International Monetary System

 

Complete the requirements mentioned below:
1. Summaries article by Conway with particular reference to its relevance for investors in emerging markets of developing countries and understanding of roles of the IMF
2. Evaluate the extent to which the bargaining model can be viewed as a practical implementation of the law of comparative advantage.

Part 1

There was a time in the international monetary system when all the countries were hit by hyperinflations then the Tequila crisis hit the economies of these countries. Due to all this, the savings of these countries wiped out, jobs got eliminated and purchasing power of people got reduced. Then the role of IMF came, and it was considered as the initial line of defense against this crisis. Various forecasts were made by IMF, it gave advice on policies and managed the crisis with the help of financing packages that were subject to the condition that it will assist the adjustment of the country.
IMF is a place where one can understand how the concepts of economic costs, inflation, and disinflation works. The central bank has the power to reduce inflation by adopting some measures, and it also has the ability to eliminate inflation.
IMF advises developing countries to carry out policies that helps them to achieve macroeconomic stabilization and way by which they could maintain continued access to the financial markets of the world. The policy were carried out to achieve the economic growth rapidly. It will also be a perquisite for reduction of poverty. For the countries to sustain their growth, the countries should focus on achieving macroeconomic stability. In the researches carried out by various researchers, it was found that with inflation, the poor becomes worse. The first step to reduce poverty is to achieve macroeconomic stabilization but as per the author, this is not sufficient. There are some areas where the reform is necessary, they are human-capital investment, labor market liberalization, agricultural market liberalization, and macroeconomic stabilization. This policy primarily aims to get the countries a sustained growth as it is necessary to increase the living standards of population.
According to Fisher, there are some purposes of IMF. The cooperation in international monetary problems can be promoted through collaboration and consultation which is taken care of by IMF. It facilitates the expansion of international trade and it also balances the growth of that trade. Then the exchange stability is promoted so that orderly exchange arrangements can be maintained among members. IMF also helps in avoiding the competitive exchange depreciation. IMF assists in the setting up of system of payments that is multilayered and it eliminates the restrictions of foreign exchange that has the potential to hamper the growth of world trade. IMF also instills confidence among the members by temporarily making available the general resources of the funds. These are provided to then under proper safeguards and gives them opportunity to rectify the maladjustments in the BOP without resorting to measures destructive of national or international prosperity. Another purpose of IMF is to reduce the duration and reduce the degree of disequilibrium in the BOP of members internationally. To achieve these purposes, IMF uses both ex ante and ex post instruments. When crisis don’t exist, the exchange stability is maintained by IMF with the surveillance of macroeconomic policy of members and with consultations on the reform of macroeconomic policy.
The reform was needed because the international capital flows were very volatile in the emerging markets and there was presence of too much contagion in the system. Central banks have a role to play when adverse shocks hit the countries. They can increase their holding of forex reserves, they can increase the surveillance of the financial firms leverage and they can also increase the prudential supervision of operations of financial sector. Here the assistance of IMF plays an important role.  IMF provides technical advice by the surveillance of performance of member country. It broadcasts the information to the market participants about the performance and through its lending program. At the time of crisis, the government has the responsibility to re-establish the optimism among the people. So in this, the IMF stands ready to assist the countries in adjusting without resorting to measures destructive of national or international prosperity.
IMF is known as the lender of last resort. The role of IMF in the consequences of moral hazard is that it plays the role0 of lender of the last resort. This reduces the dangers of international financial crisis. IMF was also involved in the battlefield medicine at the time of crisis which solved many problems of the economy at that time. IMF has successfully played the role of lender of last resort for the emerging economies. These economies were the ones which had met the specific preconditions of economy and financial problems. It ceases the lending to economies of countries for the development assistance for long-term and for the structural transformation for the long term. It writes off all the claims against those countries that are highly indebted and are poor and needs to implement an effective strategy for economic development.
With the increase in the intervention by IMF, the perception of investor that it will be able to recover the investments that it had put into the country that is going through the crisis improves. With the intervention of IMF, the prices of stocks for banks with more exposure to the crisis countries rises more than the stock prices for banks which had less exposure.
Some critics have suggested that IMF is the cause of problem in economies and it has not solved any problem but from the above evidences it can be said that IMF has contributed in the recovery of many economies.  IMF has played major roles in dealing with the moral hazards, it has predicted the crisis in right manner and it has used almost all correct policies to manage those crisis. There needs to be a research done on the empirical investigation of the impact of the IMF on economic choices, either in international financial markets or in the policy decisions of participating countries. This investigation will be of use if the analysis of all countries will be done and a comparative view will be considered. It is recognized that not only what the author thinks of the institution but how he thinks about it as well. This makes the volume an invaluable starting point for those wishing to answer the many questions that remain about the effectiveness of IMF activities.

Reference:

Conway, P. (2006). The International Monetary Fund in a Time of Crisis: A Review of Stanley Fischer's IMF Essays from a Time of Crisis: The International Financial System, Stabilization, and Development. Journal Of Economic Literature, 44(1), 115-144. http://dx.doi.org/10.1257/002205106776162690

Part 2

Law of Comparative advantage

This law or theory was given by David Ricardo. All nations cannot be equally efficient in producing and trading all kinds of goods. If one nation is less efficient than other nation in production of one, two or all goods or it can be said that one country has an absolute disadvantage with respect to another country, still there is the scope for a successful trade between the two countries, and both countries can benefit from the trade. Absolute advantage/disadvantage means that a country has the ability to manufacture a good or service with less/more factor inputs. In this law of comparative advantage, two countries are trying to gain benefits from trading with each other. One country produces and exports that commodity in which it has a smaller absolute disadvantage as compared to another commodity (Kiyota, 2011). The good which the country has decided to produce and export are the good of comparative advantage to this nation. In contrast to this, the country does not produces and imports that commodity in which it has a larger absolute disadvantage as compared to another commodity. The good which the country has decided to import is the good of comparative disadvantage to this nation. This law or theory works when the nation does not have a same absolute advantage in both the goods or there should be disproportionate absolute disadvantage for two goods.
There are few assumptions of this law (Kiyota, 2011). In this, there exists only two countries and two goods. The two nations who trade are free to trade, and there are no rule or restrictions on them to trade. The only factor of production is labor and cost of goods are determined by the time that labor spends in producing that good. It is also assumed that there are no transportation costs in trade. Labor is mobile in the respective nations due to same wage rate in the country, but it is immobile within the trading nations as wage rate differs across countries. No matter what is the level of production, the returns to scale in production remains constant. The labor is fully employed, and the total labor is constant. The last assumption is that there is no change in technology.
The working of this law:
Good Country A Country B
Machinery (units/labor hours 2 4
Food (units/labor hours) 1 6

Two nations- Country A and Country B are trying to trade with each other. The two goods being traded is machinery and food. Country B has an absolute advantage in the production of both the goods as it can produce more quantity than Country A in the same working hours. In one labor hour, Country A produces 2 units of machinery whereas Country B produces 4units of machinery in one labor hour. It can also be interpreted that the labor has more efficiency in country B than in Country A and accordingly Country B would be paying more wages to its laborers than Country A but the labor from Country A cannot be moved to Country B or vice versa because it is assumed in the law that labor is immobile among nations. Though Country B has an absolute advantage in both commodities but still it has a comparative advantage in producing food because it can produce 6units of food in one labor hour and it can produce only 4units of machinery in one labor hour. With the same logic, Country A has an absolute disadvantage in the production of both goods as compared to Country B, but it has a comparative advantage in the production of machinery as it can produce 2units of machinery in one hour, but it can produce only 1units of food in one labor hour.
Now Country A has a comparative advantage in producing machinery and Country B has a comparative advantage in producing food. So Country A will export machinery and import food whereas Country B will export food and import machinery.

Gains to both countries from trade:

If there was no international trade, then both the commodities will be exchanged within the respective countries at their existing exchange rates depending on the labor contents. Since the labor contents of two countries differ, so the exchange rates will be different too in both countries. In Country A, the rate of exchange will be 2:1, 2units of machinery for 1units of food as the labor hour is same i.e. one hour. Country A will not be willing to trade if it gets 1units of food by giving up 2units of machinery as it can do it in-house by diverting one hour of labor from machinery to food. Country A will refuse to trade if it was given less than 1units of food for sacrificing 2units of machinery. In the same way. The exchange rate of Country B is 4:6 that it will not trade if it gets anything less than 4units of machinery for sacrificing 6units of food.
Now suppose Country A agrees to exchange 2units of machinery for 2units of food, it will be able to gain 1units of food and also one labor hour will be saved as if Country A was producing food in-house, it was able to produce 1units in one hour, now it is getting 2units in one hour, so an entire one hour of labor is saved by Country A. This saved one hour can be dedicated to the production of more machinery that can be exported to Country B, or it can be used as a leisure time. Country B is getting 2units of machinery from Country A. For producing this 2units of machinery in the home country; Country B requires 1/2 hour. If is ½ it dedicates this ½ hour in the production of food, then it will be able to produce 3units of food, but it has to export only 2units of food to Country A, so Country B gains 1units of food or labor time of 10  minutes.  
Though Country A has gained more than Country B, but both countries have benefitted from trade and they are better by trading than without trading.

Bargaining model

This model analyzes the relations between the government of host country (HC) and MNE (multinational enterprise).  This model is the basic building block of the relation between these two. This model predicts that at the time of entry, the bargains of HC and MNE should favor the firm but later, the bargains are likely to become obsolete as over time, the perceptions of state regarding the benefits and costs changes. The structure of model changes when the number of entrants increases and differing entry dates is allowed to examine post entry bargains. Suppose the first wave of multinational enterprises enters a host country and then the second wave of foreign firms are faced by the country in the same industry (Eden & Molot, 2002). If the original MNEs have become fully integrated into the host economy and no longer suffer from the liability of foreignness that plagues foreign entrants, subsequent entries by rival MNEs disturbs this equilibrium. New entrants necessitate new bargains that affect the status quo of the first movers. Post-entry bargains involve three actors: the host government, first-mover firms, and latecomers. This model describes the varying nature of bargaining relations between the host country and multinational enterprise as a function of resources, goals, and constraints. Here it is assumed that the process of bargaining is a sum game which is positive in the way that both the parties bargains voluntarily and achieves absolute gains. However, the relative gains depend on upon relative bargaining power. The party which has stronger resources, higher issue salience, weaker constraints and greater coercive power, the outcome favors that party. The initial favor of relative bargaining power is on the multinational enterprise. Since these enterprises have a range of alternatives, the locational incentives are offered by host countries to attract inward FDI (foreign direct investment). However, it is expected that the bargain will obsolesce over time. An opportunistic host country government can hold these resources when the multinational enterprise makes sector-specific investments in the host country. The more the multinational enterprise is in the host country, it becomes more likely that the perception of the government of the benefit-cost ratio given by the multinational enterprise falls, especially if the investment if found to be highly profitable and there are more remittances to the foreign parent. Over time, host country becomes less dependent on multinational enterprise because the spillovers in technology and economic developments encourages the emergence of local competitors. This implies that host country plans to demand more from the multinational enterprise which causes the original bargain to obsolesce (Eden & Molot, 2002).
In the studies on this model the testing of the model suggested that multinational enterprises were successful in retaining the relative bargaining power and prevented the opportunistic behavior of host country government. This seldom obsolesced the bargains in practice. In today's scenario. There are very few governments that restrict the inward FDI by screening or by performance requirements, so the formal bargaining requirements are reduced between multinational enterprises and the host country.  
Bargaining model can be viewed as a practical implementation of the law of comparative advantage.  
In the law of comparative advantage, there are two nations or parties who are trying to get benefitted from trades by using their comparative advantages in the production of commodities. In the bargaining model also, there are two parties who transact with each other-the host country and the multinational enterprise.
Bargaining model analyzes the relations between the government of host country and MNE which is the indirect implication of law of comparative. In the law it is stated that how the countries can gain by bargains and do mutually beneficial trade with each other which is applied in bargaining model of Rugman as here the structure of model changes when the number of entrants (like the countries in the law) increases and differing entry dates are permitted to examine bargains after the entry of players  (Rugman & Brewer, 2001). Similar to the gains of trade between country A and country B explained above, the bargaining model applies it in practice as here suppose the first wave of multinational enterprises enters a host country and then the second wave of foreign firms are faced by country in the same industry, the original MNEs fully integrates into the host economy and saves itself from the liability of foreignness that plagues foreign entrants. The law of comparative advantage explains that how two countries who have absolute advantage and disadvantage in the production of goods trade with each other by exporting that good in which it has absolute advantage and imports that good in which it has an absolute disadvantage. This model takes the explanation and relevance of the law and describes the varying nature of bargaining relations between the host country and multinational enterprise as a function of resources, goals and constraints. Here it is assumed that the process of bargaining is a sum game which is positive in the way that both the parties bargains voluntarily and achieves absolute gains (which is similar to the example of two countries described above). However, the relative gains depend on upon relative bargaining power, but this is not the case in the law of CA as the countries do not bargain in reality, they just calculate their relative gains and starts to trade. The party which has stronger resources, higher issue salience, weaker constraints and greater coercive power, the outcome favors that party which is similar to the concept of absolute advantage and disadvantage of the law of comparative advantage (Rugman & Brewer, 2001). The initial favor of relative bargaining power is on a multinational enterprise which probably has a more absolute disadvantage like in country A in the above example. Since these enterprises have a range of alternatives, the locational incentives are offered by host countries to attract inward FDI (foreign direct investment). However, it is expected that the bargain will obsolesce over time. This is similar to the case of two countries above as when the country will start getting imported products, and it will start dedicating its labor hours to other products, it will have a higher absolute advantage in the first product. Over time, host country becomes less dependent on multinational enterprise because the spillovers in technology and economic developments encourages the emergence of local competitors. This implies that host country plans to demand more from the multinational enterprise which causes the original bargain to obsolesce which is also implied by the law of comparative advantage.
Hence, it is very clear from the above explanation that bargaining model can be viewed as a practical implementation of the law of comparative advantage.

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References:

Apart from the attachments, the following references were used:
Eden, L. & Molot, M. (2002). Insiders, outsiders and host country bargains. Journal Of International Management, 8(4), 359-388. http://dx.doi.org/10.1016/s1075-4253(02)00095-9
Rugman, A. & Brewer, T. (2001). The Oxford handbook of international business. New York: Oxford University Press.
Kiyota, K. (2011). A test of the law of comparative advantage, revisited. Review Of World Economics, 147(4), 771-778. http://dx.doi.org/10.1007/s10290-011-0105-y

 

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