International Economy

Chapter 18 Why we trade

An Autarky appears when countries are self sufficient and thus do not have
trade partners.
Specialization is the basis for trade and leads to the highest efficiency and, thus
leads to economic wealth.
The principle of absolute advantage by Adam Smith: A country has an absolute
advantage over a competitor when it uses fewer resources for production than
them (or to produce more while using the same amount of resources).
This is incorrect though, because when one party excels more than another party
there will be no trade and no gains from trade.

Opportunity costs: the highest valued alternative that must be given up to

engage in an activity: What do I have to give up for this certain action?
A comparative advantage (by David Ricardo) occurs when one has lower
production costs (and thus lower opportunity costs) than a competitor.
As we can see in the tables below, Friday is more productive than Robinson in
both producing fish and coconuts; however, every hour of producing coconuts
costs him 1/2 fish. While every hour of fishing cost Robinson 6 coconuts. The
opportunity costs for Friday to fish and Robinson to produce coconuts reduces
costs and makes trade beneficial. Shifting production to the more efficient person
(the one with the comparative advantage) increases the total production.
Thus, countries gain from specializing in producing goods in which they have a
comparative advantage and trading for goods in which other countries have a
comparative advantage.
Production per hour
Friday
Robinson

Fish
4
1

Coconut
8
6

Opportunity costs
Friday
Robinson

Fish
2 coconuts (8/4)
6 coconuts (6/1)

Coconut
1/2 fish (4/8)
1/6 fish (1/6)

Possible division of food:

Friday: 2 fish, 5 coconuts
Robinson: 2 fish, 1 coconut

Gains from trade:

3 main reasons for why dont we see complete specialization:

1. Not all goods and services are traded internationally (medical services are
hard to export or import)
2. Production of most goods involves increasing opportunity costs. (countries
learn to produce more effectively and fade opportunity costs making trade
no longer desired)
3. Tastes for products differ. (different countries have different wishes)
4. Transportation costs (not from book)
Main sources of comparative advantage:
1. Climate and natural resources (oil in Saudi Arabia instead of in the
Netherlands)
2. Relative abundance of labour and capital (Europes highly skilled
employees for high tech machinery vs Chinas unskilled employees for
simple machinery)
o Heckscher & Ohlin theory: Based on trade patterns
3. Technology (firms in different countries have different access to
technology)
4. External economies (Brainports: once an industry becomes established in
an area, firms that locate in that area fain advantages over firms located
elsewhere)
Paul Krugman, new economics (reaction to David Ricardo and Heckscher Ohlin):
The home market effect: the country with the larger demand for a good shall,
at equilibrium, produce more than the proportionate share of that good and
become an exporter.

Chapter 18 Trade restrictions

Tariffs: taxes imposed by a government on goods imported into a country.
Methods of trade restrictions:

Tariffs (price)
Quotas (volume) and voluntary export restraints
Subsidies on domestic products

The figure below shows the equilibrium of supply and demand of a country
without, and with tariffs.
Economic welfare = consumer surplus + producer surplus + government surplus
In the situation without tariffs:
Consumer surplus: Area 1 + 2 + 3 + 4 + 5 + 6
Producer surplus: Area 7
Imports:
Q2 Q1
In the situation with tariffs:
Consumer surplus: Area 1 + 2
Producer surplus: Area 3 + 7
Government surplus:
Area 5
Deadweight loss: Area 4 + 6 (nobody benefits from deadweight loss)
Imports:
Q4 Q3

As concluded, tariffs and quotas result in deadweight loss (area 4 & 6) in the
economy. Though, we still maintain these tariffs and quotas to protect our own
firms. This reduces globalization, which is the process of countries becoming
more open to foreign trade and investment. By the end of WWII the General
Agreement on Tariffs and Trade (1948) was established to reduce tariffs and
quotas (volume) to improve international trade. The GATT was later replaced by
the World Trade Organization. Reasons to oppose the WTO come from 3 sources:

1. Specifically against globalization: free trade and foreign investment

destroy the distinctive cultures of many countries. Globalization has
allowed multinational corporations to relocate factories from high-income
countries to low-income countries.
2. To help domestic firms by rising tariffs on foreign imports. In the United
States the Smoot-Hawley Tariff raised tariffs rates more than 50% in 1930.
3. The WTO favours the interests of high-income countries over low-income
countries
Protectionism is the use of trade barriers to shield domestic firms from foreign
competitors and is usually justified on the basis of following arguments:
1. Saving jobs. Free trade reduces employment by driving domestic firms out
of business. In reality, erasing protectionism causes employment in other
sectors and erases employment in the currently protected sectors.
2. Protecting high wages. Firms in high-income countries will have to start
paying much lower wages to compete with firms in developing countries.
This is misplaced as free trade actually raises living standards by
increasing economic efficiency. When a country practices protectionism
and produces goods and services it could obtain more inexpensively in
other countries, it reduces its standards of living.
3. Protecting national security. A country should not rely on other countries
for goods that are critical to its military defence. (USA buying all its M16s
in China)
4. Protecting infant industries. It is possible that firms in a country may have
a comparative advantage in producing a good, but because the country
begins production of the good later than other countries, its firms initially
have higher costs while learning by doing occurs. As the firms in the
infant industry gain experience, their costs will fall, and they will be able
to compete successfully with foreign producers. While under free trade,
they may not get the chance to practice the economies of scale.
No country is an autarky, but every country in the world has trade restrictions,
which makes us less wealthy.
Milton Friedman believes that in all economics agree on one thing in 200 years:
The desirability of free trade and thus, erasing protectionism. Protectionism
protects the consumer of low prices.
Tariffs are currently widespread; however, the interest for protection is
concentrated among producers while the harm of protection is widespread and
experienced by the majority (consumers).
The opinions against protectionism (above) are not of economical nature (except
infant industries), but are based on political or social circumstances. This causes
that we collectively choose second best solutions on this matter, which is
political feasibility (haalbaarheid).
Dumping: Selling a product for a price below its costs of production. The US has
extended protection to some domestic industries by using a provision in the WTO
agreement that allows governments to impose tariffs in case of dumping. The

WTO allows countries to determine that dumping has occurred when if a product
is exported for a lower price than it sells for on the home market. However, there
are good business reasons for firms to do so which makes it unclear why these
normal business practices should be unacceptable when used in international
trade.
Positive analysis: concerns what is (to possess)
Normative analysis: concerns what ought to be
Trading blocks:

Free trade area: no tariffs and quotas between themselves, but restrictions
(free to choose) to non-member countries.
Customs union: like free trade area but with common external tariffs and
quotas with non-member countries.
Common market: like customs union but also with futures of one single
market, like a tax system.

BRIC-Economies: Marketing terminology for growing countries such as Brazil,

Russia, India and China. Also called BRICM (including Mexico) or BRICS (including
South Africa) etc.
These countries have a potential of becoming global economic heavyweights. It is
all about their ability to influence the global economy and global markets. This
are not just developing countries with growth successes. They are almost half of
the worlds population and the majority of the worlds GDP growth. They could
have major effects by reshaping the global economic order.

Chapter 29 The monetary system

Money is the set of assets in the economy that people regularly use to buy
goods and services from other people. There are several kinds of money. When
money takes the form of a commodity (handelsartikel), it is called commodity
money. The term intrinsic value means that the item would have value even if
it were not used as money (so the value of the paper or coin itself). Money
without intrinsic value is called fiat money (fiat = goedkeuring). A fiat is simply
an order or decree (besluit), and fiat money is established as money by
governmental decree (like the euro in 16 countries). When an economy uses gold
as money (or uses paper money that is convertible into gold on demand), it is
said to be operating under a gold standard.
Money has several functions:

Medium of exchange - ruilmiddel (money is an item that buyers give to

sellers when they want to purchase goods and services)
Unit of account - rekenmiddel (method to post prices and record debts)
Store of value waarde-eenheid (people can use it to transfer purchasing
power from the present to the future, like saving money)
Liquidity (liquidity is the ease with which an asset can be converted into
the economys medium of exchange. Because money is the economys
medium of exchange, it is the most liquid asset available)
o The most obvious asset is currency: the paper notes and metal
coins in the hands of the economy.
o Other assets are debit cards (electronically transfer of money) and
personal cheques (transferring money between current accounts),
but these are not real money; it is the bank account on which the
cheque or debit card contains the money, and thus the means of
transferring money between accounts.
Credit cards use a method of deferring (uitstellen) payment; the
bank pays for what you do with the credit card, but eventually you
have to pay it back to the bank (perhaps with interest).
Although a debit card, a personal cheque, and a credit card can each
be used to pay with, each of them are a METHOD OF TRANSFERRING
MONEY.

The role of central banks

Whenever an economy relies on a system of fiat money (as all modern advanced
economies do), some agency must be responsible for regulating the system: the
central bank. This is an institution designed to regulate the quantity of money
(money supply) in the economy, this set of actions is also known as the
monetary policy.
The central bank does so by doing open-market operations: purchasing and
selling non-monetary assets from and to the banking sector.
For example if the central bank decides to increase the money supply, it can do
this by creating currency and using it to buy bonds (obligatie: verhandelbaar

schuldbewijs voor een lening die door een overheid, een onderneming of een
instelling is aangegaan) from the public in the bond market. After the purchase,
the money is in the hands of the public.
Conversely, if the central bank decides to decrease the money supply, it can do
this by selling bonds from its portfolio to the public. After the sale, the currency it
receives for the bonds is out of the hands of the public.
One of the Ten Principles of Economics is that prices rise when too much money
is printed (because the value of money decreases). Another principle is that
society faces a short-run trade off between inflation and unemployment.
Monetary transmission mechanisms

Causes of increases in the money supply:

Banks reduce their reserve ratio

The non-bank private sector chooses to hold less cash
Public sector builds up deficit
Inflow of funds from abroad

Different measures of the money supply

The money supply or money stock is the total amount of monetary assets
available in an economy at a specific time. 3 measures of the money supply:
1. M1 (narrow money): all the coins and notes in circulation and other money
equivalents that are easily convertible into cash.
2. M2 (broad money): M1 + short-term deposits in banks
3. M3 (broad money): M2 + long term deposits
The quantity theory of money / Target inflation
MV = PY
M = Money supply
V = Velocity of circulation

P = Price level (inflation)

Y = Real output (total production)

Delta M can be limited by increasing the interest rate which will result in a lower
demand for credit less money creation.

A crucial assumption in this theory is that Velocity of Money is very stable,

causing a solid relationship between M and P; however, V is usually not that
stable as believed. When V increases people become busier sign of healthy
economy.
When people are busier V increases Prices usually also increase!

Money creation with fractional reserve banking

The amount of money you hold includes both currency (the banknotes and coins
in your wallet) and demand deposits (the balance in your current account).
Deposits that banks have received but not lend out are called reserves. When all
deposits are hold as reserves, it is called 100 per cent reserve banking, in which
banks do not influence the supply of money.
First European Bank
Assets
Reserves: 100.00

Liabilities
Deposits: 100.00

Fractional reserve banking is a banking system in which banks hold only a

fraction of deposits as reserves. The fraction of deposits that banks hold as
reserves is called the reserve ratio. Central banks and the US Federal Reserve
place a minimum amount of reserves that banks hold, called a reserve
requirement. Reserves above the legal minimum are called excess reserves.
Lets suppose a bank reserves 10% of the deposits.
First European Bank
Assets
Reserves: 10.00
Loans: 90.00

Liabilities
Deposits: 100.00

The money supply (which equals currency plus demand deposits) equals
190.00, thus when banks hold only a fraction of deposits in reserve, banks
create money.
At the end of this process of money creation, the economy is more liquid in the
sense that there is more of the medium of exchange, but the economy is no
wealthier than before (wealth, as a concept, is a stock as opposed to a flow).
The Money Multiplier
The creation of money does not stop here. Suppose that the borrower from the
First Bank uses the 90.00 to buy something from someone who then deposits
the currency in the Second European Bank, which also has a reserve ratio of 10%.
Second European Bank
Assets
Reserves: 9.00
Loans: 81.00

Liabilities
Deposits: 90.00

The Second Bank keeps assets of 9.00 in reserve and makes 81.00 in loans,
creating an additional 81.00.

Eventually the 81.00 is deposited in the Third European Bank, which also has a
reserve ratio of 10% and keeps 8.10 in reserve and makes 72.90 in loans.
Third European Bank
Assets
Reserves: 8.10
Loans: 72.90

Liabilities
Deposits: 81.00

Each time money is deposited and a bank loan is made, more money is created.
Continuing this process, the total money supply shall be increased with a total of
1.000.00.
The amount of money the banking system generates with each euro of reserves
is called the money multiplier. In this economy, where the 100.00 reserves
generates 1.000.00 of money, the money multiplier is 10.
Although this money is not physically placed somewhere, the banking system is
such that we have trust that if we did wish to withdraw all that money in cash the
bank would have sufficient funds to be able to meet our demand.
The size of the money multiplier
The money multiplier is the reciprocal of the reserve ratio (R). If R is the reserve
ratio for all banks in the economy, then each euro of reserves generates 1/R
Euros of money. In the example above, R=1/10, so the money multiplier is 10.
If the reserve ratio would be only 5 per cent (R = 1/20), then the banking system
would have 20 times as much in deposits as in reserves, implying a money
multiplier of 20. Each euro of reserves would generate 20.00 of money.
If the reserve ratio would be 20 per cent (R = 1/5), deposits would be 5 times
reserves, the money multiplier would be 5 and each euro of reserves would
generate 5.00 of money.
Thus the higher the reserve ratio, the less of each deposit banks lend out, and
the smaller the money multiplier.
The Central Banks Tools of Monetary Control
When the Central Bank decides to change the money supply, it must consider
how its actions will work through the banking system. A Central Bank has three
main tools in its monetary toolbox: open market operations, refinancing rate and
reserve requirement.

Open-market Operations

An open-market operation is the outright sale or purchase of non-monetary

assets to or from the banking sector by the Central Bank without a corresponding
agreement to reverse the transaction at a later date.
If the central bank decides to increase the money supply, it can do this by
creating currency and using it to buy bonds (obligatie: verhandelbaar

schuldbewijs voor een lening die door een overheid, een onderneming of een
instelling is aangegaan) from the public in the bond market. After the purchase,
the money is in the hands of the public.
Conversely, if the central bank decides to decrease the money supply, it can do
this by selling bonds from its portfolio to the public. After the sale, the currency it
receives for the bonds is out of the hands of the public.

The Refinancing Rate

The sale of a non monetary asses together with an agreement to repurchase

(repurchasing agreement = repo) it at a set price at a specified future date.
Because deposits and withdrawals at banks can fluctuate randomly, some banks
may find that they have an excess of reserves one day, while other banks may
find that they are shourt of reserves and their reserve ratio is too low. Therefore,
the commercial banks in an economy will generally lend money to one another
on a short-term basis (overnight to a couple of weeks) so that banks with excess
reserves can lend them to banks who have inadequate reserves to cover their
lending.
This market for short term-reserves is called the money market. If there is a
general shortage of liquidity in the money market (because the banks together
have done a lot of lending), then the short-term interest rate at which they lend
to one another will begin to rise, while it will begin to fall if there is excess
liquidity among banks.
Because the commercial bank is legally bound to repurchase the assets as a set
price, this is called a repurchase agreement and the difference between the
price the bank sells the assets to the central bank and the price at which it
agrees to buy them back is called the repurchase or repo rate by the Bank of
England, refinancing rate by the European Central Bank, and discount rate by
the US Federal Reserve bank(expressed as an annualized percentage of the
selling price).
If the Central Bank lowers the refinancing rate, banks will be able to borrow more
cheaply from the central bank in order to meet their reserve requirements,
causing the money supply to rise.

Reserve Requirement

Reserve requirements are regulations on the minimum amount of reserves that

banks must hold against deposits. Reserve requirements influence how much
money the banking system can create with each euro of reserves. An increase in
reserve requirements means that banks must hold more reserves and. Therefore,
can lend out less of each euro that is deposited; as a result, it raises the reserve
ratio, lowers the money multiplier and decreases the money supply. Conversely, a
decrease in t reserve requirements lowers the reserve ratio, raises the money
multiplier and increases the money supply.

The ECB sets minimum reserve requirements, but it applies them to the average
reserve ratio over a specified period rather than at a single point in time. It does
this to stop the amount of lending fluctuating wildly, in order to maintain stability
in the money market. Hence, the ECB uses reserve requirements in order to
maintain stability in the money market rather than as an instrument to increase
or decrease the money supply.
Problems in controlling the Money Supply
The central bank cannot perfectly control the Money Supply, because in a system
of fractional banking, the amount of money in the economy depends in part on
the behaviour of depositors and bankers. This causes the Central Bank to face
two problems:
1. The Central Bank does not control the amount of money that households
choose to hold as deposits in banks.
The more money households deposit the more reserves banks have, and
the more money the banking system can create.
The less money households deposit, the less reserves banks have, and the
less money the banking system can create.
2. The Central Bank does not control the amount that bankers choose to lend.
When money is deposited in a bank, it creates more money only when the
bank lends it out. Because banks can choose to hold excess reserves
instead, the central bank cannot be sure how much money the banking
system will create.

Motives for holding money:

Transactions motive
Precautionary motive
Assets/speculative motive

Determinants of demand for money:

The nominal national income

Frequency with which people are paid
Financial innovations
Speculation about future return on assets
Rate of interest

Chapter 14 The balance of payments

The Balance of Payments (BoP) is the record of all the flows of money between
residents of that country and the rest of the world. There are three main parts of
the BoP account: the current account, the capital account and the financial
account.

The current account

The current account records payments for imports and exports of goods and
services, plus incomes flowing into and out of the country, plus net transfers of
money to and from abroad. A current account surplus is where credits exceed
debits and a current account deficit is where debits exceed credits. The current
account is usually divided into four subdivisions:
1. The trade in goods account: records imports and exports of physical
goods. This balance is also called the balance on trade in goods or balance
in visible goods or merchandise balance. A surplus is when exports
exceed imports. A deficit is when imports exceed exports.
2. The trade in services account: records imports and exports of services
(transport, tourism). The balance is called the services balance.
The balance of both the goods and services account is known as the
balance on trade in goods and services or simply the balance of
trade.
3. Income flows: wages, interest and profits flowing into and out of the
country.
4. Current transfers of money: government contributions to and receipts
from the EU and international organisations, and international transfers of
money by private individuals and firms. (for example: money sent from the
Netherlands to a Dutch student studying in the UK)

The capital account

The capital account records the flows of funds (into the country (credits) and
out of the country (debits) )associated with the acquisition or disposal of fixed
assets, the transfer of funds by migrants, and the payment of grants, by the
government for overseas projects and the receipt of EU money for capital
projects.

The financial account

The financial account records flows of money into and out of the country for the
purpose of investment or as deposits in banks and other financial institutions. It
records the holding of shares, property, bank deposits and loans, government
securities etc.
In other words, unlike the current account, which is concerned with money
incomes, the financial account is concerned with the purchase and sale of assets
(bezittingen).

1. Direct investment: A foreign company invests money from abroad in one of

its branches or associated companies in the UK (credit item).
o Any subsequent profit from this investment that flows abroad will be
recorded as an investment income outflow on the current account.
2. Portfolio investments: Changes in the holding of paper assets, such as
company shares. (buying shares abroad is an outflow of money and thus a
debit item)
3. Other investments and financial flows: Short-term monetary movement
between a country and the rest of the world. (Common to take advantage
of differences in countries interest rates and changes in exchange rates.)
4. Flows to and from the reserves: all countries hold reserves of gold and
foreign currencies. From time to time, Central Banks will sell some of these
reserves to purchase their own currency on the foreign exchange market. It
does this normally as a means of supporting the rate of exchange. The
reserves can be used to support a deficit elsewhere in the balance of
payments. Drawing on reserves represents a credit item in the balance of
payments account: money drawn from the reserves represent an inflow to
the balance of payments (and an outflow from the reserves account).
o Net errors and omission item is included in the accounts to
ensure that there will be an exact balance. A number of errors are
likely to occur when the statistics are compiled.
Current account
Export > Imports
Dcur > Scur
Exchange rate appreciates
Import > Exports
Scur > Dcur
Exchange rate depreciates

Financial and capital accounts

Inflow > Outflow
Dcur > Scur
Exchange rate appreciates
Outflow > Inflow
Scur > Dcur
Exchange rate depreciates

Automatically balance in BoP free exchange market

In a free foreign exchange market, the balance of payments will automatically
balance, since changes in the exchange rate will balance the demands for the
currency (credits on the balance of payments) with the supply (debits on the
balance of payments).
In a free foreign exchange market, the balance of payments will automatically
balance because the credit side of the balance of payments constitutes (vormt)
the demand for the sterling while the debit side constitutes the supply for the
sterling.
A floating exchange rate ensures that the demand for pounds is equal to the
supply. It thus also ensures that the credits on the balance of payments are equal
to the debits: that the balance of payments balances. This does not mean that
each part of the balance of payments account separately balances, but simply
that any current account deficit must be matched by a capital plus financial
account surplus and vice versa.

Example:
Financial account: interest rates rise larger short-term inflows / smaller shortterm outflows more demand for sterling / less supply sterling financial
account will go into surplus the exchange rate will appreciate.
Current account: interest rates rise exchange rate appreciates imports
become cheaper / exports become expensive current account will go into
deficit
At this point, any financial account surplus is matched by an equal current (plus
capital) account deficit!
Purchasing Power Parity
Over the long-term, exchange rates should be such that you are able to buy the
same product for the same price anywhere in the world. Based on how over- or
undervalued a currency is, it is predictable to determine whether the exchange
rate rises or decreases.
BMI
The Big Mac is identical anywhere in the world. Therefore the Big Mac index is
created to determine how over- or undervalued a currency is, making it a
predictor of future exchange rates.
For example:
Switzerland:
1 Big Mac = 6.5 Swiss francs
1 Swiss franc = $1.16
USA:
1 Big Mac = $4.79
How over-valued is the Swiss franc?
Exchange rate (PPP) = 1 franc = 4.79 / 6.5 = $0.74
Actual exchange rate = 1 franc = $1.16
Thus: (n o) / o x 100 = (1.16 0.74) / 0.74 x100 = %56.7

Chapter 14 Exchange rates

An exchange rate is the rate at which one currency trades for another on the
foreign exchange market.
One of the problems in assessing what is happening to a particular currency is
that its rate of exchange may rise against some currencies (weak currencies) and
fall against others (strong currencies). In order to gain an overall picture of its
fluctuations it is best to look at a weighted average exchange rate against all
other currencies, also known as the exchange rate index or the effective
exchange rate. This is expressed as an index where the value of the index is
100 given in a base year.
Floating exchange rate
When the government does not intervene in the foreign exchange markets, but
simply allows the exchange rate to be freely determined by demand and supply,
we are speaking of a floating exchange rate. The equilibrium exchange rate is
where the demand for pounds equals the supply.
Any shift in the demand or supply curves will cause the exchange rate to change.
A fall in exchange rate is called depreciation and a rise in exchange rate is
called an appreciation.
The following are the major possible causes of a depreciation:

A fall in domestic interest rates. UK rates would now be less competitive

for savers and other depositors more UK residents deposit their money
abroad and fewer people would deposit in the UK demand for sterling
falls.
Higher rates of inflation in the domestic economy than abroad.
o At the same time:
UK exports will become less competitive demand for
sterling will fall.
Imports will become cheaper for UK residents Supply
sterling will rise.
o To the extent that a higher rate of inflation causes the Central Bank
to raise interest rates, this could have the opposite effect.
Rise in domestic incomes relative to incomes abroad. Incomes rise
imports rise supply sterling rise currency rises.
o If incomes in other countries fall: demand for UK export falls
demand sterling falls
Relative investment prospects improving abroad. Demand will fall and
supply will rise.
Speculation that the exchange rate will fall. If people believe that the
exchange rate is about to fall, they will sell their pounds before the rate
actually falls supply rises currency depreciates.

Reducing short-term fluctuations of an exchange rate

The government or Central Bank may intervene in the foreign exchange market
to reduce day-to-day fluctuations in the exchange rates or prevent longer-term,
more fundamental shifts in the rate. There are several options:

Using reserves: the Central Bank can sell gold and foreign currencies from
the reserves to buy their own currency, causing the demand for this
currency back to the right (increase demand).
Borrowing from abroad: It can use foreign borrowed currencies to buy their
own currency and shifting the demand for this currency to the right
(increase demand).
Raising interest rates: demand for currency increases and supply
decreases.

Maintaining a fixed rate of exchange over the longer term

Governments may choose to maintain a fixed rate over a number of months or
even years. The following are possible methods to achieve this, assuming that
there are downward pressures on the rate:
1. Contractionary (verkrappende) policies: governments deliberately curtail
aggregate demand (all demand in society that leads to production) by
either fiscal policy (raising taxes and/or reducing government
expenditure) or monetary policy (reducing money supply and raising
interest rates).
A reduction in aggregate demand works in two ways:
I. Reduces consumer spending (directly cuts imports less
supply currency)
II. Reduces rate of inflation (makes domestic goods more
competitive abroad increasing demand currency) (it also
reduce imports as a result of competitive prices in the home
market less supply currency)
2. Supply-side policies: increase long-term competitiveness of domestic
goods (increase imports) by encouraging reduction in the costs of
production and/or improvements in quality.
3. Control on imports and/or foreign exchange dealing: Governments restrict
the outflow of money either by restricting peoples access to foreign
exchange or the use of tariffs and quotas.
Fixed exchange rates
Advantages of fixed exchange rates:

Certainty. International trade and investments become less risky, since

profits are not affected by movements in the exchange rate.
Little or no speculation. Provided the rate is absolutely fixed there is no
point in speculating.
Prevents governments pursuing irresponsible macroeconomic policies.
Governments cannot allow their economies to have a persistently
(aanhoudend) higher inflation rate than competitor countries without
running into balance of payment crises, and hence a depletion (uitputting)

of reserves. Fixed rates force governments (in the absence of trade

restrictions) to keep the rate of inflation roughly to world levels.
Disadvantages of fixed exchange rates:

Competitive contractionary (verkrappende) policies leading to world

depression. If deficit countries pursued contractionary policies, but surplus
countries pursued expansionary policies, there would be no overall world
contraction or expansion. The result of these policies is to lead to general
world recession and a restriction in growth.
Problems of international liquidity. International liquidity: the supply of
currencies in the world acceptable for financing international trade and
investment.
If trade is to expand, there must be an expansion in international liquidity.
Countries reserves of these currencies must grow if they are to be
sufficient to maintain a fixed exchange rate at times of balance of
payments disequilibrium.
PPP does not work!
Inability to adjust to shocks. When sudden balance of payments crises
arise, countries will need huge reserves or loan facilities to support their
currencies in the short-run. In the long-run, countries may be forced into a
depression by having to deflate. The alternative may be to resort to
protectionism, or to abandon the fixed rate and devalue.
Speculation. If speculators believe that a fixed exchange rate simply
cannot be maintained, speculation is likely to be massive. Speculative
selling will worsen the deficit and may itself force devaluation.

Free-floating exchange rates

Advantages of a free-floating exchange rate:

Automatic correction. The government simply lets the exchange rate

move freely to the equilibrium.
No problem of international liquidity and reserves. Since there is no
Central Bank intervention, there is no need to hold reserves.
Insulation from external economic events. A country is not tied to a
possibly unacceptably high world inflation rate, as it could be under a fixed
exchange rate.
Governments are free to choose their domestic policy. Governments
can freely choose what level of domestic demand it considers appropriate
and simply leave exchange rates movements to take care of any balance
of payments effect. Similarly, the central bank can choose what interest
rate is necessary to meet domestic objectives, such as achieving a target
rate of inflation.

Disadvantages of a free-floating exchange rate:

Unstable exchange rates.

Speculation. Considerable exchange rate overshooting can occur in an

uncertain world where speculation can be highly destabilizing in the short
run.
Uncertainty for traders and investors. The uncertainty caused by
currency fluctuations can discourage international trade and investments.
Forward exchange market can overcome this problem by making
contracts for the price at which a currency will be exchanged at some
specified future date.
Lack of discipline in the domestic economy. Governments may pursue
irresponsibly inflationary policies (like for example short-term political
gain)causing adverse effects over the long term as the government will at
some point have to deflate the economy again, with a resulting fall in
output and rise in unemployment.

The origins of the Euro

The Bretton Woods system was a form of adjustable peg exchange rate,
where countries pegged (fixed) their exchange rates to the US dollar, but could
re-peg it at a lower or higher level if there was a persistent and substantial
balance of payments deficit or surplus.
This system was abandoned in 1971 as a result of the US inflation and increasing
trade deficit on the BoP. A period of managed floating occurred afterwards,
which is a system of flexible exchange rates, but where the government
intervenes to prevent excessive fluctuations or even to achieve an unofficial
target exchange rate.
The ERM (Exchange Rate Mechanism) was a semi-fixed system whereby
participating EU countries allow fluctuations against each others currencies only
within agreed bands. Collectively their currencies float freely against all other
currencies. The ERM came into existence in 1979 and was replaced by the single
currency in 1999.
Before countries could join the single currency, members were obliged to achieve
convergence of their economies. Each country had to meet five convergence
criteria:

Inflation: should be no more than 1.5% above average inflation rate of the
three countries in the EU with the lowest inflation.
Interest rates: the long term government bonds should be no more than
2% over the average of the three countries with the lowest inflation.
Budget deficit: no more than 3% of GDP.
National debt: no more than 60% of GDP.
Exchange rates: the currency should have been within the normal ERM
bands for at least two years with no realignments or excessive
intervention.

Advantages of the single currency

Elimination of the costs of converting currencies.

Increased competition and efficiency. There became more transparency in
pricing because price differences remained between countries. This has
put pressure on prices in high-cost firms and countries.
Elimination of exchange rate uncertainty (between the members).Removal
of exchange rate uncertainty has helped to encourage trade between
eurozone countries.
Increased inward investment. (the injection of money from an external
source into a region, in order to purchase capital goods for a branch of a
corporation to locate or develop its presence in the region)
Lower inflation and interest rates.

Opposition to EMU

The lack of an independent monetary and exchange rate policy. If some

countries have higher rates of inflation, then how are they to make their
goods competitive with the rest of the Union? With separate currencies
these countries could allow their currencies to depreciate.
Asymmetric Shocks. Shocks (such as an oil price increase or a recession in
another part of the world) that have different-sized effects in different
industries, regions or countries.

Optimal Currency Area

The optimal size of a currency area is one that maximizes the benefits from
having a single currency relative to the costs. If the area were to be increased or
decreased in size, the costs would rise relative to the benefits.
Robert Mundell states that a group of countries for which the benefits of replacing
national currencies with a currency exceed the costs, is an optimal currency
area.
Costs of a common currency:

Sacrifice of policy independence (the loss of exchange rate policy as a

means of stabilizing the domestic economy) This cost will be the highest
when countries experience asymmetric shocks.

Benefits of a common currency:

Reduction in transaction costs

Reduction in exchange rate uncertainty

It is more likely that benefits outweigh the costs if:

Countries experience symmetric shocks.

o European core (France, Germany, Belgium, the Netherlands) =
symmetric
o GIIPS (Greece, Ireland, Italy, Portugal, Spain) = asymmetric
Extensive trade with each other
o European core = YES

GIIPS = NO

Current issue: TTIP (Transatlantic Trade and Investment Partnership)

ISDS: Investor State Dispute Settlement