Unit 3: Foreign Direct Investment: ECON 401 The Changing Global Economy

ECON 401
The Changing Global Economy
Unit 3: Foreign Direct Investment
Unit Overview
Introduction
The growth of foreign direct investment (FDI) is a key aspect of todays global economy.
World GDP increased by 45 percent between 1992 and 2006, but FDI increased by 700
percent.
The acceleration of economic development in many parts of the less developed world is tied
to increases in FDI. FDI may provide more (and cheaper) capital, access to new
technologies and business practices, and improved access to developed country markets.
FDI growth reflects the growing relative importance of multinational corporations (MNCs) in
the global economy. While the investment activities of these giants often bring important
economic benefits, critics are concerned that these MNCs may possess undue political
influence and distort the pattern of economic development.
Note: The textbook refers to multinational corporations as multinational enterprises or
MNEs. Either term is acceptable, but we use MNC throughout these course materials.
Web Links
These articles on the WTO Web site address specific issues related to foreign direct
investment.

z Foreign direct investment seen as primary motor of globalization, says WTO
Director-General

z Trade and foreign direct investmentNew Report by the WTO

z Does globalization cause a higher concentration of international trade and investment
flows? (select ERAD-98-08 under the year 1998)
References
Statistics Canada. (2008). Canadas international investment position, 2007. Catalogue
No. 67-202-X. Ottawa: Minister of Industry.
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Section 3.1: Foreign Direct Investment
Reading Assignment and Learning Objectives
In the textbook:
z Chapter 7 (pp. 240254; pp. 257262; pp. 265268)
z Closing Case: Cemex's Foreign Direct Investment (pp. 269270)
After completing Section 3.1, you should be able to
1. describe recent trends in the levels and directions of foreign direct investment (FDI) in
Canada and worldwide.

2. define the following terms:

z foreign portfolio investment
z foreign direct investment
z multinational enterprise
z licensing
z internalization theory
z green-field investments
z location-specific advantages

3. explain the market imperfection theory of FDI.

4. explain the strategic behavior theory of FDI.

5. explain the main factors that will determine whether a firm will export, license, or engage
in FDI.

6. discuss the main costs and benefits of FDI to host or receiving nations.

7. discuss the main costs and benefits of FDI to sending nations.
8. explain why the composition of foreign direct investment has shifted more toward services
over the past two decades.
Types of Foreign Investment

The integrated nature of economies and financial markets has increased the ease and
flexibility with which foreign investors and corporations can seek out and take advantage of
opportunities that yield higher rates of return, diversified portfolios, and reduced risk. This
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section describes some basic theories of foreign investment and reasons that firms
undertake foreign direct investment rather than simply exporting products. We will also
discuss recent patterns of foreign investment in Canada.
Foreign investment can take different forms. One is simply to lend money (in the form of
bank loans or new bond purchases) or to buy relatively small blocks of stock in companies.
The injection of funds into the host economy does not involve any control over the assets of
that country. There is foreign funding but no foreign ownership or control; the transaction
transfers funds and represents a portfolio investment. This type of investment is called
foreign portfolio investment and involves very low transaction and transportation costs, as
it is often just an electronic transfer of funds.
Foreign investment can also involve the outright purchase of a Canadian asset such as a
factory. This type of investment is called foreign direct investment (FDI), and can take the
form of purchasing enough stock in an existing firm to become a controlling shareholder,
taking over a firm outright or building a new plant or enterprise from scratch. It may or
may not result in additional investment in Canada, depending on the financing. If the
foreign investor uses their own funds to create a new plant in Canada, Canadas capital
stock has increased and, therefore, Canadas capacity to produce goods and services has
increased. Even if the foreign investor buys an existing plant from Canadian owners, it may
eventually lead to new capital formation (investment). In that case, the Canadian seller
would have to use the money from the sale to create new capital in Canada. If the seller
uses the money to buy assets in another country, spends it on high living, or uses it to
retire somewhere warm, Canada does not benefit from increased capacity. Similarly, if the
foreign investor uses Canadian funds for their venture into Canada, there is no gain. A
substantial number of foreign takeovers are financed by loans from Canadian banks.
With FDI, a firm could have a significant ownership in a foreign operation and the potential
to affect managerial decisions. By using FDI, multinational corporations are able to
circumvent the effects of changing exchange rates, enabling them to secure and maintain
market share.
A firm may choose to undertake FDI in a particular foreign market or region because of
location-specific advantages, perhaps to gain access to specific natural resources (e.g.,
Albertas energy industry) or expertise (e.g., Silicon Valley in California or Ottawa), or to be
located near customers, specific feedstocks, or suppliers with unique characteristics (e.g.,
Fort Saskatchewans petrochemical industry).
Recent FDI Trends in Canada

Table 3.1 highlights Canadas current international investment position, with information on
direct and portfolio investment by Canadians abroad as well as foreign investment in
Canada. The important trend to observe from this table is the significant gap between total
Canadian investment abroad ($1,176,870,000) and total foreign investment in Canada
($1,309,392,000). The predominance of foreign investment in Canada has been a key
feature in Canada for years; in 2007, direct investment abroad decreased due to the
appreciation of the Canadian dollar against foreign currencies. Canadian direct investments
abroad are denominated in foreign currencies. Consequently, the appreciation of the
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Canadian dollar lowered the value of the assets held abroad.

Canadian investment abroad is split between direct and portfolio investment, as is foreign
investment. There are significantly more holdings of Canadian stocks than bonds.
Table 3.1 Canadas International Investment Position, 2007
Assets
Canadian Direct Investment Abroad
Portfolio Investment
(Foreign Bonds: $136,701,000)
(Foreign Stocks: $210,064,000)
Other Investment
(Loans: $76,122,000)
(Allowances: $0)
(Deposits: $156,890,000)
(Official International Reserves: $40,593,000)
(Other Assets: $41,960,000)
Total

Liabilities
Foreign Direct Investment in Canada
Portfolio Investment
(Canadian Bonds: $382,080,000)
(Canadian Stocks: $82,658,000)
(Canadian Money Market Instruments: $21,999,000)
Other Investment
(Loans: $52,971,000)
(Deposits: $243,525,000)
(Other Liabilities: $25,307,000)
Total

Net International Investment Position
$ 514,540,000
346,765,000
315,565,000
1,176,870,000
$ 500,851,000
486,738,000
321,804,000
1,309,392,000
-132,522,000
Adapted from Statistics Canada. (2008). Canadas international investment position, Second Quarter 2008. Catalogue No.
67-202-X, Minister of Industry.
Note. Discrepancies due to rounding.
Figure 3.1 and Figure 3.2, below, illustrate (by geographic area) the foreign direct
investment flows in Canada from abroad and the direct investment abroad by Canadians.
Note that other EU includes Belgium, Denmark, France, Germany, Greece, Ireland, Italy,
Luxembourg, the Netherlands, Portugal, Spain, Austria, Finland, Sweden, Cyprus, the Czech
Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, the Slovak Republic, and
Slovenia.
Figure 3.1 FDI in Canada, 2007 (percent of total)
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Source: Statistics Canada. (2008). Canadas international investment position, Second Quarter 2008. Catalogue No. 67-202-X,
Minister of Industry.
According to the figures above, the United States is, by far, the largest direct investor in
Canada, followed by other EU countries (excluding the United Kingdom). The American
share of total foreign direct investment has fallen steadily since its peak of 70 percent in
1999. This is despite the fact that the overall level of FDI in Canada has nearly doubled
over this period. As we discussed in Unit 1, the relative share of US investment has fallen
as the relative shares of other nations have risen, led by strong FDI from the United
Kingdom and other EU nations. Direct investment in Canada by foreign companies has been
expanding rapidly, and this has had a major impact on the Canadian economy. It has
affected Canadian trade, employment prospects, industrial and business location, and
regional economic growth prospects, and it has also led to the appreciation of the Canadian
dollar.
Figure 3.2 Canadian FDI Abroad, 2007 (percent of total)
In 2007, US assets accounted for only 44 percent of total Canadian direct investment
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abroad, the lowest proportion on record. American investors accounted for 58 percent of
FDI in Canada. Net direct investment with the United States has never been positive,
meaning that American investors have always held more assets in Canada than Canadian
investors have held in the United States.
Figure 3.3 below highlights the trends in Canadas direct investment abroad (outflows) and
foreign direct investment in Canada (inflows). Since 1980, the average annual inflow of FDI
totalled $204.4 billion and grew by an annual average rate of 7.9 percent. By comparison,
the average annual outflow of direct investment totalled $207.9 billion and grew at an
average annual rate of 11.3 percent.
Figure 3.3 Canadas International Investment Position (millions of dollars)
The influx of FDI into Canada was significant in the early 1980smore than twice that of
Canadian direct investment abroad. Even during the Canadian recessions of the early 1980s
and 1990s, FDI continued to expand. One of the attractions of the Canadian economy was
the Canadian dollar, which was undervalued against the US dollar, making Canadian
purchases cheaper for foreigners. Land and labour costs were significantly lower than in
competing countries. As well, the Canadian dollar returns abroad rose, due to a dollar
appreciation against other major currencies. Foreign investors were attracted to Canadas
dynamic and stable economy and favourable political environment. The significance of
NAFTA also created a new market for foreign investors. Governments at all levels in Canada
provide a favourable investment climate for foreign companies. Not only does the federal
government place few restrictions on foreign investors, but provincial and municipal
governments compete vigorously for investments by offering tax and financial incentives.
Canadian direct investment abroad has become greater than foreign direct investment in
Canada. This change occurred in 1997. This unprecedented trend reflects an economy in an
expansionary phase of the business cycle, with strong natural resource prices. Firms
earning strong corporate profits are able to invest abroad. In addition, Canadian investors
holdings of foreign stocks have risen due to the higher foreign content limits for Registered
Retirement Savings Plans. The rapid rise in inflows can also be interpreted by comparing
this trend with Canadas production and trade patterns over the same period. Despite the
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general decline in trade barriers, growth in foreign direct investment since 1980 has
exceeded growth in nominal GDP and exports.
Globally, FDI has taken off since the mid 1970s. In 1975, global FDI amounted to $25
billion. It increased to $1.2 trillion in 2000, and remained at this level until 2006. Rates of
growth of world output, trade, and FDI provide a picture of the globalizing economy.
Consider the following:
z
z
z
Between 1992 and 2006, world output increased by 45 percent.

Between 1992 and 2006, world trade increased by 150 percent.
Between 1992 and 2006, FDI increased by 700 percent.
Why has FDI increased so rapidly? There are a number of reasons:

z
z
z
z
FDI can help a firm overcome trade barriers.

Deregulation and privatization has opened up economic space that had been closed off
to private investment in the past.

Trade and investment are complements, not substitutes, in many cases. A high
proportion of trade consists of intra-firm trade between divisions of a single firm. Firms
may invest in many different regions in order to best capture location economies. The
new information and communication technologies have reduced the cost of managing at
a distance.

Russia and eastern Europe are no longer under communist rule.

Government regulations that limited FDI in many countries have been replaced by a
new receptiveness to FDI.

Many multinational firms wanting to sell in multiple markets may believe they need a
presence close to their consumers in order to serve them properly. In other words, they
feel exporting is a poor substitute for direct investment.
It should not be surprising that most FDI comes from the developed world, but it may be
surprising that most FDI goes to the developed world. As Figure 7.3 on page 244 of the
textbook shows, although FDI flowing to the developed world has increased substantially
over the 1990s and beyond, the proportion going to the developing world has increased
marginally.
Theories of Foreign Direct Investment

Hill identifies five key factors that help to explain the relative attractiveness of FDI,
exporting, and licensing:
z
z
z
z
z
transportation costs
market imperfections
strategic behaviour
product life cycle
location-specific advantages
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If transportation costs are relatively high, then exporting may simply not be cost effective.
Cement, for example, is not widely traded.
Many international firms have developed unique competitive advantages on the basis of
their technology, marketing strategies, or management know-how and ability. If this
collective know-how is employed across a wider market, profits will be greater. A firm will
choose FDI over licensing if the costs of doing so are lower. Transportation costs, tariffs,
and non-tariff barriers often raise the cost of exporting.
Licensing is the main method by which firms sell the rights to their know-how.
Unfortunately, markets for such knowledge are likely to be incomplete. A licence generally
gives the purchaser the right to use the production methods, technologies, and
management and marketing practices of the seller. However, it is difficult to protect
ownership once the information has been shared. Hill refers to the case of RCA, which
licensed its technology to Sony and Matsushita. Soon after, the Japanese companies were
able to take the US technology, make some minor adaptations to it that rendered US
patents invalid, and produce in competition with RCA. Sony managed to capture much of
RCAs market in the United States.
Pricing is also difficult with a licensing agreement. Skills, know-how, and procedures are
extremely difficult to specify, let alone price efficiently, because the true value of the
technology or the management practice cannot really be known until it has been employed
in the field by the licensee. Only the seller has a good idea of how much these are worth
(sometimes even the seller cannot value this properly), and the buyer has inadequate
information. This alone precludes an efficient market solution.
The selling firm may also be concerned about the purchaser's devaluing the selling firms
brand value. A restaurant chain may highly value its reputation for a clean eating
environment, but by licensing its brand, it runs the risk of finding itself working with a
partner that does not wish to pay the costs of keeping such a clean environment. The brand
may become devalued or the selling firm may have to spend a lot of money monitoring and
enforcing very detailed licensing agreements.
A licensee that is given a regional exclusive agreement may not expand as rapidly as the
selling firm wishes. The selling firm relinquishes substantial control over production and
expansion, and the selling firm may not wish to give up so much control.
Licensing is unlikely to be an efficient solution when one of the following three conditions
applies:
1. The selling firm has valuable know-how that cannot be protected in a licensing contract.

2. The selling firm wishes to have control over the business strategy of the licensee in
order to maximize global profits.

3. The selling firms know-how is simply not amenable to licensing. (Hill, p. 251)
Hill (pp. 251252) summarizes two alternative explanations of FDI. Strategic Behaviour
theory begins with the assumption that FDI is a strategic tool of oligopolistic competitors.
Raymond Vernon's Product Life Cycle theory argues that a firm will pioneer a new product
in its home market first, but as the market for the product grows in other regions, and as
production methods become routine and standardized, it may be profitable to shift
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production to other locations with lower labour costs. Vernon argued that many firms FDI
in developing countries fits this explanation.
Location-Specific Advantages
There are some resources or assets that may be more valuable in one location than in
others. Obviously, this applies to resource-based industries and agriculture. It also applies
to a number of technologically advanced industries. Silicon Valley in California has become
one of the worlds leading centres of cutting-edge research and development for the
computing and semiconductor industries. Local universities turn out large numbers of
graduates who are well trained for these sectors. There are hundreds of small firms that are
world leaders in niche markets. The knowledge that exists in Silicon Valley is difficult to
reproduce elsewhere. Firms seeking to establish production and new product development
in these sectors will seek to go where the best knowledge is and can be tapped into fairly
easily. The existence of such pools of knowledge or talent (think of the fashion design
houses in France and Italy) tends to attract new entrants and the expansion of existing
firms. This knowledge pool constitutes an external benefit that is available only in this
location.
This also explains why governments everywhere attempt to subsidize the development of
centres of excellence for particular sectors or technology applications. They are attempting
to catch up and overtake the first-mover advantage claimed by Silicon Valley and similar
centres in other sectors.
See Figure 7.6 in the textbook (p. 266) for a useful decision framework that firms implicitly
use when facing the decision to export, license, or engage in FDI.
Benefits and Costs of FDI

The major benefits of FDI are the following:
z
z
z
increased access to capital

access to superior technology
access to superior management methods (pp. 257260)
FDI will often mean an injection of new investment in the host country. This is one of the
main benefits of FDI. Multinational firms can often access international capital at a lower
price than is available to domestic firms. In addition, FDI is often attached to investment
decisions that local firms are unprepared or unwilling to make, thus increasing the domestic
rate of investment and economic growth.
New technologies are often not for sale or lease but become available only if the owners of
those technologies decide to invest in the domestic market. Governments will often attempt
to negotiate terms that include provisions for the transfer of technology to other sectors of
the local economy. Multinational firms are usually unwilling to license or sell key
technologies, but host economies can capture many of the benefits of these technologies
through FDI.
These are the resource-transfer effects that host countries are most interested in capturing.
FDI from global multinational firms often brings new technologies and management
practices that are simply not available elsewhere. Local managers hired by multinational
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firms learn new managerial practices. Host governments often attempt to maximize the
local benefit of the investment by ensuring that provisions are made for local training and
hiring, local purchasing, technology transfers to local partners, and so on. Section 3.2, The
Age of the Multinational, examines these issues in more depth.
Hill identifies three additional benefits:
a. employment effects
b. balance-of-payments effects
c. effects on competition and economic growth
FDI alone will not have an impact on the rate of unemployment in an economy at or near
full employment, but in some less developed countries (LDCs), FDI will usually contribute to
a relative expansion of the higher paid segment of the labour force. Multinational firms
operate in sectors that typically pay wage rates that are between 50 percent and 100
percent higher than local wage rates for comparable skill levels. In countries where
regulations keep labour markets from approaching full employment levels, FDI alone can
cause the rate of unemployment to fall.
FDI normally involves flows of capital in both directions. Initially, capital flows in as a
multinational firm acquires local assets or builds facilities. This produces an initial positive
impact on the host countrys balance of payments through enhanced exports.
Study Questions
Provide complete answers for each of the following study questionsyou need to be able to
explain how and why a factor or consideration is important or relevant. Students often
lose marks on their assignments or examinations by providing answers that are too short
and incomplete. Some questions have answers provided at the end of this section. The rest
of the answers can be found in the assigned readings or the lesson notes. If you still have
problems answering any question, contact the Call Centre.
1. What is the difference between a green-field investment and acquiring or merging with
an existing firm?

2. Describe the trends and characteristics of FDI in the past 30 years.

3. Consider why firms selling products with low value-to-weight ratios choose FDI over
exporting. Answer

4. What are location-specific advantages, and why might they be an important factor in
explaining FDI? Answer

5. Under what circumstances might a firm prefer to engage in FDI rather than exporting or
licensing? Answer

6. What are the advantages and disadvantages of licensing as compared to FDI? Answer

7. What are the main advantages of FDI for host (recipient) countries?

8. What are the potential costs of FDI for host (recipient) countries?
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9. What are the possible costs and benefits of FDI for sending (home) countries?
10. Which theoretical explanation (or explanations) of FDI best explain(s) Cemex's FDI?
Answer
Answers to Selected Study Questions

3.
Products with low value-to-weight ratios, such as soft drinks or cement, are
frequently produced in the market where they are consumed. When transportation
costs are added to production costs, it becomes unprofitable to shift such products
over a long distance. For firms that can produce low value-to-weight products at
almost any location, the attractiveness of exporting decreases and FDI or licensing
becomes more appealing. Back
4.
Location-specific advantages are advantages that arise from using resource

endowments or assets that are tied to a particular foreign location and that a firm
finds valuable to combine with its own unique assets. Natural resources such as oil
and minerals, for example, are specific to certain locations. Firms must undertake
FDI to exploit such foreign resources. Back
5.
A firm will favour foreign direct investment over exporting as an entry strategy when
transportation costs or trade barriers make exporting unattractive. Furthermore, the
firm will favour foreign direct investment over licensing (or franchising) when it
wishes to maintain control over its technological know-how or its operations and
business strategy or when the firm's capabilities are simply not amenable to
licensing, as may often be the case. Back
6.
Licensing occurs when a domestic firm (the licensor) licenses a foreign firm (the
licensee) to produce the licensors product, to use its production processes, or to use
its brand name or trademark. In return, the licensor collects royalty fees on every
unit the licensee sells or on total revenues.
The advantage of this type of arrangement over FDI is that the licensor does not
have to pay (in terms of cost, time, or risk) to open up a foreign market, as this has
already been established by the licensee.
There are several disadvantages to licensing as a strategy to exploit foreign market
opportunities. Licensing may require that a firm relinquish valuable knowledge or
technology to a potential foreign competitor. Licensing does not give the firm
adequate control over the manufacturing, marketing, and strategy-making aspects
of a business located in a foreign country. As well, the firm providing the licence
may not feel that the licensee is adequately exploiting all of the profit potential
inherent in the foreign market. Back
10. Cemex is a cement company. Consequently, exporting is difficult because of the

weight of the product. If Cemex wants to expand into new markets, the company
would either need to license a local company or make an investment in the market
directly. Cemexs success is due in part to its top-notch customer service and its
relationship with distributors. Because these advantages could be difficult to transfer,
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the company will probably choose to invest directly. Back
Section 3.2: The Age of the Multinational
In the Reading File:

z Age of the Multinational, by Robert Gilpin. The Challenge of Global Capitalism:
The World Economy in the 21st Century, pp. 163192
In the textbook:
z Government Policy Instruments and FDI, pp. 262-265
In the DRR:
z Worldbeater, Inc. The Economist, November 22, 1997, pp. 9395
1. explain how MNCs have accelerated the integration of the global economy.

2. describe how the national ownership of MNCs has changed over the past 40 years.

3. describe the regional allocation of MNC investment.

4. explain why countries are interested in attracting MNC investment.

5. explain some potential costs and concerns related to MNC investment.

6. explain the meaning of performance requirements.

7. discuss why there is no set of international rules governing global investment that would be
similar to global trading rules.

8. discuss what principles might be built into a new Multilateral Agreement on Investment
(MAI).
The Age of the Multinational Enterprise and FDI

In the assigned reading Age of the Multinational, Gilpin examines how MNCs have
established an overwhelming and growing presence in the global economy. MNCs are
behind much of the very rapid growth in FDI over the past 25 years. An MNC may be
defined as a firm of a particular nationality with partially or wholly owned subsidiaries
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within two or more national economies (Gilpin, p. 164).

In earlier days, the purpose of much investment by MNCs was to gain access to raw
materials or to establish a presence in a major market that was protected by tariffs. FDI
was often seen as a way of jumping over tariff walls.
FDI by MNCs has now changed in dramatic ways. The globalization of production introduced
in Unit 1 describes how MNCs have begun to unbundle the components and services that
are used to produce a final product and reallocate the production site for each separate
component or service to the most efficient location. Outsourcing is a part of this
phenomenon.
We have seen that FDI has grown much faster than trade over the past quarter century,
and FDI is the way in which MNCs expand into new territory. MNCs are key actors in the
emergence of the global economy.
Technological change and a more open, market-friendly approach to FDI has facilitated
MNC expansion. The new communications technologies have greatly reduced the cost of
managing at a distance. Industrial and distribution systems can be effectively managed on
a global scale now. This has greatly reduced the costs of such coordination, essentially
permitting firms, for the first time, the opportunity to search the world for the best location
for a specific activity. In the not too distant past, communication and coordination costs
would simply rise too rapidly if an organization tried to globalize production the way many
MNCs do today.
The globalization of production via FDI is integrating the world economy in a much more
profound way than the globalization of markets ever could. As MNCs search the world for
the best location for a new call centre, a new factory to produce tires, or a site to conduct
research and development activities, national governments come to understand that their
economic success will depend, in large part, on developing the ability to find a niche or a
role to play in the global investment plans of MNCs. Corporate investment strategy is
affected by many policies of potential host countries: tariff policies, tax policies, regulatory
environment, and so on.
Although initially the United States dominated MNC FDI, the situation has changed
dramatically since 1980. MNC FDI has grown rapidly in Europe, Japan, South Korea,
Canada, and, to a lesser extent, a few Southeast Asian countries. At present, MNC FDI is
concentrated in the high-income regions of the world. North American, European, and
Japanese MNCs are largely investing in each others markets. MNC activity in less
developed countries is still surprisingly small, although it is growing rapidly. As Figure 6.1 in
Gilpin shows, MNC FDI in less developed countries rose from about US$22 billion in 1990 to
over US$120 billion by 1997. MNC FDI in the less developed regions was very concentrated
as wellChina alone received over 31 percent of the FDI going to less developed countries.
Mexico, Brazil, Poland, Indonesia, and Malaysia also received significant amounts. Very little
MNC FDI was recorded in Africa.
MNCs are crucial sources of capital, technology, management methods, and access to new
markets for almost all countries, especially the less developed countries that, in the
absence of MNCs, simply would not have access to these benefits. National policy makers
have come to recognize that market-friendly regimes have simply outperformed
market-unfriendly regimes in all regions of the globe. As a result, there has been a shift
worldwide, from regulatory regimes that attempt to keep out MNCs toward regulatory
regimes that attempt to attract MNC investment.
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Economic and Political Significance of the MNC

Gilpin comments that a bargaining relationship exists between MNCs and host
governments. While it is true that attracting the investment of MNCs can accelerate
economic development, the terms on which that investment is available are very important.
Host nations will attempt to maximize the external benefits that may arise. For example, a
government might
z seek to ensure that locals are employed, trained, and taught how to use specific
technologies
z seek to ensure that the MNC meets export targets and sources inputs from domestic
producers
z attempt to force the MNC to work in partnership with a local firm and promote
technology transfer to that firm.
These obligations are called performance requirements.
While host governments are interested in deriving maximum benefit from the MNC, the
MNC will also attempt to bargain for maximum benefits for itself. This bargaining is not a
one-time affair; it will continue as long as the MNC continues to operate in the host
country. The MNC may seek a wide range of benefits, including
z
z
z
z
z
z
z
z
z
protection from import competition

lower tax rates
subsidized power and water
tax holidays
direct and indirect subsidies
research and development tax credits
low-interest loans
a less burdensome regulatory environment
improved public infrastructure.
Many nations also wish to protect certain sectors of the economy from foreign involvement.
Canada, for example, limits the activities of foreign firms in banking, airlines, and all media
or cultural industries such as film, television, radio, and publishing.
Governments that are home to a large number of MNCs worry from time to time about
possible negative impacts of MNC investment in other countries. The question that is asked
is, Wouldnt it be better for us if company X invested at home rather than in a foreign
country?
It is important to remember the comparative advantage argument raised when we
examined trade. Free trade allows each region to specialize in those activities for which it
possesses a comparative, or relative, advantage. As resources are limited, it is best to focus
on what we do best and not try to do all things. MNC investment abroad produces the same
kind of advantages. It permits those agents with unique technologies or business practices
to locate production facilities in the most efficient location.
For example, an American MNC might choose to operate its call centre out of India. If it was
prohibited from doing so, then it would be at a competitive disadvantage compared to other
international firms that were free to locate production and other facilities in the most
desirable location. There is also no guarantee that this investment would take place by the
firm in the United States. The firm might simply buy call centre services from an Indian firm
operating in India.
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Nations that are home to many MNCs often object to the performance requirements
imposed by other governments. These are often seen as detrimental to the home country.
Boeing has recently signed an agreement with China to produce aircraft in China, but under
the terms of the agreement, Boeing must form a joint partnership with a Chinese firm and
produce the aircraft in China. The United States is concerned that China may gain access to
valuable technology which might have military applications.
Gilpin (p. 181) notes that regionalization, as opposed to globalization, characterizes much
MNC investment in recent years. American MNCs focus on Mexico and Latin America,
European MNCs are focusing on eastern Europe, and Japanese MNCs are concentrated in
the lower income areas of Asia. This may permit MNC networks to remain physically closer
to their main markets, while taking advantage of lower wage costs in nearby regions.
In the assigned textbook reading (pp. 262265), Hill notes that many governments have
policies that both promote and restrict outward and inward FDI. This may not be as
contradictory as it sounds. Canada, for example, attempts to attract MNC investment in
most sectors, but has regulations in place that limit foreign investment in banking,
transportation, cultural industries, and other sectors. Over the past 20 years or so, there
has been a growing recognition that MNC investment can, and usually does, accelerate
economic growth, especially in the less developed regions of the world, and more countries
have adopted MNC-friendly investment policies that are designed to attract, as opposed to
repel, foreign investment. However, it is still a major political issue in most countries that
attract substantial amounts of FDI; concern that local control or national sovereignty will be
reduced due to the dominating position of these foreign entities is seldom far from the
surface.
Rules for FDI and MNCs

World trade is governed via a host of global (e.g., WTO) and regional (e.g., NAFTA) trade
agreements that set out the rules that all must follow. Free trade agreements usually
require that signatories agree not to impose tariffs on goods from other parties to the
agreement and spell out, often in great detail, the limits on the use of non-tariff barriers
(rules on subsidies, anti-dumping, and so forth). Normally, a general objective is to ensure
that foreign goods are treated in the same manner as domestically produced goods. This
kind of trading regime provides the incentive structure that will permit firms to produce
efficiently on a global basis.
It is somewhat odd that no similar agreements exist with respect to investment rules. No
common set of rules exists, so each nation must establish its own rules. Economists
generally favour an even-playing-field approach, one that would ensure that foreign firms
are treated in the same way as domestic firms with respect to rules governing investments,
but this is seldom the case.
It is fairly easy for MNCs to set up operations in the United States, and few performance
requirements are needed. In Canada, it is easy for MNCs to set up operations in many
sectors; indeed, foreign MNCs dominate many sectors of the Canadian economy. In other
sectors, foreign ownership is severely limited. In Europe and much of the developing world,
detailed performance requirements are the norm. Japan has shown little interest in
permitting foreign MNCs access to the local marketplace and has used a variety of
bureaucratic measures to keep them out. South Korea and many other LDCs have adopted
Page 15 of 52
aggressive industrial policies that aim to develop local industrial champions in major sectors
of the economy. These governments provide subsidies and various types of protection to
these firms, including a type of infant industry protection model in which the government
picks out and protects firms it hopes will develop into leading world-class firms.
Gilpin argues that globally, efficiency could be enhanced if the world were able to develop a
global investment regime based on universal and neutral principles analogous to the free
trade principle (p. 191). This would have the same advantages as a global free-trade
agreement, in that investment and output would tend to move according to the dictates of
comparative advantage, not according to which government was offering the largest
subsidies at the moment.
A global investment regime would likely have the following characteristics:
z
z
z
the right of establishment

the right of national treatment
the right of non-discrimination (Gilpin p. 183)
In 1995, the United States proposed a Multilateral Agreement on Investment (MAI) that
attempted to establish such global principles. Massive opposition to this idea arose in many
countries. It quickly became apparent that such an agreement would limit the ability of
states to pursue independent industrial policies or policies to promote and subsidize
approved firms. Such policies are firmly entrenched in many nations.
Gilpin sees little hope for such an international rules-based approach to global investment.
There are a number of difficult technical questions, such as how to tax profits earned in a
supply chain that includes more than one nation. However, the major challenges are
political. The terms under which investment takes place are seen as critical by many
national governments, and they are not willing to surrender their right to negotiate
technology transfer, employment, export, and local content performance requirements.
Study Questions
and incomplete. The answers can be found in the assigned readings or the lesson notes. If
you still have problems answering any question, contact the Call Centre.
1. Why does Gilpin regard the post-1980 era as the era of the MNC?

2. Describe how the pattern of ownership of MNCs has changed over the past 25 years.

3. What are the possible advantages to a nation of attracting MNC investment?

4. What are the major concerns that national governments may have with respect to
attracting MNC investment?

5. What kinds of policies might national governments use to attract MNC investment?

6. Define performance requirements and indicate when they might be used.
Page 16 of 52

7. What are the arguments in favour of developing a global set of rules governing MNC
investment?

8. Why has it been so difficult for nations to agree on such a set of rules?
ECON 401
The Changing Global Economy
Unit 4: The Global Monetary System
Unit Overview
Introduction
Unit 3 discussed the tremendous growth in capital flows over the past 30 years. The volume
of foreign direct investment has grown much more rapidly than the volume of world trade
in recent years. There are several potential benefits to this trend, including the ability of
capital to move into regions where it is scarce and valuable. Foreign direct investment can
make a positive contribution to a host economy by supplying capital, new technology, and
management resources that would otherwise not be available. This is particularly the case
for the less developed countries and poorer regions of the world.
Firms and governments around the world are increasingly able to access the global capital
markets. Innovations in telecommunications systems have created instantaneous access to
global financial markets, while the banking industry is being revolutionized to meet the
needs of institutional changes required to remain competitive. These technological advances
have created new opportunities to develop alternative banking instruments, and they
provide greater access to financing. Capital can be moved around the globe at a keystroke,
and at virtually no cost.
In Unit 4, we will look at the
z
z
z
z
z
specific functions of the foreign exchange market

tools designed to deal with and manage the risk of adverse consequences of
unpredictable changes in exchange and interest rates

different types of exchange rate regimes

current theories used to determine the future value of exchange rates

growth of global capital markets.
Page 17 of 52
There are many debates surrounding the global financial market instability. While the
International Monetary Fund (IMF) has pushed LDCs toward financial market liberalization,
many economists have challenged this wisdom. These debates and the recent experience in
Mexico, the Congo, and Russia are examined briefly in this unit, and the Asian crisis is
examined more fully in Unit 5.
Web Links
The following Web links highlight some interesting issues related to the role of the IMF and
the debate that surrounds that effectiveness of the IMFs macroeconomic stabilization
policies (see Section 4.4).
z
The IMF at a Glance
International Capital Markets: Developments, Prospects, and Key Policy Issues
Finance and Development
The IMF and its Critics
The following Web links highlight some interesting issues related to global capital market
(see Section 4.5) as presented by the IMF as well as some issues surrounding the use of
capital controls.
z
IMF Global Financial Stability Report
Institute of Economic Affairs
IMF Policy Discussion Paper
References
World Bank. (2002). Globalization, growth, and poverty: Building an inclusive world
economy . Washington, DC and New York: World Bank and Oxford University Press.
Section 4.1: Foreign Exchange Markets
In the textbook:
z Chapter 9 (pp. 322330 only)
Page 18 of 52

1. describe the major functions of the foreign exchange market.

2. explain the factors that determine the demand and supply of foreign exchange.

3. define spot exchange rates .

4. define forward exchange rates .

5. define foreign exchange risk .

6. describe how firms might use forward exchange markets to manage foreign exchange risk.

7. explain the meaning of the following terms:

z exchange rate
z currency speculation
z currency swaps
z arbitrage.
Foreign Exchange Rates

You have probably bought an American dollar at one time or another. Before vacationing in
the United States, you might go to your bank to buy American dollars and pay for them
with Canadian dollars. Foreign exchange markets deal in American dollars, Canadian
dollars, pounds sterling, and all other currencies. These markets are complex networks of
institutions, banks, foreign exchange dealers, and government agencies through which the
currency of one country may be exchanged for that of another. In many ways, these
markets operate in the same way as the markets for apples or French wine. There is a
supply of a foreign currency and a demand for it; in a free market, supply and demand
interact to determine the price.
Your textbook defines an exchange rate as the rate at which one currency is converted
into another (p. 324). There are two ways to report the exchange rate between Canadian
and US currency: one way is to state that one Canadian dollar is now worth US$0.82, and
the other is to report that one US dollar is worth Can$1.22.
In one sense, the price of a currency is unique. We can speak of the price of the Canadian
dollar, for example, only by relating it to the value of another currency, often the US dollar.
We could, however, correctly speak of the price of Canadian dollars measured in Turkish lire
or British pounds. When we speak of the price of beef, chicken, or stereos, on the other
hand, we measure price in terms of units of the domestic currency.
To convert US$1 into Canadian dollars, perform the following calculations:
Page 19 of 52
1current exchange rate

= 1$0.82
= Can$1.22
To convert Can$1 into US dollars, perform the following calculations:
1current exchange rate
= 1$1.22
= US$0.82
Under a flexible exchange rate system, the value of a currency is determined by the
demand and supply for that currency. This is determined in the foreign exchange market.
The demand for US dollars comes mainly from non-US citizens or firms who wish to buy
American goods and services, travel to the United States, or invest in the United States.
International visitors to the United States must first go to their local bank to purchase US
dollars (by selling local currency to their bank) in order to have US currency to spend while
in the country.
If you live in Europe and want to purchase American-produced cars, CDs, or beer, you must
arrange to acquire US dollars to buy the goods. These transactions show up in the Balance
of Payments as exports from the United States. If Toyota, the Japanese car producer,
wishes to build a car plant in the United States, it must exchange its Japanese yen for US
dollars in order to make this investment in the United States. If an individual living in
Malaysia wishes to buy shares in a firm listed on the New York Stock Exchange (NYSE), he
will first have to sell some Malaysian currency in order to buy US dollars to make the
purchase. Often the individual is not even aware that such an exchange takes place. The
Malaysian investor will likely have an account with a Malaysian stockbroker and enter an
order to purchase stocks on the NYSE. His Malaysian currency account is reduced by a
certain amount, and the broker makes the purchase on his behalf.
The demand for US currency is determined largely by
z
z
z
z
exports of US goods
foreign direct investment into the United States
the purchase of US financial instruments by those living outside the United States
foreign visitors to the United States.
These are the major determinants of demand, but there are a few other activities that
produce a demand for US currency.
Factors that influence the value of currency include
z
z
z
z
z
z
political instability
investor psychology
perception and rumour
the level of domestic and foreign economic activity
the level of domestic and foreign interest rates
bandwagon effects (which will be discussed in the next section).
As you know from your introductory economics course, demand is only one side of the
equation. Where does the supply come from? It is helpful to remember that, in a foreign
exchange market, those supplying one currency in the marketplace do so only to purchase
Page 20 of 52
another currency. If I sell US dollars in the foreign exchange market, I am doing so to

purchase another currency. Who in the United States will want to sell US dollars in order to
purchase Japanese yen, Canadian dollars or other currencies? The answer is, those in the
United States who wish to
z
z
z
z
purchase goods produced abroad

make investments in other countries
purchase stocks, bonds, or other financial instruments issued in other countries
travel to other countries.
You will notice that this list is a mirror of the list above that explains the demand for US
currency.
Not surprisingly, the demand curve for US dollars has the familiar downward slope. If the
price of US currency (in terms of foreign currency) rises, the quantity demanded will fall.
For example, if the cost of purchasing one US dollar rises (in terms of Canadian dollars),
which is the same as stating that the value of the Canadian dollar falls, Canadians will buy
fewer US goods; Canadian FDI into the United States will fall; purchases of US stocks,
bonds, and other financial instruments by Canadian residents will fall; and Canadians will
take fewer holidays in the United States. If the price of US dollars is relatively high, it will
be more expensive in terms of local currency, and individuals and firms will reduce their
purchases of US dollars.
The supply curve also looks like a normal supply curve, although in the case of foreign
exchange, it is important to remember that the supply of US dollars in the marketplace
really represents the demand for all currencies other than the US dollar.
Why does the supply of US dollars slope upward, as in Figure 4.1 below? If the price of the
US dollar rises, then, by definition, the price of the currency it is being measured against
has fallen, and the quantity of the non-US currency demanded will go up as its price has
fallen. To US residents, a rise in the US dollar means that foreign travel becomes cheaper,
foreign goods become cheaper, it becomes cheaper (in terms of US dollars) to buy foreign
stocks and bonds, and so on.
Figure 4.1 The Demand and Supply of Foreign Exchange
Page 21 of 52
Looking for the moment at the demand curve, we can see that if the price of US dollars is
high, at Can$1.50, only Q0 units are demanded. If the price is lower, at Can$1.25, then Q1
units are demanded.
Similarly, if the price of US dollars is high (meaning that the price of Canadian dollars is
low), then the supply of US dollars in the foreign exchange market is high. When the price
of US$1.00 is Can$1.36, Qd = Qs, and the market is in equilibrium.
Figure 4.2 Demand and Supply Shifts
The market for foreign exchange adjusts in the same way that other markets adjust to
changes in the determinants of demand or supply. If, for example, more foreign tourists
wish to visit the United States, the demand for US currency will rise, shifting D to the right
to D2. The new equilibrium exchange rate will be higher, at Can$1.45.
Other factors could have shifted the demand curve to the right. If foreigners wanted to buy
more US goods, then US exports would rise, shifting the demand curve to the right. If
foreigners wanted to buy more US stocks or bonds, the effect would be the same.
To understand what causes shifts in the supply curve, you need to remember that the
desire to sell US dollars in the foreign exchange markets exists only because firms and
individuals want to buy other currencies. If US citizens want to take more trips to France,
the supply curve above will shift to the right. If US citizens want to buy more Canadian or
British stocks, or make more investments in other countries, the supply curve will also shift
to the right. If D1 is the initial demand for US dollars (and the price is Can$1.36) and S1 is
the initial supply curve, any of the above changes would cause the supply curve of US
dollars to shift to the right, to S2. This causes the equilibrium value of the price of the US
dollar to fall from Can$1.36 to Can$1.28.
Spot and Forward Exchange Markets

Page 22 of 52
Foreign exchange markets are like auction marketsdemand and supply interact
constantly, and the price may rise or fall many times over the course of a day or even an
hour. This is called the spot market for foreign exchange. When you check the newspaper
to find out the current rate of exchange, you will most likely see the rate established at the
end of trading on the previous day.
Forward exchange rates are rates established today for a specified date in the future. This
may seem a bit odd, but there are good reasons for such markets to exist. Basically, they
permit those who know they will need foreign exchange at a certain date in the future to
buy that foreign exchange now at a given price. As every act of buying foreign exchange
also entails an act of selling a different currency, it means there is both a demand crowd
and a supply crowd willing and able to make such a market function.
Consider the Canadian farmer who plants wheat in the spring for fall harvest and sale.
Assume that much of the harvest is sold in the United States and abroad. The farmer
makes a business decision regarding what and how much to plant based on an
understanding of expected costs and revenues. But the spot price of foreign exchange can
move around quite a bit over a six-month period. The farmer faces a number of risks, many
of which he can do little about. The weather may be good or bad, farm prices in the fall
may be high or low, and so on. But if he plans on selling abroad, he also a faces a different
risk: foreign exchange risk. This is the risk that he may get less when he exchanges his
Canadian dollars for another currency six months into the future than he could get now. As
a farmer and businessman, he may be willing to take on certain risks, but the forward
exchange market allows him to lock in the price of foreign exchange. He buys a contract to
sell Canadian dollars for US dollars at a price fixed today, to be executed when he sells his
grain six months from today. In this way, the farmer can determine, today, the price of
foreign exchange in the future.
In practice, many market participants prefer to lock in future prices of foreign exchange
today, and as long as there are individuals prepared to buy and sell such contracts, these
markets will exist.
Currency swap is also an important term to understand. A currency swap occurs when a
firm or bank simultaneously buys and sells a certain amount of foreign exchange for two
different valuation dates. A firm will engage in a currency swap to eliminate foreign
exchange risk. Hill illustrates the merits of a currency swap by discussing Apple Computer,
which buys parts from Japan, assembles computers in the United States, and then sells
some computers to consumers in Japan. Reread this detailed example on page 328 of the
textbook and ensure that you understand this concept.
Arbitrage
Fluctuating currencies are an opportunity to speculate on currencies and, it is hoped, gain a
profit. Consider the following illustration. A Spanish professor, while a graduate student,
lived in Mexico with a group of American and Canadian students who, like himself, had
limited funds. When they had some free time, they made money by going to various
currency exchange outlets, trading dollars for pesos or pesos for dollars. The exchange
rates varied slightly from one exchange site to another. For example, the First Bank of
Mexico City exchanged 255 pesos for Can$1, and the Mexican Bank of Commerce
exchanged 252 pesos for Can$1. The students had Can$100 between them. At First Bank,
they bought 25,500 pesos. They then walked to the Commerce Bank and used 25,200 of
those pesos to buy $100. They now had a 300 peso profit. Returning to First Bank, they
Page 23 of 52
used their $100 to buy 25,500 pesos. Back at the Commerce, they bought $100 with
25,200 of their pesos, for another 300 peso profit and a total profit of 600 pesos. They
continued the exercise until they had enough profit for each to buy a drink at a local hotel.
It was hard work, but a sure profit. These students were engaged in what is called arbitrage
. In todays world of computers, it is unlikely that you could earn much money this way, but
arbitrage still exists and it is very important.
Arbitrage is defined as the simultaneous buying and selling of currencies or commodities for
profit in two or more markets with inconsistent prices. Arbitrage can exist in any type of
market. If wheat prices in London and Toronto vary by more than can be explained by
shipping costs and other trade barriers, a profit can be made by buying in the lower-priced
center and selling in the higher-priced centre. Our concern in this course is how arbitrage
influences foreign exchange rates.
It is possible for a bank to make a profit from inconsistent prices, but it must work fast,
because all of the big banks watch for such inconsistencies. An employee of a Canadian
bank calls New York and sells Can$10,000,000 for US$7,519,000. At the same time,
another employee calls Toronto and sells US$7,515,000 for Can$10,000,000. The profit is
US$4,000, less the costs of the transactionnot bad for a couple of minutes work on the
phone. In addition to the profit the Canadian bank made from the transaction, this buying
and selling increased the demand for American money in New York (or it increased the
supply of Canadian dollars). As a result, the bank brought down the price of Canadian
money in New York. On the other hand, it increased the demand for Canadian money in
Toronto and, as a result, increased the price of Canadian money in Toronto. The process of
arbitrage continues until the price for Canadian money is the same in both markets.
Arbitrage ensures that prices in all markets are the same.
Study Questions

1. What is the difference between a spot exchange rate and a forward exchange rate?
Answer

2. What are the main determinants of demand for a nations currency in the foreign
exchange market?

3. What are the main determinants of supply of a nations currency in the foreign
exchange market? Answer
4. What are the main uses of foreign exchange markets for international business? Answer

5. Explain how each of the following will affect the price of the US dollar:

a. There is an increase in the number of foreign tourists heading to Disneyland in
California.
Page 24 of 52
b. American consumers decide to buy more French wine.

c. Japanese investors decide to purchase more US stocks and bonds.
d. Prices in the United States begin to rise more rapidly than prices in the rest of the
world.

6. Explain how a firm or an individual can use forward exchange rates to reduce or
eliminate foreign exchange risk.

7. What is arbitrage?

8. Explain how currency swaps work and why a firm may engage in a currency swap.
Answer

1.
The spot exchange rate is the rate at which a foreign exchange dealer converts one
currency into another currency on a particular day. Spot exchange rates are reported
daily in the financial section of the newspapers. Spot rates are continually changing,
their value being determined by supply and demand for that currency relative to
others.
A forward exchange occurs when two parties agree to exchange currency and
execute the deal at some specific date in the future. Exchange rates governing such
transactions are referred to as forward rates. Most major currencies are quoted 30,
90, and 120 days into the future. Back
3.
There are a number of factors that determine the supply of a domestic currency in
the foreign exchange market. If we consider the case of the Canadian dollar, supply
of the Canadian dollar is determined by the change in the amount of goods and
services imported. For example, as an economys employment and output rises,
there is greater demand for foreign-produced goods and services, which leads to a
greater supply of Canadian dollars as Canadians convert their currency into the
foreign currency. This is also the case if there is a greater amount of FDI made by
Canadians to foreign markets or if more Canadians are visiting international locations
such as the United States. If international interest rates are higher than those found
in Canada, Canadians would purchase international financial instruments rather than
Canadian instruments, causing the supply of Canadian dollars in the foreign
exchange market to rise. Back
4.
The foreign exchange market serves four primary functions for international
companies:
z
The market is used to convert payments a company receives in foreign

currencies into the currency of its home country.
The market is used to convert the currency of a company's home country into
another currency when the company must pay a foreign company for its products
and services in the currency of the foreign company's country.
International businesses may use foreign exchange markets when they have
Page 25 of 52
spare cash that they wish to invest for short terms in money markets (of another
country).
z
8.
The market is used for currency speculation. Back
A currency swap is the simultaneous purchase and sale of a certain amount of

foreign exchange for two different valuation dates. This activity is conducted in order
to eliminate foreign exchange risk. Swaps can be conducted between banks,
between a firm and a bank, or between governments where large amounts of
currency are moved from one location to another. Back
Section 4.2: Theories of Exchange Rate Determination
In the textbook:
1. explain the purchasing power parity (PPP) theory of exchange rate determination.

2. calculate predicted exchange rates using PPP.

3. explain why PPP may not work well in the short run.

4. explain how a change in the rate of expected inflation will affect the exchange rate.

5. explain what is meant by

z law of one price
z the Fisher Effect
z the International Fisher Effect (IFE)
z real and nominal interest rates
z bandwagon effects
z capital flight
z efficient and inefficient markets .

6. explain currency convertibility and why governments may attempt to limit it.
Purchasing Power Parity

Page 26 of 52
One of the most difficult economic indicators to forecast is the value of a domestic currency.
An exchange rate is determined by the market forces of demand and supply. These forces
can be influenced by factors such as political instability, perception and rumour, commodity
price fluctuations, the level of domestic and foreign economic activity, and the level of
domestic and foreign interest rates, all of which make it difficult to determine the value of a
currency in the coming year with any degree of certainty.
One of the simplest theories of exchange rates is called purchasing power parity (PPP),
which states that a unit of any given currency should be able to buy the same quantity of
goods in all countries. For example, Can$5 should buy one Big Mac in Canada, while Can$5,
when converted to US dollars, should buy the same Big Mac in the United States.
PPP theory predicts that exchange rates are determined by relative prices and that changes
in relative prices will cause changes in exchange rates. Many economists believe that the
theory of PPP determines the long-run value of a currency. The theory asserts that if a
commodity has two different prices in two different locations, forces are set in motion to
equalize the prices. If a Canadian dollar can buy more coffee in Canada than in the United
States, international traders could profit from buying coffee in Canada and selling it in
Japan (an example of arbitrage, which we discussed in the Section 4.1). The export of
coffee to Japan from Canada will cause the price of Canadian coffee to rise and the price of
Japanese coffee to fall. Eventually, the two prices equalize. This is called the law of one
price, which states that a Canadian dollar should be able to buy the identical amounts of a
certain good in two different markets. The textbook provides a good example of this law on
the bottom of page 331.
There is an important conclusion to be drawn from PPP theory. PPP predicts that if prices in
country A rise by more than prices in country B, then the value of the currency in A will fall
by an amount that exactly offsets the price change difference, in order to maintain PPP.
This is, in fact, a logical conclusion to be drawn if PPP holds.
Suppose Canada and the United States both have inflation rates of 5 percent and PPP
holds. If inflation starts to accelerate in Canada, the value of the Canadian dollar will have
to fall in order to maintain PPP. This is one reason the Bank of Canada has a significant
preoccupation with keeping inflation under control in Canada. Canadas high inflation affects
Canadas competitive position vis--vis its trading partners and puts downward pressure on
the value of the dollar. This is true for all countries: other things being equal, an
acceleration of the rate of inflation relative to major trading partners will cause the value of
the domestic currency to fall.
Money Supply, Prices, and Exchange Rates

We have seen that PPP predicts that a change in relative inflation between two countries
will lead to an equal and opposite change in the value of the exchange rate.
In your introductory economics course, you learned that inflation is a monetary
phenomenon. Consider an economy with output growing at 3 percent per annum. We can
say that the economy will need its money supply to grow at roughly 3 percent per annum
to ensure that cash balances are adequate for households and firms to make their planned
Page 27 of 52
purchases. What happens, though, if the money supply grows at a higher rate, say at 5
percent, and the real supply of physical goods rises by only 3 percent? This means that
demand for goods is rising by 5 percent per year, but since the supply of goods is rising by
only 3 percent, the only possible outcome is that prices will have to rise.
The money supply, therefore, gives market actors a good idea of what is likely to happen to
exchange rates. If the money supply in country A increases rapidly, we expect that prices
will also rise rapidly in the not too distant future. If the money supply in country B is rising
only modestly, we do not expect inflation to rise significantly. Given this information, we
would expect that the currency in country A will fall relative to the value of the currency in
country B.
Economists often use newspaper articles to issue stern warnings to governments that are
bent on expanding the money supply to pay for an ambitious agenda. The warning is
always the same: If you expand the money supply rapidly, prices will rise, and if prices rise
more rapidly at home than they do for our trading partners, we can expect the value of our
currency to fall.
Empirical Tests of PPP Theory
If markets were competitive, transportation costs were zero, there were no non-traded
goods, and uncertainty was not an issue, we would expect exchange rates to be determined
by PPP most of the time.
While the theory of PPP is a simple model to determine exchange rates over the long run, it
does have limitations:
z It is not completely accurate, in that exchange rates do not always move to ensure that
a Canadian dollar has the same purchasing power in all countries.
z
It does not address differences in transportation costs and barriers to trade and
investment, which could also influence prices.
It does not account for investor psychology or for the fact that perception can cause a
herd mentality or the bandwagon effect. Capital flows may be guided, to a much
greater extent, by investor perceptions of expected profits, and these may be linked
only weakly to relative price inflation.
It may not hold if markets are dominated by several large MNCs that may have
influence over market prices.
All of these factors will cause actual exchange rates to differ from those predicted by PPP.
Also, the theory is less useful for predicting short-term exchange-rate movements between
nations that have relatively small inflation-rate differentials. However, most economists
argue that PPP is the exchange value that real exchange rates will tend toward in the long
run, but in the short run, many variables can keep the PPP exchange rate from being
realized.
z
Interest Rates and Exchange Rates

Investors and borrowers are primarily interested in the real interest rate, not the nominal
Page 28 of 52
interest rate, which is simply the rate of interest charged on a loan or attached to a
financial instrument. A nominal rate of 10 percent is quite good if the rate of inflation is 1
percent; this means that the actual rate of return, after taking inflation into account, is 9
percent. If, on the other hand, inflation is running at 10 percent, that nominal rate of 10
percent implies that the investor will receive an after-inflation rate of return of zero (10
percent minus 10 percent). Investors are interested in real, inflation-adjusted rates of
interest, not nominal rates of interest.
Thus, we can say that the nominal rate of interest, let's call it i, is equal to the real rate of
interest, r, plus the expected rate of inflation, I. This relationship can be written as
i= r+I
When expressed in this form, it is referred to as the Fisher Effect, after Irvin Fisher, the
economist who first formalized the relationship.
In a world where capital is free to move across borders, arbitrage is going to make sure
that the real rate of interest, r , is the same in all countries, assuming that the level of risk
is the same. If risk is higher in one country than in another, then the real rate of return
required to induce investors to invest in the risky country will have to be higher. For the
moment, let us assume that we are looking at only two countries and that there is no risk
differential between the two.
In this case, we can see why the real rate of interest in the two countries will have to be
the same. If, for example, risk-free government bonds offer a 5 percent rate of interest in
the United States and a 5 percent rate of interest in Canada and expected inflation is equal
to zero in both countries, then the real rate of return is 5 percent in both countries.
What if the real rate of return was higher in Canada? Let us assume, for the moment, that
the US government decided that interest rates were too high in the United States and
decided to expand the money supply to lower interest rates in order to stimulate economic
activity. As the nominal interest rate fell in the United States, a gap would open up between
the real interest rate in Canada and the real interest rate in the United States. Let us
assume that nominal and, therefore, real rates of interest fall to 3 percent in the United
States.
Is this likely to be a stable situation? Clearly, the answer is noreal interest rates are 5
percent in Canada, but only 3 percent in the United States. Will investors alter their
behaviour now? Yes, they most certainly will. Investors will sell off US stocks, bonds, and
other assets to buy Canadian stocks, bonds, and other financial assets that can earn a
higher rate of return. This will also cause the value of the Canadian dollar to appreciate as
foreign capital flows into Canada.
This is simply engaging in arbitrage. The demand for financial instruments (stocks, bonds,
and so on) will rise in Canada, and the demand for financial instruments in the United
States will fall. Through the simple interaction of demand and supply, real and nominal
interest rates in Canada will rise, and real and nominal rates in the United States will fall.
Equilibrium will be restored only when the real rates of interest are the same in both
countries again.
If the real interest rate is the same worldwide (for the moment, we need to assume away
differences in risk and government regulations limiting capital flows), then what will explain
differences in nominal interest rates? It has to be the expected rate of inflation. If, for
Page 29 of 52
example, real interest rates are 5 percent in both Canada and the United States, but the
nominal rate is 10 percent is Canada and 6 percent in the United States, it means that the
expected rate of inflation in Canada is 5 percent (10 minus 5), and the expected rate of
inflation in the United States is 1 percent (6 minus 5).
The International Fisher Effect summarizes the relationship between exchange rates,
interest rates, and inflation. It states that for any two countries, the spot exchange rate
should change in an equal amount but in the opposite direction to the difference in nominal
interest rates between the two countries (pp. 337338).
This is simply the logical conclusion to what we have learned about the relationships
between interest rates, inflation, and the exchange rate. If real interest rates are the same
in two countries, then nominal interest rates will differ only because of differing rates of
inflation. If the rate of inflation in one country is higher than it is in the other country, the
value of the currency of the inflating country must fall.
Investor Psychology, Bandwagon Effects, and Short-run

Exchange Rate Movements
PPP and the International Fisher Effect are based on sound economic principles, but in the
short run, we often find that exchange rates are not based on these principles. It is often
said that these principles will determine exchange rates in the long run, or that exchange
rates are tending toward the exchange rates predicted by these principles, but that, in the
short run, exchange rates can be well above or well below predicted values. There appears
to be a lot of overshooting or undershooting when an exchange rate begins to move.
Why might this be the case? Hill suggests that investor information is often poor, especially
concerning risks in emerging countries, and that investors will often tend to follow bursts of
optimism (during which expectations of economic performance are very rosy) by bursts of
pessimism (when expectations turn dramatically downward). This kind of boom/bust
investor psychology will result in exchange rates that do not quickly settle down at
predicted values.
Currency Convertibility
z
Freely convertible currencythe domestic government places no restrictions on

residents or non-residents with respect to the buying and selling of currency.

Externally convertible currencythe domestic government places no restrictions on
non-residents with respect to the buying and selling of currency, although it may place
some restrictions on residents.

Non-convertible currencyneither residents nor non-residents are permitted to
convert the domestic currency to a foreign currency.
Countries may limit convertibility in order to protect foreign exchange reserves. Not
surprisingly, it is the weaker economic countries that most often limit convertibility. If a
government of a particular country fears that market participants may wish to sell off that
countrys currency, that government may take action to limit convertibility. This will usually
occur if the government has done something that would likely lead to a fall in the value of
Page 30 of 52
its currency. If a government attempts to spend money that it does not possess by printing
more money and increasing the money supply, a rise in the domestic inflation rate would
normally result. If inflation in that country suddenly rises, we would expect the value of its
exchange rate to fall, as market participants move to sell that currency and buy foreign
exchange.
This great rush by residents and non-residents to convert their holdings of domestic
currency to foreign currency is known as capital flight (Hill, p. 343). It is a danger that can
occur when government policies are expected to lead to very high rates of inflation.
Investors fear that, if the government stays on the path to high inflation, it will have to
permit the currency to devalue in the near future.
Study Questions
1. Explain the theory of purchasing power parity (PPP). Use an example to show how PPP
can help explain exchange rates. Answer

2. In a two-country, one-good model, Trinidad and Jamaica both produce only rum. The
domestic price of one bottle of rum in Jamaica is 10 Jamaican dollars. The domestic
price of one bottle of rum in Trinidad is 15 Trinidadian dollars. What will the exchange
rate between the two countries be, according to PPP?

3. Why might PPP not be a good predictor of exchange rates in the short run? Answer

4. What is the International Fisher Effect?

5. What is the relationship between interest rates, the rate of inflation, and exchange
rates?

6. Consider the following scenario. The rate of inflation in Malaysia is 10 percent; in
Singapore, it is 5 percent. The nominal rate of interest in Malaysia is 3 percent; in
Singapore, it is also 3 percent. Is this a stable equilibrium position? If not, explain what
will happen to capital flows, nominal interest rates, and the exchange rate between the
two countries. Assume that both currencies are fully convertible. Answer

7. What is the most common approach to exchange rate forecasting?

8. What is meant by currency convertibility ?

9. What is meant by capital flight ?

10. What is meant by non-convertibility ?
Page 31 of 52

1.
PPP theory states that, given relatively efficient markets, the price of a basket of
goods should be roughly equivalent in each country. So, if a basket of goods costs
$200 in the United States and 20,000 in Japan, PPP predicts that the dollar/yen
exchange should be $200/20,000 or US$.01 per Japanese yen. Back
3.
There are a number of reasons why exchange rates may differ from the exchange
rates predicted by the PPP theory.
z
6.
The PPP theory assumes no transportation costs or barriers to trade, but we

know that there are differences in transportation costs and trade barriers
between countries. Government intervention in cross-border trade affects the
efficient workings of the market, as prices of goods and services are influenced.

Government intervention in the form of buying and selling currencies in the
foreign exchange market further weakens the link between price changes and
changes in exchange rates. The PPP theory tends to be less useful when applied
to currencies of advanced industrialized nations that have small differences in
inflation rates.

The PPP theory also does not take into account the influence of the changes in
investor psychology or perceptions that can lead to large changes in the
exchange rates. Back
This is not a stable equilibrium situation because the real interest rates are higher in
Malaysia than in Singapore. This situation will lead to investors looking to take
advantage of the higher rate of return in Malaysia. Investors located in Singapore
will sell off their stocks, bonds, and other assets and then convert them to the
Malaysian currency. This creates an increase in the demand for the Malaysian
currency in the foreign exchange market, which leads to an appreciation of the
currency as capital flows into Malaysia. The demand for financial instruments will rise
in Malaysia, and the demand for financial instruments in Singapore will fall.
Conversely, as investors leave Singapore, there is a capital outflow and greater
supply of Singapores currency in the foreign exchange market, which leads to a
depreciation of the currency. An opposing influence to all of this is that arbitrage will
soon equalize the differences in real interest rates. Because the real interest rate is
lower in Singapore, investors will borrow money in Singapore and invest it in
Malaysia, causing an increase in the demand for money in Singapore. This has the
effect of raising the real interest rate, while the increase in the supply of money
flowing into Malaysia will lower the real interest rate in Malaysia. Equilibrium will be
restored only when the real rates of interest are the same in both countries.
Another issue to consider is the fact that the inflation rates are vastly different
between Malaysia and Singapore. Inflation in Malaysia is double that of Singapore,
which will put downward pressure on Malaysias currency. To slow this trend,
nominal interest rates have to rise. Back
Section 4.3: The International Monetary System

Page 32 of 52
Sect o
te
at o a
o eta y Syste
In the textbook:

z floating exchange rate
z pegged exchange rate
z dirty float
z IMF conditionality
z fixed exchange rate
z currency board

2. explain how the gold standard worked and why it collapsed.

3. explain the objectives and key components of the Bretton Woods system established in
1944.

4. explain the factors that led to the collapse of the Bretton Woods system.

5. compare the advantages and disadvantages of flexible and fixed exchange rates.

6. discuss the role of the IMF in the post-war international monetary system.
Exchange Rate Models

Floating Exchange Rate
The model of exchange rate determination introduced in Section 4.1 is the model of a
floating exchange rate. Simply put, a floating exchange rate system is said to exist when
the forces of demand and supply in the marketplace are permitted to determine the value
of the exchange rate.
This is not the only model in use, however. It probably wont surprise you to find out that
governments intervene, in varying degrees, in an effort to control, manage, or affect the
exchange rate. This is because the price of foreign exchange, especially in an economy that
is relatively open to foreign trade and investment, is the most important price in the
economy.
Why do you think this might be so? Remember that, as the exchange rate changes, so
does the price of all imports and exports and so does the relative profitability of investing at
Page 33 of 52
home relative to investing in other countries. It is no wonder that governments pay so

much attention to the value of the domestic currency.
There are three other important exchange rate models: pegged, fixed, and dirty float.
Pegged Exchange Rate
Under a pegged exchange rate regime, a government declares that it will not permit the
value of its currency to deviate by more than a small margin from a chosen reference
currency, usually a major one like the US dollar or the Japanese yen. For example, Trinidad
may declare that it is pegging its dollar to the US dollar at a rate of, say, seven Trinidadian
dollars to one US dollar.
But what does this mean and why would Trinidad do it? In practice, it means simply that
the government of Trinidad promises to intervene in foreign exchange markets and buy or
sell foreign exchange if necessary to keep the value of the Trinidadian dollar from changing
from the pegged rate of 7 to 1. So, if there is a sell-off of Trinidadian dollars in the
marketplace and the price of the currency is threatening to fall, the Trinidadian central bank
will intervene by selling US dollars or other currency in the foreign exchange markets and
buying up Trinidadian dollars.
A central issue is the credibility of the peg. Does the central bank have enough foreign
exchange reserves to ensure that it can buy up enough Trinidadian dollars if there is a large
sell-off? A problem arises if markets suspect that the government is engaging in policy
changes that will cause the value of the currency to fall. If, for example, a government
wants to engage in a public spending spree but does not have the tax revenues, it can
simply increase the money supply (print more money) and ensure that new funds are lent
to the government. This acceleration of the rate of growth of the money supply will lead to
more inflation. Do you remember what happens to a floating exchange rate if the rate of
inflation in country A begins to increase relative to the rate of inflation in country B? The
value of country As currency must fall. country As prices rise, and it finds it more difficult
to compete in foreign markets. Exports decline and the balance of trade moves toward a
deficit position. Country A is not earning as much foreign exchange (from exports) as
before.
If markets conclude that the pegged rate is too high (because the peg is sustaining a rate
that, under a floating exchange rate, would be falling), then the pegged rate can be
maintained only as long as the central bank has enough foreign exchange reserves to
continue purchasing domestic currency. When foreign exchange reserves fall too low,
markets will conclude that the central bank may not be able to sustain its peg at the
established level. Speculators may make (or lose) fortunes by making large bets against
the ability of central banks to maintain pegged exchange rates.
Dirty Float
It is possible to manage an exchange rate regime that is neither fully pegged nor
completely floating. This is often called a dirty float. A dirty float is said to exist when a
country has not formally adopted a pegged or fixed exchange rate regime, but its central
bank will intervene from time to time to buy or sell foreign exchange in order to keep the
value of the currency from rising or falling too much or too rapidly. Many central banks may
engage in such smoothing currency sales or purchases because they do not like to see
highly volatile exchange rates. Canada essentially operates under a dirty float exchange
rate regime.
Page 34 of 52
Fixed Exchange Rate

A fixed exchange rate is similar to a pegged exchange rate, but in the case of a fixed
exchange rate, two or more nations agree to fix their exchange rates against each other.
The Gold Standard
The gold standard was a special form of fixed exchange regime that existed in many
countries between the 1870s and 1914. Countries that were on the gold standard fixed
their domestic currency in terms of gold and promised to convert currency into gold. The
British pound was fixed at 1 = 113 grains of gold, and the US dollar was fixed as being
equivalent to 23.22 grains of gold. This effectively fixed the exchange rate between US
dollars and British pounds.
The gold standard imposed monetary discipline on participating nations. As nations on the
gold standard had to maintain a ratio between paper currency and gold supplies, a country
that began to lose gold because its imports exceeded its exports would have to reduce its
money supply. This would cause the economy to slow down, imports to fall, domestic prices
to fall, exports to rise, and the gold outflow to eventually stop. Losing gold amounted to
imposing a restrictive or contractionary monetary policy.
The central problem with a fixed exchange rate regime is that any major economic
dislocation will inevitably alter the underlying economic conditions that allowed that specific
fixed rate to work. Fixed exchange rate regimes seldom survive wars, for example, and WW
I destroyed the gold standard. In order to finance various war efforts, governments wanted
to print more money and they were not willing to see the war effort scaled back or halted
because the loss of gold was causing the money supply to contract. In 1914, most nations
at war abandoned the gold standard and opted for flexible exchange rates that would allow
them to print money at will.
After the end of the WW I, many nations attempted to return to the gold standard or some
form of pegged exchange rate. They agreed to fix the price of their currency to gold under
the gold standard and to accept the monetary discipline that gold imposed, but these
agreements collapsed under the weight of the Great Depression of the 1930s.
As the Depression spread, each country saw its exports to other nations fall. In an effort to
boost exports, countries unilaterally devalued their currency against gold or against the US
dollar. In 1933, the United States devalued its dollar relative to gold by a substantial
amount. This amounted to a devaluation against other currencies.
Each country devalued its currency, based on the belief that rising exports would keep
domestic employment from falling and lead to a domestic economic recovery.
Unfortunately, this strategy could not succeed for all countries at the same time. If country
A devalues its exchange rate relative to country B, it expects its imports to B to fall, since
Bs prices (in As currency) are now higher, and it expects its exports to B to rise, since As
exports (in Bs currency) are cheaper.
To B, however, this is a disaster. It sees its exports to A fall and its other industries losing
market share to As exporters. B follows the same path and devalues its currency. Thus
begins a pattern of competitive devaluations that attempt to stimulate local employment by
reducing foreign employment. These devaluations have often been called beggar thy
neighbour devaluations. It should be no surprise that world trade largely collapsed during
Page 35 of 52
the depression of the 1930s. Confidence in the world trading and financial system also
collapsed.
The Bretton Woods System

In 1944, the statesmen of 44 countries convened a historic conference with an ambitious
agenda at Bretton Woods, New Hampshire. The worlds leading nations wanted to establish
an agreement on an international monetary system that would keep the world economy
from slipping back into a deep economic recession. John Maynard Keynes from the United
Kingdom was one of the main architects of what has come to be known as the Bretton
Woods system. To Keynes, and to almost all other participants, the key problem was how
to devise a set of rules governing international monetary arrangements that all would agree
to follow and that would keep the world from falling back into the protectionist trend of the
1930s. The natural tendency for a country with international economic difficulties is to try
to export the problem by devaluing its currency; this raises the demand for its domestic
goods and services and, at the same time, reduces its imports, which have become more
expensive. Unfortunately, once one nation devalues its currency in order to improve its
competitive position relative to other countries, it is very likely that other countries will
follow suit, and international trade and investment could collapse again. The central issue
for Keynes and the other participants was how to ensure that international markets were
kept open.
Keynes saw that a successful international monetary regime had to provide both discipline
and flexibility. Adhering to a fixed exchange rate regime means that competitive
devaluations are not a permissible policy option. It also forces all nations to pursue
monetary stability. If a certain country increased its money supply too quickly, domestic
prices would rise, and it would soon face emerging balance-of-payments deficits as exports
fell and imports rose. The only way of restoring the balance of payments would be to
restrict the rate of growth of its money supply to reduce the rate of inflation. Fixed
exchange rate regimes are a way of disciplining governments to follow a non-inflationary
monetary policy.
Discipline alone would not likely produce a long-lasting monetary regime. Some flexibility
was also required. It was important that, when underlying economic fundamentals
changed, a corresponding change to the fixed exchange rate was reflected. As well, a
country might very well experience a short-term disequilibrium in its balance of payments.
If the prices of its main exports, for example, fell by an unusually large amount, a country
might find that its new lower export earnings did not earn enough foreign exchange to pay
for its imports. If this was a short-term problem, reducing the money supply and raising
interest rates would also reduce investment and would likely throw the economy into a
recession. The Bretton Woods system devised a mechanism by which nations experiencing
short-term balance-of-payments difficulties could borrow foreign exchange from a new
international organization, the International Monetary Fund (IMF).
The Role of the International Monetary Fund

The IMF was a new multinational institution established at Bretton Woods. It was charged
with the task of maintaining order in the international monetary system. Member nations
Page 36 of 52
paid contributions to the IMF and, under the Bretton Woods Agreement, agreed to establish
a system of fixed exchange rates that would be policed by the IMF. Nations also agreed not
to use devaluation as a tool to improve competitive trading positions.
Nations would have to go to the IMF when they ran into difficulty maintaining the fixed
exchange rate they had committed to keeping. Small devaluations were permitted on a
regular basis, but for devaluations in excess of 10 percent, IMF approval was required.
Nations that ran into balance-of-payments difficulties could also borrow limited quantities of
foreign exchange from the IMF without any conditions. If the problem was very temporary,
this would often be sufficient. If, however, the underlying problem was sufficiently large
and deemed to be permanent, the borrowing country would have to agree to economic
conditions imposed by the IMF. This provision is called "IMF conditionality." IMF conditions
could be contingent on the debtor nation's agreeing to a program of trade liberalization,
deflation, deregulation, and reduced government spending. Opening borders to trade and
investment is viewed as a necessary condition as is, under some circumstances, reducing
the value of the currency in order to promote export growth and improvement in the trade
balance.
A country facing persistent deficits was permitted to borrow funds to give it time to make
the necessary adjustments to whatever new economic realities existed or to correct
macroeconomic policies that were not consistent with the fixed exchange rate. These
adjustments usually required a tightening of monetary policy, which meant higher interest
rates and unemployment in the short run. Access to IMF funds allowed countries to avoid
hard, sharp economic collapses and steeply rising unemployment, while giving them time to
put their economic houses in order.
If a borrowing country failed to take the required policy actions to restore
balance-of-payments equilibrium, however, the IMF would step in and impose
conditionality on additional borrowing. It would review this countrys economic and
macroeconomic policies and specify, often in great detail, the macroeconomic policies it
needed to follow if it wanted to access additional amounts of foreign exchange.
The Collapse of the Fixed Exchange Rate System

The fixed exchange rate system proved to be rather stable for almost 30 years. During this
era of fixed exchange rates the world economy grew at a remarkable pace. Trade and
international investment also grew more rapidly than world output, and the Bretton Woods
system was associated with this period of growth and stability.
And yet, like other fixed exchange rate systems, it too eventually collapsed. As Hill notes, a
fixed exchange rate system has a difficult time coping with major economic changes in
important countries, especially when a major country is determined to introduce a
monetary policy that will cause inflation to rise. This is precisely what happened in the
United States between 1968 and 1972. The US government was not willing to reduce
spending on either the Vietnam War or the Great Society welfare programs that were
dear to President Lyndon Johnsons heart. Inflation in the United States accelerated and the
US trade deficit began to soar. Speculators began selling off US dollars and buying other
currencies, which forced other central banks, especially the German Bundesbank, to sell
German Deutschmarks in order to accumulate more dollars to keep the German DM from
rising. Other nations did not want to increase their holdings of US dollars when common
Page 37 of 52
sense told them that the United States would have to either reduce spending domestically
or devalue its own currency.
The Floating Exchange Rate Regime

In 1976, the Jamaica Agreement formally revised the IMFs Articles of Agreement to formally
permit flexible exchange rates. IMF quotas were increased, which meant that the IMF had
more resources to lend to countries experiencing balance-of-payments difficulties.
Since 1973, exchange rates have become more volatile. Major economic shocks continue to
create balance-of-payments problems for many countries, who often seek IMF short-term
loans to help deal with these problems. The choice of exchange rate regime is a major issue
facing all countries today. Unfortunately, economics provides no clear-cut answer.
Fixed and Floating Exchange Rates
There are advantages and disadvantages to both fixed and floating exchange rate regimes.
You should be able to explain the meaning of each of the factors listed below.
z
z
Fixed Exchange Rates

Advantages
Disadvantages
z Can become unfixed; when rates are
Limit destabilizing effects of uncertainty
and speculation
expected to become unfixed, currency

speculation can cause severe economic
dislocation
Provide international monetary stability

Limit foreign exchange risk; reduce
uncertainty regarding the value of the
exchange rate
(Note that the following two points are identicalwhat some authors see as an
advantage, others see as a disadvantage!)
z Limit a central banks ability to
Limit a central banks ability to
implement independent monetary
implement independent monetary
policythe advantage, as argued by
policythe disadvantage, as argued by
some authors, is that fixed exchange
other authors, is that if a government
rates impose much-needed monetary
wants to stimulate the economy with an
discipline on governments. Since they
expansionary monetary policy (thereby
cannot engage in monetary policy that is
reducing interest rates), it will not be
unduly inflationary, they must, therefore,
able to do so under a fixed exchange rate
adjust monetary policies so as to
regime.
maintain the value of the fixed exchange
rate.
Flexible Exchange Rates
Advantages
Disadvantages
z Add to uncertainty of currency
Can implement independent domestic
monetary policies
movements and speculation

Help adjust trade balances
Page 38 of 52
Who is right?
There is no definitive answer. A completely fixed exchange rate regime will not be able to
manage major changes in economic fundamentals that dictate an adjustment in the exchange
rate. It is, therefore, probably unworkable, and we are not likely to see one emerge. On the
other hand, many less developed countries are willing to give up much monetary
independence in order to reduce foreign exchange risk and attract foreign capital. These
countries have opted for pegging their currencies to one of the major world currencies, often
the US dollar.
These pegs, however, may last only as long as the underlying economic fundamentals remain
constant. When these change, the exchange rate will likely have to change as well.
Currency Boards
A currency board, like the one operating in Hong Kong, is a strong form of a pegged
exchange rate. The government of Hong Kong announced that it was pegging its dollar to
the US dollar. It also took the additional step of announcing that the currency board would
hold US dollars equal to 100 percent of the local currency issued, which ensured that it
would have enough foreign exchange to meet a speculative sell-off of Hong Kong dollars.
This also meant that Hong Kong was giving up the ability to implement an independent
monetary policy.
Before you conclude that a currency board is the best way to ensure that foreign
investment flows into a country and that monetary discipline is imposed on a government
that would otherwise likely print too much money (leading to runaway inflation), you should
consider the case of Argentina (see pp. 352353 and pp. 368369).
Argentinas currency board appeared to be working well for a few years. Then some
important underlying economic fundamentals changed. The Argentinean peso was pegged
to the US dollar, but the US dollar was rising against other currencies, especially the
Brazilian real. Argentina did a lot of trade with Brazil. As the US dollar rose in value, so did
the Argentinean peso, and its exports were too expensive in Brazil and other countries.
World prices for several important Argentine exports also fell, causing a recession in
Argentina. However, the currency board arrangements kept the Argentine government from
responding to the deepening recession with an expansionary monetary policy to lower
interest rates. The opposite happened. In order to retain the foreign exchange reserves
necessary to make the currency board work, interest rates in Argentina rose substantially,
investment fell, and unemployment rose to over 25 percent. The currency board kept
Argentina from responding to the recession in the usual manner of stimulating demand by
pursuing an expansionary monetary policy and letting interest rates fall.
As the economic situation in Argentina worsened, foreign capital began to flee the country,
due to fear that the pegged rate regime was not going to be sustained. Argentina did not
fulfill its function of providing an effective guarantee to foreign investors that the
exchange rate was indeed pegged to the US dollar. When the currency board was finally
abandoned and a floating regime put in place, the Argentine peso fell from 1 to the US
dollar to 3.5 to the US dollar.
Page 39 of 52
Study Questions
1. Explain how a flexible exchange rate system operates. What are the advantages and
disadvantages of this model?

2. Debate the relative merits of fixed and floating exchange rate regimes. From the
perspective of an international business, what are the most important criteria for
choosing between the systems? Which system is the more desirable for an international
business? Answer

3. What were international policy makers most concerned about when they gathered in
1944 in Bretton Woods, New Hampshire?

4. What were the key elements of the postWW II international monetary system that was
put together at Bretton Woods?

5. What factors led to the breakdown in the fixed exchange regime between 1968 and
1972?

6. What is a currency board? Why do countries choose this type of system? What are the
disadvantages of this type of arrangement? Answer

7. What role does the IMF play in the international economy?

2.
The case for fixed exchange rates rests on arguments about monetary discipline,
speculation, uncertainty, and the lack of connection between the trade balance and
exchange rates. In terms of monetary discipline, the need to maintain fixed
exchange rate parity ensures that governments do not expand their money supplies
at inflationary rates. In terms of speculation, a fixed exchange rate regime
precludes the possibility of speculation. In terms of uncertainty, a fixed rate regime
introduces a degree of certainty in the international monetary system by reducing
volatility in exchange rates. Finally, in terms of trade balance adjustments, critics
question the closeness of the link between the exchange rate and the trade balance.
The case for floating exchange rates has two main elements: monetary policy
autonomy and automatic trade balance adjustments.
In terms of the former, it is argued that a floating exchange rate regime gives
countries monetary policy autonomy. Under a fixed rate system, a countrys ability
to expand or contract its money supply as it sees fit is limited by the need to
maintain exchange rate parity.
Page 40 of 52
In terms of automatic trade balance adjustments, under the Bretton Woods system,
if a country developed a permanent deficit in its balance of trade that could not be
corrected by domestic policy, the IMF would agree to a currency devaluation. Critics
of this system argue that the adjustment mechanism works much more smoothly
under a floating exchange rate regime. They argue that if a country is running a
trade deficit, the imbalance between the supply and demand of that countrys
currency in the foreign exchange markets will lead to depreciation in its exchange
rate. An exchange rate depreciation should correct the trade deficit by making the
countrys exports cheaper and its imports more expensive.
Which system is better for an international business is a matter of personal opinion.
We do know, however, that a fixed exchange rate regime modelled along the lines of
the Bretton Woods system will not work. Nevertheless, a different kind of fixed
exchange rate system might be more enduring and might foster the kind of stability
that would facilitate more rapid growth in international trade and investment. Back
6.
A country that introduces a currency board commits itself to converting its domestic
currency on demand into another currency at a fixed exchange rate. To make the
commitment credible, the currency board holds reserves of foreign currency equal,
at the fixed exchange rate, to at least 100% of the domestic currency issued. The
system is attractive because it limits the ability of the government to print money
and thereby create inflationary pressure. Under a strict currency board, interest
rates will adjust automatically. However, critics point out that if local inflation rates
remain higher than the inflation rate in the country to which the currency is pegged,
the currencies of countries with currency boards can become uncompetitive and
overvalued. Also, the system does not permit governments to set interest rates.
Back
Section 4.4: Crisis Management by the IMF
In the textbook:
z Chapter 10 (pp. 369371 to The Asian Crisis)
z Case: The Tragedy of the Congo, pp. 412413
z Case: The Russian Ruble Crisis and Its Aftermath, pp. 413415
1. discuss the role and function of the IMF.


a. currency crisis
Page 41 of 52
b. banking crisis
c. foreign debt crisis.

3. discuss the factors that led to the Mexican peso crisis of 1995.

4. discuss the factors that led to the Russian ruble crisis of 1997/98.

5. discuss the role played by the World Bank and the IMF in the Congo since the 1970s.
The IMF and Financial Crises

One of the major functions of the IMF is to provide emergency loans to countries
experiencing balance-of-payments difficulties. The purpose of these loans is to ease the
transition while that country makes necessary policy reforms to restore the external
account to equilibrium. IMF loans are contingent upon a debtor country's agreeing to follow
IMF-approved economic policies aimed at restoring external balance.
External balance can be restored only by actions that serve to reduce a particular countrys
need for foreign exchange and increase its capacity to earn foreign exchange. The IMF is
generally not concerned with the question of whether the debtor is to be blamed for the
crisis. If external circumstances have changed for the worse (e.g., rising interest rates and
falling commodity prices), domestic policies must be reoriented accordingly. Nevertheless,
there has emerged a typical IMF view as to the origins of the crisis and the policies needed
to return the debtor to external equilibrium and a sustainable growth path.
The IMF claims that it does not attempt to influence development strategies. Its advice is of
a technical nature, designed to achieve external equilibrium, which is a precondition to
restoring economic growth. Critics argue that, in practice, the IMF has moved far beyond
merely offering technical advice and that it has rejected virtually all alternatives to its own
strategy.
As mentioned earlier, an IMF agreement is usually contingent upon the debtor nation's
agreeing to a program of liberalization, deflation, and privatization. Liberalization involves
removing barriers to trade and eliminating government interference in financial markets
and global capital markets. Trade liberalization, an aspect of liberalization that has received
widespread support, opens borders to trade and investment and leads to greater economic
growth and higher standards of living. Countries that have attempted to open trade have
typically done better than those who restrict access to international trade and foreign
investment.
The IMF also wants to see evidence of monetary disciplineusually, a measure of deflation.
If a certain country has pegged its exchange rate and inflation in this country is increasing
more rapidly than in that of its trading partners, then its exports will fall, imports will rise,
and foreign exchange reserves will be further reduced. As well, if this government is
running a deficit, it must borrow to finance the deficit, and this reduces the available supply
of funds for private-sector investment. This crowding out of investment is viewed as being
harmful to growth prospects.
In many less developed countries, budget problems may emerge because the government
has chosen to rely on government-owned firms (usually protected with a local monopoly) to
produce key goods and services. These public-sector monopolies often require extensive
Page 42 of 52
subsidies, which can cause public-sector deficits to rise, and are often both inefficient and
corrupt.
Less developed countries have also tended to rely on exchange rates pegged to a major
currency, usually the US dollar, whereas developed countries have tended to rely on flexible
exchange rates since the collapse of the Bretton Woods system in the early 1970s. This
reliance on flexible exchange rates may explain, in large part, why developed nations have
not had to rely on IMF lending to deal with balance-of-payments problems since 1973.
Financial Crises in the PostBretton Woods Era

There are three important aspects of a financial crisis, and any particular financial crisis
may contain one or more of these aspects:
z
Currency crisishappens when a country with a pegged exchange rate finds its
currency being sold off in large volumes in foreign exchange markets to the extent that
the ability of the government to maintain the peg is threatened. This crisis may also
happen when widespread selling is taking place and the value of the domestic currency
is falling. Currency crises often accompany more fundamental economic crises or
imbalances.
Banking crisishappens when there is widespread loss of confidence in the banking

system; may show up as a run on banks, when depositors attempt to remove deposits
on a large scale.
Foreign debt crisishappens when a country either cannot service its foreign debt
obligations or is in danger of not being able to service those debts.
These crises tend to have macroeconomic causes and can arise very quickly. One type of
crisis can often quickly lead to the emergence of one or both of the other types (e.g., a
foreign debt crisis can lead to a currency crisis and a banking crisis).
Mexican and Russian Currency Crises
The Mexican currency crisis shows what can happen under a fixed exchange rate regime
when economic fundamentals (inflation and interest rates) become inconsistent with the
exchange rate. In Mexico, the government permitted the money supply to grow rapidly in
the early 1990s, and prices were accelerating much more rapidly than prices in the United
States, its main trading partner. This caused Mexicos trade deficit to rise as Mexican
exports were priced out of foreign markets. Mexicos leaders declared that they would
defend the value of the peso if it came under attack by investors and speculators. For a
while, this lulled investors into a sense of security, and foreign investment poured into the
country: $64 billion between 1990 and 1994 alone.
As currency traders became aware that only the massive capital inflow was preventing a
currency collapse (as the trade deficit would otherwise have been unsustainable), they
started to sell off financial assets in Mexico and buy non-Mexican assets. There was only
one action open to the government of Mexico if it wished to maintain its fixed exchange
rate: it would have to sell off its foreign exchange reserves in order to buy up the Mexican
pesos that investors were dumping into the foreign exchange market. Eventually, the
government realized that it was running out of foreign exchange reserves, and it could no
Page 43 of 52
longer defend the peso. The government announced a devaluation in mid-1994 that caught
many investors by surprise. The mood of optimism was replaced by one of pessimism, and
more investors attempted to sell Mexican stocks and bonds. The peso continued to fall.
Finally, Mexico arranged for massive loans from both the IMF and the US government. In
the absence of these loans, Mexico would no doubt have had to default on many of its
international financial obligations.
In order to restore external equilibrium, the IMF insisted on its usual array of economic
policies. Money supply growth was reversed, interest rates rose rapidly, public spending
was reduced, and investment and output fell. Eventually, imports also fell, exports picked
up, and Mexico climbed out of the deep recession it had fallen into.
Read Hills description of the Russian ruble crisis (pp. 413415 of the textbook). Russia
faced unique problems as it attempted to make the transition from a centrally planned
economy to a market economy.
We will examine the Asian crisis (pp. 371374) in Unit 5.
Case Study: The Tragedy of the Congo

This case study (textbook, pp. 412413) illustrates an important limitation of a strictly
economic analysis of balance-of-payments problems. The citizens of the Democratic
Republic of the Congo have long had the misfortune to live in one of the most corrupt
nations in the world. In the 1980s and 1990s, the then dictator Mobutu Sese Seko set new
records regarding theft of national wealth. Mobutu and his colleagues regularly raided the
national treasury and placed the expropriated funds in personal accounts in Europe and the
Caribbean. Private investors soon learned that the government would simply steal earned
profits, if possible, and most private-sector investment dried up.
The economy stagnated and infrastructure deteriorated. However, Mobutu had one key
supporter. He declared that he was a strong anti-communist, and this stance so pleased the
US government that it used its influence to ensure that the World Bank continued to make
large loans to the Congo. As Hill notes, Mobutu and his cronies were taking these funds out
of the back door of the banks shortly after the international institutions had deposited them
via the front door.
Most of the World Bank and IMF monies arrived as loans, not grants. The post-Mobutu
governments in the Congo have argued that these loans are not legitimate loans that the
new government is responsible for, because the World Bank, the US government, and the
IMF were all aware of what was happening. The question of whether the desperately poor
citizens of the Congo should be held responsible for the repayment of these loans remains
an outstanding issue.
Study Questions
Page 44 of 52
1. Name the three types of financial crisis and describe the characteristics of each.

2. How did the Mexican peso crisis differ from the Russian ruble crisis?

3. Compare and contrast currency crises, banking crises, and foreign debt crises. Answer

4. Why do you think IMF and World Bank lending to the Congo failed to have the expected
results?

5. Should the citizens of the Congo be held accountable for the loans incurred by the
government of Mobutu Sese Seko? Why or why not?

3.
A currency crisis occurs when a speculative attack on the exchange value of a

currency results in a sharp depreciation in the value of the currency or forces
authorities to expend large volumes of international currency reserves and to sharply
increase interest rates in order to defend the prevailing exchange rate. In contrast, a
banking crisis refers to a loss of confidence in the banking system that leads to a run
on banks as individuals and companies withdraw their deposits. Finally, a foreign
debt crisis is a situation in which a country cannot service its foreign debt
obligations, whether private-sector or government debt. Back
Section 4.5: The Global Capital Market
In the textbook:
z Chapter 11 (pp. 386404)
1. discuss the functions and nature of capital markets.

2. explain the role of commercial banks and investment banks in mediating between savers
Page 45 of 52
3.
4.
5.
6.
7.
and investors.

explain what is meant by cost of capital and how it is determined.

explain the main advantages to eliminating the restrictions on the development of global
capital markets.

outline the reasons for the recent growth of the global capital market.

explain the difference between hot money and patient money.

discuss the functions and nature of the Eurocurrency market, the global bond market, and
global equity investments.
What are Capital Markets?

Global capital markets play a very important role in our global economy. They are
institutions through which savers can directly provide funds to borrowers and investors;
that is, they help match one persons savings with another persons investment. The
process of saving and investment are key ingredients to long-run economic growth and
productivity.
Commercial and investment banks mediate between savers and investors. A commercial
bank will take deposits from firms and individuals that wish to save out of current income
and lend to individuals and firms that wish to spend more than current income. In the
household sector, such borrowing may be either for consumption purposessay, to finance
a holidayor for investment purposessay, to finance the purchase of a house. In the
business sector, such borrowing is almost always for business or investment purposes.
Investment banks bring lenders and borrowers directly together. In the case on pages 386
387 of the textbook, the Industrial and Commercial Bank of China completed the worlds
largest ever initial public offering by raising $21 billion. Given that this amount of capital
could not be raised entirely in China, the Bank had to attract foreign investors by listing the
shares on one of the worlds largest stock market exchanges, the Hong Kong stock
exchange. It was the only way to attract the necessary investors.
Two important markets constitute capital marketsthe bond market and the stock market.
When a firm issues a bond, it sells a promise to pay a fixed amount, plus a fixed rate of
interest, according to a fixed schedule. Thus, a firm might issue or sell a 10-year $1,000
bond with an interest rate of 8 percent per annum. The firm promises to pay the interest
each year and the principal at the end of the stated time period.
On the other hand, a stock certificate is a certificate of ownership. If, for example, a family
that owns a steel mill wishes to expand into new markets, it will need funds for this
investment. The family might decide to retain only 50 percent ownership of the firm and to
sell off the remaining 50 percent through the issuance and sale of stock certificates to
private investors. Investment banks provide advice and assistance to firms seeking to raise
new capital in this manner.
Page 46 of 52
The Cost of Capital

The term cost of capital refers to the cost of raising or borrowing capital. In the example
discussed on the previous page, a firm issued a bond with an interest rate of 8 percent. This 8
percent is said to be the cost of capital for this firm. The cost of capital will vary according to
the expected risk of default. Bonds issued by the Canadian and US governments are regarded
as almost risk-free financial instruments and are very popular with investors who do not wish
to bear very much risk. If a firm with a strong balance sheet and good prospects issues a bond,
it can expect to pay a higher price than that attached to Canadian and US government bonds,
but not as high a price as investors will demand for buying bonds issued for a smaller firm with
heavy debt and, perhaps, an uncertain future. The cost of capital, therefore, may vary from
borrower to borrower.
Figure 4.3 The Cost of Domestic Capital
Figure 4.3 illustrates a national

market for capital. In capital
markets, as in most markets, it is
the demand and supply that will
determine the equilibrium price.
As you can see, the demand for
capital varies inversely with its
price. If the rate of interest is
high, savers will provide more
dollars into the market. At a high
rate of interest, however, the
demand for borrowed funds will be
relatively low. At a low rate of
interest, borrowers wish to borrow
more (called demand), but
suppliers are not willing to risk as
much.
The equilibrium rate of interest, or
the cost of capital in this case, will
be r = 9 percent.
So far, we have considered only a national or domestic market for capital. We have implicitly
assumed that capital cannot cross national borders. What will happen when we allow
international capital flows to take place?
Let us assume that Figure 4.3 represented the market in a typical less developed country.
Capital is scarce, at least relative to the situation in more developed countries, so the price of
capital is fairly high. But what if these firms could borrow in international markets? The
potential supply of capital would be much greater. This situation is represented in Figure 4.4,
below.
Figure 4.4 The Cost of International Capital
Page 47 of 52
S2 represents the supply of capital

facing the same firm if it had
access to global capital markets.
For such firms, the ability to
borrow abroad would lower the
cost of capital and would also
increase the amount of borrowing.

From the perspective of the
developing country as a whole,
access to global capital markets
means, therefore, access to capital
at lower rates of interest. Lower
rates of interest usually mean
higher levels of investment and
output. If this hypothetical firm
had access to global capital
markets, it would be able to
borrow at 7 percent, and it would
borrow (and invest) more.
So, for less developed countries, where domestic capital tends to be relatively scarce and,
therefore, relatively expensive, access to global capital markets can be very important.
What about countries in the developed world? In the developed world, capital is relatively
abundant, and so its price will be relatively low, which means that investors are accepting a
relatively low rate of return. Let us say that investors are accepting a rate of return (the
borrowers cost of capital) of only 5 percent. If, however, they are able to lend to our
hypothetical firm abroad or to other firms in global capital markets, they will be able to lend in
markets where capital is scarce and the price of capital is high.
What does it mean when capital markets are limited by national boundaries as outlined above?
It means that the price of capital will be lower in the developed regions of the world where
capital is relatively abundant, and the price of capital will be higher in the less developed
regions where capital is relatively scarce.
Does this not seem to violate the law of one price, since the price of capital is not the same
in all regions? It does indeed. By eliminating barriers on capital flows, we allow capital to move
out of regions where it is relatively abundant. This is reflected in a relatively low cost of capital
that simply reflects the relatively low productivity of capital at the margin in capital-abundant
regions. Capital will move to regions where it is scarce; hence, the price of capital is high.
Thus, capital will move toward those regions where the rate of return on the investment of that
capital is highest. Global efficiency and output will increase by moving to a policy of free capital
flows, assuming that there are no market imperfections.
In the next unit, we will see that market imperfections for certain capital markets in less
developed regions are a very real and significant problem. Many authors now argue that
governments of less developed countries should impose some capital controls to limit the
damage that can be caused by unduly large and quick inflows and outflows of capital. However,
the main advantage remains; if capital markets are opened, then the global allocation will be
more efficient, and if less developed regions have access to global capital markets, the cost of
capital in such regions will decline and investment will rise.
The Growth of the Global Capital Market

Page 48 of 52
p
In the past 20 years, there has been a significant rise in the number of international bond
and equity offerings in the global capital market. This market is seen as an extremely easy
and effective mechanism to raise capital. The growth in the global capital market is due to a
number of factors, including the advancements in information technology, the widespread
deregulation of financial services, and the relaxation of regulations governing cross-border
capital flows.
As mentioned in the previous section, capital controls are a major hindrance to the efficient
movement of capital and foreign direct investment. In its study entitled Globalization,
Growth and Poverty: Building an Inclusive World Economy (2002), the World Bank
observes that
controls on capital outflows from high-income countries were gradually lifted: for
example, the United Kingdom removed capital controls in 1979. Governments in
developing countries have also gradually adopted less hostile policies toward investors.
Partly as a result of these policy changes and partly due to the oil shock of the 1970s,
significant amounts of private capital again began to flow to developing countries.
(p. 42)
Global Capital Market Risks

In the next unit, we will consider the issue of financial crises in less developed countries
more thoroughly. For now, though, it is important to make a distinction between short-term
capital flows, often called hot money, and longer term investments, which Feldstein has
called patient money (textbook, p. 396).
FDI, for example, is not often associated with currency, banking, or debt crises. By
definition, FDI means that a firm has built or purchased real assets that it is using to
produce goods or services. Hot money, on the other hand, refers to various kinds of
international investments in financial instruments that can be liquidated and taken out of
the country at very short notice.
Feldstein argues that hot money can move around the globe very quickly, searching out the
highest short-run returns. However, investors involved in this sector usually have very poor
information about the firms and economies in which they are investing. Money floods in
when short-run returns appear to be high relative to other countries and there is a lot of
enthusiasm and optimism regarding investing opportunities in that country. However, these
sentiments often tend not to be grounded in economic reality. Access to large amounts of
such funds over a short period of time often leads to overbuilding and the eventual
emergence of excess capacity. This excess capacity will cause profit margins to fall or
disappear, and the boom psychology is replaced by investor panic and a bust
psychology as foreign investors all make a mad dash for the exit. They rush to sell off
stocks and bonds or to call in international loans to convert local currency to US dollars or
other foreign currencies to take out of the country. The hot money flows out as quickly as it
flowed in, but the outflow takes place at the worst possible time, as the economy is
attempting to deal with a recession brought on by overinvestment and excess capacity. This
can easily lead to a currency crisis as foreigners attempt to sell off local currency, which
leads to inflation and forces the government to raise interest rates in an often futile effort
to reverse the capital outflow.
Page 49 of 52
As we will see in Unit 5, many less developed countries do not have the efficient and
transparent financial markets that are needed to manage large shifts in demand or supply
of financial instruments in the short run, and thus financial markets do not operate
efficiently. In the next unit, we will examine a number of different policy approaches that
may be adopted to deal with financial instability.
In the Asian financial crisis, many Asian firms had taken advantage of the lower cost of
capital in international markets by borrowing abroad, in US dollars or other foreign
currency, and then investing at home in what was often a booming market. This pattern of
borrowing meant that these investors were taking on a substantial amount of foreign
exchange risk. They might borrow in world markets at 6 percent, when the lending rate
from domestic institutions was, for example, 10 percent, but this lending was denominated
in US dollars. If the value of the local currency against the dollar fell unexpectedly, then
these firms would face often dramatically increased costs of servicing their debt, as their
incomes were received in the local currency. This pattern of borrowing, followed by a
currency depreciation, was a major component of the Asian financial crisis.
Eurocurrencies, and the Global Bond and Equity Markets

Any currency that is banked outside of its country of origin is called a eurocurrency.
National governments tend not to impose regulations on banks regarding the holding of
foreign currency deposits. Nor do they provide deposit insurance to those holding
eurocurrency bank accounts. The relative absence of regulations means that banks can
offer higher deposit rates and lower lending rates to consumers willing to bear the
additional risk of depositing or lending in this market. Many large firms do indeed borrow in
the eurocurrency market, and the relatively high rate of interest has attracted many
depositors as well.
Similarly, firms may issue international bonds that face fewer regulatory requirements
hence, lower costs to the issuerthan is normally the case with bonds denominated in the
local currency of the issuer and sold within the domestic market.
There are two types of international bonds:
z
Foreign bonds are sold outside the borrowers country and denominated in a currency
other than that of the borrower. If a Canadian firm issues a bond denominated in US
dollars and sells it in the United States (a Yankee bond), it is called a foreign bond.
Eurobonds are slightly different. If a US firm issues a bond denominated in Japanese

yen and sells it in Europe and Asia, it is called a eurobond.
Advances in information technology and falling barriers to capital flows have facilitated the
growth of investment in cross-border equity markets. The growth of mutual funds has also
helped accelerate this trend. It is now fairly easy for an investor in Toronto or Manila to buy
shares in a firm listed on the New York, Tokyo, London, or Hong Kong stock markets. Many
investors seek to diversify their portfolios geographically in order to reduce overall risk.
The development of the mutual fund industry has allowed many small investors to
participate in the rapid growth of Asian economies without having to become well informed
about distant markets.
Page 50 of 52
Study Questions
1. What is a capital market? Define market makers . Answer
2. Describe how a domestic capital market functions, and explain what is meant by cost of
capital.
3. What are the benefits of a global capital market as compared to a purely domestic
capital market? Answer
4. What is the role of commercial and investment banks?
5. Describe the growth of the global capital market over the past 15 years.
6. What are the major factors that account for the growth of the global capital market?
7. What is the eurocurrency market, and why is it an attractive market to both lenders and
depositors? Answer
8. Describe the difference between "hot money" and "patient money. " Which of the two is
preferable to enhance economic development and prosperity? Why?

1.
A capital market brings together those who want to invest money and those who
want to borrow money. Those who want to invest money include corporations with
surplus cash; individuals; and non-bank financial institutions. Those who want to
borrow money include individuals, companies, and governments. Between these two
groups are the market makers. Market makers are the financial service companies
that connect investors and borrowers, either directly or indirectly. They include
commercial banks and investment banks. Back
3.
In a purely domestic capital market, the pool of investors is limited to residents of

the country. This places an upper limit on the supply of funds available to borrowers.
In other words, the liquidity of the market is limited. A global capital market, with its
much larger pool of investors, provides a larger supply of funds for borrowers to
draw on. An important drawback of the limited liquidity of a purely domestic capital
Page 51 of 52
market is that the cost of capital tends to be higher than it is in an international

market.
In a purely domestic market, the limited pool of investors implies that borrowers
must pay more to persuade investors to lend them their money. The larger pool of
investors in an international market implies that borrowers will be able to pay less.
Back
7.
A eurocurrency is any currency banked outside of its country of origin. Eurodollars,

which account for about two-thirds of all eurocurrencies, are dollars banked outside
the United States. Other important eurocurrencies include the euroyen, the
europound, and the euro-euro. A eurocurrency can be created anywhere in the
world; the persistent "euro" prefix reflects the European origin of the market. The
main factor that makes the eurocurrency market attractive to both depositors and
borrowers is its lack of government regulation.This means that the spread between
the eurocurrency deposit rate and the eurocurrency lending rate is less than the
spread between the domestic deposit and lending rates. Companies have strong
financial motivations to use the eurocurrency market. By doing so, they receive a
higher interest rate on deposits and pay less for loans. Back
Page 52 of 52

Unit 3: Foreign Direct Investment: ECON 401 The Changing Global Economy

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Unit 3: Foreign Direct Investment: ECON 401 The Changing Global Economy

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ECON 401

The Changing Global Economy

Unit 3: Foreign Direct Investment

Section 3.1: Foreign Direct Investment

Reading Assignment and Learning Objectives

Types of Foreign Investment

Recent FDI Trends in Canada

Canadian dollar lowered the value of the assets held abroad.

Between 1992 and 2006, world output increased by 45 percent.

Why has FDI increased so rapidly? There are a number of reasons:

FDI can help a firm overcome trade barriers.

Theories of Foreign Direct Investment

Benefits and Costs of FDI

increased access to capital

Answers to Selected Study Questions

Location-specific advantages are advantages that arise from using resource

10. Cemex is a cement company. Consequently, exporting is difficult because of the

the company will probably choose to invest directly. Back

Section 3.2: The Age of the Multinational

Reading Assignment and Learning Objectives

In the Reading File:

The Age of the Multinational Enterprise and FDI

within two or more national economies (Gilpin, p. 164).

Economic and Political Significance of the MNC

protection from import competition

Rules for FDI and MNCs

the right of establishment

Unit 4: The Global Monetary System

specific functions of the foreign exchange market

The IMF at a Glance

International Capital Markets: Developments, Prospects, and Key Policy Issues

Finance and Development

The IMF and its Critics

IMF Global Financial Stability Report

Institute of Economic Affairs

IMF Policy Discussion Paper

Section 4.1: Foreign Exchange Markets

Reading Assignment and Learning Objectives

After completing Section 4.1, you should be able to

Foreign Exchange Rates

1current exchange rate

another currency. If I sell US dollars in the foreign exchange market, I am doing so to

purchase goods produced abroad

Spot and Forward Exchange Markets

b. American consumers decide to buy more French wine.

Answers to Selected Study Questions

The market is used to convert payments a company receives in foreign

The market is used for currency speculation. Back

A currency swap is the simultaneous purchase and sale of a certain amount of

Section 4.2: Theories of Exchange Rate Determination

Reading Assignment and Learning Objectives

Purchasing Power Parity

Money Supply, Prices, and Exchange Rates

Interest Rates and Exchange Rates

Investor Psychology, Bandwagon Effects, and Short-run

Freely convertible currencythe domestic government places no restrictions on

Answers to Selected Study Questions

The PPP theory assumes no transportation costs or barriers to trade, but we

Section 4.3: The International Monetary System

Reading Assignment and Learning Objectives

Exchange Rate Models

home relative to investing in other countries. It is no wonder that governments pay so

Fixed Exchange Rate