Topic 1 - Globalisation and the Multinational Firm Flashcards
- How is international financial management different from domestic financial management?
There are three major dimensions that set apart international finance from domestic finance. They are:
- foreign exchange and political risks,
- market imperfections, and
- expanded opportunity set.
Discuss the major trends that have prevailed in international business during the last two decades.
The 1990s brought a rapid integration of international capital and financial markets. Impetus for globalized financial markets initially came from the governments of major countries that had begun to deregulate their foreign exchange and capital markets. The economic integration and globalization that began in the eighties is picking up speed in the 1990s via privatization. Privatization is the process by which a country divests itself of the ownership and operation of a business venture by turning it over to the free market system. Trade liberalization and economic integration continued to proceed at both the regional and global levels. Despite sovereign debt crisis in Europe, more EU member countries have adopted the common currency, euro, which effectively became the second global currency after the U.S. dollar.
What considerations might limit the extent to which the theory of comparative advantage is realistic?
The theory of comparative advantage was originally advanced by the nineteenth century economist David Ricardo as an explanation for why nations trade with one another. The theory claims that economic well-being is enhanced if each country’s citizens produce what they have a comparative advantage in producing relative to the citizens of other countries, and then trade products. Underlying the theory are the assumptions of free trade between nations and that the factors of production (land, buildings, labor, technology, and capital) are relatively immobile. To the extent that these assumptions do not hold, the theory of comparative advantage may not realistically describe international trade.
Explain the mechanism which restores the balance of payments equilibrium when it is disturbed under the gold standard.
The adjustment mechanism under the gold standard is referred to as the price-specieflow mechanism expounded by David Hume. Under the gold standard, a balance of payment disequilibrium will be corrected by a counter-flow of gold. Suppose that the U.S. imports more from the U.K. than it exports to the latter. Under the classical gold standard, gold, which is the only means of international payments, will flow from the U.S. to the U.K. As a result, the U.S. (U.K.) will experience a decrease (increase) in money supply. This means that the price level will tend to fall in the U.S. and rise in the U.K. Consequently, the U.S. products become more competitive in the export market, while U.K. products become less competitive. This change will improve U.S. balance of payments and at the same time hurt the U.K. balance of payments, eventually eliminating the initial BOP disequilibrium.
Suppose that the pound is pegged to gold at 6 pounds per ounce, whereas the franc is pegged to gold at 12 francs per ounce. This, of course, implies that the equilibrium exchange rate should be two francs per pound. If the current market exchange rate is 2.2 francs per pound, how would you take advantage of this situation? What would be the effect of shipping costs?
Suppose that you need to buy 6 pounds using French francs. If you buy 6 pounds directly in the foreign exchange market, it will cost you 13.2 francs. Alternatively, you can first buy an ounce of gold for 12 francs in France and then ship it to England and sell it for 6 pounds. In this case, it only costs you 12 francs to buy 6 pounds. It is thus beneficial to ship gold due to the overpricing of the pound. Of course, you can make an arbitrage profit by selling 6 pounds for 13.2 francs in the foreign exchange market. The arbitrage profit will be 1.2 francs. So far, we assumed that shipping costs do not exist. If it costs more than 1.2 francs to ship an ounce of gold, there will be no arbitrage profit
Discuss the advantages and disadvantages of the gold standard
The advantages of the gold standard include:
(I) since the supply of gold is restricted, countries cannot have high inflation;
(2) any BOP disequilibrium can be corrected automatically through cross-border flows of gold.
On the other hand, the main disadvantages of the gold standard are:
(I) the world economy can be subject to deflationary pressure due to restricted supply of gold;
(ii) the gold standard itself has no mechanism to enforce the rules of the game, and, as a result, countries may pursue economic policies (like de-monetization of gold) that are incompatible with the gold standard.
Explain the arrangements and workings of the European Monetary System (EMS).
EMS was launched in 1979 in order to
(i) establish a zone of monetary stability in Europe,
(ii) coordinate exchange rate policies against the non-EMS currencies, and
(iii) pave the way for the eventual European monetary union.
The main instruments of EMS are the European Currency Unit (ECU) and the Exchange Rate Mechanism (ERM). Like SDR, the ECU is a basket currency constructed as a weighted average of currencies of EU member countries. The ECU works as the accounting unit of EMS and plays an important role in the workings of the ERM. The ERM is the procedure by which EMS member countries manage their exchange rates. The ERM is based on a parity grid system, with parity grids first computed by defining the par values of EMS currencies in terms of the ECU. If a country’s ECU market exchange rate diverges from the central rate by as much as the maximum allowable deviation, the country has to adjust its policies to maintain its par values relative to other currencies. EMS achieved a complete monetary union in 1999 when the common European currency, the euro, was adopted.
List the advantages of the flexible exchange rate regime.
The advantages of the flexible exchange rate system include: (I) automatic achievement of balance of payments equilibrium and (ii) maintenance of national policy autonomy.
Criticize the flexible exchange rate regime from the viewpoint of the proponents of the fixed exchange rate regime.
If exchange rates are fluctuating randomly, that may discourage international trade and encourage market segmentation. This, in turn, may lead to suboptimal allocation of resources.
Rebut the above criticism from the viewpoint of the proponents of the flexible exchange rate regime
Economic agents can hedge exchange risk by means of forward contracts and other techniques. They don’t have to bear it if they choose not to. In addition, under a fixed exchange rate regime, governments often restrict international trade in order to maintain the exchange rate. This is a self-defeating measure. What’s good about the fixed exchange rate if international trade need to be restricted?
Privatization
Privatization
How is a country’s economic well-being enhanced through free international trade in goods and services?
With free international trade, it’s mutually beneficial for 2 countries to each specialize in the production of the goods that it can produce relatively most efficiently and then trade those goods. By doing so, the 2 countries can increase their combined production, which allows both countries to consume more of both goods.
What considerations might limit the extent to which the theory of comparative advantage is realistic?
Underlying the theory are the assumptions of free trade between nations and that the factors of production (land, buildings, labor, technology, and capital) are relatively immobile. To the extent that these assumptions do not hold, the theory of comparative advantage may not realistically describe international trade.
Gersham’s Law
Phenomenon that bad (abundant) money drives good (scarce) money out of circulation. Often observed under the bimetallic standard under which both gold and silver were used as means of payments, with the exchange rate between the two fixed.
Price-specie-flow Mechanism
Adjustment mechanism under the gold standard. Under the gold standard, a balance of payment equilibrium will be corrected by a counter-flow of gold.
