Vanessa shortly, becoming even easier with globalization

Vanessa Nguyen

ECON 495

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Professor Suhler

January 25, 2018

Mini Case: Iceland –
A Small Country in a Global Crisis

1.      Do
you think a country the size of Iceland or New Zealand is more or less
sensitive to the potential impacts of global capital movements?

Smaller countries with smaller size
of economy and population are generally more sensitive to global capital
movements. The sensitivity of countries like Iceland is magnified because of
the relative scales. Capital investments that are considered minor or
insignificant to larger markets can cause a much bigger impact on a small
economy scale like Iceland. Iceland are usually considered an emerging market, comparatively
stable and low-risk country; thus, making them even more attractive as a
destination for short-term capital investments. Thus, short-term capital
integration could dominate small markets shortly, becoming even easier with
globalization and technology. Short-term fluctuation risk is extremely high and
could impact the entire government reserve and a significant part in smaller countries
GDP.

 

2.      Many
countries have used interest rate increases to protect their currencies for
many years. What are the pros and cons of using strategy?

Direct intervention by buying and
selling currencies to adjust according to economic objectives, has been largely
replaced by monetary policy and the adjustment of interest rates. A country,
often small, may choose to protect its currency value by raising interest rates.
This action would provide higher returns to global investments. Therefore,
raising interest rates will attract capital inflows into the country. Since
foreign investment needs to be converted into local currency, demand for the
local currency up – and therefore either maintain or increasing its value.

However, interest rate policies
have weaknesses:

a.       First,
higher interest rate means higher costs of borrowing, including domestic
businesses. It is understandable that small countries like Iceland might have limited
alternatives to debt financing at affordable rates. Less debt financing will
later result in slower growth. Businesses in small countries like Iceland find
themselves pulling a larger portion of the economy than other economies; slower
growth nationwide could be a massive problem very quickly.

b.      Secondly,
higher currency value will increase the price of exporting goods, making them less
competitive in global market. The imbalance between exporting and importing
could cause trouble in trading balance

c.       Finally,
increasing interest rates to strengthen currency value also brings about the threat
coming from arbitrage trading, day trading, or short selling. Investors follow
the changes of interest rates and sell quickly when things are going south. A
small investment compared to bigger economies could be a big investment in
Iceland and could have significant impact on the economy’s stability.

 

3.      How
does the Iceland story fit with our understanding of the impossible trinity? In your opinion, which of the three elements of
the trinity should Iceland have taken steps to control more?

Impossible trinity is
a concept suggesting that the forces of economics do not allow a country to
simultaneously target and fulfill all three macroeconomics goals: exchange rate
stability, full financial integration and monetary independence (Eiteman et al.
37) The Iceland story shows that when there exists capital mobility and the
central bank has monetary policy autonomy, Iceland could not adopt fixed
exchange rate to maintain currency value. Of the three elements of the impossible trinity, Iceland should focus
on the independency of the central bank and the interest rate stability, and
potentially restrict the free flow of capital mobility. The exchange rate seems
to be the source of many issues of the 2008 financial crisis in Iceland, with the
help of a large portion of overseas ventures. Therefore, focusing on adjusting
exchange rate and protect the currency value should be a priority.

In the case of Iceland, the country was able to sustain a large current
account feficit for serveral years , and at the same time have ever-rising
interest rates and a stronger and stronger currency. Then one day, it all
changes. How does that happen? The case of Iceland which happened so fast in a
short time may appear to be unstructuredand unexpected;Vanessa Nguyen

ECON 495

Professor Suhler

January 25, 2018

Mini Case: Iceland –
A Small Country in a Global Crisis

1.      Do
you think a country the size of Iceland or New Zealand is more or less
sensitive to the potential impacts of global capital movements?

Smaller countries with smaller size
of economy and population are generally more sensitive to global capital
movements. The sensitivity of countries like Iceland is magnified because of
the relative scales. Capital investments that are considered minor or
insignificant to larger markets can cause a much bigger impact on a small
economy scale like Iceland. Iceland are usually considered an emerging market, comparatively
stable and low-risk country; thus, making them even more attractive as a
destination for short-term capital investments. Thus, short-term capital
integration could dominate small markets shortly, becoming even easier with
globalization and technology. Short-term fluctuation risk is extremely high and
could impact the entire government reserve and a significant part in smaller countries
GDP.

 

2.      Many
countries have used interest rate increases to protect their currencies for
many years. What are the pros and cons of using strategy?

Direct intervention by buying and
selling currencies to adjust according to economic objectives, has been largely
replaced by monetary policy and the adjustment of interest rates. A country,
often small, may choose to protect its currency value by raising interest rates.
This action would provide higher returns to global investments. Therefore,
raising interest rates will attract capital inflows into the country. Since
foreign investment needs to be converted into local currency, demand for the
local currency up – and therefore either maintain or increasing its value.

However, interest rate policies
have weaknesses:

a.       First,
higher interest rate means higher costs of borrowing, including domestic
businesses. It is understandable that small countries like Iceland might have limited
alternatives to debt financing at affordable rates. Less debt financing will
later result in slower growth. Businesses in small countries like Iceland find
themselves pulling a larger portion of the economy than other economies; slower
growth nationwide could be a massive problem very quickly.

b.      Secondly,
higher currency value will increase the price of exporting goods, making them less
competitive in global market. The imbalance between exporting and importing
could cause trouble in trading balance

c.       Finally,
increasing interest rates to strengthen currency value also brings about the threat
coming from arbitrage trading, day trading, or short selling. Investors follow
the changes of interest rates and sell quickly when things are going south. A
small investment compared to bigger economies could be a big investment in
Iceland and could have significant impact on the economy’s stability.

 

3.      How
does the Iceland story fit with our understanding of the impossible trinity? In your opinion, which of the three elements of
the trinity should Iceland have taken steps to control more?

Impossible trinity is
a concept suggesting that the forces of economics do not allow a country to
simultaneously target and fulfill all three macroeconomics goals: exchange rate
stability, full financial integration and monetary independence (Eiteman et al.
37) The Iceland story shows that when there exists capital mobility and the
central bank has monetary policy autonomy, Iceland could not adopt fixed
exchange rate to maintain currency value. Of the three elements of the impossible trinity, Iceland should focus
on the independency of the central bank and the interest rate stability, and
potentially restrict the free flow of capital mobility. The exchange rate seems
to be the source of many issues of the 2008 financial crisis in Iceland, with the
help of a large portion of overseas ventures. Therefore, focusing on adjusting
exchange rate and protect the currency value should be a priority.

In the case of Iceland, the country was able to sustain a large current
account feficit for serveral years , and at the same time have ever-rising
interest rates and a stronger and stronger currency. Then one day, it all
changes. How does that happen? The case of Iceland which happened so fast in a
short time may appear to be unstructuredand unexpected;