Addis Ababa University

College of Business and Economics

Department of Economics
Econ. 2082: International Economics II

Yohannes azegaj
ID No BER/1713/11
Instructors: Dr. Helen Berga

ADDIS ABABA UNIVERSITY

1. What is a foreign exchange market and what are its unique
characteristics? Explain
 The foreign exchange market or the ‘forex market’ is a system which establishes an
international network allowing the buyers and sellers to carry out trade or exchange
of currencies of different countries. It also can be stated as one of the most liquid
financial markets which facilitate ‘over-the-counter’ exchange of currencies.
Unique Characteristics of foreign exchange market

 Market Transparency: It is effortless to monitor the fluctuations in the value of

currencies of different countries in a forex market easily through account tracking and
real-time portfolio, without the involvement of brokers.
 Dollar is Extensively Traded Currency: The USD, which is paired with almost every
country’s currency and listed on the forex, is the most widely traded currency in the
world.
 Most Dynamic Market: The value of the currencies in the forex market keeps on
changing every second and function twenty-four hours a day. This makes it one of the
most active markets in the world.
 International Network of Dealers: The foreign exchange market establishes a
medium among the dealers and also with the customers. There are dealer’s
institutions located globally to carry out the exchange and trading activities.
 “Over-The-Counter” Market: In different countries, the forex market is the highly
unregulated market initiating over the counter trade by the banks through telex and
telephone.
 High Liquidity: The currency is considered to be the most widely traded financial
instrument across the globe, making the forex market highly liquid.
 Twenty-Four Hour Market: The foreign exchange market is operational for twenty-
four hours of the day, initiating the active trade and exchange of currencies at any
time.

2. What are the major purposes of a foreign exchange market? Discuss

 The principal function of foreign exchange markets is the transfer of funds or
purchasing power from one nation to another or from one currency to another.
 Other functions include the provision of short term credits to finance trade and
the facilities in order to avoid foreign exchange risks.
 To make provision for hedging facilities.
3. How do you distinguish between spot foreign exchange transaction
and forward foreign exchange transaction? Explain
(a) Spot Market: If the operation is of daily nature, it is called spot market or current
market. It handles only spot transactions or current transactions in foreign exchange.

Transactions are affected at prevailing rate of exchange at that point of time and delivery
of foreign exchange is affected instantly. The exchange rate that prevails in the spot

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 market for foreign exchange is called Spot Rate. Expressed alternatively, spot rate of
exchange refers to the rate at which foreign currency is available on the spot.

For instance, if one US dollar can be purchased for birr 40 at the point of time in the
foreign exchange market, it will be called spot rate of foreign exchange. No doubt, spot
rate of foreign exchange is very useful for current transactions but it is also necessary to
find what the spot rate is. In addition, it is also significant to find the strength of the
domestic currency with respect to all of home country’s trading partners. Note that the
measure of average relative strength of a given currency is called Effective Exchange
Rate (EER).

(b) Forward Market:

A market in which foreign exchange is bought and sold for future delivery is known as
Forward Market. It deals with transactions (sale and purchase of foreign exchange)
which are contracted today but implemented sometimes in future. Exchange rate that
prevails in a forward contract for purchase or sale of foreign exchange is called Forward
Rate. Thus, forward rate is the rate at which a future contract for foreign currency is
made.

This rate is settled now but actual transaction of foreign exchange takes place in future.
The forward rate is quoted at a premium or discount over the spot rate. Forward Market
for foreign exchange covers transactions which occur at a future date. Forward exchange
rate helps both the parties involved.

4. How does the demand for a foreign exchange arise and how does the
supply of a foreign exchange arise? Explain

The demand (or outflow) of foreign exchange comes from those people who need it to
make payment in foreign currency.

The demand for foreign currency rises in the following situations:

1. When price of a foreign currency falls, imports from that foreign country become cheaper.
So, imports increase and hence, the demand for foreign currency rises.

2. When a foreign currency becomes cheaper in terms of the domestic currency, it promotes
tourism to that country. As a result, demand for foreign currency rises.

3. When price of a foreign currency falls, its demand rises as more people want to make
gains from speculative activities.

The supply (inflow) of foreign exchange comes from those people who receive it due to
following reasons

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 The supply of foreign currency rises in the following situations:

1. When price of a foreign currency rises, domestic goods become relatively cheaper. It
induces the foreign country to increase their imports from the domestic country. As a result,
supply of foreign currency rises.

2. When price of a foreign currency rises, supply of foreign currency rises as people want to
make gains from speculative activities.

5. Write short notes on each of the following concepts/phrases. Give

examples, where necessary
a) Foreign Exchange Rate:

 Foreign exchange (Forex or FX) is the conversion of one currency into another at a
specific rate known as the foreign exchange rate. The conversion rates for almost all
currencies are constantly floating as they are driven by the market forces of supply
and demand.

b) Nominal Exchange Rate:

 The nominal exchange rate E is defined as the number of units of the domestic
currency that can purchase a unit of a given foreign currency. A decrease in this
variable is termed nominal appreciation of the currency. (Under the fixed exchange
rate regime, a downward adjustment of the rate E is termed revaluation.) An increase
in this variable is termed nominal depreciation of the currency. (Under the fixed
exchange rate regime, an upward adjustment of the rate E is called devaluation.)

C) Real Exchange Rate:

 The real exchange rate R is defined as the ratio of the price level abroad and the
domestic price level, where the foreign price level is converted into domestic
currency units via the current nominal exchange rate. Formally, R=(E.P*)/P, where
the foreign price level is denoted as P* and the domestic price level as P. A decrease
in R is termed appreciation of the real exchange rate, an increase is termed
depreciation. The real rate tells us how many times more or less goods and services
can be purchased abroad (after conversion into a foreign currency) than in the
domestic market for a given amount.
d) Real Effective Exchange Rate:

 The Real Effective Exchange Rate (REER) is an indicator of the external

competitiveness of a countries currency. It is the weighted average of a countries
currency against a basket of other major currencies (after adjusting for inflation
differentials). The REER is expressed as an index number relative to a base year.

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 e) Freely Floating or Flexible Exchange Rate:
 A floating exchange rate is a regime where the currency price of a nation is set by
the foreign exchange market based on supply and demand relative to other
currencies. It is one that is determined by supply and demand on the open market.
But it doesn't mean countries don't try to intervene and manipulate their
currency's price, since governments and central banks regularly attempt to keep
their currency price favorable for international trade. Became more popular after
the failure of the gold standard and the Bretton Woods agreement.

f) Fixed exchange Rate or Pegged Exchange Rate:

 Fixed exchange rate is the rate which is officially fixed by the government or
monetary authority and not determined by market forces. Only a very small
deviation from this fixed value is possible. In this system, foreign central banks stand
ready to buy and sell their currencies at a fixed price. A typical kind of this system
was used under Gold Standard System in which each country committed itself to
convert freely its currency into gold at a fixed price.

g) Managed Float or Dirty Float Exchange Rate:

 A dirty float is a floating exchange rate where a country's central bank occasionally

intervenes to change the direction or the pace of change of a country's currency
value. In most instances, the central bank in a dirty float system acts as a buffer
against an external economic shock before its effects become disruptive to the
domestic economy. A dirty float is also known as a "managed float."

h) Arbitrage:

 Arbitrage occurs when an investor can make a profit from simultaneously buying
and selling a commodity in two different markets.
i) Hedging:
 Hedging – Setting up an investment positions which helps to protect against losses
from a related investment.
j) Speculation:
 Speculation is the purchase of an asset (a commodity, goods, or real estate) with the
hope that it will become more valuable in the near future. In finance, speculation is
also the practice of engaging in risky financial transactions in an attempt to profit
from short term fluctuations in the market value of a tradable financial instrument—
rather than attempting to profit from the underlying financial attributes embodied in
the instrument such as value addition, return on investment, or dividends.
6) How do you distinguish between depreciation and devaluation of a
currency? Appreciation and revaluation of a currency?

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Depreciation

 Depreciation happens in countries with a floating exchange rate. A floating exchange

rate means that the global investment market determines the value of a country's
currency. The exchange rate among various currencies changes every day as
investors reevaluate new information. While a country's government and central
bank can try to influence its exchange rate relative to other currencies, in the end it is
the free market that determines the exchange rate. All major economies use a
floating exchange rate.

 Depreciation occurs when a country's exchange rate goes down in the market.

 The country's money has less purchasing power in other countries because of the
depreciation.

Devaluation

 Devaluation happens in countries with a fixed exchange rate. In a fixed-rate

economy, the government decides what its currency should be worth compared with
that of other countries. The government pledges to buy and sell as much of its
currency as needed to keep its exchange rate the same. The exchange rate can change
only when the government decides to change it.

 If a government decides to make its currency less valuable, the change is called
devaluation.

 Appreciation is when the value of a currency goes up in comparison to other

currencies. Revaluation is an official rise in the price of the currency within a
fixed exchange rate system.

7)

i) What are the theoretical arguments for currency devaluation?

What is your view on currency devaluation in the context of
primary commodities – producing developing countries?
Explain
 Currency devaluation is a deliberate downward adjustment of the value of a
country’s currency against another currency. Devaluation is a tool used by
monetary authorities to improve the country’s trade balance by boosting
exports at moments when the trade deficit may become a problem for the
economy.

In my view developing countries has devalue its currency.

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 Because devaluing the currency makes a nation's exports more competitive
in global markets, and simultaneously makes imports more expensive.
Higher export volumes spur economic growth, while pricey imports also
have a similar effect because consumers opt for local alternatives to
imported products. This improvement in the terms of trade generally
translates into a lower current account deficit (or a greater current account
surplus), higher employment, and faster GDP growth. The simulative
monetary policies that usually result in a weak currency also have a positive
impact on the nation's capital and housing markets, which in turn boosts
domestic consumption through the wealth effect.

ii) What are some of the inflationary impacts of currency

devaluation? What do you think is the way forward to address
such impacts? Explain

Generally, devaluation is likely to contribute to inflationary pressures because of higher

import prices and rising demand for exports. However, the overall impact depends on the
state of the economy and other factors affecting inflation.

In theory, devaluation could cause inflation for three reasons:

1. Cost-push inflation
2. Demand-pull inflation
3. Fewer incentives in long-term to cut costs.

1. Cost-push inflation

If there is devaluation then there will be an increase in the price of imported goods. Imports
are quite a significant part of the CPI; therefore they will contribute towards cost-push
inflation.

2. Demand-pull inflation

With devaluation, there is likely to be an increase in AD. (AD = C+I+G+X-M), if exports are
cheaper, there will be more exports sold and the quantity of imports will fall. If the economy is
close to full capacity then higher AD will cause inflation.

3. Fewer incentives for firms

Thirdly, if there is a devaluation, exports become more competitive (cheaper to foreign buyers)

without firms having to make much effort, therefore there is less incentive for them to cut costs
and therefore in the long run costs will increase and therefore inflation will increase. However,
this may not occur if firms are well run and they keep incentives to cut costs.

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To addresses such impacts the country must increase its currency value

So to increase the value of their currency, countries could try.

1. Sell foreign exchange assets, purchase own currency

2. Raise interest rates (attract hot money flows
3. Reduce inflation (make exports more competitive
4. Supply-side policies to increase long-term competitiveness.

8)

i) What do you understand by money market? What is money in

the context of international finance? Discuss
 Money market basically refers to a section of the financial market where
financial instruments with high liquidity and short-term maturities are
traded. Money market has become a component of the financial market for
buying and selling of securities of short-term maturities, of one year or
less, such as treasury bills and commercial papers.
 Money market consists of negotiable instruments such as treasury bills,
commercial papers. And certificates of deposit. It is used by many
participants, including companies, to raise funds by selling commercial
papers in the market. Money market is considered a safe place to invest
due to the high liquidity of securities.

 It has certain risks which investors should be aware of, one of them being
default on securities such as commercial papers. Money market consists of
various financial institutions and dealers, who seek to borrow or loan
securities. It is the best source to invest in liquid assets.

 Money: is an economic unit that functions as a generally

recognized medium of exchange for transactional purposes in an economy.
Money provides the service of reducing transaction cost, namely the
double coincidence of wants. Money originates in the form of a
commodity, having a physical property to be adopted by market
participants as a medium of exchange. Money can be: market-determined,
officially issued legal tender or fiat moneys, money substitutes and
fiduciary media, and electronic crypto currencies. 

ii) What are the major functions of money? Explain

 Money is often defined in terms of the three functions or services that it
provides. Money serves as a medium of exchange, as a store of value, and as a
unit of account.

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  Medium of exchange. Money's most important function is as a medium of
exchange to facilitate transactions. Without money, all transactions would
have to be conducted by barter, which involves direct exchange of one
good or service for another. The difficulty with a barter system is that in
order to obtain a particular good or service from a supplier, one has to
possess a good or service of equal value, which the supplier also desires. In
other words, in a barter system, exchange can take place only if there is a
double coincidence of wants between two transacting parties. The
likelihood of a double coincidence of wants, however, is small and makes
the exchange of goods and services rather difficult. Money effectively
eliminates the double coincidence of wants problem by serving as a
medium of exchange that is accepted in all transactions, by all parties,
regardless of whether they desire each others' goods and services.
 Store of value. In order to be a medium of exchange, money must hold its
value over time; that is, it must be a store of value. If money could not be
stored for some period of time and still remain valuable in exchange, it
would not solve the double coincidence of wants problem and therefore
would not be adopted as a medium of exchange. As a store of value, money
is not unique; many other stores of value exist, such as land, works of art,
and even baseball cards and stamps. Money may not even be the best store
of value because it depreciates with inflation. However, money is more
liquid than most other stores of value because as a medium of exchange, it
is readily accepted everywhere. Furthermore, money is an easily
transported store of value that is available in a number of convenient
denominations.
 Unit of account. Money also functions as a unit of account, providing a
common measure of the value of goods and services being exchanged.
Knowing the value or price of a good, in terms of money, enables both the
supplier and the purchaser of the good to make decisions about how much
of the good to supply and how much of the good to purchase.

iii) How does the use of money overcome the problems with a barter
system? Explain
 Money overcomes the problem of barter system by replacing the C-C economy with
monetary economy (where 'C stands for commodity).
 In the barter system, there was a problem of double coincidence of wants. It
was very difficult to match the expectations of two different individuals. Thus,
money was invented to overcome the problem of double Coincidence of wants.

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  When there was no money, it was difficult to give common unit of value to
goods or commodities, but when money was evolved, it gave a common unit of
value to every goods and services.
 Money facilitates the contractual future payments which were impossible at
the time of barter system.
iv) What is monetary policy and what are the tools of monetary
policy? At a theoretical level, when does monetary policy become
impotent or ineffective? Explain
Monetary policy: is an economic policy that manages the size and growth rate of
the money supply in an economy. It is a powerful tool to regulate macroeconomic
variables such as inflation and unemployment.

Tools of Monetary Policy

Central banks use various tools to implement monetary policies. The widely utilized policy
tools include: 

Interest rate adjustment

A central bank can influence interest rates by changing the discount rate. The discount rate
(base rate) is an interest rate charged by a central bank to banks for short-term loans. For
example, if a central bank increases the discount rate, the cost of borrowing for the banks
increases. Subsequently, the banks will increase the interest rate they charge their
customers. Thus, the cost of borrowing in the economy will increase, and the money supply
will decrease.

Change reserve requirements

Central banks usually set up the minimum amount of reserves that must be held by a
commercial bank. By changing the required amount, the central bank can influence the
money supply in the economy. If monetary authorities increase the required reserve
amount, commercial banks find less money available to lend to their clients and thus, money
supply decreases.

Commercial banks can’t use the reserves to make loans or fund investments into new
businesses. Since it constitutes a lost opportunity for the commercial banks, central banks
pay them interest on the reserves. The interest is known as IOR or IORR (interest on
reserves or interest on required reserves). 

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Open market operations

The central bank can either purchase or sell securities issued by the government to affect
the money supply. For example, central banks can purchase government bonds. As a result,
banks will obtain more money to increase the lending and money supply in the economy.

When does monetary policy become impotent or ineffective?

 Monetary policy becomes ineffective when a liquidity trap situation is occurred.

 When this situation is occurred the policymaker's attempt to influence nominal

interest rates in the economy by altering the nominal money supply is frustrated by
private agents' willingness to accept any amount of money at the current interest
rate.

v) What does purchasing power parity (PPP) theory postulate? How

does PPP theory differ from the law of one price?
Purchasing power parity (PPP) is a form of exchange rate that takes into
account the cost of a common basket of goods and services in the two
countries compared. The PPP between any two currencies is the measure
of the actual purchasing power of those currencies at a given point in time
for buying a given basket of goods and services.
 Purchasing power parities (PPP) are the rates of currency conversion
that equalize the purchasing power of different currencies by eliminating
the differences in price levels between countries. In their simplest form,
PPP are price relatives that show the ratio of the prices in national
currencies of the same good or service in different countries.
PPP theory differ from the law of one price
 The law of one price is an economic concept that states that the price of an identical
asset or commodity will have the same price globally, regardless of location, when
certain factors are considered rather Purchasing power parity states that the value of
two currencies is equal when a basket of identical goods is priced the same in both
countries. It ensures that buyers have the same purchasing power across global
markets.

9).

i) What is balance of payments and what are its major

purposes?

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  Balance of Payment (BOP): is a statement which records all the monetary
transactions made between residents of a country and the rest of the
world during any given period. This statement includes all the transactions
made by/to individuals, corporate and the government and helps in
monitoring the flow of funds to develop the economy.
 The purpose of balance of payments (BOP): is to summarize all transactions
that a country's individuals, companies, and government bodies complete
with individuals, companies, and government bodies outside the country.
These transactions consist of imports and exports of goods, services, and
capital, as well as transfer payments, such as foreign aid and remittances.

ii) Write and explain the components of balance of

payments. List and explain the items under each
component.

The BOP consists of three main components—current account, capital account, and
financial account.

Current Account:

This part of the balance of payments is regarded as the most important, as it shows a
nation’s trading strength. If payments are greater than receipts, there is a deficit which is
undesirable.

This account is subdivided in to:

1. Visible Trade — trade in goods

2. Invisible Trade — trade in services.

A — Visible Trade:

The money earned from Indian exports of goods (e.g., cars sold to Nepal) is credited (added)
to this account, whilst payments for imported goods (e.g., American aircraft sold in India)
are debited. The difference between the totals is known as the Balance of Trade.

B — Invisible Trade:

The income earned from the sale of Indian services abroad is known as an invisible export,
e.g., an insurance premium paid by a British ship-owner to an Indian broker. When Indian
residents spend money on foreign services, e.g., a week’s accommodation in London, they
are creating invisible imports, because payment is going out of India.

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The main invisibles are as follows:

1. Government expenditure: Government expenditure on embassies, contributions to IMF

or ADB and other international bodies, military bases/forces abroad, and overseas aid. All
these create a substantial deficit.

2. Interest, profits and dividends: The earnings from loans, companies and shares,
respectively, earn substantial surpluses for the Indian economy.

3. Other financial services: The earnings of solicitors, brokers, merchants and pensioners
also contribute benefits to the invisible account.

4. Transport: The earnings on passenger carrier by sea and air are two major items.

5. Tourism: This covers the expenditure of travelers abroad.

6. Private transfers: Individuals transfer money to other countries. Most industrialized

nations contain migrants who remit fluids to relatives in Capital Account:

3. Official Financing:

The Balance for Official Financing (which used to be termed Total Currency Flow) shows the
balance of monetary movements into and out of the country. A positive figure reveals a net
inflow of funds into a country

iii) At a theoretical level, what can you say about balance of

payments surplus and deficit?

Balance of Payments Surplus: The account by which the money coming into a nation is
more than the money going out in a particular time frame.

Balance of Payments Deficit: A balance of payments deficit means the nation imports
more commodities, capital and services than it exports. It must take from other
nations to pay for their imports

iv) What are some of the corrective mechanisms for balance

of payments deficit?
Balance of Payment deficit is a situation when autonomous receipts are less than
autonomous payments.
[Current A/c + Capital A/c Receipts] < [Current A/c + Capital A/c Payments]

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Autonomous transactions are those transactions which are carried out with economic
motive irrespective of the present position of the BOP.

This situation arises only on account of autonomous transactions.

To correct the deficit i.e. Adverse BOP position government will:

i. Withdraw the required amount from its Foreign Exchange Reserves or

ii. If required, it can borrow from the IMF.

These are the accommodating transactions of the government made only to bring
equilibrium in the Balance of Payment.

10.

i) What do you understand by an International Monetary System

(IMS)? Explain
An international monetary system is a set of internationally agreed rules,
conventions and supporting institutions that facilitate international trade,
cross border investment and generally the reallocation of capital between
nation states. It should provide means of payment acceptable to buyers and
sellers of different nationalities, including deferred payment. To operate
successfully, it needs to inspire confidence, to provide sufficient liquidity for
fluctuating levels of trade, and to provide means by which global imbalances
can be corrected.

ii) What are the criteria for evaluating an IMS? Explain each
Criteria for evaluating an IMS

• Adjustment refers to the process by which the balance of payment

disequilibria can be corrected. A good IMS is one that minimizes the
Cost of and the time required for adjustment.

Liquidity refers to the amount of international reserve assets that

are available to settle temporary balance of payments disequilibria.
A good IMS is one that provides adequate international reserves so
that nations can correct balance of payments deficits without
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 deflating their own economies or being inflationary for the world as
a whole.

• Confidence refers to the knowledge that the adjustment

mechanism is working adequately and that international reserves
will retain their absolute and relative values.
iii) Discuss and explain the evolution of the IMS. Distinguish
between the Bretton Woods system and the Gold Standard
system?
International monetary systems have evolved as follows.
Gold standard, until 1914 (fixed rates under UK dominance):
throughout most of the 19th century and up to 1914 (outbreak of
WW1), the world was on a gold standard. Especially, the period of
1879-1913 was called the Classical Gold Standard (or International
Gold Standard) because all major countries participated in it. Trade
was liberalized and capital was mobile.
Interwar period: after WW1, the world powers tried to return to the
gold standard at prewar parities (i.e., at the previous exchange rates),
but the attempt to restore gold convertibility did not succeed, except
momentarily. The 1920s-30s were characterized by recessions,
banking crises, the Great Depression and the rise of fascism. Exchange
rates were mostly floating and protectionism increased. There was a
hegemonic power shift from the UK to the US.
Bretton Woods system, 1950s-1971 (US-centered fixed rates):
Under the international dollar standard, the world economy
experienced high growth, price stability and movement toward freer
trade. Unlike the gold standard days, however, there were severe
restrictions on private capital mobility.
General floating and attempts to reduce instabilities, 1973-: After
the transition period of 1971-73, the major currencies started to float.
Soon, it was discovered that currency sometimes fluctuated too much.
Crises and calm periods alternated. Overshooting, currency crises and
massive capital flows became common. From 1985, major countries
occasionally intervened jointly to correct currency levels. At the same
time, European countries strived to create a unified currency in steps,
which was achieved in 2002.

Differences between the gold standard and the Bretton Woods system are as follows:

 A Bretton wood is a system under which the currencies are pegged with dollar
whereas under the gold standard the currencies are pegged to gold.

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 The gold standard is a floating exchange rate system, whereas, the Bretton woods
system was different because it was a fixed exchange rate system.

iv) What were the reasons for the collapse of the Bretton Woods
system?
 The collapse of the Bretton Woods system was due to internal inconsistency. The
American monetary discipline served as the nominal anchor for the Bretton
Woods system. But when the US started to inflate its economy, the international
monetary system based on the US dollar began to disintegrate.
 It was destroyed, in the first place, on the most general level, because of
insufficient flexibility in the system. Exchange rates had hardened, a discussion of
alteration had become impossible outside of the dramatic circumstances of a
major crisis, and other sorts of adjustment (for instance, in fiscal policy) were too
contentious politically.
 Second, the immediate disturbance that destroyed the system had a particular
cause, the monetary expansion of the United States in the late 1960s associated
with the Viet Nam war, and a very loose approach to monetary policy in the face
of an exchange crisis in 1971. The criticism that had been most cogently
expressed by General de Gaulle in the mid-1960s now seemed vindicated by the
manner of the collapse.
Third, the trigger that demonstrated the incompatibility of different national
policy stances within the system was given by the larger flows of capital.
11. Write short notes on each of the following. Give examples,
where necessary
i) The Mint Parity Theory
When the currencies of two countries are on a metallic standard (gold or
silver), the rate of exchange between them is determined on the basis of
parity of mint ratios between the currencies of the two countries. Thus, the
theory explaining the determination of exchange rate between countries
which are on the same metallic standard (say, gold coin standard) is known as
the Mint Parity Theory of foreign exchange rate.

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 ii) Stocks versus Bonds

Bonds Stocks
Bonds are financial instruments that
Stocks are instruments that
highlight the debt taken of the issuing
highlight the interest of ownership
Meaning body towards the holders and a promise
issued by the company in exchange
to pay back at a later stage with interest
for funds
Govt. institutions, financial institutions,
Issuers companies, etc. Corporates

Status Holders are the lenders to the firm Stockholders are the owners of the
Relatively low
Risk Levels High
Form of Interest, as a fixed payment
Dividend, which is not guaranteed
Return
Liquidation and preference in terms of
Additional
repayment Shareholders get voting rights
benefit
Over the Counter
Market Centralized/Stock Market
Type of Debt
Equity
investment
Fixed at the time of purchase
Time of Depends on investors
maturity

Owners Bondholders Stockholders

iii) Exchange Rate Pass Through

Exchange-rate pass-through (ERPT) is a measure of how responsive

international prices are to changes in exchange rates.

Formally, exchange-rate pass-through is the elasticity of local-currency

import prices with respect to the local-currency price of foreign currency.

iv) The Dutch Disease

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 Dutch disease is the apparent causal relationship between the increase in the
economic development of a specific sector (for example natural resources)
and a decline in other sectors (like the manufacturing sector or agriculture).

12.

i) What are the major factors (or forces) that have led to
increasing interdependence between or among nations?
Please make your own evaluation of these factors

Interdependence describes when two or more international actors impact

and rely on each other. Consider the flour industry, for example. One person
specializes in growing crops, another on milling, one on packing, distributing,
and finally selling it. They need each other to deliver the final product, and if
one day the mill stops, everyone is affected; they are all interdependent.

Think of those individuals as a country and the flour as the products and
services we consume. This gives you an idea of the interdependence of human
societies. We fulfill our needs by relying on a massive network of other
people.

Nowadays, most countries are also interdependent because they rely on other
countries for supplying local demand and for selling local products. This
interdependence is strong, and one nation's actions often have consequences
on another's. For example, China's labor costs impact employment in other
countries, Russia's policies on gas affects transport costs in Europe, and air
pollution generated in the United States has global effects.

ii) What is your evaluation of economic globalization? Please

provide explanations
Economic globalization involves a wide variety of processes, opportunities,
and problems related to the spread of economic activities among countries
around the world.

Economic globalization is the growing global integration not only of markets

but also of systems of finance, commerce, communication, technology, and
law that bypass traditional national, cultural, ethnic, and social boundaries.

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 It leads to more efficient division of labor, greater specialization, increased
productivity, higher standards of living and wealth, and ultimately the end of
poverty. Recent economic growth has greatly contributed to the high standard
of living enjoyed by many within the developed world and raised living
standards of many people formerly living in abject poverty. Many others have
not made such gains.

13.

i) What is meant by international macroeconomic policy

coordination (IMPC)? Explain

IMPC refers to the modifications of national policies in recognition of international

interdependence.

ii) What are the reasons for an IMPC and how does such
coordination take place? Discuss
The reasons for an IMPC
1. Trade flows:
 Countries are connected via trade flows, for example, the exports of
one country are the imports of another and vice versa.
 Changes in the volume of exports and imports will affect the
national incomes and employment levels of the trading partners.
 In general, the policies that influence the current account position
of a country will have spillover effects on its trading partners’
current account positions.
2. International capital movement:
 Like, policies that influence the domestic interest rate (and
thus affecting capital – inflow of capital outflow) will have effect on
trading partners.
How does such coordination take place?

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a) The Exchange of Information:
• A minimal type of coordination is the exchange of information
between/among the authorities of two/more countries.
b) Mutually Consistent Policies:
• The exchange of information may provide the basis for
more active coordination in that the countries concerned
agree either formally or informally to adopt consistent
macroeconomic policy stances.
• In other words, each country takes into account the aims
and policies stance of other countries when formulating its
own policy stance.
c) Joint Action
• Having exchanged information and agreed on mutually
consistent target values for the objectives of economic
policy, the authorities could go one step further and
agree on joint action to achieve desired targets.
• Joint action would mean a concerted action (collective
action) to achieve the desired objective.
• In joint action, for example, fiscal and monetary
policies could be adjusted to maximize joint welfare.
iii) What are the benefits (advantages) and the costs
(disadvantages) of an IMPC and what should be the way
forward? Explain
Advantages
 The benefits are associated with
the gains from trade and access to international capital markets.
 It reduces of uncertainty and avoidance of
excessive deflation.
 It has the potential to reduce the possibility of serious
conflict through the exchange of information.
 It competitive manipulation of
exchange rates (or competitive devaluations) and can remove the
danger of excessive deflation.
Disadvantages

 Lack of consensus about the functioning of the

international monetary system.

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  Lack of agreement on the precise policy mix
required.
 It has a problem of how to distribute the gains from
successful policy coordination among the participants and
how to spread the cost of negotiating and policing
agreements.

14.

i) Distinguish between foreign direct investment (FDI) and foreign

portfolio investment (FPI).

Foreign investment, quite simply, is investing in a country other than your home one. It
involves capital flowing from one country to another and foreigners having an ownership
interest or a say in the business. Foreign investment is generally seen as a catalyst for
economic growth and can be undertaken by institutions, corporations, and individuals.

Investors interested in foreign investment generally take one of two paths: foreign portfolio
investment or foreign direct investment.

Foreign portfolio investment (FPI) refers to the purchase of securities and other financial
assets by investors from another country. Examples of foreign portfolio investments include
stocks, bonds, mutual funds, exchange traded funds, American depositary receipts (ADRs),
and global depositary receipts (GDRs).

Foreign direct investment (FDI) refers to investments made by an individual or firm in

one country in a business located in another country. Investors can make foreign direct
investments in a number of ways. Some common ones include establishing a subsidiary in
another country, acquiring or merging with an existing foreign company, or starting a joint
venture partnership with a foreign company.

ii) What are the basic motives for FDI and FPI? Discuss

Three most common investment motivations:

 Labor-seeking investment is usually undertaken by manufacturing and service

MNEs from countries with high real labor costs, which set up or acquire
subsidiaries in countries with lower real labor costs to 4supply labor intensive
intermediate or final products. Frequently, to attract such production, host countries
have set up free trade or export processing zones.

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 Market-seeking investment is attracted by factors like host country‟ market size,
per capita income and market growth. For firms, new markets provide a chance to
stay competitive and grow within the industry as well as achieve scale and scope
economies. Traditionally, market size and growth as FDI determinants related to
national markets for manufacturing products sheltered from international
competition by high tariffs or quotas that triggered "tariff-jumping”. Apart from
market size and trade restrictions, MNEs might be prompted to engage in market-
seeking investment, when their main suppliers or customers have set up foreign
producing facilities and in order to retain their business they need to follow them
overseas.
 The motivation of efficiency seeking FDI is to rationalize the structure of
established resource based or market-seeking investment in such a way that the
investing company can gain from the common governance of geographically
dispersed activities. The intention of the efficiency seeking MNE is to take advantage
of different factor endowments, cultures, institutional arrangements, economic
systems and policies, and market structures by concentrating production in a limited
number of locations to supply multiple markets. In order for efficiency seeking foreign
production to take place, cross-border markets must be both well developed and
open, therefore it often flourishes in regionally integrated markets .However it is
worth noting that many of the larger MNEs are pursuing pluralistic objectives and
most engage in FDI that combines the characteristics of each of the above categories.
The motives for foreign production may also change as, for example, when a firm
becomes an established and experienced foreign investor.
15. Write short notes on each of the following. Give examples,
where necessary
i) The International Debt Crisis
Debt crisis is a situation in which a government loses the ability of paying
back its governmental debt. When the expenditures of a government are
more than its tax revenues for a prolonged period, the government may
enter into a debt crisis. Various forms of governments finance their
expenditures primarily by raising money through taxation. When tax
revenues are insufficient, the government can make up the difference by
issuing debt.
Example:
 The 1980s crisis.
 The 1990s crises.
 The Asian crisis of 1997-98.

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ii) The Reasons for the International Debt Crisis
a) Official grants and loans (often concessional--i.e., at low interest
rates and with grace periods and long maturities).
b) Long-term commercial bank loans.
c) Short-term commercial bank loans.
d) Securities markets (bonds, equity).

iii) The Role and Viewpoints of the Actors in the International

Debt Crisis and the Possible Remedies to the Debt Crisis
The actors are:
• International Banks – Commercial Banks
• the Authorities of the Developed Nations
• International Institutions – IMF and WB
• Debtor Nations
• Commercial Banks: argue that the debt problem is a
temporary liquidity problem, so give the debtor nations
some time. Commercial banks preferred rescheduling debt
repayments and at the same time ensuring that additional
interest are paid on the postponed principal repayments.
• They are opposed to granting debt forgiveness arguing that:
– a) Granting debt forgiveness for one country would lead other
debtors to seek similar relief,
– b) Debt relief might discourage the debtors from taking the
measures necessary to improve their economic performance.
The banks have also been keen to treat each debtor on a “Case
by Case” approach because each debtor faces different
circumstances.
National Authorities (of the lender):
• Their concern is to avoid the collapse of their banking system.
Because of their strategic and economic interests, the
authorities are prepared to allow some concessions.
• International Institutions (IMF and WB):
• The IMF wants the debtor countries to accept an IMF
sponsored adjustment package (IMF Conditionality), for
example, reduction of government budget deficits and money
supply, devaluation, elimination of government subsidies,
elimination of distorted price controls, and allowing markets
to function. The WB has been concerned about the costs in

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 terms of slower development that debt repayments impose
upon debtor nations.
The Debtor Nations – They claim that the
debt issue is not their making, but due to a
combination of external factors beyond their
control. They felt that the creditor banks
should consider the possibility of debt
forgiveness.
Possible Remedies to the Debt Crisis
There are three sets of proposals:
– Alter the structure and nature of the debt (Commercial
banks view) – e.g., lengthening the time horizon to make it
more manageable for repayment of the debt.
– Economic reform in the debtor nations (IMF and WB view)
– The argument is that the reforms will improve the debtor
nations’ ability to service their debts.
– Debt forgiveness – Write off part of the debts the debtors
owe by:
• Reducing the principal owed,
• Reducing the interest payments below the market rates,
• Mixture of the above two.

iv) The Paris Club

The Paris Club is an informal group of creditor nations whose objective is
to find workable solutions to payment problems faced by debtor nations.
The Paris Club has 19 permanent members, including most of the western
European and Scandinavian nations, the United States of America, the
United Kingdom and Japan. The Paris Club stresses the informal nature of
its existence and deems itself a "non-institution." As an informal group, it
has no official statutes and no formal inception date, although its first
meeting with a debtor nation was in 1956, with Argentina.
v) Default and moratorium
Moratorium
A moratorium refers to the delay or temporary deferral of a law or an
activity. It can be enforced by either a business or a government.

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 A moratorium continues to be in force until the issues causing its
enforcement are solved. Moratoriums can also be imposed to delay debt
payments under qualified circumstances, which make the lenders
incapable of paying off their debts. The process is called a debt
moratorium.
In legal terms, a moratorium can refer to a temporary postponement of a
law to allow the resolution of a lawful opposition.
Moratoriums are usually authorized when normal routines are
interrupted by a crisis.
For example, federal and state governments may grant moratoriums on
several financial activities immediately after a natural calamity or a
disaster. The governments may lift the restrictions once business returns
to normal.
Default
Default is the failure to repay a debt including interest or principal on a
loan or security. A default can occur when a borrower is unable to make
timely payments, misses payments, or avoids or stops making payments.
Individuals, businesses, and even countries can fall prey to default if they
cannot keep up their debt obligations.

References

 www.elibrary.imf.org
 Teacher hand outs
 Ocw.mit.edu
 www.google.com

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