AN INTRODUCTION TO INTERNATIONAL TRADE AND FINANCE

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Introduction to Economics ECO401

UNIT - 15

Lesson 15.1

AN INTRODUCTION TO INTERNATIONAL TRADE AND FINANCE

INTERNATIONAL TRADE

By international trade, we mean the exchange of goods and services between different

countries. For any individual country, trade is important for several reasons: the trade balance

drives the BOPs and deeply influences foreign exchange reserves and the exchange rate;

trade helps determine the overall production and consumption possibilities in the economy

(both in the static and dynamic contexts, as we shall see below); net exports are an important

component of aggregate demand, and hence income and employment; and so on.

Interesting Facts about the World Trade:

Four interesting facts about world trade help place it in perspective:

The value of world trade has increased 20 fold over the 1930-2000 period

ii.

On average, the contribution of a country's exports to its GDP has doubled from

about 30% to 50% over the same period

iii.

Over the last 50 years, the share of world exports has changed from 50%-50%

between manufactured goods and primary products to 75%-25% in favour of

manufactures.

iv.

50% of world trade happens between HICs, 14% happens between LICs and the rest

involves both HICs and LICs.

Why do countries trade?

Because there are mutual gains from trade. But then, what are these gains, and how are these

realized? Comparative advantage theory provides the first answers to such questions. The

theory says that countries will gain by specializing in and then exporting the good they have a

comparative advantage (or lower opportunity cost advantage) in.

The Concept of Comparative Advantage:

To illustrate the concept of comparative advantage, we take the example of two equi-sized

equi-endowment countries, US and UK. US produces 40 and 60 units of cotton and food p.a.

respectively (using all available resources), while the UK produces 30 and 20 units of cotton

and food p.a. respectively (using all available resources). Clearly, the US has an absolute

advantage in the production of both cotton and food. By absolute advantage it is meant that

the US is more efficient at producing both food and cotton than the UK. However, upon

computing the opportunity costs of producing cotton and food in either country, is revealed that

the opportunity cost of producing one unit of cotton in the US is 1.5 units of food, whereas the

opportunity cost of producing one unit of food in the US is 0.67 units of cotton. By comparison,

the opportunity cost of producing one unit of cotton in the UK is 0.67 units of food, whereas the

opportunity cost of producing one unit of food in the UK is 1.5 units of cotton. Thus, the US has

a lower opportunity cost (comparative advantage) in the production of food while the UK has a

lower opportunity cost (comparative advantage) in the production of cotton. By specializing in

the goods they have comparative advantage in and then trading between them, both two

countries can enhance their consumption possibilities beyond those implied by autarky (i.e., a

situation of no trade where the PPF and CPF are the same).

The Source of Comparative Advantage:

The source of comparative advantage can be productivity differentials (Ricardo) or differences

in factor endowments (Hechshcer-Ohlin). In the latter case, given two countries (one abundant

in labour and one abundant in capital), and a labour-intensive good and a capital intensive

good, the labour abundant country will have comparative advantage in the production of the

labour-intensive good while the capital abundant country will have comparative advantage in

the capital-intensive good.

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A natural policy prescription emanating from the above argument was that LICs which are

often abundant in labour should produce primary products while rich countries alone should

produce capital-intensive goods.

Criticism against Hechscher-Ohlin type trade theories:

The major criticism leveled against Hechscher-Ohlin type trade theories are that they views

comparative advantage in an essentially static sense; i.e. if Pakistan is better at producing

cotton and Japan better at producing, then this situation will always prevail. Critics argued that

comparative advantage can and should be viewed in a dynamic (time-varying) sense, and that

it was not wise to rule out the possibility of Pakistan developing comparative advantage in cars

at some future point in time.

Naturally, the policy advice of such dynamic comparative advantage theorists was very

different from 6 above. These people argued that countries build comparative advantage in

capital-intensive goods by protecting their domestic industries against cheap manufactured

imports from abroad. The protection is operationalised through tariffs (tax on imports) or

outright quota restrictions. The output from the local infant industries (protected in this way)

then be used to substitute imports of manufactures. Many LICs (e.g. Mexico, India) religiously

followed this policy prescription in the mid-20th century, but with mixed results.

While it is true that many countries pursued, fully or partly, the policy prescription suggested by

dynamic comparative advantage theories, only a handful of them were genuinely successful in

changing their comparative advantage: Korea developed comparative advantage in the auto

industry, Taiwan in microchips, Malaysia in shipbuilding and consumer electronics, Brazil in

light aircraft. Of these, most countries (like the East Asian tigers) had a marked export

orientation in their industrialization and trade policies. This is what set them apart from the

failures, which had a more import-substituting approach to industrialization. These issues are

taken up again in lecture handout 45.

Welfare Effects of Tariff:

It is important to understand what the welfare effects of a tariff are. While a tariff may seem

desirable because it generates revenue, and may help protect domestic producers, it can often

leave domestic consumers quite worse off. This is because domestic producers only have to

compete with the higher (tariff-inclusive) price of imported goods, not with the actual price

those goods are being produced at. Thus domestic consumers in a way are forced to consume

goods produced by less efficient domestic producers.

OPTIONAL: It is instructive to place trade theories in the context of the actual history of the

international trading system. In particular, it is useful to see:

How trade liberalization efforts have proceeded under the GATT/WTO8 framework? For

this, please see file attached: WTO.ppt

ii.

If the recent rise in regionalism a threat to multilateral trade liberalization and the WTO

system? See file attached: Regionalism.ppt

INTERNATIONAL FINANCE

International finance is concerned with, among other thing, the mobility of financial capital

across countries, and the problems and opportunities this mobility presents individual

countries with. It would not be too inaccurate (in present day context) to say that while

international trade deals with the current account, international finance deals with the capital

account of the BOPs. That said, issues like the choice of exchange rate regime and of

modern-day balance of payments crises also fall firmly within the purview of international

finance.

GATT stands for the General Agreement on Tariffs and Trade; WTO stands for World Trade Organization.

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Types of Transaction on the Capital Account:

It is useful to recall the major types of transactions recorded on the capital account: foreign

direct investment, foreign portfolio investment, debt flows and aid flows. FDI and FPI are

examples of essentially private capital flows. Debt flows could be official (involving multilateral

agencies or other country governments) or private (commercial). Aid flows are almost always

official.

Growth in Private Capital Flows:

There has been a phenomenal growth in private capital flows since the 1990s. To give an

example, the value of capital flow transactions has risen to about 100 times the value of trade

transactions. This was not always so, as until a long time after the start of the 20th century,

trade flows remained either equal to or greater than private capital flows!

The rapid rise in private capital flows highlights the speed of integration of financial markets

across the world. Innovations in communications technology and financial market engineering

today permit cross-country transactions worth billions of dollars to be executed in real-time. At

the same time, capital account liberalization in many countries, rich and poor, has played an

important role in boosting these flows.

International Capital Mobility:

The case for international capital mobility was most clearly articulated by MacDougal in 1960.

He presented a framework involving two countries, one abundant in financial capital and one

scarce in financial capital. As has been discussed earlier, the abundance of money within an

economy leads to low interest rates, whereas its scarcity causes interest rates to be high.

Thus, the capital-rich country has low interest rates, while the capital-scarce country has high

interest rates. As a result, there is over-investment in the former, and under-investment in the

latter.

If both countries could jointly liberalize their capital accounts, some of the capital would fly

from the capital-rich countries to the capital-scarce countries to take advantage of the higher

interest rates prevailing there. This would equalize the supply of capital in both countries

causing their interest rates to equalize. Thus, desirably, interest rates in the formerly capital-

rich country rise (causing over-investment to disappear), while interest rates in the formerly

capital-scarce country fall (causing under-investment to disappear). Another way to state this

is that capital would flow to (or be allocated to) its most productive uses.

Benefits of International Capital Mobility:

People have suggested other benefits of international capital mobility:

Consumption smoothing: the ability to borrow from the international capital market

allows a country to sustain a higher level of expenditures in times of recession or

current account difficulties, than would be possible if the economy were not integrated

into the international financial market.

ii.

Risk diversification: given international investors' ability to invest in other the assets

(bonds, stocks, property etc.) of countries other than their home countries permits them

to diversify their investment risks. Similar benefits may also accrue to issuers of debt

(or borrowers of capital) who now enjoy a more diversified creditor pool. This enables

them to bargain down their borrowing rates as well as cushions them in the face of any

one of the funding sources drying up.

iii.

Fiscal policy becomes more effective: Given fixed exchange rates, expansionary

fiscal policy would not have any crowding out effects if the capital account is open. This

is because as soon as interest rates begin to rise due to higher government borrowing

(to finance the higher spending), capital flows in through the capital account, which

given a fixed exchange rate, expands the foreign exchange reserves and hence the

money supply. This is tantamount to the LM curve to shifting to the right. As such,

given excess capacity in the economy, income and output rises by much more than

would have been possible without an open capital account. By similar logic, the effects

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of a fiscal contraction on income become more pronounced given a fixed exchange

rate and open capital account.

Disadvantages of International Capital Mobility:

As with everything else in economics, there is another side to the story as well; i.e. there are

disadvantages of free capital mobility as well, and it is important to understand them in order to

form an informed view on the issue.

Monetary policy becomes ineffective: Given fixed exchange rates, imagine what

would happen if the central bank tried to increase money supply. LM would shift down

putting downward pressure on the interest rates. However, as soon as domestic

interest rate falls below the world interest rate, the capital account starts experiencing a

deficit (outflows). This outflow is mirrored by a fall in foreign exchange reserves which

causes a money supply contraction. Thus the effects of the initial expansion are totally

undone. The inability of a country to retain monetary policy autonomy, at the same time

as a fixed exchange rate and an open capital account is called the unholy trinity

principle. The unholy trinity principle simply says that the three things above cannot

coexist; one must be sacrificed. It can be monetary autonomy, or capital account

openness or fixed exchange rates.

ii.

Capital flows are pro-cyclical and therefore exacerbate boom-bust cycles: One of

the criticisms of global capital is that it moves in sync with countries' business cycles,

thus magnifying economic fluctuations (rather than smoothing them out); e.g.: more

foreign money would flow to a country when it is experiencing a capital inflow boom

(i.e. exactly the time when it does not need more money, per se) often leading to credit

booms, property bubbles, inflationary pressures, loss of competitiveness and BOPs

problems. Conversely, when conditions are tight, and countries are need foreign

capital, the latter is not available, as all foreign investors "want out."

iii.

Global capital is highly volatile, making countries targets of speculation: Some

types of capital flows are more volatile than others. For example, foreign direct

investment, official concessional aid etc. is more stable than foreign portfolio

investment, and commercial bank lending, which are immediately reversible. The

recent rise in capital flows reflects an asymmetric increase in this highly reversible and

short-term type (also called hot money). Capital follows short term rates of return (1-6

month interest rates for e.g.) in the world, and as soon as this rate falls in one country,

it exits that country and enters another with a higher rate, with no regard for the effects

on the economy left behind (stock market crash, recession, financial crisis). Also, due

to this inherent volatility, the timing and volume of these flows is often determined by

financial speculators, increasing the likelihood that any BOPs difficulties and financial

or currency crises will be attributable more to a reversal in such investors' preferences

and attitudes than to a weakening of the affected country's macroeconomic and

financial sector fundamentals (healthy financial system, low inflation, stable real

exchange rate, absence of unholy trinity etc.). There is agreement that the recent spate

of financial crises in Latin America, East Asia and Russia was at least partly due to

such speculation activity (and subsequent herding behaviour of investors9).

Herding is a term used to describe how investors enter and exit countries, i.e. all at once. Thus, if foreign

investors have invested money in a country and some of them (and these are usually the ones with greater

speculative tendencies) think the economy is going down and it's time to take their money out, and they act on

their expectations, the other investors will all follow their lead. This is because the other investors would not want

to take the chance of staying behind and suffer through either a devaluation of the currency of a BOPs crisis.

However, by acting together, they often lead to greater losses for both themselves and the host country.

Importantly, herds are often defined in regional terms, i.e. if investors take their money out of one economy in a

region, foreign investors in the other regional economies will join the herd as well, plummeting the whole region

into crisis. In the very recent crises of the late 1990s, such crisis contagion was also seen between regions, i.e. an

exit Asia strategy being followed by an exit all emerging markets strategy (irrespective of whether those markets

are in Asia or in Latin America or in Central or South Asia).

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Suggestions to Cure the Problems of Global capital Mobility:

Given these problems with global capital mobility, there are three major cures suggested. The

first focuses on recipient countries and the importance of these countries to further strengthen

their financial and macroeconomic fundamentals. The second focuses on reforming the

international financial architecture in a way that speculators and irresponsible herding

behaviour can be discouraged (through a threat of penalty). Also this approach argues for the

setting up of an international lender of last resort which could lend to countries in dire need of

foreign exchange, so that full-blown crises can be avoided. The third approach stresses the

use of tax-like controls on capital movements, structured so as to penalize round-trippers more

heavily.10 This approach recognizes that the main culprit in modern day financial crises is often

foreign investors, and therefore host countries themselves should find ways to control (and

tame) them. Supporters of this policy route also point out the difficulties, or lack of international

willingness to, reforming the international financial architecture.

OPTIONAL: For a detailed discussion on crises, and also on how exchange rate policy can

help avert them, see Financial crises and exchange rates.ppt

Chile, for e.g., imposed an unremunerated reserve requirement on all foreign capital coming in. The requirement

essentially was that 10% of any individual investment inflow would have to be deposited with the Chilean central

bank for a fixed period of one year. For long-term investors, the implied tax of such a requirement would be small,

but for round-trippers who wish to bring money in and out of Chile several times within a year, the tax would be

huge.

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END OF UNIT 15 - EXERCISES

Why does the USA as a whole not specialise as much as General Motors or Texaco

(individual US companies)? Why does the UK not specialise as much as ICI? Is the

answer to these questions similar to the answer to the questions, `Why does the USA not

specialise as much as Luxembourg?', and `Why does ICI or Unilever not specialise as

much as the local butcher?'

There are two elements to the answer. One concerns costs, one concerns demand and

revenue.

In terms of costs, as a firm or country specialises and increases production, so the opportunity

costs of production are likely to fall at first, due to economies of scale, and then rise as resources

become increasingly scarce. The butcher's shop may not have reached the point of rising long-

run opportunity costs. Also it is too small to push up the price of inputs as it increases its

production. It is a price taker. ICI and Texaco, however, probably will have reached the point of

rising opportunity costs. Countries certainly would have if they specialised in only one product.

Thus the larger the organisation or country, the more diversified they are likely to be.

Turning to the demand side: the butcher's shop supplies a relatively small market and faces a

relatively elastic demand. It is therefore likely to find that complete specialisation in just one type

of product is unlikely to lead to market saturation and a highly depressed price. Large

companies, however, may find that complete specialisation in one product restricts their ability to

expand. The market simply is not big enough. Countries would certainly find this. The USA

could hardly just produce one product! The world market would be no where near big enough

for it. The general point is that overspecialisation would push the price of the product down and

reduce profits.

If Parvez took two minutes to milk the sheep and Tauqeer took six, how could it ever be

more efficient for Tauqeer to do it?

Because Tauqeer might take more than three times longer than Parvez to do other jobs, and

thus Tauqeer would have a comparative advantage in milking the sheep.

Country L can produce 6 units of wheat or 2 units cloth using X amount of resources in a

year; Country D can produce 8 units of wheat or 20 units of cloth using X amount of

resources in a year. What are the opportunity cost ratios and which country has

comparative advantage in what?

The opportunity cost of wheat in terms of cloth is 2/6 in L and 20/8 in D (i.e. 7.5 times higher in

D).

The opportunity cost of cloth in terms of wheat is 6/2 in L and 8/20 in the D (i.e. 7.5 times higher

in L).

Thus L has a comparative advantage in wheat production while D has comparative advantage in

cloth production.

Under what circumstances would a gain in revenues by exporting firms not lead to an

increase in wage rates?

When there is such surplus labour (e.g. through high unemployment or the firms being legally

required to pay minimum wages) that an increase in demand for labour will not bid up the wage

rate. At least, however, unemployment will probably fall, unless new workers flood in from the

countryside to take advantage of new jobs created in the towns.

Two countries produce televisions and exchange with each other. If 4 units of one country's TV

exports exchange for 3 TV sets imported from the other country, the terms of trade are:

3/4

If the terms of trade are 3, how many units of the imported good could I buy for the

money earned by the sale of 1 unit of the exported good? What is the exchange ratio?

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If Px/Pm = 3/1, then 3 units of imports can be purchased with the money earned by the sale of 1

unit of the exports. The exchange ratio is 1x:3m.

Why will exporters probably welcome a `deterioration' in the terms of trade?

Because a fall in the price of exports relative to imports would probably be the result of a

depreciation in the exchange rate. This would mean that exporters could now reduce the foreign

exchange price of their exports and hence sell more, without reducing their price in domestic

currency. They would therefore end up earning more.

Is it possible to gain from trade if competition is not perfect?

Yes. Production would not initially take place at the Pareto optimum position (i.e. "on" the PPF),

but it is quite likely that trade would lead to a consumption on a higher indifference curve, and

that therefore there would be some gain: a Pareto improvement.

Is it possible to gain from trade if it is already producing on the PPF?

Yes. When trade happens, there are both production and consumption gains by expanding the

production and consumption possibilities frontiers respectively. Thus even if production is

already Pareto efficient, trade will open up possibilities for higher consumption at the lower world

prices; this might require a slight movement along the PPF as well however.

Would it be possible for a country with a comparative disadvantage in a given product at

pre-trade levels of output to obtain a comparative advantage in it by specialising in its

production and exporting it?

Yes, if the country has potential economies of scale in producing that good (which it had not yet

exploited). Specialisation could then reduce the opportunity costs of that good below that of the

same good in other countries. (This assumes that the other country does not have potential

economies of scale in that good or does not exploit them if it does.)

Should the world community welcome the use of tariffs and other forms of protection by

the rich countries against imports of goods from lower income countries that have little

regard for the environment?

There is no simple answer to this question. In terms of social efficiency, trade should take place

as long as the marginal social benefit was greater than the marginal social cost (where

environmental benefits and costs are included in marginal social benefits and costs). The

problem with this approach is in identifying and measuring such benefits and costs. Then there

is the problem of whether a social efficiency approach towards sustainability is the appropriate

one. Then there is the issue of the response by lower income countries to the protection. Will

they respond by introducing cleaner technology? This may prove difficult to predict.

How would you set about judging whether an industry had a genuine case for

infant/senile industry protection?

Whether it can be demonstrated that, with appropriate investment, costs can be reduced

sufficiently to make the industry internationally competitive.

Does the consumer in the importing country gain or lose from "dumping"?

Dumping happens when an exporter sells its products in another country (the importing country)

at an extremely low price (sometimes below cost). The purpose of dumping is often to capture a

monopoly position in the importing coountry market and drive other competitors (including local)

out.

In the short run the consumer in the importing country may gain from the cheaper prices of the

dumped product. In the long run the consumer could lose if domestic producers were driven out

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of business, which then gave the foreign producer a monopoly. At that point, it is likely that

prices would go up above the pre-dumping levels.

In what ways may free trade have harmful cultural effects on developing countries?

The products and the lifestyles which they foster could be seen as alien to the values of society.

For example, many developing countries have complained about the `cocacolonisation' of their

economies, whereby traditional values are being overcome by Western materialist values.

Go through each of these four arguments and provide a reply to the criticisms of them.

`Imports should be reduced since they lower the standard of living. The money goes

abroad rather than into the domestic economy.' Imports are not always matched by

exports. If imports exceed exports, then the resulting trade deficit has to be matched by

a surplus elsewhere on the balance of payments account, which might bring problems

(e.g. short-term financial inflows leading to exchange-rate volatility). A rise in imports,

being a withdrawal from the circular flow of income, will tend to reduce income unless

matched by a corresponding rise in exports. Sometimes imports may influence

consumer tastes, and this may be seen as undesirable. For example, imports of soft

drinks into poorer developing countries has been criticised for distorting tastes.

`Protection reduces unemployment.' The greater competition from free trade will provide a

permanently less certain market for domestic producers and possibly a permanently

higher rate of structural unemployment, given the greater rate of entry and exit of firms

from markets.

`Dumping is always a bad thing, and thus a country should restrict subsidised imports.' The

gain to consumers may be short-lived, and if more efficient domestic firms have been

driven from the market, there will be a long-term net welfare loss to the country.

What would be the `first-best' solution to the problem of an infant industry not being able

to compete with imports?

If the problem is a lack of domestic infrastructure, then the first-best policy is for the government

to provide the infrastructure. If the problem is a lack of finance for the firms to expand (due to

imperfections in the capital market), then the first-best solution is for the government to remove

imperfections in the capital market, or to lend money directly to the firm. In other words, the first-

best solution is to get to the heart of the problem: to tackle imperfections at source.

Airbus, a consortium based in four European countries, has received massive support

(protection) from European country governments, in order to enable it to compete with

Boeing (a US company), which until the rise of Airbus had dominated the world market

for aircraft. To what extent are (a) air travellers; (b) citizens of the four European

countries likely to gain or lose from this protection?

a) To the extent that the resulting competition reduces the costs of aircraft and hence air

fares, the traveller will gain.

b) Whether citizens of the EU as a whole gain depends on whether the costs of the support

(including external costs), as are recouped in the benefits of lower fares to travellers,

profits to Airbus Industries and external benefits (such as spillover research benefits to

other industries). Of course, the costs and benefits will not be equally distributed to EU

citizens and thus there will be redistributive effects of the policy, effects which may be

considered to be desirable or undesirable.

Can the US action of early 2002 to protect its steel industry be justified on economic

grounds?

In terms of economic efficiency, then probably not, unless the protection was temporary while

the industry was given the opportunity to invest to allow it to realise a potential comparative

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advantage (assuming that an imperfect capital market failed to lend it the requisite funds). But

given that the industry almost certainly does not have a potential comparative advantage, there

would be no efficiency gains: rather, there would be net loss in efficiency.

The main argument, then, would have to be in terms of distributive justice: that giving the

industry protection helps save US jobs and the livelihoods of people working in the industry.

From a US perspective, there is some justification here. In world terms, however, the gain to US

jobs could well be at the expense of jobs elsewhere, causing a net loss, as production was

diverted from lower-cost producers in other countries to higher-cost producers in the USA.

What alternative economic strategy might the US government have adopted to improve

the competitiveness of steel producers?

Encouraging investment in new efficient plants by giving tax breaks or grants. Again, unless

these plants had a comparative advantage, this would still be regarded as unfair protection.

Even if they did have a potential comparative advantage, any such support would have to be

purely temporary to be justified on efficiency grounds.

Outline the advantages and drawbacks of adopting a free-trade strategy for lower income

countries. How might the Doha Development Agenda go some way to reducing these

drawbacks?

There are two main advantages:

a. The developing countries can gain from specialisation in goods in which they have a

comparative advantage. Other things being equal, this increases national income in

these countries.

b. It can encourage inward investment into these countries.

The disadvantages are as follows::

a. Developed countries may continue to protect their industries. This makes free trade a

risky strategy for developing countries, which might find the market for key exports

suddenly cut off.

b. Freely allowing imports into developing countries may mean that developed countries

dump surplus products on them (especially agricultural surpluses), with damaging

consequences for producers within the developing countries.

c. It may encourage developing countries to use low-cost, dirty technology, with adverse

environmental consequences.

d. Multinational investment in developing countries, encouraged by an open trade policy,

may lead to culturally damaging influences (the culture of McDonald's and Coca-Cola)

and political control over the developing countries.

To the extent that the Doha Development Agenda focuses on sustainable development, fair

access for developing countries to the markets of rich countries and maintaining justifiable

protection by the developing countries for specific sectors, then some of these drawbacks will be

reduced. How much they will be reduced, however, depends on the terms of any agreement and

how rigorously they are enforced.

What would be the economic effects of (a) different rates of VAT, (b) different rates of

personal income tax and (c) different rates of company taxation between member states

of a regional union (or single market like EU) if in all other respects there were no barriers

to trade or factor movements?

a) Consumers would buy items in those countries that charged the lower rates of VAT. This

would push up the prices in these countries and thus have the effect of equalising the

tax-inclusive prices between member countries. This effect will be greater with

expensive items (such as a car), where it would be worthwhile for the consumer to incur

the costs of travelling to another country to purchase it.

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b) Workers would move to countries with lower income taxes, thus depressing gross wage

rates there and equalising after-tax wages. This effect would be greater, the greater is

the mobility of labour between member countries.

c) Capital would move to countries with lower rates of company tax, thus depressing the

rate of profit in the low tax countries and equalising the after-tax rate of profit. This effect

will be greater, the greater is the mobility of capital between member countries.

Would the adoption of improved working conditions in poor countries necessarily lead to

higher labour costs per unit of output?

No. They could lead to an increase in labour productivity which more than offset the cost of the

improved working conditions.

When the UK joined the exchange rate mechanism ERM in 1990, it was hoped that this

would make speculation pointless. As it turned out, speculation forced the UK to leave

the ERM in 1992. Can you reconcile this with the argument that fixed rates discourage

speculation?

As long as speculators believe that the fixed rate can be maintained, there is no point in

speculation. Thus when the UK first joined, there was little speculation. But later, when there

was a clear tension between the German desire to keep interest rates high and the UK desire to

reduce interest rates in order to help lift the economy out of recession, speculators began to

believe that rates might have to be realigned. The more they became convinced of this, the

more the speculative pressures mounted.

If speculators on average gain from their speculation, who loses?

People buying or selling internationally traded goods who are not themselves speculating. For

example, if speculation drives the exchange rate below what it would otherwise have been, then

purchasers of imports will be paying a higher price than they otherwise would.

Why would the adjustable peg system have been less suitable in the world of the mid-

1970s than it was back in the 1950s?

Because the world economy was in much more of a state of turmoil than in the previous two

decades. The amount of adjustment required was therefore much greater. Under an adjustable

peg system, pegged exchange rates would much more rapidly have become disequilibrium

rates. This would have necessitated more severe stopgo policies and/or more frequent

devaluations/revaluations, with the disruption that such adjustments entail. What is more, with

much of the increased oil revenues of OPEC being placed on short-term deposit in Western

banks, the size of short-term financial flows had increased substantially and this worsened the

problem of currency instability.

Why do high international financial mobility and an absence of exchange controls

severely limit a country's ability to choose its interest rate?

Because if its interest rate were lower than international rates, there would be a massive outflow

of finance if international finance were highly mobile and there were an absence of exchange

controls. The resulting fall in the money supply would push the interest rate up to the

international level. Similarly if its interest rate were higher than international rates, the resulting

massive inflow of finance would increase the money supply and drive its interest rate down to

the international level. These effects are stronger if the country is attempting to peg its

exchange rate.

Would any of these problems be lessened by the world returning to an adjustable peg

system? If so, what sort of adjustable peg system would you recommend?

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No. All these problems would have existed with an adjustable peg. Predicting the appropriate

rate at which the currency should be pegged would have been a problem. Speculative financial

movements would still have been a problem as long as speculators believed that there was a

possibility of devaluation or revaluation. There would still have been a conflict with internal

policy given that interest rates would have been used to maintain a pegged rate. There could

still have been competitive pressures to raise interest rates. Just how bad these problems would

have been would have depended on (a) the determination of countries to defend the pegged

rate, and (b) the amount of support given by the IMF, or central banks collectively, to maintain

pegged rates.

A return to an adjustable peg system is best when the required adjustments are easily made,

without building up large deficits or surpluses, and most importantly, when countries pursue

consistent policies: when their economies are harmonised.

What will be the effect on the UK economy if the European Central Bank cuts interest

rates?(The European Central Bank is the central bank for the Euro zone; this currently

excludes Britain)

There will an outflow of funds from the euro-zone and the euro will probably depreciate. Funds

will flow to the UK and sterling will probably appreciate. UK exports will become less competitive

and there will probably be a rise in imports. UK aggregate demand will fall. This will put

downward pressure on inflation. (To some extent the downward pressure on aggregate demand

in the UK will be offset by a rise in aggregate demand in the euro-zone and hence a boost to the

UK economy via the international trade multiplier.)

The net result of a forecast of lower inflation in the UK and a worsening balance of trade may

encourage the Monetary Policy Committee to lower the rate of interest. If this happened, it could

neutralise the balance of payments effect of the ECB's interest rate cut. In fact, if rates of

interest in the UK fell by the same amount as in the euro-zone, the UK's balance of trade would

probably improve, as sterling depreciates against the dollar, the yen and other currencies other

than the euro.

Why did `contagion' spread to countries outside south-east Asia after the latter region

experience currency crises in 1997-98?

Having witnessed the power of speculative flows to undermine relatively strong countries of

south-east Asia, speculators turned their attention to other economies perceived as having

weaknesses. The speculation against these economies then considerably worsened their

position, causing their currencies and stock markets to fall dramatically. The speculation was

worsened by the perceived inability (or unwillingness) of institutions such as the IMF to provide

rapid support for these economies.

What policy measures could the south-east Asian countries have adopted before the

crisis to prevent it occurring?

Tighter controls over their banking and financial systems, with better regulation and monitoring

by the authorities and higher minimum reserve requirements; greater exchange rate flexibility;

more rigorous attempts to reduce government debt over a long period of time (so as to avoid the

shock of sudden deflation); controls over the financing of corporate debt (so as to reduce the

levels of corporate debt held overseas).

George Soros, multi-millionaire currency speculator, has referred to global capital

markets as being like a wrecking ball rather than a pendulum, suggesting that such

markets are becoming so volatile that they are damaging to all concerned, including

speculators. What might lead Soros to such an observation?

Because financial movements are so vast that they are largely beyond the control of

governments or international agencies. Once the sentiment of currency traders and

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speculators is affected in a particular direction (e.g. losing confidence in a particular economy,

such as Argentina in late 2001/early 2002) currency movements can become large and very

damaging. Such short-term movements may bear little relation to long-term fundamentals.

Why may inflows of short-term deposits create a problem?

Because they may be very rapidly withdrawn again and thus can contribute to instability of the

exchange rate. To prevent sudden outflows of deposits (arising, say, from a fear by depositors

that the exchange rate is about to fall) governments may be forced to raise interest rates:

something they may otherwise prefer not to do.

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