Econ 488: International Trade & Finance

What is a currency crisis?

"big" depreciation in the value of a country's currency. -"big" is different for advanced (10-15%) and emerging & developing economies (20-25%)

What role did the housing market play in the crisis?

The recession started in the housing market. First, there was a housing bubble. Houses were overvalued. Second, banks were giving loans to people that shouldn't have qualified. Then banks were bundling these loans and selling them to others as "Diversified". When the housing bubble burst, people defaulted on their loans. This started a chain of events that led the Great REcession.

What is the Bretton Woods System?

Under this system the U.S. pegged its currency to the price of gold at a fixed price. Other countries then agreed to peg their currrency to the U.S. Trilemma problems - down fall of Bretton Woods. Controls on capital mobility failed. Thus to keep their currency pegged to USD, would have meant giving up monetary policy independence.

What is consumption smoothing?

Way of managing money so that you save enought during good times that can consume the amount you want at the end of your life or if you experience a temporary shock

What is a twin crisis?

When a country experiences two of the three types of crises: Banking crisis, default crisis, and currency crisis. If a banking and a currency crisis occur (almost) at the same time

What is relative purchasing power parity?

the rate of depreciation of the nominal exchange rate equals the differences between the inflation rates of two countries % change in Exchange rate C1/C2 = Expected rate of inflation in C1 - Expected rate of inflation in C2 C1= country 1 C2= country 2 Based on the expected inflation rates in two countries. The equation tells us how much a countries currency might depreciate. You used this in the country project. You expected the rupiah to depreciate about 6%.

Currency crisis in developing economies (examples covered in class)

developing economies experiences much greater levels of depreciation during a currency crisis. They tend to experience a notable decline in economic growth before and during a currency crisis. In addition, it often takes about 3 years for the economy to return to its previous rate of economic growth. Ex.Indonesian rupiah, Mexican peso,

Temporary versus permanent shocks to income

temp- got sick and couldn't work. permanent - spouse dies or you lost your job and can't fina naother job.

Explain current account?

CA > 0, then production exceeds consumption. It means that the country is exporting their excess production and, on net, accumulating assets. CA < 0, then production is less than consumption. It means that the country is importing the difference and accumulating debt.

What is the Balance of Payments?

Summary of all the transaction that take place between the residents of one country and the ROW • A country that has a current account surplus is called a (net) lender. Any lender, on net, buys assets (acquiring IOUs from borrowers). For example, China is a large net lender. • A country that has a current account deficit is called a (net) borrower. Any borrower, on net, sells assets (issuing IOUs to lenders). As we can see, the United States is a large net borrower.

Explain the Life Cycle Theory of consumption/saving.

Early in life and at the end of your life, your consumption exceeds your earnings. During the middle of your life, you are earning enought that your earnings exceed your consumption, so you are saving money for when you retire and you earn less.

Explain current account from an inter temporal perspective.

CA = Y - C - I - G subtract and add taxes: CA = Y - T - C - I + T - G (CA) = (S - I) + (T - G)

What are some of the benefits of diversification?

Diversification smooths shocks by promoting risk sharing. If a country only exports oil, that country will be greatly harmed if oil prices suddenly drop by a half.

What is NUT?

Net Unilateral Transfers = Foreign Aid and Money Transfers

What caused the global crisis (2007-2013)?

- Lack of regulation - savings glut

What is a 2nd generation crisis?

- The authorities' commitment to the peg is contingent. If the domestic economy is suffering too high a cost from pegging, the authorities will consider floating and using expansionary monetary policy to boost output by allowing the currency to depreciate, thus breaking the peg. - If investors anticipate that the government will break the peg, they will demand a currency premium, making interest even higher under the peg and raising the costs of pegging still further. - The authorities will maintain the peg as long as investors find the peg credible, but they will allow their currency to depreciate if investors find the peg not credible. This creates multiple equilibria and self-fulfilling crises.

What is absolute purchasing power parity? Why does it usually not hold true? Under what conditions and for what items might it hold true? Reasons for deviations for PPP

- purchasing power parity (PPP) is the macroeconomic counterpart to the microeconomic law of one price (LOOP) - It is the application of the law of one price across countries for all goods and services, or for representative groups ("baskets") of goods and services. Implies: Exchange of US$/Canadian$ = Pu.s./Pc. Pu.s. = Price level in the U.S. Pc. = Price level in Canada. The PPP is helpful in looking at long-term changes in nominal exchange rates, but not very accurate in the short run. Reasons for Deviations in the Short Run: - Transactions costs (tarrifs, transportion/shipping, duties, etc) are part of the price of goods in the market. -Non-traded goods - It assumes that all goods entering country are traded, and this is not true. If you eat a meal, the raw food you ate was tradeable, but the work of the chef was non-traded. - Imperfect competition and legal obstacles - this model assumes that goods are undifferentiated. But many goods are differentiated, which causes imperfect competition because firms can set the price for their good. Think of an iPhone. Apple charges outragously high prices for their iPhones, but you still buy them because you think they're better than other phones on the market. - Price stickiness - Prices do not or cannot adjust quickly and flexibly to changes in market conditions. You don't see the price of eggs drastically changing all the time because of market conditions.

Euro crisis: reasons and possible solutions

1)Weak and inadequate oversight of EU countries: Shortcomings of the SGP: • Surveillance failed because member states concealed the truth about their fiscal problems. • Punishment was weak, so even when "excessive deficits" were detected, not much was done about it. • Once countries joined the euro, the main "carrot" enticing them to follow the SGP's budget rules (or to pretend to follow them) disappeared. Hence, surveillance, punishment, and commitment all quite predictably weakened once the euro was up and running. 2) Lack of unification between fiscal and monetary policy. Solution: could create a central European government that would control fiscal policy. 3) ECB

What is money? Understand the money market

3 Key Functions of Money: 1. Store of value - because it can be used to buy goods and services in the future. If the opportunity cost of holding money is low, we will hold money more willingly than we hold other assets. 2. Unit of account - prices in economy are quoted with this 3. Medicum of exchange - allows us to buy and sell goods and services without the need to engage in inefficient barter. Money Market: - This determines price levels. - This has a supply and demand curve. - Supply is controlled by the U.S. Federal Reserve (FED) or the country's central bank. - The Fed uses three main tools to control the Money Supply 1. OMO (Open market operations) - buying and selling bonds 2. Discount rate - rate at which banks borrow money from the FED 3. Required reserve ratio - the % of checkable deposits that the bank must have in their vaults. Check November 9 notes for more info. You may want more info!!!

Be able to use some examples of real world prices to illustrate how purchasing power differs around the world. For example: Big Mac Index

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Explain how a currency peg works

A currency peg is a country or government's exchange-rate policy of attaching, or pegging, the central bank's rate of exchange to another country's currency For example, suppose mexico wants its currency to move along with the USD. If peso falls, mexico can use foreign reserve, such as Euro to buy pesos, which will allow peso's value to go up. If the value of the peso is high, Mexico will sell pesos in the forex market. Demand for a currency determines its value in the forex market.

What is the current account?

CA = TB + NFI + NUT In the Open Economy Identity: Y (GDNI) = C + I + G + CA CA = Y - C - I - G In CA = Y - C - I - G, the "Y" is domestic production and "-C-I-G" is domestic consumption.

Exchange Rate Regimes

An exchange-rate regime is the way an authority manages its currency in relation to other currencies and the foreign exchange market. It is closely related to monetary policy and the two are generally dependent on many of the same factors. Way country manages it's currency and it's price in the forex market.

Demand for a particular currency *ADDED BY SARA

An important question for investors is in which currency they should hold their liquid cash balances. • Would selling euro deposits and buying dollar deposits make a profit for a banker? • These decisions drive demand for dollars versus euros and the exchange rate between the two currencies. Demand for an asset is influenced by: - Rate of return = the total net increase in wealth resulting from holding the asset for a specified period of time, typically one year. - Risk = the volatility of it's rate of return. - Liquidity = the ease and speed with which it can be liquidated, or sold.

Arbitrage and Spot Exchange Rates

Arbitrage: means to buy low and sell high for a profit. If such profit opportunities exist in a market, then it is considered to be out of equilibrium. The absense of arbitrage is important to ensure people do not exploit exchange rates. Spot Exchange Rate: immediate exchange rate of one currency for another between two parties. - the price of buying or selling a particular currency at this moment

What is a banking run? What is a "modern bank run"?

Bank run: Modern bank run: Banks use short-term loans to fund themselves. But during the crisi, banks could no longer get these-short term loans. They had to stop making loans to people and they had to let old loans "roll off" books. they had to sell asets into the market.

Cross Rates and Vehicle Currencies

Cross Rates: A cross rate is the currency exchange rate between two currencies when neither are official currencies of the country in which the exchange rate quote is given. Source: Investopedia Vehicle Currencies: Is a third currency used as an intermediate currency when exchanging currencies for which there is very little demand in the forex market. A country doesn't want the Indonesian Rupiah, they want an in demand currency like the USD to change from the rupiah to another obscure currency. It is not the home currency of either of the parties involved but is used as an intermediate currency. Often: USD, euro, yen, pound

What is external wealth?

Difference between assets owned abroad and home assets owned by ROW. ROW assets owned by Home - (minus) Home Assets owned by the ROW ROW = Rest of the World

National Income Accounts (GDP, GNI, GNDI) Gross Domestic Product Gross National Income Gross National Disposable Income

GDP - production within our borders = C + I + G + TB - Consumption (C) - Investment (I) - Goverment Spending (G) - TB (Trade Balance = exports -imports) GNI - production by factors of production owned by the nation. = C + I + G + TB + NFI - NFI = Net Factor Income - NFI = $$$ home country citizens earned abroad - (minus) $$$ foreign citizens earned in home country GNDI - = C + I + G + TB + NFI + NUT - NUT (Net unilateral transfer) = Foreign Aid and Money Transfers

What is the Fisher effect?

Important Background Info: Nominal Interest Rate: The interest rate before taking inflation into account. The nominal interest rate is the rate quoted in loan and deposit agreements Nominal Interest rate = real interest rate + inflation Real Interest Rate: Nominal Interest Rate - Inflation (Expected or Actual) Fisher Effect: All else equal, a rise in the expected inflation rate in a country will lead to an equal rise in its nominal interest rate. Basically the difference between the nominal interest rates in C1 & C2 and the difference between the expected nominal inflation rate in C1 & C2 will stay the same. So as inflation rises, so will nominal interest rates. ???????????????

Characteristics of ECB

Instrument & Goals: Interest rate was the instrument used by the ECB. Uses interest rates to "maintain price stability" Accountability & Independence: The ECB has more independence than most banks. Not controlled by any political body. Governance & Decision Making: Monetary policy decisions are made at meetings of the ECB's Governing Council. (ECB = European Central Bank)

Covered Interest Parity

Investors want to choose to hold their money in the currency that will make them a profit. While investors know interest rates, they don't know what the future exchange rate will be. If a U.S. investor puts all their $$ in euros for a year but after a year the euro value drops to half its previous value, then when the investors converts their money to the UDS the investment will be worth less than before. Thus, exchange rates pose a risk to investors. To account for this, some investors agree to invest their money in a certain currency for a period of time with a contact stating the exchange rate they'll recieve at the end of the period (the forward exchange rate). The agreement protects the investors because the exchange rate risk has been "covered" by the forward contract.

What is the vicious cycle of financial crisis?

Loss of confidence by investors -> leads to capital outflows -> leads to a sharp depreciation of domestic currency -> worsening firm's balance sheet (loans and bank deposits denominated in foreign currency) -> drop in investment and output -> drop in confidence

What were the rules to enter the Eurozone?

There are three rules requiring convergence in nominal measures and two rules requiring fiscal discipline. Nominal Convergence 1) Under a peg, the exchange rate must be fixed or not vary beyond tight limits. 2) Purchasing power parity (PPP) then implies that the two countries' inflation rates must be very close. 3) Uncovered interest parity (UIP) then implies that the two countries' long-term nominal interest rates must be very close. Last 2 Rules: • The other two Maastricht rules are openly aimed at constraining fiscal policy. The rules say that government debts and deficits cannot be above certain reference levels. • These levels were chosen somewhat arbitrarily: a deficit level of 3% of GDP and a debt level of 60% of GDP.

What is precautionary saving?

They accumulate a lot of international currency as reserves. Ex. think of Indonesia. Gains from trade are put in a fund that is used to invest in the economy.

What is the trade balance (TB)?

Trade Balance = exports -imports

What is the Gold Standard? Pros and Cons

When a country's currency is fixed to the price of gold. The central bank thn buys and sells gold in exchange for paper money. They Cons: Doen't allow for deficit spending during recession. Limits economic goals - Trilemma

What is a 1st generation crisis?

When domestic credit grows at a constant rate forever, reserves drain and money supply increase, which causes inflation. Some investors will sell their domestic currency in order to prevent this, and cause a speculative attack and a sudden drain of reserve. • Domestic credit grows at a constant rate forever, usually due to the monetization of a chronic fiscal deficit • Eventually, reserves drain and the money supply grows at the same rate, causing inflation and depreciation. • Myopic investors do not anticipate the drain, and when reserves run out, they see a sudden jump (depreciation) in the exchange rate. • Investors with foresight will try to sell domestic currency before that jump happens and by doing so will cause a speculative attack and a sudden drain of reserves.

What is a sudden stop?

When the ROW stops lending you money. Probably not the best example, but think of Iceland and how other banks stopped lending money to Iceland's banks. (Analogy: Paying for your mortgage with your credit card line of credit. If that credit line is suddenly reduced.......)

Uncovered Interest Parity

With uncovered interest parity, investors are not "covered" by a forward contract. Instead, investors make a forcast about the future spot rate (expected exchange rate). Their caluclations of their expected currency return are based on their expected exchange rate.

Exchange rates and trilemma. Explain what the trilemma is.

You can't have monetary policy independence, fixed exchange rates, and capital mobility.

What is a liquidity trap?

a situation in which monetary policy can't be used because nominal interest rates cannot fall below the zero bound The Fed uses low interest rates to increase money supply. The government buys bonds to increase the money available to consumers. During the great recession, the extra liquidity was being held by the banks as excess reserves rather than becoming available to the public. But the Fed coudn't decrease interest rates any more because interest rates were pretty much at zero.

What is interest rate parity?

expected real interest rates are equalized across countries. If the Fisher effect holds, then this makes sense. Real exchange rate = nominal interest rate - inflation ??????????????

What is the law of one price (LOOP)?

this states that in the absense of trade frictions (such as transport costs and tariffs), and under the conditions of free competition and price flexibility (wehre not individuals seller has the power to manipulate prices and prices can freely adjust, AKA no one has a monopoly) identical goods sold in different locations must sell for the same price when prices are expressed in a common currency. Why? Arbitrage ensure that this occurs. If diamonds were more expensive in New York, aritrager would buy at a low price in Holland and sell at a high price in Manhattan. If Dutch prices were higher, arbitragers would profit from the reverse trade. This may or may not hold.

What is a saving glut?

unexpectedly high levels of savings

Ins and outs of Eurozone

• The European Union (EU) is a mainly economic, but increasingly political, union of countries that is in the process of extending across the geographical boundaries of Europe. • The main impetus for the euro project came in 1992 with the signing of the Treaty on European Union, at Maastricht, in the Netherlands. • Under the Maastricht Treaty, the EU initiated a grand project of Economic and Monetary Union (EMU). • A major goal of EMU was the establishment of a currency union in the EU whose monetary affairs would be managed cooperatively by members through a new European Central Bank (ECB). • As of 2014, the EU comprised 28 countries (EU-28). • Those who wish to get "in" must first peg their exchange rates to the euro in a system known as the Exchange Rate Mechanism (ERM).