W2 - Reserves as a tool

Question 1

What does the basic national accounts identity tell us?

Answer 1

The total disposable income of domestic residents is equal to the uses for this income

Question 2

What does a positive current account balance suggest about income?

Answer 2

When the current account balance is positive income is greater than expenditures in a country

Question 3

To change the current account balance, what must a country do?

Answer 3

To change the current account a country must evaluate it’s saving and investment make-up

Question 4

What is a larger currency account surplus associated with?

Answer 4

A depreciated currency

Question 5

What could large currency account surpluses be interpreted as being?

Answer 5

The high CA surpluses (and over depreciated currency) could be interpreted as being the result of high savings (combine private and public savings)

Question 6

How can the current account surplus be reduced?

Answer 6

It would be necessary to change the incentives for investment and savings for te economy to save less or invest more. The current account balance will then be lower and the exchange rate will appreaciate

Question 7

What does the double-entry system always say?

Answer 7

A credit in one account always corresponds to a debit in another. Therefore the balance of payments should equal 0

Question 8

Why would a country like China want to accumulate a large amount of foreign reserves?

Answer 8

These inflows would have changed the ER but the government wanted to keep a fixed ER because of the inflow of investment from this hence why they started to accumulate foreign reserves to stabilise the ER to maintain financial inflows).

Question 9

What does the financial account measure?

Answer 9

The change in net indebtedness of a country

Question 10

What happens to the current account if the financial account increases?

Answer 10

If the financial account increases, so your indebtedness increases, you must be running down your current account.

Always think in terms of CA+FA+KA=0

Question 11

What is the financial capital account (FKA)?

Answer 11

The sum of the capital and financial balances excluding reserve assets

Question 12

What must happen to an economy if a current account deficit is not financed by enough investment (capital inflow)?

Answer 12

There must be a reduction in reserve assets when a current account deficit is not financed by investment (capital inflows) a corresponding surplus in the capital and financial accounts, that is, if there is insufficient external financing

Question 13

What must happen if CA<FKA?

Answer 13

Meaning that if CA<FKA, (usually they have opposite signs) it means that CA+FKA<0 meaning that reserves must decrease

Question 14

If a country was maintaining a fixed exchange rate as in Argentina in 2001 and capital inflow was insufficient to cover the current account deficit, what would the government be able to do?

Answer 14

• Sell reserve assets or
• Allow the ER to depreciate

Cannot achieve both

Question 15

Why do countries not want to depreciate their exchange rates?

Answer 15

Signalling to foreign investors, nobody wants to invest in your currency if it’s depreciating causing capital flight. In a country such as Argentina with a low level of exports (and hence wouldn’t benefit a huge amount from a currency devaluation in terms of export growth), it is very important to maintain a stable exchange rate at this point in time.

Question 16

When is the balance of payments said to be in equilibrium?

Answer 16

When its composition can be sustained without intervention and without sudden shocks to the economy

Question 17

What do the conditions of balance of payments equilibrium depend upon?

Answer 17

The condition of equilibrium can vary depending on domestic economic conditions and international economic conditions

Question 18

In what scenarios can currency account deficits financed by foreign indebtedness be sustainable and even desirable?

Answer 18

• If the rate of return for investment in the country is high
• The productive capability of the country increases allowing a future increase in savings without reducing consumption generating the surplus in currency account necessary to pay it’s foreign debt

Question 19

What does the term sudden stop mean?

Answer 19

It describes abrupt reversals to the inflow of capital. If capital inflows suddenly stop and revert to outflows, this can have massive impacts

Question 20

What are some examples of sudden-stops?

Answer 20

• The Asian Financial Crisis
• The Euro Crisis

Question 21

What happened as a result of the sudden stop in the Asian financial crisis?

Answer 21

The ASEAN5 were running a current account deficit from large capital inflows from investors. Then investors lost confidence in the ASEAN5’s ability to maintain fixed ER with USD, pulled money forcing the ASEAN-5 to run CA surpluses and therefore crush imports to allow for a trade surplus

Question 21

What is the issue for short-term capital flows?

Answer 21

If the maturity date is very short, foreign investors can take their money out quickly without restrictions, because of this, you want foreign investment to be long term in nature so that it is less volatile

Question 22

What were the growing weaknesses in the ASEAN5 that lead to the current account sudden stop?

Answer 22

• Slow productivity growth
• Investment increasingly in non-traded sector
• Fixed exchange rates to USD without substantial reserves
• Large short-term capital flows with relatively few restrictions

Question 22

What are the implications of a sudden stop?

Answer 22

BoP must balance so imports are crushed:
- Large currency depreciation
- Contraction in investment
- Fall in consumption
- Widespread economic dislocation

Question 23

What was the issue in the Euro crisis?

Answer 23

Underlying issues with investment from low productivity growth, low economic growth, large budget deficits, Uncompetitiveness as wage growth outstripped productivity, Investment in non-traded sectors

All exacerbated by GFC

Question 24

Why was running a current account surplus hard for the periphery Euro countries?

Answer 24

These countries were unable to sustain a current account surplus because first they have a lot of wage growth and high wages make high prices making your economy uncompetitive in the international trade market not generating lots of exports so the only way out was through inflows of capital from the ECB providing unlimited financing to these countries to pull them out of this.

Question 25

What factors make sudden stops more likely?

Answer 25

• Free cross-border movement of capital
• Reliance on short-term funding
• Reliance on foreign-currency debt
• Reliance on credit inflows rather than equity or direct investment
• Small tradable sectors
• Rigid economies
• Rising global risk
• Unstable ER regimes

Question 26

What is the NIIP?

Answer 26

The Net International Investment Position

Question 27

What is the Net International Investment Position?

Answer 27

The difference between the amount of foreign assets held by domestic residents and the amount of domestic assets held by foreigners. If this is positive, your income exceeds your expenditure

Question 28

Let Bt be the NIIP at the beginning of period t, what does it mean if Bt>0?

Answer 28

It means the country is a net lender

Question 29

If you Bt+1 is smaller than your Bt what type of current account are you running?

Answer 29

If B_t> B_(t+1) you are running a current account deficit

Question 30

What is the transversality condition?

Answer 30

Essentially that a country will choose an optimal level of debt to maximise wellbeing

Question 31

Why do we discount the present value of debt by the interest rate?

Answer 31

Because this is what your debt is paying, you could in theory invest this alternatively

Question 32

What is the present value of the debt or credit of a country assumed to be?

Answer 32

0

Question 33

What does a positive value of the limit B_s+1/(1+i*)^s-t imply?

Answer 33

A strictly positive value means that the country’s credit grows indefinitely at a rate greater than interest rates. Therefore the country could increase welfare by consuming more and accumulating less credit

Question 34

What does a negative value of the limit B_s+1/(1+i*)^s-t imply?

Answer 34

It means that debt forever growing at a rate greater than interest rates. But to have explosive debt, another country needs to have explosive credit which isn’t possible

Question 35

What is the amount of debt equal to?

Answer 35

The amount of debt is equal to the present value of future trade balances

Question 36

What does an indebted country need to do at some point?

Answer 36

Generate surplus

Question 37

When are current account deficits sustainable?

Answer 37

When future trade surpluses can be generated, without abrupt shocks, to limit the foreign debt generated by the current account deficits

Question 38

What is the key takeaway?

Answer 38

The Key takeaway is this: B_t<0 menas that TB_s>0 at some point in the future a country must generate a level of trade surplus to sustain this long-term debt. No country can persistently run current account deficits.

Question 39

What conditions are necessary for debt to be sustainable?

Answer 39

1. The counterpart of a current account deficit should be an increase in the level of investment in the country and not an increase in consumption
2. Investment should be effective in increasing production capabilities, so that a higher level of investment would truly increase the rate of growth for a country
3. The inflow of capital should be stable during the investment period

Question 40

What does the sustainability of the composition of current and financial account balances depend on?

Answer 40

• International credit market conditions
• International investors perception of a country’s ability to pay
• The composition of foreign financing
• What foreign financing is used for