Baumol & Blinder MACROECONOMICS (11th ed)

1.The following table describes the number of yards of cloth and barrels of wine that can be produced with a week’s worth of labor in England and Portugal. Assume that no other inputs are needed.

a.If there is no trade, what is the price of wine in terms of cloth in England?

b.If there is no trade, what is the price of wine in terms of cloth in Portugal?

c.Suppose each country has 1 million weeks of labor available per year. Draw the production possibilities frontier for each country.

d.Which country has an absolute advantage in the production of which good(s)? Which country has a comparative advantage in the production of which good(s)?

e.If the countries start trading with each other, which country will specialize and export which good?

f.What can be said about the price at which trade will take place?

2.Suppose that the United States and Mexico are the only two countries in the world and that labor is the only productive input. In the United States, a worker can produce 12 bushels of wheat or 2 barrels of oil in a day. In Mexico, a worker can produce 2 bushels of wheat or 4 barrels of oil per day.

a.What will be the price ratio between the two commodities (that is, the price of oil in terms of wheat) in each country if there is no trade?

b.If free trade is allowed and there are no transportation costs, which commodity would the United States import? What about Mexico?

c.In what range would the price ratio have to fall under free trade? Why?

d.Picking one possible post-trade price ratio, show clearly how it is possible for both countries to benefit from free trade.

1.You have a dozen shirts and your roommate has six pairs of shoes worth roughly the same amount of money. You decide to swap six shirts for three pairs of shoes. In financial terms, neither of you gains anything. Explain why you are nevertheless both likely to be better off.

2.In the eighteenth century, some writers argued that one person in a trade could be made better off only by gaining at the expense of the other. Explain the fallacy in this argument.

3.Country A has a cold climate with a short growing season, but a highly skilled labor force (think of Finland). What sorts of products do you think it is likely to produce? What are the characteristics of the countries with which you would expect it to trade?

4.After the removal of a quota on sugar, many U.S. sugar farms go bankrupt. Discuss the pros and cons of removing the quota in the short and long runs.

5.Country A has a mercantilist government that believes it is always best to export more than it imports. As a

consequence, it exports more to Country B every year than it imports from Country B. After 100 years of this arrangement, both countries are destroyed in an earthquake. What were the advantages or disadvantages of the surplus to Country A? To Country B?

6.Under current trade law, the president of the United States must report periodically to Congress on countries engaging in unfair trade practices that inhibit U.S. exports. How would you define an “unfair” trade practice? Suppose Country X exports much more to the United States than it imports, year after year. Does that constitute evidence that Country X’s trade practices are unfair? What would constitute such evidence?

7.Suppose the United States finds Country X guilty of unfair trade practices and penalizes it with import quotas. So U.S. imports from Country X fall. Suppose, further, that Country X does not alter its trade practices in any way. Is the United States better or worse off? What about Country X?

Price of Wheat per Bushel

0

Quantity of Wheat

(b) Importing Country

Similar reasoning shows that no price below $2.50 can be sustained. Thus:

In international trade, the equilibrium price is the one that makes the exporting country want to export exactly the amount that the importing country wants to import. Equilibrium will thus occur at a price at which the horizontal distance AB in Figure 3(a) (the excess of the exporter’s quantity supplied over its quantity demanded) is equal to the horizontal distance CD in Figure 3(b) (the excess of the importer’s quantity demanded over its quantity supplied). At this price, the world’s quantity demanded equals the world’s quantity supplied.

HOW TARIFFS AND QUOTAS WORK

However, as noted in the text, nations do not always let markets operate freely. Sometimes they intervene with quotas that limit imports or with tariffs that make imports more expensive. Although both tariffs and quotas restrict supplies coming from abroad and drive up prices, they operate slightly differently. A tariff works by raising prices, which in turn reduces the quantity of imports demanded. The sequence associated with a quota is just the reverse—a restriction in supply forces prices to rise.

The supply and demand curves in Figure 4 illustrate how tariffs and quotas work. Just as in Figure 3, the equilibrium price of wheat under free trade is $2.50 per bushel (in both countries). At this price, the exporting country produces 125 million bushels— point B in Panel (a)—and consumes 80 million

FIGURE 4

(point A). So its exports are 45 million bushels—the distance AB. Similarly, the importing country consumes 95 million bushels—point D in Panel (b)—and produces only 50 million (point C), so its imports are also 45 million bushels—the distance CD.

Now suppose the government of the importing nation imposes a quota limiting imports to 30 million bushels. The free-trade equilibrium with imports of 45 million bushels is now illegal. Instead, the market must equilibrate at a point where both exports and imports are only 30 million bushels. As Figure 4 indicates, this requirement implies that there must be different prices in the two countries.

Imports in Panel (b) will be 30 million bushels—the distance QT—only when the price of wheat in the importing nation is $3.25 per bushel, because only at this price will quantity demanded exceed domestic quantity supplied by 30 million bushels. Similarly, exports in Panel (a) will be 30 million bushels—the distance RS—only when the price in the exporting country is $2.00 per bushel. At this price, quantity supplied exceeds quantity demanded in the exporting country by 30 million bushels. Thus, the quota raises the price in the importing country to $3.25 and lowers the price in the exporting country to $2.00. In general:

An import quota on a product normally reduces the volume of that product traded, raises the price in the importing country, and reduces the price in the exporting country.

A tariff can accomplish exactly the same restriction of trade. In our example, a quota of 30 million bushels

leads to a price that is $1.25 higher in the importing country than in the exporting country ($3.25 versus $2.00). Suppose that, instead of a quota, the importing nation were to impose a $1.25 per bushel tariff. International trade equilibrium would then have to satisfy the following two requirements:

1.The quantity of wheat exported by one country must equal the quantity of wheat imported by the other, just as before.

2.The price that consumers in the importing country pay for wheat must exceed the price that suppliers in the exporting country receive by the amount of the tariff (which is $1.25 in the example).

By consulting the graphs in Figure 4, you can see exactly where these two requirements are met. If the exporter produces at S and consumes at R, while the importer produces at Q and consumes at T, then exports and imports are equal (at 30 million bushels), and the two domestic prices differ by exactly $1.25. (They are $3.25 and $2.00.) But this is exactly the same equilibrium we found under the quota. What we have just discovered is a general result of international trade theory:

Any restriction of imports that is accomplished by a quota normally can also be accomplished by a tariff.

In this case, the tariff corresponding to an import quota of 30 million bushels is $1.25 per bushel.

We mentioned in the text that a tariff (or a quota) forces foreign producers to sell more cheaply. Figure 4 shows how this works. Suppose, as in Panel (b), that a $1.25 tariff on wheat raises the price in the importing country from $2.50 to $3.25 per bushel. This higher price drives down imports from an amount represented by the length of the brick-colored line CD to the smaller amount represented by the blue line QT. In the exporting country, this change means an equal reduction in exports, as illustrated by the change from AB to RS in Panel (a).

As a result, the price at which the exporting country can sell its wheat is driven down—from $2.50 to $2.00 in the example. Meanwhile, producers in the importing country, which are exempt from the tariff, can charge $3.25 per bushel. Thus, as noted in the text, a tariff (or a quota) can be thought of as a way to “rig” the domestic market in favor of domestic firms.

1.The prices of goods traded between countries are determined by supply and demand, but one must consider explicitly the demand curve and the supply curve of each country involved. Thus the equilibrium price must make the excess of quantity supplied over quantity demanded in the exporting country equal to the excess of quantity demanded over quantity supplied in the importing country.

2.When trade is restricted, the combinations of prices and quantities in the various countries that are achieved by a quota can also be achieved by a tariff.

3.Tariffs or quotas favor domestic producers over foreign producers.

1.The following table presents the demand and supply curves for microcomputers in Japan and the United States.

NOTE: Price and quantity are in thousands.

a.Draw the demand and supply curves for the United States on one diagram and those for Japan on another one.

b.If the United States and Japan do not trade, what are the equilibrium price and quantity in the computer market in the United States? In Japan?

c.Now suppose trade is opened up between the two countries. What will be the equilibrium price in the world market for computers? What has happened to the price of computers in the United States? In Japan?

d.Which country will export computers? How many?

e.When trade opens, what happens to the quantity of computers produced, and therefore employment, in the computer industry in the United States? In Japan? Who benefits and who loses initially from free trade?

PUZZLE: WHY HAS THE DOLLAR SAGGED?

WHAT ARE EXCHANGE RATES?

EXCHANGE RATE DETERMINATION IN A FREE MARKET

Interest Rates and Exchange Rates: The Short Run Economic Activity and Exchange Rates:

The Medium Run

The Purchasing-Power Parity Theory: The Long Run Market Determination of Exchange Rates: Summary

WHEN GOVERNMENTS FIX EXCHANGE RATES: THE BALANCE OF PAYMENTS

A BIT OF HISTORY: THE GOLD STANDARD

AND THE BRETTON WOODS SYSTEM

The Classical Gold Standard

The Bretton Woods System

ADJUSTMENT MECHANISMS UNDER FIXED EXCHANGE RATES

WHY TRY TO FIX EXCHANGE RATES?

THE CURRENT “NONSYSTEM”

The Role of the IMF

The Volatile Dollar

The Birth and Adolescence of the Euro

PUZZLE RESOLVED: WHY THE DOLLAR

ROSE AND THEN FELL

The exchange rate states the price, in terms of one currency, at which another currency can be bought.

A nation’s currency is said to appreciate when exchange rates change so that a unit of its currency can buy more units of foreign currency.

A nation’s currency is said to depreciate when exchange rates change so that a unit of its currency can buy fewer units of foreign currency.

We noted in the previous chapter that international trade is more complicated than domestic trade. There are no national borders to be crossed when, say, California lettuce is shipped to Massachusetts. The consumer in Boston pays with dollars, just the currency that the farmer in Modesto wants. If that same farmer ships her lettuce to Japan, however, consumers there will have only Japanese yen with which to pay, rather than the dollars the farmer in California wants. Thus, for international trade to take place, there must be some way to convert one currency into another. The rates at which such conversions are made are called exchange rates.

There is an exchange rate between every pair of currencies. For example, one British pound is currently the equivalent of about $2. The exchange rate between the pound and the dollar, then, may be expressed as roughly “$2 to the pound” (meaning that it costs $2 to buy a pound) or about “50 pence to the dollar” (meaning that it costs half a British pound to buy a dollar).

Exchange rates vis-à-vis the United States dollar have changed dramatically over time. In a nutshell, the dollar soared in the period from mid-1980 to early 1985, fell relative to most major currencies from early 1985 until early 1988, and then fluctuated with no clear trend until the spring of 1995. From then until early 2002, the dollar was mostly on the rise. Then, from February 2002 through December 2004, the dollar reversed course and fell steadily. From then until 2007, the dollar was relatively stable, on balance until early 2007 when, as noted above, it started dropping once again. This chapter seeks to explain such currency movements.

Under our present system, currency rates change frequently. When other currencies become more expensive in terms of dollars, we say that they have appreciated relative to the dollar. Alternatively, we can look at this same event as the dollar buying less foreign currency, meaning that the dollar has depreciated relative to another currency.

What is a depreciation to one country must be an appreciation to the other.

For example, if the cost of a pound rises from $1.50 to $2, the cost of a U.S. dollar in terms of pounds simultaneously falls from 67 pence to 50 pence. The United Kingdom has experienced a currency appreciation while the United States has experienced a currency depreciation. In fact, the two mean more or less the same thing. As you may have noticed, these two ways of viewing the exchange rate are reciprocals of one another, that is, 1/1.5 5 0.67 and 1/2 5 0.50. And of course, when a number goes up, its reciprocal goes down.

When many currencies are changing in value at the same time, the dollar may be appreciating with respect to one currency but depreciating with respect to another. Table 1 offers a selection of exchange rates prevailing in July 1980, February 1985, June 1995, April

TA B L E 1

Exchange Rates with the U.S. Dollar

NOTE: Exchange rates are in U.S. dollars per unit of foreign currency.

*These exchange rates were locked together at the start of the euro in January 1999.

†On January 1, 1993, the peso was redefined so that 1,000 old pesos were equal to 1 new peso. Hence, the numbers 44 and 5 listed for July 1980 and February 1985 were actually 0.044 and 0.005 on the old basis.

2002, April 2005, and April 2008, showing how many dollars or cents it cost at each of those times to buy each unit of foreign currency. Between February 1985 and April 2002, the dollar depreciated sharply relative to the Japanese yen and most European currencies. For example, the British pound rose from $1.10 to $1.44. During that same period, however, the dollar appreciated dramatically relative to the Mexican peso; it bought about 0.2 pesos in 1985 but more than 9 in 2002.1 Since April 2002, the dollar has depreciated against most currencies, and sharply against the euro.

Although the terms “appreciation” and “depreciation” are used to describe movements of exchange rates in free markets, a different set of terms is employed to describe decreases and increases in currency values that are set by government decree. When an officially set exchange rate is altered so that a unit of a nation’s currency can buy fewer units of foreign currency, we say that a devaluation of that currency has occurred. When the exchange rate is altered so that the currency can buy more units of foreign currency, we say that a revaluation has taken place. We will say more about devaluation and revaluation shortly, but first let’s look at how the free market determines exchange rates.

A devaluation is a reduction in the official value of a currency.

A revaluation is an increase in the official value of a currency.

EXCHANGE RATE DETERMINATION IN A FREE MARKET

In 1999, eleven European countries adopted a new common currency, the euro. But why does a euro now cost about $1.50 and not $1.25 or $1.75? In a world of floating exchange rates, with no government interferences, the answer would be straightforward. Exchange rates would be determined by the forces of supply and demand, just like the prices of apples, computers, and haircuts.

In a leap of abstraction, imagine that the dollar and the euro are the only currencies on earth, so the market need determine only one exchange rate. Figure 1 on the next page depicts the determination of this exchange rate at the point (denoted E in the figure) where demand curve DD crosses supply curve SS. At this price ($1.50 per euro), the number of euros demanded is equal to the number of euros supplied.

In a free market, exchange rates are determined by supply and demand. At a rate below the equilibrium level, the number of euros demanded would exceed the number supplied, and the price of a euro would be bid up. At a rate above the equilibrium level, quantity supplied would exceed quantity demanded, and the price of a euro would fall. Only at the equilibrium exchange rate is there no tendency for the rate to change.

Floating exchange rates are rates determined in free markets by the law of supply and demand.

D

S

FIGURE 1

Determination of

Exchange Rates in a

Free Market

As usual, supply and demand determine price. But in this case, we must ask: Where do the supply and demand come

Sfrom? Why does anyone demand a euro? The answer comes in three parts:

1.International trade in goods and services. This factor was the subject of the previous chapter. If, for example, Jane Doe, an

American, wants to buy a new BMW, she will first have to buy euros with which to pay the car dealer in Munich.2 Thus, Jane’s demand for a European car leads to a demand for European currency. In general, demand for a country’s exports leads to demand for its currency.3

2. Purchases of physical assets such as factories and machinery over-

D seas. If IBM wants to buy a small French computer manufacturer, the owners will no doubt want to receive euros. So IBM will first have to acquire European currency. In general, direct foreign investment leads to demand for a country’s currency.

3.International trade in financial instruments such as stocks and bonds. If American investors want to purchase Italian stocks, they will first have to acquire the euros that the sellers will insist on for payment. In this way, demand for European financial assets leads to demand for European currency. Thus, demand for a country’s financial assets leads to demand for its currency. In fact, nowadays the volume of international trade in financial assets among the major countries of the world is so large that it swamps the other two sources of demand.

Now, where does the supply come from? To answer this question, just turn all of these transactions around. Europeans who want to buy U.S. goods and services, make direct investments in the United States, or purchase U.S. financial assets will have to offer their euros for sale in the foreign-exchange market (which is mainly run through banks) to acquire the needed dollars. To summarize:

The demand for a country’s currency is derived from the demands of foreigners for its export goods and services and for its assets—including financial assets, such as stocks and bonds, and real assets, such as factories and machinery. The supply of a country’s currency arises from its imports, and from foreign investment by its own citizens.

To illustrate the usefulness of even this simple supply-and-demand analysis, think about how the exchange rate between the dollar and the euro should change if Europeans become worried about the safety of U.S. assets, as happened during the financial crisis of 2007–2008. As European investors reduce their desires to buy U.S. assets, they will supply fewer euros for sale (in order to buy the necessary dollars). In terms of the supply-and-demand diagram in Figure 2, that decreased sale of euros will shift the supply curve inward from the black line S1S1 to the brick-colored line S2S2. Equilibrium would shift from point E to point A, and the exchange rate would rise from $1.30 per euro to $1.50 per euro. Thus, the decreased supply of euros by European citizens would cause the euro to appreciate relative to the dollar— which is just what happened.

Exercise Test your understanding of the supply-and-demand analysis of exchange rates by showing why each of the following events would lead to an appreciation of the euro (a depreciation of the dollar) in a free market:

1.American investors are attracted by prospects for profit on the German stock market.

2.A recession in Italy cuts Italian purchases of American goods.

2Actually, she will not do so because banks generally handle foreign-exchange transactions for consumers. An American bank probably will buy the euros for her. Even so, the effect is exactly the same as if Jane had done it herself.

3See Discussion Question 2 at the end of this chapter.

3.Interest rates on government bonds rise in France but are stable in the United States. (Hint: Which country’s citizens will be attracted to invest by high interest rates in the other country?)

To say that supply and demand determine exchange rates in a free market is at once to say everything and to say nothing. If we are to understand the reasons why some currencies appreciate whereas others depreciate, we must look into the factors that move the supply and demand curves. Economists believe that the principal determinants of exchange rate movements differ significantly in the short, medium, and long runs. So in the next three sections, we turn to the analysis of exchange rate movements over these three “runs,” beginning with the short run.

Number of Euros

FIGURE 2

FIGURE 4

The Effect of an Economic Boom Abroad on the Exchange Rate

D1

S

Economic Activity and Exchange Rates: The Medium Run

The medium run is where the theory of exchange rate determination is most unsettled. Economists once reasoned as follows: Because consumer spending increases when income rises and decreases when income falls, the same thing is likely to happen to spending on imported goods. So a country’s imports will rise quickly when its economy booms and rise only slowly when its economy stagnates.

For the reasons illustrated in Figure 4, then, a boom in the United States should shift the demand curve for euros outward as Americans seek to acquire more euros to buy more European goods. And that, in turn, should lead to an appreciation of the euro (depreciation of the dollar). In the figure, the euro rises in value from $1.50 to $1.60.

However, if Europe was booming at the same time, Europeans would be buying more American exports, which would shift the supply curve of euros outward. (Europeans must offer more euros for sale to get the dollars they want.) On balance, the value of the dollar might rise or fall. It appears that what matters is whether exports are growing faster than imports.

ing only about trade in goods and services leads to the conclusion that faster growth should weaken the currency. But thinking instead about trade in financial assets (such as stocks and bonds) leads to precisely the opposite conclusion: Faster growth should strengthen the currency. Which side wins this tug of war?

As we have suggested, it is usually no contest—at least among the major currencies of the world. In the modern world, the evidence seems to say that trade in financial assets is the dominant factor. For example, rapid growth and soaring imports in the United States in the second half of the 1990s were accompanied by a sharply appreciating dollar as investors from all over the world brought funds to America. We conclude that

Stronger economic performance often leads to currency appreciation because it improves prospects for investing in the country.

The Purchasing-Power Parity Theory: The Long Run

We come at last to the long run, where an apparently simple principle ought to govern exchange rates. As long as goods can move freely across national borders, exchange rates should eventually adjust so that the same product costs the same amount of money, whether measured in dollars in the United States, euros in Germany, or yen in Japan—except