Macroeconomics 2 for ECO International Economics: Theory & Policy Krugman and Obstfeld Chapter 12 National Income Accounting and the Balance of Payments GNP = national income depreciation + net unilateral transfers. GNP = GDP + net receipts of factor income from abroad. Balance of payments accounts: - Current account: exports and imports of goods and services. - Financial account: purchase and sale of financial assets. - Capital account: other. The balance of payments must equal zero (after the statistical discrepancy is added). Chapter 13 Exchange Rates and the Foreign Exchange Market: an Asset Approach The dollar is a vehicle currency: widely used to denominate international contracts made by parties who do not reside in this country. Spot exchange rate: two parties agree to an exchange rate of bank deposits and execute the deal immediately. Forward exchange rate: the price is set now, but the currencies are exchanged at the value date. Foreign exchange swap: spot sale of a currency combined with a forward repurchase. Futures contract: promise that a specified amount of foreign currency will be delivered on a specified date in the future. Put option: right to sell foreign currency at a know exchange rate at any time during the month (buy: call option). Interest parity condition: Chapter 14 Money, Interest Rates and Exchange Rates Equilibrium:. 1
In the short run, P and E e are given. Temporary increase in the money supply: - R. - Home currency depreciates against the foreign currency (E ). Permanent increase in the money supply: - Proportional increase in the price level s long-run value (P ). - Output, relative prices and the interest rate do not change. - Home currency depreciates against the foreign currency (E ). - Expectations change (E e ). If the money supply rises, the price level will rise because of three sources: - Excess demand for output and labor. - Inflationary expectations. - Raw material prices adjust sharply. Chapter 15 Price Levels and the Exchange Rate in the Long Run Law of one price: identical goods must sell for the same price in different markets. Purchasing power parity: all countries price levels are equal when measured in the same currency. Absolute PPP:. Relative PPP:. 2
Monetary approach to the exchange rate: - Factors that do not influence money supply or money demand play no explicit role. - Long-run: does not allow for price inflexibility. - PPP holds:. -. - The exchange rate is fully determined in the long run by the relative supplies and relative real demands of those monies. - If the price level goes up, the currency depreciates. Predictions about the long-run effects on the exchange rate: - M S US P US E $/. - R$ L(R$, Y US ) P US $ depreciates, E $/. - Y L(R, Y) P US $ appreciates, E $/. Effects of ongoing inflation in the long run: - Real income stays constant (higher prices, higher wages). - Full-employment output level does not change (depends on supplies of productive factors). - A rise in a country s expected inflation rate will eventually cause an equal rise in the interest rate. Fisher effect: R$ - R = π e US - π e EU. PPP performs badly because: - Transport costs and restrictions on trade are not taken into account (also, non-tradables exist). - There is no full competition (monopolists sell a commodity for different prices in different markets). - Inflation data of different countries is based on different commodity baskets. The Fed unexpectedly increases the growth rate of US money supply: Real exchange rate: prices of one country s goods and services relative to the other s.. However, the baskets are not the same! If relative PPP holds, the real exchange rate can never change. Reasons why long-run values of real exchange rates can change: - A change in (world) relative demand (RD is an upward sloping curve). - A change in relative output supply (RS is a vertical line). The long-run nominal exchange rate is affected by: - Changes in money demand or supply. - Changes in the long-run real exchange rate. 3
Most important determinants of long-run swings in nominal exchange rates: - Money supply level: M s P E. - Money supply growth rate: Growth rate M s long-run inflation nominal interest rate M D P E. - Output demand: demand P in the long-run unchanged, rise in relative prices q E. - Output supply: ~ supply q ~ supply transactions L(R, Y) P. ~ E = q * P/P*, q, p ambiguous effect. Real interest rates: measured in terms of a country s output. This is an uncertain measure, so expected real interest rates are used... Real interest parity condition:. When relative PPP holds, expected real interest rates are the same in different countries. Chapter 16 Output and the Exchange Rate in the Short Run ( ). EP*/P foreign products are more expensive, domestic products cheaper, effects: - Effect on exports: domestic goods become relatively cheap, so exports go up. - Effect on imports: ~ Value effect: imports are measured in terms of domestic goods. When q rises, a given quantity of foreign goods has a higher value in domestic goods: it raises the value of imports. ~ Volume effect: foreign goods become relatively expensive and imports decline. The volume effect is stronger, so imports decrease when q rises. Y d domestic spending on all goods rises IM worsens CA D C D Output market equilibrium, short run: DD-schedule: shows all combinations of output and the exchange rate for which the output market is in short-run equilibrium. Any variable that increases demand for a given exchange rate, shifts DD to the right (and vice versa). 4
AA-schedule: shows all combinations of output and the exchange rate that are consistent with equilibrium in the domestic money market and the foreign exchange market: -. -. The AA-schedule depends on two types of variables: - Variables which influence the money market: ~ Real money supply: A rise in M s or a drop in P shifts the AA-curve upward. For a given Y, a rise in the real money supply decreases R and depreciates the currency. ~ Real money demand: if people demand less money for a given R and Y (L(R, Y) decreases), the effects are similar to a rise in real money supply. - Variables which influence the interest parity: ~ Expected exchange rate: E e rises, so for a given R, E rises and the AA-curve shifts upwards. ~ Foreign interest rate: a rise in R*, requires an increase in E. The AA-curve shifts upwards. Short-run equilibrium for an open economy: 5
Temporary expansionary monetary policy induces an increase in output and a currency depreciation. Temporary expansionary fiscal policy induces an increase in output and a currency appreciation. XX-curve: plots all the combinations of Y and E for which the current account is equal to a constant X. - XX is upward sloping. - XX is less steep than DD: when Y rises, people consumer more domestic output but also import and save more. A monetary expansion causes the current account balance to increase in the short run. A temporary fiscal expansion causes the current account to worsen. A permanent fiscal expansion causes the current account to worsen even more (because of the stronger currency appreciation). Currency depreciation firms want to export more, but need time to produce more or to establish a distribution network abroad immediate effect of depreciation: raises the price of imports in terms of domestic currency (price effect) in the very short run, the current account will worsen. It increases in the long run. 6
Chapter 17 Fixed Exchange Rates and Foreign Exchange Intervention Managed floating exchange rates: governments may attempt to moderate exchange rate movements without keeping exchange rates rigidly fixed (dirty float). Central Bank balance sheet: Assets Foreign assets Domestic assets Liabilities Deposits held by private banks Currency in circulation Money multiplier: the impact of central bank transactions on the money supply, > 1. Sterilized foreign exchange intervention: CB s carry out equal foreign and domestic transactions in opposite directions to nullify the impact of their foreign exchange operations on the domestic money supply. By purchasing assets, the central bank can increase the money supply. Stabilization policies with a fixed exchange rate: - Monetary policy: hoping to increase output, the central bank decides to increase the money supply by buying domestic assets AA shifts upwards. However, the CB must maintain the fixed exchange rate sterilization: sell foreign assets for domestic currency money supply decreases AA shifts downwards, back to the initial position. Monetary policy can affect international reserves, but nothing else! - Fiscal policy: fiscal expansion DD shifts to the right. The CB must maintain the fixed exchange rate buy foreign assets with domestic money money supply increases AA shifts to the right higher output and same (fixed) exchange rate. - Changes in the exchange rate: devaluation causes a rise in output, a rise in official reserves and an expansion of the money supply. Devaluation Y excess demand for money R is pushed upwards to maintain the new fixed exchange rate, the CB buys foreign assets Ms AA shifts to the right. Balance of Payments crisis: sharp change in official foreign reserves sparked by a change in expectations about the future exchange rate. E e a balance of payments crisis is marked by a sharp fall in reserves and a rise in R above R*. The reserve loss is called capital flight. Self-fulfilling currency crisis: an economy can be vulnerable to currency speculation without being in such bad shape that a collapse of its fixed exchange rate regime is inevitable. Perfect asset substitutability: the foreign exchange market is in equilibrium only when the expected returns on domestic and foreign currency bonds are the same (interest parity). Imperfect asset substitutability: it is possible for assets expected returns to differ in equilibrium, because of risk. CB actions that alter the riskiness can move the exchange rate even when the money supply does not change. 7
p: risk premium, B: stock of domestic government debt, A: domestic assets of the central bank. Sterilized purchases of foreign exchange causes p(b-a) to rise depreciation of the home currency. Systems for fixing the exchange rates of all currencies against each other: - One currency is singled out as a reserve currency. The others fix their currencies against the reserve currency by standing ready to trade domestic money for reserve assets at that rate. The reserve center is the one country in the system that can enjoy fixed exchange rates without the need to intervene. It is still able to use monetary policy for stabilization purposes. - Gold standard: CBs peg the prices of their currencies in terms of gold and hold gold as official international reserves. Desirable properties of the Gold Standard: - Symmetry: no country occupies a privileged position. - The price of gold is fixed. CBs cannot allow their money supplies to grow more rapidly than real money demand, since that would make prices rise. Real values of national monies are more stable and predictable. Drawbacks of the Gold Standard: - It places undesirable constraints on the use of monetary policy (to fight unemployment). - It only ensures a stable overall price level if the relative price of gold and other goods and services is stable. - An international payments system based on gold is problematic because CBs cannot increase their holdings of international reserves unless there are continual new gold discoveries. - It could give countries with potentially large gold production ability to influence macroeconomic conditions throughout the world through market sales of gold. Gold exchange standard: CBs reserves consist of gold and currencies whose prices in terms of gold are fixed. Each country fixes its exchange rate to a currency with a fixed gold price. This allows for more flexibility in the growth of international reserves, which can consist of assets as well. Chapter 18 Internal balance: - Full employment of production factors: ~ Underemployment: waste of resources, deflation. ~ Overemployment: waste of leisure time, capital depreciates faster, inflation. - Price level stability (low inflation): ~ Unexpected inflation redistributes from creditors to debtors, makes future planning more difficult. ~ Extreme case: hyperinflation, domestic currency may stop functioning huge social costs. External balance: focuses on the optimal current account balance. - Unbalanced current account: ~ Dampens output shocks. 8
~ Allow for better investment opportunities abroad (intertemporal trade). - Balanced current account: not always appropriate. - Very large CA deficits are problematic if: ~ Future repayment of foreign loans will be difficult when borrowed funds are badly invested or consumed. ~ Foreigners lose confidence and stop lending. - Very large CA surpluses are problematic if: ~ Less is invested domestically (S = I + CA). ~ Vulnerable to non-repayment by foreigners. ~ Vulnerable to protectionist measures by foreigners. 1870-1914: Gold standard: - Each currency has a fixed price in terms of gold. - Ensures world price stability. - The Central Banks need stocks of gold reserves to assure convertibility. - External balance: ~ Current Account + Capital Account + Nonreserve Financial Account = 0. ~ Required to avoid large inflows or outflows of gold. How to assure external balance within the Gold standard system? Price-specie-flow mechanism: automatic mechanism, changes in gold reserves change the money supply, which leads to changes in prices and the real exchange rate adapts to restore equilibrium. Rules of the game: buying or selling domestic assets by central banks to influence flows of financial assets. ~ Inflow of gold: buy domestic assets M, R, reduces capital (gold) inflow. ~ Outflow of gold: sell domestic assets M, R, reduces capital (gold) outflow. Asymmetric incentives: a country with decreasing gold reserves has strong incentives to follow the rules, whereas surplus countries did not take action. Genoa Conference (1922): large countries hold gold reserves, small countries partly hold currencies of large countries as reserves. 1929: Great Depression: - Some countries devalued their currencies (USA), others clung to the Gold Standard (FR, NL). - Growing number of protectionist measures. - Sharp reserve movements/exchange rate movements. restrictions on financial transactions. more autarkic countries (external balance). big cost: lower gains from trade. 1944-1973: Bretton Woods system: - Aim: internal and external balance, without trade restrictions: ~ Fixed exchange rate against the US Dollar, fixed dollar price of gold ($35 per ounce). ~ Official international reserves in gold or dollars. Actually a gold exchange standard system. US dollar is the Nth country. Internal balance: - Price stability: 9
~ Non-US countries increased M: capital outflow unable to maintain fixed $ exchange rate. ~ US increased M: capital outflow foreigners hold more dollars FED unable to maintain dollar price of gold. - Full employment: ~ Fiscal policy (G, T). ~ Flexibility in external adjustment. Requirement for the Bretton Woods system: all currencies must be convertible to facilitate international trade, which leads to greater flows of capital and a stronger link between R and R*. Downside of financial market integration and convertibility: risk of speculative attacks, currency crisis. Macroeconomic policy under the Bretton Woods system, assumptions: - E, P and P* are fixed (short run) real exchange rate is fixed in the short run. - Expectations (inflation, exchange rate) play no role. - International capital mobility R = R*. The four zones of economic discomfort: Without de- or revaluation, only horizontal movements are possible policy dilemma. Options under the Bretton Woods system: - One instrument available (fiscal policy), but two goals. - Fiscal policy takes time and will have to be reversed at some time (prevent too high debt ratio). - Mostly, internal balance had political priority. - Danger: too big external imbalances speculation against the currency. The role of the US: - Needed to have sufficient stock of gold to assure the price of $35 an ounce. - Foreign countries grew fast, stock of gold did not extra dollars, accumulated as reserves by foreign central banks. - At a certain point, this will lead to a confidence problem: how credible is the price of gold? speculation against the dollar. The collapse of the Bretton Woods system: - 1965-1968: large increase in US government spending. - 1967-1968: expansionary monetary policy in the US P US, CA, speculators sold huge amounts of dollars for gold. - March 1968: two-tier system installed: private gold market and gold market for central banks. 10
- 1970: recession in the US, speculation about dollar devaluation. For such a devaluation, all countries with a fixed dollar exchange rate will have to agree. - August 1971: Nixon decides to suspend the dollar-gold convertibility and impose import tariffs until other countries agreed on dollar devaluation. - December 1971: $38 per ounce of gold, US dollar devaluation against foreign currencies of 8%. - Repeated devaluation afterwards. - Early 1973: massive speculative attacks against the dollar, closure of foreign exchange market. - March 1973: currencies of Japan and most European countries started to float End of the Bretton Woods system. Consequences of the end of the Bretton Woods system: - Inflation in US in the second half of the 1960s. - Other countries: maintain exchange rate with dollar expand money supply inflation. Worldwide inflation, a rise in P*: Most countries did not want to import (more) inflation, which was one of the reasons that the Bretton Woods system collapsed. Chapter 19 Worldwide inflation, a rise in P*: - Short run: P is fixed XX and II curve shift down. - Two possibilities: ~ Do nothing P gradually rises and both curves move back. ~ Immediately revalue domestic currency new equilibrium at the intersection of both new curves, P does not change. Pros of floating exchange rates: - Monetary policy autonomy: ~ Under BWS: non-us countries had to keep R = Rus. Under floating exchange rates, the monetary policy tool can be used again to restore internal balance. ~ Under BWS: non-us countries imported inflation from the US. Under floating exchange rates, countries can choose their own desired long-run inflation rate. - Symmetry: under BWS, US determined the world money supply and did not have the option to re- /devaluate its currency without multilateral agreement (other BWS could). - Exchange rates as automatic stabilizers: ~ Floating exchange rates: Negative temporary demand shock: Y so L(R, Y) R to 11
restore L(R, Y) = M S / P currency depreciation, E Exports stimulated Point 2: effect on Y dampened. ~ Fixed exchange rates: to prevent a depreciation, the central bank has to reduce money supply AA curve shifts down a lot less output but same exchange rate. Cons of floating exchange rates: - Discipline: central banks do not need to keep sufficient foreign reserves danger of too expansionary monetary policy. - Destabilizing speculation: if speculators expect a depreciation, they start selling the currency and the depreciation will actually happen large fluctuations in exchange rate and inflation. - Vulnerability to money market disturbances: if there are more DD-shocks, floating exchange rates are better. With more AA-shocks, fixed exchange rates are preferred (M s (AA back)). - Injury to international trade and investment: exchange rate uncertainty is bad (buy/sell in the forward market, foreign trade and investment have expanded). - Uncoordinated economic policies: each country has an incentive to depreciate its currency beggar-thy-neighbor policies. - Illusion of greater autonomy: with floating exchange rates, a change in M s leads to a faster change in P. 12
Chapter 20: Optimum currency areas and the European experience Goals of the European Union: - Make Europe politically stable and peaceful (political and legal institutions, consistent with liberaldemocratic ideas). - Enhance Europe s power in international affairs. - Turn Europe into a unified market. 1979-1988: The European Monetary System: - Fixed exchange rates through: ~ Credit system: credit from strong to weak-currency members. ~ The Exchange Rate Mechanism (ERM): most currencies could float +/- 2.25% (some +/- 6%) around a target value. - Until 1987: 11 realignments, some capital controls to prevent speculation. - After 1987: controls lifted to promote integration and reduce realignments. - 1990: German unification economic boom, higher inflation. ~ Reactions of the German Central Bank: restrictive monetary policy. ~ Other countries: not booming (France, Italy and UK: recession), unwilling to increase R. 13
speculative attacks: speculators bought German assets (high R) and sold other assets. - 1992: ~ UK left the EMS ( Black Wednesday ), Italy withdraws too. ~ Broader band of +/- 15% for remaining countries (except NL and Germany) not interesting for speculation anymore. Theory of Optimum Currency Areas: - Robert Mundell (1961). - Benefits of joining the euro: good for international trade, since there is less uncertainty and lower transaction costs. This gain will be higher if countries are highly economically integrated. Provided that members of the euro zone have stable prices. upward-sloping GG-curve. - Costs of joining the euro: loss of monetary policy for stabilizing output and employment, loss of automatic adjustment of exchange rates to changes in aggregate demand (DD-curve) that dampen the effect on Y downward-sloping LL-curve. Is the EU an Optimum Currency Area? - High degree of economic integration: ~ Most EU members export 10-20% of GDP to other EU members. This is high compared to exports from EU to US (2%), but low compared to trade flows between US states. ~ Still quite some price differences between some products in EU countries. - High degree of capital and labor mobility: ~ Capital mobility: yes. ~ Labor mobility: no: No extensive regional migration (even within countries). Different languages and cultures. Different institutions (e.g. unions, regulations). More persistent differences in unemployment rates between EU members. ~ Danger that capital mobility without labor mobility can make the economic stability loss greater: Those who will emigrate are most likely high skilled. E.g. negative demand shock financial capital flows out higher unemployment. - Low degree of asymmetric shocks: ~ Yes, if economic structure is rather similar among EU countries: For: high volume of intra-industry trade. Against: Northern European countries have higher levels of capital per (more 14
skilled) worker compared to Southern Europe. - Sufficient degree of fiscal federalism: ~ Fiscal payments from healthy economies to economies that are adversely hit by shocks. ~ Not much compared to e.g. transfers between US regions. ~ Even more required as SGP limits national fiscal policy options to stabilize the economy. ~ Closer political union required (also as counterpart of the currently powerful ECB, and to credibly enforce the Stability and Growth Pact). 25 th March 2011: European Stability Mechanism: ~ Permanent facility as of mid 2013. ~ Capacity of about 500 billion. ~ Not backed by government guarantees. ~ Instead, it attracts capital itself (like a bank). ~ Fines resulting from the SGP are deposited in the fund. ~ Interest rates similar to rates charged by the IMF. ~ ESM bonds senior to common government bonds. Chapter 21: The global capital market: performance and policy problems Comparative advantage of international trade: with a finite amount of resources (K, L, ) and time, the country produces what it is most productive at specialization Policy trilemma: a country can have only two out of these three: - Fixed exchange rate. - Monetary policy autonomy. - Free international capital flows (capital mobility). end of BWS: giving up fixed exchange rate allowed for more international capital mobility. Offshore banking: banking outside the boundaries of the home country. Eurocurrencies: deposits in a currency other than that of the country in which the bank is located. E.g. dollar deposits in Japan = Eurodollars. Instruments of regulation: - Deposit insurance: to avoid bank runs. The danger is that it stimulates moral hazard behavior. - Reserve requirements: compulsory bank deposits at the central bank. - Capital requirements and asset restrictions: ~ Minimum required level of bank capital (asset liabilities = equity). ~ Maximum amount of (very) risky assets a bank may hold. ~ Not too much of one asset. - Bank examination: check if regulations are followed. - Lender of last resort facilities: ~ Central bank can lend to banks in trouble by creating currency. ~ Decreases risk of confidence crisis. ~ Also here risk of moral hazard behavior by banks. 15
Difficulties in regulating international banking: - Effectively no deposit insurance (too high amounts). - No reserve requirements on foreign currency holdings. - Bank examination is more difficult internationally national regulators are less strict towards foreign subsidiaries (which regulator is responsible?). - Financial stability is difficult to assess due to new, complicated financial assets (e.g. securitized assets: combined assets with different risk characteristics). - No international lender of last resort. international coordination is crucial! Performance measures of international capital markets: - Extend of international portfolio diversification: foreign assets held by US residents as % of US capital stock has increased, foreign claims on US residents as % of US capital stock has increased. - Extend of intertemporal trade: ~ If capital can move freely, there should be no strong correlation between S and I (countries with CA surplus have S > I). ~ However, factors that generate a high saving rate may also generate a high investment rate (rapid output growth) and governments tried to enact policies to avoid large CA imbalances. - Onshore-offshore interest differentials: no big differences in interest rates on onshore and offshore assets in the same currency. - Efficiency of the foreign exchange market: ~ Interest parity:. If we replace the expected exchange rate by the actual exchange rate at t+1, it turns out that R R* fails to predict large swings in actual exchange rates (even the direction of the change). The error of prediction can be partly predicted using past information. ~ Modeling risk premium: if assets denominated in different currencies are imperfect substitutes, then. The risk premiums may vary over time. ~ The best prediction of tomorrow s exchange rate appears to be today s exchange rate, regardless of economic variables (e.g. money supply, government deficit, output). But over longer time horizons (>1 year), economic variables do better at predicting exchange rates. Topical: Aging, pensions and the international capital market Pay-As-You-Go pensions: The old-age dependency ratio (#retired/#working) depends on: - Population growth. - Life expectancy. - Retirement age. - Value of assets has decreased due to the financial crisis. 16
- Lower r and higher life expectancy higher PV of liabilities lower coverage ratio. Typically, a larger PAYG-scheme implies lower savings Aging in a small open economy: - Interest rate r is determined on the world capital market. - If expected aging increases savings increase net exports (CA > 0). - Excess savings invested abroad (S > I): net foreign asset holdings increase, no effect on r. - When retired: foreign assets used to finance higher imports: ~ The aging economy has become a rentier economy. ~ Helps to cushion the negative effects of aging. - If many countries are aging at the same time, the assumption of constant interest rates does not hold. Aging in a closed economy: - Capital deepening : lower L increases K/L. - Capital thickening : higher savings increase K/L. wages increase, interest rates decrease. danger of dynamic inefficiency (interest rate becomes too low): r < growth of effective labor supply. Aging in an intermediate case: open economies with a common capital market - Free capital mobility. - Large enough to affect each other through changes in K/L, r etc. - If initially r < r world, an outflow of capital occurs until r = r world. Capital owners benefit (higher r), but wages decrease (outflow of capital), so workers are worse off. The net effect of open capital markets depends on the initial situation. 17
As a result of aging, the interest rate is expected to decrease and the wages to increase. Investing a larger part of pension savings in the home country does not help. Merely relying on (more) capital is a risky strategy, it should be accompanied by strengthening human capital: labor market policies that increase the labor force. Chapter 22: Developing countries: growth, crisis and reform Standard theory: - Growth model (e.g. Solow): ~ Convergence: economies that start off poor will grow faster than those that start off rich (catch up). ~ Steady state is determined by the saving rate, population growth and labor efficiency. - If trade is free, capital is mobile, knowledge can move: ~ Absolute convergence: all to the same steady state. ~ Relative convergence: each country to its own steady state. In theory, there is no reason for large differences in per-capita income to persist. Geography theory: - Geography, climate and ecology of a society shape both technology and incentives of inhabitants. - Determinant of work effort. - Technology is available to a society, especially agriculture. - Burden of infectious diseases. Institutions theory: - Institutions are the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction (the system). - Institutions hypothesis: countries with good institutions encourage investment etc. They structure incentives in human exchange (whether political, social or economic) to create order and reduce uncertainty. - Institutions will determine the extent of: ~ Good enforcement of property rights. ~ Constraining elites, politicians and other powerful groups. ~ Sufficiently equal opportunities for broad segments of society. - Causality could also be the other way around; richer countries can spend more on policy protection, judicial system etc. Possibility: geography income institutions. Features of developing countries: - Direct government control on the economy. - Expansionary monetary policy high inflation. - Weak financial institutions. - Heavily managed/pegged exchange rates and capital controls. - Exports depend heavily on agriculture and natural resources. - Much corruption. - Low national savings. - Potentially high investment opportunities: 18
~ CA = S I < 0: capital inflow. ~ Debt accumulation (intertemporal trade). ~ Only good if loans are made for profitable investments, not for e.g. consumption. The problem of default: initially, there is a CA deficit, so borrowing from abroad. - Debt crisis loss in confidence no new loans, demand of full repayment of short-term loans ( sudden stop ) = financial outflow CA surplus required: S I > 0 depresses output. - Pay with foreign reserves balance of payment crisis if exchange rate is fixed fear of depreciation/devaluation makes depositors want to withdraw funds or change into foreign currency bank crisis. The problem of original sin : - Rich countries: can borrow in terms of their own currency. - Poor countries: most debts are denominated in terms of foreign currencies advantage for rich countries. A depreciation of the own currency raises the value of net foreign debt in terms of domestic currency. Guest lecture: Global Financial Architecture 19