© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko “The Economic Way of Thinking” 11 th Edition Chapter 19: National Policies and International Exchange

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 2 of 42 Chapter 19 Outline Introduction Accounting for International Transactions Why Credits Must Equal Debits Equilibrium and Disequilibrium The Ambiguities of International Disequilibrium Disequilibrium as a Disguised Policy Judgment

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 3 of 42 Chapter 19 Outline But Will it Go on Forever? Foreign Exchange Rates and Purchasing Power Parity The Bretton Woods System Fixed or Floating Exchange Rates? Nobody Knows The Trouble We’ve Seen

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 4 of 42 Chapter 19 Outline The Case for a Common Currency Private Interests, National Interests, Public Interests In Defense of Comparative Advantage Globalization and its Discontents The Power of Popular Opinion

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 5 of 42 Chapter 19 Outline The Power of Special Interests The Outsourcing Controversy: Soundbytes vs. Analysis

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 6 of 42 Introduction Adam Smith –Believed exports and imports analysis caused absurd speculation. However –Balance of Payments accounting does demonstrate effects of international transactions on national economies Balance of Payments always balances

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 7 of 42 Accounting for International Transactions Categories of Balance of Payment Transactions –Exchange of merchandise –Exchange of services –Exchange of IOUs –Unilateral Transfers

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 8 of 42 Accounting for International Transactions The Balance of Payments –Exports generate payments into a country or a balance of payment credit. –Imports generate payments out of a country or a balance of payment debit

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 9 of 42 Why Credits Must Equal Debits Assume: –Total dollar value of US imports (debits) exceeds the total dollar value of US exports (credits) for a year. –There are no unilateral transfers.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 10 of 42 Why Credits Must Equal Debits Assume: –Americans owe (IOUs) the difference between imports (debits) and exports (credits) IOUs to foreigners. –The value of the IOUs equals the difference between imports (debits) and exports (credits).

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 11 of 42 Why Credits Must Equal Debits Imports (debits) = Exports (credits) + IOUs

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 12 of 42 Equilibrium and Disequilibrium Disequilibrium implies that something will change.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 13 of 42 Equilibrium and Disequilibrium P Q D S Ceiling Price P1P1 QsQs QdQd shortage

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 14 of 42 The Ambiguities of International Disequilibrium Since 1983, US merchandise and service imports have exceeded exports. When US imports exceed exports, the US exports IOUs. The US can export (sell) IOUs because people demand them (i.e., a market for IOUs).

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 15 of 42 The Ambiguities of International Disequilibrium Does foreign investment in the US imply that the US economy is weak or that it is strong?

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 16 of 42 Disequilibrium as a Disguised Policy Judgment The balance of payments reflects our situation, it does not cause it. If foreigners don’t invest in the US: –Disequilibrium might occur and markets would have to adjust

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 17 of 42 But Will it Go on Forever? Claim of disequilibrium –Prediction that things will change –Adjustments will occur

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 18 of 42 Foreign Exchange Rates and Purchasing Power Parity Foreign Exchange Rates –Express the relative purchasing power of two currencies. Example –$0.67 = 1 German mark –$ = 1 Japanese yen

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 19 of 42 Foreign Exchange Rates and Purchasing Power Parity Example –Then $1.00, 1.5 marks and 150 yen will buy the same amount of goods in goods in the US, Germany, and Japan, respectively. Exchange rates adjust to create a purchasing power parity among national currencies.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 20 of 42 Foreign Exchange Rates and Purchasing Power Parity An example: –$1.00 = 150 yen –If 150 yen will purchase more in Japan than $1.00 will buy in the US. –Dollar holder will want more yen to increase their purchasing power. –Yen holder will exchange <150 yen for dollars.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 21 of 42 Foreign Exchange Rates and Purchasing Power Parity The expectation that an asset will increase in value –Causes its value to increase now

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 22 of 42 The Bretton Woods System Bretton Woods System (1944) –Established fixed exchange rates –Each country was to buy and sell its currency to keep it pegged at the official rate of exchange with the US dollar. Bretton Woods System –US dollar was the benchmark currency –Dollar was pegged to gold

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 23 of 42 The Bretton Woods System International Monetary Fund (IMF) –Attempted to provide foreign exchange reserves to help restore equilibrium. –Divergent policies created disequilibrium.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 24 of 42 Fixed or Floating Exchange Rates? Early 1970’s –US abandoned fixed exchange rates. Exchange rates have adjusted (floated) to changing economic conditions. Since 1975: –Global volume of trade increased more than twice as fast as global GDP.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 25 of 42 Nobody Knows The Asian Crisis (1997) –Fear of devaluation –Foreign investors withdrew funds –Governments and central banks buy own currency to support value. –May run out of own currency

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 26 of 42 Nobody Knows Possible remedies –Let the currency value fall –Raise interest rates And stop economic growth –Borrow from IMF

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 27 of 42 The Trouble We’ve Seen Assume –IMF assistance delayed –The country devalues –A “capital flight” occurs –World-wide confidence in investments in foreign countries falls –Capital begins to exit other countries

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 28 of 42 The Trouble We’ve Seen What if… –The capital flight of the late 1990s slows world-wide economic growth –The uncertainty created by the economic weakness in these countries reduces their ability to return to their recent prosperity.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 29 of 42 The Case of a Common Currency Fixed rates are the ideal system with ideal governments. Floating exchange rates are the ideal system when economic polices diverge January 1, 1999 – Euro –Common currency –European Monetary Union –11 nations

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 30 of 42 Private Interests, National Interests, Public Interest Why does trade occur? Who benefits from trade? Who benefits from trade restrictions? –Protection from foreign competitors makes life more comfortable.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 31 of 42 In Defense of Comparative Advantage The political process may be the greatest barrier to free trade. Who has the louder voice? –Those who expect to gain from restrictions. –Those who expect to lose from restrictions.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 32 of 42 In Defense of Comparative Advantage Comparative advantage demonstrates that: –Exchange creates wealth. –A country cannot become wealthy by exporting more than it imports. –One country cannot be more efficient than another in the production of everything.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 33 of 42 In Defense of Comparative Advantage What are the arguments for trade barriers?

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 34 of 42 Globalization and Its Discontents Some believe –Large corporations are in a global quest to help the “have-nots” of the world. Others say –Large corporations will “roll over” the poor in searching for profits.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 35 of 42 Globalization and Its Discontents Evidence suggests globalization achieves positive changes: –Lifts up the poor from miserable poverty. –Environmental quality improves. –Workers better off. Income Working conditions

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 36 of 42 The Power of Popular Opinion Strong opinions are not the same as valid arguments. Popular opinion often focuses on the consequences of public policy. Exchange and production emerges from globalization. –Usually a marked pattern of improvement.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 37 of 42 The Power of Popular Opinion Productivity increases sourced from –Labor skill improvements. –Technological knowledge increases. –Improvements in economic organization. Globalization brings all from –More developed world to –Less developed world

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 38 of 42 The Power of Special Interests Politics exhibit a short-sightedness in economic decision making. –Concentrated benefits bias –More so in non-democratic governments that are not secure.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 39 of 42 The Outsourcing Controversy: Soundbytes vs. Analysis Number of jobs lost in the US due to outsourcing of jobs to foreign workers –Miniscule compared to size of US economy Law of comparative advantage works –Trade between nations is positive-sum

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 40 of 42 Once Over Lightly Balance of payments (credits = debits) Disequilibrium in balance of payments implies credits and debits are not equal. Foreign exchange rates link relative prices in nations with separate currencies. Exchange rates can be set arbitrarily by governments.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 41 of 42 Once Over Lightly Fixed exchange rates reduce uncertainty and promote trade but presuppose compatible economic policies. The Asian Crisis Floating exchange rates The Euro as a common currency Debate over globalization

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 42 of 42 End of Chapter 19