Exam 2

Question 1

What is the gold standard?

Answer 1

A fixed exchange rate system where governments fix the price of their currency to gold

Question 2

What is a floating exchange rate?

Answer 2

A system which governments do not establish a central or official rate for their currency and are under no obligation to engage in foreign exchange market intervention to influence the value of their currency. In this system, the value of one currency in terms of another is determined purely by the interaction between supply and demand in the foreign exchange market.

Question 3

What is a fixed exchange rate?

Answer 3

A system in which governments establish a central or official rate for their currency, usually expressed in terms of some standard, such as gold or another currency. Governments are required to use monetary policy and foreign exchange market intervention to maintain their currency in a band around the official rate.

Question 4

What is an adjustable exchange rate?

Answer 4

A system in which governments establish a central or official rate for their currency against some standard, like a fixed exchange rate system, but are allowed to change the official rate occasionally, usually under a set of well defined circumstances.

Question 5

What is balance of payments?

Answer 5

An accounting device that records a country’s international transactions. Divided into two broad categories: current account and capital account.

Question 6

What is balance of payments adjustments?

Answer 6

The use of government policies to correct a balance of payments surplus or deficit.

Question 7

What is a current account?

Answer 7

One of the two principal components of the balance of payments. It records all payments between a country and the rest of the world in terms of goods, services, income on foreign investments, royalties, licenses, unilateral transfers, government expenditures on foreign aid, and overseas military spending.

Question 8

What is a capital account?

Answer 8

One of the two principal components of the balance of payments. It records all financial flows into and out of a particular country. Include bank loans, equities, and foreign direct investment.

Question 9

What is Bretton Woods?

Answer 9

The international monetary system created in 1944 in Bretton Woods, New Hampshire. It is based on fixed but adjustable exchange rates in an attempt to provide a stable international monetary system and at the same time allow governments to use monetary policy to manage the domestic economy. The system collapsed in 1973 and represented the last time that governments attempted to create and maintain an international monetary system based on some form of fixed exchange rates.

Question 10

What is dollar overhang?

Answer 10

Foreign holdings of dollars and dollar-denominated assets in excess of US holdings of monetary gold necessary to redeem foreign dollar holdings. In other words, outstanding claims on US monetary gold greater than the stock of monetary gold the United States held. Many argue the dollar overhang lay at the base of the instability of the Bretton Woods system.

Question 11

What is the stabilization fund?

Answer 11

The credit mechanism controlled by the IMF created by contributions from IMF member governments. The pool of liquidity thus established is, in turn, loaned to member governments when they face balance of payments crises.

Question 12

What are the IMF conditionality principles?

Answer 12

Property applied to terms governing transactions between the IMF and member governments. In order to gain access to IMF financial resources, a government must agree to a set of policy changes designed to correct its balance of payments deficits. Typically they must tighten the money supply and reduce government spending. In more extreme cases, governments are also required to undertake structural reforms.

Question 13

What are the exchange restrictions under Bretton Woods?

Answer 13

Government regulations on the use of foreign exchange. The central bank establishes a monopoly on foreign exchange. Any private actor that wants foreign currency must petition the central bank, which can then restrict the types of transactions for which it exchanges currencies. By doing this, governments can limit financial capital flows into and out of their domestic economies.

Question 14

What is monetary policy?

Answer 14

Changes in a country’s money supply undertaken in an attempt to manage aggregate economic activity. An expansionary monetary policy is typically associated with rising inflation, a restrictive monetary policy with falling inflation and rising unemployment.

Question 15

What is the central bank?

Answer 15

An institution that manages the currency and monetary policy of a country or a monetary union.

Question 16

What is central bank independence?

Answer 16

The degree to which a country’s central bank can set monetary policy free from interference by the government. Typically considered to be a function of one of three things: the degree to which the central bank is free to decide what economic objectives to pursue, the degree to which the central bank is free to decide how to set the monetary policy in pursuit of this objective, and the degree to which central bank decisions can be reversed by other branches of government. Contemporary economic theory argues that independent central banks are better able to deliver low inflation than are central banks controlled by the governments.

Question 17

What is credible commitments?

Answer 17

When the cost to an individual of changing a current policy or policy position is greater than the benefits conferred to the individual by the new policy or policy position. A credible commitment is seen as a solution to a time-consistency problem.

Question 18

What is the Phillips Curve?

Answer 18

Curve that posits a tradeoff between inflation and unemployment. Governments can reduce unemployment and can reduce inflation only by causing higher unemployment. This tradeoff now seems to hold only in the short run.

Question 19

What is the time-consistency problem?

Answer 19

Situations in which the best course of action in the present is not the best course of action in the future.

Question 20

What is the natural rate of unemployment?

Answer 20

The economies long run equilibrium rate of unemployment, or the rate of employment to which the economy will return after a recession or boom. It is never 0, and can be substantially above 0.

Question 21

What is the acceleration principle?

Answer 21

A central component of monetarist theories that claims that a government can only keep unemployment below the natural rate of unemployment only if it is willing to accept a continually increasing rate of inflation. So, there is no long term tradeoff between inflation and unemployment

Question 22

What is the political business model?

Answer 22

The stimulation of the economy just prior to the election in order to improve prospects of the incumbent government getting reelected.

Question 23

What is the sectoral model of exchange rate policy?

Answer 23

Different interests in society will have different exchange rate preferences. Ex: Export Oriented industries prefer a stable exchange rate that is undervalued so they are more competitive.

Question 24

What is the partisan model of exchange rate policy?

Answer 24

Exchange rate policies can differ along partisan lines.

Question 25

What is electoral model of exchange rate policy?

Answer 25

Exchange rate policy is made in order to get politicians reelected. Ex: Before an election, the exchange rate will be appreciated, so the consumers will feel as though they are doing better, and vote for the current administration.

Question 26

What is the unholy trinity?

Answer 26

Governments have three policy goals, each of which is desirable in its own right: 1. Maintaining a fixed exchange rate, 2. Having the ability to use monetary policy to manage the domestic economy (monetary policy autonomy), 3. Allowing financial capital to flow freely into and out of the domestic financial system (capital mobility). The government can only achieve two of these three goals simultaneously.

Question 27

What is capital account liberalization?

Answer 27

The process by which a country to move from a closed capital account regime, where capital may not move freely in and out of the country, to an open capital account system where capital can enter and leave at will. Related to the unholy trinity, and the government must give up monetary policy or a fixed exchange rate.

Question 28

What is Keynesian economic theory?

Answer 28

An approach to macroeconomic policy that places primary emphasis on using fiscal and monetary policies to manage domestic demand in order to maintain domestic full employment. Widely adopted after WWII, but lost favor in the 1980s.

Question 29

What is a monetary union?

Answer 29

An exchange rate system in which governments permanently fix their exchange rates and introduce a single currency. Ex: The EU and the euro.

Question 30

What is a target zone in exchange rates?

Answer 30

An exchange rate system in which all currencies have an official rate surrounded by very wide margins within which the rate is allowed to fluctuate. When a currency moves outside the margins, the government is obligated to intervene in the foreign exchange market or alter domestic interest rates to bring the currency back inside. Was discussed in connection with the Plaza Accord, but never implemented.

Question 31

What is the Brady Plan?

Answer 31

Proposed in 1989 by Secretary of the Treasury Nick Brady, it attempted to bring the developing country debt crisis to a close. It encouraged commercial banks to negotiate debt reduction agreements with debtor governments. To make the proposal attractive to commercial banks, the advanced industrialized countries and the multilateral financial institutions advanced $30 billion with which to guarantee the principal of the Brady bonds, which the new debt instruments came to be called.

Question 32

What is debt-service capacity?

Answer 32

The ability of countries to make payments of interests and principal on foreign debt. Because debt service, especially within developing countries, must be made in foreign currencies, export earnings are a good measure of a country’s debt-service capacity.

Question 33

What is the Latin American Debt Crisis?

Answer 33

A financial crisis in the late 70s and early 80s caused by over investment in Latin American countries, due to petrodollar recycling, even as the Latin American countries were unable to pay back their debts and faced declining debt service ratios. Eventually, the Mexican government told the US it could no longer make scheduled payments on their debt. Initially, the crisis was thought to be a short term liquidity crisis, but it eventually became clear that an economic reconstruction was necessary to solve the problems. The Latin American countries also failed to solve the collective action problem, while the banks were able to, leading to better terms for the banks.

Question 34

What is foreign aid?

Answer 34

Financial assistance provided to developing countries’ governments by the advanced industrialized countries and by multilateral financial institutions like the World Bank in order to finance development projects. Foreign aid can be supplied as a grant (no repayment) or a loan (requiring repayment). Loans can be offered on concessional terms (below market rates of interest) or non-concessional terms (at market rates of interests)

Question 35

What is foreign direct investment (FDI)?

Answer 35

A form of cross-border investment in which a resident or corporation of one country owns a productive asset located in a second country. Such investments are made by multinational corporations. FDI can involve the construction of a new or the purchase of an existing plant or factory.

Question 36

What is a short term liquidity problem?

Answer 36

A situation that arises in financial markets in which a financial institution or other actor is solvent (assets are greater than liabilities) but cannot readily trade its assets for the cash required to settle a liability.

Question 37

What is macroeconomic stabilization?

Answer 37

The correction, through various policy programs, of macroeconomic imbalances that are producing high and rising inflation. Most programs involve the reduction of a government budget deficit and a tight monetary policy. Most conditionality agreements with the IMF contain such a program.

Question 38

What is petrodollar recycling?

Answer 38

The revenues earned by OPEC governments in the wake of the 1973 oil price rise. These funds were channeled by commercial banks to some developing country governments to finance their current-accounts deficits.

Question 39

What is a structural adjustment?

Answer 39

Policy reforms supported and promoted by the World Bank and the IMF that seek to increase the role of the market and reduce the role of the state in developing countries’ economies. A standard component of IMF conditionality agreements.

Question 40

What is the IMF?

Answer 40

Established at the Bretton Woods conference in 1944, they were charged with helping governments finance and ultimately eliminate balance of payments deficits. Since the shift to floating exchange rates, the IMF has become increasingly focused on the management of debts and balance of payments crises in developing countries.

Question 41

What are heterodox strategies?

Answer 41

An approach to macroeconomic stabilization adopted by some Latin American governments during the 1980s. Seen as an alternative to the orthodox approach promoted by the IMF, these strategies attempted to reduce inflation through government controls on wages and prices, rather than by restricting aggregate demand by reducing government deficits and slowing the rate of growth of the money supply. In most instances, they failed to stabilize the economy.

Question 42

What is the London Club?

Answer 42

A private association established and ran by the large commercial banks engaged in international lending. Developing countries’ governments that want to reschedule their commercial bank debt must work out the terms of the rescheduling agreement with the London Club.

Question 43

What was the East Asian Financial Crisis?

Answer 43

A financial crisis in 1997 in Thailand, Indonesia, South Korea, and Malaysia. These banks attracted foreign investment, which they then lent back out to private interests in their country. This was risky, because they faced the risk that the East Asian governments would devalue their currency, meaning that they could not service dollar denominated loans. They also needed the foreign lenders to renew loans, because if they didn’t, the Asian banks wouldn’t be able to pay back the loans. The banks also believed that the government would bail them out if they were to fail, a moral hazard, which caused them to make risky loaning decisions. Then, the panic began, and foreign lending dried up, and the banks were insolvent. Many governments abandoned a fixed exchange rate during this time. It led to East Asian governments having one goal: don’t let it happen again through large stockpiles of foreign reserves and large current-accounts surpluses.

Question 44

What is Bretton Woods II?

Answer 44

In the wake of the East Asian financial crisis, East Asian countries pegged their currency to the US dollar, ran persistent trade surpluses with the US, finance exports in excess of imports, and hold US government debt instruments. It is stable as long as East Asian countries were willing to accumulate claims on the US government and US trade deficits drove growth in East Asia.

Question 45

What are heavily indebted poor countries?

Answer 45

A plan developed in September 1996 to reduce the debt owed by the world’s poorest countries to multilateral lenders; linked debt reduction to a two stage conditionality process. The goal was to bring a country’s total foreign debt down to sustainable levels, defined as less than 150 percent of export earnings. HIPC was succeeded by the Multilateral Debt Relief Initiative.

Question 46

What is a moral hazard?

Answer 46

A consideration that arises when banks believe that the government will bail them out if they suffer large losses on the loans they have made. If the bank believes the government will cover their losses, they have little incentive to carefully evaluate the risks that are associated with the loans they make. If the loans are not repaid, the government picks up the tab. In such an environment, banks have an incentive to make riskier loans than they would in the absence of a guarantee, thereby raising the likelihood of the crisis.

Question 47

What is the Paris Club?

Answer 47

An informal group composed of 19 permanent members, all of which are governments that hold large claims on other governments. Its primary goal is to negotiate the rescheduling of these debts.

Question 48

What is the Multilateral Debt Relief Initiative?

Answer 48

A plan for 100% debt forgiveness announced by the Group of 8 governments, the World Bank, and the IMF in March 2006. It is based on the same conditionality principle as the HIPC initiative but provides full forgiveness of all debt to multilateral lenders for eligible countries.

Question 49

What is the ILO?

Answer 49

The International Labor Organization whose mandate is to advance labor standards globally. In 1998, they adopted the Core Labor Standards, which were controversial.

Question 50

What is an environmental Kuznet’s curve?

Answer 50

An inverted U-shaped relationship between per capita income and environmental degradation. Low and high income societies both have low environmental impacts. The most severe environmental damage occurs in middle income rapidly industrializing countries.

Question 51

What is the Gini Coefficient?

Answer 51

A metric employed to measure income inequality. It ranges from 0 to 1, with higher values indicating further inequality.

Question 52

What are the core labor standard?

Answer 52

Principles elaborated by the ILO that include freedom of association, the right to bargain collectively, abolition of forced labor, non-discrimination in the workplace, and a minimum employment age.

Question 53

What is the race to the bottom?

Answer 53

Government deregulation in an attempt to attract MNCs to their country over another.

Question 54

What is policy conversion?

Answer 54

The subset of countries that are catching up with the leading economies.

Question 55

What is the Calvo Doctrine?

Answer 55

Argues that no government has the right to intervene in another country to enforce the private claims of the government’s citizens. Invoked by Latin American governments to challenge the right of governments to use diplomatic pressure and military force to protect foreign investments made by their citizens.

Question 56

What are export processing zones?

Answer 56

Industrial estates where the government provides land, utilities, transportation infrastructure, and, in some cases, buildings to the exporting firms, usually at subsidized rates. They are often established by developing countries to attract foreign direct investments by multinational corporations.

Question 57

What is the UN Resolution on Permanent Sovereignty over Natural Resources?

Answer 57

Adopted in 1962, this doctrine recognizes the rights of host countries to exercise full control over their natural resources and over the foreign firms operating within their borders extracting those resources. The resolution affirmed the right of host country governments to expropriate foreign investments and to determine appropriate compensation in the event of expropriation.

Question 58

What is the obsolescing bargain?

Answer 58

Explains how an MNC and a host government divide the income generated by an MNC investment in the host country. The MNC has the bargaining advantage in pre-investment negotiations. So, the initial investing agreement will direct a larger share of the resulting income to the MNC. But, once the investment is made, the government gains bargaining power, and uses it to renegotiate the initial agreement and claim a larger share of the investment income. The initial bargain then becomes obsolete by the changes in relative bargaining power.

Question 59

What is an intangible asset?

Answer 59

Something whose value is derived from knowledge or from skills or production processes of a firm. Can be based on a patented process or design, or it an arise from production specific know how shared by workers in the firm. The inherent difficulty. of selling or licensing this kind of asset provides an important rationale for horizontal integration.

Question 60

What is vertical integration?

Answer 60

A form of industrial organization in which a single firm controls the different stages of the production process, rather than relying on the market to acquire the inputs and sell outputs. A single corporation, for example, may own oil wells, the associated pipeline, the oil refinery, and a chain of gas stations. Difficulties inherent in long term contracting create incentives for vertical integration.

Question 61

What is a locational advantage?

Answer 61

Country characteristics, such as its factor or natural resource endowments or market size, that create incentives for a foreign corporation to invest in the country.