Global Economics Flashcards
(40 cards)
Optimal currency area
A geographical area which would maximise its efficiency if the entire region shared a single currency
What are the criteria for a successful currency union as established by Mundell?
1) Labour mobility, including physical ability to travel (e.g. visas), lack of cultural barriers (e.g. language) and institutional arrangements (e.g. ability to transfer pensions)
2) Capital mobility and wage and price wage flexibility so that market forces can distribute money and goods where they are needed
3) Risk sharing (e.g. fiscal transfers to redistribute income to less well off areas)
4) Economic cycle convergence so that the central bank is able to promote growth in downturns and contain inflation in booms
What are the main arguments for adopting a fixed exchange rate?
1) Trade and investment
2) Reductions in the costs of currency hedging for businesses
3) Disciplines on domestic producers
4) Reinforcing gains in comparative advantage
How does a fixed exchange rate boost trade and investment?
Overseas investors will be more certain and confident that the returns from their investments will not be destroyed by sudden fluctuations in the value of a currency (less currency risk)
How does a fixed exchange rate create discipline on domestic producers?
Forces them to keep costs and prices down as in the LR one country’s inflation must fall in line with another, potentially encouraging attempts to raise productivity and focus on research and innovation
How does a fixed exchange rate reinforce gains in comparative advantage?
Differences in relative until labour costs will be reflected in the growth of exports and imports
What are the main arguments for adopting a floating exchange rate?
1) Less need to hold huge foreign currency reserves
2) Can be a useful instrument of macroeconomic adjustment (e.g. a lower currency can boost AD)
3) Provides partial ‘automatic correction’ for a trade deficit (i.e. large trade deficit should lead to an excess supply of sterling and hence cause a depreciation)
4) Freedom for domestic monetary policy
What are the risks with a floating exchange rate?
1) Currency volatility could damage international trade and capital investment
2) Fluctuating currencies increase the need for hedging costs by exporters and importers
What is the Mundell Fleming Trilemma?
States that a country always faces constraints in choosing their exchange rate regime, only being able to access two of the following three:
1) An independent monetary policy (freedom to set interest rates)
2) A fixed exchange rate (currency stability and predictability)
3) An open capital account (freedom to finance a current account deficit)
What is the theory on exchange rates?
Mundell Fleming Trilemma
Formula for Terms of Trade
Terms of Trade index = [ (price index for exports) ÷ (price index for imports) ] x 100
Terms of Trade
The amount of imported goods or services an economy can purchase per unit of exported goods or services
How does a rise in the price index affect the Terms of Trade?
Improves the ToT since a country can buy more imports for any given level of exports
What factors cause a change in the Terms of Trade?
1) A rise/fall in the world price of a country’s main export (e.g. heavy reliance on primary commodities can see volatile ToT)
2) Changes in the exchange rate that change the price of imported goods
3) A change in relative inflation rates
What impact does a improvement in the ToT have?
1) Standard of living improves as a nation is able to import cheaper food so may increase real incomes
2) The price of imported technology decreases
3) Import and export prices affect the value of trade flows and hence the Balance of Payments
Balance of Payments
Records all financial transactions made between consumers, businesses and the government in one country with others
What does the Balance of Payments do and why?
Balances because if a £ is sold someone must be buying that £
What are the components of the BoP?
1) Current account
2) Financial account
3) Capital account
4) The balancing item
What does the current account consist of?
1) Balance of trade in goods
2) Balance of trade in services
3) Net primary income (i.e. net investment income) - includes income from interest, profits and dividends from foreign investment
4) Net secondary income (i.e. transfers) - includes aid and remittances
What does the financial account consist of?
Assets: Direct investment, portfolio investment, hot money and loans
What does the capital account consist of?
The financial transactions that affect a country’s future income, production or savings (least important account)
Why can a Current Account deficit be a problem?
1) Can reduce AD, affecting growth
2) Can create unemployment
3) Sign of an uncompetiive economy
4) Size of deficit may be unsustainable
5) BoP crisis (potentially from capital flight) may require intervention from the IMF
Why may a Current Account deficit not be a problem?
1) Some of the richest countries in the world have deficits (e.g. US’ = 2.4% in 2019)
2) Does not necessarily impact unemployment (e.g. UK experiencing record low unemployment)
3) May indicate that the citizens of these countries are buying lots of imports and enjoying a high standard of living
4) Many developed countries generate most of their income from services which are mainly domestically traded, hence deficit not surprising
What level of BoP deficit is regarded as sustainable?
2-3%
