investment income and transfers exceed imports and outflows Current account deficit means imports of goods and services, and outflows are greater than exports and inflows; must be financed by borrowing (capital account inflows) 172 Balance of Payments US Balance of Payments, 2001 ($ bill.) Current account Merchandise trade exports $720.8 imports -1,147.4 Net Services Travel & transport recpts. 13.4 other services, net 65.4 All services, net Balance on goods & services -426.6 78.8 -347.8 Cont’d. 173 Balance of Payments US Balance of Payments, 2001 ($ bill.) Current account (cont’d) Income receipts & payments investment income, net -13.7 employee compensation -5.4 All income, net -19.1 Unilateral transfers, net -50.5 Balance on current account $-417.4 174 Balance of Payments US Balance of Payments, 2001 ($ bill.) Capital & financial account Capital account transactions, net 0.7 Financial account transactions, net 455.8 Statistical discrepancy -39.1 Balance on capital & financial account $417.4 175 Balance of Payments US Balance of Payments 1970-2001 176 Balance of Payments Current account deficit a problem? Current account deficit has little to do with foreign trade practices or competitiveness Determined mostly by domestic macroeconomic conditions that cause demand to exceed supply and increase imports (paid for with borrowing) Whether a current account deficit is good or bad depends on whether the borrowed funds are used to pay for consumption or investment 177 Balance of Payments Balance of international indebtedness Summarizes one nation’s overall quantity of assets and liabilities against the rest of the world Shows whether the nation is a net debtor or a net creditor Indicates sensitive items, such as short term debt held by foreigners which could be liquidated quickly, straining finances 178 International Economics By Robert J. Carbaugh 9th Edition Chapter 12: Foreign Exchange Foreign exchange Foreign exchange market Largest and most liquid market in the world No central market - key markets in several cities around the world Participating banks and brokers are in constant contact via phone and computer Three general types of transaction Between banks and their customers Domestic interbank market conducted through brokers Trading with overseas banks 180 Foreign exchange Types of FX transactions Spot transactions - executed nearly immediately Forward transactions - agreement to buy or sell a currency at a date in the future, at a rate agreed in advance Currency swaps - agreement to trade one currency for another now, and to trade currencies back again later, both at prices agreed at the beginning 181 Foreign exchange Foreign exchange quotations Exchange rate is the price of one currency in terms of another One country’s currency has depreciated when more of it is needed to buy a unit of a foreign currency (is worth less relative to the other currency) A currency has appreciated when less of it is needed to buy a foreign currency (is worth more relative to the other currency) 182 Foreign exchange Foreign exchange quotations Cross exchange rate between two currencies is calculated from their exchange rates with a third, benchmark currency - frequently the US dollar 183 Foreign exchange markets Forward markets, futures & options Forward contracts obligate buyer to buy or sell a certain amount of foreign currency at a future date Usually made between banks and firms who expect to receive or make payments in foreign currency; the amount of currency and the date are set by the agreement 184 Foreign exchange markets Forward markets, futures & options Futures, traded on special exchanges, are contracts to trade given amounts of currencies at a specified date Only a small number of major currencies can be so traded, and only in fixed lots with fixed trade dates 185 Foreign exchange markets Forward markets, futures & options Options provide the holder with the right (but not the obligation) to buy or sell foreign currencies at an agreed rate within a period of time, in return for a fee paid to the seller of the option Options to buy are called call options, and those to sell are called put options Options are frequently used to reduce risk from exchange rate changes 186 Foreign exchange markets Exchange rate determination 187 Foreign exchange Impact of an appreciating US dollar Pros Lower prices on foreign goods Keeps inflation down Foreign travel is cheaper Cons Exporters’ products become more expensive abroad Imports-competing firms face price competition Travel more expensive for foreign tourists 188 Foreign exchange Impact of a depreciating US dollar Pros Exporters can sell abroad more easily Less competition for US firms from imports Foreign tourism is encouraged Cons Higher prices on imports Upward pressure on inflation Travel abroad more expensive 189 Foreign exchange markets Arbitrage and hedging Exchange arbitrage involves taking advantage of exchange rate differences in different markets to make a profit Helps equalize exchange rates globally Interest arbitrage involves taking advantage of differences in international interest rates to get a higher return Subject to exchange rate risk 190 Foreign exchange markets Arbitrage and hedging Hedging involves making use of forward contracts or options to minimize exchange rate risk in international transactions Firms which expect to need to make or receive payments in the future can use forward contracts or options to “lock in” rates and avoid the disruptive effects of sudden exchange rate swings 191 Foreign exchange markets Speculation Speculation differs from arbitrage, in that it involves the purchase or sale of a currency in the expectation that its value will change in the future 192 Foreign exchange markets Speculation Speculation can either reduce or increase volatility in foreign exchange rates If speculators expect a current trend in rates to change, then their purchase or sale moderates the price movements If they expect a current trend in rates to continue, their transactions can accelerate the rise or fall of the target currency 193 International Economics By Robert J. Carbaugh 9th Edition Chapter 13: Exchange-Rate Determination Exchange rates Factors influencing exchange rates Market fundamentals Bilateral trade balances Real income Real interest rates Inflation rates Consumer preferences for domestic or foreign products Productivity changes affecting production costs Profitability and riskiness of investments 195 Exchange rates Factors influencing exchange rates Market fundamentals (cont’d) Product availability Monetary policy and fiscal policy Government trade policy Market expectations News about future market fundamentals Speculative opinion about future exchange rates 196 Exchange rates When are these factors important? Short run (days) Dominated by financial transfers responding to: Differences in real interest rates Shifting expectations of future exchange rates Medium run (months) Primarily influenced by economic cycles 197 Exchange rates When are these factors important? Long run (years) Dominated by movements of goods, services, investment, which are influenced by: Inflation rates Investment profitability Consumer tastes Real income Productivity Trade policy How these factors interact to affect exchange rates depends on the relative importance of trade and financial relations between the countries 198 Exchange rates Exchange rate components 199 Factors influencing exchange rates Real income differentials A country with faster economic growth than the rest of the world will have a depreciating currency (other things being equal) Imports rise faster than exports, so demand for foreign currency rises faster than its supply Real income changes can also reflect other processes, which might lead to rising exports 200 Factors influencing exchange rates Impact of real income differentials 201 Factors influencing exchange rates Real interest rates Short term real interest rate differences influence international capital movements Real interest rate is nominal minus inflation Low short term rates lead to less demand for the currency and depreciation High rates lead to greater demand for the currency and appreciation 202 Factors influencing exchange rates Impact of interest rate differentials 203 Factors influencing exchange rates Purchasing power parity Law of one price: In theory, a good should cost the same in all countries (aside from tariffs or transportation costs) As a result, exchange rates should end up making prices equal across countries By this theory, if two countries have different inflation rates, exchange rates will move in the opposite direction to keep prices the same The theory may be more useful for predicting long-term trends than short-run fluctuations 204 Factors influencing exchange rates Impact of inflation rate differentials 205 Factors influencing exchange rates Market expectations As with stock markets, foreign exchange markets react quickly to news or even rumors that point to future changes affecting rates Future expectations can be self-fulfilling; speculative bubbles can start without any real information but can become self sustaining - for a while 206 Alternative approaches to exchange rates Monetary approach Focus on exchange rates as the result of supply and demand for money at home and abroad Demand depends on real income, prices, interest rates Supply is controlled by central banks Exchange rates seen as returning domestic money supply to equilibrium after a change 207 Alternative approaches to exchange rates Asset-markets approach Investors (firms and individuals) balance their portfolios among domestic money, stocks and bonds and foreign stocks and bonds Short run exchange rate changes are caused by shifts in the kind and location of financial assets investors want to hold Investors shift between assets based on market expectations for expected returns 208 Exchange rate markets Short, long run equilibrium: overshooting 209 Exchange rate markets Forecasting exchange rates Judgmental forecasts Subjective forecasts based on economic, political and other data for a country Technical analysis Uses historical exchange rate trends to project short-run future movements Fundamental analysis Includes macroeconomic and policy information in a predictive model 210 Alternative approaches to exchange rates Equilibrium in asset-markets approach 211 Alternative approaches to exchange rates Asset-markets approach: shift in demand 212 Alternative approaches to exchange rates Asset-markets approach: shift in supply 213 International Economics By Robert J. Carbaugh 9th Edition Chapter 14: Balance-of-Payments Adjustments Under Fixed Exchange Rates Balance of payments adjustments Balance of payments adjustments If part of the balance of payments is in deficit or surplus for a period of time, mechanisms are needed to restore equilibrium Adjustment mechanisms can be: Automatic - economic processes Discretionary - government policies 215 Balance of payments adjustments Automatic adjustment under fixed exchange rates Key variables Prices Interest rates Income Money 216 Balance of payments adjustments Schools of thought on adjustment Classical approach (1800s - early 1900s) Centered on gold standard Emphasized role of prices and interest rates Keynesian approach (1930s onward) Emphasized income changes affecting adjustment Monetarist approach (1960s-, Chicago school) Focus on role of money in changes and adjustment 217 Balance of payments adjustments Price adjustment - background Under the gold standard, each nation’s currency was backed by gold and had a fixed price in terms of gold Imports and exports were paid for in gold A nation’s money supply (total amount of gold and gold-backed currency) was directly tied to balance of payments whether gold was flowing in or out overall 218 Balance of payments adjustments Price adjustment - background (cont’d) Balance of payments surplus would expand money supply; deficit would shrink money supply By the classical quantity theory of money, increases in the money supply led directly to an increase in overall prices (and a shrinking money supply caused overall prices to fall) 219 Balance of payments adjustments Price adjustment of the BOP Deficit nations Would be losing gold, therefore shrinking their money supply and causing prices to fall Lower prices would make their exports more competitive and lessen demand for imports, restoring equilibrium Surplus nations Would be gaining gold, increasing money supply and price level Higher prices would cut exports and encourage imports until the surplus was eliminated 220 Balance of payments adjustments Problems with price adjustment theory Gold flows are not directly linked to domestic money supply Nations are often not at full employment If economy is not at capacity, less likely that prices will rise as money supply does Prices and wages are often not able to fall in the short run Falling money supply will cut output and employment rather than prices 221 Balance of payments adjustments Interest rate adjustment Inflows of gold expand the money supply, causing short-term interest rates to fall; outflows cause rates to rise Investors in surplus nations would send gold abroad in search of higher rates; deficit nations would receive gold from abroad for investment, restoring equilibrium 222 Balance of payments adjustments Interest rate adjustment 223 Balance of payments adjustments Income adjustment Surplus nations will experience rising national income, leading to an increased demand for imports - partially offsetting the surplus Deficit nations will experience falling income, leading to a drop in demand for imports - partially offsetting the deficit Foreign repercussions effect - one country’s deficit is another’s surplus, so that while income is declining in one country, its exports will increase to the country with rising income 224 Balance of payments adjustments Income adjustment applied 225 Balance of payments adjustments Disadvantages of automatic mechanisms Require governments not to intervene Automatic systems seem desirable when they are believed to lead to full employment; when nations face unemployment and shrinking output, automatic mechanisms seem inadequate 226 Balance of payments adjustments Monetary adjustment - background BOP disequilibrium represents an imbalance between the supply and demand for money Demand for money is: Directly related to income and prices Inversely related to interest rates Supply of money has two components: Domestic component - credit created by national government International component - foreign exchange reserves 227 Balance of payments adjustments Monetary adjustment Payments deficits are the result of an excess supply of money at home Excess supply of money encourages imports, which results in foreign exchange reserves flowing overseas and reducing the money supply 228 Balance of payments adjustments Monetary adjustment Excess demand for money leads to a payments surplus Excess demand is reflected in higher interest rates and less spending on imports, encouraging a flow of foreign exchange into the country 229 Balance of payments adjustments Monetary adjustment - implications Theory focuses on domestic monetary policy as key to balance of payments Other policies designed to affect the balance of payments - tariffs, quotas, devaluation of the currency - are ineffective in the long run according to the theory 230 International Economics By Robert J. Carbaugh 9th Edition Chapter 15: Exchange-Rate Adjustments and the Balance of Payments Exchange rate adjustments Exchange-rate adjustment and the BOP Automatic mechanisms may restore balance-of-payments equilibrium, but at the cost of recession or inflation As an alternative, governments allow exchange rates to change Floating exchange rates, determined by markets Devaluing or revaluing fixed exchange rates 232 Exchange rate adjustments Exchange rate effects on costs & prices Impact of appreciation or depreciation on costs depends on the proportion of inputs priced in foreign vs. domestic currency As foreign-currency denominated costs rise as a proportion of total costs, exchange rate changes have less effect on the foreign currency price and more effect on the domestic price If foreign-currency costs are a small part of total costs, exchange rate changes have more impact on foreign currency price of the product and less on domestic price 233 Exchange rate adjustments Exchange rate effects on costs & prices Generally, currency appreciation increases the costs of exports in foreign currency terms, which hurts total exports (while depreciation encourages exports) Effect on prices is modified by the ability and willingness of sellers to change their prices 234 Exchange rate adjustments Requirements for successful devaluation When can devaluation correct a payments deficit? Elasticity approach Emphasizes price effects; devaluation works best when demand is elastic Absorption approach Focus on income effects; domestic spending must fall, too Monetary approach Focus on change in purchasing power of money and effect on domestic spending 235 Devaluation as adjustment tool Elasticity approach Impact of currency devaluation depends on price elasticity of domestic demand for imports and of foreign demand for exports The less either foreign or domestic demand responds to price changes, the less effect a devaluation will have on the payments imbalance 236 Devaluation as adjustment tool Elasticity approach Marshall-Lerner condition: Devaluation will improve the trade balance if domestic demand elasticity for imports plus foreign demand elasticity for exports is greater than 1 Devaluation will worsen the trade balance if the sum of the two elasticities is less than 1 If the sum is equal to 1, devaluation will have no effect 237 Devaluation as adjustment tool Devaluation and time horizon The J-curve effect: in short run, devaluation worsens trade balance, but with time the balance improves (3-5 years) Recognition lags; decision lags; delivery lags; replacement lags; production lags Currency pass-through: effect of devaluation depends on how quickly producers pass on higher or lower costs to their customers 238 Devaluation as adjustment tool Absorption approach Emphasizes impact of devaluation on spending behavior of domestic economy Balance of trade is the difference between total domestic output and domestic absorption Positive balance means output exceeds domestic spending Negative balance means spending exceeds total production 239 Devaluation as adjustment tool Absorption approach (cont’d) Devaluation will only improve the trade balance if output rises relative to domestic absorption If an economy is operating below capacity, a devaluation will shift resources into export production and encourage spending on import substitutes If an economy is operating at full employment, production cannot rise; trade balance can only be cut by slowing the domestic economy 240 Devaluation as adjustment tool Monetary approach Elasticity and absorption approaches apply only to the trade balance; monetary approach includes capital account Devaluation may induce a temporary improvement in the balance of payments Devaluation increases the domestic price level, increasing demand for money and drawing foreign capital flows (because of higher interest rates that result) 241 Devaluation as adjustment tool Monetary approach (cont’d) In the long run, the inflow of money increases domestic spending, increasing imports and returning the economy to the starting point Devaluation affects real economy only temporarily; only long run effect is to raise the domestic price level 242 International Economics By Robert J. Carbaugh 9th Edition Chapter 16: Exchange-Rate Systems Exchange rate systems Exchange rate practices Floating rate - market determined Float independently Float in unison with a group of other countries Adjust according to a formula Fixed (“pegged”) rate Peg to a single major currency Peg to a basket of currencies Peg to gold (obsolete) 244 Exchange rate system alternatives Exchange rate arrangements of IMF members, 2001 Exchange Arrangement Exchange arrangements with no separate legal tender Currency board arrangements Conventional pegged (fixed) exchange rates Number of Countries 39 8 31 Pegged rates within horizontal bands 6 Crawling pegged exchange rates 4 Exchange rates within crawling bands 5 Managed floating exchange rates 33 Independently floating exchange rates 47 245 Exchange rate system alternatives Fixed exchange rates Fixed exchange rates are normally used by small developing nations to peg to a key currency For international settlement purposes To stabilize import/export prices with the main trading partner To reduce inflationary expectations Pegs can be established To a single currency To a trade-weighted basked of currencies To the special drawing right (SDR), a basket established by the IMF 246 Exchange rate system alternatives Key currencies: Share of national currencies in total identified official holdings of foreign exchange, 2000 Key currency All countries Industrial countries Developing countries US dollar Japanese yen Pound sterling Swiss franc Euro Other 68.2% 5.3 3.9 0.7 12.7 9.2 73.3% 6.5 2.0 0.2 10.2 7.8 64.3% 4.4 5.2 1.1 14.6 10.4 247 Exchange rate system alternatives Fixed exchange rate system Establish a par value against one or more key currencies Create a stabilization fund to defend this fixed rate Government must be ready to make good on all demands to convert to/from foreign currency At some point, because of basic economic changes, the fixed rate can become impossible to defend and must be changed 248 Exchange rate system alternatives Exchange rate stabilization under fixed rates 249 Exchange rate system alternatives Exchange rate stabilization under fixed rates 250 Exchange rate system alternatives Devaluation and revaluation Devaluation is intended to lower the value of a currency relative to other currencies, correcting a balance of payments deficit Revaluation is intended to raise the currency’s value relative to other currencies, correcting a surplus 251 Exchange rate system alternatives Devaluation and revaluation Legally, the changes are made in the par value of the home currency in terms of the reference currency Economically, the effect is to change the value of the currency relative to the main trading partners - who may retaliate by changing their own fixed rates 252 Devaluation and revaluation Devaluation/revaluation: legal and economic impact 253 Devaluation and revaluation Devaluation/revaluation: legal and economic impact 254 Stabilizing developing country currencies Currency boards vs. dollarization A currency board is a monetary authority empowered to issue domestic currency which can be converted at a fixed exchange rate The rate is usually set in law, and the board must have foreign exchange reserves large enough to cover the domestic currency in circulation Put another way, the domestic money supply is limited by the amount of foreign reserves on hand Currency boards do not make loans or finance government deficits 255 Stabilizing developing country currencies Currency boards vs. dollarization (cont’d) Currency boards have become popular as a solution for countries which have not been able to control inflation or hold to a fixed exchange rate The boards guarantee stability, and political independence (sometimes more than central banks, which they sometimes replace) But the boards also leave no flexibility in monetary policy to respond to changing circumstances and require large foreign exchange reserves; experience has been mixed 256 Stabilizing developing country currencies Currency boards vs. dollarization (cont’d) Dollarization: residents of a country use the US dollar with or instead of their local currency Unofficial dollarization: residents hold assets and bank accounts denominated in dollars Official dollarization: US dollar replaces local currency Countries use dollarization to reduce risks for investors and avoid problems with domestic inflation and devaluations 257 Stabilizing developing country currencies Currency boards vs. dollarization (cont’d) Dollarization implies acceptance of monetary policy set in the US by the Federal Reserve Less subject to domestic politics Cannot respond to local problems, or run deficits US Federal Reserve would not be a lender of last resort, however By holding dollars rather than US government bonds, the country gives an interest-free loan to the US 258 Exchange rate system alternatives Floating exchange rates Currency prices established daily by an unrestricted market Large foreign exchange reserves are not needed to defend a fixed rate Rates respond to economic shifts; payments imbalances are corrected by rate changes Gives greater freedom to domestic economic policy 259 Exchange rate system alternatives Floating exchange rates (cont’d) Works only if there is enough trade in a currency to make a viable market Greater freedom for domestic policy may mean poor economic policy has fewer immediate consequences Market rates may move erratically 260 Exchange rate system alternatives Bretton Woods and after Postwar economic system negotiated at Bretton Woods (1944) included adjustable pegged rates In practice, countries were reluctant to adjust their exchange rates, causing stresses that ended the system by 1973 In 1973, the adjustable peg system was replaced with a “managed float” system, which used government intervention in exchange markets to stay close to a target exchange rate 261 Exchange rate system alternatives Adjustable pegged rates 262 Exchange rate system alternatives Managed floating exchange rates 263 Exchange rate system alternatives Exchange rate stabilization and monetary policy 264 Exchange rate system alternatives Crawling peg Establishing a fixed exchange rate is difficult in an economy with high inflation A number of nations use a crawling peg, under which the fixed rate is frequently adjusted to account for inflation or other factors Frequent changes keep pegged rates from becoming unrealistic, and unannounced changes keep speculators at bay 265 Exchange rate system alternatives Exchange controls Some nations (most, until the 1950s) use controls over foreign exchange to control the balance of payments At the extreme, the government can have a monopoly over buying and selling foreign exchange, capturing export income and limiting import expenditures Multiple exchange rates are also used, with different rates set for more or less desired transactions (discouraging imports, for example) 266 International Economics By Robert J. Carbaugh 9th Edition Chapter 17: Macroeconomic Policy in an Open Economy Open economy macro policy Policy in an open economy Countries which are open to the world economy cannot make domestic economic policy choices without considering the impact on trade and payments and their international relationships Nor can open economies entirely insulate themselves from other countries’ policy choices As a result, nations make efforts to coordinate their international economic policies Economic policies are also subject to domestic and foreign institutional constraints 268 Open economy macro policy Economic objectives Internal balance Fully employed economy Little or no inflation External balance Current account is close enough to balance that foreign debts can be repaid (deficit) or that other nations can repay their debts (surplus) 269 Open economy macro policy Policy instruments Expenditure-changing policies: alter aggregate demand for goods Fiscal policy (government taxes and spending) Monetary policy (money supply) Expenditure-switching policies: shift demand to/from imports or domestic goods Devaluation or revaluation (fixed rates) Exchange market intervention (managed float) Direct controls Tariffs, quotas, subsidies, capital controls 270 Open economy macro policy Economic objectives and macro policy 271 Open economy macro policy Exchange rate policies & overall balance If a nation was experiencing recession and a BOP deficit, a currency devaluation would encourage exports and help boost domestic production If it were experiencing inflation and a BOP surplus, a revaluation would cut back on exports and cool domestic spending 272 Open economy macro policy Exchange rate & overall balance (cont’d) Such policy moves are not made in a vacuum; one country’s devaluation effectively means a revaluation for its main trading partners If done without international consultation, these policy shifts might invite retaliation (as occurred during the Great Depression) 273 Open economy macro policy Fiscal & monetary policy: internal effects Fiscal and monetary policy are generally used to achieve internal balance, but their effectiveness depends on the external sector Under a fixed exchange rate system, fiscal policy is more successful in promoting internal balance than is monetary policy Under a floating rate system, monetary policy is more effective than fiscal policy at achieving internal balance 274 Open economy macro policy Fiscal policy: short run internal effects Under fixed exchange rates Aggregate demand rises Increase in government spending Money demand and interest rates increase Output and employment rise Net capital inflows Central bank sells currency and money supply rises Output and employment rise further Assumes high degree of capital mobility For contractionary fiscal policy, reverse all changes 275 Open economy macro policy Fiscal policy: short run internal effects Under floating exchange rates Aggregate demand rises Increase in government spending Money demand and interest rates increase Imports rise and trade account worsens Output and employment rise Net capital inflows Decrease in aggregate demand, output, employment Currency appreciation Assumes high degree of capital mobility For contractionary fiscal policy, reverse all changes 276 Open economy macro policy Monetary policy: short run internal effects Under floating exchange rates Money supply increases Aggregate demand rises Output and employment rise Interest rate falls Net capital outflows Currency depreciates Exports rise and trade account improves Output and employment rise further Assumes high degree of capital mobility For contractionary monetary policy, reverse all changes 277 Open economy macro policy Monetary policy: short run internal effects Under fixed exchange rates Money supply increases Aggregate demand rises Interest rate falls Net capital outflows Output and employment rise Central bank purchases currency Money supply decreases Output and employment fall Assumes high degree of capital mobility For contractionary monetary policy, reverse all changes 278 Open economy macro policy Fiscal & monetary policy: external effects Since floating rates foster BOP equilibrium, focus is on fixed rates In short run, monetary policy has a clear effect on BOP Expansion worsens BOP balance Contraction improves BOP balance Short run effects of fiscal policy are not certain they depend on capital mobility 279 Open economy macro policy Monetary policy: short run external effects Under fixed exchange rates Aggregate demand rises Money supply increases Trade account worsens Interest rates fall Overall BOP worsens Net capital outflows Capital account worsens Assumes high degree of capital mobility For contractionary fiscal policy, reverse all changes 280 Open economy macro policy Fiscal policy: short run external effects Under fixed exchange rates Aggregate demand rises Trade account worsens Increase in government spending Overall BOP may improve Money demand rises Interest rates rise Net capital inflows For contractionary fiscal policy, reverse all changes 281 Open economy macro policy Policy agreement and policy conflict Monetary policy If a nation has unemployment with a BOP surplus, or inflation with a BOP deficit, an increase/decrease in the money supply will restore both internal and external balances But if a nation has unemployment with a BOP deficit, or inflation with a BOP surplus, a policy aimed at solving one problem will worsen the other Fiscal policy - effects are unclear under those circumstances 282 Open economy macro policy Policy agreement and conflict (cont’d) In such cases where policy aims do conflict, some combination of fiscal and monetary policy measures will be necessary Some imbalances are even more intractable, such as the case where a nation experiences both inflation and unemployment along with a BOP imbalance, and require a wider range of policy instruments 283 Open economy macro policy International policy coordination Domestic economic policy moves can spill over to affect other countries Major industrial nations have worked to coordinate economic policy so that external balances are maintained without sacrificing domestic objectives 284 Open economy macro policy International policy coordination Annual Group of Seven (G-7) economic summits Regular meetings of central bank heads at the Bank for International Settlements Major international policy agreements, such as the Smithsonian Agreement (1971); Bonn Summit (1978); Plaza Accord (1985); Louvre Accord (1987) 285 International Economics By Robert J. Carbaugh 9th Edition Chapter 18: International Banking: Reserves, Debt and Risk International reserves Nature of international reserves Reserves of foreign currency and other suitable assets are used to finance payments imbalances Reserves allow a nation to take more time to correct BOP disequilibrium (but may also delay needed action) Demand for reserves depends on the monetary value of international transactions and the size of payments imbalances 287 International reserves Demand for international reserves Main factor in demand for reserves is the nature of the adjustment mechanisms to correct BOP imbalances Exchange rate flexibility is a crucial element of the adjustment process Key use for reserves is to intervene in currency markets to defend an exchange rate The more a nation is willing to let its currency float, the less it will need sizable reserves 288 International reserves Demand for international reserves Other factors affecting demand for reserves: Automatic adjustment mechanisms that respond to payments imbalances Economic policies used to correct payments imbalances International coordination of economic policies Level of world prices and income 289 International reserves Demand for reserves and exchange rate flexibility 290 International reserves Supply of international reserves International reserves may be owned by nations or may be borrowed if reserves on hand prove insufficient Owned reserves: Reserve currencies (US dollar, Japanese yen, etc,) Gold - once central, now rarely used Special drawing rights Borrowed reserves can come from the IMF and other official arrangements, or can be borrowed from major commercial banks 291 International reserves Gold as a reserve asset Gold was originally used as currency, but it began to be replaced by paper money and bank deposits Post-World War I inflation prompted many nations to return to a gold standard, where all currency in circulation was backed by gold Gold standard collapsed during the Great Depression, to be replaced by a gold exchange standard after World War II 292 International reserves Gold as a reserve asset (cont’d) The US dollar was set to be convertible to gold at a fixed rate, and the dollar became a key reserve asset Stresses from persistent US payments deficits brought an end to the gold exchange standard by 1973, and in 1975 gold was removed as an international reserve asset 293 International reserves Special Drawing Rights (SDRs) Because a gold standard limits the amount of currency available to the supplies of gold on hand, the IMF created the SDR to increase international liquidity SDRs represent rights to draw foreign currencies from the IMF to use for settlement purposes; they are allocated to IMF members proportionally SDRs are pegged to a basket of key international currencies, and are useful because they are not tied to any one currency 294 International reserves Facilities for borrowing reserves IMF drawings - members may purchase foreign currency with their own currency, with limits and sometimes conditions General Arrangements to Borrow - major industrial nations agreed to make further reserves available to the IMF if needed Swap arrangements - major industrial nations agree to swap currencies with each other; can be done more quickly and less visibly than Fund drawings 295 International reserves Facilities for borrowing reserves (cont’d) Special financing facilities - to compensate mostly developing countries which face hardships which are transient or beyond their control: Compensatory Financing Facility, Oil Facility, Buffer Stock Facility Commercial bank lending 296 International lending International lending risk Credit risk - potential for financial default Country risk - whether government policies will help or hinder the servicing of the loan Currency risk - whether devaluations or exchange controls will interfere with the repayment of the loan 297 International lending International debt problems Many developing nations borrowed heavily on easier terms in the 1970s because major banks were flush with deposits from oil producing states In the 1980s, rising interest rates caused payments on the variable rate international loans to increase, and the ability of many of these major debtor nations to service their loans came into question 298 International lending International debt problems (cont’d) Most loans were denominated in dollars, meaning that these nations had to run current account surpluses to earn foreign exchange with which to make loan payments - just as the industrial nations went into a recession Measures used to gauge debt burden: debt-to-export ratio; debt service/export ratio 299 International lending Options for debt-service problems Nations can stop making payments - but there are severe consequences Service debt at any cost - but may be politically impossible Reschedule the debt - stretch out repayment schedule (but pay more overall) Obtain emergency loans from the IMF - but conditionality may be hard to stomach 300 International lending Reducing bank exposure to developingcountry debt Loan sales in secondary market Debt buybacks or debt-for-debt swaps Debt-for-equity swaps Debt reduction and forgiveness 301 International lending Eurocurrency markets Deposits in dollars and other major currencies in banks outside the US Main advantage over US deposits is interest rate differential Eurocurrency market facilitates financing of trade and investment, but there are concerns that some of the banks in this market do not face the same regulations as do large banks in the industrial nations 302