Solution Manual for International Macroeconomics, 4th Edition

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12 The Global MacroeconomyNotes to theChapter SummaryThis chapter provides students with a broad overview of international macroeconomics.The chapter uses several key concepts to introduce the subject to students without formalmodeling. At the end of each topic, there are two sections that review the content of thesection (Key Topics) and prepare students for what’s coming next (Summary and Plan ofStudy).CommentsInstructors may want to cover this chapter in several lectures or in one short lecture. Butremember, this chapter is an overview. Don’t fall into the trap of trying to cover too muchdetail. There are 10 more chapters to take care of that! However, covering this chapter indetail at the beginning may serve to motivate students’ interest in the topic. If studentsread 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 becovered through the rest of the textbook.Plan of StudyEach of the topics in this chapter concludes with a plan of study that discusses howselected 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 inthe long run (Chapter 17)c.The relationship between the BOP, exchange rates, and the demand for outputin 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 TopicsEach topic and subtopic in this chapter include discussion questions that tie these broadtopics together, as well as look forward to future chapters in the text.Lecture NotesThree key elements (corresponding to parts 1–3 of the chapter in organization):■Money:Many different currencies are used in the world today. Why? What istheir purpose? What are the implications of using so many different currencies?■Finance:Capital is more mobile internationally—the scale of internationalfinance is immense. Why? What is the purpose of this? Who lends/borrows? Whobenefits? What are the costs and to whom do they accrue?■Policy:The role of the government. How are economic policy failuresunderstood? What is the role of government in perpetuating/preventing theseevents? What are the trade-offs?1 Foreign Exchange: Currencies and CrisesTheexchange rateis the price of a foreign currency. Therefore, when countries tradegoods and services or engage in financial transactions with each other, the exchange rateis one of the main factors that determine the prices that will be used. When an individualbuys a product, such as a car, the components of this product may come from all over theworld. At each step of the production process, the exchange rate affects the costs ofproducing this good and, therefore, the price that one pays in domestic currency.

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How Exchange Rates BehaveExchange rate regimes can be divided into two broad groups:floatingandfixed.Floatingexchange rates are those that change frequently, implying that the price of one currencychanges relative to another. For example, the euro–dollar exchange rate has changed asmuch as 5% within a single month. These changes are a reflection of changes in thedemand and supply of each currency in the foreign exchange market, which is studied inthe next chapter.Fixed exchange rates are those that remain relatively constant over time, such that theprice of the currencies relative to one another is stable. For example, the yuan–dollarexchange rate has remained relatively constant with only occasional adjustments. Theseoccasional adjustments are not accidental. They are the result of deliberate governmentpolicy.Why Exchange Rates MatterThere are two channels through which the exchange rate affects the economy: relativeprices of goods and relative prices of assets. When the exchange rate changes, this affectsthe price people pay for goods imported from abroad. Similarly, changes in the exchangerate 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 theprices that Americans paid for European goods and the prices Europeans paid forAmerican goods. To see why, consider the price of a pair of leather boots that initiallycost $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 Americanboots pay €80 ($100/$125 per euro). We can see that the increase in the dollar–euroexchange rate implies an increase in the price of European goods purchased byAmericans and a decrease in the price of American goods purchased by Europeans.Therefore, therelative priceof European goods to American goods increases when thedollar–euro exchange rate increases.Not only consumers are affected by these changes in relative prices; producers are aswell. In the previous example, the producer of the Italian boots faces an increase in itsrelative costs of manufacturing boots for export to the United States. If the Italianmanufacturer wants to avoid a decrease in sales to its U.S. market, it may choose tocontinue charging $100 per pair of boots for export. However, if it hires workers andmaterials 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 Americanproducers 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 purchase1,000 euros in September 2002, depositing that into your German checking account. Ifyou left the funds in this account until February 2006, you would still have €1,000, butthis €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 53months. A Spanish citizen depositing U.S. dollars into an American bank in September2002 would be worse off by February 2006. An initial deposit of €1,000 ($1,000 inSeptember 2002) would be worth only €800 because each U.S. dollar was worth only 0.8euros (1/1.25). Thus, an increase in the dollar‒euro exchange rate leads to an increase inwealth for Americans who own Eurozone assets and a decrease in wealth for Eurozoneresidents who own American assets.When Exchange Rates MisbehaveAnexchange rate crisisoccurs when a country experiences a sudden and dramatic lossin the value of its currency (a depreciation) relative to another currency following aperiod of fixed or stable exchange rates. These crises are relatively common. There havebeen 24 crises between 1997 and 2009.Exchange rate crises can have significant economic consequences. The cost ofimported 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 severeeconomic contraction soon follows the exchange rate crisis. FDI will fall as foreignexchange denominated profits fall, while at the same time, the merchandise trade balancewill deteriorate. Countries experiencing exchange rate crises may also be forced todefaulton debt. Because of the dramatic decrease in the value of domestic foreign assetsand 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 poorercountries. 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, theycan be associated with political and social instability, as in the example of Iceland in2008 (see Headlines: Economic Crisis in Iceland).Often these countries seek external help from foreign allies or from internationaldevelopment organizations, such as theInternational Monetary Fund (IMF)orWorldBank.These agencies may loan the government money to mitigate the economicconsequences of an exchange rate crisis, but the costs of such loans can becomeburdensome on society.Summary and Plan of StudyIn subsequent chapters, we learn about the structure and operation of the foreignexchange market (Chapter 13). Chapters 14 and 15 present the theory of exchange rates.Chapter 16 discusses how exchange rates affect international transactions in assets. Weexamine 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 asthey choose between fixed and floating exchange rates. Chapter 20 covers exchange ratecrises in detail and Chapter 21 the euro, a common currency used in many countries.2 Globalization of Finance: Debts and DeficitsFinancial globalization has taken hold around the world. Competition among countrieshas reduced barriers to financial flows. To understand the financial transactions amongcountries, 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, andcapital 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 PaymentsIncomerefers to the amount earned by the economy’s factors of production.Expendituremeasures how much is spent on goods and services. If there is a differencebetween the two, then there is either asurplus(income > expenditure) or adeficit(expenditure > income). For international transactions, the aggregation of income andexpenditures is thecurrent account(studied in detail in Chapter 16). If a country spendsmore than its income, its current account is in deficit and it finances the difference byborrowing from foreigners. If a country spends less than its income, the current account isin surplus and the saving is loaned to foreigners.Countries pay for current account deficits by borrowing from countries runningcurrent account surpluses. For example, the U.S. has had persistent current accountdeficits since 1992 (Table 12-1). These deficits have been financed by foreign purchasesof U.S. assets. When China’s central bank buys U.S. Treasury securities, China is lendingto the United States. Singapore has a current account surplus, meaning its income islarger 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 areborrowers, there also must be lenders. It is not possible for the entire world to borrow atonce—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 thebalance of payments.The balance of payments must balance.Debtors and Creditors: External WealthWealth(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 totalwealth increases. When a nation runs a current account deficit, it borrows, causing adecrease in its wealth. External wealth is equal to the total foreign assets owned less totalforeign 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 itsbusiness operations in the United States. It can issue bonds to raise these funds. Whenthese funds are purchased by Americans, there is no effect on the current account becauseno international transaction takes place. In this transaction, both assets and liabilities inthe United States increase by the same amount, leaving wealth unaffected. However, ifforeigners purchase these bonds, then the United States experiences a decrease in itsexternal 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 innew capital) by borrowing from abroad.What does this transaction mean for the current account? Note that the United Statesincreases expenditures by $500,000 without increasing income; therefore, the currentaccount goes into a deficit. What happens to external wealth? U.S. ownership of foreignassets 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 havecurrent account deficits associated with negative external wealth. Net creditor nationssuch as Singapore have current account surpluses and positive external wealth.There are other factors that affect external wealth. First, foreign assets can change invalue, either because the domestic prices of these assets change or because of a change inthe exchange rate.Capital gainsare profits earned on assets, resulting from a change inprice. For example, if the price of a German company’s stock increases, it generatescapital 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. Ifa U.S. company goes out of business, the value of its liabilities decreases as investorsrealize the company will be unlikely to pay off all of its debts and to pay profits tostockholders. 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 RisksSince 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 oneexplanation of why a sovereign government has an incentive to default on debt during anexchange rate crisis. Defaulting improves its external wealth position.

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There are consequences to defaulting. It makes the country far less attractive toforeign investors. Much like a household or firm, a country will have to pay higherinterest rates to borrow following a default.Country riskrefers to the additional interestthe country must pay to compensate investors for risking a default. Every country’s debtis compared to a benchmark risk-free interest rate, usually U.S. Treasury securities oreuro-denominated German government securities. Once a country defaults, its countryrisk will increase substantially.Summary and Plan of StudyAn in-depth discussion of the balance of payments begins in Chapter 16, on nationalincome accounting in the open economy. That chapter explains the internationaltransactions described here in much more detail. Once we have established anunderstanding of the accounting rules, we will develop theories of the causes and effectsof these international transactions. Chapter 18 offers a short-run model, while Chapter 19addresses the long run. In Chapters 20 and 21, we study the role of balance of paymentsin fixed versus floating exchange rate regimes, and learn why fixed exchange rateregimes sometimes lead to exchange rate crises. These issues are explored in more detailin Chapter 22.3 Government and Institutions: Of Policies and PerformanceWe will study the role of the government in two dimensions: (1) macroeconomic policiesand regimes, and (2) institutions.Policiesare designed to achieve specificmacroeconomic objectives, such as easing recessions, keeping inflation low, or

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stabilizing interest rates. Policies are often made by the government. Examples ofmacroeconomic policies include changes in the tax code or (in many countries) themoney supply. (In some countries, the money supply is not under the direct control of thegovernment. Examples include the U.S. and the European Monetary Union.)Regimesrefer to limitations on government discretion—the rules they must follow. Availablepolicy and regime choices depend on the institutions the economy supports.As examples of policies, regimes, and institutions, consider three features of thenation’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 FinanceSince 1970, there has been a general trend toward increased financial openness. Therehas also been an increase in the volume of international financial transactions. But growthin both areas has not been even across all countries. Consider three groups of countriesgrouped according to their per capita income, economic growth, and degree of integrationinto the global economy:■Advanced countries—high levels of per capita income and well integrated intothe global economy■Emerging markets—mainly middle-income countries that are growing andbecoming more integrated into the global economy■Developing countries—low-income countries that are not yet well integrated intothe global economyThe 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 theadvanced economies benefiting from the largest increase in financial transactions. Forexample, 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 anddeveloping countries lagged far behind in both these areas, with emerging markets onlyachieving 50% financial openness and a doubling of the ratio of foreign assets andliabilities to GDP.Independence and Monetary Policy: The Choice of Exchange Rate RegimesThere are two broad categories of exchange rate regimes: fixed and floating. Both arecommon among the countries of the world. The choice of exchange rate regime is one ofthe most important decisions a government can make. On the one hand, a fixed exchangerate eliminates the uncertainty associated with exchange rate fluctuations (exchange raterisk). In our previous examples, we saw that a change in the exchange rate affects relativeprices, profits, and external wealth. This uncertainty could potentially limit trade andfinancial transactions. However, we have also seen that fixed exchange rates can lead toexchange 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 countrieshave moved toward the adoption of acommon currency.For example, as of 2009, theEurozone included 16 countries, each of which previously had its own currency. Othercountries have chosen to replace their own currency, using another country’s money astheir 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 GovernanceThere are several different criteria for evaluating the quality of governance. This textbookfocuses on six: voice and accountability, political stability, government effectiveness,regulatory quality, rule of law, and control of corruption. Better governance is stronglyassociated with better economic outcomes. There is a positive relationship between goodgovernance and real income per person. And there is a somewhat weaker negativecorrelation between good governance and the standard deviation of the rate of economicgrowth. The differences are substantial, with advanced economies experiencing incomeper person that is 50 times higher than the poorest developing countries. This gap inliving standards is known asThe Great Divergence.There is a negative relationship between quality institutions and income volatility.Those countries with higher institutional quality tend to experience less volatility inincome. There are several reasons why this might be, including shifts in political powerand internal conflict.We must confront thepost hoc, ergo propter hocfallacy here: Does the existence ofquality institutions lead to better economic outcomes? Or do good economic outcomesmake it possible to establish quality institutions? The research favors the firstexplanation. Institutional quality appears to cause better economic outcomes. Given thisresult, 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 differentinstitutions according to geographySummary and Plan of StudyThe government plays an important role in several facets of the internationalmacroeconomy. In Chapter 13, we will see how the government participates in theforeign exchange market. In subsequent chapters, we will see how the government’schoice of exchange rate regime is related to financial openness (Chapter 15), the benefitsof 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 thesechapters is that governments must acknowledge the trade-offs involved in their choicesrelating to discretionary policy, choice of regime, and the decision to adopt a commoncurrency.4 ConclusionsTo understand the issues and debates surrounding exchange rates, the rise in internationalfinancial transactions, and the role of institutions, we first need to understand how eachhas changed over time. Then we move on to develop theories of how exchange rates andinternational transactions affect the economy and the government’s role in this process.

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