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International Economics
By Robert J. Carbaugh
9th Edition
Chapter 1:
The International Economy
Elements of interdependence
Trade: goods, services, raw materials, energy
Finance: foreign debt, foreign investment, exchange rates
Business: multinational corporations, global production
Forces driving globalization
Technological change:
- Production
- Communication & information
- Transport
Liberalization of trade & investment:
- Tariff, non-tariff barrier reductions
- Liberalized financial transactions
- International financial markets
Waves of Globalization
1st wave: 1870-1914
- Falling tariff barriers
- improved transportation
2nd wave: 1945-1980
- Agreements to lower barriers again
- Rich country trade specialization
- Poor nations left behind
3rd wave: 1980-present
- Growth of emerging markets
- international capital movements regain importance
Exports of goods and services as percent of Gross Domestic Product, 2001
Leading trading partners of the United States, 2000
Interdependence: Impact
Overall standard of living is higher
- Access to raw materials & energy not available at home
- Access to goods & components made less expensively elsewhere
- Access to financing and investment not available at home
- International competition encourages efficiency
Interdependence: Impact (cont’d)
Other impacts – good & bad
- Curtails inflationary pressures at home
- Limits domestic wage increases
- Makes economy vulnerable to external disturbances
- Limits impact of domestic fiscal policy on economy
Comparative advantage means:
If the relative cost of making two items is different in two countries, each can gain by specializing in the one it makes most cheaply – each has a comparative advantage in that product
Even countries that make nothing cheaply can benefit from specialization
Common fallacies of international trade
“Trade is zero-sum” – trade can bring benefits to both partners
“Imports bad, exports good” – if you buy nothing from other countries, they have no income to buy from you
“Tariffs and quotas save jobs” – cutting imports makes it harder to export, so other jobs are lost
Competitiveness & trade
Main objective of any nation is to generate high and rising standard of living
No nation can efficiently make everything itself
International trade allows countries to focus on producing what they make efficiently
Inefficient sectors will be squeezed out
Sectors open to competition become more efficient and productive
Ups and downs of globalization
Advantages
- Productivity increases faster when countries produce according to comparative advantage
- Global competition and cheap imports keep prices low and inflation at bay
- An open economy encourages technological development and innovation with ideas from abroad
- Jobs in export industries pay more than those in import-competing industries
- Free movement of capital gives the US access to foreign investment and keeps interest rates low
Ups and downs of globalization
Disadvantages
- Millions of US jobs lost to imports or production abroad; those displaced find lower-paying jobs
- Millions of other Americans fear getting laid off
- Workers face pressure for wage concessions under threat of having the jobs move abroad
- Service and white-collar jobs are joining blue-collar ones in being vulnerable to moving overseas
- US workers can lose their competitiveness when firms build state-of-the-art factories in low-wage countries, making them as productive as plants in the USInternational Economics
By Robert J. Carbaugh
9th Edition
Chapter 2:
Foundations of Modern Trade Theory
Historical development of trade theory
Mercantilism
- Regulation to ensure a positive trade balance
- Critics: possible only for short term; assumes static world economy
Absolute advantage (Adam Smith)
- Countries benefit from exporting what they make cheaper than anyone else
- But: nations without absolute advantage do not gain from trade
Comparative advantage (David Ricardo)
- Nations can gain from specialization, even if they lack an absolute advantage
Absolute & Comparative Advantage
Ricardo’s Comparative Advantage in money prices
Production possibilities schedule
Generalizes theory to include all factors, not just labor
Shows combinations of products that can be made if all factors are used efficiently
Slope, or marginal rate of transformation, shows the opportunity cost of making more of one good (how much of one good must be given up to make more of another)
Marginal Rate of Transformation
Production possibilities schedules: constant opportunity costs
Supply schedules: constant opportunity costs
Trading under constant opportunity costs
Production gains from specialization: constant opportunity costs
Consumption gains from trade: constant opportunity costs
Complete specialization under constant opportunity costs
Changing comparative advantage
Trade restrictions and gains from trade
Production possibilities schedule under increasing costs
Supply schedule under increasing costs
Trading under increasing costs: US
Trading under increasing costs: Canada
Production gains from specialization: increasing opportunity costs
Consumption gains from trade: increasing opportunity costs
Chapter 3: International Equilibrium
Indifference curves
Final pattern of trade depends not just on supply, but also on demand – which is determined by income & individual tastes
Tastes can be shown graphically with indifference curves, which show the various combinations of two goods that give a consumer the same total level of satisfaction
A consumer’s indifference map
Indifference curves have a negative slope
- Keeping satisfaction constant means giving up some of one good for more of another
Indifference curves are convex
- As the consumer gets more of one good, she is less willing to give up what is left of the other
- The rate of substituting one good for another is shown by the slope of the curve, the marginal rate of substitution
“Higher” indifference curves (those farther from the origin) represent greater levels of satisfaction
Individual preferences cannot really be added up into a “community indifference curve” but it is useful to imagine that they can for the purposes of trade theory
Indifference curves and int’l. trade
Basis for trade, gains from trade
Equilibrium terms-of-trade limits
Theory of Reciprocal Demand (Mill)
Actual trading prices depend on the interaction of trading partners’ demands
Final terms of trade will be closer to the domestic price ratio of the nation with stronger demand for the imported good
Applies to nations of equal economic size, which will share gains nearly equally
Small nations trading with large ones can receive the bulk of the gains from trade
Offer curves: supply and demand
Equilibrium terms of trade
Changing equilibrium terms of trade
Immiserizing growth
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 4:
Trade Model Extensions and Applications
Factor endowment theory (Heckscher-Ohlin)
Comparative advantage is explained entirely by different national supply conditions, especially resource endowments
Nations export products that use inputs which are relatively abundant (cheap) at home, and import products which need inputs which are relatively scarce (expensive) at home
Factor endowment theory: assumptions
Nations all have the same tastes and preferences (same indifference curves)
They use factor inputs which are of uniform quality
They all use the same technology
Comparative advantage according to factor endowment theory
Comparative advantage according to factor endowment theory
Factor endowment theory: implications
Factor price equalization
- The shift within each nation towards use of cheaper factors, and away from expensive ones, leads to more equal factor prices (if factors are mobile)
Distribution of income
- Trade changes domestic distribution of income as demand for different factors changes
Tests of factor endowment theory
- Emphasize the importance of varieties of different factors (such as human capital) and accounting for changes in resource endowment; other explanations are also important
Does trade worsen inequality?
Trade theory suggests that countries with abundant skilled labor will import goods which are made with unskilled labor
Equilibrium wage ratios for skilled/unskilled labor are affected by trade and technology change, immigration, and education & training
Evidence suggests that trade contributes relatively little to wage inequality, compared to technological change and other factors; better education and training are potential solutions
Economies of scale & specialization
Economies of scale provide incentives for specialization, since per unit costs go down as production increases
Trade provides a larger potential market for products, making higher production levels possible
Economies of scale as basis for trade
Trade & specialization under decreasing costs
Other extensions of the theory
Overlapping demands
Intra-industry trade
Product cycles
Dynamic comparative advantage – industrial policy
Trade & the environment
Environmental regulation can lead to a policy tradeoff
- Increased costs can reduce comparative advantage of regulated industry
- Public receives health and environmental benefits
Concern that polluting industries would move to poor countries with less regulation
- But studies indicate that environmental rules have a small role in investment location decisions
Polluter-pays principle: incentive to find ways to reduce pollution at least cost
Trade effects of pollution-control regulations
Free trade under increasing costs
Free trade under increasing costs
Specific factor theory
Looks at the income distribution effects of trade in the short run, when some factor inputs are not mobile among sectors
Indicates that workers may be better or worse off, depending on preferences
Predicts that owners of factors used in export industries gain from trade, while owners of factors used in import-competing industries will lose from trade
Relative prices and the specific factor model
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 5:
Tariffs
Why restrict trade?
Benefits of free trade come in the long term, and are usually spread widely across society
Costs of free trade are felt rapidly and are usually concentrated in specific sectors of the economy
Defining tariffs
A tariff is a tax (duty) levied on products as they move between nations
- Import tariff – levied on imports
- Export tariff – levied on exported goods as they leave the country
- Protective tariff – designed to insulate domestic producers from competition
- Revenue tariff – intended to raise funds for the government budget (no longer important in industrial countries)
Types of tariff
Specific tariff
- Fixed monetary fee per unit of the product
Ad valorem tariff
- Levied as a percentage of the value of the product
Compound tariff
- A combination of the above, often levied on finished goods whose components are also subject to tariff if imported separately
Effective rate of protection
The impact of a tariff is often different from its stated amount
The effective tariff rate measures the total increase in domestic production that the tariff makes possible, compared to free trade
- Domestic producers may use imported inputs or intermediate goods subject to various tariffs, which affects the calculation
Effective rate of protection (cont’d)
When tariff rates are low on raw materials and components, but high on finished goods, the effective tariff rate on finished goods is actually much higher than it appears from the nominal rate
This is referred to as tariff escalation
Avoiding and postponing tariffs (US)
Production sharing and special treatment for foreign assembly using domestic components
Bonded warehouses
Foreign trade zones
Tariff welfare effects
Consumer surplus
- The difference between the price buyers would be willing to pay and what they actually pay
Producer surplus
- The revenue producers receive above the minimum amount required to induce them to produce a good
Consumer and producer surplus
Tariff trade and welfare effects
Tariff trade and welfare effects
Who pays for import restrictions?
Domestic consumers face increased costs
- Low income consumers are especially hurt by tariffs on low-cost imports
Overall net loss for the economy (deadweight loss)
Export industries face higher costs for inputs
Cost of living increases
Other nations may retaliate, further restricting trade
Arguments for trade restrictions
Job protection
Protect against cheap foreign labor
Fairness in trade – level playing field
Protect domestic standard of living
Equalization of production costs
Infant-industry protection
Political and social reasons
Politics of protectionism
“Supply” of protectionism (trade policy) depends on:
- the cost to society of restricting trade
- the political importance of the import-competing industries
- Magnitude of the adjustment costs from free trade
- Public sympathy for those sectors hurt by free trade
Politics of protectionism
“Demand” for protectionism depends on:
- The amount of the import-competing industry’s comparative disadvantage
- The level of import penetration
- The level of concentration in the affected sector
- The degree of export dependence in the sector
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 6:
Nontariff Trade Barriers
Import quotas
Quotas are a restriction on the quantity of a good that may be imported in any one period (usually below free-trade levels)
Global quotas restrict the total quantity of an import, regardless of origin
Selective quotas restrict the quantity of a good coming from a particular country
Import quota: trade & welfare effects
Effects of a quota on sugar imports
Comparing tariffs and quotas
Tariff-rate quota
The tariff-rate quota is a two-tiered tariff
- A specified number of goods (up to the quota limit) may be imported at one (lower) tariff rate, while imports in excess of the quota face a higher tariff rate
Tariff-rate quota: trade & welfare effects
Orderly marketing agreements
Market sharing pact signed by trading partners
Intended to protect less efficient domestic producers
Usually involve voluntary export restraints, or export quotas
Recent trade negotiations have restricted the use of these agreements
Effects of a voluntary export quota
Domestic content requirements
Rules that require a certain percentage of a product’s total value to be produced domestically
Often has the effect of forcing lower-priced imports to include higher-cost domestic components or be assembled in a higher-cost domestic market
Domestic content: trade & welfare effects
Subsidies
Domestic subsidy
- Payments made to import-competing producers to raise the price they receive above the market price
Export subsidy
- Payments and incentives offered to export producers intended to raise the volume of exports
Subsidies: trade & welfare effects
Subsidies: trade & welfare effects
Dumping
The practice of selling a product at a lower price in export markets than at home (or exporting at prices below production cost)
- Sporadic dumping – to clear unwanted inventories or cope with excess capacity
- Predatory dumping – to undermine foreign competitors
- Persistent dumping – reaping greater profits by engaging in price discrimination
Other NTBs
Government procurement policies
Social regulations (health, environmental and safety rules can also restrict trade)
Sea transport and freight restrictions
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 7:
Trade Regulations and Industrial Policies
The US and international trade
Smoot-Hawley Tariff Act (1930)
- High point of US protectionism
Reciprocal Trade Agreements Act (1934)
- Introduced “most favored nation” (MFN) clause (now called “normal trade relations”)
General Agreement on Tariffs and Trade [GATT] (1947)
World Trade Organization (1995)
GATT – Postwar trade liberalization
Founded on the principle of non-discrimination, including:
- “Normal Trade Relations” treatment
- National treatment of imported goods
Included trade dispute resolution mechanisms
Committed signatories to use tariffs rather than quotas
GATT – Postwar trade liberalization (2)
Started regular negotiations to reduce tariffs and NTBs
Exceptions allowed nations to sidestep the rules when they felt threatened, without abandoning the entire process
GATT negotiations
Early bilateral agreements
Kennedy Round (1964-67) – first multi-lateral negotiations; focus on tariff cuts
Tokyo Round (1973-79) – focus on lowering non-tariff barriers
Uruguay Round (1986-93) – covered new issue areas (intellectual property, services, agriculture), included developing nations
GATT becomes WTO
GATT agreement became World Trade Organization in January 1995
- WTO members must adhere to all agreements negotiated under GATT (not pick and choose)
- Covers trade in goods, services, intellectual property and investment
- WTO strengthens GATT’s dispute-settlement mechanisms
Controversy over WTO
Worries about infringement on national sovereignty
Concern about trade liberalization undermining environmental protection
WTO became a target for broader opposition to “globalization”
US trade remedy laws
Escape clause
Countervailing duties
Anti-dumping duties
Unfair trade practices (Section 301)
Protection of intellectual property
Trade adjustment assistance
Effects of dumping, subsidies, and remedies
Effects of dumping, subsidies, and remedies
US “industrial policy”
Broad policies to foster economic growth
Aid to targeted sectors
- Agriculture, ship-building, energy, technology, manufacturing (autos, for example), etc.
Tariff protection of declining sectors
Export promotion and financing
- Export-Import Bank
- Commodity Credit Corporation
Knowledge based growth policy
Japan’s industrial policy
Trade protection and subsidies (especially early on)
Assistance to targeted sectors
- Shipbuilding, steel, autos, machine tools, high-technology
- Ministry of International Trade and Industry (MITI) to target aid to promising sectors
It is unclear how much of Japan’s success can be attributed to government assistance
Strategic trade policy
Response to competition in sectors with imperfect competition – small number of producers, each large enough to affect market price
Subsidies can give the advantage to domestic manufacturers over foreign ones
Critics argue that it is too difficult to determine where assistance makes economic sense
Welfare effects of strategic trade policy
Economic sanctions
Trade sanctions
Financial sanctions
Success of sanctions depends on:
- Number of nations imposing sanctions
- Nature of ties between target and imposing nations
- Extent of political opposition in target nation
- Cultural factors in target nation
Chapter 8:
Trade Policies for the Developing Nations
Developing nations’ trade
Very dependent on the developed industrial countries as export markets and source of imports
Exports are heavily weighted toward primary products (agricultural goods, raw materials, fuels) and labor-intensive manufactures
Share of manufactured exports is increasing, but mainly in a small number of newly industrialized nations (such as South Korea, Hong Kong)
Developing nations’ concerns
Question whether gains from trade with industrial countries have been fairly distributed
Face problems of unstable export markets
- Concentration on one or a few primary-product exports combined with inelastic supply and demand conditions
Argue that they face worsening terms of trade as relative value of primary products has fallen compared to manufactured goods they import
Face limited market access for exports because of protectionism
- Especially for agricultural and labor-intensive goods
Export price instability for a developing nation
Remedies for developing nation problems
Stabilizing commodity prices – international commodity agreements
- Production and export controls
- Buffer stocks
- Multilateral contracts
Generalized system of preferences (GSP)
But experience with commodity agreements has been mixed, at best, and application of the GSP is spotty
Production and export controls
Buffer stocks: price ceiling and price support
Cartels
Attempt to restrict competition among producers and support higher prices for their product
Face obstacles:
- Incentive to cheat
- Number of sellers
- Cost and demand differences
- Potential competition
- Economic downturns
- Substitute goods
Growth strategies
Import substitution
- Trade barriers protect emerging domestic industries
- Popular in 1950s and 1960s
Export-led growth
- Focus on export of manufactures as engine of growth
- Became more common starting in 1970s
Import substitution: pros
Risk of establishing home import-replacing industry is low because home market already exists
Easier for developing nations to protect their own markets than to force industrial nations to open theirs
Gives foreign firms an incentive to locate production in developing country, providing jobs
Import substitution: cons
Trade restrictions shelter home industry from competition, giving no incentive for efficiency
Small size of most developing country markets makes it difficult to benefit from economies of scale
Protection of import-competing industries draws resources away from all other sectors, including potential exporters
Export-led growth: pros
Encourages industries in which developing countries are likely to have a comparative advantage – such as labor-intensive manufactures
Export markets allow domestic producers to utilize economies of scale
Low level of trade restrictions forces domestic firms to remain competitive
Export-led growth: cons
Main disadvantage to export-led growth is that it depends on the ability and willingness of industrial nations to absorb large quantities of manufactures from developing countries
In other words, it is sensitive to economic cycles and protectionist pressures in the export markets
Economic performance of developing nations by trade orientation, 1963-92 (World Bank, 1987; OECD, 1998)
Growth strategies: case studies
Brazil – import substitution in computers
- Policy backfired, and was abandoned by 1991
East Asian newly industrialized countries – export-led growth
- Generally very successful, until 1997 crisis
- High rates of investment and building human capital
- Problems overlooked: pollution, income distribution
- Vulnerable to protectionist reactions elsewhere
China – transformation from extreme import-substitution to focus on exports
- Dramatic change in China’s role in the world economy has accompanied rapid growth in its domestic economy
- Heavy state role in economy (legacy of central planning) raises issues of fairness
- Political issues, lack of enforcement of some agreements (intellectual property) complicate economic relations
- Accession to the WTO will mean adherence to global trade rules – and coping with the dislocations that will involve
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 9:
Regional Trading Arrangements
Types of regional trade arrangements
Free trade areas (NAFTA, for example)
Customs unions (Benelux)
Common markets (EU)
Economic/monetary union
Effects of regional trade agreements
Static effects
- Trade creation effect (consumption effect, production effect)
- Trade diversion effect
Dynamic effects
- Economies of scale
- Greater competition
- Investment stimulus
Static effects of a customs union
The European Union
Created by the Treaty of Rome (1957)
Policy aims included:
- Abolition of tariffs, quotas and other restrictions
- Common external tariff
- Free movement of capital, labor and business
- Common policies on transport, agriculture, and competition and business conduct
- Coordination of monetary and fiscal policies
The European Union (cont’d)
Lowering of barriers caused within-region trade to grow much more quickly than overall world trade in the 1960s
Steps to remove remaining barriers (1985-92) further increased integration
Maastricht Summit (1991) began process of economic and monetary union (EMU)
- EMU came into full effect in 2002 with the introduction of a common currency, the euro
EU Economic & Monetary Union
Member nations which met economic criteria by 1999 replaced their national currencies with the euro in 2002
New European Central Bank created to control monetary and exchange rate policy
“Convergence criteria” required for membership:
- Price stability
- Low long-term interest rates
- Stable exchange rates
- Sound public finances
Other key EU policies
Common agricultural policy (CAP)
- Support payments to farmers
- Variable import levies
- Export subsidies
Government procurement policies
- All EU businesses can bid for larger contracts in any nation
CAP: variable levies and export subsidies
Opening up government procurement
European Union enlargement
The EU is negotiating with 12 applicant nations, mostly transition economies in eastern Europe, for EU membership by 2004
Candidate members had to demonstrate their fitness by achieving:
- Stability of institutions, and guaranteed democracy, rule of law, human rights and protection of minorities
- A functioning market economy which is ready to compete in the EU market
- Adherence to the EU’s aims of political, economic and monetary union
Costs & benefits of EMU
Europe does not meet all the requirements of a theoretical “optimal currency area”
Advantages of EMU – real but small:
- Lower transaction costs
- Price comparisons easier
- Exchange rate risk eliminated
- Stimulates competition
Costs & benefits of EMU (cont’d)
Disadvantages of EMU:
- Loss of monetary policy and the exchange rates as economic adjustment tools
- Use of fiscal policy for adjustment is also constrained
- Adjustment to shocks therefore depends on wage flexibility and labor mobility, which are both low in Europe
North American Free Trade Agmt. (1994)
Gradual and comprehensive elimination of trade barriers among US, Mexico and Canada over 15 years:
- Full, phased elimination of import tariffs
- Elimination of most NTBs
- Protection of intellectual property rights
- Dispute settlement procedures
- Side agreements on environmental protection and labor law
NAFTA’s benefits
Mexico stood to gain the most, with access to large industrial markets and new inward investment flows
Canada maintained its preferences in the US market and hoped for future access to South American markets
US stood to gain from access to the Mexican market and cheap labor and parts, access to reliable oil supplies, and less immigration pressure; but the benefits were modest
Concerns about NAFTA
Main US losers from NAFTA would be import-protected industries competing with Mexican producers, and unskilled workers
US industrial workers also worried about lower pay scale in Mexico and plant relocations
Concerns Mexico would not enforce environmental protection measures
Side agreements on environment and labor law were concluded to address those concerns
NAFTA’s impact so far
Trilateral trade increased significantly
Some US jobs were lost to Mexico, but the numbers were small compared to job creation that came with US growth
Changes in investment flows were small (in relation to total US foreign investment)
Closer political ties were built among the three nations, and they refrained from building new trade barriers even during recession
Special case: economies in transition
Nations of eastern Europe and the former Soviet Union have been making a transition from a non-market (planned) economy to a market economy since the early 1990s – which has been very disruptive
These nations’ planned economies required them to be largely isolated from world trade – instead, set up their own trading bloc, the Council for Mutual Economic Assistance (CMEA) with only limited trade with the West
Economies in transition (cont’d)
Even after the collapse of the central planning system, the nations remained tied together because of historical trade links inside CMEA and their common legacy as non-market economies
There is an ongoing debate over the best pace for economic reform (including trade and financial liberalization) – “shock therapy” vs. gradualism
Economies in transition (cont’d)
Barriers to trade with the West used to make strategies such as countertrade, co-production agreements, joint R&D agreements, and contract manufacturing agreements very common
Gradual elimination of barriers to foreign business in most transition countries has allowed foreign firms to operate in the region more normally in recent years
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 10:
International Factor Movements and Multinational Enterprises
Factor movements
International movement of factors of production (capital, labor) is a substitute for international trade in goods
International capital flows (investment) can substitute for trade in capital-intensive goods
Labor mobility can substitute for trade in labor-intensive goods
Multinational enterprises
Various business operations in numerous host countries
Headquarters often far from operations
Stock ownership and management are usually multi-national
Frequently employ vertical integration, horizontal integration, conglomerate structure
Foreign direct investment
A foreign or multinational firm can buy a controlling interest in a local firm
Buy or build new plants or equipment overseas
Shift funds abroad to expand a subsidiary
Reinvest the earnings of a foreign subsidiary
Reasons for foreign direct investment
Demand factors
- Serve different local markets
- Respond to market competition
Cost factors
- Access to key raw materials
- Labor costs
- Transportation costs
- Government policies
Choice between export and FDI
Choice between licensing and FDI
International joint ventures
Two companies can operate a venture in a third country
A foreign firm can work with a local company
A foreign firm can form a venture with a unit of the local government
Reasons for international JVs
Cost sharing – R&D, capital expenditures (in mining and oil, for example)
Avoiding restrictions on foreign ownership of local firms (ensuring local participation)
Forestalling pressure for protectionism
Problems: divided control means success of JV depends on ability of firms to work together
Effects of an international JV
Controversy over multinationals
Employment
- Host country may not gain many jobs, foreign managers often brought in; source country worries about losing jobs
Technology transfer
- MNEs are reluctant to share technology with host nations; source country worries about giving away advantage
Controversy over multinationals (Cont’d)
National sovereignty
- Host country worries about power of MNE to influence affairs; source country worries about ability to regulate MNE activities elsewhere
Balance of payments
- MNE investments and profits (internal transfers) have impacts on the payments status of both source and host nations
Controversy over multinationals (Cont’d)
Taxation
- Source countries may have difficulty taxing MNE income stemming from foreign operations
- Tax rate differences may discourage investment at home
Transfer pricing
- Both host and source governments worry that MNEs may illegally manipulate prices paid between subsidiaries to avoid taxes
Transfer pricing illustrated
Migration
Tends to equalize wage rates between countries
Shifts distribution of income between capital and labor
Other concerns:
- Fiscal drain from immigration
- Brain drain from developing countries
- Impact of illegal migration
- Wider gulf between skilled and unskilled workers
Effects of labor migration
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 11:
The Balance of Payments
Balance of Payments
A record of international transactions between residents of one country and the rest of the world
International transactions include exchanges of goods, services or assets
“Residents” means businesses, individuals and government agencies, including citizens temporarily living abroad but excluding local subsidiaries of foreign corporations
Double-entry accounting in the BOP
All transactions are either debit or credit transactions
Credit transactions result in receipt of payment from abroad
- Merchandise exports
- Transportation and travel receipts
- Income received from investments abroad
- Gifts received from foreign residents
- Aid received from foreign governments
- Local investments by overseas residents
Double-entry accounting (cont’d)
Debit transactions lead to payments to foreigners
- Merchandise imports
- Transportation and travel expenditures
- Income paid on investments of foreigners
- Gifts to foreign residents
- Aid given by home government
- Overseas investments by home country residents
Each credit transaction has a balancing debit transaction, and vice versa, so the overall balance of payments is always in balance
Current account
Goods and services balance
- Merchandise trade balance
- Services balance
Investment income (net)
Unilateral transfers
- Private transfer payments
- Governmental transfers
Capital and financial account
All purchases or sales of assets, including:
- Direct investment
- Securities (debt)
- Bank claims and liabilities
- Official settlements transactions
Current account surplus and deficit
Current account and capital & financial account balance each other; when one is in surplus the other must be in deficit
Current account surplus means exports of goods and services, investment income and transfers exceed imports and outflows
Current account deficit means imports of goods and services, and outflows are greater than exports and inflows; must be financed by borrowing (capital account inflows)
US Balance of Payments, 2001 ($ bill.)
US Balance of Payments, 2001 ($ bill.)
US Balance of Payments, 2001 ($ bill.)
US Balance of Payments 1970-2001
Current account deficit a problem?
Current account deficit has little to do with foreign trade practices or competitiveness
Determined mostly by domestic macro-economic conditions that cause demand to exceed supply and increase imports (paid for with borrowing)
Whether a current account deficit is good or bad depends on whether the borrowed funds are used to pay for consumption or investment
Balance of international indebtedness
Summarizes one nation’s overall quantity of assets and liabilities against the rest of the world
Shows whether the nation is a net debtor or a net creditor
Indicates sensitive items, such as short term debt held by foreigners which could be liquidated quickly, straining finances
Chapter 12:
Foreign Exchange
Foreign exchange market
Largest and most liquid market in the world
No central market – key markets in several cities around the world
Participating banks and brokers are in constant contact via phone and computer
Three general types of transaction
- Between banks and their customers
- Domestic interbank market conducted through brokers
- Trading with overseas banks
Types of FX transactions
Spot transactions – executed nearly immediately
Forward transactions – agreement to buy or sell a currency at a date in the future, at a rate agreed in advance
Currency swaps – agreement to trade one currency for another now, and to trade currencies back again later, both at prices agreed at the beginning
Foreign exchange quotations
Exchange rate is the price of one currency in terms of another
One country’s currency has depreciated when more of it is needed to buy a unit of a foreign currency (is worth less relative to the other currency)
A currency has appreciated when less of it is needed to buy a foreign currency (is worth more relative to the other currency)
Foreign exchange quotations
Cross exchange rate between two currencies is calculated from their exchange rates with a third, benchmark currency – frequently the US dollar
Forward markets, futures & options
Forward contracts obligate buyer to buy or sell a certain amount of foreign currency at a future date
- Usually made between banks and firms who expect to receive or make payments in foreign currency; the amount of currency and the date are set by the agreement
Futures, traded on special exchanges, are contracts to trade given amounts of currencies at a specified date
- Only a small number of major currencies can be so traded, and only in fixed lots with fixed trade dates
Options provide the holder with the right (but not the obligation) to buy or sell foreign currencies at an agreed rate within a period of time, in return for a fee paid to the seller of the option
- Options to buy are called call options, and those to sell are called put options
- Options are frequently used to reduce risk from exchange rate changes
Exchange rate determination
Impact of an appreciating US dollar
Pros
- Lower prices on foreign goods
- Keeps inflation down
- Foreign travel is cheaper
Cons
- Exporters’ products become more expensive abroad
- Imports-competing firms face price competition
- Travel more expensive for foreign tourists
Impact of a depreciating US dollar
Pros
- Exporters can sell abroad more easily
- Less competition for US firms from imports
- Foreign tourism is encouraged
Cons
- Higher prices on imports
- Upward pressure on inflation
- Travel abroad more expensive
Arbitrage and hedging
Exchange arbitrage involves taking advantage of exchange rate differences in different markets to make a profit
- Helps equalize exchange rates globally
Interest arbitrage involves taking advantage of differences in international interest rates to get a higher return
- Subject to exchange rate risk
Arbitrage and hedging
Hedging involves making use of forward contracts or options to minimize exchange rate risk in international transactions
- Firms which expect to need to make or receive payments in the future can use forward contracts or options to “lock in” rates and avoid the disruptive effects of sudden exchange rate swings
Speculation
Speculation differs from arbitrage, in that it involves the purchase or sale of a currency in the expectation that its value will change in the future
Speculation
Speculation can either reduce or increase volatility in foreign exchange rates
- If speculators expect a current trend in rates to change, then their purchase or sale moderates the price movements
- If they expect a current trend in rates to continue, their transactions can accelerate the rise or fall of the target currency
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 13:
Exchange-Rate Determination
Factors influencing exchange rates
Market fundamentals
- Bilateral trade balances
- Real income
- Real interest rates
- Inflation rates
- Consumer preferences for domestic or foreign products
- Productivity changes affecting production costs
- Profitability and riskiness of investments
Factors influencing exchange rates
Market fundamentals (cont’d)
- Product availability
- Monetary policy and fiscal policy
- Government trade policy
Market expectations
- News about future market fundamentals
- Speculative opinion about future exchange rates
When are these factors important?
Short run (days)
- Dominated by financial transfers responding to:
Differences in real interest rates
Shifting expectations of future exchange rates
Medium run (months)
- Primarily influenced by economic cycles
When are these factors important?
Long run (years)
- Dominated by movements of goods, services, investment, which are influenced by:
Inflation rates
Investment profitability
Consumer tastes
Real income
Productivity
Trade policy
How these factors interact to affect exchange rates depends on the relative importance of trade and financial relations between the countries
Exchange rate components
Real income differentials
A country with faster economic growth than the rest of the world will have a depreciating currency (other things being equal)
- Imports rise faster than exports, so demand for foreign currency rises faster than its supply
Real income changes can also reflect other processes, which might lead to rising exports
Impact of real income differentials
Real interest rates
Short term real interest rate differences influence international capital movements
- Real interest rate is nominal minus inflation
Low short term rates lead to less demand for the currency and depreciation
High rates lead to greater demand for the currency and appreciation
Impact of interest rate differentials
Purchasing power parity
Law of one price: In theory, a good should cost the same in all countries (aside from tariffs or transportation costs)
As a result, exchange rates should end up making prices equal across countries
By this theory, if two countries have different inflation rates, exchange rates will move in the opposite direction to keep prices the same
The theory may be more useful for predicting long-term trends than short-run fluctuations
Impact of inflation rate differentials
Market expectations
As with stock markets, foreign exchange markets react quickly to news or even rumors that point to future changes affecting rates
Future expectations can be self-fulfilling; speculative bubbles can start without any real information but can become self sustaining – for a while
Monetary approach
Focus on exchange rates as the result of supply and demand for money at home and abroad
Demand depends on real income, prices, interest rates
Supply is controlled by central banks
Exchange rates seen as returning domestic money supply to equilibrium after a change
Asset-markets approach
Investors (firms and individuals) balance their portfolios among domestic money, stocks and bonds and foreign stocks and bonds
Short run exchange rate changes are caused by shifts in the kind and location of financial assets investors want to hold
Investors shift between assets based on market expectations for expected returns
Short, long run equilibrium: overshooting
Forecasting exchange rates
Judgmental forecasts
- Subjective forecasts based on economic, political and other data for a country
Technical analysis
- Uses historical exchange rate trends to project short-run future movements
Fundamental analysis
- Includes macroeconomic and policy information in a predictive model
Equilibrium in asset-markets approach
Asset-markets approach: shift in demand
Asset-markets approach: shift in supply
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 14:
Balance-of-Payments Adjustments Under Fixed Exchange Rates
Balance of payments adjustments
If part of the balance of payments is in deficit or surplus for a period of time, mechanisms are needed to restore equilibrium
Adjustment mechanisms can be:
- Automatic – economic processes
- Discretionary – government policies
Automatic adjustment under fixed exchange rates
Key variables
- Prices
- Interest rates
- Income
- Money
Schools of thought on adjustment
Classical approach (1800s – early 1900s)
- Centered on gold standard
- Emphasized role of prices and interest rates
Keynesian approach (1930s onward)
- Emphasized income changes affecting adjustment
Monetarist approach (1960s-, Chicago school)
- Focus on role of money in changes and adjustment
Price adjustment – background
Under the gold standard, each nation’s currency was backed by gold and had a fixed price in terms of gold
Imports and exports were paid for in gold
A nation’s money supply (total amount of gold and gold-backed currency) was directly tied to balance of payments – whether gold was flowing in or out overall
Price adjustment – background (cont’d)
Balance of payments surplus would expand money supply; deficit would shrink money supply
By the classical quantity theory of money, increases in the money supply led directly to an increase in overall prices (and a shrinking money supply caused overall prices to fall)
Price adjustment of the BOP
Deficit nations
- Would be losing gold, therefore shrinking their money supply and causing prices to fall
- Lower prices would make their exports more competitive and lessen demand for imports, restoring equilibrium
Surplus nations
- Would be gaining gold, increasing money supply and price level
- Higher prices would cut exports and encourage imports until the surplus was eliminated
Problems with price adjustment theory
Gold flows are not directly linked to domestic money supply
Nations are often not at full employment
- If economy is not at capacity, less likely that prices will rise as money supply does
Prices and wages are often not able to fall in the short run
- Falling money supply will cut output and employment rather than prices
Interest rate adjustment
Inflows of gold expand the money supply, causing short-term interest rates to fall; outflows cause rates to rise
Investors in surplus nations would send gold abroad in search of higher rates; deficit nations would receive gold from abroad for investment, restoring equilibrium
Interest rate adjustment
Income adjustment
Surplus nations will experience rising national income, leading to an increased demand for imports – partially offsetting the surplus
Deficit nations will experience falling income, leading to a drop in demand for imports – partially offsetting the deficit
Foreign repercussions effect – one country’s deficit is another’s surplus, so that while income is declining in one country, its exports will increase to the country with rising income
Income adjustment applied
Disadvantages of automatic mechanisms
Require governments not to intervene
Automatic systems seem desirable when they are believed to lead to full employment; when nations face unemployment and shrinking output, automatic mechanisms seem inadequate
Monetary adjustment – background
BOP disequilibrium represents an imbalance between the supply and demand for money
Demand for money is:
- Directly related to income and prices
- Inversely related to interest rates
Supply of money has two components:
- Domestic component – credit created by national government
- International component – foreign exchange reserves
Monetary adjustment
Payments deficits are the result of an excess supply of money at home
- Excess supply of money encourages imports, which results in foreign exchange reserves flowing overseas and reducing the money supply
Monetary adjustment
Excess demand for money leads to a payments surplus
- Excess demand is reflected in higher interest rates and less spending on imports, encouraging a flow of foreign exchange into the country
Monetary adjustment – implications
Theory focuses on domestic monetary policy as key to balance of payments
Other policies designed to affect the balance of payments – tariffs, quotas, devaluation of the currency – are ineffective in the long run according to the theory
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 15:
Exchange-Rate Adjustments and the Balance of Payments
Exchange-rate adjustment and the BOP
Automatic mechanisms may restore balance-of-payments equilibrium, but at the cost of recession or inflation
As an alternative, governments allow exchange rates to change
- Floating exchange rates, determined by markets
- Devaluing or revaluing fixed exchange rates
Exchange rate effects on costs & prices
Impact of appreciation or depreciation on costs depends on the proportion of inputs priced in foreign vs. domestic currency
- As foreign-currency denominated costs rise as a proportion of total costs, exchange rate changes have less effect on the foreign currency price and more effect on the domestic price
- If foreign-currency costs are a small part of total costs, exchange rate changes have more impact on foreign currency price of the product and less on domestic price
Exchange rate effects on costs & prices
Generally, currency appreciation increases the costs of exports in foreign currency terms, which hurts total exports (while depreciation encourages exports)
- Effect on prices is modified by the ability and willingness of sellers to change their prices
Requirements for successful devaluation
When can devaluation correct a payments deficit?
Elasticity approach
- Emphasizes price effects; devaluation works best when demand is elastic
Absorption approach
- Focus on income effects; domestic spending must fall, too
Monetary approach
- Focus on change in purchasing power of money and effect on domestic spending
Elasticity approach
Impact of currency devaluation depends on price elasticity of domestic demand for imports and of foreign demand for exports
- The less either foreign or domestic demand responds to price changes, the less effect a devaluation will have on the payments imbalance
Elasticity approach
Marshall-Lerner condition:
- Devaluation will improve the trade balance if domestic demand elasticity for imports plus foreign demand elasticity for exports is greater than 1
- Devaluation will worsen the trade balance if the sum of the two elasticities is less than 1
- If the sum is equal to 1, devaluation will have no effect
Devaluation and time horizon
The J-curve effect: in short run, devaluation worsens trade balance, but with time the balance improves (3-5 years)
- Recognition lags; decision lags; delivery lags; replacement lags; production lags
Currency pass-through: effect of devaluation depends on how quickly producers pass on higher or lower costs to their customers
Absorption approach
Emphasizes impact of devaluation on spending behavior of domestic economy
Balance of trade is the difference between total domestic output and domestic absorption
- Positive balance means output exceeds domestic spending
- Negative balance means spending exceeds total production
Absorption approach (cont’d)
Devaluation will only improve the trade balance if output rises relative to domestic absorption
- If an economy is operating below capacity, a devaluation will shift resources into export production and encourage spending on import substitutes
- If an economy is operating at full employment, production cannot rise; trade balance can only be cut by slowing the domestic economy
Monetary approach
Elasticity and absorption approaches apply only to the trade balance; monetary approach includes capital account
Devaluation may induce a temporary improvement in the balance of payments
- Devaluation increases the domestic price level, increasing demand for money and drawing foreign capital flows (because of higher interest rates that result)
Monetary approach (cont’d)
In the long run, the inflow of money increases domestic spending, increasing imports and returning the economy to the starting point
Devaluation affects real economy only temporarily; only long run effect is to raise the domestic price level
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 16:
Exchange-Rate Systems
Exchange rate practices
Floating rate – market determined
- Float independently
- Float in unison with a group of other countries
- Adjust according to a formula
Fixed (“pegged”) rate
- Peg to a single major currency
- Peg to a basket of currencies
- Peg to gold (obsolete)
Exchange rate arrangements of
IMF members, 2001
Fixed exchange rates
Fixed exchange rates are normally used by small developing nations to peg to a key currency
- For international settlement purposes
- To stabilize import/export prices with the main trading partner
- To reduce inflationary expectations
Pegs can be established
- To a single currency
- To a trade-weighted basked of currencies
- To the special drawing right (SDR), a basket established by the IMF
Key currencies: Share of national currencies in total identified official holdings of foreign exchange, 2000
Fixed exchange rate system
Establish a par value against one or more key currencies
Create a stabilization fund to defend this fixed rate
- Government must be ready to make good on all demands to convert to/from foreign currency
At some point, because of basic economic changes, the fixed rate can become impossible to defend and must be changed
Exchange rate stabilization under fixed rates
Exchange rate stabilization under fixed rates
Devaluation and revaluation
Devaluation is intended to lower the value of a currency relative to other currencies, correcting a balance of payments deficit
Revaluation is intended to raise the currency’s value relative to other currencies, correcting a surplus
Devaluation and revaluation
Legally, the changes are made in the par value of the home currency in terms of the reference currency
Economically, the effect is to change the value of the currency relative to the main trading partners – who may retaliate by changing their own fixed rates
Devaluation/revaluation: legal and economic impact
Devaluation/revaluation: legal and economic impact
Currency boards vs. dollarization
A currency board is a monetary authority empowered to issue domestic currency which can be converted at a fixed exchange rate
The rate is usually set in law, and the board must have foreign exchange reserves large enough to cover the domestic currency in circulation
Put another way, the domestic money supply is limited by the amount of foreign reserves on hand
Currency boards do not make loans or finance government deficits
Currency boards vs. dollarization (cont’d)
Currency boards have become popular as a solution for countries which have not been able to control inflation or hold to a fixed exchange rate
The boards guarantee stability, and political independence (sometimes more than central banks, which they sometimes replace)
But the boards also leave no flexibility in monetary policy to respond to changing circumstances and require large foreign exchange reserves; experience has been mixed
Currency boards vs. dollarization (cont’d)
Dollarization: residents of a country use the US dollar with or instead of their local currency
- Unofficial dollarization: residents hold assets and bank accounts denominated in dollars
- Official dollarization: US dollar replaces local currency
Countries use dollarization to reduce risks for investors and avoid problems with domestic inflation and devaluations
Currency boards vs. dollarization (cont’d)
Dollarization implies acceptance of monetary policy set in the US by the Federal Reserve
- Less subject to domestic politics
- Cannot respond to local problems, or run deficits
US Federal Reserve would not be a lender of last resort, however
By holding dollars rather than US government bonds, the country gives an interest-free loan to the US
Floating exchange rates
Currency prices established daily by an unrestricted market
Large foreign exchange reserves are not needed to defend a fixed rate
Rates respond to economic shifts; payments imbalances are corrected by rate changes
Gives greater freedom to domestic economic policy
Floating exchange rates (cont’d)
Works only if there is enough trade in a currency to make a viable market
Greater freedom for domestic policy may mean poor economic policy has fewer immediate consequences
Market rates may move erratically
Bretton Woods and after
Postwar economic system negotiated at Bretton Woods (1944) included adjustable pegged rates
In practice, countries were reluctant to adjust their exchange rates, causing stresses that ended the system by 1973
In 1973, the adjustable peg system was replaced with a “managed float” system, which used government intervention in exchange markets to stay close to a target exchange rate
Adjustable pegged rates
Managed floating exchange rates
Exchange rate stabilization and monetary policy
Crawling peg
Establishing a fixed exchange rate is difficult in an economy with high inflation
A number of nations use a crawling peg, under which the fixed rate is frequently adjusted to account for inflation or other factors
Frequent changes keep pegged rates from becoming unrealistic, and unannounced changes keep speculators at bay
Exchange controls
Some nations (most, until the 1950s) use controls over foreign exchange to control the balance of payments
At the extreme, the government can have a monopoly over buying and selling foreign exchange, capturing export income and limiting import expenditures
Multiple exchange rates are also used, with different rates set for more or less desired transactions (discouraging imports, for example)
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 17:
Macroeconomic Policy in an Open Economy
Policy in an open economy
Countries which are open to the world economy cannot make domestic economic policy choices without considering the impact on trade and payments and their international relationships
Nor can open economies entirely insulate themselves from other countries’ policy choices
As a result, nations make efforts to coordinate their international economic policies
Economic policies are also subject to domestic and foreign institutional constraints
Economic objectives
Internal balance
- Fully employed economy
- Little or no inflation
External balance
- Current account is close enough to balance that foreign debts can be repaid (deficit) or that other nations can repay their debts (surplus)
Policy instruments
Expenditure-changing policies: alter aggregate demand for goods
- Fiscal policy (government taxes and spending)
- Monetary policy (money supply)
Expenditure-switching policies: shift demand to/from imports or domestic goods
- Devaluation or revaluation (fixed rates)
- Exchange market intervention (managed float)
Direct controls
- Tariffs, quotas, subsidies, capital controls
Economic objectives and macro policy
Exchange rate policies & overall balance
If a nation was experiencing recession and a BOP deficit, a currency devaluation would encourage exports and help boost domestic production
If it were experiencing inflation and a BOP surplus, a revaluation would cut back on exports and cool domestic spending
Exchange rate & overall balance (cont’d)
Such policy moves are not made in a vacuum; one country’s devaluation effectively means a revaluation for its main trading partners
If done without international consultation, these policy shifts might invite retaliation (as occurred during the Great Depression)
Fiscal & monetary policy: internal effects
Fiscal and monetary policy are generally used to achieve internal balance, but their effectiveness depends on the external sector
Under a fixed exchange rate system, fiscal policy is more successful in promoting internal balance than is monetary policy
Under a floating rate system, monetary policy is more effective than fiscal policy at achieving internal balance
Fiscal policy: short run internal effects
Fiscal policy: short run internal effects
Monetary policy: short run internal effects
Monetary policy: short run internal effects
Fiscal & monetary policy: external effects
Since floating rates foster BOP equilibrium, focus is on fixed rates
In short run, monetary policy has a clear effect on BOP
- Expansion worsens BOP balance
- Contraction improves BOP balance
Short run effects of fiscal policy are not certain – they depend on capital mobility
Monetary policy: short run external effects
Fiscal policy: short run external effects
Policy agreement and policy conflict
Monetary policy
- If a nation has unemployment with a BOP surplus, or inflation with a BOP deficit, an increase/decrease in the money supply will restore both internal and external balances
- But if a nation has unemployment with a BOP deficit, or inflation with a BOP surplus, a policy aimed at solving one problem will worsen the other
Fiscal policy – effects are unclear under those circumstances
Policy agreement and conflict (cont’d)
In such cases where policy aims do conflict, some combination of fiscal and monetary policy measures will be necessary
Some imbalances are even more intractable, such as the case where a nation experiences both inflation and unemployment along with a BOP imbalance, and require a wider range of policy instruments
International policy coordination
Domestic economic policy moves can spill over to affect other countries
Major industrial nations have worked to coordinate economic policy so that external balances are maintained without sacrificing domestic objectives
International policy coordination
Annual Group of Seven (G-7) economic summits
Regular meetings of central bank heads at the Bank for International Settlements
Major international policy agreements, such as the Smithsonian Agreement (1971); Bonn Summit (1978); Plaza Accord (1985); Louvre Accord (1987)
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 18:
International Banking: Reserves, Debt and Risk
Nature of international reserves
Reserves of foreign currency and other suitable assets are used to finance payments imbalances
Reserves allow a nation to take more time to correct BOP disequilibrium (but may also delay needed action)
Demand for reserves depends on the monetary value of international transactions and the size of payments imbalances
Demand for international reserves
Main factor in demand for reserves is the nature of the adjustment mechanisms to correct BOP imbalances
Exchange rate flexibility is a crucial element of the adjustment process
- Key use for reserves is to intervene in currency markets to defend an exchange rate
- The more a nation is willing to let its currency float, the less it will need sizable reserves
Demand for international reserves
Other factors affecting demand for reserves:
- Automatic adjustment mechanisms that respond to payments imbalances
- Economic policies used to correct payments imbalances
- International coordination of economic policies
- Level of world prices and income
Demand for reserves and exchange rate flexibility
Supply of international reserves
International reserves may be owned by nations or may be borrowed if reserves on hand prove insufficient
Owned reserves:
- Reserve currencies (US dollar, Japanese yen, etc,)
- Gold – once central, now rarely used
- Special drawing rights
Borrowed reserves can come from the IMF and other official arrangements, or can be borrowed from major commercial banks
Gold as a reserve asset
Gold was originally used as currency, but it began to be replaced by paper money and bank deposits
Post-World War I inflation prompted many nations to return to a gold standard, where all currency in circulation was backed by gold
Gold standard collapsed during the Great Depression, to be replaced by a gold exchange standard after World War II
Gold as a reserve asset (cont’d)
The US dollar was set to be convertible to gold at a fixed rate, and the dollar became a key reserve asset
Stresses from persistent US payments deficits brought an end to the gold exchange standard by 1973, and in 1975 gold was removed as an international reserve asset
Special Drawing Rights (SDRs)
Because a gold standard limits the amount of currency available to the supplies of gold on hand, the IMF created the SDR to increase international liquidity
SDRs represent rights to draw foreign currencies from the IMF to use for settlement purposes; they are allocated to IMF members proportionally
SDRs are pegged to a basket of key international currencies, and are useful because they are not tied to any one currency
Facilities for borrowing reserves
IMF drawings – members may purchase foreign currency with their own currency, with limits and sometimes conditions
General Arrangements to Borrow – major industrial nations agreed to make further reserves available to the IMF if needed
Swap arrangements – major industrial nations agree to swap currencies with each other; can be done more quickly and less visibly than Fund drawings
Facilities for borrowing reserves (cont’d)
Special financing facilities – to compensate mostly developing countries which face hardships which are transient or beyond their control: Compensatory Financing Facility, Oil Facility, Buffer Stock Facility
Commercial bank lending
International lending risk
Credit risk – potential for financial default
Country risk – whether government policies will help or hinder the servicing of the loan
Currency risk – whether devaluations or exchange controls will interfere with the repayment of the loan
International debt problems
Many developing nations borrowed heavily on easier terms in the 1970s because major banks were flush with deposits from oil producing states
In the 1980s, rising interest rates caused payments on the variable rate international loans to increase, and the ability of many of these major debtor nations to service their loans came into question
International debt problems (cont’d)
Most loans were denominated in dollars, meaning that these nations had to run current account surpluses to earn foreign exchange with which to make loan payments – just as the industrial nations went into a recession
Measures used to gauge debt burden: debt-to-export ratio; debt service/export ratio
Options for debt-service problems
Nations can stop making payments – but there are severe consequences
Service debt at any cost – but may be politically impossible
Reschedule the debt – stretch out repayment schedule (but pay more overall)
Obtain emergency loans from the IMF – but conditionality may be hard to stomach
Reducing bank exposure to developing-country debt
Loan sales in secondary market
Debt buybacks or debt-for-debt swaps
Debt-for-equity swaps
Debt reduction and forgiveness
Eurocurrency markets
Deposits in dollars and other major currencies in banks outside the US
Main advantage over US deposits is interest rate differential
Eurocurrency market facilitates financing of trade and investment, but there are concerns that some of the banks in this market do not face the same regulations as do large banks in the industrial nations