International Business Chapter 11 This Section Addresses Two Major Shortcomings The Ppp Hypothesis The Assumption That

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Homework Help
Book Title
International Economics 4th Edition
Alan M. Taylor, Robert C. Feenstra
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
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.
1. Exchange Rates in the Long Run: Deviations from Purchasing Power Parity.
2. Exchange Rates in the Short Run: Deviations from Uncovered Interest
Parity. This section reconsiders empirical tests of the UIP condition and the
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
market (DM) economies were the borrowers. Much of this massive flow was used
An outline of the chapter follows.
1. Exchange Rates in the Long Run: Deviations from Purchasing Power Parity
a. Limits to Arbitrage
b. Application: It’s Not Just the Burgers That Are Cheap
c Nontraded Goods and the Balassa‒Samuelson Model
i. A Simple Model
ii. Changes in Productivity
iii. Generalizing
d. Overvaluations, Undervaluations, and Productivity Growth: Forecasting
Implications for Real and Nominal Exchange Rates
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?
ii. Argentina: Was the Peso Overvalued?
iii. Slovakia: Obeying the Rules?
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
e. Limits to Arbitrage
i. Trade Costs Are Small
f. Conclusion
3. Debt and Default
a. A Few Peculiar Facts About Sovereign Debt
i. Summary
b. A Model of Default, Part One: The Probability of Default
i. Assumptions
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
Rate Crises
f. Conclusion
g. Application: The Argentina Crisis of 2001–2002
i. Background
ii. Dive
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
c. Panic and the Great Recession
i. A Very Modern Bank Run
ii. Financial Decelerators
5. Conclusion: Lessons for Macroeconomics
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
Is UIP a viable theory of exchange rates in the short run? In reality, forex traders
make large profits, and these returns may be predictable. This runs contrary to the
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
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
1 Exchange Rates in the Long Run: Deviations from Purchasing Power
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
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:
Traders will buy the good in Foreign and sell in Home only if:
This gives us a new no-arbitrage condition:
Zero costs. When there are no trade costs (c = 0), q = 1, and the law of one price
(LOOP) holds exactly. This is shown in Figure 22-1, panel (a).
Low costs. When c is low, the deviations from PPP (and LOOP) will be small.
High costs. When c is large, the deviations from PPP (and LOOP) will be large.
The real exchange rate can fluctuate within a larger no-arbitrage band, shown in
Figure 22-1, panel (c).
When the costs of arbitrage are higher, the deviations from PPP and LOOP will be larger.
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
Transportation costs:
Trade policy:
Average tariffs are 5% for advanced economies, 10% for developing
Other costs may arise from:
Distance between markets
A recent summary of international trade costs for advanced countries estimates the trade
costs, expressed as a percent-age markup over the pre-shipment price of the goods, are
equal to 74% (averaged over all goods), disaggregated by source:
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.
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.).
Figure 22-2, panel (a): The dollar price of the Big Mac is strongly correlated
with the local hourly wage (in dollars).
Most goods have some local, nontraded content–local value added or retail and/or
Nontraded Goods and the BalassaSamuelson 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
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
Note that LOOP holds for this good.
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:
For the foreign country,
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
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 BalassaSamuelson 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
Forecasting the Real Exchange Rate Forecasting the real exchange rate, q can be
broken down into two problems:
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
approximately 2% each year.
Trend We now consider whether the equilibrium real exchange rate will change. To see
Convergence + Trend We can now calculate the implied change in the real exchange
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
Adjustment to Equilibrium The previous expression shows us that changes in the
nominal exchange rate occur because of:
the BalassaSamuelson effectchanges in the real exchange rate stemming from
Based on the model, we know:
Real undervaluation—home goods will become more expensive.
Home goods’ prices must increase, or
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
What will happen to the real exchange rate?
Convergence: Model predicts China will experience a 38% real appreciation
to close the gap (0.088/0.231).
Trend: China’s growth rate exceeds that of the United States by 6%, implying
Convergence + Trend: Model predicts a real appreciation of 5.9% (= 3.5 +
Forecasting the nominal exchange rate
Nominal appreciation of yuan or increase in China’s inflation rate
China pegged the yuan to the U.S. dollar but then adopted a crawling peg to
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
Deflation meant wage and price cuts, and the overvalued peso hurt demand
for Argentine goods. An eventual crisis in the government and financial
Slovakia: Obeying the Rules?
Slovakian koruna in 2000
Planned to join the EU and eventually the Eurozone. This required
Model predictions:
(0.252/0.656). Using the half-life estimates, this implies a 7.5% real
appreciation per year.
Because Slovakia is growing more rapidly than the rest of the EU, this will
Combined effects: real appreciation of 8.5% to 9.5% per year
Slovakia experienced real appreciation of 5% to 10% per year from 1992 to
EU membership requires low inflation (within 2% of the lowest in the EU). In
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

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