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Modern Principles:
Macroeconomics
Tyler Cowen
and Alex Tabarrok
Chapter 19
International Finance
Slide 1 of 54
Copyright © 2010 Worth Publishers • Modern Principles: Macroeconomics • Cowen/Tabarrok
Introduction
• In this chapter we build on the principles of
•
international trade.
We learn…
 What it means when we are told that the dollar
is “strong” or “weak”.
 What a trade deficit is and if it is worse than a
trade surplus.
 Why people protest against the World Bank
and the IMF.
• What are these institutions?
Slide 2 of 54
Introduction
• There are three principles underlying this
chapter.
1.
2.
3.
Gains from trade occur when people trade
across different countries with different
currencies.
The rate of saving is a key variable.
Market equilibrium means that, at the
margin, the gains from holding or spending
one currency are equal to holding or
spending some other currency.
Slide 3 of 54
U.S. Trade Deficit and Your Trade Deficit
•
•
•
Trade deficit (surplus)—The value of a
country’s imports (exports) exceeds the
value of its exports (imports).
Surplus good, deficit bad—right?
Not necessarily
 All of us run trade deficits with our grocery store,
gas station…
 These deficits are balanced with a trade surplus
with someone else…those who buy our labor.
 Same is true for the U.S.
•
What if the U.S. runs a deficit with the world
as a whole?
Slide 4 of 54
The Balance of Payments
• Balance of payments: yearly summary of
all economic transactions between
residents of one country and residents of
the rest of the world.
 Goods and services
 Transfers of financial claims: stocks, bonds,
loans, and ownership rights.
 When there is no borrowing/lending, trade
deficits must be balanced with other trade
surpluses.
Slide 5 of 54
The Balance of Payments
• A trade deficit with the rest of the world is
possible if a country can borrow from the
rest of the world.
 This borrowing is called a capital inflow.
•
A trade surplus is possible if on balance
U.S. residents lend money to the rest of the
world.
 This lending is called a capital outflow.
•
Capital surplus (deficit)—when the inflow of
foreign capital is greater (less) than the
outflow of capital to other nations.
Slide 6 of 54
The Balance of Payments
• Another way a trade deficit can be financed
 Sell assets and spend the proceeds.
•
The following identities put this all together.
 For individuals:
Earning - Spending  debt   assets cash reserves
 For countries:
Current account  Capital account  official reserves
• Let’s look at each of these in turn.
Slide 7 of 54
The Balance of Payments
• The Current Account—sum of three items
1. Balance of trade
2. Net income of capital held abroad
• Profits
• Interest
• Dividends
3. Net transfer payments, such as foreign aid
 All transactions are completed in the current
period.
 Categories (2) and (3) tend to be stable.
 Balance of trade and capital account are where
the action is.
Slide 8 of 54
The Balance of Payments
• The Capital Account (Financial Account)—
measures changes in foreign ownership of
domestic assets, physical or financial.
 Investments are divided into three categories:
1. Foreign direct investment (FDI): Plants or
other specific tangible operations in the U.S.
2. Portfolio investment: Purchase of U.S.
stocks, bonds, or other asset claims.
3. Other investment: Movements of bank
deposits from another country to the U.S.
Slide 9 of 54
The Balance of Payments
• The Official Reserves Account—Includes
U.S. government holdings of…
 Foreign currencies
 Gold reserves
 International Monetary Fund claims—Special
drawing rights (SDRs)
 Sometimes governments stockpile U.S. dollars
or other currencies such as the Euro.
•
Chinese government currently holds more
than $1 trillion in dollar-denominated
assets.
Slide 10 of 54
The Balance of Payments
• How the pieces fit together
 Suppose Wal-Mart buys more toys from China
• U.S. current account deficit increases.
• Chinese receive the dollars. If they…
 Buy U.S. goods→ ↓ current account deficit.
 Buy U.S. government bonds → ↓ U.S.
capital account deficit.
 Send the money to a bank in the U.S. → ↓
U.S. capital account deficit.
 Keep the money in a Chinese bank → ↓
U.S. reserves.
 Conclusion: The B of P will always balance.
Slide 11 of 54
The Balance of Payments
•
Two Sides, One Coin
 Usually major changes in the balance of
payments come through the current account
and the capital account.
 Implication: A country that is running a
current account deficit is also running a
capital account surplus.
• That is, current account deficits in the U.S.
are financed by foreigners investing in the
U.S.
• The following figure shows this clearly.
Slide 12 of 54
The Balance of Payments
•
Two Sides, One Coin (cont.)
U.S. Balance of Payments 1980-2005
1000
800
Capital Account
600
400
200
0
-200
-400
-600
Current Account
-800
-1000
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
Year
Current Account (in Billions)
Capital Account (in Billions)
Source: Bureau of Economics Analysis
Slide 13 of 54
The Balance of Payments
•
Two Sides, One Coin (cont.)
 Is our trade deficit a problem? → Same
question: Is our capital surplus a problem?
 Two Views
• “The U.S. is a great place to invest.”
 Capital account surplus → current
account deficit
 Investment → ↑ wealth
• “Americans are foolishly saving too little.”
 Tied to government budget deficit.
 Results in lower future living standards.
Slide 14 of 54
The Balance of Payments
•
The Bottom Line on the Trade Deficit
 Most economists believe that the trade deficit
per se is not a problem.
 A trade deficit might indicate or signal a
problem of low savings.
• Trade restrictions are unlikely to solve a
savings problem.
 If Americans are saving too little, a better
solution:
• Tax hikes and/or
• Spending cuts
Slide 15 of 54
CHECK YOURSELF
An inhabitant of Lincoln, Nebraska, buys a
German sports car for $30,000. What
changes does this make to the U.S. current
account?
A German sports car manufacturer opens a
new plant in South Carolina. How does this
affect the U.S. current account and capital
account?
Is there a link between a current account
deficit and a capital account surplus?
Slide 16 of 54
What Are Exchange Rates?
• Exchange rate: price of one currency in
another currency (February 28, 2007)
Slide 17 of 54
What Are Exchange Rates?
•
Exchange Rate Determination in the Short Run
$/¥
Supply of Yen
Exchange rate is
determined
by supply and
demand just
like any other
commodity.
$0.0085
Demand for Yen
Market for Yen
Quantity of Yen
Slide 18 of 54
What Are Exchange Rates?
•
Factors that Shift the Demand Curve
1. An increase (decrease) in the demand for a
country’s exports increases (decreases) the
value of its currency.
2. The more desirable (undesirable) a country is
for foreign investment, the higher (lower) the
value of that country’s currency.
3. An increase in the demand to hold dollar
reserves boosts the value of the dollar.
 Let’s use the supply and demand model to
illustrate each of these…
Slide 19 of 54
What Are Exchange Rates?
1a. U.S. residents order more Toyotas
$/¥
Supply of yen
↑ demand for Japan’s
exports → ↑ value of
the yen
$0.0090
Demand for yen
w/↑ orders of
Toyotas
$0.0085
Demand for yen
Market for Yen
Quantity of Yen
Slide 20 of 54
What Are Exchange Rates?
1b. U.S. residents order fewer Toyotas
$/¥
Supply of yen
↓ demand for Japan’s
exports → ↓ value of
the yen
Demand for yen
w/↓ orders of
Toyotas
$0.0085
$0.0080
Demand for yen
Market for Yen
Quantity of Yen
Slide 21 of 54
What Are Exchange Rates?
2. Mexico becomes a better investment
$/peso
Supply of pesos
The Mexican peso
↑ in value
0.090
0.075
Demand for peso
w/↑ foreign
investment
Demand for pesos
Market for Pesos
Quantity of Pesos
Slide 22 of 54
What Are Exchange Rates?
3. Change in the demand for dollar reserves
 Many governments prefer to hold dollars as a
means of saving and enjoying liquidity.
 Of all currencies held in the world U.S.
dollars comprise 2/3.
 The Swiss franc is also another global
currency.
• It has long been regarded as a “safe
haven” currency.
 Let’s use our model to see this…
Slide 23 of 54
What Are Exchange Rates?
3. Japan ↑ its demand for $ reserves
¥/$
Supply of dollars
The U.S. $ increases
in value
120.000
Demand for dollars
w/↑ demand for
U.S. $ reserves
118.225
Demand for dollars
Market for Dollars
Quantity of dollars
Slide 24 of 54
What Are Exchange Rates?
•
Factors That Shift the Supply Curve
 Depreciation: A decrease in the price of a
currency in terms of another currency.
 Central banks have the power to increase the
supply of their country’s currency.
• Zimbabwe had been printing trillions of
Zimbabwe dollars.
 By 2006: ↓ U.S.$/Z$ → 0.018 to 0.00001
• If the Federal Reserve increases the
supply of U.S. dollars → depreciation of $.
• Let’s use the model once more…
Slide 25 of 54
What Are Exchange Rates?
•
Fed Increases the Supply of Dollars
€/$
The U.S. $ depreciates
against the euro
Supply of dollars
Supply of dollars
w/↑ money supply
0.76
0.68
Demand for dollars
Market for Dollars
Quantity of dollars
Slide 26 of 54
What Are Exchange Rates?
• Exchange rate determination in the long run
 Important principle: Equilibrium requires that
the benefit of spending should be the same.
• Whether in Chicago, Berlin, or Paris.
• Whether on goods, services, or investments.
 Nominal exchange rate: rate at which one
currency can be exchanged for another.
 Real exchange rate: rate at which goods and
services of one country can be exchanged for
the goods and services of another.
Slide 27 of 54
What Are Exchange Rates?
• Exchange rate determination in the long run
(cont.)
 Purchasing Power Parity (PPP) Theorem:
The real purchasing power of a money should
be about the same, whether it is spent at home
or converted into another currency and spent
abroad.
 Two predictions of the PPP:
• Toyotas should cost the same in Tokyo or
Chicago.
• A general bundle of goods should cost the
same everywhere.
Slide 28 of 54
What Are Exchange Rates?
• Exchange rate determination in the long run
(cont.)
•
•
•
 PPP is an application of the law of one price.
Law of one price—If trade were free, then
identical goods should sell for about the same
price throughout the world.
In order for this to happen prices and exchange
rates have to adjust to equalize the rate of return.
These adjustments will determine the real
exchange rate.
Slide 29 of 54
What Are Exchange Rates?
• Exchange rate determination in the long run
(cont.)
 PPP is only approximately true. Why?
1. Transportation costs
 PPP only applies when goods can be
transported easily.
 Services are a good example; It’s possible
but costly to fly to London for a haircut.
2. Some goods cannot be shipped.
 Sipping coffee in Paris is different than
sipping it in Mobile, Alabama.
 Apartments
Slide 30 of 54
What Are Exchange Rates?
• Exchange rate determination in the long run
(cont.)
 PPP is only approximately true. Why? (Cont.)
3. Tariffs and quotas—To the extent
governments restrict trade, prices will not
equalize across countries.
 PPP holds more tightly in the long run than in
the short run.
• In the long run, entrepreneurs are able to
bring prices closer.
Slide 31 of 54
What Are Exchange Rates?
• Short-run movements within the boundaries
set by PPP
 About $1.9 trillion in foreign exchange
transactions take place on a typical day.
• Most trades are speculative.
• Daily price movements are set largely by
psychology and expectations.
• Some traders are simply guessing what
other traders are going to do.
• Sometimes these short-run movements are
called “noise.”
Slide 32 of 54
CHECK YOURSELF
 If the U.S. dollar is a safe haven currency and
risk increases, what does this do to the value of
the dollar: send it higher or lower?
 If the Federal Reserve increases the U.S.
money supply, what will this do to the value of
the dollar compared to the euro?
 If purchasing power parity holds and the
nominal exchange rate is one pound for two
dollars, how much should a Big Mac cost in
London if a Big Mac costs $4.00 in New York?
 How does a tariff affect purchasing power
parity?
Slide 33 of 54
How Exchange Rates Affect Aggregate Demand
• Monetary Policy
 Suppose the Fed increases M through open
market operations.
• Short-run
 The supply curve for dollars shifts to the
right → depreciation of the dollar.
 A depreciation of the dollar → ↑ Exports
 ↑ Exports → ↑ AD
• Long-run
 Money is neutral → ↑ domestic prices to
match ↑ M
 If ↑ M is permanent → U.S. p rises.
Slide 34 of 54
How Exchange Rates Affect Aggregate Demand
• A depreciation ↑ AD in the short run
Inflation
rate
Solow
growth
curve
New SRAS
(pe = 7%)
Longrun
c
7%
4%
b
SRAS
(pe = 2%)
Short-run: a → b
↑p: 2% → 4%
Long-run: b → c
↑p: 4% → 7%
2%
a
AD(M  v  10%)
Short-run
AD(M  v  5%)
3%
6%
Real GDP
growth rate
Slide 35 of 54
How Exchange Rates Affect Aggregate Demand
•
Dynamics of the Real Exchange Rate
 Once a Fed action is announced, the dollar
moves on international currency markets
within minutes.
 Because domestic prices do not move as
quickly, the dollar has lower value → ↓ real
exchange rate.
 In the long run as prices adjust, the real
exchange rate returns to the PPP value.
 The following figure illustrates this...
Slide 36 of 54
How Exchange Rates Affect Aggregate Demand
•
Dynamics of the Real Exchange Rate
Slide 37 of 54
How Exchange Rates Affect Aggregate Demand
•
Fiscal Policy
 Government borrows more money → ↑
demand for loanable funds → ↑ interest rates
 ↑ interest rates attract foreign capital inflow →
appreciation in the U.S. dollar.
 Appreciation in the U.S. dollar reduces U.S.
exports → trade deficit.
 Result: Twin deficits
 Using fiscal policy to boost AD is partially
offset by the rise in the trade deficit.
 Conclusion: Fiscal policy is less justified in an
open economy.
Slide 38 of 54
CHECK YOURSELF
In the short run, what will happen to
exports if the Fed increases the
money supply? What will happen in
the long run?
Which tends to be more effective in an
open economy: monetary policy or
fiscal policy?
Slide 39 of 54
Fixed vs. Floating Exchange Rates
•
Definitions:
 Floating exchange rate: determined primarily
by market forces.
 Fixed (pegged) exchange rate: the central
bank has promised to convert its currency at
a fixed rate.
 Dollarization: occurs when a foreign country
uses the U.S. as its currency.
•
Today, floating exchange rates are most
common.
Slide 40 of 54
Fixed vs. Floating Exchange Rates
•
Fixed exchange rate systems take three
forms:
1. Adopting the money of another country.
• Called “dollarization”
• Panama, Ecuador, and El Salvador
• Disadvantage: the country must buy and
save sufficient dollars.
• Advantage: Once in place, the country
receives U.S. monetary policy.
 Avoids high inflation that has plagued
other Latin American countries
Slide 41 of 54
Fixed vs. Floating Exchange Rates
•
Fixed exchange rate systems take three
forms: (cont.)
3. Backing a currency with a high level of
reserves and promising convertibility at a
certain rate.
• Holding sufficient reserves makes the
policy credible.
• Central bank buys and sells its country’s
currency to maintain the pegged rate.
• Dirty float: currency isn’t pegged but kept
within a certain range.
Slide 42 of 54
Fixed vs. Floating Exchange Rates
•
Fixed exchange rate systems take three
forms: (cont.)
2. Setting up a currency union.
• A country gives up its own currency for a
common currency, e.g., the euro.
 Larger countries saw it as a way to unify
Europe economically.
 Smaller countries saw it as a way to
obtain a more stable currency.
Slide 43 of 54
Fixed vs. Floating Exchange Rates
• The Problem with Pegs
 Thailand, Indonesia, Brazil, and Argentina
attempted pegs to the U.S. dollar.
• They were all broken by speculators.
• These countries could not match U.S.
economic policy.
 Argentina couldn’t control inflation → ↓
value of their peso.
 To maintain the peso at the pegged rate,
the Argentine central bank would have to
buy large amounts of pesos with U.S.
dollars.
Slide 44 of 54
Fixed vs. Floating Exchange Rates
• The Problem with Pegs (cont.)
 Speculators didn’t believe that the pegs could
be maintained.
• They would buy dollars instead.
• This would maintain value of the dollar and
keep the Argentine peso below the peg.
• Argentina did not have enough dollars to
maintain the peg.
 Conclusion: Without an economy as sound as
the U.S., countries cannot peg their currency
to the dollar in the long run.
Slide 45 of 54
CHECK YOURSELF
When the value of a country’s
currency is determined by the forces
of supply and demand, is this a
floating exchange rate or a fixed
exchange rate?
 Who controls the monetary policy of
the European Union?
Slide 46 of 54
What Are the IMF and the World Bank?
•
International Monetary Fund (IMF)
 Created after the end of WWII to serve as
lender of last resort.
• When countries face financial difficulties,
IMF steps in to organize a rescue package.
 Historically the President is a European.
 Income comes from…
• Contributions from each member
government.
• Income from its loans.
Slide 47 of 54
What Are the IMF and the World Bank?
•
International Monetary Fund (IMF) (cont.)
 Controversial
• Critics: Argue that it forces borrowing
governments to adopt painful economic
policies.
 Cut government spending
 Tighten monetary policy
 Raise interest rates
 In other words they force a contractionary
economic policy when perhaps
expansionary policies were called for.
Slide 48 of 54
What Are the IMF and the World Bank?
•
International Monetary Fund (IMF) (cont.)
 Controversial (cont.)
• Defenders: IMF advice is more subtle
than sometimes portrayed.
 Tough fiscal reforms are sometimes
needed.
 Borrowing countries do not follow the
advice even if it is good advice.
Slide 49 of 54
What Are the IMF and the World Bank?
• The World Bank (IBRD, International Bank for
Reconstruction and Development)
 Also set up after WWII.
 Designed to facilitate the flow of capital to
poor countries.
• 2006—Loans to developing nations = $21
billion; loan repayments = $15 billion.
 Currently its largest borrower is China.
 Other top borrowers: India, Brazil, Mexico,
and Turkey.
Slide 50 of 54
What Are the IMF and the World Bank?
•
The World Bank (cont.)
 Also controversial
• Critics: Not enough attention is given to
whether projects deliver promised benefits.
 Lent funds often end up in developed
countries as the funds are spent on
materials and experts from countries that
control the bank.
 Accountability is low because each year
another round of loans will be made in any
case.
Slide 51 of 54
What Are the IMF and the World Bank?
•
The World Bank (cont.)
 Also controversial (cont.)
• Defenders—argue that the bank has
responded to its critics.
 Improved environmental record
 Avoided many previous mistakes
 Foreign aid is difficult to succeed at;
overall the World Bank is a force for good.
•
Final comment: The IMF and the World
Bank are not as important—for better or
worse—as many people think.
Slide 52 of 54
Takeaway
• Trade deficits are not necessarily a problem
•
•
•
unless the country is investing foolishly or
not spending enough.
The trade balance is one side of the coin,
with the capital account serving on the other
side.
Exchange rates are set in active markets
following the laws of supply and demand.
Monetary policy can affect the real exchange
rate in the short run but not in the long run.
Slide 53 of 54
Takeaway
• In the long run exchange rates are set by
•
purchasing power parity.
Both monetary and fiscal policy affect a
country’s real exchange rate in the short run.
 These effects change AD by affecting exports,
imports, and the flow of capital from one country
to another.
 Most countries have floating exchange rates.
 Fixed or pegged exchange rates are possible
but difficult to maintain over the long run.
• Combinations of currency unions and floating
exchange rates have become the norm.
Slide 54 of 54