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spending on imports, tariffs and quotas will
thereby reduce the supply of dollars on the world market”which will push the value of
the dollar up. A rising dollar, of course, would hurt U.S. exports and encourage more
imports. The fundamental equation
X 2 IM 5 (S 2 I) 2 (G 2 T)
reminds us that protectionism can raise X 2 IM only if it raises the budget surplus, raises
saving, or reduces investment.4

When the poet John Donne wrote that “no man is an island,” he was not referring to eco-
nomic globalization. But in the modern world, no nation is isolated from economic devel-
opments elsewhere on the globe. Instead, we live in a world economy in which the fates
of nations are intertwined. The major trading countries are linked by exports and imports,
by capital flows, and by exchange rates. What happens to national income, prices, and in-
terest rates in one country affects other nations. No events make this point clearer than the
international financial crises that erupt from time to time.
As we noted in Chapter 18, one root cause of almost all of the crises of the 1990s was
countries™ decisions to fix their exchange rates to the U.S. dollar. Unfortunately for nations
such as Thailand, Indonesia, and South Korea, the dollar rose spectacularly from 1995 to
1997. With their exchange rates tied to the dollar, the Thai baht, the Indonesian rupiah,
and the Korean won automatically appreciated relative to most other currencies”making
their exports more costly. Soon these one-time export powerhouses found themselves in
an unaccustomed position: running large trade deficits.
Then the crisis hit, and all four of these countries watched their currencies tumble in
value. The sharp depreciations restored their international competitiveness, but they also
impoverished many of their citizens. Naturally, the shrinking Asian economies curbed
their appetites for American goods, so our exports to the region fell”which contributed
to further deterioration in the U.S. trade deficit.
Thus, a primarily American development (the rise of the dollar) harmed the Asian
economies, and then a primarily Asian development (deep recessions in the Asian Tigers)
hurt the U.S. economy. Similarly, the subprime mortgage crisis of 2007“2008, an American
phenomenon, threatened economic growth around the world. The nations of the world
are indeed linked economically.

Here tariffs, which raise revenue for the government, have a clear advantage over quotas, which do not.

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Licensed to:

Chapter 19 391
Exchange Rates and the Macroeconomy

Recall the question with which we began this chapter: Should the United States
let the dollar fall or try to stop it? Remember that a falling dollar boosts exports
and growth in the United States but reduces exports and growth in, say, Europe
and Japan. With economic growth in both Japan and Europe already slow, it
was easy to understand why foreign leaders wanted the U.S. government to
stop, or at least slow down, the dollar™s rapid descent in 2007 and 2008.
But it was also easy to understand why the United States was not eager to do so, es-
pecially with elections on the horizon, because a falling dollar could reasonably be ex-
pected to help the United States grow faster”even if that meant that Europe and Japan
would grow slower. And indeed, foreign demand for U.S. goods helped support the
weakening U.S. economy in 2007 and 2008.
Unfortunately, there is no way to avoid this conflict of interests. A cheaper dollar
means a dearer euro and a dearer yen. For better or for worse, we all live in one world.

1. The nations of the world are linked together economi- interest rates and the stronger currency reduce aggre-
cally because national income, prices, and interest rates gate demand. Hence, international capital flows make
in one country affect those in other countries. They are monetary policy more powerful than it would be in a
thus open economies. closed economy.
2. Because one country™s imports are another country™s ex- 8. Expansionary fiscal policies also raise interest rates and
ports, rapid (or sluggish) economic growth in one coun- make the currency appreciate. But in this case, the inter-
try contributes to rapid (or sluggish) growth in other national repercussions cancel out part of the demand-
countries. expanding effects of the policies. Hence, international
capital flows make fiscal policy less powerful than it
3. A country™s net exports depend on whether its prices are
would be in a closed economy.
high or low relative to those of other countries. Because
exchange rates translate one country™s prices into the 9. Because eliminating the budget deficit in the 1990s com-
currencies of other countries, the exchange rate is a key bined tighter fiscal policy with looser monetary policy, it
determinant of net exports. lowered interest rates. That should have pushed the dol-
lar down and led to a smaller trade deficit in the United
4. If the currency depreciates, net exports rise and aggre-
States. However, changes in private economic behavior”
gate demand increases, thereby raising both real GDP
specifically, lower saving and higher investment”offset
and the price level. A depreciating currency also reduces
the presumed international effects of deficit reduction,
aggregate supply by making imported inputs more
and the trade deficit kept growing.
10. Budget deficits and trade deficits are linked by the fun-
5. If the currency appreciates, net exports fall and aggre-
damental equation X 2 IM 5 (S 2 I) 2 (G 2 T).
gate demand, real GDP, and the price level all decrease.
An appreciating currency also increases aggregate sup- 11. It follows from this equation that the U.S. trade deficit
ply by making imported inputs cheaper. must be cured by some combination of lower budget
deficits, higher savings, and lower investment.
6. International capital flows respond strongly to rates of
return on investments in different countries. For example, 12. Protectionist policies might not cure the U.S. trade
higher domestic interest rates lead to currency apprecia- deficit because (a) they will make the dollar appreciate
tions, and lower interest rates lead to depreciations. and (b) they may provoke foreign retaliation.
7. Contractionary monetary policies raise interest rates and
therefore make the currency appreciate. Both the higher

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Part 4
392 The United States in the World Economy

Open economy 379 Depreciation 381 Budget deficits and trade
deficits 387
Net exports 380 International capital flows 384
X 2 IM 5 (S 2 I) 2 (G 2 T) 387
Exchange rate 381 Closed economy 385
Appreciation 381 Trade deficit 387

1. Use an aggregate supply-demand diagram to analyze a 5 percent interest rate is r 5 5.) Exports and imports
the effects of a currency appreciation. are as follows:
2. Explain why X 2 IM 5 (S 2 I) 2 (G 2 T). Now multiply
X 5 300
both sides of this equation by “1 to get
IM 5 250 1 0.2Y
IM 2 X 5 (I 2 S) 1 (G 2 T)
Government purchases are G 5 800, and taxes are
and remember that the trade deficit, IM 2 X, is the 20 percent of income. The price level is fixed and the
amount we have to borrow from foreigners to get central bank uses its monetary policy to peg the interest
rate at r 58.
Borrowing from foreigners 5 (I 2 S) 1 (G 2 T)
a. Find equilibrium GDP, the budget deficit or surplus,
Explain the common sense behind this version of the and the trade deficit or surplus.
fundamental equation.
b. Suppose the currency appreciates and, as a result,
3. (More difficult) Suppose consumption and investment exports and imports change to
are described by the following:
X 5 250
C 5 150 1 0.75DI
IM 5 0.2Y
I 5 300 1 0.2Y 2 50r
Now find equilibrium GDP, the budget deficit or sur-
Here DI is disposable income, Y is GDP, and r, the inter- plus, and the trade deficit or surplus.
est rate, is measured in percentage points. (For example,

1. For years, the U.S. government has been trying to get indicated in the closed-economy model described earlier
Japan and the European Union to expand their in this book.
economies faster. Explain how more rapid growth in 5. Given what you now know, do you think it was a good
Japan would affect the U.S. economy. idea for the United States to adopt a policy mix of tight
2. If inflation is lower in Germany than in Spain (as it is), and money and large government budget deficits in the
the exchange rate between the two countries is fixed (as it early 1980s? Why or why not? What were the benefits
is, because of the monetary union), what is likely to hap- and costs of reversing that policy mix in the 1990s?
pen to the balance of trade between the two countries? 6. In 2001, 2002, and 2003, Congress passed the series of tax
3. Explain why a currency depreciation leads to an cuts that President Bush had requested. What effect did
improvement in a country™s trade balance. this policy likely have on the U.S. trade deficit? Why?
4. Explain why American fiscal policy is less powerful and 7. In 2007 and 2008, the international value of the dollar fell.
American monetary policy is more powerful than This development was viewed with alarm in Japan. Why?

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Licensed to:

Appendix: Answers to Odd-Numbered Test Yourself Questions
Answers to odd-numbered Discussion Questions are available on the text support site
at academic.cengage.com/economics/baumol.

What Is Economics?

Answers to Appendix Questions 6
Slope is 1

# of job offers

3,400 3

3,300 2
Total Enrollment

Slope is 3
0 1 2 3 4
# of grades B+ or

A marginal increase in the number of job offers is
1994“ 1995“ 1996“ 1997“ 1998“
relatively larger with the first good grade compared to
1995 1996 1997 1999 1999
additional good grades.
5. A 5. 30 hr labor and 40 yd cloth 5 20 units of output.
B 5. 40 hr labor and 28 yd cloth 5 20 units of output.
Common: 20 units of output; Difference: Amount of labor
Slope is 100 interpreted as 100 new students each
and cloth charge”more labor, less cloth.
academic year.

The Fundamental Economic Problem:
Scarcity and Choice

Economics Enrollment

1. This question asks the students to apply opportunity cost
to a straightforward decision: to rent or buy. After buying
the house, the person would no longer have to pay
$24,000 annual rent. On the other hand, she would lose
the $8,000 she currently earns in interest from her bank
account. She would be ahead by $16,000, and the pur-
chase is therefore a good deal. In order to get a service
(housing) for which she had been willing to pay $24,000,
she only has to give up (that is, the opportunity cost is)
goods and services worth $8,000. It is worth pointing out
to students that if she did continue to rent the house, it
must be because the services she receives from the land-
1994“ 1995“ 1996“ 1997“ 1998“
lord are worth more than $16,000. Also, it is important to
1995 1996 1997 1999 1999


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