Baumol & Blinder MACROECONOMICS (11th ed)

1.Exchange rates state the value of one currency in terms of other currencies and thus translate one country’s prices into the currencies of other nations. Exchange rates therefore influence patterns of world trade.

2.If governments do not interfere by buying or selling their currencies, exchange rates will be determined in free markets by the usual laws of supply and demand. Such a system is said to be based on floating exchange rates.

3.Demand for a nation’s currency is derived from foreigners’ desires to purchase that country’s goods and services or to invest in its assets. Under floating rates, anything that increases the demand for a nation’s currency will cause its exchange rate to appreciate.

4.Supply of a nation’s currency is derived from the desire of that country’s citizens to purchase foreign goods and services or to invest in foreign assets. Under floating rates, anything that increases the supply of a nation’s currency will cause its exchange rate to depreciate.

5.Purchasing-power parity plays a major role in very- long-run exchange rate movements. The purchasingpower parity theory states that relative price levels in any two countries determine the exchange rate between their currencies. Therefore, countries with relatively low inflation rates normally will have appreciating currencies.

6.Over shorter periods, however, purchasing-power parity has little influence over exchange rate movements. The pace of economic activity and, especially, the level of interest rates exert greater influences.

7.Capital movements are typically the dominant factor in determining exchange rates in the short and medium runs. A nation that offers international investors higher interest rates, or better prospective returns on investments, will typically see its currency appreciate.

8.An exchange rate can be fixed at a nonequilibrium level if the government is willing and able to mop up any excess of quantity supplied over quantity demanded or provide any excess of quantity demanded over quantity

supplied. In the first case, the country is suffering from a balance of payments deficit because of its overvalued currency. In the second case, an undervalued currency has given it a balance of payments surplus.

9.The gold standard was a system of fixed exchange rates in which the value of every nation’s currency was fixed in terms of gold. This system created problems because nations could not control their own money supplies and because the world could not control the total supply of gold.

10.After World War II, the gold standard was replaced by the Bretton Woods system, in which exchange rates were fixed in terms of U.S. dollars and the dollar was in turn tied to gold. This system broke up in 1971, when the dollar became chronically overvalued.

11.Since 1971, the world has moved toward a system of relatively free exchange rates, but with plenty of exceptions. We now have a thoroughly mixed system of “dirty” or “managed” floating, which continues to evolve and adapt.

12.Floating rates are not without their problems. For example, importers and exporters justifiably worry about fluctuations in exchange rates.

13.Under floating exchange rates, investors who speculate on international currency values provide a valuable service by assuming the risks of those who do not wish to speculate. Normally, speculators stabilize rather than destabilize exchange rates, because that is how they make profits.

14.The value of the U.S. dollar has been volatile. It rose dramatically from 1980 to 1985, making our imports cheaper and our exports more expensive. From 1985 to 1988, the dollar tumbled, which had precisely the reverse effects. Then the dollar climbed again between 1995 and 2002, leading once again to a large trade imbalance. From 2002 to 2004, and then again in 2007–2008, the dollar fell further.

15.The European Union has established a single currency, the euro, for most of its member nations.

1.Use supply and demand diagrams to analyze the effect of the following actions on the exchange rate between the dollar and the yen:

a.Japan opens its domestic markets to more foreign competition.

b.Investors come to believe that values on the Tokyo stock market will fall.

c.The Federal Reserve cuts interest rates in the United States.

d.The U.S. government, to help settle the problems of the Middle East, gives huge amounts of foreign aid to Israel and her Arab neighbors.

e.The United States has a recession while Japan booms.

f.Inflation in the United States exceeds that in Japan.

2.For each of the following transactions, indicate how it would affect the U.S. balance of payments if exchange rates were fixed:

a.You spent the summer traveling in Europe.

b.Your uncle in Canada sent you $20 as a birthday present.

c.You bought a new Honda, made in Japan.

d.You bought a new Honda, made in Ohio.

e.You sold some stock you own on the Tokyo Stock Exchange.

3.Suppose each of the transactions listed in Test Yourself Question 2 was done by many Americans. Indicate how each would affect the international value of the dollar if exchange rates were floating.

4.We learned in this chapter that successful speculators buy a currency when demand is weak and sell it when demand is strong. Use supply and demand diagrams for two different periods (one with weak demand, the other with strong demand) to show why this activity will limit price fluctuations.

1.What items do you own or routinely consume that are produced abroad? From what countries do these items come? Suppose Americans decided to buy fewer of these things. How would that affect the exchange rates between the dollar and these currencies?

2.If the dollar appreciates relative to the euro, will the German camera you have wanted become more or less expensive? What effect do you imagine this change will have on American demand for German cameras? Does the American demand curve for euros, therefore, slope upward or downward? Explain.

3.During the first half of the 1980s, inflation in (West) Germany was consistently lower than that in the United States. What, then, does the purchasing-power parity theory predict should have happened to the exchange rate between the mark and the dollar between 1980 and 1985? (Look at Table 1 on page 363 to see what actually happened.)

4.How are the problems of a country faced with a balance of payments deficit similar to those posed by a government regulation that holds the price of milk above the equilibrium level? (Hint: Think of each in terms of a supply-demand diagram.)

5.Under the old gold standard, what do you think happened to world prices when a huge gold strike occurred in California in 1849? What do you think happened when the world went without any important new gold strikes for 20 years or so?

6.Explain why the members of the Bretton Woods conference in 1944 wanted to establish a system of fixed exchange rates. What flaw led to the ultimate breakdown of the system in 1971?

7.Suppose you want to reserve a hotel room in London for the coming summer but are worried that the value of the pound may rise between now and then, making the room too expensive for your budget. Explain how a speculator could relieve you of this worry. (Don’t actually try it—speculators deal only in very large sums!)

8.In 2003 and 2004, market forces raised the international value of the Japanese yen. Why do you think the government of Japan was unhappy about this currency appreciation? (Hint: Japan was trying to emerge from a recession at the time.) If they wanted to stop the yen’s appreciation, what actions could the Bank of Japan (Japan’s central bank) and the Federal Reserve have taken? Why might the central banks have failed in this attempt?

No man is an island, entire of itself.

JOHN DONNE

O ne prominent aspect of globalization is that economic events that originate in one country reverberate quickly around the globe, sometimes at the speed of electricity. A stunning example arose in 2007, after the housing boom ended in the United

States. A number of so-called subprime mortgages (meaning mortgages granted to people with questionable credit) started to go bad. As the trickle of defaults turned into a flood, it triggered a worldwide financial crisis when several financial businesses in—of all places—France and Germany ran into serious trouble. Why there? It turned out that these institutions, thousands of miles away, had invested heavily in U.S. subprime mortgages. It is indeed a small world.

This was just one example of a general phenomenon. Fluctuations in foreign growth, inflation, and interest rates profoundly affect the U.S. economy. And economic events that originate in our country reverberate around the globe. Anyone who ignores these international linkages cannot hope to understand how the modern world economy works.

The macroeconomic model we developed in earlier chapters does a bit of that, but not enough because it ignores such crucial influences as exchange rates and international financial movements. The previous chapter showed how major macroeconomic variables such as gross domestic product (GDP), prices, and interest rates affect exchange rates. In this chapter, we complete the circle by studying how changes in the exchange rate affect the domestic economy. Then we bring international capital flows into the picture and learn how monetary and fiscal policy work in an open economy. In particular, we build a model suitable for a large open economy with substantial capital flows and a floating exchange rate—in short, a model meant to resemble the contemporary United States, which is indeed not “an island, entire of itself.”

An open economy is one that trades with other nations in goods and services, and perhaps also trades in financial assets.

LICENSED TO:

FIGURE 2

The Effects of Exchange Rate Changes on Aggregate Demand

Real GDP

This simple analysis helps us understand why the U.S. trade deficit grew so enormously in the late 1990s and early 2000s and has fallen a bit recently. We learned in the previous chapter that the international value of the dollar began to climb in 1995. According to the reasoning we have just completed, within a few years such an appreciation of the dollar should have boosted U.S. imports and damaged U.S. exports. That is precisely what happened. In constant dollars, American imports soared by over 40 percent between 1997 and 2002, while American exports rose by only 7 percent. The result was that a $105 billion real net export deficit in 1997 turned into a monumental $471 billion deficit by 2002. More recently, the dollar’s decline has helped push the trade deficit down from a record $625 billion in 2006 to “only” $556 billion in 2007.

FIGURE 3

The Effects of Exchange Rate Changes on Aggregate Supply

D

Price Level

S1

S0

S2

So far we have concluded that a currency depreciation increases aggregate demand and that a currency appreciation decreases it. To complete our model of macroeconomics in an open economy, we must turn to the implications of international trade for aggregate supply.

Part of the story is already familiar. We know from previous chapters that the United States, like all economies, purchases some of its productive inputs from abroad. Oil is by far the most prominent example. But we also rely on foreign suppliers for metals such as titanium, raw agricultural products such as coffee beans, and thousands of other items used by American industry. When the dollar depreciates, all of these imported inputs cost more in U.S. dollars—just as if foreign prices had risen.

The consequence is clear: With imported inputs more expensive, American firms will be forced to charge higher prices at any given level of output. Graphically, this means that the aggregate supply curve will shift upward (or inward to the left).

When the dollar depreciates, the prices of imported inputs rise. The U.S. aggregate supply curve therefore shifts inward, pushing up the prices of American-made goods and services. By exactly analogous reasoning, an appre-

International capital flows are purchases and sales of financial assets across national borders.

One important piece of our international economic puzzle is still missing. We have analyzed international trade in goods and services in some detail, but we have ignored international movements of capital up to now.

For some nations, this omission is inconsequential because they rarely receive or lend international capital. But things are quite different for the United States because the vast majority of international financial flows involve either buying or selling assets whose values are stated in U.S. dollars. In addition, we cannot hope to understand the origins of the various international financial crises of the 1990s and 2000s without incorporating capital flows into our analysis. Fortunately, given what we have just learned about the effects of exchange rates, this omission is easily rectified.

Recall from the previous chapter that interest rate differentials and capital flows are typically the most important determinants of exchange rate movements. Specifically, suppose interest rates in the United States rise while foreign interest rates are unchanged. We learned in the previous chapter that this change in relative interest rates will attract capital to the United States and cause the dollar to appreciate. This chapter has just taught us that an appreciating dollar will, in turn, reduce net exports, prices, and output in the United States—as indicated in Figure 5. Thus:

A rise in interest rates tends to contract the economy by appreciating the currency and reducing net exports.

Notice that this conclusion has a familiar ring. When we studied monetary policy in Chapter 13, we observed that higher interest rates deter investment spending and hence reduce the I component of C 1 I 1 G 1 (X 2 IM). Now, in studying an open economy with international capital flows, we see that higher interest rates also reduce the X 2 IM component. Thus, international capital flows strengthen the negative effects of interest rates on aggregate demand.

If interest rates fall in the United States, or rise abroad, everything we have just said is turned in the opposite direction. The conclusion is

A decline in interest rates tends to expand the economy by depreciating the currency and raising net exports.

Exercise Provide the reasoning behind this conclusion.

closed economy, that is the end of the story. But in an open economy with international capital flows, we must add in the macroeconomic effects that work through the exchange rate. We do this by answering two questions.

First, what will happen to the exchange rate? We know from earlier chapters that a fiscal expansion pushes up interest rates. At higher interest rates, American securities become more attractive to foreign investors, who go to the foreign-exchange markets to buy dollars with which to purchase them. This buying pressure drives up the value of the dollar. Thus, at least for a rich country that can easily sell its bonds on the world market,

A fiscal expansion normally makes the exchange rate appreciate.

A closed economy is one that does not trade with other nations in either goods or assets.

FIGURE 6

A Fiscal Expansion in

an Open Economy

FIGURE 7

A Monetary

Contraction in an

Open Economy

D0

D1

D2

Price Level

S0

S2

Monetary Policy Revisited

Now let us consider how monetary policy works in an open economy with floating exchange rates and international capital mobility. To remain consistent with the history of the 1980s, we consider a tightening, rather than a loosening, of monetary policy.

International capital flows increase the power of monetary policy.

In a closed economy, higher interest rates reduce investment spending, I. In an open economy, these same higher interest rates also appreciate the currency and reduce net exports, X 2 IM. Thus, the effect of monetary policy is enhanced.

It may seem puzzling that capital flows strengthen monetary policy but weaken fiscal policy. The explanation of these contrasting results lies in their effects on interest rates. The main international repercussion of either a fiscal expansion or a monetary contraction is to raise interest rates and the exchange rate, thereby crowding out net exports. But that means that the initial effects of a fiscal expansion on aggregate demand are weakened, whereas the initial effects of a monetary contraction are strengthened.