Financial Globalization Flashcards
What are the movements of Globalization? (6)
Goods, Jobs, Technology & Stages/Process, Capital and People
What are the sides to the Capital Market (2)
Demand -> Who demands and what does the demand depend on?
Supply -> Who supplies the funds for investment and what does this supply depend on?
Capital Demand (Where does it come from and what causes the investment?)
Capital Demand primarily comes from firms and businesses because it is a productive input. The investment decision depends on cost & profitability calculations
What makes the key feature of Capital? (Relates to productivity)
It’s key feature is the diminishing marginal product of capital. As the capital stock grows, each additional unit of capital adds less to output than before. The last unit of invested capital adds less to output than the previous unit.
What is the link between Capital Demand & Investment Demand?
Demand for new capital is linked to investment demand Equation for Investment Demand : I(t) = K(t+1) - (1-d) K(t)
K(t+1) = Desires capital stock for tomorrow
Investment rises with increases in desired capital.
NOTE : Investment is a flow while capital is a stock
What is the desired Capital Stock?
Firms invest in capital till the expected MPK equals the real rental cost of capital
Equation for MPK : MPK = r + d = R (Rental cost of K)
The desired capital stock is the capital at which this equality is reached
NOTE : Lower r = higher is the desired K
What is Investment?
Desired Capital - Current Capital + Depreciation
I(t) = K(t+1) - (1-d)K(t)
What determines Saving (& PROS)
Private saving is determined by households
Greater saving today implies
1. Lower consumption today
2. Higher consumption tomorrow through higher interest income
Reward for saving = interest earning
What is Capital Account Liberalization (CAL)?
A decision by a country’s government 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 in which capital can enter and leave at will.
Consider two countries A + B. Both are identical except B has more capital & GDP than A. What will CAL do?
More capital -> Lower MPK -> Lower autarkic interest rate
Less capital -> Higher MPK
CAL causes open capital flows across borders so capital will flow from B -> A = GDP convergence
What are the PROS of CAL? (3)
Idea was that it would lead to better allocations of world savings. More productive economics would attract more funds thus a higher return to savers, greater efficiency and more incentive to invest globally
What are Net Foreign Assets?
Net Foreign Assets are the claims towards the rest of the world
Equation : NFA(t+1) = NFA(t) + CA(t)
Negative value for NFA = Foreign Debt
What is Current Account and what kind of effect does it have on NFA?
Definition: The EX/IM of goods and services
CA gives the change in claims on foreigners. Accumulate claims when CA > 0 and decumulate otherwise.
NOTE : Accumulation could be of both financial or real assets
What is Sovereign Debt and how is it different?
Sovereign debt is the government debt of a country, a sovereign nation.
Sovereign debt is distinct and different than domestic debt as it is NOT collateralizable. Sovereign debt is more risky due to an enforcement problem.
How did Capital Flows work between 1870-1914?
The world had been on the gold standard and currency values pegged against gold. The Gold Standard was viewed as good for external balance and force towards automatic stabilization
What was the relationship between the Gold Standard and Automatic Stabilization?
The Gold Standard had an automatic stabilization mechanism build in. If there were external imbalances, they would lead to gold flows which would reverse them.
NOTE : Was called a price-specie-flow mechanism
What are the effects of a rising Money Supply in the short term (2) and long term?
Rising money supply leads to…
1. Rising demand and output as price initially sticky
2. Gradually prices start rising
Long run effect of rising money is a higher price level
What are Assets?
Assets are domestic currency bonds or foreign currency assets
What is the difference between Domestic and Foreign Assets?
Domestic Assets are bank bonds & government bonds
Foreign Assets are foreign T-bills, foreign currency and gold
What is a Money Base?
A money base is currency and bank reserves
What is the Price-Specie-Flow Mechanism
Created by David Hume’s, the price-specie mechanism illustrates how trade imbalances can self-correct and adjust under the gold standard. Hume argued that when a country with a gold standard had a positive balance of trade, gold would flow into the country in the amount that the value of EX > value of IM. Conversely, when such a country had a negative balance of trade, gold would flow out of the country in the amount that the value of IM > value of EX.
How did Capital Flows work between 1914-1939?
Gold standard was abandoned during WWI. Afterwards, they tried to reintroduce it but didn’t work.
The UK tried but there was a massive overvaluation -> big CA deficit and gold outflow. Interest rates were raised to prevent gold outflow but there was a unemployment and economic disruption so they ditched it in 1931
What were the biggest problems with the Gold Standard? (4)
- The sustainability of peg depends on credibility of gov
- Gold outflows require higher interest rates to attract gold back (causes asymmetric burden and surplus countries didn’t cut rates)
- Recessionary pressure tests gov’s commitment to peg.
- Can result in speculative attacks on gold reserves
What is a Speculative Attack (relates to Gold Standard)
Markets bet that governments will not defend attack on gold reserves and thus expect devaluation of currency against gold
What is an Exchange Rate?
The price of one money in terms of another
Who sets the exchange rate?
The Central Bank. The CB stands ready to buy and sell any quantity at that rate.
How does the ER stay stable?
The stability of the ER regime depends on people believing the CB commitment
What are the policy options of the CB (Open Economy) (3)
- Actively manage the money base
- Set the exchange rate
- Allow foreign assets to flow freely in and out
What is the Policy Trilemma
Out of the three policy options, the CB can only choose to implement two of them
What happens when you have free capital mobility but a fixed ER?
- The Money Base becomes endogenous
- They supply whatever M public wants
NOTE : if there is a excess supply of M = conversion to foreign currency
In the end there is NO Independent Monetary Policy
Can monetary independence and ER pegs coexist?
Yes, they can with capital controls -> They don’t allow public to convert domestic money into foreign currency
Can monetary independence and capital mobility coexist?
Yes, they can. It allows the exchange rate to be flexible (no fixed exchange rate)
Can the CB choose both prices and quantities with capital mobility?
No
What did people remember from WWI? (3)
- Fixed ERs and free capital mobility
- It led to speculative attacks
- No monetary independence
What was the main consensus (main) and the other consensus (3) after WWII?
Main Consensus : Fixed ERs and Capital Controls
Other consensus:
1. Liberalized trade across countries is good
2. Fixed ERs are good for trade
3. We require domestic agency over monetary and fiscal policy
What was the Bretton Woods Policy Map? (4)
- Fixed ERs -> Encourage trade
- Capital controls -> allow monetary independence
- Short run external imbalances -> IMF lending to help maintain peg
- Long run external imbalances -> Adjust level of peg
What was the 1945-1970 experience? (3)
- Trade grew
- The IMF was able to deal with payment problems
- No large capital flows so no major international crisis
What was the problem with Bretton Woods?
The world was on fixed ERs but all of them were pegged against the US. In addition, the US was on a gold standard and maintained a fixed price on gold
When did Capital Controls end?
In the late 1970’s-80’s, they moved to financial liberalization which was led by the US and the UK.
In the late 1980’s, capital controls ended in Europe
Why did countries want financial liberalization? (4)
- Capital flows would encourage investment, growth and international financial efficiency
- Poorer countries would catch up faster
- It imposed policy discipline on countries
- Helped by fading memory of inter-war stability
