Economics 2

Demand elasticity depends on at least four factors:

1. Existence or absence of close substitutes 2. Structure of the market for that product (e.g., monopoly, perfect competition) 3. Portion of the household budget 4. Nature of product and role in the economy Price changes will trigger both the substitution effect and the income effect.

Exchange Rates and the Trade Balance: The Elasticities Approach

A country that is seeking to reduce its trade deficit may choose to devalue its currency, which would make its products more attractive to foreigners and make imports less attractive. Economists Alfred Marshall and Abba Lerner proposed that this strategy's success was conditional on demand elasticities. The price elasticity of demand reflects the relationship between the percentage change in quantity (%ΔQ) and the percentage change in price (%ΔP) This means that if the price elasticity of demand is elastic (ϵ>1), a price increase will reduce total expenditure. If the price elasticity of demand is inelastic (ϵ<1), then a price increase will increase total expenditure.

customs union

A customs union extends the free trade area by having common policies against non-members.

monetary union

A monetary union is an economic union with a common currency. The Eurozone (which consists of most of the EU member countries) is an example.

The government has the following net impact on aggregate demand:

Impact = G − T + B where G is spending T is taxes B is transfer benefits

The International Monetary Fund (IMF) has classified actual exchange rate regimes into eight categories.: 7. Managed Float

In this approach, a country bases its exchange rate policy on internal or external policy targets.

Leveraged accounts

Leveraged accounts - entities like hedge funds and commodity trading advisers that engage in active trading for profit

Sovereign wealth funds (SWFs)

Sovereign wealth funds (SWFs) - used by countries with large current account surpluses to hold capital flows rather than reserves managed by central banks

Spot transactions

Spot transactions are used to exchange currencies immediately. Usually, settlement takes place within two days of the trade date (T+2).

Spot Rate

SpotSpot = Forward Rate − Forward Points

The International Monetary Fund (IMF) has classified actual exchange rate regimes into eight categories.: 4. Target Zone

Target zone regimes are fixed-rate parity regimes with wider bands (up to ± 2%). This gives the monetary authority more latitude.

When a central bank announces a decrease in its official policy rate, the desired impact is an increase in:

investment

Exchange rate changes effectiveness using the elasticity method.

Exchange rate changes will be more effective in adjusting the trade balance when the elasticity is high. This is true for goods that have close substitutes, are traded in competitive markets, are luxuries, or represent a large portion of household expenditures.

Fiscal policy

Fiscal policy relates to the government's taxation and spending.

Governments

Governments - could be transactional or following policy goals

If the domestic currency is trading at a forward premium, then relative to the interest rate of the domestic country, the interest rate in the foreign country is most likely:

Higher The currency with the higher (lower) interest rate will always trade at a discount (premium) in the forward market. The lower interest rate in the domestic country will be offset by the appreciation of the domestic country's currency over the investment horizon.

Quantitative Easing and Policy Interaction

Quantitative easing (QE) is one of the few policy options available to central banks when interest rates are zero. Central banks implement QE by purchasing securities from individuals, institutions, and banks. The objective of QE is to lower interest rates and stimulate economic activity with direct cash transfers. However, economists note that by making large-scale purchases of government bonds, central banks are effectively printing money to fund the budget deficit and abandoning their commitment to independent monetary policy.

Real money accounts

Real money accounts - investment funds managed by entities like insurance companies and mutual funds; restricted in the use of leverage

J-curve effect

The Marshall-Lerner condition implies that the impact of a currency devaluation is felt immediately. However, it is possible that the trade balance would initially worsen before eventually improving. This is called the J-curve effect and it happens because there is a lag on ordered goods that already have a specified price. As noted earlier, prices and consumer choices typically adjust relatively slowly to changes in exchange rates.

The Marshall-Lerner condition

The Marshall-Lerner condition states that a country can improve its trade balance by devaluing its currency if demand elasticities are sufficient to increase export receipts more than export expenditures. There is a trade deficit if ωM>ωX. A depreciation of the domestic currency is needed to move back toward a surplus.

money multiplier

The amount of money the banking system generates with each dollar of reserves

Broad money

The broad money definition includes narrow money and also other liquid assets that could be used to make purchases.

Narrow money

The narrow money definition includes notes and coins in circulation plus liquid deposits.

The relationship between trade balance and expenditure/saving decisions can be expressed as follows:

X−M = (S−I) + (T−G) A trade surplus (X>M) must be reflected in excess private savings over investment (S>I) or fiscal surplus (T>G). A country that has sufficient domestic savings to fund its own investment will use these surplus funds to lend to foreigners or purchase foreign assets. In general, individuals are relatively slow to adjust the shares of their disposable income that they use for consumption (as opposed to savings) as well as their propensity to purchase imported goods and services. Therefore, over the short-to-intermediate term, changes in international capital flows are primarily determined by fluctuations in exchange rates and asset prices.

The International Monetary Fund (IMF) has classified actual exchange rate regimes into eight categories.: 6. Fixed Parity with Crawling Bands

This regime allows a country to wean off a fixed parity system gradually (e.g., starts from ± 1%, then ± 2%, then ± 3%, and so on).

The International Monetary Fund (IMF) has classified actual exchange rate regimes into eight categories.: 8. Independently Floating Rates

This regime allows the market to determine the exchange rate and the monetary authority to carry out an independent monetary policy. Most major currencies use this approach, although some government intervention is still present.

Trade creation

Trade creation replaces higher-cost domestic production with lower-cost imports from member countries.

The International Monetary Fund (IMF) has classified actual exchange rate regimes into eight categories.: 5. Active and Passive Crawling Pegs

Under this regime, exchange rates are adjusted frequently to keep pace with inflation. The approach is active if the adjustment is announced in advance. This helps the monetary authority influence inflation rates.

Exchange Rates and the Trade Balance: The Absorption Approach

Unlike the elasticities approach, which analyzes the microeconomic level impact of expenditure-switching, the absorption approach takes a macroeconomic approach to the trade balance. According to this perspective, a devaluation of the domestic currency will only improve a country's trade balance if it increases domestic savings relative to investment in physical capital. Put differently, income must increase relative to expenditure. If the economy is operating below capacity, a devaluation that increases the demand for domestic goods and services can increase output/income as long as some of the additional income is saved. However, if the economy is operating at full employment, the stimulative effect of a currency devaluation will be offset by upward pressure on domestic prices. Under such conditions, a devaluation will only produce a lasting improvement in the trade balance if domestic expenditure decreases and residents use their additional savings to acquire foreign assets.

A forward premium indicates:

the interest rate is higher in the price currency than in the base currency. To eliminate arbitrage opportunities, the spot exchange rate (S), the forward exchange rate (F), the interest rate in the base currency (ib), and the interest rate in the price currency (ip) must satisfy:

Fiscal Policy and Aggregate Demand

Fiscal policy uses government spending and taxation to impact the economy. Keynesians believe fiscal policy can greatly affect aggregate demand, output, and employment. Monetarists believe only temporary effects are possible. Often, the government revenue and government expenditures are measured as a percentage of GDP. There is an automatic stabilizer effect because as economic activity decreases, taxation will decrease, and government expenditures will increase.

Forward transactions

Forward transactions are agreements to exchange currencies further in the future. Most FX transactions are done through forward contracts, FX swaps, and FX options.

Indirect taxes

Indirect taxes include excise duties on fuel, alcohol, tobacco, and other items.

Retail accounts

Retail accounts - includes exchanging currency at the airport kiosk and small electronic trading accounts

Balance of Payment Components: The capital account

The capital account measures the transfer of capital. It includes the sub-accounts of capital transfers (e.g., debt forgiveness) and sales and purchases of non-produced, non-financial assets (e.g., patents, franchises, mineral rights, etc).

Advantages and Disadvantages of Different Fiscal Policy Tools

There are advantages and disadvantages to using the various tools of fiscal policy. Indirect taxes can have immediate impact and discourage unwanted behavior. Direct taxes take longer to change. Capital spending takes a long time to formulate and plan.

real exchange rate

This represents the real price you pay to purchase foreign goods. Thus, a higher value means less purchasing power. Note that the real exchange rate is an increasing function of the nominal exchange rate and a decreasing function of the domestic price level.

Trade diversion

Trade diversion substitutes lower-cost imports from non-member countries with higher-cost imports from member countries.

Cross-Rate Calculations

Two exchange rates involving three currencies can be used to determine the third exchange rate. Usually, the dealer or the electronic platform will perform the calculation. The cross-rate calculations must be consistent to avoid triangular arbitrage.

Gains from Trade: Absolute and Comparative Advantage

A country has an absolute advantage if it can produce a good or service at a lower total cost than its trading partner. A country has a comparative advantage if its opportunity cost of producing a good or service is less than its trading partner.

The Ideal Currency Regime

A country's exchange rate regime is the policy framework adopted by its central bank. The ideal currency regime would have the following properties: 1. Exchange rates between currency pairs are credibly fixed. 2. All currencies would are fully convertible (i.e., unrestricted capital flows). 3. Each country undertakes an independent monetary policy for domestic objectives. However, these three properties are inconsistent with each other. If the first two were true, different currencies would be interchangeable like coins and bills of the same currency. Under such conditions, the impact of using lower interest rates as part of an independent monetary policy would be offset by capital outflows. Similarly, attempts to raise interest rates would be rendered ineffective by capital inflows. Therefore, it is not possible to achieve the ideal currency regime.

The International Monetary Fund (IMF) has classified actual exchange rate regimes into eight categories.: 2. Currency Board System

A currency board system (CBS) is a legislative commitment to fix the exchange rate with a specified foreign currency. The foreign currency is held as a reserve to back the entire monetary base. Hong Kong is an example of a CBS backed by US dollar reserves. This system is similar to the gold standard in that changes in the money supply are linked to trade flows. It works best if domestic prices and wages are flexible and the reserve asset grows at a slow, steady rate. Unlike dollarization, a currency board system allows the monetary authority to earn a profit (called seigniorage) on the spread between the interest earned on assets (reserves) and the minimal interest paid on its liabilities (the monetary base).

currency peg

A fixed exchange rate target is called a currency peg. Rather than maintaining a precise peg, some countries use a "managed exchange rate policy," which allows the value of the domestic currency to float within a specified range relative to the currency to which it is pegged. For this strategy to be successful, investors must believe that the developing economy is credibly committed to the target exchange rate.

Ricardian equivalence

A government's effort to stimulate economic activity by running fiscal deficits will be unsuccessful if consumers respond by saving more in anticipation of higher future taxes that will be required to repay the government's debts. This behavior, theorized by economist David Ricardo, is called Ricardian equivalence. According to this view, deficit spending will only stimulate aggregate demand if individuals fail to anticipate the need for future tax increases correctly.

Quotas

A quota restricts the quantity of a good that can be imported. The quantity is specified with an import license. Foreigners can often raise the prices of their goods since the supply is limited. This will give them extra profits called quota rents.

Regional trading bloc

A regional trading bloc is a group of countries that attempts to reduce or eliminate trade barriers. Regional trading blocs include the North American Free Trade Agreement (NAFTA) and the European Union (EU). There are different levels of integration. Regional integration (e.g., customs unions) results in trade creation and trade diversion.

countervailing duties

Additional import taxes levied on imports that have benefited from export subsidies

FX swap

An FX swap is a simultaneous spot and forward transaction. The swap transactions can extend existing forward positions to later dates. Rolling the position forward leads to cash flow on the settlement date. FX swaps are also used to convert funding from one currency into another.

autarky

An autarky (or closed economy) is a state in which a country does not trade with other countries. Countries with open economies trade with other countries. Free trade occurs if countries impose no restrictions on foreign trading. Some countries impose trade protections including tariffs and quotas.

economic union

An economic union requires an even greater degree of integration. It incorporates all aspects of a common market and in addition requires common economic institutions and coordination of economic policies among members.

Increase in Exchange Rate

An increase in the exchange rate will represent an appreciation for the base currency (B) and depreciation for the price currency (A). For a given change in an exchange rate, the percentage change in the direct quote will not be the same magnitude as the change in the indirect quote.

Indirect Quote

An indirect quote is simply the reciprocal of the direct quote. For example, for an investor in the eurozone, Direct quote: EUR/GBP = 1.25 (1 GBP costs 1.25 Euro). Indirect quote: GBP/EUR = 1/1.25 = 0.80 (1 Euro costs 0.80 GBP).

Inflation Targeting The success of inflation targeting policy depends on three key concepts:

Central Bank Independence The central bank needs independence from the government to keep politicians out of the way. However, the central bank still has some accountability to the government. Target independence gives the bank authority to set the interest rate level target. Operational independence means the bank can get the target level from another branch of government, but it is otherwise not under the influence of the government. Credibility A government with a lot of debt would be inclined to have high inflation. Credibility would be undermined if the government were in charge of managing inflation. If the public believes the central bank will hit its target inflation, this belief can help it happen. Transparency Most central banks produce quarterly reports on the economy.

Central banks

Central banks - sometimes intervene to protect the domestic exchange rate

Contractionary and Expansionary Monetary Policies and the Neutral Rate

Contractionary policy strives to reduce the rate of growth in the money supply and real economy. This can be done by increasing the policy rate. Decreasing the policy rate is an expansionary policy done to increase the rate of growth in the money supply and the real economy. The policy rate is defined as high or low by comparing it to the neutral rate of interest. Contractionary policy: Policy rate is greater than the neutral rate of interest (to encourage saving rather than spending) Expansionary policy: Policy rate is smaller than the neutral rate of interest (to encourage spending rather than saving) The neutral policy rate is the sum of the economy's real trend growth and the long-run expected inflation. Monetary policy must consider the source of the shock. For example, contractionary monetary policy is useful when a demand shock is causing high inflation. It is not good if a supply shock (such as a spike in oil prices) causes inflation.

Corporate accounts

Corporate accounts - purchases and sales of goods and services; investment flows

Market Size and Composition

Daily turnover in the FX market is approximately USD 4 trillion. Of this, about one-third is done through spot transactions, with the rest coming in the form of forward contracts, FX swaps, and FX options. The vast majority of trading occurs between financial institutions such as banks, sovereign wealth funds, and central banks. Governments, corporations, and individuals account for only a small fraction of FX trading. London is the world's largest FX trading market, followed by New York and Tokyo. The USD is part of the five most actively traded currency pairs.

Ricardian model

David Ricardo argued that countries could benefit from trade even with only comparative advantages. The Ricardian model assumes that labor is the only factor of production. Differences in technology are assumed to be reflected in labor productivity. Technological gaps between countries are expected to close over time.

The International Monetary Fund (IMF) has classified actual exchange rate regimes into eight categories.: 1. Arrangements with No Separate Legal Tender

Dollarization and monetary union are two examples of countries abandoning their domestic currency. In other words, these countries no longer have their own legal tender. In both cases, countries are not able to exercise their own independent monetary policies. In dollarization, the country uses the currency of another nation (usually the U.S. dollar). The country inherits currency credibility. Dollarization imposes fiscal discipline by stopping the central bank from monetizing government debt through purchasing government bonds. The European Economic and Monetary Union is the largest example of a monetary union. Member countries jointly determine monetary policy for the entire union.

Purchasing Power Parity (PPP)

FX quotes represent nominal exchange rates. By contrast, real exchange rates are used by economists to compare currencies in terms of their purchasing power. Purchasing power parity (PPP) asserts nominal exchange rates will adjust, so identical baskets of goods have the same real price in different countries. In practice, PPP rarely holds because baskets are not identical across countries and trade barriers exist.

Factors Influencing the Mix of Fiscal and Monetary Policy

Fiscal policy is relatively difficult to adjust due to political concerns. It is easier for politicians to loosen fiscal policy than tighten the budget. In many cases, fiscal tightening is attributable to automatic stabilizers (e.g., fewer unemployment benefits during an economic expansion) rather than a deliberate policy choice. By contrast, monetary policymakers can act with far less concern for political considerations. Studies have shown government spending increases have a much larger impact on GDP than social transfer increases because the former are seen as less likely to be reversed. Social transfers are more effective if targeted at lower-income earners rather than distributed evenly to all citizens. The fiscal multiplier effect is greater when government spending and social transfers are coupled with monetary accommodation.

The International Monetary Fund (IMF) has classified actual exchange rate regimes into eight categories.: 3. Fixed Parity

Fixed parity differs from CBS in two ways. First, there is no legislative commitment to maintain a fixed exchange rate. Second, the foreign exchange reserves' target level is discretionary rather than linked to the domestic money supply. The exchange rate can be pegged to a single currency or index of multiple currencies. The country must be willing to offset private demand for the currency. A band is specified (up to ± 1%) around the parity level, and monetary authority intervenes when the exchange rate goes beyond those bands.

Forward Calculations

Forward exchange rates are typically quoted in points (or "pips"). The points represent the difference between the forward rate quote and the spot rate quote. The points will be positive when the forward rate is greater than the spot rate, which is described as a forward premium for the base currency. If the points are negative, the base currency is described as trading at a forward discount. Forward points are scaled to represent the last decimal place in the quoted rate. For example, if an FX rate is quoted to four decimal places, one point equals 0.0001. However, certain FX rates, often those that have the Japanese yen as the price currency, are only quoted to two decimal places. For those rates, one point equals 0.01.

Free trade areas

Free trade areas eliminate all barriers among member groups. Each country in the group can determine its own policies against non-members. NAFTA is an example.

Gross domestic product (GDP) vs Gross national product (GNP)

Gross domestic product (GDP) is the market value of final goods and services produced by factors located within a country. Gross national product (GNP) is the market value of final goods and services produced by factors supplied by citizens of a country. So, GDP includes contributions from foreign citizens in the country while GNP includes the production of goods and services by domestic citizens operating in other countries. In practice, GDP is the more commonly used measure.

Some argue there should be concern about the national debt because:

High debt levels could lead to high future tax rates, which may discourage economic activity. The government may have to print money to service the debt, leading to high inflation. Government borrowing could crowd out private sector borrowing.

Smithsonian Agreements

In 1973, the Smithsonian Agreements put an end to the Bretton Woods system, and the world moved to a system of flexible exchange rates. In response to unexpectedly high exchange rate volatility following this liberalization, European countries created an Exchange Rate Mechanism (ERM) that allowed for currency values to fluctuate within a narrow band. The UK was forced to abandon the ERM in 1992 when the Bank of England could not keep the pound pegged to the German mark.

Large vs Small countries (In the context of international trade)

In the context of international trade, a country is considered to be large if its imports are sufficient to influence the prices of goods and services. By contrast, small countries have no choice but to accept the world price (price takers). If a large country imposes tariffs on imported goods and services, small country exporters will reduce their prices to retain their share of the large country's market.

Tariffs

In theory, imposing tariffs can improve a large country's terms of trade and welfare by reducing the cost of imports. However, this improvement is contingent on the following assumptions: • Other countries do not retaliate. • The deadweight loss imposed by the tariff is less than the benefit from better terms of trade. Tariffs will reduce the net global welfare, regardless of how the losses are distributed among trading partners.

A Taxonomy of Currency Regimes

Many countries adopt regimes somewhere between fixed and flexible exchange rates. Fixed approaches are better for countries that lack credibility. The financial markets are very complex and diverse. The International Monetary Fund (IMF) has classified actual exchange rate regimes into eight categories.

The Functions of Money Money fulfills three important functions:

Medium of Exchange Money can be used to purchase goods and services. To do this, money must be readily acceptable, have a known value, be easily divisible, have a high value to its weight, and be difficult to counterfeit. Precious metals like gold and silver have often been used. Store of Value Money can be a store of value provided people believe it will continue to be valuable. Measure of Value All prices, debts, and wealth can be measured in monetary terms.

Monetary policy

Monetary policy is used by the central bank to influence the quantity of money and credit.

Some argue there should be no concern about the national debt because:

Much of the debt is owed to residents of the country. Some of the debt could have been incurred for capital investment projects. Beneficial tax changes could be required. The private sector could increase saving to finance the debt. Accumulation of debt could be increasing employment.

The Fiscal Multiplier

Net taxes (taxes less transfer benefits) reduce disposable income. Assuming t is the net tax rate, disposable income is YD = (1−t)Y The fiscal multiplier helps determine how much the output will change for a given change in government spending or taxes. If mpc is the marginal propensity to consume, then 1−mpc will be saved.

Developing countries face significant hurdles regarding monetary policy, including:

No liquid government bond market Rapidly changing economy Rapid financial innovation Low credibility Lack of central bank independence

Monetary Policy Tools Central banks use three primary monetary policy tools:

Open Market Operations Open market operations involve the purchase and sale of government bonds from commercial banks. If the central bank buys bonds, this increases the reserves of the private sector banks and thus increases the money supply. Central Bank's Policy Rate The central bank can set the official interest rate. It usually sets the rate it will charge when lending to commercial banks. Increasing the rate will reduce the money supply. The name of the refinancing rate varies by countries, such as the refinancing rate in England and the discount rate in the United States. The federal funds rate is the interbank lending rate in the United States. Reserve Requirements The central bank can reduce the money supply by increasing the reserve requirement. This is not used much in developed countries because it is disruptive to the bank's lending practice.

dollarization

Other countries simply abandon their domestic currency and adopt the US dollar as their functional currency. This practice is known as dollarization.

Limitations of Monetary Policy

Problems in the Monetary Transmission Mechanism Often, monetary policy changes are not transmitted smoothly through the economy. For example, central banks increasing short-term interest rates could lead to a drop in long-term interest rates if the market expects a recession. Bond market vigilantes can influence long-term interest rates through buying and selling bonds. Occasionally, the demand for money is infinitely elastic, which means that monetary policy will not be effective. This is called a liquidity trap. Interest Rate Adjustment in a Deflationary Environment Deflation is difficult for monetary policy to handle because interest rates cannot be cut below zero. Deflation raises the real value of debt. Quantitative easing (QE) tries to address it by printing more money. In the United States, QE was done by purchasing mortgage bonds and other long bonds. However, the central bank could just be purchasing bad debt. Ultimately, monetary policy is limited because it cannot control how much households deposit at the bank and how much banks are willing to lend.A liquidity trap is most closely associated with:

Quota Diagram

Since supply is limited, foreign producers can raise the price and generate profits • These profits are called quota rents Extra Revenue goes to the foreign producer or foreign government Welfare loss for importing country is now the sum of areas B, C, and D • Total welfare loss under quota is greater than total welfare loss under tariff.

The Roles of Central Banks

Supplier of Currency Banker to Government and Bankers' Bank Lender of Last Resort Regulator of Payments System Conductor of Monetary Policy Supervisor of Banking System Maintain Foreign Currency Reserves and Gold Reserves

Target Independence vs Operational independence

Target independence gives the bank authority to set the interest rate level target. Operational independence means the bank can get the target level from another branch of government, but it is otherwise not under the influence of the government.

Price Currency vs Base Currency

The "A/B" quoting convention for exchange rates represents how many units of currency A can be purchased by one unit of currency B. Currency A is the price currency, and currency B is the base currency.

The Fisher Effect

The Fisher effect states the real rate of interest (Rreal) is stable. Changes in the nominal interest rate (Rnom) are a function of expected inflation Investors also demand a risk premium, so really there are three components to the nominal rate.

General Agreement on Tariffs and Trade (GATT)

The GATT was the only multilateral body governing international trade from 1948 to 1995. It operated for almost half a century as a quasi-institutionalized, provisional system of multilateral treaties and included several rounds of negotiations.

Heckscher-Ohlin model

The Heckscher-Ohlin model uses both capital and labor as factors of production. Both factors can trigger comparative advantages. Companies will specialize in labor-intensive or capital-intensive goods. This two-factor model (also known as the factor-proportions theory) allows for income redistribution. Based on this model, the prices of the factors of production of all countries will eventually converge, assuming identical technologies as well as homogeneous products and inputs.

International Monetary Fund

The IMF has a mandate to: • Provide a forum for cooperation on international monetary problems. • Facilitate international trade. • Promote employment, economic growth, and poverty reduction. • Support exchange rate stability. • Lend to members temporarily under adequate safeguards. This was enhanced following the 2007-2009 financial crisis. • Monitor global, regional, and country economies. • Help resolve global economic imbalances. Assess financial sector vulnerabilities.

World Bank Group

The World Bank helps countries fight poverty and enhance economic growth. It seeks to assist developing countries with the following activities: • Strengthening government institutions and educating government officials. • Implementing legal and judicial systems that encourage business. • Protecting individual rights and honoring contracts. • Developing robust financial systems. • Combating corruption. The International Bank for Reconstruction and Development (IBRD) and the International Development Association (IDA), provide low-interest loans to countries that need it. The IBRD and IDA are both closely affiliated with the World Bank.

World Trade Organization (WTO)

The World Trade Organization (WTO) is a forum of multilateral trade negotiations. In recent years, the WTO has had limited success in bridging the differences between its diverse range of member countries. As a result, many countries have concentrated their efforts on regional integration. Although regional trade agreements may be easier to negotiate over the short term, they can result in less efficient allocations if trading is diverted away from more cost-effective non-member countries.

common market

The common market takes the integration further by allowing free movement of production factors among the members.

The current account balance

The current account balance is the difference between exports and imports, or X−MX−M, which is equivalent to the trade balance. If the exports exceed the imports, then the current account is in a surplus position (trade surplus). If the imports exceed the exports, then the current account is in a deficit position (trade deficit). The capital and financial accounts must offset the surplus or deficit in the current account. A country with a current account deficit must increase its debts with foreign countries. The current account balance can be expressed as: CA = X−M = Y−(C+I+G) A current account deficit will arise from low private savings, government deficit, or high private investment.

Balance of Payment Components: The current account

The current account measures the flow of goods and services. It includes the sub-accounts of merchandise trade, services, income receipts, and unilateral transfers. Patent fees and legal services are both captured in the services sub-account of the current account.

Deficits and the Fiscal Stance

The deficit can change for reasons unrelated to fiscal policy (e.g., automatic stabilizers), so its size does not necessarily indicate expansionary or contractionary policy. Economists focus on structural budget deficits, which is the deficit that would occur if the economy was at full employment. At lower unemployment, tax revenues would be greater and social transfers lower.

Diagram of Tariffs

The diagram below illustrates what happens when a country imposes a tariff. Under free trade, the world price would be P∗, and the domestic demand would be Q4. The domestic supply is Q1, and the imports are Q4−Q1. A tariff of t would increase the price from P∗ to P∗ + t and reduce the domestic demand to Q3. • Area A represents gains for domestic firms, which benefit from increased production and higher prices. • Area C represents the revenue that is earned by the government from tariffs paid by foreign firms. • Areas B and D represent deadweight losses to the importing country's welfare. • The sum of these areas (A+B+C+D) is the decrease in domestic consumer surplus.

Balance of Payment Components: The financial account

The financial account records investment flows through the sub-accounts of financial assets abroad and foreign-owned financial assets within the country.

The Foreign Exchange Market

The foreign exchange market, which is by far the world's largest in terms of daily turnover, is global in scope and operates 24 hours a day. While FX markets facilitate international trade in goods and services, the dominant transactions in FX markets are from capital transactions. Market participants can either use FX trading for speculation or hedging. Often the hedging must be done for uncertain future payments or receipts, so estimates are required.

Sell-Side

The sell-side is composed of major multinational banks (e.g., Deutsche Bank, Citigroup). With their economies of scale, IT expertise, and global client bases, these tier-one banks are able to offer the most competitive FX quotes. Regional and local banks act as sell-side participants as well, but to a much lesser degree than larger banks.

The Supply and Demand for Money

The supply and demand for money will intersect at the equilibrium price. The price of money is the nominal interest rate. If the supply of money is fixed, the supply curve (MS) will be vertical. The demand curve (MD) will have a negative slope because people will hold less money when interest rates are high. If the demand for money is greater than the supply of money (the point on MD that is to the right of MS), people will sell bonds to get more money. This would drive the price of bonds down and hence the interest rate up, which would reduce the demand for money back to the equilibrium point. In the long run, increasing the money supply will increase the aggregate price level because only real resources can increase the real output. This is called money neutrality. However, monetary policy can have real short-run effects.

The terms of trade

The terms of trade are the ratio of export prices to import prices. An increase in this ratio allows a country to purchase more imports with the funds received from exports.

quantity theory of money

The velocity of money is often assumed to be constant, so P×Y is proportional to M. Monetarists believe the price level, and hence inflation, can be controlled by the quantity of money. However, the quantity of money may be determined by the level of economic activity.

Difficulties in Executing Fiscal Policy

There are difficulties in executing fiscal policy. A recognition lag occurs because it takes time for data to indicate the economy is slowing. It then takes time to implement the policy changes, which is the action lag. The impact lag measures how long the actions take to impact the economy. Also, it is tough to know where the economy is really headed. Economic forecasts have not been known for accuracy. There are other macroeconomic issues also. Fiscal policy does not work well when combating unemployment and inflation. High budget deficits may preclude more deficit spending to provide a stimulus. The actual level of full employment is difficult to determine. Fiscal policy will not work if there are supply resource shortages. The government may crowd out private sector borrowing.

Export Subsidies

To encourage exports, governments may offer export subsidies. Such subsidies distort trade by encouraging companies to shift their sales to foreign markets and ultimately decrease the exporting country's consumer surplus and national welfare. Trading partners may respond to export subsidies by imposing countervailing duties.

The Demand for Money People hold money balances for three reasons:

Transactions-related balances, which are held to facilitate routine consumption, are usually a stable percentage of GDP. Precautionary balances, or funds that have been set aside as a buffer against unforeseen events, are also a stable percentage of GDP. Speculative balances are held based on the expectation that other assets will decline in value, so they tend to increase as assets such as stocks and bonds are perceived to be riskier.

foreign direct investment (FDI) and foreign portfolio investment (FPI).

With the expansion in trade, there has been an increase in both foreign direct investment (FDI) and foreign portfolio investment (FPI). FDI is an investment by companies in physical productive assets in foreign countries, while FPI involves holding securities such as stocks or bonds issued by foreign companies or governments. FDI tends to be longer-term in nature than FPI.

A liquidity trap is most closely associated with:

deflation. A liquidity trap arises when the demand for money is infinitely elastic because individuals elect to hold additional money balances rather than respond to stimulative rate cuts by spending. As a result, weakening consumption leads to deflation.

Direct Quote

A direct quote uses the domestic country for the price currency and the foreign country for the base currency.

Bretton Woods system

A system in which all currencies were pegged at a fixed rate to the US dollar that were periodically adjusted.

voluntary export restraint (VER)

A voluntary export restraint (VER) is a self-imposed limit on the quantity of exports to other counties. VERs allow the exporting country to capture quota rents and impose welfare losses on the importing country.

Capital restrictions

Capital restrictions impose limits on the ability of foreign investors to own domestic assets and the ability of domestic investors to own foreign assets.

The Objectives of Monetary Policy

Central banks have a variety of objectives. They range from maintaining full employment to keeping confidence in the financial system. The most important objective is that of maintaining price stability.

Direct taxes

Direct taxes come from income, wealth, and corporate profits. This could include property tax and inheritance tax.