Econ 3345 Global Economics - Assessment Answers

Case Study

Argentina and the Limits to Macroeconomic Policy

In 1900, Argentina was among the richest countries in the world. Its good fortune was not to last, however, and by mid-century its per capita income had fallen behind. Although it still had the highest per capita income in Latin America, the gap with Western Europe and North America was substantial, and it was not getting smaller when it was hit by the Latin American debt crisis and the Lost Decade of the 1980s (see Chapter 15). The debt crisis was vicious and hard to shake off. In 1989, seven years after it began, Argentina was still caught in it, and its GDP fell 7 percent while inflation hit 3,080 percent. Politicians tried a variety of experiments to get out of the recession and hyperinflation, but none of them led to sustained growth or brought down the inflation rate. In 1991, a radical experiment was tried. The country fixed its currency to the dollar at a 1:1 rate and dramatically restricted the creation of new money. For every new Argentine peso put into circulation, the central bank was required to have a dollar to back it up, and a newly created currency board was there to oversee the exchange rate system and enforce the rules.

The currency board worked extremely well through most of the 1990s. Argentina was back on a strong growth path with low inflation and was widely viewed as a successful model for other countries. Problems began to develop in 1998, however, when the global fallout from a crisis in East Asia spread to Latin America. Argentina’s main trading partner, Brazil, devalued its currency in early 1999, giving Brazilian firms an advantage and putting Argentine firms at a disadvantage since goods valued in pesos were now more expensive. Argentina’s current account balance developed a relatively large deficit of 4–5 percent of its GDP, and the loss of exports led to a recession in 1999.

At this point, conventional economic theory prescribed a demand-side stimulus for Argentina. Total expenditures in the economy were down, in part because it was more difficult to export, so the country should have cut taxes, raised government spending, increased the money supply, or some combination of those policies. There were a few obstacles, though. First, anything that might upset the 1:1 exchange rate was viewed as a potential problem. All else being equal, expansionary macroeconomic policies cause prices to rise, and it was feared that deliberately increased government deficits might undermine confidence in the anti-inflation commitment of the government. Argentina was already running a budget deficit that was hard to control, and increased spending and tax cuts were not an option. Monetary expansion was also out since that would undermine the peg to the dollar by increasing the circulation of pesos beyond the level of dollars available to back them up.

Second, a currency devaluation, whether intentional or not, would be a problem. During the growth years of the 1990s, Argentine firms and Argentina’s government had borrowed dollars in international capital markets. There was nothing particularly unusual about Argentina’s borrowing, except that its ability to raise revenue to service its debts was constrained by domestic political factors. Taking on debt denominated in dollars is common, but it imposes a high price when there is a currency devaluation, since the dollar value of the debt does not change, but the domestic currency value of debt rises. Given that the government and most firms earned revenues in pesos, but that their international debts were in dollars, anything that caused the value of the peso to decline would increase the burden of debt.

The debate over policy was intense: Should Argentina devalue and increase the debt burden, or maintain the exchange rate and continue to watch the current account deficit grow and the economy shrink? Cut government spending to create confidence in the fiscal soundness of the government, or use expansionary fiscal policy to address the recession while undermining confidence in the government’s commitment to the 1:1 exchange rate? In effect, there were two choices. On the one hand, the government could use expansionary macroeconomic policies to try to combat the recession, but at the cost of a probable devaluation of the peso since no one would believe that it was still committed to anti-inflation policy and fiscal prudence. On the other hand, it could maintain the peso’s link to the dollar at the 1:1 ratio, but at the cost of ignoring the recession.

Argentina’s recession began in 1999. Two years later, in 2001, the country was still in recession, and prospects seemed to be getting worse. As people lost confidence in the government’s ability to maintain the 1:1 exchange rate, they decided that a devaluation was coming and began to take their money out of banks. After enormous losses in the banking sector, the government closed all banks in early December 2001. When they reopened in January 2002, the peso’s link to the dollar had been cut. The peso began a steady decline, dropping from 1 peso per dollar to 2.0 pesos in February 2002, and 3.8 pesos per dollar by June. After that, it recovered slightly and stabilized around 3 pesos per dollar, where it remained for several years.

Some observers argue that Argentina should have sought more flexibility in its policies by severing the one-to-one relationship between the peso and the dollar much earlier—in 1997 or 1998. Others argue that it should have made deeper cuts in its budgets, because that was the only way to maintain confidence in its currency. At first, the government tried the latter approach, but political and institutional obstacles prevented the budget cuts from being large enough.

The Argentine case still poses questions for economists. Recessions caused by a decline in demand are most effectively fought by increasing demand through government spending, tax policy, or monetary policy. If a country needs to demonstrate to the world that it is fiscally prudent, however, because doing so will prevent speculation against its own currency and maintain the inflow of foreign currency, then expansionary macroeconomic policies may be impossible. Does this mean that developing countries cannot use expansionary macroeconomic policies?

Case Analysis

Quantitative Analysis

Answer

Global Economics 

Introduction

It is the desire of every country to see its economy shining in the global markets. However to achieve this objectives, a lot of dedication must get into play bearing in mind that global markets keeps on fluctuating. At one point, a country’s economy may be flourishing while in other times under gloom. This calls for strategies especially when making decisions regarding economics. To adjust economic growth, approaches such as currency devaluation, use of policies are being used today. This paper scrutinizes some of the challenges facing global economies and presents some approaches being used to adjust them as well as their consequences.

Overview of Argentina Economy Case Analysis

In the case study of Argentina and its limits to macroeconomic policy, we have presented with the economic progress of Argentina from the year 1900 to where it stands to date. What comes out clear from this case study is that, wherever we see different economies stand at the moment should not be taken for granted because it takes a lot of ups and downs. For instance, we are taken through the economic journey of Argentina where it begins when it’s among the richest countries in the world but at the mid-century its per capita income falls behind. This has been associated with the debt crisis in Latin America and the Lost Decade of 1980s. From the two incidences, it comes out clear that a decline in another country’s economy can be of much impact to another country especially if they are trading partners.

Also, we get to understand that fixing the country’s currency to the global and restriction of money creation can be a superb way of restoring a deteriorating economy. Through this approach, we witness the economy of Argentina getting back to its past glory with low inflation. We continue to witness the impacts of economy deterioration of trading partners of any country however from the similar case to that of debt crisis of Latin America when Brazil’s currency devalues following the fallout of global crisis in East Asia. This incidence disadvantages the Argentine economy because its exports which were valued in pesos became too expensive in its trading partner, Brazil, hence affecting its markets. The economy of Argentina was negatively affected by this incidence and continues to be a dilemma up to date.

Currency Devaluation as a Problem

Just from the case of currency devaluation we witness in Argentina and how it impacted the country’s trading deals with Brazil, it is without any reasonable doubt that currency devaluation whether intentional or not can be very risky to an economy (Dreger, Kholodilin, Ulbricht & Fidrmuc, 2016). First of all, it reduces the purchasing power of the country’s citizens abroad. This means that any firm, organization or a company which operates on any imported goods stands at the receiving end of the consequences. This is because those goods becomes very expensive and will in turn affect the firm’s profitability. On the same note, when those goods or raw materials are imported at such escalated prices, this also affects the prices of the finished goods locally (Eme, Chukwurah & Iheanacho, 2015). As a result of high prices, if local consumers have alternative to those products and which don’t rely on imported raw materials will divert to the alternatives because obviously they will be cheaper. This has a huge impact on the firm because it implies lack of enough market for its products.

Also, if the country or local consumers have debts like loans and mortgages in terms of the foreign currency. After the devaluation, the cost of debt repayments will obviously rise. In the case of country’s debt, this becomes a burden to its citizens because taxes must be increased to cater for the risen cost of debts (Furtado, 2018). On the case of individual debts, it becomes an added burden because the interest rates are likely to increase while the repayment period remains constant. Increased taxations in a country are an indication that the country’s economy is fairing badly and the standards of living deteriorates (Aysan, Fendo?lu & Kilinc, 2015)

In a case where the devaluation is large and rapid, international investors are scared off because the trend makes them less willing to hold government debts which they are likely to reduce the value of their holdings. An economy without investors is an economy down because investors create job opportunities in a country (Farhi & Werning, 2014). Through the creation of employment to the local citizens, the standards of living in a country rises and that encourages economic growth.

The Pros & Cons of Current Account Deficits

It is without reasonable doubt that many economies currently run under account deficits. People react to this fact with both doom and gloom; others associate it with foreign governments not playing fair in global markets. Still there are those who argue that account deficits means that citizens are living beyond their means and hence accumulating too much debts. Account deficit pros and cons can be perceived in different sectors of an economy as below (Galí, 2015).

A country operating under current account deficit has an advantage of getting high money supply especially from foreign borrowing which enables it have a high growth rate and productivity. In special cases, this leads to growth booms. The country experiences periods of high exports owing to the devaluation of its domestic currency against the foreign currency. On the other hand, imports decreases owing to the increase in import duties and which is done by the RBI to narrow down the CAD (Höpner & Spielau, 2018). The country will also witness infrastructural development due to capital investment of foreign entities. These and others indicate the bright side of a country under current account deficit.

Contrally to the above, a country experiencing account deficits persistently is likely to undergo negative consequences that affect its growth and stability. The trend of imports having more demand than the exports leads to loss of domestic jobs. So, unemployment is among the cons of account deficits. On the other hand, considering the fact that a country’s export demands has impacts on its currency value, as export demands fall as compared to imports, the currency value declines. A decline in currency will scare away investors and encourage inflation hence a con to the economy (Martinoty, 2015).

Volatile Capital Flows, Cause of Argentina Economy Problem

From the case study, Argentina’s current economic crisis is caused by volatile capital flows. This is in consideration to the few crises which hit the economy of this country and whose origin has been traced from the external markets, the markets conducting trade deals with it. In its first economic deterioration at the mid-century when its per capita income falls behind, it has been associated with the debt crisis in Latin America and the Lost Decade of 1980s (Mishkin, 2017). Again, in its second incidence, similar case to that of debt crisis of Latin America is witnessed when Brazil’s currency devalues following the fallout of global crisis in East Asia disadvantaging the country’s economy because its exports which were valued in pesos became too expensive in its main trading partner, Brazil, hence affecting its markets.

Developing Countries and Expansionary Macroeconomic Policies

From the case study of Argentina, it is clear that expansionary macroeconomic policies usage in developing countries is deemed to fail. This is in consideration to the fact that these countries are in their process of growth and would require partnership with other developed countries to be able to grow (Peksen & Son, 2015). Adopting some of these policies is likely to bring about currency devaluation and that’s the point when the rain starts beating such economies. This is because currency devaluation comes with a lot of disadvantages for the country including the scaring of foreign investors who are very important for growth of a small economy.

Conclusion

Right from the case study of Argentina scrutinized at the start of this paper to some of the concepts which have been discussed in the paper. It comes out clearly that economic growth is a challenging venture which calls for much attention and carefulness lest some decisions takes the economy on an opposite decision from what they were expected . Again, economic situations as seen from the current account deficit scenario may have both advantages and disadvantages. This is where some economies may get it wrong especially if they consider the bright side only.

Recommendations

From the study, there are several lessons learned from the discussion. Above them, it’s the importance of sound decisions in economic ventures as this will act as the pillar for the economy to grow. Sound decisions in this case imply adequate scrutiny of both sides of the coin before settling for a decision. For that matter, I recommend economic experts to be keen especially when making economic decisions because it’s a hit or miss scenario.

References

Aysan, A. F., Fendo?lu, S., & Kilinc, M. (2015). Macroprudential policies as buffer against volatile cross-border capital flows. The Singapore Economic Review, 60(01), 1550001.

Dreger, C., Kholodilin, K. A., Ulbricht, D., & Fidrmuc, J. (2016). Between the hammer and the anvil: The impact of economic sanctions and oil prices on Russia’s ruble. Journal of Comparative Economics, 44(2), 295-308.

Eme, O. I., Chukwurah, D. C., & Iheanacho, E. N. (2015). An analysis of pros and cons treasury single account Policy in Nigeria. Arabian Journal of Business and Management Review (OMAN Chapter), 5(4), 20.

Furtado, C. (2018). Economic Development of Latin America. In Promise Of Development (pp.124-148). Routledge.

Farhi, E., & Werning, I. (2014). Dilemma not trilemma? Capital controls and exchange rates with volatile capital flows. IMF Economic Review, 62(4), 569-605.

Galí, J. (2015). Monetary policy, inflation, and the business cycle: an introduction to the new Keynesian framework and its applications. Princeton University Press.

Höpner, M., & Spielau, A. (2018). Better Than the Euro? The European Monetary System (1979–1998). New Political Economy, 23(2), 160-173.

Martinoty, L. (2015). Intra-Household Coping Mechanisms in Hard Times: the Added Worker Effect in the 2001 Argentine Economic Crisis.

Mishkin, F. S. (2017). Making Discretion in Monetary Policy More Rule-Like (No. w24135). National Bureau of Economic Research.

Peksen, D., & Son, B. (2015). Economic coercion and currency crises in target countries. Journal of Peace Research, 52(4), 448-462.