Exchange Rates

The $ of one country’s currency stated in terms of a second country’s currency

Allows us to compute $ of one country’s exports in terms of other country’s money

Depriciation=Increase in Imports=Decrease in CA=Increase in Financial Assets

Appreciation=Decrease in Imports

Reasons for holding Foreign Currency:

Trade and investment-to make receive payment for transactions; include tourists

Interest Rate arbitrage-borrow rates are low, loan where rates are high, primary linkage between economies, keeps interest rates from diverging too much

Speculation-chance for profits by correctly predicting exchange rate movements, some believe this keeps currency values in alignment, others consider destabilizing

Foreign Exchange Market

Commercial banks are at the center of market.  Almost every sizable international transaction involves accounts at commercial banks.  They hold inventories of foreign currencies as part the services to customer.

Interbank trading:

Currency trading between banks

Corporations and individuals

Nonbank Financial Institutions-Mutual Funds, Hedge funds, Passion funds

Foreign exchange brokers-most major banks don’t deal with each other, but rather through a broker

Permits banks to maintain desired foreign exchange balance

Central Banks

  • Volume of foreign exchanges not large

Effects of Changes in the rates of home and foreign economic growth on the supply and demand curves for foreign exchange Graphs

F-forward exchange rate

R-spot rate

The Effects of an Increase in Home’s Interest Rates

Real Exchange Rate=Nominal Exchange Rate x Foreign Prices/Domestic Prices

Fixed exchange rate system

Flexible (floating) exchange rate system

Banking Crisis-steep recession

An Exchange rate crisis is caused by macro imbalances.  Imbalances in government budgets, trade balances and currency values may set off.  This may be a result of over-expansionary fiscal policies.  Cause budget and current account imbalances, inflation.  Inflation causes appreciating real exchange rates.  Difficult to maintain fixed/pegged rate, currency becomes overvalued, leads to capital flight (get out before rate falls).  Describes many issues that began in developing countries.  This in turn usually leads to a recession.

Crises caused by Volatile Capital Flows

Economics are highly vulnerable to high votality of financial capital and ability to instantaneously shift capital. ¬†Large volume of saving remains domestic, but increasing amount going international and responds to interest rates, exchange rate expectations, and economic activity. ¬†The¬†‚Äúherd‚ÄĚ mentality can turn small crisis into big one. ¬†There is a mismatch between time frame of borrowers and lenders can exacerbate problem (short-term deposits but long-term loans)

In domestic policies, crises are not avoidable, but can be mitigated.  Maintain credible and sustainable fiscal/monetary policy.  Active supervisors and regulation of financial system.  Provide timely information about key economic variables.  Desired extent of domestic policies uncertain.  Bail out banks?  Limit capital outflows/inflows?  Manage exchange rates.

Moral Hazard-financial sector dysfunction spreads problems to the rest of economy, creating a large incentive to keep financial sector operational.  However, if it is someone will bail you out of your problems.  You are less likely to act prudently or manage risk: MH.  Financial sector regulation: Basel Capital Accord II.  Captial requirements decrease Moral hazard by requiring bank owners to invest in their own banks

Supervisory review: provide standards for daily business practices and risk management oversight

Information disclosure: encourage market discipline by requiring disclosure

Why didn’t it prevent 2007 meltdown?  New forms of finance and financial instruments.

Crises Management

Cured by: Cutting deficit (and intensify problems of collapsing currency).  Raising interest rates to help defend the currency (and spread recession).  Letting currency float.  Politically difficult.  Caused by sudden Capital flight; are harder to cure.  Collapsing currency can be defended through interest rate hikes, may cause bankruptcies and other problems.

Countervailing Duty: Tariff granted to U.S. industry hurt by a foreign country’s subsidizing its firms; if industry can prove: Subsidies allow foreign firms to sell products at lower prices, Countervailing duty seeks to counter the effect of the benefits from a subsidy.  Problem: defining a subsidy is subjective and it is infrequent only being used 4-5 times a year.

Uruguay Round defined subsidies as:

(1) Direct loan or transfer

(2) Preferential tax and treatment

(3) Government provided goods/services other than infrastructure; ie-training

(4) Income and price supports

Antidumping Duty-tariff levied on an import that is selling at a price below product’s fair value

Problems: defining fair value is subjective, source of tension between countries, approximately 21 duties imposed per year.  Ultimately a country can disagree with WTO or other world organizations and get out.  WTO Policy-Dumping occurs when an exporter sells a product at a price below the one it charges in their home country.

To determine whether a good is being dumped:

  • Compare to price in third country markets
  • Estimate cost of production
  • Estimate foreign firm‚Äôs production costs
  • Countries will probably be pissed if you accuse them of dumping
  • Not only does a country have to prove other country is dumping, also has to prove that it‚Äôs hurting them

Problems: Economic theory and legal definitions are not in agreement.  If a firm is not earning a share above average profits somewhere, it cannot maintain a price somewhere else that is below the cost.  Firms often sell below costs.  They may sell at below costs in order to penetrate a market.  May go for extended periods selling at prices that do not cover fixed costs as long as the costs of variable inputs (labor and materials) are covered.  The labor argument for tariffs, argues that it is unfair for a country to face imports from countries that have lower wages.  The problem with this argument is that it ignores the fact that cross country wage differences reflect productivity differences and ignores the fact that tariffs or quotas are an expensive method of saving jobs

Escape Clause Relief-Temporary tariff of imports to allow a domestic industry to escape the pressure of imports and obtain a period of adjustment.  Refers to a clause in U.S. and GATT trade rules.  Initiated when a firm or industry petitions the VSITC directly for relief.  Not very common.

Section 301-U.S. Trade Representative (USTR) to take action against any nation that persistently engages in unfair trade practices; US defines meaning of unreasonable and unfair trade policies

Nontariff Trade

Labor Standards

  • Formal Trade Barriers have been declining since WWII
  • New obstacles have been appearing
    • Unintentionally as a result of national laws and regulations for domestic reasons

Achieving Deeper Levels of Integration:

(1) Harmonization of Standards: Share common standards

EX: Electric sockets (shape), flash drives

(2) Mutual Recognition of standards

We will honor your law and you will honor ours

Keep domestic standards

Recognize foreign standards

Ex: minimum wage in different countries

(3) Separate Standards

Keep domestic standards

Refuse to recognize

Ex: China Lead Paint

No one approach is best

  • Some create larger markets and greater efficiency (Ex. Common size electrical outlets)
  • Some freeze in place inferior technology
  • Some less-developed countries have less ability to enforce standards
  • Can be probably for less developed countries what works best for situations?

‚ÄúRace to the Bottom‚ÄĚ

  • Countries with high standards-forced to lower standards or experience a loss of jobs and industry
  • Unfair trade practice complaint: failure to enact or to enforce standards gives firms in the countries with lower standards a commercial advantage

How do you compete?

Ex: We have to lower our minimum wage because it’s hurting our trade

-In order to compete, countries have to lower standards

What are labor standards?

Wide ranging with no universal agreement

Basic rights proposed by international labor organization and OECD

  • Prohibition of forced labor
  • Freedom of association
  • Right to organize and bargain collectively
  • End to exploitation of child labor
  • Nondiscrimination in Employment

Other potential standards-no agreements-most contentious

Ex: minimum wages, limits on hours worked, health and safety issues

Arguments for Anti-globalization

Transbouundary vs. nontransboundary effects

Pollution havens

Kuznet’s Curve

Pollution Spillovers


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