International Economy Essay
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.