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and the early part of this decade, prospective returns
on American assets rose well above comparable re- D1
turns in most other countries”especially those in
S2 D2
Europe and Japan. In consequence, foreign capital
was attracted here, American capital stayed at Number of Pounds
home, and the dollar soared”to levels that proved

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Part 4
366 The United States in the World Economy

unsustainable. Similarly, if a nation suffers from capital flight, as Argentina did in 2001, it
must offer extremely high interest rates to attract foreign capital.

Economic Activity and Exchange Rates: The Medium Run
The medium run is where the theory of exchange rate determination is most unsettled.
Economists once reasoned as follows: Because consumer spending increases when income
rises and decreases when income falls, the same thing is likely to happen to spending on
imported goods. So a country™s imports will rise quickly when its economy booms and rise only
slowly when its economy stagnates.
For the reasons illustrated in Figure 4, then, a boom in the United States should shift
the demand curve for euros outward as Americans seek to acquire more euros to buy more
European goods. And that, in turn, should lead to an appreciation of the euro (deprecia-
tion of the dollar). In the figure, the euro rises in value from $1.50 to $1.60.
However, if Europe was booming at the same time, Europeans would be buying more
American exports, which would shift the supply curve of euros outward. (Europeans
must offer more euros for sale to get the dollars they want.) On balance, the value of the
F I GU R E 4
dollar might rise or fall. It appears that what matters is whether exports are growing
The Effect of an
faster than imports.
Economic Boom Abroad
on the Exchange Rate
A country that grows faster than the rest of the
world normally finds its imports growing faster
than its exports. Thus, its demand curve for for-
eign currency shifts outward more rapidly than its
supply curve. Other things equal, that will make its
currency depreciate.
Price of a Euro

A This reasoning is sound”so far as it goes. And it
(in dollars)

leads to the conclusion that a “strong economy”
might produce a “weak currency.” But the three most
$1.50 important words in the preceding paragraph are
“other things equal.” Usually, they are not. Specifi-
cally, a booming economy will normally offer more
attractive prospects to investors than a stagnating
one”higher interest rates, rising stock market
values, and so on. This difference in prospective
Number of Euros investment returns, as we noted earlier, should at-
tract capital and boost its currency value.
So there appears to be a kind of tug of war. Think-
ing only about trade in goods and services leads to the conclusion that faster growth
should weaken the currency. But thinking instead about trade in financial assets (such as
stocks and bonds) leads to precisely the opposite conclusion: Faster growth should
strengthen the currency. Which side wins this tug of war?
As we have suggested, it is usually no contest”at least among the major currencies of
the world. In the modern world, the evidence seems to say that trade in financial assets is
the dominant factor. For example, rapid growth and soaring imports in the United States
in the second half of the 1990s were accompanied by a sharply appreciating dollar as in-
vestors from all over the world brought funds to America. We conclude that
Stronger economic performance often leads to currency appreciation because it improves
prospects for investing in the country.

The Purchasing-Power Parity Theory: The Long Run
We come at last to the long run, where an apparently simple principle ought to govern
exchange rates. As long as goods can move freely across national borders, exchange rates
should eventually adjust so that the same product costs the same amount of money,
whether measured in dollars in the United States, euros in Germany, or yen in Japan”except

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Chapter 18 367
The International Monetary System: Order or Disorder?

for differences in transportation costs and the like. This simple statement forms the basis
of the major theory of exchange rate determination in the long run:
The purchasing-power parity theory of exchange rate determination holds that the exchange
rate between any two national currencies adjusts to reflect differences in the price levels
in the two countries.
An example will illustrate the basic truth in this theory and also suggest some of its
limitations. Suppose German and American steel are identical and that these two nations
are the only producers of steel for the world market. Suppose further that steel is the only
tradable good that either country produces.
Question: If American steel costs $300 per ton and German steel costs 200 euros per ton,
what must be the exchange rate between the dollar and the euro?
Answer: Because 200 euros and $300 each buy a ton of steel, the two sums of money
must be of equal value. Hence, each euro must be worth $1.50. Why? Any higher price for
a euro, such as $1.60, would mean that steel would cost $320 per ton (200 euros at $1.60
each) in Germany but only $300 per ton in the United States. In that case, all foreign cus-
tomers would shop for their steel in the United States”which would increase the demand
for dollars and decrease the demand for euros. Similarly, any exchange rate below $1.50
per euro would send all the steel business to Germany, driving the value of the euro up
toward its purchasing-power parity level.

Exercise Show why an exchange rate of $1.25 per euro is too low to lead to an equilib-
rium in the international steel market.

The purchasing-power parity theory is used to make long-run predictions about
the effects of inflation on exchange rates. To continue our example, suppose that steel
(and other) prices in the United States rise while prices in Europe remain constant. The
purchasing-power parity theory predicts that the euro will appreciate relative to the dol-
lar. It also predicts the amount of the appreciation. After the U.S. inflation, suppose that
the price of American steel is $330 per ton, while German steel still costs 200 euros per
ton. For these two prices to be equivalent, 200 euros must be worth $330, or one euro
must be worth $1.65. The euro, therefore, must rise from $1.50 to $1.65.
According to the purchasing-power parity theory, differences in domestic inflation rates
are a major cause of exchange rate movements. If one country has higher inflation than
another, its exchange rate should be depreciating.
For many years, this theory seemed to work tolerably well. Although precise numer-
ical predictions based on purchasing-power parity calculations were never very accu-
rate (see “Purchasing Power Parity and the Big Mac” on the following page), nations
with higher inflation did at least experience depreciating currencies. But in the 1980s
and 1990s, even this rule broke down. For example, although the U.S. inflation rate was
consistently higher than both Germany™s and Japan™s, the dollar nonetheless rose sharply
relative to both the German mark and the Japanese yen from 1980 to 1985. The same
thing happened again between 1995 and 2002. Clearly, the theory is missing something.
Many things. But perhaps the principal failing of the purchasing-power parity theory
is, once again, that it focuses too much on trade in goods and services. Financial assets
such as stocks and bonds are also traded actively across national borders”and in vastly
greater dollar volumes than goods and services. In fact, the astounding daily volume of
foreign-exchange transactions exceeds $3 trillion, which is far more than an entire month™s
worth of world trade in goods and services. The vast majority of these transactions are fi-
nancial. If investors decide that, say, U.S. assets are a better bet than Japanese assets, the
dollar will rise, even if our inflation rate is well above Japan™s. For this and other reasons,
Most economists believe that other factors are much more important than relative
price levels for exchange rate determination in the short run. But in the long run,
purchasing-power parity plays an important role.

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Licensed to:
Part 4
368 The United States in the World Economy

Purchasing-Power Parity and the Big Mac
Since 1986, The Economist magazine has been using a well-known By how much? The price

SOURCE: © mediablitzimages (uk) Limited/Alamy
international commodity”the Big Mac”to assess the purchasing- in China was just 44 percent
power parity theory of exchange rates, or as the magazine once put of the price in the United
it, “to make exchange-rate theory more digestible.” States ($1.41/$3.22 5
Here™s how it works. In theory, the local price of a Big Mac, 0.438). So the yuan was 56
when translated into U.S. dollars by the exchange rate, should be percent below its Big Mac
the same everywhere in the world. The following numbers show parity”and therefore should
that the theory does not work terribly well. appreciate. The other num-
For example, although a Big Mac cost an average of $3.22 in bers in the table have similar
the United States in January 2007, it sold for about 11 yuan in interpretations.
China. Using the official exchange rate of 7.77 yuan to the dollar, True Big Mac aficionados
that amounted to just $1.41. Thus, according to the hamburger may find these data helpful
parity theory, the yuan was grossly undervalued. when planning international travel. But can deviations from Big Mac
parity predict exchange rate movements? Surprisingly, they can.
When economist Robert Cumby studied Big Mac prices and ex-
Deviations from Big Mac Purchasing Power Parity,
change rates in 14 countries over a 10-year period, he found that
January 2007
deviations from hamburger parity were transitory. Their “half-life”
was just a year, meaning that 50 percent of the deviation tended
Big Mac Over (1)
Prices or Under (2) to disappear within a year. Thus, the undervalued currencies in
(converted Valuation the accompanying table would be predicted to appreciate during
Country to dollars) Against Dollar 2007, whereas the overvalued currencies would be expected to
United States $3.22 ” depreciate.
Norway 6.63 1106%
Great Britain 3.90 121
Euro area 3.82 119
Canada 3.08 24
Mexico 2.66 217 SOURCE: “Big Mac Index” from The Economist, February 1, 2007. Copyright © 2007
Japan 2.31 228 The Economist Newspaper Ltd. All rights reserved. Reprinted with permission. Fur-
Russia 1.85 243 ther reproduction prohibited; and Robert Cumby, “Forecasting Exchange Rates and
China 1.41 256 Relative Prices with the Hamburger Standard: Is What You Want What You Get with
McParity?” Georgetown University, May 1997.

Market Determination of Exchange Rates: Summary
You have probably noticed a theme here: International trade in financial assets certainly
dominates short-run exchange rate changes, may dominate medium-run changes, and
also influences long-run changes. We can summarize this discussion of exchange rate
determination in free markets as follows:
1. We expect to find appreciating currencies in countries that offer investors higher
rates of return because these countries will attract capital from all over the world.
2. To some extent, these are the countries that are growing faster than average because
strong growth tends to produce attractive investment prospects. However, such fast-
growing countries will also be importing relatively more than other countries, which
tends to pull their currencies down.
3. Currency values generally will appreciate in countries with lower inflation rates than
the rest of the world™s, because buyers in foreign countries will demand their goods
and thus drive up their currencies.
Reversing each of these arguments, we expect to find depreciating currencies in
countries with relatively high inflation rates, low interest rates, and poor growth

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Licensed to:

Chapter 18 369
The International Monetary System: Order or Disorder?

Many exchange rates today are truly floating, determined by the forces of supply and de-
mand without government interference. Others are not. Furthermore, some people claim
that exchange rate fluctuations are so troublesome that the world would be better off with Fixed exchange rates are
fixed exchange rates. For these reasons, we turn next to a system of fixed exchange rates, rates set by government
decisions and maintained
or rates that are set by governments.
Naturally, under such a system the exchange rate, being fixed, is not closely by government actions.
watched. Instead, international financial specialists focus on a country™s balance of
F I GU R E 5
payments”a term we must now define”to gauge movements in the supply of and
demand for a currency. A Balance of Payments
To understand what the balance of payments is,
look at Figure 5, which depicts a situation that
might represent, say, Argentina in the winter of
2001“2002”an overvalued currency. Although the D
supply and demand curves for pesos indicate an Balance of
payments deficit
equilibrium exchange rate of $0.50 to the peso
(point E), the Argentine government is holding the
Price of a Peso

(in dollars)
rate at $1.00. Notice that, at $1 per peso, more peo-


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