ECO 204--Part Four Notes
The final quarter! We turn our attention to
international economics--international trade, trade barriers,
exchange market, and the economics of poor countries.
There is NO CLASS on Friday, March 30, 2007. The classroom has
been confiscated for use in the RISE symposium. As a result, QUIZ #6 will
be on Wednesday,
April 11. QUIZ #7 will be on Friday, April 20. The last subject
matter is about poor countries.
You will need to read this material, which is at the end of part four notes.
It's an easy read!
Global macro economics
This begins our inquiry into international
economics. We start with some facts, then move to
nations trade and how trade is financed with different currencies.
economics is important because there is increasing activity
between the United States and
foreign interests. Let's not overstate its
importance, however. Exports in the United States
are about 10.7 percent of GDP and imports are about 16.3 percent. That's a smaller international
sector than a number of other countries, e.g. the United Kingdom.
At the outset, it is important to understand that
a very important reason for international
trade is imports. We want things we cannot produce, e.g. coffee. We
also want things
which can be produced more efficiently in other countries. A second reason
want to trade is because there are profits to be made from exporting goods and
services to other countries.
What determines the level of our imports?
Imports depend on our domestic level of income
and on relative prices. The
higher our income, the more we import. Part of the reason we
import more than we export is because of our robust economy
which gives rise to a demand
imports. Prices are also important. We import VCRs because they are
cheaper than VCRs
we make ourselves.
There is also a marginal propensity to import (MPIM).
It is equal to the change in imports
divided by a change in GDP.
What determines the level of our exports?
They depend on income levels in other countries--not
on our domestic
GDP. If another country's income increases, they will want more goods and
services from us--just as we want more from them when our income rises.
are also a factor in determining the level of our exports.
Equilibrium conditions with the foreign sector
Our last visit to the aggregate demand and
aggregate supply model showed aggregate demand as
consisting of C + I + G.
That is now expanded to include net exports, that is the difference
exports (X) and imports (IM). As seen above, net exports are presently
because imports exceed exports. That causes total output to be
lower than without the
foreign sector, but not by much. Net exports are
presently negative 5.6 percent of GDP.
The now familiar equilibrium
looks like this:
Because there is a marginal propensity to import,
the value of the multiplier is affected. The
value will be lower with
imports than it was in our earlier "closed economy" multiplier.
formula for the multiplier now is:
MPS + MPIM
If the MPS is .1 and the MPIM is .05, the
multiplier would be 1/0.15 = 6.7. In our closed
economy multiplier, with
no MPIM, the multiplier would be equal to 10.
Changes in exports and/or imports affect the
level of real output. Look at the diagram
above and note that an increase
in exports would shift AD to the right and increase both
real output and the
price level. An increase in imports leads, ceteris paribus, to a
decrease in domestic real output. But that's not all bad. Imports
permit us to enjoy
things not included in our measure of GDP.
One of the most frightening words in the popular
press is "imbalance." A trade imbalance and a capital imbalance
are commonly regarded as evil. (So are unbalanced diets.) A trade
imbalance is when imports exceed exports--i.e. we spend more dollars on foreign
goods than we receive from selling our goods to foreigners.
There is really nothing inherently good or bad
about a trade deficit or a trade surplus. A trade deficit is a bit like
the other foreboding deficit, that being a government spending deficit. When there is a trade
deficit, domestic output is lower than it would be absent the deficit. But
we are consuming things we didn't produce--things we really want. That
leads to higher living standards.
What, then, is the problem with a trade
deficit? It causes problems with domestic macro policy and might frustrate
our efforts to attain full employment. (Surpluses can also cause problems
for domestic policy.) Suppose we are fighting recession--with any of
the anti-recession policies we have available. If those policies work (which, as we
have seen, they might not), then income increases, imports will increase, and
real output is lower. If we are fighting inflation and the inflation rate
falls, then exports increase. An increase in exports increases aggregate
demand which increases the price level.
It can be more confusing, because foreign
governments may also be following domestic policies which can affect our imports
and exports. If we have a trade deficit, some other countries will have a
surplus. That surplus might cause them inflation problems. They fight that
inflation and, if successful, we may import more which reduces our domestic
output. And on and on. You get the point, however.
Now we change the meaning of
"capital." Here we use the financial meaning of the
term--money. Capital (i.e. money) flows in and out of an economy for a
number of reasons:
rate differentials among countries
opportunities for business firms
traveling in other countries
Does a capital flow also affect domestic macro
economic policy? Yes it does. Consider one example. Suppose we
have a restrictive monetary policy to fight either real or imaginary
inflation. This, as we have seen, leads to higher interest rates.
That attracts foreign investment to the U. S. But the increase in foreign
investment increases the supply of investment funds which reduces interest
rates. That makes it harder for the Fed to attain its objectives.
So what do we conclude from all this? As we
have seen, and will see more clearly shortly, there are MANY benefits to
international trade and investment. There is also a cost in the form of
constraints on domestic policies which result from international trade and
As noted earlier, we import things we don't
produce very well--coffee, bananas and platinum. Other countries buy
things from us they can't produce-e.g. wheat, soybeans and airplanes. Why
do we import things we also export--e.g. clothing and cars? So, why do
countries trade? They trade because of the
principle of comparative advantage.
Comparative advantage--a simple illustration
The principle of comparative advantage is a
little tricky. We will start with a very simplified
comparative advantage. Then, in the next class, will do a more expanded
analysis. The simple analysis which follows is not very realistic, but it
will help you to
think about international trade.
Here comes the simple illustration. Suppose we
have two countries, the United States and
Cleveland. (Sorry if I offend
those of you from that foreign country of Cleveland!) Assume
countries produce exclusively either widgets or gidgets, and that one person
one day can produce the following dollar amounts of widgets or gidgets:
The United States is a richer country than Cleveland, and one
person working one day can produce more widgets than Cleveland and more gidgets
than Cleveland. In economics jargon, that says that the United States has
an absolute advantage in both widgets and gidgets. Does that
mean there is no benefit to trading? NO!
The United States can produce a larger value of widgets per
day than it can gidgets. Cleveland,
however, can produce a larger value of
gidgets per day than it can widgets. Economists observe
that the U. S. has a comparative
advantage in widgets, while Cleveland has a comparative
advantage in gidgets. Here is the surprising thing about this
countries will benefit by producing the good in which
they have a comparative advantage
and then trade with the other country.
If we consider two persons working one day, and there is no
trade, then the United states can
enjoy $100 worth of widgets and $50 worth of
gidgets. Cleveland, with two persons working
one day without trade, can
enjoy $20 worth of widgets and $40 worth of gidgets. What if the
uses its two persons working one day and produces only widgets? That would
an output worth $200. And what if Cleveland uses its two persons
working one day and
produces only gidgets? That would involve an output in
Cleveland of $80. The U. S.
could trade with Cleveland and could use
its $200 worth of output to buy $100 in widgets
domestically and another $100 in
gidgets imported from Cleveland. Cleveland could
produce a daily output of
$80 and buy $40 in widgets domestically and import $40 of
widgets from the U.
S. So with trade, the U. S. could have $100 worth of widgets and
$100 worth of gidgets (for two days of labor)--and Cleveland could have $40
widgets and $40 worth of gidgets (for two days of labor).
That's a better outcome than
what happened with no trade. TRADE
IMPROVED THE OUTCOMES OF BOTH THE
UNITED STATES AND CLEVELAND.
Producing those goods in which a country has a
comparative advantage and trading
with other countries for goods in which they have
a comparative advantage
benefits both countries--even if one country has an absolute
advantage in both
As noted, this illustration is very
simplified. It assumes that both countries produce only
widgets or gidgets.
Next we look at a better example that will help you better understand
of comparative advantage.
Comparative advantage--extended illustration
Assume the following annual production possibilities for bread
and wine in France and in the United States. This is depicted as linear,
for simplification (even though we saw earlier that production possibilities
frontiers aren't really linear). Assume that the numbers represent
zillions (or whatever) of loaves of bread and zillions of bottles of wine.
Now we need to draw graphs of these production
possibilities. Here they are:
Suppose there is no trade and that the U. S chooses point D
which involves 40 units of bread and 30 units of wine. These outputs are
determined by the usual market conditions. Also suppose France chooses
point I which involves 9 units of bread and 24 units of wine. Note the total
output of both goods. Total bread output is 49 (40 in the U. S. and 9 in
France) and total wine output is 54. That's okay, but there
are points where total output of both is greater.
Suppose the U. S. produced at point C and France produced at
point K. What would total output be? Total bread output would be 60
units in the U. S. and 3 units in France. That's a total output of 63,
which is better than 49. Total output of wine would be 20 units in the U.
S. and 48 units in France, for a total world output of 68. That sounds
like a better deal, but how do we get there? And could both countries
Suppose the U. S. does produce at point C--60 bread and 20
wine. Also suppose that France decides to produce at point K--3 bread and
48 wine. Here's what might happen:
We offer to send France 6
units of bread in exchange for 20 units of wine. (This is an example only, but
it will show how both countries can benefit. Other trade offers would also
How does this offer benefit both
countries? Look closely--very closely--at this:
|BEFORE trade, France enjoyed 9 bread and 24 wine.
With trade, they produce 3 bread and 48 wine. They send the U. S. 20
wine and the U. S. sends France 6 bread. France now enjoys 9 bread and 28
wine. That's point M on the diagram. FRANCE NOW CONSUMES AT A
POINT BEYOND THEIR DOMESTIC PRODUCTION POSSIBILITIES!
|BEFORE trade, the United States produced 40 bread and 30
wine. With trade, we produce 60 bread and 20 wine. We send
France 6 bread and France sends the U. S. 20 wine. Now the U. S.
enjoys 54 bread and 40 bread. THE UNITED STATES NOW CONSUMES AT
POINT N--BEYOND OUR DOMESTIC PRODUCTION POSSIBILITIES!
That's the basic case for free trade. Both countries are
better off, and both can consume beyond
their domestic production possibilities. Is this some slight of hand?
No. Will it work in all
cases? Generally yes. There are some isolated cases in
which it might not, but generally it
works as in this illustration. Let's
look a little more at what happened--and why--with the
Opportunity costs and comparative advantage
Let's look at the opportunity costs of the two goods in both
countries. The United States can produce a maximum of 100 bread or 50
wine. The opportunity cost of 1 loaf of bread is one-half bottle of
wine. We give up one-half a bottle of wine for an additional loaf of
bread. In France, the opportunity cost of 1 loaf of bread is 4 wine.
(Look back at the table or the diagram to make certain you understand
that.) We export bread because the opportunity cost is lower than in
France. In its best form, that's what comparative advantage means--we have
a comparative advantage in bread because the opportunity cost of bread is lower
(in terms of foregone wine) than in France.
The opportunity cost of wine in the United States is 2 loaves
of bread. In France, the opportunity cost of wine is 1/4 a loaf of
bread. France has a comparative advantage in wine--the opportunity cost of
wine is lower than in the U. S. That's why we export bread to France and
import wine from France.
Notice that we have not said anything about the absolute costs
of production. It doesn't matter. Even if France could produce both
bread and wine at a lower dollar (or euro) cost, we would still export bread
and import wine. If we can get a bottle of wine for less bread by trading
than by producing more bread, we'll do it.
Terms of trade
One final piece will improve your understanding of what's
going on here. The terms of trade refers to the rate at which goods are
exchanged. In the illustration above, the terms of trade for the U. S.
were that 6 bread were exchanged for 20 wine, (or 3.33 wine for each 1
bread). If we wanted 20 more bottles of wine, and we got that wine
internally, we would have to give up 40 loaves of bread. But with trade,
we give up only 6 bread to get 20 more wine. Trade occurs when the
international terms of trade are superior to domestic opportunity cost.
Comparative advantage presents the basic case for free trade,
and the reason why economists typically
favor free trade. Nevertheless,
there are strong voices to impose trade barriers for a variety of reasons.
There are generally four types of trade barriers which nations may erect:
tariffs--designed to keep foreign goods out; not primarily as a revenue
barriers--e.g. licensing, unreasonable standards
We will focus primarily on protective tariffs, with a note
later on about voluntary export restrictions.
Import quotas and non-tariff
barriers have the same general effects as protective tariffs.
General effects of a protective tariff
The following diagram illustrates the general effect of a
protective tariff on a specific good
In the diagram, SF represents the supply schedule
for foreign producers--the amounts they will supply at various prices. The
SD represents the domestic supply schedule and ST
represents the total of foreign and domestic supplies. Notice that below
price "a" there is no foreign supply. The ST curve is
the horizontal sum of the SF and SD curve. So at any
price less than "a," total supply is the same as domestic
supply. Above price "a" the total supply curve juts outward
reflecting the sum of foreign and domestic supply. The demand curve (D) is
domestic demand and assumes that domestic customers don't care if the good is
produced domestically or by foreigners (an assumption that doesn't always hold).
Assuming free trade, equilibrium is where total supply equals
demand. That involves an output of QT and a price of PT.
(The T subscripts stand for free trade conditions.) With free trade, Q*
shows the domestic output. The rest of it, the amount from Q* to QT
is the amount supplied by foreign producers.
Now suppose the United States erects a tariff barrier high
enough to drive out all of the foreign supply. Take the SF
curve away and equilibrium will be where demand intersects SD.
That involves an output of QP and a price of PP (where the
subscripts stand for protective tariff). So, compared to free trade, a
tariff reduces domestic consumption and increases the price of the good.
That obviously imposes a burden on domestic consumers.
Domestic production does increase with the tariff, from Q* to
QP. That's why protection is popular with domestic
producers. That gain, however, is illusory. Remember our discussion
about comparative advantage. If we keep foreign goods out, we are no
longer able to consume more than our domestic production levels and the
increased domestic output involves a higher opportunity cost than if we imported
some of the good. This general case shows why economists almost always
prefer free trade.
Specific arguments for trade barriers
We next examine a number of popular arguments as to why trade
barriers are desirable, in spite of comparative advantage and the general
outcomes we just looked at.
1. Buy at home
This is a popular, but relatively meaningless
argument. Many argue that you should buy what America builds just because
it was built in America. You hear the same argument from local chambers of
commerce--e.g. everyone is somehow better off if we buy what Dayton
builds. Abraham Lincoln picked up on this noting that he would not by an
overcoat from England. Why not? England would end up with the money,
he said. The argument simply ignores the consumption
possibilities we saw when we looked at comparative advantage.
2. Full employment
This, to many, is a very compelling
argument. As we saw in the diagram of the general case of protection
above, a tariff does increase domestic output--and therefore expands employment
for workers producing the protected good. In the United States, auto
workers have always argued for measures to keep Japanese automobiles out of the
U. S. so as to promote greater employment for domestic auto workers.
What it really does, however, is preserve
visible jobs at the expense of invisible ones. Suppose, for example, we
keep shrimp from Taiwan out of the U. S. If we do that, we will not be
able to export phones to Taiwan. The shrimp we buy from them gives them
the funds to buy U. S. phones. So, someone who makes phones in the United
States loses his or her job because we can't sell them to Taiwan. We
preserve shrimp fishermens' jobs at the expense of phone workers jobs. That's an
invisible effect and certainly neither the employed shrimp fisherman nor the
unemployed phone worker see what really happened. As we noted earlier,
keeping out shrimp from Taiwan (or anything else) reduces our total consumption
3. Cheap foreign
Another popular argument is that American
producers cannot be expected to compete with firms in countries that pay much
lower wage rates to workers than we do. That's a half truth,
however, One must compare wage rates to labor productivity. If our
wage rate is ten times higher than in some other country, there isn't a problem
if our labor productivity is more than ten times greater. If our higher
wages are not accompanied by higher productivity, then perhaps we don't have
comparative advantage in that product and should be producing something else
instead. Comparative advantage just keeps on working to our benefit!
This argument is not pertinent to the United
States but it is for countries which rely heavily on one (or a few)
products. A so-called banana republic is a good example.
The concern in such a country is that it would be better off
if it had more diversified outputs. A lack of diversification can lead to
instability if, e.g., poor weather dramatically reduces output or if world wide
demand falls. How can a country diversify? Keep out foreign goods
with a tariff on goods other than bananas to encourage domestic production. Diversification may lead
to greater stability, but it will also lead to lower output through time if done
with a tariff. There are other, and better, ways to deal with
diversification and instability. Comparative advantage . . . you know the
The infant industries argument is not as
relevant for the United States as it is for lesser developed countries.
The argument is that protection is needed for a new industry so that it has time
to grow, become efficient and achieve economies of scale, and then compete
effectively in global markets. If, for example, some country wants to
become competitive in the production of paper, it erects a high tariff to keep
foreign produced paper out. That permits its domestic production of paper
to increase and, eventually, become competitive.
There are at least two problems with this
argument. One is that government, which obviously enacts the tariff,
doesn't really know if the paper industry is likely to achieve success or
not. Governments can't anticipate future market conditions. The
second is that the infant frequently never grows up. Once the tariff is in place,
it's politically very hard to get rid of it. If a government really thinks
this is compelling, a better way is to give the infant a direct subsidy for a
time. That, too, is suspect because it suggests that government is better
at resource allocation than private markets.
This is sort of the reverse of the previous
argument. If an industry is declining
--for whatever reason--some argue it
should be give protection to halt the decline. It's
sort of a jobs
argument. An example is the U. S. textiles industry. But if textiles
anything else) can be made more efficiently elsewhere, then so be it.
comparative advantage changes through time and, when that happens,
need to be reallocated. We have a long history of resource
reallocation for various
reasons. How could we be doing so well in
computer technology if resources had
not been attracted away from declining
industries into computer technology
Dumping occurs when a foreign
firm or a foreign government overproduces something and then, to get rid of the
surplus, temporarily sells the good in another country below cost.
Domestic producers howl that this is not fair because they can't meet the lower
price. There are short term benefits to consumers, obviously--the lower
prices. There is no real evidence that temporary dumping does a lot of
harm to domestic producers in the long run. Sometimes it isn't clear when
a sale is really below cost. If there is any validity to this argument, it
is an argument for a very temporary tariff.
Foreign subsidy argument
Sometimes a foreign government
subsidizes one or more of its industries making it more difficult for producers
in other countries to compete. This has a curious effect. If, for
example, Taiwan subsidizes its clothing industry then clothing will be cheaper
in the United States than it would be absent the subsidy. The effect is
that Taiwanese people are subsidizing U. S. citizens. That's not all
bad--if that's what they want to do. Providing protection in such a case
could encourage U. S. producers to be less efficient. Perhaps our
resources would be better used for something else. The Trade Act of 1988,
however, requires the U. S. to retaliate when other governments subsidize their
Critical self sufficiency argument
A final argument is that we
should provide protection for some things that are critical to our well
being. This argument often centers around things which are critical during
a potential war. We would not, for example, want to import a missile
guidance system from North Korea--even if they had a comparative advantage in such
systems! But there are many other critical things--e.g. steel, plastic,
etc. In the event of war, the U. S. government would have no problem
suspending trading relationships where necessary.
|Answers to Quiz #6--April
11, 2007--10:00 section
|Answers to Quiz #6--April 11, 2007--
5. B 10. B
We continue with some other international trade
topics and then begin a discussion of international
finance--how payments are
made between countries with different currencies.
Rather than enact a protective tariff, sometimes
the U. S. (or other countries as well) persuades a foreign government to
voluntarily limit shipments of some good to the U. S. We have done this
with Japan's automobiles. There aren't zero imports, just fewer than the
free market quantity. This sounds good, but it's actually worse than a
If we use a tariff, we will likely get some
revenue from it--if it's not high enough to keep all foreign goods out.
With a voluntary restriction, the U. S. doesn't get any revenue, but the foreign
government does. Why? No foreign producer voluntarily limits exports
to the U. S. So the foreign government establishes export licenses or
taxes to keep exports within the agreed limit. When the foreign government
does that, it gets the revenue--either the fee for an export license or the tax
revenue. That's what makes voluntary restrictions worse than a tariff.
Tariff reduction efforts
Currently there are over 9,000 tariffs involving
an annual cost of at least $20 billion. In 1790, there was one page of
tariffs. Even so, there have been significant tariff reductions in recent
years, even if we still have over 9,000 of them.
World Trade Organization (WTO)
In 1947, 23 countries set up an international
agreement to reduce tariffs--called the General Agreement on Tariffs and Trade (GATT). GATT
in turn set up the WTO in 1995. There are currently over 140 member
countries. The group meets periodically and negotiates tariff reductions among
members. When GATT first started, tariff rates averaged 40 percent in
developed countries. Now average tariffs are less than 4 percent.
Part of the purpose pf the WTO is to enforce free trade rules.
It can cite and impose remedial action on countries violating trade
agreements. Why do sovereign nations buy in to this? Partially
because most are committed to free trade. When the WTO meets, there are
often huge demonstrations on the part of those opposed to free trade--unions, environmentalists and others.
That's the logo of the WTO for its 1999 meeting
in Seattle. At that meeting, the demonstrations were so intense that little
was accomplished during the meeting. For more information about GATT and
the WTO--and a ton of information about free trade and related topics--go to: http://www.GATT.org.
Regional trading blocs
The European Union (EU) is an agreement among
37 European countries to provide free trade among member nations.
Not all of these countries participate in the common
currency, called the Euro--e.g. the United Kingdom has not given up its British
pound. There are also a number of countries who are candidates for
membership in the EU; some will likely be admitted at some point.
The Euro currency phased in in three steps.
The first step, which started in January of 1999, provided for major
corporations, financial institution and governments to begin using Euros
electronically. Exchange rates between the Euro and local currencies were
set up. Beginning in January, 2002, Euro coins and currency were issued. For six months, EMU members
could use either Euros or local
currencies. Beginning June 1, 2002, old currencies were no longer
used--everything is now exchanged using the Euro.
The symbol for the Euro looks like this:
And a 20 Euro bill looks like this:
What is the likely impact of the EU? The
elimination of tariffs obviously benefits consumers in all EU countries.
There will be a stronger economic environment--the EU has 290 million people and
produces about 20 percent of the world's total output. Most think growth
will be enhanced as a result of mergers and lower prices. There will of
course be greater simplicity for members of the EMU--you don't have to convert
francs to lira and so on. There were some initial disruptions, but most
think it a very positive move and a real victory for free trade.
North American Free Trade Agreement (NAFTA)
Signed in 1992, NAFTA eliminates all tariffs over
a 15 year period between the United States, Canada and Mexico. Although it
was controversial, most think it has obvious benefits of lower prices for
consumers in all three countries. Of course there will be winners and
losers. The federal government predicted that losers in the U. S. would
include construction workers and some apparel makers. Winners were
predicted to include farmers, truckers and those in financial services.
A Spanish producer selling goods in the United
States wants to be paid in pesos, not in dollars. And if we ship goods to
Germany we want to be paid in dollars, not euros. The way this happens is
through a foreign exchange market, where currencies are valued in terms of one
another and exchanged for international goods and services.
The foreign exchange market
Schematically, the foreign exchange market looks
something like this:
The top part of the diagram shows goods, services
and financial assets moving from the U. S. to France. The French
purchasers take euros to the foreign exchange (FE) market and exchange them for
dollars, which are used to pay the U. S. exporters. The bottom part shows
the U. S. receiving goods, services and financial assets from France. They
take dollars to the foreign exchange market and exchange them for euros to pay
the French producer. Where is the foreign exchange market? Financial
institutions or governments make these exchanges; much of it is now done
electronically. The rate at which euros exchange for dollars is
determined in the foreign exchange market. Shortly we will see how
exchange rates are determined.
The official balance of payments
In total, all our payments to all other
nations must equal our receipts, i.e. they must balance. The official
balance of payments is a summary of all kinds of international transactions
between private parties and governments. Following is the balance of
payments for the United States in 2006, where the dollar amounts are in billions
||TRADE BALANCE (1-4 above)
||Income from U.S. foreign investments
||Income outflow for foreign owned U.S.
||Unilateral transfers (mostly government
and private pensions)
||CURRENT ACCOUNT BALANCE (1-7 above)
||U.S. capital inflow
||U.S. capital outflow
||CAPITAL BALANCE (8-9 above)
The first thing to note is that the net balance
is always zero--by definition! The statement is divided
into two parts: items 1-7 is the current account and items 8-9 is the
capital account. Note that the trade balance was -$766 billion in 2006--a
matter of great concern to many resulting in banner headlines in the financial
and popular press.
The capital accounts are straight forward and
show that there was more foreign investment in the U. S. than there was U. S.
investment in foreign economies. Finally note item
statistical discrepancy. It's not possible to catch every international
transaction. Participants in the underground economy hide some
transactions. We know that the net balance has to be zero by
definition. So if we add up all the other items, we know that there was a
money outflow of $137 billion which was not reported. A
deficit in the current account will always be accompanied by a surplus in the
Next we look at how exchange rates are
determined. How many dollars does it take to buy a Mexican peso? Or
how many dollars can someone obtain for a euro? Most exchange
rates are determined in free markets. But it is possible for governments
to intervene and fix exchange rates at some level--in much the same way we saw
earlier how governments sometimes try to control prices of particular goods or
services. We look first at freely fluctuating exchange rates; then we look
at what happens with fixed exchange rates.
Freely fluctuating exchange rates
In order for the U. S. to purchase stuff from the
United Kingdom, we have to convert dollars to pounds in the foreign exchange
market. We have a demand for British pounds, derived from our demand for
British goods and services. We supply dollars to the foreign exchange
market. Residents in the U. K. have a demand for dollars, derived from
their demand for U. S. goods and services. And they supply pounds to the
foreign exchange market. We have to look at the foreign exchange market
(and the supplies and demands of both currencies) from the perspective of the U.
S. and of the U. K. The following diagrams put this together:
Our demand for British pounds (shown in the left
diagram) give rise to our willingness to supply dollars (shown in the right
diagram). Our demand for pounds would be downward sloping--the lower the
dollar price of a pound, the more we will demand. The higher the pound
price of dollars, the more we will supply. The same thing holds true for
the U. K. They will have a demand for dollars (right diagram) which slopes
downward. This gives rise to their willingness to supply pounds (left
diagram). An equilibrium exchange rate arises, such that the price of a
pound in the U. S. is $2, i.e. $2 = £1.
In the U. K., the equilibrium price is £0.5 =
$1. There has to be a consistency between
these two rates. If it takes 2 dollars to get 1 pound in the U.S., that
same two to one relationship must hold in the U.K. That's why we
know that, in the U. K., one-half a pound fetches one U. S. dollar. With
free exchange rates, these "cross rates" are always in the same
ratio. It can't be any other way!
Changes in exchange rates
Of course, exchange rates can and will change as
the result of changes in the demand or supply of foreign currency.
Suppose, for a first example, the U. S. has an increased demand for British
goods and services. That will mean an increase in the demand for pounds--and
a corresponding increase in the supply of dollars to the foreign exchange
market. The diagrams below show what happens:
Look what happened. The demand for pounds
shifted to the right from D to D'. That produced a new equilibrium at an
exchange rate of $3 for one British pound. Looking at the United Kingdom,
our increase in the demand for pounds is accompanied by an increase in the
supply of dollars. That produced a new equilibrium in the U. K. such that
the price of one U. S. dollar is now £0.33. Exchange rate changes have a
sometimes confusing lingo. If the pound price of a dollar falls (as in
this example), the dollar is said to have depreciated against the
pound--it takes fewer pounds to get a dollar or, put differently, dollars are
Notice that the cross rates are
appropriate. A $3 price for one pound means that, across the ocean, the
pound price of a dollar will be £0.33--the same three to one ratio in both
countries. Note that an increase in
the dollar price of a pound will involve a decrease in the pound price of a
To make sure you understand all
this, let's do one more example of a change in exchange rates. This one is
a bit more complicated. (Sorry!) Suppose inflation increases in the
U. K. relative to the U. S.--i.e., the U. K. experiences a higher
rate of inflation than we do in the U. S. This means U. S. households and
businesses will be less eager to do business in the United Kingdom--while the
United Kingdom will be more interested in buying things from the United
States. Why? Our prices are not rising as rapidly so they can get
better deals in the United States.
This means the U. S. demand
for pounds will fall, and the supply of dollars will fall. The U. K. will
experience an increase in the demand for dollars and an increase in the supply
Note the following
Note carefully the little prime marks. They
are a little hard to see, but they show the shifted demand and supply
functions. In the U. S., there is an increase in the supply of pounds and
a decrease in the demand for pounds. The U. K. wants to offer us more
pounds (because our prices are not as high as theirs), while we demand fewer of
their pounds. The result is that the exchange rate falls from $2 for £1
to $1 for £1. In the U. K., there is a decrease in the supply of dollars
and an increase in the demand for dollars. That causes the exchange rate
to rise from £0.5 for $1 to £1 for $1. This is described by saying the
dollar has appreciated. Make sure you understand what all happened
Let's take two other examples. I won't draw
diagrams, but it would be a good idea if you did to check your understanding of
exchange rate changes. A simple example would be if income in the U. S.
increased relative to that of the U. K. That means we would want to import
more from the U. K. That's an increase in the demand for pounds, which
would lead to a higher dollar price of pounds--and a lower pound price of
Here is a more complex one. Suppose
interest rates fall in the United States, while they remain unchanged in the
United Kingdom. That makes it more attractive for us to invest in the U.
K. and it makes it less attractive for people in the U. K. to invest in the U.
S. Figure out what will happen. (Hint: The dollar price of
pounds will rise.) Interest rate fluctuations are largely responsible for
day-to-day fluctuations under free exchange rates.
Evaluation of free rates
There are obvious advantages of free rates.
They are the market solution, which always suggests an optimum condition.
We can be certain that rates reflect relative purchasing power. If it
costs $2 for £1, we can be sure that $2 in the United States will buy about the
same stack of goods and services as £1 will buy in the U. K. If that
wasn't so, the rates would quickly adjust.
Many, however, are not enamored of free
rates. Some say there is risk associated with rate fluctuations.
Yeah, there is. There is risk associated with any market activity, for
that matter. Risk is hardly confined to possible adverse effects of
changes in exchange rates. Some are concerned that free rates might
encourage speculators. If you think the price of a Dutch guilder will rise
in the future, buy some guilder now and resell it later. (Of course if a
lot of people did that the price of the guilder would rise quickly.) There
are all kinds of speculation in contemporary business. The New York Stock
Exchange which, to some, epitomizes capitalism is a good place to see
speculation at work. That doesn't bother many, so why should speculating
in exchange rates bother people either?
Fixed exchange rates
The United States has had a system of free
exchange rates since 1973. But before that we were on a system of fixed
rates--as were most other countries. The argument for fixed rates is
simply to overcome the (alleged) disadvantages of free rates. There is
still a lot of sentiment to return to fixed rates, so we want to look at how
they worked and what problems there were.
How did governments fix exchange rates?
Back in the time of fixed rates, most major
countries were on a gold standard. That meant several things. First,
central bank liabilities were partially backed by gold. Second, gold was
often used to settle balance of payments differences between nations.
Third, currencies were defined in terms of gold. It is that latter feature
that gave rise to fixed exchange rates.
(That's a stack of gold bars, which is how
countries stored gold under the old gold standard.)
Here's how it worked. Each country defined
its currency in terms of a common standard--gold. After World War II, the
United States officially defined the U. S. dollar as .0294 ounces of gold.
The United Kingdom defined the pound as .0823 ounces of gold. Hence 1
pound = .0823/.0294 = $2.80. The pound was defined as consisting of 2.8
times as much gold as the dollar. In the U. K., the price of one dollar
was £0.357. Hence the exchange rates were determined by the definitions
of gold, and could not change unless one or the other country changed the
official definition of its currency.
Under the gold standard, countries were not
supposed to change official definitions of their currencies. The United
States broke the rules several times before going off the gold standard in
1973. There has always been, among many, a belief that gold possesses
magical qualities and that perhaps the price of gold is determined in
heaven. Many were fearful when we abandoned the gold standard that somehow
our whole monetary system would collapse. It didn't. Part of the
reason we abandoned the gold standard was because our government finally
understood that free rates worked better. There are still some far out
groups that want to return to the gold standard, however.
Disequilibrium possibilities with fixed rates.
With fixed rates, (unlike with free rates),
disequilibrium in a country's balance of payments can result--i.e. the balance
of payments is not always automatically balanced. In the diagram below,
suppose the demand for pounds is initially at D1. Suppose that
the equilibrium exchange rate of e1 just happens to coincide with
legal fixed rate, also e1. The quantity of pounds exchanged is
equal to Q1.
Now suppose the demand for pounds increases to D2.
With free exchange rates, the dollar price of pounds would rise above e1,
as we saw earlier. But the rate is legally fixed at e1 and
can't rise. So what happens? The quantity of pounds demanded is at Q2 but the quantity supplied remains at Q1.
The result is an excess demand for pounds, shown by the difference between Q2
and Q1. This excess demand means there is obviously a shortage
of pounds, so one thing that often happened is a black market developed in which
pounds were illegally sold at a price higher than e1.
This situation produces a balance of payments
deficit for the United States, because more dollars are flowing out of the U. S.
than are flowing in to the U. S. The U. S. has to cover the resulting
deficit in one of two ways. With the gold standard, countries were
required to hold reserves of foreign currencies and also to hold gold
reserves. To settle up the deficit, the U. S. must either sell pounds or
ship gold to the U. K. If we sell pounds, that shifts the supply of pounds
Prior to abandoning the gold standard in 1973,
the United States had a balance of payments deficit for 22 consecutive
years. That caused our foreign exchange reserves to become depleted.
The balance of payments deficits exceeded the gold we held in Fort Knox so that
our gold reserves were no longer a credible way to ensure fixed exchange rates.
Setting rates above equilibrium results in the
opposite of the above. A balance of payments surplus results and a country
would have to purchase foreign exchange.
Other problems with fixed rates
When exchange rates stay fixed over time, the
optimal pattern of trade becomes distorted. If inflation is high in the U.
K. (relative to the U. S.) that would normally reduce the dollar price of
pounds. But with fixed rates, that doesn't happen. We would then
trade less with U. K. than would be suggested by comparative advantage.
The balance of payments problems explained above
can also cause domestic fiscal and monetary policies to become distorted.
A country with a payments deficit might have to follow policies that lead to
higher unemployment; a country with a payments surplus might end up following
domestic policies which aggravate inflation. With a deficit, a country
might seek policies designed to reduce imports. How can you reduce
imports? Raise taxes or cut government spending. Countries don't
like to do this and that's what sometimes caused countries to change their
official price of gold. But if one country changes its gold price to get
rid of balance of payments imbalances, another might retaliate so that the
imbalance does not always go away.
Even with free rates, governments can and do
sometimes get involved by trying to alter equilibrium exchange rates. In
the U. S. either the Treasury or the Federal Reserve can influence free rates by
buying or selling dollars or buying or selling other foreign currencies.
Both monetary agents hold foreign currencies.
Why would they do this? To remedy a
"disorderly" market--whatever that is. My normative opinion is
that monetary authorities don't know what a disorderly market is. Put
differently, if there is some disorder I am confident the market will cure
it--not the Treasury or Federal Reserve.
How does this process--sometimes called
"dirty float"--work? Suppose either agency decides the dollar
price of pounds is "too low." The authorities can go into the
market and buy British pounds. That's the same as an increase in the
demand for pounds which would raise the dollar price of pounds. In 1992,
the Fed bought German marks on two different occasions. That increased the
dollar price of marks and was done to reduce the trade deficit.
Like any intervention in free markets, trying to
micro manage exchange rates is suspect. It certainly doesn't please
trading partners when that happens and is often accompanied by political
ramifications as well.
|Answers to Quiz #7--April 20, 2007-- 10:00 section
5. D 10. C
|Answers to Quiz #7--April 20, 2007--
5. D 10. E
Here's a tough multiple choice
If all the economists in the world were laid
end to end,
A. it would be a good thing.
B. they would be more comfortable.
C. they would never reach a conclusion.
D. all of the above
E. none of the above
The following material is something for you to read on your own. Because
of the earlier
canceled class, I will likely not have time to cover much of this in class.
I will try to hit the
highlights if I can.
We want to look next at the economics of
development. Specifically we want to look at poor countries. Now,
notice the word I used--poor. If you go back about forty years, you will
find that they used to be called "underdeveloped" countries.
Then, later on, "less developed" countries. Currently they are
often called "third world" countries. That term is puzzling.
|I use the term poor countries, because
that's what they are.
The U. S. has a per capita GDP of over $40,000. Three billion people--over half of the world's population--live
in countries where per capita income is less than $700. Can you imagine
what it would be like to live in that kind of environment? That's why I
call them poor countries.
There are over 200 countries in the world.
Only 24 of those countries have a per capita income of $12,000 or more. The
World Bank refers to these as "rich" countries.
The poorest areas are in Africa, Asia and Latin
America. And, unfortunately, many countries that are poor are getting
poorer. Not all of them. Some poor countries are beginning to
experience income growth. We want to look at the characteristics of these
countries and then offer a few thoughts on how poor countries might advance to
higher standards of living.
Common characteristics of poor countries
1. Very little
Poor countries have very limited
amounts of physical capital. As we have pointed out several times, capital
equipment is a major requirement for prosperity. There is little or no
saving from which to obtain funds for investment because of subsistence
incomes. Consider the following production possibilities curve which shows
capital and consumption possibilities:
Suppose a poor country is operating at point A,
and suppose that point involves an absolute minimum amount of consumption.
Even with that level, there may be widespread hunger. But the amount of
capital, shown by Y, is not enough to support economic growth. The economy
needs an amount of capital shown by point B, but there's no way to get
there. This is one of the many vicious circles of underdevelopment.
2. Limited human
There is typically a glut of
unskilled labor and very little skilled labor. A further complication is
that there is poor health and a lot of disease. Sometimes when talented
people live in poor countries, they move to countries with a higher standard of
Aggravating the hunger problem is
the lack of agricultural development. Although some poor countries are not
adept at agricultural production, almost all countries have the natural
resources to produce some food. The need for agricultural development is a
precondition for industrial development. This reflects the problem
outlined in #1 above of inadequate physical capital.
industry and agriculture
As if the internal problems
weren't enough, poor countries often enact all kinds of protectionist
policies--tariffs, quotas, etc. This denies them access to world markets
which further impairs their ability to grow.
In many poor countries, there has
been a migration of workers from farms to cities. The trouble is there
aren't many jobs in urban areas, so unemployment rises when this migration to
cities takes place.
6. Limited access
This is similar to some of the
items listed earlier, but they are all inter-related. Poor countries are
isolated from other countries and it is difficult for them to transfer
technology in from other countries. Sometimes they are quite unreceptive
to technological assistance--for political and, I guess, other reasons.
7. Unstable macro
As noted, there are often high
rates of unemployment in poor countries. They also often have high rates
of inflation--stagflation in its worst form. There is also typically
enormous government regulations and controls which further inhibit the prospects
It is simple arithmetic to note
that, if population grows faster than output, output per capita will
decline. This is why some poor countries are becoming even poorer--too
much population growth. Although some countries, e.g. China, have
established family planning programs, most have not.
Birth rates are high in most poor
countries and, historically, as countries have become richer (or at least not as
poor) the birth rate falls. When the birth rate falls, by definition, per
capita output rises. How can we explain this phenomenon? However
strange this may sound, we can look at the benefits and costs of having
additional children in poor countries and in rich countries. This will
help us understand what's going on.
What are the benefits of
There are the usual
nonmonetary benefits of enjoyment, companionship, etc. But there are two
additional important monetary benefits. One is the productive agent
benefit. Children are seen as potential income earners to improve the
welfare of the family. The other is the security benefit.
Children are seen as care providers when parents age or become ill.
What are the costs of
The direct cost of food,
clothing and shelter is minimal. There is zero opportunity cost of
parent's time away from the work force.
Compared to rich countries,
the benefits are high and the costs are low. Hence procreation benefits
the family--even if it doesn't benefit the whole country.
What are the benefits?
Only the nonmonetary
ones. In the U. S., for example, parents don't look at children as income
earners or as care providers. The benefits are low relative to poor
What are the costs?
They are high. The
direct cost of food, clothing, shelter, education, vacations--and on and on--are
very high compared to poor countries. There is also a very high
opportunity cost if one parent withdraws from the labor force to care for
Compared to poor countries,
the costs are high and the monetary benefits are low.
See what has happened? As
families and nations get richer, the benefits of additional children fall and
the costs rise. Hence the birth rate falls as they get richer. This
is another dilemma for poor countries. Although the country would be
better off if birth rates fell, that is not in the best interests of families in
How to acquire funds for developing physical and human
Obviously the real key to economic development is acquiring
funds to develop both physical and human capital. How does a poor country
do that? Generally, there are two sources--internal
saving, and external
There really isn't much hope here. The subsistence
incomes don't permit much saving to occur. Some governments have attempted
to force savings through taxes and controls. (The tax receipts can
theoretically channeled into investment in capital equipment.)
Some--notably the former Soviet Union--restricted the production of consumer
goods which forced saving. Rapid money creation has also been tried, but
that brings serious inflation. Even where saving has taken place, there is
sometimes capital flight to other countries. So most poor countries must
rely on external funding.
External funding sources
There are three types of external funding possibilities:
foreign private investment, foreign aid (from foreign governments) and
loans. Looking at these will further illustrate the many serious problems
which impede development efforts.
Foreign private investment
How in the world does a poor country entice private investors
in rich countries to invest? Would you invest in a country with an
unstable macro economy, an unstable political system--and all those
characteristics we listed above? Although some have done this, the volume
of foreign investment is very low. Sometimes it's done for altruistic
reasons. Until a country establishes some important preconditions
(discussed below), foreign investment is not likely to improve the lot of poor
countries very much.
Foreign aid is gifts by foreign governments or various
international agencies-e.g. World Bank, International Monetary Fund. These
groups also make loans to poor countries.
The volume of foreign aid is not large. The average aid
from rich countries has been 0.3 percent of GDP--and the U. S. has given only
half that much. Many poor countries don't want foreign aid.
They fear becoming dependent on foreigners and there are a zillion political
issues involved as well. Sometimes foreign aid is used
inappropriately. A country might, for example, use the funds to build a
hydroelectric generating plant when what it really needs is an irrigation
system. Sometimes it finds its way into the hands of politicians who use
it for their own gain.
Loans may be made to poor countries from private banks or
financial institutions, governments and international organizations. There
have been a lot of loans; usually they are tied to the poor country promising to
do something to its own benefit. This has resulted in very serious
debt problems for many poor countries. The Vatican has called on lenders
to forgive many of these loans, but that is fraught with all kinds of problems,
especially when the lenders are private parties.
So how can development take place?
Most experts think that economic development is most likely to
occur in a market based
environment, with a minimum of four elements:
competitive micro economy
A stable macroeconomy
Investment in human capital
Integration with the global economy
Some other desirable elements would help countries take off
into sustainable growth:
structure of financial institutions
Increased agricultural productivity
Emergence of an entrepreneurial class
Increased domestic saving and investment (obviously)
That's a tough agenda and it makes you wonder how the vicious
cycle of poverty can ever be broken. Are there any success stores?
Three very brief examples follow.
Three success stories
Three countries that used to be poor, but aren't any more, are
South Korea, Taiwan and Hong Kong. Each took a different route, but all
three found ways to facilitate positive incentives and all three stressed
South Korea. South Korea went about development
by establishing large conglomerates, e.g. Samsung. They sold these
products around the globe and that gave them funds for development.
Taiwan. Taiwan developed a highly competitive
model such that 40,000 firms account for three-fourths of their exports.
These firms produce a huge variety of goods, allowing for the benefits of
competition familiar to capitalist economies.
Hong Kong. Hong Kong, famous for its capitalistic
approach, essentially followed a laissez faire model--with very low taxes
and very few restrictions. This worked impressively in Hong Kong.
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