BulletPointsummary with the 15th edition of International Economics by Pugel

Why are factor availability and factor proportions key to international economics? - BulletPoints 4

• Increasing marginal costs means that when one industry expands at the expense of other industries, increasing amounts of the other products in that industry must be decreased to get each extra unit of the expanding industry its product. 
• A country or economy its production-possibility curve (PPC) shows the amounts of different products that a country can produce, given the country or economy its available factor resources and maximum feasible productivities. Now, when the marginal costs increase of one product, the pc becomes ‘bowed out’. The supply curve shows an upward-sloping curve with the product that increases in marginal costs.This means there are two ways to show increasing marginal costs: the supply curve and the production-possibility curve.
• But what combination of production does the country chose? The production-possibility curve provides many points, but the country needs to select the point that fits best with the price ratio that competitive firms have.
• The indifference curve depicts combinations of amounts of consumption that result in an equal level of well-being or happiness. A point to the right or above this line is even better. A person has an infinite amount of indifference curves, but has a budget constraint.
• Without trade, the U.S. amount of production and consumption will be where the PPC is tangent to the highest indifference curve. If for instance, the price ration would be 1P/C instead of 2W/C, corn would seem so cheap that consumers buy more corn, so producers produce more corn and fewer potatoes and the point where the PPC is tangent to the highest indifference curve will be reached again. When there is no trade, different countries have different price ratios. Those differences form the immediate basis for trade. The U.S. relative price of 1 unit of corn would be 2 potatoes, and in the rest of the world, 1 unit of corn would be 0.67 of potatoes.
• When free trade is allowed, it has several implications for the country. For production, it means that there will be an output of the good that is exported. In our example, this means that more potato is produced within the U.S. and more corn in the rest of the world. That does not mean that complete specialization takes place, because of the bowed-out shape of the PPC which we looked at before. Furthermore, the production in the whole world is more efficient. Moreover, consumption of the imported products increases. This is because the lower market price creates a higher demand and a higher income because of the gains from trade. The latter is called a positive income effect. The consumption of the exported product can increase, stay the same, or decrease (the latter because it becomes relatively more expensive).
• Heckscher developed the core idea of the determination of a nation's trade patterns. A general explanation was developed by Ohlin, Heckscher's student.The Heckscher-Ohlin theory (HO) is about abundant and scarce factors. Countries export those goods which they can make with factors that are relatively abundant, and import those goods which they can make with factors that are relatively scarce. A labor-abundant country is a country with a higher ratio of labor to other factors than the rest of the world. A labor-intensive country is a country for which labor costs are a greater share of its value than they are of the value of other products. So in labor-intensive countries, the relative proportion of labor that is required for production is higher than the amount of capital required.

Which forms of imperfect competition exist, what are scale economies and which effects do monopolies and oligopolies have on trade? - BulletPoints 6

• When firms want to produce more, their total cost increases. The key problem here is the proportionate changes in total cost and output quantity. Constant returns to scale means that for every unit of output, the input and total cost rises relatively the same. This results in the average cost (which is the total cost divided by the number of units produced) remaining steady.
• Scale economies happen when the output its amount increases by a bigger proportion than the total cost. There are two types of scale economies: internal and external scale economies. With internal economies, the firm’s actions and decisions itself matter. When scale economies are internal, they can drive industries away from perfect competition. This happens because they push individual firms to be bigger than very small firms that locate in perfectly competitive industries. If scale economies contain differentiated products, chances are that an imperfect competition named monopolistic competition is created. This is a type of market structure where many firms compete with each other, selling products that are similar, but not identical, products. Since each firm sells a different product, every firm has price control over its own product. An example of monopolistic competition is the restaurant business or the hotel business. Here the product or service is similar, but each restaurant has its own menu and each hotel has a different style. Another type of market is an oligopoly. Oligopoly happens in scale economies when only a few firms compete in an industry. When this occurs, these firms can influence the prices. An example of an oligopoly is smartphone operating systems. Apple's iOS and Google's Android run the market here.
• The other kind of scale economy is external. External scale economies arise when many firms choose to locate in the same area and produce the same product there. Something that we call clustering then occurs: when economic forces concentrate on one specific area. An example of an external economy is the K-Pop industry locating in Seoul, South Korea.
• Inter-industry trade is when a country exports products to another country but in exchange for very different products from that other country. An example is one country trading agricultural products with a country that produces technological products. There also is intra-industry trade (IIT). This is when a country exports and imports similar or the same products.
• IIT is most important for manufactured products. Also, it happens more when transport costs and trade barriers are low. It also occurs more in industrialized countries. IIT can be explained since we define the categories too broad. For example, we say vegetables and we export leeks and import onions. Or within a category, different types of land (fertile versus unfertile land) might be necessary. Or it might concern seasonal products. Product differentiationmakes for a diversity of products that consumers see as similar but not exact substitutes. Product differentiation can be a solid basis for trading. Some consumers like products from foreign countries (or the choice to pick out of local versus foreign products) but imported products are not by definition cheaper. For example, this is true for shampoo: there are a lot of brands with different smells, that promise that it will give volume or shine. However, they are all shampoos and it is just the preference of the customer that is key here.
• Monopolistic competition is similar to monopoly: all firms produce their unique variant of a product. It is also like perfect competition because there are many sellers and the barrier to entry is low. Monopolistic competition makes for an industry with three characteristics. First, they produce a basic type of product but differentiate it from the products of other firms. The products of the firms all fall into the same category but vary enough to trick consumers to buy one product over the other. Second, there are a few internal scale economies that make a product variant. Third, in the long run, there is easy entry and exit for firms.
• Monopolistic competition is similar to monopoly: all firms produce their unique variant of a product. It is also like perfect competition because there are many sellers and the barrier to entry is low. Monopolistic competition makes for an industry with three characteristics. First, they produce a basic type of product but differentiate it from the products of other firms. The products of the firms all fall into the same category but vary enough to trick consumers to buy one product over the other. Second, there are a few internal scale economies that make a product variant. Third, in the long run, there is easy entry and exit for firms.

What are the main forms of international factor movement? - BulletPoints 15

• When multinationals invest in their country, they are afraid that these large corporations will exploit them. On the other hand, they want these multinationals to invest because developing countries can use their capital, technology, marketing and management skills. And industrialized countries have the same feeling. They are also afraid that if companies from their country to invest in other countries, they will be reducing the export and employment in that sector. They as well fear that if foreign companies invest in their country, they will lose control over their local economy. Governments, however, prohibit, restrict or encourage direct investments. They are able to regulate this by for example requiring partly local management or local research. High taxes are also a method, or subsidies and low or no taxes, if governments want them to invest in their country.
• Foreign Direct Investment (or FDI) happens when a lender or investor provides funding to establish or buy a company abroad or to finance a company abroad that is already owned by them. An example is when a company buys all the shares of a foreign company and gains full control over the establishment. However, if you (as in you as an individual) buy 0.1% of all shares, this is not FDI. You will not have any control or influence on the company below the international standard of 10% shares owned. When you only buy shares for financial return, not for management control, this is called international portfolio.
• The most obvious answer to the question ‘what the purpose of multinational enterprises (MNEs)?’ is that they are profitable. However, this is more complicated. There are five factors to understand this eclectic approach. The first is the inherent disadvantages of being a foreign firm. There is a major disadvantage when entering a foreign market because the firm competes against firms that are locals. Besides that, it will cost a MNE to control management there and to establish political connections. 
• Second is the firm-specific advantages that a MNE has. There are certain assets that the MNE possesses but local competitors do not have. And with these advantages, the MNE can rule out the inherent disadvantages. Examples are an established international brand name or a special patent. However, even if the firm-specific advantages cancel out the inherent disadvantages, the firm does not have to become a MNE perse. 
• The next step is to make a choice between exporting or establishing a foreign production plant. Also, a choice should be made between licensing the local firms abroad or developing fully owned and controlled foreign plants. And this brings us to the third factor: location factors.These factors include a comparative advantage, scale economies, governmental barriers to import in that foreign country and trade blocs. These are the main location factors, but this also entails transport costs, taxes and subsidies and the need for adaption of products.
• Fourth is the internalization advantages, that occur when using your own asset instead of selling, lending of licensing them to another firm. A license is given to one firm when another firm agrees that this firm can use its asset under specific conditions and with payment. Many inherent disadvantages can be avoided by licensing, however, transaction costs and risks are involved. The firm can never know whether for example the quality will remain as good as the firm desires to or what will happen with the brand its reputation. The internalization advantages occur as a result to avoid these costs and risks.
• The final factor is oligopolistic rivalry. Larger firms are competing in oligopolistic competition, meaning that they compete for market shares and profits. Intangible assets may be the key to obtain large market shares and these assets also help their FDI. An example is that a firm establishes a foreign affiliate simply because they do not another firm to start a foreign affiliate there. They do this so that they remain first-mover advantage over the firms that follow to establish there. FDI is also used to increase market power. This happens by for example acquiring a competitor in a foreign market. Another way to do this is to establish a foreign affiliate in the home country of the competition.

How to define the payments among nations? - BulletPoints 16

• With balance of payment accounting, there are two directions the value flow can go in and out of a country: one direction out of the country and one direction into the country. A credit item is an item that the country gets a payment. This is measured with a positive sign (+). Credit items can be exports, but can also occur when you sell something to a foreigner in the country or a foreigner invests in the country. The opposite direction is a debit item. This is an item that the country has to pay for. This is measured with a negative sign (-). These items can be imports, but can also occur when you buy shares of a foreign country. Each transaction will have two items: either one positive and one negative, or sometimes two negatives or positives. This is the international approach of the fundamental accounting principle called double-entry bookkeeping. It is important to know that when you add all the debit and credit items of a country together, the total will always be zero. The interesting part of a balance of payment is when you look closer, into smaller categories of the balance: a sub-balance. This sub-balance (or just called a balance) actually can be positive or negative, unlike the whole balance of payment. A positive balance is a surplus and a negative balance is a deficit.
• The current account (CA) records all credit and debit that comes in the form of exports and imports of goods and services (also called merchandise). These imports and exports are a balance within the CA called the goods and services balance. The goods and services balance is good for measuring the country its net exports. 
  Receipts and payments of income are also part of the CA and are called the income flows. They are mainly the payments to holders of foreign financial assets. These include interest, dividends and other claims on the profits by the owners of businesses abroad. Payments to foreign workers are also included in the income flow. An example of this is a Dutch student works for a few months in the U.S. as an au pair. 
  Lastly, unilateral transfers are added to the CA. These are items that keep track of gifts that a country receives or gives from and to other countries. These debit and credit items are necessary to sustain a double entry for each gift.
• The financial account balance (FA) sums up the flows of financial assets. These are the net flows of financial assets or other similar claims. It is important to note that this does not include the official international reserve asset flows. Only principle amounts of these financial assets are taken into account. Earnings on foreign assets are recorded in the CA. But what is a debit or a credit is on the FA? For example, when you, a Dutch citizen, buy a stock in Australia, it is a debit. You make a payment to a foreigner, so the money is flowing out of the Netherlands into Australia. However, if you want to decrease or increase your holding of the Australian stock, it is a credit. This is because you receive payment from Australia.
  When you bought the stock, this was the Netherlands importing financial assets to Australia. This is also called capital export. But when you increased or decreased your holding, it was the Netherlands exporting financial assets to Australia. This is called capital import. 
• The final part of balance of payments is the official international reserve assets (OR). As mentioned before this is actually part of the FA, however important enough to name as a part on the balance of payments on its own. These are money-like assets owned by the government. We say ‘money-like’ because they are accepted as payments between governments, but it is not actual money. Other monetary institutes hold them too. Centuries ago, gold was the OR. Now the major reserve assets are foreign exchange assets, assets that are ready to be accepted in international transactions.
• Every country has its national savings (S), which comes from a surplus in the financial account for example. With this S, a country could do two things: invest in net If abroad or invest in domestic capital formation (also called domestic real investment (Id)) at home. The S is the Id plus the If. And if we look at it another way, the If is the S minus the Id. As we mentioned, the CA showed us the S that is not invested at home. To calculate this, you do national savings minus Id.
• The overall balance depicts if a country has a balance of payments that developed a pattern that is relatively sustainable over time. However, it is difficult to show a perfect representation of the overall balance. To indicate this, the net foreign investment (If) is divided into two components: net private capital flows (which can be found on the financial account balance (FA)), and net official reserve assets flow (OR). The sum of CA and FA forms B, the official settlements balance (B). So B is CA plus FA. All items on the balance of payments have to sum up to zero. If there is an imbalance in the B, it should be financed through OR. This makes the sum B plus OR will be zero.

How does the foreign exchange market work? - BulletPoints 17

• Different countries use different currencies as much as they use different languages. We call the price of one country’s currency expressed in the currency of another country the exchange rate. Two forces are looked at when we study exchange rates: competition and profit maximization. In international trade, exchange rates are rather important. The trade of different currencies is foreign exchange. Next to that, we have two types of exchange rates. First, the price of an immediate change. This is called the spot exchange rate. Second, we have the forward exchange rate. This is for the exchange rate price in the future.
• The retail part of the market is the currency trade with customers. This is trading in smaller amounts. Trade between banks is the interbank part of the market and fifty per cent of this trade happens between banks in New York City and London. The banks are central in the foreign exchange market. With telephones and computers, they do foreign exchange trades with the rail part and the interbank part of the market. A lot of trade involves the U.S. dollar. The U.S. dollar acts are a mediator almost: when you want to go from euro to won, the euro first gets exchanged for U.S. dollars and then to won. This is why we call the U.S. dollar a vehicle currency.
• The spot foreign market makes sure that money flows between individuals, businesses and other entities. Whether they need to acquire foreign money to pay or to sell foreign money that they received, the sport foreign market serves the retail part of the market in clearing the flows of foreign money. 
• The interbank part of the market has multiple functions. The participation of a bank in this market indicated that this bank has up-to-date information because of its interaction with other banks and by observing the exchange rates. Also, amounts of unbalanced currencies that are being held by a bank after a transaction with customers will be traded with other banks to make it balanced again. Furthermore, a bank can change the exchange rates based on a speculation, but these are only held for a short period of time (maximum of one day). A quick response on a preferable exchange rate could provide the buyer with a huge amount of extra currencies in a short time span.
• Buying and selling currencies with the goal of making a profit is called arbitrage. To be able to do that, currency prices must differ. With this, we mean that a currency should be cheap somewhere and more expensive somewhere else. Arbitrage can also be done with three different currencies and this is called triangular arbitrage. When this continues for a longer time, demand for these preferable currencies will increase which will increase the price. But the increase will stop itself. Arbitrage is difficult nowadays since currency rates around the world are very similar because of globalisation.

How to hedge the exchange-risk rate - BulletPoints 18

• When we agree on a certain price for a currency now for a transaction in the future, we establish a forward foreign exchange contract. That price is then called the forward exchange rate. If the value of a person’s wealth or income changes if the exchange rates change in the future unpredictably, it is called an exchange-rate risk. This can be a positive but also a negative change.
• To reduce or eliminate the exchange-rate risk, you can use hedging. This is the act of eliminating or reducing a net asset or liability position that is in foreign currency. Another way to do this is speculating. The people who speculate basically guess what the rates will be in the future, with the objective of making a profit. In this manner, they can take a net asset position (which is called a ‘long’) or net liability position (which is called a ‘short’) in a foreign currency. 
• There are several ways to hedge the exposure to exchange-rate risk. Hedging you can do by getting an asset in a foreign currency to balance out a net liability position that you currently have un that currency or by getting a liability to balance out a net asset position that you currently have. When you have completely hedged a position in a specific currency, you are certain that if anything changes in exchange rates in the future it will not affect your net value.
• Also speculating can be used for the forward exchange rate. An example would be someone that thinks that the current spot exchange rate of 1.98 dollar/euro will fall to 1.70 dollar/euro. This person will then get into a forward foreign exchange contract for 5 million dollar with a forward rate of 1.98 in two months, even though he does not have the money right now. On the date that the money is due, he is able to buy the 5 million dollar at the rate of 1.70 dollar/euro and thus earn a profit of 560.000 dollars. This is because (1.98-1.70) times 2 million. However, if he is wrong about this it will cost him and it is considered a loss.
• There are also alternatives to a forward foreign exchange contract. The first one is the currency futures contract. By signing onto a currency futures contract, you are able to lock in at a price that you buy or sell a foreign currency for at a specific date in the future. Although it sounds similar to the forward foreign exchange contract, it is slightly different. For instance, the currency futures contract can be traded because it is a standard contract. A forward foreign exchange contract is customized so it can meet the needs of the customer.
• If you want to put money in a foreign financial asset, you receive some amount of foreign currency in the future. When you do nothing and simply see what the exchange rate will be by then, it is an uncovered international investment. You can also enter into a forward exchange contract. If you do the last one, it is called covered international investment.
• If many people speculate, then the forward rate is equal to the average expectation of the spot exchange rate in the future. We can relate that to the interest parties. The covered interest parity applies to actual rates, and testing whether the forward rate is right is the same as testing the uncovered interest parity. One difference: the current forward exchange rate is replaced by the currently expected spot exchange rate in the future. So when the covered interest parity is true, any conclusion about the forward rate is equal to any conclusion about the uncovered interest parity. But no method for forecasting is completely accurate.

What determines the exchange rates? - BulletPoints 19

• We are able to observe several trends about the change of exchange rates. The first one is the long-term trends. This is a trend where a currency appreciates or depreciates for a long period. Second, we have the medium-term trends, which only covers several years. These trends can be opposite to the long-term trends. The third one is the short-term variabilities (this is months to even minutes)
• The first thing is the determinant of the exchange rates in the short run. Remember here that the overall return of an investment is decided by the interest rate and the loss or gain on the currency exchanges. Usually, the international interest is not so different, since the difference gets balanced out by the demand pressure. When the domestic interest rate increases while the foreign interest rate and the future spot rate stay the same, this is more attractive for investors to invest in bonds of our currency. If you want to be able to buy these bonds, the domestic currency needs to be known. This results into an increase in demand for the domestic currency and this increases the value of the domestic currency. This means that the spot exchange rate will decrease. 
• We are expecting that the future spot exchange rate will change instead of the interest rate. Our expectation is that it will be higher than we thought before. This will result in the expected return from investment in foreign financial assets to become higher. But before this occurs, the investors need the foreign currency. As you can imagine, the demand for that foreign currency then increases, which increases the current spot rate. That means that the foreign currency appreciates, while the domestic currency depreciates. 
• A variety of things determine the floating exchange rates in the short run. In the long run, however, economic principles are becoming more and more determining. To understand the changes in the long run, we look at the effect of product price levels on exchange rates. There are three different versions of the relationship between product price levels and exchange rates. The first one is the law of price. This law states that there should be one price for a product so it can be traded more easily and feely in a perfect competitive global market. 
• The second version is called absolute purchasing power parity (PPP). This theory states that a basket of multiple products in different countries will have the same price. The product its price level is found by taking the average of all these products. This is done again by doing the same calculation as the law of price: the spot exchange rate multiplied by the foreign currency of the product. However, now the P does not stand for one product but for all the products in the basket. This represents the average cost of an entire country. 
• These two versions are useful but not entirely representable. See, the two versions only look at the prices at a given point in time. That is why the third version, the relative purchasing power parity, looks at changes over time. If a product-price level changes over time, the difference between the two countries will be undone because of the changes in exchange rates of the two countries.
• It is a basic economic principle that the more of a good is available, the lower the price is. The same principle holds for currencies; the more money is supplied of one currency, the more the price of that currency decreases. We want to keep money since we want to be sure that we can pay for something with money in returns for something else. The quantity theory equation is the theory that money supply is equal to the demand for money. For the money supply in the domestic country and a foreign country, an equation is established. The extra amount of money that people in the domestic currency hold multiplied by the price of the product in the domestic currency multiplied by the gross domestic product (GDP). This is the same for the foreign country; just switch the numbers to the foreign country its data. With the two equation of domestic and foreign, we can establish the price ratio between two countries.
• An overshooting is when the exchange rate moves part its long-term equilibrium in the short run. When this happens, it slowly moves back to the determined long-term rate. An example is that the domestic money supply jumps 20% and this was not expected. Then the domestic money supply grows further, to a rate that was expected. This means that it followed the path that was predicted, but then 20% higher. In the end, this should increase the price of the foreign currency by 20% (if the monetary approach and the PPP approach are as reliable as we think they are). This means that the expected future spot rate will be a little higher: 20% higher to be exact. It takes a little time before a price level increased by 20%, since product prices tend to be sticky in the short run.
• No model seems to apply well to predict exchange rates in the short run. However, for the long run, the PPP and the monetary approach are helpful in some ways. But why is it so hard to make predictions that are good? Firstly, new information that comes in is a major determinant of changes in the exchange rates. Secondly, anyone can predict and that is why often the bandwagon effect appears. Also, the speculative bubble is created when predictions are more self-fulfilling, even though the changes that follow are not correct economically.

How can governments intervene in the foreign exchange market? - BulletPoints 20

• There are two types of government policies available. There are there to influence the exchange market. The first one is policies directed towards the exchange rates itself. These affect the price. The second one is about policies towards the use of the foreign exchange market. This is about the quantity. A government is able to decide on a floating or a fixed exchange rate. A government can also choose not to impose with any restrictions. When this happens, the currency is convertible for all users. It can also have exchange control. This means that a government does impose with restrictions on the use of the market. The stronger form of this is that everybody who wants another currency must have some sort of approval from a monetary authority. An example is the government permit the use of the market to make payments for exports and imports of services and goods. When this occurs, the currency is convertible for current account transport. Together with this, a government can impose on capital controls. Here it is required to have approval for some financial activities.
• If the government decides not to intervene, it is called a clean float. The government can also let the exchange rate float a little but impose onsome official intervention. They can do that by buying or selling foreign currencies. So a government lets the rate flow but influences the supply and demand by selling or buying, which is called a managed float (put nicely) or a dirty float (if you do not like it).
• As we know, no exchange rate is fixed forever. This is why we better call it pegged exchange rate. If there is a big disequilibrium, a government can change the pegged-rate value. This approach is called the adjustable peg. Another approach to this is a crawling peg. When this happens, the peg value is changed on the basis of a set of indicators, for example, the relative inflation, the holdings of official reserve assets or the growth of the money supply.  
• There are four ways to keep a certain fixed rate. The first one is to buy or sell other currencies in exchange for the domestic currency. The second one is to exchange control. The third one is to change the interest rates in the home country. This will have an effect on the short-term capital flows. The last one is to change the macroeconomic position of a country until it fits with the fixed rate. This can be done by directing international capital flows, increasing export capacities or altering the demand for imports. When this does not work, the fixed rate can be adjusted or ‘pegged'. There is also a fifth option, which is to alter the fixed rate or to switch to a floating exchange rate.
• A disequilibrium can also last longer than just temporary. Then it becomes a fundamentaldisequilibrium. In this case, the monetary authority loses borrowing the whole time. This will result in a lack of reserves and a harder time to borrow. If speculators see this happening, this can become even worse; they can bet that the currency will devalue. This is called a ‘one-way speculative gamble'. Here they will sell the domestic currency in exchange for a foreign currency, with the result that the government has to sell even more of a foreign currency. When a surplus happens, this will increase reserves continuously. Reserves that are too big are seen as a bad thing. This has several reasons. There is no profit made on it since assets are chosen with low interest (since this has lower risk). Also, when the domestic currency is revalued, this automatically devalues the foreign currency. This means that the assets’ value in that foreign currency will fall. Lastly, other countries can find the reserves too big since they have deficits because of the surplus in a country with large reserve holdings. Concluding, when a fundamental disequilibrium exists, financing is not enough.
• We had the Bretton Woods Era (1944-1971), where adjustable pegged rates became dominant. The U.S. leaders were dominant at the meetings. Keynes from Britain and White from the U.S. design a plan for an international central bank. This bank could add to the reserves of countries having a deficit to eliminate this deficit. So fixed rates should be established and be defended through the intervention of governments, and the help of a central bank to finance deficits. The U.S. had a surplus and had to allow for some inflation because of the agreement. They did not like that. As a result, Britain and others were afraid that they could not finance their deficit. Therefore, they wanted the right to de-valuate or to impose exchange controls if they could not get rid of their deficits. There was a compromise between the different needs which was called the Bretton Woods system. The most important element was the adjustable peg. So a fixed exchange rate and the possibility to finance deficits or reduce surpluses except for when these were fundamental.
• Nowadays countries are very free in choosing a policy towards exchange rates. Some countries use another currency as their own, for instance, the euro or the dollar, or peg their currency to these currencies. The rates between the major currencies are floating, with sometimes a little intervention.

What is an international financial crises? - BulletPoints 21

• In the first best world, international lending would bring a net gain to the world, like international trade. We can distinguish between two countries. The first, we call Japan, which is a net lender to the world so has a lot of financial wealth but is not really attractive to invest in. The other, we call America. This country has less wealth but is more attractive to invest in. We can draw a graph. The horizontal axis represents the wealth of Japan and America, together forming the wealth of the whole world. Capital investments are financed with this wealth. The return on these investments is depicted on the vertical axes. Then we draw two lines in the graph, representing the marginal product of capital (MPK) for Japan and for America. If international financing is not allowed at all, then they both have to finance their own stock of real capital with their own financial wealth. That means that in Japan the investors get a low rate of return (2%). In America, the rate of return is high (8%) since funds are scarce. The area under the MPK curves represents the value of the total production.
• Sovereign debt forms the biggest part of the debt of developing countries. That is different because nobody can force a government to repay if they do not want to. Then why do they repay? To be able to lend some more in the future, you would say. But that is not true! If new loans are available all the time, repayment is also possible all the time. But then the full amount will never be repaid. Collateral can be included in the lending contract to serve as an extra security. But that may not be enough as a cover for the total value of the debt. Apart from future lending, and possible collateral, what can a government lose when it does not repay debts? First, the country can incur macroeconomic costs. We saw that defaults disorganize the financial system and economy (recession). Also, imports and exports might be reduced as a result of less available financing or trade barriers. Second, reputation loss can generate other losses.
• Now, international lending can bring grains to the world. However, it can also bring crisis. There are five causes that lead to financial crisis. The first one is waves of too much lending and borrowing. When governments impose on expansionary money, they will need money. They borrow this to finance the deficits and this can lead to too much borrowing. People often are willing to lend some money to governments. They believe that this does not involve high risk. But this can indeed involve high risks. 
  Too much lending can also happen when too much is lend to private borrowers. When there is too much lending, the stock and real estate prices will go up immensely. When the lenders realize that they have lent too much, they stop lending and try to get their money back. However, this results into financial crisis.
  The second one is exogenous international shocks. When these affect economies, investors will check whether a country will be able to pay back the money they have lent. A shock like this can be a decline in earnings on exports, which results into a country unable to pay its debts. An example of a source of exogenous shocks are the real interest rates in the U.S.
  The third one is the exchange rate risk. This happens when private borrowers are borrowing lots of a particular foreign currency, then convert it into their domestic currency and then lend or invest it. There is no problem when a fixed exchange rate is defended well. However, as soon as de-valuation or depreciation occurs, borrowers try to sell domestic currency to hedge. And this pushes the de-valuation or deprecation even more.
  The fourth one is unpredictable international short-term lending. Short-term lending is more than often repaid by new short-term lending. When investors do not want to give new lending, there is no possibility to pay back the money. To make investment more attractive, the interest rates could be raised but domestic borrowers could lose because of this and the fact that returns to loans of banks will be lower. A possibility for governments here is to take over the foreign borrowing the banks do. However, if the governments are also not able to pay, this can result into a financial crisis. There is a lot of risk in short-term lending, since it is easy to go to another country for lenders if they perceive it as lesser risk.
  The fifth and final one is spreading to other countries. This is called global contagion. This occurs because some countries trade lots with other countries. Herding behaviour happens since there is no transparent or complete information available. Contagion can also happen since similar signals are spotted in similar countries, and thus investors fear that similar situations will occur in these countries.
• One solution is proving rescue packages. These packages are usually provided by the World Bank, IMF or a nations’ government. They provide this because the loans replace private lending that does not happen any more. A country can use the money in this package to invest or to reduce the decline in production and demand. It gives investors also more confidence. Also, the package can reduce the effects of contagion. Finally, the attached conditions to a package like this, to help a country get out of the crisis. Most of the time, the packages turn out to be moderately helpful at the least. Critics say that these packages might even generate more crisis since countries in the crisis know that they will be supported so they might take on more high risk borrowing. This is moral hazard.
• Another option is debt restructuring. This includes rescheduling the debt (to pay it later on) and reduction of the debt (making the debt a lower amount). Also with this option a problem arises: the free-rider problem. Every lender prays that someone else will restructure the debt he or she has, so the country is able to pay the remaining debts he or she has. But when every lender has this mindset, nothing will ever be solved. This is why sometimes collective action clauses are included in international bonds.
• A controversial proposal is imposing capital controls to limit borrowing. That can be in the form of limiting, prohibiting, taxing, or requiring that a bank puts a certain part of the borrowing in deposits. These controls can reduce the possibility of a financial crisis. First, the risk of over lending and over borrowing is reduced. Second, short-term borrowing is discouraged. Third, the possibility of contagion is reduced. A drawback of capital controls is that there are no gains from international borrowing. A better policy would be to follow the specificity rule and to find the source of the problem.