Copyright 1998 R.H. Rasche EC 827 International Economic Structures and Interactions

Copyright 1998 R.H. Rasche International Economic Interaction u National Economies which interact with other National Economies = Open Economies u Two Types of Open Economies –Small Open Economies »Unable to affect key prices in world markets (especially interest rates) –Large Open Economies »Able to converge world market prices (again, esp. interest rates) towards national prices.

Copyright 1998 R.H. Rasche Law of One Price u More extreme assumption would be that domestic prices of all goods are determined by the prices of goods in a world market = Law of One Price u P d = P w *ER –ER is the nominal exchange rate for the domestic currency (domestic currency per unit of “world currency”

Copyright 1998 R.H. Rasche Globalization? u What has happened over the past 50 years that makes the term Globalization meaningful with regard to economic interaction on an economy-wide scale? u If we think of U.S. States or Canadian provinces as the ultimate in integrated economies, what if anything, has changed on the international scene to make countries more like states or provinces?

Copyright 1998 R.H. Rasche Fixed vs Floating Exchange Rate Regimes u Businesses and governments would like stability. What could be more stable than fixed exchange rates? u Fixed Exchange Rates = Governments must intervene in exchange markets to maintain a set price (or range of prices) for their currency. E.g. if the $ falls, we buy $ and sell Yen, DM etc. to pull the $ back up. u Pure Floating Exchange Rate System = no foreign currency market interventions. Let the market set the value of the $ relative to other currencies.

Copyright 1998 R.H. Rasche Mixed Exchange Rate Regimes u “Managed Float” or “Dirty float”. Let the currency float within bands. When the currency hits the limit of its band, the central bank intervenes to push the currency back into the middle of the band. u Politically popular, but technically debatable. E.g., who decides when to change the limits? Managed floats work best when both nations cooperate. But will both nations share their interests?

Copyright 1998 R.H. Rasche Changes in Nominal Exchange Rate u ER = Yen /US Dollar (How many Yen it takes to buy $1) u If ER increases, then one dollar (domestic currency) exchanges for more Yen (foreign currency) = Nominal Apprecation of Domestic Currency u If ER decreases, then one dollar (domestic currency) exchanges for fewer Yen (foreign currency) = Nominal Depreciation of Domestic Currency

Copyright 1998 R.H. Rasche Exchange Rate Policy and Domestic Monetary Policy u Fixed Exchange Rates => Loss of Control over Domestic Monetary Policy –Why? Because if you want to maintain the value of the Dollar, you can’t keep printing more Dollars. If there are more (or less) Dollars, each Dollar will be worth less (or more). u (Pure) Floating Exchange Rate Regime => Independent Domestic Monetary Policy –You can choose your monetary policy, print or withdraw Dollars, and let the markets adjust.

Copyright 1998 R.H. Rasche Exchange Rate Systems u Classical Gold Standard –Tie every currency to gold –System backed by the British Empire & its trade u Bretton Woods System ( ) –Tie currencies to the Dollar –Easy to adjust any currency’s value, except the Dollar u “Post Bretton Woods Period” ( present) –mixed bag of conflicting policies

Copyright 1998 R.H. Rasche World-Wide Trade Liberalization u GATT (General Agreement to Talk and Talk  World Trade Organization (WTO)) –Tariffs and Quotas –Trade Negotiation Rounds and the reduction of tariffs and quotas. Attempts to not stop cheating, just allow everyone to cheat equally. –Emergence of non-tariff barriers to trade in goods and services (e.g. Voluntary Export Restraints = VERs)

Copyright 1998 R.H. Rasche World-Wide Financial Structures u Post-WWII Developments and International Institutions u Bretton Woods Fixed Exchange Rate System ( ) –U.S. Dollar as the International Reserve Currency –Obligation of other national participants u International Monetary Fund (IMF) –SDR’s as a source of international liquidity

Copyright 1998 R.H. Rasche Exchange Rate Crises under Fixed Rate System u What happens when monetary authorities and/or exchange rate traders come to a consensus that a particular country cannot maintain the fixed nominal exchange rate? –Italy, UK, 1992 –Sweden, 1992 –Mexico, December, 1994 –Thailand, Indonesia, S. Korea, 1997

Copyright 1998 R.H. Rasche World-Wide Financial Market Integration u Elimination of Exchange Controls –Europe in the 60s –Japan in the 80s u Emergence of “Euro-” Markets –“recycling” of “petrodollars” in the 1970’s through the “Euro-” markets.

Copyright 1998 R.H. Rasche Real Exchange Rates u Bilateral real exchange rate measures the change in the relative purchasing power two currencies u measured as the nominal exchange rate (foreign currency/domestic currency) adjusted by the ratio of the domestic price index to the foreign price index u RER = (ER*P d )/P f u The RER tells you how much of a foreign good you can buy with enough Dollars to buy one US unit of the good.

Copyright 1998 R.H. Rasche Purchasing Power Parity u Arbitrage Condition: Same goods should cost the same (adjusted for transportation costs) in different countries. –“the Big MAC standard” u Measurement Problems: Traded vs Nontraded Goods and Services u Continuous equilibrium PPP => constant real exchange rate (properly measured)

Copyright 1998 R.H. Rasche Deviations from PPP u Clearly, PPP does not hold in the short run u Permanent or Transitory Deviations: Does Adjustment occur in the long run? –Empirical results not clear; if adjustment does occur, it occurs only slowly!

Copyright 1998 R.H. Rasche Regional Economic Integration

Copyright 1998 R.H. Rasche NAFTA as an Integrated Set of Economies u As a Free Trade Area (FTA) NAFTA addresses limited aspects of international economic integration. u Financial markets of U.S. and Canada became highly integrated long before NAFTA. u U.S. & Canadian Regulatory and Legal Structure reasonably similar. –What about Mexico?

Copyright 1998 R.H. Rasche Europe: Progressive Economic Integration u Common Market –Focused on Trade in Goods and Services –Special case of Agriculture u European Monetary System –coordinated currency prices (fixed exchange rate system) u European Union: –labor market integration –regulatory and legal homogenization –common currency = EMU? Why did it fall?