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Y376 International Political
Economy
January 18, 2012
What is an exchange rate?
• The price of a currency
expressed in terms of
other currencies or
gold.
What the International Monetary
System Has to Do
• Assure currency convertibility
• Maintain sufficient availability of
currencies for trading and capital flows
(liquidity)
• Maximize stability of exchange rates given
changes in demand and supply
• Allow balances of payments to equilibrate
over time via changes in exchange rates
Definitions
• Balance of Trade
– Exports minus Imports
• Balance of Payments
– trade balance minus net financial flows
• Budgetary Balance
– govt. revenues minus govt. expenditures
“surplus” means balance is positive
“deficit” means balance is negative
Figure 2-12. U.S. Balance of Trade in Goods and
Services and Balance of Payments on Current
Account, 1946-2006, in Billions of Current Dollars
Source: Economic Report of the President 2008,
http://www.gpoaccess.gov/eop/tables08.html.
US Trade Balance, 1980-2009
Structural Imbalance
• When a trade or balance of payments deficit
or surplus persists over a relatively long
period of time, it is called a “structural
imbalance.”
• If a country has a structural deficit, it needs
to import less and export more, especially
after it can no longer borrow funds to
“finance” its deficit.
What is a Key Currency?
• Currency used in international trade
settlement, or as a reference currency in
setting exchange rates. The current key
currency is the U.S. Dollar. Central banks
hold a portion of their reserves in a key
currency.
Figure 2-6. The Dollar as Percent of Total Official Foreign
Currency Holdings, 1978, 1986, 1996, and 2007
Source: International Monetary Fund, Annual Reports, various
years.
Special Status of Key Currency
Country
• A key currency country does not have to
worry as much as others about dealing with
a structural deficit, since its currency is
needed for international transactions.
• A key currency country can “export its
inflation” to other countries by keeping
domestic demand high during a period of
structural deficits.
Structural Surplus Countries
• Germany and Japan maintained structural
surpluses from late 1960s on.
• They refused to upwardly revalue their
currencies so that their payments would
come into balance.
• They did this because the growth of their
economies depended heavily on exports.
Balance of Payments in the G-5 Countries, 19702010, in Billions of Current Dollars
$400
$200
$0
1970
1974
1978
-$200
-$400
-$600
-$800
France
Germany
Japan
UK
US
-$1,000
Source: OECD.
1982
1986
1990
1994
1998
2002
2006
The Nixon Shock of 1971
• August 1971, US has a small balance of
payments deficit (first for many years)
• Nixon and Treasury Secretary John
Connally agree on new policy:
– dollar no longer tied to gold
– import surcharge of 10 percent on all imports
– US will withdraw surcharge if surplus countries
(Germany and Japan) agree to revalue
currencies
Nixon, Connally, and the
Smithsonian Agreement
Plaza Accord
Agreement signed on September 22, 1985
at the Plaza Hotel in New York City by 5
nations - France, West Germany, Japan, the
United States and the United Kingdom. The
five agreed, among other things, to
depreciate the US dollar in relation to the
Japanese yen and German Deutsche Mark
by intervening in currency markets.
Plaza
Accords
Nixon Shock
Year
Yen-Dollar
DM-Dollar
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
DM per Dollar
400
350
300
250
200
150
100
50
0
19
64
19
66
19
68
19
70
19
72
19
74
19
76
19
78
19
80
19
82
19
84
19
86
19
88
19
90
19
92
Yen per Dollar
Yen-Dollar and DM-Dollar
Exchange Rates, 1964-1993
Shift in the Monetary Regime
After 1971
1945-71
1973-present
Exchange
Rates
Dollar/Gold
Fixed
Dirty Floating
$35/ounce
Market price
Dealing with
Structural
Imbalances
Periodic
Continual
adjustments of adjustments of
exchange rate exchange rate
Predictions of Doom
• End of fixed exchange rates would lead to
“competitive devaluations” -- as in the
1930s -- which could lead to another Great
Depression.
• End of U.S. hegemony would result in an
unstable world economy.
Alternative View
• Flexible exchange rates came just in time to
deal with the shock created by the OPEC
price increases of the 1970s.
• Although there would be greater volatility
in exchange rates, there would be fewer
crises brought on by delayed devaluations.
• Many countries would continue to peg their
currencies against the dollar.
DM-Dollar, Yen-Dollar, and Euro-Dollar Exchange Rates, 19852010
300
3.5
Yen-Dollar
Euro-Dollar
DM-Dollar
200
3
2.5
2
150
1.5
100
1
50
0.5
0
0
1985
1988
1991
1994
1997
Year
2000
2003
2006
Source: Economic Report of the President, various years.
DMs/Euros per dollar
Yen per dollar
250
8
Volatility in Deutsche Mark (DM) and Yen
Exchange Rates with the U.S. Dollar, 1965-1979,
Percentage Changes from the Previous Month
6
DM
Yen
4
2
0
-21965
1967
1969
1971
1973
1975
1977
1979
-4
-6
-8
-10
-12
Source: International Financial Statistics CD-ROM (Washington, D.C.: IMF,
January 2002.
Figure 2.14. US-China and US-Japan Bilateral Trade Deficits, in
Billions of Dollars,1991-2010
$0
1990
1993
1996
1999
2002
2005
-$50
-$100
-$150
-$200
US-China
US-Japan
-$250
Source: Economic Report of the President 2000 and 2008.
US Trade Deficit vs. Deficit with
China, 1990-2004
Yuan-Dollar Exchange Rate
Yuan-Dollar Exchange Rate,
2000-2010
Per Capita Income in China, 1960-2008
Yuan-Dollar Fight in Context
Video on November 2010 G20 Meeting