Capital inflows can affect a country's exchange rate by pushing the currency above its intrinsic value and fueling inflation or borrowing booms. This is known as the capital flow effect. When capital flows into a country, it increases demand for that country's currency, leading to currency appreciation. However, an increase in interest rates can reduce capital inflows and cause currency depreciation. Self-insurance refers to countries creating extremely high levels of foreign reserves to stabilize their currency exchange rates and intervene in currency markets. This prevents their currencies from being devalued during speculative attacks, when speculators borrow currency hoping it will decline in value. However, large foreign reserves pose problems globally by slowing monetary cooperation and acting as a zero-sum

1. CHAPTER 4&5
GROUP 3

2. *4a How do capital
inflows affect a
country’s
exchange rate?

3. INTEREST RATE PARITY
It’s a theory in which the interest between two countries is equal to the
differential between the forward exchange rate and the spot exchange
rate.
Interest rate parity plays an essential role in foreign exchange markets,
connecting interest rates, spot exchange rates and influencing foreign
exchange rates.

4. CAPITAL FLOWS
can push a currency far above its intrinsic value
may increase inflation on a country’s currency
and cause deficits
“…capital flows can push a currency far above its intrinsic value, widening the trade deficit and
hollowing out domestic manufacturing. Second, they can fuel borrowing booms, especially in
countries with underdeveloped financial systems, leading to devastating busts when the money
flows out.”
Economist, OCT12, 2013 Chapter 4

5. CAPITAL INFLOW
CURRENCY
APRECIATION
Capital inflow  increases the value
of country’s currency
PROPERTY & STOCK
MARKET
Investors are moving into property and
stocks  an increase in the interest rate
reduces capital inflows  depreciation
in the exchange rate
CAPITAL FLOW EFFECT
CURRENCY
DEPRECIATION
Positive Negative

6. *4b What is meant
by self-insurance?

7. EXCHANGE RATE FLUTUATIONS
CURRENCY A
CURRENCY B
 High demand for A
 People convert B into A
 Central bank of B sells its reserves of A
and buys its own currency B
 More demand for B
 More supply of A
Result:
1. Enough reserves of A to keep B exchange rate stable
2. No reserves of A and B gets devalued

8. SPECULATIVE ATTACK
In the example: B is likely to get devalued, as…
The speculator borrows Bs and converts those into As;
The central bank of B runs out of As even faster.
Once B gets devalued:
1. Speculators change their As back into Bs;
2. Speculators can pay off their debt and still have Bs left.

9. Thai baht attack in
1997
CASES OF
SPECULATIVE
ATTACKS
George Soros
US investor who (in 1992)
speculated on the devaluation
of the british pound, thereby
earning a profit of $1 billion
The man who broke
the bank of England
Thai central bank kept the baht
stable when people exchanged
their bahts into $  ran out of
$ quickly  speculative attack
was successful

10. HOW DOES SELF-INSURANCE RELATE TO THIS?
1
Countries create extremely high
resources of foreign reserves.
3
Stabilization of a currency and being able
to intervent in the exchange rate market.
2
Enough reserves not to run out of
foreign currencies even during
attacks.
GLOBAL VOLUME OF RESERVES
FROM
$2 TRILLION
TO 11$ TRILLION

11. PROBLEMS OF SELF-INSURANCE
For particular countries:
 Bad experiences in the past;
 More control over the exchange rate market.
Globally:
 Foreign exchange rate intervention is a zero sum game;
 If one country improves its trade balance another country‘s trade balance is made worse;
 Poor countries see a bad investment in holding many low-yielding government bonds;
 Global monetary cooperation is slowed down.

12. *5a What is the impact of a
multilateral and a
regional trade pact,
respectively, on
international firms?

13. MULTILATERAL TRADE AGREEMENT
 The goal is to lower or remove trade barriers such as import tariffs
 This levels the playing field by treating all involved nations equally
 All involved Nations get treated equally
 Increases the export of a country
Disadvantages
Very complicated and difficult to negotiate!
Example:
The agreement between US/Canada/Mexico (NAFTA)

14. REGIONAL TRADE AGREEMENT
Leads to both trade liberalization and discrimination
 Liberalization because more regions/producers can be accessed leading
to trade creation;
 Discrimination because the partners who are not involved in the
agreement might become less desirable.
Some concerns …
 The creation of RTA slows down the creation of MTA;
 RTA’s might create ‘trade blocks’ which have no interest in others.

15. SNOWBALL EFFECT?
REGIONAL
AGREEMENT
MEDIA
AATTENTION
OTHER PARTIES A NEW
AGREEMENT
Every Regional Trade Agreement creates (media) attention;
Which might convince other parties to join the agreement;
This will lead to more multilateral deals.

16. 1
 Allow firms to trade
internationally at a lower cost
 Access to new markets for the
firms
 Higher trade 
more production 
more investments 
higher development!
3
By excluding sensitive
sectors/imposing rules of origin 
complicates life for international
firms
CONCLUSION
ADVANTAGES DISADVANTAGES