EC 431 Comprehensive Final

Given the following information, what is the CA balance for this country? Merchandise trade balance=-300 billion, Services trade balance=+75B, unilateral transfers made in excess of those received=60B

-285B

True statements regarding emerging markets:

-financial institutions have generally proven to be weaker than those in industrialized countries -are the capital markets of poorer, developing countries that have liberalized their financial system to allow private asset trade with foreigners -countries with emerging markets include Brazil, Mexico, and Thailand -financial institutions contributed to the financial crisis of 1997-99

Benefits of joining a fixed-exchange area

-gains from the stability of the area and reduced uncertainty -efficiency gain from a fixed exch rate w/euro is greater when trade between is extensive than when it is small -fixed exch rate simplify economic *calculations* -provide a more *predictable* basis for *decisions* that involve international transactions than floating rates -*monetary efficiency gain from pegging* will be higher if factors of production can migrate freely between Norway and the euro area. -the more *extensive are cross-border trade* and factor movements, the greater the gain from a fixed cross-border exchange rate

Costs of joining a fixed-exch rate area

-give up ability to use exchange rate and monetary policy for purpose of stabilizing output and employment -when the economy is disturbed by a change in the output market, a floating exch r. has an advantage over a fixed rate -flexible exchange rate automatically cushions the economy's output and employment by allowing an immediate change in the relative price of domestic and foreign goods -purposeful stabilization is more difficult b/c monetary policy has no power to affect domestic output and employment

What are three things to measure for in evaluating the performance of the capital markets?

-level of portfolio diversification -intertemporal trade -efficiency of foreign exchange

The CPI in Holland is 124, and the CPI in Israel is 186. If absolute purchasing power parity holds then the Euro/Shekel exchange rate should be:

0.667

What are the main lessons economists learned from the developing country crisis?

1) Choosing the right exchange rate regime 2) The central importance of sound banking system 3) The proper sequence of reform measures 4) The importance of contagion

Describe the extensive "safety net" that has been set up in the United States in order to reduce the risk of bank failure

1) Deposit insurance 2) Reserve requirements 3) Capital requirements and asset restrictions 4) Bank examination 5) Lender of last resort facilities

Explain the difficulties in regulating international banking:

1) No deposit insurance, in particular, inter-bank deposits are unprotected 2) Absence of reserve requirements 3) Bank examination more difficult to enforce 4) Not clear which group of regulators has responsibility for monitoring a given bank's assets 5) Not clear which central bank, if any, is responsible for providing Lender of Last Resort assistance

Describe some of the features hindering developing countries from growing faster:

1) corruption - govts control the economy by developing restrictions that would not allow international trade among other countries (knowing that while having the doors open for international trading the country can be better off) -govts also owning and controlling the largest industries, that produce more in the countries, and controlling international transactions, they do not let new opportunities come into their society -gov't also do tax evasion, which most of the time in some countries it's been out of control. Basically, developing countries have been managed by corrupt and inexperience peoples that just want to disturb instead of encourage new opportunities for a better future

What prompted the EU countries to seek closer coordination of monetary policies and greater exchange rate stability in the 1960's?

1) to enhance Europe's role in the world monetary system 2) to turn the EU into a truly unified market

What is the expected dollar rate of return on dollar deposits if today's exchange rate is $1.10 per euro, next year's expected exchange rate is $1.165 per euro, the dollar interest rate is 10% and the euro interest rate is 5%?

10%

Explain what 4 main categories of world economies are and give examples:

4 main categories (categorized by annual per-capita income levels) -Low-income economies (India, Pakistan, Sub-Saharan Africa) -Lower middle income (Middle East, Latin America, Caribbean, former Soviet countries and most African countries) -Upper middle income (Latin American countries, Saudi Arabia, Malaysia, South Africa, Poland, Hungary, Czech Republic, Slovak Republic) -High-income economies (Korea, Israel, Kuwait, Singapore and the US)

Eurobanks are...

A financial institution that accepts foreign currency denominated deposits and makes foreign currency loans. As such, a eurobank does not necessarily have to be located on the continent of Europe; it can be anywhere in the world.

Describe the main provisions of the Maastricht Treaty of 1991

Called for a single currency by January 1, 1999 harmonizing social security policy within the EU, and centralizing foreign and defense policy decisions.

Explain the theory behind convergence and why it is a "deceptively simple" theory:

Convergence: the tendency for gaps between industrialized countries' living standards (i.e. per capita income) to narrow. If trade is free, if capital can move to countries offering the highest returns, and if knowledge itself moves across political borders so that countries always have access to new production technologies, then there is no reason for international income differences to persist for long. Some differences, however, do exist b/c of policy differences across industrial countries.

How were the initial members of EMU chosen? How will new members be admitted? What is the structure of the complex of financial political institutions that govern economic policy in the euro zone?

EU countries should satisfy: 1) Low inflation rate (no more than 1.5% above the average of the 3 EU member states with the lowest inflation) 2) A stable exchange rate with the ERM 3) Public-sector deficit no higher than 3% of its GDP in general 4) A public debt below or approaching a reference level of 60% of its GDP

Explain the difference between equity instruments and debt instruments

Equity instruments are share of stocks. It is defined as a claim to the firm's profit. Debt instrument are bonds and bank deposits. They specify that the issuer of the instrument must repay a fixed value.

Is the EU an optimum currency area? Why or Why not?

Europe is not an OCA. Labor mobility is highly limited. Economic and political conflicts within the euro zone have been persistent and they continue to result in questions regarding the ability of the EZ to survive going forward

T/F countries with emerging markets have been unable to liberalize their financial systems to allow private trade with foreigners

F

Explain why the EU's current combination of rapid capital migration with limited labor migration may actually raise the cost of adjusting to product market shocks w/o exchange rate change?

If the Netherlands suffers from an unfavorable shift in output demand, Dutch capital can flee abroad, leaving even more unemployed Dutch workers behind than in the case of govt regulations that were to hinder the movement of capital outside the Netherlands. Severe and persistent regional depressions could result, worsened by the likelihood that the relatively few workers who did successfully emigrate would be precisely those who are most skilled, reliable, and enterprising. This is another example of the *theory of the second best*

Who is the Basel Committee? Discuss both their involvement in the Concordat as well as the role of the Concordat in international banking.

In 1975, the Basel Committee reached an agreement, called the Concordat, which allocated responsibility for supervising multinational banking establishments. In addition, the Concordat called for the sharing of information about banks and the granting of permission to inspect any such banks.

Discuss studies based on the interest parity conditions.

In general, the formula does not hold and is not a good predictor of future devaluations. Even worse, it failed to predict correctly even the direction in which the spot exchange rate would change.

What factors lie behind capital inflows to the developing world?

Many developing countries have received a lot of capital inflows that lead them to a huge debt to foreigners. -debts have been produced b/c the economy of developing world is very small compared to the economy of industrial world -national savings is often low (poor financial institutions and poverty) they're always facing CA deficit -still opportunities for profitable introduction or expansion of firms and equipments which give good reason for a high level of investment -due to deficits in CA a country can obtain resources from abroad to invest even if its domestic savings level is low -which means the country will have to borrow money from a foreign country -these ways of production are the one that lie behind capital inflows b/c by helping these countries to grow/expand, the price to pay is a big debt which they know based on their circumstances its going to be hard to repay.

Explain why despite enormous natural resources, much of Latin America's population remains in poverty and the region has been repeatedly experiencing financial crises:

Most of LA population remains in poverty b/c bad advice and inefficient proliferated about investment decisions having taken. At the same time, the revenues available to those able to exploit limited domestic markets inspired lobbying for imports licenses and expanding the market as well as corruption. -Discrimination in the import that alternates financial system and poverty at the lowest income levels grew over time -Gov't corruption/bad administration of money -since the 50's and 60's many LA countries were able to attain amazing growth rates by exploiting the initially high returns from moving resources into industrial uses from inefficient agricultural activities -instead of using growth to get rid of debts and decrease the deficit gov'ts along w/corrupt people wasted for getting about the debt that the country was facing

Under fixed exchange rate: the following condition should hold for domestic money market equilibrium

Ms/P = L(R*,Y)

Needing to pay 9,000 yen per radio to its suppliers in a month, Radio Shack makes a forward-exchange deal to buy yen. This is an example of:

Radio Shack hedging its foreign currency risk

T/F Any central bank purchase of assets automatically* results in an increase in the domestic money supply, while any central bank sale of assets *automatically causes the money supply to decline

T

Based on the 1997 Crisis and your own experience, what are the main weaknesses of the East Asian economies?

Textbook raised 3 issues: 1) little productivity increase (most of the growth due to capital and labor inputs increase, eventually leading to diminishing returns) 2) the poor state of banking regulation in most of the asian economies 3) inadequate legal framework for dealing with companies in trouble

Explain what the GG-LL model tells us about the benefits of extensive trade between EU member states and comment on the significance of similarity of economic structure in this framework:

The GG-LL model shows that extensive trade with the rest of the euro zone *makes it easier for a member to adjust to output market disturbances* that affect it and its currency partners differently. A key element in minimizing such disturbances is similarly in economic structure especially in the types of products produced. Euro zone countries are, in fact, not entirely dissimilar in the manufacturing structure, as evidenced by the *very high volume of intraindustry trade*. The hope is that any *difference in EU member country factor endowments will be minimized* by the completion of a *single European market* and the redistribution of capital and labor across Europe. This will bring about the desired similarity of economic structure.

How did the European single currency evolve?

The answer is related to the collapse of Bretton Woods and the European Currency reform. The Werner Report of '71 establishes three-phase program to lead to the EMU.

Explain why large interest rate differences would be strong evidence of unrealized gains from trade.

The difference between onshore and offshore interest rates on similar assets denominated in the same currency should be small if information about global investment opportunities is transmitted efficiently. Data show that this is the case for the U.S., Germany, Japan and the Netherlands.

What is securitization?

The term refers to financial instrument in which bank assets are repackaged in readily marketable forms. This kind of "derivatives" although useful for the international investors and the banks that underwrite them, causes huge problems in government abilities to monitor bank assets and independently assess their risk to the soundness of the international banking system.

How and why did Europe set up its single currency?

The why part is because large fluctuations in the exchange rates among the European countries disturbed trade. Also, one of the main reason was to design a way to prevent future world war. The part of the question is related to the collapse of Bretton Woods and the European Currency reform of 1969-78. The Werner Report of '71 establishes three-phase program to lead to the EMU.

What types of international transactions are recorded in the BoP accounts?

Three types: transactions that involve exports and imports of goods and services; transactions that involve the purchase or sell of financial assets; and exports and imports of goods and services; other activities resulting in transfer of wealth between countries which are recorded in the capital account

T/F (on test it was which of the following is the MOST accurate) Spot exchange rates and forward exchange rates are equal when the value date and the date of the spot transaction are the same

True

How do constraints on monetary policy in the US differ from those experienced by the euro zone countries?

US -monetary policy constraints are different -can print dollars to pay off debt as necessary (might result in inflation, it makes it virtually impossible for the US to default on public debts) Euro Zone -have a European Central Bank that makes decisions on monetary policy that will affect all the EZ countries -has been discussed to make it possible to conditionally remove countries from the EZ to prevent the destruction of the monetary union

Explain why the distinction between debt and equity finance is useful in analyzing the response of developing countries to unforeseen events such as recession or terms of trade change?

When a country's liabilities are in the form of debt, its fixed scheduled payments to creditors do not fall when its real income falls. This makes it difficult to honor the developing country's foreign obligations and may lead to default

Assume the output market adjusts more rapidly than the asset market. A point of disequilibrium that is below both AA and DD will therefore initially result in:

a decrease in output

In the short-run, any fall in EP*/P, regardless of its causes will cause:

a downward shift in the aggregate demand function and a reduction in output

A debit entry in the balance of payments system could be from which of the following?

a payment made while abroad by a domestic resident

MA: For a fixed exchange rate, a rise in the expected future exchange rate causes:

a rise in the current exchange rate

Most Accurate (MA): For a given euro interest rate and constant expected exchange rate:

a rise in the interest rate offered by dollar deposits causes the dollar to appreciate

The expectation of future revaluation causes a BoP crisis marked by:

a sharp rise in reserves and a fall in the home interest rate below the world interest rate

What is a difficulty encountered in regulating international banking?

absence of reserve requirements

Offshore banking can take place at which institution?

agency office, subsidiary bank, and foreign bank

What would cause the current account balance to decrease?

an increase in disposable income

What are the 5 major channels, which developing countries use to finance their external deficit?

bonds finance, banks finance, official lending, foreign investment, and portfolio investment

International Economic Integration incorporates

both real and financial sector transactions

Brazil's 1999 crisis was relatively short lived because...

brazil's financial institutions avoided heavy borrowing in dollars

If a trader thinks that the value of yen with respect to the euro is about to fall, which of the following would enable him to make a profit?

buy a forward contract for euros

How was South Korea able to become one of the East Asian Economic Miracles?

by launching a series of economic reforms, shifting from an inward-looking, important-substitution development strategy to one that emphasized exports

Fiscal expansion stimulates aggregate demand and:

causes output to rise

Using the relationship between expected exchange rates and inflation differentials in combination with uncovered interest parity we find:

changes in inflation rates are directly related to changes in nominal interest rates

Suppose you study abroad in England. When you purchase books and food, these transactions should really be recorded as:

credits to the capital account and debits to the current account

Given P(us) and Y(us), and increase in the European money supply causes the euro to:

depreciate against the dollar but it does not disturb the US money market equilibrium

MA: a permanent increase in a country's money supply causes a proportional long run ____________ of its currency against foreign currencies

depreciation

The PPP theory fails in reality for all of the following reasons except: a) transport costs b) monopolistic or oligopolistic practices in goods market c) the inflation data reported in different countries are based on different commodity baskets d) restrictions on trade e) inflation rates are unrelated to money supply growth

e) inflation rates are unrelated to money supply growth

Capital markets of poor developing countries that liberalized their financial systems to allow private asset trade with foreigners are called:

emerging markets

Using the asset model of short-run exchange rate determination, once the domestic rate of return is determined by Ms and Md, the short-run equilibrium __________ can be determined if prices are inflexible and expectations are given.

exchange rate

Which of the following is one component of the "trilemma" that is faced by policy makers in choosing monetary arrangements?

exchange rate stability

The US issues ad $10,000 debt forgiveness to Argentina. How is this accounted for in the BoP?

financial account, US asset export

What is fiscal federalism?

fiscal federalism in the EZ involves establishing a larger centralized budget managed by a central fiscal authority with the capability to tax, spend, and issue euro bonds.

MA: Fiscal policy affects employment more under:

fixed than under flexible exchange rate regimes

MA: Depreciation is a rise in E when the exchange rate ______ while devaluation is a rise in E when the exchange rate is _______

floats; fixed

When a country's currency depreciates:

foreigners find that its exports are cheaper and domestic residents find that imports from abroad are more expensive

future contracts ensures you will receive a certain amount of foreign currency at a specified future date

future contracts allow you to sell your contract on an organized futures exchange

In the short run, a permanent increase in the domestic money supply:

has stronger effects on the exchange rate and output than an equal and temporary increase

Explain the theory of optimum currency area:

implies that countries will wish to join fixed exchange rate areas closely linked to their own economies through trade and factor mobility. This decision to join is, in turn, determined by the difference between the monetary efficiency gain from joining and the economic stability loss from joining. These factors are both related to the degree of economic integration between the joining country and the larger fixed exchange rate zone. Only when economic integration passes a critical level is beneficial to join.

In the short run monetary expansion causes the CA to:

increase & fiscal expansion causes the CA to decrease

A devaluation of the home currency:

increases output and makes domestic goods and services cheaper relative to those sold abroad

If the dollar interest rate is 8% and the euro interest rate is 4%, then an investor should:

invest only in dollars if the exchange rate is expected to remain constant

Risk Aversion (give example)

is a characteristic of a person that dislikes risk. An example of this is someone who takes out rental or home insurance to reduce the risk of some kind of catastrophe

What is Argentina's Convertibility Law of 1991?

is the law that made Argentina currency fully convertible into US dollars at a fixed rate of exactly one peso per dollar. The law also required that the monetary base be backed entirely by gold or foreign currency

If a country chooses to have a monetary policy oriented toward domestic goals and the freedom of international capital movements, then

it cannot have a fixed exchange rate

MA: Relative price changes could:

lead to PPP violations even if trade were free and costless

Under the gold standard, a shortage of currency leads to:

low domestic prices and a foreign payments surplus

MA: an increase in the money supply __________ the interest rate while a fall in the money supply _______ the interest rate, given the price level and output

lowers, raises

If the goods' money prices do not change, a depreciation of the dollar against the pound makes:

makes British sweaters more expensive in terms of American jeans

Under a gold standard, countries control

monetary policy oriented toward domestic goals

The definition of a country that is called a __________ when its stock of foreign financial assets greater than the foreign-owned holdings of domestic assets

net creditor

Credit Suisse, Goldman Sachs, and Lazard Freres are examples of

non-bank financial institutions, such as insurance companies, pension funds, and mutual funds. This includes investment banks, which specialize in underwriting sales of stocks and bonds by corporations and in some cases government agencies.

Under fixed exchange rates monetary policy is:

not an effective policy

When expected dollar-euro exchange rates rise, the foreign expected dollar return curve shifts:

out

Privatization refers to:

process of transferring an enterprise or industry from the public sector to the private sector

Eurodollars are....

refers to U.S. dollar-denominated deposits at foreign banks or foreign branches of American banks; by being located outside of the United States, eurodollars escape regulation by the Federal Reserve Board, including reserve requirements

A permanent fiscal expansion:

shifts the DD to the right and the AA schedule to the left, leaving out the same

The practice of buying an asset in one market and selling it immediately in a second market that is located in another country is known as:

spatial arbitrage

If a country's nominal interest rate is zero, then

the country's economy is in a liquidity trap

Unilateral transfers between countries are:

the difference between Y and DNP if the identity Y = C + I + G + CA hold exactly

After a permanent increase in money supply the exchange rate:

the exchange rate overshoots in the short run

The expected rate of change in the nominal dollar/euro exchange rate is best described as:

the expected rate of change in the real dollar/euro exchange rate PLUS the US-Europe expected inflation difference

The monetary approach basically looks at _________ as the fundamental variable affecting ________ exchange rates

the price level; long-run

The J-curve illustrates which of the following:

the short-term effects of depreciation on the current account

Which of the following compete to determine whether the current account improves or worsens following a rise in the real exchange rate?

volume effect and value effect

Imperfect asset substitutability exists

when there is risk in the foreign exchange market