Lecture 11

Presented by Amir Khan

 Absolute Advantage
Number of units of factors of production required per unit of final product

Coal Wheat
US 2 units/ton 1 unit/ton
Germany 1 unit/ton 4 units/ton

Since the US is more efficient in the production of wheat, it will produce wheat; Germany
is more efficient in the production of coal; hence it will produce coal. The US will export
wheat to the Germany and import coal.
Assumptions: 1) Factors of production cannot move freely across countries.
2) Factors of production are not specialized.
 Comparative Advantage
Number of units of factors of production required per unit of final product

Coal Wheat
US 2 units/ton 1 unit/ton
UK 3 units/ton 4 units/ton

Even though the US is more efficient in the production of both wheat and coal, it has a
comparative advantage in the production of wheat; hence, it will produce wheat; the UK
has a comparative advantage in producing coal; hence it will produce coal. The US will
export wheat to the UK and import coal.
 Gains from Trade
 Prior to the introduction of trade, the exchange rate between wheat and
coal in the US and UK must be as follows:
US 1 ton wheat = 0.5 tons of coal
UK 1 ton wheat = 1.33 tons of coal

 Clearly, UK producers of coal will find it advantageous to sell their coal to

the US, since they can get more than 0.75 tons of wheat for each ton of
coal. Similarly, US producers of wheat can get more if they sold to the UK
than the 0.5 ton of coal they could get in the US. Hence, the final terms of
trade, i.e. the common exchange rate after trade is introduced will be
somewhere between the two exchange rates, above. For example, it might
be 1 ton of wheat = 1 ton of coal. Exactly where it will be, will depend
upon the demand and supply schedules for coal and wheat.
 International Capital Budgeting
How does a firm make an international capital budgeting decision?

1. Estimate expected cash flows in the foreign currency.

2. Compute their U.S.-dollar equivalents at the expected exchange
rate.
3. Determine the NPV of the project using the U.S. required rate of
return, with the rate adjusted upward or downward for any risk
premium effect associated with the foreign investment.
 International Capital Budgeting
 Only consider those cash flows that can be “repatriated”
(returned) to the home-country parent.

 The exchange rate is the number of units of one currency that

may be purchased with one unit of another currency.
 For example, the current exchange rate might be 2.50
Freedonian marks per one U.S. dollar.
 International Capital Budgeting Example
 A firm is considering an investment in Freedonia, and the initial
cash outlay is 1.5 million marks.

 The project has 4-year project life with cash flows given on the next
slide.

 The appropriate required return for repatriated U.S. dollars is 18%.

 The appropriate expected exchange rates are given on the next slide.
International Capital Budgeting Example
 International Capital Budgeting Issues
 International diversification and risk reduction

 U.S. Government taxation

 Taxable income derived from non-domestic operations through
a branch or division is taxed under U.S. code.
 Foreign subsidiaries are taxed under foreign tax codes until
dividends are received by the U.S. parent from the foreign
subsidiary.
 International Capital Budgeting Issues
 Foreign taxation
 Tax codes and policies differ from country to country, but all
countries impose income taxes on foreign companies.
 The U.S. government provides a tax credit to companies to avoid
the double taxation problem.
 A credit is provided up to the amount of the foreign tax, but not to
exceed the same proportion of taxable earnings from the foreign
country.
 Excess tax credits can be carried forward.
 International Capital Budgeting Issues
 Political Risk
 Expropriation is the ultimate political risk.
 Developing countries may provide financial incentives to enhance
foreign investment.
 Bottom line: Forecasting political instability.
 Protect the firm by hiring local nationals, acting responsibly in
the eyes of the host government, entering joint ventures, making
the subsidiary reliant on the parent company, and/or purchasing
political risk insurance.
 Bill of Lading
 A shipping document indicating the details of the shipment and
delivery of goods and their ownership.
 It serves as a receipt from the transportation company to the
exporter, showing that specified goods have been received.
 It serves as a contract between the transportation company and
the exporter to ship goods and deliver them to a specific party at a
specific destination.
 It serves as a document of title.
 Letter of Credit
 A promise from a third party (usually a bank) for payment in
the event that certain conditions are met. It is frequently
used to guarantee payment of an obligation.
 A letter of credit is issued by a bank on behalf of the
importer.
 The bank agrees to honor a draft drawn on the importer,
provided the bill of lading and other details are in order.
 The bank is essentially substituting its credit for that of the
importer.
 Global: Should We Worry About the Large U.S.
Current Account Deficit?
 Persistent trade (balance-of-payment) deficits are a concern for several
reasons.

 First, it indicates that, at current exchange rates, foreign demand for U.S.
exports is far less than the U.S. demand for foreign goods.

 Second, a current account deficit means that foreigners’ claim on U.S.

assets is growing.
 How Did China Accumulate $4 Trillion of
International Reserves?
 By 2014, China had accumulated $4 trillion in international reserves.

 China’s rapid growth of productivity, accompanied by an inflation rate

lower than that of the U.S., caused the long-run value of the yuan to
increase.

 The Chinese central bank engaged in massive purchases of U.S. dollar

assets to maintain the fixed relationship between the Chinese yuan and
the U.S. dollar.
 Monetary Unions
 A variant of a fixed exchange rate regime is a monetary (or currency)
union (e.g., EMU), in which a group of countries decides to adopt a
common currency, thereby fixing the countries’ exchange rates in relation
to each other.
 Pros: Trade across broader is easier
 Cons: Individual countries no longer have their own independent monetary
policies
 Global: Will the Euro Survive?
 The global financial crisis of 2007–2009 led to economic contraction
throughout Europe, with the countries in the southern part of the
Eurozone hit especially hard.
 Adopting easier monetary policy in southern countries to stimulate
economic activities is not a possible option.
 This “straightjacket” effect of the euro has weakened support for the euro
in the southern countries, leading to increased talk of abandoning the
euro.
 Capital Controls
 Restrictions on capital mobility can help avoid financial instability
 Controls on capital outflows:
 Promote financial instability by forcing a devaluation
 Seldom effective and may increase capital flight
 Lead to corruption
 Lose opportunity to improve the economy
 Capital Controls
 Controls on capital inflows:
 Lead to a lending boom and excessive risk-taking by financial intermediaries
 Controls may block funds for production uses
 Produce substantial distortion and misallocation
 Leads to corruption
 The Role of the IMF
 It was originally set up under the Bretton Woods system to help countries
deal with balance-of-payments problems and stand by the fixed exchange
rates by lending to deficit countries
 May be able to prevent contagion.
 It acts as an international lender of last resort, but the safety net may lead
to excessive risk-taking (moral hazard problem).
 How Should the IMF Operate?
 May not be tough enough (not put enough pressure on the governments).
 Austerity programs focus on tight macroeconomic policies rather than
financial reform.
 Too slow, which worsens crisis and increases costs.
 Countries were restricting borrowing from the IMF until the recent
subprime financial crisis.
 International Considerations and Monetary
Policy
 Monetary policy can be affected by international matters in several ways
 Balance of payment considerations:
 Current account deficits in the United States suggest that American
businesses may be losing ability to compete because the dollar is too strong.
 U.S. deficits mean surpluses in other countries ⇒ large increases in their
international reserve holdings ⇒ world inflation.
 International Considerations and Monetary
Policy
 Exchange rate considerations:
 A contractionary monetary policy will raise the domestic interest rate and
strengthen the currency.
 An expansionary monetary policy will lower interest rates and weaken
currency.
 Exchange-Rate Targeting As an Alternative
Monetary Policy Strategy
 Advantages of exchange-rate targeting:
 Contributes to keeping inflation under control
 Automatic rule for conduct of monetary policy
 Simplicity and clarity
 Disadvantages of exchange-rate targeting:
 Cannot respond to domestic shocks and shocks to anchor country are transmitted
 Open to speculative attacks on currency
 Weakens the accountability of policy makers as the exchange rate loses value as
signal
 When Is Exchange-Rate Targeting Desirable for
Industrialized Countries?
 Exchange-rate targeting for industrialized countries is desirable if
 Domestic monetary and political institutions are not conducive to good
policy making
 Other important benefits such as integration arise from this strategy
 When Is Exchange-Rate Targeting Desirable for
Emerging Market Countries?
 Exchange-rate targeting for emerging market countries is desirable if
 Political and monetary institutions are weak (strategy becomes the
stabilization policy of last resort).
 Currency Boards
 An arrangement in which domestic currency is backed 100% by a foreign
currency.
 Stronger commitment to fixed exchange rate by central bank.
 Solution to lack of transparency and commitment to target.
 Note issuing authority establishes a fixed exchange rate and stands ready to
exchange currency at this rate.
 Money supply can expand only when foreign currency is exchanged for domestic
currency.
 Loss of independent monetary policy and increased exposure to shock from
anchor country.
 Loss of ability to create money and act as lender of last resort.
 Global: Argentina’s Currency Board
 The currency board experiment in Argentina was initially a stunning
success, with inflation falling from 800% in 1990 to less than 5% in 1994.
 Due to the long-term weakness in Argentine exports and bad timing, the
currency board ultimately ended in widespread violence and bloodshed in
January 2002.
 Dollarization
 Another solution to lack of transparency and commitment
 Adoption of another country’s money
 Even stronger commitment mechanism
 Completely avoids possibility of speculative attack on domestic currency
 Lost of independent monetary policy and increased exposure to shocks
from anchor country
 Inability to create money and act as lender of last resort
 Loss of seignorage