Deck 21: Capital Flows and the Developing Countries

Question 1

Briefly describe why capital flows to developing countries and the different forms it takes.

Answer 1

As described in Chapter 5, capital flows from the developed to the developing countries in search of a higher rate of return. In 2005, nearly $122 billion went from developed to developing countries. Of this total, $10 billion went to the low-income countries and nearly $147 billion went to middle-income countries. Most of this capital flow was in the form of FDI; $111 billion of FDI went from developed countries to the developing countries. The majority of the FDI ($261 billion) went to the middle-income countries. FDI to middle-income countries dominates the flow of capital from the developed to developing countries. The remainder of the capital flows is in the form of portfolio investment (bonds and equity).

Question 2

What factors influence the ability of a country to pay its foreign debt?

Answer 2

The ability of a country to pay its foreign debt is related to two factors. The first factor is the level of foreign reserves. Foreign reserves refer to the stock of previously accumulated foreign exchange. The higher the level of foreign reserves, the easier it will be for a country to make payments on its foreign debt. The second factor is the debt/export ratio. This ratio measures the amount of debt payments in relation to the country's earnings of foreign exchange from exports of goods and services. The lower this ratio is, the easier it will be for a country to pay its debts out of current earnings of foreign exchange from exports.

Question 3

Briefly describe an exchange-rate shock.

Answer 3

An exchange rate shock occurs when there is a large depreciation of the exchange rate in a relatively short period of time. This usually occurs when there is a leftward shift of the supply of foreign exchange. Such a shift causes a depreciation of the exchange rate. If imports are a high percentage of GDP then the depreciation of the currency can cause a large increase in the cost of production in the economy. If the shock is large enough, it may cause a change in the aggregate supply curve. Specifically, an exchange rate shock could cause a leftward shift of the AS curve. Such a shift could cause a higher price level (P) and a lower level of real GDP (Y).

Question 4

Describe a commodity-price shock.

Question 5

Describe what the term "Dutch disease" means.

Question 6

How can exchange controls lead to an exchange-rate shock?

Question 7

Describe the potential relationships among intervention, capital flight, and defaults.

Question 8

Explain what the term IMF conditionality means.

Question 9

Over time, the IMF is becoming more like the World Bank. Is this statement true, false, or uncertain?

Question 10

Explain how the IMF may have created a moral hazard problem in international lending by commercial banks.