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6-1 The Terminology of TradeIn discussing the international flows of goods, services, and capital, we have made some

important simplifications. We have used the terms net exports and trade balanceinterchangeably, although in practice these terms sometimes differ slightly in meaning.More importantly, we have also shown how the simple income identity requires that netexports equal net capital outflow, although in practice this is not precisely correct. Thesesimplifications helped us highlight the important features of the analysis without bringing in too much detail. This supplement provides some additional background on conceptsrelating to the international flow of goods, services, and capital.

The term trade balance is sometimes used to describe merchandise trade or the partof trade involving only goods, not services. When the term is used in this way, it is notequivalent to net exports. Net exports include trade both in goods and in services. Fornational income accounting this distinction is important because net foreign demand fordomestic production includes purchases of services as well as goods.

Another simplification we have made is to equate net exports with net capital outflow.

Because residents of a country may earn interest on assets held abroad and/or earn wagesfrom working abroad, national income may differ from GDP. In addition, because residentsof a country may give gifts to and/or receive gifts from foreigners, their income again maydiffer from GDP. These net factor payments and net foreign transfer payments are importantin measuring domestic saving and thus in measuring the difference between domestic saving and domestic investment. Since the difference between domestic saving and domesticinvestment equals net capital outflow, these payment flows have implications for therelationship between net exports and net capital outflow.

To see how this changes the basic identity, first rewrite the GDP identity

Y = C + I + G + NX

as

Y + Net Factor Payments + Net Foreign Transfers= C + I + G + NX + Net Factor Payments + Net Foreign Transfers,

where income includes net factor payments from abroad and net transfer payments fromabroad. Rearranging this equation gives

Y + Net Factor Payments + Net Foreign Transfers C G I = NX + Net Factor Payments + Net Foreign Transfers.

As in the text, domestic saving is given by income minus spending, so we can rewrite thisequation as

S I = NX + Net Factor Payments + Net Foreign Transfers

or

Net Capital Outflow = Current Account.The modified identity thus relates a broader measure of trade flowsknown as the

current account to net capital outflow.One final term sometimes used in place of net capital outflow is the capital account.

When we experience positive net capital outflow, the capital account is said to be in deficitwe are purchasing more foreign assets than foreigners are purchasing our assets (orequivalently, we are making more loans to foreigners than they are making to us). Thus, thecondition that the current account equal net capital outflow is sometimes described by thecondition that the current account and capital account must sum to zero.

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6-2 Saving and Investment in Open EconomiesOur theory of the small open economy suggests that there should be no simple link between

the level of saving and the level of investment. With perfect capital mobility, the level of investment depends primarily on the world interest rate, whereas the level of saving depends on the level of domestic output. Martin Feldstein and Charles Horioka made asomewhat surprising discovery in the face of this theory: There is a close correspondencebetween saving and investment in many countries. 1 Figure 1 illustrates the FeldsteinHorioka finding: It shows a scatterplot of domestic saving and domestic investment, eachexpressed as a percentage of gross domestic product, for 21 countries. 2

140

0.380.360.340.320.30.280.2 0.22 0.24 0.26

0.24

0.230.22

0.21

0.2

0.19

0.18

0.37

0.360.350.34

0.33

0.32

0.310.3

0.29

0.28

0.27

0.26

0.25

0.18Saving/GDP

I n v e s t m e n

t / G D P

The Saving Investment Correlation

Figure 1

Source: M. Feldstein and C. Horioka, Domestic Saving and International Capital Flows, Economic Journal 90 (June 1980): 319.

1 M. Feldstein and C. Horioka, Domestic Saving and International Capital Flows, Economic Journal 90 (June 1980): 31429.2 The countries are those of the OECD except Iceland, Portugal, Turkey, and Yugoslavia. The data cover the period 19601974. Figure 1 is constructed

from the data in Feldstein and Horioka, ibid., Table 1.

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Chapter Supplements 141

Feldstein and Horiokas work has been updated and modified by many authors over theyears. Although the correlation between saving and investment rates varies with particularssuch as which countries are included and which time periods are considered, the basicfinding remains the same: Countries that have high saving rates are also countries withhigh investment rates and countries with low saving rates are also countries with low

investment rates.Should we conclude that capital is actually immobile? Not necessarily. Other evidenceshows that interest rates on comparable assets are quite similar even though the assets arelocated in different industrial countries. 3 And casual observation finds that financial mar -kets seem to have become more global over time. Furthermore, since saving and investmentare both endogenous variables, common influences on saving and investment could yield apositive correlation even if capital is completely mobile across national boundaries.

Concern about common influences is the main reason why Feldstein and Horiokaaveraged saving and investment rates across long periods of time and studied the cross-country relationship. This technique allowed them to separate the effect from short-run busi -ness cycle fluctuations that may induce a correlation between saving and investment with ina country from year to year. But even over long periods of time, saving and investmentcontinue to be endogenously determined, and common influences may still be important.

One way that a correlation might occur is in response to sustained shifts in a countrysproductivity or demographics that lead to an increase in its long-run investment rate and itslong-run saving rate. 4 For instance, a technological advance in one country may increaseinvestment at the world interest rate and, because it also increases income, may lead to anincrease in saving. Another possible reason for the correlation is that government policiesmay be oriented to running zero average trade deficits because certain constituencies favorbalanced trade. Thus, saving and investment may be forced into equality over time throughthis policy of an average trade deficit equal to zero.

Finally, as Supplement 5-3 emphasizes, long-run budget constraints apply equally tocountries, just as they do to governments or households. Accordingly, a country cannot bor -row (or lend) forevereventually the foreign debt will have to be repaid. This means thatover long periods of time, a country will tend to have balanced trade and saving will tend toequal investment.

3 For details, see the survey by M. Obstfeld, International Capital Mobility in the 1990s, in P. B. Kenen, ed., Understanding Interdependence: The Macroeconomics of the Open Economy, Princeton: Princeton University Press, 1995.

4For details, see M. Obstfeld and K. Rogoff, Foundations of International Macroeconomics, Cambridge: MIT Press, 1996, 16164. See also L. Tesar,Savings, Investment and International Capital Flows, Journal of International Economics, 31 (1991), 5578.

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6-3 The Open Economy in the Very Long RunThe small open economy model of Chapter 6 explains that the trade balance is determined in

the long run by the levels of domestic saving and investment. For example, if domesticsaving is less than domestic investment at the world interest rate, then net exports arenegative and there is a trade deficit. The counterpart to this trade deficit is an increase inindebtedness to foreigners.

The model of Chapter 6 evidently cannot describe the economy in the very long runbecause a country cannot run large trade deficits forever. 1 At some point, the foreign debtmust be repaid. Something is, therefore, missing from the Chapter 6 model if we wish to talkabout the very long run.

One approach to this problem is simply to recognize that aggregate saving andinvestment are indeed aggregates of the behavior of individuals, firms, and the government.

At any given point in time, an individual may be in deficitthat is, she may be spending more than she is earning. But, as emphasized in Chapter 16 of the textbook, individualsmake their consumption and spending decisions by looking over their entire lifetime. An

individual who borrows now expects to repay laterit is not possible always to spend inexcess of income. The same kind of intertemporal budget constraints apply to firms and tothe government. As a result, a trade deficit today will be matched by a trade surplus at somepoint in the future.

We can capture these kinds of ideas by a very simple amendment to our model.Suppose that consumption depends not just on current income but also on wealth:

C = C(Y T, W ).(As explained later in the textbook, we can derive such a consumption function from arealistic theory of consumption behavior.) Now, suppose that, in the long run, a country issaving less than it is investing and hence running a trade deficit. Foreigners are purchasing domestic assets, so domestic wealth is falling. As a consequence, consumption will fall andsaving will increase over time. The increase in saving will tend to reduce the trade deficit. In

the very long run, the economy will be in equilibrium where net exports equal zero. In thiscase, saving equals investment and so wealth is constant.

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1It may be possible for a country to have persistent small trade deficits, provided the foreign debtGDP ratio is not increasing over time.

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6-4 Benefits of a Trade Deficit A common misconception on the part of the public is that trade deficits are bad for a country

because they reflect either unfair trade by foreign countries or a lack of competitiveness athome. But since the trade deficit is ultimately determined by the difference betweendomestic saving and domestic investment, we need to understand how macroeconomicpolicies influence saving and investment before making judgments as the whether a tradedeficit reflects good or bad policy. The following article from The Washington Post illustratesthis point and also describes how the trade deficit may work as a safety valve for an economythat is growing more rapidly than its trading partners.

Our Friend, the Trade Deficit

143

It helps to keep the economy fromoverheating and inflation down.The U.S. trade deficit ballooned to a recordlevel last year [1998], reaching $233 billionon a current-account basis. Although thedeficit was smaller relative to the economythan the previous high reached in 1987,projections for this year show it widening tomore than $300 billion and place the gap atan all-time high as a share of the economysoutput. The burgeoning deficit is likely tofuel protectionist sentiment alreadysimmering in the steel industry and farmsector. And presidential hopeful PatBuchanan has pledged to make the tradedeficit a central issue in next years

campaign.But the deficit is not caused by, andshould not be attributed to, unfair practicesof our trading partners. While ensuring fairplay in international markets must alwaysbe an important aim of U.S. trade policies,the overall deficit says nothing at all aboutthe success or failure of those policies.Instead, the expanding deficit is largely asymptom of faster economic growth at homecompared with growth abroad, which hasspurred a greater rise in imports to theUnited States than exports from the United

States. This widening shortfall betweenreceipts for exports and payments forimports requires Americans to borrow morefrom abroad. Whether this rise in foreignborrowing is good or bad depends onwhether it helps finance an increase indomestic investment or merely substitutesfor a decline in national saving.

As in the 1980s, foreign borrowing hasrisen during recent years in line with anexpanding trade deficit. But this time

around, the rise in foreign borrowing hasbeen associated with an investment boomthat has outpaced a solid gain in nationalsavingunlike the 1980s, when the rise inforeign borrowing largely offset a sharpdrop in national saving. Accordingly, themushrooming trade deficit along with theconcomitant increase in foreign borrowing are helping support a rising rate of invest -ment that already may be paying dividendsthrough the recent step-up in U.S. produc -tivity.

Investment has surged by about threepercentage points as a share of grossdomestic product since the currentexpansion began in 1991, while the share of

national saving has risen roughly 1.5percentage points. The larger increase ininvestment compared with saving has beenmade possible by a jump in net foreignborrowing and the trade gap from roughlyzero in 1991 to about 2.5 percent of grossdomestic product in 1998. By comparison,the share of investment rose by just underone percentage point, and the share of national saving fell by two percentagepoints between 1982 (when the 1980sexpansion started) and the peak trade-deficit year of 1987. This drop in saving was

offset by a rise in net foreign borrowing andthe trade deficit from about zero in 1982 tomore than 3 percent of gross domesticproduct in 1987.

The gain in national saving during the1990s may seem surprising given recentattention-grabbing headlines about thepersonal saving rate falling below zero. Butalthough private saving has droppedsharply, government saving has risen bymore, pushing up national saving. The rise

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in government saving reflects an enormous swing in the federal budget from a deficit of $290 billionin fiscal year 1992 to a surplus of $69 billion lastyear.

By contrast, during the early 1980s a decline

in private saving was accompanied by anexploding federal budget deficit and a substantialdrop in national saving. A common refrain of thosedays highlighted the evils of twin deficits, where -by foreign borrowing was seen as financing fiscalprofligacy. But because todays widening deficithas supported a surge in investment financed byforeign borrowing, this solo deficit will pay off over time in productivity gains and a rising standard of living.

Besides financing investments for the future,the trade deficit also provides economic benefitstoday. First, the deficit helps keep the economy

from overheating as strong growth in business andconsumer spending is met with imports. Thissafety valve has allowed the economic expansion tocontinue into its ninth year without hitting thecapacity limits and bottlenecks so often seen atmature stages of an expansion.

Second, the rising trade deficit had beenaccompanied by a decline in prices of importedgoodsuntil recently, especially oil and relatedproductskeeping a lid on inflation despite tightlabor markets. The rate of unemployment hasbeen at or below 4.5 percent for the past year, andbelow 5 percent for well over two years, withabsolutely no sign of price pressure.

Finally, increased foreign competition asso -ciated with the widening trade gap has spurredrecent gains in productivity as U.S. firms areforced to improve their efficiency. Indeed, thestrongest gains in productivity during the past few

years have been in the manufacturing sector,precisely where foreign competition has beenkeenest. Perhaps the best example is the signi -ficant gain in productivity over the past decade inU.S. auto manufacturing, which is universally

viewed as a response to intense com petition fromabroad. And while such gains may sometimesresult in lost jobs, the appropriate policy responseis not to pull up the drawbridge and refuse tocompete but to provide adjustment and training assistance to workers.

Over the next year, international trade criticslikely will point to record-breaking U.S. deficits as

a symptom of failed trade policies and unfaircompetition from abroad. But the trade deficit tellsus nothing about whether competition is fair orunfair in any particular marketonly economicanalysis on a case-by-case basis can uncover

violations of trade rules. The deficit, however, doesreflect a shortfall of national saving relative todomestic investment. And on this score, thedeficits recent rise has been associated with asurge in investment that should enhance futureeconomic performance.

144 C H A P T E R 6 The Open Economy

Source: Robert G. Murphy, Our Friend, the Trade Deficit, The Washington Post, Friday, May 21, 1999; A31.

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A D D I T I O N A L C A S E S T U D Y

6-5 How Businesses Respond to the Exchange RateCompanies engaged in international trade monitor the exchange rate closely. The following

article from the New York Times shows how some industries responded in early 1993 to afall in the real exchange rate. According to the article, net exports do respond to changes inthe exchange rate, but the response may take some time.

Source: New York Times, April 26, 1993, D1.

145

The Clinton Administration is proclaiming the dollars latest plunge against the yen asa windfall for Americaone that shouldfinally shrink the nations painful tradedeficit with Japan. The stronger yen is thebest single thing that could have happenedto the trade deficit, a senior Adminis -tration official said last week.

But improvement is not likely to comequickly, even though a stronger yen pushesup the price of Japanese goods sold in theUnited States while enabling Americanproducts to be sold for less in Japan.Indeed, the yen might have to stay strong for two years or more, many experts say, tohave much impact on American-Japanesetrade. The reason is that American andJapanese companies are resisting anyadjustment in prices to reflect the changing

values of their currencies.

Cooper Industries, for example,exports spark plugs and crankshafts toJapan, but as with many Americancompanies, Cooper says it will not cut theyen prices of its products. . . .

But the stronger yen and weakerdollar certainly give American companies apricing advantage in their competition withthe Japanese, if the companies want to useit. In two months, the dollar has fallen 11percent against the yen, to 110 yen to thedollar, compared with 124 in February. At110, the level is the lowest since World War

II. That means that an American-madespark plug sold in Japan for 124 yen nowbrings the manufacturer $1.11, rather than

$1 collected in February. That leaves roomto cut the yen price, which could increasesales in Japan.

The Japanese, conversely, must raisedollar prices in the United States to collectthe same number of yen once the dollars areexchanged for the Japanese currency. A fewcompanies, including Honda and Nissan,announced price increases this month . . . .

The Clinton Administration iscounting on the yens strength to shrink thetrade deficit . . . . Administration officialseven cite a trade theory that says that forevery 1 percent increase in the value of theyen, the trade deficit with Japan willeventually shrink by $5 billion.

The Boeing Companys transactionswith Japan tend to support this theory.Boeing prices the planes it sells to Japan indollars, not yen. So the fall in the value of

the dollar means that the Japanese canspend less in yen to buy the dollars to buythe planes.

We sell planes under long-termnegotiated contracts, and we dont expectany impact on prices from the latestcurrency changes, said Paul Binder, aBoeing spokesman. Boeing, the nationssingle biggest importer, sold the Japanese$2.5 billion in commercial airliners lastyear, or 5 percent of the total Americanexports to Japan in 1992. The shipment toJapan will be similarly large this yearand

less costly to the Japanese in yen, whichcould encourage them to buy more planes.

No Quick Gain from Stronger Yen

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A D D I T I O N A L C A S E S T U D Y

6-6 Tourism and the Exchange RateExpenditures on international tourism are likely to be sensitive to changes in exchange ratesbecause a significant amount of tourism probably represents discretionary purchases that aresensitive to relative prices. Vacations taken abroad by Americans contribute to U.S. imports, whileexpenditures by foreigners on visits to the United States add to U.S. exports. Table 1 presents thepercentage change each year in real tourism exports and imports between 1973 and 2010, along with a measure of the real exchange rate. As the table shows, the sharp appreciation of the dollarduring the early 1980s was accompanied by a decline in tourism exports and a rise in tourismimportslikely reflecting a decline in foreign visits to the United States and a rise in Americans

venturing abroad. During the mid to late 1980s, as the dollar reversed course, exports rose andimports fell (or generally grew more slowly). In the late 1990s, as the dollar again gained value,exports declined and imports grew more quickly. During the early 2000s, both tourism exports andtourism imports fell sharply as a result of the pullback in travel following the September 11attacks. A rebound in both exports and imports occurred in 2004, as the initial shock of the attacksbegan to recede. By 2005, the expected pattern appeared to be reasserting itself, as a weakening

dollar was associated with increased exports and more slowly growing imports.Table 1Real Tourism Real Tourism Real Exchange Rate

Year Exports (% change) Imports (% change) (Index, March 1973 = 100)1973 18.5 1.2 99.01974 7.1 8.3 95.61975 4.1 2.4 94.51976 13.6 7.0 94.51977 1.3 2.3 92.91978 8.9 5.5 87.31979 11.9 0.9 88.41980 10.8 0.8 89.81981 10.2 8.6 96.61982 9.3 13.5 106.11983 9.8 16.9 110.61984 Break in series Break in series 117.91985 1.8 11.6 122.71986 13.9 6.1 107.41987 12.1 16.8 98.71988 20.6 2.5 92.11989 18.6 3.9 93.81990 18.1 8.8 91.21991 2.8 10.9 89.71992 8.8 3.1 87.81993 3.1 5.9 89.11994 0.5 6.0 89.01995 6.9 2.5 86.51996 7.6 4.6 88.51997 4.1 8.4 93.21998 3.5 12.0 101.21999 0.7 2.5 100.32000 4.4 10.3 104.22001 13.5 7.4 110.22002 6.8 8.5 110.32003 8.0 6.2 103.62004 11.0 9.9 99.02005 4.7 0.8 97.32006 1.3 0.4 96.22007 8.5 2.6 91.62008 9.3 1.7 87.82009 9.5 6.9 91.42010 5.5 1.1 87.1

Source: U.S. Department of Commerce, Bureau of Economic Analysis and Federal Reserve Board. Note: Real tourism exports and imports are constructed by summing travel and passenger fare categories measured in 2005 chaineddollars available from the National Income and Product Accounts (http://www.bea.gov). The real exchange rate is a weightedaverage of the foreign exchange values of the U.S. dollar against the currencies of a large group of major U.S. trading partners. Theindex weights, which change over time, are derived from U.S. export shares and from U.S. and foreign import shares. For details onthe construction of the weights, see the Winter 2005 Federal Reserve Bulletin.

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6-7 The Exchange Rate and the Inflation RateThe relationship between the nominal exchange rate and the inflation rate is particularly

evident for countries experiencing hyperinflation. If the price level in one country isincreasing rapidly, then movements in foreign prices and in the real exchange rate will berelatively insignificant. We therefore expect to see depreciation of the domestic currency at arate approximately equal to the inflation rate. Figures 1 and 2 illustrate this for the Israeliand Mexican hyperinflations of the 1980s. 1

147

1Figures 1 and 2 present changes in the logarithms of the two variables. The change in the logarithm is a measure of the growth rate of a variable. Theclose negative relationship between the inflation rate and the change in the exchange rate thus illustrates that price level increases were indeedmatched by currency depreciation. See Supplement 7-5, Growth Rates, Logarithms, and Elasticities, for more information on growth rates andlogarithms.

P e r c e n t

Change in log CPI

Change in log exchange rate

Inflation and Exchange Rate Change,Mexico, 19841994

Figure 2

100

75

50

25

0

25

50

75

1001984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

180

140

100

60

20

20

60

100

140

1801979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990

Change in log CPI

Change in log exchange rate

Inflation and Exchange Rate Change,Israel, 19791990Figure 1

P e r c e n t

Source (Figures 1 and 2): International Monetary Fund, International Financial Statistics.

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A D V A N C E D T O P I C

6-8 Covered Interest ParitySuppose that a U.S. company wishes to purchase goods from a U.K. producer. The U.S. firm

agrees to take delivery of the goods three months hence and to pay an agreed-upon price inU.K. pounds at that time. The U.S. company, however, might be concerned about exactlywhat was going to happen to the dollarpound exchange rate over the next three months. 1 Itcan avoid this uncertainty by buying U.K. pounds at the forward rate. Internationalfinancial institutions not only buy and sell currencies at the current ( spot ) rate, they are alsowilling to write an agreement to exchange currencies at a future date and at a prespecifiedrate. Thus, if the U.S. company needs 10,000 pounds in three months time, it knows nowthat it will have to pay 10,000/ f dollars at that time, where f is the appropriate forward rate. 2

There is an important relationship between the spot rate ( e) and the forward rate ( f )that is guaranteed by arbitrage . An investor could take a dollar, invest it at the U.S. interestrate (say in three-month Treasury bills), and earn (1 + i) dollars at the end of three months.

Alternatively, she could convert her dollars into pounds (obtaining e pounds), invest thosepounds at the U.K. interest rate [obtaining e(1 + i*) pounds at the end of three months], and

then exchange those pounds for dollars at a previously agreed-upon forward rate. Thesetransactions would earn the investor ( e / f )(1 + i*). Both transactions must yield the samereturn, for otherwise, she could make arbitrarily large riskless profits by borrowing in onecountry and investing in the other.

Thus, we have

1 + i = ( e / f )(1 + i*).If we define the forward premium to be ( f e )/ e, then we have a good approximation 3:

Premium i* i.The premium will be positive (i.e., the forward rate will be above the spot rate) if the U.K.interest rate exceeds the U.S. interest rate. The premium will be negative if the opposite istrue.

The forward rate should be a good predictor of the future spot rate. To see this, notethat if investors expect the spot rate in the future to be lower than the forward rate, theywould buy pounds forward. For each pound, they agree to pay 1/ f dollars. They expect eachpound to be worth 1/ ee dollars, where ee is the expected future spot rate, so they expect tomake a profit. Similarly, if investors expect the spot rate in the future to be higher than theforward rate, they will sell the foreign currency forward. Thus, we can look to the forwardrate for information about the markets expectations of exchange rate movements. 4

Remember also that we expect to see appreciation of the nominal exchange rate in thelong run if domestic inflation is lower than overseas inflation. Thus, one reason why wemight see a positive forward premium is that domestic inflation is relatively low, soinvestors expect the dollar to be more valuable in the future.

148

1This is a particular concern since exchange rates can be quite volatile in the short run. See Chapter 13 of the textbook and Supplement 13-11,Exchange Rate Volatility.

2Note that we are, of course, defining the forward rate ( f ) in an analogous manner to the spot rate ( e)it is the number of units of foreign currency perdollar.

3To see this, let the premium be p . Then, f / e = 1 + p , so the arbitrage condition is (1 + p )(1 + i) = (1 + i*). Since p and i are small numbers, their productis very small and can be ignored; multiplying out thus gives the result in the text. Note that this is exactly the same as the reasoning used to derivethe Fisher equation (Supplement 5-6, Deriving the Fisher Equation).

4This underlies uncovered interest parity, which is discussed in more detail in Supplement 13-7, Uncovered Interest Parity.

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6-9 Purchasing-Power Parity and Real Exchange RatesIf the principle of purchasing-power parity provided an accurate theory of real exchange rate

determination, then we would expect real exchange rates to be relatively stable. Major short-run fluctuations in the real exchange rate would not occur because of arbitrage in goodsmarkets. Such stability is, quite simply, not observed in the data. As an example, Figure 1shows the real exchange rates for Canada, the United Kingdom, and Japan. Economists,therefore, look to behavior in financial markets rather than goods markets for explanationsof short-run fluctuations in exchange rates.

149

160

120

140

80

60

100

40

1973 1976 1979 1982 1985 1988 1991 1994 20001997

Canadian Dollar

UK Pound

Yen

2003 2006

Figure 1 Real Exchange Rates, 19732009(Foreign Currency per U.S. Dollar, Index, 1973 = 100)

2009 Source: Federal Reserve Board and U.S. Department of Labor, Bureau of Labor Statistics.

Note: Real exchange rate is computed as nominal exchange rate multiplied by ratio of U.S.consumer price index to foreign consumer price index.

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C A S E S T U D Y E X T E N S I O N

6-10 More on the Big Mac and PPPThe following graphs use the series of Big Mac prices and exchange rates collected by The

Economist to illustrate the failure of PPP.1

For each of the four countries (Canada, Germany,Hong Kong, and South Korea), the graph shows the actual exchange rate (foreign currency perU.S. dollar) and the exchange rate implied by PPP. The latter is simply the ratio of the price of a Big Mac in each country to the price of a Big Mac in the United States, both prices measuredin local currency terms. If PPP held, the actual exchange rate and the PPP implied exchangerate would be the same. If the actual exchange rate is above the PPP implied exchange rate,then the dollar is said to be undervalued . If the actual exchange rate is below the PPP impliedexchange rate, then the dollar is said to be overvalued.

The dollar was undervalued relative to the deutsche mark throughout the sampleperiod. Thus, it cost more to buy a Big Mac in Hamburg, Germany, than in Hamburg,Connecticut. In contrast, the dollar was overvalued relative to the Hong Kong dollarthroughout the sample period. Thus, it cost less to buy a Big Mac in Hong Kong than in theUnited States. (Hong Kong fixes the value of its currency relative to the U.S. dollar, which

explains the lack of variability in the exchange rate line in the graph.)For most of the sample period, it would have been cheaper to buy a Big Mac in

Windsor, Ontario, than in Detroit, Michigan, with the exception of 1992, when the reversewas true. From 1989 through 1997, a U.S. traveler to Seoul, Korea, would be advised tosquelch the urge to have a Big Mac attack until he were back on American soil. While the

Asian financial crisis resulted in a sharp appreciation of the dollar relative to the won, therelative price of a Big Mac in Seoul did not rise nearly as much. As a result, it is nowcheaper to consume a Big Mac in Seoul than in San Francisco.

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1 A number of studies use the Big Mac data to analyze PPP. See, for example, R. Cumby, Forecasting Exchange Rates and Relative Prices with theHamburger Standard: Is What You Want What You Get With McParity? National Bureau of Economic Research Working Paper no. 5675 (July1996); M. Pakko and P. Pollard, For Here or To Go? Purchasing Power Parity and the Big Mac, Federal Reserve Bank of St. Louis Review(January/February 1996): 321; L. Long, Burgernomics: The Economics of the Big Mac Standard, Journal of International Money and Finance(December 1997): 86578; R. Click, Contrarian MacParity, Economics Letters (November 1996): 20912.

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e PPP

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19981997199619951994199319921991199019891988

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PPP

D M / U S $

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e PPP

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South Korea

Chapter Supplements 151

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