Questions for Week 12 Flashcards
(24 cards)
What is the Balance of Payments (BOP), and why is it important?
The BOP records all economic transactions between residents of a country and the rest of the world, indicating the balance of payments across the current and capital accounts, and revealing trade imbalances and capital flow trends.
What are the two main components of the BOP?
The BOP includes:
- Current Account (CA): Reflects trade in goods, services, income, and transfers.
- Capital and Financial Account (KA): Records cross-border investments and financial flows.
What does a positive current account balance indicate?
A positive current account balance indicates that a country exports more goods, services, and income than it imports, typically leading to a surplus and potential accumulation of foreign reserves.
How does the capital account balance offset the current account?
A current account deficit must be offset by a capital account surplus (net capital inflows), balancing the BOP by bringing foreign investment or borrowing into the country.
How does an Australian exporter selling software to Israel impact Australia’s accounts if she buys stock in Israel?
This transaction:
- Credits the current account (CA) from software exports.
- Debits the capital account (KA) as the funds are used to purchase foreign stock.
How does a foreign firm buying Australian government bonds impact the BOP?
The purchase:
Credits the capital account (KA) due to foreign investment in domestic assets.
Leaves the current account (CA) unaffected as no goods or services are exchanged.
What are capital inflows and outflows?
Capital inflows: Foreign investments into domestic assets, adding funds to the capital account.
Capital outflows: Domestic investments in foreign assets, reducing the capital account balance.
How does political instability affect capital inflows and domestic interest rates?
Political instability reduces capital inflows as investors seek safer assets, likely raising domestic interest rates due to a reduced supply of investment funds.
Describe the relationship between national saving, investment, and the current account.
The current account balance equals national saving minus domestic investment:
Current Account (CA) = National Saving (S) - Investment (I)
What happens if national saving declines relative to investment?
A decline in national saving relative to investment leads to a current account deficit, typically financed through net capital inflows.
How do we determine equilibrium in the market for saving and investment?
Equilibrium occurs where national saving S equals investment I, adjusted for net capital inflows KI:
S + KI = I
How do changes in national saving or capital inflows affect the equilibrium interest rate?
Increased saving or capital inflows reduce the equilibrium interest rate, while lower saving or outflows raise it, affecting domestic investment levels.
What are the advantages of a flexible exchange rate system?
- Insulates the economy from external shocks (e.g., foreign inflation).
- Allows independent monetary policy to achieve goals like inflation control or full employment.
What are the advantages of a fixed exchange rate system?
- Provides exchange rate stability, reducing uncertainty for trade and investment.
- Lowers transaction costs and promotes confidence among investors.
In what situations is a flexible exchange rate system preferable?
Flexible rates are preferred when countries need insulation from external shocks, wish to maintain independent monetary policy, or when financial markets can self-stabilize exchange rates.
Under what conditions is a fixed exchange rate system beneficial?
Fixed rates are beneficial when exchange rate stability is critical, such as in highly integrated economies with low factor mobility, or when managing speculation is challenging.
In an open economy model, if investment opportunities improve, what happens to capital inflows and interest rates?
Improved investment opportunities attract more capital inflows, increasing supply in the capital account, potentially lowering interest rates and raising investment.
What effect does a rise in government budget deficits have on the current account balance?
A higher budget deficit reduces national savings, leading to a current account deficit if not matched by increased capital inflows.
What is the Twin Deficits Hypothesis?
The Twin Deficits Hypothesis suggests a link between government budget deficits and current account deficits, where higher budget deficits reduce national savings and worsen the current account.
How do twin deficits impact interest rates and foreign investment?
Twin deficits raise interest rates as demand for funds increases, attracting foreign capital inflows and often leading to currency appreciation.
Summarize the primary advantages and disadvantages of flexible exchange rates.
Advantages: Economic insulation from external shocks, independent monetary policy. Disadvantages: Potential for speculative attacks and exchange rate volatility.
What are the primary benefits and risks of a fixed exchange rate?
Benefits: Stability in trade, reduced speculation, and transaction cost savings. Risks: Loss of monetary policy autonomy and potential for currency misalignment or speculative attacks.
What is a speculative attack on a currency, and what are its effects?
A speculative attack occurs when investors sell a currency en masse due to expected devaluation, forcing the central bank to use reserves to defend the fixed rate or devalue the currency.
Why are fixed exchange rate systems more vulnerable to speculative attacks?
Fixed rates require maintaining a target rate, which can strain foreign reserves and limit monetary flexibility, making them vulnerable to large capital outflows during market uncertainty.
