Summary of International Economics and Business.

Nations and Firms in the

Global Economy (Beugelsdijk, Brakman, Garretsen, Van Marrewijk)
Chapter 6
6.1 Information on transport costs
Recap: Core of international economics and business = goods and services are being
produced and/or sold outside a firms home country. The distance between home country
and there where products are produced and/or sold generates transport costs.

See Table 6.1 in the book, it shows the origin and destination composition of trade flows for
Europe as a whole between 1860 and 2009. Two conclusions can be drawn:

Shares of destination countries for exports and origin countries for imports are
quite stable over time. Furthermore, intra-European trade is dominant.

The intra-European trade explains that distance is quite important in explaining

trade flows, as more distance means higher transport costs.

The exact quantification of transport costs is not easy. Many measures of transport costs
arose the past years, and the most straightforward one was the difference between CIF
(Cost, Insurance, Freight) and FOB (Free on Board).

CIF = Measures he value of imports at the point of entry in a country and covers the costs
of carriage, insurance and freight.
FOB = Measures the value of the same commodities free on board, that is, the value
inclusive of all costs, of the merchandise in the exporting port

Note: these measure underestimate the real costs > commodities need to be transported to
the port and from the importing port to the final destination.
[(CIF/FOB)-1]*100 > measure of the transport cost rate on imports. One expects, that
goods with high value added will have relatively low CIF/FOB ratios.

The importance of transport costs is also reflected in the ratio of freight costs relative to
other trade costs, like tariffs as transport costs seem to be at least as important as policyinduced trade barriers.

Transport modes can be either by sea, air, road and rail. Traditionally, shipping costs have
been used as key determinant to understand international trade patterns.

6.2 Different models of distances impact on firms

This paragraph focuses on the impact of distance and transport costs on micro-economic
level. The decision tree already introduced in chapter A shows five potential outcomes (See
Figure 6.4): Stay Domestic, Export, Horizontal Multinational Activity, Vertical
Multinational Activity, Import. The Stay Domestic option is deleted in this section and we
take export and import together, as import is the inverse of export. Furthermore, the
models we are going to discuss are based on the idea in chapter C (see: Midterm summary
or chapter 4 in the book) > imperfect competition and increasing returns to scale.
Some simplifying assumptions:

Firms can locate their production in one or two identical countries (no countryspecific effects)

Home and foreign markets are segmented > Price can be set independently without
the risk of arbitrage

Only labour is used as production factor

Four types of costs, all in terms of labour:

o

Firm-specific fixed costs F (investments in R&D, marketing, management

services and headquarters costs). Incur only once

Plant-specific fixed costs P (finding a suitable location, hiring the right

people, buying machines and office equipment. These costs are incurred only once;
total costs of all plants = total plants * P

Marginal costs MC, constant per unit of production and identical in both
countries

Transportation costs t, exporting unit X goes along with transportation costs

t the amount of t in terms of labour

Take Figures 6.5-6.7, where various options for internationalizing firms are depicted. Left
hand of the panel: Home market, right hand: Foreign market.

Exporting; Figure 6.5

Profits are derived in the usual way: Taking MR=MC as the maximum profit volume, then
projecting the maximum profit volume to the Demand-curve D and the Average Cost curve
AC. Profits then equal the shaded area A. Average Cost curve AC consists of both fixed
costs F and P > the shape shows the increasing returns to scale argument.

When exporting to the foreign country, profits are again derived in the usual way.
Exporting means your marginal costs per unit became higher by transport costs t due to
the geographical distance involved with exporting. MCh+t gives the new MC curve.
Maximum profit then arises where MR=MCh+t, leading to area B being the profit. Of

course you noticed area B being way higher than area A, even with the transport costs
being added to the marginal costs > Fixed costs are assigned to the Home Country; matter
of accounting principles.

Total Firm profits = A + B

Horizontal Multinational Activity; Figure 6.6

Horizontal Multinational firms are market seeking firms, like McDonalds setting up
different restaurants all over the world. The choice between exporting and HMA is driven
by the degree to which a firm benefits form increasing returns to scale and has to deal with
transport costs.

In the horizontal case, firms set up production plants in each country they operate in. Now
refer to Figure 6.6. Firm fixed costs F are assigned to the home country, so home countrys
total fixed cost become F+P, whereas foreign countrys total fixed costs are only P. Also,
the foreign firm does not have to deal with transport costs, due to locating the production
in the foreign country > Total profits for the home country are represented by C, foreign
countrys profits are again higher with area D.

Total Firm profits = C + D

Vertical Multinational Activity; Figure 6.7

Vertical Multinational firms are efficiency or natural resource seeking firms, as these firms
want to benefit from differences in factor endowments (see Chapters B&C from the
midterm, or Chapters 3&4 in the book). The value chain of VMFs are split up into different
parts, each part located in the country that is most endowed in performing the tasks of that
part.

When the Home firm has a plant in the Foreign country, it owns and controls the
foreign firm (note the crucial difference with just importing here!!). The Foreign firm is
part of the overall organizational structure of the Home firm. Suppose, for example that
Volkswagen (Home country = Germany) sets up a plant in China and exports cars
produced in China (China is endowed in low skilled labour) to the German market. These
flows are intra-firm trade flows > Refer to Figure 6.7.

Fixed costs at home only consist of fixed costs F, as there are no production plants at
home; only headquarters. Fixed costs at the Foreign plant only consist of fixed cost P, as it
is only a plant. The home firm has to be served from abroad, resulting in Marginal Costs at
home to be influenced by transportation costs t, resulting in MCf+t as Marginal Cost curve.
Profits in the Home country thus equal area E.

Note: Vertical Multinational activity is only attractive if the marginal costs of producing at
home and serving the market from there are higher than MCf+t. This could be the case if,
for example, wages are substantially higher abroad than at home. Another decision
consists of how to organize the foreign sourcing; do you as a Home firm simply order a
certain product, set a contract and agree on a price or are you going to do it yourself?

Hybrid cases of horizontal and vertical multinational activity

Horizontal and vertical multinational activity can also be combined. Several cases:

Export Platform multinational activity = Firms internationalize and locate in a

certain country to serve customers in a third country. This is a combination of market
seeking and efficiency seeking.
Strategic Asset Seeking multinational activity = It resembles the natural resource
seeking type because it also concerns the need to have access to crucial inputs. In this case
it is not based on natural resources, but on crucial knowledge of a product or how to
produce a product.

Extensions on the previous models

The book assumed that Home and Foreign are identical, which is highly seldom in reality
of course. Suppose The book drops this decision, but The book still assumes that MC are
the same in both countries and that Fixed costs can be assigned to any market. For total
profits, it does not matter where to assign them to. For the decision to either export or
become a Horizontal Multinational firm market size does matter > If Foreign is way
smaller than Home, exporting might be way more profitable, as the Foreign market sells
less than the Home market, but pays the same Plant costs P.

Another issue in the book is the possibility of domestic firms reacting on foreign firms
entering the market > The success of these reactions depends on the market power of each
firm and how the entry affects market conditions.

6.3 The gravity model

Gravity model = Generally, it relates the mass of two bodies to each other, and weighs
them by the distance between them to calculate the gravity. In trade terms, bilateral trade
between two countries is large if the two economies are large and if they are close to each
other. > The smaller the countries and the more distant, the smaller the bilateral trade
flow.

The Gravity model was introduced by Nobel prize winner Jan Tinbergen and became really
popular but was also criticized a lot, because;

It lacked strong theoretical framing

It lacked micro foundations

It could be derived from different existing models like the Ricardian trade model
and the Heckscher-Ohlin model, making it impossible to test which theory applies

The gravity equation developed by Anderson and Bergstrand:

Where; i and j are country indices, Y is income, disij is the distance between countreis I
and j and Z represents other possible variables that may affect the trade or FDI flow
between home and host countries (being member of NAFTA or WTO, having a port or not
having a port and volatility in exchange rates for example). Note: About 70% in the
variance of trade flows is explained by this particular model and the model assumes that
there are no differences within countries for simplifying reasons.

6.4 Other types of distance

So far, The book focused on geographical distance. Other distances, however, are also of
influence on international trade and investment patterns. Take cultural, economic and

institutional differences for example, which result in internationalizing firms incurring

costs that domestic firms dont have.

Zaheer identified four sources of the liability of foreignness as being of significant

importance:

Costs that are directly related to spatial distance (travel, transportation and
coordination over distance and across time zones)

Firm-specific costs based on a firms unfamiliarity with a new, local environment

Costs as a result of the host country environment (lack of legitimacy of foreign

firms)

Costs from the home country environment

As you can see, the first source refers to geographical distance, the second and the third to
cultural distance and the fourth to institutional distance.

An explanation of all kinds of distances is as follows:

Geographic distance = Directly related to transport costs. Measurement of geographic

distance between a home and a host country is frequently based on the distance between
the capital cities of these countries.
Figure 6.8 shows the relation between geographic distance and the foreign sales of US
multinationals. As you can see, for all countries there is a flat line, meaning no
relationship. Recap: Chapter A, Rugman and Verbekes antithesis > multinationals

concentrate sales in regions (Americas, Europe&Africa and Asia), making working

relationships.

Cultural distance = Differences in norms and values between the home and the host
country. When firms cross the border, they face a different set of informal rules of the
game.
Research on cultural distance is now dominated by Geert Hofstedes framework, which
knows four dimensions. The cultural distance between countries is often measured by
comparing he scores of a home country and a host country on the different culture
dimensions and taking the average distance along all dimensions > See Box 6.3.

Institutional distance = Reflects differences in formal rules and regulations. Such legal
differences between countries are smaller when countries share a common history or when
they are both members of trade agreement such as NAFTA or EU. Institutional distance
does not per se have to mean something negative, it may create opportunities too:
countries with less strict legal norms and protectionist measures may be attractive
locations for multinationals, also with higher quality institutions, the rule of law improves
and corruption goes down.

Economic distance = The difference in welfare and economic development stage

between home and host country. If you want to sell products in a less rich country you have
to take into account that it is likely that people wont buy your product if its too expensive.

> How can these distances be included in the models discussed in paragraph 2?

Liability of foreignness = Affects the costs of doing business by affecting the choice
between staying domestic and becoming internationally active. LoF effects exist for export,
horizontal- and vertical multinational activity.
Example: The LoF is higher for horizontal multinational activity than for exports, as
cultural distance creates a LoF in the case of horizontal multinational activity (foreign
employees, trade unions) but not in the case of exports (no factory abroad). In the same
way, LoF will be higher for horizontal multinational activity than for vertical multinational
activity, as output generated abroad in horizontal multinational firms is target at culturally
different foreign customers, whereas vertical multinational firms output generated abroad
is targeted at home country customers.

Refer to Figure 6.2 > Local firms profits equal cbp0f and the foreign firms profits equal
dbp0e, meaning the LoF equals cdef. How, then, can the multinational compete with the
local? The multinational should offset the costs resulting from LoF via a firm specific
advantage that raises revenues or decreases costs.

6.5 Porters diamond and Dunnings OLI models

So far The book discussed both firms and countries, as firms become internationally active
to generate value added that is based on country- or location specific characteristics
(exporting, horizontal multinational activity or vertical multinational activity). The book
discusses two frameworks that integrate firm- and national-level factors.

Porters diamond model

Porters diamond = Ideas on how firms can compete and be successful globally and on
how to push economic development.

The resulting model is depicted in Figure 6.12

The essence of Porters theory is to explain why for example the Dutch flower industry and
the Japanese electronics industries are global winners. According to Porter, this is because
of the four related factors in his diamond model. The factors are as follows:

Production factors = Include labour, capital, infrastructure, technology and

entrepreneurial spirit. This is similar to resource endowments discussed in chapter 3 and
chapter 4.

Demand conditions = The size of the market (a large home markets creates economies
of scale) and the quality of demand, which refers to consumers pushing firms to
continuously satisfying their demand by coming up with new products and services.

Related and supporting industries = A strong home base of suppliers, which adds to
the continuous development of new products.

Firm strategy, structure and rivalry = The way firms are created, organized and
managed.

A fifth factor not included in the model is the role of the government. The role of the
government is of influence to all four factors. Take as an example the government
developing policies for the capital market

Dunnings Ownership-Location-Internalization (OLI) framework

Dunning wondered whether differences in productivity between the US and the UK were
due to the superior resources of the US economy (location-effect) or whether it was due to
more efficient management of these resources across national borders by the US
(ownership-specific effect). The final effect is related to the organization of cross-border
activities. To fully explain the extent and pattern of foreign value adding, Dunning argued
that an explanation was required of why some firms exploited their ownership-specific
advantages internally, rather than selling or acquiring these, the internalization-effect.

Thus:
Ownership dimension = Why a firm goes abroad
Location dimension = Where firms go when they go abroad
Internalization dimension = How firms go abroad
Chapter 7
7.1 Introduction
Recap: liability of foreignness (chapter F); different types of distance that affect
international business activity. This chapter elaborates on how firms an overcome their
liability of foreignness. We focus on the role of firm-specific advantages (FSAs from now
on), as FSAs make it possible to overcome the liability of foreignness. This chapter focuses
on international management, rather than international business. The difference;
International business = The study of enterprises crossing national borders, which
includes cross-border activities of business, interactions of business with the international
environment and comparative studies of business as an organizational form in different
countries.

International management = The study of the process of planning, organizing,

directing and controlling the organization. Managers use this to achieve an organizations
goals when it is involved in cross-border activities or functions outside its nation-state.
Key question; How can firms organize their foreign activities in the most efficient and
effective way, such that it contributes to their firm-specific advantage?

7.2 The resource-based view

The main view on competitive advantages is that it is the result of the application of a
bundle of valuable resources (resource-based view). A firm is thus nothing more than a
bundle of productive resources, namely the both tangible and intangible (human resources
for example) assets it uses. Assets can be bought and used by other firms as well, so it is
crucial how to handle them. As such, resources need to be complemented with capabilities.
The combination of the right resources and capabilities offer a sustainable competitive
advantage (FSA).
A resource can be a lot; tangible, intangible, it can include physical, financial or
knowledge-related resources. A resource can only be part of an FSA if;

It is valuable

It is rare

It is inimitable

It is non-substitutable

You can conclude from this that FSAs should always be seen relative to a firms rivals.
FSAs can be derived from efficient use of infrastructure, a favourable financial position or
specific know-how. Now about those capabilities, who are way more important than
resources on their own. Capabilities are needed to bundle the resources present in a firm.
One of the most important capabilities of firms is the entrepreneurial ability to constantly

reinvent themselves. To stay ahead of your rivals, you should constantly develop new
products, services or ways of working.
Critics on the resource- based view;

It is tautological > a kind of circular reasoning

It is very difficult to find resources that satisfy all four criteria

The theory has limited practical implications

The theory tends to underestimate the role of industry factors external to the firm

7.3 A classification of firms- domestic, multi-locational or multinational

How are FSAs related to internationalizing firms; firms that want to gain a competitive
advantage abroad or firms that want to create added value in another country > Refer to
Table 7.2 on page 194. This Table classifies firms among two dimensions [number of
locations a firm has] [number of countries a firm is active in]. The two dimensions provide
domestic firms, the simplest case, multi-locational domestic firms, a bit harder, and
multinational firms, the hardest form as the transfer of firm-specific advantages across
borders shows up here and not just the having of FSAs.
Take a New-York jeweller who only operates in New-York and its FSA is its excellent
service and communication with the customer. If this jeweller wants to expand to Los
Angeles it has to expand its FSA within a country but to another location, so no big
difficulties involved. Communication styles and language do not differ between New-York
and Los Angeles. If the jeweller now wants to expand to Berlin, the transfer becomes much
harder due to cultural distance. In this case, there are a lot of costs involved in training
staff and finding out what the appropriate way of communication with customers is.

7.4 The tension between global integration and local responsiveness

Each multi-locational and especially each multinational firm is confronted with a tension
between the pressure to be cost effective (standardize within the entire firm) and the
pressure to be locally responsive for local tastes and styles (adapt). The tension between
global integration and local responsiveness is illustrated in Table 7.3 on page 197 of the
book, among two dimensions [pressure for global integration] and [pressure for local
responsiveness] which can either be low or high. The two dimensions offer four possible
outcomes;

International strategy = A firm internationalizes by copy-pasting their home

operations. Firms that produce goods or services that serve universal needs

Localization strategy = Also called a multi-domestic strategy. This strategy is

focused on maximising profits by customizing the firms products and services to the
host country market. Each host market is treated separately and functional units like
R&D, marketing and sales can be found in each market. In a way this means multiple
domestic markets

Global standardization strategy = Concentrating functional activities and

achieving economies of scale, learning effects and location economies. Instead of
customizing products, firms standardize products worldwide, where R&D may be
concentrated in one host country and production in another country

Transnational strategy = Both high pressure for global standardization and high
local responsiveness is demanded. The key to this strategy is the ability to organize
knowledge flows within the multinational group as a whole, not just from headquarter
to subsidiary, but also between subsidiaries. These knowledge flows should be
organized such that local learning feeds back in to the global FSA for the multinational
as a whole. Subsidiaries adapt to be locally responsive. Figure 7.1 on page 198
illustrates the complexity of this strategy.

7.5 Examples of how to manage the global-local challenge

In general, the need to be locally responsive depends on the nature of the product/service
in combination with the demand from the local business environment. Three specific

examples to illustrate this;

* International marketing
A crucial aspect of marketing is the understanding of consumer preferences. In
international marketing, the key question is whether or not consumer preferences can be
assumed to be the same all over the world. This is a very important question, as if
consumer preferences are the same all over the world, economies of scale through
standardization can be achieved. When preferences differ between countries, the whole
marketing mix (product, place, price, promotion) needs to be adapted. A deep
understanding of local differences in values and practices is crucial for the success of
international marketing. When explaining the role of cultural distance, the work of
Hofstede should be used. He developed four dimensions of national culture;

Power distance = Power distance is about the hierarchy in an organization, high

power distance means that employees rely largely on their bosses

Uncertainty avoidance = About how people react to change, challenges and risk.
Strong uncertainty avoidance means people are more likely to avoid risk and to rely on
authorities to solve problems. It also means a preference for bureaucracies and
routines

Individualism = About how people think about themselves and society.

Individualist societies tend to put family and self-interest first and society second. Selfrespect and independence are dominant factors. In collectivist cultures, people put the
group first and group harmony is more important that individual freedom and success

Masculinity versus femininity = About how people see gender differences.

Feminine cultures are associated with gender roles overlap. Man and women are
equal. Masculine cultures are associated with traditional macho-type values implying
that man are in charge

See Table 7.4 for the highest three and lowest three scores on all dimensions and Figure 7.2
for the correlations in cultural characteristics.

To come back to the main question of this section, whether or not consumer preferences
are the same all over the world, is related to the question of whether cultures are
converging or not. Some scholars argue that our world is characterized by increased
similarity, which is also referred to as McDonaldization, given the position of American
brands. At the same time, researchers have argued that this may be true for some products,
but not for all. According to Inglehart, there is a general development mostly driven by
economic progress (people becoming richer which leads to changing preferences) that
holds for all countries, but there are country-specific aspects of culture that are historically
grown. This means there is no full global cultural convergence.

Finding out whether a global or a local approach is most appropriate is important for the
marketing mix. The need for global integration or local responsiveness affects market
segmentation possibilities between countries and within countries. It also affects product
attributes, distribution strategies, communication and pricing strategies. Apart from
exchange rate risks and trade restrictions, an internationalizing firm should consider their
chargeable price really well, as for example what price to ask for one same Ford car in
Germany, France and Japan is quite an important decision. Price discrimination (asking
the maximum price in each market taking into account local competition) is affected by
arbitrage possibilities. If Ford sells its Focus model in Germany for 2000 more than in
France and people can go easily to France to buy their Focus there, arbitrage possibilities
are high and Fords pricing strategy is not effective.
Country of origin effect = Certain products/services are appreciated more or less by
foreign consumers because they are offered by a firm coming from a specific foreign
country. The product than may be superior or inferior, even if this is objectively not the
case.

* Corporate social and environmental responsibility

The present view on corporate social and environmental responsibility is well reflected in
three 2006 movies; Blood Diamond (social conditions of the exploration of diamonds), An
Inconvenient Truth (environmental aspects and sustainability) and Enron, the Smartest
Guys in the Room (societal responsibility). Todays corporate social and environmental
responsibility policies should deal with the global-local tension;

Are ethical standards universal? Take Figure 7.3 on page 206 of the book. It
shows peoples opinions in different countries on the question if taxes should be used
to prevent environmental pollution. Significant differences exist within the opinions.
Also take the giving of gifts as a token of appreciation and networking or paying
government officials money to get things done. In some countries this is totally
normal, whereas in other countries it is inappropriate or even illegal

Interdependencies; local events triggering global responses. Take

horizontal multinationals with different subsidiaries in different countries who are
hardly linked. If one subsidiary pays fees to government officials (which is normal in
the country that particular subsidiary operates in) it can lead to major global
responses, which hurts the overall image of the multinational

The discussion of global footprints. Take a vertical multinational which has to

develop a global value chain. This firm has to track all their global value chain
footprints at all stages of production, which requires them to be knowledgeable of all
their different subcontractors and how this affects the overall global footprint of the
multinational as a whole.
Total carbon footprint = The production, transportation, consumption and waste
disposal of for example a can of food. For each of the mentioned stages, the total
amount of energy used can be approximated.

* Human resource management

Human resource management refers to how employees are being treated. For
internationalizing firms that deal with different cultures this is also an important aspect.
Again, Hofstedes dimensions should be taken into account.

7.6 Different entry modes

What we have discussed so far is illustrated in Table 7.7 on page 212. There are 6 possible
entry modes for firms when they go abroad, each of them having advantages and
disadvantages. Three non-equity (exporting, licensing and franchising) and three equity
modes (greenfields, acquisitions and joint ventures) are discussed.
* Licensing
Firm A licenses to Firm B in another country the right to use Firm As technology or
trademark for a certain fee.
Dissemination risk = The firm that licenses the technology, knowledge or trademark
may be confronted with a licensee that uses the technology, knowledge or trademark for
something else than what the licence was intended to deal with.

* Franchising
Firm B in a host country uses the business model developed by Firm A, and Firm A
provides assistance in making the local activity a success. The franchisee has the right to
use the franchisors logo, trademark and way of working for which the franchisor receives a
fee. Here, the degree of control is higher than for licensing. An example is McDonalds.

* Greenfield
When a firm expands to a foreign country by establishing a completely new firm that it
fully owns. Full control and 100% entitlement to the profits is generated. A crucial
disadvantage is the high cost and risk involved.

* Acquisition
When a firm buys shares of a firm established in a foreign country. Full acquisition means

buying all shares, partial acquisition means buying some shares. An acquisition does not
add additional production capacity, but instead changes the ownership of existing capacity.
A popular way to obtain an immediate position in a foreign market is acquiring a foreign
competitor, which offers reduced risk as an acquisition does not only involve buying
tangible assets like factories, but also intangible assets like employees with certain local
know-how.

* Joint venture
Firm A from country 1 and Firm B from country 2 join forces and jointly establish a firm C
in a foreign country (which can be either country 1, 2 or a third country). The advantages
are that both firms pool their FSAs in order to both benefit. Moreover, costs can be shared
and partnering with a local firm offers knowledge of the local market. A major
disadvantage is the risk of knowledge spillovers due to the pooling of FSAs. Joint ventures
also have a big risk of failing due to conflicts between the partners.

7.7 The optimal entry mode

When making the entry mode decision, a lot of factors should be taken into account. These
factors can be categorized into three main factors;

The degree of control

The level of resource commitment

The dissemination risk

Each factor changes for different entry modes. Take greenfields and acquisitions, where
the degree of control is very high and low for licensing and franchising. Depending on
which aspect is most important for a firm, an entry mode is chosen. For many high
technology firms for example, the risk of knowledge leaks to partners may be so big they
choose an entry mode with full control and minimum dissemination risks.

The most robust theory to predict the entry mode is the transaction costs theory. It deals
with the fundamental question, what is the most efficient way of organizing a transaction:
market or hierarchy? In the first case, a transaction is organized by setting a price using a
contract and in the second case, the transaction is best organized by pooling the resources
of the two individuals within one organizational unit. Transaction costs theory predicts
that firms arise when they are the most efficient way to organize the transaction.

Despite the predicting theories, managers may deviate from them in their actual decision
due to bounded rationality issues. Bounded rationality = Not all necessary information
can be processed to make the optimal decision. Also note that not only managers
determine the entry mode, as governments of host countries may also have strict rules
concerning the way they allow foreign firms to enter their country.

Apart from where and how to enter, when to enter also plays a role. According to the
Uppsala model of internationalization, firms need to learn and internationalization is a
dynamic learning process. Learning is based on learning-by-doing, experience.

Chapter 8
8.1 Introduction
This chapter focuses on the monetary aspects of the interactions between nations, firms
and consumers in the global economy, with the focus on exchange rates.
Due to different countries having their own currency, international business activity is
associated with a risk. This risk is two-fold: there is a transaction risk and a translation
risk.

Exchange rate = Price of one currency in terms of another currency.

Economic exposure = Exposure of a firms value to changes in the exchange rates.

Transaction risk = Gains and losses that may be incurred when monetary transactions
are settled in a foreign currency.
Example: A British firm buys cars from a German firm with a contracted price of
1.000.000, where the payment has to be done within 60 days. At day one (contract date),
pound/euro exchange rate is 1:1. However, on day 60 the pound/euro exchange rate is
1.1:1, meaning that the pound decreased in value > To get one euro, more pounds are
needed. In other firms, the British firm has to pay 1.100.000 instead of 1.000.000 and
the German firm receives 1.000.000.

Translation risk = The risk of having assets and liabilities on a firms balance sheet
denominated in a foreign currency.
For example: You are travelling from Paris to the USA (euros to dollars). To get some
dollars, you go to ATM in New York to get $1000. At the time of this transaction, the
exchange rate is 1.25, meaning you get 800. Now, your friends card wont work in New
York, so you offer to lend her the money and go to ATM again for $1000; she will pay back
as soon as the card works, so you have a liability. After one week, she pays you back, so
now you have $1000 in assets. In the meantime, the exchange rate became 1.40, meaning
you get back only 714 instead of the 800 you expected.

For the adapted version of the decision tree, see Figure 8.1 in the book.

Exporters face transaction risks

Horizontal multinationals face translation risks

Vertical multinationals face both transaction and translation risks

Importers face transaction risks

8.2 Exchange rates- general information and definitions

Recap: Exchange rate = Price of one currency in terms of another currency.
The price is determined by supply and demand in the foreign exchange market. A rise in
exchange rate means that the item being traded has become more expensive > If the
exchange rate of a Singapore dollar in terms of a European euro rises, the Singapore dollar
has become more expensive.

* Spot exchange rates

Spot exchange rate = The price of buying or selling a particular currency at this
moment. They are extremely variable, they change in a matter of seconds. See Figure 8.2

See Table 8.2:

Bid rate = The price at which banks are willing to buy one US dollar for example.
Ask rate = The price at which banks are willing to sell one US dollar for example.
Spread = bid rate ask rate ; generates revenue for the currency trading activities of the
banks (margin). In practice, the spread is quoted relative to the bid price.

US$0.9915-18 means a bank is willing to buy dollars at 0.9915 and to sell dollars at 0.9918

See Figure 8.2

Depreciation = a currency to become less expensive. In Figure 8.2, over the period as a
whole, the US dollar has depreciated.
Appreciation = a currency to become more expensive. In Figure 8.2 the US dollar
appreciated particularly at the end of 2008

* Arbitrage
Exchange rates vary very quickly over time, but the same is not true for the exchange rate
at different locations for a given point in time.
Arbitrage activity = Making a profit by buying currencies where they are cheap and
selling them where they are expensive.

Suppose: we know the price of one US dollar at noon on 3 august, 2011 in terms of
Canadian dollars (0.9581), Swiss francs (0.7759) and South African rand (6.7849). In view
of arbitrage opportunities, this suffices to calculate all cross-exchange rates as given in
Table 8.3
For example: We know one Swiss franc must cost 8.7446 South African rand, because >
6.7849 rand = 1 US dollar
1 US dollar = 0.7759 Swiss francs
6.7849 rand = 0.7759 Swiss francs

1 Swiss franc = 6.7849 / 0.7759 = 8.7446 rand

* Players and markets

The main players on the foreign exchange market:

Commercial banks = All major international transactions involve the debiting

and crediting of accounts at commercial banks (most transactions relate to the
exchange of bank deposits). Commercial banks thus are intermediaries for their clients
by bringing together their demands and supplies.

Firms = The exchange of goods and services almost always involves foreign
exchange trading to pay for these activities.

Non-bank financial institutions = As a result of financial deregulation, foreign

exchange transactions are also offered by institutions such as pension funds and other
investors

Central banks = Depending on various circumstances (think of the

unemployment rate, economic growth rate, inflation) the central bank of a country
may decide to buy or sell foreign exchange.

* Forward rates and hedging

As we already know, the extreme variability of exchange rates creates transaction and
translation risks. If you sell for 20.023.500 Yen on one day and your cost are 19.000.000,
you account for a profit. However, the currency of the country you are trading with might
depreciate, making the amount you receive on your bank account 18.051.000 Yen for
example; a loss. Could you avoid this loss?
Yes you could have > If you had made an agreement to sell on a forward price of the value
of the currency on the day of the sell or a pre-determined value of the currency, you could

have avoided the loss. This is Hedging = passing your own foreign exchange risk exposure
on to the forward exchange market.

Speculating = Taking a gamble on the direction and size of changes in the exchange rate,
a whole range of forward looking markets has developed, with associated rather exotic
technology, such as:

Plain vanilla instruments = Instruments which are traded in generally liquid

markets according to more or less standard contracts and market conventions

Forward = Price at which you agree upon today to buy or sell an amount of a
currency at a specific date in the future

Swap = Simultaneous buying and selling of an amount of currency at some point in

the future and a reverse transaction at another point in the future

Option = The right to buy or sell a currency at a given price during a given period

Selling at premium = Forward rate > Spot rate

Selling at discount = Forward rate < Spot rate

8.3 Effects of exchange rates on prices

Suppose, the exact same product is freely traded between America and Britain. There are
no transportation costs, no tariffs, etc. needed for arbitrage. Should the price in Britain be
exactly the same as in America?

Law of One Price = Identical goods should under certain conditions sell for the same
price in two different countries at the same time.

Absolute Purchasing Power Parity = A bundle of specific goods should cost the same
in France and the US once you take the exchange rate into account.
> When calculating PPP, you should use price indices that are constructed in the same way
in the different countries.

Relative Purchasing Power Parity = Differences in the rates of inflation between two
countries.
> The rate of inflation in France is higher than that in the USA, causing the price of the
basket of goods in France to rise. PPP says the baskets have to cost the same in each
country, so the French currency has to depreciate against the USA currency.

So far, no distinction was made between nominal and real exchange rates.
Real exchange rate is defined as Z, nominal exchange rate is denoted as S (how many euros
you have to pay for one dollar).
In this example we take the EU as home country and the USA as foreign country.
Z = S * (Pus/Peu), where Pus/Peu is the price ratio (price of American goods relative to
European goods).

The real exchange rate Z increases if:

The nominal exchange rate S increases

The price level in America increases

The price level in Europe decreases

We expect an increase in Z to cause a substitution of consumption away from American

goods towards European goods in both countries. This of course will affect import and
export flows between Europe and the US, where export equals X and import equals M. So
if Z increases, the European demand for imports decreased and the demand for European
exports increases. We can summarize both effects in the current account balance (Recap:
Ch. 2)
CA(Z) = X (Z+) Z * M (Z-)

See Figure 8.7 in the book

Initial equilibrium is at point A at an exchange rate equal to s0

SM(S) curve shifts to the right, so imports increase

o

Under flexible exchange rates (monetary institutions do not intervene) this

shift leads to a new equilibrium in point B > Appreciation of the US dollar

If the European Central Bank now wants to fix the value of the euro at s0
level, so they only allow the dollar to appreciate within limits > A band width arises
around the parity rate and the dollar exchange rate will appreciate to
s0 + (band/2) with the difference of demand and supply (D-C) supplied by the ECB
in order to make that happen

8.4 Effective exchange rates

Most of the time a certain currency is appreciating relative to one currency and
depreciating relative to some other currencies. Has the currency then become more or less
valuable over time?

Effective exchange rate = It is useful to distil the divergent movements in (bilateral)

exchange rates into a key (index) number summarizing the overall movement of a
countrys exchange rate.
> Countries are interested in the general development of their competitive position relative
to various countries . The real effective exchange rate does that by calculating the weighted
average of the bilateral real exchange rates

See Figure 8.9 in the book:

Panel a shows the development of the real and nominal exchange rate in a broad
range of currencies (high-inflation countries included)

Panel b shows the development of the real and nominal exchange rate in the major
foreign currencies

Can we now deduce from Figure 8.9 that PPP holds? > Yes and no:

If relative PPP were hold to for every time period and for all countries, the real
effective exchange rate would have to be a horizontal line

If absolute PPP holds, the level of this line would be determined

Taking a look at panel c, there clearly is no horizontal line, therefore relative PPP
does not hold

However, there is not a consistent upward or downward movement; two

large upward deviations in 1981-1988 and 1997-2004 with peaks in 1985 and 2002

Short run PPP does not hold

However, we do not see a consistent upward/downward movement >

Relative PPP tends to return to some base level, so in the long run relative PPP does hold

Reasons for short run deviations are / Reasons why arbitrage does not always work well:
Transaction cost ; An obvious reason for the failure of the Law of One Price are
transaction costs (shipping, insurance, tariffs)
Differentiated goods ; In deriving the Law of One Price we assumed homogeneous
goods, while in practice very few goods are perfectly homogeneous > Very much types of
wine and cars for example. The one car is not the other
Fixed investments and thresholds ; Before one can take advantage of arbitrage,
investments such as establishing reliable contacts, building networks, organizing shipping
and having a distribution network have to be made
Non-traded goods ; A large share of income is spent on non-tradable goods, or services
actually. Examples are health care services and recreational activities
Composition issues ; We assumed that the price indices in the two countries when
deriving the PPP exchange rate were constructed in an identical way, which in practice is
not always the case

8.5 Issues around portfolio investments

Fisher equation = Explains the real interest rate r (how many goods you can buy with a
certain amount of money) by taking a nominal interest rate i, your reward in terms of
money and substracting the Geek letter pi, denoting the inflation rate in the economy.
r = i pi > See Figure 8.11 for a relationship between nominal and real interest rates.
Notes: The real interest rate can be higher than the nominal interest rate and the real
interest rate can be negative.

Covered interest parity

The discussion of this section is based on two options for a European investor: buying
European bonds or American bonds. The two assets are perfect substitutes, meaning that
the one carries not more or less risk than the other. Assume: large sum of L euros, return
in euros. Figure 8.13 shows your investment options:

Option I > You purchase a European bond. End of the period: L*(1+iEU) euros of
return

Option II > You purchase an American bond. These are in dollars, so: first you have
to exchange your L euros for L/E US dollars, where E is the spot exchange rate of the
US dollar (its price in euros). Second, you have to invest these L/E US dollars in
American bonds. End of the period: L/E*(1+iUS) dollars by the end of the period.
Then, you have to convert these dollars back to euros again, and this forms the risk: at
the point of making your investment choice, you do not know yet what the future spot
exchange rate of the dollar is going to be

If the two assets are perfect substitutes and both are held in equilibrium, the return to
those assets must therefore be the same. The following equilibrium condition:

Uncovered interest parity

The previous section The book assumed that there was no difference in riskiness involved.
There are more options available and one of these options (option III) is not to hedge your
risk on the forward exchange market, but adding a subindex t to denote time in your
formula.
Comparison of revenues from option I with option III, which is buying the American bond
and not hedging on the forward exchange market.
End of the period: (L*(1+iEU,t).

Before purchasing the American bond, convert euros in dollars at exchange rate Et, which
offers you L/Et dollars and a revenue of L/Et*(1+iUS,t) dollars. You dont hedge your
foreign exchange risk, so: next period exchange currency on the spot exchange market. In
this period, you have to make your investment decision and you dont know next periods
spot exchange rate > Form expectation about the future spot exchange rate.
Expected revenue end of the period:
, where is the expected value of the forecasting process

Uncovered interest parity then is:

Interest parity, risks, transaction costs, exchange rates and capital mobility
The book expects individuals to be risk averse: other things equal, they prefer less risk to
more risk. Risk premium = Risk averse investors will demand for a compensation for

holding risk carrying assets. Rises if: risk aversion rises, perceived riskiness increases. >
Firms with bad credit must pay a higher interest rate than those with a good credit.

In The books analysis, it distinguishes between home and foreign and under a system of
fixed exchange rates that is fully credible the future exchange rate E^e is equal to the spot
exchange rate (so E^e/E=1).
rHome = rForeign + risk + Transaction Costs
Transaction Costs TC only concern home, so TC > 0. The risk difference may relate to
political and expected exchange rate risks. If Homes currency depreciates to Foreigns
currency, portfolio investors want a higher return for carrying a risk. If risk = dE and TC =
0
rHome = rForeign + dE, with E = exchange rate

Chapter 9
9.1 Introduction
When firms trade with or invest in different countries, they are confronted with multiple
currencies. Supply to and demand for currencies can have implications for exchange rates.
This chapter focuses on an issue affecting internationalizing firms directly: currency crises;
the potential drawbacks of international capital mobility for firms and the economy and
the economy as a whole.

9.2 Currency crises- general information

Exchange rate E = The price of the local currency per unit of foreign currency.

Exchange rate changes = A rise in exchange rate E means a depreciation of the local
currency. A fall means an appreciation of the local currency.

A currency crisis now consists of significant appreciations or depreciations of a currency.

Two players: Portfolio investors and local monetary authorities (central banks), where
central banks care about the level of the exchange rate > They want to keep it fixed, due to
maintained certainty. Internationalizing firms love this certainty.

Now The book wants to know the relevance of a currency crisis for explaining a financial
crisis and here The book is mostly interested in the impact of exchange rate depreciations.
Speculative attack = Investors lose confidence in a currency and start to sell their
investments in that currency on a large scale within a very short period of time. If attacks
like this succeed, the currency depreciates.
In chronological order:

Pressure on the exchange rate to depreciate for some (unknown and irrelevant)
reason

Investors immediately and collectively start to sell their investments in that

currency

Authorities start to support the present exchange rate, as they dont want a
depreciation > Either done by raising interest rates or selling part of foreign exchange
reserves and thus buying their own currency

Speculative attack continues and the authorities have to give in > Depreciation
starts

Other aspects of currency crises that are less obvious:

Unsuccessful attacks that still trigger a currency crisis

A perceived weakness of a local economy can lead to a currency crisis

Eichengreen, Rose and Wyplosz developed a currency crisis indicator for empirical
research. Bordo et al. analyse whether currency crises have become more frequent over
time. To answer this, they define for each period the probability of a crisis as the total
number of crises in period divided by the total number of country-year observations during
that period. It turns out that the frequency has increased, leading to a 7% probability these
days.

9.3 Currency crises- characteristics

Emerging economies are much more a prone to currency crises than developed countries,
as they have a low level of domestic savings and offer a quite high return on investment.
Before a currency crisis, emerging economies typically had a net capital inflow and a
current account deficit. A currency crisis then is very much like huge capital withdrawal,
leading to the need for a current account surplus. This reversal in capital flows and the
accompanying exchange rate depreciation may contribute really strong to a financial crisis,
as a sharp decrease in capital inflows means that fewer funds will be available to finance
domestic investment. With many loans denominated in foreign currencies such as the US
dollar, a depreciation of exchange rates means an increase in the real value of the debt of
domestic firms and banks.

9.4 Explanations of currency crises- First Generation Models

Models of currency crises can be classified into:

The first dimension > Concerns the role that international investors play in bringing
about the crisis: How do they react to a changed outlook for the exchange rate? Do
they even react or do they themselves determine what this outlook looks like?

The second dimension > This dimension is the rationale for the crisis. Is the crisis
due to flaws in the domestic economy or are the fundamentals of the economy sound
and is the attack on the currency purely speculative?

In the earliest models (or first-generation models) developed by Krugman (1979) and
Flood&Garber (1984), investors are quite passive and the crisis is totally due to bad
economic conditions, which are incompatible with the fixed exchange rate.
(9.1) P = m(M), with dP/dM > 0 ; The domestic price level P is a positive function of
domestic money supply M
(9.2) P = EfP*, with P* = Ef = 1 ; Shows that in the long run PPP holds (See chapter A in
midterm summary, chapter 1 in the book), as if the domestic price level exceeds one, this
equation shows us that as long as the foreign price level remains unchanged, the exchange
rate has to increase (depreciate) in order to maintain PPP.
(9.3) dM = dF + dR ; This equation shows that this country finances deficits F by lending
from the central bank, which increases money supply. This equation can be looked
upon as a balance sheet of the central bank > F is loans to the government; asset, R
is foreign exchange reserves; asset and M is the money supply; liability.

dF > 0 means an increase in governments budget deficit and thus an increase in money
supply, which leads to an increasing domestic price level and makes sticking to a fixed
exchange rate thus impossible : Domestic economic conditions are incompatible
with the fixed exchange rate. The monetary authorities might also sell part of its
foreign exchange reserves R to the public in exchange for the domestic currency, so money

supply M shrinks. As long as dF = -dR, money supply does not increase and the fixed
exchange rate can be maintained.
Problem: R is limited. Once R = 0, money supply will start to increase, dF = dM, meaning
exchange rate cant stay fixed.

What will investors do in this situation? > if they wait for R = 0 to happen, they lose money
as their investments will be worth less. So before R = 0, investors start to attack the
currency, which is selling their investments in the currency. This means the currency crisis
will occur at some point when the foreign exchange rates start to run down.

So, first generation models = There is one possible outcome; devaluation of the
currency and investors simply bring home the bad news a bit earlier by attacking the
currency than would have been the case if government had had its way. Also, the currency
crisis is due to the fact that domestic economic conditions are at odds with the fixed
exchange rate objective.
Is this model useful?

Most economist think that currency crises are at least to some degree the result of
bad fundamentals > Speculative attacks are not random

The model explains why a currency crisis can occur at a time when the authorities
still seem to be able to stick to the fixed exchange rate

A speculative attack can only succeed if a sufficiently large number of investors decides to
sell their investments at the same time. But how do these investors coordinate their
believes? First, the willingness of central banks to keep the exchange rate fixed produces a
focal point for individual investors. Here, the fundamentals of the economy are the signal

to investors. Second, investors use information as a focal point that is not necessarily
related to the actual economy. One example here might be a large single investor with a
good reputation selling its investments in a particular currency.

9.5 Explanations of currency crises- Second Generation Models

Some of the shortcomings of the first generation models of currency crises are named in
the more recent models, in which the expectations of investors and policy-makers
determine whether or not a currency crisis takes place. Currency crises thus also depend
on the behaviour of investors.

Three assumptions on these second-generation models;

Policy makers have a reason to give up the fixed exchange rate > Policy makers may
have various reasons to devalue, boosting exports for example

Policy makers also have a reason to maintain the fixed exchange rate > Enhancing
credibility of their domestic policies

The costs for policy makers to hold on to the fixed exchange rate increase if
investors expect that at some point in the future the currency will be devalued

The basic mechanism of these models is quite simple: assumptions one and two tell us that
there is a trade-off for policy makers; there are costs and benefits of sticking to a fixed
exchange rate. Assumption three then shows us that investors determine the position of
the policy maker in this trade-off.
Suppose: investors think the fixed exchange rate is credible (they dont expect a future
devaluation) > Policy makers also conclude the fixed exchange rate is credible and the
situation wont be changed. Also possible: investors expect a future devaluation and

demand for higher interest rates, the higher interest rate raises the costs of sticking to a
fixed exchange rate, so policy makers decide to devalue the currency.

9.6 Other models and thoughts on currency crises

In both models, investors never get it wrong > The currency market is an efficient market
where there is no room for surprises.
Evidence for currency crises not always being self-fulfilling:
Once a crisis arises, it is shown that not only until very late that investors see the

crisis coming
Once the crisis is there, policy-makers can behave differently than was expected

before the crisis

So in previous models, the role of expectation and self-fulfilling mechanisms is quite high.
Empirical research, however, shows that on average crises can be attributed to economic
fundamentals being at odds with the fixed exchange rate objective that many countries
have.

Contagion = A case where knowing that there is a crisis elsewhere increases the
probability of a crisis at home
> See research Kaminsky and Reinhart in the book ; Table 9.3 gives evidence for contagion
to happen.

Evidence of contagion does not mean that currency crises are self-fulfilling due to mass
behaviour of investors. It can also be explained by the fundamentals when the country that
is hit by a crisis is linked to other countries, via international trade for example. If A and B,

both developing countries have a fixed rate against the US dollar and they compete on the
same export market, a devaluation of country As currency for improving competitiveness,
this means a less good competitive position for country B. > The fundamentals of country
B weaken and provoke a currency crisis; capital flows drop and the currency crisis arises.
This is an example of fundamentals-based contagion.
Pure contagion = Contagion that is of a pure self-fulfilling nature.

9.7 What can be done about crises?- Policy trilemma

What actually can be done about currency crises? Authorities can limit the crises, but they
are confronted with a dilemma. To understand this, you first should know that policy
makers care about three policy objectives: A fixed exchange rate, Monetary policy
independence, Capital mobility. They care about these objectives, because:

A fixed exchange rate benefits international trade, because traders dont have to
deal with uncertainty

Monetary policy is a powerful tool to guide the economy

Capital mobility stimulates a better allocation of savings and investments and more
risk spreading

The dilemma: only two of the three objectives can be achieved in one point of time, at the
expense of the third. Recap: uncovered interest rate parity condition
rHome = rForeign + dE + TC
If there is capital mobility, transaction costs are low. Taken rForeign as given, rHome =
rForeign + dE > Exchange rate changes are the only reason for interest rate differentials
between home and foreign. So choosing for capital mobility, leaves policy makers with a
choice between a fixed exchange rate and monetary policy independence. If for example,
they choose for a fixed exchange rate, so dE = 0, then rHome = rForeign, which makes
monetary policy independence impossible.

Figure 9.6 illustrates Robert Mundells policy trilemma, where the squares are the choices
and the circle cant be met.
Until recently, policy makers in small, open economies for sure want a fixed exchange rate
to protect the exporting sector. As a consequence, policy autonomy for these countries
reduced. Now, three questions arise:
1.

2.
3.

Is the loss of policy autonomy really a cost from the perspective of a countrys social
welfare?
Is the policy trilemma vindicated empirically?
What made countries in the late 1990s reconsider their position with respect to the
trilemma?

Is the loss of policy autonomy really a cost?

A decrease in policy autonomy means that policy makers have less pressure on the
domestic economy. If you take it in the social welfare perspective, the loss of autonomy
only means a cost if policy makers used their autonomy to increase social welfare. The
costs of the loss of policy autonomy depend on the credibility of the domestic monetary
policy and on their preferences.

Does the trilemma really exist?

Obstfeld, Shambaugh and Taylor developed an equation that confirms the hypothesis that
policy autonomy decreases when capital mobility is high. They confirmed the hypothesis
with this formula using data for three important periods: gold standard, Bretton Woods
and post-Bretton Woods.

, where i is the country, t is the year of observation, r^b is the benchmark interest rate and
mu is the error term. The benchmark interest rate fulfils the role of our theoretical interest
rate rForeign. With capital mobility and fixed exchange rated, we expect beta to be 1. If
capital mobility is less than perfect and/or exchange rates arent fixed, beta < 1.
To confirm the hypothesis, beta should be lowest for Bretton Woods and highest for gold
standard.

From trilemma to dilemma?

Around 1990, most developed countries were characterized by almost full international
capital mobility. At the same time, most countries had a fixed exchange rate. From 1999. A
floating exchange rate started to become popular, as in that period many currency crises
occurred > The trilemma was reduced to a dilemma ; Countries should choose. Or full
capital mobility or a fixed exchange rate (Recap: speculative attacks, if investors dont have
confidence, they sell investments and fixed exchange rate cannot be maintained).
Chapter 10
10.1 Introduction
This chapter focusses on the potential gains from international capital market integration,
as chapters C and D mainly focused on the potential losses. The two main benefits:

The possibility that international capital flows lead national savings to their most
productive investment opportunities

International capital mobility permits an improved allocation of investment risk

10.2 International capital mobility- consequences

Recap: chapter B, book chapter 2 > Current Account balance = Savings S Investments I.
Also remember that a CA-surplus means a capital outflow and a CA-deficit means a capital
inflow.

From this accounting identity it becomes clear that if S I > 0, this surplus has to be
invested abroad (capital outflow). In other words: If exports are larger than imports, the
excess capital has to go somewhere. But what causes these capital flows? To answer this ,
we need a model.

A macroeconomic model of international savings and investment

Recap: Trade models in chapters B, C and D from the midterm and chapters 3, 4 and 5 in
the book. Financial transactions are different from goods transactions, where the main
difference is the risk involved. Savings are channelled towards investment opportunities
(direct or indirect via intermediaries like banks) in the assumption that the investments
will yield a positive return. If you want agents to save more, interest rate r has to increase,
also to compensate savers for the higher risk involved.
sH = sH (rH+); sF = sF (rF+)
Where: sH is the savings function for the home country, sF for the foreign country. This
equation shows that if r goes up, savings go up.

In investments, the interest rate is important too. Each investment increases the existing
capital stock, which raises the productivity of capital. Each new contribution to the capital
stock market also makes a smaller contribution to the productivity of capital, due to the
law of diminishing marginal returns (paragraph D.3). What, now, is the optimal level of
investments?

iH = iH (rH-) ; iF = iF (rF-)
This equation shows that an increase in interest, investments decrease

Refer to Figure 10.1. Savings curves are upward sloping, investment curves are downward
sloping, see the equations. In the absence of international capital mobility, the equilibrium
interest rate equals rH0, point 1 and rF0, point 2 for Home and Foreign respectively. Note:
without mobility rH > rF. In equilibrium, there is a current account balance, no net inflow
or outflow of capital. Now The book introduces international capital mobility. The
worldwide interest rate will be somewhere in between rH0 and rF0 for both countries. If
this would not be the case: arbitrage. The world interest rate becomes rH1 and rF1 > Net
gains are illustrated with shaded triangles, which can be explained:

In autarky, Home is in situation 1. International capital mobility leads to a lower

interest rate at rH1, which makes a loss for the suppliers of funds of rH0,1,3a,rH1 and
a gain for the demanders of funds equal to rH0,1,3b,rH1 > Net gain = 1,3a,3b.

In autarky, Foreign is in situation 2. International capital mobility leads to a lower

interest rate at rF1, which makes a gain for the suppliers of funds of rF0,2,4a,rF1 and a
loss for the demanders of funds equal to rF0,2,4a,rF1 > Net gain = 2,4a,4b.

Time preference = Assume: for any interest level, home saves less than foreign. Present
consumption in home decreases, and increases in the future. The relative price of present
consumption in terms of future consumption is (1+r), as by giving up 1 unit of present
consumption, your return is (1+r) units of future consumption. The higher the degree of
time preference, the higher will be the interest rate.

Inter-temporal trade = Trade in goods over time. By lending to home, foreign van
increase its future consumption, whereas home can increase its present consumption >
Both countries are better off. Thats exactly the conclusion of international capital mobility.

10.3 The direction of capital flows

Paragraph 10.3 in the book describes the findings of Feldstein and Horioka, who found
that the correlation between national savings and investment ratios were very high and
thus international capital mobility actually was rather limited. This was a puzzling finding,
as the popular conviction is that the world is highly globalized and the capital market is
highly integrated. See Tables 10.2&10.3 for results.

Refer to Figure 10.2 in the book.

Diminishing marginal productivity = An economic principle that states that while
increasing one input and keeping other inputs at the same level may initially increase
output, further increases in that input will have a limited effect, and eventually no effect or
a negative effect, on output.
Assume that Home is capital rich, kH > kF. In other respects, the two countries are alike.
The horizontal axis is world capital stock, which is divided between Home and Foreign, as
indicated by point E0. An increase in kH must lead to a decrease in kF and vice versa. The
left vertical exis is the Marginal Product of Capital MPC for Home, the right hand one is for
Foreign. Given the initial capital distribution at point E0, the respective interest rates are
rH0 and rF0. This is all under autarky. When allowing for capital mobility, agents see that
return on capital is higher in foreign, as foreign is capital scarce. So it is beneficial to
reallocate capital from Home to Foreign. The size of reallocation equals the distance
between E0 and E1. The reallocation stops at point A, where an equilibrium is achieved
and interest equals rH1 = rF1. The net gain is represented by triangle ABC, where the gai
for Foreign equals E0, E1, A, C and the loss for Home eqals E0, E1 A, B.

What is happening to the direction of capital flows?- Historical overview

First era of globalization, 1870-1914 > Capital flows were mainly long term, from rich
countries like Europe to poor countries.
Currently > Short term flows of capital between developed countries, which is puzzling, as
moving capital from rich to poor is even more attractive now than it was during the first
era of globalization. But what can account for this? Three qualifications:

The assumption of diminishing returns to capital may not be correct

Potential gains from international capital mobility need not be realized

The overall conclusion as to the fairly limited degree of capital flows to developing
countries masks large cross-country differences

10.4 The risk diversification benefit

This paragraph deals with the second main benefit: The improved risk diversification.
Suppose, The book permits international capital mobility, but the current account is in
balance, which means there are no net flows of capital. This doesnt imply that there are no
international capital transaction, domestic investors probably only have bought foreign
shares and domestic banks have most likely used their funds to provide loans to foreign
firms. Furthermore, savings and investments refer only to S and I out of this year > A large
part of international capital flows are not included in S and I as such.

Portfolio investment and risk sharing

The second main advantage of capital mobility Is risk diversification. This is best
understood from the perspective of the individual portfolio investor. Suppose, a portfolio
investor can invest savings in loans to firms in Home or Foreign. In both countries the
interest rate is r and they do not differ in country risk (political uncertainty for example).
Also assume that the exchange rate is irrevocably fixed. > You would say the investor is
indifferent of where to invest. This is not the case!! What is Home and Foreign are
specialized in the production of different goods? The associated risks of lending to either
Home or Foreign are different in this case.Country-specific risk = If there is no capital
mobility and Home is hit by a negative shock (economic downturn), the stock values
decrease and the investment portfolio of the investor decreases too. So with international
capital mobility, there is a possibility for risk diversification. Also, as long as investor differ
in risk profile and outlook, the diversification, or dont put all your eggs in the same
basket argument makes perfect sense.

Home-bias puzzle = If a country has a share of 15% in world GDP, investors invest 15%
of their savings into domestic financial assets and 85% abroad, so a large share of wealth is
held in domestic assets. The actual degree of cross-country risk diversification now turns
out to be rather limited. Explanations:

Capital mobility has increased, but is still far from perfect. If transaction costs of
investing in Foreign are positive, more is invested in Home

10.5 The supply of funds for individual firms

Figure 10.1 suggested that firms, when they seek funds to finance the expansion of their
capital stock face a supply of fund that is the macroeconomic savings function S. This is not
the case > National assets are used to buy all kinds of assets and funds to finance firm
investment is only a small part of where total savings are put. Also, households and the
government also engage in investment activities. Households invest in cars and houses for

example and the government in infrastructure. Therefore, the macroeconomic savings

curve S is not suited to describe the supply of funds to individual firms.
What does a supply of funds for the individual firm then look like? Remember that
investment projects of firms are risky in the sense that they are large and unique and they
are associated with incomplete information about the return on investment. Risk
diversification is not possible in this case!! Information is not only incomplete, but also
distributed asymmetrically, as all suppliers of finance want to be compensated for the risks
involved.

Refer to Figure 10.3. Fd gives the demand for funds, its like the I curve on macroeconomic
level, but then on firm level. R0 is the risk free interest rate of internal finance (the firm
financing their investments themselves). Only when firms run out of internal finance, they
seek external finance, where they prefer debt over equity. The partly upward-sloping
supply curve depends on the extent of the asymmetric information problem. The problem
of asymmetric information can be divided into:

The adverse selection problem = The situation where the supplier of external
finance through his own actions ends up with firms that it wishes to avoid.

The moral hazard problem = After funds have been granted to the firm, the
supplier can observe only in an imperfect manner if the funds are being put to good
use.

The supply of funds and international capital mobility

The problems of asymmetric information are to be seen in Figure 10.3 through the Fs
schedule on a firms net worth, which equals assets liabilities. A fall in net worth means
in increase in both information problems: In the adverse selection problem, because the
firm enters financial trouble and there is less to reclaim > Suppliers of money may cut back
their lending or apply even more strict borrowing conditions. The more the firm is in

trouble, the higher the chance the firm cant meet these stricter conditions. In the moral
hazard problem, because if the net worth falls, there is less money and the firms start to
engage in even more risky behaviour. Changes in net worth shift the supply of
funds schedule.

What is the relevance of international capital mobility for firms willing to invest, using the
supply of funds Fs?

The access to international capital increases the availability of external funds,

making the supply curve shift to the right

Access to international capital mobility may increase the efficiency of the supply of
external funds (operating costs are too high, lack of competition, etc.) Figure 10.4
shows bank efficiency > Differences in efficiency can be included in Figure 10.3. Take a
level of funds X, the costs of intermediation are given by the distance between a and b.
The corresponding interest rates are then rA and rB. You see there is a wedge between
rA and rB; The supplier asks rB but gets rA and the demander pays rB. A decrease of
this wedge would boost both supply and investments. Equilibrium: wedge = 0 and Fs =
Fd, point c

International capital mobility is also relevant for the sensitivity of the supply of
funds curve in NW and hence for changes in the problems of asymmetric information