Lecture Notes International Economics for E&BE

Deze aantekeningen zijn gebaseerd op het vak International Economics van het jaar 2015-2016.



Lecture 1

The lecturer started with mentioning the difference between International Economics and International Business:

  • Objective International Economics: to explain how international economic interactions influence the allocation of scarce resources, both within and between nations. This objective takes a macro prospective of the economy.

  • Objective International Business: analyze managerial decisions taken on the basis of a cost-benefit analysis in the global economic environment. This objective takes a micro prospective of the economy.

The remaining part of the lecture was about chapters 1.4-1.8 and 3.1-3.3. The first part of the lecture a few facts about the world economy were mentioned, then in the second part the topics of globalization and economic efficiency were addressed and the last part was about competitive advantages.

A few facts about the world economy

From the second wave of economic prosperity which began in 1950, real GDP per capita doubled, which means that we are twice as rich as two generations ago, world production quadrupled, the world trade multiplied 18-fold, and world FDI multiplied 25-fold. At the same time globalization took place. We distinguish five types of globalization:

  • Cultural globalization

  • Economic globalization

  • Geographical globalization

  • Institutional globalization

  • Political globalization

The most important type of globalization is the economic globalization. The economy globalized due to the rapid increase in cross-border flows of goods, services, capital, and technology. Two factors used as an indication of the level of globalization are the level of trade liberalization and technological developments. Trade liberalization is often voluntary, but also many countries are forced. For example, Greece liberalizes it's economy in order to get loans from the ECB.

Globalization does not only entail positive effects, the negative outcomes of globalization are called disruptive effects. Because of the negative effects of globalization also anti-globalization activists exist. Examples of important disruptive effects are the MNEs that are so large that they can adapt policies to their own preferences, the widening income gap between the rich and the poor, low wages and bad working conditions in developing countries and the destruction of local markets by greater firms. The book mainly discusses the opportunities globalization is bringing, but the downsides, the disruptive effects, should not be ignored. However, the gains outweigh the losses and the comment of the lecturer was that we should strive to stay international, after an international period often a collapse happens, an example is the Second World War. Therefore, effort should be put in staying international.

Globalization and economic efficiency

It has become much easier to locate different activities around different part of the world, therefore also price effectiveness has increased. There exists a global price for goods, countries that have an equilibrium price under the global price will export the good and gain producer surplus. Countries that have an equilibrium price above the global price will become an importer of the good and gain consumer surplus. By trading both countries' welfare are maximized. Still, this equilibrium can be disturbed by the appearance of tariffs, transport costs, or any other barrier to trade. When this is the case, a price wedge appears between the prices of the good in the two countries and global welfare will be decreased. Tariff do have a function, Japan has for example a tariff because of disruptive effects, without tariffs, a lot of Japanese farmers would be out of competition. Consumers would win, but farmers would lose. Lastly, an important rule is that the volume of trade must always be such that exports equals imports.

Globalization is partly determined by:

  1. Changes in supply and demand (with a constant price wedge)

  2. Changes in the size of the price wedge (with constant demand and supply)

  3. A combination of 1. and 2.

In the following point the possible changes on the international market are outlined:

  • As the prize wedge increases, holding demand and supply constant, global trade will decrease. Also the opposite holds true. This is logic because if trade liberalization increases global trade then when the economy becomes less open due to tariffs then the global trade must decrease. Since global trade is positively related to globalization an increasing price wedge is thus anti-globalization. An example is the increase in protectionism of government during the Second World war and the decrease in global trade and welfare. Now markets are opened again and also welfare has increased.

  • Demand in the importing country rises with constant price wedge. In this situation there will be excess demand in the world market and as a result the price will increase. The price wedge will shift along the XS curve to the right. As long as demand exceeds supply the volume of trade and the country prices will increase. (pro-globalization)

  • Demand in the exporting country rises with a constant price wedge. Also in this case the world market experiences excess demand which leads to an increase in price. The price wedge will shift along the MD curve to the left and the prices in both countries rise. However, the volume of trade falls because when demand in the exporting country rises, less of the good will be available for export.(anti-globalization)

  • Supply in the exporting country rises with a constant price wedge. In this situation the world market experiences an excess supply which will lead to a fall in the price of the concerning good. When the market moves to it's new equilibrium, the price wedge shifts along the MD curve to the right. Now, the volume of trade will increase because more is available for export. (pro-globalization)

  • Supply in the exporting country falls with a constant price wedge. Th market will face an excess demand due to the fall in supply, this will lead to a rise in the price of the good. The price wedge will shift along the MD curve to the left. The volume of trade will decrease, again because less will be available for export in the exporting country. (anti-globalization)

  • Supply and demand both increase proportionally in the exporting country. In this situation there will be no change in the trade in the world market because no excess supply or demand will exist, the amount of the product available for export will be the same. Only the exporting country will be affected, here an increase in the amount produced for the home market will increase. (globalization neutral)

The easiest way to go about these changes is to first draw the changes in the importing or exporting graph and translate these changes into the world market.

The gains from specializing: comparative advantage

The theory on comparative advantage is discovered by David Ricardo. He found that differences in labour productivity motivate international trade. A country that has a higher productivity for making a specific product relative to another country can produce it at lower opportunity cost. There exist several simplifying assumptions for this theory:

  • There is one factor of production: labour

  • Labour is mobile within countries, but not across countries

  • The wage rate is the same across sectors within countries, but may be different between countries.

  • Markets are characterized by perfect competition and constant returns to scale.

Example of an situation in which a comparative advantage will motivate international trade:





 

Cheese

Chocolate

Opportunity cost for cheese

Opportunity cost for chocolate

The Netherlands

10

6

6/10=0,6

10/6=1,67

Belgium

2

3

3/2=1,5

2/3=0,67

The values given in the table are labour productivity, the units of output per hour, for producing the concerning good. As can be seen from the table The Netherlands have an absolute advantage for producing both goods. However, The Netherlands have a lower opportunity cost for cheese and Belgium for chocolate. Also, the relative cost advantage of The Netherlands will be greater for cheese and the relative cost disadvantage will be less for producing chocolate. Thus, both countries will be better off producing the product for which they have a comparative advantage and will profit from relocating their labour units to this product.

Even though both countries as a whole will gain, individual firms might not. Because of their absolute advantage both the Dutch cheese and chocolate producers want to produce more and export their products. However, the two sectors cannot expand at the same time because of limited supply of labour. The firms with the greatest cost advantage have the greatest incentives en resources to bid up wages and will win the competition for employees. In our case this will be the Dutch cheese industry, the Dutch chocolate industry will lose. The opposite applies for Belgium. Here, chocolate producers will win and cheese producers will lose. Concluding, also on firm level the comparative advantage determines which country will produce and trade what product.

Lecture 2

Last week the theory on comparative advantage from differences in productivity by David Ricardo was discussed. This lecture an alternative model to explain why countries trade with each other is introduced. In this theory, trade is explained by differences in factor endowments. In the second part of lecture was about intra-industry trade, why countries trade the same product with each other. The literature discussed in this lecture is from the chapters 3.4 to 4.3.

The gains from specializing: comparative advantage

Eli Hecksecher and Bertil Ohlin have found a second theory on comparative advantage. According to them, differences in factor endowments motivate international trade. These factor endowments are capital and labour.

The theory is as following. Cooperations of course want to produce their goods at the lowest cost possible. For this theory is assumed that capital and labour are the only production factors. Production is then optimized by producing a quantity of a good at the lowest cost combination of capital and labour. This optimal combination is different for different countries for the same product. This is the case because some countries have cheaper labour and are labour abundant, while others have cheaper capital and are capital abundant.

A situation in which the importance of relative prices of production factors becomes clear, is a price increase in a labour intensive good. When the price of labour intensive product rises relatively the price of labour rises too. The relative wage line, the isocost line, is going to become steeper. Companies will make more use of capital because the production factors are substituted toward the relatively more intensive application of the relatively cheaper factor. This price increase in labour will not only affect the labour intensive goods, but also the capital intensive good. Also for this product the costs of wage will rise and the company will make more use of capital in order to remain having the cheapest combination of the production factors. As the country replaces labour by capital and becomes more capital abundant the relative price of the labor intensive good will be higher.

However, this is not all. The relative price of an labour intensive good is positively related to the relative wage w/r. Labour abundant countries will thus have a low relative price of the labour intensive good and capital abundant countries will have a high relative price of the labour intensive good. In the same way, capital abundant countries will have a low relative price of the capital intensive good and labour abundant countries will have high relative prices for these products.

This price advantage both countries experience in comparison to each other will provide incentive to export the goods for which the countries have an comparative advantage and import the products for which the countries have no comparative advantage. This trade between the two countries will lead to a equalization of the relative price of the products and to a equalization of the factor prices, international wages and interest rates, the price of capital, have moved closer together.

From last week we have all kinds of trade barriers, with these barriers the equalization will not happen. Instead, again there will be a wedge. Even though convergence will still happen, this wedge will prevent product prices and factor prices from becoming completely equally.

This theory explains international trade by the different factor endowments countries have. When the economy is open, countries will specialize in the industry for which they experience a factor endowment, labour or capital, and export to the countries that have a factor endowment in the other production factor.

Understanding intra-industry trade

Indra-industry trade occurs when two countries import ánd export goods from the same industry with each other. This happens especially a lot within regions. For example 34,5% of manufactured goods in Europe is traded within Europe. This goes again the classic theories of trade which state that a counties will export only the products for which it has a comparative advantage and import only the products for which it has a comparative disadvantage.

We can use a model with a monopolist market to explain why intra-industry trade is taking place. A monopolist will produce a quantity at which its revenues are maximized, this will be where marginal cost equal marginal revenues. We assume that there exists an identical monopolist in a foreign county. When the economy opens this foreign monopolist will seek to make a profit in home's market. For this firm the part of the market that the home monopolist already has captured can be ignored, we can assume that the amount of the market the home monopolist has taken will not change. The foreign monopolist will only look at the remaining part of the market and enter the particular home market when the price is higher than the average cost. For the remaining part of the market the foreign monopolist will again determine the quantity at which it's profits are maximized by exporting a quantity at which its marginal costs equal its marginal revenues. Because the two monopolists are identical, the same opportunity to export will be available for the home monopolist and both monopolists will have some extra revenues from exporting.

The decision to the foreign monopolist to enter the market will have consequences for the home monopolist. As a result of the extra supply the price will fall, and thus also the revenues for the home monopolist. This fall in revenues is compromised to some extend due to the fact that cost per product will fall because a larger quantity is produced by both the monopolists that both start exporting to each other. Still, the losses due to a lower market price are higher than the gains because of an increase in scale. The monopolists will thus be worse of than before they started trading. However, this example does explain why countries engage in intra-industry trade. Even though the both monopolists have maximized their revenues in their home markets, they want to benefit from opportunities in the foreign country.

Lecture 3

The lecture started with a short video containing a recent talk from Barak Obama about the potential of the United Kingdom leaving the European union. In this case, United States would have to renegotiate free trade agreements with the United Kingdom. Obama advises to give up on this idea because of the limitations for trade it would create. The video was thus about trade agreements, a topic that will be discussed later during this lecture.

After this introduction, the lecturer gave a short review of the material from the previous week. The first part of this lecture build on this material from last week, just like monopolists can enter the market of a foreign country also firms in monopolistic competition can act like this. The second part of the lecture was about trade policies and who wins and who loses from these policies.

Trade due to market structure

In monopolistic competition, each firm produces unique variety and has therefore some market power. At the same time, the market is competitive because there are a lot of companies that can procure their own unique variety as a result free entry and exit in the market. You can think about different brands of cars. Just like for monopolists, the maximum revenue for firms in monopolistic competition is at the point where MR equals MC. When a firm makes a profit at this point, new firms will enter the market until there are no profits anymore.

If more firms are going to sell their unique variety on the same market, the demand curve for a firm is shifting inwards. At the same time demand for its product is becoming more elastic as the firm's product closer substitutes to other products. This happens when you allow for trade and foreign firms will enter the market. In this situation firms can also export their goods, the demand for their product increases again and the demand curve shifts outward. However, this only applies to the firms that are lucky enough to survive. Some firms will leave the market as a consequence of the increased competition when new firms enter the market.

Summarized, international trade in the case of monopolistic competition will lead to a higher level of output and lower prices. The consumer will benefit from more variety and a lower price. Lastly, since both countries are now trading similar goods with each other this situation is an explanation for intra-industry trade

Tariffs and similar trade impediments

In a situation where no tariffs, transportation costs or other barriers to trade exist between two countries, an equilibrium on the world market is characterized by the same price in these countries. This similarity in prices is caused by imports and exports between countries. As the countries start trading with each other both countries' welfare is maximized in equilibrium. The exporting country will benefit from a producer surplus and the importing country from a consumer surplus. The increase in world welfare is equal to the sum of this producer surplus and this consumer surplus.

When on the contrary tariffs, transport costs or any other barrier to trade does exist, there will be a price wedge between the two countries prices. The price in the exporting country falls, and the price in the importing country rises. The larger the price wedge is, the more the welfare in the countries falls. However, the tariff has a different effect on different parties. The consumers will face a loss in surplus as a result of a higher price, but producers will benefit from an increase in their surplus for the same reason. Because some of the consumer surplus is transferred to the producers, this part is actually domestically welfare neutral. The government that imposes a tariff will have tariff revenue at the expense of the exporting country, this will increase the welfare in the importing country. Also some part of the government surplus comes from the consumer surplus, this part is thus domestically welfare neutral too. The last effect is that due to the tariff deadweight losses will exist.

The net effect on the countries welfare is thus the gain in welfare from the government revenue minus the part of the loss of consumer surplus that is not transferred to either producers or the government, the deadweight losses. Depending on which effect is the largest, the countries welfare will increase or decrease after the tariff. Intuitively the effect on the exporting country will always be negative, also the exporting country will face a deadweight loss. The world welfare will fall by the sum of the deadweight losses in both countries. Applied to a real life case, when England indeed decides to step out of the European Union and starts imposing tariffs to European countries the welfare both the United Kingdom and the European Union will decrease.

Trade creation and trade diversion

An implication of the welfare analysis in the previous section is that for the world as a whole a decrease in tariffs is welfare-increasing. To find out whether a partial reduction of tariffs between a group of countries is also welfare increasing the following analysis was presented.

Let's say that there is a country that wants to import a specific good. The country can choose to import the good from country A and B, of which A is the cheapest alternative. Off course, the home country will now choose to import the good from country A. Now, suppose that a tariff is levied on imports from both countries. A will in this case still be the cheapest supplier. However, if the home country and country B decide to integrate and thus to abolish tariffs country B will become the cheapest alternative and goods will be imported from B. Prices decrease from A's price plus a tariff to B's price without a tariff.

This reduction in price wedge will increase the trade and this scenario is thus an example of trade creation. As this happens, the consumer surplus will increase because part of the government revenue will be transferred to the consumer surplus and because the deadweight losses due to the former less efficient production will decrease. This reduction of the deadweight losses represents the welfare gain due to trade creation. Simultaneously, because country B is not the cheapest producer also a trade diversion effect is present. As a consequence the remaining part of the former government revenue is lost to country B. This welfare loss is thus due to the trade diversion effect. Whether a partial reduction of tariffs between a group of countries is welfare increasing depends thus on which effect is larger, the trade creation effect or the trade diversion effect.

Even though trade barriers entail welfare losses for society there are some arguments for protection that take the distributional aspects of trade barriers into account.

  • Infant Industry Protection

  • Strategic behaviour on imperfect markets

  • Income distribution

  • Employment considerations

  • Source of government finance

  • Distribution mechanism

An argument against free trade is that producer and consumer surplus do not properly measure social costs and benefits. An example of such a social benefit is when a firm, for example, contributes to the environment. A tariff may in this case raise welfare if there is a marginal social benefit to the production of a good that cannot be captured by producer surplus measures.

Strategic interaction

On imperfect markets trade barriers can be a strategic policy. This is the case when a firm has high fixed cost and it has to produce at a large scale to make profits. When this firm will face competition this will lower the price of the product and the firm will make a loss. A classic example of this situation is the Boeing-Airbus case. Because governments still wanted Airbus to produce the airplane it gave Airbus a subsidy so that no matter if Boeing also would enter the market or not, Airbus would make a profit. However, it is likely that the US government will also provide Boeing with a subsidy wich will make both companies produce the airplane. The result will be a subsidy war with both firms producing. The taxpayers will have to pay for this subsidies. A strategic policy can be beneficial when there exist market failures such as R&D spillovers that benefit the society. When on the contrary the policy is in response to business interest with firms seeking government assistance to increase their profitability the argument is against a strategic trade policy.

Lecture 5

This fifth lecture of International Economics discussed the most important topics from chapter 2 and 6, which are trade and capital accounts, MNE strategies, the liability of foreignness, and finally, Porter's diamond and the OLI framework.

Trade and capital accounts

A country's balance of payments contains its payments to and its receipts from foreign countries. We distinguish three broad types of accounts:

  • Current account: imports and exports

  • Financial account: financial capital

  • Capital account: typically non-market, non-produced, or intangible assets like debt forgiveness, copyrights and trademarks

Remember the following equation: current account + capital account + financial account = 0. This equation holds because of the double entry of each payment on both the credit side and the debit side of the balance.

Recall that the national income for an open economy is determined by: Y = C+I+G+EX-IM

Now, since the current account (CA) is equal to EX-IM, by rearranging the equation we get CA= EX-IM = Y-(C+I=G). When a country exports more than it imports, net foreign wealth in form of reserves is increasing. At the same time, when a country exports less than it imports, its foreign wealth is decreasing.

In a closed economy saving must be equal to investment (S=I), but in a open economy can be saved either by building up its capital stock or by acquiring foreign wealth. In an open economy therefore S= I + CA applies.

However in the equation above we have not yet taken the fact that saving is composed of private and government saving T-G. From + (T-G) = I + CA we obtain CA = - I – (G-T).

MNE strategies

There are three different manners of entering a foreign market as a MNE with different characteristics:

Case 1: the exporting firm

  • Low transport that allow production to be take place in the home country while the firm still has a competitive advantage

  • A large home market in comparison to the foreign market

  • High plant level fixed costs discourage both decreasing the scale of production in the home country and setting up a new plant in the foreign country

In this case the home country produces all the goods and sells them also abroad by transporting the finished goods. This transporting of the goods involves transportation costs and therefore in the foreign country these costs must be added to the marginal costs: . Because only these marginal costs apply in the foreign country average costs are equal to marginal costs: . The optimal quantities sold are found by MR=MC. The profits are then equal to the difference between the demand curve and the average costs in the home country times the optimal quantity plus the difference between the demand curve and marginal costs plus transportation cost times the optimal quantity.

Case 2: Horizontal MNE

  • High transport costs that make exporting the good from the domestic country to the foreign country uncompetitive

  • High firm level fixed costs like R&D costs that can be spread over a multitude of foreign plants.

  • Low plant level fixed costs that allow duplication of the company's plant in many foreign locations with little loss of benefits from economies of scale

A horizontal MNE has production taking place both in the home and in the foreign country. Average costs in the home country reflect both firm level costs and plant level costs, but in the foreign country the average costs only consist of plant level costs as the headquarter of the company is in the home country. Profits are determined by adding up the profits in the home country and in the foreign country, in both cases the average costs must be subtracted from the demand curve and multiplied by the optimal quantity at MR=MC.

Case 3: Vertical MNE

  • Low transport costs that make shipping intermediate products and finished goods cost effective

  • Low disintegration costs that enable the company to match distinct production stages with specific locations.

  • Low plant level fixed costs that allow the company to split up the production in stages in different locations with little loss of benefits from economies of scale

A vertical MNE has all the production in the foreign country, to meet the home sales part of the production is transported to home country. The home country only faces firm level costs and the foreign country faces only plant level costs. Profits are in both countries equal to the difference of the price and the average costs times the optimal quantity at MR=MC.

The liability of foreignness

A firm operating in a foreign country will face a distance in areas such as culture, economics, and institutions. These differences imply additional costs for the firm operating in a foreign country, whether exporting, horizontal FDI, or vertical FDI. These costs are positively correlated with distance between countries. Furthermore, these extra operating costs for the home country make that this country faces a 'liability of foreignness'.

Four sources of liability of foreignness:

  1. Cost directly associated with spatial distance

  2. Unfamiliarity with and lock of roots in a foreign environment

  3. Host country environment (for instance lack of legitimacy of foreign firms)

  4. Home country environment (for instance restrictions in high technology sales to certain countries)

The four Hofstede dimensions of cultural distance:

  1. Power distance

  2. Uncertainty avoidance

  3. Individualism

  4. Masculinity

In order to compensate the lower profit due to the liability of foreignness, the MNE must offset them with superior inherent qualities the MNE possesses or from the MNE's ability to better adapt to and benefit from a country's characteristics.

Porter's diamond and the OLI framework

Dunning’s approach to assessing the conditions which determine how a firm goes multinational identifies three factors that form the OLI framework:

  • Ownership: capability to transfer the company specific knowledge and abilities

  • Location: country-specific characteristics

  • Internalization: the determinant of how the firm enters the foreign country, for example licensing or greenfield FDI

Porter questioned what country characteristics promote a firm’s international competitiveness and came up with four characteristics that together form the Porter diamond:

  • Factor conditions: characteristics of a country's available resources such as land, labor, and capital

  • Demand conditions: characteristics of a country's demand that influence expectations about product innovation and quality

  • Related and supporting industries: quality and quantity of the supply of and the demand for intermediate products in the same industry

  • Firm strategy, structure, and rivalry: the corporate culture, market structure, and legal institutions which influences how the firm organizes its business

However, these factors are not the only determinants, also the government policy plays an important role. The government can actively influence a country's factors by for example promoting education or funding R&D to make a country or a specific area more attractive for firms.

Lecture 6

See attached PDF

Lecture 7

This week’s lecture was about the material from chapter 10. The first topic was the international capital market and assessed capital markets and welfare if capital is mobile. On top of that also frictions for individual firs were discussed, which are about internal funding, asymmetric information and the wedge.

The international capital market

Capital markets

An economy faces diminishing returns of capital which is visually represented in a downward sloping line that becomes less steep as more capital is added. Total production will grow by MPK when one extra unit of capital is added. In equilibrium, the cost of capital is equal to the interest rate. The output of a country depends on the availability of capital, if the availability is low, output will as a result also be small. In this situation of low availability, the rental rate will be high. Furthermore, the part under the MPK line represents labour’s and capital’s share of national income. Above the interest rate is labour’s share and under the interest rate is capital’s share.

Now we have assessed the basics of capital markets, let’s assume the world consists of two countries; Home and Foreign. Initially capital mobility is not possible. In this case each country has a different level of capital, together these levels are the total amount available in the world. Since output depends on the level of capital the country with the lower level of capital (let’s assume this is the foreign country) will also have lower output. On top of that Foreign will also have a higher interest rate. Because of decreasing returns of capital, a one-unit increase in Foreign will entail a greater increase in output than in Home because Home has already a lot of capital.

If we allow for capital mobility, the higher interest rate in Foreign attracts capital from Home. As a result, capital will move from Home to Foreign, this process will continue until the interest rates are equal in Home and Foreign. However, these change cannot happen without changes in the output in the two countries, the output in Home decreases and the output in Foreign will increase. Because the added capital in Foreign increases Foreign’s output more than Home’s output decreases, there will be a net global gain. This gain reflects the fact that the relocation of capital has led to an overall rise in capital productivity, since productivity of capital was initially higher in Foreign. Aggregate production has gone up because of more efficient allocation of capital.

Welfare if capital is mobile

If there exist complete capital mobility exist between two countries, the equilibrium on world capital markets will have the same interest rate in both countries. In this equilibrium, international supply of funds equals the international demand for funds. In the country where the savings exceed the investments there will be a supply of funds and in the country where the investments exceed the savings there will be a demand for funds. When we consider only two countries this demand for funds must equal the supply for funds and represent the international capital flow on the world market. As a result of the relocation of funds, the interest rate will converge between the countries and increase in the capital exporting country. This will in turn result in a welfare gain for the lenders. At the same time the interest rate in the capital importing country will become lower, which creates a welfare gain for the borrowers. Notice the capital balance resembles the trade balance discussed in early chapters. Furthermore, if there doesn’t exist complete capital mobility for example because a country imposes a tax on capital from Foreign in Home, there will be a wedge between the rental rates in the two countries. This wedge will decrease the lender’s and the borrower’s welfare and also output will decrease as capital cannot be allocated in the most efficient way.

Frictions for individual firms

Internal funding, asymmetric information, and the wedge

Now we will take a look at a single company’s perspective. A company will use its own funds first because of the pecking theory. This theory states that the cost of financing increases with asymmetric information. A company will thus prefer internal funding, as it has perfect information about its own funds. After own funds, debt will be preferred and lastly a company will increase its equity. When two parties have asymmetrical information, in this case the borrower and the lender, there will exist a moral hazard. This moral hazard exists when the lender doesn’t know what the borrower is going to do with the borrowed money. Because of the risk that the borrower doesn’t use the money as the lender intended, the lender will demand a higher return. However, low-risk companies will not accept this high interest rate. Only firms that already had to pay a high interest rate because of their high risk will accept this high interest rate. As a consequence, adverse selection takes place.

When we make a graph of the demand and supply of investment funds the asymmetric information will be represented in this graph. The first part of the supply curve is namely flat, this part represents internal funding of which perfect information is available and a constant interest rate is demanded. The length of the flat line represents the amount of internal funds that are available. After this flat part the supply curve will slope upwards, the more asymmetric the information is the higher the return demanded. When a company undertakes screening and monitoring of its borrowers, the information will become less asymmetric and this is represented in the graph as a less steep upward sloping curve.

However, it is costly and difficult to gather information about your borrowers, because of imperfect markets it is not possible to obtain perfect information about your borrowers. Because of the increased cost, a company will demand a higher return to cover this costs. Again, adverse selection will take place. On top of that, because of the difficulty and the costliness of gathering information, the supplier of funds gains less than the borrower pays. This difference represents a wedge between the interest rate of which a particular amount of funds is demanded and supplied. The more information problems exist, the greater the wedge will be.

In this model, suppose capital mobility increases:

  • Firms have access to more funds, net worth increases

  • More suppliers at any r, the supply curve becomes less steep

  • The change in the wedge is not obvious

Suppose the capital market integrates

  • The change in net worth is not obvious

  • The change in the slope of the supply curve is not obvious

  • The wedge will become smaller as the difference between what the borrower pays and what the supplier receives decreases

Note that the world can be characterized by increasing capital mobility and so a greater supply of funds on a market without there being any increase in market integration. In this case the external supply of funds curve can shift right and become flatter without a decrease in the wedge. Similarly, the world can be characterized by increased capital market integration without any change to capital mobility. The supply curve remains the same, but the size of the wedge falls.

Lecture 8

This last lecture captured the material of chapter 11, in which chapter 9 and 10 are brought together. We analysed financial crises and how the effects of a financial crises affect firm’s and policy maker’s decision making.

Financial crises and firms

A financial crisis is the situation a county faces in which because of worsening of the problems associated with incomplete and asymmetric information the financial institutions no longer function effectively. As a result, they cannot channel funds to the most productive investment opportunities.

We distinguish five different causes of such a financial crisis:

  1. Increasing interest rates, which cause moral hazard and adverse selection.

  2. Rising uncertainty, which results again in increasing interest rates

  3. Falling asset prices, which lowers a firm’s net worth

  4. Deflation, which increases the real debt burden and reduces future cash flow, this will cause the net worth to fall

  5. Bank panics/runs, which increases the interest rate, lowers the availability of funds, increases uncertainty, and lowers a firm’s net worth

Last week we discussed the demand and supply of investment funds. Today we will discuss what happens on this market when a financial crisis occurs. The first thing that can happen is that the net worth declines. Because of this firms have less internal funding available. Secondly, also a fall in capital mobility can happen. This will make the supply curve for money steeper. On top of that a disruption of financial market integrating might occur, which results in a larger gap between the interest rate at which money is demanded and at which money is supplied. Lastly, the interest rate rises making it more expensive for firms to lend money and invest. Investment will as a result drop.

Perverse savings

Intuitively you would expect the supply of money to increase when the interest rate increases. However, this is not the case, people start again saving less when the interest becomes so high that they expect that the people who lend the money won’t be able to pay them back. This is represented in a backward bending supply curve in the money market. At a certain point the interest rate will become so high that people start saving more, the return will then be so high that even when a large amount of lenders doesn’t pay their money back, they still will make a profit. The supply curve will again move to the right.

As a consequence of this saving behaviour, the supply curve has three intersections with the demand curve instead of one. Because of this we can also divide the supply curve in three parts. The first part is the ‘normal’ part. With excess demand the interest rate will rise and with excess supply the interest rate will fall, point one is therefore a stable equilibrium. When we arrive at the backward bending ‘perverse’ part of the curve, with excess supply the interest rate will fall and thus move away from the second equilibrium. When the market faces an excess demand, the interest rate will rise and again move away from the equilibrium. Consequently, point two is an unstable equilibrium. The third part of the curve is normal again, with excess demand or supply, the market will move towards the third equilibrium. The economy will thus never end up in the second equilibrium, but always move towards the first or the third. When the economy ends up in the third equilibrium, with low savings and a very high interest rate it is very difficult to get out of the crisis and move towards the first equilibrium.

From a financial crisis the economy can also become in a currency crisis. This happens as follows. A financial crisis leads to deterioration in the overall characteristics of the financial market and institutions. This weakening will tend to lead to withdrawal of foreign funds, which in turn will place pressure on the government to abandon the fixed exchange rate. This will make depreciation more likely. When, as a result of this, private investors lose confidence in the fixed exchange rate, a self-fulfilling vicious circle of the currency crisis will start. People will start to put their money elsewhere and capital outflows will increase. This worsens the financial fragility, because when foreign funds decline, three possible causes of a financial crisis are present: increasing interest rates, rising uncertainty, and falling asset prices.

It is crucial for policy makers to know where the crisis has its origin. If the crisis started with a financial crisis they should improve the fundamentals in the economy. If, on the other hand, the crisis started with a currency crisis, the policy makers should strive to reduce international capital mobility.

The ongoing financial crisis

There are some main causes of a financial crisis. The first is that countries end up in a housing bubble with houses having prices that rise to quickly. Another cause is the financial innovation. Securities are created that are perceived to be safe but are exposed to risks that are neglected. The third cause is that policy makers and investors often think ‘it will be different this time’ when they see signs of a crisis. Finally, large imbalances between countries can contribute to a financial crisis.

engineering securities perceived to be safe but exposed to neglected risks (Gennaioli et al. 2012), and by helping banks and investment banks design structured products to exploit investors’ misunderstandings of financial markets (Henderson and Pearson 2011). Paul Volcker, former chairman of the Federal Reserve, claims that he can find very little evidence that the financial innovations in recent years have done anything to boost the economy.

The interest rate faced by the company exists because there is an opportunity cost, a risk free interest rate.

Capital mobility

Finally, the lecturer made some extra concluding remarks on capital mobility. The two largest benefits of capital mobility are improved allocation of savings and investment and improved risk-diversification. However, there also exist downsides of capital mobility. The first cost is loss of policy autonomy and the second is increased financial fragility. Broadly policy makers thus face a trade of between efficiency and stability. The ultimate question is how much risk should be borne by private investors and how much by the government

 

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