topic 19.1

ALTERNATIVE INTERNATIONAL MONETARY STANDARDS

topic 19.1

THE GOLD STANDARD 1880-1914

Currencies had a fixed rate of excahnge with gold.

For example $20.67 = 1 ounce of gold

So all countries had in effect fixed their rates of exchange against other countries' currencies.

The benefit was price and exchange rate stability.

If a country tried to inflate its currency it would lose gold as people turned in their money for gold at the fixed rate. Since no country has unlimited gold reserves this prevented inflation.

A disadvanatge was that growth in the world gold supply determined the rate that money could grow. If too much gold was supplied there would be inflation, too little and there would be deflation.

After the first world war there were attempts to restablish this system, but they failed. A strict gold standard was not sustainable as countries tried to print more mony. Eventually even the US gave up on the gold standard.

topic 15.1

EXCHANGE RATES, INTEREST RATES, AND INTEREST PARITY

topic 15.1

INTEREST PARITY

Countries trade goods and services at a point in time. They also trade over time through buying and selling financial assets.

Under free trade with costless arbitrage the price of 'bonds' is constrained in a manner similar to that of goods. Just as traded goods should (in theory) conform to the 'law of one price', so too assets should exhibit parity conditions. Assets are actually a much better candidate for parity conditions than goods because they are homogeneous and easily traded, unlike goods which are neither.

The best known parity condition applies to international trade in bonds: 'interest rate parity'.

Assume there are two bonds, a US bond denominated in dollars and a UK bond denominated in pounds. Assume both are risk free.

Then

(1 + i)$ = (1 + i) pounds * (F/E)

where:

i$ and ipounds are the returns on the US and UK bonds
F and E are future and spot exchange rates ($/pounds)

To explain this - consider a US person with $1 to spend on a US one-year bond or a UK one-year bond. Absent any risk differences or transaction costs the investor should be indifferent between:

• investing in a US bond today or
• investing in a UK bond today with the necessary use of the exchange rate to convert dollars to pounds today (E), and then back the other way one year from now (F)

Another way to express the equation is:

i$ - ipound = (F-E)/E

In this example (F-E)/E is the 'forward premium'

The intuition here is that if US bonds paid a higher nominal interest rate than UK bonds then the higher expected US return must be offset by an expectation that the dollar will depreciate against the pound (F is higher than E).

If the forward premium is insufficient to cover exchange rate risk the traders will move into US bonds, driving the US bond price up and theUS bond expected return down (and the opposite for the UK bond) - this will drive the system toward parity.

There are reasons why interest rate parity may not hold: different risks between the bonds or the forward rate is not certain - it is an expected rate.

We can extend a similar analysis to equities.

The advantage of parity conditions is that they allow us to cut through the complexity of international finace to establish core fundamental relationships.

topic 17.2

THE MONETARY APPROACH TO THE BALANCE OF PAYMENTS

Topic 17.2

The MABP emphasizes the monetary aspects of the balance of payments.

The MABP is based on the idea that any balance of payments disequilibrium is based on monetary disequilibrium.

Monetary disequilibrium is an imbalance between the amount of money people wish to hold and the amount supplied by the monetary authorities.

So the determinants of money demand and money supply also determine the balance of payments.

David Hume understood the concept of the MABP.

The MABP is based on fixed exchange rates. If there is a disequilibrium money must move because the exchange rate cannot adjust. In economics, if prices are not allowed to adjust, then quantities must carry all the burden of adjusting to exogeneous shocks.

topic 8.1 and topic 9.1

COMMERCIAL POLICY THEORY AND PRACTICE

Topic 8.1

Figure 8.1 depicts levels of tariffs for the U.S.. It has fluctuated between 60 percent and 5 percent.

The last general tariff bill was the Smoot-Harley tariff in 1930. This general tariff contributed to the Great Depression.

The General Agreement on Tariffs and Trade (GATT) was instituted after WWII. It served as a mechanism for setting rules of conduct in international commerce and an arena to resolve international commercial disputes.

Key GATT principles:

• trade barriers should be lowered in general and quotas eliminated
• trade barriers should be non-discriminatory
• no trade concession shouldbe rescinded without compensation
• trade disputes should be settled by consultation

GATT provided a forum for talks to lower protection.

There have been 9 rounds. The current Doha round has been inclusive.

The U.S. President has authority to negotiate trade agreements, which have to be ratified by Congress.

The World Trade Organization (WTO) is the successor to the GATT. The WTP has enforcement authority. Cases are brought to the WTO which can render decisions.

Currently the WTO rules prohibit trade restrictions aimed at changing another countries’ domestic policies (on the environment for example). For example U.S. prohibition of tuna imports to protect dolphins was disputed.

PREFERENTIAL TRADE ARRANGEMENTS

Topic 9.1

Free trade areas (FTA) are agreements to eliminate trade barriers between the members.

A customs union (CU) eliminates trade barriers between members and creates a common barrier against non members.

The European Union (EU) is a CU Founded in 1957. The EU has expanded its charter to become more like a United States of Europe.

The North American Free Trade Agreement links the U.S. Canada and Mexico. It is an FTA created in 1994.

Other trade agreements exist in Africa, Asia, Europe and Latin Europe.

There is a tension between “regionalism” and “multilateralism”. To the extent that trade agreements increase total world trade, this “trade creation” increases world welfare. Agreements that only divert trade from one nation to another - “trade diversion” - are actually distorting the natural pattern of trade and lowering world welfare.

There is an argument that trade diversion effects are small because trade agreements tend to follow the natural direction of trade - they tend to be “natural” trading areas.

Measuring the benefits of free trade areas is difficult because it involves calculating “what if” the agreement had not occurred. These agreements may generate dynamic benefits from technology diffusion and international movement of skilled people to where they are most productive.

At this point we have not addressed the free low of assets – international financial liberalization.

topic 17.1

BASIC THEORIES OF THE BALANCE OF PAYMENTS

Topic 17.1

The Elasticities Approach

The elasticities approach requires strong assumptions:

• there is no trade in assets
• there is no macroeconomic consideration of employment conditions - what if an economy is at full output and cannot increase output?

Relative price determines consumption patterns through substitution effects.

As relative demands and supplies for goods change, relative prices will adjust.

The elasticities approach is concerned with the way changing relative prices of domestic and foreign goods will change the balance of trade.

Elasticity measures the responsiveness of quantity to changes in price.

Ed = %ΔQd / %ΔP

Es = %ΔQs / %ΔP

where:

Ed = elasticity of demand
Es = elasticity of supply
Qd = quantity demanded
Qs = quantity supplied


The ‘law of one price’ is the concept that.

P = e.P*

where:

P = price of a good in domestic currency
P* = price of a foreign good in foreign currency
e = exchange rate


an example

If the good in questions is identical shoes that are produced and sold in Japan and also produced and sold the U.S.:

P = $50
P* = ¥500
E = 1/100 [units are $/¥]
Then P=eP* holds true


For the law of one price to hold there are strong assumptions:

• no transport costs
• these are traded goods
• these are identical goods

arbitrage is perfect

If we extend this relationship to all the goods in a country we call this ‘purchasing power parity’, PPP.

Under PPP the P, P* are the general price levels in the two countries:

P = e.P*

where:

P = domestic price level
P* = foreign price level

For PPP to hold the assumptions are even stronger, especially the assumption that all goods are traded. While shoes are traded goods haircuts are not. This form of PPP is called ‘absolute PPP’. A weaker form of PPP is ‘relative PPP’.

%Δe = %ΔP - %ΔQP*

Relative PPP says that differences in inflation rates are reflected in the exchange rate.

Absolute PPP requires that both the levels and rates of change in P, P* must be matched.

Relative PPP does not require that levels of P, P* must follow the formula.

The elasticities approach uses two concepts:

• the law of one price
• elasticity

The elasticities approach to the balance of trade provides an analysis of how devaluations will affect the balance of trade depending on elasticities of supply and demand for goods and for foreign exchange.

There is a condition for a devaluation to improve the balance of payments: The Marshall-Lerner Condition.

Marshall-Lerner Condition

A devaluation will improve a country’s trade balance and provide a stable foreign exchange market if the domestic elasticity of demand for imports plus the foreign elasticity of demand for imports is more than 1.

This is an application of the fact that high elasticities are ‘good’.


The J Curve

The J curve is a phenomenon whereby a devaluation will temporarily worsen the balance of payments even if the Marshall-Lerner Condition is satisfied.

It arises from having trade contracts which cannot be rewritten immediately.

If U.S. export prices are fixed in $ and imports are fixed in ¥ and the dollar devalues then (temporarily) the U.S. receives the same $ revenue from exporting but has to pay more (in $) for the same quantity of imports. So there is a trade deficit.

The Pass-Through Period

The currency contract period is the period after a devaluation when contracts reflect pre-negotiation prices.

Pass-through analysis considers the ability of international prices to adjust in the short-run.

‘Pricing to market’ behavior occurs when exporters deliberately adjust profit margins to limit the pass-through of higher prices to importers. In the previous example this would occur if the Japanese exporters chose to lower their ¥ prices to allow for the fact that the $ has fallen in value.

topic 5.1

TESTS OF TRADE MODELS

topic 5.1

Tests of the Classical Model

MacDougall tested the classical model in 1937

• compared the U.S. and The U.K.
• obtained measures of labor productivity for each industry in each country
• U.S. wages were double those in the U.K.
• this implies that the U.S. should be exporting more (relative to the U.K.) of the goods from industries with double or greater the productivity of their counterparts in the U.K.
• the classical model only uses labor inputs - so capital does not enter the story
• the data semmed consistent with this
• a problem is that the classical model does not deal with two countries exporting to a third country with unknown productivities
• other models can explain the export pattern he found

Leontieff tested the HO model

• he invented the input-output table, originally used during WW II to plan the economy
• he used data from the 1950s
• he carried out the following calculation - if the U.S. decreased exports and decreased imports by $1 million each, and the free capital and labor was moved from the export sector to the import sector, would there be enough caspital and labor to replace the missing imports?
• he found that extra capital would be needed and tehre would be surplus labor available after replacing the imports
• this means that the U.S. exported more labor intensive products and imported more capital intensive goods
• since the U.S. was assumed to be capital abundant (an exporter of capital intensive goods)
• this contradicts the HO model - hence the "Leontieff Paradox."
• Vanek explained the paradox as the result of missing a third factor - natural resources
• the HOV model is an HO model that adds a third factor of production - natural resources
• Travis claimed that tariffs distorted the results
• Other suggested explanations were that tastes should be included, or that technologies are not really identical across countries
• a more recnt test by leamer concluded that many other factors should be considered in adddition to labor and capital
• other economists looking at these emprical issues include Maskus, Bowen, Trefler, and Harrigan

topic 6.1

TARIFFS

topic 6.1

Commercial policy is actions taken by government to influence the volume and composition of trade flows:

• tariffs
• quotas
• subsidies
• nontariff barriers

Gains from trade:

• static gains
• dynamic gains

Static gains from trade:

• figure 6.1 depicts the static gains
• there are two parts to the gain - consumption and production
• consumption gains arise because even if production doesn't change imported goods are cheaper
• production gains arise from specialization

Dynamic gains from trade:

• importing capital
• technology diffusion
• competitive pressures
• economies of scale from expanded market
• immigration (not in text!)

TARIFFS

Revenue effect
Protective effect

Figure 6.4 depicts the gain from trade (on the import side) for a small country:

• consumer surplus increases by a+b+c
• producer surplus increases by a
• so total welfare gain is b+c

Figure 6.6 depicts the welfare loss due to a tariff (ie loss on import side):

• the tariff effectively raises the price of imports from pw to pw+t
• before the tariff the welfare gain from trade was (b+c+d+e) (e is not in the text)
• after the tariff consumers lose b+c+d
• government gains revenue c
• deadweight loss is b+d
• why isn't the whole area (b+c+d+e) lost? Becasue the world is not actually charging a higher price for the imported good. A tariff is a tax that causes losss only to the extent it distorts behavior (quantities consumed and produced).

Complications to tariffs:

• deadweight loss depends on elasticities
• a large country theoretically could benefit - "optimal tariff"

Estimating the protectiveness of tariffs is difficult - there are so many different rates.

Tariffs on inputs contribute to protection.

The ERP is an attempt to get at the effective rate of protection.

Countries negotiate;

• multilaterally
• bilaterally

Tariffs can be ad valorem, specific, or compound.

MFN: most favored nation status

GSP: generalised system of preferences

Trade agreements include NAFTA, the EU, free trade agreements

Multilateral is the most globally efficient but also the most politically difficult.