Case 1: Kennedy and balance of payment

Question no 1: What is the relationship between interest rate and short term capital flows?
Higher interest rates will attract more capital flows into a country, it will push capital account of
BOP in direction of surplus and thus funding a movement in the current account of the BOP in
direction of deficits. If interest rate is high investors are more likely to invest in rather than where
interest rate is lower. In exhibit 4, interest rates for Treasury bill in US increases in 1955-1957
then it was decreased in 1958, in 1959 it was increased then in 1960 it was decreased as
compared to other European countries.
Interest rates:
United States
Years:
1955 1956 1957 1958 1959 1960
1.74% 2.66% 3.26% 1.84% 3.42% 2.94%

And overall balance was negative from 1950-1960 excluding 1957 it is shown in the exhibit 3.

Question no 2: What account reflects increased US investment in EEC?

An increase in U.S investment in Europe and growing dollar reserves overseas reduced the
incentives for foreign governments to hold U.S currency. With the formation of EEC among
Europeans, their need for dollars to finance internal trade declined. The dollar shortage was
turning into dollar glut. Foreign central banks began to exchange dollars for gold in 1958 and
$2.3 billion in gold flowed out of U.S., an amount equivalent to 1/10 of all US holdings. In
exhibit 3, it was clear that foreign dollar holdings would soon exceed U.S gold reserves (1960).

By class of holder: 1959 1960

US $ billions
Official 10.37 9.14
Banks 4.83 4.69
other 2.21 2.40

Question no 3: What is the role of US capital market in the global economy?

Answer: US capital market used to be essential for the world but, specifically European countries
as they needed continuous flow of cash for their economic development. US market had less
interest rates which used to be attractive for international borrowers to borrow money from US
market. Many investors have been feeling protected to issue bonds in US market due to its
political and economic stability. As long as the US is offering enough dollar to the countries,
international trade will continue to flourish.
Question no 4: What expenditures are necessary to sustain the US leadership? What is the impact
of these expenditures on BOP?
Answer: The military and financial aid provided by the US and their policies supporting different
countries to offer their product to US was important for their leadership however their BOP was
significantly affected. US current account which was healthy in 1957 was decreased enormously
in 1958. This was due to high cost, import was causing the US economy and furthermore due to
less capital inflow, as many countries had just selling US their products but not buying from
them. Their military costs were also increased from US$3,444 million in charge in 1957 to
US$3,666 million in 1958 as they were giving military and financial aid to different countries
and also increasing their military hold in middle-east.

Comprehensive case:
In year 1960, US president elect Kennedy faced the matter he feared most “Balance of payment
deficit” together with nuclear war. The traditional approaches could not be implemented to
counter this problem due to U.S future goals. One in every of the way is to create changes within
exchange rate. By devaluation of the currency, the product of the country becomes relatively
cheaper for other countries and export increases and import becomes expensive, in order to they
decrease. But U.S had taken the lead after the World War 1, as it was the sole country in the
world that was able to sustain its economy. U.S officials believed that world wants to avoid time
period of 1930s, then they need to eliminate their trade barriers. For this purpose they had
opened U.S border for trade and decreased their tariffs. They wanted to construct barrier free
trading system after war, based on the David Ricardo’s comparative advantage theory.
Additionally, they reached Bretton wood agreement with many countries in which they may
repair their exchange rates and will most effective fluctuate by +1 or - 1% and can only fluctuate
by more than 10%, if IMF approves it. Due to Bretton wood system, the devaluation option was
not possible for US it had been just opposite of what they obliged other countries under
agreement to try to do. Other option is to place trade barriers, increase tariffs on imports to
decrease balance of payment deficit. But as discussed above these option was also inconsistent
with their long term goal of creating a trading system in which every country freely sell their
products to other country and country produce only those goods within they are Best, in other
words “Specialization”.
Worst component for the Kennedy was that the very reason for this deficit was their future goals
itself. The US had made EEC to assist European countries make trade with one another and had
allowed to impose tariffs on US products, this caused U.S problem when these countries
stabilized and they had no need of U.S. So U.S was sideline resulting in the loss of all the cash
invested in these countries. Third option was deflation in the U.S meaning increase in U.S
interest rates but this can leave its people with less income to buy foreign products and they will
buy cheaper local products. But this was also not acceptable. So Kenney had the dilemma that he
must solve the Balance of payment problem but without damaging US long term goals of
Liberalizing Trade.

Case 2: Bretton wood system and financial crisis 1971

Question no 1: What motivated John Maynard Keynes and Harry Dexter White to design the
Bretton Woods system? How would that system help to
address the problems they saw?
Answer: Bretton woods system was designed as the result to address the following key problems
world economy or trade was facing.
I. Unstable Currencies:
That creates uncertainty and could trigger devaluation. This will assist that country with
increasing its export yet can be disadvantageous for other country.
II. Destabilizing flows of speculative finance:
The impact of unstable currencies and political condition causing the outflow of cash
from the country adversely influencing their economy, employment and bank sector.
III. Gold imbalance:

US had most of the gold reserves which was causing dependence of other countries on
US assistance.
IV. Inflexible monetary standards:

Currencies were totally fixed with gold and they were managed according to countries
need but it was causing one country profit at the expense of others.

V. Trade Wars:

Trade war was because of the tariffs and other barriers which had prevented free flow of
goods from one country to other. Countries were doing this to protect their local
industries however it had disadvantages too in the time of depression as they cannot get
help from other countries
Countries would join the IMF and they should contribute to IMF and share is determined by the
size of the economy and gold reserves, they could get loans from IMF to balance their imbalance
of payment, every country will peg its currency with USD and gold, as reserve currency and they
will fluctuate their currency according just by +1% or -1% through purchasing and selling of
gold and can only devalue by over 10% by IMF approval.

Question no 2: How would the IMF function?

Answer: IMF function would be to provide financial assistance to the countries, when they need
it. They will also direct those countries with applying certain policies to improve their economic
position better. It will also not provide assistance to countries that are not following the policies
IMF had made for trade development, like fluctuation of currency and devaluation restrictions.

Question no 3: Please examine abridged case Exhibits 6 and 7 for trends in federal government
receipts and outlays that show the impact of
President Lyndon Johnson’s policies. What was the impact of those policies on net borrowing by
the government? How did this affect
the US balance of payments given in abridged case Exhibit 10? Why was the United States
unable to hold to the dollar-gold peg?
Answer: The consequences of increase taxes was positive for US government as there was a
major increase in income tax from US$ 68,726 million in 1968 to US$ 87,249 million in 1969.
This was the only year in which receipts which are USD 187,784 million, were higher than the
expenditures which were USD 184,548 million and 1969 was the only year in which there was
budget surplus. The net borrowing was negative only in 1960 year too from USD 23,100 million
which was a significant change however after that it again begins climbing positively from 1970.
The balance of payment was also positively affected as current account balance became positive
in 1970 which was negative in 1968 and 1969. Because of many emerging markets against the
US market, their GDP share in world economy was decreased from 35% to 27%, and their gold
reserves were also too less. Foreign countries had 14 billion USD of holding and US had just 3.2
billion USD of gold reserves to back it, so that is the reason they couldn’t hold to dollar- gold
peg.

Question no 4: Why did Nixon add the other features to his New Economic Policy? Why didn’t
he just close the gold window?
Answer: The Nixon added others features like import tax surcharge to his policy because he
wanted others country to do the same, it was the purpose of Nixon that other country also stop
converting dollar to gold otherwise their product will not be able to sell in United States. Other
countries were actually selling dollar for gold which were increasing US balance of payment
deficit.

Question no 5: What should Nixon do next?

Answer: Recommendations:
1. Nixon should focus on flexible system instead of fixed system and Bretton wood system.
Because fixed system with gold creating problems and also Bretton wood system.
2. Nixon should decrease inflation in US.
3. Nixon should decrease interest rate.
4. Also reduced military spending.
5. Should introduced autonomous monetary system.
Comprehensive case:
In 1971 US President Richard Nixon thought of introducing a New Economic Policy to change
the US position on international market as he closes Gold Window and impose tax surcharge on
imports. This is to end the losses suffered by the American economy as a result of post-war
policies. The United States was the only country that suffered the loss of World War I and the
entire world turned to allies, especially those who had won the war and allied with the United
States during the war. For this reason, the United States took the opportunity to devise a new
trading system to reduce the risks of depression that hit the world in the 1930s. The United States
pursued a policy of liberalization of trade, i.e. fewer trade restrictions and fixed currency. The
United States is the only country with sufficient liquidity to finance world trade. He signed the
Bretton Wood Agreement with major European countries, declaring it a stable currency and a
currency pegged to gold or USD. U.S. dollar is tied to gold, but the U.S. is trying to stabilize
other countries and buy their products. Outflows due to policies, the lack of gold reserves is
occurred. But because of the Bretton Woods system, they were not able to devalue their
currency, so Richard Nixon was the president who faced the current account deficit, the federal
budget deficit problem. So he decided to deal with these problems by doing simply contrary of
the policies US had followed for 2-three decades. He closed the gold window, means changing
of dollar into gold as many countries were doing this because of much less consider in USD and
greater in gold which become reducing USD and to preserve its value, USD have been spending
gold, reducing their reserves. He also charged tax import surcharge to nations who do not
observe in US footstep. They will now not have the ability to promote their product in US cheap,
resulting in decrease in their export to US. Nixon felt that ultimate the window gained be
enough, so he additionally added new capabilities to his NEW Economic Policy.