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EC 827
International Economic Structures and
Interactions
Copyright 1998 R.H. Rasche
International Economic
Interaction

National Economies which interact with other National
Economies = Open Economies

Two Types of Open Economies
– Small Open Economies
» Unable to affect key prices in world markets
(especially interest rates)
– Large Open Economies
» Able to converge world market prices (again, esp.
interest rates) towards national prices.
Copyright 1998 R.H. Rasche
Law of One Price

More extreme assumption would be that domestic prices of
all goods are determined by the prices of goods in a world
market = Law of One Price

Pd = Pw*ER
– ER is the nominal exchange rate for the domestic
currency (domestic currency per unit of “world
currency”
Copyright 1998 R.H. Rasche
Globalization?

What has happened over the past 50 years that makes the
term Globalization meaningful with regard to economic
interaction on an economy-wide scale?

If we think of U.S. States or Canadian provinces as the
ultimate in integrated economies, what if anything, has
changed on the international scene to make countries more
like states or provinces?
Copyright 1998 R.H. Rasche
Fixed vs Floating Exchange
Rate Regimes

Businesses and governments would like stability. What
could be more stable than fixed exchange rates?

Fixed Exchange Rates = Governments must intervene in
exchange markets to maintain a set price (or range of
prices) for their currency. E.g. if the $ falls, we buy $ and
sell Yen, DM etc. to pull the $ back up.

Pure Floating Exchange Rate System = no foreign
currency market interventions. Let the market set the value
of the $ relative to other currencies.
Copyright 1998 R.H. Rasche
Mixed Exchange Rate Regimes

“Managed Float” or “Dirty float”. Let the currency float
within bands. When the currency hits the limit of its band,
the central bank intervenes to push the currency back into
the middle of the band.

Politically popular, but technically debatable. E.g., who
decides when to change the limits? Managed floats work
best when both nations cooperate. But will both nations
share their interests?
Copyright 1998 R.H. Rasche
Changes in Nominal
Exchange Rate

ER = Yen /US Dollar (How many Yen it takes to buy $1)

If ER increases, then one dollar (domestic currency)
exchanges for more Yen (foreign currency) = Nominal
Apprecation of Domestic Currency

If ER decreases, then one dollar (domestic currency)
exchanges for fewer Yen (foreign currency) = Nominal
Depreciation of Domestic Currency
Copyright 1998 R.H. Rasche
Exchange Rate Policy and
Domestic Monetary Policy

Fixed Exchange Rates => Loss of Control over Domestic
Monetary Policy
– Why? Because if you want to maintain the value of the
Dollar, you can’t keep printing more Dollars. If there
are more (or less) Dollars, each Dollar will be worth
less (or more).

(Pure) Floating Exchange Rate Regime => Independent
Domestic Monetary Policy
– You can choose your monetary policy, print or
withdraw Dollars, and let the markets adjust.
Copyright 1998 R.H. Rasche
Exchange Rate Systems

Classical Gold Standard
– Tie every currency to gold
– System backed by the British Empire & its trade

Bretton Woods System (1946-71)
– Tie currencies to the Dollar
– Easy to adjust any currency’s value, except the Dollar

“Post Bretton Woods Period” (1971 - present)
– mixed bag of conflicting policies
Copyright 1998 R.H. Rasche
World-Wide
Trade Liberalization

GATT (General Agreement to Talk and Talk  World Trade
Organization (WTO))
– Tariffs and Quotas
– Trade Negotiation Rounds and the reduction of tariffs
and quotas. Attempts to not stop cheating, just allow
everyone to cheat equally.
– Emergence of non-tariff barriers to trade in goods and
services (e.g. Voluntary Export Restraints = VERs)
Copyright 1998 R.H. Rasche
World-Wide
Financial Structures

Post-WWII Developments and International Institutions

Bretton Woods Fixed Exchange Rate System ( - 1971)
– U.S. Dollar as the International Reserve Currency
– Obligation of other national participants

International Monetary Fund (IMF)
– SDR’s as a source of international liquidity
Copyright 1998 R.H. Rasche
Exchange Rate Crises under
Fixed Rate System

What happens when monetary authorities and/or exchange
rate traders come to a consensus that a particular country
cannot maintain the fixed nominal exchange rate?
– Italy, UK, 1992
– Sweden, 1992
– Mexico, December, 1994
– Thailand, Indonesia, S. Korea, 1997
Copyright 1998 R.H. Rasche
World-Wide Financial Market
Integration

Elimination of Exchange Controls
– Europe in the 60s
– Japan in the 80s

Emergence of “Euro-” Markets
– “recycling” of “petrodollars” in the 1970’s through the
“Euro-” markets.
Copyright 1998 R.H. Rasche
Real Exchange Rates

Bilateral real exchange rate measures the change in the
relative purchasing power two currencies

measured as the nominal exchange rate (foreign
currency/domestic currency) adjusted by the ratio of the
domestic price index to the foreign price index

RER = (ER*Pd)/Pf

The RER tells you how much of a foreign good you can
buy with enough Dollars to buy one US unit of the good.
Copyright 1998 R.H. Rasche
Purchasing Power Parity

Arbitrage Condition: Same goods should cost the same
(adjusted for transportation costs) in different countries.
– “the Big MAC standard”

Measurement Problems: Traded vs Nontraded Goods and
Services

Continuous equilibrium PPP => constant real exchange
rate (properly measured)
Copyright 1998 R.H. Rasche
Deviations from PPP

Clearly, PPP does not hold in the short run

Permanent or Transitory Deviations: Does Adjustment
occur in the long run?
– Empirical results not clear; if adjustment does occur, it
occurs only slowly!
Copyright 1998 R.H. Rasche
Regional Economic Integration
Copyright 1998 R.H. Rasche
NAFTA as an Integrated
Set of Economies

As a Free Trade Area (FTA) NAFTA addresses limited
aspects of international economic integration.

Financial markets of U.S. and Canada became highly
integrated long before NAFTA.

U.S. & Canadian Regulatory and Legal Structure
reasonably similar.
– What about Mexico?
Copyright 1998 R.H. Rasche
Europe: Progressive Economic
Integration

Common Market
– Focused on Trade in Goods and Services
– Special case of Agriculture

European Monetary System
– coordinated currency prices (fixed exchange rate system)

European Union:
– labor market integration
– regulatory and legal homogenization
– common currency = EMU? Why did it fall?
Copyright 1998 R.H. Rasche