Following the description and specific instructions, briefly, explain and illustrate how each is used as an analytic tool in international finance. In doing so, be certain your discussion includes content from the provided readings. This paper has 2 parts:
Part A
Foreign Exchange Market and Exchange Rates
The role of Real Exchange Rate (RER) policies for economic development is still largely debated. There are two central and interconnected issues regarding exchange rate policies in the macroeconomic literature on emerging economies in recent decades that relate to the links between the balance of payments and macro stability and growth: (i) the role that the exchange rate plays in facilitating or hindering economic growth, including through promoting diversification; and (ii) the extent to which the exchange rate regime and capital account management help manage cyclical swings in external financing and terms of trade fluctuations, especially in commodity-exporting countries, and open or limit the space for counter-cyclical macroeconomic policies. Both of these issues highlight the potential importance of exchange rate policies in open economies, alongside monetary and fiscal policies, and also the specific and somewhat contradictory links between exchange rate and monetary policies in emerging economies subject to strong boom-bust cycles in external financing. Furthermore, volatile capital flows present complex trade-offs to central banks around the world. Chief among them is Mundell’s famous trilemma, which in economies with open capital accounts manifests itself in a tough trade-off between employment and exchange rate stabilization. In search of solutions, the vast majority of open economies has turned to foreign exchange (FX) interventions. In the context of a small open economy with two key ingredients: (i) partial segmentation of home and foreign bond markets and (ii) a pecuniary externality that makes the real exchange rate excessively volatile in response to capital flows:
First, discuss why partial segmentation implies that, by intervening in the bond markets, the central bank can affect the exchange rate and the spread between home- and foreign-bond yields.
Then, discuss why such interventions allow the central bank to address the pecuniary externality, but they are also costly, as foreigners make carry-trade profits.
Next, characterize the optimal intervention policy that solves this trade-off.
Lastly, discuss the trade-offs associated with alternative stable and competitive Real Exchange Rate policies and the relationship between the use of exchange rate policies for macro-stability and for development.
Your answer should rely heavily on the provided reading from Guzman and from Fanelli
Part B
Flow Approaches
The traditional approach to international finance is to view capital flows as the financial counterpart to savings and investment decisions, assuming further that the GDP boundary defines both the decision-making unit and the currency area. This “triple coincidence” of GDP area, decision-making unit and currency area is an elegant simplification but misleads when financial flows are important in their own right. In the context of flow approaches:
First, graphically illustrate how the neglect of gross flows, when only net flows are considered, can lead to misdiagnoses of financial vulnerability.
Then, graphically illustrate how the inattention to the effects of international currencies may lead to erroneous conclusions on exchange rate adjustment.
Next, graphically illustrate how sectoral differences between corporate and official sector positions can distort welfare conclusions on the consequences of currency depreciation, as macroeconomic risks may be underestimated.
Lastly, discuss an alternative analytical framework based on balance sheets as the unit of analysis.
Your answer should rely heavily on the provided reading from Avdjiev
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