Term
| Trade and Economic Development Strategies of Import-substitution Industrialization (Def) |
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Definition
| Def: Support growth of domestic import-competing industries in order to replace imports with domestic production, restrain outflow of foreign exchange, and avoid negative terms-of-trade effects. |
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Term
| Trade and Economic Development Strategies of Import-substitution Industrialization (Aspects of...) |
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Definition
Aspects of:
1.Identification of “infant industries” for protection.
2.Imposition of high tariffs and non-tariff barriers to protect domestic industrial sectors; often tariff escalation.
3. Overvalued exchange rate.
4. Substitution of domestic production for imports. |
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Term
| Trade and Economic Development Strategies of Import-substitution Industrialization (Experience) |
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Definition
Experience:
1. Trade barriers become permanent; economic rents created.
2. Guaranteed market reduces incentives for domestic producers to become efficient.
3. Small markets: inability to take advantage of economies of scale; excess capacity problems.
4. Incentive to use capital intensive production regardless of country’s factor endowments; lack of labor absorption.
5. Neglect of agriculture and other primary sectors in which country has genuine comparative advantage. |
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Term
| Trade and Economic Development Strategies of Import-substitution Industrialization (Prevelance) |
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Definition
| Prevelance: in 1950’s–1970’s in developing countries; led to inefficient capital-intensive industrial production, high trade protection, low rates of economic growth, low employment generation, food imports |
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Term
| Trade and Economic Development Strategies of Export-oriented growth (Def) |
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Definition
| Strategy of achieving economic growth through promotion of export industries in which country has potential comparative advantage. |
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Term
| Trade and Economic Development Strategies of Export-oriented growth (Aspects of...) |
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Definition
Aspects of strategy:
• Open markets and low trade barriers to maintain prices at international levels.
• Maintain market-oriented (or undervalued) exchange rate to keep exports price-competitive.
• Take advantage of economies of scale through seeking foreign markets.
• Seek production efficiency through exposure to international competition.
• Special incentives and benefits for exporters, including tax breaks, preferential access to transportation and port services, etc. |
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Term
| Trade and Economic Development Strategies of Export-oriented growth (Experience) |
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Definition
Experience with export-oriented growth:
• Overall association (correlation) of export growth and “outward-oriented” trade policies with national rates of economic growth.
• Great success in some countries: Japan, Hong Kong, South Korea, Singapore, Taiwan, Chile.
• Exposure to international price trends, especially for primary commodities:
- Long-term price declines for many primary commodities
- Price instability for primary commodities
• Potential terms-of-trade problems
• Has stimulated economic restructuring and trade liberalization initiatives in many developing countries (in conjunction with structural adjustment policies). |
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Term
| Growth according to trade orientation, 1963-1998 |
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Definition
1. Most growth occured between 1963 and 1973
2. Most growth occured if your trade orientation was "strongly outward"
3. Inward orientations in the late 80s and 90s caused shrinkage |
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Term
International Monetary Fund = IMF
(Facts) |
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Definition
1. Established, along with World Bank, at Bretton Woods Conference in July 1944, in anticipation of end of WWII, and to avoid financial chaos which followed WWI.
2. Includes 180+ nations
3. Financed through member countries' quotas (proportional to a nation's global financial and economic importance) and loans.
4. Played a key role in stabilizing international finance through Bretton Woods international monetary system which existed from 1940's to early 1970's. |
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Term
International Monetary Fund = IMF
(Goals) |
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Definition
Main goals are to:
• Promote cooperation on issues related to international monetary system
• Facilitate international trade and a multilateral system of international payments
• Promote stability of exchange rates
• Make short-term financial resources available to member nations to correct payments disequilibria |
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Term
| IMF Economic Stabilization Programs |
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Definition
For countries experiencing high inflation, overvalued currency, chronic budget deficits and/or current account deficits:
➢ Reduction of budget deficit through higher taxes or lower expenditures
➢ Controlled growth of money supply to limit inflation
➢ Devalue currency to stimulate exports, reduce imports, and restore equilibrium in current account.
➢ Remove price controls
➢ Reduce wage growth (to no more than productivity growth) |
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Term
IMF Economic Stabilization Programs
(Part II) |
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Definition
IMF's 'quid pro quo':
➢ Helps government reschedule debt payments
➢ Offers loans (standby credits) at reduced interest rates
But…conditional on domestic economic and policy reforms |
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Term
World Bank (International Bank for Reconstruction and Development)
(Facts) |
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Definition
Established at Bretton Woods Conference (July 1944) to provide long-term loans for Europe's reconstruction following WWII.
Since 1950's, has focused on providing long-term loans for projects and programs in developing countries
More than 150 member nations
Funded through capital stock (U.S. is major stockholder with approx. 1/3 of total stock) and sale of bonds backed by credits from member countries. |
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Term
World Bank (International Bank for Reconstruction and Development)
(What they do) |
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Definition
1Bank loans to developing countries finance development projects such as communications and transportation systems, agricultural and rural development, health and nutrition programs, dams and irrigation systems, economic development projects, etc. (Loans must be repaid!)
2. For countries facing economic difficulties, Bank works with IMF in coordinating short-term economic stabilization and longer-term structural adjustment programs to achieve economic stability and growth. |
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Term
| World Bank Structural Adjustment Programs (Overview) |
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Definition
1. Begun in early 1980's, as developing countries experienced problems in paying back loans incurred in 1970's.
2. Aimed at stimulating long-term economic growth and transformation of low-income countries
3. Structural adjustment loans provide financial support to governments and sectors undergoing adjustment, conditional on economic and policy reforms in those sectors ('conditionality'). |
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Term
| World Bank Structural Adjustment Programs (Reforms) |
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Definition
Typical reforms:
• Reducing/eliminating producer and consumer subsidies
• Lowering trade barriers
• Streamlining of the public sector
• Stimulating private sector through less government intervention and greater use of markets
• Tax reform
…typically in concert with exchange rate reforms |
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Term
| World Bank Structural Adjustment Programs (Example) |
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Definition
Example: Structural adjustment in agricultural and food sector
• Lower (zero) subsidies for farmers
• Eliminate (reduce) generalized consumer food subsidies
• Eliminate parastatal marketing organizations; support replacement by private markets.
• Replace administered prices with market prices.
• Increase subsidized interest rates to market level.
• Devalue local currency to reduce imports and stimulate exports (part of ‘export-oriented’ growth strategy) |
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Term
| “False Conflict”? (J. Bhagwati) |
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Definition
The trade-growth-environment linkage:
1. Trade growth leads to economic growth (as evidenced by the trade orientation graph)
2. Econ growth leads to higher incomes
3. Higher incomes leads to increased demand for environmental amenities and conservation |
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Term
| What does the fales conflict conclude? |
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Definition
1. Environmental amenities are “luxury goods”
2. Many environmental indicators improve as incomes increase
a. Urban air pollution: sulphur dioxide and particulate matter (Grossman & Krueger)
b. Fuel efficiency and auto export restraints (Feenstra)
c. The “Environmental Kuznets Curve” |
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Term
| Environmental Kuznets Curve: What does it look like? |
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Definition
X-axis: Income per capita
Y-axis: Envirnomental degredation
1. Horizontal line at ecological threshold
2. Environmental Kuznets Curve increases at a decreasing rate until apex and then decreases at a decreasing rate (i.e. inveres parabola) |
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Term
| Justifications for EKC-type relationships |
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Definition
1. Changing structure of economy and environmental implications:
a.Agriculture & natural resources b. Manufacturing
c. Services
d. Information and knowledge
2. Changes in technology: ‘dirty’ ‘clean’
3. Higher incomes lead to increased demand for environmental quality
4. Assimilative capacity of the environment reached at higher income levels.
5. Political economy of the environment: richer countries can best ‘afford’ a clean environment, through legal, governmental and enforcement institutions |
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Term
| Empirical Evidence for EKC |
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Definition
1. There have been studies that prove this relationship
2. Some graphs are perfect, others show the rise, some show the fall |
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Term
| Trade and Environment: Protectionism, not free trade, can harm environment |
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Definition
1. Agricultural subsidies encourage high production
2. Energy subsidies encourage high use |
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Term
| Trade and Environment: Different countries have different environmental preferences |
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Definition
1. Sovereignty of national decision-making, unless international externalities are present
2. “Eco-Imperialism” |
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Term
| Perils and problems of free trade (Part I) |
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Definition
Free trade ignores “externalities” spillover effects on non- market participants:
1. External cost if SMC > P
2. External benefits if SMC < P
3. Can get socially non-optimal levels of production if social (e.g. environmental) costs are not fully included in private decision-making |
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Term
| Perils and problems of free trade (Part II) |
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Definition
| Subsidization of energy use increases energy-intensive resource use, distorts production patterns and worsens pollution |
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Term
| Trade and Environment (Facts) |
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Definition
“Sustainable scale” of production: “free trade” is really “unregulated international commerce”
Through cost-cutting, increased competition can lower standards (environmental, labor, worker safety, etc.)
“race to the bottom” vs. “harmonizing upward”
Countries that internalize costs should be able to employ “compensating tariffs” to protect higher-cost domestic industries |
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Term
| Alternative solutions to environmental problems |
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Definition
1. “Command and control” administrative regulation, enforcement and penalties
2. Changes in property rights
a. Privatization to avoid free ridership and the ‘tragedy of the commons’
b. Assignment of property rights to avoid environmental degradation by matching incidence of benefits and costs
Example: tropical deforestation
3. Use of government taxes and subsidies to alter behavior of polluters
a. “Polluter pays” principle ‘Pigouvian tax’ can alter producer incentives to pollute and achieve a socially preferred outcome
b. Pigouvian tax is optimal when marginal external costs = marginal net private benefits |
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Term
| Alternative solutions to environmental problems (Part II) |
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Definition
1. Payments for environmental services
a. Compensatory payments to resource owners/managers who provide environmental services, to encourage the provision of uncompensated public goods and reduce negative externalities.
b. Example: compensate landowners landowners in headwaters of watershed for watershed protection and provision of improved water quality and quantity downstream.
2. Specificity rule” precise targeting of solutions to the cause of the problem |
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Term
The World Bank, The New Wave of Globalization and its Economic Effects
(When and Who?) |
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Definition
| 1980-present (Argentina, china, Hungary, India, Malaysia, Mexico, Philippines, Thailand, etc.): |
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Term
The World Bank, The New Wave of Globalization and its Economic Effects
(Characteristics) |
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Definition
1. Trade liberalization in developing world: “new globalizers” have cut tariffs sharply: 34 pts. vs. 11 pts., from mid-’80’s to late ‘90’s
2. Shift of “new globalizers” into manufactured product exports: 25% of developing country exports in 1980 80% in 1998!
3. Larger markets intensify competition and innovation
4. Continuing progress in technology and transport
5. Communications and information advances have benefited geographically dispersed supply chains |
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Term
The World Bank, The New Wave of Globalization and its Economic Effects
(First) |
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Definition
| First wave of globalization, 1870-1914, spurred by falling transport costs, technological change, massive migration, etc., was reversed by nationalism, protectionism, depression, and war, 1914-1945. |
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Term
The World Bank, The New Wave of Globalization and its Economic Effects
(Second) |
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Definition
| Second wave of globalization, 1945-1980, resulted from declines in trade barriers, reductions in transport costs, agglomeration and scale economies. Rich countries benefited greatly, poor countries little. |
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Term
| The World Bank, The New Wave of Globalization and its Economic Effects (Other Factors) |
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Definition
1. Some developing countries (Sub-Sahara Africa, former Soviet Union) not participating in growth due to: poor economic policies, poor infrastructure, geographic disadvantage, late to realize agglomeration economies, trade barriers, dependence on primary exports, civil war
2. Importance of capital flows and migration
3. Reduction of poverty (China, Vietnam, etc.) but increase in income inequality, for example, rural-urban inequality in China
4. Reduction of inequality between countries (both industrialized and developing), but growing inequality within countries, both industrialized and developing |
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Term
| International capital flows (Types) |
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Definition
| Portfolio investments vs. direct investments |
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Term
| International capital flows (Motivations) |
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Definition
Motivations for international capital flows:
1. Maximize expected rate of return on capital
2. Diversify risk within international portfolio (explains two-way investment flows)
3. Market expansion and diversification
4. Minimize costs of production (low wage countries)
5. Horizontal or vertical integration
6. Secure access to raw materials
7. Secure access to promising markets |
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Term
| DFI stock among TRIAD members and their clusters, 1997 (billion dollars) |
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Definition
1. DFI = Direct Foregin Investment
2. The Triad was U.S., E.U., Japan
3. E.U. had the highest total outflow of stock, then US, then Japan |
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Term
| Net Capital Flows from US to Developing Countried between 1970-1998 |
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Definition
1. FDI was the largest by type
2. Increased significantly starting 1990
3. Total reached about $300 billion by 1998 |
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Term
| US/Foregin Long Term Private International Investments |
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Definition
1. All have increased since 1950 through 2002
2. Main types were in petroleum, manufacturing, and finance |
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Term
| US Direct Investments Abroad |
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Definition
1. Increased from 1950-2002
2. Mostly in Europe and Latin America |
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Term
| Benefits of FDI for host country: |
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Definition
1. Increased production, exports and employment
2. Generation of tax revenues
3. Realization of scale economies and price reductions
4. Human capital development, increased managerial and technical skills
5. Technology transfer
6. Increased competition with domestic industry may lower market power and reduce prices |
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Term
| Problems with FDI for host country: |
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Definition
1. Adverse impact on terms of trade (if investment is sizable, if investment goes into export sector, and if country is ‘large’)
2. Instability in the exchange rate and balance of payments
3. “Crowding out” of domestic investment, and shifting of investible funds away from alternative investments
4. Loss of control over domestic policy |
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Term
| Multinational Corporations (Def) |
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Definition
| Often are oligopolies selling differentiated products produced under economies of scale: motor vehicles, petroleum products, electronics, metals, office equipment, chemicals, food |
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Term
| Multinational Corporations (Competetive Advantage) |
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Definition
Sources of...
1. Vertical integration: raw materials, intermediate materials, improved distribution networks
2. Horizontal integration: through foreign affiliates, can exploit market power, adapt products to local conditions, ensure product quality
3. Economies of scale in production (outsourcing of labor functions), financing, R&D, market information
4. Knowledge of market and flexibility in responding to changing market conditions and new opportunities
5. Rapid technology transfer
6. Lower risk through diversification |
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Term
| Multinational Corporations (Where and what type of business?) |
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Definition
1. Mostly in U.S. and Japan
2. Three biggest sectors are: petroleum, electronics, and motor vehicles |
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Term
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Definition
1. Local labor market effects: ability to minimize collective bargaining power; expatriate workers lower local employment gains; buying local businesses (vs. creating new ones) lowers employment gains
2. Abuses of transfer pricing internal pricing of goods within a MNC, typically in order to reduce overall tax burden.
3. Technology transfer:
a. In host country, imported technology can threaten local firms (but may increase competition)
b. For source country, technology transfer reduces competitive advantage, economic growth, etc.
4. For source country, tax concessions (foreign tax credits, tax deferrals for overseas subsidiary earnings) represent a loss to Treasury
5. Loss of sovereignty in host country; exploitation of country through excessive tax concessions, excessively low raw material prices, repatriation of maximum benefits to source country |
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Term
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Definition
| Def: The act of using foregin subsidiaries to avoid payment of taxes. (for an example see lecture 16) |
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Term
| International Factor Movements: Migration (Def) |
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Definition
1. Migration International labor movements; function of international labor mobility (though frequently limited by government laws and regulations)
2. Effect of labor mobility is tendency to equalize wage rates internationally (“factor price equalization”) |
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Term
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Definition
Three big spurts:
1. 1841-1860
2. 1881-1890
3. 1901-1910 |
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Term
| International Factor Movements: Migration (Benifits of...) |
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Definition
1. Economic benefits to worker and family (income, educational and job opportunities, etc.).
2. Remittances to source country often an important source of income
3. Filling available labor demands (both low-skill and high-skill) in destination country, along with economic multiplier effects involved.
4. Help solve demographic challenges in destination country (e.g., paying for future Social Security benefits) |
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Term
| International Factor Movements: Migration (costs of...) |
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Definition
1. “Brain drain” in source country; particularly important in the new economy based on technology, innovation and knowledge generation.
2. Public sector and social services costs in destination country (short-term effects).
3. Wage effects on low-skill labor force by enabling firms to avoid having to raise wages to attract and retain workers |
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Term
| Educational structure of U.S. immigration |
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Definition
Immigrants as a % of native born workers from 1890 to 1900 increaed in all ofthe following categories:
1. High School Dropouts
2. High School
3. Some college
4. College |
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Term
| Importance of Monetary Aspects of Trade |
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Definition
1. International financial market transactions dwarf trade in goods and services:
a. $1-2 trillion/day turnover in foreign exchange markets
b. Foreign ex. turnover/world exports: 12:1 (1979) → 69:1 (1998)
2. Important source of increased global integration
3. Exchange rates strongly influence merchandise trade
4. Role of government policies in affecting interest rates, exchange rates and economic growth |
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Term
| Balance of Payments (Def/Origin) |
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Definition
Def: A statistical account of the transactions between the residents of one country and the rest-of-the-world for one year or a fraction thereof.
Origin:
1. Under Bretton Woods system (post WWII through 1973), emphasis on BOP surplus/deficit as indicator of pressure to devalue or revalue currency.
2. Since 1970’s, less stress on BOP due to acceptance of monetarist principle that BOP surplus/deficit is temporary; focus on XC rates as long-run equilibrating mechanism. |
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Term
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Definition
| BOP accounts based on a system of double-entry bookkeeping with a credit and debit entered for each transaction |
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Term
| Balance of Payments (Credit) |
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Definition
Credit: Any payment to a resident or anything that creates a claim to payment to a resident.
• Exports
• Income on foreign investments
• Unilateral transfers to residents |
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Term
| Balance of Payments (Debit) |
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Definition
Debit: Any payment by a resident or anything that creates a claim by a resident.
• Imports
• Interest-dividends paid to foreign bond- or stockholders
• Capital outflows
• Unilateral transfers abroad |
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Term
| Balance of Payments (Current Account) |
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Definition
Current Account -- Measures net balance of exports and imports of goods and services
• Merchandise balance (“balance of trade”): net trade in goods (exports – imports)
• Services balance: net trade in services
• Investment income
• Unilateral transfers
• “Current account balance” a more comprehensive measure than “balance of trade”
**Has been in a decficit since 1977 and has grown significantly worse |
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Term
| Balance of Payments (Capital Account) |
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Definition
Capital Account -- Records financial transactions which affect balance of assets between countries
• U.S. investments in foreign assets (capital outflow)
• Foreign investments in U.S. assets (capital inflow)
• Special drawing rights (SDR’s): international reserve currency used to clear financial transactions
• “Statistical discrepancy”: residual (unrecorded and illegal activity, calculation errors) |
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Term
| Balance of Payments (Settlement Account) |
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Definition
| Settlement Account -- Records net changes in gold inventories, foreign exchange holdings, loans to IMF, foreign holdings of domestic currency, etc. |
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Term
| Sources of imbalances in balance of payments (Short Run) |
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Definition
1. Demand for currency changes as price of substitute investments (and currencies) changes
2. Income in ROW may increase or decrease (or domestic income may change), leading to changes in currency demand through trade sector
3. Prices of tradables (imports and exports) change
4. Natural and man-made disasters and chocks
5. Consumer tastes and preferences |
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Term
| Sources of imbalances in balance of payments (Long Run) |
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Definition
1. Inflationary changes:
a. As inflation goes up so does ES of currecy which leads to depreciation
b. Especially relative inflation vis-a-vis trading partners
2. Rate of economic growth (esp. relative rates):
Econ growth leads to.....
a.higher demand for imports
b.higher demand for foreign exchange relative to domestic currency
c.higher balance of payments deficit |
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Term
| Sources of imbalances in balance of payments (Long Run Part II) |
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Definition
3. Interest rates (esp. relative rates):
-Higher interest rates lead to:
a. higher demand for domestic curreny
b. captial inflow
c. BOP surplus
4. Technology
5. Resource discovery and depletion
6. Policy:
a. Preferential trading agreements
b. Trade liberalization
c. Fiscal and monetary policy |
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Term
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Definition
The "J curve" can show how the trade balance can respond to a drop in value of the home currency.
X-axis: Time elasped after valuation (typically in months)
Y-axis: Net Change in balance
Shape: Starts at the origin then swoops below zero and then up again, like a J |
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Term
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Definition
“J-curve” effect suggests that BOP initially worsens but improves over time as lags work their way out of the system:
Recognition lags (of changes in economic conditions)
Contracting lags
Decision lags (between new orders)
Replacement lags
Investment and production lags |
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Term
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Definition
| Foreign exchange rate is the PRICE of foreign currency denominated in terms of domestic currency |
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Term
|
Definition
Functions of money:
Medium of exchange
Unit of account
Store of value |
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Term
|
Definition
M1 = currency + demand deposits + other checkable deposits + travelers checks
M2 = M1 + savings deposits + MMF
M3 = M2 + savings bonds + short-term treasury securities + commercial paper |
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Term
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Definition
Two observations about exchange rates:
1. Demand and supply of foreign exchange are two sides of the same phenomenon
2. Foreign exchange rate represents equilibrium price as in any other market |
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Term
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Definition
Demand: Country A's demand for goods/services of country B or a deman to invest in country B
Supply: Country B's demand for Country A's exports or Country B's demand to invest in Country A
Price: Price of Country B in terms of Country A |
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Term
| Market Fundamentals (Decrease => Depreciate) |
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Definition
The following factors depreciate the USD when they decrease and appreciate the USD when they increase:
1. Foregin demand for US exports
2. Foregin demand for US assets (stocks, bonds, bank deposits)
3. US interest rates relative to other nations
4. US productivity relative to other nations
5. US trade restrictions relative to other countries |
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Term
| Market Fundamentals (Decrease => Depreciate) |
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Definition
The following factors depreciate the USD when they decrease and appreciate the USD when they increase:
1. Foregin demand for US exports
2. Foregin demand for US assets (stocks, bonds, bank deposits)
3. US interest rates relative to other nations
4. US productivity relative to other nations
5. US trade restrictions relative to other countries |
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Term
| Foregin Exchnage Rate Prices (Property I) |
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Definition
-Can be defined in terms of many other currencies (N-1 unique exchange rates)
-If there are N countries (currencies), there are N-1 exchange rates:
-Assuming: A: α B: β C: γ
and if β/α = 0.8 and γ/α = 1.2,
then β/γ = β/α ÷ γ/α = 0.8/1.2 = 0.67
→ 1) there are N-1 unique exchange rates
→ 2) exchange rates are relative prices |
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Term
| Foregin Exchnage Rate Prices (Property II) |
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Definition
-Exchange rates are constantly and instantaneously changing
-Depreciation of a foreign currency is a fall in its domestic currency value
-Appreciation of a foreign currency is a rise in its domestic currency value |
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Term
| Foregin Exchnage Rate Prices (Property III) |
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Definition
-Extensive government intervention in foreign exchange markets
-Devaluation - government policies decreasing a currency’s value in foreign currency terms
-Revaluation - government policies increasing a currency’s value in foreign currency terms |
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Term
| Multiplicity of currency markets |
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Definition
| Multiplicity of currency markets in which exchange rates are determined |
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Term
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Definition
| Spot market: sale and purchase of foreign currency for immediate delivery |
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Term
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Definition
Def: simultaneous purchase and sale of a currency in different markets, taking advantage of different exchange rates in those markets – profit made on the difference.
1. Arbitrage drives price differential to zero (excluding transactions costs)
2. Example: If 100 Yen = $1.00 in New York and = $0.95 in Tokyo:
a. Dealer buys 10 million Yen in Tokyo for $95,000
b. Simultaneously sells 10 million Yen in New York for $100,000
c. Earns profits of $5,000 (minus transactions costs) |
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Term
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Definition
| Forward markets: buying or selling for future delivery |
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Term
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Definition
| Forward transaction: an agreement (contract) to buy or sell a specified amount of a foreign currency at a specified future date at an agreed upon price (“forward rate”) |
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Term
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Definition
| Futures markets: obligation to buy or sell a specific quantity of a foreign currency at a specific future time at a specific price. |
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Term
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Definition
| Futures markets: obligation to buy or sell a specific quantity of a foreign currency at a specific future time at a specific price. |
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Term
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Definition
Using foward currency markets:
1. Want to buy 10 cars @ 2 million Yen each, where $1 = 100 Yen (cars = $20,000 each)
2. Make order, cars shipped, you’re billed for 20 million Yen (or $200,000)
3. Need 1 month for delivery and to arrange financing, so you owe 20 million Yen in 1 month upon delivery
4. Assume there are pressures in international currency markets which may lead to appreciation of Yen vs. U.S. dollar
a. If Yen appreciates to 80 Yen = $1 U.S., you still owe 20 million Yen in 1 month, but the cost is now $250,000 (↑ 25%!) |
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Term
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Definition
1. Purchase Yen on spot market before delivery
-No currency risk, but foregone interest earnings
2. Purchase Yen at time of delivery
-Use of money in interim, but risk of appreciation of Yen
3. Hedge exchange rate risk:
-Buy contract for future delivery of 20 million Yen in 1 month at 100 Yen = $1 U.S., at a given price.
-Price of contract will depend on:
a. Market expectations of future exchange rate
b. “Risk premium”
c. Interest rates |
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Term
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Definition
| Interest rate parity: forward premium or discount is equal to the interest rate differential (between countries) |
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Term
| Uncovered interest arbitrage |
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Definition
Uncovered interest arbitrage: making foreign financial investments without obtaining “cover” for exchange rate risk
Example: see lecture 19 |
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Term
| Uncovered interest arbitrage |
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Definition
Uncovered interest arbitrage: making foreign financial investments without obtaining “cover” for exchange rate risk
Example: see lecture 19 |
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Term
| Covered interest-rate differential |
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Definition
| “Covered interest-rate differential” = uncovered differential – forward discount = 1% - 0.5% = 0.5% |
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Term
|
Definition
Fixed exchange rates – currency pegged to one major currency or a “market basket” of currencies
1st of the four regimes |
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Term
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Definition
Adjustable peg – domestic currency pegged to one (or more) foreign currency(ies), with periodic adjustments to achieve devaluation/revaluation.
2nd of the four regimes |
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Term
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Definition
Managed (“dirty”) float – exchange rate fluctuations are based primarily on market forces, but central banks intervene to limit rate movements when necessary.
3rd of the four regimes |
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Term
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Definition
Free (“clean”) float – exchange rates clear at currency market equilibria, with inpayments and outpayments equated.
4th of the four regimes |
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Term
| Alternative Exchange Rate Regimes |
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Definition
Movement in 1970’s to 1990’s away from fixed rates to flexible, managed floating rates
In 1975, countries with pegged rates accounted 70% of developing world trade
By 1996, only 20%. |
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Term
| Alternative Exchange Rate Regimes |
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Definition
Movement in 1970’s to 1990’s away from fixed rates to flexible, managed floating rates
In 1975, countries with pegged rates accounted 70% of developing world trade
By 1996, only 20%. |
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Term
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Definition
| Fixed exchange rates: Nominal exchange rate is fixed; country’s central bank buys and sells foreign exchange to maintain domestic currency at “par” value, or within a narrow band. |
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Term
| Fixed exchange rates can be achieved by “pegging” currency value against two things....1 |
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Definition
1. A gold standard
U.S. used gold standard from 1791 to 1933, with dollars freely convertible into gold at fixed rate = $20.67/oz.
From 1933 to 1971, some features of gold standard retained: money supply linked to gold reserves, dollar devalued to $35/oz.
Gold standard has advantage of self-correcting balance of payments but many problems. |
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Term
| Fixed exchange rates can be achieved by “pegging” currency value against two things....2 |
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Definition
2. Another currency, or “basket of currencies”
Fix currency against the value of a major currency or currencies (U.S. dollar, etc.)
Example was Bretton Woods system, 1944-1973, which pegged all currencies against the U.S. dollar, which served as official reserve currency. |
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Term
| Fixed Exchange Rates (Disadvantages) |
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Definition
Key disadvantage: under fixed exchange rates, difference in efficacy of different macroeconomic policies:
1. Monetary policy becomes ineffective
Central bank buys and sells foreign currency with domestic currency to maintain equilibrium currency values (“sterilization”)
Increase or decrease in domestic currency is offset by changes in central bank’s official international currency reserves – ratio of domestic currency reserves to international currency reserves changes, but total supply is unchanged.
2. Fiscal policy becomes more effective:
a. Fiscal stimulus occurs, leads to increase in money demand and resultant increase in money supply, reinforcing fiscal policy.
b. Yet under floating rates, fiscal stimulus leads to increase in money demand, currency appreciation, increase in prices of goods and services, and a contractionary effect, offsetting initial stimulus. |
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Term
| (Adjustable) Pegged Exchange Rates (Def) |
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Definition
Similar to fixed exchange rates, except that pegged currency values are allowed to change over time.
Currency value fixed against a major currency ($, Euro) with adjustments (ad hoc or scheduled) reflecting changes in domestic and international economies.
Changes may be preannounced and scheduled (“crawling pegs”) |
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Term
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Definition
Adjustable pegs...
-System designed to stabilize post-WWII international monetary system, avoid chaos that followed WWI, and provide orderly procedures for exchange rate changes
-Created International Monetary Fund to supervise the international monetary and exchange rate system and to extend credit (loans and short-term reserves) to member countries to help overcome BOP deficits.
-Official currency values established (fixed) against the dollar (the official reserve currency), with periodic adjustments
-Central banks obligated to intervene to maintain exchange rates at “par” values within a 1% (+/-) currency band.
-Countries with persistent BOP surpluses or deficits required to devalue or revalue their currencies to a new par value with an “adjustable peg” |
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Term
| Bretton Woods system ultimately ended (1973) due to |
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Definition
Inability of exchange rates to simultaneously balance the BOP and reflect comparative advantage.
Frequency of speculation and currency market distortions
Fixed exchange rates encourage transmission of excess demand and inflation abroad
Excess demand for dollar reserves and “crisis of confidence” in dollar. |
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Term
| Managed exchange rate systems include |
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Definition
1. Parallel exchange rate systems
2. Surrender of foreign currency
3. Capital and exchange restrictions
4. Adjustable pegs
5. Crawling pegs |
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Term
| Reasons for exchange rate management |
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Definition
1. Maintain BOP equilibrium, fine-tune macroeconomic policy
2. Maintain overvalued exchange rates
3. Protect “infant industries’
4. Prevent capital flight
5. Allocate scarce foreign exchange. |
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Term
| Problems with exchange rate management and controls |
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Definition
1. Currency over/under valuation distorts comparative advantage
2. May encourage black markets for foreign currencies.
3. Distortions of capital flows; capital flight |
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Term
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Definition
1. One extreme: “clean float”: exchange rates clear at currency market equilibria, based on supply and demand for currencies.
-Major limitation of freely floating rates: increasing the likelihood of exchange rate volatility.
2. One step back: “managed float” or “dirty float”
-What we’ve basically had since 1973 (end of Bretton Woods)
-Central banks try to moderate exchange rate movement without keeping rates rigidly fixed.
-Accomplished by central banks buying or selling reserves to manage the value of their currency.
-Requires policy coordination among central banks. |
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Term
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Definition
Concern about inherent instability of foreign exchange rate
• Chronic trade deficits thought to lead to an inherent tendency toward currency depreciation.
• Problem “solved” by Marshall-Lerner condition for market stability: to improve a country’s trade balance, sum of elasticities of foreign demand for domestic currency (e.g., exports) and domestic demand for foreign currency (e.g., imports) must be > 1.0: εX + εM > 1
A real devaluation will yield a stable outcome if Marshall-Lerner condition is met. |
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Term
| Balance of payments or “absorption” approach |
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Definition
Given: GNP = Y = C + I + G + (X – M)
Net exports (“BOP”) = Y – C – I – G
= Domestic money income – total domestic expenditures (“absorption”)
• Approach recognizes that a country’s macroeconomic policies can have unequal effects on income and expenditures. A currency devaluation will improve a country’s trade balance only if national output increases relative to absorption.
• Refocused interest on trade balance and on government policies which affect BOP.
• “Equilibrium exchange rate” is the exchange rate that reconciles national balances (unemployment and inflation) and external (current account) balance. |
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Term
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Definition
-Focuses on monetary policy, money supply and excess S and D for money as primary determinant of foreign exchange outcomes.
• A devaluation can lead to a temporary improvement in BOP.
• Explains phenomenon of exchange rate “overshooting” – rapid initial changes in exchange rate due to monetary policy changes, since other macro variables (prices, wages) can’t adjust in short run; in long run, rate returns to equilibrium value.
• Monetary approach best at explaining long-run changes, not short run changes, in floating rate regimes; emphasizes role of monetary policy and money supply as exchange rate determinant. |
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Term
| Exchange rate overshoting |
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Definition
X-axis: Time
Y-axis: Exchange value of the dollar
Def: When the exchange value of the dollar rises (declines) from A to B it first rises (declines) to C and then retreats to A |
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Term
| Portfolio Balance approach |
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Definition
• Assumes that: 1) firms and individuals balance their portfolios, maximizing returns while minimizing risk; 2) domestic and foreign assets are imperfect substitutes.
• A major determinant of portfolio balancing and the distribution of assets is relative interest rates (rates of return) across countries; also, expected future inflation, etc.
• Foreign exchange composition of portfolios will shift as balancing occurs, necessitating adjusting the demand and supply of financial assets (money, domestic and foreign bonds, etc.) denominated in different currencies. |
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Term
| Purchasing Power Parity approach |
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Definition
• Suggests that exchange rates adjust to equalize the relative purchasing power of currencies; thus exchange rates are determined by relative price levels across countries.
• But other factors also determine exchange rate movements; factor supplies, technology, market structure changes, commodity price shocks, monetary policy changes, etc.
• Principle of PPP sets long-term guidelines to exchange rate changes, but does not predict short-run movements well. |
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Term
| Purchasing Power Parity (PPP) |
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Definition
Def: “The exchange rate between two countries equals the ratio of their currencies’ purchasing powers, as measured by national price levels.”
• Analogous to “Law of One Price”
Ex:
• PPP posits that the purchasing power of a country’s currency is reflected in the country’s price level (for a market basket of goods). Implies equalization in costs of living.
• PPP predicts that a fall (rise) in a currency’s purchasing power, as given by a rise (fall) in prices, will cause a proportional depreciation (appreciation) in domestic currency value in the foreign exchange market. |
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Term
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Definition
Absolute PPP:
Exchange rates = relative price levels; that is, the exchange rate is given by the relative purchasing powers of two currencies
-“Parity” exists when
Relative PPP:
The % change in the exchange rate between two currencies over a given time period equals the difference between % changes in national price levels.
see lecture 20 for an example |
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Term
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Definition
On avergae from 1975 to 2004 strong support is found for PPP. If the US inflation rate is higher than the other country's inflation rate, the country's currency tends to sppreciate; if the US inflation rate is lower, the currency tends to depreciate.
Inflation rates are measured using wholesale (or similar product-oriented) price indexes. Annual rates of change are calculated using the differnce in natural logarithms. |
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Term
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Definition
| The PPP method is about the same, however is often slightly higher. |
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Term
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Definition
Provides a rough guide to long-run movements in foreign exchange rates, but does not explain short-run movements well.
In the short run, many other factors explain exchange rate movements: differential interest rates of countries, different buying habits, commodity price shocks (that affect countries differently), monetary policy changes, etc.
Explain bias in market exchange rates, which don’t adequately reflect the prices of cheaper non-tradables. |
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Term
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Definition
| Def: “Spending multipliers” measure total response of national income to policy stimulus |
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Term
| Types of spending multipliers |
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Definition
m = marginal propensity to import (“leakage”)
=change in imports at margin/change in real national income
s = marginal propensity to save
(“leakage”)
=change in savings at margin/change in real national income |
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Term
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Definition
In a small open economy, income change stimulated by fiscal policy stimulus (∆G):
∆Y = ∆G + (1 - m - s) ∆Y
% of income change returned to domestic economy (in short run)
Spending multiplier for small open economy:
(change in Y)/(change in G) = 1/(m+s) |
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Term
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Definition
In a small open economy, income change stimulated by fiscal policy stimulus (∆G):
∆Y = ∆G + (1 - m - s) ∆Y
% of income change returned to domestic economy (in short run)
Spending multiplier for small open economy:
(change in Y)/(change in G) = 1/(m+s)
See lecture 20 for an example |
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Term
| Large Open Economy Multiplier |
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Definition
A country (esp. large country) may also experience increased jobs and income as a result of foreign trading partners induced income growth (from policy change) and resulting imports increasing from first country.
Spending multiplier including foreign income effects:
(change in Y)/(change in G)=[1+(Mf/Sf)]/[S+M+(SMf/Sf)]
*where (change in G) = initial stimulus
If no foreign income effect, mf = 0 reduces to first multiplier |
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Term
| Why are multipliers important? |
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Definition
Show total response to national fiscal policy change
Shows importance of large countries in global trade and economic growth, both at home and abroad
Explains related (“parallel”) business cycles among major industrial countries |
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Term
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Definition
| Devaluation - government policies decreasing a currency’s value in foreign currency terms |
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Term
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Definition
| Revaluation - government policies increasing a currency’s value in foreign currency terms |
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Term
| Most common reasons for exchange rate adjustments: |
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Definition
1. Reduce current account (and BOP) deficit
2. Increase export competitiveness |
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Term
| Three ways of looking at Devaluation/Revaluation policies: |
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Definition
1. Large vs. small country
2. Importer vs. exporter
3. Domestic vs. foreign currency |
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Term
| Importing Country – A; Exporting Country – B + Devaluation of home urrency (alpha) in terms of alpha : |
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Definition
1. Excess Supply of goods from B sifts left causing a decrease in the quantity traded.
2. Price in terms of alpha rises
3. Total import expenditures (P*Q) goes up or down depending on the elasticity of ED for country A |
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Term
| Importing Country – A; Exporting Country – B + Devaluation of alpha in terms of foreign currency beta : |
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Definition
Price of beta is now on the Y-axis.
1. ED of country A shifts to left, causing a decrease in quantity traded as well as a decrease in price in terms of beta.
2. Imports now more expensive (expressed in foreign currency terms), so buyers in country A restrict demand (demand shift) |
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Term
| Exporting Country – A; Importing Country – B + Devaluation of home currency (alpha) in terms of alpha : |
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Definition
1. Now A is the supplier and B is the demander.
2. Increase in foreign demand shifts ED curve; domestic price and exports increase
3. Quantity traded increases |
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Term
| Exporting Country – A; Importing Country – B Devaluation of (alpha) in terms of beta foreign currency : |
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Definition
1. At each foreign currency price, domestic exporters receive more money, exports as price in foreign currency
2. Excess supply from country A increases, because PXf goes down which leads to an increase in domestic price which leads to great domestic X |
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Term
| Explaining the Value of the U.S. Dollar |
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Definition
1. Record U.S. current account deficit: $805 billion (2005)!
2. Record U.S. budget deficit: $319 billion (2005)
-$600B surplus projected in 2001!
3. Low –but since 2004, rising –interest rates
4. Economic growth in U.S. –2.6% (Q4:2006) vs. 3.5% earlier
5. Low savings rates of U.S. consumers
6. Globalization of capital markets
7. Investor confidence in dollar and U.S. |
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Term
| Major steps toward a single European currency |
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Definition
1. Dissolution of Bretton Woods system in early 1970’s, which had fixed all currencies to U.S. dollar
2. European Monetary System announced in 1979, with goal of moving toward greater monetary integration
3. Between 1979 and 1992, 11 currency realignments of the EMS; countries with high inflation (Italy, France) forced to devalue frequently
•Major weakness of EMS: currency bands maintained, but monetary, tax and other economic policies not integrated
4. Delors Committee (1989) proposed a three-stage transition to a single currency
5. Maastrict Treaty (1991) set up “Convergence Criteria”for EMS member countries to meet to qualify for unification. |
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Term
| EU would create integration by |
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Definition
1.Creating fixed but adjustable exchange rate system: currencies of each country allowed to fluctuate within a 2.25% (+/-) band of parity, jointly floating vs. the U.S. dollar
2.Established European Currency Unit (ECU) –weighted average of member countries’currencies.
3.European Monetary Cooperation Fund (EMCF) created to provide short-and medium-term BOP assistance to member countries. |
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Term
| Delors Committee (1989) proposed a three-stage transition to a single currency: |
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Definition
1.Convergence of monetary and fiscal policies and removal of all restrictions on intra-EU capital movements
2.Centralization of member countries’macroeconomic policies and narrowing of exchange rate bands.
3.Monetary union, establishment of a single currency and a European Central Bank. |
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Term
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Definition
1.Inflation no more than 1.5 percentage points above the average rate of the three members with the lower inflation.
2.Long-term interest rates no more than 2 percentage points above the average of the three members with the lowest rates.
3.Budget deficit 3% of GDP or less.
4.Government debt 60% of GDP or less.
5.Currency within EMS trading banks for at least two years. |
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Term
| Currency crisis of 1992-1993: |
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Definition
•Italy and U.K. abandoned ERM, allowing their currencies to depreciate and lowering interest rates.
•Germany refused to lower interest rates; led to speculative attack on currencies of France, Denmark, Spain, Portugal and Belgium
•Despite $100 billion in currency market transactions by central banks, intervention failed; wider bands (+/-15%) adopted. |
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Term
| EU Monetary Union timetable |
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Definition
Jan. 1, 1999: Conversion of national currencies into Euros; European Central Bank begins operations.
Jan. 1, 2002: Deadline of introduction of Euro notes and coins
July 1, 2002: Euro becomes sole legal tender; national |
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Term
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Definition
1. Eliminated costs of exchanging currencies, estimated at 0.4% of GDP (as much as $30 billion annually).
2. Reduced exchange rate risk and volatility, and associated transactions costs.
3. More rapid economic and financial market integration
4. Preventing competitive devaluations and speculative attacks.
5. Imposing greater economic discipline through member countries having to abide by jointly imposed conditions
6. Seignorage from the use of the Euro in international currency transactions
7. Reduced cost of borrowing in international markets.
8. Enhancing political economic role of EU in international affairs. |
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Term
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Definition
1. Inability of member countries to pursue independent monetary and exchange rate policies.
2. European labor markets are less flexible than those in the U.S. and less able to adjust (less willingness to accept lower wages; less labor mobility) –a further source of rigidity. |
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Term
| The Asian Financial Crisis, 1997-1999 (Timeline) |
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Definition
Early 1997: Major industrial and finance company bankruptcies in Korea and Thailand
July, 1997: Floating of Thai baht and its rapid depreciation.
August, 1997: Floating of Indonesian rupiah and depreciation.
Late 1997 – July 1998: “Contagion” effect spreads to economies and currencies of Malaysia, Philippines, Korea.
1998: Further contagion effect in Asian countries — Singapore, Japan — and elsewhere: Russia, Venezuela, South Africa, Brazil. |
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Term
| Asian Currencies Against the Dollar |
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Definition
| While in the beginning part of 1998 some asian countries did have a positive percent change, overall by the end of 1998 many countries had significantly decreased in value |
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Term
| The Asian Financial Crisis, 1997-1999 (General Effects) |
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Definition
Decline in stock markets and real estate markets – up to 65-75% among five main affected countries.
Rapid depreciation of currencies – 40-84% among five main countries
Recession in affected countries: fall in GDP (13-15% in Indonesia), rise in unemployment, etc. |
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Term
| Response of IMF and International Community (Objectives) |
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Definition
Prevent default on foreign loans
Limit currency depreciation
Preserve fiscal balance
Limit inflation
Rebuild foreign exchange reserves
Reform banking sector and domestic economy
Restore credit worthiness and confidence
Limit decline in production and economic growth |
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Term
| Major Policy Components of IMF-based Programs |
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Definition
Contractionary fiscal policy to defend exchange rate and provide funds to assist financial sector.
Close failing banks to limit their losses, implement banking system reforms, and restore confidence.
Recapitalize banking system.
Contractionary monetary policy to raise interest rates, reduce domestic credit and defend the exchange rates.
Repay foreign debt with “bailout” funds
Structural reforms in trade policy, foreign investment and reduce monopoly powers of key companies. |
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Term
| IMF and donor-based financial packages introduced in 1997 |
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Definition
Thailand: $17.2 billion standby arrangement.
Indonesia: $40 billion package.
Korea: $57 billion standby package.
Philippines: Continued previous standby package. |
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Term
| Limitations of IMF Strategy |
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Definition
Bank squeeze and loss of confidence exacerbated by wholesale bank closures, rather than comprehensive banking and financial sector reform
Insistence on too much rapid capitalization of banks led to worsening of credit crunch, as banks cut back on lending in order to meet increased capital requirements.
Higher interest rates undermined profitability of banks and cut off growth, while not leading to currency appreciation.
Guidelines for fiscal contraction too severe, choked off growth. |
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Term
| Financial Crisis Hurts Trading Partners |
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Definition
| The US, EU, and Japan, all had decreases in real GDP in 1997 and 1998. |
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Term
| Causes of Asian Financial Crisis (Part I) |
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Definition
1. Overheated “bubble economy” of Asian markets – asset values (stocks, real estate, etc.) overvalued well beyond values justified by market fundamentals
a. Outgrowth of rapid growth (“Asian miracle”) of the 1960’s – 1990’s, and attractiveness of investments in East & SE Asia.
2. Asian banks use short-term renewable credit to finance long-term loans
a. High proportion (14-19%) of non-performing loans to total outstanding bank loans
b. Lack of adequate enforcement and regulation of financial markets and use of standard financial market practices
c. Foreign lenders did not adequately monitor assets and liabilities of borrowers.
3. Large inflows of short-term capital that could be invested and withdrawn quickly.
a. Financial market deregulation, lax supervision and government incentives (tax breaks) encouraged foreign capital inflows.
b. Capital inflows increased from 1.4% GDP in 1986-1990 to 6.7% GDP in 1990-1996 (10.3% in Thailand)
c. Net capital inflows of $93 billion in 1996 changed to outflow of $12 billion in 1997.
d. Withdrawal of capital combined with curtailing of loans led to collapse of stock and real estate markets. |
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Term
| Causes of Asian Financial Crisis (Part II) |
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Definition
4. Large current account deficits (financed by short-term capital inflows, which increased significantly during the first half of the 1990s
5. Pegging (fixing) exchange rates (vs. the U.S. Dollar):
a. Pegging complemented currency appreciation due to large capital inflows
b. As dollar appreciated after 1995, countries’ competitiveness declined, leading to declining export growth in 1995-97 and economic slowdown.
6. Insufficient foreign currency reserves to offset large withdrawal of capital – inability of central banks to defend currencies
7. Sluggish economic growth and low interest rates in Japan and Europe, leading investors to search for high yields in other Asian markets.
8. “Contagion” effect lowered international credibility of East Asian countries’ banks, currencies and government intervention measures.
9. Other factors: political instability: elections coincided with financial crisis in 4 of 5 countries; prevalence of lax, nonstandard business practices in banking and other sectors; “crony capitalism” |
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