International Business Chapter 12 Income Expenditure And Wealth Are Three Familiar Measures That Will Use Study

subject Type Homework Help
subject Pages 14
subject Words 1996
subject Authors Alan M. Taylor, Robert C. Feenstra

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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
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
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
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1. Exchange rates (Chapters 13–15)
a. Overview of the foreign exchange market (Chapter 13)
2. Balance of payments (Chapters 1618)
a. Overview of balance of payments (BOP) and national income accounting
3. Exchange rate regimes and institutions (Chapters 19–22)
a. Overview of fixed and floating exchange rate regimes (Chapter 19)
b. Exchange rate crisis (Chapter20)
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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
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
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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
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
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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
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.
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.
The bank account balance would be denominated in euros. You used $1,000 to purchase
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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
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sector, among households and firms, and in government finance. In extreme cases, they
can be associated with political and social instability, as in the example of Iceland in
2008 (see Headlines: Economic Crisis in Iceland).
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
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
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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
This highlights a key fact in international income accounting: as long as there are
borrowers, there also must be lenders. It is not possible for the entire world to borrow at
once—these resources have to come from somewhere. In fact, total global lending should
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Debtors and Creditors: External Wealth
Wealth (or net worth) is equal to total assets (amount owned) less total liabilities
(amount owed). Each time a nation saves (e.g., runs a current account surplus), its total
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
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,
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$500,000 is owed to the foreigners who purchased the U.S. firm’s bonds. Therefore,
external wealth is now negative.
There are other factors that affect external wealth. First, foreign assets can change in
value, either because the domestic prices of these assets change or because of a change in
the exchange rate. Capital gains are profits earned on assets, resulting from a change in
Similarly, when the value of foreign liabilities changes, this affects external wealth. If
a U.S. company goes out of business, the value of its liabilities decreases as investors
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.
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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
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
of these international transactions. Chapter 18 offers a short-run model, while Chapter 19
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
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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
government. Examples include the U.S. and the European Monetary Union.) Regimes
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 countrieshigh levels of per capita income and well integrated into
the global economy
Emerging marketsmainly middle-income countries that are growing and
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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
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
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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
There is a negative relationship between quality institutions and income volatility.
Those countries with higher institutional quality tend to experience less volatility 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:
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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.
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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
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
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(CHN), Colombia (COL), Egypt (EGY), India (IND), Indonesia (IDN), Israel (ISR),
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
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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?
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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
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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
currency, the exchange rate between countries is fixed because there is only one

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