08/26/2014

CHAPTER 1: The Theory of Comparative Advantage

Each country possesses comparative advantage in the production of one of the two products, and if
two countries exchange/trade products, both countries would then benefit by specializing completely in one
product and trading for the other.
Assumptions: First, the two countries enjoy free trade. Second, perfect competition. Third, no
uncertainty. Fourth, costless information. Fifth, no interference.
But in todays world, this theory is far from perfect--false.

Markets are imperfect opportunities for Multinational Enterprises to seek production

efficiency, political safety, special skills, raw materials, etc.
o Demand Consumers Global Financial Markets Supply producers
L Assets (securities & loans)
L Exchange Rate
L Euro currencies with interest rate (LIBOR) -- depositing
currency of the home country outside of that country
L Institutions / governments
Banks
- Central Banks (aka the US Federal Reserve*)
- Commercial Banks
- Investment Banks
Why would firms deposit elsewhere in another country aka euro currency?
Ease of transactions, law & regulations are different therefore manipulation is easy (taxes, etc.)
What is the primary goal of the central bank?
To create and control the money supply

This chapter summarizes a brief history of the IMS from the days of the gold standard to the present
time, and some of the IMSs related topics.
THE EVOLUTION OF CAPITAL MOBILITY
1860: the gold standard
1914: the interwar years
1945: the Bretton woods era
1971: the floating era
1997: the emerging era
1. The Gold Standard (1876-1913)
Since 300BC, gold has served as a medium of exchange and store of value.
Each country set the rate at which its currency unit could be converted to a weight of gold.
Ex. The USD was set at $20.67/ounce of gold
The British pound was pegged at 4.2474/oz.
Exchange rate

$ pound = 4.8665

pound $ = 0.2055
Because of fixed parity rate, and fixed exchange rate, countries were limited to expand their money
supply.

2. The Interwar Years (1914-1944)

Currencies were allowed to fluctuate over a fairly wide range in terms of gold and each other.
In 1934, the USD was devalued to $35/oz of gold
1944 WWII ended, ending this interwar period
floating exchange rate

3. The Bretton Woods Era (1945-1971)

(Fixed Exchange Rate Regime)
After WWII, the allied powers met at B.W. to create a post-war IMS (international monetary system).

Bretton Wood Agreement: all countries fixed the value of their currencies in terms of gold, but
werent required to exchange their currency for gold. Created 2 institutions:
1. International Monetary Fund (IMF)
i. Help countries defend heir currencies against shocks
ii. Assist countries having structural trade problems
iii. Implement Special Drawing Right (SDR) which is the IMF reserve access to
supplement existing foreign exchange reserves
2. World Bank
i. Helped fund post-war reconstruction and supported general economic development

only the USD remained convertible to gold at $35/oz. therefore, each country established its
exchange rate in relative to the USD, and then calculated the gold par value of its currency to
create a desired dollar exchange rate.
This results in a problem in money supply hard to grow not accurate measure of the economy when fixed.
Because of widely diverging monetary and fiscal policy, different rates of inflation, currency shocks, the fixed
exchange rate regime has come to an end.
In addition, the US experienced a consistent and growing balance of payment (BOP) deficit.

BOP implies that there was an excess supply of the countrys currency on world markets, and the
government then has 2 options to ease the problems
o Devalue the currency (this increases worlds confidence)

Expand its official reserve to support its currency value (this will meet the supply of each
of the growing economieswhich is a large task)
In fact, US devalued the USD and the treasury department in 1971, suspended purchase/sell of gold
so therefore, most currencies were allowed to float to levels determined by market force as of 1973.
o

4. The Floating Era (1973-1997)

Exchange rate became much more volatile and less predictable than they were during the fixed
period
5. The Emerging Era (1997- Present)
IMF CLASSIFICATION OF CURRENCY REGIMES
Category 1 (Hard Pegs)
These are the countries that have given up their own sovereignty over monetary policy so theyve
adopted other country currencies (i.e., dollarization this can be dangerous) or countries utilizing a
currency board structure, which limits monetary expansion to the accumulation of foreign exchange.
Currency Board exists when a countrys central bank commits to back its monetary base (aka money
supply) entirely with foreign reserves at all time.
Therefore, a unit of domestic currency cannot be introduced into the economy without an additional
unit of foreign exchange reserve being obtained first.
Ex. Argentina (1991-2002)
Dollarization is the use of the US dollar as the primary currency of the country
Arguments for:

sound monetary & exchange rate policies no longer depend on the discipline of domestic
policymakers
Downfalls:

Loss of sovereignty over monetary policy


The country looses the power to print its own money

The central bank no longer serves as the lender of last resort

Ex. Panama, Ecuador
Category 2 (Soft Pegs)
Countries under fixed exchange rates
Ex. China
Category 3 (Floating)
These are countries that are primarily market driven; free float with government intervention
Ex. US
Category 4 (Residual)
All other countries
FIXED VS. FLEXIBLE EXCHANGE RATE
A nations choice as to which currency regime to follow reflects national priorities about all facets of
the economy (i.e., inflation, unemployment, interest rate, etc.)
Therefore, the choice between fixed and flexible rates may change over time as priorities change
Fixed exchange regime is preferred because
stability in international prices
inherent anti-inflamatory nature of fixed prices

Fixed exchange shortfalls

Central banks need to maintain large quantities of hard currencies & gold to defend fixed rate
Fixed rate can be maintained at rates that are inconsistent with economic fundamentals
The Impossible Trinity or The Policy Trilemma
If the currency existed in todays world, it would possess 3 attributes

1. exchange rate stability

2. full financial integration (i.e., free capital mobility)

3. monetary independence
These qualities are termed impossible trinity because a country must give up one of three goals since
the forces of economics dont allow the simultaneous achievement of all three.

Fixed Exchange Rate

Denmark
China
Hong Kong
Free Capital
(US & most
Independent Monetary
Mobility
Euro countries)
Policy

THE EURO
Officially launched in 1999
Backed up by the European Central Bank (ECB)
Goal was to promote stability within the European Union (EU) and prevent/fight inflation
Intention was to compete with the US dollar

Problems because of countries differences like growth rates etc.

Current
Capital

Debit (+)

Credit (-)

ex. when USD buys foreign goods

$800k
$2mil

$800k | $2mil

current acct/debt (+) capital acct/credit (-)

$800k
$800k

ex. When Japanese yun buys American goods

(short term assets) capital acct/debit
$2mil

capital acct/credit
$2mil

Every international transaction gives rise to both debit and credit entries

The EOP must always balance in an accounting sense

THE BANK BALANCE SHEET (source: the Fed 2011)
ASSETS
LIABILITIES
Reserves & cash (15%)
Checkable Deposits (10%)

Because ST liabilities
increased

Securities (19%)
Non-checkable Deposits (savings) (55%)
Loans (56%)
Borrowings (23%)
Other (10%)
Bank-capital (12%)
TOTAL ASSETS = TOTAL LIABILITIES + (BANK) CAPITAL (OR NET WORTHY)
Is a cushion against
borrowings from the fed are called discount loans
a drop in value of its assets.

Financial Crisis is a major disruption in financial markets i.e., sharp declines in asset prices and firm
failures
Ex. tech shock market bubble in 1990s and defaults in the subprime mortgage in 2007-2009.
During the financial crisis, firms and commercial banks suffered billions of dollars worth of
losses.
Households and businesses paid higher interest rates on their borrowings.
This led to the stock market crash

What is a Financial Crisis?

A well functioning financial system overcomes asymmetric information (AI) problems so that
capitals allocated to its most productive uses.

AI is a situation where one partys insufficient knowledge about the other party involved in a
transaction makes it impossible to make accurate decisions when conducting the transaction.
(adverse selection & moral hazard are key components to AI)
o if AI exists, then consumer surplus decreases and producer surplus increases
AI is one of the causes for the financial crisis

Adverse Selection occurs before (ex-ante) the transaction: where potential bad credit risks are the ones who
most actively seek out loans.

Because AS increases the chances that a loan might be made to a bad credit risk, lenders might
decide not to make any loan, even though good credit risks can be found in the marketplace.

AI = AS + MH agency theory or principle-agent problem, which means that they dont

have the same interest or that theres a missing link from the agent so the principle cant monitor.
o This is cause of financial frictions (barriers to efficient allocation capital) leading to
the financial crisis
Moral Hazard occurs after (ex-post) the transaction: where the lenders run the risk that the borrower will
engage in activities that are undesirable that makes it less likely that the loan will be paid back.

Because moral hazard lowers probability that loan will be repaid, vendors may decide not to
make a loan.
Dynamics of Financial Crisis in Advanced Economies
Stage 1. Initiation of financial crisis
a. Mismanagement of financial liberalization (elimination of restrictions on financial markets
& institutions) and/or innovation

in the short run, prompts financial institutions to go on a lending spree i.e., credit boom
leading to a rise in risky lending risky lending leads to default on loans

eventually, losses on loans begin to accumulate banks net worth will then decrease.
recall A (normal terms) = L (real terms)+ Capital/Net Worth
o banks will have less loans to give out, leading to deleveraging

leads to lenders / investors pulling out funds leading to credit freeze leading
to a lending crash
b. Asset-price Boom and Bust

investors irrational or illogical thinking drive prices of assets such as equity shares and real
estate above their fundamental economic values asset-price bubble (credit boom)
when the bubble bursts, asset prices realign with fundamental economic value banks net worth
declines deleveraging (aka, the price will fall and hurt the banks network)
c. Increase in Uncertainty

increase in uncertainty leads to increase in financial friction

Stage 2: Banking Crisis

Credit freeze, deleverage, & weak net worth, some institutions were in state of insolvency bank
panic (a situation in which many banks fail simultaneously) contagion
Stage 3: Debt Deflation
Debt deflation occurs when a substantial unanticipated decline in the price level net worth goes
down and burden of indebtedness increases

because, in advanced economies, debt payments are contractually fixed in nominal terms,
therefore, when price levels decrease, liabilities (in real terms) increases
o assets are still in nominal terms

Ex. (before price level decreases)

A = L + NW 100 = 90 + 10
(after price level decreases 10%) 100 = ((10% x 90) + 90) 100 = 99 + 1
Dynamics of Financial Crisis in Emerging Market Economies
Stage 1. Initiation of Financial Crisis
a. Mismanagement of Financial Liberalization and Globalization
b. Severe Fiscal Imbalances

fiscal Imbalances are either when a. the debts greater than future incomes or when b.
expenditures are greater than revenue.

govts. in emerging market countries (Russia 1998, Ecuador 1999, Turkey 2001, Argentina 2002)
when are faced with large fiscal imbalances and cannot finance their debt, they often react by
persuading banks to purchase government debt. (banks are unhappy about this)
o bank net worth will then shrink bank panic
o investors will sell their bonds prices of bonds will then drop bank system weakens
Stage 2. Currency Crisis

Domestic currency became weaker currency mismatch speculative attack (which is when
speculators engage in massive sales of currency)
Supply > demand the value of the currency collapses, which all leads to a currency crisis
What can the government do about this to help the currency?
> use reserves of foreign currency to buy the domestic currency (comes with potential probs.)
> increase interest rate to attract more investment (but theres big problems with this, i.e., domestic banks
will pay more for their borrowings)
> devaluation
Stage 3. Full-Pledged Financial Crisis
Whenever one talks about financial crisis, one must talk about currency crisis, since financial crisis
and currency crisis are referred to as twin crisis

International parity conditions are the econ. theories that link exchange rates, price levels, &
interest rates

The Law of One Price is if 2 countries produce an identical good, and transportation costs are negligible,
then the price of the good should be the same throughout the world no matter which country produces
it.
Therefore, comparing prices would require only a conversion from one currency to the other.
Ex. (in written notes)
Theory of Purchasing Power Parity (PPP): exchange rates between any 2 currencies will adjust to
reflect changes in (national) price levels (measure by CPI not by similar baskets of goods) of the 2
countries.
EX. if P (price level) rises 10% relative to the USs, for the law of one price to hold, the USD will
appreciate by 10%
Absolute PPP: the spot E(sub t) is determined by the relative prices of similar baskets of goods.
Ex. suppose that American steel costs $100/ton and identical Japanese steel costs 10,000/ton
(continued on written notes)
From the example, whats the demand for American steel in both countries?
Answer: demand for American steel decreases to zero, unless E(sub t)= 100/$
PPP through Real Exchange Rate is rate at which domestic goods can be exchanged for foreign goods;
its the price of domestic goods relative to the price of foreign goods denominated in the domestic
currency.
Ex. (in written notes)
Relative PPP: if the spot exchange rate between 2 countries starts in equilibrium, any change in the
differential rate of inflation between them tends to offset over the long run by an equal but opposite
change in the spot exchange rate
Ex. (in written notes)
Exchange Rate Pass-Through is the measure of response of imported and exported product pairs to
exchange rate changes.
Ex. (in written notes)
Concept of price elasticity of demand (e sub p) is used when determining the desired level of passthrough.