International Economic Relations Final Exam

During a Republican presidential debate in 2015, Texas Senator and former presidential candidate Ted Cruz said, "I think the Fed should get out of the business of trying to juice our economy, and simply be focused on sound money and monetary stability, ideally tied to gold." Do you agree? Make the strongest case you can. (continued)

For: Provides stable + predictable exchange rates Limits excessive printing of currency, which could trigger massive inflation Against: The strength of a gold standard is its greatest weakness too: Because the money supply is determined by the supply of gold, it cannot be adjusted in response to changing economic conditions. And in particular, under a gold standard, typically the money supply goes up and interest rates go down in periods of strong economic activity. So that's the reverse of what a central bank would normally do today, because they may want to prevent the strong economic activity from triggering inflation. [Suppose there is a real economic boom due to introduction of a new invention. As the economy heats up, upward pressure on interest rates will lead to capital inflows, holding interest rates down in the country rather than letting higher rates cool off the economy.] All countries on the gold standard are forced to maintain fixed exchange rates. As a result, the effects of bad policies in one country can be transmitted to other (mainly smaller) countries if both are on the gold standard. If not perfectly credible, a gold standard is subject to speculative attack and ultimate collapse as people try to exchange paper money for gold. The gold standard did not prevent frequent financial panics. Although the gold standard promotes price stability over the very long run, over the medium run it sometimes caused periods of inflation and deflation.

TOPIC: Political economy of trade policies

In summary, the benefits of the U.S. sugar program are concentrated, and the costs to consumers are diffuse. Clearly it is the producers who have the stronger incentives to lobby Congress, partly because they also have much lower costs of organizing for political action than do the hundreds of millions of U.S. consumers (although organizations like the Sweetener Users Association have emerged to represent the major soft drink manufacturers and other industrial users of sugar and HFCS). An argument made in favor of preferential trade agreements is that the countries participating in an agreement may gain bargaining power vis-à-vis countries outside the bloc, particularly if the agreement entails a high level of integration as in an economic and political union like the EU

TOPIC: Infant Industry Protection

(1) The industry must be able to survive on its own after some period of time. (2) Some market failure must be hindering the development of the industry. Capital market imperfections. Businesses that wish to invest in the new industry may find it difficult to do so because they are unable to borrow at commercial rates due to information problems in the capital market. The appropriability problem. The social benefits of development of the industry could exceed the private benefits to the firms that enter it, if some sort of positive externalities are present, so that the activities of initial entrants into the industry lower the costs of firms that follow later. This is similar to our earlier analysis of positive externalities in production due to knowledge spillovers, but takes the passage of time into account: Disadvantages to being a trailblazer. An initial entrant may generate technological externalities, for example by investing in the training of workers in the application of new technologies, only to find some workers lured away by subsequent entrants into the market who can take advantage of their knowledge and skills. Among the social benefits generated by the initial entrants, then, could be knowledge and skills that accrue to the workers or other firms and that are not fully capturable by the initial entrants into the market. Coordination problems. A final rationale for infant-industry protection relates to our earlier analysis of external economies—the idea that expansion of an industry can reduce costs for the firms within that industry, so that firms in the industry will benefit from forming geographic clusters. It also potentially relates to strategic trade policy—the idea that our country may be able to benefit if we can expand our market share in imperfectly competitive world markets, grabbing a greater share of the excess profits in those markets for firms in our nation. In summary, strict criteria must be met, if infant industry protection is to make sense, and even then political economy considerations may indicate that supporting a new industry could become a long-term liability if the industry is unable to grow up and compete on its own.

The Nixon Administration radically changed the "rules of the game" of international monetary relations in August 1971. Assess the principal economic and political motivations behind this change. At the heart of your answer should be an evaluation of the ways that the Bretton Woods system and managed floating differ in their handling of the basic problems that all international monetary regimes must address.

(see study guide)

What is the most pressing problem today for the United States in its international economic relations? What are the risks or implications of that problem? How can we best go about solving the problem or at least lessening the threat that it presents? Support your answer in detail, with arguments grounded in our course. There is no single correct answer, but make a strong case, drawing upon materials from the course.

CHINA! (explain what you wrote in the paper)

TOPIC: Covered and open interest parity

Covered interest parity (a) Convert this dollar into (1/es) pounds at the spot exchange rate. (b) Lend these (1/es) pounds in the U.K. at interest rate r*. The total return in pounds after one period will be £(1/es)(1 + r*). (c) While buying pounds spot in part (a), at the same time sell forward the amount of pounds to be received in part (b). At the end of the period, convert these pounds back into dollars at the agreed-upon forward rate, getting back $(ef /es)(1 + r*). Profits RISK FREE! Does not work so well if there are transaction costs Open-interest parity Like covered interest parity, but applies to risky, speculative transactions rather than transactions hedged in the forward market Requires perfect asset substitutability, capital mobility, and risk-netural investors Speculators are looking at their expected capital gain from holding foreign currency rather than domestic currency (vs fwd premium on foreign currency) The amount by which interest rates in US exceed foreign interest rates should equal the expeted rate of appreciation of foreign currency in terms of dollars If a foreign currency is expected to appreciate against the dollar (eE > e), the interest rate on dollars must be higher than the interest rate on foreign currency to compensate for the expected capital loss from holding dollars rather than the foreign currency, if open interest parity is to hold. If interest rates in 1 country go down, the other country's currency must also depreciate against the lower interest rate country. A heuristic to remember how this works is as follows: if interest rates in a country go down, the currency of that country should depreciate, all else equal, as there is less demand among investors to hold that currency.

"If the victorious allies after World War I had been willing to run deficits on goods and services, the German reparations problem would have been a problem only for Germans." Comment in theoretical and historical terms.

Theoretical. Country sending financial transfer (Germany) Financial account deficit (receiving money in exchange for goods and services) Current account surplus (exporting more goods and services than received) Country receiving financial transfer (France and UK) Financial account surplus (the money they would "pay" for the goods and services Current account deficit (importing goods and services from Germany) Historical. Because France and the UK both owed war debts to the US, they were not as willing to completely run current account deficits equal to the current account surplus Germany would have to run. France and the UK were in a tricky position of wanting reparations from a country not in a great position to deliver (Germany), and another country insisting that France and the UK pays their debts (US). The terms of the Versailles agreement following World War I included the imposition of indemnities to be paid by Germany. This was an enormous sum, estimated to be in the tens of billions of dollars, to be paid over 30 years to France and Britain. As such, the Versailles agreement provides us with a classic example of the observation that any international financial transfer must be accompanied by a transfer of real resources. In particular, to transfer financial capital to other countries, a country must run a financial account deficit, and thus a current account surplus. To receive financial resources from other countries, a country must run a financial account surplus, and thus must run a current account deficit. At the end of World War I, Germany had stocks of precious metals, foreign securities, foreign currencies, and other commodities with which to make payments. As these stocks ran low, however, Germany would have to provide currently-produced goods and services. To reiterate, just as Germany would have to run surpluses on current account, so the claimant countries would have to run deficits.

TOPIC: Impact of exchange-rate changes

2 distinct effects; on relative prices on the general price level These effects have implications for important macroeconomic variables like the trade balance, output, employment, and inflation. An x percent appreciation of foreign currencies against our own is equivalent in its price effects to an x percent tariff on all imports plus an x percent subsidy on all exports. Thus, the prices of all tradable goods (goods that are imported, compete with imports, or are exported) will rise relative to non-tradable items (mostly services, but also electrical power, municipal water, and so on). YOU WILL PRODUCE WHAT IS MOST LUCRATIVE//expensive This will cause: Reduced consumption of tradables, as consumers substitute away from these goods and toward non-tradables. Increased production of tradables, as resources are drawn out of production of nontradables. With increased production of exports and import substitutes, and decreased consumption of these products, the trade balance should improve eventually. Whether we see a net improvement in the trade balance over time due to the relative price effect depends on the elasticities of supply and demand for exports and imports.

TOPIC: Optimum Currency Areas

A currency area is a geographic area that has a single currency. Prereqs: In particular, a fundamental prerequisite for the formation of a currency area is a willingness to have the same inflation rate as other countries within the area. If inflation were persistently higher in one country than in others, fixed exchange rates would be problematic. In addition, participants in a currency area must essentially be willing to have the same benchmark level of interest rates (if financial capital moves freely between the countries; it is hard to imagine that it would not). What makes it work If the real economic shocks that hit individual countries tend to be similar, due to similar industrial structures within the countries, or at least if their business cycles tend to be reasonably synchronized, then the appropriate monetary policy is similar everywhere, and there may not be much to be gained by exchange rate flexibility. If nominal prices and wages in an economy are rigid, then exchange rate fluctuations may be an important means of adjustment to shocks. Currency depreciation tends to lower real wages relative to those in other countries, which can restore a country to competitiveness internationally, Mobility of labor Fiscal integration

TOPIC: Economic analysis of trade blocs

From wiki: A trade bloc is a type of intergovernmental agreement, often part of a regional intergovernmental organization, where barriers to trade (tariffs and others) are reduced or eliminated among the participating states. Trade blocs can be stand-alone agreements between several states (such as the North American Free Trade Agreement) or part of a regional organization (such as the European Union). Depending on the level of economic integration, trade blocs can be classified as preferential trading areas, free-trade areas, customs unions, common markets, or economic and monetary unions.[1] Advantages Competition. Force manufacturers in participating countries to compete with each other, creates pressure for greater efficiency and lower prices for consumers Economies of scale. Larger markets created by trade blocs allow companies to take advantage of external economies of scale. Lower prices for consumers. Improve Market Efficiency: less deadweight loss because of the removal of tariffs and the increased consumption that occurs from the lower prices Increased foreign direct investment Trade effects: eliminate tariffs, which drives down cost of imports. As a result, consumers can save money when buying imported goods when cheaper than locally produced ones--these savings spent on other goods. Disadvantages Concessions: countries joining bloc must make concessions to join. Interdepence: increasing dependence on trading bloc partners. Disruption of trade, which can occur because of a natural disaster, conflict, etc. can have severe consequences for all countries involved. Loss of sovereignty. Ex: EU with political rules. Regionalism vs. multinationalism: inherently favors the participating countries' trading partners

TOPIC: Immigration issues

Global economic efficiency is enhanced when workers more freely Sometimes workers are high skilled vs. low skilled: depends on their home country situation More than a quarter century ago, economist George Borjas (1990) summarized the conclusions of the empirical literature on immigration rather colorfully: T he methodological arsenal of modern econometrics cannot detect a single shred of evidence that immigrants have a sizable adverse impact on the earnings and employment opportunities of natives in the United States.

TOPIC: Specific Factors Model

I am unsure what to do here. The specific factors model is the entire framework for a lot of the things we've done. We also assume constant returns to scale (CRS) in production: if we boost the usage of all factors of production by some multiple, then output will increase by that multiple as well. A key implication of CRS is that marginal productivities of the factors of production depend only on the ratios in which the factors are used (such as K/LC), not on the absolute levels of employment of these factors (LC and K separately). The scale of production is irrelevant to how the technology works Thus, combining diminishing marginal returns and CRS, if K/LC then C MPL and C MPK . A change in the capital-labor ratio will push the marginal products of the two factors in opposite directions. Individuals will undertake an activity to the point where additional costs = additional benefits. Small country, prices set outside Increasing marginal opportunity costs

You are a member of an IMF staff mission sent to an African country. The country is in desperate straits, with a massive foreign debt problem and rampant inflation. These problems may be a function of economic mismanagement by the government, or may in part reflect internal or external circumstances beyond its control. Discuss the kinds of data and the analytical approaches you could use to identify the origins of this crisis.

Kinds of data helpful to diagnose the origins of the crisis: (1) Recent trends in fiscal and monetary policies. Have the policies been excessively expansionary? One could look to G/Y, (G - T)/Y, and the percentage rate of change in the money supply. One could also ask how the government is spending its resources. Particularly looking at high levels of gov't spending in terms of social welfare spending, IMF likes to cut gov't spending on social programs as main part of austerity measures (2) How has the real exchange rate evolved over time? Has the currency gotten overvalued? This could lead to current account deficits and capital flight, causing the central bank to lose foreign exchange reserves. This triggered the crisis of 1995 in Mexico, and contributed to the crisis in 1997 in Thailand, for example. Fundamentally, this can occur if there is substantial domestic inflation not offset by nominal depreciation of the currency. (3) Is regulation of the banking and financial systems adequate? Are risk management practices by banks and corporations adequate? Moral hazard can emerge in the banking system due to existence of explicit or implicit provision of deposit insurance by the government. In Indonesia, for example, some corporate conglomerates had their own captive banks, which the corporate groups looted to some extent during the crisis. Corporations and banks may also carry too much unhedged foreign debt, a concern that was particularly relevant to the 1997-98 crises in South Korea and Indonesia. Indonesia in particular had had an open capital account since about 1970: capital could easily flow in, which was normally good for the economy, but it could also flow out if there was a problem. (4) Are there any severe "structural" problems present? Do they indicate that a longer-term, more generous approach by the IMF would be appropriate? This includes transition from a different economic system like communism to capitalism, drought or natural disaster/natural resource issues, worldwide financial crisis, shifting terms of trade

Mercantilist world views arguably suffered from three basic flaws. Discuss the flaw that David Hume exposed in his essay, Of the Balance of Trade. Is his point valid today? Are there other reasons why it may be difficult to run a persistent current account surplus?

Mercantilists want to run huge surpluses in order to accumulate wealth. The mercantilist system involved maximization of exports and limits on imports via tariffs: they believed that a nation's economic health relied primarily upon its supply of capital. However, Hume wrote that the inflow of monetary gold into a country set in motion forces that, over time, would bring the inflows to an end. "Hume's analysis revealed one of the basic flaws of mercantilist thought: he showed that trade imbalances are self-correcting. If we run a trade surplus, for example, we will be importing gold. As gold flows in, the money supply will expand, which will cause commodity prices to increase, which over time will cause the trade surplus to shrink away to zero. It is difficult to run a current account surplus for many reasons." This example speaks to the opposite circumstance (current account deficit) but still highlights the point that current account imbalances are self-correcting. "The glut of dollars circulating among people who don't need them will push down the value of the dollar, just like the value of Christmas trees declines after December 25th. A falling dollar makes U.S. exports cheaper, and foreign imports into the United States become more expensive. Cheaper U.S. exports will entice foreigners to buy more American products—including manufactured goods—while more expensive foreign imports will make Americans buy less foreign products, reversing the original trade deficit. So a deficit changes the value of the dollar, which in turn brings the deficit back into balance. Current account surpluses can be signs of low domestic spending and relatively weak domestic demand. In addition, these surpluses can be a sign that a currency is undervalued, like the renminbi was in the early 2000s. This weak demand leads to lower consumer spending and lower spending on imports. Therefore, in this case, domestic employment will suffer from the weak economy. In a recession, consumer spending falls, leading to lower imports, lower inflation, and an improvement in the current account. The deficit may convert to a surplus, but this is due to the recession, and therefore leads to higher unemployment. A current account surplus could lead to lower domestic employment if: The surplus is caused by a recession which has hit domestic demand and led to a fall in import spending. In a global recession where a surplus is caused by falling exports and an even bigger fall in imports A large current account surplus can be a controversial political issue - especially if other countries feel the surplus is a result of an undervalued exchange rate. Some economists have argued the excess current account surplus of Germany and China have directly caused less output and jobs in deficit countries. On the other hand, a country running a current account deficit is able to have a higher level of consumption than otherwise with a current account surplus.

TOPIC: Monetary Trilemma

Moreover, we saw in the "Mundell-Fleming" open economy macroeconomic framework that a country cannot have an independent monetary policy under fixed exchange rate in a world of perfect capital mobility. In particular, these three phenomena are mutually inconsistent: Fixed exchange rates International capital mobility Independent monetary policy Policymakers may not be able to set an independent monetary policy in the long run, but in the short run may have some autonomy. In reality the world offers neither perfect capital mobility nor zero capital mobility. Instead, investors may have some limited opportunities to move funds in and out of a country. In the case of free-flowing capital and fixed exchange rates, independent monetary policy is impossible because interest rate fluctuations would create an opportunity for currency arbitrage, stressing the currency pegs and causing them to break In the case of fixed exchange rates and independent monetary policy, little to no flows of "hot money" in and out of a country make it such that the country is able to exercise such monetary policy because an opportunity for arbitrage is not realized. In the case of large capital flows and independent monetary policy, changing the interest rate to any degree will also change the exchange rate, and, as such, it cannot be fixed

Central banks in other developed countries—Japan, the eurozone, and other European countries—have applied aggressive "quantitative easing" and even negative interest rate policies in an effort to avoid deflation and boost economic growth. Based on our open economy macroeconomic policy framework (also known as the Mundell-Fleming model) and other recent perspectives on the situation, should the United States be concerned about these policies in terms of their impact on our economy? How could the United States best respond to these policies, through its own monetary or fiscal policies? Explain.

Mundell-Fleming Equations: Y = C(Y-T) + I(r) + G + NX(Y-T, ep*/p) M/P = L(r, Y) r = r* + [eE/e - 1] Why the US should be worried. The prompt states that there is "quantitative easing" in Japan which we can take to mean that they are practicing loose monetary policy - aka letting the money supply increase. This results from Japan applying "negative interest rate policies" [meaning they are letting their domestic interest rate fall - this results in an increase in liquidity demand/demand for actual paper cash L and an increase in money supply M via equation (2)]. It also results from the yen depreciating against the $. Through the Mundell-Fleming model, these policies affect the US in various ways. US interest rate r increases and the exchange e rate increases [$ appreciates against the yen] US liquidity preference goes down due to increase in interest rate r, meaning people are going to hold more money in accounts versus spending it and slowing down growth of economy US intended investment I goes down due to increase in interest rate US net exports NX go down due to appreciation of the $ against the yen US GDP goes down due to decrease in L and NX US Fiscal policy response. Via equation (1), an increase in government expenditure G would create an increase in GDP Y. While we can't quantify if this would offset the decrease in GDP caused from the decrease in NX resulting from what Japan has done, this increase in G causes other problems: an increase in US interest rate r and a decrease in exchange rate e [meaning the $ appreciates against the yen]. As a result, fiscal policy would not be the rest response to the worries the US should have. US Monetary policy. The US would increase the money supply, which has the following effects: US interest rate r decreases, investment (I) increases, the spot exchange rate (e) increases [meaning the $ depreciates against the yen], and then net exports (NX) increases. This more or less does the opposite of what Japan's policies have done to us, which returns us back the previous state where the US is not harmed. To increase the money supply, the US Central Bank (aka the Fed) will buy foreign or domestic assets in order to pump more money into the economy.

TOPIC: Purchasing power parity (PPP)

Purchasing power parity (PPP) is a relationship between national price indexes and the nominal exchange rate. Let p be the home price index, and p* the foreign index. There are two versions of PPP (the exchange rate e shows the home-currency price of foreign currency): Absolute PPP: p = e p* or p / p* = e Price levels are almost invariably expressed as index numbers, equal to 100 in some base year, and nominal exchange rates can similarly be expressed as index numbers. Relative PPP: % p = % e + % p* Relative PPP holds if inflation at home equals the rate of appreciation of foreign currency plus foreign inflation. Assumptions for ABSOLUTE PPP: Law of 1 price: no barriers to intl commodity arbitrage All items tradeable All items have same weights in price indexes of dif countries Products not differentiated internationally Relative PPP: some leeway Goods could have dif weights in national price indices PPP as a tendency Over the long run - if foreign prices are constant, and our currency depreciates due to our more rapid monetary expansion, we will eventually have inflation. On the other hand, if real economic shocks predominate, and impact different countries differently, then there could easily be permanent deviations from earlier PPP relations. PPP as a constraint unavoidable by policy makers Government or the central bank may seek to engineer a real depreciation of our currency through nominal depreciation, for example, but inflation will eventually tend to offset it.

TOPIC: Balance of Payments accounting

Record of all transactions between a country and the rest of the world Items of value: goods, services, and assets Wealth: assets, like stocks, bonds, money, metals, etc. OUTFLOWS of value: credits in BOP. Foreigners make a payment on this, we sell to them. INFLOWS of value: debits in BOP. purchases from rest of world, we pay them. Double entry accounting BOP accounts record both sides of all transactions All transactions have 2 sides (except for unilateral transfer) Current account Exports and imports of currently-produced goods and services, as well as labor, investment, and unilateral transfers Financial account Assets: stock, gold bars... If foreigner buys an asset from us, they are acquiring claims on our future income. We are borrowing from the rest of the world. This is a DEBIT. We owe the world. Export an asset = capital inflow= debit. Import an asset = capital outflow=credit. Statistical discrepancy can occur Official reserve transactions Central banks buy/sell reserve assets If current account surplus (net credit) central bank adding to foreign exchange reserves: reserve transaction balance would be in deficit (net debit) Our country sells an excess of goods and services overseas (CA surplus), then we will buy assets from ROW on net (FA deficit) ROW has purchasing power to buy the goods we sell. CAPITAL OUTFLOW: we get claims on income of ROW Our country buys an excess of goods and services overseas (CA deficit), we will sell assets to ROW on net (FA surplus) We get purchasing power to buy things CAPITAL INFLOW: ROW gets claims on our future income U.S. has been running CA deficit for years. Erode our international asset position since we must keep selling But valuation change happens, so you never know. U.S. net income from investments remains positive - U.S. is investing in search of returns though. Twin deficit concerns

TOPIC: Trade and economies of scale

Same as above I don't really know what he wants here but an economy of scale is the idea that as the economy grows, costs can be cut to increase production. This encapsulates all other concepts of trade policy from infant industry discussion to larger tariff debates In the short term, some inputs into production may be fixed (can't be varied) External economies of scale: costs diminish as the industry expands Leads to clusters of producers

TOPIC: Alternative Exchange Rate Systems

See handout lol Pure floating, managed/dirty floating, crawling peg, adjustable peg, fixed exchange rates, currency baord, dollarization, monetary union

TOPIC: The implications of seignorage

The privilege was seigniorage, which refers to the advantage that accrues to the provider of money. The way that seigniorage worked under Bretton Woods (and beyond) is that the United States, by acting as the informal provider of international money, had the first chance to spend it. The United States gave up paper for foreign goods. In effect, it received a perpetual interest-free loan from the rest of the world, as long as other countries did not trade in U.S. currency for interestbearing assets. The responsibilities for the United States under the Bretton Woods system were both formal and fundamental: Formal: the obligation to convert dollars into gold upon demand from foreign central banks, which helped maintain confidence in the currency (price anchor). Fundamental: to carry out fiscal and monetary policies in a responsible manner so as to maintain the intrinsic worth of the dollar (quantity anchor). The problem was that an excess supply of dollars could undermine the system, and that process started as early as 1958.

TOPIC: Ricardian Trade Model

The ricardian trade model essentially introduces a widespread critique of mercantilism in the form of comparative advantage, absolute advantage, and specialization. Assumptions: Labor is the only factor of production. It is homogenous and fully employed. Labor can move between sectors, not between nations Labor time required per unit of output is constant at all output levels Zero transportation costs for goods, perfect competition Expenditure = income Comparative Advantage: A country has a comparative advantage in the production of a good if it has a lower opportunity cost per unit (before trade). If a country has a comparative advantage it will export that good and import goods where it does not hold a comparative advantage. A country can have an absolute advantage in all goods but not a comparative advantage. This flows into the idea of PPF and benefits of specialization Slope of PPF is opportunity cost of x axis Trade lets countries consume outside the PPF Cheaper to import some goods than to produce them Absolute advantage matters for incomes earned by workers in a country relative to workers in other countries

TOPIC: Intervention, sterilized and unsterilized

Unsterilized An important conclusion is that central-bank intervention, on its own, changes fundamental monetary conditions in a country. Indeed, this is an important reason why it works: a change in the net supply of the local currency relative to other currencies should influence the value of that currency versus other currencies, all else equal. Open-market operation, except that the central bank is buying or selling foreign currency assets rather than domestic assets The Fed gains foreign exchange reserves, and in return pumps out dollars. With the increase in U.S. bank deposits, there is a corresponding increase in commercial bank reserves at the Fed, shown above on the liability side of the Fed's balance sheet. This can then fuel a multiple expansion of bank deposits and thus the money supply, by the same amount as the open-market operation examined above. On the other hand, if the Fed sells foreign exchange reserves, it pulls in dollars, which will lead to a multiple contraction of bank deposits and thus of the money supply. ***** Would it affect the money supply of the United States if a foreign central bank intervenes to support or weaken the dollar against its own currency? The answer is no, as long as the foreign central bank does not transact with the U.S. central bank Sterilized Suppose, for example, that the Fed wants to support the dollar against the yen, so it buys dollars and sells yen. This would cause a multiple contraction of the U.S. money supply. But the Fed is also concerned about U.S. unemployment, and recognizes that monetary contraction could aggravate that problem. The Fed may thus wish to "sterilize" the intervention—to offset the impact of foreign exchange intervention on the money supply through an appropriate open-market operation. The offset may be partial or full. In summary, we see that central bank intervention can be effective because it influences monetary fundamentals. Even if the intervention is sterilized, it may be able to play a signaling role or induce private market participants to rebalance their portfolios, consistent with the goals of the central bank.

TOPIC: Mundell-Fleming macro model

Utilizes three equilibrium conditions (3 endogenous variables) This model allows us to examine the impacts of monetary and fiscal policies under fixed and flexible exchange rates in a world of perfect international capital mobility. The model is used to describe how an economy cannot simultaneously have a fixed exchange rate, free capital movement, and an independent monetary policy. This is the Mundell-Fleming Trilemma (1) Y = C(Y-T) + I(r) + G + NX(Y-T, ep*/p) For net exports of goods and services, an increase in our disposable income worsens our trade balance as we spend more on imports. An increase in the real exchange rate ep*/p (with e defined as the home-currency price of foreign currency)—real depreciation of our currency—should improve our trade balance as it makes items produced in our economy more competitive relative to their foreign counterparts. Depreciation of our currency affects equilibrium GDP as follows: e(UP) NX(up) AD(up) Y(up) via (1). GDP would increase directly via net exports, but also indirectly as multiplier effects cause consumption to increase. As disposable income increases, though, the improvement in the trade balance may diminish to some extent as we import more. (2) M / p =L(r, Y) M/P = real money L is real money demand Depends negatively on nominal interest rates As interest rates on assets go up, opportunty cost of holidng money goes up, so demand for money goes down. The combination of loose fiscal policy and tight monetary policy caused interest rates to rise dramatically, and the value of the dollar to appreciate significantly, against other currencies.

TOPIC: Economic impact of tariffs and quotas

Via the Lerner Symmetry Theorem, a tariff on imports is equivalent to a tax on exports. This theorem helps us understand another aspect of import tariffs—how they destroy jobs in export industries. Import restraints = export restraints. If foreign countries are blocked in their ability to sell their goods in the United States, they will be unable to earn the dollars they need to purchase U.S. goods. Throughout U.S. history, large tariff increases have failed to stimulate greater employment because any increase in employment in import- competing industries was offset by a decrease in employment in industries that are export oriented. The indirect consequences of import restrictions include a reduction in exports and lower employment in downstream industries, and we consider each in turn. If there is imperfect competition, quotas and tariffs differ in their effects. . It can be shown that a quota that limits imports to the same quantity will allow the monopoly to charge a higher price, because it puts a quantitative limit on foreign competition faced by the monopoly. Because quotas that are arbitrarily assigned can harbor inefficiencies (point 1 above), tend to be more rigid than tariffs in their effects (point 2), may facilitate the exercise of monopoly power (point 3), and are far less transparent than tariffs (point 4), quotas are for the most part prohibited by the World Trade Organization (WTO). However, quotas may be allowed for agricultural and fisheries products when such quotas do not discriminate between supplying countries. I Under the Tariff : Summary The TOT gain for the United States under the tariff comes about because we now get sugar from the rest of the world at a lower price (P1 versus P0); even though U.S. consumers actually pay a higher price (P2), the U.S. government gets tariff revenues equal to the difference between P2 and P1 on a per-unit basis. The rest of the world suffers a TOT loss because of the decrease in the price in the world market, given that the rest of the world is a net sugar exporter. Quota summary The TOT loss for the United States under the quota comes about because we now get sugar from the rest of the world at a higher price. The rest of the world enjoys a TOT gain because it now sells sugar to the United States at a higher price. An implication of this analysis is that—if net national welfare maximization is the objective, and if we want to improve our terms of trade—imposition of a tariff rather than a quota is the only way to go. However, our earlier comparison of tariffs and quotas suggests some political-economy reasons why a quota has been used by the United States: there is more secure protection against drops in world prices, the fog factor obscures the impact on the U.S. sugar price, and there is a lessened risk of foreign retaliation. An import tariff pushes up the domestic relative price of the import, while an export tax pushes down the domestic relative price of the export—and it is relative prices that matter for resource allocation. In a very simple world, domestic relative prices could be exactly the same with an import tariff or an export tax! Now suppose that a tariff is imposed on imports at a rate t. This changes the domestic relative price as follows: The tariff lowers the relative price of exports compared to imports. Now consider an export tax, also set at a rate t, which is applied to the domestic price of the exports:This means that the domestic price of exports must go down relative to the international market price. Otherwise, after the tax is applied, our exports could not compete internationally.

5. Are floating exchange rates among the currencies of major industrial countries (or blocs of such countries) a good idea nowadays, compared to the alternatives? Explain.

We are in a world of generalized floating. When considering whether floating is feasible and optimal, there are two sets of issues: the degree of openness of the economy, and the extent of development of asset markets. One way to measure openness is (X+M) / GDP. Flexible exchange rates are usually more fitting for a more closed economy, like the United States. However, for an open economy, exchange rate volatility could have a major impact on domestic prices and employment—thus, a fixed exchange rate can provide economic stability. Floating is more feasible and maybe more optimal in more highly developed asset markets, like those found in the major industrial countries. If asset markets within a country are highly integrated with those in the rest of the world, then the possibilities for hot money to flow in or out make it difficult to maintain the exchange rate away from equilibrium. It is better to let the currency float. Though the exchange rate may then be subject to considerable volatility, developed asset markets also will provide a variety of mechanisms to hedge against exchange rate risks. However, in the absence of forward markets for foreign exchange hedging, trade may be deterred. In this case, a fixed rate might be better at promoting trade. In addition, if foreign exchange markets are very limited or "thin," the exchange rate may be unstable if it is allowed to float, or a few speculators may be able to manipulate it. In this case, it also tends to be better to fix the exchange rate. Other considerations include the extent of hedging of exchange rate risks in the loan portfolios within the country, on the liability side and on the asset side, which tends to reflect the degree of sophistication of risk management practices within a country in general. It is likely, but not guaranteed, that the portfolios of the industrial countries reflect a large proportion of hedged investments. On the other hand, the East Asia crisis of 1997-98 provides an example about the risks of unhedged investment under floating exchange rates. There, corporate balance sheets in Indonesia!!! and South Korea in particular were severely damaged by currency depreciation, given their extensive unhedged foreign borrowing. The Chinese banking system could similarly be damaged by sudden appreciation of the renminbi against the dollar, given the extent of dollar assets held by the People's Bank of China and state 6 banks. In both these cases, the problem is more the inadequate risk management practices and insufficient diversification than it is exchange rate flexibility per se. Also, in countries whose markets are highly integrated with the rest of the world, floating currencies might be better if there is a chance of hot money to flow. If trade is geographically diverse, floating on your own might be best, and this is the case in large countries such as the US. However, if trade is not geographically diverse, a joint float might be better, like in the case in the EU. Overall, the industrial countries' credible monetary policy, which largely exists unblemished by excess inflation, makes it such that flexible exchange rates are beneficial. For many industrial countries, the eurozone has provided an example as to why it can be problematic to band together in a common currency area. The eurozone has suffered because of the one-size-fits-all monetary policy, which has been unable to respond to peripheral shocks like that in Greece. Floating rates allow for necessary currency revaluation and general adjustment which can avoid the unintended creation of massive unemployment. Summary: Pros: Autonomy of Monetary Policy, Automatic Mechanism for BoP Adjustment, Avoid sitting duck nature of adjustable pegs under bretton woods, less dependence of vehicle currencies Cons: Costs and risks of foreign trade and investment heightened Destabilizing Speculation, Lack of Discipline, Breakdown of communication

TOPIC: Operation of a gold standard

We start by examining the essential elements that any gold standard will entail: (1) Convertibility of domestic money into gold, and gold into money, at a fixed official price. The central bank stands ready to buy or sell gold in order to hold the price of gold fixed in terms of money. (2) Free export and import of gold by residents of a country, so that gold can be used to finance international transactions. (3) A set of rules linking the quantity of money in circulation to the quantity of gold in the country—specifically a price of gold in money terms, and a required reserve ratio that implies a deposit expansion multiplier. In particular, during the IGS era, the Bank of England (BOE) reinforced the effects of gold movements to promote BOP adjustment. If it experienced a gold drain, the BOE would raise its discount rate, the interest rate that was an important policy instrument. This restricted credit, and tended to lead to improvements in both the current and private financial accounts.

The rules of the Economic and Monetary Union (EMU) of Europe include strict limits on the size of the fiscal deficit each year and the total fiscal debt relative to GDP. Use our basic open economy macroeconomic theory to explain in detail why this is necessary.

X-M = (S-I) + (T-G) A fiscal deficit is a current account account deficit. This means that we need a financial account deficit surplus, which we achieve by selling assets to the ROW in order to obtain the the purchasing power necessary to buy this excess of goods and services. Overall, this capital inflow means that the ROW acquires claims on our future income. In effect, we are indebted to the ROW. This current account deficit erodes our net international asset position, since we have to sell assets from abroad to cover that deficit. Overall, this is potentially desirable b/c a large shock could cause the ROW to stop financing our debt, which would make it insolvent. This shock could lead to a domestic macroecon crisis depending on whether the country's currency is flexible or fixed. Flexible. The currency would be decreasing at a high rate, leading to high inflation Fixed. A BoP crisis would result in the central bank losing foreign exchange In general, if interest payments on debt become untenable, the government has to either: Cut spending, sell assets (limits economic growth) Aggressively print money (causes inflation) Default on loan obligations None of these options are desirable. [It is difficult to fix currency crisis, because central bank intervention requires financial resources (in the form of forex) that it can sell to support the currency (appreciate it versus foreign currency). In the absence of adequate financial resources, countries often turn to the IMF for financial and technical assistance]

President Trump and Democrats in Congress recently announced a framework to spend $2 trillion on infrastructure over the coming years. a) If this spending is not paid for by higher taxes, how would we expect it to affect real GDP, interest rates, the value of the dollar, the trade deficit, and inflation? b) If the Federal Reserve responds by tightening monetary policy, how would that influence the effects of the policy on those variables? You may wish to distinguish between short-run and long-run effects.

a) The increase in infrastructure spending is an example of expansionary fiscal policy, which is an increase in the money supply that is generally undertaken with the goal of boosting economic growth. Since this spending is not paid for by higher taxes, then it is simply an increase in government expenditure. We observe G↑ . In turn, we see Y ↑ via 1). This triggers a feedback effect as C(Y-T) ↑, as consumption will increase along with Y↑. This Y↑ causes L( ) to increase via 2)--this puts an upwards pressure on r, also via 2). Thus, we see m/p ↑ via 2), which is an increase in the real money supply. This increase in the real money supply will reduce unemployment and spur consumer spending, yet it will cause inflation (unless the growth in real output exceeds the growth in money supply). Higher interest rates attract foreign investment, which increases the value and demand for the dollar. We observe this via equation 3). Given that r ↑, we observe via equation 3) that e↓, meaning that the dollar has appreciated. This e↓ contributes to the NX↓, which is also driven by the increase in Y that we see in equation 1). Although NX↓ and I() ↓ due to r↑, this is not enough to crowd out the Y↑. In summary: r ↑ via 2) e↓ via 3) NX ↓ via 1) Y↑ via 1) Inflation ↑ via 2) b) This is an example of expansionary fiscal policy in tandem with contractionary monetary policy. For the same reason in part a), we observe that r↑, as the Fed actively raises interest rates and makes lending becomes more expensive. We again observe that gross private investment I↓ because of the r↑. Again, e↓. The dollar appreciates because of the reasons from part a), as well as because the contractionary monetary policy is a reduction of the monetary supply, which contributes towards appreciation. In this case, NX↓ again . Since e↓ there is downwards pressure on NX via 1), which is amplified by Y↑. Again, Y↑ for the same reasons as in part a). However, the major difference under contractionary monetary policy is that the effect on inflation is uncertain. Contractionary monetary policy has the effect of decreasing the money supply by raising, as businesses borrow less and hire fewer workers. Overall, there is less demand, which depresses inflation. Yet inflation is also driven by Y↑ as shown in part a), which makes the overall effect on inflation uncertain. In summary: r ↑ as the Fed makes lending more expensive. e↓ via 3) NX ↓ via 1) Y↑ via 1) Inflation: uncertain

TOPIC: Triangular Currency Arbitrage

sequence of foreign exchange transactions, involving three different currencies, that one can use to profit from discrepancies in the different exchange rates Implied cross rate n(n-1)/2 different exchange rates with n countries (no double-counting) Dollar is the intermediary between the currencies. Look at dollar against all other currencies.