International Economic Problems

（this picture is the answer of question 8）

· Use a J-curve to illustrate the effect on the current account of an exchange rate depreciation. Explain why the curve has the shape that it does. What condition must be fulfilled to have a positive effect of the depreciation of the currency on the current account?

After a depreciation, there is usually a short period of no noticeable impact on the flow of goods and services. When imports and exports begin to respond, the immediate change is an increase in the value of imports, pushing the current account balance deeper into deficit. A depreciation makes foreign goods immediately more expensive, but it takes time for households and businesses to find substitutes. Over time, domestic buyers substitute away from imports, and likewise, the appreciation of the foreign currency increases the demand for exports (which are also likely to be slow to adjust in the short run). Thus eventually, the current account balance should improve.

· How does a weak financial sector intensify the problems created by volatile capital flows?

For example, consider a banking sector that borrows internationally and lends locally. If the funds obtained in the international market are short-term and are used to fund long-term loans such as real estate, problems arise when the international loans must be repaid. If lenders believe that there is a problem with a borrowing bank, they refuse to roll over the debt, creating a liquidity problem if the bank's assets are tied up in real estate loans. In the short run, real estate is relatively illiquid and cannot be used to make a payment. When a number of banks are confronted with similar problems, their attempt to unload real estate depresses prices even further and undermines the solvency of the banking system since every bank with real estate investments is suddenly holding a portfolio of declining value. In turn, this reduces the ability of the banking system to lend, which further reduces investment and consumption.

· Explain how exchange rate policies affected economies during the Great Depression.

Many countries were on the gold standard at the beginning of the Great Depression. A gold standard requires that monetary authorities keep the stock of money in a constant ratio relative to the stock of monetary gold that the nation holds. This restricts the ability of a nation to use monetary policy. In 1931, it was widely expected that the United Kingdom would leave the gold standard altogether, and speculation turned against the pound. In September 1931, Britain left the gold standard and speculators immediately shifted their attention to the dollar. Expecting a similar decline in the value of the dollar, they began to sell dollars and dollar denominated assets, all of which resulted in gold outflows. The Fed was forced to respond by raising interest rates, and thus the U.S. economy continued its downward spiral. Countries that left the gold standard more quickly were able to use expansionary monetary policy sooner, and thus they recovered more rapidly. The U.S. did not leave the gold standard until after Roosevelt's election, and after that point, the economy began its recovery.

· Explain the pros and cons of a crawling peg.

A crawling peg involves fixing the exchange rate to a major world currency. This involves regular devaluations of a fixed amount in order to stabilize the real exchange rate in a country with higher inflation than its trading partners. Maintaining the peg requires the monetary authority to exercise discipline in the creation of new money and is anti-inflationary in that sense. Countries frequently try to reinforce the anti-inflation tendency of the crawling peg by intentionally devaluing at a slower pace than the difference between home and foreign inflation. This creates real appreciation in the exchange rate, and is intended to act as a brake on domestic inflation as foreign goods become cheaper in real terms. The use of the exchange rate in this manner has mixed success in helping control inflation, but in a number of cases it has led to severe overvaluation of the real exchange rate and increased the country's vulnerability to a crisis.

Another way in which a crawling peg exchange rate system increases a country's vulnerability to crisis is that it is sometimes politically difficult to exit from the system if it becomes overvalued. When a government announces a change in the system, it runs the risk of losing its credibility. A sudden large devaluation leads to economic losses and a loss of confidence in the country's policy makers, and thus it is common for countries to delay addressing the problem of overvaluation, so that when the correction comes, it has to be larger.

· Describe the policies that a nation would follow to correct a current account deficit. What are the primary purposes of each type of policy?

Policy makers need to turn domestic expenditures away from foreign-produced products toward domestic products (expenditure switching) and reduce the overall level of demand in the economy (expenditure reducing). Expenditure reducing policies are intended to avoid inflation. Expenditure switching policies are intended to avoid recession.

· Explain why in an economy with fixed exchange rates, monetary policy will not cause expenditure switching.

Expenditure switching refers to switching back and forth between domestic and foreign goods, in this case, in response to a change in the exchange rate. Expenditure switching magnifies the effects of monetary policy when rates are flexible. In an economy with a fixed exchange rate, changes in the money supply will not cause expenditure switching because the exchange rate does not change.

· How did the vulnerabilities in Asian economies lead to the Asian financial crisis of 1997-1998?

First, a number of Asian countries had large trade and current account deficits. This implied large financial account borrowing and large capital inflows, particularly because rates of growth in these economies were relatively high, making them attractive places to invest. Secondly, many economies had currencies that were pegged to the dollar, and as the dollar appreciated, these currencies appreciated as well, causing overvaluation and misalignment of currency values, as well as reducing the competitiveness of exports. Third, the financial sectors of these countries were weak, with mismatches between the maturities of assets and liabilities and inadequate regulation due to corporate structures that relied heavily on personal and family relationships. The crisis was triggered by reductions in export earnings in Thailand, which then reduced confidence in the ability of the country to maintain its overvalued exchange rate. The expectation of devaluation of the baht caused speculation against it, and at the same time, monetary authorities were reluctant to devalue because it would increase the cost of dollar-denominated international loans. Eventually, the baht had to be devalued, and in turn, this may have caused investors to lose confidence in related economies with similar vulnerabilities, spreading the crisis to other Asian economies.

· Explain the meaning of IMF conditionality and why it has been criticized.

IMF conditionality refers to the changes in economic policy that borrowing nations are required to make in order to receive IMF loans. Conditionality typically covers monetary and fiscal policies, exchange rate policies, and structural policies affecting the financial sector, international trade, and public enterprises. Each additional installment of an IMF loans is conditional on some of these requirements being met. Often these types of reforms generate significant opposition since they seem to override national sovereignty and generally impose contractionary macroeconomic policies. Some argue that conditionality requirements intensify the recessionary tendencies of a crisis, although there is a debate over whether countries recover faster with IMF assistance than without it. Until the early 1990s, the IMF focused its efforts on economic policy reforms in a way that more or less ignored their social consequences. Public outcry against the effects of conditionality on the vulnerable members of societies have forced a closer look at the social impacts of policies, and the IMF has tried to make adjustments. However, there are still widespread complaints that IMF conditionality is too punitive and too contractionary, and a few countries in crisis have refused IMF assistance.