The Global Economy: Finance

Chapter 18 The Global Economy: Finance

What's in This Chapter and Why

The U.S. balance of payments is discussed and the current account deficit is described. The effects of this deficit are considered. Exchange rate determination is discussed in both the flexible and fixed exchange rate context. After discussing the current international financial system, the authors outline the advantages and disadvantages of flexible and fixed exchange rates. Finally, the Asian financial crisis is described in terms of capital outflows and depreciating currency. The pros and cons of restricting capital flows are presented.

Instructional Objectives

After completing this chapter, your students should know:

1. That the large and persistent current account deficit is undesirable. 2. That in a flexible exchange rate system, exchange rates are determined by the demand for and supply of foreign exchange. 3. That GDP and interest rates are important in determining exchange rates. 4. That fixed exchange rates require the intervention of central banks. 5. That some economists argue that flexible rates lead to greater economic stability and leave central banks free to pursue monetary policy. 6. That some economists believe that fixed exchange rates have a stabilizing effect on an economy and force central banks to practice monetary discipline. 7. That the Asian financial crisis started in financial markets, but spread to all parts of the affected economies. 8. That controls may be applied to capital outflows or inflows in order to prevent currency depreciation or appreciation.

Key Terms

These terms are introduced in this chapter:

Balance of payments Fixed exchange rates Exchange rate Balance of payments deficit Flexible (floating) exchange rates Balance of payments surplus Appreciation Devaluation Depreciation Revaluation

Suggestions for Teaching

Some students will know a little about exchange rates from their personal travels. Ask students to share their experiences in trading dollars for pesos, etc. Be sure to stay up to date with actual exchange rates by following the Wall Street Journal, or some other financial newspaper.

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Additional References

In addition to the references in the text, instructors may wish to read or assign one or more of the following:

1. K. Alec Chrystal and Geoffrey E. Wood, "Are Trade Deficits a Problem?" Federal Reserve Bank of St. Louis, Review 70 (January/February 1988), pp. 3-11. 2. Michael P. Dooley, “Capital Controls and Emerging Markets,” International Journal of Finance and Economics 1 (July 1996), pp. 197-205. 3. Robert F. Graboyes, "International Trade and Payments Data: An Introduction," Federal Reserve Bank of Richmond, Economic Review (September/October 1991), pp. 20-31. 4. Juann Hung and Susan Charrette, “The Looming U.S. External Debt: How Serious Is It?” Contemporary Economic Policy 15, (July 1997), pp. 32-41. 5. Masahiro Kawai, “The East Asian Currency Crisis: Causes and Lessons,” Contemporary Economic Policy 16, (April 1998), pp. 157-172. 6. Suduk Kim, “Currency Crisis in Korea–When and Why it Happened,” Asia-Pacific Financial Markets 7 (March 2000), pp. 11-30. 7. Jane Sneddon Little, "Foreign Investment in the United States: A Cause for Concern?" Federal Reserve Bank of Boston, New England Economic Review (July/August 1988), pp. 51-58. 8. Jane Sneddon Little and Giovanni P. Olivei, “Rethinking the International Monetary System: An Overview,” Federal Reserve Bank of Boston, New England Economic Review (November/December 1999), pp. 3-24. 9. Larry Neal and Daniel Barbezat, The Economics of the European Union and the Economies of Europe, (New York: Oxford University Press, 1998). 10. Organization for Economic Co-operation and Development, EMU: Facts, Challenges, and Policies, (Organization for Economic Cooperation and Development, 1999). 11. Carmen M. Reinhart and Vincent R. Reinhart, “On the Use of reserve Requirements in Dealing with Capital Flow Problems,” International Journal of Finance and Economics 4 (January 1999), pp. 27-54. 12. Andrew Rose, “One Money, One Market: The Effect of Common Currencies on Trade,” Economic Policy: A European Forum 0 (April 2000), pp. 7-33. 13. "Studies on U.S. External Imbalances," Federal Reserve Bank of New York, Quarterly Review 13/14 (Winter-Spring 1989), pp. 1-82. 14. Aaron Tornell and Andres Velasco, “Fixed versus Flexible Exchange Rates: Which Provides More Fiscal Discipline?” Journal of Monetary Economics 45 (April 2000), pp. 399-436. 15. Jeffrey M. Wrase, “The Euro and the European Central Bank,” Federal Reserve Bank of Philadelphia, Business Review, (November/December 1999), pp. 3-14.

Outline

I. THE BALANCE OF PAYMENTS A. Deficits, Surpluses, and Their Consequences 1. The balance of payments is a summary of all economic transactions between the residents of one country and those of all other countries during a given period of time. a. These transactions include exports, imports, and various capital flows. 2. Since the early 1980s, the United States has run a deficit in its current account and a surplus in its capital account. a. Much of this deficit occurs because the United States imports more than it exports. 3. There is good reason to be concerned with the deficit. Instructor's Manual  243

a. The deficit is financed primarily through foreign investment in the United States. 1. This investment means that ownership of the nation's assets is transferred to foreigners. 2. As foreigners accumulate more of the nation's assets, they receive more income and interest from the United States.

II. EXCHANGE RATES AND THEIR DETERMINATION A. Flexible (Floating) Exchange Rates 1. An exchange rate is the number of units of one currency exchangeable for one unit of another. 2. Under a flexible system, exchange rates are determined by the demand for and the supply of dollars. a. The demand for dollars is based on other countries' desires to purchase our domestic goods and services and to invest in this country. b. The supply of dollars is based on U.S. citizens' desires to purchase the goods and services from other countries. c. The equilibrium exchange rate occurs where the quantity of dollars demanded equals the quantity of dollars supplied. 3. If the exchange rate is not at its equilibrium level, there is a tendency for it to move towards the equilibrium rate. a. If the quantity of dollars supplied exceeds the quantity of dollars demanded, the exchange rate will fall (a depreciation of the dollar occurs). b. If the quantity of dollars demanded exceeds the quantity of dollars supplied, the exchange rate will increase (an appreciation of the dollar occurs). B. Real GDP 1. One factor affecting exchange rates is real GDP. a. Increases in real GDP in the United States will increase the supply of dollars to foreign countries, causing the dollar to depreciate. C. Interest Rates 1. Another factor affect exchange rate is the rate of interest. a. An increase in U.S. interest rates will decrease the supply of dollars to foreign countries and increase the demand for dollars in foreign countries, causing the dollar to appreciate. D. Fixed Exchange Rates 1. In a fixed exchange rate system, central banks intervene in foreign markets to keep exchange rates constant. a. If exchange rates are fixed above the equilibrium level, the supply of dollars is greater than the demand for dollars and a balance of payments deficit occurs. b. If exchange rates are fixed below the equilibrium level, the demand for dollars is greater than the supply of dollars and a balance of payments surplus occurs. 2. If an excess supply of dollars exists, the Federal Reserve must use foreign currency to buy dollars (to keep exchange rates constant). a. The Federal Reserve will sooner or later exhaust its supply of the foreign currency. b. The exchange rate may be allowed to drop–a devaluation of the dollar. 244  Chapter 18/The Global Economy: Finance

3. If an excess demand for dollars exists, the Federal Reserve must sell dollars for some other currency(to keep exchange rates constant). a. The Federal Reserve may become reluctant to accumulate more dollars. b. The exchange rate may be allowed to increase–a revaluation of the dollar. E. The Current International Financial System 1. In the early 1970's many countries, including the United States, abandoned the fixed exchange system. 2. The international system is mixed. 3. In 1992 the European Union was formed and 11 countries formally launched a common currency, the euro. The euro floats against other currencies.

III. THE CASE FOR FLEXIBLE RATES A. Flexible exchange rates will result in greater economic stability. B. A commitment to keeping exchange rates constant prevents the central bank from altering the domestic money supply to lower inflation or unemployment.

IV. THE CASE FOR FIXED EXCHANGE RATES A. Less risk and uncertainty exist under a fixed system. 1. Fluctuations result in too-frequent reallocations of domestic resources between export and import-competing sectors of the economy, and lead to less international trade and investment. 2. Proponents of flexible rates note than firms can take action to protect themselves against unforeseen changes in exchange rates. B. Flexible rates lead to destabilizing speculation. 1. If speculators believe that a depreciating currency will depreciate further, they sell the currency, causing it to depreciate even more. 2. Opponents of fixed exchange rates argue that destabilizing speculations is less likely to occur when exchange rates adjust continuously than when a country is forced to devalue because of a balance of payments deficit. C. Fixed exchange rates provide a discipline to central banks. 1. If central banks must keep exchange rates constant, this prevents them from increasing the money supply too rapidly which is inflationary. 2. Opponents of fixed exchange rates argue that central banks should be free to pursue whatever policies are necessary for full employment.

V. SHOULD CAPITAL FLOWS BE CONTROLLED? A. Controls may be applied to either capital outflows or capital inflows (or both). 1. To prevent devaluation or depreciation of its currency, a country may impose controls to prevent the capital outflow. 2. To prevent appreciation or revaluation of its currency, a country may impose controls to prevent capital inflow. B. Capital controls may include outright bans and the taxing of capital transactions. 1. In 1972, James Tobin proposed that a tax be applied to foreign-currency transactions in order to reduce the short-term volatility of capital flows. C. The Traditional View of Capital Flows Instructor's Manual  245

1. The traditional view is that capital should be free to flow. 2. Proponents claim that capital controls are ineffective. 3. Proponents claim that controls invite corruption among government officials and disrespect for the law. D. Claims by Proponents of Controls 1. Capital flows can result in large changes in prices and exchange rates, which destabilize the economy. 2. Capital controls allow time for countries to initiate new policies and undertake fundamental reforms in their banking systems and financial markets.

VI. THE ASIAN FINANCIAL CRISIS A. Prior to the crisis, the affected countries were growing rapidly with low unemployment, moderate inflation, budget surpluses, and moderate current account deficits. B. A large increase in foreign-bank lending took place just before the crisis and many of these loans were questionable. C. Several events triggered the crisis in 1997. 1. Two large Korean conglomerates failed, and Korea’s third largest automaker, Kia, was in great difficulty. 2. In Thailand, nonbank financial companies were experiencing difficulty because of bad real estate loans. 3. In July of 1997, the Bank of Thailand announced that the baht would be allowed to float (instead of remaining fixed). a. The baht depreciated significantly. b. Other currencies plummeted as speculators sold them and capital flowed from the countries c. The crisis spread to stock markets and the real economy.

D. By 1999, the worst was over and the East Asian countries began to grow once more. 1. The International Monetary Fund played a positive role in the recovery.

Answers to Review Questions

1. Even though the United States has a large current account deficit, it has an overall balance of zero. Why, then, is there concern about the large current account deficit?

Most of the deficit in the current account is financed by foreign investment in the United States. So long as this continues, more and more of the nation's assets will become the property of foreigners. As foreign ownership of U.S. assets increases, foreigners will receive more income and interest from the United States. As foreigners receive more, U.S. citizens receive less.

Thus, the United States finds itself in an uncomfortable position. It is dependent on foreign investment to finance the current account deficit. If foreign investment diminishes, it will be forced to reduce the deficit. So long as foreign investment in the country continues, it will be able to finance its current account deficit; however, increasing amounts of U.S. assets will be 246  Chapter 18/The Global Economy: Finance

held by foreigners. There will be a redistribution of income from domestic citizens to foreigners.

2. With regard to the balance of payments, classify each of the following as to whether they fall in the current or capital accounts. Also, indicate whether they are a credit or debit. a. U.S. purchase of beef from Argentina. b. Japanese purchases of IBM stock. c. Your spring break vacation in Mexico. d. A U.S. fast-food chain opening a series of restaurants in Canada.

a. A U.S. purchase of beef from Argentina in an import and thus belongs in the current account. It represents a flow of dollars out of the U.S. so it is a debit. b. A Japanese purchase of IBM stock belongs in the capital account. It is a credit because it is a flow of capital into the U.S. c. Your spring break vacation in Mexico is a debit in the current account because you took dollars out of the U.S. and “left them” in Mexico. d. A U.S. fast food chain opening restaurants in Canada is a debit in the capital account.

3. If the yen-dollar exchange rate is 100 yen per dollar, what is the dollar-yen exchange rate?

The dollar-yen exchange rate is 0.01 dollars per yen, obtained by dividing both sides of the equation: 100 yen = 1 dollar.

4. Explain how exchange rates are determined in a. A flexible exchange rate system. b. A fixed exchange rate system.

a. In a system of flexible exchange rates, exchange rates are determined by the forces of demand and supply. In order to understand this statement, observe the following diagram.

Pounds per Dollar

Dollars

In this diagram, D represents the demand for dollars. It is based on other countries' desire to purchase goods made in the United States and invest in the United States. S represents Instructor's Manual  247

the supply of dollars. It is based on U.S. citizens' desires to purchase goods from Great

Britain and invest in that country. The exchange rate, E1, is determined by the intersection of D and S. Suppose the exchange rate is E2. At this rate, U.S. citizens would wish to purchase more British goods while the British would wish to purchase fewer goods made in the United States. The quantity of dollars supplied would exceed the quantity of dollars demanded. As a result, there would be a tendency for the exchange rate to fall until quantity demanded and quantity supplied were equal.

If the exchange rate were E3, U.S. citizens would wish to purchase fewer British goods while the British would wish to purchase more goods made in the United States. In this instance, the quantity of dollars demanded would exceed the quantity of dollars supplied

and the exchange rate would increase to E1.

b. In a fixed exchange rate system, supply of and demand for currencies do not determine the exchange rate. Instead, central banks intervene in foreign exchange markets in order to keep exchange rates constant. For instance, if the exchange rate is below (above) the rate that equates the quantity of dollars supplied and the quantity of dollars demanded, there will be an excess demand for (supply of) dollars. The exchange rate will tend to rise (fall). To keep the exchange rate fixed the central bank must sell (buy) dollars in foreign exchange markets.

5. Suppose the British pound-American dollar exchange rate falls. Does the dollar appreciate or depreciate? Defend your answer.

Suppose that the British pound-American dollar exchange rate is 5 pounds per dollar. Now, let the exchange rate fall to 4 pounds per dollar. The dollar has just depreciated. A dollar now has less value in terms of pounds. You get fewer pounds per dollar.

6. Suppose the U.S. dollar appreciates relative to the Japanese yen. How will exports and imports of the two countries be affected.

If the U.S. dollar appreciates relative to the Japanese yen, Japanese goods and services will be less expensive to Americans. Americans can now purchase more Japanese goods and services for a dollar. As a result, there will be a tendency for imports to increase. The appreciation will cause American goods to cost more to the Japanese. The yen will now purchase fewer goods and services. As a result, imports will decrease. Thus, appreciation will cause an increase in imports and a decrease in exports.

7. Assuming flexible exchange rates, how will each of the following affect the home country’s currency? a. An increase in real GDP abroad. b. An increase in the home country’s inflation rate. c. An increase in foreign interest rates. d. Renewed confidence in the home country’s economy.

a. If real GDP increases abroad, but stays constant in the home country, the result is that foreigners want to buy more of all goods including goods from our home country, there will be a demand for the home country’s currency, causing that currency to appreciate.

b. If the domestic inflation rate increases relative to the rest of the world, a nation's exports will become less competitive. Other nations will substitute away from these more 248  Chapter 18/The Global Economy: Finance

expensive goods, and the demand for domestic dollars will decreases, thereby pushing down the exchange rate. At the same time, the increase in inflation will make foreign goods look more attractive to domestic citizens. As a result the supply of dollars in foreign markets will increase . This will tend to push down the exchange rate. Thus, the overall effect of an increase in inflation is to cause the dollar to depreciate.

c. If the foreign interest rate increases relative to the domestic rate, other countries will wish to invest less in the United States. This will decrease the demand for dollars and decrease the exchange rate. At the same time, it becomes more attractive for domestic citizens to invest abroad. This will increase the supply of dollars and lead to a decrease in the exchange rate. The overall effect of the increased foreign interest rate is to cause the dollar to depreciate.

d. If there is a renewed confidence in the domestic economy that is felt worldwide, the result is that foreign countries may want to purchase more of our exports. This means a greater demand for the dollar and the dollar will appreciate. At the same time, domestic citizens, feeling the same new confidence, may choose to purchase domestic goods over foreign ones. The result is that there are fewer dollars supplied to foreign markets, which also causes an appreciation of the dollar.

8. What is the euro? Why should Americans be interested in it?

The euro is the single currency of the European Economic and Monetary Union. Currently, the euro is not circulating as currency, but bank accounts, credit cards and travelers’ checks have been denominated in euros since January 1, 1999. The euro will begin replacing each EMU’s currency and coins starting January, 1, 2002.

The countries in the EMU are trading partners with the U.S. and anything that affects their economies has the potential to affect the American economy to some extent. While the move to one currency has some definite advantages for these countries, it also has some associated costs. For one thing individual countries will not be able to engage in independent monetary policy. What if some shock affects some countries more than others? Also exchange rate policies between the member nations is now eliminated. There is the potential for this move to one currency to cause some strain among the relations of the EMU countries.

9. Summarize the advantages and disadvantages of flexible and fixed exchange rates.

There are two primary advantages to flexible exchange rates. Proponents argue that flexible exchange rates result in greater economic stability. For instance, if our trading partner experiences a recession, they will purchase fewer U.S. exports; however, this will be partially offset because, if exchange rates are free to adjust, the U.S. dollar will depreciate, making U.S. exports less expensive for foreign buyers.

Second, if central banks become committed to keeping exchange rates constant, they do so by buying foreign currency with domestic currency. This commitment keep the central bank from being able to alter the domestic money supply in attempt to lower inflation or unemployment. With flexible rates, they are free to pursue monetary policy.

Proponents of fixed rates argue that there is less uncertainty under such a system, but proponents of flexible rates contend that firms can take action to protect themselves from unforeseen changes in the exchange rate. Proponents of fixed rates also argue that flexible Instructor's Manual  249

exchange rates can lead to destabilizing speculation, others disagree. Finally, proponents of fixed rates believe that fixed rates provide a discipline to central banks because they are not free to increase the money supply too rapidly. As mentioned earlier, others believe that central banks need the freedom to pursue policies for full employment.

10. Suppose a country suddenly experiences a capital outflow. Describe the impact on the country assuming a. Flexible exchange rates b. Fixed exchange rates

a. If capital starts flowing from a country with fixed exchange rates, the demand for its currency decreases, causing a balance of payments deficit. The country’s central bank must use its holdings of foreign currencies to buy the domestic currency to keep exchange rates constant. If the central bank has meager balances, they may be forced to devalue their currency.

b. If capital starts flowing from a country with flexible exchange rates, the country’s currency will depreciate.

11. Critically evaluate the following statement: “The Asian financial crisis was about transactions; the countries involved continued to grow.”

This statement is not correct. The Asian financial crisis began primarily in financial markets. For example, in 1997 Thailand’s largest finance company failed. Capital flowed out of the affected countries and central banks decided to let currency float or be flexible. The result is that the value of the currencies plummeted. The crisis next spread to stock markets, and stock prices dropped dramatically. Eventually, the affected economies turned downward. Output decreased and unemployment increased. By 1999, with the intervention of the International Monetary Fund, the East Asian countries began the road to recovery.

12. What impact did the Asian financial crisis have on U.S. exports to that region? Defend your answer.

The crisis clearly meant that U.S. exports to the region would decline. If the value of the Asian currencies plummeted, this means that the currencies lost value next the dollar. For example, it would take a lot more Malaysian ringgits to get one dollar; consequently, U.S. goods became more expensive to the people of Malaysia. Couple this with the receding economy in which Malaysian people had less income with which to purchase American exports, and you get a situation where the U.S. was clearly affected by the crisis.

13. What are capital controls? Why might a country wish to impose them?

Capital controls are mechanisms used to prevent either capital outflows, capital inflows, or both. For instance, the best known approach to this may be the Tobin plan in which a tax is applied to foreign currency transactions. Some countries may impose an outright ban on such transactions. Proponents of controls claim that capital flows can result in large changes in prices and exchange rates, which destabilize the economy. For instance, a sudden inflow of capital into an economy will cause a currency to revalue or appreciate. A sudden outflow of capital will cause the currency to devalue or depreciate, such as what occurred in the Asian financial crisis. 250  Chapter 18/The Global Economy: Finance

14. What is the traditional view regarding capital movements? Why are economists reassessing this view?

The traditional view of capital movements is that capital should be free to flow from countries offering low prospective returns to countries offering higher prospective returns. Barring distortions, such as taxes, this will ensure the appropriate allocation of resources. Events such as the Mexican and Asian financial crises have caused economists and policymakers to take another look at this issue. Proponents of controls claim that capital flows can lead to changes in prices and exchange rates that destabilize the economy (as in Asia); however, in countries that have sound banking systems and well-developed financial markets, capital flows have been less of a problem. Proponents of controls also argue that they allow time for countries to initiate new policies and undertake fundamental reforms in their banking system and financial markets. Some countries have done this, but others have not.