Global Governance Lectures + Tutorials + Exam Questions PDF

## Lectures + Tutorials + Exam Questions ### Dokumente **Die besten Jobs für Absolvent:innen in der Steuerberatung** Mehr erfahren ### Chapter 1: Introduction * Global Governance * Chapter 2: Global Governance of Finance * International Monetary Fund (IMF) * Bank for International Settlements (BIS) * World Bank * Investor-State Dispute Settlement (ISDS) * Credit Rating Agencies * Chapter 3: Global Governance of Trade * World Trade Organization (WTO) * Regionalization of Economic Governance * Fair Trade * Chapter 4: Further Aspects of Global Governance * Multinational Corporations (MNCs) * Policy Coordination * Transparency International * Global warming and the Paris Agreement * Chapter 5: Exam ### What is global governance? Definition - political scientists: We understand global governance as the sum of the informal & formal ideas, values, norms & procedures & institutions that help all actors - states, IGOs, civil society & TNCs identify, understand & address trans-boundary problems. **(Weiss & Wilkinson, 2014)** ### Global Governance * no single world order with a top-down hierarchical structure of authority * encompasses (international) law & international organizations created by states * involves formal & informal governance & a wide variety of different actors * collective effort by many actors to deal with "problems without passports" * (à international, transnational; not to a single state) financial crisis, global warming, pandemic ### Tut: Actor * Sovereign States * possess sovereignty which has rendered them authority over their own territory, people, powers delegated to international institutions * sovereignty affected by factors such as weaknesses, globalization, international norms, global financial markets & NGOs * contribute to the funding of intergovernmental organizations * create international law & norms * Traditionally the primary sources of funding for IGOs & military capabilities for peace enforcement / peacekeeping * E.g.: USA dominant state after WWII; Reasons: * Economic power * Predominance in many international organizations * Some of the biggest TNC or MNC * Emerging powers (China, India, Brazil) challenge the US * Experts & epistemic communities (eg: IPCC - Panel Climate Change) * from governmental agencies, research institutes, private industries & universities * can belong to international networks & attend international conferences & negotiations * present the state of scientific knowledge, frame topics for debate & suggest solutions. ### Geographic Scope | Scope | Examples | |---|---| | Global | WHO, WTO, UN | | Regional | ASEAN, EU | | Subregional | ECOWAS, GCC | ### IGO/IOS (Intergovernmental Organizations) * at least three states as members * states - activities in several states & are based on a formal intergovernmental agreement * possess headquarters, executive heads, bureaucracies, budgets * recognized subjects of international law involving a separate standing from their member states * long been regarded as agents of their member states * increasingly IOs have also been seen as actors in their own right * E.g. WHO; UN, EU; ASEAN; ECOWAS etc. ### NGOS (Non-Governmental Organizations) * private nonstate voluntary organizations whose members join to reach a common goal * not-for-profit groups or for-profit corporations * Also Terrorist, criminal & drug-trafficking groups * important sources of information & technical expertise in many international issues * environment, human rights & corruption * lobby for policy changes by states, international organizations, firms ### MNCS (Multinational Corporations) * form of nonstate actor = TNCS (Transnational Corporations) * maximize profits & operate internationally * contribute to foreign investment & international trade flows * addressing trade, labor & environmental topics ### Private foundations * Bill & Melinda Gates Foundation * not-for-profit organizations * serve charitable or community purposes * are financed by individuals or firms yet serve public purposes * have played an important role in financing international programs ### Tut: Leading Economic Groups: | Group | Member Countries | |---|---| | BRICS | Brazil, Russia, India, China, South Africa | | BRICS+ | Brazil, Russia, India, China, South Africa, Iran, Austria, Belgium, Chile, Colombia, Costa Rica, Czech Rep., Denmark, Estonia, Finland, Greece, Hungary, Iceland, Ireland, Israel, Latvia, Lithuania, Luxembourg, Netherlands, New Zealand, Norway, Poland, Portugal, Slovakia, Slovenia, Spain, Sweden, Switzerland, UAE, Mexico, South Korea, Turkey, Argentina, Indonesia, Saudi Arabia | | G-7 | Canada, France, Germany, Italy, Japan, United Kingdom, United States | | Former G-8 | Russia (1998-2014) | | G-20 | Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, United Kingdom, United States, European Union | | Former BRICS | Brazil, Russia, India, China, South Africa | | African Union | N/A | | European Union | N/A | | OECD | N/A | ### Exam Question: How can we order the following economic groups in terms of the number of member countries? * a) OECD > BRICS+ > G8 > G20 * b) BRICS+ > OECD > G20 > G8 * c) G20 > G8 > G7 > OECD * d) OECD > G7 > G8 > BRICS+ * **e) None of the other answers is correct.** ### Recent Challenges : * **Donald Trump (office from 2017 – 2021):** * International security (U.S. withdrawal from „Iran Nuclear Deal" in May 2018) * Climate change (U.S. withdrawal from Paris Agreement in June 2017) * Global governance of trade by initiation of trade war with China & other partners & hollowing-out of WTO * Global health governance (suspension of WHO-funding in April 2020) * "America will always choose independence & cooperation over global governance, control & domination" * ---> President Biden took office in Jan. 2021, return of the US to the Paris Agreement ### Key Actors of Climate Change: * Intergovernmental Panel of Climate Change (IPCC) * UN * Major greenhouse gas emitters: China, India, USA * Alliance of small island states ### Important Agreements: * UN Framework Convention on Climate Change (UNFCC) * Kyoto Protocol * Paris Agreement ### The Effects of Chinese imports on the US Economy * **Macro-level:** * US unemployment rate has fallen to 4.9% * Manufactoring imports from low-income countries to US increased * China is responsible for 89% of this growth * China joined WTO in 2001 * **Micro-level:** * Strong negative local labor market effects in regions with the highest increase in Chinese imports * Increase in unemployment & transfer benefits, decrease in labor force participation & wages * US announced traiffs on chinese goods ### Tut: Populism: * **a) How can we define populism & populist leaders, respectively?** * political style - narrative of a conflict between "the people" & "the elites" * populist leader represent "true people" * representing the general majority are typically referred to as authentic, suffering, ordinary, & inherently good, whose collective will is represented in the populist leader * "the elites" - self-serving, inherently corrupt & power-hoardening minority * By using this narrative, populist leaders divide society into 2 artificial groups * left-wing populists frame their antiestablishment narratives in economic terms, eg by criticizing globalization, MNCs or IOs such as the IMF or the World Bank * right-wing populists aim third groups that are said to pose a threat to national identity bc of cultural differences within populist rhetoric & accuse "elites" of protecting minorities against the will of majority * **b) Has populism risen in the long-run?** * share of populist governments increased substantially during the 1930s (e. g. Hitler, Mussolini) * another high in the 1950s * 1980s were characterized by a low share of populist governments * Since the fall of the Iron Curtain (Eiserner Vorhang), the share of populist leaders increased substantially, mostly due to right-wing populism, reaching an all-time high in 2018 * More than 25% of the analyzed countries were reigned by populist governments * **c) Are populist leaders good or bad for economic growth?** * In the short run (up to 3 years after a populist comes into power), no significantly worse economic performance * in the medium and longer run, populist lead countries perform considerably worse * 15 years after a populist comes into power, the GDP per capita is 10% lower than for non-populist counterfactuals * negative growth effect increases over time - effect does not depend on whether the populist is left- or right * **d) What are other economic outcomes?** * no significant reductions in inequality as measured by the Gini index * international economic integration suffers under populist regimes * e.g: non-populist governments exhibit lower tariffs, are more open to trade and are better financially integrated * macroeconomic variables: sovereign debt levels are up to 10 percentage points higher than for non-populist lead countries after 15 years * accelerating effect on inflation rates - short run. ### Chapter 2: Global Governance of Finance International economics is about how sovereign states interact through trade of goods & services, flows of money & investments ### Important tools for analyses in international finance: * National income accounting records all expenditures that contribute to a country's income & output * Balance of payments accounting records both changes in country's indebtedness to foreigners & the fortunes of its export & import-competing industries ### Gross National Product (GNP): Value of all final goods & services produced by a country's factors of production in a given time period * Productions factors are **workers** (labor services) & **physical capital** (buildings, equipment) * Value of production can be computed as **amount of all expenditures by buyers** * or **amount of all income for sellers** Here, GNP calculated as sum of types of expenditures: 1. **Consumption:** Expenditure by domestic consumers 2. **Investment:** Expenditure by firms on buildings & equipment 3. **Government purchases:** Expenditure by governments on goods & services 4. **Current account balance (EX – IM):** net expenditure by foreigners on domestic goods & services ### Gross Domestic Product (GDP): Measures the final value of all goods & services produced **within** a country in a given time * GDP = GNP - net receipts of factor income from the rest of the world * E.g.: payments of expatriate worker sent to their home country etc. * GDP & GNP do not differ greatly * most pronounced difference between GNP and GDP: * GNP tends to measure national income more closely * GDP does not correct as GNP does for the portion of countries' production carried out using services provided by **foreign-owned capital and labor.** ### Closed economy: Y = C + I + G ### National income Accounting for an open economy: * **Y=C+I+G + EX-IM** * **=C+I+G+ CA** * Expenditure by domestic individuals and institutions * Net expenditure by foreign individuals and institutions ### Current Account Balance: Difference between exports & imports of goods & services * **CA = EX - IM = Y - (C + I + G )** * **Current account surplus (Überschuss):** * production > domestic expenditure * exports > imports * current account > 0 * trade balance > 0 * Net foreign wealth is increasing * **Current account deficit:** * Production < domestic expenditure * Exports < imports * Current account < 0 * Trade balance < 0 * Net foreign wealth is decreasing → A country with current account deficit: * Must be increasing its net foreign debts by the amount of deficit * Is importing present consumption & exporting future consumption * International borrowing & lending: intertemporal trade * CA imbalance is not necessarily a worrying sign #### Reasons CA - deficit is **[not]** worrying: * i) Temporarily high consumptions relative to income * ii) overoptimistic Badly planned investment decisions * iii) size undermining (untergraben) foreign investor confidence * iv) Good productive domestic investment projects * **Ratio of CA imbalance to GDP** > 3% is perceived as large & potentially worrying #### Reasons CA - **surplus** is **[not]** worrying: * i) To smooth consumptions due to demographic development. * ii) Strong dependence on one creditor country. * iii) Lack of productive domestic investment projects. ### National savings (S): National income (Y) that is not spent on consumption or government purchases (G) * **S=Y-C-G** * **in closed economy: S = I** * save only by building up its capital stock * **in open economy: S = I ± CA** * save either by building up its capital stock or by acquiring foreign wealth * **S < 0 implies that I < CA** or **CA > S** * **Sum of private & government savings:** **S = SP + Sg** * **Private saving (SP):** part of disposable (verfügbares) income that is saved rather than consumed; (T = net taxes collected by government) * **SP = Y - T - C** * **Government savings (Sg):** net tax revenue minus government purchases * **Sg = T - G** ### Tutorial: Reasons why a government might be concerned about a large current account deficit or surplus and its official settlements balance: #### 1. Current Account Deficit / Surplus Concerns: * Definition: The current account measures the balance of trade, including goods, services, income, and transfers. * Unsustainability: Large deficits or surpluses might be unsustainable in the long run. * Borrowing Dependence: Deficits are financed by borrowing from foreigners, leading to increased foreign debt. * Impact on Future Consumption: Deficits imply importing present consumption and exporting future consumption, while surpluses do the opposite. * **Formulas:** * Current account = Exports - Imports * Current account = Gross National Product (GNP) - Total Domestic Spending (C + I + G) * Equation: Y = C + I + G + CA (Current Account) * Implication: If (C + I + G) < Y, the country has a current account surplus, lending to foreigners. #### 2. Official Settlements Balance (Balance of Payments) Concerns: * Balance of Payments Identity: Current account + capital account = financial account. * Definition: The balance of payments records all international transactions. * Double-Entry Bookkeeping: Transactions appear twice, once as a credit and once as a debit. * Official Reserves and Financial Flows: Central banks hold reserves to cushion against instability. Net central bank financial flows indicate the increase or decrease in reserves. * Relation to Current Account Deficit/Surplus: A negative balance of payments finances a current account deficit, while a positive balance of payments increases the need for private foreign funding. #### Concerns: * Crisis Signal: A deficit may signal a crisis as it depletes reserves or incurs large debts to foreign central banks. * Constraint on Exchange Rate Policy: Depletion of reserves may limit the central bank's ability to influence or peg exchange rates. * Importance for Developing Countries: Reserves may be crucial for maintaining consumption or investment during periods of reduced private foreign loans. * **Formulas:** * Balance of Payments Identity: Current account + capital account = non-reserve part of financial account + balance of payments * Official Settlements Balance = Net increase in official reserves - Increase in foreign official reserve claims on the home country * Example: Entries in balance of payments and financial accounts: * $40,000 car imported by the US (current account) debited. * An American buys lunch in France and pays by credit card * French restaurant receives payment from the American's credit card company. * Meal purchase (current account, U.S. service import) -$-30 * Sale of credit card claim (financial account, U.S. asset sale) +$-30 * $40,000 payment made by the US (financial account) credited. ### Tutorial: The argument that an import tariff t can reduce a current account deficit is based on the identity that CA = EX - IM(1 + τ) i.e. imports are reduced bc their price increases due to the tariff, thus reducing the initial negative difference between exports and imports. Why might this argument be too simplistic to reflect the real effects between economies? Which additional factors not considered above might play a role and which effects could they have? Import tariffs have been traditionally viewed as a means to address current account deficits by increasing the price of imports, thereby potentially decreasing import quantities and narrowing the trade balance. However, this viewpoint oversimplifies the intricate dynamics of international trade and fails to consider several crucial factors that significantly impact the outcomes: 1. **Elasticities of Demand and Supply:** * The demand elasticity for imported goods and the supply elasticity of domestic producers are pivotal in determining the effectiveness of tariffs in reducing the current account deficit. * If the demand for imported goods is inelastic, meaning consumers are relatively insensitive to price changes, tariff-induced price increases may not significantly reduce imports. Similarly, if domestic producers heavily rely on imported inputs covered by the tariff, their exports may suffer due to increased production costs. * Formula: **CA = EX - IM(1 + τ)** 2. **Exchange Rates:** * The role of exchange rates is paramount in understanding the true impact of import tariffs on the current account. In a system of flexible exchange rates, tariff implementation can influence currency appreciation or depreciation. * Specifically, as import tariffs raise the demand for domestic currency due to increased import prices, the domestic currency may appreciate. Conversely, persistent trade deficits, indicating higher demand for foreign currency, may exert pressure for the depreciation of the domestic currency. ### Tutorial: Show that in an open economy the current account surplus CA can be described as follows: * **CA = Sp - I (G - T)** 1. **Y = C + I + G + EX - IM (National income identity for an open economy)** 2. **CA = EX - IM (Definition of the current account)** 3. **Y = C + I + G + CA (National income identity rearranged)** 4. **Y - C - G = I + CA (Rearranging the national income identity)** 5. **S = Y - C - G (Definition of national saving)** 6. **S = I + CA (Using the definition of national saving)** 7. **Sp = Y - T - C (Definition of private saving)** 8. **Sg = T - G (Definition of government saving)** 9. **S = Sp + Sg (Definition of national saving as the sum of private and government saving)** 10. **Sp + Sg = I + CA (Substituting S = Sp + Sg into equation 6)** 11. **CA = Sp + Sg - I** 12. **CA = Sp - I + (T - G) (Rearranging equation 10)** 13. **CA = Sp - I - (G - T) (Transforming equation 12)** ### International transaction involves 2 parties; each transaction enters the accounts twice: * once as a credit (+ ) & once as debit (-) * **Double-entry bookkeeping** * **Balance of payments accounts separated into 3 accounts:** * **Current Account:** imports & exports * Merchandise: shipping services; tourist meals; earnings from workers operating in foreign countries * Net unilateral (einseitige) transfers: gifts across countries * CAB is equal to trade balance, if net unilateral (einseitige) transfers are zero * **Financial Account:** financial capital * **Capital account:** flows of special categories of assets, which are non-market like debt forgiveness, copyrights or trademarks * **Current account + capital account = financial account** ### Higher disposable (verfügbares) income leads to more private consumption & higher demand for foreign goods & services; worsening the current account ### Has Donald Trump's trade war lowered the U.S. CA deficit? * unilateral trade barrier increases do not improve the CA balance. * Fundamental determinants like saving and investment have a greater impact on the CA than trade policy. * Despite constant trade barriers since late 2019, the US CA deficit has worsened recently. ### Tutorial: "How would higher American barriers to imports affect private saving, investment, and the government budget deficit in the USA? Do you agree that import restrictions would necessarily reduce the American current account deficit?" * **Impact on private saving, investment, and government budget deficit:** * Little to no effect expected. * Considering equation **CA = Sp - I (G - T):** * To reduce a current account deficit: * Increase private saving (Sp), * Reduce domestic investment (I), * Cut the budget deficit (G - T). * **Import restrictions might not affect these variables significantly.** * Without impact on these variables, import restrictions would not improve the current account deficit. * **Possible scenarios:** * Investment might increase in protected industries, worsening the current account. * Investment might decrease due to higher costs of imported goods, improving the current account. * Conclusion: * Prediction of the impact on the current account requires a macroeconomic analysis. * General-equilibrium analysis involving behavioral equations is necessary. ### International Transactions and Gains from Trade ### Three Types of potential gains from trade due to international capital markets: 1. Gains due to comparative advantage: * Gains from trade of goods & services for other goods & services * Countries should specialize in the production of the good or service 2. Gains due to intertemporal trade: * Gains from exchange of goods & services for claims to future goods & services (for assets) * Developing country borrows abroad to finance domestic project 3. Gains due to portfolio diversification: * Gains from trade of assets for assets * = risk aversion * People care about the riskiness of assets return * As long as assets of portfolio are not positively correlated #### a) Risk Aversion: * Risk aversion refers to individuals' preference to avoid risk when making investment decisions. * It means assessing a portfolio not just based on its expected return but also considering its riskiness. * Consider a gamble where you win €1000 half the time and lose €1000 half the time. * The expected value of this gamble is 0, indicating no net gain or loss: (0.5 * €1000) + (0.5* -€1000) = €0. * A risk-averse indiv. would avoid this gamble bc the possibility of losing €1000 outweighs the possibility of winning. #### b) Portfolio Diversification and International Asset Trade: * example to illustrate how two countries are made better off by trade in assets * Portfolio diversification helps lower the riskiness of returns on wealth. * 2 countries, Germany and France, each have farmland yielding (Ernte) potatoes, with uncertain yield (Ernte) s. * On average, both countries have a yield (Ernte) of 75 tons of potatoes. * To avoid the risk of bad harvests, they could trade assets, each selling 50% of their assets to the other country. * By diversifying their portfolios, both countries ensure they receive an average yield (Ernte) of 75 tons regardless of individual harvest outcomes. * If Germany's yield (Ernte) is 50 tons and France's yield (Ernte) is 100 tons, both countries receive: * (0.5*50) + (0.5 * 100) = 75 tons. * That means, both economies earn same return on their portfolio, half of the German harvest + half of the French harvest. * If Germany's yield (Ernte) is 100 tons and France's yield (Ernte) is 50 tons, both countries receive: * (0.5*100) + (0.5*50) = 75 tons. So, each country still earns 75 tons. * International trade in assets allows both countries to enjoy moderate yield (Ernte) consistently without being affected by variability. * Portfolio diversification through trade removes risk without changing average returns, making both economies better off, especially if they are risk-averse. #### c) Which portfolio is better diversified - one with stocks in a petrol company and a car company or one with stocks in a petrol company and a pharmaceutical company? * The better diversified portfolio is the one with stocks in the petrol company and the pharmaceutical company. * These 2 sectors do not experience identical cyclical fluctuations. * They should not be perfectly positively correlated. * A portfolio consisting of positively correlated sectors like petrol and automobile should be more volatile than one where developments could compensate one another. #### a) Interest Rate Calculation: * Given: Payment after a year = $150 * Formula: i = $150-$PB / $PB #### Main actors in the international capital market: * **Commercial banks** * At the center of int. Capital markets * Loans to cooperations & governments, sovereign & private bonds; initital public offerings (IPOs) * Global economic governance: Basel Committee, Policy coordination G7/G20 * **Mulinational corporations (MNCs)** * Coca-Cola, IBM; Nike, Toyota * Issue (verklagen) stocks, which give owners an equity claim to corporation's assets / corporate bonds * **Nonbank financial institutions (France, Germany, Allianz, AXA, United Health Group)** * Insurance companies, pension funds, hedge funds, investment banks * **Central banks & other government agencies** * Hold an important part of their international reserves as sovereign bonds from foreign countries ### Important distinctions between different assets: * **Debt instruments:** borrower must repay a fixed amount regardless of economic conditions * **Equity instruments:** specify ownership of variable profits or returns, which vary according to economic conditions ### International Monetary Fund (IMF) * international leader of last resorts by providing financial assistance to countries hit by financial crisis #### Features: 1. Member countries pool financial resources for members in need (quota; IMF conditionality) 2. Devaluations (Abwertung) occur if IMF determined that economy experiencing a „fundamental disequilibrium (Ungleichgewicht) " #### Convertible currency = currency can be freely exchanges for foreign currencies ### Balance of Payments Accounts * Central banks (e.g. ECB) responsible for monetary policy * **Official international reserves** = foreign assets held by central banks to cushion against financial instability; „war chest" against foreign loans; include government bonds, currency, gold & accounts at IMF * Important role as a measure of disequilibrium (Ungleichgewicht) in int. Payments * part of balance of payments accounts = **net central bank financial flows** = balance of payments (BoP) * Balance of payments deficit indicates that a country: * Has not access to private foreign borrowing * Depleting its official international reserve assets * Incurring large new debts to foreign banks ### Exchange Rate * = price of one currency in terms of another currency #### Fixed exchange rate regime: * rate is fixed vis-à-vis yanother currency or gold * promise by the central bank to hold exchange rate constant * they need to intervene in exchange market to ensure by buying or selling domestic currency for foreign currency * caused by central bank #### Floating exchange rate system: * exchange rate is market determined & central bank hardly intervenes #### (Depreciation/appreciation = decrease/increase in value of currency relative to another one) ### Historical International Monetary Systems: * **The gold standard (1870-1914):** fixed exchange rate between its currency & gold * **The interwar years (1918-1939):** some countries returned to gold standard, but suffered from reduced output & unemployment during 1930s * **The Bretton-Woods System (1945 – 1971):** * 44 countries met in 1944 few weeks after D-Day to prepare the Post-WWII international monetary system * Key players: John Maynard Keyes (UK Treasury) & Harry Dexter White (US Treasury) * Led to the IMF, International Bank für Recontruction & Development (World Bank) * agreement called for fixed exchange rates visavis US$ & gold fixed at $35 an ounce * General Agreement on Tariffs & Trade (GATT) in 1947; WTO on 1995 * **The Post-Bretton-Woods System (1971 - today):** no real int monetary system, many countries floating exchange rates ### Reasons for collapse of Bretton Woods system: * U.S. imbalances during 1960s/70s * Incurred a current account deficit from 1971 & increasing government expenditures due to Vietnam War * US$ became overvalued * Problem: all countries must agree to revalue their currencies against US$ * Fundamental disquilibrium à Devaluation (Abwertung) necessary * International agreement in Dec. 1971 leads to 8% US$ Devaluation (Abwertung) * Smithsonian realignment (new dollar standard) proved to be short-lived * March 1973: major currencies start to float currencies * Collapse of Bretton Woods system ### !! Types of financial crises: * **Balance of payments crisis:** sharp change in international reserves due to change in expectations about future exchange rate * **Banking crisis:** Bankruptcy & other problems for private sector banks * May lead to sovereign crisis: * private banks become illiquid, government need to re-capitalize banking sector (bail-outs) * Sovereign/Public debt crisis: Governments' inability or unwillingness to repay its sovereign debt * May lead to banking crisis: if country defaults on ist debt, domestic banks face large losses ### Stylized Crisis Model: * 3 Players: * Central bank/government: commits a fixed stock of international reserves (R) to defend fixed exchange rates * 2 private investors: both hold 6 units of domestic currency & maximes profits each („Hold" or „Sell") * Transaction costs (domestic --> foreign): one unit * Game theory: Non-repetitive, non-cooperative game T=1 * **High Reserve (R=20)** * Dominant strategy for both to „hold" domestic currency * **Low Reserve (R=6)** * Dominant strategy for both to „sell" domestic currency * exchange rate devalues supposedly by 50 percent ### First generation crises (Paul Krugman 1979): * balance of payments crises are a consequence of inconsistent economic policies * Fiscal deficit + fixed exchange rates = balance of payments crisis * As long as inconsistency in economic policies is not resolved, crisis will start ### Second generation crises (Maurice Obstfeld 1986): * Self-fulfilling financial crises can occur * If both traders believe that government continues to see net benefit in definding exchange rate, both hold domestic assets à no financial crisis * If both traders believe that government stops to see net benefit in definding exchange rate, both sell domestic assets à financial crisis ### A) High Reserve Game: R = 20 * **Pay-off Streams:** * Both hold: 0/0 * One sells: 0/-0.5 or -0.5/0 (transaction cost) * Both sell: -0.5/-0.5 (transaction cost) * **Nash Equilibrium:** * Both hold (0/0, peg stable) * In this scenario, the central bank's high reserves ensure that the fixed exchange rate (peg) is credible. Investors are dissuaded from selling their domestic currency because the central bank can easily defend the peg. ### B) Low Reserve Game: R = 8 * **Pay-off Streams:** * Both hold: 0/0 * One sells: 1.5/0 or 0/1.5 (currency devalues by 25%, gain 2 - cost 0.5) * Both sell: 0.5/0.5 (currency devalues by 25%, gain 1-cost 0.5) * **Nash Equilibrium:** Both sell (0.5/0.5, peg abandoned, currency devalues) * Here, low reserves make the peg vulnerable. Investors anticipate the central bank's inability to maintain the fixed exchange rate, leading both to sell domestic currency, triggering a devaluation. ### C) Intermediate Reserve Game: R = 12 * **Pay-off Streams:** * Both hold: 0/0 * Transaction costs = T = 0.5 units * Currency devalue = 25% * One sells: transaction costs for the one who sells (-0,5 units) and currency does not devalue * Both sell: transaction costs (-0,5 units p.p.), currency devalues (12 x 25% = 3 gain for both → 1,5 gain p.p.) → payoff: 1 p.p. * **Nash Equilibria:** Multiple: Both hold (0/0, peg stable) or both sell (1/1, currency devalues) * With intermediate reserves, the outcome depends investor expectations. If both believe the peg will hold, they hold their currency. If both expect a crisis, they sell, causing the peg collapse. ### D) Intermediate Reserve Game - Variation 1: R = 12 * **Pay-off Streams:** * Both hold: 0/0 (no transaction costs for both and currency does not devalue) * Transaction costs = T = 0.5 units * Currency devalue = 10% * One sells: transaction costs for the one who sells (-0,5 units) and currency does not devalue * Both sell: transaction costs (-0,5 units p.p.), currency devalues * (12 x 10% = 1,2 gain for both → 0,6 gain p.p.) → payoff: 0,1 p.p * **Nash Equilibria:** Multiple: Both hold (0/0, peg stable) or both sell (0.1/0.1, currency devalues) * Similar to the intermediate reserve game, but with a smaller devaluation (10%). The potential pay-offs for selling are lower, but the dynamics of expectation-driven crises remain. ### E) Intermediate Reserve Game - Variation 2: R = 12 * **Pay-off Streams:** * Both hold: 0/0 (no transaction costs for both and currency does not devalue) * Transaction costs = T = 0.5 units * Currency devalue = 5% * One sells: transaction costs for the one who sells (-0,5 units) and currency does not devalue * Both sell: transaction costs (-0,5 units p.p.), currency devalues * (12 x 5% = 0,6 gain for both → 0,3 gain p.p.) → payoff: -0,2 p.p * **Nash Equilibria:** Both hold (0/0, peg stable) * This variation shows that even with intermediate reserves, if the devaluation is minor (5%), the cost of selling outweighs the benefits. Investors prefer holding, ensuring the peg's stability. ### Summary: * High Reserve Game: * Stable peg, both investors hold. High reserves effectively deter speculative attacks. * Low Reserve Game: * Currency devalues, both investors sell. Low reserves trigger a self-fulfilling crisis as investors expect and cause the peg to fail. * Intermediate Reserve Game (R = 12): * Multiple equilibria (self-fulfilling expectations) for both hold and sell. Outcomes depend heavily on investor sentiment and expectations, illustrating the delicate balance central banks must maintain to uphold the peg. * Intermediate Reserve Game Variations: * Variation 1: Multiple equilibria, similar to the base intermediate game but with a smaller devaluation (10%). * Variation 2: Unique equilibrium with holding, as minimal devaluation (5%) makes selling unattractive. * Thematic

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