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Chapter 18
The Global Economy: Finance
What's in This Chapter and Why
The U.S. balance of payments is discussed and the current account deficit is described. The effects
of this deficit are considered.
Exchange rate determination is discussed in both the flexible and fixed exchange rate context.
After discussing the current international financial system, the authors outline the advantages and
disadvantages of flexible and fixed exchange rates.
Finally, the Asian financial crisis is described in terms of capital outflows and depreciating
currency. The pros and cons of restricting capital flows are presented.
Instructional Objectives
After completing this chapter, your students should know:
1. That the large and persistent current account deficit is undesirable.
2. That in a flexible exchange rate system, exchange rates are determined by the demand for and
supply of foreign exchange.
3. That GDP and interest rates are important in determining exchange rates.
4. That fixed exchange rates require the intervention of central banks.
5. That some economists argue that flexible rates lead to greater economic stability and leave
central banks free to pursue monetary policy.
6. That some economists believe that fixed exchange rates have a stabilizing effect on an
economy and force central banks to practice monetary discipline.
7. That the Asian financial crisis started in financial markets, but spread to all parts of the affected
economies.
8. That controls may be applied to capital outflows or inflows in order to prevent currency
depreciation or appreciation.
Key Terms
These terms are introduced in this chapter:
Balance of payments
Exchange rate
Flexible (floating) exchange rates
Appreciation
Depreciation
Fixed exchange rates
Balance of payments deficit
Balance of payments surplus
Devaluation
Revaluation
Suggestions for Teaching
Some students will know a little about exchange rates from their personal travels. Ask students to
share their experiences in trading dollars for pesos, etc. Be sure to stay up to date with actual
exchange rates by following the Wall Street Journal, or some other financial newspaper.
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242  Chapter 18/The Global Economy: Finance
Additional References
In addition to the references in the text, instructors may wish to read or assign one or more of the
following:
1. K. Alec Chrystal and Geoffrey E. Wood, "Are Trade Deficits a Problem?" Federal Reserve
Bank of St. Louis, Review 70 (January/February 1988), pp. 3-11.
2. Michael P. Dooley, “Capital Controls and Emerging Markets,” International Journal of
Finance and Economics 1 (July 1996), pp. 197-205.
3. Robert F. Graboyes, "International Trade and Payments Data: An Introduction," Federal
Reserve Bank of Richmond, Economic Review (September/October 1991), pp. 20-31.
4. Juann Hung and Susan Charrette, “The Looming U.S. External Debt: How Serious Is It?”
Contemporary Economic Policy 15, (July 1997), pp. 32-41.
5. Masahiro Kawai, “The East Asian Currency Crisis: Causes and Lessons,” Contemporary
Economic Policy 16, (April 1998), pp. 157-172.
6. Suduk Kim, “Currency Crisis in Korea–When and Why it Happened,” Asia-Pacific Financial
Markets 7 (March 2000), pp. 11-30.
7. Jane Sneddon Little, "Foreign Investment in the United States: A Cause for Concern?" Federal
Reserve Bank of Boston, New England Economic Review (July/August 1988), pp. 51-58.
8. Jane Sneddon Little and Giovanni P. Olivei, “Rethinking the International Monetary System:
An Overview,” Federal Reserve Bank of Boston, New England Economic Review
(November/December 1999), pp. 3-24.
9. Larry Neal and Daniel Barbezat, The Economics of the European Union and the Economies of
Europe, (New York: Oxford University Press, 1998).
10. Organization for Economic Co-operation and Development, EMU: Facts, Challenges, and
Policies, (Organization for Economic Cooperation and Development, 1999).
11. Carmen M. Reinhart and Vincent R. Reinhart, “On the Use of reserve Requirements in Dealing
with Capital Flow Problems,” International Journal of Finance and Economics 4 (January
1999), pp. 27-54.
12. Andrew Rose, “One Money, One Market: The Effect of Common Currencies on Trade,”
Economic Policy: A European Forum 0 (April 2000), pp. 7-33.
13. "Studies on U.S. External Imbalances," Federal Reserve Bank of New York, Quarterly Review
13/14 (Winter-Spring 1989), pp. 1-82.
14. Aaron Tornell and Andres Velasco, “Fixed versus Flexible Exchange Rates: Which Provides
More Fiscal Discipline?” Journal of Monetary Economics 45 (April 2000), pp. 399-436.
15. Jeffrey M. Wrase, “The Euro and the European Central Bank,” Federal Reserve Bank of
Philadelphia, Business Review, (November/December 1999), pp. 3-14.
Outline
I. THE BALANCE OF PAYMENTS
A. Deficits, Surpluses, and Their Consequences
1. The balance of payments is a summary of all economic transactions between the
residents of one country and those of all other countries during a given period of time.
a. These transactions include exports, imports, and various capital flows.
2. Since the early 1980s, the United States has run a deficit in its current account and a
surplus in its capital account.
a. Much of this deficit occurs because the United States imports more than it exports.
3. There is good reason to be concerned with the deficit.
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a. The deficit is financed primarily through foreign investment in the United States.
1. This investment means that ownership of the nation's assets is transferred to
foreigners.
2. As foreigners accumulate more of the nation's assets, they receive more
income and interest from the United States.
II. EXCHANGE RATES AND THEIR DETERMINATION
A. Flexible (Floating) Exchange Rates
1. An exchange rate is the number of units of one currency exchangeable for one unit of
another.
2. Under a flexible system, exchange rates are determined by the demand for and the
supply of dollars.
a. The demand for dollars is based on other countries' desires to purchase our
domestic goods and services and to invest in this country.
b. The supply of dollars is based on U.S. citizens' desires to purchase the goods and
services from other countries.
c. The equilibrium exchange rate occurs where the quantity of dollars demanded
equals the quantity of dollars supplied.
3. If the exchange rate is not at its equilibrium level, there is a tendency for it to move
towards the equilibrium rate.
a. If the quantity of dollars supplied exceeds the quantity of dollars demanded, the
exchange rate will fall (a depreciation of the dollar occurs).
b. If the quantity of dollars demanded exceeds the quantity of dollars supplied, the
exchange rate will increase (an appreciation of the dollar occurs).
B. Real GDP
1. One factor affecting exchange rates is real GDP.
a. Increases in real GDP in the United States will increase the supply of dollars to
foreign countries, causing the dollar to depreciate.
C. Interest Rates
1. Another factor affect exchange rate is the rate of interest.
a. An increase in U.S. interest rates will decrease the supply of dollars to foreign
countries and increase the demand for dollars in foreign countries, causing the
dollar to appreciate.
D. Fixed Exchange Rates
1. In a fixed exchange rate system, central banks intervene in foreign markets to keep
exchange rates constant.
a. If exchange rates are fixed above the equilibrium level, the supply of dollars is
greater than the demand for dollars and a balance of payments deficit occurs.
b. If exchange rates are fixed below the equilibrium level, the demand for dollars is
greater than the supply of dollars and a balance of payments surplus occurs.
2. If an excess supply of dollars exists, the Federal Reserve must use foreign currency to
buy dollars (to keep exchange rates constant).
a. The Federal Reserve will sooner or later exhaust its supply of the foreign currency.
b. The exchange rate may be allowed to drop–a devaluation of the dollar.
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3. If an excess demand for dollars exists, the Federal Reserve must sell dollars for some
other currency(to keep exchange rates constant).
a. The Federal Reserve may become reluctant to accumulate more dollars.
b. The exchange rate may be allowed to increase–a revaluation of the dollar.
E. The Current International Financial System
1. In the early 1970's many countries, including the United States, abandoned the fixed
exchange system.
2. The international system is mixed.
3. In 1992 the European Union was formed and 11 countries formally launched a
common currency, the euro. The euro floats against other currencies.
III. THE CASE FOR FLEXIBLE RATES
A. Flexible exchange rates will result in greater economic stability.
B. A commitment to keeping exchange rates constant prevents the central bank from altering
the domestic money supply to lower inflation or unemployment.
IV. THE CASE FOR FIXED EXCHANGE RATES
A. Less risk and uncertainty exist under a fixed system.
1. Fluctuations result in too-frequent reallocations of domestic resources between export
and import-competing sectors of the economy, and lead to less international trade and
investment.
2. Proponents of flexible rates note than firms can take action to protect themselves
against unforeseen changes in exchange rates.
B. Flexible rates lead to destabilizing speculation.
1. If speculators believe that a depreciating currency will depreciate further, they sell the
currency, causing it to depreciate even more.
2. Opponents of fixed exchange rates argue that destabilizing speculations is less likely to
occur when exchange rates adjust continuously than when a country is forced to
devalue because of a balance of payments deficit.
C. Fixed exchange rates provide a discipline to central banks.
1. If central banks must keep exchange rates constant, this prevents them from increasing
the money supply too rapidly which is inflationary.
2. Opponents of fixed exchange rates argue that central banks should be free to pursue
whatever policies are necessary for full employment.
V. SHOULD CAPITAL FLOWS BE CONTROLLED?
A. Controls may be applied to either capital outflows or capital inflows (or both).
1. To prevent devaluation or depreciation of its currency, a country may impose controls
to prevent the capital outflow.
2. To prevent appreciation or revaluation of its currency, a country may impose controls
to prevent capital inflow.
B. Capital controls may include outright bans and the taxing of capital transactions.
1. In 1972, James Tobin proposed that a tax be applied to foreign-currency transactions in
order to reduce the short-term volatility of capital flows.
C. The Traditional View of Capital Flows
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1. The traditional view is that capital should be free to flow.
2. Proponents claim that capital controls are ineffective.
3. Proponents claim that controls invite corruption among government officials and
disrespect for the law.
D. Claims by Proponents of Controls
1. Capital flows can result in large changes in prices and exchange rates, which
destabilize the economy.
2. Capital controls allow time for countries to initiate new policies and undertake
fundamental reforms in their banking systems and financial markets.
VI. THE ASIAN FINANCIAL CRISIS
A. Prior to the crisis, the affected countries were growing rapidly with low unemployment,
moderate inflation, budget surpluses, and moderate current account deficits.
B. A large increase in foreign-bank lending took place just before the crisis and many of these
loans were questionable.
C. Several events triggered the crisis in 1997.
1. Two large Korean conglomerates failed, and Korea’s third largest automaker, Kia, was
in great difficulty.
2. In Thailand, nonbank financial companies were experiencing difficulty because of bad
real estate loans.
3. In July of 1997, the Bank of Thailand announced that the baht would be allowed to
float (instead of remaining fixed).
a. The baht depreciated significantly.
b. Other currencies plummeted as speculators sold them and capital flowed from the
countries
c. The crisis spread to stock markets and the real economy.
D. By 1999, the worst was over and the East Asian countries began to grow once more.
1. The International Monetary Fund played a positive role in the recovery.
Answers to Review Questions
1. Even though the United States has a large current account deficit, it has an overall
balance of zero. Why, then, is there concern about the large current account deficit?
Most of the deficit in the current account is financed by foreign investment in the United
States. So long as this continues, more and more of the nation's assets will become the
property of foreigners. As foreign ownership of U.S. assets increases, foreigners will receive
more income and interest from the United States. As foreigners receive more, U.S. citizens
receive less.
Thus, the United States finds itself in an uncomfortable position. It is dependent on foreign
investment to finance the current account deficit. If foreign investment diminishes, it will be
forced to reduce the deficit. So long as foreign investment in the country continues, it will be
able to finance its current account deficit; however, increasing amounts of U.S. assets will be
246  Chapter 18/The Global Economy: Finance
held by foreigners. There will be a redistribution of income from domestic citizens to
foreigners.
2. With regard to the balance of payments, classify each of the following as to whether they
fall in the current or capital accounts. Also, indicate whether they are a credit or debit.
a. U.S. purchase of beef from Argentina.
b. Japanese purchases of IBM stock.
c. Your spring break vacation in Mexico.
d. A U.S. fast-food chain opening a series of restaurants in Canada.
a. A U.S. purchase of beef from Argentina in an import and thus belongs in the current
account. It represents a flow of dollars out of the U.S. so it is a debit.
b. A Japanese purchase of IBM stock belongs in the capital account. It is a credit because it
is a flow of capital into the U.S.
c. Your spring break vacation in Mexico is a debit in the current account because you took
dollars out of the U.S. and “left them” in Mexico.
d. A U.S. fast food chain opening restaurants in Canada is a debit in the capital account.
3. If the yen-dollar exchange rate is 100 yen per dollar, what is the dollar-yen exchange
rate?
The dollar-yen exchange rate is 0.01 dollars per yen, obtained by dividing both sides of the
equation: 100 yen = 1 dollar.
4. Explain how exchange rates are determined in
a. A flexible exchange rate system.
b. A fixed exchange rate system.
a. In a system of flexible exchange rates, exchange rates are determined by the forces of
demand and supply. In order to understand this statement, observe the following diagram.
Pounds per Dollar
S
E2
E1
E3
D
Dollars
In this diagram, D represents the demand for dollars. It is based on other countries' desire
to purchase goods made in the United States and invest in the United States. S represents
Instructor's Manual  247
the supply of dollars. It is based on U.S. citizens' desires to purchase goods from Great
Britain and invest in that country. The exchange rate, E1, is determined by the intersection
of D and S. Suppose the exchange rate is E2. At this rate, U.S. citizens would wish to
purchase more British goods while the British would wish to purchase fewer goods made
in the United States. The quantity of dollars supplied would exceed the quantity of dollars
demanded. As a result, there would be a tendency for the exchange rate to fall until
quantity demanded and quantity supplied were equal.
If the exchange rate were E3, U.S. citizens would wish to purchase fewer British goods
while the British would wish to purchase more goods made in the United States. In this
instance, the quantity of dollars demanded would exceed the quantity of dollars supplied
and the exchange rate would increase to E1.
b. In a fixed exchange rate system, supply of and demand for currencies do not determine the
exchange rate. Instead, central banks intervene in foreign exchange markets in order to
keep exchange rates constant. For instance, if the exchange rate is below (above) the rate
that equates the quantity of dollars supplied and the quantity of dollars demanded, there
will be an excess demand for (supply of) dollars. The exchange rate will tend to rise (fall).
To keep the exchange rate fixed the central bank must sell (buy) dollars in foreign
exchange markets.
5. Suppose the British pound-American dollar exchange rate falls. Does the dollar
appreciate or depreciate? Defend your answer.
Suppose that the British pound-American dollar exchange rate is 5 pounds per dollar. Now, let
the exchange rate fall to 4 pounds per dollar. The dollar has just depreciated. A dollar now has
less value in terms of pounds. You get fewer pounds per dollar.
6. Suppose the U.S. dollar appreciates relative to the Japanese yen. How will exports and
imports of the two countries be affected.
If the U.S. dollar appreciates relative to the Japanese yen, Japanese goods and services will be
less expensive to Americans. Americans can now purchase more Japanese goods and services
for a dollar. As a result, there will be a tendency for imports to increase. The appreciation will
cause American goods to cost more to the Japanese. The yen will now purchase fewer goods
and services. As a result, imports will decrease. Thus, appreciation will cause an increase in
imports and a decrease in exports.
7. Assuming flexible exchange rates, how will each of the following affect the home
country’s currency?
a. An increase in real GDP abroad.
b. An increase in the home country’s inflation rate.
c. An increase in foreign interest rates.
d. Renewed confidence in the home country’s economy.
a. If real GDP increases abroad, but stays constant in the home country, the result is that
foreigners want to buy more of all goods including goods from our home country, there
will be a demand for the home country’s currency, causing that currency to appreciate.
b. If the domestic inflation rate increases relative to the rest of the world, a nation's exports
will become less competitive. Other nations will substitute away from these more
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expensive goods, and the demand for domestic dollars will decreases, thereby pushing
down the exchange rate. At the same time, the increase in inflation will make foreign
goods look more attractive to domestic citizens. As a result the supply of dollars in foreign
markets will increase . This will tend to push down the exchange rate. Thus, the overall
effect of an increase in inflation is to cause the dollar to depreciate.
c. If the foreign interest rate increases relative to the domestic rate, other countries will wish
to invest less in the United States. This will decrease the demand for dollars and decrease
the exchange rate. At the same time, it becomes more attractive for domestic citizens to
invest abroad. This will increase the supply of dollars and lead to a decrease in the
exchange rate. The overall effect of the increased foreign interest rate is to cause the dollar
to depreciate.
d. If there is a renewed confidence in the domestic economy that is felt worldwide, the result
is that foreign countries may want to purchase more of our exports. This means a greater
demand for the dollar and the dollar will appreciate. At the same time, domestic citizens,
feeling the same new confidence, may choose to purchase domestic goods over foreign
ones. The result is that there are fewer dollars supplied to foreign markets, which also
causes an appreciation of the dollar.
8. What is the euro? Why should Americans be interested in it?
The euro is the single currency of the European Economic and Monetary Union. Currently, the
euro is not circulating as currency, but bank accounts, credit cards and travelers’ checks have
been denominated in euros since January 1, 1999. The euro will begin replacing each EMU’s
currency and coins starting January, 1, 2002.
The countries in the EMU are trading partners with the U.S. and anything that affects their
economies has the potential to affect the American economy to some extent. While the move
to one currency has some definite advantages for these countries, it also has some associated
costs. For one thing individual countries will not be able to engage in independent monetary
policy. What if some shock affects some countries more than others? Also exchange rate
policies between the member nations is now eliminated. There is the potential for this move to
one currency to cause some strain among the relations of the EMU countries.
9. Summarize the advantages and disadvantages of flexible and fixed exchange rates.
There are two primary advantages to flexible exchange rates. Proponents argue that flexible
exchange rates result in greater economic stability. For instance, if our trading partner
experiences a recession, they will purchase fewer U.S. exports; however, this will be partially
offset because, if exchange rates are free to adjust, the U.S. dollar will depreciate, making U.S.
exports less expensive for foreign buyers.
Second, if central banks become committed to keeping exchange rates constant, they do so by
buying foreign currency with domestic currency. This commitment keep the central bank from
being able to alter the domestic money supply in attempt to lower inflation or unemployment.
With flexible rates, they are free to pursue monetary policy.
Proponents of fixed rates argue that there is less uncertainty under such a system, but
proponents of flexible rates contend that firms can take action to protect themselves from
unforeseen changes in the exchange rate. Proponents of fixed rates also argue that flexible
Instructor's Manual  249
exchange rates can lead to destabilizing speculation, others disagree. Finally, proponents of
fixed rates believe that fixed rates provide a discipline to central banks because they are not
free to increase the money supply too rapidly. As mentioned earlier, others believe that central
banks need the freedom to pursue policies for full employment.
10. Suppose a country suddenly experiences a capital outflow. Describe the impact on the
country assuming
a. Flexible exchange rates
b. Fixed exchange rates
a.
If capital starts flowing from a country with fixed exchange rates, the demand for its
currency decreases, causing a balance of payments deficit. The country’s central bank
must use its holdings of foreign currencies to buy the domestic currency to keep exchange
rates constant. If the central bank has meager balances, they may be forced to devalue their
currency.
b. If capital starts flowing from a country with flexible exchange rates, the country’s currency
will depreciate.
11. Critically evaluate the following statement: “The Asian financial crisis was about
transactions; the countries involved continued to grow.”
This statement is not correct. The Asian financial crisis began primarily in financial markets.
For example, in 1997 Thailand’s largest finance company failed. Capital flowed out of the
affected countries and central banks decided to let currency float or be flexible. The result is
that the value of the currencies plummeted. The crisis next spread to stock markets, and stock
prices dropped dramatically. Eventually, the affected economies turned downward. Output
decreased and unemployment increased. By 1999, with the intervention of the International
Monetary Fund, the East Asian countries began the road to recovery.
12. What impact did the Asian financial crisis have on U.S. exports to that region? Defend
your answer.
The crisis clearly meant that U.S. exports to the region would decline. If the value of the Asian
currencies plummeted, this means that the currencies lost value next the dollar. For example, it
would take a lot more Malaysian ringgits to get one dollar; consequently, U.S. goods became
more expensive to the people of Malaysia. Couple this with the receding economy in which
Malaysian people had less income with which to purchase American exports, and you get a
situation where the U.S. was clearly affected by the crisis.
13. What are capital controls? Why might a country wish to impose them?
Capital controls are mechanisms used to prevent either capital outflows, capital inflows, or
both. For instance, the best known approach to this may be the Tobin plan in which a tax is
applied to foreign currency transactions. Some countries may impose an outright ban on such
transactions. Proponents of controls claim that capital flows can result in large changes in
prices and exchange rates, which destabilize the economy. For instance, a sudden inflow of
capital into an economy will cause a currency to revalue or appreciate. A sudden outflow of
capital will cause the currency to devalue or depreciate, such as what occurred in the Asian
financial crisis.
250  Chapter 18/The Global Economy: Finance
14. What is the traditional view regarding capital movements? Why are economists
reassessing this view?
The traditional view of capital movements is that capital should be free to flow from countries
offering low prospective returns to countries offering higher prospective returns. Barring
distortions, such as taxes, this will ensure the appropriate allocation of resources. Events such
as the Mexican and Asian financial crises have caused economists and policymakers to take
another look at this issue. Proponents of controls claim that capital flows can lead to changes
in prices and exchange rates that destabilize the economy (as in Asia); however, in countries
that have sound banking systems and well-developed financial markets, capital flows have
been less of a problem. Proponents of controls also argue that they allow time for countries to
initiate new policies and undertake fundamental reforms in their banking system and financial
markets. Some countries have done this, but others have not.