GS ECO 2301 CH 19 The International Financial System
Although at one time the U.S. capital market was larger than all other capital markets combined, that is no longer the case. Today, there are large capital markets in
Europe and Japan, and there are smaller markets in Latin America and East Asia. The three most important international financial centers today are New York, London, and Tokyo. Each day, the Wall Street Journal provides data not just on the Dow Jones Industrial Average and the Standard & Poor's 500 stock indexes of U.S. stocks but also on foreign stock indexes such as the Nikkei 225 average of Japanese stocks and the FTSE 100 index of stocks on the London Stock Exchange. By 2017, corporations, banks, and governments were raising more than $1 trillion in funds on global financial markets each year.
The Euro (continued) A new European Central Bank (ECB) was also established. Although the central banks of the member countries continue to exist, the ECB has assumed responsibility for monetary policy and for issuing currency.
The ECB is run by a governing council that consists of a six-member executive board—appointed by the participating governments—and the governors of the central banks of the 19 member countries that have adopted the euro. The ECB represents a unique experiment in allowing a multinational organization to control the domestic monetary policies of independent countries.
In 2010, a sovereign debt crisis developed when investors began to believe that a number of European governments, particularly those of Greece, Ireland, Spain, Portugal, and Italy, would have difficulty making interest payments on their bonds—or sovereign debt.
The International Monetary Fund and the European Union put together aid packages to keep the countries from defaulting. In exchange for the aid, these countries were required to adopt austerity programs—cutting government spending and raising taxes—even though doing so sparked protests from unions, students, and other groups. The controversy was greatest in Greece, which had large debts and a high unemployment rate, and where political resistance to multiple rounds of austerity made it uncertain whether the country would remain in the euro zone. In 2017, the Greek economy again fell into recession, pushing higher an unemployment rate that was already well above 20 percent.
The Four Determinants of Exchange Rates in the Long Run We can take into account the shortcomings of the theory of purchasing power parity to develop a more complete explanation of how exchange rates are determined in the long run. There are four main determinants of exchange rates in the long run:
1. Relative price levels. 2. Relative rates of productivity growth. 3. Preferences for domestic and foreign goods. 4. Tariffs and quotas.
19.2 The Current Exchange Rate System The current exchange rate system has three important features:
1. The United States allows the dollar to float against other major currencies. 2. Nineteen countries in Europe have adopted a single currency, the euro. 3. Some developing countries have attempted to keep their currencies' exchange rates fixed against the dollar or another major currency.
Three real-world complications keep purchasing power parity from providing a complete explanation of exchange rates, even in the long run: 1. Not all products can be traded internationally. Where goods are traded internationally, profits can be made whenever exchange rates do not reflect their purchasing power parity values. However, more than half of all goods and services produced in the United States and most other countries are not traded internationally. When goods are not traded internationally, their prices will not be the same in every country.
2. Products and consumer preferences are different across countries. We expect the same product to sell for the same price around the world, but if a product is similar but not identical to another product, their prices might be different. For example, a 3-ounce Hershey candy bar may sell for a different price in the United States than does a 3-ounce Cadbury candy bar in the United Kingdom. Prices of the same product may also differ across countries if consumer preferences differ. 3. Countries impose barriers to trade. Most countries, including the United States, impose tariffs and quotas on imported goods. A tariff is a tax imposed by a government on imports. A quota is a government-imposed numerical limit on the quantity of a good that can be imported. For example, the United States has a quota on imports of sugar. As a result, the price of sugar in the United States is much higher than the price of sugar in other countries. Because of the quota, there is no legal way to buy up the cheap foreign sugar and resell it in the United States.
Figure 19.6 shows the distribution in March 2017 of foreign holdings of U.S. stocks and bonds by country. Japan and China together held
20 percent of foreign-owned U.S. securities. The large holdings in the Cayman Islands and Luxembourg were due to investors taking advantage of the favorable tax treatment of investment income available in those countries.
Figure 19.3 shows the exchange rate between the dollar and the Thai baht. The figure is drawn from the Thai point of view, so we measure the exchange rate on the vertical axis as dollars per baht. The figure represents the situation in the 1990s, when the government of Thailand pegged the exchange rate between the dollar and the baht above the equilibrium exchange rate, as determined by demand and supply.
A currency pegged at a value above the market equilibrium exchange rate is said to be overvalued. A currency pegged at a value below the market equilibrium exchange rate is said to be undervalued. The situation Thailand faced during these years is worth analyzing because it is the situation that any country pegging its currency can face.
A persistent shortage or surplus of a currency under the Bretton Woods system was seen as evidence of a fundamental disequilibrium in a country's exchange rate.
After consulting with the IMF, countries in this position were allowed to adjust their exchange rates. In the early years of the Bretton Woods system, many countries found that their currencies were overvalued versus the dollar, meaning that their par exchange rates were too high.
The crisis over Greece highlighted another key problem facing the euro: the lack of coordinated government spending policies. The euro zone is a monetary union—the member countries all use the same currency and follow a joint monetary policy—but not a fiscal union—the member countries pursue independent fiscal policies.
Although we don't usually think of countries in these terms, the states of the United States, the provinces of Canada, and the prefectures of Japan represent both monetary unions and fiscal unions. If during a recession, Nevada suffers a particularly sharp decline in production and employment, the federal government provides support to the economy of Nevada through unemployment insurance and other transfer programs. Greece, by contrast, must fund such payments largely from its own revenues. The resulting large government budget deficits contributed to the sovereign debt crisis discussed earlier.
A decline in the value of a country's currency lowers the foreign currency prices of the country's exports and increases the prices of imports.
An increase in the value of a country's currency has the reverse effect. Firms can be both helped and hurt by exchange rate fluctuations.
The increased demand for deutsche marks by investors hoping to make a profit from the expected revaluation of the mark shifted the demand curve for marks to the right, from D1 to D2. Because of this expectation, the Bundesbank had to increase the marks it supplied in exchange for dollars, raising further the risk of inflation in Germany.
As we saw in this chapter, because these actions by investors make it more difficult to maintain a fixed exchange rate, they are called destabilizing speculation. By May 1971, the Bundesbank had to buy more than $250 million per day to support the fixed exchange rate against the dollar. Finally, on May 5, the West German government decided to allow the mark to float. In August, President Richard Nixon elected to abandon the U.S. commitment to redeem dollars for gold. Attempts were made over the next two years to reach a compromise that would restore a fixed exchange rate system, but by 1973, the Bretton Woods system was effectively dead.
Although the chemical formula for aspirin had been known for decades, it was only in 1899 that Bayer began marketing aspirin as a pain reliever.
Because no other effective over-the-counter pain relievers were available until the 1950s, Bayer aspirin was probably the most profitable medication ever sold.
When the value of the euro increases, the prices of goods exported from Germany increase, and Bayer's sales can be hurt.
But when the value of the euro falls, it's good news for Bayer and other German exporters. For example, in 2016, the value of the euro remained roughly constant against the U.S. dollar but rose against most other major currencies, leading to a decline in Bayer's export sales.
Most of Europe experienced relative economic stability from the introduction of the euro in 2002 to the beginning of the global economic recession in 2007. With low interest rates, low inflation rates, and expanding employment and production, the advantages of having a common currency seemed obvious, and the euro experiment appeared to be a success. Firms no longer had to worry about exchange rate instability when selling within Europe, and the cost of doing business was reduced because, for example, it was no longer necessary for a French firm to exchange francs for marks to do business in Germany.
By 2008, however, some economists and policymakers argued that the euro was making the effects of the global recession worse for two key reasons. First, the countries using the euro cannot pursue independent monetary policies because the ECB determines those policies from its headquarters in Frankfurt, Germany. Countries that were particularly hard hit by the recession—for example, Spain, where the unemployment rate had more than doubled to 18 percent by 2009 and was still at the level in mid-2017—were unable to pursue a more expansionary policy than the ECB was willing to implement for the euro zone as a whole. Second, countries could not attempt to revive their exports by allowing their currencies to depreciate because (1) many of their exports were to other euro zone countries, and (2) the value of the euro was determined by factors affecting the euro zone as a whole.
3 of 4 Long Run Exchange Rate Determinant : Preferences for domestic and foreign goods. If consumers in Canada increase their preferences for U.S. products, the demand for U.S. dollars will increase relative to the demand for Canadian dollars, and the U.S. dollar will increase in value relative to the Canadian dollar.
During the 1970s and 1980s, many U.S. consumers increased their preferences for Japanese products, particularly automobiles and consumer electronics. This greater preference for Japanese products helped increase the value of the yen relative to the dollar.
Pegging against the Dollar (continued) Finally, some countries fear the inflationary consequences of a floating exchange rate. When the value of a currency falls, the prices of imports rise. If imports are a significant fraction of the goods consumers buy, a fall in the value of the currency may significantly increase the inflation rate.
During the 1990s, an important part of Brazil's and Argentina's anti-inflation policies was a fixed exchange rate against the dollar. (As we will see, there are difficulties with following a fixed exchange rate policy, and ultimately, both Brazil and Argentina abandoned fixed exchange rates.)
Under the Bretton Woods system, a fixed exchange rate was called a par exchange rate. If the par exchange rate was not the same as the exchange rate that would have been determined in the market, the result would be a surplus or a shortage.
For example, Figure 19A.1 shows the exchange rate between the dollar and the British pound. The figure is drawn from the British point of view, so we measure the exchange rate on the vertical axis as dollars per pound. In this case, the par exchange rate between the dollar and the pound is above the equilibrium exchange rate, as determined by demand and supply.
Pegging against the Dollar (continued) In the 1980s and 1990s, an additional reason developed for having fixed exchange rates. During those decades, the flow of foreign investment funds to developing countries, particularly those in East Asia, increased substantially. It became possible for firms in countries such as South Korea, Thailand, Malaysia, and Indonesia to borrow dollars directly from foreign investors or indirectly from foreign banks.
For example, say that a Thai firm borrows U.S. dollars from a Japanese bank. If the Thai firm wants to build a new factory in Thailand with the borrowed dollars, it has to exchange the dollars for the equivalent amount of Thai currency, the baht. When the factory opens and production begins, the Thai firm will be earning the additional baht it needs to exchange for dollars to make the interest payments on the loan. A problem arises if the value of the baht falls against the dollar. Suppose that the exchange rate is 25 baht per dollar when the firm takes out the loan. A Thai firm making an interest payment of $100,000 per month on a dollar loan could buy the necessary dollars for 2.5 million baht. But if the value of the baht declines to 50 baht to the dollar, it would take 5 million baht to buy the dollars necessary to make the interest payment. These increased payments might be a crushing burden for the Thai firm. The government of Thailand would have a strong incentive to avoid this problem by keeping the exchange rate between the baht and the dollar fixed.
The End of the Gold Standard From a modern point of view, the greatest drawback to the gold standard was that the central bank lacked control of the money supply. The size of a country's money supply depended on its gold supply, which could be greatly affected by chance discoveries of gold or by technological change in gold mining.
For example, the gold discoveries in California in 1849 and Alaska in the 1890s caused rapid increases in the U.S. money supply. Because the central bank cannot determine how much gold will be discovered, it lacks the control of the money supply necessary to pursue an active monetary policy. During wartime, countries usually went off the gold standard to allow their central banks to expand the money supply as rapidly as was necessary to pay for the war. Britain left the gold standard at the beginning of World War I in 1914 and did not resume redeeming its paper currency for gold until 1925.
The Decline in Pegging Following the disastrous events experienced by the East Asian countries, the number of countries with pegged exchange rates declined sharply. Most countries that continue to use pegged exchange rates are small and trade primarily with a single, much larger, country.
For instance, several Caribbean countries continue to peg against the dollar, and several former French colonies in Africa that formerly pegged against the French franc now peg against the euro. Saudi Arabia and other oil-exporting states in the Persian Gulf peg their currencies to the dollar because the price of oil is in dollars. Overall, the trend has been toward replacing pegged exchange rates with managed floating exchange rates.
Figure 19.4 shows the results of this destabilizing speculation. The decreased demand for baht shifted the demand curve for baht from D1 to D2, increasing the quantity of baht the Bank of Thailand needed to buy in exchange for dollars.
Foreign investors also began to sell off their investments in Thailand and exchange their holdings of baht for dollars. This capital flight forced the Bank of Thailand to run through its dollar reserves. Dollar loans from the IMF temporarily allowed Thailand to defend the pegged exchange rate. Finally, on July 2, 1997, Thailand abandoned its pegged exchange rate against the dollar and allowed the baht to float. Thai firms that had borrowed dollars were now faced with dollar interest payments that were much higher than they had planned. Some large firms were forced into bankruptcy, and the Thai economy plunged into a deep recession.
Pegging against the Dollar A final key feature of the current exchange rate system is that some developing countries have attempted to keep their exchange rates fixed against the dollar or another major currency.
Having a fixed exchange rate can provide important advantages for a country that has extensive trade with another country. When the exchange rate is fixed, business planning becomes much easier. For instance, if the South Korean won increases in value relative to the dollar, South Korean car manufacturer Hyundai may have to raise the dollar price of cars it exports to the United States, which would reduce sales. If the exchange rate between the Korean won and the dollar is fixed, Hyundai's planning is much easier.
These were both fixed exchange rate systems, in which exchange rates remained constant for long periods.
Historically, the two most important alternatives to the managed float exchange rate system were the gold standard and the Bretton Woods system.
The United Kingdom, Iceland, and the United States all use their own currencies and all recovered more quickly from the financial crisis and recession than did most of the countries using the euro. The United Kingdom is a member of the European Union (although in 2017 it was in the process of withdrawing) but continues to use the pound as its currency.
Iceland is not a member of the European Union and does not use the euro. The situation in Iceland is particularly interesting because no country was more severely affected by the global financial crisis. Although it is a small country, its banks aggressively made loans around the world in the years leading up to the crisis. By 2007, Icelandic banks had made loans equal to nine times the country's GDP. When many borrowers defaulted on those loans, the government of Iceland took over the banks and assumed their debt of about $100 billion—or more than $300,000 for each citizen of Iceland. Iceland's krona, the British pound, and the U.S. dollar all depreciated against the euro in the period immediately following the financial crisis, which was good news for these countries because it helped them increase exports, but it was bad news for countries using the euro, many of which faced declining exports outside Europe.
The Theory of Purchasing Power Parity (example) Consider a simple example: Suppose that a Hershey candy bar has a price of $1 in the United States and £1 in the United Kingdom and that the exchange rate is £1 = $1. In that case, at least with respect to candy bars, the dollar and the pound have equivalent purchasing power. If the price of a Hershey bar increases to £2 in the United Kingdom but stays at $1 in the United States, the exchange rate will have to change to £2 per $1 in order for the pound to maintain its relative purchasing power. As long as the exchange rate adjusts to reflect purchasing power, it will be possible to buy a Hershey bar for $1 in the United States or to exchange $1 for £2 and buy the candy bar in the United Kingdom.
If exchange rates are not at the values indicated by purchasing power parity, it appears that there are opportunities to make a profit. Suppose a Hershey candy bar sells for £2 in the United Kingdom and $1 in the United States, and the exchange rate between the dollar and the pound is £1 = $1. In this case, it would be possible to exchange £1 million for $1 million and use the dollars to buy 1 million Hershey bars in the United States. The Hershey bars could then be shipped to the United Kingdom, where they could be sold for £2 million. The result of these transactions would be a profit of £1 million (minus any shipping costs). In fact, if the dollar-pound exchange rate fails to reflect the purchasing power for many products—not just Hershey bars—this process could be repeated until an extremely large profit was made. In practice, though, as people attempted to make this profit by exchanging pounds for dollars, they would bid up the value of the dollar until it reached the purchasing power parity exchange rate of £2 = $1. Once the exchange rate reflected the purchasing power of the two currencies, there would be no further opportunities for profit. This mechanism appears to guarantee that exchange rates will be at the levels determined by purchasing power parity.
1 of 4 Long Run Exchange Rate Determinant : Relative price levels. The purchasing power parity theory is correct in arguing that, in the long run, the most important determinant of exchange rates between two countries' currencies is their relative price levels.
If prices of goods and services rise faster in Canada than in the United States, the value of the Canadian dollar has to decline to maintain demand for Canadian products. Over the past 45 years, the price level in Canada has risen somewhat faster than the price level in the United States, while the price level in Japan has risen more slowly. These facts help explain why the U.S. dollar has increased in value against the Canadian dollar while losing value against the Japanese yen.
2 of 4 Long Run Exchange Rate Determinant : Relative rates of productivity growth. When the productivity of a firm increases, the firm is able to produce more goods and services using fewer workers, machines, or other inputs. The firm's costs of production fall, and usually so do the prices of its products.
If the average productivity of Japanese firms increases faster than the average productivity of U.S. firms, Japanese products will have relatively lower prices than U.S. products, which increases the quantity demanded of Japanese products relative to U.S. products. As a result, the value of the yen should rise against the dollar. For most of the period from the early 1970s to the early 1990s, Japanese productivity increased faster than U.S. productivity, which contributed to the fall in the value of the dollar versus the yen. However, between 1992 and 2017, U.S. productivity increased faster than Japanese productivity, which explains why in the early 1990s, the value of the dollar stopped its rapid decline against the yen.
A reduction in a fixed exchange rate is a devaluation. An increase in a fixed exchange rate is a revaluation.
In 1949, there was a devaluation of several currencies, including the British pound, reflecting the fact that those currencies had been overvalued against the dollar.
The Euro A second key aspect of the current exchange rate system is that most countries in Western Europe have adopted a single currency.
In 1957, Belgium, France, West Germany, Italy, Luxembourg, and the Netherlands signed the Treaty of Rome, which established the European Economic Community, often called the European Common Market. Tariffs and quotas on products being shipped within the European Common Market were greatly reduced. Over the years, the United Kingdom, Sweden, Denmark, Finland, Austria, Greece, Ireland, Spain, and Portugal joined the European Economic Community, which was renamed the European Union (EU) in 1991.
The pegged exchange rate was 25.19 baht to the dollar, or about $0.04 to the baht. By 1997, this exchange rate was well above the market equilibrium exchange rate of 35 baht to the dollar, or about $0.03 to the baht. The result was a surplus of baht on the foreign exchange market. To keep the exchange rate at the pegged level, the Thai central bank, the Bank of Thailand, had to buy these baht with dollars.
In doing so, the Bank of Thailand gradually used up its holdings of dollars, or its dollar reserves. To continue supporting the pegged exchange rate, the Bank borrowed additional dollar reserves from the International Monetary Fund (IMF). The Bank of Thailand also raised interest rates to attract more foreign investors to investments in Thailand, thereby increasing the demand for the baht. The Bank of Thailand took these actions even though allowing the value of the baht to decline against the dollar would have helped Thai firms exporting to the United States by reducing the dollar prices of their goods. The Thai government was afraid of the negative consequences of abandoning the peg even though the peg had led to the baht being overvalued.
The globalization of financial markets has helped increase growth and efficiency in the world economy. It is now possible for the savings of households around the world to be channeled to the best investments available.
It is also possible for firms in nearly every country to tap the savings of foreign households to gain the funds needed for expansion. No longer are firms forced to rely only on the savings of domestic households to finance investment.
Did the euro contribute to the slow recovery from the 2007-2009 financial crisis? The following figure shows the average unemployment rate for the euro zone countries for the period 2007-2016 compared with the unemployment rates for the United States, the United Kingdom, and Iceland. The euro zone was still suffering from high unemployment rates more than seven years after the beginning of the financial crisis. The German economy, however, performed very well during and after the financial crisis, with its unemployment rate in 2016 being less than half what it had been in 2007.
In fact, German firms, including Bayer, benefited from the euro because if the country had retained the deutsche mark as its currency, the deutsche mark would likely have increased significantly in value beginning in 2014. The value of the euro decreased sharply from mid-2014 to mid-2015 and then remained roughly constant through mid-2017, thereby increasing German exports by more than what would have happened without the common currency. As the blue line shows, the unemployment rate in the euro zone looks significantly worse if Germany is left out.
The exception is the period from July 2008 to May 2010, when the exchange rate stabilized at about 6.83 yuan to the dollar, indicating that China had apparently returned to a "hard peg." This change in policy led to renewed criticism from policymakers in the United States.
In mid-2010, President Barack Obama argued that "market-determined exchange rates are essential to global economic activity." In the face of this criticism, the PBOC allowed the yuan to resume its slow increase in value versus the dollar.
Currently, many countries, including the United States, allow their currencies to float most of the time, although they occasionally intervene to buy and sell their currency or other currencies to affect exchange rates.
In other words, many countries attempt to manage the float of their currencies. As a result, the current exchange rate system is a managed float exchange rate system.
The Collapse of the Bretton Woods System By the late 1960s, the Bretton Woods system faced two severe problems. The first was that after 1963, the total number of dollars held by foreign central banks was larger than the gold reserves of the United States.
In practice, most central banks—with the Bank of France being the main exception—rarely redeemed dollars for gold. But the basis of the system was a credible promise by the United States to redeem dollars for gold if called upon to do so. By the late 1960s, as the gap between the dollars held by foreign central banks and the gold reserves of the United States grew larger and larger, other countries began to doubt the U.S. promise to redeem dollars for gold. The second problem the Bretton Woods system faced was that some countries with undervalued currencies, particularly West Germany, were unwilling to revalue their currencies. Governments resisted revaluation because it would have increased the prices of their countries' exports. Many German firms put pressure on the government not to endanger their sales in the U.S. market by raising the exchange rate of the deutsche mark against the dollar. Figure 19A.2 shows the situation the German government faced in 1971. The figure takes the German point of view, so the exchange rate is expressed in terms of dollars per deutsche mark (DM). By selling deutsche marks and buying dollars to defend the par exchange rate, the Bundesbank was increasing the West German money supply, risking an increase in the inflation rate. Because Germany had suffered a devastating hyperinflation during the 1920s, the fear of inflation was greater in Germany than in any other industrial country. No German government could survive politically if it allowed a significant increase in inflation. Knowing this fact, many investors in Germany and elsewhere became convinced that, eventually, the German government would have to allow a revaluation of the mark.
Although higher domestic interest rates helped attract foreign investors, they made it more difficult for Thai firms and households to borrow the funds they needed to finance their spending. As a consequence, domestic investment and consumption declined, pushing the Thai economy into a recession.
International investors realized that there were limits to how high the Bank of Thailand would be willing to push interest rates and how many dollar loans the IMF would be willing to extend to Thailand. These investors began to speculate against the baht by exchanging baht for dollars at the official, pegged exchange rate. If, as they expected, Thailand were forced to abandon the peg, they would be able to buy back the baht at a much lower exchange rate, making a substantial profit. Because these actions by investors make it more difficult to maintain a fixed exchange rate, they are called destabilizing speculation.
When a country keeps its currency's exchange rate fixed against another country's currency, it is pegging its currency.
It is not necessary for both countries involved in a peg to agree to it. When a developing country has pegged the value of its currency against the dollar, the responsibility for maintaining the peg has been entirely with the developing country.
What Determines Exchange Rates in the Long Run? In the short run, the two most important causes of exchange rate movements are • changes in interest rates—which cause investors to change their views of which countries' financial investments will yield the highest returns—and • changes in investors' expectations about the future values of currencies.
It seems reasonable that, in the long run, exchange rates should be at a level that makes it possible to buy the same amount of goods and services with the equivalent amount of any country's currency The idea that in the long run exchange rates move to equalize the purchasing power of different currencies is called the theory of purchasing power parity.
In addition to the collapse of the gold standard, the global economy suffered during the 1930s from tariff wars. The United States had started the tariff wars in June 1930 by enacting the Smoot-Hawley Tariff Act, which raised the average U.S. tariff rate to more than 50 percent.
Many other countries raised tariffs during the next few years, leading to a collapse in world trade. As World War II was coming to an end, economists and government officials in the United States and Europe concluded that they needed to restore the international economic system to avoid another depression. In 1947, the United States and most other major countries, apart from the Soviet Union, began participating in the General Agreement on Tariffs and Trade (GATT), under which they worked to reduce trade barriers. The GATT was very successful in sponsoring rounds of negotiations among countries, which led to sharp declines in tariffs.
The Euro (continued) EU members decided to move to a common currency beginning in 1999. Three of the 15 countries that were then members of the EU—the United Kingdom, Denmark, and Sweden—decided to retain their domestic currencies. The move to a common currency took place in several stages.
On January 1, 1999, the exchange rates of the 12 participating countries were permanently fixed against each other and against the common currency, the euro. At first, the euro was a pure unit of account. No euro currency was actually in circulation, although firms began quoting prices in both domestic currency and in euros. On January 1, 2002, euro coins and paper currency were introduced, and on June 1, 2002, the old domestic currencies were withdrawn from circulation. Figure 19.2 shows the 19 countries in the EU that had adopted the euro as of the end of 2017. These countries are sometimes called the euro zone.
In 1978, China began to move away from central planning and toward a market system. The result was a sharp acceleration in economic growth. Real GDP per capita grew at a rate of more than 8 percent per year between 1979 and 2016. An important part of Chinese economic policy was the decision in 1994 to peg the value of the Chinese currency, the yuan, to the dollar at a fixed rate of 8.28 yuan to the dollar.
Pegging against the dollar ensured that Chinese exporters would face stable dollar prices for the goods they sold in the United States. By the early 2000s, many economists and policymakers argued that the yuan was undervalued against the dollar—possibly significantly undervalued. Some policymakers claimed that the undervaluation of the yuan gave Chinese firms an unfair advantage in competing with U.S. firms. During the 2016 presidential campaign, Donald Trump accused China of manipulating its currency to increase its exports to the United States.
The Floating Dollar Since 1973, the value of the U.S. dollar has fluctuated widely against other major currencies. Panel (a) of Figure 19.1 shows the exchange rate between the U.S. dollar and the Canadian dollar between January 1973 and June 2017, and panel (b) shows the exchange rate between the U.S. dollar and the Japanese yen for the same period.
Remember that the dollar increases in value when it takes more units of foreign currency to buy $1, and it falls in value when it takes fewer units of foreign currency to buy $1. From January 1973 to June 2017, the U.S. dollar lost more than 60 percent in value against the yen, while it gained more than 30 percent in value against the Canadian dollar. Both exchange rates fluctuated substantially during these years. Panel (a) shows that from the end of the Bretton Woods system in 1973 through June 2017, the U.S. dollar gained more than 30 percent in value against the Canadian dollar. Panel (b) shows that during the same period, the U.S. dollar lost more than 60 percent in value against the Japanese yen.
19.1 Exchange Rate Systems A country's exchange rate can be determined in several ways.
Some countries simply allow the exchange rate to be determined by demand and supply, just as other prices are. A country that allows demand and supply to determine the value of its currency is said to have a floating currency. Some countries attempt to keep the exchange rate between their currency and another currency constant. For example, China kept the exchange rate constant between its currency, the yuan, and the U.S. dollar, from 1994 until 2005, when it began allowing greater exchange rate flexibility. When most countries allow their exchange rates to be determined in the same way, economists say that there is an exchange rate system.
In 2015, the Chinese government was concerned because the growth rate of real GDP had slowed to about 7 percent, the lowest rate in more than 6 years. On August 11 of that year, the yuan was once again in the news, when the PBOC made a surprise announcement that it would buy dollars with yuan in order to reduce the value of the yuan by about 3 percent—the largest one-day decline in the currency since 1994. The figure shows that the value of the yuan continued to drift lower against the dollar into 2017.
The PBOC insisted that this trend was the result of market forces and that it had not been taking action to push the value of the yuan lower. In fact, some economists believed that the PBOC had actually been buying yuan with dollars—keeping its value from falling more than it otherwise would have—as indicated by the fact that the PBOC's holdings of dollars had declined by nearly $700 billion. Adding to the downward pressure on the yuan was the fact that many Chinese investors were taking advantage of new rules allowing them to invest abroad for the first time. To make these investments, the investors needed to exchange yuan for dollars or other foreign currency.
Remember That Modern Currencies Are Fiat Money Although the United States has not been on the gold standard since 1933, many people still believe that somehow gold continues to "back" U.S. currency. The gold in Fort Knox no longer has any connection to the amount of paper money issued by the Federal Reserve. U.S. currency—like the currencies of other countries—is fiat money, which means it has no value except as money (see Chapter 14, Section 14.1). The link between gold and money that existed for centuries has been broken in modern economies.
The U.S. Department of the Treasury still owns billions of dollars' worth of gold bars, most of which are stored at the Fort Knox Bullion Depository in Kentucky. (Even more gold is stored in a basement of the Federal Reserve Bank of New York, which holds about one-quarter of the world's monetary gold supply—almost 10 percent of all the gold ever mined. This gold, however, is entirely owned by foreign governments and international agencies.)
The Theory of Purchasing Power Parity (example 2) The following table is from January 2017, when Big Macs were selling for an average price of $4.93 in the United States. The "implied exchange rate" shows what the exchange rate would be if purchasing power parity held for Big Macs. For example, a Big Mac sold for 49 pesos in Mexico and $4.93 in the United States, so for purchasing power parity to hold, the exchange rate should have been: 49 pesos / $4.93, or 9.94 pesos = $1.
The actual exchange rate in January 2017 was 17.44 pesos = $1. So, on Big Mac purchasing power parity grounds, the Mexican peso was undervalued against the dollar by 43 percent: [(9.94−17.44) / 17.44] × 100 = −43% That is, if Big Mac purchasing power parity held, it would have taken 43 percent fewer Mexican pesos to buy a dollar than it actually did. Could you take advantage of this difference between the purchasing power parity exchange rate and the actual exchange rate to become fabulously wealthy by buying up low-priced Big Macs in Mexico City and reselling them at a higher price in New York? Unfortunately, the low-priced Mexican Big Macs would be a soggy mess by the time you got them to New York. The fact that Big Mac prices are not the same around the world illustrates one reason purchasing power parity does not hold exactly: Many goods are not traded internationally.
A conference held in Bretton Woods, New Hampshire, in 1944 set up an exchange rate system in which the United States pledged to buy or sell gold at a fixed price of $35 per ounce.
The central banks of all other members of the new Bretton Woods system pledged to buy and sell their currencies at a fixed rate against the dollar. By fixing their exchange rates against the dollar, these countries were fixing the exchange rates among their currencies as well. Unlike under the gold standard, neither the United States nor any other country was willing to redeem its paper currency for gold domestically. The United States would redeem dollars for gold only if they were presented by a foreign central bank.
Under the gold standard, a country's currency consisted of gold coins and paper currency that the government was committed to redeeming for gold.
The gold standard was a fixed exchange rate system that lasted from the nineteenth century until the 1930s. Under the gold standard, exchange rates were determined by the relative amounts of gold in each country's currency, and the size of a country's money supply was determined by the amount of gold available. To rapidly expand its money supply during a war or an economic depression, a country would need to leave the gold standard. By the mid-1930s, in response to the Great Depression, the United States and most other countries had abandoned the gold standard.
During the 1960s, most European countries, including Germany, relaxed their capital controls, which are limits on the flow of foreign exchange and financial investment across countries.
The loosening of capital controls made it easier for investors to speculate on changes in exchange rates. For instance, an investor in the United States could sell $1 million and receive about 3.7 million deutsche marks at the par exchange rate of $0.27 per deutsche mark. If the exchange rate rose to $0.35 per deutsche mark, the investor could then exchange deutsche marks for dollars, receiving $1.3 million at the new exchange rate: a return of 30 percent on an initial $1 million investment. The more convinced investors became that Germany would have to allow a revaluation, the more dollars they exchanged for deutsche marks.
The United States would redeem dollars for gold only if they were presented by a foreign central bank. The United States continued the prohibition, first enacted in the early 1930s, against private citizens owning gold, except in the form of jewelry or rare coins.
The prohibition was not lifted until the 1970s, when it again became possible for Americans to own gold as an investment. Under the Bretton Woods system, central banks were committed to selling dollars in exchange for their own currencies. This commitment required them to hold dollar reserves.
4 of 4 Long Run Exchange Rate Determinant : Tariffs and quotas. The U.S. sugar quota forces firms such as Hershey Foods Corporation to buy expensive U.S. sugar rather than less expensive foreign sugar.
The quota increases the demand for dollars relative to the currencies of foreign sugar producers and, therefore, leads to a higher exchange rate. Changes in tariffs and quotas have not been a significant factor, though, in explaining trends in the U.S. dollar-Canadian dollar or U.S. dollar-yen exchange rates.
Many currency traders became convinced that other East Asian countries, such as South Korea, Indonesia, and Malaysia, would have to follow Thailand and abandon their pegged exchange rates. The result was a wave of speculative selling of these countries' currencies.
These waves of selling—sometimes called speculative attacks—were difficult for countries to fight off. Even if a country's currency was not initially overvalued at the pegged exchange rate, the speculative attacks would cause a large reduction in the demand for the country's currency. The demand curve for the currency would shift to the left, which would force the country's central bank to quickly exhaust its dollar reserves. Within a few months, South Korea, Indonesia, the Philippines, and Malaysia abandoned their pegged currencies. All these countries also plunged into recession.
Solved Problem 19.2 Calculating Purchasing Power Parity Exchange Rates Using Big Macs Fill in the missing values in the following table. Remember that the implied exchange rate shows what the exchange rate would be if purchasing power parity held for Big Macs. Assume that the Big Mac is selling for $4.93 in the United States.
To calculate the purchasing power parity exchange rate, divide the foreign currency price of a Big Mac by the U.S. price. For example, the implied exchange rate between the Brazilian real and the U.S. dollar is 13.5 reais/$4.93, or 2.74 reais per dollar.
Countries attempting to maintain a peg can run into problems, however.
When the government fixes the price of a good or service, the result can be persistent surpluses or shortages
Shares of stock and long-term debt, including corporate and government bonds and bank loans, are bought and sold on
capital markets. Before 1980, most U.S. corporations raised funds only in U.S. stock and bond markets or from U.S. banks. And U.S. investors rarely invested in foreign capital markets. In the 1980s and 1990s, European governments removed many restrictions on foreign investments in their financial markets. It became possible for U.S. and other foreign investors to freely invest in Europe and for European investors to freely invest in foreign markets.
But the globalization of financial markets also has a downside, as the events of 2007-2009 showed. Because financial securities issued in one country are held by investors and firms in many other countries, if those securities
decline in value, the financial pain will be widely distributed. For example, the sharp decline in the value of mortgage-backed securities issued in the United States hurt not only U.S. investors and financial firms but investors and financial firms in many other countries as well.
Because of the euro, Bayer and other German firms don't have to worry about fluctuations in exchange rates within most of Europe. Before the adoption of the euro, countries such as France, Italy, and Spain were able to
decrease the exchange values of their currencies, which made the output of their companies' products more competitive with those of Germany.
Fixed exchange rate regimes can run into difficulties because
exchange rates are not free to adjust quickly to changes in demand and supply for currencies. As we will see in the next section, central banks often encounter problems if they are required to keep an exchange rate fixed over a period of years. By the early 1970s, the difficulty of keeping exchange rates fixed led to the end of the Bretton Woods system. The appendix to this chapter contains additional discussion of the gold standard and the Bretton Woods system.
Beginning in the 1990s, the flow of foreign funds into U.S. stocks and bonds—or
portfolio investments—increased substantially. As Figure 19.5 shows, foreign purchases of stocks and bonds issued by corporations and bonds issued by the federal government increased dramatically between 1995 and 2007. In 2016, foreign purchases of U.S. corporate bonds were substantial, but foreign purchases of U.S. corporate stocks and U.S. government bonds were negative; foreign investors sold more U.S. stocks and U.S. government bonds than they purchased. Very low interest rates on U.S. Treasury bonds, the high exchange value of the dollar, and growth in China, India, and some European countries attracted both U.S. and foreign investors to securities issued in those countries.
We saw in this chapter that when the average productivity of firms in one country increases faster than the average productivity of firms in another country, the value of the faster-growing country's currency should—all else being equal
rise against the slower-growing country's currency. Therefore, the savings that you accumulate in yen while you are in Japan are likely to be worth more in U.S. dollars than they would have been worth without the gains in Japanese productivity.
One important reason exchange rates fluctuate is that investors seek out
the best investments they can find anywhere in the world. For instance, if Japanese investors increase their demand for U.S. Treasury bills, the demand for dollars will increase, and the value of the dollar will rise. But if interest rates in the United States decline, foreign investors may sell U.S. investments, and the value of the dollar will fall.
In July 2005, the Chinese government announced that it would switch from pegging the yuan against the dollar to linking the value of the yuan to the average value of a basket of currencies
the dollar, the Japanese yen, the euro, the Korean won, and several other currencies. Although the PBOC did not explain the details of how this linking of the yuan to other currencies would work, it declared that it had switched from a peg to a managed floating exchange rate. As the figure below shows, the value of the yuan gradually increased versus the dollar for most of the period from 2005 to the end of 2014. (Note that the figure shows the number of yuan per dollar, so an increase represents a depreciation of the yuan relative to the dollar, and a decrease represents an appreciation of the yuan relative to the dollar.)
The earlier a country abandoned the gold standard, the easier
time it had fighting the Depression with expansionary monetary policies. The countries that abandoned the gold standard by 1932 suffered an average decline in production of only 3 percent between 1929 and 1934. The countries that stayed on the gold standard until 1933 or later suffered an average decline of more than 30 percent. The devastating economic performance of the countries that stayed on the gold standard the longest during the 1930s is the key reason no attempt was made to bring back the gold standard in later years.
If a central bank ran out of dollar reserves, it could borrow them from the newly created International Monetary Fund (IMF). In addition
to providing loans to central banks that were short of dollar reserves, the IMF would oversee the operation of the system and approve adjustments to the agreed-on fixed exchange rates.