ECN202: Macroeconomics

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ECN202 Macroeconomics

• 1970s Experiments with Money- The International
  Dimension
• the memory of the Great Depression meant that
  the US was highly likely to suffer an
  inflationary episode like the 1970s in the
  post-World war II period-maybe not as long, and
  maybe not exactly when it occurred, but
  nevertheless a similar episode."

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1970s Setting

• The signature 1970sgraph is of real earnings
  which shows the decade marked the end of the rise
  in post WWII earnings for American workers. In
  part this was driven by demographics as baby
  boomers began to enter the labor market, and in
  part by the rise of foreign competition as the
  world continued to get flatter. Countries the US
  helped rebuild after WW II were now rebuilt and
  offering competition to American companies and
  workers. And we cant forget OPEC, which became a
  household word after it caused two painful oil
  crises that marked the end of cheap oil. In terms
  of public policy, the federal government
  continued to expand with creation of the EPA and
  the Departments of Energy and Education, and
  passage of Roe v Wade. It was also the decade of
  Watergate and the end of the Vietnam War.

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1970s in Macro

• In macroeconomics the 1970s was quite the decade
  the only period of sustained peacetime
  inflation in US history and an economy that
  performed badly enough to produce only the second
  ideological shift in this countrys history. Just
  as the conservatives could not solve the economic
  problems of the 1930s, liberals could not solve
  the economic problems of the 1970s. This
  ideological void opened the to conservatives led
  by the Chicago School economists including Milton
  Friedman who stepped in to fill that void. In
  this unit we will look at this ideological shift
  with a focus on the international monetary system
  and the domestic monetary system where the most
  significant changes took place in the 1970s.

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SD again and again

• At the center of this unit is money, one of the
  greatest inventions - money. Some money is
  involved in international transactions you buy
  that Chinese T-shirt - and some is part of
  domestic transactions you get that student loan.
  In both cases there is a price the exchange
  rate for those international exchanges and the
  interest rate for the domestic one. In this unit
  we look at the two markets to understand these
  two prices as you can see in the diagram that
  follows. The key to understanding these markets
  is the same as always pay attention to the
  details. You need to follow the rules and you
  will be able to understand those two important
  prices exchange rates and interest rates.

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1970s unit
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• Foreign Exchange Domestic Money
  Market Market

r
e
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1970s International

• The 70s opened with the US running out of gold,
  which forced president Nixon to abandon the
  Bretton Woods system and adopt a flexible
  exchange rate. The US s value would now be
  determined in a market rather than by the
  government. We begin with a brief overview of the
  Books so you will better understand Nixons
  dilemma and the nature of international trade. To
  facilitate the trade recorded in those books, we
  need an international monetary system, and here
  we look at the evolution of these systems that
  all possess one imperfection the trilemma.
  Special emphasis is placed on the flexible
  exchange rate system and the euro experiment plus
  we examine MAD II, a modern version of MAD that
  dominated life when I was in school. To give you
  an idea of the unit, here are a few headlines
  related to topics in the unit.

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In the news those pesky exchange rates

• U.S. to Press Saigon for Devaluation of Piaster
  to a More Realistic Exchange Rate 1970
• The dollar reached an all-time exchange-rate
  high of 634 lire at the Milan foreign exchange
  today in the third straight increase from the
  floor level. 1970
• 'Undervalued' Yen Held Target Of Nixon Surcharge
  on Imports 1971
• Stable Exchange Rates in Wind? Pragmatism Is Now
  the Catchword In Currency 1975
• U.S. Tries to Reassure Its Allies New Deficit
  Won't Depress Dollar 1978

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In the news and meddling governments

• THE world had a fright last fall when the
  dollar, the currency that holds the world
  monetary system together, suffered a severe
  sinking spell. 1979
• Japan acts alone to weaken its currency
• Joining Switzerland, Japan acts to ease
  currencys strength
• Dollars fall tests nerve of Asias central
  banks
• When weakness is strength
• Talk in Japan shakes dollar and Treasuries
• Germanys export prowess weighs on euro-zone
• Will the euro survive?
• Europe tries to lure Chinese cash to rescue
  euro

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To trade or not to trade

• We looked at this question before, so we know the
  answer. There are benefits and costs to trading
  and to not trading but we live in a world where
  the movement is toward more trade as you can see
  in the graphs that follow. In the map that
  follows you can see countries have developed
  their own language and eventually we needed
  translators to bridge the language differences.
  The same is true with trade countries developed
  their own currencies so we needed to bridge the
  individual monetary systems to facilitate trade.
  In fact we needed two systems an international
  accounting system and an international monetary
  system.

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In the beginning!!
Russian
ruble
English
Japanese
Chinese
dollar
yuan
yen
Portuguese
real
Grammar/ translations
Spanish
peso
Monetary systems commodity / fiat
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Trade has expanded much faster than GDP since the
end of WW II
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You can see this in the ratio of world exports to
world GDP from about 1/10th of world GDP to 2
times GDP.
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The growth in trade was accompanied by a faster
rate of economic growth. In the next two graphs
compare how China did under Maos policy of
closing off China from the West and Dengs policy
of embracing trade with the west.
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China sleeps
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and wakes begins to shake the world
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1. Build an International Accounting System

• Record of international transactions
• Money flowing in (what we sell and to whom we
  sell it)
• Money flowing out (what we buy and from whom we
  buy)

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International accounting system
Positive Effects (credits) s flow into country
  Any receipt from a foreign country
  Any earnings on investment in a foreign country
  Any sale of goods or services abroad
  Any gift or aid from a foreign governments
  Any purchase of stocks or bonds by a foreign investor
Negative Effects (debits) - s flow out
  Any payment to a foreign country
  Any investment in a foreign country
  Any purchase of goods or services abroad
  Any gift or aid to foreign governments
  Any purchase of stocks or bonds in a foreign country
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Two components of account

• Current Account (consumption purchase of
  things)
• Goods and services (exports imports)
• Factor income (interest dividend income)
• Transfer income (foreign aid, remittances)
• Capital Account (investment purchase of assets)
• Private capital flows (assets stock, bonds,
  land)
• Public capital flows (assets gold, foreign
  currency)

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US Current Account Transactions
Exports of goods services plus income receipts on US owned assets
Japanese tourists visit US / French buys California wine
American investors receive interest income on German bonds
- Imports of goods and services and income payments on foreign-owned assets in the United States
American tourists visist China / Americans buy French wine
Chinese investors receive interest income on US bonds
Unilateral current transfers, net
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The rise in these numbers mean that when I
checked the labels on my stuff when I was in
college I found many more Made in America
labels than you find today AND The widening gap
means we have a bigger trade deficit today
Imports
Exports
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Check out these graphs to see the pattern of
world and US trade
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1983
1948
2008
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1983
1948
2008
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Imports Exports
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Balancing the books Balance of US International
Transactions
The flip side of the flow of stuff is the flow of
money, so we keep records on the balance. In fact
there are many different measures of balance as
you can see below. The Balance on Goods measures
the difference between imports and exports of
stuff. A deficit would mean that we import more
than we export so money flows OUT.
Balance on goods
Balance on services
Balance on goods and services
Balance on income
Unilateral current transfers, net
Balance on current account
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You can see how big the imbalance is here, but a
better measure is the next one where the numbers
are divided by GDP.
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Can you see the impact of the Great recession? Do
you have any idea what is happening to the US s
that are flowing out?
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Peculiarities of system

• Current Account (Cu) and Capital Account (Ca)
  must balance out each other
• Cu Ca SD 0
• Or
• -Cu Ca

This means that the USs flowing out to pay for
the foreign made Stuff are returned to the US
by foreigners buying US assets. If we run a
Current Account deficit ( US s flowing out) then
we run a Capital Account surplus ( US s flowing
in)
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US Capital Account Transactions

- U.S.-owned assets abroad, net (increase/financial outflow (-))
Direct investment Foreign securities
US investors buy stock on Chinas stock exchange
US government buys Japanese yen.
US firm buys European company
Foreign-owned assets in the United States, net (increase/financial inflow ())
    U.S. Government securities Direct investment
English investors buy stock on US stock exchange
Chinas government buys US Treasury securities.
Japans government buys US.

Statistical discrepancy (sum of above items with
sign reversed)
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US sends to buy stuff CU account
World sells US stuff
World sends s to buy US assets CA account
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2. Build an International Monetary System

• Desirable features of international monetary
  system
• free flow of capital (money)
• stable exchange rates
• control of the domestic money supply
• Trilemma - you only get 2 features

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Evolution of international monetary system

• Gold standard (1717-1945)
• Give up control of Ms
• Ends with Great Depression and WWII
• Bretton Woods (1946 -1971)
• Restrict capital flows
• Ends in early 1970s with Nixons closing of gold
  window
• Flexible exchange rates (1972- )
• Give up fixed exchange rates

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Case Study Englands options after wartime
inflation made its goods too expensive
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Englands Situation after War

• Goals
• Mobility of capital
• Fixed exchange rate
• Control of Ms
• Trilemma (only 2 goals possible)
• Three Possibilities
• Give up control of money supply
• Devalue the currency
• Restrict capital flows

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Option 1 Give up control on money supply (gold
standard)

1. Price of shirt rises in UK during war
2. UK imports rise and UK exports fall
3. UK runs trade deficit and gold leaves UK
4. Outflow of gold reduces money supply
5. Lower money supply means lower prices and lower
   wages and higher unemployment and trade imbalance
   is eliminated BUT

UK loses control of its money supply but problem
is solved
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Option 2 Devalue currency

1. Price of shirt rises in UK during war
2. Devalue UK currency / increase price of gold
3. lower value of currency means exports look
   cheaper and imports look more expensive
4. Lower price for exports means rise in exports
   higher prices of imports reduces imports
5. Trade deficit eliminated

UK loses control of its currency value, but the
deficit is eliminated
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Option 3 Restrict capital flows

1. Price of shirt rises in UK during war and UK
   consumers want to buy shirts outside of UK
2. Government simply refuses to allow currency to
   leave country to buy imported shirts

UK loses control of its capital mobility, but
solves the deficit problem
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Case Study Nixons Problem

• In the early 1970s president Nixon had two
  overriding goals - Reelection in 1972 and
  Maintaining an image of strength in Cold War.
• He also faced some very real problems.
• High unemployment stubborn inflation and the
  Phillips Curve indicated there was no easy
  solution
• High foreign military spending (Vietnam War)
  needed to contain communism US s flow out
• US households had a high demand for imports
  for foreign travel US s flow out
• Trade surplus disappearing meant US gold supply
  was falling US was running out of gold

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Nixons Problem Trade Surplus disappears
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Nixons 3 BAD 1971 options (trilemma)

1. Devalue bad for image of superpower
2. Restrict capital flows bad for image of
   superpower
3. Reduce outflow of gold by
4. Reducing military spending abroad bring home
   troops - bad for image
5. Increasing exports - raise tariffs bad for
   image and against rules of post WWII free trade
6. Reducing consumers import spending by creating a
   recession - bad for election

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Nixons Choice New Economic Policy

• Nixon surprises everyone. First, a conservative
  Republican orders wage-price freeze meaning the
  government and not markets would set prices.
  Second, he abandons the gold standard and blames
  speculators. By abandoning the gold standard the
  US s value would now be set in the market, so
  now we will look at that market.
• "NIXON ORDERS 90-DAY WAGE-PRICE FREEZE, ASKS TAX
  CUTS, NEW JOBS IN BROAD PLAN SEVERS LINK BETWEEN
  DOLLAR AND GOLD."  headline of the New York Times
  on August 16, 1971

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Understanding Flexible Exchange Rates
Remember the Cookbook approach to SD. Now you
need to follow the rules once again. Below are
the Rules of the foreign exchange game. It may
seem slow, but follow the rules carefully if you
are to avoid the common pitfalls of those who
have come before you.

• Rules of the game
• Specify exchange rate
• Identify participants
• Identify determinants of behavior
• Convert into SD diagram

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Specify the Exchange Rate

• There are two ways to specify the price of the
  US, what some would refer to as the value of
  dollar or the exchange rate.
• the number of units of a foreign currency needed
  to buy a dollar (ex. 97 per US ).
• the number of US s to buy one unit of a foreign
  currency (ex. 1.3 per 1 )
• In the next four slides you will see a few
  examples. When we talk about the value of the US
  we will be using the approach used in the Japan
  and Swiss examples.

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US s to buy a euro
What does this rise here mean about the value of
the US ?
The US is getting weaker more US s to buy
the foreign currency
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US s to buy a UK
What does this decline here mean about the value
of the US ?
The US is getting stronger fewer US s to buy
the foreign currency
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US s to buy a euro
What does the decline here mean about the value
of the US ?
The US is getting weaker less foreign
currency to buy the US
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US s to buy a euro
What does this rise here mean about the value of
the US ?
The US is getting stronger more foreign
currency to buy the US
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2. Identify the players

• There are four major players in the foreign
  exchange market.
• US consumers who want to buy foreign Stuff
• Foreign consumers who want to buy US Stuff
• US investors who want to buy foreign assets.
• Foreign investors who want to buy US assets

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3. Specify determinants of players behavior

• Everyone wants their own currency.  German
  workers want euros while the US government wants
  US dollars when it sells Treasuries to British
  investors.
• US consumers purchases of foreign Stuff depends
  upon US income and wealth
• Foreign consumers purchases of US Stuff depends
  upon foreign income and wealth
• US investors who buy foreign assets are looking
  for good returns high interest rates abroad.
• Foreign investors who buy US assets are looking
  for good returns high interest rates in US.

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4. Convert into graphs

• supply of dollars is generated every time someone
  in the US tries to buy goods, services or assets
  from abroad. Americans must go to the
  international money market where they will supply
  US dollars to the money market to finance their
  purchases of foreign goods and assets. 
• Supply curve has slope because as increases
  in value, imports look cheaper to Americans so
  imports to the US increase which means more s
  being supplied to the international money market.

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Supply of s in international money market

• Who comes to international money market with US
  s?
• Americans with US s who want to buy things
  (consumers) or assets (investors) in other
  country.
• Supply depends on (US) residents

S (US)
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Supply of s in international money market

• Initial situation (S)
• Increase in supply of US s to international
  money market (because US consumers feel wealthier
  and travel abroad more OR US investors move more
  money to investments in Europe where interest
  rates are higher)

S (US)


P1
Q1
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Ground Rules

• Demand for dollars is generated every time
  someone anywhere in the world wants to buy US
  goods, services or US assets. Foreigners will
  need to go to the international money market
  where they will demand US dollars in the money
  market in order to finance their purchases of US
  goods and assets.
• As increases in value US exports look more
  expensive so exports decrease which means fewer
  s being demanded on the international money
  market.

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Demand for s in international money market

• Who comes to international MM demanding US s?
• Foreigners with currency who want to buy things
  (consumers) or assets (investors) in US.
• Demand depends on foreign (ROW) residents

D (ROW)
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Demand for s in international money market

• Initial situation (D)
• Increase in demand for US s in international
  money market(because foreign consumers feel
  wealthier and buy more US stuff OR foreign
  investors move more money to investments in the
  US where interest rates are higher)

D


P1
Q1
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Model of exchange rate

• As with all markets, the equilibrium exists when
  S D. In this case the exchange rate would be
  e, and any story about changes in exchange
  rates is a story about a shift in the S or D
  curve.

S (US)
e
D (ROW)
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Whats happening with exchange rates

• In the following graph you see a time-series
  graph of the exchange rate for Japanese yen.
  Every movement in the exchange rate coincides
  with a shift in either the S or D curves in the
  foreign exchange market. For example, in the
  1975-1978 period the value of the US dollar is
  falling. This happens IF the supply curve shifts
  to the right (US consumers or investors buy more
  from abroad) OR the D curve shifts to the left
  (foreign consumers and investors buy less from
  the US)

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US
Explain / forecast this
S
D
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What would happen to the dollar if?
Now lets get some practice

1. Japan lowered interest rates that affected
   Japanese investors. What is impact on US ?
2. OPEC raises price of oil and US imports rise.
   What is impact on US ?
3. The Fed lowered interest rates and US investors
   move money abroad?
4. Europe falls into a recession and buys fewer US
   exports?

Try to convert the story into the SD graphs so
get out those writing utensils and start shifting
those curves.
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Questions

• a. Japan lowered interest rates that affected
  Japanese investors. What is impact on US ?

S (US)
D (ROW)
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Questions

• b. OPEC raises price of oil and US imports rise.
  What is impact on US ?

S (US)
D (ROW)
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Questions

• c. the Fed lowered interest rates and US
  investors move money abroad. What is impact on US
  ?

S (US)
D (ROW)
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Questions

• d. Europe falls into a recession and buys fewer
  US exports. What is impact on US ?

S (US)
D (ROW)
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Compare your results

1. Japan lowered interest rates that affected
   Japanese investors. Foreign investors D curve,
   lower interest rates in Japan make US more
   attractive increase demand outward shift in D
   stronger
2. OPEC raises price of oil and US imports rise.
   What is impact on US ? US imports S curve,
   imports rise increase supply as we buy more
   from abroad outward shift in S weaker

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Compare your results

• c. The Fed lowered interest rates and US
  investors move money abroad? US investors S
  curve, lower interest rates in US make US less
  attractive increase supply as investors buy
  foreign assets outward shift in S weaker
• d. Europe falls into a recession and buys fewer
  US exports? Foreign consumers D curve, recesson
  in Europe means lower US exports decrease
  demand inward shift in D weaker

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What would happen to the dollar if?
Try a few more

1. World recession deepened and foreign investors
   became very nervous about ?
2. US investment in China slows down as result of
   recession?
3. US recession lowers imports from China ?
4. Chinese investors get nervous about and sell US
   treasuries?
5. Foreign investors get worried about financial
   crisis and begin to buy US government securities?

Try to convert the story into the SD graphs so
get out those writing utensils and start shifting
those curves.
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Questions

• a. World recession deepened and foreign investors
  became very nervous. What is impact on US ?

US
ROW
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Questions

• b. US investment in China slows down as result of
  recession. What is impact on US ?

US
ROW
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Questions

• c. US recession lowers imports from China. What
  is impact on US ?

US
ROW
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Questions

• d. Chinese investors get nervous about and sell
  US treasuries. What is impact on US ?

US
ROW
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The short answers

1. World recession deepened and foreign investors
   became very nervous about ? Foreign investors
   D more nervous lower D D shifts left
2. US investment in China slows down as result of
   recession? US investors S Less investment
   lower S S shifts left
3. US recession lowers imports from China? US
   consumers S lower imports lower S S shifts
   left

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The short answers

• d. Chinese investors get nervous about and sell
  US treasuries? Foreign investors D sell
  Treasuries lower D D shifts left
• e. Foreign investors get worried about financial
  crisis and begin to buy US government securities?
  Foreign investors D buy Treasuries higher D
  D shifts right

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Special cases

• Now lets look at two special cases Europe and
  China.
• China is special because it has tried to hold its
  exchange rate constant and override the
  influences of SD, which is why it is accused of
  being a currency manipulator.
• Europe has embarked on an experiment in which a
  number of countries have given up control of
  their own money supply and currencies and adopted
  a common currency the euro ().

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China
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What is happening?
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Why would China try to keep the exchange rate at
8 instead of letting it fall to 4 yuan per
US? The answer can be seen with the simple
example the US price of a China T-short.
Tshirt costs 16 yuan in China _at_ exchange rate of
8 costs 2 Tshirt costs 16 yuan in China _at_16
yuan _at_ exchange rate of 4 costs 4
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Question How does China manipulate its currency?

• You can see in the next slide that at the
  exchange rate of 8 the US has a trade deficit
  with China so USs are flowing out of the country
  as we buy Chinas exports. This would put
  downward pressure on the US - increase the
  value of the yuan. The only thing China can do is
  to offset the outflow of s by using them to buy
  US assets. So we buy Chinese toys and computers
  and they buy US Treasuries and US land and US
  companies. So, why would China do this?

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Here is the situation
US trade deficit
stable yuan
D
S
US
P2
The US runs a trade deficit at the existing
exchange rate, which should push the US lower.
Why does it not fall?
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And here is the answer
US trade deficit
stable yuan
D
S
US
P2
The Chinese buy US assets and this increase D for
US .
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Europes euro
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Europes euro

• Winston Churchill proposed the creation of the
  United States of Europe right after WW II, and
  since then a number of countries have joined in
  the experiment. We have not quite gotten to the
  US of E, but a number of European countries did
  adopt a common currency the euro that has
  been in the news a lot since the financial
  crisis. In the diagrams that follow you can see
  the growth of the European Union that allows
  pretty free movement between these countries and
  the subset of those countries that have adopted
  the euro. You also see the slide of unrest in
  Greece, a country that was running a trade
  deficit that needed to be closed.

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European Union Political and Economic

• 1951 European Coal and Steel Community (Treaty of
  Paris)
• 1957 European Economic Community (Treaty of Rome)
• 1973 add England, Ireland, and Denmark
• 1986 Greece, Spain, Portugal
• 1995 Austria, Norway, Finland
• 2004 Poland, Estonia, Latvia, Lithuania, Hungary,
  Czech Republic, Slovenia, Slovakia, Cyprus, Malta

2015
?
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Europes 21st century US of E?
EU European Union
Euro Common currency
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Greece
Greece was running a trade deficit, so what were
its options and why did they choose one that
ended up with scenes like the one above?
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Greeces Options

• We know from our earlier work that Greece had
  three options because of the trilemma
• Simply stop the flow of currency could not do
  this while on the euro
• Devalue its currency could not do this while on
  the euro
• Strangle its economy to reduce imports and
  increase exports the only option if it stayed
  on the euro and you can see the results.

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Englands Suez Moment
Greeces problem looks very much like Englands
Suez moment
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Americas Suez Moment?
Will the US suffer its own moment?