Download INTERNATIONAL MONETARY ECONOMICS IoBM, FEBRUARY

INTERNATIONAL MONETARY ECONOMICS
IoBM, FEBRUARY 2014
Section A
1. a)
What do you understand by the concept of gold standard?
(2 marks)
A gold standard is a monetary system in which the standard economic
unit of account is based on a fixed quantity of gold. In the gold
standard, monetary system of paper money is free convertible into a
fixed amount of gold, such that in that monetary system gold backs
the value of money.
b. What were the 2 main functions of the gold standard? (4 marks)
i) The gold standard was used to back currencies; gold was used to
settle international accounts.
ii) The gold standard maintained fixed exchange rates that were seen
as desirable because they reduced the risk when trading with other
countries.
Mention the any 3 factors which led to the death of the gold
standard. (9 marks)
The factors which led to the death of the gold standard are:
i) The postponement of both domestic and international payments that
made the international gold standard non-operational;
ii) Convertibility was not legally suspended;
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iii) Gold exports were restricted by extralegal means with the Bank of
England
commandeering all gold imports and applying moral suasion to
bankers and bullion brokers;
iv) the universal removal of currency convertibility leading to
ineffectiveness of mint parities and inapplicability of gold point.
2. (a) In order to avoid the mistakes of the interwar period, the Bretton
Woods System was created. What do you understand by Bretton Woods
System? (3 marks)
The Bretton Woods System is the international monetary systems which
were set as
internationally agreed rules to conventions and supporting institutions
that facilitate international trade, cross boarder investment and
generally the reallocation of capital between nation states.
The system provides means of payment acceptable between buyers
and sellers of different nationality, including deferred payment.
These set of monetary arrangements were perceived to combine the
advantages of the classical gold standard (exchange rate stability) with
the advantage of floating rates (independence to pursue national full
employment policies) setting an adjustable peg system of fixed
parities that could be changed only in the event of a fundamental
disequilibrium.
b. State 2 conditions set for successful operation of the Bretton Woods
System? (2 marks)
i) to inspire confidence;
ii) to provide sufficient liquidity for fluctuating levels of trade;
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iii) to provide means by which global imbalances can be corrected.
c. What was the main cause of the collapse of the Bretton Woods System?
(2 marks)
The inability or unwillingness of governments to maintain effective capital
controls and instabilities related to the central of the dollar.
d. Describe the 4 events following the collapse of the Bretton Woods
System. (8 marks)
The IMF member states have:
i) been free to choose any form of exchange arrangement desired
(except pegging their currency to gold);
ii) allowed the currency to float freely;
iii) pegged their currency to another currency or a basket of
currencies;
iv) adopted the currency of another country; and
v) participated in a currency bloc or forming part of a monetary union.
Question 3:
Mention and describe the three types of loans created under the new Poverty
Reduction and Growth Trust (PRGT) of the IMF. (15 marks)
These are the Extended Credit Facility, the Rapid Credit Facility and the
Standby Credit Facility.
 The Extended Credit Facility (ECF) provides financial assistance to
countries with protracted balance of payments problems. It is the main
tool for providing medium term support to Low Income Countries
with higher levels of access, more concessional financing terms, more
flexible program design features as well as streamlined and more
focused conditionality.
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 The Rapid Credit Facility (RCF) provides rapid financial assistance
with limited conditionality to Low Income Countries facing an urgent
balance of payments needs. It streamlines the Fund’s emergency
assistance, provides significantly higher levels of concessionality, can
be flexibly in a wide range of circumstances, and places greater
emphasis on the country’s poverty reduction and growth objectives.
 The Standby Credit Facility (SCF) provides financial assistance to
low-income countries with short term balance of payments needs. The
SCF replaces the High Access Component of the Exogenous Shocks
Facility and provides support under a wider range of circumstances,
allows for higher access, carries a lower interest rate, can be used on a
precautionary basis and places greater emphasis on the country’s
poverty reduction and growth objectives.
4. Study the table below:
Year 2005
PRODUCT
Year 2010
QUANTITY
PRICE
QUANTITY
PRICE
(‘000kgs)
(K’000)
(‘000kgs)
(K’000)
Tobacco
80
40
100
50
Tea
90
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80
10
Cotton
15
90
20
100
Sugar
50
25
30
50
Rice
60
15
45
120
Required:
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Use the information in the table to compute the Real GDP for the year
2010, assume the base year is 2005.
Real GDP = summation of all output at each point for all the years.
GDP calculated at base year price times quantity in current year i.e. the value of
current goods and services at base year prices
Base year
40
X
x
current quantity
100
GDP
4,000
(2 marks)
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x
80
880
(2 marks)
90
x
20
1,800
(2 marks)
25
x
30
750
(2 marks)
15
x
45
675
(2 marks)
Total = 4,000 +880+1,800+750+675=K8,105 million.
(2 marks)
a) Discuss the Output/Production Approach in the context of the following
(i)
Its methodology for measurement of GDP
(1 mark)
(ii)
The major weakness with this approach
(1 mark)
(iii)
The methodology used to address such weakness in (ii) above.
(1 marks)
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 This approach sums up the production of each and every firm or industry in
an economy during the year under review.
 Double counting: since what has been produced by one film may be used as
raw material in another industry
Calculation of value addition by each firm/industry. i.e. value of a
firm’s production less the value of the intermediate good used in the
production process
Section B
5. a)
i.
Briefly explain the following:
Gross Domestic Product (2 marks)
ii.
Gross National Product (2 marks)
iii.
Net Domestic Product (2 marks)
iv.
Aggregate Demand. (2 marks)
i) Gross Domestic Product is the money value of all final goods and services
produced in the domestic territory of a country during an accounting or
financial year. It is the basic measure of an economy’s economic
performance. It can be estimated at current and constant prices.
ii) Gross National Product is the market value of all goods and services
produced in one year by labour and property supplied by the residents of
a country. It measures the final value of output by factors of production
whether they are located in the country or overseas.
iii) Net Domestic Product is the depreciation allowance (also called the
capital consumption allowance) subtracted from the gross domestic
product. It is calculated as follows:
NDP = GDP – Depreciation
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iv) Aggregate Demand is the sum of the final expenditure on country
produced goods and services measured at current market prices.
b) Explain why Balance of Payments are used as an economic indicator. (2
marks)
Balance of Payments are used as an economic indicator because of its ability
to show a country’s relative value. If a country has a consistently balance of
payment it could mean that there is significant foreign investment within that
country and may also mean that the country does not export much of its
currency. It should be used with caution though.
c) Describe the 2 components of the Balance of Payments giving examples.
(10 marks)
The components of the Balance of Payments are two separate accounts of a
current account and a capital account.
a. The current account shows the net amount a country is earning if it is
in surplus, or spending if it is in deficit. It is the sum of the balance of
trade (net earnings on exports – payments for imports), factor income
(earnings on foreign investments – payments made to foreign
investors) and cash transfers. It covers current transactions.
[it records trade in goods and services, transfers in the form of
income from abroad and interest payments abroad and grants
such as foreign aid. The current account is commonly used to
illustrate the trade balance.]
b. The capital account records the net change in ownership of foreign
assets. It includes reserve account (the international operations of a
nation’s central bank), along with loans and investments between the
country and the rest of the world (but not the future regular
repayments/dividends that the loans and investments yield which are
earnings and are recorded in the current account).
[it records inflows and outflows of financial assets and direct
investment from abroad, including bank loans from abroad,
foreign direct investment, trade credit and holdings of foreign
currency.]
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6. Discuss the International Monetary Fund (IMF) with reference to the
following:
i)
ii)
iii)
Its original and extended objectives; (5 marks)
Its key activities (5 marks)
Its operations. Mention any 5. (10 marks)
i) The original objective of the IMF was to stabilize exchange rates
and assist the
reconstruction of the world’s international payment system. The
extended objective is to improve the economies of its member
countries providing policy advice and financing to members in
economic difficulties and help developing nations achieve macroeconomic stability and reduce poverty.
ii) The activities of the IMF are policy advice to governments and
central banks based on analysis of economic trends and cross-country
experiences; research, statistics, forecasts and analysis based on
tracking of global, regional and individual economies and markets;
loans to help countries overcome economic difficulties and technical
assistance and training to help countries improve the management of
their economies.
iii) The main operations of the IMF are:
a) Enhancing IMF lending facilities – enable it to better serve
its members, creating a Short – Term Liquidity Facility
designed to help emerging market countries with a track
record of sound policies address fallout from the current
financial crisis;
b) Strengthening the monitoring of global, regional and country
economies – has a framework for providing advice to
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c)
d)
e)
f)
g)
h)
member countries on macroeconomic policies through
economic and financial surveillance;
Help resolve global economic imbalances – analyses global
economic developments contained in its World Economic
Outlook to provide finance ministers and central banks
governors with a common framework for discussing the
global economy. Facilitates multilateral consultations to
discuss specific problems facing the global economy with a
select group of countries.
Analyzing capital market developments – devoting
resources to analysis of global financial markets and their
linkages with macro-economic policies, publishing a Global
Financial Stability Report twice a year providing up – to –
date analysis of developments in global financial markets.
Also working with member countries to identify potential
risks to financial stability including through the Financial
Sector Assessment Program.
Assessing financial sector vulnerabilities – the IMF and WB
jointly run the Financial Sector Assessment Program aimed
at alerting countries to vulnerabilities and risks in their
financial sectors in addition to advising on how to strengthen
oversight and supervision of banks and other financial
institutions.
Working to cut poverty – changing its role for low – income
countries as they grow and mature in helping to promote
economic stability and growth, laying ground work for deep
and lasting poverty reduction.
Improving its governance – conducted internal governance
reforms to reflect current global realities: becoming leaner
and more efficient and trimming expenditures and
reorganizing the way it earns revenue to pay for its
operations.
Greater accountability and transparency – publishing its
annual economic health checks and updating its lending
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programs its performance assessed by an independent
evaluation office.
7. Mention 5 factors which led to increases in debts in developing
countries? (5 marks)
Debt in developing countries increased due to the following reasons:
a. Unfavorable terms of trade;
b. Rising international interest rates;
c. Increasing protectionism in the international market;
d. Irresponsible lending by international finance organizations; and
e. The rescheduling of punitive terms where countries delay payment.
State 3 ways in which developing countries have solved the problems of
debt crisis. (3 marks)
The developing countries have solved these problems through:
i. International trade;
ii. High levels of export to lead to reduced reliance on
international aid and loans, achieved through import
substitution and export production strategies, which improve
balance of payments leading to a reduction in debt burden;
iii. Collecting enough revenue through taxation that finances
spending and that the spending side should always be equal or
less than the revenue side of the budget.
Describe the Effects of Capital Flight in Developing Countries (4 marks)
The Effects of Capital Flight in Developing Countries
The outflow of capital can result to liquidity shortage in the domestic
economy and consequently, put an upward pressure on the domestic interest
rate. If the monetary authorities are operating a floating exchange rate
system, the shortage of liquidity could lead to a depreciation of the domestic
currency as well as a loss in foreign reserves. The loss of resources from the
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domestic economy has several long-term effects: firstly, there would be a
drastic shortage in resources available for domestic investment, as well as a
decline in the rate of capital formation, thus, adversely affecting the
country’s current and future growth prospects. The income that is generated
abroad by the flown capital as well as assets held abroad are outside the
reach of domestic authorities and cannot therefore be taxed. As a result
government revenue, which could be used in domestic investment and
external debt servicing, is reduced.
What is the difference between Debt-driven Capital Flight and Debt-fueled
Capital Flight
Debt-driven Capital Flight
In a debt-driven capital flight, residents of a country are motivated to move
their assets to foreign countries due to excessive external borrowing by the
domestic government. The outflow of capital is, therefore, in response to
fear of the economic consequences of heavy external indebtedness. The
consequences of debt-driven capital flight include expectations of currency
devaluation, expropriation risk, and the imposition of high taxes.
The link between external borrowing and capital flight is established through
the desire to avoid such taxes in the future. Similarly, external borrowing
can drive down the domestic rate of return, thus, crowding out domestic
capital and encouraging it to flee to foreign countries.
Debt-fueled Capital Flight
In a debt-fueled capital flight the capital borrowed from abroad is itself
transferred to foreign countries. This form of capital flight is motivated by
the inflow of foreign capital in the form of loans, which are then siphoned
away by corrupt leaders.The domestic government could acquire foreign
capital (foreign exchange) by externalborrowing, and then sell the currency
to domestic residents who transfer it abroad eitherby legal or illegal means.
The government can on-lend funds to privateborrowers through a national
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bank, and the borrowers in turn transfer part or all of thecapital abroad. In
this case, external borrowing provides the necessary fuel for capitalflight.
8. a. Mention 3 features of a liquid asses (6 marks)
i) Features of a liquid asset include:
 it can be sold rapidly, with minimal loss of value any time
within market hours;
 the price of a liquid asset is less volatile
 its market has ready and willing buyers and sellers at all times
What is the difference between liquid and illiquid assets? (5 marks)
ii) A liquid asset is sold easily and quickly without causing significant
movement in the price and with minimum loss of value while an illiquid
asset is an asset which is not readily saleable due to uncertainty about its
value or the lack of a market in which it is regularly traded.
Define international liquidity. (4 marks)
iii) International liquidity is foreign currency or gold in the reserve of any
country which is used to pay for the amount of imported goods and reduce
balance of payment deficit. It is all resources that are available to the
monetary authorities of the country for the purpose of meeting balance of
payment deficits.
Discuss the term financial liberalization (5 marks)
iv) Financial liberalization is the deregulation of domestic financial markets
and the liberalization of the capital account.
OR It refers to reduction of any sort of regulations on the financial industry
of a given country.
OR Financial liberalization is the liberalization of the capital account and
the deregulation of domestic financial markets. It strengthens financial
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development and also contributes to higher long-run growth and it induces
risk-taking, raises macroeconomic volatility and leads to frequent crises.
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