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Economics of Latin America
Question 1
The serious inflation problem experienced in   the sub-continent of Latin America and the Caribbean the In the 1980s and 1990s, originated from:
The Latin American countries had spent a lot of funds on industrialization and development of infrastructure in the 1970s.The funds were mainly borrowed from international creditors like the World Bank. External debt grew from $75 billion in 1975 to more than $315 billion in 1983, which was equivalent to 50 percent of the region’s product. The economies were also generating a substantial amount of money from oil investments hence commercial banks had a lot of funds which they rented to their respective governments for investment. Due to huge borrowing by governments, debt management crisis resulted; Interest payments and the repayment of principal grew faster, reaching $66 billion in 1982, up from $12 billion in 1975 .governments opted printing of money to finance these debts. This resulted in an overall increase in money supply in Latin American countries resulting in inflation as explained by the Quantity theory of money equation below:
M X V = P X Q
Where M = money supply
V= money velocity
P = Price level
In the short run, we hold V and Q are constant over the short term; any increase in M translates into higher price levels (inflation).
Milton Friedman holds that inflation is always and everywhere a monetary phenomenon that arises from a more rapid expansion in the quantity of money while Keynes emphasized the increase in aggregate demand as the main source of demand-pull inflation.
High inflation and debt crisis led to very severe economic problems to Latin America economies: income dropped, economic growth stagnated, unemployment rose to high levels and purchasing power of the middle class reduced. Precisely, real wages in urban areas dropped between 20 and 40 percent.
Question Two

  • Explain principle of trilemma using examples. Explain options available for a country.

The principle of trilemma notes that in an open economy, it is impossible for a country to pursue policies on free capital movement, fixed foreign exchange rate, and independent monetary policy. To elaborate, if the global interest rate is high, at about 10% but the country’s central bank decides to lower its rate below this level, there will be capital flight since investors will dump the low yielding local currency and buy high yielding foreign currencies.
On the contrary, if the central bank wants free capital inflows, it can only achieve this goal by selling currency reserves. This policy would have the effect of stabilizing the interest, ensuring there is more money supply, and lowering interest rates. However, once the reserves are depleted, the domestic currency would depreciate. For example, country ZZZ wants to attract capital from investors, it can sell some of its capital reserves and ensure that the country’s currency has high interest rate. As a result, investors would be willing to investors would be willing to buy the country’s currency. However, once the reserves are over, the currency’s interest rate would fall back to its old price and the investors would flee.
If the country increases monetary supply, the exchange rates would fall below the international levels, which would make investors to buy foreign currency. As a result, this policy will be inappropriate in encouraging investments.
Available options

  1. Establishing a stable exchange rate regime and frees capital flow but not establishing an independent monetary policy. If the central bank establishes interest rates above or below the global rates, it would undermine a country’s exchange rates due to appreciation or depreciation of currency.
  2. Forming an independent monetary policy and free capital flows but establishing a flexible exchange rate. An increase in monetary policies by the country would lead to depreciation pressures on the local currency. The opposite would be true if the country minimizes money supply.
  3. Establishing a stable exchange rate and independent monetary policy but no free cash flows. The control in money supply and interest rates would ensure that the value of the country’s currency is stable. However, if the current exchange rate is higher than the global average, there would result in inflows that would affect this system.
  4. Policies proposed by monetarist and structuralists in controlling inflation in Latin America

According to the monetarist, the cause of inflation in the country was the high level of spending in the country by the government. In particular, the issuance of too much money was leading to a situation of too much money chasing too few goods. In order to stop this problem, the government had to stop printing money.
The structuralist economist on their side argued that the inflation was due to the under development in the economy, which was causing the economy not to reach its full employment equilibrium. To stop inflation, the government had to eliminate market structures that are not optimal such as oligopolies.

  1. Compare policies undertaken by Brazil, Bolivia, and Argentina to combat inflation?

In 1986, the Bolivian government floated the country’s currency, peso, with the United States dollar after adopting the New Economic Policy (NPE). It also liberalized import policies, through tax reduction. Moreover, the government steadily decided to privatize the public sector. To begin with, it laid off many of the employees that were employed by the government. It also eliminated subsidies, abolished price controls, and eliminated subsidies (Pateman & Cramer, 1996).
In 1990, the government of Argentina established policies that aimed at controlling the country’s hyperinflation. Firstly, the country started by complete liberalization of foreign trade and capital movements. It also privatized state owned enterprises and deregulated the economy. In addition, it reconstructed the tax system and removed bureaucracies in the public sector. Finally, it established a new monetary system. The country’s central backed each peso with an equivalent amount of gold or dollars, which enabled citizens to convert this currency to American dollars.
Brazil had hyperinflation between 1990 and 1994, which ravaged the county’s economy. To eliminate this problem, the country introduced a new currency, the Real as well as a new economic plan, the Real Plan. Simply, this plain aimed at privatizing state owned enterprises, abolishing wage price indexing, and lowering tariffs (Sachs, 1999).
In all of these countries, they undertook privatization of state owned policy as one of their tactics. In Brazil, the country introduced a new currency as the main economic reform. In Argentina, the liberalization of the economy and backing of peso with the dollar was the main reform. Finally, in Bolivia, privatization as well as comparing the peso with the US dollar was the main reform.
Question Two

  1. Trend of remittance in Latin America. Characteristic of receiving households in terms of income distribution.

The remittances in Latin America have been increasing steadily from the 1990’s till today. The bulk of these cash originates from the US. Mostly, the receiving households are parents and siblings who are send these funds by relatives abroad. In most cases, women are the recipients. In some countries, especially those that the remittances are higher than the country’s average, there has been an effect in income distribution. Generally, families that receive remittances have a higher average income than locals.

  1. Characteristic of Latin American immigrants? Is there “brain drain”?

There are high levels of skilled labour mobility from Latin America to OECD countries. In most cases, the immigrants are young and energetic youth who seek employment in more developed countries. As a result, there is brain drain in Latin America. The increased remittances from abroad is an indication of increased level of individuals migrating to these nations. In some countries, there has been a decline in the number of college educated individuals since most of them migrate to OECD countries. Although the characteristics of the educational level differ among countries, there are a significant number of educated individuals who live in foreign countries. There are 4% college-educated Mexican migrants in US, 7% for Central America, 24% for Andean region, and 30% for South America countries (Fajnzylber & Lopez, 2008, 6)

  1. Evidence of remittances in alleviating poverty and inequality while spurring economic development

The impact of remittances in spurring economic development and eliminating inequality largely depends on a county’s ability to implement sound economic policies. However, as a whole, high remittances result in reduction in poverty, improvement in human capital indicators, increased investment and growth, and low output velocity. To elaborate, on the impact of remittances in eliminating inequality, 9 out of 11 countries in Latin America show a higher Gini coefficient if the proportion of remittances were to be eliminated. This information indicates that remittances reduce income inequality (Fajnzylber & Lopez, 2008, 7). Further, the results from the Gini coefficient show that remittances are effective in eliminating poverty especially where these incomes are from individuals who are from low income groups in the society.

  1. Impact of remittance on household expenditure?

The impact of the remittances varies depending in the demographics of the recipient in terms of household income. In Mexico for example, it has been observed that remittances in lower income groups have the effect of increase their share of expenditure in durable goods such as education and housing improvement. Among rich individuals, remittances increase the expenses on non-durable goods and lower the share spent on durable items such as housing and education. Among most Latin American countries, it has been observed that remittances increase the share spent on nondurable goods. In fact, only the middle and upper class increase their share on durable goods (Fajnzylber & Lopez, 2008,9). To sum up, remittances enable in overcome borrowing constraints, which limit human capital investments.

  1. Evidence of increased banking due to remittances

Increased remittances lead to increased banking activities especially in regions where people send cash through banks. To begin with remittances increase bank deposits and credit, which in turn increase the amount of loanable funds. It has been observed that a 1% increase in remittance results in a 2 % increase in deposits. To elaborate, in a census conducted in Mexico, it was observed that municipalities that have a lot of individuals receiving remittances also have more deposit per capital (Fajnzylber & Lopez, 2008,11-12).
6.) Impact of remittances on real exchange rate?
Remittances increase the supply of foreign exchange in a country, which makes the local currency to appreciate. As a result, imports become cheap and the country spends less on essential imports.
Local Currency                                                                                                                                                                                                           Supply (S2)
600                                                                  Equilibrium (2)            Supply (S1)
500                                                                                          Equilibrium (1)
250                                                                                          Demand for US$
250                  500      750                  US$
From the diagram, an increase in foreign exchange shifts the supply curve from S2 to S1. In turn, the amount of local currency needed to buy dollar changes from 600 local currencies for $ 500, to about 500 local currencies for $750. Therefore, an increase in foreign remittances leads to appreciation of local currency.
Role of “sterilization” of remittances in this process?
Remittances may have negative effects on government policies. It is estimated that doubling of remittances in Latin America may lead to between 3% and 24% increase in real exchange of local currency. In general, such an increase would make a country’s exports more expensive, which would reduce the volumes exported. Therefore, in order to ensure that monetary and fiscal policies are effective, the government may be forced to sterilize these remittances. A popular method may be the use of bonds to buy these foreign exchange.

  • Policies or actions undertaken to encourage investment out of remittances.

In Peru, individuals are able to access government backed mortgage if they have at least 5% of the home value in an overseas account. The interest rate for this mortgage is 3% as long as the borrower pays the funds when they are due. In light of this, individuals are enticed to invest remittances in durable products.
In Mexico, the “Su Pedacito de Mexico” the government offers a mortgage program that is similar to that of Peru. Generally, an individual is able to access a government-owned mortgage if he/she has more than 5% of the value of the house in a foreign account. Similarly, the rate for this mortgage is 3% for the first three month if he/she makes prompt payments for the instalments in the first six months.
Fajnzylber, P., & Lopez, J. (2008). Remittances and Development: Lessons from Latin America. Washington, DC: World Bank
Pateman, R., & Cramer, M. (1996). Bolivia: Cultures of the world. New York, NY: Marshall Cavendish Benchmark.
Sachs, J. (1999). Developing Country Debt and Economic Performance, Volume 2: Country Studies Argentina, Bolivia, Brazil, Mexico. London, UK: University of Chicago Press.