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What primarily determines net capital inflows in an economy?
A high real return on domestic assets tends to result in which of the following?
What effect does a high real return on foreign assets have on net capital inflows?
How do changes in international risk premia affect capital flows?
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In a small open economy, the domestic real rate is denoted as what?
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What happens during a financial crisis in terms of capital flows?
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If a country has a lower real return on its domestic assets compared to the world real rate, what is likely to occur?
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What does 'capital' refer to in the context of net capital inflows?
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What is a likely consequence of an increase in the risk premium on domestic assets?
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In an autarky situation, how is the real rate of interest determined?
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What occurs when the world real rate $r∗$ is less than the domestic rate $rA$?
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How do shocks to domestic savings or investment affect capital flows?
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What is a consequence of the Stability and Growth Pact for Eurozone countries?
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What happened in the global financial crisis of 2007-2008 regarding government debt?
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What characterized the lending boom from 2002 to 2007 in Southern Europe?
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What were the conditions of the EU/IMF bailout packages during the Eurozone sovereign debt crisis?
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What was a significant turning point in the Eurozone crisis in July 2012?
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Which countries were notably shut out of international bond markets during the Eurozone crisis?
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What can be inferred about interest rates on government debt in the Eurozone initially following the adoption of the euro?
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What ultimately happened to Ireland and Portugal regarding their bailout programs by July 2014?
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High real return on foreign assets $r∗$ increases net capital inflow.
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Net capital inflows can increase when risk premia on domestic assets rise.
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In a small open economy, the world real rate $r∗$ is taken as constant.
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A flight to safety occurs when investors prefer domestic assets during a crisis.
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Risk averse investors do not require a risk premium to invest in international assets.
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In autarky, capital flows freely between countries.
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High real returns on domestic assets can decrease net capital inflow.
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Domestic demand for foreign assets is influenced by both real returns and risk premiums.
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In the context of net capital inflows, 'capital' only refers to physical assets.
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When domestic real rate $rA$ is lower than the world real rate $r∗$, net capital flows are likely to occur into the country.
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If world real rate $r∗$ is less than the domestic rate $rA$, capital flows out of the country.
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The Stability and Growth Pact imposes strict fiscal policies on Eurozone countries to prevent deficits from exceeding 5% of GDP.
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Countries that did not satisfy the fiscal criteria, like Italy and Greece, faced no consequences during the Eurozone crisis.
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During the lending boom from 2002 to 2007, Southern Europe had large current account deficits.
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A flight to safety during the Global Financial Crisis reduced international lending.
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The Euro was adopted as a single currency in 2000.
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The ECB pledged 'whatever it takes' to preserve the euro in July 2012.
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Ireland and Portugal completed their bailout programs by July 2012.
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An increase in domestic savings can flip the economy from importing to exporting capital.
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During the Eurozone Sovereign Debt Crisis, Greece's government deficit reached 12% of GDP.
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What results from a situation where the world real rate $r∗$ is lower than the domestic rate $rA$?
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Explain how an increase in domestic savings affects capital flows.
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What was a significant consequence of the Stability and Growth Pact for Eurozone countries?
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How did the Global Financial Crisis of 2007-2008 impact government debt in affected countries?
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What occurred in October 2009 regarding Greece's government deficit?
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What effect did the ECB's pledge in July 2012 have on the Eurozone crisis?
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During the lending boom from 2002 to 2007, what was observed in Southern Europe?
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What were the conditions tied to the EU/IMF bailout packages during the Eurozone sovereign debt crisis?
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What happened to Ireland and Portugal regarding their bailout programs by July 2014?
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How do changes in the real return on domestic assets impact foreign investment?
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How did the 'flight to safety' during the Global Financial Crisis influence international lending?
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What factors contribute to a domestic investor's demand for foreign assets?
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In a small open economy, how is the world real interest rate perceived?
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What happens to net capital inflows when the risk premium on domestic assets increases?
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Describe the situation when the domestic real rate is less than the world real rate.
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What is the impact of a flight to safety on capital flows during a financial crisis?
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How does exchange rate risk affect investor preferences between domestic and foreign assets?
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What role does exchange rate play in the decision-making of international investors?
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In the context of the Eurozone sovereign debt crisis, what happened to government deficits?
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What is the effect of lower domestic returns compared to the world real rate on capital flows?
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The net capital inflows depend on both foreign demand for domestic assets and domestic demand for ______ assets.
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A high real return on domestic assets makes them relatively more attractive to ______ investors.
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An increase in risk premium on domestic assets typically ______ capital inflows.
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During a crisis, investors may exhibit a 'flight to ______' when seeking safer investments.
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In a small open economy, the domestic real rate is denoted as ______.
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Most investing involves some kind of ______, especially in international markets.
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Net capital inflows are said to be increasing in the real return on ______ assets.
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If the world real rate is less than the domestic rate, it can lead to net capital ______ from the country.
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Exchange rate risk and sovereign risk are components of international ______.
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In an autarky setting, capital flows are ______.
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If world real rate r∗ < rA, there is excess demand for capital and capital flows in from ______.
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During the Eurozone Sovereign Debt Crisis, countries like Greece faced increasing government ______ and were shut out of international bond markets.
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The Stability and Growth Pact aimed to coordinate fiscal goals but did not establish a eurozone-wide ______ policy.
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The lending boom in Southern Europe saw large current account deficits in countries like Greece, Italy, and ______.
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In July 2012, the ECB vowed to do 'whatever it takes' to preserve the ______.
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In the event of a financial crisis, countries often experience a 'flight to ______', where investors prefer to hold domestic assets.
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The adoption of the euro as a single currency occurred in the year ______.
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In response to the Global Financial Crisis, government debts increased due to higher ______ as tax collections fell.
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Countries like Ireland and Portugal completed their bailout programs by ______.
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When world real rate r∗ is greater than rA, there is excess supply for capital, leading to capital flowing ______ to the rest of the world.
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Study Notes
Determinants of Net Capital Inflows
- Net capital inflows are determined by both foreign demand for domestic assets and domestic demand for foreign assets.
- The demand for domestic and foreign assets is influenced by the real return on domestic assets (r), the real return on foreign assets (r*), and risk premia in both domestic and foreign markets.
- A higher real return on domestic assets (r) encourages foreign investors to invest in domestic assets, decreasing the outflow of capital and increasing the inflow of capital, resulting in a higher net capital inflow.
- A higher real return on foreign assets (r*) encourages domestic investors to invest in foreign assets, decreasing the inflow of capital and increasing the outflow of capital, resulting in a lower net capital inflow.
- International risk premia can impact net capital inflows. An increase in risk premia associated with domestic assets decreases capital inflows, making domestic assets less attractive to foreign investors.
- During crises, investors often experience a 'flight to safety,' seeking more secure investments, which can further decrease capital inflows.
Small, Open Economy Setting
- For economies like Australia, which are small relative to the rest of the world, the level of capital inflows is determined by the difference between the autarky real rate (rA) and the world real rate (r*).
- If the world real rate is lower than the autarky real rate (r* < rA), there is excess demand for capital, meaning that domestic investment exceeds domestic savings at the world real rate. In this scenario, capital flows into the country from abroad to meet the excess demand.
- Conversely, if the world real rate is higher than the autarky real rate (r* > rA), there is excess supply of capital, meaning that domestic savings exceed domestic investment at the world real rate. This leads to capital flowing out of the country to the rest of the world.
- Changes in domestic savings or investment can influence the direction of capital flows. A significant increase in domestic savings could potentially flip the economy from being a capital importer to a capital exporter.
Eurozone Sovereign Debt Crisis
- The eurozone, with its single currency (the euro) adopted in 1999, operates with a centralized monetary policy controlled by the European Central Bank (ECB) and decentralized national fiscal policies.
- The Stability and Growth Pact aimed to coordinate member nations' fiscal goals, limiting their ability to overborrow. This pact included deficit limits (less than 3% of GDP) and debt limits (less than 60% of GDP). However, it did not include a eurozone-wide fiscal policy or automatic stabilizers.
- Despite not always meeting the criteria, some eurozone countries, such as Italy and Greece, experienced significant convergence in interest rates on their government debt.
- During the period between 2002 and 2007, there was a lending boom in the Eurozone, with 'Southern European' countries borrowing from 'Northern European' countries. This resulted in large current account deficits in countries like Greece, Italy, Portugal, and Spain, while Germany and the Netherlands experienced large current account surpluses.
- The global financial crisis of 2007-2008 magnified the problems within the Eurozone. Government debt increased in response to the crisis, driven by factors like official guarantees for private bank debt and higher deficits due to falling tax collections and rising spending. This led to a reappraisal of risk, a 'flight to safety' among investors, and reduced international lending.
- The Eurozone Sovereign Debt Crisis, spanning from 2009 to 2012, emerged when Greece revealed a large government deficit (12% of GDP) in October 2009.
- This revelation triggered a wave of uncertainty and concerns about the sustainability of the Eurozone. As a result, spreads on government debt widened and became more dispersed.
- Greece, Ireland, and Portugal were effectively shut out of international bond markets in 2010 and 2011, as investors became increasingly hesitant to lend to these countries.
- The EU/IMF bailout packages offered to these countries were contingent on significant fiscal austerity measures.
- While the Eurozone faced considerable challenges throughout this period, the ECB's commitment to preserving the euro in July 2012, followed by the launch of an "unlimited support" program in September 2012 to purchase government debt for crisis countries, helped restore confidence and gradually returned normality to the market. Ireland and Portugal eventually completed their bailout programs in 2014.
Determinants of Net Capital Inflows
- Net capital inflows depend on the demand for domestic and foreign assets.
- The demand for these assets is influenced by the real return on domestic assets (r), the real return on foreign assets (r*), and risk premia for both home and abroad.
- A high real return on domestic assets (r) makes domestic assets more attractive to foreign investors, increasing inflows.
- Conversely, a high real return on foreign assets (r*) makes foreign assets more attractive to domestic investors, decreasing inflows.
- Risk-averse investors demand a premium for international investing due to exchange rate risk and sovereign risk.
- An increase in the risk premium on domestic assets decreases capital inflows.
- In crises, there can be a "flight to safety," where investors move away from higher-risk assets.
Small Open Economy Model
- In a small open economy like Australia, the autarky real rate (rA) is determined by domestic savings and investment.
- The world real rate (r*) is taken as given.
- The sign and size of net capital flows depend on the relationship between rA and r*.
- If r* is less than rA, there is excess demand for capital, leading to capital inflows.
- If r* is greater than rA, there is excess supply of capital, leading to capital outflows.
- Shocks to domestic savings or investment can change the direction of capital flows.
Eurozone Sovereign Debt Crisis
- The euro was adopted in 1999, creating a shared monetary policy with the European Central Bank (ECB) but leaving fiscal policies decentralized.
- The Stability and Growth Pact aimed to coordinate fiscal goals but lacked effective enforcement mechanisms.
- Despite not meeting the criteria, some countries like Italy and Greece experienced convergence in interest rates on their government debt.
- This led to a lending boom from 2002 to 2007, with "Southern Europe" borrowing from "Northern Europe".
- This resulted in large current account deficits in Greece, Italy, Portugal, and Spain, and large current account surpluses in Germany and the Netherlands.
- The Global Financial Crisis of 2007-2008 increased government debt and led to a reappraisal of risk, reducing international lending.
- This severely impacted countries heavily reliant on international lending, particularly Greece, Ireland, and Portugal.
- In 2009, Greece's government deficit reached 12% of GDP, prompting a sharp increase in spreads on government debt.
- Greece, Ireland, and Portugal were effectively shut out of international bond markets.
- The EU and IMF provided bailout packages conditional on fiscal austerity measures.
- Speculation about "Grexit" and the viability of the eurozone persisted.
- In 2012, the ECB's "whatever it takes" pledge to preserve the euro and its subsequent commitment to unlimited support for government debt of crisis countries helped restore stability.
- Ireland and Portugal exited their bailout programs in 2014.
Determinants of Net Capital Inflows
- Net capital inflow depends on foreign demand for domestic assets and domestic demand for foreign assets.
- Factors affecting the demand for domestic and foreign assets are real return on domestic assets (r), real return on foreign assets (r*), and risk premia.
- A high real return on domestic assets (r) makes domestic assets more attractive to foreign investors, increasing inflow, and less attractive to domestic investors, decreasing outflow, resulting in a higher net capital inflow.
- A high real return on foreign assets (r*) makes foreign assets more attractive to domestic investors, increasing outflow, and domestic assets less attractive to foreign investors, decreasing inflow, resulting in a lower net capital inflow.
- Risk averse investors need a risk premium for compensation, which can be affected by exchange rate risk and sovereign risk.
- An increase in risk premium on domestic assets will decrease capital inflows.
- In crises, there can be a "flight to safety" causing a sudden shift in investor demand for capital.
Small Open Economy Model
- Small, open economies like Australia with a real rate (rA) can be influenced by the world real rate (r*).
- The direction of capital flows (inflows or outflows), is determined by the relationship between rA and r*.
- If r* < rA there is excess demand for capital, as domestic investment at r* exceeds domestic savings, thus capital flows in.
- If r* > rA there is excess supply for capital, as domestic saving at r* exceeds domestic investment, resulting in capital flows out.
- Shocks to domestic saving or investment can change the direction of capital flows.
Eurozone Sovereign Debt Crisis
- The Eurozone adopted a single currency in 1999 with a common monetary policy by the European Central Bank (ECB), but national fiscal policies remain decentralized.
- The Stability and Growth Pact aimed to "coordinate" fiscal goals, limiting national incentives to over-borrow, but lacks eurozone-wide fiscal policy.
- Despite this, there was remarkable convergence in interest rates on government debt.
- A lending boom from 2002-2007 led to "Southern Europe" borrowing from "Northern Europe" creating large current account deficits (Greece, Italy, Portugal, Spain) and large current account surpluses (Germany, Netherlands).
- The global financial crisis (2007-2008) resulted in increased government debt due to rescuing private bank debt and higher deficits.
- The crisis prompted a reappraisal of risk, "flight to safety," and reduced international lending impacting countries dependent on international lending the most.
- By October 2009, Greece's government deficit reached 12% of GDP, sparking a crisis.
- "Spreads" on government debt increased and became dispersed leading to Greece, Ireland, and Portugal facing exclusion from international bond markets in 2010-2011.
- EU/IMF bailout packages were introduced with conditions focused on fiscal austerity.
- Ongoing speculation about "Grexit" (Greece leaving the eurozone) and the eurozone's viability emerged.
- In July 2012, the ECB announced "whatever it takes to preserve the euro," marking a major turning point.
- In September 2012, the ECB committed to unlimited support for the purchase of government debt from crisis countries, restoring normalcy to the market.
- By July 2014, both Ireland and Portugal completed their bailout programs.
Learning Outcomes
- Understand and explain the determinants of net capital flows.
- Explain the causes and consequences of the Eurozone sovereign debt crisis and the actions taken to counter it.
Determinants of Net Capital Inflows
- Net capital inflows depend on both foreign demand for domestic assets and domestic demand for foreign assets.
- Real return on domestic assets (r) and foreign assets (r*), and risk premia (both home and abroad) influence demand for assets.
- A high real return on domestic assets (r) makes domestic assets more attractive to foreign investors, increasing inflow, and foreign assets less attractive to domestic investors, decreasing outflow.
- This translates to higher net capital inflows correlating with higher r.
- Conversely, a high real return on foreign assets (r*) makes foreign assets more attractive to domestic investors, increasing outflow, and domestic assets less attractive to foreign investors, decreasing inflow.
- This results in lower net capital inflows correlating with higher r*.
- International risk premia, which include exchange rate risk and sovereign risk, require risk averse investors to be compensated for taking on the risk.
- An increase in the risk premium on domestic assets decreases capital inflows.
Small Open Economy Model
- Australia, being a small open economy, provides an example of how net capital flows are influenced by the relationship between the autarky real rate (rA) and the world real rate (r*).
- If the world real rate (r*) is less than the autarky real rate (rA), there is excess demand for capital, leading to capital inflows from abroad.
- Conversely, if the world real rate (r*) is greater than the autarky real rate (rA), there is excess supply for capital, resulting in capital outflows to the rest of the world.
- Shocks to domestic savings or investment can alter the direction of capital flows.
Eurozone Sovereign Debt Crisis
- The Eurozone was created in 1999 with a single currency (Euro) and a centralized common monetary policy (ECB) but decentralized national fiscal policies.
- The Stability and Growth Pact was introduced in 2002 to coordinate fiscal goals, aiming to prevent excessive borrowing.
- The pact stipulated government deficits below 3% of GDP and government debt below 60% of GDP.
- Despite this, some countries like Italy and Greece did not meet the criteria.
- Interest rates on government debt converged significantly during this period.
Lending Boom: 2002-2007
- "Southern Europe" borrowed heavily from "Northern Europe" during this period.
- Large current account deficits were observed in Greece, Italy, Portugal, Spain, etc.
- Conversely, Germany and the Netherlands experienced large current account surpluses.
Global Financial Crisis: 2007-2008
- Government debt increased due to crisis-related measures such as official guarantees of private bank debt and higher deficits.
- Risk reassessment and a "flight to safety" trend caused a decrease in international lending.
- This impact was particularly pronounced for countries reliant on international lending.
Eurozone Sovereign Debt Crisis: 2009-2012
- In October 2009, Greece's government deficit reached 12% of GDP (similar to Australian government deficits in 2020).
- Spreads on government debt widened and became more dispersed.
- Greece, Ireland, and Portugal were shut out of international bond markets in 2010 and 2011.
- Bailout packages from the EU/IMF were conditional on fiscal austerity measures.
- Speculations surrounding a "Grexit" and the sustainability of the eurozone emerged.
- In July 2012, the ECB declared its commitment to safeguarding the euro, marking a turning point.
- Subsequent unlimited support for the purchase of government debt from crisis countries in September 2012 allowed for a return to normalcy.
- Ireland and Portugal completed their bailout programs in July 2014.
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Description
This quiz explores the factors influencing net capital inflows, including foreign demand for domestic assets and domestic demand for foreign assets. It delves into the impacts of real returns on both domestic and foreign assets, as well as the influence of international risk premia. Test your understanding of these critical concepts in international finance.
