Final

Question 1

What are the features that make the choice between hard peg or free floating difficult for emerging markets?

Answer 1

1. Weak fiscal, financial and monetary institutions
2. Tendency to allow currency substitution and denomination of liabilities in dollars
3. Vulnerability to sudden stoppages of outside capital flows

Question 2

What are the pros and cons of free-floating regime for emerging markets

Answer 2

Pro: independent monetary policy, free movement of capital allowed

Con: Loss of stability and possibility of sudden outflows. Volatility might be more than what a small country with small financial market can withstand

Question 3

What are the pros and cons of fixed rate regime for emerging markets

Answer 3

Pro: Stability and political influence on monetary policy is eliminated

Con: independent monetary policy is lost, Seignorage (benefit to government of printing its own money) is lost

Question 4

What are the two ways a currency can lose value

Answer 4

1. Internally (inflation)
2. Externaly (exchange rate devaluation/depreciation)

Question 5

What are the issues with inflation uncertainty?

Answer 5

Investors guess inflation and set expectations of interest rates and exchange rates accordingly. therefore:

1. Hard to do when inflation is high and unpredictable
2. Uncertainty in prices makes it hard for markets to optimally allocate resources
3. Uncertainty makes investors nervous so they add a risk premium above what it would normally be.

Question 6

What are the three ways to fill a deficit?

Answer 6

1. borrow from bond investors
2. draw down foreign reserves
3. Sell bonds to the CB that creates an account for the government. Creates increase of money supply but same quantity of goods. Aka inflation and hurts independence of the central bank

Question 7

What is the relationship between deficits and monetary growth in emerging and developed markets?

Answer 7

DM: CB are independent and built credibility so they can implement monetary policies independent of the government

EM: not usually independent (obliged to buy gov debt) and have little control over monetary policy, thus monetary policy is subordinate to fiscal decisions

Question 8

What is inflation crisis?

Answer 8

Inflation above 20% annually

Question 9

What is a currency crash?

Answer 9

An annual depreciation against the
dollar (or anchor currency) of 15% or
more

Question 10

What is currency debasement: type 1

Answer 10

A reduction in the metallic content of
coins in circulation of 5 % or more

Question 11

What is debasement: type 2

Answer 11

A currency reform whereby a new
currency replaces a much depreciated
currency earlier in circulation

Question 12

What are symptoms of overvalued currencies?

Answer 12

Declining exports, high unemployment and low levels of reserves

Question 13

What are the pros and cons of using fixed exchange rates as inflation controls?

Answer 13

Pros: anchor to overcome domestic currency weakness and limit volatility

Con: Loss of monetary policy, vulnerable to shocks of the strong currency and target for speculative attacks

Question 14

How do people take advantage of collapses

Answer 14

1. Borrow/short vulnerable currency even at high local interest rates
2. convert local currency to hard currency (downward pressure on currency and drain hard currency reserves)
3. After collapse, local currency is much cheaper in hard currency terms so loan is cheap
4. Sell currency forward, if/when the peg breaks, buy at spot at a depreciated rate and gain

Question 15

What is the Central bank’s intervention against speculative attacks?

Answer 15

• CB buys HC with $ (international reserves)
• $ reserves decrease
• home currency supply decreases
• Sterilization could be used:
• CB buys local currency bills from local banks in equal quantity to foreign reserves draw down so the monetary base is unchanged
• Makes stabilization less painful but equivalent to monetization of the deficit and will undermine long-run credibility of the peg

Question 16

What is capital mobility?

Answer 16

The degree to which capital moves freely across borders is critically important to a country’s BoP

Question 17

how does inflation explain currency crises? (Peg)

Answer 17

1. Peg in effort to control inflation
2. Pegged currency tend to become overvalued due to continuing inflation
3. First sign of overvaluation is deterioration of the currency account (Deficit is financed by drawing down reserves)
4. if it were free floating exchange rate, adjustment might be gradual and manageable

Question 18

What happened with Argentine currency crisis?

Answer 18

They had currency board that was backed by hard currency reserves. Every unit of domestic currency, was convertible to equivalent amount of foreign currency. money supply is limited by rate at which the country receives net inflows of US dollars from trade and general surplus.

Since they have restrictive monetary policy, its hard to come out of recessions and their currency appreciated in real terms therefore decreased competitiveness in exporting

Question 19

What is the relationship between PPP and real exchange rates?

Answer 19

1. If PPP holds, e(f/h) is constant
2. If PPP doesn’t hold, home prices translated to foreign currency are higher than foreign prices. (then e(f/h) increases or real exchange rate will change between periods)

OR

If PPP doesn’t hold, home prices translated to foreign currency are lower than foreign prices. (then e(f/h) decreases or real exchange rate will change between periods)

Question 20

How do capital flows explain currency crises?

Answer 20

Capital flows, overborrowing and illiquidity

• High level of borrowing (inflow) usually comes before financial crisis
• These flows are reversed and a crisis happens (worse when inflows are short term debt in $ or external currency)
• Creates liquidity risk (borrowers under pressure to repay debts instead of refinance which causes low reserves and high debt at excessively short term)

Question 21

What is capital control?

Answer 21

Restriction that limits or alters the rate or direction of capital movement into or out of a country.

Purpose is to:
- Control inflows to correct BoP surplus (prevent appreciation, volatility, restrict foreign ownership of domestic assets)
- Control outfows to correct BoP deficit (financial repression, protect domestic financial sector

Question 21

What is capital flight?

Answer 21

Rapid outflow of capital due to fear of domestic political or economic conditions and policies. (capital controls are meant to protect against)

Question 22

Review that diamond chart on slide 26

Question 22

How do troubled banks and moral hazard explain crises?

Answer 22

Moral hazard: When a risk decision is asymmetric. Agent benefits if it is a good decision but does not bear any consequence if it is bad
- Countries with weak institutions open to global markets before good reforms
- Banks and firms take too much risk (borrow short term in foreign currency)

Question 23

What are the leading indicators of crises?

Answer 23

1. Problems in the financial sector: (Over‐borrowing cycles, bank runs, monetary policy ): Money multiplier, domestic credit/GDP, Excess M1 balances, ending‐deposit rate spreads
2. Problems with the current account: Exports, imports, real exchange rates,trade balance/GDP, fiscal balance/GDP
3. Problems with financial account: foreign reserves, real interest differential, foreign debt, capital flight
4. Problems in the real sectors (growth slowdown): output, real interestrates, stock prices
5. Foreign growth slowdown: US real interest rate, US GDP, world oil prices, Dollar/Yen XR

Question 24

What is relatonship betwene cryptocurrencies and emerging markets?

Answer 24

Banks cannot guarantee convertiblity at par at all times.

Ems already have financila instability, unpredictable inflation, volatile exchange rates, restrictions

But crypto helps international payments but less capital controls.

Bitcoin is legal tender in El Salvador

Question 25

What are open economy macroeconomics

Answer 25

Determination of macro variables such as income, prices and exchange rates

Question 26

What is internal balance vs external balance/

Answer 26

Internal: steady grwoth of domestic economy consistent with low unemployment rate

External: achievement of a desired (sustainable) trade balance or desired international capital flows. Linked to global imbalances

Question 27

What are the assumptions of macroeconomic and monetary policy?

Answer 27

Domestic and foreign interest rate are equal to start (same risk and maturity)

Perfect capital mobility

Question 28

What is the case for fixed vs floating regime?

Answer 28

• The case for FIXED regime
  – Strong monetary discipline (less or no independence)
  – Stability in international prices helps trade
  – Use of the exchange rate as a policy instrument (Competitive devaluations (beggar‐thy‐neighbor), are they good?)
  – But… requires large quantities of international reserves
• The case for FLOATING regime
  – Monetary policy autonomy (independence)
  – Easier exchange rate adjustments
  – Avoid currency crises
  – But… detrimental to cross‐border trade?

Question 29

What is the european monetary system?

Answer 29

• system of fixed but adjustable exchange rates based on central rates defined in relation to the European currency unit

Question 30

What is the goal of european monetary system?

Answer 30

Avoid competitive devaluations. Trade and investments should be determined by comparative advantage and efficient allocation of resources. Not Exchange rates

Question 31

What is the ECU made of?

Answer 31

composit currency (basket) that has fixed amount of the the 12 european community member currencies

• Quantity of each currency is reflected by that country’s relative strength
• ECU used as unit of account and settlement but not legal tender.

Question 32

How was ECU supposed to work?

Answer 32

Exchange rate mechanism (mutually agreed-on central parities for each currency’s equilibrium value. Countries participating in the ERM pledged to keep their currencies within fluctuations bands on each side of the parity)

Question 33

What is bilateral intervention?

Answer 33

Happened if a currency hit the limit of the band. Most bands were +/- 2.25 but different for some

Question 34

Howdid the European monetary system help member states prepare for Union?

Answer 34

Helped prepare ground for monetary union: Stabilized exchange rates and narrowed inflation differentials. Frequent devaluations to offset higher inflation in early years declined between 1979 and 1995.What

Question 35

were the weakness of EMS?

Answer 35

foreign exchange interventions have limited effect on exchange rates if not supported by changes in a country’s policy

Question 36

Why was a european economic and monetary union created

Answer 36

Promote price stability and foster economic growth in the euro area. Goal is a stable economic environment leading to low inflation and low interest rates.

• Benefits countries with poor inflation record (spain, vitality)
• Currency certainty, low inflation, increased trade and more efficient markets

Question 37

What are convergence criteria for Europe?

Answer 37

1. Stabilize exchange rates: maintain currency within ERM bands
2. Control inflation: reduce to less than 1.5% above average of three lowest rates
3. Harmonize long-temr interest rates: bring to within 2% of the average of the three lowest rates
4. government deficit: less than 3% of national GDP
5. Government Debt: less than 60% of national GDP

Question 38

how does European monetary policy work? (ESCB)

Answer 38

European central bank creates money. They are independent and named the European system of central banks which consists of the member states and european central bank.

Since they are independent, they cannot receive instructions from memeber states or institutions

Question 39

What are the tasks of the ESCB?

Answer 39

1. Define and implement monetary policy for Euro area
2. Conduct foreign exchange operations
3. Hold and manage official foreign reserves of the member states

Question 40

What are the rules regarding fiscal policy for Euro area?

Answer 40

Remains responsibility of nation governemnts. Free to choose as long as tehya re sustainable and responsible.

• Governments can issue bonds in eruos but unable to print currency to service debts.
• Need to attract investors by convincing them of their credit worthiness (can lead to some differences in long term interest rates)
• Main danges is excess budget deficits which are prohibited

Question 41

What are the benefits of a monetary union?

Answer 41

• Reduced transaction costs due to elimination of currency exchange (estimated 1% of European GDP)
• lower costs due to competition (easier to compare)
• Eliminate exchange rate risk (more favorable trading and investment)

Question 42

What are the costs of monetary union?

Answer 42

• Giving up right to set exchange rates
• Negative shock worldwide demand of french goods (France must make goods less expensive, so reduce wages but unlikely to do so quickly) Depreciating french franc would achieve the same thing
• Positive shock to worldwide demand of french goods (give rise to inflation unless france allowed currency to appreciate)

Question 43

What is theory of optimal currency areas

Answer 43

• Union is feasible if countries are economically similar
• if two countries share a currency, they should not be exposed to different types of shocks and business cycles should be similar
• If they are affected differently by economic shocks, they need to be able to have a speedy adjustment (labor or capital move from depressed region to flourishing, Wages and prices fall in depressed region to boost demand)