Various Practical Theories on International Monetary Economics and Finance

International Monetary Economics
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International Monetary Economics
This discussion will focus on the various practical theories on international monetary economics. An article touching on international finance will be retrieved from the media and reviewed, through written explanations and graphs, in line with the tools learned in class. This will be followed by an explanation of the lower price levels in poorer countries, the effect of a temporary fiscal expansion on output, the ramifications, on the exchange rate, of the central bank holding the money stock constant instead of purchasing foreign assets when output increases, and the weakest measure, among the Government Safeguards Against Financial Stability, that contributed to the 2007-2009 U.S. Financial Crisis.
The Economist Article
In “Inflation in America,” (2021), economists and officials have engaged in a debate whether the condition is short-term, brought about by the overstretched supply chains, or it is a long-term one. One of the causes of inflation is the increase in the supply of money into the economy, especially the currency in circulation, leading to increased monetary assets. In this article, the economists and other experts are uncertain as to the cause of the current situation and whether it will last in the short run or it will spiral into the long run. For this review, it is assumed that this situation is demand-pull inflation that has been brought about by an increased supply of money, with too much cash or money chasing after too few goods. The Federal Reserve System, or simply the Fed, is the central bank of the U.S. and is in charge of controlling the supply of money, specifically the currency in circulation, to forestall an economic crisis like inflation.
Therefore, the Fed is in charge of both the supply and demand of the currency in circulation. It is directly involved in the regulation of the currency in circulation (Krugman, et al., 2018). In the case of an increase in the supply of money in the economy, the prices of goods have insufficient time to make adjustments to the conditions in the market. On the contrary, in the long run, prices of outputs and that of factors of production have sufficient time to make adjustments to the conditions in the market thus; wages make adjustments to the supply and demand for labor, amount of labor coupled with other factors of production determine income and real output, the supply and demand of saved funds determine the real interest rates. In addition, in the long run, the average price level adjusts proportionally based on the amount of supply of money, leading to the conclusion that there exists a direct relationship between the amount of supply of money and the inflation rate, which is predicted to be the difference between the supply of money growth rate and the demand of money growth rate (Krugman, et al., 2018). See the below illustration;
Percentage increase in money supplyPercentage increase in the price level1040302010203040
Subsequently, “Inflation in America,” (2021) writes that if the prevailing inflationary environment is a short-term one, then the Federal Reserve should not rush into increasing the interest rates as such a move would be detrimental to the economy. The inflation that is a result of excess supply of monetary assets in the economy leads people to be willing to buy the interest-bearing assets, taking advantage of the opportunity cost of holding onto the monetary assets during inflation. The forces of demand and supply will lead to a drop in interest rates. There is no strong evidence to the effect that if inflation is left unchecked in the short run, it will spiral out of control in the long run (Rowan, 1974). Since the Federal Reserve controls the interest rates in the money markets, in an environment of high inflation as being witnessed, it has the option through a fiscal policy, to increase the interest rates to sustain the demand for nonmonetary assets to ‘mop up’ the excess monetary assets, which earn low or no interest rate, from the economy. If the inflationary condition is a short run, then any interference by the Fed through such fiscal policies is bound to destabilize the market. The best thing in this scenario is to let the market correct itself.
In addition, “Inflation in America,” (2021) notes that the central bank ought to intervene if the inflation is stubbornly high given that in October the prices were too high and the situation is putting pressure on the Fed. If the inflation persists in the long run, then the Fed intervenes to prevent further depreciation of the domestic currency, which is proportional to the domestic price level increase. The Fed will also work to tame inflation to avoid a situation of a rise in domestic interest rates that leads to low demand for real monetary assets. Though the rise in the rate of inflation leads to a rise in the interest rates, sufficient fiscal policies can work to contain the situation both in the short and long run.
“Inflation in America,” (2021) further posits that the higher inflation will result in demands for higher wages as already being witnessed. Inflation is also caused by higher salaries that translate to increases in disposable incomes. With such increases, workers can afford the goods and services that were hitherto out of reach for them. The higher demand brought about by this situation leads to rising prices of goods and services in conformity with the market forces of supply and demand. If the output level remains the same, the high demand forces the prices to rise in response.
Lastly, “Inflation in America,” (2021) notes that the Fed had instituted measures to control the supply of money by reducing its hitherto high monthly asset purchases, being one of its ultraloose policies implemented at the peak of the Covid-19 pandemic, with some banks postponing their forecasted increases in the interest rates. A reduction in the purchase of assets by the Fed will lead to a decrease in the amount of domestic currency in circulation since the Fed will be holding onto the money as opposed to if it did purchase and let the money into the economy. This is one of the measures to tame the high inflation since the supply of money will be reduced.
Price Levels in Poorer Countries
Prices of non-tradable goods are variable internationally thus this is a contributing factor in the price differences between poorer and rich nations. The price levels in poorer countries are lower because of the lower real income per capita since these price levels have a positive relation to the real income per capita levels if such prices are expressed in a single currency. This concept means that the conversion of a dollar into local currency at the prevailing market exchange rate is much more valuable in a poorer country than in a rich country (Krugman, et al., 2018). Goods are easily tradable as opposed to services which are mostly non-tradable and as such the price level differences are mainly concerned with goods. The prices of tradable goods do not differ as much between countries, since they follow the law of one price, which dictates that under normal economic conditions without barriers and not considering transportation costs, the same good must sell at the same price in different competitive markets.
The Balassa-Samuelson theory looks at this concept through the lenses of productivity and is of the view that since labor wages in poorer countries are low due to the low productive nature of labor used in the production of tradable goods in these countries, then it follows that there will be lower production costs for non-tradable goods, leading to low prices for these non-tradable goods, as opposed to the higher price of non-tradable goods in rich countries occasioned by high productivity of labor (Krugman, et al., 2018). The non-tradable goods do not compete internationally and as such, they are not subject to the law of one price. As such, since these goods compete domestically under low productivity conditions, their prices are lower in poorer countries than in rich countries owing to the lower productivity. The rich countries however have higher productivity of labor, given their advanced technological development, which also translates to higher productivity in the production of non-tradable goods, and as such have higher prices for non-tradable goods.
The Bhagwati-Kravis theory approaches it in terms of endowment observing that the lower prices in the poorer countries are a result of higher labor: capital ratios in the poorer countries. This labor-intensive production means that the marginal product of the labor factor of production is lower making the product in whose production it is vital cheaper as compared to other products (Friedman, 2008). Given that non-tradable go...