Baumol & Blinder MACROECONOMICS (11th ed)

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for differences in transportation costs and the like. This simple statement forms the basis of the major theory of exchange rate determination in the long run:

The purchasing-power parity theory of exchange rate determination holds that the exchange rate between any two national currencies adjusts to reflect differences in the price levels in the two countries.

An example will illustrate the basic truth in this theory and also suggest some of its limitations. Suppose German and American steel are identical and that these two nations are the only producers of steel for the world market. Suppose further that steel is the only tradable good that either country produces.

Question: If American steel costs $300 per ton and German steel costs 200 euros per ton, what must be the exchange rate between the dollar and the euro?

Answer: Because 200 euros and $300 each buy a ton of steel, the two sums of money must be of equal value. Hence, each euro must be worth $1.50. Why? Any higher price for a euro, such as $1.60, would mean that steel would cost $320 per ton (200 euros at $1.60 each) in Germany but only $300 per ton in the United States. In that case, all foreign customers would shop for their steel in the United States—which would increase the demand for dollars and decrease the demand for euros. Similarly, any exchange rate below $1.50 per euro would send all the steel business to Germany, driving the value of the euro up toward its purchasing-power parity level.

Exercise Show why an exchange rate of $1.25 per euro is too low to lead to an equilibrium in the international steel market.

The purchasing-power parity theory is used to make long-run predictions about the effects of inflation on exchange rates. To continue our example, suppose that steel (and other) prices in the United States rise while prices in Europe remain constant. The purchasing-power parity theory predicts that the euro will appreciate relative to the dollar. It also predicts the amount of the appreciation. After the U.S. inflation, suppose that the price of American steel is $330 per ton, while German steel still costs 200 euros per ton. For these two prices to be equivalent, 200 euros must be worth $330, or one euro must be worth $1.65. The euro, therefore, must rise from $1.50 to $1.65.

According to the purchasing-power parity theory, differences in domestic inflation rates are a major cause of exchange rate movements. If one country has higher inflation than another, its exchange rate should be depreciating.

For many years, this theory seemed to work tolerably well. Although precise numerical predictions based on purchasing-power parity calculations were never very accurate (see “Purchasing Power Parity and the Big Mac” on the following page), nations with higher inflation did at least experience depreciating currencies. But in the 1980s and 1990s, even this rule broke down. For example, although the U.S. inflation rate was consistently higher than both Germany’s and Japan’s, the dollar nonetheless rose sharply relative to both the German mark and the Japanese yen from 1980 to 1985. The same thing happened again between 1995 and 2002. Clearly, the theory is missing something. What?

Many things. But perhaps the principal failing of the purchasing-power parity theory is, once again, that it focuses too much on trade in goods and services. Financial assets such as stocks and bonds are also traded actively across national borders—and in vastly greater dollar volumes than goods and services. In fact, the astounding daily volume of foreign-exchange transactions exceeds $3 trillion, which is far more than an entire month’s worth of world trade in goods and services. The vast majority of these transactions are financial. If investors decide that, say, U.S. assets are a better bet than Japanese assets, the dollar will rise, even if our inflation rate is well above Japan’s. For this and other reasons,

Most economists believe that other factors are much more important than relative price levels for exchange rate determination in the short run. But in the long run, purchasing-power parity plays an important role.

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Purchasing-Power Parity and the Big Mac

Market Determination of Exchange Rates: Summary

You have probably noticed a theme here: International trade in financial assets certainly dominates short-run exchange rate changes, may dominate medium-run changes, and also influences long-run changes. We can summarize this discussion of exchange rate determination in free markets as follows:

1.We expect to find appreciating currencies in countries that offer investors higher rates of return because these countries will attract capital from all over the world.

2.To some extent, these are the countries that are growing faster than average because strong growth tends to produce attractive investment prospects. However, such fastgrowing countries will also be importing relatively more than other countries, which tends to pull their currencies down.

3.Currency values generally will appreciate in countries with lower inflation rates than the rest of the world’s, because buyers in foreign countries will demand their goods and thus drive up their currencies.

Reversing each of these arguments, we expect to find depreciating currencies in countries with relatively high inflation rates, low interest rates, and poor growth prospects.

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CHAPTER 18 The International Monetary System: Order or Disorder? 369

WHEN GOVERNMENTS FIX EXCHANGE RATES: THE BALANCE OF PAYMENTS

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A BIT OF HISTORY: THE GOLD STANDARD AND THE BRETTON WOODS SYSTEM

It is difficult to find examples of strictly fixed exchange rates in the historical record. About the only time exchange rates were truly fixed was under the old gold standard, at least when it was practiced in its ideal form.4

4 As a matter of fact, although the gold standard lasted (on and off) for hundreds of years, it was rarely practiced in its ideal form. Except for a brief period of fixed exchange rates in the late nineteenth and early twentieth centuries, governments periodically adjusted exchange rates even under the gold standard.

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The Bretton Woods System

The gold standard collapsed for good amid the financial chaos of the Great Depression of the 1930s and World War II. Without it, the world struggled through a serious breakdown in international trade.

As the war drew to a close, representatives of the industrial nations, including John Maynard Keynes of Great Britain, met at a hotel in Bretton Woods, New Hampshire, to devise a stable monetary environment that would enable world trade to resume. Because the United States held the lion’s share of the world’s reserves at the time, these officials naturally turned to the dollar as the basis for the new international economic order.

The Bretton Woods agreements reestablished fixed exchange rates based on the free convertibility of the U.S. dollar into gold. The United States agreed to buy or sell gold to maintain the $35 per ounce price that President Franklin Roosevelt had established in 1933. The other signatory nations, which had almost no gold in any case, agreed to buy and sell dollars to maintain their exchange rates at agreed-upon levels.

The Bretton Woods system succeeded in refixing exchange rates and restoring world trade—two notable achievements. But it also displayed the flaws of any fixed exchange rate system. Changes in exchange rates were permitted only as a last resort—which, in practice, came to mean that the country had a chronic deficit in the balance of payments of sizable proportions. Such nations were allowed to devalue their currencies relative to the dollar. So the system was not really one of fixed exchange rates but, rather, one in which rates were “fixed until further notice.” Because devaluations came only after a long run of balance of payments deficits had depleted the country’s reserves, these devaluations often could be clearly foreseen and normally had to be large. Speculators therefore saw glowing opportunities for profit and would “attack” weak currencies with waves of selling.

A second problem arose from the asymmetry mentioned earlier: Deficit nations could be forced to devalue while surplus nations could resist upward revaluations. Because the value of the U.S. dollar was fixed in terms of gold, the United States was the one nation in the world that had no way to devalue its currency. The only way the dollar could fall was if the surplus nations would revalue their currencies upward. But they did not adjust frequently enough, so the United States developed an overvalued currency and chronic balance of payments deficits.

The overvalued dollar finally destroyed the Bretton Woods system in 1971, when President Richard Nixon unilaterally ended the game by announcing that the United States would no longer buy or sell gold at $35 per ounce.

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ADJUSTMENT MECHANISMS UNDER FIXED EXCHANGE RATES

Under the Bretton Woods system, devaluation was viewed as a last resort, to be used only after other methods of adjusting to payments imbalances had failed. What were these other methods?

We encountered most of them in our earlier discussion of exchange rate determination in free markets. Any factor that increases the demand for, say, Argentine pesos or that reduces the supply will push the value of the peso upward—if it is free to adjust. But if the exchange rate is pegged, the balance of payments deficit will shrink instead. (Try this for yourself using Figure 5 on page 369.)

Recalling our earlier discussion of the factors that underlie the demand and supply curves, we see that one way a nation can shrink its balance of payments deficit is to reduce its aggregate demand, thereby discouraging imports and cutting down its demand for foreign currency. Another is to lower its rate of inflation, thereby encouraging exports and discouraging imports. Finally, it can raise its interest rates to attract more foreign capital.

In other words, deficit nations are expected to follow restrictive monetary and fiscal policies voluntarily, just as they would have done automatically under the classical gold standard. However, just as under the gold standard, this medicine is often unpalatable.

A surplus nation could, of course, take the opposite measures: pursuing expansionary monetary and fiscal policies to increase economic growth and lower interest rates. By increasing the supply of the country’s currency and reducing the demand for it, such actions would reduce that nation’s balance of payments surplus. But surplus countries often do not relish the inflation that accompanies expansionary policies, and so, once again, they leave the burden of adjustment to the deficit nations. The general point about fixed exchange rates is that

Under a system of fixed exchange rates, a country’s government loses some control over its domestic economy. Sometimes balance of payments considerations may force it to contract its economy in order to cut down its demand for foreign currency, even though domestic needs call for expansion. At other times, the domestic economy may need to be reined in, but balance of payments considerations suggest expansion.

That was certainly the case in Argentina in 2002, when interest rates soared to attract foreign capital and the government pursued contractionary fiscal policies to curb the country’s appetite for imports. Both contributed to a long and deep recession. Argentina took the bitter medicine needed to defend its fixed exchange rate for quite a while. But high unemployment eventually led to riots in the streets, toppled the government, and persuaded the Argentine authorities to abandon the fixed exchange rate.

WHY TRY TO FIX EXCHANGE RATES?

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are determined by supply and demand in free markets and do not fluctuate unduly. Unfortunately, experience since 1973 has dashed this hope. Exchange rates have proved to be extremely volatile, which is why some observers now favor greater fixity in exchange rates.

A second possibility is that speculators might relieve business firms of exchange rate risks—for a fee, of course. Consider the department store example. If each euro costs $1.50 today, the department store manager can assure herself of paying exactly $600 for the dress several months from now by arranging for a speculator to deliver 400 euros to her at $1.50 per euro on the day she needs them. If the euro appreciates in the interim, the speculator, not the department store, will take the financial beating. Of course, if the euro depreciates, the speculator will pocket the profits. Thus, speculators play an important role in a system of floating exchange rates.

The widespread fears that speculative activity in free markets will lead to wild gyrations in prices, although occasionally valid, are often unfounded. The reason is simple.

To make profits, international currency speculators must buy a currency when its value is low (thus helping to support the currency by pushing up its demand curve) and sell it when its value is high (thus holding down the price by adding to the supply curve). This means that successful speculators must come into the market as buyers when demand is weak (or when supply is strong) and come in as sellers when demand is strong (or supply is scant). In doing so, they help limit price fluctuations. Looked at the other way around, speculators can destabilize prices only if they are systematically willing to lose money.5

Notice the stark—and ironic—contrast to the system of fixed exchange rates in which speculation often leads to wild “runs” on currencies that are on the verge of devaluation— as happened in Mexico in 1995, several Southeast Asian countries in 1997–1998, Brazil in 1999, and Argentina in 2001. Speculative activity, which may well be destabilizing under fixed rates, is more likely to be stabilizing under floating rates.6

We do not mean to imply that speculation makes floating rates trouble-free. At the very least, speculators will demand a fee for their services—a fee that adds to the costs of trading across national borders. In addition, speculators will not assume all exchange rate risks. For example, few contracts on foreign currencies last more than, say, a year or two. Thus, a business cannot easily protect itself from exchange rate changes over periods of many years. Finally, speculative markets can and do get carried away from time to time, moving currency rates in ways that are difficult to understand, that frustrate the intentions of governments, and that devastate some people—as happened in Mexico in 1995 and in Southeast Asia in 1997.

Despite all of these problems, international trade has flourished under floating exchange rates. So perhaps exchange rate risk is not as burdensome as some people think.

THE CURRENT “NONSYSTEM”

The international financial system today is an eclectic blend of fixed and floating exchange rates, with no grand organizing principle. Indeed, it is so diverse that it is often called a “nonsystem.”

Some currencies are still pegged in the old Bretton Woods manner. The most prominent example is probably China, which for years maintained a fixed value for its currency (the yuan) by standing ready to buy or sell U.S. dollars as necessary. Over the years, the pegging policy required the Chinese to buy dollars steadily and in large volume. So China has acquired over $1 trillion in foreign currency reserves. Lately, the Chinese authorities seem to be backing away from their currency peg, albeit in small steps, and the yuan has appreciated relative to the dollar.

5See Test Yourself Question 4 at the end of the chapter.

6After their respective currency crises in 1995 and 1999, both Mexico and Brazil floated their currencies. Each weathered the subsequent international financial storms rather nicely. But Argentina, with its fixed exchange rate, struggled.

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A few small countries, such as Panama and Ecuador, have taken the more extreme step of actually adopting the U.S. dollar as their domestic currencies. Other nations tie their currencies to a hypothetical “basket” of several foreign currencies, rather than to just one.

More nations, however, let their exchange rates float, although not always freely. Such floating rates change slightly on a day-to-day basis, and market forces determine the basic trends, up or down. But governments do not hesitate to intervene to moderate exchange movements whenever they feel such actions are appropriate. Typically, interventions are aimed at ironing out what are deemed to be transitory fluctuations. But sometimes central banks oppose basic exchange rate trends. For example, the Federal Reserve and other central banks sold dollars aggressively in 1985 to push the dollar down and then bought dollars in 1994 and 1995 to push the dollar up. As we will discuss in the next chapter, the Japanese acquired hundreds of billions of dollars earlier in this decade trying to prevent the yen from floating up too much. The terms dirty float or managed float have been coined to describe this mongrel system.

The Role of the IMF

The International Monetary Fund (IMF), which was established at Bretton Woods in 1944, examines the economies of all its member nations on a regular basis. When a country runs into serious financial difficulties, it may turn to the Fund for financial assistance. The IMF typically provides loans, but with many strings attached. For example, if the country has a large current account deficit—as is normally the case when countries come to the IMF— the Fund will typically insist on contractionary fiscal and monetary policies to curb the country’s appetite for imports. Often, this mandate spells recession.

During the 1990s, the IMF found itself at the epicenter of a series of very visible economic crises: in Mexico in 1995, in Southeast Asia in 1997, in Russia in 1998, and in Brazil in 1999. In 2001, Turkey and Argentina ran into trouble and appealed to the IMF for help. Although each case was different, they shared some common elements.

Most of these crises were precipitated by the collapse of a fixed exchange rate pegged to the U.S. dollar. In each case, the currency plummeted, with ruinous consequences. Questions were raised about the country’s ability to pay its bills. In each case, the IMF arrived on the scene with lots of money and lots of advice, determined to stave off default. In the end, each country suffered through a severe recession—or worse.

The IMF’s increased visibility naturally brought it increased criticism. Some critics complained that the Fund set excessively strict conditions on its client states, requiring them, for example, to cut their government budgets and raise interest rates during recessions—which made bad economic situations even worse.

Other critics worried that the Fund was serving as a bill collector for banks and other financial institutions from the United States and other rich countries. Because the banks loaned money irresponsibly, these critics argued, they deserved to lose some of it. By bailing them out of their losses, the IMF simply encouraged more reckless behavior in the future.

Numerous suggestions for reform were offered, and some minor changes in the IMF’s policies and procedures were made. While the debate over IMF reform rages on to this day, it is mostly behind the scenes. The reason is simple. As the world economy improved, and the nations that formerly needed IMF help no longer required it, the Fund’s list of client states diminished and so did the prominence of the IMF. Whether this placid situation will continue is anyone’s guess.

The Volatile Dollar

As mentioned earlier, floating exchange rates have proven to be volatile exchange rates. No currency illustrates this point better than the U.S. dollar (see Figure 7). As Table 1 showed, in July 1980 a U.S. dollar bought less than 2 German marks, about 4 French francs, and about 830 Italian lire. Then it started rising like a rocket (see Figure 7). By the time it peaked in February 1985, the mighty dollar could buy more than 3 German marks,

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7 Exercise: How much does a 100-euro hotel room in Paris cost in dollars when the euro is worth $1.25? $1? 80 cents?

8 Exercise: How much does a $55 American camera cost a German consumer when the euro is worth $1.20? $1? 80 cents?

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the number of participating countries has since risen in stages to 15. All of these transformations went remarkably smoothly.

That said, the euro did not spring into life as a fully grown adult. In its earlier years, there were still plenty of doubters. And perhaps for that reason, the new European currency, which made its debut at $1.18 in January 1999, fell to a low point of $0.83 in October 2000—a stunning 30 percent decline in less than two years. Since then, however, the euro has mostly been climbing in value relative to the dollar, reaching about $1.57 in April 2008.

The establishment of the euro was a great economic experiment that marked a giant step beyond merely fixing exchange rates. A government can end a fixed exchange rate regime at any time. And, as we have seen, speculators sometimes break fixed exchange rates even when governments want to maintain them. But the single European currency was created by an international treaty and is more or less invulnerable to speculative attack because it abolished exchange rates among the participating nations. Just as there has long been no exchange rate between New York and New Jersey, now there is no exchange rate between Germany and France. Monetary unions may create other problems, but exchange rate instability should not be one of them.

PUZZLE RESOLVED: WHY THE DOLLAR ROSE AND THEN FELL

What we have learned in this chapter helps us understand what brought the dollar down between 2002 and 2004, and then again in 2007 and 2008. The story actually begins well before that.

During the Great Boom of the late 1990s, the United States was the place to invest. Funds poured in from all over the world to purchase American stocks, American bonds, and even American companies—especially in the information technology field. Yahoo! was indeed a fitting name for the age. As we have learned

in this chapter, the rising demand for U.S. assets should have bid up the price of U.S. currency—and it did (see Figure 7 again).

But the soaring dollar sowed the seeds of its own destruction. Two of its major effects were (a) to

ently began to question the wisdom of holding so many American assets. With the U.S. current account still deeply in the red, and the foreign demand for U.S. capital sagging, there

was only one way for the (freely floating) dollar to go: down. And so it did.

The real mystery was why the depreciation of the dollar stopped at the end of 2004; most economists felt that further depreciation was necessary, given the huge (and growing) current account deficit. But before that question was answered, the dollar fell again in 2007 and into the early part of 2008 and the current account deficit finally began to shrink.

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