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Answers to Pause-for-Thought Questions Chapter 12 . p465 Where would interest payments on short-term foreign deposits in UK banks be entered on the balance of payments account? As a debit on the investment income part of the current account. Payments of interest, profits and dividends are all elements in this part of the balance of payments account. p466 How did the pound ‘fare’ compared with the dollar, the (former) lira and the yen from 1980 to 2001? What conclusions can be drawn about the relative movements of these three currencies? Taking the period as a whole, the pound depreciated against the US dollar and substantially against the Japanese yen, but appreciated against the Italian lira. There were, however, fluctuations around this trend. There was, for example, an appreciation against the dollar between 1993 and 1998 and against the yen between 1995 and 1998. The movements mean that over the period as a whole there was a decrease in demand for the pound relative to the dollar and yen, but an increase in demand for the pound relative to the lira. This in turn would suggest, other things being equal, that the rate of inflation was higher in the UK than in Japan and the USA but lower than in Italy. There are, however, other possible explanations for currency demand and supply shifts: these are examined in the text. p470 Go through each of the above reasons for shifts in the demand for and supply of sterling and consider what would cause an appreciation of the pound. p473 A rise in UK interest rates relative to those abroad. A lower rate of inflation in the UK than abroad. A fall in UK incomes relative to those abroad. Better investment prospects in the UK than abroad. Speculators believe that the rate of exchange will appreciate. UK goods become more competitive (in terms of quality, etc.) than imported goods. What problems might arise if the government were to adopt this third method of maintaining a fixed exchange rate? It could invite retaliation from other countries, whereby they imposed restrictions on UK exports to them. By reducing the total amount of international trade, it would reduce the benefits that flow from it. (For a discussion of the benefits of trade and of the advantages and disadvantages of trade restrictions, see Chapter 11, sections 11.1 and 11.2.) p476 If speculators on average gain from their speculation, who loses? People buying or selling internationally traded goods who are not themselves speculating. For example, if speculation drives the exchange rate below what it would otherwise have been, then purchasers of imports will be paying a higher price than they otherwise would. Answers to pause-for-thought questions in Essentials of Economics (3rd edition), John Sloman p482 Under what circumstances may a currency bloc like the ERM (a) help to prevent speculation; (b) aggravate the problem of speculation? (a) By its persuading speculators that the combined strength of the countries’ reserves and their combined monetary policies would guarantee that rates of exchange could be maintained within their bands. Under these circumstances speculation would be pointless. (b) If exchange rates were being maintained at clearly disequilibrium levels. The longer devaluation or revaluation were put off, and the more inevitable speculators believed the devaluation or revaluation would eventually be, the more would speculation take place. p486 How might multiplier effects (the principle of cumulative causation) lead to prosperous regions becoming more prosperous and less prosperous regions falling even further behind? The prosperous regions, by expanding faster, would attract more capital and labour to the regions. The extra capital would help to expand capacity and lead to faster growth. The increased labour would increase consumption in the region. This, along with the higher investment, would lead to a multiplied rise in income within the region. As people left the less prosperous regions, consumption would fall. A decline in demand would not attract capital to these regions. This could all lead to a spiralling downwards as the fall in consumption and investment led to a multiplied fall in regional income. p490 What will be the effect on the UK economy if the European Central Bank cuts interest rates? There will an outflow of funds from the euro-zone and the euro will probably depreciate. Funds will flow to the UK and sterling will probably appreciate. UK exports will become less competitive and there will probably be a rise in imports. UK aggregate demand will fall. This will put downward pressure on inflation. (To some extent the downward pressure on aggregate demand in the UK will be offset by a rise in aggregate demand in the euro-zone and hence a boost to the UK economy via the international trade multiplier.) The net result of a forecast of lower inflation in the UK and a worsening balance of trade may encourage the Monetary Policy Committee to lower the rate of interest. If this happened, it could neutralise the balance of payments effect of the ECB’s interest rate cut. In fact, if rates of interest in the UK fell by the same amount as in the euro-zone, the UK’s balance of trade would probably improve, as sterling depreciates against the dollar, the yen and other currencies other than the euro. p494 What are the relative advantages and disadvantages to a developing country of rescheduling its debts compared with simply defaulting on them (either temporarily or permanently)? Default is a high-risk strategy. The benefits are an immediate wiping out of debt. The potential costs are great, however. Its assets in foreign institutions may be confiscated, as too may its ships and merchandise in transit. Once having defaulted, it will be virtually impossible to raise future loans to rebuild the economy. The threat of default, however, especially if made by several debtor countries acting together, could force creditor institutions to offer lower interest rates or more generous rescheduling programmes, or even to write off a certain portion of the debt. p496 Should rich countries cancel all debts owed to them by developing countries? From the perspective of a rich donor country, there might be a political gain from the welcome this would receive from debtor countries. There might also be some spin-off economic gain if it encouraged developing countries to buy its exports. 2 Answers to pause-for-thought questions in Essentials of Economics (3rd edition), John Sloman From the debtor country’s perspective there is the immediate benefit of no longer having to spend large amounts of precious foreign exchange servicing its debts. This would lead to a direct increase in living standards within the country. There is, however, the longer-term problem of whether the cancellation of debts would encourage debtor countries to be wasteful with foreign exchange and to begin building up debts again. It is for this reason that many of the creditor countries and international agencies, such as the IMF and World Bank, argue that cancellation of debt should be combined with requirements that the money saved on debt servicing should be channelled into socially beneficial projects, such as health and education. They also require such countries to undertake various economic reforms, such as cutting government budget deficits and liberalising markets. 3