Different kinds of exchange rates and their advantages and disadvantages Flexible Exchange rate: Determined by the market

(Supply/Demand) Advantage 1. Send signal to true value of currency. Very active monetary policy. Suppose you have a recession e.g. in US, rising unemployment, GDP isn t growing very much with flexible exchange rate you get depreciation which will make your exports cheaper and imports more expensive. It s a self-adjusting mechanism/buffer/shock absorber. 2. Balance of payments: If you have balance of deficit (imports are higher than exports), your currency is likely to devalue and depreciate. That will make people import less and export more which will result in reducing trade deficit. Automatic stabilizer. Disadvantage 1. Volatility: highly unstable, fluctuates a lot and therefore makes business planning and purchasing & selling decisions difficult. 2. It can encourage speculation especially if you happen to be a small country. In a world with little restriction or regulations governing speculation, under flexible exchange rate, Speculators can move that exchange rate in the direction which they desire which may not be warranted by economic fundamentals. E.g. Asian crisis 1997-98.

Fixed Exchange rate: You need mutually agreed fixed rate between countries. 1. Because they are fixed, it makes business planning easy - you can rely on Central bank, not have to buy insurance because you'll know that the rate will be fixed. It compels government to behave in order to maintain an exchange rate. So the fiscal and monetary policy under this is more disciplined. 1. You need to have an agreement which is not going to be likely anymore, they are sovereign, countries today do not make such deals any more. It s very difficult to implement. 2. EURO is a special case. You technically do not have a monetary policy. You give up lot of sovereignty when you accept a fixed exchange rate. Fixed exchange rate system collapse because they are too restrictive, you give up on monetary policy and you're constrained on fiscal policy.

Dirty float system: The dirty float exchange is good except for the volatility. It is determined in Central bank, they simply allow for changes that are regulated, managed and controlled. They don't fight market forces but they manage it. Balance of payments; attempts to limit volatility. It s not too different from a plain floating flexible exchange rate. -Volatile -Requires gvt intervention -Speculation -large swings in currency rate.

Pegged Exchange Rate: It s really a fixed exchange rate, a country determines for its own currency relative to one foreign currency (usually the US dollar), and you don t need permission to do that. Hong Kong dollar is a pegged exchange rate. Hong Kong monetary authority announces the value of the peg, and says also they will keep it at that level. 1. Gives them much like a fixed exchange rate, a price that is relatively stable so anyone who deals with Hong Kong can trust that price. Makes it easier to do business in Hong Kong since you know the value of the currency. 1. You never know the monetary policy. Exchange rate yes, but when it comes to interest rates, money supply that s determine by outside sources, and of course you could live with that if you re very disciplined. The two Countries with a peg now are oriental countries; they are conservative and disciplined. They don t like to spend money they don t have, it s the cultural feature of China. They can be disciplined because they are not like Western countries: North America, Europe we believe through our gvt we have to help the poor, whereas most oriental countries that s not an obligation. If you have obligations your fiscal looks different from that is in China and Hong Kong. 2. Peg is not easy to manage for most countries of the world. It does not stay for a long time. Also, if you happen to have an unstable economy, a peg is very hard to maintain. E.g. China has to move in recession to avoid speculations. 3. You always peg against dominant country (US dollar). Disadvantage: When peg dollar falls, the value of your currency falls. But it also means that in terms of assets, your purchasing power within the country is lower.

Where to manufacture? Country factors: Technological factors: Fixed costs: If your operations require huge fixed costs, you have to be very careful where you locate. For example, mining. The minimum efficiency scale: At what level you ve to operate to get the cost down near the minimum. If you look at manufacturing of different countries, there s different minimum-efficiency scale. China produces so much that s why it has low-average cost than many other countries. That s why there is so much investment going in China. Flexible manufacturing technology/Mass customization: Economist talk about something different called modularization. Today, businesses want to use the same technology for manufacturing in different countries; Japanese made these possible. Product Factors: Value to weight ratio: How value is your product? How heavy is it? The higher the value and the lower the weight the more you re free to locate almost anywhere. If the value happen to be low and weight happen to be high, then you re forced to locate close somewhere close because of the transportation cost. Universal need:

Make or Buy decisions: When Making it: Advantages: - Lower costs - Intellectual property is protected: Making it yourself requires specialized investments, you protect your intellectual property/propriety/technology. You are in-charge of scrabbling, inventory management When Buying it: - You can even get at a lower cost sometimes, and you can buy as needed. But you can also run into the problem of quantity restrictions: how much you can buy, how quickly it will be delivered? And product specification, quality is not in your control, you simply have to buy whatever best is available from the suppliers. E.g. Japan manufactures computer parts. They had an earthquake, tsunamis so after shock, many manufacturers in Japan got disrupted and they could not supply. Countries who were buying from Japan had a tough luck people got laid-off in U.S, India and Taiwan because of this.

Vertical integration: You buy what you have to, but most of the time you make it so you keep on making what you need within your own company. It has its advantages and disadvantages. One of them is of the cost side, many corporations have now discovered that vertical integration had lot of advantages one time, but now it has less advantages because of the high cost of production. So many of these countries for example General motors, ford and Chrysler have realized that it s far better to contract out. Buying includes contracting out.

Q: - Consultants have been asked by a Chinese auto firm to advise it on how to decide between making or buying a special battery it will need for the cars to be made in its Canadian factories". Answer: -Sourcing decisions: whether a firm should make or buy component parts. Advantages of Make: Lower costs: May pay a firm to continue manufacturing a product or component in-house if the firm is more efficient at that production activity than any other enterprise. Facilitate Specialized Investments: When one firm must invest in specialized assets to supply another, mutual dependency is created. Each part fears the other will abuse the relationship by seeking more favorable terms. Since this is a special battery, this firm would need to invest in special equipment used to make the special batter (an investment in specialized assets). Protect Proprietary Product Technology: Proprietary technology is technology unique to a firm. It enables the firm to produce a product containing superior features that give a firm a competitive advantage. Would not want this technology or knowledge to fall into the hands of competitors. You are incharge! Improve Scheduling: Scheduling problems can be exacerbated by the time and distance between the firm and its suppliers. Making the battery in-house will reduce the time and distance issues that result in delays and scheduling mishaps. Advantages of Buying: Strategic Flexibility: Greatest advantage of buying component parts from independent suppliers is that the firm can maintain its flexibility, switching orders between suppliers as circumstances dictate. Import internationally where changes in exchange rates and trade barriers can alter the attractiveness of supply sources. Lower Costs: Outsourcing may lower the firms cost structure. A firm that buys its components from suppliers can avoid three main issues with making in-house: The greater the number of subunits in a firm, the greater are the problems in coordinating and controlling those units. May find that b/c internal suppliers have a captive customer in they firm, they lack an incentive to reduce costs. If they do not have to compete for orders with other suppliers may result in high operating costs. May pass on cost increases to other parts in the firm. Have to determine appropriate prices for goods transferred to subunits within the firm. Challenge for any firm, but even more difficult for complex international businesses. Different tax regimes, exchange rate movements, etc. A firm that buys its components from independent suppliers can avoid all these problems and the associated costs. Offsets: It may help the firm capture more orders from that country. For instance, if the Chinese firm purchases the battery from the Canadian firm, the Chinese government may ask that Canadian firm to allow them to perform subcontracting on behalf of the Canadian factories. Make Trade-Off: The greatest benefits of manufacturing components in-house seem to be best when highly specialized assets are involved. This also is the case when vertical

integration is necessary for protecting proprietary technology, or when the firm is simply more efficient than external suppliers. Buy Trade-Off: Issues of strategic flexibility and organizational control are even larger for international businesses that purely domestic ones, which means `buying components are more feasible than vertical integration. Some outsourcing in the form of offsets may also help a firm gain larger orders in the future. Q: Consultants have been asked by a Canadian firm to provide a brief report on how it should select a foreign country "to produce its new biodegradable Toilets." Q: How does a firm choose which country to invest in? Answer: - Need to understand the implications involved: Three Factors 1 Country Factors: I. Political stability II. Culture III. Labour costs IV. Trade barriers V. Location externalities 2. Technological Factors: I. Fixed costs: If your operations require huge fixed costs, you have to be very careful where you locate. For example, mining. II. Efficient scale: The minimum efficiency scale, at what level youve to operate to get the cost down near the minimum. If you look at manufacturing of different countries, theres different minimum-efficiency scale. China produces so much thats why it has low-average cost than many other countries. Thats why there is so much investment going in China. III. Flexible manufacturing technology/Mass customization: Economist talk about something different called modularization. Today, businesses want to use the same technology for manufacturing in different countries; Japanese made these possible. 3. Product Factors: I. Value-to-weight ratio: How value is your product? How heavy is it? The higher the value and the lower the weight the more youre free to locate almost anywhere. If the value happen to be low and weight happen to be high, then youre forced to locate close somewhere close because of the transportation cost. II. Universal needs Where do you want to locate: vitally important for most companies. What to look at: Political economy, culture, relative costs of production, labor policies of the country (In China they are non-existent, barely any REAL unions in China), labor policies are more important than wage rates because work stoppages are very important, infrastructure (Airports, railways, roads, especially in manufacturing, etc..).

Q: - What are the advantages of economic integration? Answer: - Economic integration can be defined as a kind of arrangement where countries get in agreement to coordinate and manage their fiscal, trade, and monetary polices in order to be mutually benefitted by them. There are many degree of economic integration but the most popular is free trade. In economic integration no country pays customs duty within the integrated area, so it results in lower prices for the distributer and the consumers. Advantages y y y y y y Progress in trade Ease of agreement Improve political cooperation Opportunities for employment Beneficial for financial market Increase in FDI

Describe and comment on various levels of integration/Interdependence between countries. (Chap # 8)

Economic integration means there's a free trade agreement of some sort between two or more countries e.g. We are part of NAFTA, it is an economic integration; free-trade area between three countries. Regional means three or more, Bilateral means two e.g. agreement with Colombia. Levels 1. Free trade agreement e.g NAFTA Description -Freer trade in goods and services. It's freer, not free. Comments -Lowest level in NAFTA -not free but freer. -Mexico has 40 -NAFTA 300 -Canada and United states having a common trade policy? Not possible! Canada makes its our own trade policies. -Extremely rare.

2. Custom Unions = Free trade agreement + common foreign trade policy

Custom union is a free trade agreement, but the countries that are signing a free trade agreement also agree on the same policies with the rest of the world. e.g. Tariff barriers, quotas, investment policies -- three of these will have the same policy as in any other country.

3. Common market = CU + Free mobility/factors of production

It allows the free mobility of labour -Very rare. There was only one and capital. Canada is not a but now it's become something common market. else. * -Takes an amazing amount of political courage to even suggest a common market and

that wont happen! 4. Economic Union = Common market + Common currency(e.g. EURO) -Common currency saves billions on transaction cost, conversion fee is saved, there's a common price and above all, you create a humongous capital market. -EU is in big crisis Greece, Spain, Italy and Portuguese -- they have a huge debt, they can't pay back so the rest of the European countries have to help them out. No monetary policy, exchange rate, you lose national sovereignty. 5. Political Union = Political EU + National gvt e.g: USA -United sates with one national governance in Washington. General election. It is customs union, have common currency(US dollar), got one national government. -A lot of free trade agreements are not about economic but political integration. EU mentioned above is political. EU is history of war. -If you have a political union you can manage a common currency. Most countries history is to drive to Political union e.g. China -Political reasons to have hot wars but cold wars. -Economic union is very important for political reasons. Extremely rare EU would love to become the United states of Europe, that was the hope 40-50yrs ago and that's where they were going...