Summary of the main argument in the paper “Hot Money Flows, Commodity Price Cycles, and Financial Repression in the U.S. and China: The Consequences of Near Zero U.S. Interest Rates” by Ronald McKinnon and Zhao Liu.
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The article discusses how the near-zero U.S. interest rates affect the dollar’s stability in the international markets. On the contrary, the authors argue that higher interest rates often lead to the international banking crisis due to a worldwide increase in commodity prices (McKinnon and Liu 1). Importantly, the authors refer to the failures of zero interest policies in stimulating the country’s economy. In this context, the authors use the example of the United States and China and the different forms of the two country’s use to intervene during a financial crisis period.
The authors explain why the international standard of the American dollar is malfunctioning in recent years. For example, the article highlights how the reduction of the dollar’s interest rate in 2008 led to a world’s monetary instability (McKinnon and Liu 2). In this context, an increase of hot money flows emerge, as well as the concept of carrying traders. From the article, the authors depict how the interest rates in developed countries like the United States compare with those of the emerging markets such as China, India, and Brazil (McKinnon and Liu 2). From this perspective, strategies to stabilize the economy are revealed as hiking commodity products, speculative capital inflow, and a boom in the real estate market. However, the impact of such strategies results in monetary, macroeconomic, and political instability in advanced economies and the emerging markets.
The authors explain the concept of hot money flows and how they cause inflation in emerging markets. Over the past decade, hot money flows have been a common feature mitigated by speculative exchange rates that defy normal economic trends. Nonetheless, the hot money flows are preferred by carrying traders who benefit from varying exchange interest rates among different economies.
The article articulates on preventing pressure from economic crises and appreciating currencies by selling local currencies. In this context, emerging markets are able to maintain a favorable balance of payments compared to the competing markets or countries. In fact, this is explained as a necessary intervention strategy by central banks in emerging markets, as evidenced between 2001 and 2011. According to the article, emerging markets such as India, Russia, and Brazil have been using the strategy as an instrumental factor in stabilizing the economy.
The impact of increased hot money flow leads to price bubbles in primary commodities and political instability (McKinnon and Liu 3). However, the impact is not the same between advanced economies and emerging markets such as the United States and China, respectively. In any case, people in advanced economies are insulated from the price bubbles compared to those in emerging markets. During inflation, people spend a large part of the disposable income on food and energy.
The authors argue that low near-zero interest rates have both positive and negative impacts on the United States’ economic growth (McKinnon and Liu 6). For example, low-interest rates stabilize the country, as well as the economy of emerging markets. However, the same does not stimulate economic growth in the United States. Nevertheless, the same effect of low-interest rates in the United States is also exhibited in China.
From the article, the above economic effects can be solved through reform efforts, especially in harmonizing international monetary policies.
Explain the concept of “carry trade”, “hot money” as will as “financial repression”
Carry trade concept that involves borrowing money while the financial exchange rate is low and later sell the same at higher rates (McKinnon and Liu 2). The carry trade strategy is common among foreign exchange markets, where traders buy currencies at low-interest rates and sell them for higher returns.
The concept of hot money refers to the movement of capital from one country to another, depending on the interest rates (McKinnon and Liu 2). In most cases, carry traders buy currencies from countries with low-interest rates and exchange the same at economies with higher rates.
Financial repression entails strategies used by governments to avoid financial problems while improving the economy at the same time. Financial repression strategies include lowering interest rates, regulating capital movement, and providing subsidies to domestic investors (McKinnon and Liu 7).
In which way is the current type of financial repression in the U.S. different form the original one when the expression was first coined?
Currently, the term financial repression in the United States refers to the subsidizing of borrowers. In this context, pension funds are now targeted as a means of yielding returns. Moreover, employers are not covering employees’ pension funds. Instead, employees save pension funds at low-interest rates.
On page 5, the authors state that “this higher inflation occurred despite appreciated against the currencies of developed countries”. Which assumption of the Unified Model of Exchange Rate Determination is violated by the above statement? Dose this violation invalidate the Unified Model?
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Assumption: Note: If PPP holds, q$/€ =1 → , the deviation of q from 1 can be used as a measure of PPP violation.Equation (5) tells us that $ depreciation (i.e., ∆E/E>0) is caused by:
Increase in U.S. inflation (π_US↑)
Deflation in China ( π_(China)↓)
The assumption that a higher inflation rate occurs against the depreciation of the currency in developed economies is violated by the authors’ statement (McKinnon and Zhao 5). However, the violation does not invalidate the Unified Model of Exchange Rate Determination. Precisely, this new trend of the inflation rate is evidenced due to the existence of emerging markets. The inflation of developing countries has the same effect in emerging and developing countries. Moreover, the emerging market’s foreign exchange reserves make it difficult for developed economies to offset the same through the central bank’s bonds.
McKinnon, Ronald and Liu, Zhao. “Hot money flows, commodity price cycles, and financial repression in the US and China: the consequences of near zero US interest rates.” Unpublished working paper, Stanford University (2012). Print.