IR 292 Midterm 2

since the end of WWII, many formal barriers to trade have been removed

national laws and regulations adopted for strictly domestic reasons unintentionally limit international commerce in an integrated economic environment

conflict over standards (technical product standards, health and safety standards, labor standards, environmental standards)

Harmonization of standards (two or more countries adopt a common set of standards) 

Mutual recognition of standards (countries maitain their own standards, but accept the standards of others as valid and sufficient) 

Separate standards (countries maintain their own standards and refuse to recognize the standards of others

There are no general rules to determine which approach is most efficient or fairest in all cases (case by case basis!)

High income countries fear lazer standards in other countries induce domestic firms to 1) adopt lower standards to remain internationally competitive or 2) move to countries with lax standards (pollution haven hypothesis) 


Countries are feared to engage in a race to the bottom--adoption of the lowest level of standards possible in order to attract foreign firms 


these are NOT arguments about establishing trade barriers as protectionism in the traditional sense 


they are arguments about what is appropriate behavior with regards to how people and nature are treated

The U.S. and many other countries today want labor and environmental standards included in future trade agreements; US trade with Canada and Mexico (NAFTA) and with Jordan address labor and the environment: each country must enforce its own standards or face monetary fines

International Labor Organization (ILO) proposesd five labor standards as bassic rights, revised by OECD: prohibition of forced labor, freedom of association, the right to roganize and bargain collectively, an end to the exploitation of child labor, and nondiscrimination in employment

five standards are widely agreed upon, but also ambiguous: what is meant by exploitation? 

many potential labor standards are contentions: universal minimum wage level, limits on teh number of work hours, workplace health and safety, etc 

Low-income countries are relectant to pay much higher minimum wages: higher wages could reduce firm profits, and result in closing down of production

major source of disagrements between trade economists and labor activists is over the use of trade barriers to enforce labor standards; 

trade economists think such barriers are ineffective as an enforcement mechanism and only spur protectionism, deadweight losses, and other economic inefficiencies

• 1) effectiveness: only large countries or coalitions of countries can use trade barriers successfully to enforce standards, since small countries do not have a large enough impact on global demand; use of sanctions could be counterproductive for boosting working conditions: improved enforcement in the target country may cause producers to shift to unregulated and uninspected INFORMAL ECONOMY
• 2) Hazy Borderline between Protectionism and Concern: special interests sometimes use the issue of foreign lbaor standards in order to attain their real goal, protection against foregin competition (producers in a high income country with scarcity of cheap, unskilled labor may seek sanctions against a low-income country in order to counter the competition posed by low incom ecountry producers with abundant supplies of cheap labor) ;
• 3) The Specific Content of Labor Standards: there is no international agreement on the specific content and language of labor standards (justifying the specific goal of sanctions to the international community is difficult; may lead to conflict in international economic relations) 
• 4) The Potential to Set off a Trade War: use of sanctions is discriminatory and infraction of WTO (sanctions may cause retaliation from the targeted country, further hurting international trade rules)

generally not effective mechanism to enhance competitiveness and attract foreign investment

1) in theory, countries cannot simultaneously capture markets (run a trade surplus) and attract foreign investment: trade surplus implies capital outflows, not inflows

2) there is very little evidence that countries that lower labor standards succeed in obtaining a comparative advantage in a new line of production

• 3) Low labor standards; not a successful means to attract foreign investment: low labor standards are correlated with unskilled, illiterate labor force, lack of economic development (poor roads, ports, telecommunications, schools, and sanitation) 
• low labor costs are thus more than offset by the costs implied by a lack of development

• there is considerable overlap in debates on labor and environmental standards
• Proponents of incuding environ stand. in trade agreement believe sanctions should be used to enforce such standards

• critics of sanctions concerned about: 
• -ineffectiveness of sanctions, hazy borderline between protectinism and environmental concerns, lack of international definitions of environmental standards, and potential for trade wars

• 1) without adequate enforcement of standards, countries engage in an environmental race to the bottom to boost industrial competitiveness
• 2) lack of enforcement of standards in developing countries induce dirty rich country industries to "export polltion" and thus create POLLUTION HAVENS

Although high environmental standards reduce industrial competitiveness, they raise national well being and lead to economically optimal levels of production, making nation better off

most countries have adopted tougher environmental standards over time. In order for race to bottom to occur, sectional interests would have to be politcally powerful

do they attract foreign firms? 

• some dirty industries did move in the 1970s from high-income countries to low-income ones
• however, there is no evidence that any country competes successfully for investment on the basis of lax environmental standards
• as a result, individual firms cannot move to escape the environmental regulations of a high-standards country

• Transboundary environmental impacts happen when one country's pollution spills over into a second country
• IE a shared watershed is polluted by an upstream user or industrial production in one country creates acid rain in another country
• can occur as the result of similar activities in many countries, leading to global impacts such as global warming and ozone depletion

• impossible to predict how or if trade rules might change to accommodate labor and environmental standards
• as long as there are large income gaps between rich and poor countries it seems unlikely that differences in standards will disappear
• big question-- how to enjoy the benefits from world trade while resolving conflicts over standards?

• labels for exports
• requiring home country standards
• increasing international negotiations

• a certification process producing a label attached on exported good to indicate to consumers that the good was produced under human and environmentally sound conditions
• the method is already in place in some instances: Cambodian textile exports to the US coffee imports, etc
• Problems: 1) many countries resist labeling as an infringement of their sovereignty and 2) consumers must be convinced the label provides accurate information

• high-standard countries can require their firms to follow home country standards when operating abroad
• Pros: impedes the race to the bottom; avoids teh problem of high-income countries' dictating standards;
• Cons: addresses only firms of high-standard countries; low-country producers are not affected; a high-standard country firm may outsource production to a low-standard country producer

• using either existing international organizations or creating new agreements and organizations 
• ILO could be given a greater role and start, for ex, publicizing lack of compliance with labor standard
• WTO is not an environmental organization; however, it allows international environmental agreements to develop their own enforcement mechanism

• 1) Current Account: record of goods and services into and out of the country
• 2) Financial Account: record of the flow of financial capital to and from the country
• 3) Capital Account: record of some specialized types of relatively small capital flows

measures teh difference betwen exports and imports of goods adn services

• Trade deficit: negative trade balance
• Trade Surplus: positive merchandise trade balance

Current account balance: measures all current, non-capital transactions between a nation and the rest of the world

• Has three main components
• 1) Goods and services: the value of goods and serivces minus the value of imports
• 2) investment income: income from investments abroad minus income paid to foreigners on the US investments 
• 3) unilateral transfers: any foreign aid or other transfers received by foreigners minus that given to foreigners

• Large deficits in the current account began around 1982, and now more or less a constant feature of US economy since
• Second began in early 1990s but there is some rebound in recent years
• CA deficit is not a sign of weakness! at least in the short run
• In US, 1990s increased demand for imports while sluggish growth abroad limited the expansion of US exports
• EVERYONE AGREES THE US DEFICIT IS NOT SUSTAINABLE IN LONG TERM

• Record of flow of financial capital to and from a country
• divided into three categories
• 1) Net changes in the country's assets abroad
• 2) net changes in the foreign-based assets in the country
• 3) net change in financial derivatives

• assets include bank accounts, stocks and bonds, and real property such as factories, businesses, and real estate 
• financial derivatives are complex financial contracts traded in a variety of forms; until recently they were not included in the balance of payments (lock or option -- either a contract to buy/sell or the right to the option to enter a contact under specific terms) 
• Value of financial derivatives is derived from value of variable such as interest rates, exchange rates, or commodity prices

• record of the transfers of specific types of capital, such as 
• debt forgiveness
• personal assets that migrants take with them abroad
• transfer of real estate and other fixed assets, such as a military base or an embassy building

• both accounts present the flow of assets during the year, not the stock of assets that have accumulated 
• second, all flows are "net" changes rather than "gross" changes
• net changes are informative because they measure the monetary value of teh change in a country's financial stake in foreign economies

• 1) both the capital account and the financial ccount present the flow of assets during the year in question and not the stock of assets that have accumulated over time
• 2) all flows are net changes (differences between assets sold and bought ,ie) rather than gross (stock) changes
• 3) As long as the capital account balance is zero, financial account balance = current account balance, but with the opposite sign

• the current, capital, and financial accounts are interdependent
• current account measures flow of goods and services
• capital and financial accounts measure flow of financing 
• therefore, sum of capital account adn financial accounts equal to current account with opposite sign

=current account + capital accout + financial account

the amount by which the sum of the current, capital, and financial accounts is off teh total of zero

SD is calculated as the sum of the current, capital ,and financial accounts with teh sign reversed

SD exists because the record of all the transactions in the balance of payments is incomplete (errors tend to lie in teh financial account calculation, as it is teh hardest to measure correctly)

• financial flows originate in the public and private sectors 
• some financial flows are very mobile and represent short-run tendencies (mobility of financial flows brings economic volatility; upon sudden financial outflows, a country can sink into a financial crisis; volatility of financial flows has increased concern about the various types of flows;)

• 1) US assets abroad (outflows): official reserve assets--currencies of the largest adn most stable economies (US dollars, euros, yen); US Government Assets--loans and rescheduled loans to foreign govs, received on outstanding loans, changes in non-reserve currency holdings) 
• US Private assets: direct investment, foreign securities, loans to foreign firms and banks 
• 2) Foreign assts in the US (inflows) 
• Foreign Official assets: gold bullion, IMs special drawing rights, major currencies
• Other foreign assets: direct investment, US securities, loans to US firms and banks
• 3) Net change in financial derivatives 
• subcomponents of private assets: foreign direct investment, foreign securities, loans to foreign firms adn banks 
• FDI: tangible items (real estate, factories, warehouses, transportation facilities, and other real assets) 
• Forein Portfolio investment: securities and loans; paper assets such as stocks and bonds

BOTH FDI and foreign portfolio investment-claim in a foreng economy's future output; FDI have longer time horizons

• shifts in expectations can lead to sudden stoppages of financial inflows 
• result is a destabliizing of outflows of financial capital --this occurence labeled a SUDDEN STOP
• Sudden stops have been involved in most financial crises in last 30 years

Until recently, most nations limited the movement of financial flows related financial account transactions across their borders

EU liberalized financial flows between member countries only in 1993 

• Movement toward open markets over the 1980s and 1990s resulted in lifting of controls on financial flows 
• (developing countries in particular have liberalized financial account transactions in order to get access to financial capital for development) 
• Although financial flows can be volatile, economists agree free flows are best for economic efficiency

• balance of payments help understand broader implications of current account imbalances and how to tame current account deficits 
• BoP give cues how nations can avoid crises brought by volatile financial flows and how they can minimize the damage of financial crises if such occur

inernal, domestic accounting systems the countries use to keep track of total production adn total income

• Two fundamental concepts: 
• 1) Gross Domest Product (GDP): value of all final goods adn services produced withing a country's borders during a period of tiem (usually a year) 
• 2) Gross National Product (GNP): value of all final goods and services produced by the labor, capital, and other resources of a country within the country as well as abroad

GNP = GDP + foreign investment income received - investment income paid to foreigners + net unilateral transfers

• interplay of variable of national accounts 
• 1) GDP: C + I + X - M 
• 2) GNP: GDP + (net foreign investment income + net transfers) 
• 3) GNP: (C + I + G) + (X - M + net foreing investment income + net transfers) 
• 4) GNP in terms of current account balance: GNP = C + I + G + CA 
• 5) GNP is also the value of income received:  = C + S +T 
• 6) Since 4 adn 5 are equivalent definitions of GNP,  C + I + G + CA = C + S +T 
• 7) I + G + CA = S +T 
• 8) S + (T - G) = I + CA

S + ( T - G) = I + CA summarizes the current account balance, investment, and public adn private savings in the economy 


the four macroeconomic variables demonstrate there is not a fixed relationship between the current account balances adn government budget balances, or between savings and investment 

the four variables are determined by the other three

a change in any one of them influences all of them

• relationship between the current account balance, investment, and total national savings is an identity 
• consequently, it does not tell us WHY an economy runs a CA deficit or surplus

• debt is defined as money owed to nonresidents wich must be paid in a foreign currency
• CA deficits must be finacned through inflows of finacnial capital (loans) 
• Loans from abroad add to a country's stock of EXTERNAL DEBT and generate DEBT SERVICE obligations
• all countries, rich adn poor, have external debt
• in many low and middle income countires, external debt leads to financial problems 
• unsustainable debt occurs for numerous reasons: (sudden drop in commodity prices, natural disasters, corruption, foreign lending behavior)

• when country runs CA deficit, it borrows from abroad and increases indebtedness 
• if a country runs a current account surplus, it lends to foreigners and reduces its overall indebtedness 
• INTERNATIONAL INVESTMENT POSITION = domestically owned foreign assets - foreign owned domestic assets 

total of all domestic assets owned by foreigners, subtracted from the total of all foregn assets owned by residents of the hom country 

Costs and benefits of capital inflows: enables countries to invest more, makes it possible for governments and consumers to spend more (save less), capital inflows take the form of direct investment, may bring new technologies (TECH TRANSFER), and new management techniques

• Every country has to choose an exchange rate to determine how prices are converted to another country's currency 
• each Xchange rate sys requires gov adn central banks have credible policies to respond to pressures world econ

price of a currency stated in terms of a second curreny 

• US dollars per Mexican peso = 0.10 dollars
• Mexican pesos per US dollar = 10 pesos 

rates are reported in every newspaper with a business section and on numerous webs

appreciation: currency's becoming more valuable (or ale to buy more units of another currency) 

depreciation of a currency: currency's becoming less valuable in relation to another currency

three most frequently traded: euro, yen, poudn 

all three are flexible rates, meaning they are not fixed over time

• 1) Trade and investment: traders (imposters and exporters) and investors routinely transact in foreign currencies 
• 2) interest rate arbitrage: taking advantage of interest rate differentials between countries; arbitrageurs borrow money where interest rates are low adn sell where high
• 3) speculation: buying and selling of currency in anticipation of changes in the currency's exchange rate; speculators sell overvalued currencies and buy undervalued currencies

• 1) retail customers: firms and individuals hold foriegn currency to engage in purchases, to adjust their portfolios, to profit from expected future currency movements 
• 2) commercial banks: hold inventories of foreign currencies as part the services to customer; MOST IMPORTANT OF FOUR PARTICIPANTS 
• 3) Foreign exchange brokers: middlemen between buyers (banks) and sellers fo foreign currency 
• 4) Central banks: a country's bank of banks

• stem from the fact that currencies are constantly changing in value
• expected future payments in a foreign currency will likely be a different domestic currency amount from when the contract was signed 
• firms that do business in more than one country are thus subject to exchange rate risk 

FORWARD EXCHANGE RATE: price of currency that will be delivered in the future; allows an exporter or importer to sign a currency contract guarantees a set price the foreign currency in either 30, 90, or 180 days into future

market in which buying and selling of currencies for future delivery takes place; important mechanism for exporters, importers, financial investors, speculators

buying and selling of foreign currencies in the present

buying a forward contract to sell foreign currency at same time that teh bonds or other interest earning asset matures

the use of forward market by an interest rate arbitrageur against exchange rate risk

under system of flexible, or floating, exchange rates, and increase in demand for dollar will raise its price (cause an appreciation in value) while an increase in supply will lower its price (cause depreciation)

under a fixed exchange rate syste, value of dollar is held constant through the actions of the central bank that counteract the market forces of supply and demand


--demand curve is normal, downward sloping curve, indicating that as pound depreciates relative to dollar, the quantity of pounds demanded by Americans increases

equilibrium value of an exchange rate is at level that allows a given amount of money to buy the same quantity of goods abroad as it will buy at home

• most important medium-run forces is the strength of a country's economic growth: rapid economic growth at home translates into increased imports and an outward shift in demand for foreign currency 
• growth abroad results in an increase of exports from home country and an increase in supply of foreign currency

• Two variables in particular are responsible for a large share of short-run capital flows: 
• 1) interest rates (interest parity) 
• 2) expectations of future exchange rates

difference between any two countries' interest rates is approximately equal to teh expected change in the exhcange rate 

• if i = i* investors are indifferent 
• if i > i* investors prefer home to foreign

reflects the expected appreciation or depreciatio of home currency 

F > R: home currency expected to depreciate and home interest rates must exceed foreign rates by an equivalent percentage

i < i* and F = R: no changes are expected in the exchange rate, and investors should invest in foreign

Purchasing power Parity 

R falls = appreciation in dom. currency = home goods are less expensive than foreign goods

R rises: depreciation in dom currency = home goods are more expensive than foreign goods

Business Cycle:

R falls = appreciation = domestic economy grows more slowly than foreign 

R rises = depreciation in dom currency = domestic economy grows faster than foreign

Interest Parity 

R falls = appreciation dom currency = home interest rates rise, or foreign rates fall 

R rises = depreciation dom currency = home interest rates fall or foreign rates rise

Speculation

R falls = appreciation dom currency = expectations of a future appreciation 

R rises = depreciation dom currency = expectations of future depreciation

foreign prices determine purchasing power of domestic currency in terms of foreign currency 

RE= market exchange rate (nominal exchange rate) adjusted for price differences between countries 

real exchange rate = nominal exchange rate X foreign prices (ALL OVER) domestic price = Rr = Rn(P*/P)

Fixed exchange rate system (also called pegged exchange rate system)

• several possibilities: 
• one extreme = countries give up their currency altogether and adopt the currency of another country 

second extreme = value of a nation's money is set equal to a fized amount of another country's currency or less commonly to a basket of several currencies 

the value of a nation's money is defined in terms of a fixed amount of a commodity (gold) or of another currency (US dollar)  --> the Gold standard exchange rate system

if exchange rate is not allowed to vary it is called a HARD PEG 

Fixed rates that fluctuate w/in a set band are SOFT PEGS can take several forms depending on amount of variation allowed

value of the currency is allowed to float up and down with market forces 

less than half of the worlds nations have flexible rates

• form of fixed exchange rates 
• under pure gold standard, nations keep gold as their international reserve

• a type of gold standard in 1947- 1971 
• US dollar and British pound were fixed to each other and to gold; a modified Gold standard exchange rate system

one currency is anchored to another currency instead of gold 

• CRAWLING PEG: soft pegs that are fixed but periodically adjusted 
• idea is to offset any difference in inflation (changes in P) through regular adjustments in Rn

• in 1999, 11 EU members adopted a common currency which began circulating in 2002
• as of 2011, 17 of 27 EU members use it

• reduces currency conversions and transaction costs 
• eliminates of price fluctuations
• help increase political trust between countries 
• provides exchange rate greater credibility

• Optimal currency area: robert mundell's criteria to determine whether two or more countries would be better off by sharing a currency 
• For common currency to be viable, countires must share: 
• 1) synchronized business cycles 
• 2) a high degree of labor and capital mobility
• 3) regional policies to deal with economic imbalances 
• 4) an integration effort that goes beyond mere free trade

goods purchased by one business from another for use in production

curve calls attention to three regions of GDP: under, nearing, and at or beyond full employment equilibrium

shows expenditure by consumers (C) business (I) the government (G) and foreign purchases of exports -- domestic purchases of imports (X - M)

• on horizontal part of AS curve, economy is operating below full employment 
• middle, upward-sloping part of teh AS curve symbolizes the range of GDP where inputs begin to become scarce 
• vertical region of AS curve, the economy is at full employment and no more output is posible until new workers enter labor force or new factories and machines are built

• can occur for nuerous reasons and lead to new levels of GDP and prices
• An increase in consumption expenditure (C), business investment (I), or government spending (G), would increase aggregate demand

a quantitative relationship between income received by households and household consumption; as income rises, so do expenditures

an increase in demand ultimately results in an even large increase in production and income as effects of the deman hike run through the economy

covers government taxation and expenditures; usually formulated by legislative and executive branches

covers money supply and interest rates; usually formulated by the central bank and the finance ministry

• institutions that enact fiscal and monetary policy vary across countires
• legislative and executive branches are responsible for tax policy and for determining spendign priorities 
• central bank and the finance ministry set monetary policy, sometimes with direct input

• increase in government spending and/or cuts in taxes; these result in an increase in output 
• have a positive multiplier effect

• cuts in government spending and/or increases in taxes
• have a negative multiplier effect

works through a combination of change to the supply of money and change to interest rates 

Open market operations: most frequently used technique = the central banks buying and selling of bonds in the open market; selling bonds leasds the nations financial institutions to GIVE UP some of their chas, with cash rserves shrinking throughout the economy


increasing teh supply of money in economy reduces teh interest rate

expansionary policy: an increase in money supply and decrease in interst rates

contractionary policy: a decrease in money supply and rise in interest rates

once exchange rate effects of monetary and fiscal policy have been identified, it is relatively easy to describe effects on CA 

effect of fiscal policy on CA is definite, while effect of monetary policy is ambiguous

increase in money supply reduces interest rates causing a depreciation in domestic currency

exchange rate depreciation switches some consumer spendign from foriegn goods (imports) to domestic goods (foreign goods become relatively expensive)

a more robust expansion of teh domestic economy results; expansionary monetary policy is reinforced by changes in exchange rate

has the opposite effect: interest rates rise causing an appreciation of domestic currency, whcih makes imports relativeyl cheaper 

the reduction in demand for domestic goods reinforces the impact of contractionary monetary policy on income, consumption, adn investment

leads to a more vigorous decline in economic activity than woud occur in closed economy

A combination of fiscal, monetary, and exchange rate policies for addressing current account imabalances

expenditure swithcing: includes exchange rate depreciation and trade barriers

expenditure reducing: contractionary monetary or fiscal policies

• these two must be applied simultaneously 
• expenditure shifts without expenditure reductions are inflationary 

expenditure REDUCTIONS without shifts toward domestic producers is recessionary

describes changes in trade deficit that are caused by a change in exchange rate 

• IE depreciation raises the real price of foriegn goods, making domestic substitutes more attractive
• Depreciation has, however, a time lag 
• Moreover, the first impact of depreciation may be a J-curve: a deterioration of teh current acocunt

• leading industrial economies discuss macroeconomic issues, international relations, and relations with developing countries at G8 summit
• if global imablances arise they discuss the potential for policy coordination

• Policy coordination among all countries is hard to achieve: 
• nations want to guard sovereignty 
• nations are reluctant to pursue same policies as trading partners

integration enhances growth and development, but also made easier for crises to spread across borders

Financial Crises(currency crisis): have brought down govs, ruined economies, destoryed individual lives

CONTAGION EFFECT: do not conform to a single patter and are difficult to predict

• disproportionate impact on poor
• wealthier folks have greater "adaptive capacity"
• best personal defense against crisis: savings and high value versatile skill set

• spread of a crisis from one nation to another can have numerous causes 
• range from unified policy to geographic ignorcance

• broad consensus among economists and IR professionals that there is a neeed for reforms in the international finance 
• ESP IMF 

• many proposals usually suggest forms of INTERNATIONAL FINANCIAL ARCHITECTURE 
• and revolve around set of prosoed changes to IMF and other multilateral institutions

• have variety of potential characteristics 
• usually involve: an exchange rate crisis, a bankign crisis, a debt crisis, or some combination of the three

banking system becomes unable to perform its role of intermediation and its normal lending functions

disintermediation: banks unable to serve as intermediaries between savers and investors

sudden adn unexpectedd collapse in value of a nations currency

• occurs when debtors cannot pay and must restructure their debt
• complete debt repudiation is VERY rare, usually terms are renegotiated

• under fixed exchange rate system, crisis entails the loss of international reserves and devaluation
• under flexible exchange rate system, crisis means an uncontrolled, rapid depreciation of currency
• countries with pegged exchange rate may be more vulnerable to a crisis

• two origins
• 1) crises cause by macroeconomic imbalances such as large budget deficits cause by overly expansionary fiscal policy
• 2) crisis cause by volatile flows of financial capital that move in and out of a country quickly

• number of them over last decades have been triggered by severe macroeconomic imbalances 
• these are often accompanied by an exchange rate system that intensifies the country's vulnerability
• 2007 crisis partially fits this descript. dependign on country/time
• began when housing bubble collapsed
• banks unable to lend as they either became insolvent or close to insolvent 
• resulting in steeper decline in consumer and business spendign 
• first phase, imbalances in most countries were a resut of private sector decisions regarding saving and investment 
• second phase, gov imbalances come into play as tax collections decline and spending on social programs and health

not inevitable adn depend on many other factors, such as health of the banking system and resiliency of economy

a debt crisis in which gov cannot pay back its loans

• fundamental cause of this type of crisis is that financial capital is highly volatile and tech advances have reinforced this volatility
• weak financial sector can also intensify problems
• when banks take on short-term international debt to fund long-term domestic loans, several unsettling scenarios are possible: 
• 1) multiple possible outcomes (multiple equilibria) 
• 2) self-fulfilling crisis 
• 3) crisis affects banks that are fundamentally sound, but have mismatches between maturities of assets adn debts; illiquid byt not insolvent

• Moral Hazard: incentive to act in a manner that creates personal benefits at teh expense of the common good (banks have incentive to make riskier investments when know will be bailed out) 
• General agreement to eliminating moral hazard in financial institutions: increase CAPITAL REWUIREMENTS to raise level of capital available in time of crisis 

problem of moral hazard --inescapable if a general policy of protecting financial system from collapse exists

formulated in 1989 by bank regulatros from industrialized countries; adopted by more 100 countries; 

• New Basel Capital Accord of 2010 (BASEL III) updated previous standards 
• try to make banking systems more robust by setting new standards for bank supervision, information disclosure, and stress tests

• Capital Requirements: require ownwers fo banks to invest a certain percentage of their own capital in bank
• Supervisory review: Oversight mechanism to assist with risk management and to provide standards for daily business practices 
• Information disclosure: requires banks to disclose operational information to lenders, investors, depositors,

• crawling peg increases vulnerability to financial crises in two ways: 
• 1) requires monetary authorities to exercise discipline in issuance of new money; anti-inflationary tendencies exacerbated by intentional slow devaluation; a sever overvaluation of teh real exhcange rate may result
• 2) exiting crawling peg is difficult: a government leaving it may lose the confidence of investors

• capital controls may be imposed to prevent capital movements in the financial account 
• inflow restrictions tend to work better than outflow ones - they reduce teh inflow of short-run capital which would add to the stock of liquid, possibly volatile capital 
• outflow restrictions may help reduce the impact of a crisis when it occurs

• cutting the deficit 
• raising the interest rates to help defend the currency 
• letting the currency float 

the problem is that the economic austerity of budget cuts and higher interest rates may not be politically feasible

• harder to cure
• collapsing currency can be defended thorugh interest rate hikes, but these may cause bankruptcies and other problems

• policies for avoiding and managing financial crises 
• great variety of reform proposals focus two issues: 
• 1) role of an international LENDER OF LAST RESORT (central bank domestically) 
• 2) conditionality: changes in economic policy that borrowing nations are required to make in order to receive loans from lender of last resort 

• opponents cit moral hazard probs: trusting in bailout, failign firms have incentive to gamble on high risk 
• Proponents: state moral hazard can be decreased by financial sector regulations, such as Basel Capital Accord (if owners risk substantial loss, they are less likely to take on excessive risk)

• changes in economic policy that borrowing nations are required to make in order to receive loans from lender of last resort 
• typically covers monetary and fiscal policies, exchange rate policies, and structural policies affecting the financial sector, international tradem and public enterprises 
• IMF makes loans in TRANCHES: instalments of teh total laon, each tranche hinges on completion of reform targets
• critics say the need to comply w/conditionality may intensify the recessionary effects of a crisis & it may entail high social costs on poorest members of society 

Proponents: crises could be avoided by pre-qualification criteria; to received assistance, countries must meet requirements of sound financial sector policies 

• critics claim 1) prequalification will not deter speculative attacks on counry currency and 
• 2) IMF could not ignore crises cases that failed to pre-qualify

IMFs standards for data reporting; currently under development

how to resolve conflict between lenders? 

Standstills: IMFs recognition that a crisis country temporarily stop making repayments on its debt

Collective action clauses: lenders would have to agree on collective mediation among themselves and the debtor in event of crisis

• after Asian Crisis, at top of everyone's agenda 
• attention diverted to other areas: security, terrorism, energy, climate change

• accomplished with home loans, car loans, consumer credit loans, and other types of debt
• buyers received a return based on interest the ultimate borrowers--home owners, car owners, credit card owners, pay to their lenders
• company creates the securitized package of loans; sell shares to anyone willing to buy (anoter bank, a foreign based insurance company, a foriegn gov)

savings held by governments are called this