The aim of this essay is to analyze several questions on international economy. I will be doing this analysis on the basis of international balance. First of all I will regard the basic relations concerning international balance and then apply these relations to the given questions. So, let us see what are the main definitions in international economy. I will enumerate the basic relations and then include the number of the balance relation to the analysis of a particular question.
Export means the cost of goods that the country sells to other countries, import is the cost of goods bought by the country. The difference between exports and imports is called the net merchandise trade balance (1). The difference between the cost of services will constitute consequently the net service trade balance (2). The sum of (1) and (2) is regarded as total balance of goods and services (3).
Net investment income is the difference between the return of US assets in other countries minus return of foreign assets in US (4). Further, unilateral transfers are the payments made by foreigners living in the US to their families, different grants etc. (5) The net capital balance means the difference between net capital outflows (when US assets are being purchased abroad) and net capital inflows (when foreign assets are bought in the US) (6). The sum of the items: (3) + (4) + (5) + (6) is regarded as the international account balance of the country. If this balance is positive, we state that the country has an account surplus, and is the balance is negative, we say that the country has an account deficit. Our main question is what actions can benefit to the account surplus, i.e. if we count the whole account balance taking into account these transactions, the result will be positive. Let us start regarding the given situations.
a) IBM sends computers worth of $100 million to Jamaica, this means that the exports are $100 million increased and we have the whole balance increase for $100 millions; and in exchange IBM will use hotel services on the island, which means that the services import will increase for $100 million, and hence the whole account balance will be reduced for $100 million. After this transaction the whole balance will not change, so this barter is not contributing to the account’s surplus.
b) the US borrows $100 million long term from Europe – hence foreign investments are $100 million increased, the whole balance is $100 million reduced because of (6) being for $100 million reduced; and we have to take into account that this action will also lead to the reduction of balance of other years because of each year loan payments. After this, the USA buys $100 million of European goods, which means that (1) and hence (3) will be another $100 reduced. From this transaction we get a $200 reduction of the whole balance and therefore this transaction is not contributing to the account surplus, it is actually contributing to the account’s deficit.
c) The US sells a $100 million worth arms to Israel, which means that (1) will be increased at $100 million and therefore the whole balance will have an increase in $100 million. Further, the question states that the US makes this selling for $100 million bank deposits, i.e. Israel will have $100 million bank deposits (in US banks as far as I can understand from the statement), and this action will cause an increase of (6) for $100 million as well as future reduction of (4) due to the increase of US payments. This transaction leads to the total increase of account balance for $200 million but to future losses. So, this transaction is now contributing to the account’s surplus, but in future it s consequences will contribute to the account’s deficit.
d) the gift of US government to Colombia in the form of $100 million New York bank deposits which is means to pay for the damages made by US bombings has the form of unilateral payment (5) and currently leads to the account balance reduction for $100 million; i.e. this year this transaction is not contributing to the account’s surplus. In future years this action will be contributing to the reduction of figure (4) and to total reduction of the balance; hence in future years this transaction will not be contributing to the account’s surplus and is not contributing this year as well.
e) in this situation the European Central Bank buys $100 million in US bank deposit and pays to the US banks by providing an $100 million euro deposit in euro bank. From this we can see that this year the total net capital flow has not changed. But in future years we will witness the change of figure (4), and whether it will be contributing to the surplus or deficit of the account, depends on the relation between interest rates of both banks. Hence in this situation we do not have enough information to make a conclusion.
The second question concerns interest rates and EMS exchange rate mechanism within the context of situation in Britain in September 1992. First of all let us find out how the mechanism of the ERM was working. The European monetary system included the artificial currency called the ECU (European currency unit) which was used as a measure of counting exchange rates between countries, and the fixed exchange rate system called ERM (Exchange Rate Mechanism). The ERM system fixed the exchange rates of the countries participating in this system within a certain band. It was meant to contribute to the development of economic activity between countries, but started affecting the economy of ERM countries after the unofficial reserve currency of EMS banks has become the Deutsch Mark, due to fast development of Germain economy at that time. The economy of UK was in a deep recession in 1992; ERM system was affecting the condition of sterling and speculators found out how to use this situation for personal profit. Not long before this process has started, the Economist made a comment on the sterling situation and interest rates in UK. Let us analyze questions based on this quote.
a) Why did the British government critics think that it was possible to reduce interest rates quitting the ERM system? I think it is due to the fact that fixed exchange rates system was not letting the government control the position of sterling at that time. The critics thought that taking sterling out of the ERM system will help Britain to get out of the recession and lower interest rates in such a way.
b) The Economist stated that quitting the ERM will have the opposite effect because due to the actions of speculators and due to recession sterling has lost its power and credibility. Quitting the ERM system will lead to the increase of exchange of sterlings for Deutsch marks and / or other currency which was considered more stable at that time, which would contribute to the fall of sterling and rise of interest rates.
c) ERM membership was meant to contribute to British policymakers in various ways. The main benefits of entering the ERM system are the following: first of all ERM was meant to increase the importance of Europe (and therefore UK, in case of entering it) against global economy. Secondly, it was meant to enhance the development of trade and other economical operation within Europe and therefore unite the countries. Britain was meant to contribute from this alliance as well. Third main aim of ERM system was to improve the common policies, for example CAP (common agricultural policy) and shelter the economies from the fluctuation of interest rates.
d) The most evident explanation of the fact that high level of British interest rates relative to German interest rates will cause the high level of inflation in UK is that this situation will lead to the increase of speculation concerning sterling and to the accumulation of sterlings instead of its circulation. Therefore the amount of actually functioning sterlings will lessen and the inflation rate will increase. Another explanation may be that high interest rates will increase the flows of capital outside the country, which can also increase the inflation level.
e) The reason why the British interest rates might be higher than the German ones might be the expansive policy of German which was causing the interest rates of other countries to rise as well, despite of the current economical situation of these countries. Another explanation is that the witnessed reduction of inflation might cause the inflow of money into British economy, which may be among others the reason for expansion of financial mass in Britain and growth of the inflation level.
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