International economics
The multiplier of an open economy
- is a value that represents the amount a country will save with additional disposable income. Endogenous variable changes in response to a change in exogenous variable. It can also be viewed to determine how much a country will consume. 1/1-MPC+MPM 1/MPS+MPX Foreign Closed economy- 1/1-MPC Domestic
Price effect of a devaluation
1. Prices of domestic goods decreases 2. Causes exports to rise and imports to decline 3. Surplus created leads to an increase in national income 4. The increase in income will cause imports to rise as well as people spend more 5. This will reduce the overall effect of a devaluation 6. If there is inflation, prices will already be too high and even with the increased national income, there will be less spending. 7. As a result, the intended benefits of the devaluation will be further reduced.
Price effect of an appreciation
1. Prices of domestic goods increases 2. Causes exports to decline and imports to increase 3. Deficit caused by greater imports causes national income to decline 4. Lower national income leads to lesser spending (esp. on imports) 5. This is coupled with any inflationary affect in the devaluing country which will cause their prices of domestic goods to increase 6. End result: lower national income with lower spending on exports and smaller than anticipated spending on imports.
3. a) "External and internal equilibrium are often contradictory goals and the policymaker is forced to chose between one and the other" Discuss the validity of this statement when considering: 1. the mechanics of the gold standard; 2. a pegged exchange rate system
1. This statement seems to be a valid one. Concerning the gold standard, the countries currencies are tied to a certain amount of gold that that currency can buy. If a country is not in equilibrium, say it has a trade deficit, it will try to devalue its currency.
Foreign Trade Multiplier
1/1-MPC+MPM which equals 1/MPS+MPM. The MPS and the MPM is the smaller multiplier. Thus, saving and import is the leakage of the economy.
In a pegged exchange rate system, a country devalues its currency. 1. What circumstances would lead it to do that?
A country would devalue its currency if it was facing balance of trade deficit. Devaluing its currency will result in the country's exports being more competitive and exports would rise. This would hopefully balance out trade deficit.
Accomodating capital movement
Affected by the state of the balance of payments.
the negative impact on the UK of its return to gold standard after WWI
After WWI, UK faced high inflation, the price of UK goods arose significantly. According to PPP, high price of UK goods with respect to relative to other countries, UK should be devalued. However, UK chose to return to gold standard. That means high price with same fix rate. This return to gold made UK competitiveness to lose and then export decrease and import increase. As a result, UK had a trade deficit and huge unemployment after WWI.
Impact of capital outflow on exchange rate
Capitla outflow is the amount a country is investming abroad. If there is large capital outflow, that means that capital is being attracted abroad and away from that particular country. This results in the devaluation of the countries currency.
5. Suppose that in China it takes 2 units of labor to make 1 DVD player and 4 units of labor to make 1 TV set; and in the U.S. it takes 1 unit of labor to make 1 DVD player and 1 unit of labor to make 1 TV set. a. What should each country specialize in? Why?
China would produce DVD players and the US would produce TVs. This is because China's comparative advantage lies with making DVD players while the US's comparative advantage lies in making TV's.
Explain how the following items would be entered into the U.S. balance of payments (credit vs. debit; current, capital or other account) i. Sales of lumber to Japan
Current, credit
Explain how the following items would be entered into the U.S. balance of payments (credit vs. debit; current, capital or other account) a. A disaster relief shipment of wheat to Bangladesh
Current, debit
Explain how the following items would be entered into the U.S. balance of payments (credit vs. debit; current, capital or other account) e. Hotel expenses in Geneva
Current, debit
Explain how the following items would be entered into the U.S. balance of payments (credit vs. debit; current, capital or other account) f. The purchase of a BMW automobile
Current, debit
Explain how the following items would be entered into the U.S. balance of payments (credit vs. debit; current, capital or other account) j. The shipment of Fords to the U.S. from a Mexican production plant; and the profits from that plant.
Current, debit
Competitive Devaluations of the 1930s
During the depression of the 1930s, countries attempted to increase export of their goods as a means of combating unemployment. As each country devaluated their currency, other followed suit. Country after country devalued its currency in an effort to achieve a real devaluation and a competitive advantage at the expense of its trading partners. These policies were commonly referred to as "beggar-thy-neighbor."
Autonomous capital movement
Has nothing to do with the state of balance of payments
From your study of the theory of balance of payments adjustments, how can you explain the following historical occurrences: b. The competitive devaluations of the 1930s
In the 1930s during the depression, countries were devaluating their currencies so they could basically export their way out of the recession. Other countries would respond by devaluating its currency. In the end devaluating their currencies would aggrevate the problems of the trading partner, sending it into deeper recesiion. This was sort of a "begger thy neighbor" scenario. The competitive devaluations helped noone, and caused even more trouble for countries and sent them into deeper depressions.
Impact of Capital Movements on Exchange Rates
International capital movements will affect the supply and demand for currencies. This will have a resulting effect on the exchange rates of currencies depending on how supply and demand changes. This is why purchasing power parity isn't a good way to determine the exchange rate?
Compensatory Capital Movements
Official government transactions taken for balance of payment purposes. They are capital movements made to either increase or decrease the balance of payments to offset the autonomous capital transactions.
Explain how the following items would be entered into the U.S. balance of payments (credit vs. debit; current, capital or other account) g. Interest earned on a bank account in London Other, credit
Other, credit
Explain how the following items would be entered into the U.S. balance of payments (credit vs. debit; current, capital or other account) c. Opening of a $500 bank account in Zurich
Other, debit
Purchasing Power Parity
Purchasing power parity is s currency is set to an amount of goods it can buy. For example, 1 pound in England can buy 4 units of goods while 1 dollar in US can buy 1 unit of good. The exchange ratio would be 1:4. This is an example of purchasing power parity.
5. Suppose that in China it takes 2 units of labor to make 1 DVD player and 4 units of labor to make 1 TV set; and in the U.S. it takes 1 unit of labor to make 1 DVD player and 1 unit of labor to make 1 TV set. b. What would be an international exchange ratio which would make both countries better off?
Since the domestic ratio for China is 1dvd:.5tv and the domestic ratio for US is 1dvd:1tv, the international exchange ratio should fall inbetweent he two. In this case 1dvd : .75tvs would be a suitable exchange ratio.
From your study of the theory of balance of payments adjustments, how can you explain the following historical occurrences: a. Negative impact on the U.K. of the return gold standard after World War I
Since the world came off the gold standard during the war, coming back to it was difficult, especially for England. This is because the countries decided to keep the pairty that was laid down before the war. Inflation in countires had occurred at different rates so this pairty was not correct. England came out as a loser because price levels had gone up more in England than in US. Result was that England had huge trade deficits to US.
What factors would determine its initial success?
Some factors that would determine success is if the market has a negative or positive reaction. Also the marshall lerner conditions would come in to play here. If the sums of the elasticities for imports and exports added up to be more than 1, then the devaluation will be a success.
The decline of the Bretton Woods system
The Bretton Woods system was enacted to set the dollar, which was backed by gold, as the reserve currency. This would in effect strengthen the dollar because all international transactions would take place in dollars. The decline in the system was spurred by concerns over the large difference between U.S. liabilities and the decline U.S. gold reserves. Some countries became concerned about a potential dollar devaluation and started to trade the dollar reserves for gold, most notably France. As more and more countries began to follow suit, pressure rose and the U.S. gold stock dwindled. Countries strongly opposed to inflation completely abandoned the system and it was later officially deserted when the U.S. announced it would no longer convert dollars to gold at the fixed rate. It is also important to note that in 1971 U.S. liabilities were an outstanding 6 times greater than the actual gold stock.
Marshall-Lerner conditions
The Marshall-Lerner conditions state that if the sum of the elasticities if greater than 1, then devaulation improves the balance of trade. The sum includes both import and export elasticities. If the sum is less than 1, then worsens the balance of trade. If equal to 0, stays the same.
The Smithsonian Agreement
The Smithsonian Agreement was enacted as a result of the collapse of the Bretton Woods system. The agreement fixed the price of gold to the U.S. dollar while pegging the exchange rate for other currencies to the U.S. dollar at higher rates. Additionally, there was no guarantee by the U.S. to convert dollars to gold at the fixed rate on demand. The agreement led to a devaluation in the dollar and, in effect, created a dollar standard in place of the gold standard. However, after several mass-selling's of dollar reserves in further anticipation of a devaluation in the dollar, the fixed-exchange rates were abandoned and currencies of major industrial economies floated against the dollar.
The negative impact on the U.K. of its return to the gold standard after WWI
The U.K. borrowed lots of money and went into deficit to finance the war. This led to a high rate of inflation as prices increased substantially. When they returned to the gold standard at the same parity prior to the war, the combination of the substantial trade deficit and a highly inflated price-structure led the U.K. to enact deficit-reducing policies. As gold "left" the U.K. economy and the money supply declined, economic stagnation and high unemployment resulted.
From your study of the theory of balance of payments adjustments, how can you explain the following historical occurrences: c. The decline of the Bretton Woods system
The bretton woods system declined basically because the US was liable for more money than it kept in reserves. About 80 billion worth of liability was being held and the us only had 10 billion worth of cold. This caused panic and crisis of confidence. Eventually with the Smithsonian agreement the dollar went off gold and there was a gradual introduction of flexible exhange rates of major industial countries.
Bretton Woods System
The bretton woods system founded the IMF, World Bank and GATT. The system was a set of rules, regulations, and procedures to regulate international monetary systems. Each country adopted monetary policy that maintained exchange rate of its currency within a fixed value in terms of gold.
the competitive devaluations of the 1930's
The competitive devaluations were a retaliation of the Smoot Hawley tariff. Countries repeated devalued their currency to create trade surpluses and gain market share. Here is a diagram of a devaluation of UK relative to US: UK depreciates. The demands for UK exports goes up and demand for US exports go down. US currency appreciates. UK would have a trade surplus, increase income, high cost of production, and increased money supply. The US would be the direct opposite.
Amortization
The distribution of a single lump-sum cash flow into many smaller cash flows, usually of equal value, consisting of both principal and interest components. Amortization is chiefly used in loan repayments. A greater amount is applied towards interest during the initial payments, while during the later payments, a majority is applied towards the principal.
From your study of the theory of balance of payments adjustments, how can you explain the following historical occurrences: d. The appreciation of the dollar in the first of the 1980s, despite the growing U.S. trade deficit
The dollar was appreciating because in the early 80's there was high interest rates in the US. This caused a great deal of capital inflow. This capital inflow causes dollar to appreciate. The high interest rates were maintained because of the US budget deficit. This caused trade deficit.
Foreign Trade Multiplier
The foreign trade multiplier is a method to estimate the aggregate increase in spending caused by an initial increase in spending. The multiplier is equal to 1/(1+mpc-mpi) and is derived from the equation for national income, Y = C + G + I + X - M. The idea here is that for every additional dollar that is spent, an additional amount of money is spent as the initial spending moves through the economy.
The rise of the dollar in the first half of the 1980s despite a rising balance of trade deficit
The high interest rates that were in place to combat the high inflation rate brought lots of capital into the U.S. and worked contrary the anti-deficit policies the U.S. was employing and instead resulted in a widening deficit and an appreciation in the dollar.
Income effect of a devaluation
The income effect of devaluation is when a country's currency is devalued, it ends up importing less and exporting more. Exporting more causes an increase in national income and If mpm>0 then we can say the country will import more.
From your study of the theory of balance of payments adjustments, how can you explain the following historical occurrences: f. Issues surrounding the continued U.S. trade deficit with China
The issue surrounding the trade deficit with china is that china has been obtained trade surpluses for the past 20 or more years. This cannot go on because the US is continually showing trade deficit. China is unwilling to appreciate their currency which would make their goods more expensive and the US's goods more competitive. If China did appreciate its currency then their exports would decline and US's imports from china would decrease. Another problem is that China is holding a bunch of US debt in the forms of bonds. It cannot do anything with these bonds at the moment because if it takes out their currency invested in US then china's currency would skyrocket. It cant reinvest in Europe either because Europe doesn't wasn't the euro to skyrocket. So the Chinese are stuck with US bonds. China wants to keep exporting and keep trade surpluses up because they need to create jobs and maintain social peace.
The multiplier in an open economy
The multiplier in an open economy is the amount 1/(mps+mpm) The multiplier determines the amount of savings and investments domestically and internationally. It is a way to gauge savings and investments.
National income equilibrium with balance of payments surplus
The national income with balance of payments surplus means that the country is exporting more goods than it is importing. If it wants to come back to equilibrium, than it should appreciate the currency so it will export less and import more.
Plaza Agreement
The plaza agreement was an agreement between the worlds leading nations to devalue the American dollar. This was because there were high interest rates in the us, the dollar was appreciating, and all this was causing a trade deficit. The countries agreed to buy back their own currencies with us dollars. This would cause $ supply to increase and other currencies to decrease, thus devalueing the curreny of the $.
current account
The section of a country's balance of payments that includes the exports (on debit side), imports (on credit side), services (on credit and debit side) and the section that includes all of the money that is sent back to the home country from people who are aboard. That section also includes money that is donated as part of a relief effort. Example - natural disasters.
From your study of the theory of balance of payments adjustments, how can you explain the following historical occurrences: e. The persistence of the U.S. trade deficit since the great devaluation of the dollar in the 1980s.
The trade deficit remained because of two likely reasons. One is because of elasticities. The US may have cared for Japanese goods more than the Japanese cared for our goods. Another reason is because of long-term contracts. Since most trade deals are made with contracts, it may take months, or years until the contract is over. Only then would the devaluation come into effect.
The continued U.S. trade deficit with Japan despite the dramatic devaluation of the dollar vis-à-vis the Yen in the late 1980s and the first half of the 1990s
The trade deficit was present because: 1) Japan's high product quality, 2) the selling of items in smaller stores which discriminated against U.S. imports, 3) the fact that the prices of Japanese goods did not appreciate at the same rate as the currency (because they were targeting market share versus profits), 4) because their economy was growing at a slower rate ( 2% versus 5%), and 5) some also believe it was a conspiracy to gain revenge for World War II.
Unilateral Transfers
Transactions that aren't purchases of goods or services, including: nonmilitary aid to foreign countries, worker remittances, funds sent back to the home country by individuals working in a different country, or pensions paid to former residents now living abroad. Leaders felt WWI was an aberration Wanted to return to the G.S. Many countries prior were un-industrialized They started to industrialize through and after Problems started after re-initiation U.K. -borrowed lots of money to finance war -lead to high rate of inflation -U.S. had price stability -declared same gold content as before war -prevailing prices were actually much higher than before -too high of a price-structure for old parity -lead to a substantial trade deficit -gold goes out U.K. to reduce deficit -declining money supply -interest rates went up -many years of unemployment and economic stagnation
The impact of capital inflow on exchange rate
a capital inflow will result in a surplus in the balance of payments. As this occurs an appreciation of the currency in which the capital is going to would take place.
Explain how the following items would be entered into the U.S. balance of payments (credit vs. debit; current, capital or other account) h. The Union Carbide purchase of a French chemical plant
capital debit
Explain how the following items would be entered into the U.S. balance of payments (credit vs. debit; current, capital or other account) b. Imports of textile machinery
current, debit
the rise of the dollar in the first half of the 1980's despite a rising balance of trade deficit
high interest rates and a huge US deficit plagued the US. The Fed Reserve increased its prime rate to above 20%. President Reagan (supply side economics) lowered taxes because he thought this would push the economy forward. Too much government spending led to an even greater deficit. Also foreigners found it profitable to invest in the US because of the high interest rates. This caused a huge capital inflow, further appreciating the dollar and enlarging the trade deficit.
Pegged exchange rates
is a fixed exchange rate where a currency's value is matched to the value of another currency to measure the value. It is usually used to stabilize the value of a currency.
Critique of purchasing power parity
is that the difference in the quality of goods is not sufficiently reflected. The PPP can very with the type of goods used making it an estimate. Also does not take into account transportation costs or barriers to trade. For PPP there must be competitive markets for the goods and services and the one law price applies only to tradable goods and not immobile goods such as houses.
Autonomous Capital Movements
is the movement of capital for profit motivation. It had nothing to do with BOP but long term profitability. Direct investment, World Bank loan, amortization and error and omission are example of this.
Offer curve
is used to evaluate the comparative advantages of two trading countries, how much they should supply and where there would be excess demand and supply. The point where the offer curves meet is the quantity of their respective goods that is traded between the countries. (Graph)
Smithsonian Agreement of 1971
is when the dollar went off the gold standard and there was a gradual introduction of flexible exchange rates of major industrial countries. The result was the dollar devalued.
National income equilibrium with balance of payments surplus
national income equilibrium refers to a point that lies on the Y-Y line (downward sloping curve). A balance of payments surplus means that the point is to the left of the B-B line. Point A on the graph on the left illustrates a national income equilibrium with a balance of payments surplus. This means that there is an internal equilibrium and not an external equilibrium. In this example the country has full employment with full price stability but there is a surplus in the balance of payments.
Explain how the following items would be entered into the U.S. balance of payments (credit vs. debit; current, capital or other account) d. A 1 million dollar Japanese purchase of U.S. government bonds
other, credit
Impact of capital movement on exchange rates
quantifies the amount of money being invested from abroad and affects the control of money in the country. For example, there was a large amount of capital inflow in the U.S. in the 1980's when interest rates where high and this appreciated the dollar significantly. During the 1990's there was a capital inflow in Asia which resulted in the overvaluation of several currencies and caused a crisis when the bottom dropped out.
Fixed exchange rate system
the exchange rate system that backs all currencies to an underlying entity. An example of this is the gold standard where currencies were valued in ounces of gold.
the continued US trade deficit with Japan despite the dramatic devaluation of the dollar vis-à-vis the Yen in the late 1980's and first half of the 1990's
the trade deficit continues because of stubborn countries (Japan and China) who would not appreciate their currency relative to dollar. Japan would not follow exchange rate rules and appreciated only very little to keep market share. This furthered the US deficit because Japan was seeing surpluses the US was constantly seeing deficits. The US demand inelasticity also did not help. The US continued to buy Japanese products no matter what the price. Also import restrictions play a large role.
Price Effect of an appreciation
when a currency appreciates then the country that experiences that appreciation will be able to buy more foreign goods. This lowers the exports of that country and the demand for that currency will go down. Therefore an appreciation (depreciation) will cause deflation (inflation) to occur. Thus the overall prices will go down will imports will go up because the currency is stronger.
Monetary Effect
• As exports increase, the domestic currency-earnings of the exports will increase. • This will result in an increase in the money supply • Importers will trade domestic currency for foreign currency, thus reducing the money supply. • If exports > imports increase in money supply • If imports > exports decrease in money supply • • Devaluation o Demand for exports rise increases money supply o If demand curve is elastic, and
Income effect of a devaluation2
• Devaluation o Exports rise and imports decline Increase national income o This will lead to an increase in imports if MPI > 0. o This undoes the gains from the devaluation • In appreciating Country o Exports decline and imports rise Decreases national income o If MPI > 0 Decline in imports (demand curve shifts left) o Offset initial increase in imports
