In The Name of God, the Merciful, the Magnificent
King Fahd University of Petroleum & Minerals
College of Industrial Management
Department of Finance & Economics
Class Notes of
ECON. 410
Husted & Melvin, International Economics
9th
Ed., 2012
www.aw-bc.com/husted_melvin
Part II –International Finance
Dr. Usamah Ahmed Uthman
Associate Professor of Economics
http://faculty.kfupm.edu.sa/finec/osama/
E- mail: osama@kfupm.edu.sa
Students may visit www.sama.gov.sa for information on Saudi balance of
payments, and other information on the Saudi economy in general.
1
Remember from Chapter 1, of Husted & Melvin, 9thEd.that the
Questions of International Finance are:
1) Theories of the balance of payments
2) Theories of the exchange rates ( ER)
3) The relationship between ER, prices & interest rates.
4) International banking , debt & risk
5) The interaction of macroeconomic policies among nations
6) The world's international monetary system & the role of international organizations,
such as the International Monetary Fund (IMF) & the World Bank.
Exchange Rates and the Balance of Payments
CH.37 from Lipsey, et al, 12th Ed.
The Exchange Rate: The price of one currency in terms of another. Usually, it
is the price of a unit of foreign currency in terms of a local currency. Example:
($1=SR.3.75).
Foreign Exchange: Holdings of a country o f foreign currencies and financial
assets denominated in foreign currencies.
Currency Appreciation: Arise in the external value of home currency
>>>According to the above definition of the ER, the Exchange rate will
decrease. The opposite will happen if the currency depreciates.
Note: When one currency appreciates, the other depreciates. See Fig.37.1
2
Figure 37-1
The Dollar-Yen Exchange Rate, 1972-1998
©1999 Addison Wesley Longman
Slide 37.2
The Balance of Payments (BOP): It is an accounting record of all transactions
between a country and the rest of the world.
*Sales of any assets (real or financial) or services >>> Receipts >>> Credit to
BOP.
*Purchases of any assets (real or financial) or services >>> payments >>>
debit to BOP.
3
Table 37-1.U.S Balance of Payments,1997, (Billions of dollars)
I- CURRENT ACCOUNT
(a)
(b)
Trade Account
Merchandise exports
+679.3
Service exports
+258.3
Merchandise imports
-877.3
Service imports
Trade balance
-170.5
-110.2
Capital-Service Account
Net investment income (including Unilateral transfers)
Current Account balance
-45.0
=====
-155.2
II- CAPITAL ACCOUNT
Net change in U.S. investments abroad [capital outflow (-)]
Net change in foreign investments In the U.S [capital inflow (+)]
-477.5
+717.6
=====
Capital Account balance
+240.1
III- OFFICIAL FINANCING ACCOUNT
Change in official reserves [increases (-)
-1.0
Change in liabilities to official foreign agencies[(increases (+)]
+15.8
Statistical Discrepancy
-99.7
=====
Official Financing balance
-84.9
BALANCE OF PAYMENTS
0.0
The overall balance of payments always balances, but individual components do not have to.
4
Structure of BOP: (Table 37.1 above):
1- Current Account: a) Trade Account. b) Capital Service Account (net income
from foreign investment).
2- Capital Account: _ Foreign investment in the country >>> Capital inflow
>>> Receipts >>> credit to BOP
_ Our investment abroad >>> Capital outflow >>>
Payments >>> Debits to BOP.
a) Short Term Capital Movements: Buying & selling short term financial
assets such as bank accounts and/or treasury bills.
b) Long Term Capital Movements: Purchasing or selling long term financial
assets and/or physical assets…
*if the long term capital is for a voting, or controlling share, it is called
Foreign Direct Investment (FDI)
*if the long term capital is NOT for voting share >>>It is a Portfolio
Investment.
3- Official Reserve (Settlement) Account: transactions of the central bank
buying and selling foreign currencies, foreign financial assets, gold and SDR.
*Note: BOP must balance >>> sum of the sub-accounts must be zero.
However, this does not mean that each account must be zero.
*Balance >>> Total Receipts = Total Payments
>>> (Cr +Kr +Fr) = (Cp +Kp + Fp)
>>> (Cr-Cp) + (Kr-Kp) + (Fr-Fp) = 0
*Surplus in one or two accounts >>> Deficit in at least one account…WHY? In
other words, a deficit in one or two accounts, must be financed by a surplus
in the other account(s)
5
*Ex., a favorable balance in the current account (a Surplus) must be either
invested abroad (Capital Outflow) >>> Capital account is negative >>> and/or
the official reserves balance must decrease.
What does it mean that the official reserve balance decreases?
It means that the central bank would be buying foreign exchange from the
private sector.
* If the other two accounts of the BOP are in surplus, the central bank is
adding to its reserves.
*In day-to-day language of news, a BOP is: Current Account + Capital
Account
*Under flexible exchange regime, the official reserve account = 0, because
central bank does not need to intervene in the foreign exchange market:
BOP = (Cr-Cp) + (Kr-Kp) = 0
(Cr-Cp) = - (Kr-Kp)
* This implies that a deficit in one account must be balanced by a surplus in
the other account.
*National Assets Formation = I + (X-M). Since the surplus of the current
account is invested abroad >>> an increase the size of national assets. Both
domestic investment and surplus in current account contribute to national
assets & thus generate incomes to the country. This is a very important
concept of macroeconomics.
Students may visit www.sama.gov.sa for information on Saudi balance of
payments, and other information on the Saudi economy in general.
* The Sources of Foreign Exchange Market:
1- Exports: These are payments by foreigners.
6
2- Capital Inflow: When foreigners buy some of the country’s financial assets
and/or physical assets. Example: Foreign companies invest in Saudi
petrochemicals and telecommunication sector,
3- Reserve Currency: Changing the country's portfolio of foreign exchange.
* Supply and Demand Curves of Foreign Exchange: Fig.37.2
Figure 37-2
The Market for Foreign Exchange
©1999 Addison Wesley Longman
Slide 37.3
- On the Supply Curve: Suppose the Yen appreciates >>> $/Yen will increase
>>> Japanese find it cheaper to buy $ and American products >>> Japanese
supply more Yen (the quantity supplied of the Yen increases).
- On the Demand Curve: American finds the Yen more expensive >>> they
demand less Yen and less Japanese products >>> the quantity demanded of
Yen decreases.
* Determination of Exchange Rate: Generally, there are three major ER
regimes:
7
1) A Country could choose a fixed exchange rate against another currency (or
gold).
2) Completely flexible (floating) exchange rate >>> exchange rate determined
by the market.
3)Between these two extremes, there could be many intermediate
arrangements such as adjustable peg( where the ER is essentially fixed, but
adjusted once- and- a while), a managed float( where the ER is essentially
floating but the central bank seeks to have some stabilizing influence.
However it does not try to fix it at some publicly announced value. Another
regime is pegging against a basket of currencies. (See Table 19.2, Chap.19 in
Husted &Melvin.) See Fig.37-3 below
Figure 37-3
Fixed and Flexible Exchange Rates
©1999 Addison Wesley Longman
Slide 37.4
_ At e1: the value of the home currency is kept artificially low >>> X will
increase and M will decrease >>> C\A tend to a surplus. Also, the low value of
home currency may encourage an inflow of foreign investment >>> the K/A
tend to a surplus. >>> As a result of both sub-accounts, foreign reserves
increase >>> central bank purchases the surplus of FR to maintain exchange
rat at e1 >>> (Fp> Fr).
8
_ At e2: Home currency is kept artificially high >>> an opposite scenario takes
place.
*Causes of Changes in Exchange Rates:
Figure 37-4
Changes in Exchange Rates
©1999 Addison Wesley Longman
Slide 37.6
1-A Rise in the Prices of Exports: Assume elasticity of exports (  X >1) >>>
receipts (supply) of foreign currency will decrease (  TRX=  PX.QX   ) >>> at
the same time, quantity demanded for home currency will decrease >>>
supply curve for foreign currency will shift upward (Panel ii)>>> ER will
increase >>> home currency will depreciate.
2-A Rise in the Prices of Imports: Assume elasticity (  M >1) >>> Payments for
F.C decrease (  TPM=  PM.QM   ) >>> demand curve for foreign currency will
shift downward (Panel i. Note: the shift of the D- curve in the fig. is wrong. It
should be downward))>>> at the same time the quantity supplied of foreign
currency decreases, and ER will decrease >>> home currency will appreciate.
Note: the assumption about elasticity is very crucial about what should
happen to the ER. If the assumption is reversed, the conclusion about the ER
is reversed.
9
3-Changes in the Overall Price Levels:
a) Equal inflation in both countries: if home & foreign prices change in the
same direction and at the same magnitude >>> terms of trade (PX/PM) is not
affected >>> NO effect on the exchange rate.
b) Inflation in Only One Country: >>> terms of trade are disturbed >>>
exchange rate will change.
C) Inflation at Unequal Rates: Here also the terms of trade are disturbed >>>
exchange rate will change.
However, in all cases, remember that the direction of change depends on the
assumption about elasticity.
4-Capital movements:
a) Short term capital movement: Most important factor is changes in
interest rates. If the interest rate of a country increases >>> its financial
assets are more attractive >>> demand for the country’s currency will
increase >>>its exchange rate will decrease >>> its currency will appreciate.
b) Speculation about future value of a country's exchange rate: If a country's
ER is expected to appreciate in the future, investors rush to buy assets
denominated in that currency. The country's currency appreciates, & visa
versa.
c) Long term capital movements: are largely affected by long term
expectations about profit opportunities in a country and the long term value
of its exchange rate.
5-Structural changes: Are large and Long- lasting changes that may affect
the economy. They are not necessarily permanent. They may affect long
term terms of trade & thus long term ER, such as:
a) Changes in cost structure of production, such as a permanent rise in real
wages and real interest rates,
10
b) R&D that leads to growth in some sectors at expense of others,
c) Discovery of natural resources… The development of natural gas in the
Netherlands in 1960s, and the development of North Sea oil in the UK in
1970s brought about the so-called the Dutch Disease in both countries. It led
to the appreciation of Dutch Guilder & the sterling Pound respectively and
had a negative effect on Dutch & British exports.
d) Major changes in the terms of trade may generate structural changes and
affect exchange rates, as happened in 1997-1998 when commodity prices in
many countries declined and affected the currencies of major commodity
exporters such as Australia, New Zealand, Canada and South Africa. Also, in
that period, oil prices severely declined and had a profound effect on the
oil exporting countries.
* Behavior of Exchange Rate:
- The Law of one price: In the absence of all trade barriers, the price of
identical baskets of goods should be the same in all countries. If not,
arbitrage will take place until prices are equalized.
-The Purchasing Power Parity Exchange Rate (the PPP exchange rate): It is
the exchange rate that guarantees the validity of the law of one price. This
means If the market ER is equal to the PPP rate, the purchasing power of a
currency should the same both at home & abroad. Or, the price of identical
goods should be the same in the two countries when expressed in the same
currency. This means:
Ph= e X Pf
-Example: Suppose that the price of a Shawrma Sandwich in Dhahran is SR10
and the price of the same Sandwich in Bahrain is 1 Dinar. If the exchange rate
is: BD 1 = SR 10 >>> the exchange rate makes the cost of the Sandwich the
same across the two countries. This exchange rate is called the PPP rate. If
the exchange rate is different from PPP rate >>> currency is either
overvalued or undervalued.
11
-Definition (V.V. Imp.): An overvalued currency is one that has a stronger
purchasing power abroad than it has at home. In this case, imports are
encouraged and exports are discouraged. The BOT and the BOP will tend to
be in deficit. An undervalued currency (abroad) implies the opposite.
-Note that: the PPP rate is an equilibrium exchange rate. So, PPP theory of
exchange rate is an equilibrium theory of the ER. It says that in the long run,
exchange rates should adjust to make the prices of identical goods the same
across countries when expressed in the same currency.
-Why PPP theory may NOT hold in the short run???...See chapter 14 of
Husted & Melvin…
-PPP in the short run (Effect of speculation): Some economists argued that
speculation in currencies may not be bad, for it will eventually bring
exchange rates to their PPP values. However, this may be true only if
speculators know that deviations from PPP are small and short-lived.
-Experience shows that under flexible exchange rates, swings around PPP
have been wide and long lasting. Changes in interest rates have been a
major cause of swings in exchange rates. Whatever the causes of
swings, speculation has been destabilizing to exchange rate.
*Exchange Rates, Interest Rates and Monetary Policy:
*If monetary policy is tight >>> interest rate will increase >>> exchange rate
will decrease >>> the currency will appreciate >>> Expenditures on (I,C,X) will
decrease and M will increase >>> AD (AE) will decrease >>> a recessionary
gap may take place.
*The appreciation of the currency will continue until it has appreciated
enough so that investors expect a future depreciation that just offsets the
interest premium for investing in the securities of that country.
12
*The implication of this theory is that a central bank that is seeking to use its
monetary policy to achieve its domestic policy targets may have to put up
with large fluctuations in the ER.
* Other countries may be affected by the monetary a policy of another
country. The interest rate differential among countries >>> capital outflows
from other countries into the country with a higher interest rate. Also, the
appreciation of one country's currency implies depreciation of currencies of
other countries. This stimulates exports from other countries to the country
that started a tight monetary policy. As a result wages & prices in other
countries may rise. This leaves these countries with the uncomfortable
choice of either following the example of the other country (raising interest
rates), or maintaining a lower interest rate and suffer inflation.
This scenario assumes that the capital markets of the concerned countries
are strongly integrated.
*In 1980s when the US tightened it monetary policy, other central banks in
major industrial countries were forced to follow the US example, which led
to sever world recession. See Application 37-2 on Beggar-My- Neighbor
Policies, Past And Present.
END of CHAPTER 37
13
CHAPTER.14
Prices and Exchange Rates; Purchasing Power Parity
The PPP theory asserts that as prices change internationally, exchange rates
must also change to keep prices measured in a common currency equal across
countries.
*Absolute Version of PPP Theory: P/Pf = E
(14.1),
Where P is the home price level, and Pf is the foreign one.
This is called the strong version of PPP theory. The exchange rate is a
nominal value, that is, its value is dependent on current price levels.
* Law of One Price: P = Pf * E
(14.2)
* PPP theory is a theory of equilibrium of prices across markets in different
countries.
* Why the absolute version of PPP theory may NOT hold???
1) Differentiated products that may enter into the calculation of different
price indexes. This makes basket of goods are not identical across countries.
Consequently, it renders the comparison of price indexes difficult.
2) Costly information about prices.
3) The theory assumes the absence of trade barriers. In reality, there are
many trade barriers. Thus, the law of one price cannot be fully validated.
4) Price indexes include prices of both tradable and non-tradable goods. Only
tradable goods affect exchange rate.
5) Changes in relative prices of some goods affect supply and demand of
foreign exchange rate & thus affect exchange rates. This may happen while
the overall price levels are NOT affected.
*The Relative (Weaker) Version of PPP Theory of Exchange Rate:
14
Percentage changes in the exchange rate equals the inflation differential
between the two countries.
*NOTE: If the strong PPP theory holds >>> weak version also holds.
If the strong PPP theory does NOT hold >>> weak version MAY still
hold.
Time, Inflation and PPP:
- Researchers found that PPP theory holds better for high inflation countries.
- PPP holds better over longer periods of time. In other words, fluctuations of
exchange rate over the short run are much more than in the long run. Also,
in the short run relative prices shifts can have an important role
determining ER. However, in the long run, relative price movements cancel
out over time, giving dominance to general price level movements (See
Figure 14.1)
15
- Note the definition and the exchange rate is Yen/$ contrary to the usual
definition.
- Blue line refers to E  , while the black line refers to inflation differentials.
- Suppose E^ = 5% and Pj^ - PUS ^ = 3% - 7% = -4% (blue line above black line).
- Thus, E^ > (Pj^ - Pu.s^) … which currency is undervalued (overvalued)???
- Answer: For PPP to hold, E^ must be negative >>> exchange rate of Yen/$
must decrease.
- It follows that Yen is undervalued ($ is overvalued).
16
• Overvalued currency—a currency worth more abroad than its PPP
value.
• Undervalued currency—a currency worth less abroad than its PPP
value.
- Same thing can be said about Figure 14.3
- Exchange rates change more frequently than inflation rates. Why?!
- This is because the prices of financial assets in general, are much more
volatile than the prices of real goods and services.
Real Exchange Rates:
E real = E/(P/Pf )
(14.4)
17
The real ER represents changes in the competitiveness of a currency. It is
an alternative way to think about currencies being over- and undervalued.
As represented in equation (14.4), the real rate is the nominal rate
discounted by the ratio of domestic to foreign price levels.
If the absolute PPP holds, then the real ER would equal 1. This is because
E real = E/(P/Pf ) = EPf/P
If PPP holds, EPf = P
This means that the purchasing power of the currencies should be identical.
Note: There could be as many as five different ways to measure the real ER,
not all of them may lead to same conclusion about over- and undervaluation.
The above version is called the PPP version of the real ER.
18
04 August 2008
Burgernomics says currencies are very dear in Europe but very cheap in Asia
EVER since the credit storms first broke last August, the prices of stocks, bonds, gold and other investment
assets have been blown this way and that. Currencies have been pushed around too. Did this buffeting bring
them any closer to their underlying fair value? Not according to the Big Mac Index, our lighthearted guide to
exchange rates. Many currencies look more out of whack than in July 2007, when we last compared burger
prices.
The Big Mac Index is based on the theory of purchasing-power parity (PPP), which says that exchange
rates should move to make the price of a basket of goods the same in each country. Our basket
contains just a single item, a Big Mac hamburger, but one that is sold around the world. The exchange rate
that leaves a Big Mac costing the same in dollars everywhere is our fair-value yardstick.
Only a handful of currencies are close to their Big Mac PPP. Of the seven currencies that make up the Federal
Reserve's major-currency index, only one (the Australian dollar) is within 10% of its fair value. Most of the rest
look expensive. The euro is overvalued by a massive 50%. The British pound, Swedish krona, Swiss franc and
Canadian dollar are also trading well above their burger benchmark. All are more overvalued against the dollar
than a year ago. Only the Japanese yen, undervalued by 27%, could be considered a snip.
The dollar still buys a lot of burger in the rest of Asia too. The Singapore dollar is undervalued by 18% and the
South Korean won by 12%. The currencies of less well-off Asian countries, such as Indonesia, Malaysia and
Thailand, look even cheaper. China's currency is among the most undervalued, though a bit less so than a
year ago.
The angrier type of China-basher might conclude that the yuan should revalue so that it is much closer
to its burger standard. But care needs to be taken when drawing hard conclusions from fast-food
prices. PPP measures show where currencies should end up in the long run. Prices vary with local
costs, such as rents and wages, which are lower in poor countries, as well as with the price of
ingredients that trade across borders. For this reason, PPP is a more reliable comparison for the
currencies of economies with similar levels of income.
For all these caveats, more sophisticated analyses come to broadly similar conclusions to our own. John
Lipsky, number two at the IMF, said this week that the euro is above the fund's medium-term valuation
benchmark. China's currency is "substantially undervalued" in the IMF's view. The dollar is sandwiched in
between. The big drop in the greenback's value since 2002 has left it "close to its medium-term equilibrium
level," said Mr Lipsky.
If that judgment is right, the squalls stirred up by the credit crises have moved at least one currency the world's
reserve money closer to fair value. Curiously the crunch has not shaken faith in two currencies favoured by
yield-hungry investors: the Brazilian real and Turkish lira. These two stand out as emerging-market currencies
that trade well above their Big Mac PPPs. Both countries have high interest rates. Turkey's central bank
recently raised its benchmark rate to 16.75%; Brazil's pushed its key rate up to 13% on July 23rd. These rates
offer juicy returns for those willing to bear the risks.
Those searching for a value meal should look elsewhere.
19
© The Economist 2008
Under(-)/ Over(+) valuation against the dollar= (PPP ER – Actual ER) / Actual ER
Example: From the table above, in case of the Saudi riyal, we have (2.8 – 3-75) / 3.75 = -0.25. This implies
that the Saudi riyal was 25% undervalued against the dollar in 2008. However, note that the method is
reversed in case of the British Pound and the Euro. It is;
(Actual ER – PPP ER) / PPP ER. Can you explain why?
20
What might be wrong with the Big Mac Index?
Daily ER USD/Euro Jan.1999- Nov.2009
Source:The European Central Bank
http://sdw.ecb.europa.eu/quickview.do?SERIES_KEY=120.EXR.D.USD.EUR.S
P00.A#top
http://www.ecb.int/home/html/index.en.html
Answer:
Aside from the fact that this index uses a single product for price- level
comparisons, the attraction of using the Big Mac Product for an index is the fact that it is
quite standardized product on the one hand, and that it exists in many countries, on the
other. However, since the Big Mac is not tradable across countries, it may be less
susceptible to the law of one price, and thus less reflective of the PPP Theory of exchange
rates. Remember that it is tradable products that affect exchange rates, much more that nontradeables. For a better index, we should look for a tradable, standardized product. See the
links below for more information on the Big Mac product and Index.
http://en.wikipedia.org/wiki/Big_Mac_Index
http://www.economist.com/topics/big-mac-index
21
http://www.economist.com/content/big-mac-index?fsrc=nlw|newe|1-272014|7650068|34513951|
Rank
Country
GDP (purchasing power parity) (Billion $)
1
United States
15,290
2
China
11,440
3
India
4,515
4
Japan
4,497
5
Germany
3,139
6
Russia
2,414
7
Brazil
2,324
8
United Kingdom
2,290
9
France
2,246
10
Italy
1,871
11
Mexico
1,683
12
Korea, South
1,574
13
Spain
1,432
14
Canada
1,414
15
Indonesia
1,139
16
Turkey
1,087
17
Iran
1,003
18
Australia
926.2
19
Taiwan
887.3
20
Poland
781.5
Definition: This entry gives the gross domestic product (GDP) or value of all final goods and
services produced within a nation in a given year. A nation's GDP at purchasing power parity (PPP)
22
exchange rates is the sum value of all goods and services produced in the country valued at prices
prevailing in the United States. This is the measure most economists prefer when looking at percapita welfare and when comparing living conditions or use of resources across countries. The
measure is difficult to compute, as a US dollar value has to be assigned to all goods and services in
the country regardless of whether these goods and services have a direct equivalent in the United
States (for example, the value of an ox-cart or non-US military equipment); as a result, PPP
estimates for some countries are based on a small and sometimes different set of goods and
services. In addition, many countries do not formally participate in the World Bank's PPP project
that calculates these measures, so the resulting GDP estimates for these countries may lack
precision. For many developing countries, PPP-based GDP measures are multiples of the official
exchange rate (OER) measure. The difference between the OER- and PPP-denominated GDP
values for most of the weathly industrialized countries are generally much smaller.
Source: CIA World Factbook - Unless otherwise noted, information in this page is accurate as of
January 1, 2012
The World's Richest Countries, Based on Gross Domestic
Product (PPP) Per Capita 2009-2013:
http://www.gfmag.com/component/content/article/119-economic-data/12538-the-richestcountries-in-the-world.html#ixzz2gRIzoTS3
=====================================================
============================
23
The Twin Deficits
Relates to Chapter 12
Of Husted & Melvin, 8th Ed.,2010
Introduction:
For simplicity, assume flexible exchange rates, so that we do not need to include the
official reserve account in the balance of payments (BOP): Thus, we have the balance
of payments as the sum of the current account and the capital account: (CR-CP) + (KRKP) =0, Where R: Receipts & P: Payments
The size of the deficit in the current account is an indication of the risk position of the
country. Why?
This is because the current account deficit has to be financed by a surplus in the
capital account (a capital inflow), which in many cases comes in the form of debt. Debt
may be financing more consumption and/or more investment. Only the latter can
expand the productive capacity of a country, and provide for economic growth in the
long run.
The relationship between the external balance (the current account) and
internal balance (the domestic economy):
Remember: GDP=Y=C+I+G+(X-M)
Which can also be re- written in the form: Y-C-G= Sn =In+(X-M)
National assets
formation
National Savings
Sn= In + (X-M)
(X-M) =Sn-In
National
Investment
Current Account
If there is a deficit in the current account, (X-M) <0
National
savings are less than domestic investment demand. In other words, the
economy is not generating enough savings to finance domestic
24
investment. So, the gap in (Sn-In) has to be financed by foreign capital
inflow (Kr-Kp)>0
When current account < 0
Sn < In
AE > Y  foreign capital
inflow is financing the saving-investment gap.  (KR-KP) > 0
Deriving the Twin Deficit Equation:
National Savings (Sn) is partially the behavior of the private sector, partially the
behavior of government. Remember from above:
Sn=Y-C-G , where C is private consumption, and G is government purchases. Add and
subtract taxes, T, and re-arrange terms,
Sn= (Y-C-T) +
Private Savings
(T-G)
Government Savings
25
Also, remember:
(X-M)=Sn-In
(X-M)= Sn-In= (Y-C-T) + (T-G)
C/A Deficit or Surplus
-I
National Savings
This is the twin deficit relationship. Obviously, there is a relationship
between the current account deficit (or surplus) and the government
budget deficit (or surplus). Also, remember the government budget, (TG), is part of national savings.
So, if there is a current account deficit, it can be reduced by increasing
national savings. This could happen by either increasing private savings
and/or government savings. Increase in private savings requires a rise in
productivity in the long-run and thus rising GDP. Also, an increase in
private savings means less consumption and less imports. More savings
finance more investment, higher output and may be more exports.
Consequently, the C/A improves.
A rise in government savings requires reducing the budget deficit by
increasing taxes and/or reducing government expenditures. This
reduction in budget deficit is the prescription usually given by the IMF,
the World Bank, and the European Central bank (ECB). The claim is that
government budget deficit is harmful to the economy and may crowd out
private investment. The problem is, as the budget deficit is reduced by an
increase in tax rates and/ or a reduction in government expenditures,
private investment may not pickup fast enough to stabilize GDP.
Some economists argue that government budget deficit may actually
crowd in, instead of crowding out, private investment, and thus the
budget deficit is not always harmful. This is an area of hot debate among
economists and policy makers.
26
CASE STUDY: GOVERNMENT DEFICIT REDUCTION MAY NOT INCREASE THE
CURRENT ACCOUNT SURPLUS
Source: KRUGMAN & OBSTFELD, INTERNATIONAL ECONOMICS: THEORY & POLICY, 8th
Ed.,Pp.299-301
The linkage among the current account balance, investment, and private and
government saving given by equation (12-2)
SP = I + CA – SG = I+ CA – (T- G) = I + CA + (G- T)
is very useful for thinking about the results of economic policies and events. Our
predictions about such outcomes cannot possibly be correct unless the current account,
investment, and saving rates are assumed to adjust in line with (12-2). Because that
equation is an identity, however, and is not based on any theory of economic behavior,
we cannot forecast the results of policies without some model of the economy.
Equation (12-2) is an identity because it must be included in any valid economic model,
but there are any number of models consistent with identity (12-2).
A good example of how hard it can be to forecast policies’ effects comes from thinking
about the effects of government deficits on the current account. During the
administration of President Ronald Reagan in the early 1980s, the United States slashed
taxes and raised some government expenditures, generating both a big government
deficit and a sharply increased current account deficit. Those events gave rise to the
argument that the government and current account deficits were “twin deficits,” both
generated primarily by the Reagan policies. If you rewrite identity (12-2) in the form
CA = Sp – I – (G – T)
You can see how that outcome could have occurred. If the government deficit rises (G –
T ) goes up and private saving and investment don’t change much, the current account
surplus must fall by roughly the same amount as the increase in the fiscal deficit. In the
United States between 1981 and 1985, the government deficit increased by a bit more
than 2 percent of GNP, while ()Sp - I fell by about a half a percent of GNP, so the current
account fell from approximate balance to about – 3 percent of GNP. (The variables in
identity (12-2) are expressed as percentages of GNP for easy comparison.) Thus, the
twin deficits prediction is not too far off the mark.
The twin deficits theory can lead us seriously astray, however, when changes in
government deficits lead to bigger changes in private saving and investment behavior. A
27
good example of these effects comes from European countries’ efforts to cut their
government budget deficits prior to the launch of their new common currency, the
euro, in January 1999. As we will discuss in Chapter 20, the European Union (EU) had
agreed that no member country with a large government deficit would be allowed to
adopt the new currency along with the initial wave of euro zone members. As 1999
approached, therefore, EU governments made frantic efforts to cut government
spending and raise taxes.
Under the twin deficits theory, we would have expected the EU’s current account
surplus to increase sharply as a result of the fiscal change. As the table below shows,
however, nothing of the sort actually happened. For the EU as a whole, government
deficits fell by about 4.5 percent of output, yet the current account surplus remained
about the same. The table reveals the main reason the current account didn’t change
much: a sharp fall in the private saving rate, which declined by about 4 percent of
output, almost as much as the increase in government saving. (Investment rose slightly
at the same time.) In this case, the behavior of private savers just about neutralized
government’ efforts to raise national saving!
It is difficult to know why this offset occurred, but there are a number of possible
explanations. One is based an economic theory known as the Ricardian equivalence of
taxes and government deficits. (The theory is named after the same David Ricardo who
discovered the theory of comparative advantage –Chapter 3 in Krugman’s book –
although he himself did not believe in Ricardian equivalence.) Ricardian equivalence
argues that when the government cuts taxes and raises its deficit, consumers anticipate
that they will face higher taxes later to pay off the resulting government debt. In
anticipation, they raise their own (Private) saving to offset the fall in government
saving. Conversely, governments that lower their deficits through higher taxes (thereby
increasing government saving) will induce the private sector to lower its own saving.
Qualitatively, this is the kind of behavior we saw in Europe in the late 1990s.
European Union (percentage of GNP)
Year
CA
Sp
I
G–T
1995
0.6
25.9
19.9
-5.4
1996
1.0
24.6
19.3
-4.3
1997
1.5
23.4
19.4
-2.5
1998
1.0
22.6
20.0
-1.6
1999
0.2
21.8
20.8
-0.8
Source: Organization for Economic Cooperation and Development, OECD Economic
Outlook 68 (December 2000), annex tables 27, 30, and 52 (with investment calculated as
the residual).
28
Economists’ statistical studies suggest, however, that Ricardian equivalence doesn’t
hold exactly in practice. Most economists would attribute no more than half the decline
in European private saving to Ricardian effects. What explains the rest of the decline?
The values of European financial assets were generally rising in the late 1990s, a
development fueled in part by optimism over the beneficial economic effects of the
planned common currency. It is likely that increased household wealth was a second
factor lowering the private saving rate (and increasing consumption)in Europe.
Because private saving, investment, the current account, and the government deficit are
jointly determined variables, we can never fully determine the cause of a current
account change using identity (12-2) alone. Nonetheless, the identity provides an
essential framework for thinking about the current account and can furnish useful clues.
See also the 5th ed., pp.311-313 for a case on US and Japan.
============================
American debt, simplified:
http://youtu.be/0-KzgbxguPo
=====================================================
Fiscal Austerity and the Euro Crisis:
Where Will Demand Come From?
http://www.ase.tufts.edu/gdae/Pubs/rp/PB1301_EUAusterity.pdf
29
Q. Why is there such concern about the
Interest payments on (American) Treasury
bonds?
http://www.nytimes.com/2013/10/04/us/politics/how-debt-ceiling-could-domore-harm-than-the-impasse-incongress.html?ref=todayspaper&nl=business&emc=edit_dlbkam_20131004&_r=0
At the most basic level, if the government shows any hesitation in
making scheduled interest payments on its outstanding bonds,
investors will demand higher interest payments when the government
borrows money in the future. That would add significantly to the federal
budget.
Treasury bonds are also used as a benchmark against which most
other financial assets are priced. If the government was forced to pay
higher interest rates, the borrowing costs for businesses and
homeowners would rise as well. This would lead to less borrowing,
which would put a brake on economic growth.
Banks, meanwhile, already have large holdings of Treasury bonds. If
the value of those bonds suddenly dropped, banks would have less
money on hand and would be less likely to lend to one another,
potentially causing a freeze in the credit markets like the one in 2008.
More broadly, because investors have long believed that the United
States government would always be able to pay its bills, Treasury
bonds have become the bedrock of the global financial system and the
dollar has become the most widely used currency in the world. If
investors come to doubt the ability of the United States to pay its debt,
the dollar could lose its special status and the basic plumbing of the
financial system could become jammed.
As the Treasury Department put it in a report released Thursday, "a
default would be unprecedented and has the potential to be
catastrophic."
=====================================================
============================
Paul Krugman however, disagrees. Read Below.
30
OCTOBER 20, 2013, 2:56 PM
Liquidity Preference, Loanable Funds, and Erskine Bowles
Here’s Erskine Bowles in March 2011:
[T]his is a problem we’re going to have to face up to. It may be two years,
you know, maybe a little less, maybe a little more. But if our bankers over
there in Asia begin to believe that we’re not going to be solid on our debt,
that we’re not going to be able to meet our obligations, just stop and think
for a minute what happens if they just stop buying our debt.
Strange to say, however, neither Bowles nor anyone else of similar views
has, as far as I can tell, actually done what he urged: “stop and think for a
minute what happens if they just stop buying our debt.” They just assume
that it would be catastrophic, without laying out any kind of model of how
that would work.
I, on the other hand, have worked out two models, one ad hoc and the
other a more buttoned-down New Keynesian-type model — and they just
don’t support Bowles’s worries.
Some commenters here have declared it obvious that a cutoff of Chinese
funds would drive up interest rates, saying that it’s just supply and
demand. That struck me, because it’s exactly what George Will said when
I tried to argue, back in 2009, that budget deficits need not lead to high
interest rates when the economy is depressed. And in fact the argument
that foreigners will reduce their lending to us, sending rates higher, and
shrinking the economy even though we have our own currency and
monetary policy is, when you think about it, more or less isomorphic to
the famously wrong argument that fiscal expansion is contractionary, because
it will drive up interest rates.
I am, by the way, grateful to those commenters — thinking about the
equivalence of the China-debt and deficit-interest fallacies nudged me
into a better, simpler formulation of my NK model, which I’ll say more
about in a few days. And my model-building has, in turn, given me a new
way to talk about what’s going on.
31
So, here we go. Start from the observation that the balance of payments
always balances:
Capital account + Current account = 0
where the capital account is our sales of assets to foreigners minus our
purchases of assets from foreigners, and the current account is our sales
of goods and services (including the services of factors of production)
minus our purchases of goods and services. So in the hypothetical case in
which foreigners lose confidence and stop buying our assets, they’re
pushing our capital account down; as a matter of accounting, then, our
current account balance must rise.
But what’s the mechanism? (Remember the fallacy of immaculate causation.)
The answer is, it depends on the currency regime.
If you’re Greece, the way it works is indeed that interest rates soar,
depressing demand and compressing imports until the current account
has risen enough; unfortunately, demand for domestic goods falls too, so
you have a nasty slump.
But if you’re America or Britain, the central bank sets interest rates, and
under current conditions that means holding them at zero. So what
happens instead is that your currency depreciates, making exporters and
import-competing industries more competitive. The effect on the
economy as a whole is therefore expansionary, not contractionary.
Things might be different if the private sector had large debts in foreign
currency, as was true in Asia in the 90s. But it doesn’t.
So the conventional wisdom about how we have to fear a Chinese bondbuying strike just doesn’t make sense — and in fact it falls down in exactly
the same way as fallacious arguments about the harm done by fiscal
deficits in a depressed economy; basically, Erskine Bowles is making the
same error as whatshisname.
You may find it hard to believe that so many important and influential
people could be dead wrong about the basic economics of our situation.
But as far as I can tell, this is simply something “everyone knows”, and
none of them have ever thought it through.
http://krugman.blogs.nytimes.com/2013/10/20/liquidity-preference-loanable-funds-and-erskinebowles/?nl=opinion&emc=edit_ty_20131021&_r=0
32
Below is a good and easy-to-read article: While inflation is normally
disliked by economists and policy makers, the article explains why, under
the current state of world affairs, inflation is not only welcomed, but
actually desired!! It also explains why economists and policy makers fear
deflation (the opposite of inflation.)A difficulty, however, arises in
reading the economic indicators: Are European economies on the verge of
deflation, or are they not? The economist's policy prescription depends upon
his reading of the indicators; just like a physician's medical prescription
depends upon his reading of the patient's symptoms.
Enjoy, and if you are in the academic profession, you may want to share with
UR undergrads.
Usamah
http://www.nytimes.com/2013/11/07/business/international/the-european-central-banksinflation-conundrum.html?pagewanted=2
November 6, 2013
The European Central Bank’s Inflation Conundrum
By JACK EWING
FRANKFURT — The European Central Bank will meet on Thursday under renewed pressure to do more to
stimulate the Continent’s sluggish economies, as evidence grows that the recovery is failing to pick up speed
and that inflation has fallen so low as to become worrisome.
Mario Draghi, the president of the central bank, has already used a mix of threats, promises and cheap money
to avoid a euro zone breakup and to help the most financially troubled governments get access to the
borrowing they need. Now a growing chorus is hoping the central bank will signal a willingness to step in
again. This time, those advocating action want the central bank to use its power over the euro currency to drive
up inflation, which is at such low levels that some economists believe it signals the possibility of deflation, or a
decline in prices and wages that can become a vicious circle of economic atrophy. It is a challenge that
perplexed Japan for years and that deeply concerned policy makers at the Federal Reserve in the United States
during the early stages of the financial crisis.
But talk of deflation is an issue that deeply divides economists, some of whom see the threat as overblown and
others who fear that the central bank is not taking it seriously enough. Those who are worried point to an
unexpectedly sharp drop in inflation last month as a warning of abysmally weak demand and a sign that the
euro zone could be headed for years of stagnation or even depression.
33
Those who are more optimistic see low inflation as a sign of stability and evidence that Europe’s troubled
southern periphery countries, like Spain and Greece, are regaining their ability to compete on price in world
markets.
Mr. Draghi has given little public indication of whether the European Central Bank will make a move on
Thursday. But many economists and analysts predict that the central bank, not wanting to appear panicky, will
wait a month until there is more data, then act in December. In any case, the closed debate among the bank’s
23-member Governing Council on Thursday is likely to be contentious, judging from the range of views among
professional economists, political leaders and business managers.
Some economists, like Simon Tilford, deputy director of the Center for European Reform in London, argue that
the euro zone is already stuck in the same kind of economic quicksand that trapped Japan for decades, and
that the European Central Bank must aggressively stimulate growth now, not only by cutting rates but also by
taking steps to pump money into the economy. “There is a point where the euro zone will pass the point of no
return,” Mr. Tilford said. “Policy needs to be focused single-mindedly on reflating the economy.”
Others, like Jörg Krämer, chief economist at Commerzbank in Frankfurt, call such doomsaying “ridiculous.”
The lower rate of inflation is a sign that wages have fallen in the euro zone’s southern tier, where they were too
high in relation to worker productivity, he and others argue. “What we see is a positive thing,” Mr. Krämer said.
“Peripheral countries have regained price competitiveness. This is a wanted correction. This has nothing to do
with deflation.”
For the European Central Bank, it is a tough call. Economic indicators have been ambiguous and subject to
wildly varying interpretation. Only a couple of weeks ago, news that Spain had returned to growth for the first
time in two years raised hopes that the euro zone was on the verge of a turnaround after five years of recession
or very slow growth.
But then came data showing how far the region still has to go. Unemployment in the euro zone remains stuck
above 12 percent, and on Tuesday official forecasts by the European Commission portrayed an economy
struggling to gain momentum and still vulnerable to shocks.
One jolt could come from currency markets. The euro has fallen in recent days against the dollar, but it
remains at high levels not seen since February. At about 1.35 euros to the dollar on Wednesday, the common
currency was close to a value that could threaten a rebound in exports by countries like Spain. A stronger euro
makes European products more expensive when purchased with other currencies.
“There is a risk that it just makes recovery even slower than it has already been,” said Ulf Mark Schneider, chief
executive of Fresenius, a German health care company. On Tuesday, Fresenius, which has major operations in
34
the United States, said that operating profit fell 1 percent in the first nine months of the year to 2.2. billion
euros. Profit would have grown 1 percent were it not for currency fluctuations, the company said.
Paradoxically, the rise in the euro is partly a byproduct of stronger exports from the most troubled countries.
They have improved their competitiveness and now have trade surpluses instead of deficits. Spain and Greece
helped the euro area trade surplus rise to 7.1 billion euros, or $9.6 billion, in August. That compared favorably
to a surplus of 4.6 billion euros in August 2012. A trade surplus tends to push up the value of the currency.
A very large trade surplus is considered unhealthy, though, because it is achieved at the expense of other
countries and can be a symptom of weak domestic demand.
Last week the United States Treasury Department, in a report to Congress, criticized Germany for a trade
surplus that has become bigger than China’s. The German surplus raises the risk of deflation, the Treasury
Department said, in a statement that caused an uproar in Berlin.
“Germany’s anemic pace of domestic demand growth and dependence on exports have hampered rebalancing
at a time when many other euro area countries have been under severe pressure to curb demand and compress
imports in order to promote adjustment,” the Treasury Department said. “The net result has been a
deflationary bias for the euro area, as well as for the world economy.”
While lower prices might seem like a good thing for consumers, in fact deflation is pernicious. It is, first of all, a
sign that consumers have little buying power and companies have no scope to raise prices.
When prices fall, people and businesses delay purchases, because they expect things to become even cheaper.
Corporate profits decline, and companies are forced to pay their workers less. A spiral begins that is difficult to
arrest, as Japanese policy makers can attest. One reason that the European Central Bank maintains an
inflation target of 2 percent is to provide itself with a cushion against falling prices.
Deflation could be particularly destructive in Europe, where governments, banks and private households are
still struggling with excess debt. When companies and individuals earn less, they have trouble repaying their
debts, which remain the same.
The euro zone has seen weak inflation before. The inflation rate was even negative for six months in mid-2009,
during the sharp recession that followed the beginning of the financial crisis. But that was before the sovereign
debt crisis had become obvious. And the European Central Bank had more room to cut the benchmark interest
rate, which was at 2 percent at the beginning of 2009, compared with 0.5 percent now.
With the benchmark interest rate already at 0.5 percent, a record low, there are questions of whether another
cut would have much effect on inflation. One benefit, however, could be a fall in the euro. Lower interest rates
35
mean that investors earn less of a return on euros they hold, giving them an incentive to buy other currencies
instead.
But some economists argue that the European Central Bank must go much further and buy large quantities of
government bonds, as the United States’ Federal Reserve and the Bank of England have done to stimulate their
economies when interest rates were already effectively at zero. So-called quantitative easing would be highly
divisive. Jens Weidmann, president of the German Bundesbank, has argued many times that the European
Central Bank’s charter does not allow it to buy government bonds. And he is not likely to be alarmed about
current inflation.
In response to a query, the Bundesbank said in a statement on Monday that its economists “see in their
prognoses no deflation scenario for the euro zone.” It would probably take many months of negative inflation
to convince skeptics. Mr. Tilford of the Center for European Reform said that at some point the European
Central Bank would have no choice but to buy bonds in a big way, despite what the rules say. “They will be
forced into it eventually,” he said.
Even if deflation is not an immediate threat, the current low inflation rate is a clear sign that the euro zone
recovery remains weak.
“The economy is not really getting going in the euro zone,” Friedrich Eichiner, chief financial officer of the
automaker BMW, said during a conference call with journalists on Tuesday.
Mr. Eichiner said that he was not expecting deflation, which he called “an extremely pessimistic scenario.” But
he added, “It’s necessary to make the right political decisions and create the conditions that allow companies to
promote growth.”
Paul Krugman: Business vs. Economics - NYTimes.com
http://www.nytimes.com/2014/11/03/opinion/paul-krugman-business-vseconomics.html?emc=edit_th_20141103&nl=todaysheadlines&nlid=40845485&_r=0
36
Economy is really bad...*
Can U help these guys?!
37
Chapter 15
Exchange Rates, Interest Rates and the Price Level
Notice: All relationships explained in this chapter are equilibrium ones. The
world reality may be different.
Interest Parity: means that return on financial investment in one country
should be the same as in another, when converted to the same currency.
Example:
In the U.S, the investor gets 1+i$ for each dollar invested. In the U.K, he gets
1+i£ for each pound. To invest in the UK: convert dollars to pounds, first. Each
dollar is $1=1/E pounds, where E is the spot exhange rate. He gets (1+i£) /E
pounds from investing one dollar in the UK. The conversion and investment
process:
At the same time, to cover himself from
exchange rate risk, he converts £ to $ by selling pounds forward at the
forward exchange rate, F. This is called covered return. At equilibrium, this is
equal to:
1+i$ = (1+i£) F/E
Where both F and E are expressed as $/£ , so that both sides of the equation
are expressed in terms of dollars. The above equation may be rewritten as:
(1+i$ ) / (1+i£ ) = F/E
(15.1)
Subtract 1 from both sides, gives the interest rate parity equation:
(15.2)
If i£ is small enough, this expression is approximated as:
i$-i£= (F-E)/E
(15.3)
38
This means that for equilibrium to take place, the interest rate differential, i$i£, must equal (F-E/E) , the forward premium or discount on the pound. We
must remember that both the interest rates and the forward rates must be
quoted in annual terms.
Knowing the interest rates on each currency, we can forecast the forward
rate.
Example: Suppose i$= 7%, i£=5%, E= $ 2.00/£, forecast the forward exchange
rate. From equation (15.3)
i$-i£=(F-E)/E  .07-.05=(F- 2.00)/2.00  F=2(.02)+2  F=2.04.
What does it mean?
It means that the dollar is expected to depreciate.
Suppose that F is greater than 2.04, what would a profit- seeking arbitrager
do? He would buy £ spot, invest them and sell them forward. The spot rate
goes up, and the forward rate goes down.
Equation (15.3) can be rewritten as:
i$ = i£ + (F-E)/E
(15.4)
This equation measures the effective return on a foreign investment. So,
even if the investor does not use the forward market, he can still estimate his
return from buying a foreign bond.
Reasons why the interest parity may not hold:
1- Transaction costs. 2- Tax differentials between countries.
3- Political risk.
4- Governments' capital control.
5- Time lags between recognizing a profit opportunity and actual
investment.
39
Interest Rates and Inflation Rates:
i = Nominal or market interest, r= real interest rate, π= expected inflation
rate
The nominal interest rate includes an inflation premium to compensate for
inflation.
(1+i) = (1+r)(1+π) The real rate is compounded by the inflation rate
(1+i) = 1+π+ r+ r π
Subtract 1 from both sides, and if r π is too small,
i=r+π
(15.5)
This is called the Fisher Equation. Thus an increase in the expected inflation
rate tends to increase the nominal (market) interest rate. Table 15.1 below
shows this relation for several countries.
Exchange Rates, Interest rates And Inflation: If we combine the Fisher
Equation (15.5), and the interest rate parity equation (15.3), we can show
how interest rates, inflation rates and exchange rates are linked. Let the
Fisher Equation for the US and the UK:
i$= r$ + π$, i£=r£ + π£
If the real rate is the same across countries, we have r$=r£ 
i$ - i£= π$-π£
(15.6)
40
This means for equilibrium, the interest rate differential between two
countries is equal to their inflation differential.
i$ - i£ = π$-π£= (F-E)/E = E^
This equation has:
(15.7)
1-The PPP theory: E^=π$-π£
2-Interest Parity: i$- i£= E^
3-Fisher equation: i$- π$= r$
If the all three relations above hold, then real interest rates are
equalized across countries.
Expected changes in the ER and the term structure of interest rates:
Definition: The term structure of interest rates is the relationship
between interest rates of different maturity periods. By using the
equation i$-i£= (F-E)/E and examining figures of term of structure of
interest rates, we can predict the expected change in exchange rates.
This assumes the absence of capital controls. Otherwise, markets
become isolated, and prediction becomes difficult, if not impossible.
Figure 15.1 plots the deposit rates for 1- through 12- months
Eurocurrency deposits at a particular point in time.
41
First we know that when when one country has higher interest rates than
another, the high- interest –rate currency is expected to depreciate relative
to the low- interest- rate currency, so that effective rates of return are
equalized across countries, as shown in Equation 15.4, i$ = i£ + (F-E)/E
If the forward rate is considered a market forecast for the future spot ER
rate, which it often is, then we can say that the interest differential is
approximately equal to the expected change in the ER. Thus even in the
absence about forward rates, we can still predict the direction of change in
ER.
Thus if the two term structures are parallel, currencies are going to
appreciate, or depreciate at a constant rate. If the two term structures lines
are diverging, or moving far apart from one another, then the high-interestrate currency is expected to depreciate at an increasing rate over time. For
converging term structures, the high- interest- rate currency is expected to
depreciate at a decreasing rate relative to low- interest- rate currency.
Term Structure of Interest Rates in Saudi Arabia: Source: Albank Al-Saudi
Al-Fransi
42
INTERNAL TERM DEPOSITS
1.2
1
0.96
0.8832
0.8928
0.864
0.8337
0.8
SAR
USD
0.695
GBP
0.6
0.576
0.5547
0.5501
0.4
JPY
0.4319
0.4171
0.3786
0.3404
0.3121
0.261
0.2
0.1985
0.1403
0.0816
0
EUR
0.4946
0.4809
0.2564
0.1708
0.1117
0.1046
0
1 Month
3 Months
6 Months
9 Months
12 Months
Something Just Snapped In Saudi Money Markets
Submitted by Tyler Durden on 04/08/2016 15:40 -0400
Away from the headlines about The Panama Papers, global financial markets turmoiled
quietly this week with a surge in equity and FX volatility and banks suffering more
death blows. However, something happened in Saudi Arabia's banking system that
was largely uncovered by anyone in the mainstream... overnight deposit rates
exploded to their highest since the financial crisis in 2009...
43
It is clear that that the stress in Saudi markets has spread from the forward
derivatives markets to actual funding problems.
This suggests one of the two main things: either Saudi banks are desperatly short of
liquidity or Saudi banks do not trust one another and are charging considerably more
to account for the suspected credit risk.
Either way, not good. So what is going on behind the scenes in Saudi Arabia?
www.zerogedge.com
44
Chapter 17
Basic Theories of the Balance of Payments (BoP)
In this chapter, we cover the following topics:
I)The Elasticities Approach to the Balance of Trade (BoT)
II)The Absorption Approach to the BoT
III)The Monetary Approach to the BoP (MABP)
I)The Elasticities Approach to the BoT:
It discusses how changes in relative prices affect supply & demand
for currencies and goods & services, and thus the BOT. In
particular, how devaluations may affect the BoT, depending upon
the elasticity of supply & demand for currencies and goods &
services.
Elasticities and the J-Curve: The J-Curve phenomenon is the fact
that after devaluation, the BOT instead of improving, it deteriorates
for a while before it improves later. See figure 17.1 below. To
explain this, we assume that both exports and imports are
inelastic in the short run.
45
On the exports side: (1) EX < 1  ↓TRx = ↓↓Px,Qx↑ BoT↓
On the imports side: (2) Em<1  ↑TP m =↑↑Pm, Qm↓ BoT↓
The combination of (1)&(2)  The BoT deteriorates instead of
improving. However, in the long run both elasticities may be
greater than one. The BOT improves (the rising part of the J-curve.)
Reasons for the J-Curve phenomenon; why Ex & Em <1 in the short
run? Two reasons: The currency contract period, and the passthrough period
1- The currency contract period: Contracts are written in terms
of a particular currency. That currency is fixed during the term
of the contract. The effect of contracts on the BOT depends
upon the currency in which the contracts are written. Fig.17.3
illustrates the timing of events.
46
As a general rule, exporters prefer contracts to be written in the
currency which is expected to appreciate, while importers
prefer contracts to be written in the currency
w
which is expected to depreciate.
The following cases in Table 17.1 are explained:
Case i: -Exports are written in foreign currency and imports are written in
local currency. If local currency is devalued, receipts from exports will
increase as foreign currency is converted into local currency >>> BOT will
improve.
-Payments for imports are NOT affected by devaluation since
imports are written in local currency. Overall effect >>> BOT will improve.
Case ii: - Both exports and imports are written in foreign currency.
- For exports, already explained that receipts increases.
- Payments for imports will also increase as more local currency has
to be paid to purchase foreign currency, to pay for imports.
- Overall, receipts from exports increase and payments for imports
increase. - Net effect depends on which is larger.
Case iii: - Exports and imports are both written in local currency.
- Devaluation does NOT affect neither exports nor imports.
47
- Overall, both exports and imports are constant >>> BOT is
unchanged.
Case iV: - Exactly the opposite of case i.
2-The pass-through period: Period after which contracts have
expired & new contracts are signed. The pass-through analysis
considers the ability of prices to adjust in the short run in
response to changes in the ER. It discusses the extent to which
devaluations are reflected in the prices of exports & imports.
The adjustment depends upon of quantities supplied and
demanded. If there is full pass-through, then prices of exports
should fall by the full percentage of the devalution & the prices
of imports should rise by the full percentage of the devalution
and the BOT should improve. If the adjustment is not full,
however, the BOT shall not show the full extent of the desired
improvement. See table 17.2 below. Note: The table assumes
both exports and imports are zero elastic.
48
Evidence from devaluations: Empirical evidence is mixed on the
impact of devaluation on BoT. The reasons for disagreements are:
1- Different researchers use different data & different statistical
methods.
2- Effect of Different profit margins. Devaluations by some
countries motivate their trading partners & competitors to
lower their profit margins & prices to reduce the effect of
devaluations on their exports. This is called Pricing to
Market. Example: Japan & Germany are known to do that. For
every 10% depreciation in U.S $ against the Yen, Japanese
automobile exporters reduce their profit margins, so that the
effect of $ depreciation is no more than 2.2% rise in the dollar
prices of their exports.
3- Countries whose currencies appreciate (example: Japan in the
1990's) may shift production into high-price, less elastic
products. The Japanese resistance to allow full pass- through
is one reason why the Japanese BOT is less sensitive to ER
changes than the US BOT
4- Importance of K/L ratio in production: Devaluation will be
more effective in increasing exports in countries where K/L
ratio is low. Why? In the Short run:
If ER ↑ (devaluation)  Pm↑(w/p)↓imports ↓. Also, as
currency is devalued, demand for exports ↑, which in turn raises
the price level further & thus (w/p) ↓ even further. Thus, the
real cost of producing exports (due to lower real wages) ↓. The
production of exports expands.
49
The evidence from several countries suggests that in countries
where the K/L ratio is low, devaluations are much more likely to
result in exports expansion and faster economic growth. This is
partially because labor may be easier to recruit than capital.
Evidence indicate that imports may take as many as three years
to reflect ER changes, exports prices typically reflect only 3/4
the effect of devaluations over three years. However, in the LR,
the cost of capital may rise, reducing the ability of the devaluing
country to expand production.
The Marshall- Lerner Condition: For Devaluation to improve
the BOT, & the foreign- exchange market to be stable:
(∑x+∑m)>1. If < 1, BOT deteriorates & FE market unstable. If =1,
no change.
II) The absorption approach to the BoT: The BOT is looked upon
as the difference between the value of domestic output and
domestic expenditures, or what the economy absorbs relative to
what it produces.
AE=Y=C+I+G+(X-M)
output) 
Y-A=(X-M)
(C+I+G = A: Absorption of domestic
This means that the BOT is the difference between what the
economy produces & what it absorbs of its output. If the difference
is positive  the economy produces more than what it absorbs 
exports > imports. And vice versa
If Y<A (X-M) <0  BOT deficit. If Y>A (X-M) > 0  BOT
surplus.
50
Under open economy AE is flatter. Why? Because an open
economy has a smaller multiplier due to leakages from imports.
1) If Y< Yf, devaluation may improve BOT, while A may not go down
2) If Y= Yf , devaluation  X↑, M↓, P↑. This implies that in order
for BOT to improve inflation has to rise, & absorption must
decrease.
III)The Monetary Approach to the BoP (MABP)
This approach was developed in the 1970’s as a result of the
growing integration of capital markets.
The Monetary Approach explains BoP disequilibrium as the result
of monetary disequilibrium. There’s either Esm or EDm
If there is Esm  P↑, X decrease & M increase, BoP <0; ER
↑(Currency dep.),
IF there is EDm BoP >0
A digression: MABP under the gold standard & fixed ER: The
monetary Approach can be viewed as a re- discovery, rather than a
modern innovation. David Hume wrote about it in his book Of the
Balance of trade, in 1752. It can be summarized as follows: If
51
BoT<0  MS↓(gold outflow)  P↓ competitive position of the
country improves  X↑ &M↓ gold inflow  P↑ until X=M 
BoT=0.
The adjustment mechanism under MABP:
Under fixed ER, Equilibrium in the BOP can be brought back via
adjustment in net monetary flows; either MS or MD or both. Under
flexible ER, no need to adjust net monetary flows, but changes in
the market-determined ER will do the job.
Definition: Monetary Base= Currency+ Bank Reserves. For purposes
of MABP, monetary base can be divided into domestic credit, D,
and international reserves, R.
Deriving the MABP Model:
MV=P Y
(the equation of exchange)
Where M is the quantity of Money Demanded, V: Velocity of money,
P: the Price level, and Y is output.
Demand for money:
Md=k p y = Md=f(p+, y+)
(17.4)
(where k=1/V), and PY is nominal GDP
A strong assumption: is that the demand for money is stable  V is
constant.
Money supply:
Ms=R+D
(17.5)
PPP ER relation:
Ph= EPf
(17.6)
Money market equilibrium: Ms=Md
(17.7)
Substitute for the ppp Equation (17.6), into Md Equation (17.4)
52
Md= kEPf Y
(17.8)
Substituting Equations 17.8 and 17.5 into Equation 17.7 we obtain
KE Pf Y = R+ D
(17.9)
Take the percentage change in both sides and K^=0 
E^+P^f+y^ = R^+D^
(17.10)
R^- E^= P^f + y^- D^
(17.11)
Equation (17.11) is the general expression of the Monetary
Approach.
NOTE: The percentage change in reserves represents the
percentage change in the BOP.
Under Fixed ER: E^ = 0 
R^= P^f + y^- D^
(17.12)
Assuming money demand is constant  P^f & y^=0  if D^↑
Ms ↑  (EMS)  P ↑ , X↓&M↑  R^↓  As money
supply is increased, people tend to spend more on imports,
which results in the loss of reserves and BOP suffers reduced
surplus or incre3ased deficit. Exports are of course reduced as
domestic prices rise. As the BOP deteriorates and reserves are
reduced, money supply decreases, until the system reverts back
to equilibrium. Increased imports, and reduced exports both
help to reduce money supply. Of course, the central bank will
have to reduce the rate of growth of credit (D^) to reduce the
loss of reserves, and maintain the desired fixed ER.
53
Conversely, if domestic credit is decreased, an ED for money
develops (assuming constant demand for money), R^ will increase
to bring back monetary equilibrium.
Summary of the Policy implications of the MABP Under Fixed ER:
1) BOP disequilibria are essentially monetary phenomenon. Thus
countries will not suffer a long term (structural) BoP deficits if
they did not rely so heavily on inflationary policies to finance
government spending.
2) BOP disequilibria must be transitory. Otherwise, if the ER
remains fixed, eventually the country must run out of foreign
reserves by trying to support a continuing deficit.
3) To reduce, or eliminate BOP disequilibrium under fixed ER,
either MS is adjusted, or the ER is adjusted. In the latter case,
the central bank can have a greater degree of freedom about
money growth rate (monetary policy). If the central bank
insists on maintaining a rigid fixed ER, it must give up control
over monetary policy.
4) Following any devaluation, if the underlying causes of the BOP
deficit are not resolved, further devaluations may be
necessary.
5) Domestic BOP will be improved by an increase in domestic
income (economic growth), which increases the demand for
money, if not offset by a greater increase in domestic credit.
END OF CHAPTER 17
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54
ECONOMICS
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GITA GOPINATH
Gita Gopinath is Professor of Economics at Harvard University. She is a visiting
scholar at the Federal Reserve Bank of Boston, a research associate with the
National Bureau of Economic Research, and a World Economic Forum Young
Global Leader.
NOV 20, 2015
The Fed’s Dollar istraction
CAMBRIDGE – In its September policy statement, the US Federal Reserve took into
consideration – in a major way – the impact of global economic developments on the
United States, and thus on US monetary policy. Indeed, the Fed decided to delay
raising interest rates partly because US policymakers expect dollar appreciation, by
lowering import prices, to undermine their ability to meet their 2% inflation target.
In reality, while currency movements can have a significant impact on inflation in
other countries, dollar movements have rarely had a meaningful or durable impact on
prices in the US. The difference, of course, lies in the US dollar’s dominant role in the
invoicing of international trade: prices are set in dollars.
Just as the dollar is often the unit of account in debt contracts, even when neither the
borrower nor the lender is a US entity, the dollar’s share in invoicing for international
55
trade is around 4.5 times America’s share of world imports, and three times its share of
world exports. The prices of some 93% of US imports are set in dollars.
In this environment, the pass-through of dollar movements into non-fuel US import
prices is one of the lowest in the world, in both the short term (one quarter out) and
the longer term (two years out), for three key reasons. First, international trade
contracts are renegotiated infrequently, which means that dollar prices are “sticky” for
an extended period – around ten months – despite fluctuations in the exchange rate.
Second, because most exporters also import intermediate inputs that are priced in
dollars, exchange-rate fluctuations have a limited impact on their costs and thus on
their incentive to change dollar prices. And, third, exporters who wish to preserve their
share in world markets – where prices are largely denominated in dollars – choose to
keep their dollar prices stable, to avoid falling victim to idiosyncratic exchange-rate
movements.
What little impact import price shocks have on US inflation is highly transitory, with
most of the effect tapering off after just two quarters. A sharp 10% appreciation of the
US dollar, for example, would reduce inflation for non-fuel imports by 4.4%
cumulatively over the next 2-3 quarters, but would have only a negligible impact on
inflation after that point.
If one accounts for consumer goods expenditure on imports, that 10% appreciation
would lower inflation, as measured by the consumer price index (CPI), by just 0.5
percentage points in the first two quarters. And that is likely to be an upper bound,
because it assumes that US retailers will pass through to consumers the full amount of
any increase in import prices.
In practice, they are more likely to increase retail markups and lower cost passthrough. The estimated price pass-through for imported manufactured goods, which
would better represent what enters the consumption bundle, is even lower than that
for all non-fuel imports.
Although these factors insulate the US from the inflationary pressures stemming from
exchange-rate fluctuations, they increase the vulnerability of other countries,
especially emerging economies. Because the dollar prices of most of these countries’
imports are not very responsive to exchange-rate movements, the pass-through of
those movements into import prices denominated in their home currencies is close to
100%.
56
The impact of exchange-rate movements on inflation in most countries is thus 3-4
times larger than in the US. A 10% depreciation of the Turkish lira, for example, would
raise cumulative CPI inflation by 1.65-2.03 percentage points, over two years, all else
being equal.
Despite this imbalance, the US dollar’s dominance as an invoicing currency is unlikely
to change anytime soon – not least because bringing about a shift would require
coordination among a huge number of exporters and importers worldwide. The euro
might seem like a strong contender, given the volume of trade among eurozone
countries; but, outside Europe, the currency is not used nearly as widely as the dollar.
In deciding when to normalize interest rates, the Fed has placed considerable weight
on the weakness of inflation, and its global underpinnings. But while it is true that
some global developments – especially falling commodity prices, and perhaps also
slowing emerging-economy growth and rising financial volatility – may push down
inflation, dollar appreciation will not, at least not in any meaningful way. A stronger
dollar thus is not a legitimate reason to delay the normalization of US interest rates.
https://www.project-syndicate.org/commentary/fed-interest-rates-dollarappreciation-by-gita-gopinath-2015-11
Read more at https://www.project-syndicate.org/commentary/fed-interest-ratesdollar-appreciation-by-gita-gopinath-2015-11#hQJkPGwiyvwKbIDR.99
57
Chapter18
Exchange Rate Theories
This chapter is a continuation of the previous chapter.
The( Financial) Assets Approach:
PPP  Ph=Epf (strong version)
E^=P^h-P^f
(weak version)
The ER adjusts to trade in financial assets and, also to trade in real
goods and services. However, the ER changes faster than prices of
real goods & services ER are more variable and volatile than
prices of real goods. Ideally, the ER should be governed by supply
and demand for real goods and services. However because trade in
financial assets is more active than trade in real goods and services,
the ER is more volatile than the prices of real goods and services.
Thus, there is reversed causation from ER into prices of real goods
and services. This is because not all supply and demand for
currencies is related to supply and demand in real sector. Some is
speculation. This makes the ER changes more rapidly than prices of
goods and services. This is why in some cases countries with trade
surpluses may have depreciating currencies, while others, with
BOT deficit, may have appreciating currencies. An implication of
the Asset Approach is that ER should be much more variable than
goods prices. This seems to be an empirical fact. See Table 18.1
below.
58
There are two brands of the Asset Approach. The major
characteristics of each are indicated in table 18.2 below.
If bonds are perfect substitutes  (1) investors are indifferent
about which bonds to hold & in which currency they are
denominated. (2) Consequently, they do not ask for risk premium
to hold either bond.
The monetary approach, Once again:
From chapter 17, we have:
R^- E^= P^f + y^- D^
Under flexible ER  R^=0. The central bank does not need to
hold foreign reserves.
 E^= D^-P^f - y^
(18.9)
59
Assuming a stable function of demand for money  P^f & y^=0  If
D^↑  E^↑ (Depreciation.)
Also if pf^ &/or y^ rise  E^↓ currency appreciates. (P^f is the
foreign inflation rate.) Under flexible ER, the adjustment in the POB
comes through ER adjustment. Theoretically, under flexible ER the
central bank can maintain control over monetary policy. However,
some external forces, to be explained later in the chapter, may
hinder that control.
The Portfolio Balance Approach(PBA): This approach takes care of
the increased importance and integration of capital markets as
more and more financial assets are traded across countries. The
equation to represent the model is:
E^=D^+B^-B^f- p^f -y^
(18.10)
Where B^ and B^f are the domestic and foreign supplies of bonds,
respectively. R^=0, since the PBA assumes flexible ER.
The relationship between B^f & E^ is negative. If B^f ↑  foreign
demand for loanable funds ↑if↑. To keep if=i˜f (constant, a
necessary condition)Msf↑p^f ↑the risk with foreign
currency ↑ foreign currency depreciates ( home currency
appreciates) E^ ↓
Question: A necessary assumption is to keep if constant. What if
the foreign interest rate isn’t kept constant?
Sterilization: is action by the central bank to offset capital flows in
order to maintain an independent monetary policy.
R^- E^= P^f +y^- D^
(18.11)
60
The RHS variables are the independent variables, the line of
causation is from right to left
Sterilization is to reverse the line of causation, indicated above,
such that if there is a capital inflow (a rise in R^) D^↑ (Ms↑) 
to sterilize, the Central Bank follows the following rule:
D^=α-βR^
(18.12)
α =the desired Ms Growth rate, β= coefficient of sterilization where
0 ≤ β ≤ 1. If β=1  complete sterilization
If β=0  no sterilization
reflects the central bank ability to use domestic credit to offset
reserve flows.
Sterilization under Flexible ER of Managed Float
If there is no sterilization:
Excess Ms i↓capital outflow loss of reserves  BoP deficit
 Ms↓(until Ms=Md) and the deficit is eliminated.
If the Central Bank intervenes and increases Ms, this is sterilization
 Ms>Md BoP deficit persists. The purpose is to have a better
control over M-policy in order to stabilize the domestic sector of
the economy.
Sterilization under flexible ER ( How is it Done?):
This assumes a managed-float ER policy & requires using the
portfolio Balance Approach. We have
E^=D^+B^- B^f- p^f- y^
Assume there is capital inflow into Japan, and the ¥ is appreciating
against the dollar. To prevent that, the Japanese Central Bank buys
61
U.S Bonds. This causes Ms¥↑ and ER↑ (depreciation ¥) . To
stabilize the Ms¥, Japanese Central Bank sells Japanese Bonds,
Ms¥. The net result ER¥ is unchanged, & Ms¥ is stabilized. The
buying and selling are done simultaneously.
The portfolio – balance model permits sterilized intervention to
alter the ER, even though money supplies are ultimately
unchanged. In the monetary approach, the relative bond supplies
are deleted from Equation 18.10. The only way that a sterilized
intervention could change the ER would be if money demand
changed so that income or prices (or perhaps the interest rate, if
we added that as a determinant of money) changed as well.
ER, BOT, News & Expectations:
News about BoT affects spot ER. Also, expectations about future BoT
and/or Debt/GDP ratios, affect expectations about future ER. When
investors act according to their expectations, they speed up the
process of change. The point is expectations about the future have
an impact on prices today.
An unexpected disturbance may cause a BOT deficit in the short
run and a consequent rise in the ER. The LR ER rate may not
return to its initial value. The new LR ER will be higher than the
old one, because foreigners will have larger stocks of domestic
currency, while domestic investors will hold less foreign currency
due to the period of the trade deficit. See Fig. 18.1 below. The
move to new LR equilibrium ER, E1, does not have to come
instantaneously because the deficit will persist for some time.
However, the forward rate could jump to E1 at time t0, as the
market now expects E1 to be the LR equilibrium ER. The dashed
line inFig.18.1 represents the path taken by the spot ER in the
SR.
62
The Usefulness of Forecasting Models:
The forecasting of future spot ER is difficult. The usefulness of
theories is limited by the propensity of the unexpected to occur. The
real world is characterized by unpredictable shocks and surprises.
The predicted change in the spot rate, as measured by the forward
premium, varies less over time than the actual change which
indicates how much of the change in spot rates is unexpected.
News may generate more deviations of ER from their implied PPP
(LR) Value because:
1- Prices of real goods are locked up in contracts.
2- Financial assets are more divisible than real ones & thus more
sensitive to news & expectations.
Currency Substitution: One of the claimed attractions of having a
flexible ER policy is that the central bank can follow an independent
monetary policy. However that independence is lost if firms &
banks are involved in active currency substitution. ER become more
volatile, and this calls for macroeconomic policy coordination
among affected countries (example: European countries during
1990’s, before the introduction of the Euro). To reduce volatility,
the high inflation countries will have to reduce their inflation
rates. Thus, currency substitution forces inflation rates to come
closer to each other, and the supposed independence of
monetary policy under flexible ER becomes largely illusory. The
63
ultimate form of policy coordination is the formation of currency
unions, which involves fixed ER.
We should expect currency substitution to be most important in a
regional setting where there is high degree of mobility of resources
between countries. Western Europe is an example. Alternatively,
there is evidence of a high degree of currency substitution between
the US dollar and Latin American currencies. In some Latin
American countries the dollar serves both as a store of value and a
medium of exchange, especially in border areas.
End of Chapter 18
A very important article: QE ended in the USA by the end of October 2014. Below is an
article that explains the history and impact of QE on the American economy.
http://www.nytimes.com/2014/10/30/upshot/quantitative-easing-is-about-to-endheres-what-it-did-in-seven-charts.html?mabReward=RI%3A14
All wars have major powers, minor powers, and peripheral players affected by
the actions of the larger powers. Currency wars are no different. In the
ongoing currency war that began in 2010, the major powers are the U.S.,
China, Japan, and the eurozone. The progress of the currency war can be
tra...
http://flip.it/0jBxW
64
Ch19: Alternative International Monetary Standards
Topics to be Covered
•The Gold Standard 1880–1914
•The Interwar Period 1918–1939
•The Gold Exchange Standard 1944–1970
•The Transition Years 1971–1973
•Floating Exchange Rates Since 1973
•Types of Exchange Rate Arrangements
•Choosing an Exchange Rate System
•Optimum Currency Area
Topics to be Covered (cont.)
•European Monetary System and the Euro
•Target Zones
•Currency Boards
•International Reserve Currencies
•Multiple Exchange Rates
The Gold Standard (1880-1914)
1- It was essentially a system of fixed ER. Each country declared
the value of its currency in terms of gold. The price was called
the Mint Parity Price. For example, in the US, an ounce of
gold was worth $20.67.
65
•Since each currency is defined in terms of its gold value, all
currencies are linked in a fixed exchange rate system.
•Each participating country must be willing and ready to buy and
sell gold to anyone at the fixed price.
2- Gold has the attributes of money: homogeneous,
recognizable, divisible, portable, and storable. Another
important feature of gold is that governments cannot easily
increase its supply.
3- The Gold standard is called commodity money standard.
4- The gold standard period was a period of stable prices
because of the relative scarcity of gold; see figure 19.1. Home
Prices would rise only if there were important gold
discoveries, and or economies were growing.
66
5- Solutions to BOP Disequilibria under a Gold Standard
A country with a balance of payments deficit would experience
net outflows of gold, thus reducing its money supply and, in
turn, its prices.
A country with a balance of payments surplus would have gold
flowing in, raising its money supply and hence its prices.
Falling prices in the deficit country would lead to increasing net
exports, while the rising prices in the surplus country would
reduce its exports.
6- During the gold standard, many international purchases took
place using the sterling pound. The sterling pound was to be the
world currency, because the UK was the most industrial country
and London was the most important financial city.
Interwar Period: 1918–1939
•7-
World War I effectively ended the gold standard.
Countries imposed capital controls on gold and introduced more
paper money to finance the war expenditures. Inflation pressures
ensued during and after the war, especially after the destruction of
production capacities in Europe due to the war.
•8-The
U.S experienced little inflation, and returned to the Gold
standard in 1919 at the old parity.
. Britain returned to gold standard in 1925, but at pre-war parity.
The result was that the pound was overvalued (gold
undervalued). People rushed to buy more gold  more pressure
on the pound, and by 1931 the British pound was declared
inconvertible. Demand for gold focused on the U.S market. A
67
“run” on U.S. gold led to the U.S. raising the official gold price
to $35 an ounce. Thus the dollar was depreciated.
9- The depression years of the 1930s were characterized by
international monetary warfare in the form of competitive
devaluations and foreign exchange controls.
10-Th First World War ended the dominance of the sterling
pound. The Dollar started to emerge as world currency, because
the US economy was strong and growing. Furthermore, it was not
destroyed by war. Consequently, US prices were more stable. The
dollar replacement of the Sterling Pound was a historical
turning point in the world economic and political affairs.
Gold Exchange Standard ( The Bretton Woods System): 1944–1970
Towards the end of Second World War, an international
conference in Bretton Woods, New Hampshire, in 1944 led to an
agreement among participating countries to fix the values of their
currencies to gold.
•
•The
U.S. dollar was the key currency, and $1 was defined as equal
in value to 1/35 ounce of gold. All currencies were linked to the
dollar and each other in a fixed exchange rate system. This became
known as the Gold Exchange Standard.
If a country had difficulty maintaining its parity value due to BoP
problems, it could turn to the International Monetary Fund (IMF)
for short-term loans as a lender of last resort. (See Item 19.1).
•
•In the case of more fundamental BOP problems, a country was
allowed to devalue its currency (refer to Table 19.1).
•The Gold Exchange Standard is also called an adjustable peg
system.
68
•Large U.S. balance of payments deficits and the consequent gold
outflows as well as the unwillingness of major trading partners to
realign (revalue) currency values led to suspension of U.S. gold
sales in 1971 and the end of fixed exchange rates system.
Transition Years: 1971–1973
•In 1971, an international conference in Washington led to the
Smithsonian agreement, which raised the gold exchange value
from $35 to $38 and also revalued the currencies of surplus
countries.
•In 1972 and early 1973, currency speculators sold large amounts
of dollars leading to further dollar devaluation.
•By March 1973, all major currencies were floating.
Floating Exchange Rates: Since 1973
69
•Although exchange rates since 1973 are described as floating (i.e.,
determined by market forces of demand and supply), the rates are
effectively “managed floats”, wherein central banks reserve the
right to intervene at any time to obtain desirable rate levels.
•Today, different countries follow different exchange rate
arrangements. See Table 19.2 for examples.
70
71
Types of Exchange Rate Arrangements
•Crawling peg—the rate is adjusted periodically in small amounts.
•Crawling band—the rate is maintained within fluctuating margins
around a central rate which is adjusted periodically.
72
•Managed floating—the central bank intervenes in the foreign
exchange market with no pre-announced path for the exchange
rate.
•Independently floating—the rate is market-determined.
•No separate legal tender— Either another country’s currency
circulates as legal tender, or the country belongs to a monetary
union with a shared legal tender.
•Currency board—a fixed rate is established by legislative
commitment to exchange domestic currency for foreign currency at
a fixed rate.
•Fixed peg—the rate is fixed against a major currency or market
basket of currencies.
•Horizontal band—the rate fluctuates around a fixed central target
rate.
Floating vs. Fixed Exchange Rates
•An
argument in favor of flexible exchange rates is that a country
can follow domestic macroeconomic policies independent from
other countries. We have seen in Chapter 18 that this may not be
entirely correct, due to capital flows and currency substitutions.
•An
argument in favor of fixed exchange rates is that fixed rates
impose international discipline on the inflationary policies of
countries.
•An
argument against flexible rates is that such rates are subject to
destabilizing speculation wherein speculators increase the
variability or fluctuations of exchange rates.
73
Country Factors and Choice of Exchange Rate System
•Country
size—Large countries tend to be less willing to subjugate
own domestic policies to maintain a fixed rate system.
•Openness—More
open economies tend to follow a pegged
exchange rate to minimize foreign shocks, while closed economies
prefer the floating rate. Why?
•Trade
pattern—A country that trades largely with one foreign
country tends to peg its exchange rate to the other’s currency. A
country with more diversified trade patterns might peg to a market
basket of currencies.
•Inflation rate—Countries with more harmonious or stable inflation
rates will prefer fixed exchange rates. Why?
•Money supply—The greater a country’s money supply
fluctuations, the more likely the country will peg its exchange rate.
See Table 19.3
74
75
Classifying Monetary Systems:
The Open-Economy Trilemma
Source: Krugman, et al, International Economics, Chap.19, Pp.539-540, 9th
Ed.
The world economy has evolved through a variety of international monetary
systems since the 19th century. A simple insight from the models we studied
in the last part of this book will prove very helpful in understanding the key
differences between these systems, as well as the economic, political, and
social factors that lead countries to adopt one system rather than another. The
insight we will rely on is that policy makers in an open economy face an
inescapable trilemma in choosing the monetary arrangements that best enable
them to attain their internal and external balance goals.
Chapter 18 (you can review it in Krugman’s book) showed how a country that
fixes its currency’s exchange rate while allowing free international capital
movements gives up control over domestic monetary policy. This sacrifice
illustrates the impossibility of a country’s having more than two items from
the following list:
1. Exchange rate stability.
2. Monetary policy oriented toward domestic goals( Independent Monetary
policy).
3. Freedom of international capital movements.
Because this list contains properties of an international monetary system that
most economists would regard as desirable in themselves, the need to choose
only two is a trilemma for policy regimes. It is a trilemma rather than a
dilemma because the available options are three: 1 and 2, 1 and 3, or 2 and 3.
As we have seen, countries with fixed exchange rates that allow free crossborder capital mobility sacrifice item 2 above, a domestically oriented
monetary policy. On the other hand, if a country with a fixed exchange rate
restricts international financial flows so that the interest parity condition,
, does not need to hold true (thereby sacrificing item 3 above),
(preventing a potential departure from external balance due to an appreciation
it is still able to change the home interest rate so as to influence the domestic
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economy (thereby preserving item 2). In this way, for example, the country
might be able to reduce domestic overheating (getting closer to internal
balance by raising the interest rate) without causing a fall in its exports of its
currency). Finally, as Chapter 17(in Krugman’s book) showed, a country that
has a floating exchange rate (and thus gives up item 1 above) can use
monetary policy to steer the economy even though financial flows across its
borders are free. But the exchange rate might become quite unpredictable as a
result, complicating the economic planning of importers and exporters.
Figure 19-1 shows the preceding three desirable properties of an international
monetary regime schematically as the vertices of a triangle. Only two can be
reached simultaneously.
Each edge of the triangle represents a policy regime consistent with the two
properties shown at the edge’s end points.
Of course, the trilemma does not imply that intermediate regimes are
impossible, only that they will require the policy maker to trade off between
different objectives. For example, more aggressive monetary intervention to
manage the exchange rate can reduce exchange rate volatility, but only at the
cost of reducing the ability of monetary policy to pursue targets other than the
exchange rate. Similarly, a partial opening of the financial account will allow
some cross-border borrowing and lending. At the same time, however, fixing
the exchange rate in the face of domestic interest rate changes will require
larger volumes of intervention, and potentially larger drains on foreign
exchange reserves, than would be needed if cross-border financial transactions
77
were entirely prohibited. The central bank’s ability to guarantee exchange rate
stability (by avoiding devaluations and crises) will therefore decline.
However the article below explains why the Trilimma is actually a
dilemma!!
World Affairs
image: https://www.projectsyndicate.org/default/library/0c6801d5f2497e556c042dc6fd0127a6.square.pn
g
Andrés Velasco
Andrés Velasco, a former presidential candidate and finance minister of Chile,
is Professor of Professional Practice in International Development at
Columbia University's School of International and Public Affairs. He has
taught at Harvard University and New York University, and is the author of
numerous studies on international economics and development.
FEB 29, 2016
The World’s Reluctant Central Banker
NEW YORK – This is supposed to be the era of powerful central banks, ready
to wield their firepower worldwide. Yet the most powerful of all central banks
– the United States Federal Reserve – is also the most reluctant to
78
acknowledge its global reach. Like all central banks, the Fed has a local
mandate, focused on domestic price stability and employment. But, unlike
most central banks, the Fed has global responsibilities. This tension is at the
root of some of the most threatening problems facing the world economy
today.
The Fed has global responsibilities for two closely related reasons, neither of
which has much to do with the need to avoid the “currency wars” that so
concerned former Brazilian Finance Minister Guido Mantega.
First, despite the birth of the euro and talk of the Chinese renminbi’s
ascendancy, the dollar remains the currency of choice for borrowing and
lending around the world. When a bank or corporation in Kuala Lumpur, São
Paulo, or Johannesburg borrows abroad, the loan is more likely to be
denominated in dollars than in any other currency.
If local banks suffer a run, or if corporations have trouble rolling over their
debt, they need to be able to borrow dollars from the local central bank, which
in turn may have no choice but to get those dollars from the Fed. When the
Fed in 2007-2008 entered into swap agreements with 14 central banks,
including those of four emerging economies (Brazil, Mexico, Singapore, and
South Korea), it de facto acknowledged that it is the world’s lender of last
resort in dollars.
Yet the Fed, its governors argue, cannot be expected to do that on a regular
basis. In a 2015 speech, Stanley Fischer, one of the most internationallyminded of the Fed’s governors, acknowledged that world financial stability
could be supported by a global central bank, yet concluded: “I should be clear
that the US Federal Reserve is not that bank.”
The second reason why the Fed has global responsibilities is that its policies
affect monetary conditions worldwide. There is mounting evidence that
monetary-policy shocks affect risk premia, and that this channel operates
79
internationally as well as domestically, with sizeable effects. In the 2013
episode known as the “taper tantrum,” the mere hint that the Fed might slow
the pace of its bond-buying program triggered large capital outflows and
asset-price drops in most emerging economies.
The traditional Fed response, expressed eloquently by former Fed Chairman
Ben Bernanke at the 2015 IMF Research Conference, is simple: Float your
currency. The standard trilemma of international monetary policy holds that
countries cannot have fixed exchange rates, monetary independence, and free
capital movement simultaneously, but they can have two of the three.
Countries that float their currencies can be free to set interest rates and
determine financial conditions at home, even with substantial international
capital mobility. If they don’t float – because they have targets for exports or
the real exchange rate – that is their problem. The Fed, Bernanke argued,
cannot be expected to help them.
But Bernanke’s argument is not entirely convincing. As London Business
School’s Hélène Rey has argued, the “risk-taking” channel of monetary policy
is so powerful internationally that Fed policy helps determine credit
conditions in many countries quite independently of their exchange-rate
regimes. When the Fed loosens policy, credit grows all over the world, and
vice versa. So it is not a policy trilemma but a dilemma: capital-account
restrictions –not just flexible exchange rates – may be necessary for central
banks to exercise effective control over domestic credit conditions.
The Fed’s reluctance to serve as the world’s lender of last resort, or to
acknowledge that exchange-rate movements cannot undo its actions abroad,
would seem to condemn it to being a parochial and inward-looking institution.
But Donald Trump should not start applauding yet.
The Fed’s domestic mandate requires it to recognize, in Fischer’s words, that
“the US economy and the economies of the rest of the world have important
feedback effects on each other.” And those effects are getting larger.
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When justifying its interest-rate decisions, the Fed has historically paid little
attention to the effect of international conditions on the US economy. But it
broke with tradition in September 2015. Both the official minutes of the ratesetting meeting and Chairman Janet Yellen in her press conference mentioned
heightened uncertainties abroad, including weakness in the Chinese economy,
as key reasons to delay the Fed’s increase in interest rates.
Other international linkages are also receiving greater attention. As the US
economy becomes more open to international trade and capital movements,
the dollar’s value matters more because of its effect on inflation and on
domestic financial conditions. In the current debate about what the Fed should
do next, Governor Lael Brainard has been arguing that real dollar appreciation
of 20% in 2014 and 2015 reduces the need for further monetary-policy
tightening.
Of course, caring about how the world affects the US is not the same as
concern about the economic health of the rest of the world. And yet these
small steps are significant. Berkeley’s Barry Eichengreen has shown that
international considerations have long played a key role in the conduct of Fed
policy, and that the last three decades, in which the Fed turned mostly inward,
were something of an aberration.
So perhaps the 102-year-old Fed is returning to its original tradition. Or
perhaps its outlook already is quite internationalist – as its actions during the
financial crisis suggest – and it is only domestic political constraints that
prevent this from being acknowledged openly.
Either way, even incremental movement in this direction is welcome, for the
last thing the world needs is a parochial Fed. Recent financial history suggests
that the next liquidity crisis is just around the corner, and that such crises can
impose enormous economic and social costs. And in a largely dollarized
world economy, the only certain tool for avoiding such crises is a lender of
last resort in dollars.
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The IMF could have been that lender, but it is not. The Fed is. The sooner the
US and the rest of the world fully recognize this, the safer the world economy
will be.
https://www.project-syndicate.org/commentary/federal-reserve-lender-of-lastresort-by-andres-velasco-2016-02
© 1995-2016 Project Syndicate
Optimum Currency Area
•Currency Area—an area where exchange rates are fixed within the
area and floating against currencies outside the area.
•The “optimum” currency area is the best grouping of countries to
achieve some objective, such as ease of adjustment to real or
nominal shocks. Real shocks come from the supply side of the
economy such as changes in the prices of imported raw materials,
or changes in technology. Nominal shocks are shocks coming from
the demand side of the economy, due to inflationary pressures and
exchange rate movements.
•The optimum currency area is the region characterized by free
and relatively costless mobility of resources such as labor and
capital.
•When factors are immobile, so that equilibrium is restored via
changes in goods prices, then there is an advantage to flexible
exchange rates.
European Monetary System and the Euro
•The European Monetary System (EMS) was established in 1979 to
maintain exchange rate stability in Western Europe.
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•The Exchange Rate Mechanism (ERM) required that each country
maintains the value of its currency within a 2.25 percent band.
•The ERM broke down in 1992(in the aftermath of the Maastricht
Treaty of 1991) as a result of the removal of capital controls and
countries pursuing different domestic macroeconomic goals.
Maastricht Treaty of 1991
•Called for a single European central bank and a single currency via
the following:
Removal of restrictions on European capital flows and greater
coordination of monetary and fiscal policies.

Creation of a European Monetary Institute (EMI) to prepare for a
single monetary policy.

Irrevocable fixing of exchange rates among member nations with a
single currency (euro).

The Euro
•The euro made its debut on January 1, 1999.
•In the transition years of 1999–2001, the euro was used as a unit
of account.
•Euro notes and coins began to circulate on January 1, 2002.
•Currently, the United Kingdom, Denmark, and Sweden have not
adopted the euro.
•See Table 19.4 for exchange rates of old European currencies.
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The European Central Bank
•The European Central Bank (ECB) began operations in 1998 in
Frankfurt, Germany.
•The Governing Council of the ECB determines the monetary policy
for the euro-area.
•The network of national central banks and the ECB is called the
European System of Central Banks.
Monetary policy and the Long Run Aggregate Supply (LRAS):
Some economists (called monetarists) argue that in the LR, monetary policy has no
impact on LRAS, and thus in the LR monetary policy can only influence the P-level.
This is called the principle of the neutrality of money. This is a highly controversial
issue. The alleged LR neutrality of money (that money cannot affect LR GDP) led
many CB's to concentrate on the inflation rate as the LR target of monetary policy.
The European Central Bank (ECB) is an example. The first Chairman of the ECB,
Wilhelm Duisenberg said in the inaugural speech of the ECB (January 1999)
"Monetary policy is neither the cause, nor the cure of unemployment." This
means that the prime policy variable for the ECB has been price level stability (i.e.
fighting inflation). Consequently, the charter of the ECB does not allow it to
purchase government bonds, and thus is not supposed to participate in financing
the member governments' budget deficits. Governments are supposed to float
bonds in the market. This has changed a little bit, however, with the current
financial crisis, since 2007, as the ECB has been participating in stabilizing
European economies, and purchased a large quantity of governments' and
corporate bonds, in what is called the Quantitative Easing Program.
84
Read Krugman's, et al, International Economics, Chapter 20, on "Optimum
Currency Areas and the European Experience."
Another more recent article, November, 2014, after six years of the international
financial crisis, is below.
THE EUROPEAN CONUNDRUM: STAGNATION, MASSIVE
UNEMPLOYMENT AND RISING DEBT - DESPITE
AUSTERITY
Tuesday, 04 November 2014 09:58 By C.J. Polychroniou, Truthout | News Analysis
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Five years after the
2008 financial crash reached Europe, its crisis is actually spreading.
(Image via Shutterstock)New data reveals, as we will show below, that Europe
is the sick man of the global economy once again. But more to the point, it is high
time to acknowledge that the European Monetary Union (EMU) is, for all practical
intents and purposes, no longer viable.
Ever since the latest global financial crisis begun in 2008, Europe's monetary
union is mired in a severe economic crisis from which it is simply unable to
recover. For starters, the euro crisis has had a devastating impact on the peripheral
eurozone countries (Greece, Portugal, Ireland, Spain, Italy and Cyprus), and it
85
consolidated even further the division between north and south, thus putting
permanently to rest illusive notions like convergence and cohesion inside the EMU.
The crisis management approach adopted on their behalf by the core euro-zone
countries - Germany in particular - made things much worse. The so-called "rescue
plans" enforced by the troika of the European Commission (EC), the European
Central Bank (ECB) and the International Monetary Fund (IMF) for the crisisridden euro member states (Italy excluded) ravaged the southern economies as the
harsh austerity policies administered caused massive declines in domestic demand
and sharp rises in long-term unemployment, brought about brutal cuts in social
programs and public investments, and resulted in rapidly declining standards of
living and large-scale migration.
FIVE YEARS AFTER THE FINANCIAL CRISIS OF 2008 REACHED EUROPE'S
SHORES, THE EURO CRISIS IS NOT ONLY NOT SLOWING DOWN, BUT IT IS
ACTUALLY SPREADING, AFFECTING MORE AND MORE MEMBER STATES AND
GIVING RISE IN TURN TO GROWING POPULAR DISCONTENT ABOUT THE
EUROPEAN INTEGRATION PROCESS WITH FAR-REACHING AND UNFORESEEN
CONSEQUENCES.
GDP in Spain, Portugal, Ireland, and Italy is on the average 7 percent below the
pre-crisis levels; Greece's GDP is nearly 25 percent below its pre-crisis peak. The
latest Eurostat data show that the unemployment rates in the peripheral countries
are stratospherically high, indicating that there is no recovery. In Greece the
official unemployment rate is over 26 percent while in Spain it is nearly 25 percent.
In Portugal it is 14 percent, in Italy 12.3 percent, and in Ireland (the country with
the highest net migration level in Europe) at over 11 percent.
In addition, all of the bailed-out countries have seen their public debt ratios
explode, leaving them in a state of debt bondage and permanent austerity from
which they are unlikely to escape any time in the foreseeable future. In Greece,
government gross debt exploded from 126.8 percent at the end of 2009 to 175
percent at the end of 2013 (and is expected to grow to exceed that mark by the end
of 2014); Spain's public debt ratio grew from 52.7 percent in 2009 to over 92
percent at the end of 2013 (and is expected to reach the historic mark of 100
percent by the end of 2014); Ireland's grew from 62.2 percent in 2009 to over 123
percent at the end of 2013; and Portugal's, from 83.6 percent in 2009 to 128
percent at the end of 2013. (1)
86
Five years after the financial crisis of 2008 reached Europe's shores, the euro crisis
is not only not slowing down, but it is actually spreading, affecting more and more
member states and giving rise in turn to growing popular discontent about the
European integration process with far-reaching and unforeseen consequences. (2)
All across the Eurolands, socially intolerable levels of unemployment, stagnating
and/or declining wages and lack of growth prospects work in tandem with the
undemocratic status of eurozone governance - the illegitimate policies dictated
mainly by Germany - and the lack of a vision for the future either at the domestic or
the European level to produce a European public sentiment that is increasingly
Euroskeptic and in fact outright hostile to further integration. (3)
It has been widely noted that European policy has been quite short-sighted in
dealing with the euro crisis because the policies pursued aimed at buying time and
nothing more. This is true, but in a partial and rather superficial manner only as
this line of criticism ignores the fact that the European integration project is built
on extreme neoliberal premises and assumptions about economic growth and
development that leave little room for the kind of policy thinking, let alone
policymaking and implementation, that the so-called "master-economist"
envisioned and articulated in an attempt to address the crisis of capitalism of the
1920s and the Great Depression of the 1930s. (4)
Moreover, the evolution of European economic integration since the Maastricht
Treaty has rested on rather undemocratic political foundations, thereby de facto
excluding claims based on empowered participation, for the explicit aim has been
principally to serve the goals and interests of European capital and European
corporations rather than the common good of Europe's citizens.(5)
The European integration process has always been about strong states imposing
their will on weaker ones and international capital finding wider and more open
space in which to operate and thus to run roughshod over domestic labor. The
bailout schemes serve as unquestionable testimony to the eurozone's
antidemocratic governance and imperial bent.
THE GERMAN MODEL IS ACTUALLY RESPONSIBLE FOR THE INTERNAL
IMBALANCES THAT INITIALLY IMPLODED IN THE AREA UNDER THE EURO
REGIME.
In this context, the structural adjustment programs conceived with the assistance
of the IMF for the over-indebted economies in the eurozone were a natural
outcome of the purpose and design of the EMU. Neoliberalism is ingrained in the
structures and relations of decision making in the EMU, including of course those
in the ECB. The policies of wage reduction and austerity imposed on the bailed-out
87
countries were guaranteed to bring about a severe depression, yet the purpose was
not to "rescue" their economies but rather the foundation of the eurozone and its
respective banks. (6)
The collapse of economic activity was certain to cause a ballooning of public debt,
but that was inconsequential as the burden would be passed on to the taxpayers of
the bailed-out countries and the draconian austerity measures ensured its
repayment at least for the foreseeable future. In the meantime, the debt menace
was used as a sledgehammer to compel peripheral governments to proceed with
further liberalization of the economy, the dismantling of the welfare state and the
sale of public assets for bargain-basement prices.
The much talked about competitiveness issue is also couched by the euro zone
leaders in neoliberal and imperial terms. The idea that all eurozone member states
can run surpluses, as Germany does, with the improvement of their competitive
position by lowering per-unit-labor costs in greater percentage than those of their
neighbors is not simply a preposterous claim, but a recipe for social disaster. It
involves a race to the bottom from which labor emerges totally impoverished while
the rate of profit for big business and global corporations increases geometrically.
GERMANY HAS DESTROYED GREECE TWICE IN THE LAST 70 OR SO YEARS: ONCE
WITH THE NAZI MILITARY INVASION DURING WORLD WAR II AND NOW WITH
ITS INHUMANE AUSTERITY AGENDA.
Indeed, it is hard to overlook the fact that the German model is actually responsible
for the internal imbalances that initially imploded in the area under the euro
regime as Germany has been pursuing policies since the early 2000s with the aim
of producing an external surplus, which reached 7.5 percent of GDP in 2013 and is
expected to be just as astonishingly high at the end of this year. (7)
As yet another example of the imperial logic and dynamic guiding governance in
the euro zone, pact violations by Germany and France never produced any
sanctions, but subsequent violations by Greece and Portugal unleashed Germany's
fury and demands that they be severely punished - which they were - with earthscorching policies highly reminiscent of those applied by the brutal military regime
of Augusto Pinochet in Chile under the auspices of the Chicago School boys and the
IMF.
In Greece, the peripheral eurozone member state that has suffered as a result of the
brutal austerity policies dictated by Germany an economic blow equivalent to those
normally experienced by countries under wartime conditions, it could take at least
20 years for the nation's GDP to return to pre-crisis levels. Indeed, Germany has
destroyed Greece twice in the last 70 or so years: once with the Nazi military
88
invasion during World War II (and where war reparations for the killing of
hundreds of thousands of people and for a massive loan that was forcibly extracted
from the Bank of Greece in 1943 were never made) and now with its inhumane
austerity agenda. In fact, the prospects of growth are actually nonexistent under
the current euro regime and with Germany as its hegemon.
In this context, what many current analyses of the Greek economy seem to
overlook is that while a major restructuring of public debt (95 percent of Greece's
government debt is in the hands of the formal sector) is an absolute necessity for
the domestic economy to receive some breathing space, the paths to growth and
development still remain a conundrum (and for most of the euro area) as the crisis
that broke out in the eurozone has actually led to more stringent fiscal rules, and
four and a half years of brutal austerity have not produced the slightest change in
the attitude of eurozone leaders toward Greece and its ailing economy.
The fiscal compact, which entered into force at the start of 2013, demands that the
government budgets of the member states be in balance or surplus and that only
those with a significantly lower than 60 percent government debt-to-GDP ratio
may set the deficit limit to 1 percent of GDP. These policies are said to provide
greater financial stability (this is while the euro zone is already the playground for
bond hedge funds) but, by restricting the fiscal space even further, they actually
enhance recessionary dynamics, thus ensuring economic and political instability by
guaranteeing that Euroland will increasingly turn into an economic wasteland.
As indication of the severity of the lack of growth in the euro zone, Spain's GDP
grew by a mere 0.6 percent in the second quarter of 2014, making a highly
indebted country with an unemployment rate of nearly 25 percent "one of the
strongest performers in the euro zone." (8)
The latest available data reveals a dismal outlook for the eurozone as a whole.
Thanks to new GDP calculating methods introduced recently by Eurostat, GDP in
the euro area increased by 0.1 percent in the second quarter of 2014 (when
according to previous calculations there was zero growth quarter-on-quarter). (9)
This is still a nearly zero growth rate and the main reason is because of
contractions in the three major economies of the euro area: Germany's GDP
declined by 0.20 percent in the second quarter of 2014 over the previous quarter;
Italy's GDP also contracted by 0.20 percent in Q2, 2014; and France's GDP for Q2,
2014 remained stagnant over the previous quarter. (10)
Much of the eurozone's awful economic performance is attributable to the ills of
industrial production, the output levels of which are below what they were four
years ago (see Figure 1 below)
89
The usually reliable German economy, with its huge export machine, seems to be
leading the way to a widespread eurozone recession: First, Germany's exports took
a huge nosedive in August, dropping by 5.8 percent (11) while its industrial
production index declined by 4.3 percent from July to August - almost three times
higher than the expected decline. (12)
Indicative of the mood that is beginning to prevail among investors over Germany's
economic model, which thrives on suppressing wages to sap domestic demand
while subsidizing exports, a study by the Centre for European Economic Research
(ZEW) in Manheim found that investors' confidence in Germany has dropped for
10 consecutive months, (13) while the Munich-based economic institute IFO, which
keeps track of business confidence in Germany, reported recently that its business
climate index dropped for the fifth consecutive month." (14)
IT IS SIMPLY REMARKABLE THAT THE EURO ZONE'S GDP HAS FAILED TO
RETURN EVEN TO ITS 2007 LEVELS.
The German economy's recent performance is seemingly so awful that it prompted
ING economist Carsten Brzeski to describe it as "a summer horror story" and to
add that "it needs a small miracle . . . to avoid a recession." (15)
90
In the eurozone's second largest economy, there is zero economic growth while
unemployment is rising (already over 10 percent), and business confidence levels
are lower than those in Germany and Spain. (16) Worse, France's deficit (currently
at 4.4 percent of GDP), is way above the expected 3 percent imposed by European
Union budget rules, which means it will be extremely hard, if not impossible, for
the "socialist" government of François Hollande to rely on expansionary fiscal
policy to boost economic growth.
France's budget for 2015, which was submitted to the European Commission in
mid-October of this year, falls short of meeting the goals to reduce its structural
deficit by 0.8 percent in 2015. The French government has indicated that it will not
meet EU budget rules until 2017, setting up a possible confrontation with Germany
and the EU chiefs. Still, it is unlikely that Germany and the European Commission
will seek to humiliate France over its budget deficit (France is anyway a consistent
violator of EU budget rules) because of the political repercussions that such an
outcome might have inside France society, where Marine Le Pen's National farright National Front party is a strong contender to win the next French presidential
election.
Meanwhile, France's government debt has kept increasing every year since 2004
(although public spending has actually decreased) and stands currently at almost
95 percent of GDP at a time when the reduction of government debt in excess of 60
percent has been enshrined in the new Stability and Growth Pact, thus raising all
kind of interesting questions about the future of fiscal policy in France, French
politics in general, and of course, Franco-German relations. As hinted earlier, a
deal may be reached between Germany and France over the latter's budget, but
there won't be unity over growth.
WHAT DOES THE FUTURE HOLD FOR THE EUROZONE?
Speaking of growth, it is simply remarkable that the euro zone's GDP has failed to
return even to its 2007 levels. Given that reality, calling the EMU a nonviable entity
could hardly qualify as an exaggeration.
An interesting illustration of the inherently depressionary nature of the euro and
the sheer failure of the current European monetary union comes across in the most
pointed way when one compares the growth experience of the eurozone since the
start of the global financial crisis of 2007-08 with that of the sterling bloc and the
gold bloc countries after the Great Depression of 1929. As Nicholas Crafts, who
undertook this comparison, notes, "the former [the sterling bloc] devalued in 1931
and experienced an early and quite rapid recovery. The latter [the gold bloc] stayed
on the gold standard till the bitter end and even in 1938 had only just regained the
1929 level of real GDP. Sadly, the Euro area is following a trajectory that looks
91
rather too reminiscent of that of the gold-bloc countries in the 1930s" (17) (see
Figure 2 below).
In light of the above, the key question is: What does the future hold for the
eurozone? The most obvious alternative for turning things around is a broad
growth-based strategy across the euro area in a spirit similar to that of the New
Deal along with specific policies that counter the internal imbalances in Euroland.
However, the political and social support for such an undertaking is largely missing
and the prospects of Europe moving toward a federal model are simply
nonexistent. Thus, investing political capital in this project is probably a wasted
and ill-conceived effort, given the sharp differences that exist in the political
cultures of the 18 member states in the euro area and the fact that Germany has
been the primary beneficiary of the current euro design, which means it is most
unlikely to accommodate calls for a social Europe.
THERE SEEMS TO BE A MOMENTUM GROWING LATELY IN THE DIRECTION OF A
EURO EXIT.
A more realistic scenario for the future of the eurozone might be the creation of a
two-tier euro system that separates the core member states from the peripheral
eurozone countries. The outcome of this scenario will probably be dictated by
political developments as much as by plain economics. Whatever the odds may be
for this scenario to materialize, it is much more likely to happen than Germany
surrendering to pressures to accept a fiscal union or euro zone debt mutualization
92
options. Indeed, one should not be surprised to see at some point in the near future
the emergence of a strategic alliance among a set of key countries for the purpose
of forming their own euro currency.
The third and most unlikely scenario is the complete dissolution of the monetary
union in Europe and the return to a mere single market, or a free-trade zone. It is a
highly unlikely scenario by virtue of the fact that too many vested economic
interests have made huge investments in the future of the euro.
The final and not so unlikely scenario entails some of the most highly indebted
member states (Greece, Portugal, Spain and Italy in particular) leaving the euro. A
widespread fear of a return to national currencies, greatly assisted by government
and media propaganda throughout the periphery of the eurozone, has severely
circumscribed public dialogue inside these countries, but there seems to be a
momentum growing lately in the direction of a euro exit, especially in Italy, a
political development that could have important contagion effects in the rest of the
periphery.
In Greece, the likely rise of Syriza into power is unlikely to play a protagonistic role
in the periphery of the eurozone, let alone become a catalyst of change in the entire
euro area. Committed as it seems to be to maintaining Greece as a member of the
monetary union, Syriza may ultimately find itself accepting European terms and
conditions for Greece, which will prolong the nation's status as a heavily indebted,
underdeveloped and dependent nation indefinitely. But growing discontent in Italy
with the euro regime, especially involving a decision to exit the eurozone, could
indeed have major political ramifications in the rest of the periphery of the
eurozone.
Meanwhile, pressures on the peripheral countries for more austerity and further
structural reforms will continue as low inflation and marginal growth will sink
them further and further into the depths of abyss, courtesy of the wildest
experiment among modern monetary unions and of neo-Hooverian policies
pursued by the eurozone's hegemon.
Footnotes:
1. Data drawn from Eurostat statistics on general government gross debt – annual
data.
2. The possibility of Marine Le Pen winning the next French presidential election
could open up a Pandora's box of more political shifts across Europe in a similar
direction. See Hugh Carnegy, "Marine Le Pen takes poll lead in race for next
French presidential election." The Financial Times. July 31, 2014.
3. See Jose Ignacio Torreblanca and Mark Leonard, "The Continent-Wide Rise of
Euroscepticism." Memo Policy. London: European Council on Foreign Relations.
May 2013.
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4. Note that, unlike in the United States, where the crisis erupted with Wall's
Street's crash of 1929, the crisis in England started in the early 1920s and Keynes known in certain economic circles as the "master" - was already assisting the
British government in developing public programs for combating unemployment.
5. See C. J. Polychroniou. "The New Rome: The EU and the Pillage of the Indebted
Countries," Policy Note 2013/5, Annandale-on-Hudson, N.Y.: Levy Economics
Institute of Bard College. May 2013.
6. As an editorial in BloombergView has pointed out, "the bailout money . . . aimed
to rescue German banks that had amassed claims of $704 billion on Greece,
Ireland, Italy, Portugal and Spain, much more than the German banks' aggregate
capital." See BloombergView, "Hey Germany: You Got a Bailout, Too." May 23,
2012.
7. Alen Mattich, "Weaker German Industry Needn't Be A Disaster." The Wall Street
Journal's blog. August 21, 2014.
8. Ashifa Kassam, "Why a little economic growth won't see an end to the pain in
Spain." The Observer. August 10, 2014.
9. Trading Economics, "Euro Area GDP Growth Revised Up." October 17, 2014.
10. Graeme Wearden, "Eurozone growth grinds to a halt as German economy
shrinks - as it happened." The Guardian Business Blog. August 14, 2014
11. Angela Monaghan, "Germany needs 'small miracle' to avoid recession after
exports fall by 5.8%." The Guardian, October 9, 2014.
12. Eurostat news release euroindicators. October 14, 2014
13. Centre for European Economic Research. ZEW Indicator of Economic
Sentiment - Further Economic Slowdown Expected. October 2014.
14. Ifo Business Climate Germany: Results of the Ifo Business Survey for
September 2014. Press release. Ifo Institute. October 10, 2014.
15. Cited in Monaghan (2014), "Germany needs 'small miracle' to avoid recession
after exports fall by 5.8%."
16. William Horobin, "France's Statistics Agency Cuts Economic Growth Forecast."
The Wall Street Journal Online. October 2, 2014.
17. Nicholas Crafts, "The Eurozone: If only it were the 1930s." Vox. December 13,
2013.
Copyright, Truthout. May not be reprinted without permission.
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C.J. POLYCHRONIOU
C.J. Polychroniou is a research associate and policy fellow at the Levy Economics Institute
of Bard College and a columnist for a Greek daily national newspaper. His main research
interests are in European economic integration, globalization, the political economy of the
United States and the deconstruction of neoliberalism’s politico-economic project. He has
taught for many years at universities in the United States and Europe and is a regular
contributor to Truthout as well as a member of Truthout’s Public Intellectual Project. He
has published several books and his articles have appeared in a variety of journals and
magazines. Many of his publications have been translated into several foreign languages,
including Greek, Spanish, Portuguese and Italian.
The views expressed in this article do not necessarily represent those of the Levy
Economics Institute or those of its board members.
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Target Zones
•Target zones allow a country’s exchange rate to fluctuate within a limited range or band
around some central fixed value.
•The closer the exchange rate gets to the upper or lower limit, the greater the probability
of central bank intervention (refer to Figure 19.2).
•A target zone backed by a credible government creates stability & confidence.
Currency Board
•Currency Board—a government institution that exchanges domestic currency for foreign
currency at a fixed rate of exchange.
•A currency board achieves a credible fixed exchange rate by holding a stock of foreign
currency equal to 100 percent of the outstanding currency supply of the country. For
example, Hong Kong.
•If government policy is inconsistent with the fixed exchange rate, the currency board
cannot last. For example, Argentina.
International Reserve Currencies
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•A reserve currency is a currency that serves the role of money in the international
economy.
•As with any money, the reserve currency must serve as a unit of account, medium of
exchange, and store of value.
•Although the U.S. dollar is not the only reserve currency, it is the dominant reserve
currency. Refer to Table 19.6
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•Also, you may want to read the article below on the Euro, in F&D magazine
published by the IMF. The article discusses the performance, and future of the
Euro. Note that the article was written before the current International Financial
Crisis. You may find on the same web site, other articles, written before and after
the Crisis.
http://www.imf.org/external/pubs/ft/fandd/2007/03/bertuch.htm
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World Affairs
Wing Thye Woo
Wing Thye Woo is Professor of Economics at the University of California, Davis, and at
Fudan University, Shanghai, and Central University of Finance and Economics, Beijing.
He is also Executive Director of the Penang Institute in Georgetown, Malaysia.
DEC 12, 2013
Renminbi Rising?
SHANGHAI – China is increasingly debating whether or not the renminbi should be
internationalized, possibly joining the US dollar and the euro as an international vehicle
currency (IVC) – that is, a currency that other countries use to denominate the prices of
their traded goods and international loans. Related to this is a debate about whether
Shanghai can become a first-tier international financial center (1-IFC) like London and
New York.
Financial history can help to answer these questions. First, a city can become a 1-IFC only
if its national currency is an IVC. But, as London’s status shows, a longtime 1-IFC can
retain its position in the international financial system even if its currency is no longer an
IVC. Second, the transaction cost of using a foreign currency as a medium of exchange is
inversely proportional to the extent to which that currency is used globally. Similar
economies of scale characterize foreign investors’ use of a particular international financial
center. As a result, there cannot be more than three or four IVCs and 1-IFCs.
Third, a country’s financial sector must be both open, with no capital-flow restrictions, and
sophisticated, with a wide range of instruments and institutions. It must also be safe, with a
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central bank maintaining economic stability, prudential regulators keeping fraud and
speculation in check, macro-prudential authorities displaying adequate financial firefighting capabilities, and a legal system that is predictable, transparent, and fair.
Last – and most important – successful convergence to IVC and 1-IFC status requires the
national economy to be strong relative to other economies for a substantial period of time.
The United Kingdom occupied a position of global economic leadership for more than a
century. In 1914, the US/UK GDP ratio was 2.1, but the US dollar was not an IVC,
suggesting that America’s relative economic strength was inadequate. A decade later, in
1924, the ratio was 3.2 and rising – and the US dollar had eclipsed the British pound as the
most important IVC. Relative economic strength explains why the Japanese yen failed to
develop into an IVC, and why Tokyo – whose financial markets satisfied the relevant
requirements – failed to become a 1-IFC. With its GDP reaching only about 60% of
America’s at its peak in 1991, Japan never attained the critical mass required to induce
foreigners to use the yen to lower transaction costs.
Determining the future international status of the renminbi and Shanghai must begin with a
calculation of China’s expected relative economic strength vis-à-vis the US under two
plausible scenarios. In the first scenario, China becomes caught in a middle-income trap,
with per capita GDP stuck at 30% of America’s – an outcome that has characterized Latin
America’s five largest economies since at least 1960, and Malaysia since 1994. This would
put China’s economic strength relative to the US at 1.1 – well below the necessary ratio.
In the second, more favorable scenario, China’s per capita GDP would reach 80% of
America’s – higher than the 70% average rate for the five largest Western European
countries since 1960 – and its economic strength relative to the US would amount to
roughly 2.8. This would make the renminbi eligible for IVC status and enable Shanghai to
choose whether to become a 1-IFC. But China’s economy still would not be strong enough
relative to the US for natural market forces to ensure the renminbi’s international success.
Given this, the Chinese government would have to implement decisive measures to
encourage international traders and creditors to price their transactions in renminbi.
Specifically, China would have to use its market power to promote pricing in renminbi for
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relevant manufactured exports and raw-material imports, and encourage renminbi
denomination of foreign financial assets that China purchases (which the country’s status
as a net creditor should facilitate).
But there are serious pitfalls to avoid in this process. As the Asian financial crisis of 19971998 demonstrated, capital-account liberalization could lead to financial meltdowns – a
danger that opponents of internationalizing the renminbi often cite. But these risks do not
outweigh the potential benefits of financial openness, and they can be minimized with
effective monitoring and regulation, including requirements for large capital buffers and
low leverage ratios, together with strong crisis-response mechanisms, like a resolution trust
corporation.
In fact, effective financial-monitoring and prudential-regulation systems do not have to
precede opening the capital account. On the contrary, developing and enacting financial
regulation must be a gradual process, shaped by both existing knowledge and firsthand
experience. After all, no financial market is either completely open or completely closed
forever; the degree of openness at a given moment depends on policy choices.
The recent establishment of the Shanghai Free Trade Zone will allow for the emergence of
an offshore international financial center that offers real-world training to China’s
regulators. This will give them the tools they need to recognize the signs of a developing
crisis, defuse the threat, and efficiently handle the recapitalization and reorganization of
failed financial institutions. China’s pursuit of an IVC and a 1-IFC city would serve not
only its own interests. Allowing the renminbi to help meet global demand for international
reserves and risk diversification would also strengthen global financial stability.
There is little time to waste in internationalizing the renminbi. Given the limited number of
currencies that can serve as IVCs, the failure of the renminbi to achieve IVC status before,
say, the Indian rupee, the Russian ruble, or the Brazilian real could mean that the renminbi
is denied IVC status – and that Shanghai fails to achieve 1-IFC status – for generations, if
not forever.
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A comment By DR. Usamah Uthman:
The effects of the Renminbi internationalization on the capital account (what the author
calls the possible meltdown) are not the only possible effects. The current account could be
more prone to be affected. China must be ready to accept a sharp appreciation of its
currency and the consequences thereof; exports will suffer, imports will rise. Consequently
investment must decline. The Balancing of the economy must come through rising
consumption. These adjustments may not be smooth as they may generate sectoral
unemployment and social dislocations. China’s overall rate of growth may also suffer.
Some of its industries are going to re-locate to benefit some of its smaller neighbors. When
the Sterling pound ascended to its supreme position under the Gold Standard (1880-1914),
it had no competitor. The First World War was a turning point as it destroyed the Gold
Standard. The dollar displaced the pound. Again, the dollar had no competitor at the time.
The stage now is already occupied with other major players, the dollar and the Euro. The
Renminbi may find a place on the stage. The question is: is it really worth it?! Furthermore,
if tension between China and its neighbors escalates into actual confrontation, the stability
and suitability of the Renminbi as an international currency shall be severely affected. It is
only curious why would China risk to sacrifice further potential for growth and prosperity
for the sake of avoidable confrontation!!!
http://www.project-syndicate.org/commentary/wing-t--woo-lays-out-the-conditions-thatchina-must-meet-to-internationalize-its-currency-and-turn-shanghai-into-a-globalfinancial-center
© 1995-2013 Project Syndicate
Read more at http://www.project-syndicate.org/commentary/wing-t--woo-lays-out-theconditions-that-china-must-meet-to-internationalize-its-currency-and-turn-shanghai-into-aglobal-financial-center#yU7ZvqeOUJhUeDe0.99
Seigniorage
•Seigniorage is the difference between the cost to the reserve country of creating new
money balances and the real resources the reserve country is able to acquire with the
103
new balances. It is a financial reward accruing to the reserve currency as a result of its
being used as a world money.
Multiple Exchange Rates
•Some countries maintain multiple exchange rates.
•Arguments against multiple rates include:

Multiple rates harm both the countries imposing them and other countries.
They are costly in that people spend scarce resources to find ways to profit from the
tiered exchange rates.


Maintenance of multiple exchange rate system requires a costly administrative structure.
______________________________________________________
CURRENCY REGIMES, CAPITAL FLOWS,AND CRISES
Paul Krugman Conference draft, 30 October 2013
“What I want to talk about instead is a question that some of us have been asking with
growing frequency over the last couple of years: Are Greek-type crises likely or even
possible for countries that, unlike Greece and other European debtors, retain their own
currencies, borrow in those currencies, and let their exchange rates float? What I will
argue is that the answer is “no” – in fact, no on two levels. First, countries that retain their
own currencies are less vulnerable to sudden losses of confidence than members of a
monetary union – a point effectively made by Paul De Grauwe (2011). Beyond that,
however, even if a sudden loss of confidence does take place, countries that have their
own currencies and borrow in those currencies are simply not vulnerable to the kind of
crisis so widely envisaged.”
http://linkis.com/ow.ly/s7yM
Article: Speculators test Saudi currency as oil crisis deepens
“A de-peg of the Saudi riyal is our number one ‘black-swan’ event for oil in 2016,” said Bank of
America Saudi Arabia’s currency regime is at risk of blowing up if oil prices fall further and the
US dollar spikes higher, Bank of America has warned. The Saudi strategy of flooding the world
with oil...
http://flip.it/3qrug
END of Chapter 19
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