Int'l Parity conditions and the Int'l Monetary System (Lecture #10)

Question 1

What are the two kinds of fixed pegs?

Answer 1

hard peg, soft peg

Question 2

def. hard peg

Answer 2

extreme currency regime peg forms such as Currency Boards and Dollarization

Question 3

def soft peg

Answer 3

fixed exchange rates where authorities maintain a set variable band about some other currency

Question 4

what are the two general types of floating rates?

Answer 4

managed float, free floating

Question 5

def. managed float

Answer 5

let market go, but sometimes jump in (occasional gov intervention)

Question 6

def. free floating

Answer 6

market forces decide exchange rate with no gov intervention

Question 7

def. crawling peg

Answer 7

intermediate peg

-start at one rate and actively manage currency to reach another rate

Question 8

def. arrangement with no separate legal tender

Answer 8

a type of hard peg

the currency of another country circulates as the sole legal tender (formal dollarization) as well as members of a monetary or currency union in which the same legal tender is shared by the members

Question 9

def. currency board arrangement

Answer 9

a monetary arrangement based on an explicit legislative commitment to exchange domestic currency for a specific foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority. restrictions imply that domestic currency will be issued only against foreign exchange and that it remains fully backed by foreign assets

Question 10

A nation’s choice as to which currency regime to follow reflects national priorities about all facets of the economy, including:

Answer 10

– inflation,
– unemployment,
– interest rate levels,
– trade balances, and
– economic growth

Question 11

does the choice about fixed vs floating ever chane?

Answer 11

yes, choice between fixed and flexible rates may change over
time as priorities change

Question 12

fixed rate regime pros (2):

Answer 12

• stability in international prices

* inherent anti-inflationary nature of fixed prices

Question 13

fixed rate regim cons (2):

Answer 13

• Need for central banks to maintain large quantities of hard currencies and gold to defend the fixed rate
• Fixed rates can be maintained at rates that are inconsistent with economic fundamentals

Question 14

When do currency boards exist? What do they mean?

Answer 14

-exist when a country’s central bank commits to back its monetary base, money supply, entirely with foreign reserves at all times
-This means that a unit of the domestic currency cannot be introduced into the economy
without an additional unit of foreign exchange reserves being obtained first

Question 15

what is dollarization?

Answer 15

the use of the USD as the official currency of the country

Question 16

what are arguments for dollarization?

Answer 16

– No currency volatility and currency crises

– Greater economic integration with dollar based markets

Question 17

what are arguments against dollarization?

Answer 17

– Loss of monetary policy
– Loss of power of seignorage
– The central bank of the country no longer can serve as lender of last resort

Question 18

what are the exchange rate regime tradeoffs

Answer 18

rules vs. discretionary and

cooperation vs. independence

Question 19

define in terms of rules vs. discretionary and cooperation vs. independence: pre WW1 Gold Standard

Answer 19

rules and independence

Question 20

define in terms of rules vs. discretionary and cooperation vs. independence: The Bretton Woods agreement (and to a certain extent the EMS)

Answer 20

rules and cooperation

Question 21

define in terms of rules vs. discretionary and cooperation vs. independence: The present system

Answer 21

no rules with varying degrees of cooperation

Question 22

define in terms of rules vs. discretionary and cooperation vs. independence: possible future systems?

Answer 22

may only succeed

combining cooperation with individual discretion

Question 23

def. balance of payments

Answer 23

The measurement of all international economic transactions between
the residents of a country and foreign residents

-Double-entry book-keeping system to record all economic transactions between
the residents of a country and foreign residents in a given period

Question 24

what is the BOP a reflection of?

Answer 24

the supply and demand of a

country’s products, services, financial assets…

Question 25

why is the BOP important for government policymakers and MNEs?

Answer 25

it is a gauge of a nation’s competitiveness or health
– An indication of pressure on a country’s foreign exchange rate
– A signal of the imposition or removal of controls in various sorts of payments
– A forecast of a country’s market potential

Question 26

debit is associated with what

Answer 26

payment OUTFLOWS (negative signs)

Question 27

credit is associated with what

Answer 27

payment INFLOWS (positive signs)

Question 28

What are the 3 main elements of actual process of measuring international economic activity

Answer 28

1. Identifying an international economic transaction
2. Understanding how transactions create debits and credits
3. Understanding the bookkeeping procedures for BOP accounting

Question 29

the BOP is composed of what to primary sub accounts

Answer 29

– the Current Account
• Measures the value of trade (goods and services), investment income and
unilateral transfers
– the Capital/Financial Account
• Measures financial activity (ex: associated with the activities in the
current account but also pure financial flows)

Question 30

is a BOP a balance sheet or cash flow statement?

Answer 30

cash flow statement

Question 31

examples of current account transactions

Answer 31

– The export of merchandise, goods such as trucks, machinery, computers
is an international transaction
– Imports such as French wine, Japanese cameras and German automobiles are international transactions

Question 32

example of financial account transactions

Answer 32

The purchase of a US Treasury bill by a foreign resident

Question 33

Examples of transactions that are counted in and captured in the U.S. BOP

Answer 33

– A U.S. based firm, manages the construction of a major water treatment
facility in a foreign country
– The U.S. subsidiary of a foreign firm pays profits (dividends) back to a
parent in its home (foreign) country

Question 34

What is in current account?

Answer 34

• Goods Trade: export/import of goods
• Services Trade: export/import of services
• Income: predominately current income associated with investments
and wages & salaries
• Current Transfers: financial settlements associated with change in ownership of real resources or financial items plus gifts and grants

• Typically dominated by the export/import of goods, for this reason the Balance of Trade (BOT) is widely quoted

Question 35

Capital and Financial accounts

Answer 35

• Capital account - transfers of fixed assets and acquisitions/disposal of
non-produced/non-financial assets

• Financial account consists of three components and uses maturity and degree of control over assets to classify them
1. Direct Investment – Net balance of long term capital which is dispersed from and into a country for the purpose of exerting control over assets.
2. Portfolio Investment – Net balance of short term capital which flows in and out of the country but does not reach the 10% ownership threshold of direct investment.
• This capital is purely return motivated
3. Other Investment Assets/Liabilities – Consists of various short and longterm trade credits, cross-border loans, currency and bank deposits and other accounts receivable and payable related to cross-border trade

Question 36

Net erros and omissions

Answer 36

Account for statistical errors and/or untraceable monies

Question 37

official reserves account

Answer 37

Held by official monetary authorities within a
country
– Typically comprised of major currencies and reserve accounts held at the
IMF
– The significance depends on whether the country is operating under a fixed exchange rate regime or a floating exchange rate system

Question 38

What four parts makeup a BOP?

Answer 38

1. current account
2. financial and capital accounts
3. net errors and omissions
4. official reserves account

Question 39

def. capital mobility

Answer 39

The degree to which capital moves freely cross-border is

critically important to a country’s BOP

Question 40

what can the free flow of capital possibly do>

Answer 40

potentially destabilize an economy

Question 41

what did the Bretton Woods Agreement promote related to capital mobility

Answer 41

promoted free movement of capital for current account transactions

Question 42

def. capital control

Answer 42

any restriction that limits or alters the rate or direction of capital movement into or out of a country

Question 43

def. capital flight

Answer 43

– Characterized as rapid outflow of capital in fear of domestic political and
economic conditions and policies
– Many heavily indebted countries have suffered capital flight, compounding
their debt service problems
– Capital can be moved via international transfers, with physical currency,
collectables or precious metals, money laundering or false invoicing of
international trade transactions

Question 44

Describe China’s twin surpluses

Answer 44

• China’s twin surpluses aka “double surplus” in the current and financial accounts was highly unusual
• Typically, these relationships are inverses of one another
• The reason for the twin surpluses is due to the exceptional growth of
the Chinese economy
• Between 2001 – 2012 China increased foreign exchange reserves by more than a 10-fold increase (2.5 times larger than the next largest)
• China is now able to manage it currency to maintain competitiveness
worldwide
– China can also maintain a relatively stable fixed exchange rate against other major
currencies