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What we have learned in this chapter helps us understand what brought the
dollar down between 2002 and 2004, and then again in 2007 and 2008. The
story actually begins well before that.
During the Great Boom of the late 1990s, the United States was the place to
invest. Funds poured in from all over the world to purchase American stocks,
American bonds, and even American companies”especially in the informa-
tion technology field. Yahoo! was indeed a fitting name for the age. As we have learned
in this chapter, the rising demand for U.S. assets should have bid up the price of U.S.
currency”and it did (see Figure 7 again).
But the soaring dollar sowed the seeds of its own
destruction. Two of its major effects were (a) to
SOURCE: © 2002 Mick Stevens from cartoonbank.com. All




make U.S. goods and services look much more
expensive to potential buyers abroad and (b) to
make foreign goods look much cheaper to Ameri-
cans. So our imports grew much faster than our ex-
ports. In brief, we developed a huge current account
deficit (which is roughly exports minus imports) to
match our large capital account surplus.
The Internet bubble, of course, started to burst in
2000, pulling the stock market down with it. Then
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the September 11, 2001, terrorist attacks raised
doubts about the strength of the U.S. economy. For
these and other reasons, foreign investors appar-
ently began to question the wisdom of holding so
“His mood is pegged to the dollar”
many American assets. With the U.S. current
account still deeply in the red, and the foreign demand for U.S. capital sagging, there
was only one way for the (freely floating) dollar to go: down. And so it did.
The real mystery was why the depreciation of the dollar stopped at the end of 2004;
most economists felt that further depreciation was necessary, given the huge (and
growing) current account deficit. But before that question was answered, the dollar fell
again in 2007 and into the early part of 2008 and the current account deficit finally
began to shrink.




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Licensed to:
Chapter 18 377
The International Monetary System: Order or Disorder?



| SUMMARY |
1. Exchange rates state the value of one currency in terms supplied. In the first case, the country is suffering from a
of other currencies and thus translate one country™s balance of payments deficit because of its overvalued
prices into the currencies of other nations. Exchange currency. In the second case, an undervalued currency
rates therefore influence patterns of world trade. has given it a balance of payments surplus.
2. If governments do not interfere by buying or selling 9. The gold standard was a system of fixed exchange rates
their currencies, exchange rates will be determined in in which the value of every nation™s currency was fixed
free markets by the usual laws of supply and demand. in terms of gold. This system created problems because
Such a system is said to be based on floating exchange nations could not control their own money supplies
and because the world could not control the total supply
rates.
of gold.
3. Demand for a nation™s currency is derived from foreign-
ers™ desires to purchase that country™s goods and services 10. After World War II, the gold standard was replaced by
or to invest in its assets. Under floating rates, anything the Bretton Woods system, in which exchange rates
that increases the demand for a nation™s currency will were fixed in terms of U.S. dollars and the dollar was in
cause its exchange rate to appreciate. turn tied to gold. This system broke up in 1971, when
the dollar became chronically overvalued.
4. Supply of a nation™s currency is derived from the desire
of that country™s citizens to purchase foreign goods and 11. Since 1971, the world has moved toward a system of
services or to invest in foreign assets. Under floating relatively free exchange rates, but with plenty of ex-
rates, anything that increases the supply of a nation™s ceptions. We now have a thoroughly mixed system of
currency will cause its exchange rate to depreciate. “dirty” or “managed” floating, which continues to
evolve and adapt.
5. Purchasing-power parity plays a major role in very-
long-run exchange rate movements. The purchasing- 12. Floating rates are not without their problems. For exam-
power parity theory states that relative price levels ple, importers and exporters justifiably worry about
in any two countries determine the exchange rate fluctuations in exchange rates.
between their currencies. Therefore, countries with rel- 13. Under floating exchange rates, investors who speculate
atively low inflation rates normally will have appreci- on international currency values provide a valuable
ating currencies. service by assuming the risks of those who do not wish
6. Over shorter periods, however, purchasing-power par- to speculate. Normally, speculators stabilize rather than
destabilize exchange rates, because that is how they
ity has little influence over exchange rate movements.
make profits.
The pace of economic activity and, especially, the level
of interest rates exert greater influences. 14. The value of the U.S. dollar has been volatile. It rose
dramatically from 1980 to 1985, making our imports
7. Capital movements are typically the dominant factor in
cheaper and our exports more expensive. From 1985 to
determining exchange rates in the short and medium
runs. A nation that offers international investors higher 1988, the dollar tumbled, which had precisely the re-
interest rates, or better prospective returns on invest- verse effects. Then the dollar climbed again between
ments, will typically see its currency appreciate. 1995 and 2002, leading once again to a large trade imbal-
ance. From 2002 to 2004, and then again in 2007“2008,
8. An exchange rate can be fixed at a nonequilibrium level
the dollar fell further.
if the government is willing and able to mop up any ex-
cess of quantity supplied over quantity demanded or 15. The European Union has established a single currency,
provide any excess of quantity demanded over quantity the euro, for most of its member nations.


| KEY TERMS |
Exchange rate 362 Purchasing-power parity Capital account 370
theory 367
Appreciation 362 Gold standard 371
Fixed exchange rates 369
Depreciation 362 Bretton Woods system 371
Balance of payments deficit
Devaluation 363 International Monetary
and surplus 369 Fund (IMF) 374
Revaluation 363
Current account 370 Dirty or managed float 374
Floating exchange rates 363




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Part 4
378 The United States in the World Economy



| TEST YOURSELF |
1. Use supply and demand diagrams to analyze the effect a. You spent the summer traveling in Europe.
of the following actions on the exchange rate between b. Your uncle in Canada sent you $20 as a birthday
the dollar and the yen: present.
a. Japan opens its domestic markets to more foreign c. You bought a new Honda, made in Japan.
competition.
d. You bought a new Honda, made in Ohio.
b. Investors come to believe that values on the Tokyo
e. You sold some stock you own on the Tokyo Stock
stock market will fall.
Exchange.
c. The Federal Reserve cuts interest rates in the United
3. Suppose each of the transactions listed in Test Yourself
States.
Question 2 was done by many Americans. Indicate how
d. The U.S. government, to help settle the problems of each would affect the international value of the dollar if
the Middle East, gives huge amounts of foreign aid exchange rates were floating.
to Israel and her Arab neighbors.
4. We learned in this chapter that successful speculators
e. The United States has a recession while Japan booms. buy a currency when demand is weak and sell it when
f. Inflation in the United States exceeds that in Japan. demand is strong. Use supply and demand diagrams
for two different periods (one with weak demand, the
2. For each of the following transactions, indicate how it
other with strong demand) to show why this activity
would affect the U.S. balance of payments if exchange
will limit price fluctuations.
rates were fixed:


| DISCUSSION QUESTIONS |
1. What items do you own or routinely consume that are 6. Explain why the members of the Bretton Woods confer-
produced abroad? From what countries do these items ence in 1944 wanted to establish a system of fixed ex-
come? Suppose Americans decided to buy fewer of change rates. What flaw led to the ultimate breakdown
these things. How would that affect the exchange rates of the system in 1971?
between the dollar and these currencies? 7. Suppose you want to reserve a hotel room in London for
2. If the dollar appreciates relative to the euro, will the the coming summer but are worried that the value of
German camera you have wanted become more or less the pound may rise between now and then, making the
expensive? What effect do you imagine this change will room too expensive for your budget. Explain how a
have on American demand for German cameras? Does speculator could relieve you of this worry. (Don™t actu-
the American demand curve for euros, therefore, slope ally try it”speculators deal only in very large sums!)
upward or downward? Explain. 8. In 2003 and 2004, market forces raised the international
value of the Japanese yen. Why do you think the gov-
3. During the first half of the 1980s, inflation in (West)
ernment of Japan was unhappy about this currency
Germany was consistently lower than that in the United
appreciation? (Hint: Japan was trying to emerge from a
States. What, then, does the purchasing-power parity
recession at the time.) If they wanted to stop the yen™s
theory predict should have happened to the exchange
appreciation, what actions could the Bank of Japan
rate between the mark and the dollar between 1980 and
(Japan™s central bank) and the Federal Reserve have
1985? (Look at Table 1 on page 363 to see what actually
taken? Why might the central banks have failed in this
happened.)
attempt?
4. How are the problems of a country faced with a balance
of payments deficit similar to those posed by a govern-
ment regulation that holds the price of milk above the
equilibrium level? (Hint: Think of each in terms of a
supply-demand diagram.)
5. Under the old gold standard, what do you think hap-
pened to world prices when a huge gold strike occurred
in California in 1849? What do you think happened when
the world went without any important new gold strikes
for 20 years or so?




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Licensed to:




Exchange Rates and the Macroeconomy
No man is an island, entire of itself.
J O H N D ON N E



O ne prominent aspect of globalization is that economic events that originate in one
country reverberate quickly around the globe, sometimes at the speed of electric-
ity. A stunning example arose in 2007, after the housing boom ended in the United
States. A number of so-called subprime mortgages (meaning mortgages granted to peo-
ple with questionable credit) started to go bad. As the trickle of defaults turned into a
flood, it triggered a worldwide financial crisis when several financial businesses in”of
all places”France and Germany ran into serious trouble. Why there? It turned out that
these institutions, thousands of miles away, had invested heavily in U.S. subprime
mortgages. It is indeed a small world.
This was just one example of a general phenomenon. Fluctuations in foreign growth,
inflation, and interest rates profoundly affect the U.S. economy. And economic events
that originate in our country reverberate around the globe. Anyone who ignores these in-
ternational linkages cannot hope to understand how the modern world economy works.
The macroeconomic model we developed in earlier chapters does a bit of that, but
not enough because it ignores such crucial influences as exchange rates and interna-
tional financial movements. The previous chapter showed how major macroeconomic
variables such as gross domestic product (GDP), prices, and interest rates affect
exchange rates. In this chapter, we complete the circle by studying how changes in the
exchange rate affect the domestic economy. Then we bring international capital flows
into the picture and learn how monetary and fiscal policy work in an open economy. An open economy is one
that trades with other na-
In particular, we build a model suitable for a large open economy with substantial capital
tions in goods and services,
flows and a floating exchange rate”in short, a model meant to resemble the contempo-
and perhaps also trades in
rary United States, which is indeed not “an island, entire of itself.”
financial assets.




CONTENTS
FISCAL AND MONETARY POLICIES IN AN ON CURING THE TRADE DEFICIT
ISSUE: SHOULD THE U.S. GOVERNMENT TRY TO
STOP THE DOLLAR FROM FALLING? OPEN ECONOMY Change the Mix of Fiscal and Monetary Policy
Fiscal Policy Revisited More Rapid Economic Growth Abroad
INTERNATIONAL TRADE, EXCHANGE
Monetary Policy Revisited Raise Domestic Saving or Reduce Domestic
RATES, AND AGGREGATE DEMAND
Investment
Relative Prices, Exports, and Imports INTERNATIONAL ASPECTS OF DEFICIT
Protectionism
The Effects of Changes in Exchange Rates REDUCTION
CONCLUSION: NO NATION IS AN ISLAND
The Loose Link between the Budget Deficit and the
AGGREGATE SUPPLY IN AN OPEN ECONOMY
Trade Deficit
ISSUE REVISITED: SHOULD THE UNITED
THE MACROECONOMIC EFFECTS OF
STATES LET THE DOLLAR FALL?
SHOULD WE WORRY ABOUT THE TRADE
EXCHANGE RATES
DEFICIT?
Interest Rates and International Capital Flows




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