Economics 10020/20020 Principles of Macroeconomics International Economics

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1 Economics 10020/20020 Principles of Macroeconomics Economics Dennis C. Plott University of Notre Dame Department of Economics Spring 2015 Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

2 United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization Is It Right to Save Jobs in the Tire Industry? Between 2004 and 2008, Chinese tire companies tripled exports to the United States. In fall 2009, President Obama responded with a tariff on tire imports from China of 35% of the tire s value. Why? This would protect U.S. tire producing firms, and fewer tire industry workers would lose their jobs. China responded by raising tariffs on some U.S. goods. In 2012, President Obama allowed the tariff to expire. Tire imports from China started to rise again. Did the tariffs in the tire industry make the United States better or worse off? Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

3 United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization United States and trade has grown more and more important to the world economy over the past 50 years. Falling shipping and transportation costs have made international trade more profitable and desirable. Traditionally, countries imposed high tariffs on imports, believing that such measures made their own firms and consumers better off. But that meant their exports were similarly taxed. Definition Tariff: A tax imposed by a government on imports Imports: Goods and services bought domestically but produced in other countries. Exports: Goods and services produced domestically but sold in other countries. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

4 Increasing Importance of to the U.S. United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization Since 1970, both imports and exports have been steadily rising as a fraction of U.S. gross domestic product (GDP). trade has been becoming a more and more important part of the American economy. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

5 Leading Exporting Countries, 2012 United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization rapid growth of the Chinese economy has made it the world s largest exporter, with 9.3% of world exports. China took over the lead from the U.S., which accounts for 9.2% of world exports. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

6 As a Percentage of GDP United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization However, trade is less important to the U.S. (and China as well) than it is to other countries largely due to the relative sizes of economies. Which country has the largest exports as a percentage of GDP? What is the percentage? Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

7 As a Percentage of GDP United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization However, trade is less important to the U.S. (and China as well) than it is to other countries largely due to the relative sizes of economies. Which country has the largest exports as a percentage of GDP? What is the percentage? 3. Singapore Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

8 As a Percentage of GDP United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization However, trade is less important to the U.S. (and China as well) than it is to other countries largely due to the relative sizes of economies. Which country has the largest exports as a percentage of GDP? What is the percentage? 3. Singapore 2. Luxembourg Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

9 As a Percentage of GDP United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization However, trade is less important to the U.S. (and China as well) than it is to other countries largely due to the relative sizes of economies. Which country has the largest exports as a percentage of GDP? What is the percentage? 3. Singapore 2. Luxembourg 1. Hong Kong (229.6%) Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

10 United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization Goodyear and the Tire Tariff You would think Goodyear, a major U.S. tire manufacturer, would have benefited strongly from reduced competition due to the tire tariff. However a spokesman for Goodyear said: tariffs didn t have any material impact on our North American business. stuff coming in from China is primarily low end. We got out of that market years ago. Even worse, tires from some of Goodyear s factories in China were subject to the tariff! At the beginning of 2013, with the tire tariff expiring, Goodyear s profits rose more than 50 percent, despite imports of Chinese tires. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

11 United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization Comparative and Absolute Advantage Definition comparative advantage: being able to produce something at a lower opportunity cost than someone else. In the table, Japan has an absolute advantage in producing both cell phones and tablet computers: it can produce each with fewer resources (hours of work) than can the U.S. (or equivalently, produce more with the same amount of resources). But comparative advantage means that trade can still be advantageous for both nations. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

12 United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization Comparative Advantage in This table shows what has to be given up to create each good: the opportunity cost. If the nations were in autarky, a situation in which they did not trade with other countries, these would also be the relative prices in each country: a cell phone would trade for half the price of a tablet computer in Japan, and double the price of a tablet computer in America. Japan would like to trade its cell phones for American tablets, and vice versa. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

13 Production in Autarky United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization Suppose that initially each country has 1000 hours available for production. In that time, Japan might produce 9000 cell phones and 1500 tablet computer. In the same time, the U.S. might produce 1500 cell phones and 1000 tablet computers. In total, cell phones and 2500 tablet computers are produced. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

14 Production in Autarky Preparing for United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization Observe what happens if each country specializes in its comparative advantage: Japan can produce cell phones. U.S. can produce 4000 tablet computers. In total, cell phones and 4000 tablet computers are produced. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

15 United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization Deciding on Terms of terms of trade is the ratio at which a country can trade its exports for imports from other countries. No country would accept terms of trade worse than its opportunity cost it would be better off producing by itself the goods that it was importing. Terms of trade of one-for-one could be acceptable to both Japan and the United States. With these terms, they might trade 1500 cell phones for 1500 computers, ending with the consumption below: Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

16 Summary of United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

17 Why Don t We See Complete Specialization? United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization In the real world, products are not generally produced by only one nation. Reasons include: Not all goods and services can be traded internationally (medical services, for example). Production of many goods involves increasing opportunity costs (so small amounts of production are likely to take place in several countries) Tastes for products differ (cars, for example); countries might have comparative advantages in different sub-types of products. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

18 United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization What s the Bad News about? So far, we have made it appear that international trade is going to be good for everybody. But this is (may be) true only on a national level. Some individual firms and consumers will lose out due to international trade; in our example: Japanese tablet computer firms and their workers American cell phone firms and their workers se groups would likely ask their governments to implement protectionist measures like tariffs and quotas, in order to protect them from foreign competition. Definition Quota: A numerical limit a government imposes on the quantity of a good that can be imported into that country. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

19 United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization Where Does Comparative Advantage Come From? Comparative advantage can derive from a variety of natural and man-made sources: Climate and natural resources Some nations are better-suited to particular types of production; particularly important for agricultural goods. Relative abundance of labor and/or capital Some nations have lots of high-or low-skilled workers, or relatively much or little infrastructure. Technological differences Technologies may not diffuse quickly or uniformly. External economies Reductions in a firm s costs may result from an increase in the (local) size of that industry; think Silicon Valley, Hollywood, or Wall Street. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

20 Leaving New York is Risky for Firms United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization In the early 19th century, New York City benefited from the Erie Canal bringing commerce from upstate New York to the city. Consequently, many financial firms (banks, traders, etc.) located in Manhattan. Now there is no particular natural advantage for financial firms to locate in Manhattan. But proximity to similar firms generates external economies for those firms. If a financial firm chooses to locate out of Manhattan, it experiences higher costs of doing business with other firms located in Manhattan. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

21 United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization Comparative Advantage over Time U.S. Electronics For several decades, the U.S. had a comparative advantage in producing consumer electronics (TVs, radios, etc.), due to having modern factories and a skilled and experienced work force. Over time, other countries like Japan developed superior process technologies, allowing them to streamline production of these goods, and produce them cheaper than U.S. firms. Rising Asian wages are starting to drive the production of consumer electronic devices back to America, along with the high computer and software design requirements of many current consumer electronic devices. Example: In 2013, Apple announced that its redesigned Mac Pro would be assembled in the United States Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

22 United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization Government Policies in Restriction of Definition Free trade: between countries that is without government restrictions. Firms that face competition from imported goods lose out when trade is allowed. se firms appear to deserve sympathy, especially when their workers start to lose their jobs. Consequently, they can often convince governments to restrict trade; usually with one of the following: Tariffs: Taxes imposed by a government on goods imported into a country. Quotas and Voluntary Export Restraints (VERs): Limits imposed upon (quotas) or negotiated between (VERs) countries on the quantity of a good imported by one country from another. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

23 Import Quota in the U.S. Sugar Market United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization Quotas and voluntary export restraints are effectively similar; the difference is that quotas are imposed unilaterally (by one country), whereas VERs are negotiated agreements. United States imposes a sugar quota, allowing no more than 5.8 billion pounds of sugar to be imported. This keeps the U.S. price of sugar ($0.43 per pound) higher than the world price ($0.27), generating large benefits for U.S. sugar producers, at the expense of U.S. sugar consumers. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

24 United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization Costs to Society of Maintaining Import Restrictions A common argument in favor of maintaining import restrictions is that it saves domestic jobs. Economists estimate that without the sugar import restrictions, about 3,000 jobs in the U.S. sugar industry would be lost. That means each job is costing U.S. consumers: $3.90 billion / 3,000 jobs = $1.3 million per job. 1 And this is probably an underestimate, since cheaper sugar would open up more jobs (in the candy industry, etc.), and encourage sugar-using manufacturers to remain in America. Sugar producers are able to lobby for the tariffs because the cost to society of the tariffs is spread over many consumers, and the benefit is concentrated among just a few people. 1 $ 3.90 billion is the estimated loss in consumer surplus. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

25 United States in the Comparative Advantage in How Countries Gain from Preserving U.S. Jobs with Tariffs and Quotas Is Expensive cost to American consumers of maintaining import restrictions and tariffs is very high. Government Policies That Restrict Arguments over Policies and Globalization Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

26 And the Same Is True in Japan! United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Japanese consumers also pay high prices to maintain Japanese jobs through import restrictions and tariffs. Arguments over Policies and Globalization Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

27 United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization Economic Impact of the Tariff U.S. tariff on Chinese tires was designed to protect U.S. tire-workers from foreign competition. Consumers either paid the higher prices, or switched to buying tires imported from non-chinese sources. At most, the tariff saved 1,200 jobs while forcing tire consumers to pay $1.1 billion extra for tires $900,000 per job saved. Economists from the Petersen Institute for Economics estimate that if that $1.1 billion had been spent on other retail products, it would have resulted in 3,731 more retail jobs. So the tariff actually resulted in 2,500 fewer jobs. tire tariff was an expensive and ineffective way to preserve jobs. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

28 Should the U.S. and Japan Drop ir Tariffs? United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization Some politicians argue that we should drop our tariffs and quotas, but only if the Japanese (and other countries) agree to do the same. This makes it easier to gain political support for actions that will genuinely cause economic pain, albeit to a limited number of people. Many economists argue there is sufficient reason for America to unilaterally remove its restrictions. U.S. economy would gain from the elimination of tariffs and quotas even if other countries did not reduce their tariffs and quotas! Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

29 United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization Other Barriers to A less-common but still important barrier to trade is the imposition of higher standards on imported goods. Example: Raw milk can be sold in many U.S. states, but cannot be sold across state lines. Many governments also restrict imports of certain products on national security grounds, fearing that in times of war, they would not have access to those products. se arguments often seem quite cynical, however; for years, for example, the U.S. government would buy military uniforms only from U.S. manufacturers, even though uniforms are hardly a critical war material. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

30 United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization Agreements in the 21st Century More trade takes place between nations when their governments encourage rather than discourage it. 1930: U.S. institutes Smoot-Hawley Tariff, increasing tariffs to > 50%. Goal is to protect domestic industry, encourage employment. 1948: Western countries seeking to revive international trade form GATT (General Agreement on Tariffs and ). Several rounds of multilateral tariff reduction followed. 1995: World Organization (WTO) replaces GATT; > 150 member states agree to liberalize international trade. WTO also provides dispute resolution process for trade disputes. Better coverage for non-physical products (intellectual property, etc.). Definition World Organization (WTO): An international organization that oversees international trade agreements. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

31 United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization Opposition to WTO and in General part 1 Three main sources: 1. Anti-globalization forces Lesser-developed countries (LDCs) have less strict regulations, creating perception of unfairness. Definition But regulations are a choice; in rich countries, we choose such regulations because we think they make us better off. Free trade and foreign investment might destroy distinctive cultures. Matter of opinion whether LDCs are better off with McDonalds and Wal-Mart; but if they choose to eat and shop there, why should we deny them that right? Globalization: process of countries becoming more open to foreign trade and investment Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

32 United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization Opposition to WTO and in General part 2 2. Old-fashioned protectionists Restricting trade saves jobs and protects high wages Definition We have seen that overall people can be made better off with trade, even though some individuals are worse off. Infant industries need protection Industries might need some time to start-up and become competitive; but tariffs must eventually be removed. Protecting national security Maybe we shouldn t import all our guns from elsewhere... Protectionism: use of trade barriers to shield domestic firms from foreign competition. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

33 Opposition to WTO and in General part 3 United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization 3. People perceiving WTO first-world bias Does WTO favor high-income countries? Maybe; less pressure can be brought to bear on large countries to remove their trade barriers. Similarly, hard for third-world companies to compete (inferior infrastructure, etc.). Inherent bias toward profits rather than equity. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

34 United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization Dumping In recent years, U.S. has protected some domestic industries using a WTO provision against dumping. Definition Dumping: selling a product for a price below its cost of production. In practice, it is difficult to tell if foreign companies are dumping goods. True production costs are not easy for governments to calculate. WTO s approach: countries can claim dumping if product is exported for lower price than it is sold domestically. This standard is arbitrary; companies might use loss-leaders or different prices in different markets in order to maximize profits. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

35 Positive vs. Normative Analysis United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization Recall positive analysis reflects what is, and normative analysis what ought to be. Judgments about free trade necessarily reflect values and morals. Though most economists disagree, it is not intellectually unreasonable to value the costs of free trade more highly than the benefits, and hence believe free trade is undesirable. Note: not all tariffs/protectionist policies are identical; some are worse than others. Important not to paint them all with the same brush. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

36 Unintended Consequences of Banning Child Labor United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization In rich nations, our reaction to child labor is one of horror: shouldn t those children be in schools, getting education? Often, this is not the reality: the alternative to work for those children is worse, like begging or prostitution. This was the reality for Pakistani children when Baden Sports was forced by public pressure to move its production of soccer balls from Pakistan to China. Of the array of possible employment in which impoverished children might engage, soccer ball stitching is probably one of the most benign... Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

37 United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization Special Interest Groups and Policy Arguments against free trade in the U.S. often come from special interest groups, like the sugar industry complaining about unfair competition from foreign producers. Although as a nation we would be better off without sugar quotas, they don t get removed, because the sugar industry is able to successfully lobby the government to keep them. jobs that would be lost if the sugar quota were removed are much easier to identify than the ones that would be gained. burden of higher prices is spread across all 300+ million Americans. Such arguments are easy to make, and hard for elected officials to ignore, even though it is correct to do so. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

38 Common Misconceptions to Avoid United States in the Comparative Advantage in How Countries Gain from Government Policies That Restrict Arguments over Policies and Globalization Comparative advantage is the basis for trade; a nation may have an absolute advantage in nothing or in everything, and still benefit from trade. Tariffs are effectively taxes imposed on imports; they do not ban imports in any way. creates winners and losers; to claim otherwise is dishonest. Whether free trade is good or not is a normative (value) judgment. But economics can inform those value judgments. Some parts of free trade are surely good; we must determine which parts are good, and which are not. It s not all or nothing. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

39 Linkages between Countries Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an Until now, we have mostly ignored the linkages between countries at the macroeconomic level. But countries are linked: By trade in goods and services By flows of financial investment In this section, we will consider how these linkages work, and what the implications are for fiscal and monetary policy. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

40 Open Economies Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an Today it is routine for consumers, firms, and investors to interact with their counterparts in foreign countries. A country that has interactions in trade or finance with other countries is known as an open economy, as opposed to a closed economy, which has no interactions in trade or finance with other countries. No economy is completely closed; though a few countries, such as North Korea, have limited foreign economic interactions. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

41 U.S. Balance of Payments, 2012 Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an A good way to understand economic interactions with other countries is by examining the balance of payments(bop): the record of a country s trade with other countries in goods, services, and assets. It is composed of the current account: the record of the country s net exports, net income on investments, and net transfers... Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

42 U.S. Balance of Payments, 2012 continued Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an... the financial account, which records purchases of assets a country has made abroad, and foreign purchases of assets in the country and the capital account, which records relatively minor transactions such as migrants transfers and sales, and purchases of non-produced, non-financial assets. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

43 U.S. Balance of Payments, 2012 continued Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an balance of payments is the sum of these three accounts. It must equal zero. In 2012, the U.S. spent $440 billion more on goods, services, and other current account items than it received. This money must have been used either to buy U.S. assets or to keep as U.S. currency holdings overseas. Statistical discrepancy is the difference. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

44 Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an Current Account and the Balance of current account records a country s net exports, net income on investments, and net transfers. An important part of this is the balance of trade, the difference between the value of the goods a country exports and the value of the goods a country imports. If this is positive, it is referred to as a trade surplus; a negative balance of trade is a trade deficit. In 2012, the U.S. had a trade deficit of $742 billion; it had a trade deficit with every world region except Latin America excluding Mexico. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

45 Current Account and the Balance of Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an Japan also ran a trade deficit of $87 billion in On the other hand, China (not shown) had a trade surplus of $231 billion in You might notice that the trade figures between the U.S. and Japan on this slide are not the same as on the previous slide (they were $149 and $72 billion respectively). This highlights the fact that trade figures are not measured exactly. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

46 Rest of the Current Account Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an balance of services is the difference between the values of the exports and imports of services. Net exports is the sum of the balance of trade and the balance of services. current account balance is the sum of net exports, net income on investments, and net transfers. For simplicity, we will frequently ignore the latter two their sum is close to zero for the U.S. and think of net exports as being equal to the current account balance. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

47 Account Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an While the current account records short-term flows of funds into and out of the country, the financial account records long-term flows: Capital outflows: purchases of assets overseas by Americans Capital inflows: purchases of American assets by foreigners se assets might be financial assets, like stocks and bonds foreign portfolio investment or physical assets, like factories foreign direct investment. balance on the financial account can be thought of as a measure of net capital flows; or alternatively as its negative, net foreign investment,which is the difference between capital outflows from a country and capital inflows. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

48 Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an Foreign Direct Investment (FDI) Definition Foreign Direct Investment (FDI): purchase or building by a corporation of a facility in a foreign country. History FDI was very important in U.S. industrialization; e.g., British firms built the railroads in the 19th century In 20th century, until the 1980s, FDI was small, and resisted by both source and host countries Governments restricted capital movements and exchange of currencies Developing countries equated FDI with colonialism and imperialism Countries blamed multinational corporations (MNCs) for interfering in domestic political and military matters Starting in 1980s, attitudes began to change Developing countries saw FDI as helping them grow Host countries saw FDI as providing employment; started using policies to attract FDI Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

49 Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates FDI U.S. U.S. and Europe are both huge sources and huge hosts of FDI U.S. has received almost as much FDI as it has sent out That means lots of U.S. assets are foreign-owned What are they? Some perhaps obvious foreign-owned companies and products in the U.S. Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

50 Capital Account Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an Prior to 1999, the financial account and the capital account were known collectively as the capital account. Since then, the capital account refers only to relatively minor transactions, like migrants transfers, or sales and purchases of non-produced, non-financial assets like intellectual property or natural resource rights. balance on the capital account is relatively small $7 billion in 2012 so we will ignore it. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

51 Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an Foreign Exchange Rate When a firm or consumer wants to buy something a good, a service, a financial asset from a foreigner, that foreigner will often want to be paid in their own currency. rate at which one country s currency can be traded for another s is known as the nominal exchange rate. Example: If one U.S. dollar can purchase 100 Japanese yen, then the exchange rate is 100 = $1; or alternatively, 1 = $0.01. Economists also calculate the real exchange rate, which corrects the nominal exchange rate for differences in prices of goods and services between countries. Foreign exchange markets are very active; over $3 trillion in currency is traded in foreign exchange markets each day. Almost all of this in electronic form. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

52 Exchange Rate Listings Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an exchange rates in the table above are for August 9, two versions of the exchange rate are reciprocals of each other; 1.03 Canadian dollars bought 1 U.S. dollar, or equivalently 1 Canadian dollar bought 1/1.03 = 0.97 U.S. dollars. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

53 Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an Demand for the U.S. Dollar Market exchange rates are determined by supply and demand, just like any price. demand for $US comes from: 1. Foreign firms and households wanting to buy U.S. goods and services 2. Foreign firms and households wanting to invest in U.S. physical or financial assets 3. Currency traders believing the value of the $US will rise re is a demand for $US in each foreign currency Japanese yen, for example. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

54 Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an Equilibrium in the Market for Foreign Exchange Unlike in markets for goods and services, the supply of $US is caused by just the same elements as cause the demand for $US, only in reverse: firms, households, and speculators wanting to obtain (say) Japanese yen, and pay for them with U.S. dollars. equilibrium exchange rate is the exchange rate at which the quantity of dollars supplied is just equal to the quantity of dollars demanded. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

55 Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an Currency Appreciation and Depreciation If the exchange rate is too high, more people will want to sell $US for yen than want to buy them a surplus. exchange rate will depreciate: the value of the $US will fall, relative to the value of the yen. If the exchange rate is too low, there will be a shortage of $US. n the exchange rate will appreciate: the value of the $US will rise, relative to the value of the yen (or any other given currency). Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

56 Are All Exchange Rates Market-Determined? Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an We assume in this chapter that exchange rates are determined by the market. But this is not always true. Example: For more than 10 years, the value of the Chinese yuan was fixed by the Chinese government at 8.28 yuan= $1. Fixed exchange rates have important consequences; we will consider them in the next section. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

57 Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an Changes in the Demand and Supply for Foreign Exchange Anything (apart from the exchange rate itself) affecting the demand for foreign exchange will shift the demand curve to the right for an increase in demand, to the left for a decrease. This might result from: 1. Changes in the demand for U.S.-produced goods and services, relative to foreign produced goods and services 2. Changes in the desire to invest in the U.S. relative to foreign countries 3. Changes in the expectations of currency traders about the likely future value of $US relative to foreign currencies supply of $US for yen is the same as the demand for yen with $US; so the same factors that change demand also change supply. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

58 Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an Adjustment to a New Foreign Exchange Market Equilibrium Suppose the exchange rate of yen for $US starts out at 120 = $1. U.S. incomes rise, increasing our demand for Japanese imports. To pay for the imports, we need to buy yen, hence we supply $US to the foreign exchange market. At the same time, interest rates in the U.S. rise, making U.S.bonds more attractive to hold than Japanese bonds. So the demand for $US rises. If the increase in demand is larger than the increase in supply of $US, the exchange rate will appreciate to 130 = $1, in this case. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

59 Currency Speculation Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an A large amount of trade in foreign exchange is by speculators, currency traders who buy and sell foreign exchange in an attempt to profit from changes in exchange rates. Speculators purchase and hold a currency when they believe it will appreciate; or they may engage in more complicated financial transactions, for example to buy currency in the future at a price agreed today. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

60 Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an Japanese Firms Ride the Yen Roller Coaster Because many large Japanese firms rely heavily on sales in the United States and other foreign countries, their profits are highly dependent upon the yen exchange rates. When the yen appreciates, as it has done overall for the last 40 years, Japanese exports become more expensive to foreigners, so Japanese exporters make less profit. However the rate has not changed consistently; this creates exchange rate risk for firms doing business internationally. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

61 Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an Exchange Rates, Imports, and Exports When the $US appreciates, the dollar price of foreign imports falls. Similarly, the foreign currency price of U.S. exports rises. Example: Suppose the exchange rate between $US and euros is $1 = e1. An iphone with a U.S. price of $200 will cost e200 to a French person. But if the $US appreciates, so the exchange rate is now $1 = e1.20, that same iphone will now cost the French person e240. n we expect French people to buy fewer iphones. But at the same time, French wine has become cheaper for Americans to buy, so we will buy more of it. An appreciation of the $US causes U.S. exports to fall and imports to rise; so net exports will fall. Hence aggregate demand will fall, and also real GDP. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

62 Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an Real Exchange Rate real exchange rate is the price of domestic goods in terms of foreign goods. Suppose initially $1 = 1, and the U.S. and British price levels are both 100. n the real exchange rate between $US and British pounds is: = 1 $ Now suppose the $US appreciates, so the new exchange rate is $1 = 1.10; and simultaneously the price level in the U.S. rises to 105 (5% inflation) while price levels stay constant in the U.K.; then: = 1.15 $ Interpretation: Prices of U.S. goods are now 15% higher than they were, relative to the prices of British goods. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

63 Balance of Payments: Linking the United States to the Net Exports Equal Net Foreign Investment When a country s spending exceeds its income, it finances the difference by selling assets or by borrowing. So Current account balance + account balance = 0 Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an refore: That is, Current account balance = account balance Net exports + Net foreign investment = 0 When U.S. net exports are negative, U.S. net foreign investment is negative by the same amount. Similarly, China exports more than it imports; so each year, their net foreign investments must be positive, and of the same amount. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

64 Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an Domestic Saving/Investment and Net Foreign Investment Saving in an economy can be expressed as: National saving = Private saving + public saving S = S private + S public = (Y T C) + (T G) = [(C + I + G + NX) T C] + T G S = I + NX n by the previous slide s identity, National saving = Investment + Net foreign investment Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

65 Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an Savings and Investment Equation National saving = Investment + Net foreign investment This is known as the savings and investment equation, showing that national saving is equal to domestic investment plus net foreign investment. Example: If you save $1,000 and use it to buy a bond issued by General Motors, GM might use the $1,000 to help build a domestic factory (I), or build a factory in China (NFI). A useful way to rewrite this identity is as: S I = NFI This highlights the fact that if net foreign investment (i.e., net exports) is negative, then domestic savings must be less than domestic investment. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

66 Budget Deficits and the Saving and Investment Equation Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an When the government runs a budget deficit, S public is negative, and national savings tends to decline. By the saving and investment equation, we know domestic investment and/or net foreign investment must decline. Why? When the government runs a budget deficit, it finances its dissaving by selling bonds. To attract buyers, the government must typically raise interest rates. Higher interest rates discourage firms from making investments. y encourage funds to flow to the U.S. to buy those bonds, causing the $US to appreciate, but this causes net exports to fall. And net exports equal net foreign investment. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

67 Twin Deficits, Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an When government budget deficits lead to declines in net exports, the situation is known as twin deficits. This was a big concern in the early 1980s: large federal budget deficits resulted in high interest rates; high $US exchange rates and large current account deficits followed. But since 1990, the budget deficit and current account deficit do not seem to be strongly related, and evidence from other countries is mixed. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

68 United States: World s Largest Debtor Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an graph shows the current account balance in the U.S. from By the end of 2012, foreign investors owned about $3.9 trillion more of U.S. assets stocks, bonds, factories, etc. than U.S. investors owned of foreign assets. This seems alarming; but (1) it is a vote of confidence in the U.S. economy, and (2) the funds have been critical in financing investment and hence growth in the U.S. despite low personal savings rates. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

69 Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an Monetary Policy in an Is monetary policy more effective in an open economy or in a closed economy? Expansionary monetary policy effectively means lowering interest rates. In a closed economy, this encourages investment, and consumption spending on durables. In an open economy, the demand for $US falls, decreasing the exchange rate, but this causes net exports to rise. refore through this additional policy channel, the expansionary monetary policy will increase aggregate demand by more in an open economy than in a closed economy. Of course, the same is true of contractionary monetary policy. Monetary policy is more effective in an open economy. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

70 Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an Fiscal Policy in an Is the same true of fiscal policy: is it also more effective in an open economy? To find out, we can explore the effect of expansionary fiscal policy on the additional policy channel, net exports: Tax cuts or increased government spending increase aggregate demand But this might result in higher interest rates, crowding out net exports due to the appreciating $US Also, the multiplier effect is lower, since some spending takes place on imported goods, which do not feed back in to real GDP. Hence expansionary fiscal policy will be less effective in an open economy than in a closed economy. Naturally, the same will be true of contractionary fiscal policy: all fiscal policy is less effective in an open economy. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

71 Common Misconceptions to Avoid Balance of Payments: Linking the United States to the Foreign Exchange Market and Exchange Rates Sector and National Saving and Investment Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an re is a lot of new terminology here, and many of the phrases, like balance of trade, balance of services, and current account balance sound very similar. Be careful not to confuse them. When the $US appreciates, the price of the $US in terms of other currencies goes up. Simultaneously, the price of other currencies in terms of the $US goes down. Depreciation is the opposite. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

72 How Are Exchange Rates Determined? Exchange Rate s Current Exchange Rate Capital Markets Gold Standard and the Bretton Woods In the previous section, we assumed exchange rates were determined by the market. A floating currency is the outcome of a country allowing its currency s exchange rate to be determined by demand and supply. But allowing the relative values of currencies to be determined by demand and supply is just one type of exchange rate system, or agreement among countries about how exchange rates should be determined. present-day exchange rate system is best described as a managed float exchange rate system, under which the value of most currencies is determined by demand and supply, with occasional intervention. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

73 Exchange Rate s Current Exchange Rate Capital Markets Gold Standard and the Bretton Woods Fixed Exchange Rate A fixed exchange rate system is one under which countries agree to keep the exchange rates among their currencies fixed for long periods. From the 19th century until the 1930s, countries currencies were redeemable for fixed amounts of gold a system known as the gold standard. amount of gold each for which currency was redeemable determined the exchange rates. After the Great Depression of the 1930s, most countries abandoned the gold standard. In 1944, a conference in Bretton Woods, NH established the Bretton Woods system: U.S. pledged to buy or sell gold at $US 35 per ounce Other member countries agreed to a fixed exchange rate between their currency and the U.S. dollar Timer permitting, we will examine these systems further in a later subsection. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

74 Highlights of the Current Exchange Rate Exchange Rate s Current Exchange Rate Capital Markets Gold Standard and the Bretton Woods current exchange rate system has three important aspects: 1. U.S. allows the dollar to float against other major currencies. 2. Nineteen countries in Europe have adopted a single European currency, the euro. 3. Some countries have attempted to keep their currencies exchange rates fixed against the $US or some other currency. Each of these aspects has important consequences, and we will examine them in turn. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

75 1. Floating Dollar Exchange Rate s Current Exchange Rate Capital Markets Gold Standard and the Bretton Woods Bretton Woods system of fixed exchange rates ended in Since then the value of the $US (in terms of how many units of foreign currency one U.S. dollar can buy) has floated. One U.S. dollar buys about as many Canadian dollars as it did in But it only buys about a third as many Japanese yen. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

76 What Determines Exchange Rates in the Long-Run? Exchange Rate s Current Exchange Rate Capital Markets Gold Standard and the Bretton Woods Why has the value of the U.S. dollar fallen so much against the Japanese yen, and yet risen then fallen to about the original level against the Canadian dollar? In the short run, the two most important influences on exchange rates are: Relative interest rates Expectations about future values of currencies But over the long run, it seems reasonable that exchange rates should move to equalize the purchasing powers of different currencies. This is known as the theory of purchasing power parity. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

77 Exchange Rate s Current Exchange Rate Capital Markets Gold Standard and the Bretton Woods Purchasing Power Parity (PPP) Suppose that candy bars sell for 2 in the United Kingdom, and for $1 in the United States. If the exchange rate were 1 = $1, then a clever entrepreneur could: Buy a million candy bars in the U.S. for $1,000,000 Transport them to the U.K. and sell them for 2,000,000 Exchange that currency for $2,000,000: a profit of $1,000,000, minus the cost of shipping. If many people did this, there would be an increase in the supply of British pounds, offered to purchase U.S. dollars; so we would expect the exchange rate to appreciate. If it appreciated to 2 = $1, currency would have equal purchasing power in each location, and there would be no more pressure on the exchange rate to change. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

78 What Stops Purchasing Power Parity from Occurring? Exchange Rate s Current Exchange Rate Capital Markets Gold Standard and the Bretton Woods When you travel, you will notice that some goods and services are cheaper overseas than here, and some are more expensive. Why doesn t purchasing power parity stop this from happening? 1. Not all products can be traded internationally (especially services). 2. Products and consumer preferences are different across countries; prices are determined by supply, but also by demand. 3. Countries impose barriers to trade, like tariffs (taxes on imports) and quotas (numerical limits on imports). Example: the U.S. sugar quota ensures that purchasing power parity cannot reduce the price of sugar in the U.S. to the world price. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

79 Exchange Rate s Current Exchange Rate Big Mac ory of Exchange Rates Economist magazine collects the prices of Big Macs in different countries. In July 2011, the average price of a Big Mac was $4.56 in the United States. Comparing this to the average prices of Big Macs in other countries offers a (light-hearted) test of purchasing power parity: Capital Markets Gold Standard and the Bretton Woods Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

80 Determinants of Exchange Rates in the Long Run part 1 Exchange Rate s Current Exchange Rate Capital Markets Gold Standard and the Bretton Woods Relative price levels Purchasing power parity explains some exchange rate movements. Example: Prices in Japan have risen slower than prices in the U.S., helping to explain why the Japanese yen has appreciated in value relative to the U.S. dollar. Relative rates of productivity growth A country with relatively high productivity growth will have less expensive products; demand for these products from foreigners will cause the domestic currency to appreciate Example: Japanese productivity rose faster than U.S productivity in the 1970s and 1980s, contributing to the depreciation of the U.S. dollar over that time. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

81 Determinants of Exchange Rates in the Long Run part 2 Exchange Rate s Current Exchange Rate Capital Markets Gold Standard and the Bretton Woods Preferences for domestic and foreign goods If consumers in Canada increase their demand for U.S. goods, they increase their demand for U.S. dollars, and hence appreciate the value of the $US. Tariffs and quotas High tariffs or restrictive quotas reduce the demand for foreign goods, and hence cause the domestic currency to appreciate. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

82 How Do Exchange Rates Affect Firms? Exchange Rate s Current Exchange Rate Capital Markets Gold Standard and the Bretton Woods An appreciation of the U.S. dollar makes imports cheaper for us to buy but makes our exports more expensive for foreigners. So importing firms tend to like it when the $US is valued more highly, and exporting firms tend to prefer it when the $US is relatively weaker. But floating exchange rates also add an element of risk to foreign transactions, making it difficult for firms to make long-term plans involving foreign trade. Markets do exist for buying future currency at current prices, but firms pay a premium for this risk-reduction. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

83 2. Euro Exchange Rate s Current Exchange Rate Capital Markets Gold Standard and the Bretton Woods In part to encourage international trade, 12 European countries decided to adopt a common currency the euro in ir exchange rates of their currencies the French franc, the Spanish peseta, the German mark, etc. were permanently fixed against one another. In 2002, the euro currency went into circulation, and the domestic currencies were withdrawn from circulation. Currently, 19 of the European Union nations had adopted the euro as their currency. A new European Central Bank (ECB) was also established; the ECB became responsible for monetary policy throughout the Euro zone. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

84 Countries Adopting the Euro Exchange Rate s Current Exchange Rate Capital Markets Gold Standard and the Bretton Woods Light blue shaded countries are members of the European Union. Countries with darker blue have adopted the euro as their currency. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

85 Exchange Rate s Current Exchange Rate Capital Markets Gold Standard and the Bretton Woods Can the Euro Survive? For the first few years of the euro, all seemed well: relative economic stability through most of Europe, expanding employment and production, and easier foreign transactions for firms and consumers. But the recession of hit Europe as well, and a weakness of the shared currency became apparent: individual countries using the euro could not pursue their own monetary policies. inability to use monetary policy was one of the reasons countries abandoned the gold standard. countries could and did use expansionary fiscal policy, but the debts incurred lead to sovereign debt crises for several Euro zone nations. Can the euro survive? No one knows for sure. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

86 3. Pegging against the Dollar Exchange Rate s Current Exchange Rate Capital Markets Gold Standard and the Bretton Woods Some developing countries have attempted to keep their exchange rates fixed against the $US or other currencies, an action known as pegging. Advantages: Easier planning for firms A more credible commitment to fighting inflation Disadvantages: Needing to support an under-or over-valued currency Potential for destabilizing speculation if speculators believe the currency will eventually appreciate or depreciate Difficulty in pursuing an independent monetary policy Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

87 Exchange Rate s Current Exchange Rate Capital Markets Gold Standard and the Bretton Woods East Asian Exchange Rate Crisis of the Late 1990s In the 1990s, the Thai baht was pegged to the $US at a rate of 1 baht = $0.04. But by 1997, the market equilibrium value of Thai baht was only $0.03. This created a persistent surplus of Thai baht on foreign exchange markets. To support the pegged rate, the Bank of Thailand had to buy baht with its U.S. dollar reserves. It also raised Thai interest rates to attract investors, but that further depressed the Thai economy. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

88 Exchange Rate s Current Exchange Rate Capital Markets Gold Standard and the Bretton Woods Destabilizing Speculation against the Baht Thai difficulties did not go unnoticed. People believed that the Bank of Thailand would not be able to maintain the high value of its currency, so they sold off Thai currency as quickly as possible. This further depressed the market equilibrium exchange rate, increasing the motivation to sell off Thai currency. In July 1997 Thailand allowed its currency to float, but now firms had debt denominated in $US, and with their earnings in Thai baht, they found it even harder to repay their loans. Many firms went bankrupt, leading to a deep Thai recession. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

89 Exchange Rate s Current Exchange Rate Capital Markets Gold Standard and the Bretton Woods Decline in Pegging Several other East Asian countries experienced similar speculative attacks on their currencies including South Korea, Indonesia, and Malaysia leading them to abandon pegged exchange rates. Today, many countries have followed this trend, allowing a managed float of their currencies instead. Some countries maintain pegged exchange rates: Several Caribbean countries peg against the $US Several former French colonies in Africa pegged against the French franc and now do against the euro Most of these countries are small, and primarily trade with the country to whose currency they peg. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

90 Chinese Experience with Pegging Exchange Rate s Current Exchange Rate Capital Markets Gold Standard and the Bretton Woods In 1994, China decided to peg its currency against the $US, at a rate of 8.28 yuan= $1. This brought predictability for Chinese firms trading with American firms. By the early 2000s, many economists believed the yuan was undervalued. To maintain the pegged exchange rate, the Chinese bank bought large amounts of U.S. currency more than $700 billion. undervalued yuan was good for Chinese exporters, but export-competing firms in the U.S., Japan, and Europe thought this was unfair, and their governments pressured China to allow its currency to float. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

91 Yuan Floats Maybe Exchange Rate s Current Exchange Rate Capital Markets Gold Standard and the Bretton Woods In 2005, China switched to linking the value of the yuan to a basket of currencies, then announced it was allowing a managed float of the yuan. But many economists remain skeptical, since the exchange rate seems to move in too predictable a manner. Is an over-valued yuan really so bad for Americans? It hurts export-competing firms, but import-consuming customers benefit from cheaper products. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

92 Rise of Capital Markets Exchange Rate s Current Exchange Rate Capital Markets Gold Standard and the Bretton Woods Before 1980, most U.S. corporations raised funds only in U.S. stock and bond markets or from U.S. banks. Similarly, U.S. investors rarely invested in foreign markets. In the 1980s and 1990s, legal restrictions on capital movement in Europe were lifted, and communication technology improved. se changes made participating in international capital markets more practical and appealing; both for Americans, and for foreigners looking to invest in the U.S. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

93 Rise of Capital Markets continued Exchange Rate s Current Exchange Rate Capital Markets Gold Standard and the Bretton Woods Through the 1990s, there was a large increase in foreign purchases of U.S. corporate stocks and bonds, and U.S. government bonds foreign portfolio investments. After the financial crisis, foreign purchases of U.S. government bonds soared, in a flight to safety from unstable European bond markets. This demand was also fueled by U.S. current account deficits; foreigners with U.S. dollars needed to do something with the currency. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101

94 Foreign Holdings of U.S. Stocks and Bonds, 2012 Exchange Rate s Current Exchange Rate Capital Markets Gold Standard and the Bretton Woods globalization of financial markets has helped increase growth and efficiency. Funds can be channeled to where they are most useful. But the increased interconnectedness of financial markets also has a downside: shocks in one market are transmitted globally much faster than previously. Dennis C. Plott (Notre Dame) Economics ECON 10020/20020 Spring / 101