CHAPTER 4&5

GROUP 3

*4a How do capital inflows affect a country’s exchange rate?

It’s a theory in which the interest between two countries is equal to thedifferential between the forward exchange rate and the spot exchangerate.

Interest rate parity plays an essential role in foreign exchange markets,connecting interest rates, spot exchange rates and influencing foreignexchange rates.

INTEREST RATE PARITY

may increase inflation on a country’s currency and cause deficits

can push a currency far above its intrinsic value

CAPITAL FLOWS

“…capital flows can push a currency far above its intrinsic value, widening the trade deficit andhollowing out domestic manufacturing. Second, they can fuel borrowing booms, especially incountries with underdeveloped financial systems, leading to devastating busts when the moneyflows out.”

Economist, OCT12, 2013 Chapter 4

CAPITAL INFLOW

Capital inflow increases the value of country’s currency

CURRENCY APRECIATION

PROPERTY & STOCK MARKET

Investors are moving into property and stocks an increase in the interest rate reduces capital inflows depreciation in the exchange rate

CAPITAL FLOW EFFECT

CURRENCY DEPRECIATION

Positive Negative

*4b What is meant by self-insurance?

CURRENCY B

CURRENCY A

High demand for A

People convert B into A

Central bank of B sells its reserves of A

and buys its own currency B

More demand for B

More supply of A

EXCHANGE RATE FLUTUATIONS

Result: 1. Enough reserves of A to keep B exchange rate stable2. No reserves of A and B gets devalued

In the example: B is likely to get devalued, as…The speculator borrows Bs and converts those into As;The central bank of B runs out of As even faster.

Once B gets devalued:1. Speculators change their As back into Bs;2. Speculators can pay off their debt and still have Bs left.

SPECULATIVE ATTACK

Thai baht attack in 1997

US investor who (in 1992)speculated on the devaluationof the british pound, therebyearning a profit of $1 billion

George Soros

CASES OF SPECULATIVE ATTACKS

The man who brokethe bank of England

Thai central bank kept the bahtstable when people exchangedtheir bahts into $ ran out of$ quickly speculative attackwas successful

1

Countries create extremely highresources of foreign reserves.

3

Stabilization of a currency and being ableto intervent in the exchange rate market.

2

Enough reserves not to run out offoreign currencies even duringattacks.

HOW DOES SELF-INSURANCE RELATE TO THIS?

FROM $2 TRILLION TO 11$ TRILLION

GLOBAL VOLUME OF RESERVES

For particular countries: Bad experiences in the past; More control over the exchange rate market.

Globally: Foreign exchange rate intervention is a zero sum game; If one country improves its trade balance another country‘s trade balance is made worse; Poor countries see a bad investment in holding many low-yielding government bonds; Global monetary cooperation is slowed down.

PROBLEMS OF SELF-INSURANCE

*5a What is the impact of a multilateral and a regional trade pact, respectively, on international firms?

The goal is to lower or remove trade barriers such as import tariffs This levels the playing field by treating all involved nations equally All involved Nations get treated equally Increases the export of a country

DisadvantagesVery complicated and difficult to negotiate!Example:The agreement between US/Canada/Mexico (NAFTA)

MULTILATERAL TRADE AGREEMENT

Leads to both trade liberalization and discrimination Liberalization because more regions/producers can be accessed leading to trade creation; Discrimination because the partners who are not involved in the agreement might become less desirable.

Some concerns … The creation of RTA slows down the creation of MTA; RTA’s might create ‘trade blocks’ which have no interest in others.

REGIONAL TRADE AGREEMENT

REGIONAL AGREEMENT

Every Regional Trade Agreement creates (media) attention;Which might convince other parties to join the agreement;This will lead to more multilateral deals.

SNOWBALL EFFECT?

MEDIA AATTENTION

OTHER PARTIES A NEW AGREEMENT

1

Allow firms to tradeinternationally at a lower cost

Access to new markets for thefirms

Higher trade

more production

more investments

higher development!

3

By excluding sensitivesectors/imposing rules of origin

complicates life for internationalfirms

CONCLUSION

ADVANTAGES DISADVANTAGES