EC104 Topic 6

amarjotsidhu's version from 2015-06-09 20:45

Section 1

Question Answer
Macreconomic trilemma (definition)You can only have 2 of: independent monetary flows, fixed exchange rate and free capital flows
3 solutions to macroeconomic trilemma block capital flows; abandon fixed exchange rates; abandon monetary policy
Block capital flows (solution)money can't leave and enter freely, preventing arbitrage; domestic and foreign prices for money= separate; but requires financial repression - investors from abroad not allowed to invest freely and domestic savers are not allowed to invest freely abroad e.g. China
Abandon fixed exchange rates (solution)currencies float in value against each other; this keeps open capital flows and allows independent monetary policy; but, introduces exchange rate risk for investors and increases price variability for imports and exporters
Abandon independent monetary policy (solution)central bank establishes fixed exchange rate by guaranteeing convertibility; global interest rates must be accepted by central bank; allowed capital flows and stabilises exchange rates; but heavily restricts policy response to demand shocks -> may require accepting severe economic downturns (GD); no guarantee that global economic conditions will match domestic ones
EU and macroeconomic trilemmaby allowing free capital flows + floating exchange rates, they had to abandon autonomous interest rates (now fixed by ECB)
Suppose if UK tries to have all 3if the US raises interest rates, then this will draw capital from the UK and to keep a fixed exchange rate, the UK will need to sell reserves of the $ to maintain a fixed exchange rate BUT, reserves don't last forever = UK must raise interest rates or end convertibility or stop investors trading between the currencies
Hume's price specie modelstates that domestic prices and exchange rate keep each other in equilibrium; assumes currency is gold coinage; based on the Quantity Theory of Money (the more money you put into the economy, the more prices will go up e.g. if a country imports more than it exports, gold will flow abroad in payment = less gold means lower domestic prices (Deflation) according to quantity theory = lower domestic prices make imports more expensive and exports less expensive = imports reduced and exports up = country in equilibrium
Gold Standard era1870-1914 = countries fixed their exchange rates to a quantity of gold through convertibility (fixed ratio of currency values according to gold)
How does gold standard work?guarantee conversion of money to gold (CB retains gold and foreign currency reserves); value of currency must stay within the "gold points"; central banks must counteract imbalances (by selling reserves) ; if CB begins to run out of reserves, it must try to raise interest rates, causing savers (domestic and international )to save more, increasing reserves
Advantages of the gold standardpredicability; stability (inflation easy to control); multilateral balance of payments clearing (all currencies equivalent = balances can be cleared easily; credibility (adhering to gold standard = good housekeeping seal of approval); lowers risk premium for peripheral countries who wanted long term investment but did not yet have good credibility
Origins of the gold sandardBritish informally adopts gold in the 18th century, fixing the value of currency to hold in 1821; by 1980, most important world economies were all on the gold standard e.g. US, Germany
Britain leading gold standardBritain was at the centre of the first globalisation (clearinghouse for world trade, world gold market, world capital market); but BoE not most important central bank, smaller than Banque de France, Reichsbank
Changes brought by WWIGold standard suspended during wartime; massive international debt obligations for Germany; sale of British foreign assets; rise of US and Germany
Return to gold standard in 1920sseen as good policy but central bank cooperation does not return, economic crises become more severe
Changing role of monetary policy in the 1920sbefore 1914, most important objective = encouragement of international trade and investment; by 1920s, domestic monetary policy more important (Severe economic crises = pressure for monetary stimulus)
"Golden Fetters"being on gold standard during great depression = harmful to growth; abandoning convertibility critical for 1930s recovery; strong correlation between leaving gold and timing of recovery e.g. Britain was amongst the first to leave and amongst the first to recover from GD

Section 2

Question Answer
International division of labour (Adam Smith)if each country specialises then incomes will increase due to increased productivity; barriers to trade prevent division of labour = decrease incomes
Comparative advantage (David Ricardo)countries should trade based on relative efficiency
Causes of comparative advantageanything that changes relative prices; factor prices, technology, institutions, external economies of scale, transportation costs
Rothbarth-Habakkukfactor prices will determine comparative advantage; labour unit labour costs for making labour intensive goods in countries where labour is relatively abundant, etc.
Technological differenceslower unit labour requirements with better technology; some products better made in high tech, high wage countries with skilled workers e.g. Silicon Valley
Impact of institutionssome industries require credible institutions (R&D , finance) e.g. require payments while others have less demanding requirements e.g. textiles and agriulture
Gains from trade liberalisation direct effects (welfare triangle) - consumers benefit from quality and price; more important = linkages (export-competitive industries can support other industries to become more efficient); indirect effects (productivity gains) - reduced costs to production, increased competition = higher productivity
Arguments against trade liberalisation (HO & SS)Hecksher-Ohlin and Stolper-Samuelson - demand for the factor used intensively in each country's comparative advantage will push up the price of that factor
Argument against trade liberalisation - Stolper-Samuelson (SS)shows that trade liberalisation can make providers of the local scarce factor of production worse off; trade can make capital owners worse off in capital scarce countries; it can make workers worse off in labour scarce countries = why unskilled labour in developed countries suffers from globalisation = trade can increase inequality in labour scarce countries
Role of institutions in trade negotiationsinstitutions can organise producers who gain from trade to lobby governments; exports on both sides fight for free trade so long as they know their competitors will face the same constraints; reciprocal market access guarantees = organised by GATT, WTO, etc.
Juggernaut effecttrade liberalisation will expand the export sector as specialisation occurs = reduce the import competing sector = anti trade liberalisation camp will shrink
Baldwin et al. on juggernaut effecttrade liberalisation becomes self reinforcing
types of trade barriersnatural barriers (transport costs, information costs); policy barriers (wars, blockades, tariffs)
barriers to trade over timeuntil mid 19th century, transport expensive and dangerous, run by only charter companies who could organise defense; mid 19th century = big fall in costs e.g. railroads, telegraphs; continue of trend in 20th century e.g. air freightm
Increasing globalisation before WWILow tariffs ; "most favoured nation" clauses (agreement that one country signs with another must be at least as favourable as other agreements that that country has signed); lower transport costs (Steam shipping, railroads) -> Britain dominant
Globalisation after WWIReverse; higher tariffs; collapse of globalisation during great depression
Globalisation post WWIIRapid trade liberalisation; further reductions in transport; maintenance of protectionism by US (big internal transport costs); US only opens up after GATT
GATTmultilateral trade liberalisation; huge welfare gains; continued protection of agriculture; big gains

Section 3

Question Answer
What are capital flows?movement of money and ownership across countries e.g. money, debt (bonds), GDI
Advantages of free capital marketsalleviate domestic savings constraint on investment; smoothing consumption (distortion from booms/crises can be cleared); imposition of discipline on government policy; diversification of risks; better allocation of resources
Disadvantages of free capital marketsrisk of financial crises increase (governments can't react to crises); constraints on policy choices (trilemma) ; foreign control and ownership
Effects of capital account liberalisationmodestly positively related to growth in non-crises periods = good for growth; but capital market liberalisation is often followed by crisis in fast growing countries ('hot money'' - liquid capital invested in short term projects) can cause volatility = bad for growth ; free capital flows increase risk of financial crises (simultaneous banking and currency crisis)
Early capital flows15-16th century - capital flows happened alongside trade; 17-18th century - foreign investment flows happened via chartered monopoly companies (EIC); international investment = insecure = low capital flows
1820s capital boomsovereign bonds issued by newly independent Latin American countries
Latin American capital flow boom problemLatin America proved unable/unwilling to pay back debt - overly optimistic, badly informed investors; no simple international enforcement mechanisms e.g. someone made up state of Poyais and sold bonds ; defaults = first global debt crisis in 1825
Capital flows during gold standard era*1870-1914) ; boom in capital flows; renewed sovereign debt markets; birth of MNC; increasing capital integration
WWI and capital marketsmarkets collapsed; massive war debts ; international cooperation broke down; defaults in 1930s destroy capital markets; wartime finance in the 1940s crowds out international finance (capital used in war rather than investment projects)
Post war capital flowsBretton woods system restricted capital markets, nationally focused; post-war rebuilding of Europe done largely with domestic savings (not international investment; after 1971 (collapse of Bretton Woods), capital market globalisation occurred (1980s-present)
Observing capital market integrationif markets are free (no controls) then rates of return should equalize -> investors should move money from low return areas (icnreasing interest rates) to high return areas (lowering interest rates)
Restoration of capital markets in 1980sAfter Bretton Woods, foreign capital growth reached pre-WWI levels
Distribution of foreign assets heldUK was dominant source of international investment capital before WWI; post 1945, US overtook UK; since 1980, much greater diversity in suppliers of foreign capital exists, suggesting integrated capital markets
Why doesn't capital flow from rich to poor countries in the 20th century?(Lucas Paradox) institutions matter; insecure property rights in poor countries; no constraints on the executive in poor countries; rate of return adjusted by risk
Asian crisis 1997/98Asia was emerging = attracted much investments; when markets turned, confidence began to collapse and foreign investors pulled out quickly = BoP came under pressure, currencies depreciated and domestic banking sector became illiquid; hot money outflow leads to currency crisis and in turn domestic crisis
Findlay and O'Rourke on link between growth of intercontinental trade, extension of New World frontiers and intercontinental factor flowsfactor flows directed toward resource abundant regions = US; clearing and cultivating land = heavy investment of labour and capital which only made sense if railroads present to transport output to distant market; constructing railroads = heavy investment of labour and capital while new populations who settled new towns needed roads, etc. = more capital and labour required to provide infrastructure; New World economies labour and capital scarce = European factors of production imported and Europe= ready market for output
Eichengreen on problem caused by tariffsthey prevented the balance restoring mechanism associated with the price specie flow model
Eichengreen on credibility of system and cooperationcredibility of the system lied in the international cooperation of Britain, France, Germany, Russia and other countries. Britain = reliable source of flows and gold from Europe to US but in times of crisis, Britain's resources were inadequate
Bordo and Rokoloff on benefits of being on gold standardthose countries that stayed on gold standard had lower fiscal deficits, more stable money growth and lower inflation rates than those who were not on it
Bordo and Rokoloff on gold standard as a commitment mechanismforced government announcements to be time consistent; govts. could no longer alter monetary growth from its preannoucned path = monetary stability
Rodrik on political trilemmayou can have 2 of - nation state, democratic politics and full economic integration. Previously Bretton Woods = integration and now EU has seen big moves towards integration
Brakman on importance of locationtransportation costs and barriers to trade = v. important in shaping world economy
O'Rourke and Williamson on when globalisation startedvery modern phenomenon - began in 18th century after which price convergence occurred
Crafts on financial liberalisationa high risk policy that on average has a weak impact on growth