Current Events:
Push for Tough Economic Control
Chapter 26 Open Economy Macroeconomics
Chapter Overview
After covering the balance of payments, this chapter examines how exchange rates are determined and then relates them back to the current and capital accounts. Fixed and flexible exchange rate systems are then discussed in the context of monetary and fiscal policy effectiveness in an open economy.
Chapter Outline
The Current Account
Current account deficits and exchange rates, 4:34
The Current Account
Cf. http://www.youtube.com/watch?v=yCjwXz7ZXwU
Imports and Exports
Income
Transfers
The Capital Account, p. 669, Slide 7, Slide 8
Checkpoint: The Balance of Payments, p. 671, Slide 9
Exchange Rates, p. 671
Exchange Rates and Globalization, 3:03
Dr. Tawni Ferrarini's International Economics course at Northern Michigan University. The video simplifies the concepts of exchange rates and globalization and puts a real world perspective on those concepts.
Defining Exchange Rates, p. 671
Nominal Exchange Rates, p. 672
International Fisher Effect, 2:58
The International Fisher effect is a hypothesis in international finance that says that the difference in the nominal interest rates between two countries determines the movement of the nominal exchange rate between their currencies, with the value of the currency of the country with the lower nominal interest rate increasing. This is also known as the assumption of Uncovered Interest Parity.
Real Exchange Rates, p. 674
Purchasing Power Parity, Slide 11
"Big Mac," PPP - Purchasing Power Parity, Real Exchange Rates, 2:26
The purchasing power parity (PPP) theory uses the long-term equilibrium exchange rate of two currencies to equalize their purchasing power. Developed by Gustav Cassel in 1920, it is based on the law of one price: the theory states that, in ideally efficient markets, identical goods should have only one price.
This purchasing power exchange rate equalizes the purchasing power of different currencies in their home countries for a given basket of goods. Using a PPP basis is arguably more useful when comparing differences in living standards on the whole between nations because PPP takes into account the relative cost of living and the inflation rates of different countries, rather than just a nominal gross domestic product (GDP) comparison. The best-known and most-used purchasing power parity exchange rate is the Geary-Khamis dollar (the "international dollar").
PPP exchange rates (the "real exchange rate") fluctuations are mostly due to market exchange rates movements. Aside from this volatility, consistent deviations of the market and PPP exchange rates are observed, for example (market exchange rate) prices of non-traded goods and services are usually lower where incomes are lower. (A U.S. dollar exchanged and spent in India will buy more haircuts than a dollar spent in the United States). PPP takes into account this lower cost of living and adjusts for it as though all income was spent locally. In other words, PPP is the amount of a certain basket of basic goods which can be bought in the given country with the money it produces.
There can be marked differences between PPP and market exchange rates. [1] For example, the World Bank's World Development Indicators 2005 estimated that in 2003, one United States dollar was equivalent to about 1.8 Chinese yuan by purchasing power parity [2] — considerably different from the nominal exchange rate that put one dollar equal to 7.6 yuan. This discrepancy has large implications; for instance, GDP per capita in the People's Republic of China is about US $1,800 while on a PPP basis it is about US $7,204. This is frequently used to assert that China is the world's second-largest economy, but such a calculation would only be valid under the PPP theory. At the other extreme, Japan's nominal GDP per capita is around US $37,600, but its PPP figure is only US $30,615.
Exchange Rate Determination, p. 675
A Market for Foreign Exchange, p. 675, Slide 12
Flexible Exchange Rates, p. 676
1971, Nixon moves the world to flexible rates, 4:06
On August 15, 1971, President Nixon announced on TV 3 dramatic changes in economic policy. He imposed a wage-price freeze. He ended the Bretton Woods international monetary system. And he imposed a temporary surcharge (tariff) on all imports. The Bretton Woods system was created towards the end of World War II and involved fixed exchange rates with the U.S. dollar as the key currency - but also a role for gold linked to the dollar at $35/ounce. The system began to falter in the 1960s because of an excess of dollars flowing out of the U.S. which foreign central banks had to absorb. A run on gold in 1968 was stemmed by a patch on Bretton Woods known as the two-tier gold system. All of this was ended unilaterally by the Nixon decision. After a brief attempt to create a modified fixed exchange rate system, the world moved to flexible rates.
Currency Appreciation and Depreciation, p. 677, Slides 13 & 14
China Currency Revaluation Debate, 2:03
China Commerce Minister says appreciation of currency will do little improve balance of payments. Better cooperation in helping increase U.S. exports to China is discussed.
Determinants of Exchange Rates, p. 678, Slide 15
What Determines the Foreign Exchange Rate?, 2:13
To determine the foreign exchange rate for different currencies, check the local paper for exchange rates, and pay attention to the inflation rate. Avoid exchanging money with countries that spend more money than they bring in with advice from a financial consultant in this free video on currency exchange.
Expert: Roger Groh
Bio: Roger Groh is the founder of Groh Asset Management.
Exchange Rates and the Current Account, p. 678, Slide 16
Exchange rates, 1:45
Changes in Inflation Rates, p. 678
Changes in Domestic Disposable Income, p. 678
Exchange Rates and the Capital Account, p. 679, Slide 17
Interest Rate Changes, p. 679, Slide 18
Exchange Rate Changes
Exchange Rates and Aggregate Supply and Demand
Checkpoint: Exchange Rates
Monetary and Fiscal Policy in an Open Economy
Fixed and Flexible Exchange Rate Systems
Policies Under Fixed Exchange Rates
Policies Under Flexible Exchange Rates
Checkpoint: Monetary and Fiscal Policy in an Open Economy
Ideas for Capturing Your Classroom Audience
Here is a true story. On a flight from the United States to France the cabin crew
announced that wine, beer, etc. could be purchased for either 5 U.S. dollars or 4
euros. Who got the better deal, the people paying in U.S. currency or the people
paying in euros? This is a very simple example of purchasing power parity.
Play a game of name that currency. Pick a country (or a currency) and see if anyone can identify the currency (or country). Illustrate the various currencies of the world by visiting a Web site such as http://www.x-rates.com/. Among other things, this site provides you with the opportunity to calculate values in different currencies and generate graphs of currencies relative to each other over different periods of time.
Put it in context. Illustrate U.S. International Trade in Goods and Services with
the graph on this Foreign Trade Statistics page from the U.S. Census Bureau. This
will give students an overview of the size of U.S. trade. The page is located at:
http://www.census.gov/indicator/www/ustrade.html.
Trade data is available on the Web site of the Bureau of Economic Analysis at
http://www.bea.gov/International/Index.htm.
Do some international comparison shopping. Visit the Web sites of Amazon.com
in the United States and in the United Kingdom (www.amazon.com.uk). Find the
price in pounds and then translate it to U.S. dollars using the current exchange
rate. You can also do this by pointing out the two prices, one in Canadian dollars
and one in U.S. dollars, listed for greeting cards and paperback books.
Chapter Checkpoints
The Balance of Payments
Question: Ronald McKinnon, writing in the April 20, 2006 issue of The Wall Street
Journal, notes, China's saving is even higher than its own extraordinary high
domestic investment of 40% of GDP. . . . The result is that China (like many other
countries in Asia) naturally runs an overall current account surplus. . . .�Why would this be true? (Hint: look back at the discussion on the relationship between federal and trade deficits in the chapter on Deficits and the Public Debt.)
The point is to check that students can: apply the extended “leakages and injections” approach to the analysis of the cited article.
Exchange Rates
Question: If China were to revalue its currency by 10% so in effect the yuan appreciated by 10%, would this have an impact on the U.S. current account?
The point is to check that students can: integrate the understanding of the effect of changes in currency values on imports and exports and therefore on the current account.
Monetary and Fiscal Policy in an Open Economy
Question: The United States seems to rely more on monetary policy to maintain stable prices, low interest rates, low unemployment, and healthy economic growth.
Does the fact that the United States has really embraced global trade (imports and
exports combined are over 25% of gross domestic product) and we have a flexible
(floating) exchange rate help explain why monetary policy seems more important
than fiscal policy?
The point is to check that students can: understand how the exchange rate system
(fixed or flexible) impacts the effectiveness of monetary and fiscal policy.
Examples Used in the End-of-Chapter Questions
Question 2 refers to remittances. For a map illustrating the amounts of remittances to various countries see the Web site of the Multilateral Investment Fund from the Inter-American Development Bank. The site is located on the Web at: http://www.iadb.org/mif/remesas_map.cfm?language=English&parid=5&item1d=2.
Question 4 asks “how are most exchange rates determined?” and the answer is by
supply and demand in free markets. China has been viewed as an exception, but in
2005 the Chinese government took an important step toward allowing its currency
to float. For more information see the story by Peter S. Goodman in The
Washington Post titled, “China Ends Fixed-Rate Currency: Administration Hails
Policy Shift” (July 22, 2005, page A01, available on the Web at: http://www .washingtonpost.com/wp-dyn/content/article/2005/07/21/AR2005072100351.html.
Question 11 refers to the devaluation of Zimbabwe’s currency in mid-2006. But they
“only” (in simple terms) removed three 0’s. Turkey, in January 2005, took six 0’s off in the “redenomination” of their currency. Learn more about Turkey (and how things have worked out) on this site from the BBC: http://news.bbc.co.uk/1/hi/business/1833730.stm.
For Further Analysis
Using the AS/AD Model to Explore the Impacts of Changes in the Value of the
Dollar
The example provided in the student handout can be used as an in-class small group
exercise or as an individual in-class exercise. It is designed to complement and
extend the text’s material exchange rates and their effect on the U.S. economy using the AS/AD model. The exercise begins with the analysis described by Figure 4 in the chapter and then has students consider the opposite case (of dollar appreciation).
The exercise concludes asking students to evaluate the differing effects and
address the question of “what’s better” for the U.S. economy: a strong dollar or a
weak dollar?
The format of the exercise asks students to demonstrate their understanding by
analyzing a reverse situation to that described in the text. It also provides a chance to introduce students to the debates about economics and to get them to think about whether appreciation or depreciation is better for an economy and whether it benefits or hurts certain portions of society.
If you wish to elaborate on the analysis you can ask students to consider financial effects such as capital flows and the interest rate; this material is covered in the chapter. You may wish to supplement the assignment with current articles about the value of the dollar and views as to whether the U.S. government should “manage” the dollar more than it does at present. Other points that could be addressed include how long the long run really is and whether the short-run effects may swamp the long run. Stone’s section in microeconomics about the different definitions of time in economics is very useful.
Web-Based Exercise
This example can be used as a small group exercise or as an individual exercise. The exercise provides an opportunity for students to apply the material in the chapter about purchasing power parity and the Big Mac Index to get a feel for forecasting exchange rates. The exercise asks students to look at the Big Mac Index data from some previous period(s) and see if the currencies noted as “overvalued” subsequently depreciated and if those noted as “undervalued” subsequently appreciated.
You can change how extensive this assignment is by adding more past periods of
time or supplementing the Big Mac data with articles about various currencies
explaining the factors affecting them.
Students may also be intrigued by The Economist’s “lattenomics” that uses
Starbucks coffee instead of burgers. A video clip and explanation are among the
resources on the site at http://www.economist.com/markets/Bigmac/Index.cfm.
PPP and the Big Mac
As described in the text, the Big Mac Index published by The Economist has always
been meant to be a humorous and intuitive way to explain purchasing power parity.
However, as simple as it is, the Big Mac Index has been pretty good at predicting the future course of some currencies. Visit the Web site for the Big Mac Index at
http://www.economist.com/markets/Bigmac/Index.cfm and answer the following:
Collect data to answer the following:
1) Pick three currencies that were listed as overvalued at the time and three
that were listed as undervalued. Have those currencies subsequently moved
in the indicated directions?
2) Describe the limitations of the Big Mac Index.
Tips from a Colleague
The most challenging part of this chapter is the material on the current and capital accounts. Students are likely to understand that if we import more than we export we have a trade deficit, but the logic of why this results in a capital account surplus is likely to elude them. You might consider a simple intuitive illustration of swapping goods. Offer to trade an inexpensive stick pen for a student’s hat or other item which has an obviously higher value. Explain that such a direct swap of goods would be similar to imports and exports. When the student suggests that the goods being traded are not equal in value, offer different amounts of money (hypothetically) to make up the difference. Explain that the willingness of someone to take U.S. money to make up the difference is analogous to the increased holdings of U.S. assets by foreigners that make up the capital account.
Ch. 26 References
JFK Confers with Advisors on Gold & the Balance of Payments
At the end of World War II, the US became the mainstay of the Bretton Woods international monetary system. Under this system, the US dollar was the key currency and interchangeable into gold at $35 per ounce. Until the late 1950s, the dollar tended to be undervalued (dollar shortage). But after that time, there was a dollar surplus and a resulting drain on the US gold supply. The standard remedy would have been a tight monetary policy and austerity. But the Kennedy administration was elected in 1960 on a platform of economic expansion. There are hours of White House tapes of Kennedy and his advisors fretting over the dollar/gold situation. This clip contains illustrative excerpt from April 18, 1963. At the meeting are JFK, Treasury Secretary C. Douglas Dillon, George Ball, and Robert V. Roosa. Kennedy can be heard responding. The speaker presenting the report is probably Dillon.
Email HW to gmsmith@shanahan.org
2. Here is a true story. On a flight from the United States to France the cabin crew announced that wine, beer, etc. could be purchased for either 5 U.S. dollars or 4 euros. Who got the better deal, the people paying in U.S. currency or the people paying in euros? This is a very simple example of purchasing power parity.
Play a game of name that currency. Pick a country (or a currency) and see if anyone can identify the currency (or country). Illustrate the various currencies of the world by visiting a Web site such as http://www.x-rates.com/. Among other things, this site provides you with the opportunity to calculate values in different currencies and generate graphs of currencies relative to each other over different periods of time.
3. As review for HW, typical questions that you may encounter on the actual AP Economics Macro Test are included daily:
Review Questions (Princeton):
a) no single loan can be larger than 20 percent of the bank's holdings
b) the central bank reserves the right to audit any bank at any time
c) the central bank holds a certain fraction of GDP on reserve at all times
d) the central bank must approve loans over $1 million
e) a bank cannot lend out all of its deposits
28. If technology makes production less expensive and at the same time exports decrease, which of the following will result with certainty?
a) Real GDP will increase
b) Real GDP will decrease
c) The price level will increase
d) The price level will decrease
e) Real output will remain the same
29. Which of the following must exist to allow for mutual benefit from specialization and trade between two countries?
a) Comparative advantage in the production of a good or service
b) Absolute advantage in the production of a good or service
c) Increasing marginal returns in production
d) Absolute and comparative advantage in the production of a good or service
e) Absolute advantage and increasing marginal returns in production
