12 The Global Macroeconomy
Notes to the Instructor
Chapter Summary
This chapter provides students with a broad overview of international macroeconomics.
The chapter uses several key concepts to introduce the subject to students without formal
modeling. At the end of each topic, there are two sections that review the content of the
section (Key Topics) and prepare students for what’s coming next (Summary and Plan of
Study).
Comments
Instructors may want to cover this chapter in several lectures or in one short lecture. But
remember, this chapter is an overview. Don’t fall into the trap of trying to cover too much
detail. There are 10 more chapters to take care of that! However, covering this chapter in
detail at the beginning may serve to motivate students’ interest in the topic. If students
read through the chapter without a guided lecture, they may become overwhelmed.
Chapter 12 tackles complicated concepts to give students an idea of the topics that will be
covered through the rest of the textbook.
Plan of Study
Each of the topics in this chapter concludes with a plan of study that discusses how
selected chapters in the text relate to the three broad elements presented in the
introduction: money, finance, and policy. An overview of these chapters is given below.
In the lecture notes, the plan of study for each of these topics is included in the summary.
1. Exchange rates (Chapters 13–15)
a. Overview of the foreign exchange market (Chapter 13)
2. Balance of payments (Chapters 16–18)
a. Overview of balance of payments (BOP) and national income accounting
(Chapter 16)
b. The relationship between the BOP, the nation’s wealth, and living standards in
the long run (Chapter 17)
c. The relationship between the BOP, exchange rates, and the demand for output
in the short run (Chapter 18)
3. Exchange rate regimes and institutions (Chapters 19–22)
a. Overview of fixed and floating exchange rate regimes (Chapter 19)
Key Topics
Each topic and subtopic in this chapter include discussion questions that tie these broad
topics together, as well as look forward to future chapters in the text.
Lecture Notes
Three key elements (corresponding to parts 1–3 of the chapter in organization):
■ Money: Many different currencies are used in the world today. Why? What is
their purpose? What are the implications of using so many different currencies?
■ Finance: Capital is more mobile internationally—the scale of international
finance is immense. Why? What is the purpose of this? Who lends/borrows? Who
benefits? What are the costs and to whom do they accrue?
■ Policy: The role of the government. How are economic policy failures
understood? What is the role of government in perpetuating/preventing these
events? What are the trade–offs?
1 Foreign Exchange: Currencies and Crises
The exchange rate is the price of a foreign currency. Therefore, when countries trade
goods and services or engage in financial transactions with each other, the exchange rate
is one of the main factors that determine the prices that will be used. When an individual
How Exchange Rates Behave
Exchange rate regimes can be divided into two broad groups: floating and fixed. Floating
exchange rates are those that change frequently, implying that the price of one currency
changes relative to another. For example, the euro–dollar exchange rate has changed as
much as 5% within a single month. These changes are a reflection of changes in the
demand and supply of each currency in the foreign exchange market, which is studied in
the next chapter.
Fixed exchange rates are those that remain relatively constant over time, such that the
price of the currencies relative to one another is stable. For example, the yuan–dollar
exchange rate has remained relatively constant with only occasional adjustments. These
occasional adjustments are not accidental. They are the result of deliberate government
policy.
Why Exchange Rates Matter
There are two channels through which the exchange rate affects the economy: relative
prices of goods and relative prices of assets. When the exchange rate changes, this affects
the price people pay for goods imported from abroad. Similarly, changes in the exchange
exchange rate increases to $1.25 per euro, the relative price of these boots changes.
Americans buying Italian boots have to pay $125, whereas Europeans buying American
boots pay €80 ($100/$125 per euro). We can see that the increase in the dollar–euro
exchange rate implies an increase in the price of European goods purchased by
Americans and a decrease in the price of American goods purchased by Europeans.
Therefore, the relative price of European goods to American goods increases when the
dollar–euro exchange rate increases.
Not only consumers are affected by these changes in relative prices; producers are as
well. In the previous example, the producer of the Italian boots faces an increase in its
relative costs of manufacturing boots for export to the United States. If the Italian
manufacturer wants to avoid a decrease in sales to its U.S. market, it may choose to
continue charging $100 per pair of boots for export. However, if it hires workers and
materials in Europe, the Italian producer must continue to pay for these inputs in euros.
When it converts the $100 back into euros, the Italian producer only receives €80. Thus,
the Italian producer will face a decrease in its profits. The reverse is true for American
producers exporting to Europe. They can continue charging €100 per pair of boots (or
$125 converted into dollar terms), leading to an increase in profits.
Similarly, changes in exchange rates affect the relative prices of financial assets.
Suppose that you deposited $1,000 into a German checking account in September 2002.
German checking account paid no interest, you would have a 25% gain over the 53
months. A Spanish citizen depositing U.S. dollars into an American bank in September
When Exchange Rates Misbehave
An exchange rate crisis occurs when a country experiences a sudden and dramatic loss
in the value of its currency (a depreciation) relative to another currency following a
period of fixed or stable exchange rates. These crises are relatively common. There have
been 24 crises between 1997 and 2009.
Exchange rate crises can have significant economic consequences. The cost of
imported goods increases and the value of financial assets in the country decreases. Thus,
for a country relying heavily on direct foreign investment (FDI) and imports, a severe
economic contraction soon follows the exchange rate crisis. FDI will fall as foreign
exchange denominated profits fall, while at the same time, the merchandise trade balance
will deteriorate. Countries experiencing exchange rate crises may also be forced to
default on debt. Because of the dramatic decrease in the value of domestic foreign assets
and economic recession, the country may lack the resources to honor its debt obligations.
The economic consequences of exchange rate crises are often more severe in poorer
countries. Exchange rate crises frequently spark problems in the banking and financial
Summary and Plan of Study
In subsequent chapters, we learn about the structure and operation of the foreign
exchange market (Chapter 13). Chapters 14 and 15 present the theory of exchange rates.
Chapter 16 discusses how exchange rates affect international transactions in assets. We
examine the short-run impact of exchange rates on the demand for goods in Chapter 18,
and with this understanding, Chapter 19 examines the trade-offs governments face as
they choose between fixed and floating exchange rates. Chapter 20 covers exchange rate
crises in detail and Chapter 21 the euro, a common currency used in many countries.
2 Globalization of Finance: Debts and Deficits
Financial globalization has taken hold around the world. Competition among countries
has reduced barriers to financial flows. To understand the financial transactions among
countries, we need an accounting framework. Income, expenditure, and wealth are three
Deficits and Surpluses: The Balance of Payments
Income refers to the amount earned by the economy’s factors of production.
Expenditure measures how much is spent on goods and services. If there is a difference
between the two, then there is either a surplus (income > expenditure) or a deficit
Countries pay for current account deficits by borrowing from countries running
current account surpluses. For example, the U.S. has had persistent current account
deficits since 1992 (Table 12-1). These deficits have been financed by foreign purchases
Debtors and Creditors: External Wealth
Wealth (or net worth) is equal to total assets (amount owned) less total liabilities
Suppose that the United States’ current account is balanced, income = expenditure.
Consider a U.S. firm that seeks to borrow $500,000 to finance the expansion of its
business operations in the United States. It can issue bonds to raise these funds. When
these funds are purchased by Americans, there is no effect on the current account because
What does this transaction mean for the current account? Note that the United States
increases expenditures by $500,000 without increasing income; therefore, the current
account goes into a deficit. What happens to external wealth? U.S. ownership of foreign
assets remains unchanged, but its foreign liabilities increase by $500,000. That is,
$500,000 is owed to the foreigners who purchased the U.S. firm’s bonds. Therefore,
external wealth is now negative.
the exchange rate. Capital gains are profits earned on assets, resulting from a change in
price. For example, if the price of a German company’s stock increases, it generates
capital gains for people owning the stock in Germany, the United States, and elsewhere.
For the United States, this will lead to an increase in the value of foreign assets owned,
implying an increase in external wealth.
Darlings and Deadbeats: Defaults and Other Risks
Since 1980, 14 countries have defaulted on their debt as a result of exchange rate crises.
Of these, fully half have defaulted twice. The preceding example provides one
explanation of why a sovereign government has an incentive to default on debt during an
exchange rate crisis. Defaulting improves its external wealth position.
There are consequences to defaulting. It makes the country far less attractive to
foreign investors. Much like a household or firm, a country will have to pay higher
interest rates to borrow following a default. Country risk refers to the additional interest
Summary and Plan of Study
An in-depth discussion of the balance of payments begins in Chapter 16, on national
income accounting in the open economy. That chapter explains the international
transactions described here in much more detail. Once we have established an
understanding of the accounting rules, we will develop theories of the causes and effects
3 Government and Institutions: Of Policies and Performance
We will study the role of the government in two dimensions: (1) macroeconomic policies
and regimes, and (2) institutions. Policies are designed to achieve specific
macroeconomic objectives, such as easing recessions, keeping inflation low, or
stabilizing interest rates. Policies are often made by the government. Examples of
macroeconomic policies include changes in the tax code or (in many countries) the
money supply. (In some countries, the money supply is not under the direct control of the
Integration and Capital Controls: The Regulation of International Finance
Since 1970, there has been a general trend toward increased financial openness. There
has also been an increase in the volume of international financial transactions. But growth
in both areas has not been even across all countries. Consider three groups of countries
grouped according to their per capita income, economic growth, and degree of integration
into the global economy:
■ Advanced countries—high levels of per capita income and well integrated into
the global economy
time, all three groups of countries adopted an increase in financial openness, with the
advanced economies benefiting from the largest increase in financial transactions. For
example, among advanced countries, the degree of financial openness approached 100%.
Independence and Monetary Policy: The Choice of Exchange Rate Regimes
There are two broad categories of exchange rate regimes: fixed and floating. Both are
common among the countries of the world. The choice of exchange rate regime is one of
the most important decisions a government can make. On the one hand, a fixed exchange
rate eliminates the uncertainty associated with exchange rate fluctuations (exchange rate
risk). In our previous examples, we saw that a change in the exchange rate affects relative
prices, profits, and external wealth. This uncertainty could potentially limit trade and
financial transactions. However, we have also seen that fixed exchange rates can lead to
exchange rate crises that are very costly.
The use of an individual currency is often viewed as part of the national identity,
something that establishes a country’s sovereignty. However, some groups of countries
Institutions and Economic Performance: The Quality of Governance
There are several different criteria for evaluating the quality of governance. This textbook
focuses on six: voice and accountability, political stability, government effectiveness,
regulatory quality, rule of law, and control of corruption. Better governance is strongly
associated with better economic outcomes. There is a positive relationship between good
governance and real income per person. And there is a somewhat weaker negative
correlation between good governance and the standard deviation of the rate of economic
growth. The differences are substantial, with advanced economies experiencing income
per person that is 50 times higher than the poorest developing countries. This gap in
We must confront the post hoc, ergo propter hoc fallacy here: Does the existence of
quality institutions lead to better economic outcomes? Or do good economic outcomes
make it possible to establish quality institutions? The research favors the first
explanation. Institutional quality appears to cause better economic outcomes. Given this
result, there is much debate about why poorer countries have weaker institutions.
Explanations include:
■ actions of colonizing powers (failure of colonization to establish quality
Summary and Plan of Study
The government plays an important role in several facets of the international
macroeconomy. In Chapter 13, we will see how the government participates in the
foreign exchange market. In subsequent chapters, we will see how the government’s
choice of exchange rate regime is related to financial openness (Chapter 15), the benefits
of financial openness (Chapter 17), the trade-offs involved in the choice of regime
4 Conclusions
To understand the issues and debates surrounding exchange rates, the rise in international
financial transactions, and the role of institutions, we first need to understand how each
has changed over time. Then we move on to develop theories of how exchange rates and
international transactions affect the economy and the government’s role in this process.
TEACHING TIPS
Teaching Tip 1: One of the footnotes to Figure 12-5 cites M. Ayhan Kose, Eswar
Prasad, Kenneth S. Rogoff, and Shang-Jin Wei, 2006, “Financial Globalization: A
Reappraisal,” NBER Working Paper No. 12484. If your institution subscribes to the
NBER working paper series, you can download the paper from http://www.nber.org. If
Advanced Economies
The 21 advanced industrial economies in our sample are Australia (AUS), Austria
(AUT), Belgium (BEL), Canada (CAN), Denmark (DNK), Finland (FIN), France (FRA),
Emerging Market Economies
This group includes 20 countries—Argentina (ARG), Brazil (BRA), Chile (CHL), China
Other Developing Economies
This group includes 30 countries—Algeria (DZA), Bangladesh (BGD), Bolivia (BOL),
Cameroon (CMR), Costa Rica (CRI), Dominican Republic (DOM), Ecuador (ECU), El
Salvador (SLV), Fiji (FJI), Ghana (GHA), Guatemala (GTM), Honduras (HND), Iran
IN–CLASS PROBLEMS
1. Go to http://www.oanda.com and download data on the following currencies relative
to the U.S. dollar: Malaysian ringgit, British (U.K.) pound, and the Chinese yuan.
What are the exchange rates today (measured as foreign currency per U.S. dollar)?
Among these currencies, which are fixed, which are floating, and which have shifted
from fixed to floating over the past 25 years and why?
Answer: Answers will vary. The yuan is fixed to the U.S. dollar and remains so even
2. Two countries recently experienced exchange rate crises, but their response was
markedly different. First, Russia experienced a dramatic decrease in the value of the
Russian ruble relative to the U.S. dollar in 1998. The Russian government responded
by suspending payments on foreign debt. Similarly, South Korea experienced a
decrease in the value of the won in 1997. In contrast, South Korea did not default on
its debt. Why might these two countries have behaved differently in response to their
respective crises? What are the benefits of default? What are the drawbacks?
Answer: They behaved differently because each faces a different set of costs and
benefits associated with default. One benefit of default is that it allows a country to
3. For several years, there has been substantial pressure on China from the U.S.
government to allow the value of the yuan to decrease relative to the U.S. dollar. Why
might the U.S. government want this change in the value of the yuan? How would
such a change affect the relative price of Chinese goods versus U.S. goods? How
would it affect the value of U.S. liabilities owned by Chinese residents?
Answer: A decrease in the yuan–dollar exchange rate would lead to an increase in the
relative price of Chinese goods. This would make Chinese goods exported to the
4. Review the data presented in Figures 12-5 and Figure 12-7. From Figure 12-5, panel
(b), what do you observe about the volume of financial transactions in developing
countries relative to those in advanced countries and emerging markets since 1990?
Drawing on the information presented in the figures mentioned above, why is this the
case? Can we attribute these patterns to financial openness or to institutions?
Answer: Developing countries have not experienced the same increase in financial
5. Consider the choice of a fixed versus a floating exchange rate regime. Is a common
currency more like a fixed or a floating exchange rate regime between the
participating countries? What is the difference between a common currency and
dollarization?
Answer: A common currency is a fixed exchange rate regime. With a common