Political economy of international finance

Foreign Exchange Market

• FOREX is the market where foreign currencies and other assets are exchanged for domestic ones.

• Major FOREX markets: New York, London, Tokyo, Frankfurt, and Singapore.

Exchange rate appreciation/depreciation

• Depreciation and appreciation refer to changes in the value of a currency due to market changes. A decrease in the value of a currency relative to another currency is depreciation. A depreciated currency means that imports are more expensive and exports are less expensive.

• An increase in the value of a currency relative to another currency is appreciation. An appreciated currency means that imports are less expensive and exports are more expensive.

Exchange rate devaluation/revaluation

• Devaluation is a monetary policy where a government or central bank lowers the official exchange rate of its currency, making it cheaper for foreigners to buy goods and services from that country

  • Boosts exports 

  • Reduces trade deficits 

• Revaluation refers to a deliberate, official increase in a country's currency value relative to another currency or a chosen baseline, typically undertaken by the government or central bank

  • Addresses currency imbalances (deficit/inflation)

Fixed (pegged) exchange rate

• In a fixed exchange-rate regime, BOP adjustment occurs through price changes in those countries with deficits and those with surpluses.  The exchange rate remains stable, and price changes are achieved by changing the money supply  The adjustment requires heavy central bank involvement

• Surplus countries see an increase in the money supply → prices rise (inflation).

• Deficit countries see a reduction in the money supply → prices fall (deflation).

• So, the domestic prices of goods and services  rise and fall. 

• The central bank maintains the fixed exchange rate by using monetary policy:

  • Interest rates go down in surplus countries.

  • Interest rates go up in deficit countries.

Flexible (floating) exchange rate

• In a flexible exchange rate regime, BOP adjustment occurs through exchange-rate movements (appreciation or depreciation). 

• Domestic prices remain stable, and changes in relative prices are brought about through exchange-rate movements.

• The adjustment requires no government action.

• Surplus countries → appreciation of their currency (an excess demand for the currency increases the “price” or exchange rate of the currency)

  • Prices of exports rise → Demand for domestic goods and services decreases, Prices for imports fall → Demand for imports increases. 

• Deficit countries → depreciation of their currency (excess supply of the currency lowers the “price” or exchange rate of the currency)

  • Prices of exports fall → demand for domestic goods and services increases, Prices of imports rise → Demand for imports decreases.

• Balance of Payments is restored as Surplus countries see imports go up and exports go down; Deficit countries see imports go down and exports go up.

Spot rate/Forward rate

• Spot rates are exchange rates for currency exchanges "on the spot" or when trading is executed in the present.

• Forward rates are exchange rates for currency exchanges that will occur at a future ("forward") date. Forward dates are typically 30, 90, 180, or 360 days in the future. Rates are negotiated between two parties in the present, but the exchange occurs in the future (the value date)

Balance of payments/Current account/Financial account/Capital account

• A country’s balance of payments (BOP) accounts summarize its transactions (private sector and government) with the rest of the world (its payments to and receipts from foreigners). An international transaction involves two parties → Each transaction enters the BOP accounts twice: once as a credit (+) and once as a debit (–). There are three major components of BOP:

• Current Account: flows of goods and services (imports and exports).

• Financial Account: flows of financial assets (e.g., money, stocks, government debt)→ financial capital.

Official (international) reserves

• Foreign assets held by central banks (e.g., the Federal Reserve in the United States) to cushion against financial instability.

• Assets include government bonds, currency, gold, and accounts at the International Monetary Fund.

• Central banks often buy or sell international reserves in private asset markets to affect macroeconomic conditions in their countries → Official foreign exchange interventions.

Balance of payments adjustment under a fixed regime

• In a fixed exchange-rate regime, BOP adjustment occurs through price changes in those countries with deficits and those with surpluses.

Bimetallic standard

• In the 19th century, there was simultaneous circulation of both gold and silver coins. However, when two currencies circulate, individuals will want to dispose of the one losing value more quickly.

• Explanations for the persistence of bimetallism: Until the discovery of steam power, the gold standard was not technically feasible, Politics: miners and farmers lobbied against silver’s demonetization, Network externalities: the international monetary arrangements that a country prefers will be influenced by arrangements in other countries (Eichengreen).

• Bimetallism ended in the 1870s.

Gresham’s Law

• when two currencies circulate, individuals will want to dispose of the one losing value more quickly

Gold standard

• Under a gold standard, a government defines the value of its currency in terms of a specific amount of gold. This means that a certain amount of currency (e.g., one dollar) is equivalent to a fixed weight of gold. The gold standard limits a government's ability to print more money because it must maintain enough gold reserves to back its currency

• Great Britain adopted a de facto gold standard in 1717 after the master of the mint, Sir Isaac Newton, standardized the English currency. It formally adopted the gold standard in 1819. The exchange rate of each currency was fixed in terms of gold; hence, all currencies were fixed against each other. Gold served as the only international reserve (the basis for countries’ money supplies).  Central banks were committed to converting domestic currency into gold at a fixed rate without limitation or condition. Individuals could freely import and export gold in whatever quantities they desired

Network externalities

• Network externalities, also known as network effects, describe how the value of a product or service increases as more people use it, creating a positive feedback loop. These occur when the utility or value a user derives from a product or service depends on the number of other users of the same or compatible product. As more people join a network, the perceived value of that network increases for everyone, leading to further adoption and growth

• The international monetary arrangements that a country prefers will be influenced by arrangements in other countries

Hyperinflation

• Inflation greater than 50% per month

• Can be caused by excessive money supply (government prints too much money to finance its spending, the money supply increases, and the value of the currency erodes) or a surge in demand that outstrips supply.

• Hyperinflation disrupts economic activity, discourages investment, and erodes savings. People lose faith in the currency and may hoard goods or switch to more stable currencies. Businesses struggle to operate, unemployment may rise, and poverty levels may increase

Great Depression

• The global nature of the Great Depression that started in 1929 shows the gold standard playing a crucial role in starting, deepening, and spreading the Great Depression. A worldwide monetary contraction combined with the shock waves from the October 1929 New York stock market crash lead to The world recession. Bank experienced failures, but they had limited government support.

Bretton Woods System

• The 1944 Bretton Woods conference (44 countries met). The Anglo-American Plan was approved in the “Joint Statement” of the British and American experts: John Maynard Keynes (advisor to the British Chancellor of the Exchequer) and Harry Dexter White (US Treasury economist). Post-war economic priorities: stable international economic order and the commitment to full employment and growth

• THE PRINCIPLES OF THE BRETTON WOODS: The U.S. dollar as the reserve currency, U.S. dollars were convertible to gold at a fixed exchange rate of $35 per ounce, Other countries fixed the value of their currencies relative to the US dollar (their exchange rates could move ± 1% of the fixed rate to the U.S. dollar), The dollar's leading global position gave the US an “exorbitant privilege” (Charles de Gaulle), The U.S. gained seigniorage: the difference between the cost of producing a currency and its actual face value

Seigniorage

• Seigniorage is the difference between the value of money (like a dollar bill or coin) and the cost of producing and distributing it. It's essentially a source of revenue for governments, as the value of money printed is generally higher than the cost of production

Currency convertibility

• A currency is considered convertible if it can be freely exchanged for another currency or for gold at a given exchange rate

  • Total Convertibility: A country's currency can be exchanged without any restrictions for any other currency, and there are no limitations on its use for foreign transactions. 

  • Partial Convertibility: Some limitations exist on the exchange of the currency, such as restrictions on the amount that can be exchanged or the types of transactions for which it can be used. 

  • Inconvertibility: The currency cannot be exchanged for other currencies or gold

The International Monetary Fund

• The International Monetary Fund (IMF) is a major financial agency of the United Nations, and an international financial institution funded by 191 member countries, with headquarters in Washington, D.C. It is regarded as the global lender of last resort to national governments, and a leading supporter of exchange-rate stability.

The Triffin dilemma

• The dilemma arises because a country issuing a global reserve currency (like the US dollar) needs to maintain a continuous supply of its currency to meet the global demand for reserves

  • Running Deficits: To supply the global economy with its currency, the reserve currency country must run trade deficits, meaning it imports more than it exports. 

  • Erosion of Confidence: Persistent trade deficits can lead to concerns about the reserve currency's value and stability, potentially causing a loss of confidence in the currency

• If it continues to run deficits to supply global liquidity, it risks undermining the value of its currency. 

• If it stops running deficits to maintain currency stability, it risks causing a shortage of global liquidity and potentially destabilizing the global economy

Special drawing rights (SDRs)

• Special drawing rights are supplementary foreign exchange reserve assets defined and maintained by the International Monetary Fund. SDRs are units of account for the IMF, and not a currency per se. They represent a claim to currency held by IMF member countries for which they may be exchanged

Stagflation

• Stagflation is a term for an economic situation that combines high inflation, stagnant economic growth, and high unemployment. Stagflation can erode purchasing power due to high unemployment and rapid inflation

Euro-currency market (Eurodollars)

• The growth of the Euro-currency markets originated in the late 1950s, primarily with Eurodollars. Eurodollars are dollar-denominated bank accounts and loans managed by banks outside the United States. It was controlled neither by state regulation nor by constraints of domestic money markets → London-based banks provided highly competitive interest rates. By contrast, deposit rates of American banks were capped by Regulation Q.  Between the 1960s and 1985, international credit extended by banks grew at an annual rate of 26 %.

The Plaza Accord (1985)

• G5 governments (the US, Japan, the UK, Germany, and France) agreed to reduce the dollar’s value against the Japanese yen and the German mark by 10−12 %. The U.S. wanted to use the dollar decline to improve the trade balance and deflect congressional pressure for protectionist trade legislation.  But the dollar dropped sharply and continued to fall as the U.S. continued an expansionary policy.

The Louvre Accord (1987)

• G-7 governments discussed the creation of target zones of ± 5% (“a reference range”) around which current exchange rates were allowed to fluctuate to stabilize exchange rates. The inability of the U.S. and Germany to find a cooperative solution to global imbalances. The stock market crashed in October 1987 → The U.S. Fed focuses on production, employment, and price stability. Exchange rate stability became less important.

Currency board

• A currency board is a monetary authority separate from (or in replacement of) a country’s central bank whose sole responsibility is maintaining the convertibility of the country’s currency. (Hong Kong)

Dollarization

• foreign money replaces domestic money as official currency

• Dollarization 

  • Use of the dollar when you are not the U.S 

  • Falls under a Fixed exchange rate because if you share the same currency as another country, the exchange rate cannot change (fixed to the other country) 

  • Dollarization = Currency Union 

    • Example: Eurozone 

  • Dollarization is more extreme because you don't have a say in monetary policy 

  • Why would you choose to do this? 

    • If you're in the middle of a crisis or in a transition period, you might choose to dollarize because of the stability 

    • You may not care about that part of your sovereignty to your country 

    • Small countries choose to dollarize because they don’t have the money to guarantee a specific currency 

  • When does it work? 

    • If you have a good economic relationship with the U.S.

    • Central bank is not credible 

    • Flexible labor market 

    • Small trade forward economy

The electoral model of exchange rate policy (pocketbook voters and sociotropic voting) 

• Voters reward a government that has delivered good economic conditions and punish a government that has delivered poor economic results.

• Economic conditions in democratic political systems influence how people vote in two ways:

• Pocketbook voters: vote for/against a government depending on how they personally fared under that government.

• The sociotropic model: voters evaluate the government based on overall economic performance.

The partisan model of exchange rate policy

• The Philips curve: trade-off between unemployment and inflation.

• A government can reduce unemployment only by causing higher inflation and reduce inflation only by causing higher unemployment.

• Left parties appeal to the working class → they are concerned with employment and wealth redistribution.

• Right parties reflect the business, financial sector, and middle-class interest employed in high-skilled and management positions→ They are concerned with controlling inflation.

The sectoral model of exchange rate policy

• Export oriented industries are fixed, while import competing industries and non-tradable services are flexible. 

• NON-TRADABLE GOODS INDUSTRY
  FINANCIAL SECTOR HAVE LOW PREFERRED DEGREE OF EXCHANGE RATE STABILITY WITH A HIGH PREFERRED LEVEL OF EXCHANGE
  RATE

• EXPORT-ORIENTED SECTOR HAVE A
  LOW PREFERRED LEVEL OF EXCHANGE RATE WITH A HIGH PREFERRED DEGREE OF EXCHANGE
  RATE

• IMPORT-COMPETING INDUSTRIES
  FINANCIAL SECTOR HAVE A LOW PREFERRED LEVEL OF EXCHANGE RATE AND LOW PREFERRED DEGREE OF EXCHANGE RATE

The European “snake” arrangement

• The “Snake” arrangement limited exchange rate fluctuations among EC currencies to a band of ± 4 ½ %.

• The European Monetary Cooperation Fund was established to monitor European monetary policies and authorize realignments.

• The Snake was established in reaction to French objections to the dollar’s asymmetric role under the Bretton-Woods system.

• Why did the Snake fail?

  • The oil-price shocks in the 1970s and the global recession.

  • Divergent macroeconomic policies of its members, leading to different inflation rates.

  • Increase in capital mobility.

The European Monetary System/European Currency Unit (ECU)

• The European currency unit (ECU): used in cross-border banking but not in commercial transactions.

• The European Monetary Fund managed the pooled foreign exchange-rate reserves of the participating countries to intervene in currency markets, to create the ECU reserves, and provided credit to weak currency members.

The Economic and Monetary Union (EMU)/Euro/European Central Bank

• The Stability and Growth Pact, negotiated in 1997, also allows for financial penalties on countries with “excessive” deficits or debt.

• The (electronic) euro was adopted in 1999; euro bills and coins were introduced, and national currencies were removed from circulation in January 2002.

• Great Britain, Denmark, and Sweden have opted out of the EMU.

• The European Central Bank conducts monetary policy through a system of member country banks called the European System of Central Banks → price stability is the primary objective

• Monetarist theory: the central bank should focus on price stability; it cannot do much to stabilize the economy.

Equity flows: Foreign Direct Investment and Portfolio Flows

Equity finance: Foreign direct investments and portfolio flows: the value of equity changes

Official development assistance (foreign aid)

• Provided by the governments of developed countries and international financial institutions (e.g., the World Bank)

• The largest share of foreign aid is provided as bilateral development assistance

  • Grants

  • Loans: non-concessional (market interest rates) and concessional loans (below-market interest rates).

Official development assistance (foreign aid)

• Provided by the governments of developed countries and international financial institutions (e.g., the World Bank)

• The largest share of foreign aid is provided as bilateral development assistance

  • Grants

  • Loans: non-concessional (market interest rates) and concessional loans (below-market interest rates).

Sovereign debt

• Sovereign debt is how much a country's government owes.

• Governments in Europe have borrowed money and created sovereign debt for centuries (e.g., the gross debt level of victorious Britain after the Napoleonic wars through 1815 had ballooned to over 250 % of GDP).

• Today, the most common way a government can generate a public debt is through bond sales (e.g., the federal US government sells Treasury bonds—T-Bonds—in auctions).

• The standard way to compare figures across countries is to examine the debt level as a percentage of GDP.

The original sin

When developing economies borrow in international financial markets, the debt is almost always denominated in US$, yen, and euro—the “original sin”

Petrodollars (petrodollar recycling)

• Oil-exporting countries accumulated huge export revenues (petrodollars) → deposited petrodollars in large Western banks → loans to developing countries.

• Revenue from oil exporters 

• Oil exporters place money into banks, who then offer loans to developing countries 

• Borrowers make poor decisions and can't overcome existing problems 

Debt crisis

• A debt crisis in which governments default on their debt can be a self-fulfilling mechanism. 

• A sudden stop of financial inflows (G. Calvo): the country suddenly loses access to all foreign sources of funds.

• A debt crisis is associated with low income and high interest rates, which makes government and private sector debts even harder to repay.

  • High interest rates cause high-interest payments for both the government and the private sector.

  • Low income causes low tax revenue for the government.

  • Low income makes loans made by private banks harder to repay → the default rate increases, which may cause bankruptcies.

• Debt crises: when a country cannot (or does not want) to service its foreign debt.

Banking crisis

• Banking crisis: bankruptcies and other problems for private sector banks.

• It can be marked by bank runs, where investors withdraw money or sell assets due to fears of declining asset value and failures

Currency crisis (speculative attack)

• Balance of payments crisis (currency crisis) under a fixed exchange rate regime. 15−25 % depreciation/devaluation of currency within a year.

• speculative attacks on the currency resulting in a devaluation (or sharp depreciation) or forcing the government to defend the currency.

Sudden stops of financial flows

• a significant fall in international capital inflows or a sharp reversal in capital flows to a country.

• apart of the financial contagion issue

A syndicated loan

•  hundreds of commercial banks each take a small share of a large loan to a single borrower

Financial contagion

• A sovereign debt problem in one country may become a sovereign debt problem in another → financial contagion.

• a process observed through co-movements in exchange rates, stock prices, sovereign spreads, and capital flows

Macroeconomic stabilization

• Macroeconomic stabilization refers to a set of policies and institutional arrangements designed to reduce economic volatility and promote sustainable, inclusive growth.

• The primary goals of macroeconomic stabilization are:

  • Price Stability: Controlling inflation and preventing hyperinflation or deflation. 

  • Sustainable Growth: Achieving stable and consistent economic growth. 

  • Full Employment: Maintaining a high level of employment and reducing unemployment. 

  • Balance of Payments Stability: Ensuring a sustainable balance of payments position. 

The central bank/The Federal Reserve System The discount rate

• A central bank is an institution that oversees and regulates the banking system and controls the money supply. They have 6 main functions: Issuing currency, Setting reserve requirements and holding reserves (the fractions of checking account balances), Lending money to banks at the discount rate, Acting as fiscal agent, Regulating and supervising banks, and Controlling the money supply

• The Federal Reserve  is a “central bank” in the U.S, serving as a last resort to the banking system. The Federal reserve system consists of The Board of Governors in Washington, D.C. (7 members appointed by the President for 14 years, Chairman for 4 years), Twelve Regional Federal Reserve Banks, each serving its district—quasi-public banks owned by private commercial banks in the district.The Federal Reserve has a dual mandate of price stability and low unemployment 

• The discount rate is the cost of acquiring reserves. The Federal Reserve charges the discount rate that member banks (not meeting reserve requirements) pay to borrow from the Federal Reserve.

Bank reserves (the reserve requirements)

• Reserve requirements are regulations set by central banks (like the Federal Reserve in the US) that mandate banks hold a certain percentage of their deposits as reserves, either in their vaults or as deposits at the central bank. A bank's required reserves were calculated by multiplying its total deposits by the reserve ratio.  For example, if a bank's deposits totaled $500 million and the required reserve was 10%, the bank's required minimum reserve would be $50 million

Monetary base/Money supply

• The monetary base is the sum of currency in circulation (physical money in the hands of the public) and reserves held by banks at the central banks. It includes currency in circulation and bank reserves 

• The money supply represents the total volume of money held by the public at a particular point in time. This includes Currency, Demand Deposits, and other Liquid Assest.

Open-market operations and Federal Funds rate

• Open-market operations allow the central bank to increase or reduce the monetary base (currency in circulation + bank reserves) by buying government debt (Treasury bills) from banks or selling government debt (Treasury bills) to banks. The Federal Reserve increases the monetary base by purchasing U.S. Treasury Bills. The Federal Reserve reduces the monetary base by selling U.S. Treasury bills to banks

• The Federal Funds Rate is the rate that commercial banks charge one another for overnight loans of reserves (the primary instrument of monetary policy). A restrictive monetary policy increases the Federal funds rate, reduces the money supply, and increases other interest rates (e.g., interest rates on home loans, auto loans, student loans, etc.) An expansionary monetary policy lowers the Federal Funds rate, increases the money supply, and lowers other interest rates.

Time inconsistency and central bank independence

• Time inconsistency: Politicians (motivated by short-run political considerations) have the incentive to announce low inflation policies and then renege on that promise to promote economic growth and employment. Politicization of monetary policy (politicians attempting to influence monetary policy decisions, promoting growth with lower interest rates, especially in the run-up to elections) destroys policymakers’ credibility, thereby reducing the effectiveness of their policies Independent central banks are solutions to the time inconsistency of monetary policy by insulating monetary policy from the direct control of politicians. 

• Central bank independence (CBI) is the degree to which the central bank can conduct monetary policy free from interference by the government. Common legal indicators of independence include procedures for the appointment, term duration, dismissal of central bank directors, budgetary autonomy of the central bank, etc. The behavioral independence of central banks shows a turnover rate in central bank leadership.

Direct finance vs. indirect finance

• Direct finance: borrowers borrow funds directly from lenders in financial markets by selling them securities (e.g., bonds).

• Indirect finance: financial intermediaries (banks, insurance companies, pension funds, mutual funds) help transfer funds

Asymmetric information problem in financial transactions (adverse selection and moral hazard)

• Financial intermediation is the process of indirect financing using financial intermediaries. It reduces transaction costs (time and money spent in carrying

• out financial transactions), and it also deals with asymmetric information problems (borrowers have information about their activities and prospects that they do not disclose to lenders).  Banks try to avoid selecting a risky borrower by gathering information about a potential borrower, a process called adverse selection. By using moral hazard, banks ensure borrowers will not engage in activities that will prevent them from repaying the loan

Banks & their types

• A bank is a financial intermediary that accepts deposits from individuals and institutions and makes loans

• Commercial banks, Savings and Loans associations, Mutual savings banks, and credit unions 

Banks and deposit creation

• A bank deposit is a claim on a bank that obliges the bank to give the depositor their cash when demanded. A bank keeps only a fraction of its customers’ deposits in the form of cash. Most of its deposits are lent out to businesses and buyers of new homes. Bank reserves are the currency banks hold in their vaults plus their deposits at the Federal Reserve. Bank capital is the resources a bank’s owners have put into the bank.

Bank-based vs. market-based financial systems

• Market-based model (United States, United Kingdom) where Capital markets channel finance to enterprises. Emphasis on shareholder dividends (short-term). The terms on which (large) firms can secure finance depend on their valuation on the equity market (publicly available financial data). 

• Bank-based model (Germany, Japan) where the close relationship between an enterprise and its bank is the key to financing (long-term development strategy). Banks and industries have close institutional ties. E.g., banks participate on the executive or supervisory boards of firms. Bank credit is the primary source of company resources.

Primary and secondary financial markets

• A primary market is a financial market in which new issues of security, such as a bond or a stock, are sold to initial buyers by the firm or government agency.  borrowing the funds

• A secondary market is a financial market in which securities that have been previously issued can be resold. Secondary markets can be organized into exchanges and over the counter markets. Markets can also be distinguished based on the maturity of the securities traded:  Money markets deal in short-term debt instruments (with a maturity of less than one year) while  Capital markets deal in longer-term debt and equity instruments (with a maturity of one year or longer).

Subprime mortgages

• These mortgages are designed for individuals who might not qualify for traditional, prime-rate loans due to factors like poor credit history, limited credit history, or a high debt-to-income ratio. Lenders charge higher interest rates on subprime mortgages to compensate for the increased risk of default associated with these borrowers. Because of the higher interest rates and potentially less stable financial situations of subprime borrowers, these loans carry a higher risk of default compared to prime mortgage