International Trade and International Finance - Essay Example

International Trade and International Finance Contents Answer Critical evaluation of Keynes’s critique 3 Answer 2) Criteria for optimum currency area and possibility of Asian Union 6 2.1) Introduction to optimum currency area theory 6 2.2) Different views on optimum currency area theory 7 2.3) Criteria for optimum currency area 9 2.4) Summary of benefits and costs of a currency union 10 2.5) Discussions of an Asian Union 11 2.6) Possibilities of smaller union such as East Asia, Central Asia and ASEAN 11 References 12 Answer 1) Critical evaluation of Keynes’s critique Great English Economist, John Maynard Keynes published a book named ‘The general theory of interest, employment and money’ in the year 1936 that brought about a revolution in the world of economics which is popularly known as the ‘Keynesian Revolution’. The theory was a cornerstone that challenged the principal concepts of classical economic theories. Some of the concepts that are discussed in this theory are the multiplier, consumption function, the marginal efficiency of capital, the principle of liquidity preference and effective demand (The Royal Economic Society, 2013). Keynes argued that for about two centuries, practical men and economic theorists have believed that there are irregular advantages to a country in favourable of balance of trade position and conversely unavoidable danger at times of unfavourable balance of trades. He further argued that modern economists are of the belief that a balance of trade from the intercontinental separation of labour is sufficient to prevail over such advantages as claimed by the mercantilist practitioners (Caldwell, 1998). To illustrate his views, Keynes cited the example of Marshall. In the similar means, the hypothetical concessions on which the liberal trade economists’ have been set to make in current controversies. In present global international trading the encouragement of new-born industries are not troubled with the bona fide essence of the mercantilist case. This also applies to or to the development of the terms of trade between nations. When Keynes’s argument is reviewed with references to balance of trade and other fiscal controversies it would be found that historically no special consideration was ever endorsed by economists to the claim that fortification of international trade or closing the economy may increase domestic employment (Michael, 2003). In present international trading economy, the process of globalisation is the key to growth and development. Globalisation not only facilitates efficient sharing of materials and resources but it also creates employment opportunities. When a nation is mounting on capital resources abruptly and very rapidly, then the additional progress of such satisfied nation’s state of affairs is accountable to be intermittent. In present international trade conditions, the phenomenon of laissez-faire may be noticed that leads to lack of the incentive to attract new investments (Lawlor, 2006). On the basis of political and social environment, the general characteristic of a nation which determines its propensity to consume (in regards to the betterment of a progressive state) fundamentally depends on the adequacy of such incentives. In context of contemporary global trades and culture, one can relate Keynes argument by highlighting the conditions for successful foreign investment (Sheehan, 2009). In such case it may be established that either in domicile outlay or in foreign investment can make up aggregate investment. It may also be noted that by the term ‘investment’, Keynes not only referred to monetary resources but it also includes access to precious metals, human capital, natural resources, and so on which have tangible economic value and benefits. A critical analysis of Keynes’ critique reveals that in conditions where the magnitude of aggregate investment is ascertained by the underlying principle of profit maximisation alone, the prospective for domestic investment will mainly be governed by factors like the domestic rate of interest in the in the long run as well as short run. In contrast, the volume of overseas investment is essentially ascertained primarily with the size of balance of trade in favour of investing nation (Tily, 2007). Hence, in a culture where there is limited enquiry of direct foreign investment under the guidance of government or public authority, the economic substances with which it is rational for the government are to be thoughtful about the fluctuations in the balance of foreign trade in contemporary environment and prevailing domestic rate of interest (Magnusson, 2002). Let us consider in present system of international trades that the unit wage is fairly steady and it is not affected by the impulsive changes of considerable scale (such conditions are almost always satisfied in practice). If the condition of liquidity preference is also rather constant (that is usually taken as the mean of its short periodic fluctuations), then the rate of interest will be inclined to be influenced by the number of the valuable resources measured in terms of the unit wage under consideration (Phillipson, 2010). If the banking conventions are also stable they can be used to persuade the community’s longing for liquidity. At the same time, in present system of international trade where substantial overseas loans and the absolute possession of prosperity is situated in foreign land, decreases and increases in the amount of the precious resources will mainly depend on whether the position of balance of trade is unfavourable or favourable (Dequech, 2003). Thus in contemporary system of internal trade and commerce, an obsession on the part of the government authorities with a constructive balance of trade serves the purposes of the theory under discussion. Furthermore, the influence of government policies also provides means of promoting international trades between nations (Davidson, 2006). At a point in time when the government authorities virtually had no direct influence over the managing domestic rate of interest (or any other incentives that will encourage investments), methods to boost the positive balance of trade was the sole and direct way at their disposal for growing foreign investment. According to Keynes, the effects of a constructive balance of trade on the arrival of the valuable resources was the only meandering way of plummeting the domestic rate of interest and hence inducement to domestic investments. However, in present environment it does not pursue from this argument that the highest degree of restriction on net imports will actually promote complimentary balance of trade positions (Hayes, 2006). In the past, mercantilists put great importance on this factor and they were frequently found to be contrasting the concept of trade restrictions because in the long run point of view such restrictions were liable to function unfavourably to a balance of trade position of a country. For this reason the economists must not arrive at an impulsive conclusion as to the practical guidelines to which this argument has led up. There are also some strong conjectures of a universal characteristic alongside trade restrictions except when they can be warranted on extraordinary grounds (Hayes, 2006). At the core of the mercantilism is the view that the best route for increasing national prosperity is to increase the amount of goods exported. Mercantilism can also be referred to as “bullionism” and is based on the idea that the true measure of the wealth of a particular country is the amount of gold that is held by the country. What this referred to is that if one country had a greater resource of the precious metal as compared to another country, then the former was in a better position than the later. The impact of the idea was also felt on the economic policy and had important consequences on the economic policy followed by a country (The economist, 2013). It was implied by the policy that the best way to ensure prosperity of a country was to make as much exports and to make as few imports as possible. This would help in generating a net inflow of foreign exchange and help in maximisation of the amount of gold that was held in stocks by the country. There was a time in the history when this particular doctrine was upheld by many countries. The economic theory by Keynes also supports the Mercantilist doctrine in his writing. The reason behind Keynes affinity towards Mercantilism arises from the fact that Keynes shared the concern about full employment along with the mercantilists. Keynes approval is found while quoting mercantilists and noting the fact that an adequate supply of the precious metal is important for maintaining low interest rate in the domestic affairs of a country. This would in turn help in the adequate use of resources within the country (Keynes, 1936). Mercantilist contributions can be seen as the basis for the Keynesian theory of under consumption – that is a situation where the consumer demand is inadequate leading to recession as its consequence. According to Keynes it was equally important to encourage and production as well as consumption at the same point of time. It was noted by Keynes that focus on the supply of bullions by mercantilists in the early modern period was important. It was noted by Keynes that in an era before paper money was widely used as a mode of currency, increase in bullion reserves was important to increase the supply of money and thus keep the interest rates in check. It was possible according to Keynes to increase both domestic and foreign investments by following mercantilist policies. Domestic investment was boosted by the lowering of the domestic interest rate and foreign investment was boosted by a favourable balance of trade. Balance of payment was an important concern for Keynes. Government intervention in the economy was also supported by Keynes and according to him government intervention in the economy was necessary. It was however argued by economists in the later period that the role of the government in the economy should be restricted. Most of the rich countries in today’s world are committed to free market in today’s context. The theories which Keynes’ have examined are directed in essence to the component of efficient demand and supply conditions. It depends on the adequacy of the encouragement to foreign investment. It is not a new concept and it also describes the ills of job loss or unemployment. The insufficiency of the other constituent is the satisfying the condition of tendency to consume (Hayes, 2006). But such substitute explanation provided by Keynes played a much smaller part during the 16th and 17th century philosophy that has only been grouped in reasonably modern times. It may be criticised that for the noticeable unconcern with which the public authorities accept the foreseeable consequence of international monetary system, such policies has relative strength and national advantage of generating employment and creating favourable balance of trade. But it may also be argued that their intellectual pragmatism is much more preferable to the perplexed philosophies of contemporary advocates who believe that it is exactly these policies which will promote peace in the best interest of the nation (Studart, 2002). Generally, it is the guiding principle of unimpeded by international preoccupations, independent rate of interest, and a prudent nationwide foreign investment programme that facilitates and directs a nation towards an optimum level of household employment. This is the main reason as to why countries in contemporary markets strategize their policies focusing on domestic employment, increased international trades and restoration of overall economic health. Answer 2) Criteria for optimum currency area and possibility of Asian Union 2.1) Introduction to optimum currency area theory The theory of optimum currency area (also known as OCA) is a theoretical concept in economics that was formulated by Robert Mundell who is the professor at Columbia University, New York. Mundell received Nobel Prize for his theory on international economics. According to this theory there are certain criteria for economies to unite and the OCA theory describes the optimum features for union of economies, creation of new currency, or merger of existing currencies. Hence many scholars hold the view that this theory can be used to debate whether or not a certain geographic region is ready to undertake currency union and complete full economic integration. When one considers this theory, the rationale behind inception of Euro can be cited as an example. The first assumption of this theory is that optimal currency area or union currency is larger than the currency of individual country (Hayes, 2006). To elaborate, member countries of European Union do not form major optimal currencies area. However, the Europe as a whole is optimal currency area in contemporary business environment. But, theoretically a small country could also become optimal currency area. This theory aims to explore the costs and benefits as well as the criteria for forming common currency area. This theory also helps to determine the optimum exchange rate regime for unified economic models. 2.2) Different views on optimum currency area theory The theory on optimum currency has been a highly debated research topic and also very controversial topic. The usefulness of the topic has been reviewed and argued by many researchers. According to the views of Krugman (1993, p.18), when international monetary policies are concerned then the theory of OCA is quiet arguable. Most of his views were based on long standing debate about demerits and merits of floating exchange rate and fixed exchange rates. Figure 1: Krugmans Specialisation Effect (De Grauwe, 1992) In contrast, Cesarano (2006) highlighted that during late 1950’s most of the laureates anticipated the fundamental tenets of optimum currency area theory. His views are based on the analysis of the efficiency of inter-regional alteration within countries. The authors during 1940’s and 1950’s mainly portrayed the attention of the readers towards the vital role played by distinct, central economic and monetary authorities and also the liberated movement of goods, services and factors of manufacturing as among the main features of regions in economic adjustment and currency unification. According to the traditional authors, their views are based on the classical adjustment system that would be valuable in present markets if the exchange rate variations among national and separate economic currencies are absent. In other words, Cesarano (2006) argues that traditional authors concentrated on the free movement of capital, labour, goods and services in a single economic policy would cancel out the requirements for variations of exchange rates. The rational annexure of this argument of reasoning is that a distinct currency would not be optimal for unified global financial system. According to Friedman (1953), the foundations for floating exchange rates were based on three major arguments. Firstly, in concept of the sticky wages and prices that differentiate the actual world, a structure of flexible or floating exchange rates would comprise of an equilibrium arrangement in which the market forces will act involuntarily to create an exterior balance while preventing the BOP (that is, balance of payments) crises. Friedman also believed that an intrinsic feature of floating but regulating rates can affect wages and prices of goods as it is a costly and lengthy process. Secondly, the floating exchange rates would offer autonomy for economic policies that will mainly aim at protecting every member country from being contaminated or influenced by the fiscal mistakes of the other members participating in creating common currency. Thirdly, a structure of floating exchange rates would be favourable to the elimination of intended regulations on the movement of capital and goods among countries. This theory is thus very important for understanding the reasons behind promotion multilateral trade and commerce in contemporary economic scenarios. In reference to Friedman’s views discussed above, Mundell (1961) emphasised on the mobility factor (specially mobility of labour) and argued that if the regime of exchange rate within a particular region causes unemployment in any part of the unified economic region, or if joblessness forces another parts of the same area to admit to inflation then this regime will not be optimal due to the exacerbation of unemployment. After a few years Kenen (1969) agreed with Mundell (1961) and further deepened the concepts of mobility factors. His studies pointed out that when areas are defined by their specific roles and activities but not on the basis of political or geographical influences then an ideal inter-regional mobility (in terms of labour) would require a perfect professional mobility. This assumption can only come about in real world when labour or employment is homogenous (Davidson, 2002). But in real world it is often found that quite a lot of areas belonging to a distinct currency area demonstrate very dissimilar as well as similar skill requirements. According to views of Barro, Tenreyero and Alesina (2002), the costs of foregoing financial independence is depends on the higher level association of shocks between countries representing a single currency. However, the findings of Melitz (1991) highlight that if economies are confronted with indistinguishable shocks then they might require dissimilar policies to respond to such shocks. His views are appreciated due to the inherent structural differences between different countries and their primary economic positions. Figure 2: Openness, OCA and Income Correlation (De Grauwe, 1992) The views of Reinhart and Calvo (2002) represented an incredible concept that was afterwards renamed as the “fear of floating”. The arguments of both the authors others emphasised that if an economy is not capable of using their economic policies effectively then the loss of financial policy will be at a considerable cost. 2.3) Criteria for optimum currency area The theory on optimum currency area was published by Mundell in the year 1961 which received Nobel Prize. The theory states that asymmetric shocks are measured to weaken the real economy and if they are very important and cannot be regulated then a regime of flexible exchange rates would be an ideal consideration. This is because the international economic policy on interest rates will not be adjusted for such meticulous state of affairs of each constituent area. Theoretically, there are four major criteria for successful optimum currency area which are discussed as follows. Mobility of labours across regions – According to Mundell, this mainly includes the material ability of human resources to travel into other areas (by using dependent resources like workers rights, visas, etc.). The free flow of labour mobility will be facilitated by lack of cultural barriers (such as diverse languages can be a hindrance to free mobility) and other institutional arrangements (like the facility to have transfer pensions throughout the region under consideration). Openness with price, wage and capital mobility across the region – The market forces of demand and supply automatically allocate monetary and material resources to required locations as and when they are needed. However, in real world this does not work flawlessly as there is no concept like real wage elasticity. Risk sharing system – Such system provides an automatic financial transfer method to reallocate monetary resources to areas or regions which have been affected unfavourably by the first two features discussed earlier. This criterion usually considers the taxation policies for redeployment of resources to less urbanized areas of a region or country. Member countries that have comparable business cycles – The basic condition for this criterion is that if one country experiencing recession or boom, then the other countries in the unified model should also follow the same trends. This will allow the common central banking authority to encourage growth during recession and to control inflation during boom periods of business cycle. Should the economies within a unified currency encompass distinctive business cycles, then monetary policy will not be optimal and diverge unfavourably in regards to union participants. This could damage the very objective of unified currency and make economic conditions of members even worse. 2.4) Summary of benefits and costs of a currency union Costs of currency union Transaction cost – There is a cost associated with currency union in the form of transaction cost. For example, the conversion of British pounds into Euro or exchange rate between different currencies. It is basically the cost of conversion from one currency into another. Exchange rate risk – In real world scenario, the exchange rates are determined by many economic factors like fiscal deficit, balance of trade, inflation levels prevailing between countries and so on. Elimination of exchange rate fluctuations is not possible in open economies. Any unfavourable conditions will bear intrinsic costs associated with exchange rate mechanism. Transparency – Prices of goods and services can be easily compared with a stable foreign currency. But, in case of European countries it has been observed that prices of cars in UK are higher than individual countries. External shocks – A unified currency entails a single rate of interest unless there are external barriers to the free movement of currency under differential tax regimes. This is mainly because of different economic structures creating asymmetric effects. Benefits of currency union Coordination of economic policies – The economic policies of member countries are established after considering mutual benefits. This creates stability in macro-economic environment. Financial stability – As no single member can influence interest rates, unified currency will ensure financial stability in the long run. Certainty in investments – When currency is unified, economies will be in a better position to formulate import-export policies leading to predictable foreign investments (Yuen, 2001). 2.5) Discussions of an Asian Union Most of the academic researches on the topic of Asian Union concurs that the conditions of optimal currency area appear to be met by subsets of Asian countries (Hefeker and Nabor, 2005). However, it may be pointed out that the eventual accomplishment of an Asian currency union pivots on factors like their sturdiness of institutional set-ups, political and historical backgrounds, amount of local union in formulating developmental stages, and so on (Huang and Guo, 2006). There is also a suitable anxiety of whether the conversion toward Asian union could be vulnerable to provisional currency attacks (Mckinnon, 2000). 2.6) Possibilities of smaller union such as East Asia, Central Asia and ASEAN The possibilities of smaller union will be successful if the member countries’ overall objective is focused on accelerating social progress, economic growth and socio-cultural development (Ogawa and Shimizu, 2006). Protection of individual stability could affect regional peace unfavourably and eliminate opportunities for associate countries of smaller union such as East Asia, Central Asia and ASEAN to their resolve differences peacefully (Zhang, Sato and McAleer, 2004). References Alesina A., R. Barro and S. Tenreyero, 2002. Optimal currency areas, NBER Working Paper, No. 9072. Caldwell, B., 1998.  Why Didnt Hayek Review Keyness General Theory.  History of Political Economy 1(4), pp. 545–569. Calvo, G. and C. Reinhart, 2002. Fear of Floating. 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