Economics Chapter 11 Homework The issue is far from resolved, both in terms of theoretical modeling

22 Topics in International Macroeconomics

Notes to Instructor

Chapter Summary

This chapter covers extensions to the models presented in earlier chapters. There are four

topics covered:

■ purchasing power parity (PPP), especially the issue of why price levels are higher

in richer countries;

■ uncovered interest parity (UIP), and the implications of the fact that forex traders

seem to make positive net profits;

■ The problem of government defaults, including issues of supply and demand for

loans to governments and the cost of default to the defaulting government; and

■ the performance of the global macroeconomy before, during, and after the 2007–

2009 global financial crisis and the Great Recession.

Comments

This chapter provides extensions to earlier models presented in the textbook. These

sections can be presented independently. There are some connections made between the

sections in the conclusion following each, and in the conclusion section for the chapter.

The sections build on the theories and empirical analysis from earlier in the textbook. An

alternative approach to these sections would be to cover each section immediately after

the chapters on which they expand.

1. Exchange Rates in the Long Run: Deviations from Purchasing Power Parity.

This section presents an extension of the relative PPP model. It describes the

2. Exchange Rates in the Short Run: Deviations from Uncovered Interest

Parity. This section reconsiders empirical tests of the UIP condition and the

reasons arbitrage may fail in financial markets (trade costs, risk‒return trade–offs,

3. Debt and Default. This section models the repayment of sovereign debt as a

contingent claim based on the benefits and costs of default. The costs of default

4. Case Study: The Global Macroeconomy and the Global Financial Crisis. This

section begins with a review of the behavior of emerging market (EM) economies

since 1997. These economies dramatically increased their stock of foreign

exchange reserves as insurance against currency crises. To do this, they ran

current account surpluses. Thus, EM countries were the lenders. Developed

market (DM) economies were the borrowers. Much of this massive flow was used

to purchase U.S. Treasury securities. Yields on those securities fell, investors

An outline of the chapter follows.

1. Exchange Rates in the Long Run: Deviations from Purchasing Power Parity

a. Limits to Arbitrage

i. Trade Costs in Practice

b. Application: It’s Not Just the Burgers That Are Cheap

c Nontraded Goods and the Balassa‒Samuelson Model

i. A Simple Model

d. Overvaluations, Undervaluations, and Productivity Growth: Forecasting

Implications for Real and Nominal Exchange Rates

i. Forecasting the Real Exchange Rate

ii. Convergence

iii. Trend

iv. Convergence + Trend

v. Forecasting the Nominal Exchange Rate

vi. Adjustment to Equilibrium

e. Application: Real Exchange Rates in Emerging Markets

i. China: Yuan Undervaluation?

2. Exchange Rates in the Short Run: Deviations from Uncovered Interest Parity

a. Application: The Carry Trade

i. The Long and Short of It

ii. Carry Trade Summary

b. Headlines: Mrs. Watanabe’s Hedge Fund

c. Application: Peso Problems

d. The Efficient Markets Hypothesis

i. Expected Profits

ii. Actual Profits

iii. The UIP Puzzle

e. Limits to Arbitrage

i. Trade Costs Are Small

ii. Risk Versus Reward

3. Debt and Default

a. A Few Peculiar Facts About Sovereign Debt

b. A Model of Default, Part One: The Probability of Default

i. Assumptions

ii. The Borrower Chooses Default Versus Repayment

iii. An Increase in the Debt Burden

iv. An Increase in Volatility of Output

v. The Lender Chooses the Lending Rate

c. Application: Is There Profit in Lending to Developing Countries?

d. A Model of Default, Part Two: Loan Supply and Demand

i. Loan Supply

ii. Loan Demand

iii. An Increase in Volatility

e. Application: The Costs of Default

i. Financial Market Penalties

ii. Broader Macroeconomic Costs and the Risk of Banking and Exchange

Rate Crises

f. Conclusion

g. Application: The Argentina Crisis of 2001–2002

i. Background

4. Case Study: The Global Macroeconomy and the Global Financial Crisis Crisis

a. Headlines: Is the IMF “Pathetic”?

b. Backdrop to the Crisis

i. Preconditions for the Crisis

ii. Exacerbating Policies and Distortions

iii. Summary

c. Panic and the Great Recession

i. A Very Modern Bank Run

ii. Financial Decelerators

Lecture Notes

In this chapter, we will examine four key questions and extension of models and analysis

from earlier in the textbook:

■ Is PPP a viable theory of exchange rates in the long run? Here, we develop an

alternative theory that explains why prices are higher in richer countries and

■ Why do lenders loan resources to governments, even if they may default on their

debt? This chapter develops a model that studies the risk of default, the conditions

under which a country will choose to default, and the costs associated with

default. The model helps explain why poor countries suffer from higher volatility

in output and default more often.

■ What went wrong during the 2007‒2009 financial crisis that led to the Great

Recession? Beginning with a discussion of the large financial flows from

emerging market economies to developed market countries, this section explores

various explanations for these events and applies the explanations to a timeline of

the meltdown.

1 Exchange Rates in the Long Run: Deviations from Purchasing Power

Parity

When we examine living standards across countries, measured in U.S. dollars, we

observe large differences that are partially attributed to deviations from PPP. That is,

although a country such as China may have low per capita income (7.5% of U.S. per

capita income) measured in dollar terms, goods in China cost less. We can see that

Limits to Arbitrage

First, we assume there are costs associated with trading goods. The trade cost, c, is

assumed to be equal to some fraction of the price of the good at its source. Therefore, the

price of the good when sold in the foreign country is

The existence of this trade cost affects the arbitrage incentives of traders. Prices in the

two locations, P (Home price) and EP* (Foreign price), can be different. Arbitrage will

only occur if the difference in the prices is large enough to compensate the trader for the

trade cost. Recall that the real exchange rate is defined as q= EP*/P.

■ Traders will buy the good in Home and sell in Foreign only if:

This gives us a new no–arbitrage condition:

Implications:

■ Zero costs. When there are no trade costs (c = 0), q = 1, and the law of one price

Trade Costs in Practice Recent research indicates that trade costs are affected by market

conditions, characteristics of goods, and economic policy. We consider these factors in

turn:

■ Transportation costs:

■ Trade policy:

● Average tariffs are 5% for advanced economies, 10% for developing

countries.

■ Other costs may arise from:

● Distance between markets

● Crossing international borders

APPLICATION

It’s Not Just the Burgers That Are Cheap

Trade costs imply that the real exchange rate will not equal 1. This application examines

the size of these deviations using The Economist’s Big Mac Index.

■ Deviations in PPP are not random.

● Big Macs tend to be cheaper in poorer countries.

● Using 2010 data, Big Macs are 30% less in Mexico and 39% less in Malaysia

■ This can be explained by the existence of nontraded goods.

● The Big Mac is produced using a combination of traded goods (flour, beef,

and special sauce) and nontraded goods (cooks, cleaners, etc.).

Nontraded Goods and the Balassa‒Samuelson Model

This section outlines a model with two goods: one traded and the other nontraded. An

overview of the model follows:

■ Two countries: Home and Foreign

● Both goods are produced in competitive markets and labor is the only input

used.

A Simple Model Solve the model in three steps:

1. The traded good has the same price in both countries. Because these goods have

no trade costs, they should sell for the same price in both countries. Prices are

denoted:

2. Productivity in traded goods determines wages. Each worker can produce A units

of the traded good per hour. The worker’s wage will be equal to $A (since the

price of the good is $1). Competition implies that each worker is paid his or her

3. Wages determine the prices of nontraded goods. Each worker can produce one

unit of the nontraded good per hour. Competition means that the dollar price of a

good is equal to the wage paid (the marginal cost). Therefore,

The model has the following implications:

■ The overall price level in the economy depends on the share of nontraded goods

in the consumption basket and on the productivity in traded goods.

Changes in Productivity Home productivity increases (A rises). The change in the price

level is calculated as the weighted average of the change in prices in traded and

nontraded goods:

Changes in productivity affect the overall price index:

■ When the productivity of traded good increases by x%, wages must increase by

the same percentage.

■ The nontraded goods price will rise by the same x% because the price of the

nontraded good is equal to the wage.

Generalizing A country has relatively low wages because it has relatively low

productivity in the production of traded goods. This low productivity keeps the price of

nontraded goods and the overall price index low.

appreciation in the real exchange rate, meaning its price level is rising.

Overvaluations, Undervaluations, and Productivity Growth: Forecasting

Implications for Real and Nominal Exchange Rates

The Balassa‒Samuelson effect tells us that overall price levels should be higher in richer

countries. This is shown in Figure 22-3. In the figure, the line that best fits the data (a

regression line) is the predicted real exchange rate, . We observe that the actual data do

Forecasting the Real Exchange Rate Forecasting the real exchange rate, q can be

broken down into two problems:

■ How quickly q will return to its equilibrium value,

Convergence Empirical estimates suggest the half-life of deviations from PPP is five

years. In this example, after five years, the real exchange rate will increase by half of the

Convergence + Trend We can now calculate the implied change in the real exchange

rate. Convergence will cause the real exchange rate (q) to increase 2% each year. The

Forecasting the Nominal Exchange Rate If we are able to forecast the real exchange

rate, this will help forecast the nominal exchange rate. From the definition of the real

When relative PPP holds, the changes in the nominal exchange rate reflect inflation

differentials between home and foreign countries. When the Balassa‒Samuelson effect is

Adjustment to Equilibrium The previous expression shows us that changes in the

nominal exchange rate occur because of:

■ the Balassa–Samuelson effect—changes in the real exchange rate stemming from

convergence of q to the equilibrium real exchange rate, ,

■ Real undervaluation—home goods will become more expensive.

● Home goods’ prices must increase, or

APPLICATION

Real Exchange Rates in Emerging Markets

Here, we apply the previous model to study the behavior of the exchange rates relative to

the U.S. dollar. The data are from Figure 22-3.

China: Yuan Undervaluation?

■ Chinese yuan, 2000

● Balassa‒Samuelson model prediction: = 0.319

● Actual real exchange rate: q = 0.231

● Yuan–dollar exchange rate peg

■ What will happen to the real exchange rate?

● Trend: China’s growth rate exceeds that of the United States by 6%, implying

a further real appreciation of 2.4% per year (= 0.4 × 6, assuming 0.4 of goods

■ Forecasting the nominal exchange rate

● Nominal appreciation of yuan or increase in China’s inflation rate

Argentina: Was the Peso Overvalued?

■ Argentine peso, 2000

■ What will happen to the real exchange rate?

● Model predicts Argentina will experience a 22% real depreciation to close the

■ What did happen?

● To maintain the peg, Argentina’s prices must decrease relative to the United

Slovakia: Obeying the Rules?

■ Slovakian koruna in 2000

● Planned to join the EU and eventually the Eurozone. This required

maintenance of a managed floating exchange rate against the euro.

● Slovakia will experience an 89% real appreciation to close the gap

(0.252/0.656). Using the half-life estimates, this implies a 7.5% real

appreciation per year.

■ Dilemma:

● Slovakia experienced real appreciation of 5% to 10% per year from 1992 to

2004.

Conclusion

In general, PPP does not hold. Prices of goods are not the same in all countries. Arbitrage

fails because of trade costs. The final stake in the heart of PPP is the Balassa‒Samuelson

theorem, which incorporates nontraded goods into the model. These effects mean that the