“The Economic Way of Thinking” 11 th Edition

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko

“The Economic Way of Thinking”

11th Edition

Chapter 19:

National

Policies and

International

Exchange

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 2 of 42

Chapter 19 Outline

• Introduction

• Accounting for International Transactions

• Why Credits Must Equal Debits

• Equilibrium and Disequilibrium

• The Ambiguities of International Disequilibrium

• Disequilibrium as a Disguised Policy Judgment


Chapter 19 Outline

• But Will it Go on Forever?

• Foreign Exchange Rates and Purchasing Power Parity

• The Bretton Woods System

• Fixed or Floating Exchange Rates?

• Nobody Knows

• The Trouble We’ve Seen


Chapter 19 Outline

• The Case for a Common Currency

• Private Interests, National Interests, Public Interests

• In Defense of Comparative Advantage

• Globalization and its Discontents

• The Power of Popular Opinion


Chapter 19 Outline

• The Power of Special Interests

• The Outsourcing Controversy: Soundbytes vs. Analysis


Introduction

• Adam Smith

– Believed exports and imports analysis caused absurd speculation.

• However

– Balance of Payments accounting does demonstrate effects of international transactions on national economies

• Balance of Payments always balances


Accounting for International Transactions

• Categories of Balance of Payment Transactions

– Exchange of merchandise– Exchange of services– Exchange of IOUs– Unilateral Transfers


Accounting for International Transactions

• The Balance of Payments

– Exports generate payments into a country or a balance of payment credit.

– Imports generate payments out of a country or a balance of payment debit


Why Credits Must Equal Debits

• Assume:

– Total dollar value of US imports (debits) exceeds the total dollar value of US exports (credits) for a year.

– There are no unilateral transfers.



• Assume:

– Americans owe (IOUs) the difference between imports (debits) and exports (credits) IOUs to foreigners.

– The value of the IOUs equals the difference between imports (debits) and exports (credits).



Imports (debits) = Exports (credits) + IOUs


Equilibrium and Disequilibrium

Disequilibrium implies that something will change.


Equilibrium and Disequilibrium

P

Q

DS

CeilingPrice

P1

Qs Qd

shortage


The Ambiguities of International Disequilibrium

• Since 1983, US merchandise and service imports have exceeded exports.

• When US imports exceed exports, the US exports IOUs.

• The US can export (sell) IOUs because people demand them (i.e., a market for IOUs).


The Ambiguities of International Disequilibrium

Does foreign investment in the US imply that the US economy is weak or

that it is strong?


Disequilibrium as a Disguised Policy Judgment

• The balance of payments reflects our situation, it does not cause it.

• If foreigners don’t invest in the US:

– Disequilibrium might occur and markets would have to adjust


But Will it Go on Forever?

• Claim of disequilibrium

– Prediction that things will change– Adjustments will occur


Foreign Exchange Rates and Purchasing Power Parity

• Foreign Exchange Rates

– Express the relative purchasing power of two currencies.

• Example

– $0.67 = 1 German mark– $0.0067 = 1 Japanese yen



• Example

– Then $1.00, 1.5 marks and 150 yen will buy the same amount of goods in goods in the US, Germany, and Japan, respectively.

• Exchange rates adjust to create a purchasing power parity among national currencies.



• An example:

– $1.00 = 150 yen– If 150 yen will purchase more in Japan than $1.00 will

buy in the US.– Dollar holder will want more yen to increase their

purchasing power.– Yen holder will exchange <150 yen for dollars.



• The expectation that an asset will increase in value

– Causes its value to increase now


The Bretton Woods System

• Bretton Woods System (1944)

– Established fixed exchange rates– Each country was to buy and sell its currency to keep

it pegged at the official rate of exchange with the US dollar.

• Bretton Woods System

– US dollar was the benchmark currency– Dollar was pegged to gold


The Bretton Woods System

• International Monetary Fund (IMF)

– Attempted to provide foreign exchange reserves to help restore equilibrium.

– Divergent policies created disequilibrium.


Fixed or Floating Exchange Rates?

• Early 1970’s

– US abandoned fixed exchange rates.

• Exchange rates have adjusted (floated) to changing economic conditions.

• Since 1975:

– Global volume of trade increased more than twice as fast as global GDP.


Nobody Knows

• The Asian Crisis (1997)

– Fear of devaluation– Foreign investors withdrew funds– Governments and central banks buy own currency to

support value.– May run out of own currency


Nobody Knows

• Possible remedies

– Let the currency value fall– Raise interest rates

• And stop economic growth– Borrow from IMF


The Trouble We’ve Seen

• Assume

– IMF assistance delayed– The country devalues– A “capital flight” occurs– World-wide confidence in investments in foreign

countries falls– Capital begins to exit other countries


The Trouble We’ve Seen

• What if…

– The capital flight of the late 1990s slows world-wide economic growth

– The uncertainty created by the economic weakness in these countries reduces their ability to return to their recent prosperity.


The Case of a Common Currency

• Fixed rates are the ideal system with ideal governments.

• Floating exchange rates are the ideal system when economic polices diverge

• January 1, 1999 – Euro

– Common currency– European Monetary Union– 11 nations


Private Interests, National Interests, Public Interest

• Why does trade occur?

• Who benefits from trade?

• Who benefits from trade restrictions?

– Protection from foreign competitors makes life more comfortable.


In Defense of Comparative Advantage

• The political process may be the greatest barrier to free trade.

• Who has the louder voice?

– Those who expect to gain from restrictions.– Those who expect to lose from restrictions.



• Comparative advantage demonstrates that:

– Exchange creates wealth.– A country cannot become wealthy by exporting more

than it imports.– One country cannot be more efficient than another in

the production of everything.



What are the arguments for trade barriers?


Globalization and Its Discontents

• Some believe

– Large corporations are in a global quest to help the “have-nots” of the world.

• Others say

– Large corporations will “roll over” the poor in searching for profits.


Globalization and Its Discontents

• Evidence suggests globalization achieves positive changes:

– Lifts up the poor from miserable poverty.– Environmental quality improves.– Workers better off.

• Income • Working conditions


The Power of Popular Opinion

• Strong opinions are not the same as valid arguments.

• Popular opinion often focuses on the consequences of public policy.

• Exchange and production emerges from globalization.

– Usually a marked pattern of improvement.


The Power of Popular Opinion

• Productivity increases sourced from

– Labor skill improvements.– Technological knowledge increases.– Improvements in economic organization.

• Globalization brings all from

– More developed world to– Less developed world


The Power of Special Interests

• Politics exhibit a short-sightedness in economic decision making.

– Concentrated benefits bias– More so in non-democratic governments that are not

secure.


The Outsourcing Controversy:Soundbytes vs. Analysis

• Number of jobs lost in the US due to outsourcing of jobs to foreign workers

– Miniscule compared to size of US economy

• Law of comparative advantage works

– Trade between nations is positive-sum


Once Over Lightly

• Balance of payments (credits = debits)

• Disequilibrium in balance of payments implies credits and debits are not equal.

• Foreign exchange rates link relative prices in nations with separate currencies.

• Exchange rates can be set arbitrarily by governments.


Once Over Lightly

• Fixed exchange rates reduce uncertainty and promote trade but presuppose compatible economic policies.

• The Asian Crisis

• Floating exchange rates

• The Euro as a common currency

• Debate over globalization


End of Chapter 19

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