Feenstra Taylor Chapter 1

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The Global Macroeconomy1

1. Foreign Exchange: Currencies and Crises

2. Globalization of Finance: Debts and Deficits

3. Government and Institutions: Policies andPerformance

4. Conclusions

2014 Worth PublishersInternational Economics, 3e | Feenstra/Taylor 1

International macroeconomics is devoted to the study of large-scale economic problems in interdependent economies.

It is macroeconomic because it focuses on key economy-widevariables such as exchange rates, prices, interest rates, income,wealth, and the current account.

It is international because a deeper understanding of the globaleconomy emerges only when the interconnections amongnations are fully considered.


Introduction


Unique features of international macroeconomics can bereduced to three key elements:

1. The world has many monies ( not one ).

2. Countries are financially integrated ( not isolated ).

3. In this context economic policy choices are made(but not always very well ).

This introductory chapter briefly explains the road ahead.

Introduction


1 Foreign Exchange: Currencies and Crises

Countries have different currencies, therefore a completeunderstanding of how a countrys economy works requiresthat we study the exchange rate (the price of foreigncurrency).

Because products and investments move across borders,fluctuations in exchange rates have significant effects onthe relative prices of home and foreign:

o goods (such as autos and clothing),o services (such as insurance and tourism), ando assets (such as equities and bonds).


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In an exchange rate crisis a currency experiences a suddenand pronounced loss of value against another currency

following a period in which the exchange rate had been fixedor relatively stable.

There have been more than 27 exchange rate crises in the 12-year period from 1997 to 2011.

In some cases, including Argentina in 2002, exchange ratecrisis lead to governments declaring default (i.e., asuspension of payments).

When Exchange Rates Misbehave


2014 Worth PublishersInternational Economics, 3e | Feenstra/Taylor

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FIGURE 1-2

Currency CrashesThe chart shows that

exchange rate crises arecommon events. Anexchange rate crisis isdefined here as an eventin which a currencyloses more than 30% ofits value in U.S. dollarterms over one year,having changed by lessthan 20% each of the

previous two years.


Economic Crisis in Iceland

Societies and individuals can be profoundly shaken by the issues studiedin international macroeconomics.

This article was written just after t hestart of the severe economic crisis thatengulfed Iceland in 2008, following thecollapse of its exchange rate, a financialcrisis, and a government fiscal crisis.

HEADLINES

Protesters outside the Icelandic parliament inReykjavik demand that the government do more toimprove conditions for the recently poor.


Real output per person shrank by more than 10%, andunemployment rose from 1% to 9%. Five years later arecovery was just beginning to take shape.

H A L L D O R K O L B E I N S / A F P / G e t

t y I m a g e s


Governments in crisis may appeal for external help frominternational development organizations, such as theInternational Monetary Fund (IMF) or World Bank , orother countries.

When Exchange Rates Misbehave

Key Topics

Why do exchange rate crises occur? Are they an inevitableconsequence of deeper fundamental problems in an economy

or are they an avoidable result of animal spiritsirrationalforces in financial markets?

Why are these crises so economically and politically costly?

What steps might be taken to prevent crises, and at what cost?



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2 Globalization of Finance: Debts and Deficits

Financial globalization has taken hold around the world, startingin the economically advanced countries and spreading to manyemerging market countries.

Deficits and Surpluses: The Balance of Payments

At the national level, economic measurements such asincome , expenditure , deficit , and surplus , are important

barometers of economic performance, and the subject ofheated policy debate.

The income measure is called gross national disposableincome ; the expenditure measure is called gross nationalexpenditure . The difference between the two is a keymacroeconomic aggregate called the current account .


TABLE 1-1 (1 of 2)

Income, Expenditure, and the Current Account The table shows data for the United Statesfrom 1990 to 2012 in billions of U.S. dollars. During this period, in all but one year U.S.expenditure exceeded income, with the U.S. current account in deficit. The last (small)surplus was in 1991.


2 Globalizat ion of Finance: Debts and Deficits

Inflation Performance and the Exchange Rate Regime


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TABLE 1-1 (2 of 2)


Income, Expenditure, and the Current Account The table shows data for theUnited States from 1990 to 2012 in billions of U.S. dollars.

2 Globaliza tion of Finance: Debts and Deficits

Inflation Performance and the Exchange Rate Regime (continued)


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FIGURE 1-3

Global ImbalancesFor more than adecade, the UnitedStates currentaccount deficit hasaccounted forabout half of alldeficits globally.Major offsettingsurpluses have

been seen in Asia(e.g., China andJapan) and in oil-exportingcountries.



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Key Topics

How do different international economic transactionscontribute to current account imbalances?

How are these imbalances financed? How long can they persist?

Why are some countries in surplus and others in deficit?What role do current account imbalances perform in a well-functioning economy?

Why are these imbalances the focus of so much policydebate?



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Debtors and Creditors: External Wealth

Total wealth or net worth is equal to your assets (what others oweyou) minus your liabilities (what you owe others).

When you run a surplus, and save money (buying assets or payingdown debt), your total wealth, or net worth, tends to rise.

Similarly, when you have a deficit and borrow (taking on debt orrunning down savings), your wealth tends to fall.

From an international perspective, a countrys net worth is called itsexternal wealth and it equals the difference between its foreignassets (what it is owed by the rest of the world) and its foreignliabilities (what it owes to the rest of the world).

Positive external wealth makes a country a creditor nation; negativeexternal wealth makes it a debtor nation.




FIGURE 1-4

External Wealth A countrys net credit position with the rest of the world is called externalwealth. The time series charts show levels of external wealth from 1980 to 2007 for theUnited States in panel (a) and Argentina in panel (b). All else equal, deficits cause externalwealth to fall; surpluses (and defaults) cause it to rise.




Key Topics

What forms can a nations external wealth take and does thecomposition of wealth matter?

What explains the level of a nations external wealth and howdoes it change over time?

How important is the current account as a determinant ofexternal wealth? How does it relate to the countrys presentand future economic welfare?



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Darlings and Deadbeats: Defaults and Other Risks

Sovereign governments can repudiate debt without legal penalty or hurt creditors in other ways such as by taking away

their assets or changing laws or regulations.

The difference between the interest paid on a safe U.S.Treasury bond and the interest paid by on a bond issued by anation with greater risk is called country risk .

On September 28, 2012, the Financial Times reported thatrelatively good investment-grade governments such asPoland (grade A ! ) carried a country risk of +1.15%,governments with junk-bond grades such as Turkey(grade BB) had a country risk of +2.69%.



Darlings and Deadbeats: Defaults and Other Risks

Key Topics

Why do countries default? And what happens when they do?

What are the determinants of risk premiums?

How do risk premiums affect macroeconomic outcomes suchas output and exchange rates?



3 Government and Instituti ons:Policies and Performance

Government actions influence economic outcomes in manyways by making decisions about exchange rates,macroeconomic policies, debt repayment, and so on.

To gain a deeper understanding of the global macroeconomy,economists study policies , rules and norms, or regimes inwhich policy choices are made.

At the broadest level, research also focuses on institutions , a

term that refers to the overall legal, political, cultural, andsocial structures that influence economic and political actions.

Three important features of the broad macroeconomicenvironment in the remainder of this book are:

the rules that a government decides to apply to restrict orallow capital mobility,

the decision that a government makes between a fixed and afloating exchange rate regime, and

the institutional foundations of economic performance, suchas the quality of governance that prevails in a country.




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International trade has grown as trade barriers have diminished, and

many nations have encouraged international capital movement bylifting restrictions on financial transactions.

Three groups of countries that will figure often in our analysis are:

Advanced countries countries with high levels of income per person that are well integrated into the global economy

Emerging markets mainly middle-income countries that aregrowing and becoming more integrated into the global economy

Developing countries mainly low-income countries that arenot yet well integrated into the global economy


Integration and Capital Controls:The Regulation of International Finance



FIGURE 1-5

Financial Globalization Since the 1970s, many restrictions on international financialtransactions have been lifted, as shown by the time series chart i n panel (a). The volume oftransactions has also increased dramatically, as shown in panel (b). These trends have beenstrongest in the advanced countries, followed by the emerging markets and the developingcountries.

3 Government and Institut ions:Policies and Performance


Key Topics

Why have so many countries pursued policies of financial openness?

What are the potential economic benefitsof removing capital controls and adoptingsuch policies?

Integration and Capital Controls:The Regulation of International Finance

For years, Zimbabwe imposed capitalcontrols. In theory, U.S. dollars could betraded for Zimbabwe dollars only throughofficial channels at an official rate. On thestreet, the reality was different.

If there are benefits, why has this policy change been so slow tooccur since the 1970s?

Are there any potential costs that offset the benefits? If so, cancapital controls benefit the country that imposes them?

H A L L D O R K O L B E I N S / A F P / G e t

t y I m a g e s



Independence and Monetary Policy:The Choice of Exchange Rate Regimes

FIGURE 1-6

Exchange RateRegimes The piechart shows aclassification ofexchange rateregimes around the

world using the mostrecent data for theyear 2010.



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Despite the abundance of currencies, we also see newlyemerging forms of monetary organization.

Some groups of countries have sought to simplify theirtransactions through the adoption of a common currencywith shared policy responsibility. The most notable exampleis the Eurozone.

Still other countries have chosen to use currencies over whichthey have no policy control, as with the recent cases ofdollarization in El Salvador and Ecuador.




Key Topics

Why do so many countries insist on the barbarism ofhaving their own currency (as John Stuart Mill put it)?

Why do some countries create a common currency or adoptanother nations currency as their own?

Why do some of the countries that have kept their owncurrencies maintain a fixed exchange rate with anothercurrency?

And why do others permit their exchange rate to fluctuateover time, making a floating exchange rate their regimechoice?



Institutions and Economic Performance: The Qualityof Governance

The legal, political, social, cultural, ethical, and religiousstructures of a society set the environment for economic

prosperity and stability, or poverty and instability.

Better institutions are correlated with more income percapita .

Better institutions are also correlated with less incomevolatility .



FIGURE 1-7

Institutions and Economic Performance The scatterplots show how an index measuring thequality of a countrys institutions is positively correlated with the level of income per capitaas shown in panel (a), and is inversely correlated with the volatility of income per capita asshown in panel (b). In each case, the line of best fit is shown.



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The Wealth of Nations

This article discusses the poorquality of governance indeveloping countries and theobstacle this poses to economicdevelopment.This map shows the World Banks

HEADLINES

composite Worldwide Governance Indicator.It measures voice and accountability, politicalstability, government effectiveness, regulatoryquality, rule of law, and control of corruption. Green indicates a country that is in the top 25%, yellow next 25%, orange next 25%, and

red bottom 25%. Dark green and dark red are the top and bottom 10%, respectively. The prosperity in Europe, North America, Australasia, and Japan coincides with the best

institutions of governance; the poverty in so much of Africa and parts of Asia with the poorest ones.


Institutions and Economic Performance:The Quality of Governance

Recent research seeks to find deep historical origins for thedivergence of institutions (and hence incomes), including factorssuch as the following:

actions of colonizing powers, types of legal codes that different countries developed, and resource endowments.



Institutions and Economic Performance:The Quality of Governance

Key Topics

Governance matters: it explains large differences betweencountries in their economic outcomes.

Poor governance generally means that a country is poorer andis subject to more macroeconomic shocks. It may also besubject to more political shocks and a general inability to

conduct policy in a consistent way. One size may not fit all, and policies that work well in a

stable well-governed country may be less successful in anunstable developing country with poor governance.



Conclusions

Todays global macroeconomy is increasingly integrated. Therefore,to effectively study macroeconomic outcomes, we must understandthe economic linkages between different countriestheir currencies,their trade, and their capital flows.

Only then can we begin to understand some of the most importanteconomic phenomena in the world today, such as:

the fluctuations in currencies,

the causes of crises,

the determinants of global imbalances,

the problems of economic policy making, and

and the origins of the growing gap between rich and poorcountries.


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1. Countries have different currencies, and the price at whichthese currencies trade is known as the exchange rate. In

learning what determines this exchange rate and how theexchange rate is linked to the rest of the economy, weconfront various questions: Why do some countries havefixed exchange rates and others floating? Why do some gofrom one to the other, often in response to a crisis? Why dosome countries have no currency of their own?

K e y T e r mKEY POINTS


2. When countries are financially integrated, it allows them todecouple their level of income from their level of

expenditure; the difference between the two is the currentaccount. An important goal is to understand what determinesthe current account and how the current account is linked tothe rest of a nations economy. Along the way, we learn howa countrys current account affects its wealth, how its creditsand debts are settled, and how the current account changes.



3. Countries differ in the quality of their policy choices and inthe quality of the deeper institutional context in which

policies are made. In studying international macroeconomicinteractions and events, it is essential to understand how

policy regimes and institutions affect policy choices andeconomic outcomes. How does quality of governance affecteconomic outcomes? Why might some policies, such as afixed exchange rate, work better in some contexts thanothers? Do country characteristics affect the costs and

benefits of financial globalization?



fixed exchange ratefloating exchange

rateexchange rate crisisdefaultInternational

Monetary Fund(IMF)

World Bank

income

K e y T e r mKEY TERMS

expendituredeficitsurpluswealthcapital gaincountry risk

policiesregimes

institutionsadvanced countriesemerging marketsdeveloping countriescommon currencydollarizationincome per capitaincome volatility


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