ECONS200 Waikato Short Answer June 2019

What is an international financial crisis, and what are the two main causes?

(Bank, Debt, ER) 1 is a financial disintermediation --> cause by collapse in the value of a currency or a group of currencies. (bank insoverigncy) followed by : 2. a steep recession. 1. is a result of definite macroeconomic imbalances (large budget deficits, hyperinflation, an overvalued exchange rate, or large current account deficits) 2. Caused by volatile flows of financial capital, resulting in speculative attacks on a country's currency and a run on its international reserves.

Describe the three kinds of evidence economists use to support the assertion that economies open to the world grow faster than economies that are closed.

1) casual empirical evidence of historical experience 2) economic models and deductive reasoning 3) evidence of statistical comparisons of countries

Describe the mechanism that leads from a change in fiscal policy to changes in interest rates, exchange rates, and the current account balance. Do the same for monetary policy.

1. Expansionary fiscal policy raises income and consumption due to changes in taxes and government 2. Increase in demand for money 3. Upward pressure on interest rate (increase) 4. Inflow of foreign funds (excess supply of foreign currency) 5. Value of domestic currency increases 6. Exchange rate rises, domestic currency appreciates - Rise in exchange rate causes domestic goods to be more expensive and results in current account deficits - Increased value of the dollar enables domestic consumers/firms to buy more foreign cuts - May result in the deterioration of the current account deficit 1. Expansionary monetary policy reduces domestic interest rates 2. Inflow of foreign financial capital decreases, decreasing the supply of foreign currency 3. Value of the domestic currency decreases 4. Economy is stimulated and causes consumption + income to rise 5. Exchange rate depreciation switches some consumer spending from foreign goods to domestic goods - Current account is ambiguous because the income effect of monetary policy on the current account is the opposite of the exchange rate effect

Draw a graph of the supply of and demand for the Canadian dollar by the U.S. market. Diagram the effect of each of the following on exchange rates, state in words whether the effect is long, medium, or short run, and explain your reasoning. a. More rapid growth in Canada than in the United States. b. A rise in U.S. interest rates. c. Goods are more expensive in Canada than in the United States. d. A recession in the United States. e. Expectations of a future depreciation in the Canadian dollar.

1. The Canadian supply of currency to the U.S market increases in response to the rise in Canadas demand for American exports. The supply curve shifts right; the U.S dollar appreciates; the Canadian dollar depreciates. This effect is medium run because effects of economic expansions and contractions -- the business cycle -- on exchange rate a run for a few years (usually less than a decade). As Canada experiences more rapid economic growth than the U.S, disposable income in Canada rises, causing consumption to rise. Consumer confidence gradually rises as jobs become secured and plentiful. Canadian expenditures on imports rise. 2. The supply of Canadian dollars to the U.S market increases in response to the higher interest rates; the supply curve shifts right; the U.S dollar appreciates; the Canadian dollar depreciates. This is a short run effect because the factors cause the interest rates to change are themselves short run processes. Good example are changes in government (fiscal and/or monetary) policies, expectations, and financial capital flows in and out of a country. 3. The U.S demand for Canadian dollars decreases in response to higher prices for Canadian goods. The demand curve shifts left causing the exchange rate to fall. The U.S dollar appreciates, and the Canadian dollar depreciates. This is a long run effect in part because the prices of goods (comparative advantage) move gradually. The higher the prices of goods in Canada could also be caused by government policies such as tariffs and quotas. In general, changing the government policies takes time. Goods arbitrage will eventually equalize the prices of goods between the two countries, but achieving purchasing power parity is a long run process because of the following factors: a) Shipping, insurance and other transportation may be prohibitively expensive; b) trade barriers such as tariffs, quotas, import license, and inspection fees may be too high; and c) A substantial number of goods may not be traded. All of these play a significant factor for purchasing power parity to exert influence only in a long run. 4. The U.S demand for Canadian dollars decreases in response to the drop-in demand for imports; the demand curve shifts left; the U.S dollar appreciates; the Canadian dollar depreciates. As explained in 1 above, the effect of recessions and expansions on exchange rates can be considered medium term. 5. The demand for Canadian dollars decreases in response to its expected loss in value; the demand curve shifts left; the U.S dollar appreciates; the Canadian dollar depreciates. Like the effects of interest rates, the effects of expectations on exchange rates are short run. As everyone knows, expectations could change swiftly and could reverse course almost instantaneously. Some expectations could be unexpected and flimsy, but they could have catastrophic effects on the exchange rates and financial sectors of the country.

Why is a current account surplus equivalent to foreign investment?

A current account surplus leads to the net accumulation of foreign assets, whether current or financial. In either case, there is the prospect of a future stream of revenue that will be generated from the assets. Another way to look at it is to consider that in order to export to a greater value than imports, a nation must not consume some of its income (production). Instead, the goods and services are sent abroad. The effect is the same as domestic investment: Consumption out of a current periodic production is postponed until a future date, and the excess output is used to increase the capacity of the economy to generate a future stream of income (production).

Explain the moral hazard problems inherent in responding to a crisis.

A moral hazard problem exists when one party involved in a transaction has both the incentive and the ability to shift costs onto the other party. Conduct business recklessly. Bail out banks For example, responding to a crisis with a lender of a last resort such as the IMF creates incentives that both invite reckless behavior on the part of the country in crisis and bad policies for the investors and host borrowing countries. If investors and the country in crisis know that they will be bailed out, they tend to take greater risks than is prudent. On the other hand, the outcome of the crisis could be worse if there is no response. Investors may lose a substantial portion, or all, of their assets and the country in crisis may plunge into a deeper recession than it otherwise would. This is the policy dilemma facing international institutions such as the IMF. The three-point Basel Capital Accord is designed to ease the moral hazard problem described above. But since there is no way to eliminate it completely, the moral hazard problem associated with the mere existence of a lender of last resort still remains

How might manufactured exports contribute to economic growth?

Achieve economies of scale- accessing the world market, supplying greater demand, increases the efficiency, driving domestic growth. More export revenue- can be used domestically to innovate, to further benefit from economies of scale, Exposed to the world market- must compete against competitors, become more efficient, more money into R&D, take on more policies and practices that lowers cost, Technology into other industries, more FDI( foreign direct investment),

Suppose that U.S. interest rates are 4 percent more than rates in the EU. a. Would you expect the dollar to appreciate or depreciate against the euro, and by how much? b. If, contrary to your expectations, the forward and spot rates are the same, which direction would you expect financial capital to flow? Why?

Capital would flow into the US increasing the supply of foreign exchange. Due to higher interest rates, investment at home is more attractive than in Europe. This also reduces the demand for foreign exchange. As a result, we expect the dollar to appreciate by 4%. This interest rate arbitrage activity reestablishes interest rate parity. This suggests that the right-hand side of the interest parity equation is equal to zero, while the left-hand side of the same equation is greater than zero. If F=R as the statement suggests, then the currency markets are signaling that no changes are expected in the exchange rate. Capital would flow to the US, decreasing the demand for foreign currency and increasing the supply of foreign currency. Both of these decrease R.

Explain the concepts of fiscal and monetary policy. Who conducts them and how do they work their way through the economy?

Deliberate manipulation of government spending and taxes in order to affect aggregate economic activity, increase consumption in the economy, increase in disposable income. Multiplier effect. Leakage- taxations, savings, expenses on imports - Conducted by Congress & the President (government) Conducted by the central bank of a country (U.S. - Federal Reserve) (Reserve Bank) and involves changes in the money supply to achieve desired macroeconomic goals

In a crisis not caused by macroeconomic imbalances, economists are uncertain whether a country should try to guard against recession or try to defend its currency. Why are these mutually exclusive, and what are the pros and cons of each alternative?

Economists are uncertain whether a country should try to guard against recession or try to defend its currency in a crisis caused by non-macroeconomic imbalances such as sudden capital flows. If policymakers decide to defend the economy by reducing interest rates, this may cause further depreciation's in the domestic currency. If domestic firms have debt that is denominated in dollars, a depreciation would lead to an increase in their debts and spread additional bankruptcies throughout the economy. On the other hand, if policymakers decide to defend the currency by raising interest rates, they would be sending the economy into a recession. To repeat, the dilemma faced by policymakers is: (1) defend the currency with high interest rates and spread the recessionary effects of a crisis; or (2) defend the domestic economy against the recessionary effects of a crisis and intensify the problems of a collapsing currency. Unfortunately, neither of these alternatives is attractive.

Economists are divided over the effectiveness of East Asian industrial policies. Provide a balanced assessment of the issues that are relevant to understanding the role of industrial policies in fostering growth. Do you think one particular point of view is better than another? Why?

Effectiveness of East Asian industrial policies in fostering growth has always been a debated issue. We cannot neglect the fact that because of industrial policies there has been an increase in growth perspective. Targeted credit programs, targeting growth, targeting credit to the free market and the activist. Uncertain.

Assume a country is currently running a large current account deficit. If the government decided to enact policies to reduce or to eliminate the deficit, what actions should they take? Describe the set of policy options that would be available to them.

Expenditure reducing policies such as tight monetary policy would be used to cut the overall level of demand in the economy. This would need to be combined with expenditure-switching policies so that reduced demand for output does not cause a recession. Expenditure switching policies increase demand for domestic output (as opposed to foreign output) and without expenditure reducing policies could cause inflation. A combination of policies switches spending from foreign producers to domestic producers in such a way as to avoid recession (too much expenditure reduction) or inflation (too much expenditure switching). An exchange rate depreciation is one way to do this.

Describe the process of Chinese reforms from their beginning in 1978 up until China's accession to the WTO.

First reforms were in agriculture. Special economic zones were introduced to try out trade and investment in a controlled setting. These were expanded. In 1986, China applied to join the WTO but did not actually join until 2001, allowing a long period of negotiations and gradual change.

What are three things countries can do to minimize the probability of being hit by a severe international financial crisis?

Governments can minimize the likelihood of, and the damage caused by, financial crises by increasing the transparency of their policies and banking systems. (1) Adopting/Maintaining credible and sustainable fiscal and monetary policies (Transparency) (2) Engaging in active supervision and regulation of their financial intermediaries (3) Providing timely information about key economic variables, like the central bank's holding of international reserves. These measures are good for both foreign investors and the countries themselves because... (1) the measures could signal investors before they massively pour their assets into the country, and (2) the country would be able to avoid a looming financial crisis when foreign investors attempt to withdraw their assets.

Suppose the dollar-yen exchange rate is 0.01 dollar per yen. Since the base year, inflation has been 2 percent in Japan and 10 percent in the United States. What is the real exchange rate? In real terms, has the dollar appreciated or depreciated against the yen?

If we assume the same basket of goods in both countries cost 100 dollars each then, Rr= .01(102/110) =.0927 dollars per yen. In real terms the real purchasing power of the U.S dollar has risen in Japan compared to what is buys at home. The real exchange rate of .00927 per yen tells us that Japanese goods are now cheaper than U.S goods. As a result, the dollar goes further in japan than at home cause the dollar to appreciate and the Japanese yen to depreciate.

What were the factors that led to economic reform in India, and what were the main elements of the reforms?

India had an economic crisis which sparked a shift to reform. It also lost the USSR both as its major trading partner and as a model. It observed the changes that had taken place in other East Asian countries, such as Korea. It changed its permitting process, denationalized industries, and opened up to foreign trade and investment, abandoning import substitution industrialization policies

What are the factors that make India competitive in business services and computer and information services? Do those factors give it a comparative advantage or do they reflect some other source of competitiveness?

India has English as the language of business and a sector of its economy that is highly trained in information technology available at lower wages than in industrialized countries. It scores poorly on ports and transport, but these are not as necessary as a strong communication system for business and information services exists.

What are the sources of China's comparative advantage and how does that show up in the goods it trades?

Low-wage, low-skill labor, economies of scale, and coastal areas with convenient logistics for trading have all led China to be a leader in manufacturing. Imports of inputs and technology have risen along with its exports.

Some countries have fixed exchange rate systems instead of flexible exchange rate systems. How does the exchange rate system limit their ability to use monetary policy?

Market-determined equilibrium exchange rate that equates the demand for and supply of a currency in a flexible exchange rate system - changes in the exchange rate affect exports + imports - Fixed exchange rate is determined by monetary authorities or pegged to a major currency - Weak/unresponsive to market forces - Could fluctuate depending on the currency it's pegged to

In relative terms, international capital flows may not be much greater today than they were a hundred years ago, although they are certainly greater than they were fifty years ago. Qualitatively, however, capital flows are different today. Explain.

More financial instruments, large share of total flow of capital across the borders is related to the need to protect against fluctuations in the value of currencies, and transaction costs of participating in international capital markets is much lower today than a century ago.

Compare the role of agriculture in China and India

Much of China's growth has stemmed from moving labor out of low valued added agriculture and into urban production, where the return is far higher. In contrast, India has not made a real push to encourage workers to move out of agriculture, and over half of the population still lives in rural areas. This reduces the efficiency and growth rate of India's economy.

Discussion of various issues related to economic/financial crisis in the global economy.

Subprime mortgage crisis- lending to pretty much everyone (low credit rating)- may not be able to pay them back. Not good borrowers. If the cost of housing decreased, the collateral of the loans did as well. Refinance the loan to reduce the interest payments required but didn't have the ability to. Creates disintermediation. US had a current account deficit, borrowing from high savings countries like China. Money from other countries flown into the US created a contagion effect as the loans wouldn't have been paid hurting the countries that had money in the US. Expansionary fiscal and monetary policy both drive aggregate demand, decrease in the interest rate. Capital flight is created when other countries take their money elsewhere instead of putting their money in that country's bonds. Consumption driven- importing more than exporting. Contagion risk rely on one another like the US does with China. When a currency appreciates, it could cause the smaller countries exports to become more expensive. Fixed exchange rates could cause it so that you can't increase or decrease the cost of your exports. Economic austerity- is politically not good.

Is the government budget deficit of a country linked to its current account balance? How so? Explain how it is possible for the United States' current account deficit to grow while the budget deficit has disappeared, as happened in the 1990s.

The budget deficit and the current account are linked but there are the other variables of domestic private savings and domestic investment that are also joined in the savings investment balance. For this reason, there is no such thing as a one to one correspondence between budget and trade balances. The basic relationship is captured in the equation (4b in the text): Sp? government budget ?/? current account. From this it can be seen that as the government budget went to zero and the current account became more negative, either savings fell, investment rose, or some combination of the two occurred. Sp+ (T-G) = I + CA

What are the characteristics of East Asian institutional environments that contributed to rapid economic growth?

The characteristics that contributed to rapid economic growth were property rights (free from the threat of nationalization) are relatively secure and free from the threat on nationalization. Bureaucracies are generally competent (neutral, whether they politically sway, transparency, needs to be based on merit), individuals and businesses are free to make contracts that will enforced, access to information is widespread, and (Business-government dialogue) regulations tend to be clear and well publicized (can get a hold of any information they want, high competency in the economy), Rent Seeking, Physical Discipline (avoid large budget deficits, reasonable control of fiscal and monetary policy, control domestic price level- avoidance of hyperinflation), shared belief that government is committed to long-term growth (avoidance of inequality) . Strong and shared economic growth, accumulation of human and physical capital (high-savings rates), rapid growth of manufactured exports (comparative advantage, need high exports to drive high savings rate), stable macroeconomic environment (stable inflow, stable exchange rates).

Suppose the U.S. dollar-euro exchange rate is 1.20 dollars per euro, and the U.S. dollar-Mexican peso rate is 0.10 dollar per peso. What is the euro-peso rate?

The euro-peso rate is (0.1 dollar per peso)/ (1.2 dollars per euro) =0.083 euro per Mexican peso.

Some countries impose capital controls as a means of preventing a crisis. Evaluate the pros and cons of this policy.

The issue of capital controls (usually accomplished by limiting the quantity of capital transactions, taxing transactions, requiring advance notices and waiting periods, etc.) is a slippery slope and an unsettled issue because there are potential benefits and costs associated with this action. On the one hand, the use of capital controls helps minimize the volatility of the capital market and the risks associated with it. Moreover, selective capital controls such as maintaining the proper balance between portfolio capital and FDI entering the country may help avoid and/or minimize a financial crisis like the one that hit Mexico in 1994-1995. Interestingly, some countries such as Malaysia and Chile were able to manage their economies by adopting capital control policies. By not heeding the IMF advice against the use of capital controls, Malaysia was able to recover as quickly, if not quicker, than other countries, even in the face of a financial crisis. Chile was able to insulate its economy from contagion effects of the financial crises by keeping a proper balance between portfolio investment and FDI. On the other hand, a country using capital controls risks at least the following drawbacks: (a) an increase in the uncertainties of its financial markets and a drying-up of needed foreign investments; (b) if (1) investors think that the value of the country's currency is overvalued, or (2) if the country's savings are insufficient to support the desired investment (i.e., domestic investment exceeds domestic saving) and therefore it wants to attract more foreign capital, then it may want to devalue its currency. However, devaluation hurts investors already in the market. In order not to lose their assets further, they may want to take it out of the country. These may create financial havoc in the country; (c) if a financial crisis has already taken place and the country is unable to control the markets, then all foreign capital may leave the country almost instantly, thereby intensifying the financial havoc. These are some of the things that took place during the 1994-1995 Mexican crisis.

Why trade and capital flows are better described and measured in relative rather than absolute terms. Explain the difference. Which term seems more valid—relative or absolute? Why?

The latter are the dollar amounts of trade and capital flows and the former are the ratio of dollar values to GDP. A relative term is when one number is compared to another making the first relative to the second. An absolute term is just raw numbers and data, like the US or china are massive. This gives very little information and is not compared with other data. Relative allows for more comparative reasoning.

What are the new issues in international trade and investment? In what sense do they expose national economies to outside influences?

The new issues involve policy differences between nations that until recently were considered the exclusive between nations that until recently were considered the exclusive responsibility of local or national governments.

What are the some of the problems in trying to use fiscal and monetary policies? Why can't economists and politicians make precise predictions about the effects of a policy change on income and output?

The problems with Fiscal policies are inflation, the substantial margin of error on the estimates of the multiplier, time lags in seeing the results, and it is complicated by the variation in effects stemming from the different possibilities for financing the policy. The problems with monetary policy is it is difficult to predict interest rates, can be ineffective if investment and consumption fail to respond to changes in interest rates, considerable uncertainty on the value of the money multiplier, and in a fixed exchange rate economy it won't work. These reasons they can't make precise predictions is because of the multiplier, they don't know how the long and how many people the change will affect.

What does the trade-to-GDP ratio measure? Does a low value indicate that a country is closed to trade with the outside world?

The trade-to-GDP ratio measures a countries imports and exports to its GDP. (Imports + Exports)/ GDP. This measures the relative importance of trade to a countries economy and shows how dependent a country is on its trade. No, a low value does not necessarily mean that the country is closed to trade. A larger country, such as the U.S. is much more likely to have a lower value because its GDP is much higher than that of a country with a smaller economy. This means that a large economy could do billions of dollars in trade but still have a very small trade-to-GDP ratio because its economy's GDP is worth trillions of dollars. A high value only means that the country is very dependent on trade

Compare and contrast portfolio capital flows with direct investment capital flows.

These two types of capital flows are similar in that they both provide a nation with the use of foreign savings. That is, they both represent financial flows that are a net increase in the moment of resources available for investment. On the other hand, they are very different in the time dimensions that they represent and in their liquidity. FDI is illiquid and generally represents funds with a longer time horizon than portfolio capital. Portfolio investment can move in or out of a nation extremely quickly and is the main focus of concerns about the destabilizing effects of foreign investment, no physical capital involvement and easy to convert into cash, high demand.

Is there a uniquely Asian model of economic growth? What are the issues, and how might we go about answering that question?

Total factor productivity (TFP) and capital accumulation, Capital accumulation- savings rates and investment , TFP- innovative processes, new technology developed to assist workers and capital, and east Asian structure

How can globalization and international economic integration be measured? In what sense is the U.S. economy more integrated with the world today than it was a century ago?

Trade Flows, Factor movements and convergence of prices (goods, factors, and assets). The U.S openness is about 60% greater than it was in 1890 or about 109% greater than 1910. Up 150% today. Labor flows down

Weigh the pros and cons of a large trade deficit.

Trade deficits are generally considered a negative for a country, but the reality is more subtle. On the negative side, large deficits signal that a country is accumulating foreign debt that can be difficult to service if the excess imports are not used to enhance national productivity. Furthermore, trade deficits require capital inflows. If foreign investors lose confidence, it may be difficult to search the necessary foreign reserves. This is partly what happened to Mexico in 1994 and Thailand and Indonesia in 1997. Exchange rate changes, becomes more expensive to service these foreign liabilities. On the positive side, a large trade deficit can also signal that foreigners have confidence in the current set of economic policies and future prospects of the economy. Furthermore, and most importantly, a large trade deficit and the attendant capital inflows allow a higher level of investment than would be possible solely on the basis of domestic savings.

Why are crises associated with severe recessions? Specifically, what happens during an international financial crisis to create a recession in the affected country or countries?

Two reasons: (1) Several economic problems and weaknesses often are present at the time of a crisis- most of which don't appear its already begun. (2) It is generally impossible to avoid a recession once a crisis has begun. Remember - two types of crises: a. those caused by macroeconomic imbalances b. those caused by non-macroeconomic imbalances (such as speculative attacks on the financial system). So, governments face the dilemma that there are costs attached to using alternative policy tools. The must carefully decide what policies should be used in order to minimize the damage caused by the crisis, and find the best ways of getting out of the recession.

China is a middle-income country with abundant supplies of low-skilled labor. How does it manage to export high-technology products? Does it have a comparative advantage in high-technology goods?

While China has abundant supplies of labor, it also has excellent coastal access and ports. China's proximity to specialized design and high-technology manufacturing in Japan and Korea enables it to take part in the production chain of high-technology products, even if its own production capacity is not yet as sophisticated as Japan's or Korea's. Thus while it would not have a comparative advantage in high technology goods in standalone production, as part of a production chain, it becomes an integral part of assembly.

Which of the three motives for holding foreign exchange are applicable to each of the following?

a. A tourist. A tourist holds foreign currency to engage in transactions. b. A bond trader. Holds foreign currency to take advantage of interest arbitrage opportunities c. A portfolio manager. Holds foreign currency to take advantage of investment opportunities (transactions), interest arbitrage opportunities, and speculative opportunities, d. A manufacturer. Holds foreign currency to engage in transactions. Investment for trade.

Look at each of the cases below from the point of view of the balance of payments for the United States. Determine the subcategory of the current account or financial account that each transaction would be classified in, and state whether it would enter as a credit or debit.

a. The U.S. government sells gold for dollars. The U.S exports official reserve assets; it is a credit in the financial account. b. A migrant worker in California sends $500 home to his village in Mexico. A resident of the U.S transfers money to a foreign locale; it is a debit in the current account and goes in the secondary income category. c. An American mutual fund manager uses the deposits of his fund investors to buy Brazilian telecommunication stocks. There is an import of foreign assets; it is a debit in the financial account under the category of a net change in U.S private assets abroad. d. A Japanese firm in Tennessee buys car parts from a subsidiary in Malaysia. An American based producer imports goods; it is a debit in the current account (imports of goods). e. An American church donates five tons of rice to the Sudan to help with famine relief. There is secondary income from the U.S to abroad foreign country; it is a debit in the current account. f. An American retired couple flies from Seattle to Tokyo on Japan Airlines. America residents purchase a service from a foreign firm; it is a debit in the current account (imports of services). g. The Mexican government sells pesos to the United States Treasury and buys dollars. There is a net increase in nonreserve foreign assets held by the U.S government; it is a debit in the financial account.

Exports of goods and services 500 Primary income received 200 Secondary income received 300 Imports of goods and services 700 Primary income paid abroad 300 Secondary income paid 100 Net acquisition of financial assets 300 Net incurrence of liabilities 400 Net change in financial derivatives 600

a. What is the trade balance? The trade balance is 500-700 = -200. Note that this is really the balance on goods and services, not the merchandise trade balance. b. What is the current account balance? The current account is trade balance + net primary income + net secondary income - Primary income paid - Secondary income Paid; -200 + 200 + 300 - 300 - 100 = -100. c. Does the financial account equal the current account plus the capital account balance? The financial account is net financial assets - liabilities + statistical discrepancies (300 - 400 + 600 = 500). d. What is the statistical discrepancy? The statistical discrepancy is financial account balance minus (current plus capital account balance) (500-(-100+0)) =600 (Note, since there is no given data on capital transfers, capital a/c balance is assumed to zero) here.