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Solution Manual for International Macroeconomics, 4th Edition

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    12 The Global Macroeconomy Notes to the Chapter Summary This chapter provides students with a broad overview of international macroeconomics. The chapter uses several key concepts to introduce the subject to students without formal modeling. At the end of each topic, there are two sections that review the content of the section ( Key Topics ) and prepare students for what’s coming next ( Summary and Plan of Study ). Comments Instructors may want to cover this chapter in several lectures or in one short lecture. But remember, this chapter is an overview. Don’t fall into the trap of trying to cover too much detail. There are 10 more chapters to take care of that! However, covering this chapter in detail at the beginning may serve to motivate students’ interest in the topic. If students read through the chapter without a guided lecture, they may become overwhelmed. Chapter 12 tackles complicated concepts to give students an idea of the topics that will be covered through the rest of the textbook. Plan of Study Each of the topics in this chapter concludes with a plan of study that discusses how selected chapters in the text relate to the three broad elements presented in the

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    introduction: money, finance, and policy. An overview of these chapters is given below. In the lecture notes, the plan of study for each of these topics is included in the summary. 1. Exchange rates (Chapters 13–15) a. Overview of the foreign exchange market (Chapter 13) b. Theory of exchange rate behavior in the long run: The monetary approach (Chapter 14) c. Theory of exchange rate behavior in the short run: The asset approach (Chapter 15) 2. Balance of payments (Chapters 16–18) a. Overview of balance of payments (BOP) and national income accounting (Chapter 16) b. The relationship between the BOP, the nation’s wealth, and living standards in the long run (Chapter 17) c. The relationship between the BOP, exchange rates, and the demand for output in the short run (Chapter 18) 3. Exchange rate regimes and institutions (Chapters 19–22) a. Overview of fixed and floating exchange rate regimes (Chapter 19) b. Exchange rate crisis (Chapter20) c. The Eurozone and the theory of optimum currency areas (Chapter 21) d. Further topics in international macroeconomics (Chapter 22)

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    Key Topics Each topic and subtopic in this chapter include discussion questions that tie these broad topics together, as well as look forward to future chapters in the text. Lecture Notes Three key elements (corresponding to parts 1–3 of the chapter in organization): ■ Money: Many different currencies are used in the world today. Why? What is their purpose? What are the implications of using so many different currencies? ■ Finance: Capital is more mobile internationally—the scale of international finance is immense. Why? What is the purpose of this? Who lends/borrows? Who benefits? What are the costs and to whom do they accrue? ■ Policy: The role of the government. How are economic policy failures understood? What is the role of government in perpetuating/preventing these events? What are the trade-offs? 1 Foreign Exchange: Currencies and Crises The exchange rate is the price of a foreign currency. Therefore, when countries trade goods and services or engage in financial transactions with each other, the exchange rate is one of the main factors that determine the prices that will be used. When an individual buys a product, such as a car, the components of this product may come from all over the world. At each step of the production process, the exchange rate affects the costs of producing this good and, therefore, the price that one pays in domestic currency.

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    How Exchange Rates Behave Exchange rate regimes can be divided into two broad groups: floating and fixed. Floating exchange rates are those that change frequently, implying that the price of one currency changes relative to another. For example, the euro–dollar exchange rate has changed as much as 5% within a single month. These changes are a reflection of changes in the demand and supply of each currency in the foreign exchange market, which is studied in the next chapter. Fixed exchange rates are those that remain relatively constant over time, such that the price of the currencies relative to one another is stable. For example, the yuan–dollar exchange rate has remained relatively constant with only occasional adjustments. These occasional adjustments are not accidental. They are the result of deliberate government policy. Why Exchange Rates Matter There are two channels through which the exchange rate affects the economy: relative prices of goods and relative prices of assets. When the exchange rate changes, this affects the price people pay for goods imported from abroad. Similarly, changes in the exchange rate affect the price of financial assets abroad. For example, a change in the dollar–euro exchange rate (the dollar price of a euro) from $1 per euro in September 2002 to $1.25 per euro in February 2006 affected the prices that Americans paid for European goods and the prices Europeans paid for American goods. To see why, consider the price of a pair of leather boots that initially cost $100 in the United States and €100 in Europe during September 2002. When the

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    exchange rate increases to $1.25 per euro, the relative price of these boots changes. Americans buying Italian boots have to pay $125, whereas Europeans buying American boots pay €80 ($100/$125 per euro). We can see that the increase in the dollar–euro exchange rate implies an increase in the price of European goods purchased by Americans and a decrease in the price of American goods purchased by Europeans. Therefore, the relative price of European goods to American goods increases when the dollar–euro exchange rate increases. Not only consumers are affected by these changes in relative prices; producers are as well. In the previous example, the producer of the Italian boots faces an increase in its relative costs of manufacturing boots for export to the United States. If the Italian manufacturer wants to avoid a decrease in sales to its U.S. market, it may choose to continue charging $100 per pair of boots for export. However, if it hires workers and materials in Europe, the Italian producer must continue to pay for these inputs in euros. When it converts the $100 back into euros, the Italian producer only receives €80. Thus, the Italian producer will face a decrease in its profits. The reverse is true for American producers exporting to Europe. They can continue charging €100 per pair of boots (or $125 converted into dollar terms), leading to an increase in profits. Similarly, changes in exchange rates affect the relative prices of financial assets. Suppose that you deposited $1,000 into a German checking account in September 2002. The bank account balance would be denominated in euros. You used $1,000 to purchase 1,000 euros in September 2002, depositing that into your German checking account. If you left the funds in this account until February 2006, you would still have €1,000, but this €1,000 is now worth $1,250 because each euro is now worth $1.25. Even if the

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    German checking account paid no interest, you would have a 25% gain over the 53 months. A Spanish citizen depositing U.S. dollars into an American bank in September 2002 would be worse off by February 2006. An initial deposit of €1,000 ($1,000 in September 2002) would be worth only €800 because each U.S. dollar was worth only 0.8 euros (1/1.25). Thus, an increase in the dollar‒euro exchange rate leads to an increase in wealth for Americans who own Eurozone assets and a decrease in wealth for Eurozone residents who own American assets. When Exchange Rates Misbehave An exchange rate crisis occurs when a country experiences a sudden and dramatic loss in the value of its currency (a depreciation) relative to another currency following a period of fixed or stable exchange rates. These crises are relatively common. There have been 24 crises between 1997 and 2009. Exchange rate crises can have significant economic consequences. The cost of imported goods increases and the value of financial assets in the country decreases. Thus, for a country relying heavily on direct foreign investment (FDI) and imports, a severe economic contraction soon follows the exchange rate crisis. FDI will fall as foreign exchange denominated profits fall, while at the same time, the merchandise trade balance will deteriorate. Countries experiencing exchange rate crises may also be forced to default on debt. Because of the dramatic decrease in the value of domestic foreign assets and economic recession, the country may lack the resources to honor its debt obligations. The economic consequences of exchange rate crises are often more severe in poorer countries. Exchange rate crises frequently spark problems in the banking and financial

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    sector, among households and firms, and in government finance. In extreme cases, they can be associated with political and social instability, as in the example of Iceland in 2008 (see Headlines: Economic Crisis in Iceland). Often these countries seek external help from foreign allies or from international development organizations, such as the International Monetary Fund (IMF) or World Bank. These agencies may loan the government money to mitigate the economic consequences of an exchange rate crisis, but the costs of such loans can become burdensome on society. Summary and Plan of Study In subsequent chapters, we learn about the structure and operation of the foreign exchange market (Chapter 13). Chapters 14 and 15 present the theory of exchange rates. Chapter 16 discusses how exchange rates affect international transactions in assets. We examine the short-run impact of exchange rates on the demand for goods in Chapter 18, and with this understanding, Chapter 19 examines the trade-offs governments face as they choose between fixed and floating exchange rates. Chapter 20 covers exchange rate crises in detail and Chapter 21 the euro, a common currency used in many countries. 2 Globalization of Finance: Debts and Deficits Financial globalization has taken hold around the world. Competition among countries has reduced barriers to financial flows. To understand the financial transactions among countries, we need an accounting framework. Income, expenditure, and wealth are three

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    familiar measures that we will use to study how flows of goods, services, income, and capital interact in the global macroeconomy. While this can make countries better off, defaults and crises mean they can fall short of the potential gains. Deficits and Surpluses: The Balance of Payments Income refers to the amount earned by the economy’s factors of production. Expenditure measures how much is spent on goods and services. If there is a difference between the two, then there is either a surplus (income > expenditure) or a deficit (expenditure > income). For international transactions, the aggregation of income and expenditures is the current account (studied in detail in Chapter 16). If a country spends more than its income, its current account is in deficit and it finances the difference by borrowing from foreigners. If a country spends less than its income, the current account is in surplus and the saving is loaned to foreigners. Countries pay for current account deficits by borrowing from countries running current account surpluses. For example, the U.S. has had persistent current account deficits since 1992 (Table 12-1). These deficits have been financed by foreign purchases of U.S. assets. When China’s central bank buys U.S. Treasury securities, China is lending to the United States. Singapore has a current account surplus, meaning its income is larger than its expenditure. Therefore, Singapore is a lender—it purchases foreign assets (from the United States and other borrowers) with its surplus. This highlights a key fact in international income accounting: as long as there are borrowers, there also must be lenders. It is not possible for the entire world to borrow at once—these resources have to come from somewhere. In fact, total global lending should

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    equal total global borrowing. All of these international transactions are recorded on the balance of payments. The balance of payments must balance. Debtors and Creditors: External Wealth Wealth (or net worth) is equal to total assets (amount owned) less total liabilities (amount owed). Each time a nation saves (e.g., runs a current account surplus), its total wealth increases. When a nation runs a current account deficit, it borrows, causing a decrease in its wealth. External wealth is equal to the total foreign assets owned less total foreign liabilities owed. Suppose that the United States’ current account is balanced, income = expenditure. Consider a U.S. firm that seeks to borrow $500,000 to finance the expansion of its business operations in the United States. It can issue bonds to raise these funds. When these funds are purchased by Americans, there is no effect on the current account because no international transaction takes place. In this transaction, both assets and liabilities in the United States increase by the same amount, leaving wealth unaffected. However, if foreigners purchase these bonds, then the United States experiences a decrease in its external wealth because its liabilities increase with no corresponding increase in assets. Therefore, the United States is able to finance an increase in spending (the $500,000 in new capital) by borrowing from abroad. What does this transaction mean for the current account? Note that the United States increases expenditures by $500,000 without increasing income; therefore, the current account goes into a deficit. What happens to external wealth? U.S. ownership of foreign assets remains unchanged, but its foreign liabilities increase by $500,000. That is,

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    $500,000 is owed to the foreigners who purchased the U.S. firm’s bonds. Therefore, external wealth is now negative. From this example, we can see that net debtor counties such as the United States have current account deficits associated with negative external wealth. Net creditor nations such as Singapore have current account surpluses and positive external wealth. There are other factors that affect external wealth. First, foreign assets can change in value, either because the domestic prices of these assets change or because of a change in the exchange rate. Capital gains are profits earned on assets, resulting from a change in price. For example, if the price of a German company’s stock increases, it generates capital gains for people owning the stock in Germany, the United States, and elsewhere. For the United States, this will lead to an increase in the value of foreign assets owned, implying an increase in external wealth. Similarly, when the value of foreign liabilities changes, this affects external wealth. If a U.S. company goes out of business, the value of its liabilities decreases as investors realize the company will be unlikely to pay off all of its debts and to pay profits to stockholders. Therefore, liabilities owed by the U.S. company to foreigners decline, causing an increase in external wealth for the United States. Darlings and Deadbeats: Defaults and Other Risks Since 1980, 14 countries have defaulted on their debt as a result of exchange rate crises. Of these, fully half have defaulted twice. The preceding example provides one explanation of why a sovereign government has an incentive to default on debt during an exchange rate crisis. Defaulting improves its external wealth position.

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    There are consequences to defaulting. It makes the country far less attractive to foreign investors. Much like a household or firm, a country will have to pay higher interest rates to borrow following a default. Country risk refers to the additional interest the country must pay to compensate investors for risking a default. Every country’s debt is compared to a benchmark risk-free interest rate, usually U.S. Treasury securities or euro-denominated German government securities. Once a country defaults, its country risk will increase substantially. Summary and Plan of Study An in-depth discussion of the balance of payments begins in Chapter 16, on national income accounting in the open economy. That chapter explains the international transactions described here in much more detail. Once we have established an understanding of the accounting rules, we will develop theories of the causes and effects of these international transactions. Chapter 18 offers a short-run model, while Chapter 19 addresses the long run. In Chapters 20 and 21, we study the role of balance of payments in fixed versus floating exchange rate regimes, and learn why fixed exchange rate regimes sometimes lead to exchange rate crises. These issues are explored in more detail in Chapter 22. 3 Government and Institutions: Of Policies and Performance We will study the role of the government in two dimensions: (1) macroeconomic policies and regimes, and (2) institutions. Policies are designed to achieve specific macroeconomic objectives, such as easing recessions, keeping inflation low, or

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    stabilizing interest rates. Policies are often made by the government. Examples of macroeconomic policies include changes in the tax code or (in many countries) the money supply. (In some countries, the money supply is not under the direct control of the government. Examples include the U.S. and the European Monetary Union.) Regimes refer to limitations on government discretion—the rules they must follow. Available policy and regime choices depend on the institutions the economy supports. As examples of policies, regimes, and institutions, consider three features of the nation’s macroeconomic environment: integration and regulation of international finance, independence and choice of exchange rate regime, and the role of institutions. Integration and Capital Controls: The Regulation of International Finance Since 1970, there has been a general trend toward increased financial openness. There has also been an increase in the volume of international financial transactions. But growth in both areas has not been even across all countries. Consider three groups of countries grouped according to their per capita income, economic growth, and degree of integration into the global economy: ■ Advanced countries —high levels of per capita income and well integrated into the global economy ■ Emerging markets —mainly middle-income countries that are growing and becoming more integrated into the global economy ■ Developing countries —low-income countries that are not yet well integrated into the global economy The most dramatic increases in openness occurred in the early 1990s. During this

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    time, all three groups of countries adopted an increase in financial openness, with the advanced economies benefiting from the largest increase in financial transactions. For example, among advanced countries, the degree of financial openness approached 100%. That same group saw foreign assets and liabilities rise to 5 times the GDP. Emerging and developing countries lagged far behind in both these areas, with emerging markets only achieving 50% financial openness and a doubling of the ratio of foreign assets and liabilities to GDP. Independence and Monetary Policy: The Choice of Exchange Rate Regimes There are two broad categories of exchange rate regimes: fixed and floating. Both are common among the countries of the world. The choice of exchange rate regime is one of the most important decisions a government can make. On the one hand, a fixed exchange rate eliminates the uncertainty associated with exchange rate fluctuations (exchange rate risk). In our previous examples, we saw that a change in the exchange rate affects relative prices, profits, and external wealth. This uncertainty could potentially limit trade and financial transactions. However, we have also seen that fixed exchange rates can lead to exchange rate crises that are very costly. The use of an individual currency is often viewed as part of the national identity, something that establishes a country’s sovereignty. However, some groups of countries have moved toward the adoption of a common currency. For example, as of 2009, the Eurozone included 16 countries, each of which previously had its own currency. Other countries have chosen to replace their own currency, using another country’s money as their medium of exchange. Since the U.S. dollar is often used for this purpose, the policy

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    is called dollarization. El Salvador and Ecuador both dollarized their economies recently. Institutions and Economic Performance: The Quality of Governance There are several different criteria for evaluating the quality of governance. This textbook focuses on six: voice and accountability, political stability, government effectiveness, regulatory quality, rule of law, and control of corruption. Better governance is strongly associated with better economic outcomes. There is a positive relationship between good governance and real income per person. And there is a somewhat weaker negative correlation between good governance and the standard deviation of the rate of economic growth. The differences are substantial, with advanced economies experiencing income per person that is 50 times higher than the poorest developing countries. This gap in living standards is known as The Great Divergence. There is a negative relationship between quality institutions and income volatility. Those countries with higher institutional quality tend to experience less volatility in income. There are several reasons why this might be, including shifts in political power and internal conflict. We must confront the post hoc, ergo propter hoc fallacy here: Does the existence of quality institutions lead to better economic outcomes? Or do good economic outcomes make it possible to establish quality institutions? The research favors the first explanation. Institutional quality appears to cause better economic outcomes. Given this result, there is much debate about why poorer countries have weaker institutions. Explanations include: ■ actions of colonizing powers (failure of colonization to establish quality

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    institutions) ■ differences in the evolution of legal codes that favored economic progress ■ differences in resource endowments that lead to the establishment of different institutions according to geography Summary and Plan of Study The government plays an important role in several facets of the international macroeconomy. In Chapter 13, we will see how the government participates in the foreign exchange market. In subsequent chapters, we will see how the government’s choice of exchange rate regime is related to financial openness (Chapter 15), the benefits of financial openness (Chapter 17), the trade-offs involved in the choice of regime (Chapter 19), and how these decisions could lead to exchange rate crises (Chapter 20). Chapter 21 studies the institutional design of the Eurozone. A key lesson from these chapters is that governments must acknowledge the trade-offs involved in their choices relating to discretionary policy, choice of regime, and the decision to adopt a common currency. 4 Conclusions To understand the issues and debates surrounding exchange rates, the rise in international financial transactions, and the role of institutions, we first need to understand how each has changed over time. Then we move on to develop theories of how exchange rates and international transactions affect the economy and the government’s role in this process.

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