Chapter Fourteen Economic Interdependence

Copyright © Houghton Mifflin Company. All rights reserved.14 | 2 Countries are not independent of one another; downturns in one country may coincide with others The relationship between these countries is the international business cycle 1.What causes the business cycles of different countries to be related? 2.Is the whole world in the same phases of the business cycle simultaneously? 3.How are shocks in one country transmitted to other countries? The International Business Cycle

Copyright © Houghton Mifflin Company. All rights reserved.14 | 3 Why Is There an International Business Cycle? Shocks may affect several countries –A shock is an unexpected change in an exogenous variable. When large enough, shocks can lead to macroeconomic fluctuations –Example: uncertainty about the price of oil demanded by OPEC (negative shock) or a change in technology (positive shock) Shocks may spread because of economic interdependence –When a shock hits one country, others are affected because of international trade –Example: a tax cut in one country to reduce aggregate demand also decreases demand for imports, affecting the output/income of another country

Copyright © Houghton Mifflin Company. All rights reserved.14 | 4 How correlated are business cycles? US-Europe US-Japan US-Canada A correlation of 1 would mean output changed in both places at the same time and by the same amount. Strong correlations existed from the 1970s through the mid-80s. Correlation sharply declined in late 80s and 90s because the U.S entered a recession two years before the other nations. The International Business Cycle

Copyright © Houghton Mifflin Company. All rights reserved.14 | 5 Three mechanisms whereby shocks are transmitted Trade effects –Exports are a component of aggregate demand, so demand from other countries bears influence Interest-rate effects –Investment flows across borders, so increased foreign investment raises output domestically Exchange-rate effects –Exchange rates help determine the prices of exports and imports, thereby affecting aggregate demand The International Transmission of Shocks

Copyright © Houghton Mifflin Company. All rights reserved.14 | 6 The exchange rate is the amount of one currency needed to purchase one unit of another currency Consumers desire foreign currency so that they can purchase goods from other countries Because currency is traded via the market, the price of currencies change –Appreciation: when the value of one currency increases relative to another –Depreciation: when the value of one currency decreases relative to another –Example: Exchange rate: Y/Z if Y/Z falls, Z depreciates & Y appreciates if Y/Z rises, Z appreciates & Y depreciates Exchange Rates

Copyright © Houghton Mifflin Company. All rights reserved.14 | 7 The euro depreciated against the dollar from January 1999-January 2001, and the dollar appreciated relative to the euro Exchange Rates (cont’d)

Copyright © Houghton Mifflin Company. All rights reserved.14 | 8 The appreciation or depreciation of a country’s currency affects the prices of imports and exports –For a given cost of production when a currency appreciates, export prices rise when a currency depreciates, export prices fall Exchange Rates (cont’d)

Copyright © Houghton Mifflin Company. All rights reserved.14 | 9 Recently, U.S. dollar depreciates vs. euro –U.S. goods sold in Europe now cheaper –European goods sold in U.S. now more expensive. –U.S. exports rise; U.S. imports fall –European exports fall; European imports rise Exchange Rates (cont’d)

Copyright © Houghton Mifflin Company. All rights reserved.14 | 10 Demand slopes downward because lower euro/$ means $1 costs fewer euro, so demand for $ will be higher ($ is cheaper) Supply slopes upward because lower euro/$ means you get more $ from selling 1 euro, so you supply more $ How Supply & Demand Determine Exchange Rates

Copyright © Houghton Mifflin Company. All rights reserved.14 | 11 Increased demand: currency appreciates Increased supply: currency depreciates How Supply & Demand Determine Exchange Rates (cont’d)

Copyright © Houghton Mifflin Company. All rights reserved.14 | 12 The law of one price: if only one good exists, it should sell for the same price everywhere The equilibrium exchange rate will hold if the law of one price is true But in reality, many goods are traded between countries How International Trade Affects Exchange Rates

Copyright © Houghton Mifflin Company. All rights reserved.14 | 13 Exchange rates depend on price indexes in different countries Absolute Purchasing Power Parity (PPP) –The exchange rate should equal the ratio of price indexes of different countries –Idea: Generalize the law of one price to all goods –Problem: does not hold in practice because goods differ across countries and not all goods are traded Purchasing Power Parity

Copyright © Houghton Mifflin Company. All rights reserved.14 | 14 Relative PPP is the idea that a currency in one country should depreciate relative to the currency in a second country by the amount by which inflation is higher in the first country –Idea: Levels of prices may not be reflected in exchange rate, so absolute PPP doesn’t hold; but changes in inflation do affect exchange rates –Evidence: works reasonably well, though other factors matter more and it takes a long time to adjust Purchasing Power Parity (cont’d)

Copyright © Houghton Mifflin Company. All rights reserved.14 | 15 Real Exchange Rates Real exchange rates are exchange rates adjusted for inflation in both countries –real exchange rate: x = number of units of foreign good per unit of domestic good –nominal exchange rate: X = amount of foreign currency per unit of domestic currency

Copyright © Houghton Mifflin Company. All rights reserved.14 | 16 In percentage change terms %ΔX = %Δx + π F – π –Under relative PPP, the real exchange rate does not change, so the nominal exchange rate changes by: %ΔX = π F – π Real Exchange Rates (cont’d)

Copyright © Houghton Mifflin Company. All rights reserved.14 | 17 A key concern with investing in another country is the risk that the exchange rate might change If you invest in a foreign security earning nominal interest rate i F, your expected return in dollar terms is: i F – %ΔX e Compare to domestic interest rate i D How Financial Investment Affects the Exchange Rate

Copyright © Houghton Mifflin Company. All rights reserved.14 | 18 In nominal terms, the dollar has mostly appreciated since In real terms, the dollar has been fairly stable How Exchange Rates Affect the Economy

Copyright © Houghton Mifflin Company. All rights reserved.14 | 19 International Payments Accounting Savings = Domestic investment + Net exports + Government budget deficit S = I + NX + (G – T) This system reflects the balance on current account system, a measure of the flow of payments between countries Net exports, net income from abroad, and unilateral current transfers are included

Copyright © Houghton Mifflin Company. All rights reserved.14 | 20 The balance on capital and financial account is the amount foreign citizens, firms, and governments invest in a country, minus the amount the country’s citizens, firms, and governments invest abroad S = I + NFI + (G – T) The negative balance is net foreign investment International Payments Accounting (cont’d)

Copyright © Houghton Mifflin Company. All rights reserved.14 | 21 How does the business cycle affect nominal and real exchange rates? The Business Cycle & Exchange Rates Figure 14.5 Recessions and the Foreign-Exchange Value of the U.S. Dollar

Copyright © Houghton Mifflin Company. All rights reserved.14 | 22 Increased openness to trade and capital flows enables a country to grow faster Being open also allows foreign shocks to be transmitted domestically Open countries must be prepared to face the consequences of foreign investors’ changing expectations How Independent Should a Country Be?

Copyright © Houghton Mifflin Company. All rights reserved.14 | 23 The Asian crisis in 1997 –Investors pulled out because their investments were not paying off well –Because those countries borrowed from foreigners and owed debt in foreign currencies, as exchange rates fell, they owed more in terms of their own currencies –Default risk necessarily increased How Independent Should a Country Be? (cont’d)

Copyright © Houghton Mifflin Company. All rights reserved.14 | 24 What can a country do if investors flee and the currency depreciates? –Buy the currency in foreign-exchange markets using reserves: but reserves may run out –Raise real interest rate to attract investors, but as real rate rises, business capital investment falls –Restrict flow of capital: don’t let foreign investors in, but then growth is slower How Independent Should a Country Be? (cont’d)