Financial Globalization and Capital Flows Quiz
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Questions and Answers

What is one reason why capital flows to developing countries are often small and in the wrong direction?

  • Sovereign wealth fund investments
  • Low levels of international risk sharing
  • High institutional quality in developing countries
  • Differences in Total Factor Productivity (TFP) (correct)

What is the expected benefit of financial integration for investors?

  • Increased home bias
  • Improved liquidity in domestic markets
  • Enhanced opportunities for portfolio diversification (correct)
  • Higher expected returns in local markets

Why do investors often hold a larger share of assets geographically close to their own market?

  • Familiarity and less transaction costs (correct)
  • Easier access to local financial information
  • Higher expected returns from local investments
  • Lower currency risks associated with local assets

What effect do portfolio home biases have on international asset holdings?

<p>They limit the diversification of investors’ portfolios (A)</p> Signup and view all the answers

What is a consequence of capital poor countries not accessing capital from capital rich countries?

<p>They will become capital poorer and worsen their situation (D)</p> Signup and view all the answers

What does UIP perform better than when looking at horizons of 1 to 12 months?

<p>Expectations of exchange rates (B)</p> Signup and view all the answers

Which phenomenon is associated with the existence of risk premiums that are non-observable?

<p>Speculative behaviors (B)</p> Signup and view all the answers

What does the covered interest parity condition relate to?

<p>Forward rates and interest rate differentials (A)</p> Signup and view all the answers

Which of the following is NOT a condition for the empirical validity of Covered Interest Parity (CIP)?

<p>Arbitrage opportunities are minimal (D)</p> Signup and view all the answers

In the long run, nominal exchange rates primarily reflect differences in what?

<p>Supply of money (D)</p> Signup and view all the answers

Which of the following factors does NOT influence the demand for money?

<p>Exchange rate variations (D)</p> Signup and view all the answers

What is the main reason that prices are considered sticky in the short term?

<p>Adjustment lags (C)</p> Signup and view all the answers

What is the opportunity cost of holding money as a liquid asset?

<p>Lower returns compared to Treasury Bonds (D)</p> Signup and view all the answers

What primarily determines today's exchange rate?

<p>Expected future exchange rates (B)</p> Signup and view all the answers

Which assumption is NOT required for the empirical validity of the uncovered interest parity (UIP) condition?

<p>High levels of risk aversion (A)</p> Signup and view all the answers

How does an unexpected increase in the interest rate differential affect the euro?

<p>It causes a euro appreciation today (B)</p> Signup and view all the answers

What is the best predictor of the future exchange rate?

<p>Today's exchange rate (D)</p> Signup and view all the answers

What characterizes the risk premium when agents are risk averse?

<p>It varies depending on the portfolio structure (D)</p> Signup and view all the answers

Which of the following does NOT relate to rational expectations?

<p>Agents make systematic forecasting errors (A)</p> Signup and view all the answers

If the share of euro assets increases in an investor's portfolio, what must happen?

<p>A risk premium on holding euro assets must be compensated (B)</p> Signup and view all the answers

The empirical relation derived from uncovered interest parity indicates that if $r€ - r$ increases unexpectedly, what is the immediate effect on the euro?

<p>Appreciation of the euro today (D)</p> Signup and view all the answers

What is the relationship between money supply and interest rates in an expansionary monetary policy?

<p>Increasing money supply reduces interest rates. (B)</p> Signup and view all the answers

What effect does a decrease in interest rates in the Eurozone have on investment in dollar assets?

<p>It makes dollar assets more attractive relative to euro assets. (B)</p> Signup and view all the answers

What is the primary goal of unconventional monetary policy?

<p>To prevent a complete collapse of the financial system (D)</p> Signup and view all the answers

What is the main consequence of a recession in the Eurozone on money demand?

<p>Money demand decreases due to lower income. (A)</p> Signup and view all the answers

How does the depreciation of the euro affect Eurozone exports?

<p>It boosts exports by making them cheaper abroad. (C)</p> Signup and view all the answers

Under what condition can unconventional monetary expansion be considered non-inflationary?

<p>As long as the economy is very weak and credit is hoarded (A)</p> Signup and view all the answers

What occurs as a result of less demand for money during a recession?

<p>Market equilibrium results in decreasing interest rates. (A)</p> Signup and view all the answers

What is a potential risk of unwinding quantitative easing too quickly?

<p>A potential recession (C)</p> Signup and view all the answers

What is the expected long-term effect of an increase in money supply on prices and nominal exchange rates?

<p>It results in monetary neutrality in the long run. (D)</p> Signup and view all the answers

Which factors make adjustments to monetary policy more painful in specific countries?

<p>Large, closed economies and fixed exchange rates (C)</p> Signup and view all the answers

How do unconventional monetary policies aim to stimulate an economy when interest rates are at zero?

<p>Through asset purchases and direct lending (C)</p> Signup and view all the answers

What is a primary expectation regarding the impact of a change in monetary policy on expected exchange rates initially?

<p>No initial impact on expected exchange rates. (A)</p> Signup and view all the answers

Why does decreasing interest rates stimulate investment and consumption?

<p>It lowers the opportunity cost of using money. (A)</p> Signup and view all the answers

What is the relationship between credit increases and inflationary pressures during recovery?

<p>Higher credit can lead to inflation due to excessive liquidity (B)</p> Signup and view all the answers

Which scenario would likely contribute to a more recessionary effect globally?

<p>Global monetary tightening (D)</p> Signup and view all the answers

What is a key concern regarding rising inflation when unwinding quantitative easing?

<p>Excess liquidity may circulate within the economy (D)</p> Signup and view all the answers

What is meant by monetary policy neutrality in the long run?

<p>It reflects a stable relationship between money supply and inflation. (A)</p> Signup and view all the answers

What is the effect of a permanent increase in the money supply on the exchange rate dynamics?

<p>The currency overshoots its long-term value and depreciates. (B)</p> Signup and view all the answers

What does Dornbush’s overshooting result illustrate?

<p>Short-run volatility can occur due to slow price adjustments. (D)</p> Signup and view all the answers

How does an increase in money supply affect interest rates in the short run?

<p>Interest rates decrease due to increased money supply. (B)</p> Signup and view all the answers

What is the implication of Purchasing Power Parity in the long run?

<p>The domestic currency is expected to depreciate with respect to foreign currencies. (B)</p> Signup and view all the answers

What is indicated by rational agents knowing that the exchange rate will increase in the future?

<p>They will adjust their expectations leading to an immediate increase in the exchange rate. (A)</p> Signup and view all the answers

What does the slow adjustment of prices signify in the context of an increased money supply?

<p>Prices are expected to rise significantly before any adjustment occurs. (C)</p> Signup and view all the answers

Why does depreciation of the domestic currency increase the expected return in foreign currency investments?

<p>It allows for more favorable exchange rates for investments. (A)</p> Signup and view all the answers

Flashcards

Lucas puzzle

Despite low capital/labor ratios, capital flows to developing countries are often low and sometimes go to richer countries.

Reasons for the Lucas puzzle

Differences in Total Factor Productivity (TFP), institutional quality, and capital market imperfections (like sovereign risk and asymmetric information) can explain why capital isn't flowing as expected.

Uphill capital flows

A capital-poor country, after financial integration, may become even more capital-poor.

International risk sharing

Diversifying investments across countries to reduce overall portfolio risk.

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Portfolio home bias

Investors tend to hold a larger share of assets in their own country, even when internationally diversified portfolios are available.

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Exchange Rate Volatility

The fluctuations in the value of one currency against another over time.

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Forward-Looking Exchange Rates

Today's exchange rate is influenced by expectations of future exchange rates, which are based on all factors that could impact future currency values.

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Uncovered Interest Parity (UIP)

A theory stating that the expected return on an investment in one currency should equal the expected return on an investment in another currency, after accounting for the expected exchange rate change.

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Assumptions of UIP

UIP relies on assumptions like perfect capital mobility, rational expectations, no speculative bubbles, no risk aversion, and perfect asset substitutability.

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Risk Premium

When investors are risk-averse, they demand a higher return (premium) for holding assets in a more volatile currency.

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UIP and Unexpected Interest Rate Changes

An unexpected increase in the interest rate differential between two currencies leads to an immediate appreciation of the currency with the higher interest rate.

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Random Walk Hypothesis

The best predictor of future exchange rates is the current exchange rate, suggesting that exchange rate movements are unpredictable.

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Empirical Validity of UIP

Empirical evidence suggests that UIP does not always hold true. The random walk hypothesis often provides a better prediction of future exchange rates.

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Expansionary Monetary Policy in the Eurozone

A policy by the European Central Bank (ECB) to increase the money supply, typically by decreasing interest rates. This aims to stimulate economic activity.

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Interest Rate Effect (Expansionary Monetary Policy)

Decreasing interest rates in the Eurozone makes borrowing cheaper, encouraging investment and consumption.

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Exchange Rate Effect (Expansionary Monetary Policy)

The euro depreciates (becomes weaker) relative to other currencies like the dollar because lower Eurozone interest rates make euro-denominated assets less attractive.

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Recessionary Impact on Money Demand

During a recession, people and businesses have less income, causing a decrease in demand for money.

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Recessionary Impact on Interest Rates

A decrease in money demand due to a recession causes interest rates to fall as the market tries to reach equilibrium.

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Depreciation of Domestic Currency (Recession)

During a recession, a decreased demand for money leads to a decline in interest rates, making euro-denominated investments less attractive, causing the euro to depreciate.

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Monetary Neutrality in the Long Run

The idea that changes in the money supply only affect prices in the long run, not real economic variables like output.

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Expected Exchange Rate (Ee)

The anticipated future value of a currency, which influences current exchange rate movements.

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UIP vs. Short-Term Horizons

The Uncovered Interest Parity (UIP) theory suggests that exchange rate changes reflect interest rate differentials. However, it's less accurate for short-term horizons (1-12 months) compared to medium-long term predictions.

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Risk Premium in UIP

The risk premium in UIP represents the compensation investors demand for holding assets in a foreign currency, which is unobservable and varies with time.

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Bubbles and Speculation

Speculative behavior and bubbles can distort exchange rate movements, particularly in short-term horizons. For instance, 'Carry Trades' involve borrowing in low-interest rate currencies and investing in high-interest ones.

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UIP's Relevance

While UIP has limitations, it remains useful for understanding how exchange rates react to unforeseen changes in economic fundamentals like interest rates.

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Riskless Arbitrage

A riskless arbitrage opportunity exploits price discrepancies between different markets to gain profit without any risk. It involves making simultaneous trades in different markets to lock in a guaranteed return.

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Monetary Policy and Exchange Rates

Monetary policy, which influences money supply and interest rates, impacts exchange rates. In the long run, exchange rates reflect differences in money supply.

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Unconventional Monetary Policy

Policy actions taken by central banks when traditional tools, like lowering interest rates, are insufficient - typically when interest rates are already near zero or negative.

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Quantitative Easing

A type of unconventional monetary policy where a central bank purchases government bonds or other assets to inject money directly into the economy.

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Credit Easing

A form of unconventional monetary policy where central banks directly lend money to businesses and banks to encourage borrowing and lending.

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Unconventional Monetary Policy and Inflation

While unconventional monetary expansion introduces substantial liquidity, it doesn't necessarily lead to inflation if the economy is weak and banks/companies hold onto cash.

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Unwinding Quantitative Easing

The process by which central banks gradually reduce their holdings of purchased assets (like government bonds) to remove liquidity from the economy.

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Unwinding Quantitative Easing and Inflation

Rapid unwinding of quantitative easing can lead to inflation as the excess liquidity finds its way into the economy, especially if there is already a strong recovery underway.

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Unwinding Quantitative Easing and Exchange Rates

The speed and magnitude of monetary tightening (like unwinding QE) relative to other countries significantly impact exchange rates.

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Unconventional Monetary Policy and Exchange Rates

Unconventional monetary policy can affect exchange rates, but the impact depends on the specific policy actions and the economic and geopolitical context.

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Purchasing Power Parity (PPP)

In the long run, the exchange rate between two currencies should adjust so that the same basket of goods and services costs the same amount in both countries when expressed in the same currency.

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Overshooting

A short-term phenomenon where the exchange rate depreciates more than it will in the long run following an increase in the money supply.

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Reasons for Overshooting

Overshooting occurs because goods prices adjust slowly to changes in the money supply, while the exchange rate reacts immediately.

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Role of Expectations

Rational agents anticipate future exchange rate changes, affecting the current exchange rate. This is a key driver of overshooting.

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Short-Term vs. Long-Term Effects

The impact of an increase in money supply is different in the short-term (overshooting, interest rate falls) and long-term (price level increases, interest rate stabilizes).

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What is the effect of a permanent increase in money supply M on exchange rate dynamics?

A permanent increase in the money supply will lead to an instantaneous depreciation of the domestic currency that overshoots its long-run value, followed by a gradual appreciation as prices adjust.

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How do changes in the exchange rate affect the expected return on foreign currency investments?

A depreciation of the domestic currency increases the expected return on foreign currency investments, as investors anticipate further depreciation and higher profits.

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Study Notes

Financial Globalization and Capital Flows

  • Financial globalization is not the same as trade globalization
  • Measures of trade openness include tariffs and regulations on free trade, and are calculated as [(Exports + Imports)/GDP]
  • Measures of financial globalization are the extent of cross-border financial transactions, including measures like de jure and de facto financial openness.
    • De jure measures look at restrictions to international capital flows based on the IMF's annual reports
    • De facto measures estimate the amount of international trade in financial assets, such as equity, debt, foreign direct investment (ownership >10%), bank loans, trade credit, and derivatives (futures, options)

Characteristics of Financial Assets

  • Mean to transfer purchasing power across time periods
  • Portfolio investments: equity or debt
  • Foreign direct investment: > 10% ownership
  • Other investments: bank loans, trade credit
  • Derivatives: futures, options
  • Reserves: held by central banks

Flows and Stocks

  • Flows: value of assets traded in a given year
  • Stocks: value of assets held in a given year
  • Stocks = cumulative flows (At = At-1 + at).

Measures of Financial Globalization

  • Stocks: Calculated as [(Domestic assets held by foreigners + foreign assets held by domestic agents)/GDP]
  • Flows: Calculated as [(capital inflows/GDP) and (outflows/GDP)]
    • Capital inflows: net purchases of domestic assets by foreign investors.
    • Capital outflows: net purchases of foreign assets by domestic investors.

Marginal Productivity of Capital (MPK)

  • Capital falls as K increases
  • MPK is the additional output produced by adding one more unit of capital, holding other factors (like labor) constant.
  • MPK typically decreases as more capital is added (diminishing returns).
  • MPK = additional unit of output per unit of capital

The First Financial Globalization

  • World capital markets were very integrated at the end of the 19th century.
  • Large share of British wealth invested overseas.
  • Similar integration in France and Germany.
  • Capital outflows from the UK were primarily to the New World.
  • The main causes of 1st financial globalization were transportation and communication advancements and global banking institutions.

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Trade & International Finance Lecture Notes PDF

Description

Test your knowledge on financial globalization and the intricacies of capital flows. This quiz explores measures of trade and financial openness, as well as characteristics of various financial assets, from equity to derivatives. Understand the differences between trade and financial globalization.

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