IMF - Block 1 Flashcards
What happens when the euro appreciates, and how does it relate to exchange rates?
When the euro appreciates, it means that the euro increases in value, and this is reflected in a decrease in the exchange rate relative to a foreign currency.
What is the preferred exchange rate definition used in this course?
In this course, the preferred exchange rate definition is “home per foreign,” where the exchange rate represents the price of a foreign currency in domestic currency.
What is the correct answer regarding the relationship between the euro’s appreciation and the exchange rate, given the exchange rate definition used in the course?
When the euro appreciates, the exchange rate decreases.
What is the risk premium in the context of forward market transactions, and why does it exist?
The risk premium is the additional amount paid in a forward market transaction to avoid risk and uncertainty. It exists because the forward exchange rate may differ from the expected future spot rate.
What is the purpose of a forward market, and how does it benefit traders in foreign exchange transactions?
The forward market allows traders to fix the price and quantity of a future foreign exchange transaction in advance, eliminating the uncertainty and risk associated with future spot exchange rates. This benefit provides a hedge against potential adverse price movements.
What is the key difference between a forward market transaction and a spot market transaction?
In a forward market transaction, a contract is signed for a future exchange rate, while a spot market transaction occurs at the current market rate.
Can you provide an example of how forward contracts are used by traders and investors?
For instance, an exporter expecting payment in a foreign currency months from now can sell that currency forward. Similarly, an investor buying foreign currency to invest in foreign bonds can sell the proceeds of the investment forward, reducing exchange rate risk.
What problem do forward contracts solve for traders and investors in international transactions?
Forward contracts help traders and investors avoid the exchange risk associated with uncovered contracts when they have future payments or transfers involving foreign currencies.
Why is it stated that the phrase “Depreciation of the exchange rate” is strictly incorrect?
The phrase is considered incorrect because an exchange rate can only increase or decrease; it cannot “lose value.”
What are intermediate exchange rate regimes, and how do central banks act in them?
Intermediate exchange rate regimes involve central banks taking actions to influence exchange rates. In reality, very few rates are perfectly fixed or floating, but for theoretical and educational purposes, extreme fixed and floating regimes are convenient.
What are the characteristics of fixed exchange rate regimes, and what instruments do central banks use in these regimes?
Fixed exchange rate regimes involve central banks acting to keep the exchange rate at an official level. Instruments used in these regimes include forex interventions, interest rates, and capital controls.
How do different exchange rate regimes vary in terms of central bank (CB) interference?
Exchange rate regimes differ in their central bank (CB) interference. Fixed regimes involve CB actions to maintain the rate at an official level, while floating regimes do not involve CB interference.
List the type of fixed exchange rate systems (in the order of decreasing fixity)
-No separate legal tender (e.g., countries with euro, Ecuador has US $)
– Currency board (e.g., Hong Kong $ vs. US $)
– Other fixed pegs
– Pegs within horizontal bands
– Crawling pegs.
What is the crawling peg system?
A crawling peg is a system in which the exchange rate is adjusted periodically or continuously but within a predetermined range, it provides more flexiblity but still offers a degree of stability compared to a floating exchange rate system
Give a real world example of a crawling peg?
The State of Kuwait employed a crawling peg to manage its currency’s exchange rate, the Kuwaiti Dinar is periodically adjusted within a specificed range in relation to a basket of various currencies, including the U.S. Dollar
What is the spot exchange rate, and how is it defined?
The spot exchange rate represents the price for an immediate transaction, although it is typically effective two days after the deal. For example, if you pay €0.86 to get one dollar now, the exchange rate is €0.86/$. It is denoted as St for the rate at time t.
Why is the future spot rate (St+1) considered risky, and how does it affect financial transactions?
The future spot rate is risky because it can change, impacting the cost of transactions. For example, if you expect St+1 to be the same as St (€0.86/$), but it increases to €0.88/$, your actual cost will be higher. This uncertainty makes St+1 risky at time t.
How can one avoid the risk associated with the future exchange rate St+1?
To avoid the risk in future exchange rates (St+1), one can enter into a forward contract. A forward exchange rate, such as €0.87/$ to get one dollar next month, provides certainty and eliminates risk.
What are the two types of multilateral spot rates, and what do they measure?
The two types of multilateral spot rates are (nominal) effective rates and real effective rates. Effective rates are trade-weighted averages of indices of nominal and real rates, respectively. They measure overall competitiveness in international trade.
What is a nominal effective exchange rate, and how is it calculated?
A nominal effective exchange rate is a trade-weighted average of nominal exchange rates, considering a country’s trade relationships with its partners. It reflects the overall value of a country’s currency in international trade. To calculate it, you take a weighted average of bilateral exchange rates.
What does a nominal effective exchange rate help assess?
A nominal effective exchange rate helps assess a country’s currency strength or weakness in international trade by considering its trade relationships and the average value of its currency concerning its trading partners.
What is a real effective exchange rate, and why is it important?
A real effective exchange rate adjusts nominal effective rates for differences in price levels (inflation) between countries. It is essential because it provides a more accurate measure of a country’s trade competitiveness.
What is the core equation used to calculate the Real Exchange Rate (RER)?
he core equation for calculating the Real Exchange Rate (RER) is RER = eP/P, where “e” represents the nominal exchange rate (e.g., dollar-euro exchange rate), “P” is the average price of a good in one currency area (e.g., the euro area), and “P” is the average price of the same good in another currency area (e.g., the United States).
How is the Real Exchange Rate (RER) calculated in the Big Mac example with specific price values?
To calculate the RER in the Big Mac example, you multiply the nominal exchange rate (e=1.36) by the price in Germany (e.g., 2.5 euros) and divide it by the price in the other currency (e.g., $3.40). This gives us a real exchange rate of 1.2.
What are the participants in the forward market, and what are their motivations?
The participants in the forward market include hedgers (such as importers and exporters looking to avoid risk in the future exchange rate), arbitrageurs (typically banks seeking riskless or risk-free profits), and speculators who take deliberate risky positions to make profits in expectation.
How do speculators take advantage of the forward market?
Speculators take advantage of the forward market by making predictions about future exchange rates. For example, if they expect a currency to be cheaper in the future, they sell that currency in the forward market to profit from the difference between the forward rate and their expected spot rate.
What does it mean to “go short” in the context of the forward market?
“Going short” in the forward market means deliberately taking an open position by selling a currency you do not currently possess. It involves entering into a forward contract to deliver the currency in the future without owning it at the time of the contract.
How does perfect capital mobility relate to the covered interest parity?
Perfect capital mobility implies that individuals can easily convert between currencies and access foreign interest rates. Covered interest parity is a condition where the interest rate of one currency should be equal to the interest rate of another currency plus the forward discount. It assumes perfect capital mobility.
What does “going short” mean in the forward market?
“Going short” in the forward market involves selling a currency through a forward contract without owning it initially, with the expectation of profiting from a future depreciation of that currency.
Can you provide an example of “going short” (bear approach) in the forward market?
Let’s say you anticipate the euro’s value will decrease. You enter a forward contract to sell 10,000 euros in three months at a predetermined rate, like 1 EUR = 1.18 USD. If the euro depreciates, you buy euros at a lower rate in the spot market to fulfill the contract, making a profit. If the euro appreciates, you may incur a loss.
How does an increase in the US interest rate (R star) impact the exchange rates (S and F) according to the lecture? r= r* x ((F-S)/S)
When the US interest rate increases, it affects the returns from investments in the US and at home. This, in turn, leads to a higher demand for US investments, causing the US dollar to appreciate (S goes up) and the forward exchange rate (F) to decrease until equilibrium is reached.
What is the balance of payments?
The balance of payments is a statistical record of all economic transactions between residents of a reporting country and residents of the rest of the world during a specified time period, typically a year. It provides insight into a country’s imports, exports, financial transactions with other nations, and changes in foreign currency reserves.
How often are the statistics included in the balance of payments typically reported?
The usual reporting period for all the statistics in the balance of payments is a year. However, some of these statistics are also published on a more frequent basis, such as monthly or quarterly.
What information does the balance of payments reveal about a country’s economic activities?
The balance of payments reveals how many goods and services a country has been exporting and importing, whether the country has been borrowing from or lending money to the rest of the world, and whether the central monetary authority (usually the central bank) has increased or reduced its foreign currency reserves.
What are the names of the sub-accounts in the BOP?
The current account, the capital and the financial account
What is the current account balance?
The current account balance is the sum of the visible trade balance and the invisible balance, reflecting a country’s economic transactions with the rest of the world over a specific period.
What is the purpose of including ‘unilateral transfers’ in the invisible balance?
‘Unilateral transfers’ in the invisible balance account for payments or receipts with no corresponding quid pro quo, meaning there is no direct exchange of goods or services. Examples include migrant workers’ remittances, pension payments to foreign residents, and foreign aid. These receipts and payments redistribute income between domestic and foreign residents. Payments are recorded as a debit (a fall in domestic income), while receipts are recorded as a credit (an increase in income).
How is the balance of trade in goods, also known as the “Visible Account,” related to the current account balance?
The balance of trade in goods (Visible Account) is a component of the current account balance. It specifically records the trade of tangible (physical) goods, encompassing items such as consumer goods, machinery, and raw materials. This component reflects the flow of funds related to physical goods in international trade.
What is the Balance of Trade in Services, also known as the “Invisible Account”?
The Balance of Trade in Services, referred to as the “Invisible Account,” is a component of the current account balance. It is dedicated to recording the trade of services, encompassing a wide range of services such as bank transactions, insurance policies, and hotel stays.
How does the “Invisible Account” differ from the “Visible Account” in the context of the current account balance?
While the “Visible Account” (Balance of Trade in Goods) deals with the trade of physical, tangible goods, the “Invisible Account” (Balance of Trade in Services) focuses on the trade of intangible services. This distinction highlights the economic transactions related to services like banking, insurance, and hospitality, rather than physical products.
Why is the concept of perfect capital mobility important in the context of covered interest parity (CIP)?
Perfect capital mobility is essential for covered interest parity (CIP) to work effectively. It allows arbitrageurs to exploit differences in interest rates between countries and ensures that the three critical transactions involved in CIP can be carried out seamlessly.
What is the national savings identity?
The national savings identity is a concept that states that private net savings (S minus I) plus government net savings (T minus G) equals the current account balance.
What is the relationship between the current account and asset flows?
The current account is directly linked to asset flows. For example, when a country like the US has a current account deficit, it means there is an outflow of assets, such as bonds, to other countries.
Is there a difference between asset outflow and capital inflow?
Asset outflow refers to assets like bonds leaving a country, while capital inflow refers to funds or money coming into a country. They are related but represent different aspects of financial transactions.
How do current accounts and capital accounts relate to financial planning?
The current account and capital account are components of the balance of payments. The current account primarily deals with trade in goods and services, while the capital account covers financial transactions, including asset purchases and sales. Both are essential for understanding a country’s economic and financial position.
Why are exports recorded as credit entries?
Exports are recorded as credit entries because they represent an inflow of money or economic value into the country. In accounting, a “credit” entry typically signifies an increase in assets or a source of funds, which aligns with the financial impact of exports.
What does a credit entry in accounting indicate?
In accounting, a credit entry usually indicates an increase in assets or a source of funds. When a country exports goods or services and receives payment for them, this payment is recorded as a credit entry because it increases the country’s assets and provides a source of funds.
How do exports contribute to a country’s financial records?
Exports contribute positively to a country’s financial records because they result in an increase in the country’s assets. The revenue generated from exports can be used to invest in domestic businesses, pay off debts, support economic growth, or finance various activities, making exports a source of funds recorded as credit entries.
What do “capital inflows” and “capital outflows” refer to in simpler terms?
“Capital inflows” and “capital outflows” refer to the movement of money in and out of a country’s financial system.
Why are “capital inflows” represented as positive entries in the ledger (credits)?
Capital inflows are recorded as positive (credits) because they signify money coming into the country from abroad, such as when the country borrows money, foreign residents invest in the country, or the country sells its investments to foreigners.
: What’s a simple way to understand why “capital inflows” are recorded as positives?
Think of capital inflows as similar to your country exporting IOUs (promises to pay) or selling a share in its businesses to foreigners. It’s recorded as a positive because it’s like receiving money from outside.
Why are “capital outflows” represented as negative entries in the ledger (debits)?
Capital outflows are recorded as negatives (debits) because they signify money leaving the country and going abroad, such as when the country lends money, buys assets in other countries, or invests in foreign businesses.
What are the three accounts involved in balance of payments?
The three accounts in balance of payments are the current account, the capital account, and the financial account.
How are international transactions booked?
International transactions are booked using the principle of double entry bookkeeping, where each transaction is recorded with both a debit and a credit entry.
What does it mean when there’s an imbalance in the balance of payments?
An imbalance in the balance of payments suggests that there might be an error or discrepancy in the bookkeeping, and it can be considered an error detection tool.
How would you define the basic rule of bookkeeping for international transactions?
The basic rule is that if there’s an export of goods, services, or assets, it’s recorded as a positive (+) because it’s a capital inflow, and if there’s an import, it’s recorded as a negative (-) because it’s a capital inflow.
Where are export of assets and import of assets typically listed in the balance of payments?
The export of assets is typically listed in the capital and financial account, whereas the import of assets is recorded in the current account.
Can a balance of payments be in deficit, and if so, which parts of it?
Yes, a balance of payments can be in deficit. It typically refers to a deficit in the current account or the combination of the current account and the capital and financial account.
How does exchange rate regime affect the official reserves account (ORA) and the balance of payments?
In a floating exchange rate regime, where the central bank does not interfere in the foreign exchange market, the ORA is typically zero, and the balance of payments should be in equilibrium. In a fixed exchange rate regime, the central bank may need to buy or sell currency to maintain the exchange rate, leading to changes in the ORA.
What was the impact of structural problems in Thailand during the East Asian crisis?
Structural problems in Thailand led to speculators questioning the fixed exchange rate of the Thai baht to the US dollar, which caused a significant devaluation of the Thai baht.
When are central banks are more likely to intervene in the foreign exchange market?
Central banks are more likely to intervene when there is a fixed exchange rate that needs to be maintained, as in the case of Denmark and the Danish krone’s peg to the euro.
What is the Marshall–Lerner condition in economics?
The Marshall–Lerner condition is an economic concept used to evaluate the impact of a currency devaluation on a country’s balance of payments.
What does the Marshall–Lerner condition specify regarding the effects of a currency devaluation?
It specifies that for a devaluation to improve a country’s balance of payments, the sum of the price elasticities of demand for a country’s exports and imports must be greater than one.
How does the condition relate to the responsiveness of demand for exports and imports?
The condition is based on the responsiveness of demand to price changes; if demand for exports and imports is highly responsive, a devaluation is more likely to have a positive impact on the balance of payments.
What happens if the sum of these elasticities is less than one according to the Marshall–Lerner condition?
If the sum of these elasticities is less than one, the condition suggests that a devaluation may not lead to an improvement in the balance of payments. This may occur when demand for exports and imports is relatively inelastic.
How do short-run and long-run elasticities of demand typically differ?
In general, short-run elasticities are lower than long-run elasticities, with long-run elasticities usually being approximately twice as great as short-run elasticities.
What is the J-curve effect, and when does it typically occur?
The J-curve effect is the phenomenon where, in the short run, the Marshall–Lerner condition may not be fulfilled, but it tends to hold over the longer run
Why might devaluation work differently for industrialized countries compared to developing ones?
Devaluation might work better for industrialized countries because they face competitive export markets, making their price elasticity of demand for exports relatively elastic. In contrast, developing countries heavily dependent on imports may have very low price elasticity of demand for imports.
What is the underlying idea of the J-curve effect in international economics?
The J-curve effect suggests that in the short run, changes in a country’s exchange rate may lead to a deterioration in its current account as export volumes don’t immediately increase and import prices rise. However, over time, export volumes start to grow, and import volumes decline, improving the current account balance.
Why does the J-curve effect involve a time lag in the improvement of a country’s current account?
The J-curve effect involves a time lag because it takes time for consumers and producers to adapt to changes in exchange rates. Consumers may switch from foreign imports to domestically produced goods gradually, and domestic producers need time to expand export production.
How does imperfect competition play a role in the J-curve effect?
Imperfect competition is a factor in the J-curve effect because it affects how foreign exporters and domestic industries respond to changes in exchange rates. Foreign exporters may reduce their export prices to maintain market share, and domestic industries might lower their prices to limit the impact of increased exports by the devaluing country. These actions depend on the presence of super-normal profit margins in imperfectly competitive markets.
What impact might higher import prices have on export prices in the context of the J-curve effect?
When import prices rise due to a devaluation, workers may seek higher wages to compensate for the increased cost of imports. This, in turn, can lead to higher export prices, reducing the competitive advantage of the devaluation.
Can you provide an example of a study that found evidence of the J-curve effect?
Krugman’s analysis of the sharp depreciation of the US dollar during 1985–87 found a J-curve effect for the US current account. Initially, the deficit worsened, but after a lag of about two years, it improved, with long-run elasticities for imports and exports summing to 1.9, exceeding what is required by the Marshall–Lerner condition.
By whom was the Bretton Wood System created?
It was created by delefates from 44 countries after World War II
Which 3 institutions were created under the Bretton Wood System?
The International Monetary Fund, The World Bank and the World Trade Organization
What was the basis of the Breton Woods monetary system?
It was based on the arrangement that lasted until 1971, where the US dollar was tied to gold at a fixed price of $35 an ounce, creating a limited gold standard.
What were the main features of the Breton Woods agreements?
The agreements established fixed exchange rates for major currencies relative to the US dollar, with the US dollar acting as a global reserve currency. It also incorporated adjustable pegs to restore balance if a country’s payments were out of line.
What was the role of the US dollar in the Breton Woods monetary system?
The US dollar served as the linchpin, tied to gold at a fixed rate of $35 an ounce, and acted as the global reserve currency, influencing international trade and currency values.
How were currencies other than the US dollar connected within the Breton Woods system?
Other major currencies were pegged to the US dollar at fixed exchange rates, allowing conversion into dollars but not directly into gold, creating an indirect gold standard.
How did the United States tackle the challenge of maintaining global circulation of the dollar?
The US constantly printed new banknotes to ensure the dollar’s global circulation, leading to a decline in its real value compared to the gold that backed it.
What does the Triffin Dilemma state?
The Triffin Dilemma states: “It is impossible to simultaneously fix the national currency to gold and make this currency the main vehicle for international trade without negative consequences for the economy.”
What does the Dornbusch Exchange Rate Overshooting Model suggest about the impact of increased money supply on the domestic currency?
According to the model, an increase in money supply results in a short-term depreciation of the domestic currency that exceeds its long-term level.
Does the increase in money supply, according to the model, affect both nominal and real variables?
No, the model suggests that the increase in money supply impacts only nominal variables and doesn’t influence real economic variables.
Define the risk premium concerning currency exchange with an importer’s perspective.
The risk premium in currency exchange pertains to an importer’s approach to minimize uncertainty in currency fluctuations when paying for goods in a different currency. By engaging in forward contracts, the importer fixes an exchange rate for future transactions, transferring the risk of currency rate shifts to the contracting agent, and compensates for this risk by paying a fee, ensuring a set exchange rate. So win-win situation
Explain the implications of a money level shock in the long run
A money level shock leads to an increased absolute price level, yet in the long run, it doesn’t affect the relative scarcity of money in terms of goods. Consequently, while the price level changes, relative prices remain constant, causing no inflation and maintaining a steady real interest rate.
What distinguishes a money level shock from a money growth shock?
A money level shock impacts the price level without affecting the real interest rate. Conversely, a money growth shock involves alterations in the rate of change of the money supply, influencing the real interest rate due to changes in the velocity of money and subsequent inflation expectations.
Why does an importer pay a risk premium in a currency exchange?
The importer pays a risk premium to compensate the agent for taking on the risk of currency fluctuations. This premium, calculated as the difference between the forward rate and the expected future rate, acts as insurance against potential losses stemming from unfavorable changes in exchange rates between the contracted forward rate and the actual future rate.
the BP curve is _________ sloping ignoring limiting cases
upward
The higher the capital mobility a change in r requires a greater change in _____ to restore equilibrium
y
The higher international capital mobility, the _______ is the BP schedule
flatter
real exchange rate is always _______, assuming PPP
constant
If absolute PPP holds, the real exchange rate is equal to_____
one ; because s1/s2 = p1/p2 = 1
The assumptions of the flexprice model are:
absolute ppp
When absolute and relative PPP holds, relative exchange rate is constant so change in r - r* = ___ so Es dot is equal to ____
0; 0
Formula for Risk Premium :
RP = r - r* + ES spot
IF RP is positive
it refers to investing in home
When did Bretton Woods negotiations start?
In 1941
What was the IBRD (International Bank for Reconstruction and Development)
Initially part of the Bretton Woods system, it later merged into the World Bank, aiming to provide financial and technical assistance for the reconstruction and development of member countries.
What was the purpose of the IMF (International Monetary Fund) under the Bretton Woods system?
The IMF was established to provide financial assistance and encourage international monetary cooperation among member nations.
What was the primary goal of the Bretton Woods system?
The primary objective was to establish a monetary system that balanced discipline and flexibility, enabling international business growth while supporting countries in maintaining equilibrium in their balance of payments without imposing trade barriers. so foster IB while maintaining EB
How were exchange rates managed in the fixed system of Bretton Woods?
Exchange rates were fixed within a narrow band, yet the system as a whole remained flexible, requiring an anchor for stability. The dollar was pegged to gold at $35 per ounce, serving as the anchor and instilling confidence in the system with the notion that “the dollar is as good as gold.”
How did the Bretton Woods system accommodate adjustments?
The system allowed for adjustments through devaluation or revaluation when a country’s balance of payments (BoP) was in fundamental disequilibrium. This occurred when there was a permanent adverse shift in demand for products, warranting a rate adjustment to avoid prolonged and painful economic adjustments.
What characterized the fixed aspect of the Bretton Woods system?
Currencies were fixed to the US dollar with a fluctuation band of ±1%, maintaining central parity. For instance, NL ratified the Bretton Woods system with a rate of 2.652 guilders for $1 on Dec 27, 1945.
What did members commit to regarding currency convertibility under the Bretton Woods system?
Members pledged to make their currencies convertible for current account transactions to promote trade.
What was the specific restriction placed on currency convertibility as per the Bretton Woods agreement, particularly concerning capital and financial account transactions?
Currencies were intentionally not made fully convertible for capital and financial account transactions within the Bretton Woods system. This restriction aimed to prevent destabilizing speculation and excessive volatility in international financial markets that could potentially disrupt the stability of member economies.
What is one of the primary goals of the IMF?
One of the key objectives of the IMF is to provide loans to countries facing temporary Balance of Payments (BoP) issues.
How has the role of the IBRD evolved over time?
Initially, the IBRD was established to finance the reconstruction of European nations after World War II, with its first loan of $250 million to France in 1947. Presently, its focus has shifted towards fighting poverty.
What does the IBRD constitute within the World Bank, and how does it obtain funds?
: The IBRD, a part of the World Bank, acquires funds by borrowing from the world’s financial markets. Additionally, the International Development Association (IDA), created in 1960, also a part of the World Bank, secures funds from wealthier member countries.
What is the overarching goal of the IBRD, especially regarding its role within the World Bank?
The primary objective of both the IBRD and IDA, as part of the World Bank, is poverty reduction through various financial mechanisms and development programs.
What were some factors contributing to the US Balance of Payments deficits by the end of the 1960s?
The deficits were a result of the Vietnam War, increased government expenditures, and expansionary monetary policies, leading to the overvaluation of the US dollar.
What were the consequences of the overvalued US dollar during this time?
The overvaluation of the US dollar led to speculation against it, resulting in interventions by non-US central banks to prevent unwanted monetary expansions.
Why did the US prefer other currencies to revalue against the dollar rather than devaluing the dollar itself?
The US was reluctant to devalue the dollar as it would have broken faith with foreign central banks, which had been persuaded to hold dollars instead of gold. Revaluation of other currencies was seen as a means to increase US competitiveness without devaluing the dollar.
What does “revaluation of other currencies” signify in the context of the US’ stance during the Bretton Woods system?
It refers to the adjustment of foreign currencies’ values, strengthening them concerning the US dollar. This strategy was pursued by the US to boost its international competitiveness without devaluing the dollar directly, maintaining confidence among foreign central banks holding dollars.
Why did President Nixon impose a 10% import tariff in the early 1970s?
President Nixon introduced the 10% import tariff as a measure to address the prevailing economic challenges. The tariff aimed to protect domestic industries from competition posed by imported goods. It was seen as a strategy to boost domestic production, create job opportunities, and reduce the trade deficit by making imported goods relatively more expensive compared to domestically produced goods. This move was part of Nixon’s broader economic policies intended to stimulate the US economy and tackle trade imbalances during that period.
What were the actions initiated by President Nixon in August 1971, and how did they lead to the Smithonian Agreement?
In August 1971, President Nixon made two significant decisions: the US ceased selling gold to foreign central banks for dollars, signaling the end of the gold standard, and imposed a 10% import tariff. This move set the stage for the Smithonian Agreement of December 1971, where key changes occurred.
What were the outcomes of the Smithonian Agreement in December 1971?
The Smithonian Agreement witnessed pivotal changes in global currency values. It devalued the US dollar to $38 per ounce of gold, reflecting a reduced gold backing for the dollar. Additionally, other major currencies were revalued upwards by approximately 8%, a measure intended to enhance US competitiveness in global trade
What occurred following the Smithonian Agreement that led to further developments in February and March 1973?
Speculations arose in February 1973, prompting a significant event on March 19, 1973: the declaration of a floating exchange rate system as an interim arrangement. This decision marked a departure from fixed exchange rates and was perceived as a potentially permanent shift in global monetary arrangements.
How did the growth in international trade contribute to a liquidity and confidence problem in the global monetary system under Bretton Woods?
The expansion of international trade necessitated increased liquidity and reserves, leading to a heightened demand for US dollars. However, the growth in the number of dollars in circulation exceeded the increase in the US gold stock, eroding confidence in the dollar’s value. This situation created a delicate balance, where maintaining confidence would impede the necessary expansion of liquidity.
How did US Balance of Payments (BoP) deficits play a role in the increase of reserves at non-US central banks?
US BoP deficits led to a surplus of dollars in the foreign exchange markets. In response, non-US central banks intervened by purchasing dollars to build up reserves, as the forex supply of dollars increased due to the BoP deficits. This process helped manage the surplus of dollars and contributed to the rise in reserves at non-US central banks.
In the Hamada diagram the EU has a __________ money supply dot curve becuase it is much larger in size when compared to Denmark
horizontal
Because Denmark is much smaller than the EU their curve will not be _______
horizontal
Any movement left, right, up, below of the optimal point in the Hamada diagram means that a country is ________
worse off
Why is the curve around the optimum point an ellipsis not a perfect circle in the Hamada diagram?
Because a perfect circle would mean that for a country IB and EB and equally important
We assume that M dot in E* is lower than M dot D in D*. Provide one possible possible explanation for this assumption.
The Germans don’t like inflation because they have had hyperinflation so they are more focused on keeping inflation low.
Pareto efficiency
you can’t make yourself better without making anyone else worse off
Nash equilibrium
all players are satisfied with their strategy and choose best possible course of action for all of them
What are the costs of monetary unification is illustrated by this loss of utility?
Loss of economic stability and politic autonomy
What point will be the new equilibrium on the Hamada diagram?
The indifference curve tangent to the diagonal line
What are the 2 measures for the indebtedness of a country?
- Debt OVER national income
- Debt/Exports
Higher exports coincides with ________
better economic structure
Why does the debt/exports formula make sense?
That’s because if you export a lot it indicates that you are an efficient producer so are more likely to pay back your debt
Characterstics of financial markets in middle income, indebted developing countries
- Low interest rates to stimulate investment, and thereby economic growth
- Low interest rates leads to capital outflow, and therefore an EXCESS demand of funds
- This increases external debt
If markets are liberalized there is:
moral hozard, weak financial institutions
Characteristics of restrictions in Forex markets of middle income countries:
- Government pegs rate to reduce inflation
- Restrictions on capital outflows
- Allocation of forex market through government decree rather than market
Internal causes of the Latin America Debt Crisis:
- Government failures
- Weak institutions
- Money creation to fund budget deficits
- Acceptance of floating interest rate on debt
1st external cause of LA debt crisis:
First oil shock in 1973-1974. So low developed countries who imported oil experienced an increase in the value of M (IMPORTS) but because there was worldwide recession due to the lower aggregate global demand, exports of that low developed country also fell, THEREBY increasing the budget deficit. This led to the increased need for funds. Because OPEC countries had a current account surplus, they had excess funds that could be used for savings so they willingly borrowed to LA countries, via eurobanks (also known as offshore banks). The OPEC countries wanted to have a floating interest rate on their deposits to hedge themselves against interest rate risk, but eurobanks also didn’t want that risk so they passed it on to LA countries in the form of a floating exchange rate.
Describe the second external cause of the LA debt crisis (the second oil shock)
It was deeply rooted in the response of industrialized countries after the second shock. This time, to battle inflation, developed countries were very strict in their monetary contraction policies, So because interest rates were very high to combat inflation, the debt burden on LA countries rose significantly. In addition to that, this significant contractionary policy also meant that recession depeened and therefore exports of low developed countries were also very low. Consequently, this further worsened the current account
what are floating interest rates?
Interest rates that are not fixed
Describe the third external cause of the LA debt crisis:
So, under Reagan’s presidency, the US shifted to a very expansionary policy, which meant that interest rate in the US was higher than in the rest of the world. As a result, this contributed to dollar appreciation, and when the dollar became more valuable, dollar denominated debt also rose significantly in home currency value.
Consequences of the LA debt crisis:
Many LDCs in Latin America could no longer meet debt obligations. This had spillover effects for banking giants, who feared that if debtor country defaulted they would go bankrupt, thus leading to a collapse of the world financial system;
How was the LA debt crisis handled?
Discuss the 3 phases of crisis management:
- Crisis is viewed as a temporary liquidity problem –> let’s give these LDCs more loands so that they have time to restructure and pay back the loans
- Try to grow out of the debt problem; so if the country’s gdp increases it will grow out of its debt
- Crisis is viewed as a solvency problem –>
Elaborate in detail Phase 1 of Crisis Management
Phase 1 = crisis is a temp. liquidity problem –> So it is focused on letting debtors restructure, by devaluating their currency, inducing deflation, (so slowing down the economy by reducing expansionary fiscal policy) and deregulation. So, the IMF by providing loands and meanwhile asking for restructuring, was able to convince commercial banks to provide further loans, thereby acting as a kind of coordinator. This helped avoid bank defaults
Elaborate in detail Phase 3 of Crisis Management (where crisis is viewed as a solvency problem)
Viewing the crisis as a solvency problem really helped solve the problem, this entailed forgiving debt. This debt forgiveness policy was in particular coordinated by Minister Brady and is therefore called Brady’s plan. That’s why IMF and World Bank should set aside funds for that
Argentina is famous for its _______ problems
repeated external debt
Despite the Brady plan in 1989, Argentina still faced _________
high inflation, so they fixed their currency to the dollar, but later on they experienced financial problems at a government level so high budget deficits and current account deficits. This caused a strain on the fixed exchange rate of 1:1 to the dollar which was changed to the 3:1 to the dollar. But because debt was denominated in dollars it tripled in value. So here first we had a currency crisis and then a debt crisis.
Lessons from crises in the 1980s
- LDC should reduce economic controls (liberalize martkets, PROVIDED that institutions are improved, reduce restrictions that create imbalances, avoid corruption)
- Umbrella organizations are useful (like IMF and WB) in case of spillovers, freeriding, and need for coordination
- Liquidity provision to buy time (reschedule debt repayments to give debtors more extra time) HOWEVER THIS MAY POSTPONE restructuring
- Debt forgiveness (aka Brady Plan)
Give an example of debt forgiveness
Debt forgiveness for Greek Govt, Bank of England gave emergency loan to Northern Rock
Evaluate the role of SDRs in the collapse of the Bretton Woods system:
The problem that arose in the end of the Bretton Woods system was that while the number of dollars went up and the amount of gold remained constant, the credibility of the dollar went down. One way to solve this issue was to keep the number of dollars constant to gold, however this would cause a liquidity problem as the dollar was used in international trade and it was in demand. A solution to this dilemma was to give out SDRs (special drawing rights) by the IMF, however the SDR solution came too late, because there was too many dollars in the economy
What was the motivation behind European integration?
It was essentially the effects of the second world war, it was the initiative of France where they wanted to bring coal and steel under a common management. (This was called the Schuman Plan), and this led to the Treaty of Paris.
When did European integration start ?
In 1950
EMS grew later into the
EMU (European Monetary Union)
What did the Schuman declaration present?
It was presented on the 9th of May and it proposed the creation of a European Coal and Steel Community
Year of Treaty of Paris
1951
What did the Treaty of Paris establish?
The European Coal and Steel Community (ECSC)
What was the Treaty of Rome about?
The creation of the European Economic Community (EEC), and the European Atomic Energy Community (Euratom), The EEC’s focus was on goods market integration so reducing tariffs and quotas
What happened in 1967 ?
The three European communities merged in 1967, this was later called the European Community (EC)
What did the Maastricht Treaty in 1991 establish?
The European Union (1991)
After the collapse of Bretton Woods in 1971 European countries were in search for : _________
exchange rate stability, because this case showed how volatile exchange rates can be, exchange rate volatility got attention
the Exchange rate mechanism was a natural follow up of the _________
snake system
The Exchange Rate Mechanism was a part of the ______
EMS (European Monetary System)
How did the parity rate and grid of parities function in the Exchange Rate Mechanism?
The parity rate here refers to the fixed central rate at which one currency could be exchanged for another in the ERM. Each participating currency had its own bilateral exchange rate fixed against other member currencies, creating a grid of parities. For instance, the British pound might be set at a specific rate against the German mark, French franc, etc.
How did the exchange rate band function in the ERM?
Currencies were allowed to fluctuate within a narrow margin or band around their fixed parity rates. In this case, the band was set at ±2.25% around the parity rate (a 4.5% band). This means that currencies could trade within this range without triggering intervention by the central bank to adjust the exchange rate.
Describe the Snake in the Tunnel Mechanism
Under this mechanism, Member States’
currencies could fluctuate (like a snake) within narrow limits against the dollar (the
tunnel) and central banks could buy and sell European currencies, provided that they
remained within the fluctuation margin of 2.25%. The original participants in the
mechanism were France, Germany, Italy, Luxembourg and the Netherlands. Denmark,
Norway and the United Kingdom joined shortly afterwards.
How did the first ERM assist weaker economies with higher inflation and more instability?
The fixed exchange rate system under ERM was intended to borrow credibility from stronger economies like the Bundesbank, so countries with high inflation and less competitive economies showed their willingness to lower inflation by maintaining a fixed exchange rate,
Was ERM successful?
yes because exchange rates were quite stable, and there was lower inflation in countries like Italy and France
What is the successor of ERM?
ERM II, which is present now
Benefits of a monetary union:
You have what’s called monetary efficiency gain, so less uncertainty, lower transaction costs, confusion, more trade, investment.
The second advantage is that you have an improved monetary system because less monetary reserves are needed (countries also using euro can lend to each other) and Union Central Bank is usually a larger play than individual central banks of smaller countries
Main costs of Monetary Union:
You are exposed to shocks of other countries, you have less economic stability because you have fewer monetary instruments, you no longer have the interest rate to handle nor the exchange rate, the European Central Bank can only do that, hence you cannot fight asymmetric shocks (shocks that only harm your country); so in a monetary union there is a serious loss of policy autonomy,
Less signficant costs of Monetary Union
Transition costs, adjustment of hardware, software and the legal system
What is the theory behind the Optimum Currency Area (OCA)?
OCA is region where economic efficieny would be maximal if one single currency were used
Why is it that the benefits and costs of Monetary Union depend on actual integration?
That’s because if you’re more integrated you have fewer asymmetric shocks that are only specific to your country, so goods markets get more integrated as well as factors of production
Is Europe an OCA?
From a labor market point of view not really, integration is pretty low, capital markets are highly integrated and goods market not too much –> hence we can see that the Euro area is not an Optimum Currency Area,
When did the Maastricht Treaty happen
1991
Why are the Danes allowed to not enter the eurozone?
Because they didn’t sign the Maastricht Treaty, which meant that if a country’s currency fullfils the coversion criteria then it must adopt the euro
Higher inflation goes together with _______
depreciation
Formula for Relative PPP =
dS/S = dP/P - dP*/P
Do we assume that foreign inflation is contant in relative PPP?
No
Higher inflation in H vs F comes with ________ of H currency vs. F
depreciation
In the long run exchange rate is determined by the _________ market.
goods ; this is connected with Purchasing Power Parity
What does the law of one price state?
It says that prices are equal across countries, once they are converted into a common exchange rate
Formula for law of one pice
price of domestic good = exchange rate * Price of foreign good
Real exchange rate formula
s * p star/p
What does relative PPP state?
that changes in nominal exchange rates should equal the difference between domestic and foreign inflation on equivalent baskets of goods
What does absolute purchasing power parity hold?
Absolute purchasing power parity holds when the purchasing power of
a unit of currency is exactly equal in the domestic economy and in a foreign
economy, once it is converted into foreign currency at the market exchange rate
If absolute PPP holds then ______ PPP must also hold
relative
What does the Law of One Price hold?
The Law of One Price holds that the
price of an internationally traded good should be the same anywhere in the world
once that price is expressed in a common currency, since people could make a
riskless profit by shipping the goods from locations where the price is low to
locations where the price is high (for example, by arbitraging).
What does the Balassa Samuelson model discuss?
In this model, rich countries supposedly grow rich by advancing productivity in traded “modern” sectors (say, manufacturing). Meantime, all nontraded “traditional” sectors, in rich and poor countries alike, remain in technological stasis (say, haircuts). As productivity in the modern sector rises, wage levels rise, so prices of nontraded goods will have to rise (as there has been no rise in productivity in that sector). If we measure the overall price index as a weighted average of traded and nontraded goods prices, relatively rich countries will tend to have “overvalued” currencies.
Outline chronologically the history of European Integration:
1.Treaty of Paris
2. ECSC
3. Treaty of Rome
4. EMS –> which consisted of ERM 1
5. Maastricht Treaty
6. SGP (Stability and Growth Pact)
7. ECB
8. Euro was launched
9. ERM II
10. ESM
What exactly is the bipolar world theory?
This is the theory where intermediate policy regimes between hard pegs and floating are not sustainable, so only extremely fixed or floating are good.
Merits of Fixed Exchange Rate
i) Stability in exchange rate
(ii) Promotes capital movement and international trade.
(iii) No scope for speculation
(iv) It forces the govt. to keep inflation in check.
(v) Attracts foreign capital
Why is stimulus to intra EU trade a benefit of the monetary union?
- This is because it is argued that in order to fully maximize trade flows between EU member states, there should be a common medium of exchange, this is because differing national currencies that fluctuate increase uncertainty which can only be eliminated by hedging (however this entails some costs).
- A common currency also eliminates transaction costs that are involved in converting different currencies for trade
IN fact The European
Commission has estimated the cost savings from elimination of these transaction costs to be around #0.4% of EU GDP per annum
Explain exactly why more efficient allocation of factors of production is a BENEFIT of monetary unions?
By introducing a single currency and removing restrictions on capital, it fosters a more efficient allocation of resources. Before this, differing rules and controls caused inefficiencies, redirecting capital to less productive areas. The union aims to create a level playing field, allowing capital to flow where it can be most productive
Explain clearly why economizing on foreign reserves is a BENEFIT of the monetary union:
In unions like the Eurozone, countries don’t need as much foreign reserves set aside to manage exchange rates within the union. This means less need for holding reserves in foreign currencies. Plus, because the euro tends to stay steady against other money types, there’s less pressure to keep these reserves. As the euro becomes more important worldwide, it challenges the dominance of the US dollar, giving the Eurozone a financial advantage worth about 0.75% of its overall economy.
How does the creation of a monetary unin in a region like Europe benefit business by providing savings in administrative costs?
When a single currency, like the euro, replaces various European currencies, businesses dealing across different markets save a lot on administrative costs. Previously, handling different currencies meant companies spent resources monitoring and adjusting for exchange rate risks. With the euro, these expenses significantly drop because businesses no longer need to constantly revise pricing strategies and monitor currency fluctuations in different European markets.
How does the introduction of a MONETARY UNION BENEFIT consumers by creating greater price transparency?
Now that all prices in the eurozone countries are quoted in euros it is more difficult for manufacturers to maintain significant price differentials in different
markets. Consumers buying from the cheapest sources will, over time, help to ensure that a single pricing policy biased towards the lower end of the prices charged in different countries is adopted by
many multinationals.
Costs of monetary union:
- Loss of monetary autonomy
- IB sacrificed for EB
- Loss of national macroeconomic policy
- Imported Inflation
Briefly list the advantages of a monetary union:
- stimulus to intra-eu trade as transaction costs are eliminated and uncertainty in currency fluctuations also is diminished thereby removing the cost of hedging
- more efficient allocation of factors of production because of reduced capital controls, so capital flows to most productive areas
- price transparency –> multinational companies are less able to maintain vast price differences in countries, as consumers will tend to buy from the cheapest area
- lower adminstrative costs surrounding the evaluation and analysis of exchange rate risks involved
- economizing on foreign reserves, eurozone countries don’t need to hold as much foreign reserves to manage exchange rates
Explain why loss of monetary autonomy is a cost of monetary union
National central banks cannot use monetary policies like raising interest rates to fight asymmetric shocks that are specific to their country, so must therefore look for instruments to use, however this poses a threat to Tinbergen’s rule which states that for every policy target there should be at least one corresponding tool
Explain why loss of national macroeconomic policy is a cost of monetary union:
The main argument against EMU is that adopting a single currency restricts countries from controlling their own monetary policies and inflation rates. In economics, the Phillips curve suggests a trade-off between inflation and unemployment in the short term. Some nations prioritize low inflation even if it means higher unemployment, while others prefer low unemployment even with higher inflation. However, within a monetary union, common inflation rates are required, causing countries with differing preferences on inflation and unemployment to lose out and not be able to freely decide their own policies
Explain why transition costs are a cost of monetary union:
Transitioning to EMU comes with various costs, including the expenses of replacing existing national notes, printing new currency, education and training, adapting information technology systems, and modifying automated machines like ATMs and vending machines.
Explain how the loss of the inflation tax is a disavanatage of monetary unions:
the “inflation tax” was beneficial for heavily indebted countries as it reduced the real value of their outstanding debt and acted as a revenue source without imposing explicit taxes. The move towards a low inflation rate (target around 2%) in the Eurozone diminished this benefit, requiring these countries to find alternative revenue sources. This shift meant they had to replace the lost “inflation tax” with more explicit taxes, impacting their revenue strategies.
What are the advantages of fixed exchange rates?
- promotes trade and investment
- promotion of economic policy discipline
3.
Why is the promotion of trade and investment a benefit of the fixed exchange rate?
Because when s is fixed, uncertainty regarding exchange rate fluctuations is eleminated and therefore investors from abroad are more likely to invest in our home currency, increasing inflows of funds which can be used for investment
Why is the promotion of economic policy discipline a benefit of the fixed exchange rate system?
If the authorities are in a fixed rate regime, this lowers room for reckless macroeconomic policies (such as excessive monetary growth) will lead to pressure for a devaluation of the currency necessitating intervention by the authorities to defend their currency and a fall in their reserves. Therefore by fixing exchange rates, the currency is viewed as more credible and stable
Provide a real world empirical example for how the fixed exchange rate can maintain discipline.
In the early 80s there was a serious recession in the Netherlands, so the Minister of Finance suggested devaluating the gilder against the Germany mark to make it more competitive, more production so lower unemployment, However this would only work in the short run. Instead the Dutch Central Bank suggested keeping the fixed exchange rate to the German Mark because of UIP and change in Expected spot rates being equal to zero, the interest rate in NL would eventually fall to that of Germany, low interest rate would mean that investments and spending would go up so unemployment would go down. This strategy was much more beneficial and effective compared to the strategy of the Minister which only works in the short run, because a depreciation will mean that imported goods become more expensive thereby causing inflation to rise, further raising unemployment.
How did the reunification of Germany contribute to the ERM crisis?
The reunification of Germany caused a surge in the value of the Deutsche Mark, resulting in high interest rates in countries such as the UK and Italy within the ERM. However, Europe was concurrently experiencing a recession, creating a policy dilemma for these countries. Speculators took advantage of this situation, selling weaker currencies for the stronger Deutsche Mark, exacerbating the pressure on those weaker currencies.
What was the policy dilemma faced by countries like the UK and Italy during this period?
The policy dilemma stemmed from the need to maintain high interest rates to support their currencies against the strong Deutsche Mark while Europe was in a recession. This posed a challenge as sustaining high rates during economic downturns was difficult and created vulnerabilities that speculators exploited by selling off weaker currencies.
How did Denmark’s rejection of the Maastricht Treaty impact the crisis?
Denmark’s rejection of the Maastricht Treaty increased tensions in the foreign exchange markets, adding to the existing strains within the ERM. This rejection further heightened uncertainty and volatility in the currency markets, contributing to the overall crisis.
Disadvantages to fixed exchange rates:
- Adjustability Concerns: Many fixed exchange rate systems allow for occasional adjustments, introducing uncertainty or exchange rate risk, contrary to the perception of total stability.
- Rigidities and Misalignment: Insisting on maintaining fixed rates without considering economic conditions can lead to rigidity and economic crises, as seen in Argentina in 2004.
- Inability to Respond to Shocks: Fixed rates limit a country’s ability to respond effectively to economic shocks, as they lack the currency adjustments available in floating exchange rate systems.
Advantages of floating exchange rates:
Ensure BoP Equilibrium: Allows for adjustment without intervention, as currency depreciation corrects market imbalances. However, it doesn’t guarantee a zero current account (CA) balance, only a balance of payments (BoP) equilibrium.
Monetary Policy Autonomy: Offers flexibility in using monetary policy to stimulate the economy. However, its effectiveness might be limited in the long run as monetary changes may not have lasting effects.
Insulate Domestic Economy: Shields the domestic economy from sudden price shocks abroad, preventing abrupt changes in the domestic price level due to changes in foreign prices.
Promote Economic Stability: Under a floating regime, vertical movements are restricted, minimizing drastic economic fluctuations as observed in fixed exchange rate systems.
Disadvantages of floating exchange rates:
Current Account Vulnerability: Exchange rate fluctuations can impact the current account balance, potentially leading to increased foreign debt if persistent deficits occur, posing risks to sustainability.
Long-Term Monetary Policy Limitations: Monetary policy benefits might be limited in the long term due to the neutrality of money, particularly in affecting real economic variables. Additionally, fiscal policy might be less effective.
Advantages of floating exchange rate regime:
Ensure BoP Equilibrium: Allows for adjustment without intervention, as currency depreciation corrects market imbalances. However, it doesn’t guarantee a zero current account (CA) balance, only a balance of payments (BoP) equilibrium.
Monetary Policy Autonomy: Offers flexibility in using monetary policy to stimulate the economy. However, its effectiveness might be limited in the long run as monetary changes may not have lasting effects.
Insulate Domestic Economy: Shields the domestic economy from sudden price shocks abroad, preventing abrupt changes in the domestic price level due to changes in foreign prices.
Promote Economic Stability: Under a floating regime, vertical movements are restricted, minimizing drastic economic fluctuations as observed in fixed exchange rate systems.
Chronoligically order the events of European Integration
- Treaty of Paris
- Creation of ESCS
- Snake system
- EMS which included ERM One
- Maastricht Treaty
- Stability and Growth Pact (SGP)
- ECB
- Euro
- ERM II
- ESM
Under Absolute PPP real exchange rate equals:
s + p* - p
Formula for private savings:
S= Y-T-C
Formula for public savings:
T - G (taxes - government spending)
National savings (closed economy) =
S (priv) + S (gov) = (Y - T - C) + T - G = S+ T- G
National savings (open economy)=
S+T-G-I
