Chapter Fourteen Economic Interdependence. Copyright © Houghton Mifflin Company. All rights...

Chapter FourteenEconomic

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


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


How correlated are business cycles?

1970-1985 1985-2000

US-Europe 0.7 0.3

US-Japan 0.6 0.0

US-Canada 0.8 0.8• 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


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


• 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


The euro depreciated against the dollar from January 1999-January 2001, and the dollar appreciated relative to the euro

Exchange Rates (cont’d)


• 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



• 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



• 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


Increased demand: currency appreciatesIncreased supply: currency depreciates

How Supply & Demand Determine Exchange Rates (cont’d)


• 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


• 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


• 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)


Real Exchange Rates

• Real exchange rates are exchange rates adjusted for inflation in both countries

F

Px X

P

– 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


In percentage change terms

%ΔX = %Δx + πF – π

– Under relative PPP, the real exchange rate

does not change, so the nominal exchange

rate changes by: %ΔX = πF – π

Real Exchange Rates (cont’d)


• 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 iF, your expected return in dollar terms is: iF – %ΔXe

• Compare to domestic interest rate iD

%D F ei i X

How Financial Investment Affects the Exchange Rate


In nominal terms, the dollar has mostly appreciated since 1973.In real terms, the dollar has been fairly stable

How Exchange Rates Affect the Economy


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


• 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)


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


• 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?


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)


• 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)

Chapter Fourteen Economic Interdependence. Copyright © Houghton Mifflin Company. All rights...

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