Sunday, April 29, 2007

FE 102|Final

FE 102

Section A:
1. “To understand the 1990s system of international finance, it is necessary to examine how the debt crisis evolved in the 1980s. Discuss this statement in the context of the following questions:
A. What were the main mechanisms and arrangements through which the debt crisis was managed and ameliorated?
As far as Mexico debt crisis of 1982, the IMF linked its willingness to lend to Mexico with the willingness of private banks to extend their lending to Mexico. IMF programs implemented before lending. Baker plan*
Change in attitudes: risk was no longer considered an either or (paid or defaulted). Secondary markets to manage risks besides the internal bank evaluations. The recycling of the ‘petrodollars’ through the system.
Increased amounts of capital available to the World Bank and the IMF for lending to LDCs.
IMF tough economic measures to improve their longer-term ability to service their debts. The IMF program (measures) summed up as devaluation, deflation (tight monetary and fiscal policies) and deregulation (market based reforms, reduce trade protectionism and removal of interest rate ceilings).
Baker plan of ‘growing out’ of the debt problems. This done by trade liberalization, cuts in government spending and relaxation of regulations relating to inward foreign investment.
Baker to Brady: secondary markets developed for selling outstanding loan assets. Provisioning of the debt to account for increased risk but not forgiving loans.
Brady: studied a case by case basis for deciding the right measures to take including voluntary debt forgiveness with funds set aside from the World Bank and IMF. Last was restructuring of the debt for 20 to 30 years and implemented medium term IMF stabilization programs.
B. What were the main effects on the international financial system of the debt crisis?
Provisioning of the debt to account for increased risk but not forgiving loans.
Developing secondary markets to evaluate risks.
The IMF and World Bank played a critically important role in encouraging adoption of sound macroeconomic policies in debtor countries and coordinating private sector claims, thus reducing the risk of defaults.
Banks were not bailed out at the public’s expense.

2. Explain the concept of arbitrage. In your answer, show how it relates to the purchasing power parity theory of exchange rates and how it relates to links between the spot and the forward exchange rates.

Arbitrage is the exploitation of price differentials for risk-less guaranteed profits. Taking price differences between different markets and making money.
For the spot exchange rates arbitrage, it is carried out by two methods. The first is arbitrage across different trading centers. The exchange rates would be the same in London as well as New York or the difference in prices can be arbitraged to gain a profit. The second is cross-currency arbitrage, and is profits derived from trading among 3 or more currencies. As long as there is differences in results from A to C is different than A to B to C.

Arbitrageurs can also make a profit with the forward exchange rates by using the Covered Interest Parity (CIP). By using the following formula:
F=((r(f)-r)*S)/(1+r)+S as F=forward, S=spot, r(f)=foreign interest rate 1 year, and r is the 1 year forward domestic interest rate.
If there is a difference between the calculated forward rates compared to the market rate then arbitrageurs will transfer monies until the rates match. “Covered interest parity is achieved as a result of arbitrage between the spot and the forward markets.”

A currency is said to be a forward premium if the forward exchange-rate quotation for that currency represents an appreciation of that currency compared to the spot quotation.
IRP (Interest Rate Parity) page 9-12 work book Unit 2.

Purchasing Power Parity is supposed to result from arbitrage between products in two different markets. If the price of product (tradable goods) is priced differently between markets then someone could purchase the products at the lower market and sell in the more expensive market.

3. The implication of the Marshall-Lerner Condition is that devaluation may be a cure for some countries balance of payments deficits, but not for others. Critically discuss this statement.
The effectiveness of the devaluation (in a fixed system) or depreciation (in a flexible system) of the currency for reducing a trade deficit depends on "well-behaved" demand and supply curves for foreign exchange. The precise conditions that guarantee that devaluations "work" are the Marshall-Lerner conditions. These conditions simply state that the sum of the absolute values of the elasticities of home demand for foreign goods and foreign demand for home goods must be greater than one. The Marshall-Lerner conditions link the effectiveness of a monetary instrument with analysis of the demands for home and foreign goods in the "real sector".
The basic idea behind the Marshall-Lerner conditions is that the exchange rate affects the terms of trade between two countries. Terms of trade are defined as the ratio of export prices, Px, over import prices, Pm. In domestic currency units, the price of imports Pm is equal to the exchange rate R multiplied by the world price level P. Thus, Pm = R P. A devaluation or deprecation thus implies a fall in the terms of trade, in domestic currency units. Similarly, in foreign currency units, a devaluation of the home currency raises the terms of trade of the foreign country.
Under the Marshall-Lerner Condition when the added values of the price elasticities of both demand for exports and demand for imports is greater than one, then devaluation/depreciation will lead to improvement in the balance of payments. The opposite holds that if the absolute sum of the elasticities is less than one then devaluation will lead to a worsening of the CA (current account) Balance. And if the sum is close to unity (1) then little effect will happen on the CA.
One assumption on this model is that only one country devalues their currency. If one country sees it to their advantage to devalue and everyone else does, then none of the countries that devalue will be better off and most will be worse off.
When devaluation occurs, it basically changes the terms of trade. It becomes more expensive for a given quantity of imports and returns less revenue for a given quantity of exports. But as the relative prices change then the volume effect will improve the CA. The question is whether the volume effect will more than offset the price effect.
For most small countries though, the relative price levels for exports and imports are fixed (near infinite elasticity) and they become price takers. This should always lead to an improvement in CA, as exports will increase without affecting the market.
And it is worth pointing out that over the short run price elasticities tend to be inelastic. This creates the J-curve effect of short run volumes that do not change much in the short run but in the longer term the market can adjust to the price levels by adjusting quantities.
But this approach leaves out some considerations that the Absorption Approach could be used to overcome. They are: 1) it does not deal with the indirect effects of devaluation (i.e. reducing real income for example) 2) It concentrates on the current account and not internal balance (e.g. full employment) 3) It concentrates on the effect of exchange rates but is not useful for analyzing the effect of other balance of payments policies.
4. Using the Mundell-Fleming model, explain the effect on internal and external equilibrium of a change in exchange rates. Explain and discuss the role of capital mobility in the model. ***

5. The Polak model is sometimes described as a version of the monetary approach to the balance of payments. Explain and discuss the main assumptions and conclusions of each theory.
The Polak model is often considered the precursor to the monetary approach to balance of payments and is derived from two simple equations:
1. M=kPy or written that a dM=k*dY
Where M is the money supply, k is the inverse of the velocity of circulation of money or in other words the parameter that measures the sensitivity of money demand to changes in nominal income, and P is the price level.
2. M=mY
Where M is the demand for imports, m is the marginal (as well as average) propensity to import and Y is a country’s income (Where applicable nominal values.). In the two above equations, m and k are assumed to be constants.
The conclusions are that changes in the money supply is the only instrument of macroeconomic policy, but that budget deficits are assumed to be the primary reason of changes in domestic credit (i.e. increases in the money supply is the primarily from bank lending to the state).
From above equations we could also conclude that changes in the money supply are by definition equal to the change in a country’s foreign reserves plus the change in domestic credit of the banking system.
D M(s)=d R + d D
And the change in foreign reserves is by definition equal to exports minus imports and plus net capital inflows of the non-bank sector.
The first significant difference the monetary approach has from the Polak model is that it defines the balance of payments as both the current account and the capital accounts. In addition to the assumption that velocity of money is constant, the monetary approach also includes two additional simplifying assumptions as in:
1. Fixed Aggregate Supply or the aggregate supply curve is vertical. That is there is no change in quantity from a change in the price level. Since Ms equals Md and k is constant then for a change in Ms then only prices can change. Even if not at full employment as Pilbeam assumes, the market could be rigid as well as wages can be sticky in the short run.
2. Purchasing Power Parity is the final assumption that underpins the monetary model. Exchange rates must change so the following equations are in equilibrium:
S= P/P(f) or P=S*P(f)
Where S is the exchange rate defined as domestic currency per unit of foreign currency, P is the domestic price level in the domestic currency and P(f) is the foreign price level in the foreign currency.
The conclusions of the monetary approach are that balance of payments disequilibrium is merely a reflection of disequilibrium in the money market. A deficit in BoP is due to an excess of the stock of money in relation to the MD. Surplus in BoP is a monetary flow resulting from an excess demand for money in relation to the stock MS.
While the Keynesian approach views the CA items as autonomous items and the capital account and reserve changes as the accommodating items, the monetarist approach is completely the reverse. Or in other words Keynesians look at the top of the balance of payments statistics (i.e. current account) and monetarists look at the bottom of the BoP (i.e. changes in reserves).
Agents decide firstly the amount of real balances they wish to hold and then spend accordingly, and not the other way around.
An important conclusion about the monetarist approach is that under a fixed exchange rate the authorities give up autonomy on their domestic monetary policy and thus inflation is not under the control by the authorities. Also whether the BoP imbalance comes from OMO (Open Market Operations) or FXO (Foreign Exchange Operations) is of little relevance. This should be emphasized that under a fixed exchange rates monetary policy is endogenously determined by the need to peg the exchange rate, while under floating authorities can exogenously determine its money supply.
6. “Since both fixed and flexible exchange rate systems have weaknesses, the optimum would be an intermediate system of managed exchange rates.” Explain and discuss that statement.
Variations of the Managed Float are the crawling peg, the gliding band and the dirty float. It should be noted that managed float may lead to one-way speculative gambles when the rates should change and has not changed yet.
The three main reasons presented for why to have a managed float is:
1. Authorities Might be able to produce a more appropriate exchange rate. That sounds like a tall order and even if they are able to produce a more appropriate rate they still may have to pay the price to go against the market. But intentions and open statements can sometimes indicate to the market what the intentions of the Central Bank are. It is also important that the officials do not become the destabilizing actor by holding to rates that are clearly indefensible.
2. Mitigate the costs of exchange rate overshooting also assumes that authorities know what the appropriate exchange rate should be. It could just as easily undershoot the mark.
3. Smooth the economic Adjustment Process is a process by which an economy is allowed time to transition. The transition can take many forms but many times if the transition is carried out too quickly then not only the economy may suffer but also the political structure may be weakened. This I feel is a very important point that transitions in economies tend to be good in the long run the short term pain can cause major problems. Price changes may prove more acceptable method of reducing real wages (Keynes) since all suffer more or less equally and do not upset the wage differentials much.
4. Since fixed exchange rates work best when the objective is price or output stability (i.e. money demand shock) and flexible exchange rates work best for aggregate demand or supply shocks when favoring income stability, thus it could be conceivable that a country may wish to switch to managed exchange rate to accomplish certain goals and switch to free floating exchange at other times.
Under perfect capital mobility then a nation’s interest rate and money supply are effectively taken away from the central bank.
7. Explain and discuss the principles of monetary unions in the light of European experience.
The first step in creating a monetary union is the setup of a currency bloc which is defined as when the currencies of all the countries are united by fixed exchange rates. This is hard to do at first so ‘Snakes’ are usually set up that maintain the exchange rates within bands usually defined as a percent change. In addition member countries attempt to follow compatible macroeconomic policies through policy coordination. This was used by most Western European countries during the 1970’s.
Eventually a single currency can replace the individual ones, and this arrangement becomes a monetary union. This system though must have coordinated monetary and fiscal policies encompassing all members. And in the system one state usually assumes the leadership role and as the key currency within the system (trading currency). For the EU experience it was the German State (especially in monetary policy) that members attempted to follow and the Deutschemark was the key currency during the process.
The European Monetary System (EMS) was setup during the 1980’s to arrange for co-operation between members through Exchange Rate Mechanism. ERM attempted to stabilize the cross exchange rates of a wider group of countries and again tied to the Deutschemark.
But some setbacks came when Britain abandoned fixed exchange rages with its partners in 1992.
Hierarchy of the three types of coordination: 1. exchange information 2. acceptance of mutually consistent policies and 3. joint action. This is versus coordination with no implied significant modification of national policies and thus little more that ‘consultation’.
European Union (EU), European Monetary Union (EMU), Exchange Rate Mechanism (ERM), European Currency Unit (ECU), European Monetary Fund (EMF),
In 1971, Snake (other EEC (European Economic Community) countries) in the Tunnel (USA exchange rate) and Belgium/Netherlands being the worm inside the snake.
In 1979, the European Monetary System was established to provide a ‘zone of monetary stability’. The ERM consisted of two parts: 1. bilateral exchange-rate bands (parities) 2. individual currency band against the ECU. The grid in #1 required mutual agreement to make changes and thus Finance Ministers of the currencies participating in the ERM decided these issues.
The ECU was a weighted basket of the 12 member currencies, and from this was an ‘indicator of divergence’. The idea was that it would single out the currency that was diverging from the average agreed parities before bilateral action was required, which in essence was an alarm bell to tell which country needed to take action.
The EMS also established the European Monetary Cooperation Fund (EMCF) where members deposited 20% of their gold dollar reserves in exchange for ECUs that were to be used for exchange market interventions instead of the US dollar. And like any other bank members could draw upon the funds to defend their exchange-rate parities and manage transitory BoP problems.
Results of EMS: Exchange Rate Stability, Anti-Inflation Zone.
Two main components of a Monetary Union; an exchange-rate union and complete capital market integration. More specifically the former means that the countries agree to no margin of fluctuation and thus by all intents and purposes creates a single currency. Complete market integration means that all obstacles to free movement of financial capital are removed and that financial capital is treated equally in all member states.
Implicit requirements: members harmonize their monetary policies, single union central bank, and central bank needs to be invested with a pool of reserves of third-country currencies.
A History of the Road to European Monetary Union:
The Rome Treaty of 1957 created the European Economic Community (No Monetary Union) and a priority was the creation of a customs union. The CU involved the adoption of a common tariff policy for third party countries and removal of trade barriers between members.
Hague Summit in 1969 the 6 agreed in principle to establish complete economic and monetary union commencing 1971 and expected completed by 1980. This set up the Werner Report (1972) which the main result was the snake in the tunnel which failed by 1978. This was because of the wide differences in how the economy was handled in each country as a result of the oil crisis and external supply shocks to the system of embargoes. Single European Act (1986) was aimed to create a single market by 1992. Delors report (1989) broadly outlined a proposal for achieving EMU which was initiated by the EEC in 1988 and was to commence in three stages:
1. Greater cooperation and coordination in fiscal and monetary policies as well as removal of financial integration which was the creation of a ‘Single Market project’. (90-93)
2. Phase II was the readying of the eventual permanent fixing of exchange rates and the amendment of the Treaty of Rome which resulted in the signing of the Maastricht Treaty. Established the European Monetary Institute which was to assist progress on economic convergence (European System of Central Banks) and make preparations for the final phase (Statute of the E Central Bank, European System of Central Banks). (1994)
3. Creation of a single monetary policy set by the ECB. 1999
8. In the light of a theory of capital flight from less developed countries, discuss policies that could reverse it.
Policy problems:
a. Debt overhang
b. Dual exchange rates causes a problem since most models are based on one exchange rate instead of one for transaction on the current account of the balance of payments (the commercial rate) and the one for capital account transactions (the financial rate).
c. Parallel Foreign Exchange Markets is the results of having ‘unofficial rates’ as well ‘black markets’.
d. Currency Substitution is when residents of a country uses currency of another country (e.g. Israel and Mexico during the 1980’s). Should have led to a North America Union.

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