Convergence in Global Finance

About the courseClass 1

June 29, 2012

Professor

• Ira Summer• Ira.summer@faculty.hult.edu• 510-459-6617

Learning Objectives

• Basic understanding of international monetary system

• Basic understanding of currency/foreign exchange

• Understanding cause and effect of current events

Assessment

• Participation in class discussions 20%

• Case study analysis and presentation 35%• Almost daily homework

15%• Final project 30%

Class Schedule

• 6/29 Lecture/Discussion– About the course– Comparative advantage– International monetary systems

• 7/3 Lecture/Discussion– European Monetary Community– Balance of payments– 2007-9 credit crisis

Class Schedule

• 7/6 Case Study– California Budget Crisis

• 7/11 Lecture/Discussion– Foreign exchange market

• 7/13 Case Study– The Greek Crisis

• 7/18 Lecture/Discussion– International parity conditions– Final project teams/topics

Class Schedule

• 7/20 Case Study– China Unbalanced

• 7/25 Lecture/Discussion– Group meetings/discussions

• 7/27 Final project presentations/discussion• 8/1 Final project presentations/discussion

Class Participation

• Candy• Recorders• Useful discussion• Be on time

Case Studies

• Be prepared – Read before class– Simple homework questions due at class time– Class discussion– Team analysis due next class

Almost daily homework

• Will post articles and questions by morning after class

• Due at beginning of next class• Will discuss at beginning of class

Final Project

• Report and presentation• In teams• Assigned/select a country to analyze– Not where you are from

Convergence in Global Finance

Comparative AdvantageClass 1

June 29, 2012

Exhibit 1.1 Global Capital Markets

The Global Financial Marketplace

• We may characterize the market place as links among three items– Assets – at the heart of the financial asset markets are government

issued debt securities. Several financial assets derive their value from these underlying financial instruments. The financial markets depend upon the health of these government securities

The Global Financial Marketplace

– Institutions• Central banks which control each country’s money

supply• Commercial banks which take deposits and make loans• Other financial institutions created to develop, market,

and trade securities and derivatives

– Linkages – the interbank networks that provide the actual medium for exchange e.g. LIBOR

The Theory of Comparative Advantage

• The theory of competitive advantage provides a basis for explaining and justifying international trade in a model assumed to enjoy – Free trade– Perfect competition– No uncertainty– Costless information – No government interference

The Theory of Comparative Advantage

• The features of the theory are as follows;– Exporters in Country A sell goods or services to unrelated importers in

Country B– Firms in Country A specialize in making products that can be produced

relatively efficiently, given Country A’s endowment of factors of production (land, labor, capital, and technology)

– Country B does the same with different products (based on different factors of production)

The Theory of Comparative Advantage

– Because the factors of production cannot be transported, the benefits of specialization are realized through international trade

– The terms of trade, the ratio at which quantities of goods are exchanged, shows the benefits of excess production

– Neither Country A nor Country B is worse off than before trade, and typically both are better off (albeit perhaps unequally)

The Theory of Comparative Advantage

• For and example of the benefits of free trade based on comparative advantage, assume Thailand is more efficient than Brazil at producing both sports shoes and stereo equipment

• With one unit of production (a mix of land, labor, capital, and technology), efficient Thailand can produce either 12 shipping containers of shoes or 6 shipping containers of stereo equipment

• Brazil, being less efficient in both, can produce only 10 containers of shoes or 2 containers of stereo equipment with one unit of input

The Theory of Comparative Advantage

• A production unit in Thailand has an absolute advantage over a production unit in Brazil in both shoes and stereo equipment

• Thailand has a larger relative advantage over Brazil in producing stereo equipment (6 to 2) than shoes (12 to 10)

• As long as these ratios are unequal, comparative advantage exists• The following exhibit illustrates total world (in this example) production

and consumption if there was no trade and if each country completely specialized in one product

The Theory of Comparative Advantage

• Clearly the world in total is better off because there are now 10,000 containers of shoes (instead of just 6,000), as well as 6,000 containers of stereo equipment (instead of just 5,600)

• However, the goods are not distributed across international boundaries!

The Theory of Comparative Advantage

• Trade can resolve that distribution problem• While total production of goods has increased with the

specialization process, international trade at a certain range of prices (containers of shoes for a container of stereo equipment) can be distributed between the countries

• This exchange ratio will determine how the larger output is distributed

The Theory of Comparative Advantage: Limitations

• Although international trade might have approached the comparative advantage model during the nineteenth century, it certainly does not today;– Countries do not appear to specialize only in those products that

could be most efficiently produced by that country’s particular factors of production

– At least two of the factors of production (capital and technology) now flow easily between countries (rather than only indirectly through traded goods and services)

– Modern factors of production are more numerous than this simple model

– Comparative advantage shifts over time

The Theory of Comparative Advantage

• Comparative advantage is still, however, a relevant theory to explain why particular countries are most suitable for exports of goods and services that support the global supply chain of both MNEs and domestic firms

• The comparative advantage of the 21st century, however, is one which is based more on services, and their cross border facilitation by telecommunications and the Internet

Convergence in Global Finance

The International Monetary SystemClass 1

June 29, 2012

Attributes of the “Ideal” Currency• Exchange rate stability – the value of the currency would be fixed in

relationship to other currencies so traders and investors could be relatively certain of the foreign exchange value of each currency in the present and near future

• Full financial integration – complete freedom of monetary flows would be allowed, so traders and investors could willingly and easily move funds from one country to another in response to perceived economic opportunities or risk

• Monetary independence – domestic monetary and interest rate policies would be set by each individual country to pursue desired national economic policies, especially as they might relate to limiting inflation, combating recessions and fostering prosperity and full employment

Attributes of the “Ideal” Currency

• This is referred to as The Impossible Trinity because a country must give up one of the three goals described by the sides of the triangle, monetary independence, exchange rate stability, or full financial integration. The forces of economics do not allow the simultaneous achievement of all three

History of the InternationalMonetary System

• The Gold Standard, 1876-1913– Countries set par value for their currency in terms of gold– This came to be known as the gold standard and gained acceptance in

Western Europe in the 1870s– The US adopted the gold standard in 1879– The “rules of the game” for the gold standard were simple

• Example: US$ gold rate was $20.67/oz, the British pound was pegged at £4.2474/oz

• US$/£ rate calculation is $20.67/£4.2472 = $4.8665/£

History of the InternationalMonetary System

• Because governments agreed to buy/sell gold on demand with anyone at its own fixed parity rate, the value of each currency in terms of gold, the exchange rates were therefore fixed

• Countries had to maintain adequate gold reserves to back its currency’s value in order for regime to function

• The gold standard worked until the outbreak of WWI, which interrupted trade flows and free movement of gold thus forcing major nations to suspend operation of the gold standard

History of the InternationalMonetary System

• The Inter-War years and WWII, 1914-1944– During WWI, currencies were allowed to fluctuate over wide ranges in

terms of gold and each other, theoretically, supply and demand for imports/exports caused moderate changes in an exchange rate about an equilibrium value• The gold standard has a similar function

– In 1934, the US devalued its currency to $35/oz from $20.67/oz prior to WWI

– From 1924 to the end of WWII, exchange rates were theoretically determined by each currency's value in terms of gold.

– During WWII and aftermath, many main currencies lost their convertibility. The US dollar remained the only major trading currency that was convertible

History of the InternationalMonetary System

• Bretton Woods and the IMF, 1944– Allied powers met in Bretton Woods, NH and created a post-war

international monetary system– The agreement established a US dollar based monetary system and

created the IMF and World Bank– Under original provisions, all countries fixed their currencies in terms

of gold but were not required to exchange their currencies– Only the US dollar remained convertible into gold (at $35/oz with

Central banks, not individuals)

History of the InternationalMonetary System

– Therefore, each country established its exchange rate vis-à-vis the US dollar and then calculated the gold par value of their currency

– Participating countries agreed to try to maintain the currency values within 1% of par by buying or selling foreign or gold reserves

– Devaluation was not to be used as a competitive trade policy, but if a currency became too weak to defend, up to a 10% devaluation was allowed without formal approval from the IMF

History of the InternationalMonetary System

• Fixed exchange rates, 1945-1973– Bretton Woods and IMF worked well post WWII, but

diverging fiscal and monetary policies and external shocks caused the system’s demise• The US dollar remained the key to the web of exchange

rates

– Heavy capital outflows of dollars became required to meet investors’ and deficit needs and eventually this overhang of dollars held by foreigners created a lack of confidence in the US’ ability to meet its obligations

History of the InternationalMonetary System

– This lack of confidence forced President Nixon to suspend official purchases or sales of gold on Aug. 15, 1971

– Exchange rates of most leading countries were allowed to float in relation to the US dollar

– By the end of 1971, most of the major trading currencies had appreciated vis-à-vis the US dollar; i.e. the dollar depreciated

– A year and a half later, the dollar came under attack again and lost 10% of its value

– By early 1973 a fixed rate system no longer seemed feasible and the dollar, along with the other major currencies was allowed to float

– By June 1973, the dollar had lost another 10% in value

Contemporary Currency Regimes

• The IMF today is composed of national currencies, artificial currencies (such as the SDR), and one entirely new currency (Euro)

• All of these currencies are linked to one another via a “smorgasbord” of currency regimes