The Global Economy and Policy - Macroeconomics 2

3 International Finance In addition to trade in goods, countries are also linked through exchange of currencies, flows of income, and purchases and sales of real and financial assets across national borders. As we consider how international finance is related to trade and to domestic macroeconomic policies, the realization that “everything is linked to everything else” can become overwhelming. Most topics that we have discussed earlier in this book— such as supply and demand, interest rates, inflation, aggregate expenditure, and the Fed—will here come back into play. In order to ease into the topic, we begin with a few basic concepts and models. The first is currency exchange rates, followed by purchasing power parity adjustments. 3.1 Exchange Rates The exchange rate refers to the rate at which one country’s currency can trade for another’s. Consider, for example, the exchange rate between U.S. dollars (US$) and euros (€). As of early 2022, US$1 was worth about €0.889. Equivalently, we could say that one euro was worth US$1.125. The two rates are inverses of one another. When we cite “the exchange rate” for the dollar in terms of a foreign currency, what we mean is the number of units of the foreign currency that you can get in exchange for a dollar. exchange rate: the number of units of one currency that can be exchanged for one unit of another currency What makes exchange rates go up and down? Currencies are traded against each other all over the world, as people offer to buy and sell. The supply-and-demand model explained in Chapter 3 can be applied to foreign exchange markets, once we realize that an exchange rate is really just another kind of price—a price for a national currency. Figure 13.4 shows an idealized foreign exchange market in which U.S. dollars are traded for euros. The quantity of dollars traded is shown on the horizontal axis, and the “price” of a dollar is given on the vertical axis, in terms of the number of euros it takes to buy a dollar. Figure 13.4 A Foreign Exchange Market for Dollars DRAFT In a well-behaved foreign exchange market, domestic residents largely determine the supply curve of dollars, by deciding how many dollars they are willing to offer in order to buy foreign-produced goods and services and foreign assets. Because foreign-produced goods, services, and foreign assets must be paid for in the currency of the country from which they will be purchased, dollars must be traded in the foreign exchange market. Professional currency traders and banks usually do the actual trading. The more euros that U.S. residents can get for their dollars, the cheaper that European items are to them, and the more they will want to buy from Europe rather than from domestic producers. Thus, the higher the exchange rate, the more dollars they will offer on the market. The supply curve slopes upward. It is residents of other countries who largely determine the demand curve for dollars. They may want to buy goods and services from the United States or to invest in U.S. bonds or businesses. To make these purchases, they must acquire dollars. The more euros, or other currencies, they have to pay to get a dollar, the more likely they are to go somewhere other than the United States for what they want and the lower will be the quantity of dollars that they demand. But if the U.S. dollar is relatively cheap in terms of euros, they will want to demand more dollars. So, the demand curve slopes downward. Market equilibrium is established at point E. † When the exchange rate falls, we say that the currency has depreciated. Suppose, for example, that a European technology firm comes out with a new device for listening to music that everyone wants to buy. In their desire to obtain euros to buy the good, people in the United States will offer more dollars on the foreign exchange market, shifting the supply curve to the right. Excess supply will, as in any other market, cause the price to fall, as shown in Figure 13.5. Commentators may say that the dollar is now “weaker” against the euro. (Conversely, of course, the euro is now “stronger” against the dollar.) currency depreciation: when a currency becomes less valuable, for example, due to a decrease in demand for a country’s exports or an increase in its demand for imports But an increase in demand for U.S. products or assets would lead to an appreciation of the dollar. For example, if European investors became eager to buy U.S. real estate, the demand curve for dollars would shift outward and the dollar would appreciate—that is, gain in value— against the euro. A currency may appreciate or depreciate relative to a specific currency, or it may appreciate or depreciate generally—that is, in relation to all or most other currencies. currency appreciation: when a currency becomes more valuable, for example, when increased demand for a country’s exports causes an increase in demand for its currency Which factors are most responsible for the depreciation or appreciation of a country’s currency? The first potentially important factor is relative prices. If prices in general rose more rapidly in the United States than in, say, Japan (meaning that inflation is lower in Japan), the Japanese would be less interested in purchasing U.S. † For simplicity, this example ignores other sources of supply and demand for currencies, such as foreign lending and currency speculation. DRAFT goods, ceteris paribus, and we would be more interested in purchasing theirs. What this means in terms of the foreign exchange market is that the United States would supply more dollars (in order to obtain yen to make purchases from Japan), and the Japanese would demand fewer dollars to purchase our higher-priced goods. A rightward shift in supply coupled with a leftward shift in demand unambiguously lowers the yen “price” of the dollar, meaning that the dollar would depreciate relative to the yen (and the yen would appreciate relative to the dollar). Note that, in this example, the dollar would not depreciate with respect to all other currencies—it would merely depreciate relative to the yen. A second factor influencing exchange rates may be a country’s GDP growth rate relative to that of its trading partners. If, for example, the United States experienced rapid growth in employment and output, it means that imports would also, ceteris paribus, increase relatively rapidly, since people would spend part of their increased disposable income on imports. This would lead the United States to demand more foreign currencies (to purchase imports) relative to the foreign demand for our dollars. Our greater demand for foreign currencies (and greater supply of dollars to purchase them) would cause the dollar to depreciate. Figure 13.5 A Supply Shift in a Foreign Exchange Market One might conclude from this discussion that countries that consistently import more than they export should have a persistently weak currency. The United States has, in fact, imported significantly more than it has exported for many years. Yet the dollar not only has not collapsed but remains one of the most stable currencies. How is this possible? One reason might have to do with interest rates, which are a third key factor in determining exchange rates. If the interest rate on, say, the six-month U.S. Treasury bill were higher than the rate on comparable investments in other countries, the United States might attract flows of money from foreign investors seeking to exploit the interest rate differential. Because Treasury bills are denominated in dollars, the foreign money would be seeking to buy dollars, raising dollar demand. The result would be an appreciation in the value of the dollar. As a general rule, then, higher relative interest DRAFT rates tend to raise demand for the domestic currency and hence lead to a currency appreciation. Yet it would be misleading to attribute dollar stability solely, or possibly even at all, to higher interest rates. Rates in the United States have been at historically low levels for the past decade and a half. Yet a strong foreign appetite for U.S. assets such as government bonds persists, and it probably explains much of the steady and reliable demand for dollars. Generally speaking, it is a country’s relative investment attractiveness that influences its currency exchange rate; the prevailing interest rate is merely one variable in what makes the country attractive to investors. Because U.S. government bonds, as well as other investments in the U.S. such as real estate, are widely regarded as safe and desirable, there is a steady flow of foreign demand for dollars to purchase these assets—independent of the inter-country interest rate differential. In addition to currency needs for trade and investment, many traders buy and sell currency for speculative reasons. As discussed in Chapter 3, sometimes people buy something not because they need it (e.g., in this case, for facilitating a trade in real items), but because they are betting that its price will go up or down in the future. Speculative buying and selling of currencies often plays a large role in foreign exchange markets. Unfortunately, because the ability of a country to participate in global trade critically depends on its exchange rate, such “bets” have the potential to produce real economic effects that are not always beneficial. As the role of speculation grows in importance relative to other factors that influence exchange rates, the ability of financial decisions to affect entire economies—especially small, relatively vulnerable economies—only increases. As discussed in Chapters 6 and 10, the relationship between speculation and finance, on the one hand, and the “real” economy, on the other, can affect the stability of the domestic economy, and this is also true internationally. Many confuse domestic currency depreciation with inflation since the latter is often (correctly) understood to be a decline in the “value” of the currency. But “value” can have more than one meaning. Price inflation refers to when a currency weakens in terms of domestic purchasing power (i.e., higher average prices mean that the currency is worth relatively less) while depreciation is the weakening of currency in relation to other currencies (a reduction of its exchange rate). The two concepts are related, but not always equivalent. What really matters for trade is the real exchange rate between currencies. Economists use the real exchange rate to express the combined effect of exchange rates and domestic inflation. For example, if a country experiences 10 percent inflation while its currency exchange rate is unchanged, the real exchange rate, which measures what foreign buyers can get for their money, is said to fall by 10 percent. † real exchange rate: the exchange rate between two currencies, adjusted for inflation in each country Most foreign exchange transactions are made in “strong” currencies or currencies that other countries would generally not hesitate to accept as payment for goods and The example presumes no inflation in the foreign country or countries. If, say, the other country experienced a five percent inflation, then the real exchange rate in the first country would fall by the inflation rate differential between the two countries, or 5 percent. † DRAFT services or for some investments. The U.S. dollar tops the list, but the euro and the yen also qualify. Beyond this, the Swiss franc, famed for its remarkable stability, and possibly the British pound sterling, could be considered members of this exclusive club. Many speculate that it is only a matter of time before the Chinese currency makes this short list, but not everyone agrees. Regardless, the dollar, the euro, and the yen stand out as the top three. These currencies are the ones often referred to as foreign exchange due to their general acceptability for foreign transactions. foreign exchange: the class of currencies that is broadly acceptable by foreigners in commercial or investment transactions. Generally limited to three currencies—the dollar, the euro, and the yen Weak economies seldom if ever accept one another’s currencies, and usually not even their own currency, as international payment for goods, services, or assets. As will become clear, it benefits them to be paid in strong currencies. Thus, the overwhelming majority of global currency trades are in dollars, euros, or yen. 3.2 Purchasing Power Parity Purchasing power parity (PPP) refers to the notion that, under certain idealized conditions, the exchange rate between the currencies of two countries should be such that the purchasing power of currencies is equalized. If, for example, one US dollar can fetch 115 Japanese yen in the market, a coffee maker selling for $100 in the United States should cost exactly 11,500 yen in Japan. If this were not so, the purchasing power of the two currencies would not be equal, and the purchasing power theory would not hold. purchasing power parity (PPP): the theory that exchange rates should reflect differences in purchasing power among countries If currencies could be traded freely against one another, if goods were freely traded and identical across countries, and if transportation costs were trivial, then there would be a strong logic to the theory of purchasing power parity. Take, as another example, a winter jacket that costs US$200 in New York. If you lived in the United States and changed US$200 into euros, the theory of PPP says that the number of euros you would receive in exchange for your dollars in this idealized world should be exactly enough for you to buy the identical winter jacket in Paris. If the exchange rate were 0.80 euros per dollar and the jacket cost €160 (= US$200 × 0.80 euros per dollar) in Paris, PPP would hold. If economies were in fact as smoothly integrated as we are assuming in this idealized world, any item (whether a winter jacket or an hour of labor services) should cost the same, no matter where you are. If this were not true, there would be pressures leading toward change. Suppose that the jacket costs US$200 in New York and €160 in Paris, but the exchange rate is higher, at €1: US$1. Why, in this case, would anyone buy a jacket in New York, if by changing their money into euros they could order it from Paris and save US$40? For jackets to be sold in both locations—in this idealized world—the price in New York would have to be bid down, the price in Paris would have to be bid up, or the exchange rate would have to fall. DRAFT But the real world is far from ideal. National economies are not nearly as integrated as the PPP theory assumes. Transportation costs are often significant; there are many varieties of goods; markets for goods and services do not work as quickly, smoothly, and rationally as is often assumed; and exchange rates are often “managed” by governments and central banks (see Section 4.4). Any of these factors can mean that converting monetary amounts from one country to another using the prevailing exchange rates may be misleading. Travelers often notice that a particular category of goods, such as books or clothing, are more expensive in one country than another; this could reflect real-world factors such as transportation costs, as well as tariffs or other market imperfections. Sometimes we see comparisons of international income levels expressed “in PPP terms.” Rather than simply using current exchange rates to convert all the various income levels into a common currency, PPP adjustments try to take into account the fact that the cost of living varies among countries. For example, converting Mexican average per capita income figures from pesos to dollars would probably understate the living standard of the average Mexican. Even though the conversion would be “correct”—in the sense that there exists a peso–dollar exchange rate that can easily be used for such an adjustment—many domestic goods and services in Mexico (e.g., haircuts or fresh produce) are generally much less expensive than in the United States. So, the dollar equivalent of what the average Mexican earns each year goes much further in Mexico. Prices tend to vary much more for goods and services that cannot be traded; haircut prices, for example, vary much more across borders than camera or jewelry prices. purchasing power parity (PPP) adjustments: adjustments to international income statistics to take into account the differences in the cost of living across countries The “Big Mac Index” published every year by The Economist is a somewhat lighthearted attempt to determine how much exchange rates and the price of goods vary from PPP predictions, by comparing the prices (converted into dollars using market exchange rates) of a McDonald’s hamburger across various countries. More sophisticated analysis uses a larger “basket” of goods to make such comparisons and estimate appropriate PPP adjustments. 3.3 The Balance of Payments The flows of foreign exchange payments into and out of a country are summed up in its balance of payments (BOP) account. Table 13.1 shows the BOP account for the United States in 2020. The top part of the table tallies the current account, which tracks flows arising from trade in goods and services, earnings, and transfers. The trade account refers exclusively to the portion of the current account related to exports and imports. balance of payments (BOP) account: the national account that tracks inflows and outflows arising from international trade, earnings, transfers, and transactions in assets DRAFT current account (in the BOP account): the national account that tracks inflows and outflows arising from international trade, earnings, and transfers trade account (part of the current account): the portion of the current account that tracks inflows and outflows arising exclusively from international trade in goods and services Various kinds of transactions lead to payments flowing into this country (hence to a demand for dollars in the foreign exchange market). When we export goods, we receive payments in return. So, the first entry under current account inflows is the US$1.4 trillion that the United States earned from exports of goods. Exports of services (such as travel, financial, or intellectual property) also bring in inflows, as do incomes earned abroad (as profits or interest) by U.S. residents. All told, inflows into the United States from exports, incomes, and transfers totalled almost US$3.3 trillion in 2020. Other transactions lead to payments going abroad (and to a supply of dollars to the foreign exchange market). When we import goods and services, we need to make payments to foreign residents. Foreign residents can take home incomes earned in the United States. The BOP account also includes a line for transfers abroad. The account consists of monies paid out in government foreign aid programs as well as remittances—money sent home to families from the host country by foreign workers. All told, outflows of payments from the United States totalled just under US$3.9 trillion in 2020. Table 13.1 U.S. Balance of Payments Account, 2020 (billions of dollars) Current account Trade Account Inflows: Payments for exports of goods Payments for exports of services Total exports Outflows: Payments for imports of goods Payments for imports of services Total imports Trade Balance Other Flows Income receipts Income payments Transfer receipts Transfer payments Total Balance on current account (= inflows – outflows) Capital account Inflows: Borrowing from abroad, and portfolio investment or FDI DRAFT 1,429 705 2,134 –2,351 –460 –2,811 958 –769 166 –294 1,457 –677 61 –616 Outflows: Lending, portfolio investment, or FDI abroad Derivatives and other misc. flows, net Balance on capital account (= inflows – outflows) –806 6 657 Official reserve account –9 Statistical discrepancy –32 Balance of payments 0 Source: U.S. Bureau of Economic Analysis, U.S. International Transactions Accounts Data, Table 1, with rearrangements and simplifications by authors. The balance on the current account is measured as inflows minus outflows. Because outflows exceeded inflows on the current account in 2020, the United States had a current account deficit of US$616 billion. The trade deficit, including just imports and exports, was slightly larger at US$677 billion. This is because other flows in the current account (incomes and transfers) added up to a net positive of US$61 billion. As you can see in Figure 13.6, the United States has had trade deficits fairly steadily since about 1980, with the gap between imports and exports widening to about 6 percent of GDP in some years, but more recently narrowing to about 3 percent. Figure 13.6 U.S. Imports and Exports of Goods and Services, 1960–2020 Source: BEA NIPA Tables 4.1 and 1.1.5, 2021 How can a country steadily import more than it exports? If you, personally, wanted to buy something that costs more than you have the income to pay for, you might take out a loan or perhaps sell something that you own, such as your bicycle or your car. DRAFT Likewise, countries can finance a trade deficit by borrowing or by selling assets. These are the sorts of transactions listed in the capital account. capital account (in the BOP account): the account that tracks flows arising from international transactions in assets To the extent the United States lends abroad (e.g., when the government extends loans to other countries, foreigners borrow from U.S. banks, or people in the United States buy foreign bonds), capital outflows are generated. This terminology may be confusing. Think about capital flows as going in the direction of the country that ends up with “the cash” or the power to purchase goods, and away from the country that provides the cash or purchasing power. In the case of a loan, the borrower received “the cash,” while the creditor receives a bond or other security representing a promise to repay; thus, a loan is an outflow from the lender and an inflow from the perspective of the borrower. Similarly, in the case of a U.S. firm engaged in portfolio investment—investment in the stocks or bonds of a foreign country or company—or foreign direct investment (FDI)—the buying of all or part of a business in another country—it is the people abroad who would end up with “the cash,” while the U.S. company would receive the asset. This is also counted as an outflow from the United States. From Table 13.1, we can see that the United States had US$806 billion in capital outflows during 2020. portfolio investment: investment in stocks or bonds of a foreign country or company foreign direct investment (FDI): investment in a business in a foreign country Capital outflows can have widely differing meanings and impacts, depending on where they occur. When a country with a large current account surplus such as China invests the proceeds from its exports abroad, say by buying U.S. Treasury bonds, it increases China’s claims against the United States, but does not necessarily have negative impacts on either country. Holding U.S. bonds may provide China with a secure investment, while the inflow of capital may promote economic activity in the U.S. Weak, unstable economies are much more vulnerable to large capital flows, and frequently suffer from what is known as capital flight, which occurs when investors fear investment losses and rush to move their assets to “safer” countries like the United States, the member countries of the European Union, and Japan. Capital flight may represent international investors rushing to take their money out of a weak country—as happened with South Korea, Indonesia, and the Philippines during the East Asian financial crisis of 1997—or wealthy elites seeking to take money out of their own countries. In many such cases, capital flight has the potential to destabilize economies by making foreign exchange scarce, and governments will often go to great lengths to try to stop it (see Box 13.2). capital flight: rapid movement of capital assets out of a country DRAFT Box 13.2 Africa Loses $89 Billion a Year to Capital Flight African countries lose almost $90 billion each year, equivalent to 3.7 percent of the continent’s economic output, in illicit capital flight, according to a recent UN Economic Development in Africa Report. 4 A report by the UN Conference on Trade and Development’s (UNCTAD) states that stopping capital flight would have the potential to generate enough capital by 2030 to finance almost 50 percent of the $2.4 trillion needed by African countries for climate change adaptation and mitigation policies. “Illicit Financial flows (IFFs) rob Africa and its people of their prospects, undermining transparency and accountability and eroding trust in African institutions,” UNCTAD Secretary-General Mukhisa Kituyi said in a statement accompanying the report. The report calls for increased transparency and cooperation between global governments and within the continent to tackle tax evasion and tax avoidance. It also urges the African Tax Administration Forum to become a platform for regional cooperation among African countries. UNCTAD also reports that African countries with the most IFFs spend 25 percent less than countries with low IFFs on health care, and 58 percent less on education. “The fact remains that the funds involved [in illicit financial flows] often come from jurisdictions with scarce resources for development financing, depleted foreign reserves, a drastic reduction in collectable revenue, tax underpayment or evasion and poor investment in-flows,” said Nigerian President Muhammadu Buhari. As a result of the pandemic, a handful of African states face debt distress, and countries like Chad and Zambia have warned that they will have to default on commercial payments. “Curbing IFF presents a key policy measure for governments, particularly in Africa, to generate the necessary financial resources to mitigate the impact of COVID-19-induced economic crisis,” Alvin Mosioma, executive director of Tax Justice Network Africa, told EURACTIV. As we have noted, a country receives capital inflows when it borrows from foreigners or when foreigners purchase assets there. In the case of the United States, many people abroad buy U.S. government bonds because they are considered a very secure investment. For similar reasons, many also put funds into bank accounts here. These are both capital inflows—the sellers of the U.S. securities and the U.S. banks receive “the cash.” Likewise, if a foreign multinational bought an interest in a U.S. publishing company, it would be a capital inflow. Another large source of inflows is foreign investment in U.S. real estate. In addition, a growing though still relatively minor source of net inflows were financial derivatives and similar instruments used primarily for speculation. In total, the United States received close to US$1.5 trillion in capital inflows in 2020. As with the current account, the balance on the capital account is measured as inflows minus outflows. Thus, the United States had a US$657 billion capital account surplus in 2020. It was the willingness of foreigners to buy U.S. securities (and other assets) that financed the deficit in the current account (as you can see from Table 13.1 the positive balance on the capital account largely cancels out the negative balance on the current account). Does this mean that the United States is putting itself in a vulnerable position by relying on borrowing to “spend beyond its means” on imports? Notice that present-day DRAFT capital inflows create the obligation to pay future income outflows: The interest due in the future on U.S. government bonds sold abroad this year, and future profits made by firms located in the United States that were bought by foreign parties this year, will become part of “income payments” in the outflows section of the current account, in years to come. Depending on how confident we are that the U.S. economy will be able to handle these payments, we may not need to be concerned about a current account deficit – and indeed some countries have run moderate current account deficits for decades with no ill effects, generating positive economic benefits from foreign investment. But if a current account deficit is very large or lasts for a prolonged period, it could lead to future problems, as has been the case for many developing countries that borrowed too heavily on international markets. Finally, we have what is known as the official reserve account. It represents the foreign exchange market operations of the country’s central bank (in the United States, the Federal Reserve). Why the central bank? Here it is probably more helpful to consider the position of a developing country—say, Indonesia. Like any other country, it needs to import some goods and services. How can it pay for the imports? Its currency, the rupiah, will not do. Most exporters will insist on being paid in foreign exchange—that is, dollars, euros, or yen. This presents a problem for Indonesia because it cannot produce its own dollars. It can, however, obtain them. official reserve account: the account reflecting the foreign exchange market operations of a country’s central bank For example, when Indonesia exports coffee, it can insist on being paid not in rupiah but in foreign exchange such as dollars. In this way, it has a strong currency available to pay for its imports. It works the same way with the capital account. Indonesia has creditors to whom it owes interest every year (reflected in the income section of the current account) that require payment in foreign exchange. Indonesia obtains this foreign exchange not only by exporting coffee and other products but also by attracting foreign capital, which it also insists should come in the form of dollars, euros, or yen. Bank Indonesia, the country’s central bank, holds reserves of foreign currency, so that it can make up for a balance of payments deficit if necessary. Of course, it cannot do so indefinitely. If the central bank runs short of foreign exchange reserves, the country will have to cut back on imports. But in the short term the central bank can supply foreign exchange to cover a balance of payments deficit or acquire foreign exchange if there is a balance of payments surplus. If the central bank supplies foreign exchange, it is recorded as a positive item in the official reserve accounts; if it acquires foreign exchange, it is recorded as a negative item. In some versions of the BOP, the official reserve account is lumped with the capital account. ‡ When this is done, the total inflows and outflows from the current and capital accounts always “balance.” When treated separately, the official reserve account, as we have seen, offsets the discrepancy between current and capital accounts. The In recent years, for example, the International Monetary Fund has adopted the practice of calling the capital account the “financial account,” with the latter calculated to include the official reserve account. We prefer to present the traditional approach to the BOP, finding it more transparent about whether a country is truly in surplus or in deficit. ‡ DRAFT United States reduced its official reserve account by about US$9 billion in 2020, which means that the Fed’s holdings of these assets increased by this amount. If this is confusing, think of it as the negative sign signifying that the Fed removed US$9 billion in reserve assets (mostly foreign exchange) from the U.S. economy. One additional caveat is the statistical discrepancy. It represents an inability of the BEA to make the accounts balance precisely, given problems in the quality of the data, and some small items in the accounts that we do not get into here. Allowing for this discrepancy, the balances in the current account, the capital account, and the official reserve account must add up to zero (the “balance of payments”). The difference between the current and capital accounts must be “balanced” by a flow of foreign exchange to or from the central bank. Any gap can be fully attributed to measurement error, which is what the statistical discrepancy reflects. Discussion Questions 1. Is it better for the United States to have a strong or weak dollar? What are the advantages and disadvantages of each? 2. Is a nation’s balance of payments analogous to a company or household income statement? Is it necessarily a bad thing for a country’s trade balance to be in deficit? 4 Macroeconomics in an Open Economy In earlier chapters, our discussion of how fiscal and monetary policy can be used to influence aggregate expenditure was limited to a “closed” economy. We are now ready to consider a more complete picture of the effects of such policies in an “open” economy. The bottom line of what is laid out in sections 4.1 and 4.2 is simple to state: The intended effects of monetary policy are strengthened, or amplified, by interactions with the foreign sector; while trade with foreign partners may either strengthen or weaken fiscal policy actions. The reasons why this is so, however, are rather complex. The value of working through them is that it is a way of showing in action some of the principles of macroeconomic supply and demand that have been laid out thus far. We will then apply our open economy model to the emergency circumstances underlying the global pandemic, and then consider how these, along with exchange rate policy, can bring about serious sovereign debt problems. 4.1 Fiscal Policy Recall from our earlier concept of a macroeconomic equilibrium that, for equilibrium to be present, injections must equal leakages. We know from Chapter 9 that a budget deficit is a net injection because it occurs when government spending (injection) is greater than tax revenue (leakage). If we assume that private savings and investment are in balance, a government budget deficit requires a net leakage from the foreign sector for macroeconomic equilibrium to be achieved—that is, imports must exceed exports (again, disregarding for now the transfers and net income). In other words, a government’s budget balance is correlated with the country’s trade balance—a government deficit, not financed from domestic savings, implies a trade deficit. In common-sense terms, if the government does not obtain the funds it needs from domestic savings, it must borrow from abroad. But what is the economic DRAFT mechanism by which they are related? A country’s budget balance can influence its trade balance through at least two separate channels, each related to the exchange rate of its currency. First, we have seen that deficit spending has the potential, in economies at or near full employment, to lead to higher interest rates—either through the classical argument of crowding out or through the central bank reacting to growing inflationary pressure with rate hikes. In an open economy, the higher interest rates are likely to attract more foreign investment in the form of bond purchases. If foreigners demand more U.S. bonds as a result of the higher interest rates that they offer, the demand for dollars increases (because U.S. bonds are all denominated in U.S. dollars). The resulting increase in demand for dollars, ceteris paribus, leads to an appreciation of the dollar compared to other currencies. We have also seen that a stronger currency makes a country’s goods relatively more expensive in the global markets. In other words, if the U.S. dollar appreciated, we would expect the United States to be able to export less than before. At the same time, imports would increase because a stronger dollar makes other countries’ goods (denominated in their currencies) appear cheaper. Through this sequence, an increase in the budget deficit might increase the size of the trade deficit. Notice, however, that while both deficits grow, the economic effect of the rising trade deficit is to offset the expansionary effect of the budget deficit. Imports (leakage from the circular flow) increase while exports (injection) decrease. Because we do not know the magnitude of each of these changes, we are not saying that the open economy effect cancels out the original effect of the fiscal stimulus. What we can say is that it probably dampens it somewhat. The other channel is a more direct consequence of the fiscal expansion. Deficit spending boosts aggregate expenditure, increasing spending and generating greater employment and more income. Yet, as the economy grows, all spending grows, including spending on imports. The greater demand for imports increases the global supply of dollars, as U.S. citizens demand more foreign currency to purchase imports. This causes the dollar to depreciate, reversing the process, because a weaker dollar results in more exports and fewer imports. Depreciation of the dollar will tend to narrow the trade deficit, resulting in a net injection to the circular flow and reinforcing the initial fiscal stimulus. Since the two effects we have described go in opposite directions, we cannot say anything specific about the magnitude of the changes, nor can we say overall whether the “open economy” on balance reinforces or countervails the domestic fiscal policy. But we can say that the effect of deficit spending is complicated by consideration of foreign sector effects. 4.2 Monetary Policy In Chapter 11 we discussed monetary policy in a closed economy. In an open economy, monetary policy is more effective in changing aggregate expenditure, because, unlike fiscal policy, its global effects unambiguously reinforce the domestic policy. Suppose that the Fed believes the U.S. economy needs a boost and acts to promote lower interest rates in an attempt to increase aggregate expenditure. As we saw in Chapter 11, the decrease in interest rates should encourage investment spending. But in an open economy, the fall in interest rates should also increase net exports, another component of aggregate expenditure. DRAFT This is because a reduction in U.S. interest rates is likely to reduce inflows of foreign financial capital. If interest rates in the U.S. fall, people abroad will be less inclined to buy U.S. government bonds or put their money in U.S. bank accounts. As they send their financial capital elsewhere, the demand for U.S. dollars will decrease. This can be portrayed as a leftward shift of the demand curve in the foreign exchange market. As discussed above (refer to Figure 13.4) a decrease in the demand for dollars would cause the dollar to depreciate. A depreciation in the dollar means that a dollar now buys fewer units of foreign exchange, which, you will recall, discourages spending on imports. Meanwhile, the fact that a dollar can be purchased for fewer units of foreign exchange means that U.S. exports become “cheap” for foreign buyers. Exports should increase. As we have discussed, an increase in net exports (caused in this case by both a rise in exports and a fall in imports) raises aggregate expenditure. This reinforces the original stimulus effect of the expansionary monetary policy. The openness of the economy can be thought of as adding an extra loop to the chain of causation discussed in Chapter 11, as illustrated below: Yet this is not the end of the story. Just as in the earlier case of deficit spending, an increase in aggregate expenditure tends to produce an increase in imports. As we have seen, this leads to dollar depreciation, as U.S. citizens trade dollars for other currencies so that they can purchase imported products. The effect is to further reinforce the initial domestic stimulus, since a weaker dollar tends to narrow the trade deficit and thus increase aggregate expenditure, ceteris paribus. So, in contrast to the fiscal policy case, where “opening up” the economy produces ambiguous effects in relation to a domestic fiscal stimulus, for monetary policy the international trade consequences clearly reinforce the domestic policy. A monetary stimulus, in other words, is amplified in an open economy. We should note that a monetary contraction would also be magnified; the same causal mechanisms would be in effect, only in reverse. 4.3 A Special Case: Economic Stimulus in the Pandemic Era The pandemic experience illustrates a variety of country experiences with macroeconomic policy and its impacts. The initial economic fallout from COVID-19 threatened to plunge the world into a full-blown depression. It is arguably thanks to widespread fiscal and monetary stimulus throughout the world that such an outcome was avoided. Yet not all countries benefited equally from economic stimulus. DRAFT Widespread illness and death, along with an imposed economic slowdown in hopes of stemming the pandemic’s spread, effectively put a brake on most economies. Most countries pursued fiscal and monetary stimulus in response to the negative economic effects of the pandemic, but with varying degrees of success. In particular, as we might expect from the discussion of fiscal policy in the previous section, countries that attempted very large spending increases did not necessarily see comparable benefits. Some of the benefits of increased spending could “leak” away in the international market, leaving the country with large increases in debt. Public health policy was also a major factor in economic health outcomes: invariably, countries that imposed stricter lockdowns and were slower in inoculating their populations suffered more adverse economic consequences (See Box 13.3). Box 13.3 The Pandemic Stimulus Backfired in Some Emerging Markets According to an analysis in the Financial Times, some of the developing countries that stimulated most aggressively got little payoff in terms of faster recovery. 5 More rapid inflation, higher interest rates, and currency depreciation at least partly cancelled out the effects of stimulus in a number of countries. Hungary, Brazil, the Philippines, and Greece, all of which spent at least 16 percent of GDP on stimulus, saw limited results. But the higher deficits and debt that they ran up “will leave them with less ammunition to fight the next battle,” according to Ruchir Sharma, global strategist for Morgan Stanley. Moreover, developing nations often lack the financial resources and the global credibility to increase spending substantially without unbalancing the economy. Those that overspend tend to get punished by global markets. Comparing countries on an index that includes factors like inflation, currency value, interest rates, and budget deficit highlights the difference between the big spenders and countries that were more conservative. Hungary, Brazil and the Philippines were among the worst scorers, while light spenders like Taiwan, South Korea, and Mexico scored the best. According to Sharma, nations that spend in haste are often forced to repent at leisure. Those that attempted to “go big” during the pandemic mostly got less added growth than they imagined and considerably more trouble, in the form of higher deficits and debt. It figures to be a major challenge in the future, as many believe that another international debt crisis looms. It matters a great deal whether the country pursuing fiscal or monetary policy is a rich country like the United States or a developing country like the Philippines. Quite simply, markets respond very differently when a country that cannot “afford” a sizable stimulus—often requiring a sizable debt to finance—attempts to undertake one regardless. Developing countries are hurt more even by moderate inflation because it means either higher interest rates, currency depreciation, or both. Either one has the effect of nullifying the impact of the initial stimulus. Countries with stable currencies need not fear such consequences, at least not to the same extent. The logic underlying fiscal and monetary policy links to the global economy is of less concern to a large economy such as United States. The U.S. also enjoys the benefits of possessing the dollar, the world’s premier international currency. What this means, for example, is that the United States government can borrow large DRAFT sums without worrying unduly about having to offer higher interest rates. Why? U.S. government debt and the currency in which it is dominated continues, arguably at least, to offer global investors the safest existing investment. Consequently, foreigners generally continue to lend to the United States, even at a low interest rate. Unlike other currencies, the dollar is not as likely to depreciate as a result of continued low rates, because investors will be expected to invest in the U.S. economy regardless. In short, while there exist important links between a country’s domestic economic policies and the global economy, we must keep in mind that the picture is invariably complicated by such factors as pandemics and other global shocks, the relative strength of the economy or its currency, or international politics. These intersecting considerations limit the extent to which we can predict the likely global consequences of domestic economic policies. 4.4 Managed Versus Flexible Foreign Exchange Thus far, we have assumed that exchange rates are determined by market forces, as modelled in Figures 13.4 and 13.5. In a flexible or floating exchange rate system, countries allow their exchange rates to be determined by the forces of supply and demand. But in practice this may not always be the case: countries may often attempt to control or manage their exchange rates. flexible (floating) exchange rate system: a system in which exchange rates are determined by the market forces of supply and demand Flexible exchange rates can create significant uncertainties in an economy. A manufacturer may negotiate the future delivery of an imported component, for example, only to find that exchange rate changes make it much more expensive than expected to complete the deal. Foreign exchange markets can also be susceptible to wild swings from speculation. A mere rumor of political upheaval in a country, for example, can sometimes create a rush of capital outflows as people try to move their financial assets into foreign banks, causing a precipitous drop in the exchange rate. Or an inability to obtain short-term foreign loans may send an economy into crisis— and its exchange rate swinging—even if over a longer period the economy would be considered financially sound. It can be hard to maintain normal economic activities when exchange rates fluctuate wildly. ‡ Many countries have tried to control the value of their currencies to create a more predictable environment for foreign trade. The strictest kind of control is a fixed exchange rate system. In this case, a group of countries commits to keeping their currencies trading at fixed ratios over time. Starting in 1944, many countries, including the United States, had fixed exchange rates under what is known as the Bretton Woods system (named after the international monetary conference in Bretton Woods, New Hampshire that created a post-war financial order including the Intentional Monetary Fund and the World Bank). It is for this reason that importers and exporters frequently resort to futures markets in order to “lock in” a given exchange rate between two currencies hence avoid any risk from such fluctuation. But such markets can also be, and often are, used for financial speculation. Perhaps as a result, futures markets are generally more a focus of finance than of economics. ‡ DRAFT fixed exchange rate system: a system in which currencies are traded at fixed ratios Bretton Woods system: a system of fixed exchange rates established after World War II, lasting until 1972 The exchange rates in such a system, however, do not usually remain perfectly fixed. For one thing, to fix an exchange rate precisely, the central bank would need to have perfect (and continuously perfect) information about all trades—something that is not feasible in real-world conditions. What the countries that participated in the Bretton Woods conference did—and countries today that fix their currency generally do—is set a “band” or range around a “target rate” and allow the “fixed” rate to fluctuate within this band. In the case of the countries that were part of the Bretton Woods system, the band was very narrow—on the order of plus or minus 1 percent. Over the long term, the target rate can change, at the government’s discretion. When a government lowers the level at which it fixes its exchange rate, what is called a devaluation occurs, and when it raises it, a revaluation takes place. But the system can be undermined if there are too many changes, and when key currencies such as the dollar come under too much selling pressure a fixed exchange rate system can break up. This is what happened to the Bretton Woods system in 1972. The U.S. dollar had been the linchpin of the system and had been convertible to gold. When the United States suffered large currency outflows, the U.S. eliminated gold convertibility and allowed the currency to float, which was quickly followed by other major countries floating their currencies also. devaluation: lowering an exchange rate within a fixed exchange rate system revaluation: raising an exchange rate within a fixed exchange rate system After the Bretton Woods system ended, many countries moved to a “floating” system, while others tried to exert some management over their currencies. Such management is performed by trying to maintain certain target exchange rates, by “pegging” the currency to a particular foreign currency or by letting it “float” but only within certain bounds (something like the Bretton Woods system, only with a much wider band). How does a country keep its exchange rate fixed, or at least within bounds? A government has at its disposal two main tools. The first is imposing capital controls. For example, a country that wants to limit foreign exchange trading may require that importers apply for licenses to deal in foreign exchange or impose quotas on how much they can obtain. By only allowing highly regulated transactions, it can control the prices at which exchange transactions are made. The second is foreign exchange market intervention. As we saw earlier in our discussion of official reserve accounts, central banks have the power to intervene in foreign exchange markets. They may do this under a floating exchange rate regime, with the object of raising or lowering the rate, or to build up or lower their holdings of foreign exchange. When a country is committed to a fixed exchange rate, it is the responsibility of the central bank to respond to upward or downward pressures on the rate with appropriate intervention in order to keep the rate at the prescribed level. DRAFT foreign exchange market intervention: an action by central banks to buy or sell foreign exchange reserves in order to keep exchange rates at desired levels To see how intervention works, consider Figure 13.7. Suppose that the government would like to keep the exchange rate of its domestic currency at the level e*, but market pressures are represented by the curves Smarket and Dmarket. At the exchange rate e*, there is an excess supply (surplus) of domestic currency, and so there is pressure on the exchange rate to fall. The central bank must artificially create more demand for the domestic currency, as shown by demand curve Dwith intervention. It does this by going into the market and exchanging foreign currency for domestic currency—essentially "soaking up" the surplus domestic currency. The problem is that the central bank can do this only as long as it has sufficient reserves of foreign exchange on hand. If it ran out of foreign exchange, it would be unable to support the currency and be forced to devalue. Devaluation is, in fact, fairly common among countries with a deficit in their current account and insufficient surplus in the capital account to cover these deficits. In particularly severe cases, countries can experience a balance of payments crisis, in which a lack of foreign exchange means that the country cannot purchase needed imports or make payments on its debt. balance of payments crisis: when a country gets precariously close to running out of foreign exchange and is therefore unable to purchase imports or service its existing debt Is devaluation a bad thing? The answer to this question is complex. Devaluation is generally thought to be good for exporters, because it makes the country’s goods cheaper abroad. But it also means that people in the country will find that imports are now more expensive. And sometimes devaluation is taken as a sign of instability or poor policy in a country, which can lead to rapid outflows of capital, forcing further devaluation. Figure 13.7 Foreign Exchange Intervention DRAFT Imagine, for example, an investor who is considering investing US$100 million in Bolivian government bonds. If it seemed likely that the country’s currency—the sucre—would at some point be devalued, the best strategy would be to avoid investing in Bolivia. If the exchange rate today were 5,000 sucres to the dollar, the investor could purchase 500 billion sucres worth of bonds with US$100 million. But if the currency were in fact later devalued—to the point where 10,000 sucres would be needed to purchase a dollar—the investment would subsequently only be worth US$50 million if the investor decided to sell the bonds and convert back to dollars. Because of the potential problems resulting from currency devaluation, many economists have grown cautious about recommending devaluation as a cure for international imbalances. Not surprisingly, countries will always prefer to plan a devaluation rather than be pressured into one by circumstances. Countries that are either export competitive or attractive to foreign investors are able to amass large amounts of foreign reserves and supply much domestic currency on the market. Doing so enables such countries to keep their exchange rates lower than market forces would dictate. China is generally known to have used this tactic in the past, keeping the value of its currency, the renminbi, artificially low to stimulate exports (the value of renminbi is often cited in terms of its most common unit, the yuan) and, in the process, becoming a large holder of U.S. dollars as well as other currencies. But China has also intervened in the opposite direction, to revalue the renminbi, particularly between 2014 and 2017 when it sold over $1 trillion from its reserves to support the currency. One complication with fixed exchange rates is that they make it impossible for a country to conduct independent monetary policy. The reason is that intervention by its central bank on money markets to buy and sell its currency for foreign exchange reasons necessarily affects the country’s domestic money supply, and consequently (as we saw in Chapter 11) its interest rates. If the domestic interest rate is influenced to a significant degree by the country’s exchange rate policy (specifically its desire to fix its rate), this severely limits the effectiveness of monetary policy. If, on the other hand, the central bank intervenes for monetary policy reasons (e.g., to control inflation), the resulting change in the money supply would affect the relative international value of the currency, so it would be impossible to keep the exchange rate fixed. A country, therefore, can set its exchange rate or its interest rate, but not both. If it keeps its exchange rate fixed relative to another currency, the interest rates in the two countries will tend to move together. 4.5 Developing Country Problems: Balance of Payments and Debt Crises Most developing countries opt for some variation of a “managed” exchange rate regime. For them, monetary policy is often necessarily a secondary concern. Their need for scarce foreign exchange is paramount. On the one hand this makes sense, since it is important that the value of an exporting country’s currency not rise too much. Allowing it to do so would make exports more expensive, hence less competitive, in global markets. Yet it is a delicate balancing act. Too weak a currency severely hampers a country’s ability to import. Perversely, developing countries with limited import potential will sometimes even go without necessities since the luxury-consuming middle class have preferential access to scarce foreign exchange. An exceedingly weak currency is also a big liability when it comes to servicing a country’s external debt. Creditors always insist on being paid in foreign exchange; the weaker a DRAFT developing country’s currency, therefore, the more of its scarce stock of foreign exchange must go to paying interest on the debt. The problem is that poor countries often fall short in their balance of payments. The current account and capital account need not fully offset; as we have seen, the central bank balances things through the operation of the official reserve account. Unfortunately, a country that is a relatively weak exporter (meaning fewer foreign exchange inflows) still depends on imports and must service its debt (both outflows). Consequently, the central bank “makes up the difference” by putting some of its scarce foreign exchange reserves into circulation. Doing so repeatedly is what provokes balance of payments crises requiring emergency lending. The worst such case on record is probably the debt crisis of the 1980s, during which several Latin American countries fell into balance of payments crises and required emergency bailouts. There have been numerous similar instances in more recent years, such as in Mexico (1994) and East Asia (1997), Russia (1998), Turkey (1999), Argentina (2001), Ecuador (2008), Greece (2012 and 2015), and Venezuela (2017)—to name only the most prominent. Many fear that a new debt crisis is brewing, possibly more consequential than any earlier one. Dozens of countries have recently applied for emergency assistance (see Box 13.4). The main cause is the unanticipated need for pandemic support. Wealthy nations can afford to “do without” for an extended period, have more fiscal clout, and also have more resources to stem the spread of diseases—in some cases not requiring their populations to undergo strict lockdown. Developing country economies have been hit especially hard because of economic paralysis and insufficient government funds. The global markets have also not favored them. Box 13.4 Poor Countries Facing a New Debt Crisis The world’s poor countries have had their finances destroyed by the global pandemic. Tanzania has called on “our rich brothers” to cancel its debt, and Argentina recently defaulted for the ninth time in its history. “This is really unlike anything we have seen,” said Mitu Gulati, a law professor at Duke University. “The last time we had this many countries likely to go under at the same time was in the 1980s.” In Latin America, that period was known as La Década Perdida—The Lost Decade. While poor countries have historically been able to borrow from the World Bank and International Monetary Fund (IMF), in recent years their debt has become popular with private investment firms. Unfortunately for debtor nations, such entities have their own interests and their own rules. Argentina’s multiyear dispute with a group of hedge funds including Elliott Management is a wakeup call. Elliott and other investors bought Argentine bonds shortly before the country defaulted in 2001 and held out for full repayment—at one point even seizing an Argentine naval vessel—rather than settle through a debt restructuring. It worked. Elliott eventually received nearly 400 percent of its original investment. As investors around the world seek refuge in the dollar, currencies in many developing countries have plummeted in value. That means it takes more of their own currency to buy the dollars they need to pay their debts, while they have also spent heavily on the logistical response to the COVID-19 pandemic. “The abruptness of this shock is much larger than the 2008 global financial crisis,” said Ramin Toloui, assistant Treasury secretary for international finance under Obama. DRAFT The International Monetary Fund has already expanded two emergency loan programs, and more than 100 countries have applied. The programs will help in the short term, Mr. Toloui said, but much more financial assistance will be required. The IMF itself has estimated the borrower countries’ total current need, from all sources, at $2.5 trillion. 6 As we have seen, persistent balance of payments deficits tend to provoke vicious cycles of continued debt dependence, except in the rare case when a country is able to export its way out of trouble. The recent economic crisis caused by the pandemic has only intensified an already chronic problem, as many countries find themselves in dire need of external assistance. While the pandemic might only be temporary, its financial consequences on developing countries could persist for decades. Together with the mounting challenges that developing countries face related to climate change, many are likely to experience an unprecedented imbalance in their foreign exchange payments. That might require widespread and massive debt forgiveness to avoid economic collapse. Discussion Questions 1. Having an “open” economy complicates a country’s conduct of fiscal and monetary policy, since international effects must be considered, and these may either reinforce or counteract the original policy. Does this mean that it might be better to have a “closed” economy? What are some of the advantages and disadvantages of “openness”? 2. Why did countries fix their exchange rates in the past? Why did many stop doing so? What are some potential problems involved in letting a country’s exchange rate “float”? 5 International Financial Institutions The Bretton Woods system of fixed exchange rates was only one aspect of the international financial structure established in the 1940s. Also formed during this period were the International Bank for Reconstruction and Development (IBRD), later expanded into the World Bank, with the goal of promoting economic development through loans and programs aimed at poorer countries, and the International Monetary Fund (IMF), established to oversee international financial arrangements. Although fixed exchange rates among the major currencies have been abandoned, the World Bank and the IMF continue—with considerable controversy—to play significant roles in international affairs. World Bank: an international agency charged with promoting economic development, through loans and other programs International Monetary Fund (IMF): an international agency charged with overseeing international finance, including exchange rates, international payments, and balance of payments management DRAFT When it was created, the IMF was charged with overseeing exchange rates, international payments, and balance of payments management and with giving advice to countries about their financial affairs. The IMF has a complicated governance structure based on voting shares allocated to member countries, but in fact its policymaking has historically been dominated by the United States and certain countries in Europe. The appointed members of its executive board represent the United States, the United Kingdom, Germany, France, and Japan. In 2010 the IMF restructured its voting system to give China, South Korea, Turkey, and Mexico slightly larger shares. Both the World Bank and IMF have their headquarters in Washington, DC. When a country is in financial trouble—for example, when it is unable to pay the interest that it owes on its foreign debts or is experiencing wild swings in its exchange rate—the IMF (in conjunction with the World Bank, if the country is poor) often advises the government on how to remedy the problem. The IMF has tended to encourage low- and middle-income countries with debt problems to remove their barriers to trade and capital flows, arguing that such liberalization promotes economic growth. The countries are also advised to minimize the size of their government and its expenditures, as a way to reduce the need for borrowing. They are told to keep their inflation rates down and are often advised about their exchange rate policies as well. The policy prescriptions of trade liberalization, privatization, deregulation, and small government became known during the 1980s and 1990s as the Washington Consensus (described in more detail in Chapter 16). The policies have also become the source of much controversy, as many economists have come to believe that rigid, “one-size-fits-all” application of such policies often works against, rather than for, human welfare and international stability. In particular, as prominent Malaysian economist Jomo Kwame Sundaram has argued, forcing smaller countries to open their borders to capital flows leaves them vulnerable to crisis caused by capital flight. This occurred in the Asian financial crisis of 1997 when an “East Asian miracle” of economic growth was rapidly replaced by economic collapse in Indonesia, Malaysia, the Philippines, and elsewhere. 7 High current debt levels, as we have noted, make renewed crises of this kind very likely. Washington Consensus: specific economic policy prescriptions used by the IMF and World Bank with a goal of helping developing countries to avoid crisis and maintain stability. They include openness to trade and investment (liberalization), privatization, budget austerity, and deregulation Many observers are currently calling for reforms in the international financial system and perhaps for new international institutions. Dissatisfaction over the IMF prescriptions for liberalization has caused some changes within the organization itself. But some argue that these changes are not sufficient and that more radical changes are necessary. Suggestions include greater regulation of international banking, substantial reforms and increased transparency in multinational corporate governance, restrictions on short-term capital flows, a tax on speculative transactions in foreign exchange, and establishment of an international bankruptcy court. DRAFT