Macro economics 3

1. Using the global capital diagram presented in class (and in handout), in which the
rate of return (or marginal product of the capital) is shown for both the home
country and rest of the world, explain effects of free trade in factor incomes when
there is zero mobility of both labor and capital, and compare this to the effects of
having perfectly free mobility of capital. What are the implications of this, if any, to
be drawn from the expanding trend toward multi nationalization?
Answer: in the heterogeneous economies the globalization is effected by integration of goods
and financial markets. The Free trade is the policy of trade followed in international trade
government does not restrict imports or exports of the country. Sometimes government
imposes policies to support local employment and protection of natural resources. Free trade
generally promotes the trade for goods without taxes, tariff and quotas. It promotes the
unregulated access to market and the avoid market distortions and also encourage trade
agreements among countries. Free trade could be better understood by the Ricardian theory
of comparative advantage. According to some economist the selective application of the free
trade is economically inefficient causing trade diversion between one country which is
having a free trade and the country facing trade barriers. Free trade would cost one producer
the lesser cost and the other a higher cost which will raise disparity. Commodity and factor
mobility are both substitutes for each other. The classical economist generally chooses factor
immobility. In a 2*2*2 model the factors mobility is discussed where two factors labor and
capital, two commodities are discussed between two countries. The model assumes there is
homogeneous production function in the economy of first degree. The marginal productivity
of labor complete depends on the mobility of factors of production. Factor endowments are

excludable from specialization. Assume that two countries are producing two final
commodities cotton and steel. With two factor of production that is labor and capital. Country
one is well endowed with the labor but there is lack of capital or in other words country one
is labor abundant country whereas country two is capital abundant. Indifference curve are
used for the model. If the factors are immobile than, if factors are immobile than there would
be factor price equalization. The country which is labor intensive will export its goods to the
capital intensive country.

Country A which is labor intensive will exchange its product with the capital intensive
country. In case if the factors are completely mobile the productivity of the countries will
increase by increasing the wage rate for the labor. Labor will get more return for their work
and earn a greater foreign exchange for the country. But there will be brain drain of the
educated and skilled labor. A multinational company operates through different branches or
subsidiaries in the other country. These firms utilize their technology that is superior to
others. These companies are gaining success in utilizing the cheap labor from its capital
resource. These firms are having more economic advantage of one on the other where the
factors are cheap. The multinationals are creating a global trend to the development of the
mobility of assets. Multinational open their branches other than home countries which lowers
the risk of brain drain. There is perfect utilization of resources without factor mobility.
2. Explain the so called forward or future currency markets and discuss how:
The future currency market is a legal binding contract which obligates two parties for the
specific amount of currency pair at a pre determined price or in other words it is the stated
exchange rate at some point in the future involved in trade. The seller exchanges or gambles
when the price of the currency will be lower before the settlement date. The main difference in
the future currency and the spot rate is the trading price determination and the physical exchange
of the currency pair takes place. Currency futures could be described as the exchange traded
futures. Traders have the accounts with the broker tat direct orders to various exchanges for
buying and selling of the future currency contracts. Corporate mangers construct hedges on the
basis of interest rate, exchange rate and some other market factors. Hedging is always used to
minimize the risk against currency exchange. A well designed hedging program reduces the cost

and risk involved. The foreign exchange currency forward or hedging process is defined by the
following diagram.

a) a U.S importer faced with making a future payment in say, Euro; and,
Foreign currency transactions are sensitive to the fluctuations in the exchange rate. The price
could rise or fall in future for this risk the currency is hedged. Suppose a lubricant importer
purchase lubricant from worth 15000 euro and places an order on June, with the delivery date
after three months. At the time of placing the contract, the on spot market rate for one euro worth
45$. However, suppose the dollar depreciate by to 40. When the payment is due in June 20145,
the value of payment for the importer goes up to 6, 75,000 rather than 6, 00,000.
b) a U.S exporter faced with a future payment made in Euros would use these markets
to hedge their currency risk.
. A U.S exporter who is exporting gems worth $45,000 in March 2015. He wants protection
against a possible appreciation in the euro in June 2015. On spot dollar rate is 50 when he is

required to pay in June 2015, suppose the dollar appreciates to 53. If he wants to lock the
exchange rate for the transaction his strategy would be t sell 50$ in March and buy 53 dollar in
June 2015 contracts. By hedging the he off set his losses.
B) Explain how a) The so called future options markets and; b) Currency swaps can be
used to hedge a companys financial position, as compared to the straight forward future
contracts
Currency swaps are the foreign exchange derivative between two institutions for the exchange of
the principal amount and the interest on the loan in one currency, and in the net present value
term in the other currency. These swaps are promoted comparative advantage. It can also be
described as the currency swaps are the agreements between two parties for the exchange of cash
flows of one partys loan for the other part of a different currency denomination. Swaps are the
integral arbitrage link between the interest rate of different developed countries. They allow the
companies to exploit the global capital markets more efficiently. Currency swaps are priced the
same as the discounted cash flows. The companies which have exposure to foreign markets
usually hedge their risk currency swaps forward contracts such as fixed rate, floating rate
gloating rate.
c) Discuss the possibilities inherent in using diversification of global operations as risk
reducing strategy
Diversification is an important policy for reducing the risk of the investor. Investment made in
different companies in different industries is an example of diversification. You can invest in
manufacturing, retail, technology and service companies. It is technique that reduces risk by
allocating investment among financial instruments, industries and other categories. There are

additional types of diversification, and much synthetic investment products have been to
accommodate investors risk tolerance levels. It helps investor manage risk and reduce volatility
of assets price movements.
3. There has been a long run argument between the developed and the less developed
countries regarding the role of the official government-directed aids vs. reliance of
the LDCs upon private foreign capital flows. (i.e. MNEs), roughly summarized as
the Washington vs. Japan consensus. Discuss this point of views, particularly
concerning the crucial role of (subjectively) determined risk in determining the
foreign investment.
Answer: the stark of developed and developing countries. The United Nations development
program (UNDP) rates the development annually according to the measurement of human
development index (HDI); this measurement includes the citizens standards of living, health
care and the educational attainment among other factors. These differences indicate the
economic inequality which is the difference in the assets and incomes of the individuals. And
the developing country which means that there is less industrialization and low rate of per
capita income level. Trade imbalances are financed through capital and financial flows that
generate changes in the net foreign assets. Economists favor the free flow of capital across
the borders because it allows the capital to seek freely the highest rate of return. Unrestricted
flow of capital reduces the risk faced by the investors allowing them to diversify the loan and
investments. The global integration of capital markets contribute to the spread of corporate
governance and legal traditions. The global mobility of capital limits the government to
pursue bad policies. Foreign direct investments also transfer the capital in shape of
technology, particularly from the capital inputs hat cannot be achieved by financial

investments. They also promote competition in the domestic market. The foreign investment
could not be beneficial when investment is geared toward serving domestic market protected
by high tariff or non tariff barriers. The difference in the developed country inflow and the
developing country inflow was most importantly due to the foreign direct investment.
In the developing countries the most important institution is the state. This is important as the
Washington consensus primarily talked about corruption risks and bureaucracy. The criticism
about the Washington consensus is deregulation, financial liberalization and limiting the role
of the state. The consensus neglected the problem of information asymmetry and more
generally the imperfections in the market structure. Dani Roderik, an economist showed that
the trade openness and FDI can be the factors contributing to the development only if the
state is strong enough to serve as intermediary and resolve internal conflicts between the
different social groups. Washington consensus simultaneously promoted commercial
liberalism, financial opening and reduced the role of the state. Whereas the Beijing consensus
was more about social changes rather economical. It is about using economic governance for
the improvement in the society. Chinese development path is unrepeatable by any other
nation but it also has some flaws and contradictions. One of the elements contributing to the
development of the china is the growing commercial influence. The Beijing consensus like
the Washington consensus holds many ideas which are not about economics. These ideas are
about politics, life standard and global power balance. The present world is plagued by
serious problems such as the widening gap between the North and South, a worsening
environment, international terrorism and international drug trafficking. The excessive FDI
bring fanatical benefits as well the excess of the FDI reflect the weakness of the state. The
Beijing Consensus, like the Washington Consensus before it, contains many ideas that are not

about economics. They are about politics, quality of life, and the global balance of power.
Inherently, this model sets China and its followers off against the development ideas and
power needs of the status quo. Policy recommendations provide that the developing countries
should focus on the improving the investment climate for all kinds of investment whether
domestic or foreign.
The phase of reconstruction and recentralization in research and development activities
within the context of increasing conflicting interpretation and integration at the technical and
economic level among the most developed countries is expanding the economy of the
country. The growing influence and power of the private sector and conversely causing the
relative decline of the state influence over the priorities, content and organization of research
and development activities at national and international and global level.
Question #4 three MNEs (oracle, star bucks, Danone) and two countries (Japan and
Greece) were discussed in class presentations. Discuss the relevant histories of the two
or more of these companies/countries, as considered in class, and asses their future
prospects in regard to commercial/economic success in both in the near and long term
drawing comparisons, if possible.
Answer:
Star bucks have minimized the corpora ion tax through companies operating in the Britain. It is
the coffee power house that took the U.S by storm and star bucks is not up around the world.
Starbucks announced a massive five-year plan to double U.S. food sales to $4 billion, and to take
advantage of opportunities in China and the Asia Pacific. SBUX expects revenues to reach $30
billion by 2019, a 46% increase over 2014 revenues. For fiscal year 2015, Starbucks expects

revenue growth to be between 16% and 18% and earnings in the range of $3.42 to $3.52 per
share. This quarter, analysts expect Starbucks to earn 80 cents per share on $4.8 billion in sales,
representing 12.7% earnings growth and 13.2% sales growth. SBUX stocks next earnings
announcement will likely be released at the end of the month. DANONE has been seeking to
bounce back from the combinations of conditions over the past years that had got sales and
profits. These started with the effects of economic crisis in Europe over the past years. Danone
said that the improvements in margin would come mostly from a better profitability from its
European business. The company has focused upon the cutting of its costs and recognizing its
production in Europe to shore up profits rather than boosting sales of the company. While
navigating through a difficult economic environment, Danone also faced heightened speculation
about its future as the group held talks with several potential suitors for the smallest of its four
business units, medical nutrition and reshuffled its top management structure by splitting the
roles of chief executive and chairman. Despite a challenging year, Danone said it would pay a
dividend of 1.5 per share for the year, up 3.5% from last year.
Greece debt is 116.1% of the GDP. Japans debt is 226.1%. Greek has a strong currency euro but
still cannot export itself from debt. They are producing everything expensive including tourist,
shipping and whole bunch of domestics industries is dying but still they are unable to reduce
price to make a competitive environment. The destruction of the domestic industry increases the
rate of unemployment in the country and the tax revenue from them. Debt to GDP is do not
present the whole view of the economic market. Its important to note how fast the denominator
grows. It describes that Japan is not growing as its growth rate is -0.7%. But the question is why
Japan is working all fine when there are imperfections in the Greece market. The answer for this
question is that most of the Japans debt is held by domestic market whereas the Greek debt id

held by foreign market. The larger portion of Japans debt is held by the domestic corporations
and the banks. Greek debt is mostly held by the north which is 7% has increased the bankruptcy
in the Greek economy. But its also the fact euro is not completely controlled by Greece. The
difference in the Greek and the Japan is that the Greek actually went through bankruptcy in 2010.
Because Greek was unable to pay the interest against the debt, thats why it could not raise more
debts. The rates rose high and nobody wanted to lend them money anymore.
As compared to the Greek Japan has its own currency and the japans economy is quite stagnant
for last 20 years whereas the Greek had recession for 7-8 years which shaved off 25% of its GDP.
Another reason for the Japan economy to hold is its economy with capital goods while Greek has
debt economy based upon the consumption from debt and some good tourism while Japan has its
huge gold reserves. Greece faces a huge political instability than Japan. As in April 2010, Greece
was on the edge of the sovereign debt crisis.
References
R. Barnet and R. Muller. 1971. Some of the origins of the Debate over Multinational Firms. New
York, basic books.
W. D. David. 2009. Fiscal competition for imperfectly mobile labor and capital: A comparative
dynamic analysis. IZA. DP No. 4463.
Smith, A. L. 2015. Greek drum to a Japanese beat. East meets west in an energetic fusion of
percussion and culture.
U.S Department of State. Peace and war: United State foreign policy, 1931-1941. Washington
D.C. pp: 3-8.
Moeller, S.E. and C. B. McGowan. 2000. A model of making foreign direct investment decisions
using real variable for political and economic risk analysis.

Baertlein, L. 2015. Star bucks U.S. cafes debuting new smooth optional. Los Angeles.
IPCS. 1999. Development of risk reduction strategies for priority chemicals. A guidance
document (pilot version).
Kaplan financial knowledge bank. 2014. Foreign exchange risk management.