Lesson 2 Flashcards
Bimetallism
A system in which gold and silver are used as the basis for the currency
-Both metals have a fixed legal value
-Coin value is determined by their gold and silver content
-Increased money supply as two metals provide more liquidity
-Fixed legal value has to be revised if there is an imbalance of supply
Gresham’s law
Economic principle that ‘bad money drives out good money’
-When gold and silver have fixed legal face value, but have different intrinsic values
-People will use the overvalued (bad) money and hoard the undervalued (good) money.
-For example, when value of the metal in coin exceeds its face value, people will melt them down, removing the coins from circulation.
The gold standard (advantages+disadvantages)
- Fixed exchange rate and free conversion between currency issued by the government and gold.
-Government issues currencies backed by equivalent gold reserves.
-This fosters a stable exchange rate regime and low inflation due to limited supply of gold.
-But hampers international trade and investment and causes deflation
-Challenges for governments to maintain gold reserves.
Price-specie-flow mechanism
- Under the gold standard, trade balance is automatically restored.
- According to this mechanism, when a country runs a trade surplus, it accumulates more gold which
allows it to issue more money, leading to higher domestic prices. - Higher prices will reduce trade competitiveness and eliminate trade surplus.
- On the other hand, country with a trade deficit will experience outflow of gold and decrease in money supply, leading to lowerprices and increase in exports until trade balance is in equilibrium.
Interwar period
- Suspend redemption of banknote in gold
- Embargo on gold exports
- Hyperinflation, predatory depreciation and protectionism
- USD replaced GBP as the dominant currency
- Gold standard was shortly restored before the Great Depression
- No coherent international monetary system
- Detrimental to international trade and investment
Bretton Woods
Post-war international monetary system
-USD was the dominant world currency
-Launch of IMF and World Bank
-Every other currency was assigned a value against the USD with +-1% fluctuations allowed - this could be revised if great misequilibrium
-Gold assigned a fixed value of $35 an oz. Only USD could be used to purchase gold
Triffin paradox
Triffin Paradox is a fundamental flaw presented in the Bretton Woods system
-With USD being the de facto global reserve currency and the US being the only country able to print USD, it had to run persistent trade deficits to supply the rest of the world with USD.
-This led to a loss of confidence in the value of the USD making it difficult to maintain the fixed exc. rate between gold and the USD
-President Nixon ended the free conversion of USD and gold in 1971
Flexible exhange rate regime
After 1971 the world gravitated towards a flexible exchange rate regime
-Currency values are determined by supply and demand
-Central banks can intervene on the market to achieve stability
-USD remains world’s reserve currency
-Fluctuations present new challenges to individuals and corporations
Balance of Payments (BoP)
Please provide formula and describe the elements that make up the BoP
BoP = Current Account + Capital Account + Financial Account
Current Account = Imports and exports of good and services (Net exports = current account)
Capital Account = Cross border transfer and acquisitions of nonfinancial assets: Land, Natural resource rights, contracts, leases…
Financial Account = Purchases and sales of assets, portfolio investment, direct investment etc.
Current Account continued - please describe its four categories
Goods: Physical goods being purchased and transfered from one country to another. (Cars, Electronics, Commodities)
Services: Payments and receipts of legal, consulting, and engineering services, royalties for patents and intellectual properties, insurance premiums, shipping fees and tourist expenditures
Primary income: payments and receipts of interest, dividends and other income on foreign investments
Secondary income: Unrequited payments such as foreign aid, reparations, grants and gifts (one-directional flows)
List four factors affecting trade
Inflation: High domestic inflation will encourage imports as foreign goods will be cheaper than domestic competitors. It will also harm exports as these goods will be more expensive abroad
National income: With higher living wages, typically you see higher demand for imported goods
Trade restrictions: Governments can impose tariffs and quotas on imports to protect domestic producers
Exchange rates: Highly valued currency encourages more imports and less exports
Please describe the J-curve effect
If a country decides to weaken or devalue its own currency to promote more exports there can be short term negative implications:
At first the trade balance may worsen. If the demand for imported goods in inelastic, the demand my not decrease and the amount spent on imports will rise in the short term, as will exports.
Over time imports will decrease leading to a decreased trade deficit
Please list five factors affecting FDI
Regulation - there may be restrictions in place limiting the amount of FDI allowed
Tax rate - lowering tax rates will encourage FDI
Privatization - privatizing previously govt. owned businesses will encourage FDI
Economic prospect - Countries with a promosing economic outlook will attract FDI
Exchange rates - An undervalued currency will encourage investment from foreign investors
Official reserve account
Reserve Account is operated by a country’s central bank to buy and sell reserve assets it holds:
* Official reserve assets decreases if BoP is in deficit, increasing demand of home
currency
* Official reserve assets increases if BoP is in surplus, increasing demand of foreign currencies
International reserve assets include:
-Foreign currencies
-Gold
-SDRs
-Reserve positions in the IMF
