ECN202: Macroeconomics

1970s: Experiments with Money- The International Dimension

“the memory of the Great Depression meant that the US was highly likely to suffer an inflationary episode like the 1970s in the post-World war II period-maybe not as long, and maybe not exactly when it occurred, but nevertheless

a similar episode."

1970s Setting1970s Setting

The signature 1970sgraph is of real earnings which shows the decade marked the end of the rise in post WWII earnings for American workers. In part this was driven by demographics as baby boomers began to enter the labor market, and in part by the rise of foreign competition as the world continued to get flatter. Countries the US helped rebuild after WW II were now rebuilt and offering competition to American companies and workers. And we can’t forget OPEC, which became a household word after it caused two painful oil crises that marked the end of cheap oil. In terms of public policy, the federal government continued to expand with creation of the EPA and the Departments of Energy and Education, and passage of Roe v Wade. It was also the decade of Watergate and the end of the Vietnam War.

1970s in Macro1970s in Macro

In macroeconomics the 1970s was quite the decade – the only period of sustained peacetime inflation in US history and an economy that performed badly enough to produce only the second ideological shift in this country’s history. Just as the conservatives could not solve the economic problems of the 1930s, liberals could not solve the economic problems of the 1970s. This ideological void opened the to conservatives led by the Chicago School economists including Milton Friedman who stepped in to fill that void. In this unit we will look at this ideological shift with a focus on the international monetary system and the domestic monetary system where the most significant changes took place in the 1970s.

S&D again – and againS&D again – and again

At the center of this unit is money, one of the greatest inventions - money. Some money is involved in international transactions –you buy that Chinese T-shirt - and some is part of domestic transactions –you get that student loan. In both cases there is a price – the exchange rate for those international exchanges and the interest rate for the domestic one. In this unit we look at the two markets to understand these two prices as you can see in the diagram that follows. The key to understanding these markets is the same as always – pay attention to the details. You need to follow the rules and you will be able to understand those two important prices – exchange rates and interest rates.

1970s unit

Foreign Exchange Domestic Money Market Market

e* r*

1970s International1970s International

The 70s opened with the US running out of gold, which forced president Nixon to abandon the Bretton Woods system and adopt a flexible exchange rate. The US $’s value would now be determined in a market rather than by the government. We begin with a brief overview of the “Books” so you will better understand Nixon’s dilemma and the nature of international trade. To facilitate the trade recorded in those books, we need an international monetary system, and here we look at the evolution of these systems that all possess one imperfection – the trilemma. Special emphasis is placed on the flexible exchange rate system and the euro experiment plus we examine MAD II, a modern version of MAD that dominated life when I was in school. To give you an idea of the unit, here are a few headlines related to topics in the unit.

In the news: those pesky exchange ratesIn the news: those pesky exchange rates

1. “U.S. to Press Saigon for Devaluation of Piaster to a More Realistic Exchange Rate” 1970

2. “The dollar reached an all-time exchange-rate high of 634 lire at the Milan foreign exchange today in the third straight increase from the floor level.” 1970

3. “'Undervalued' Yen Held Target Of Nixon Surcharge on Imports” 1971

4. “Stable Exchange Rates in Wind? Pragmatism Is Now the Catchword In Currency” 1975

5. “U.S. Tries to Reassure Its Allies New Deficit Won't Depress Dollar” 1978

In the news: and “meddling” governmentsIn the news: and “meddling” governments

6. “THE world had a fright last fall when the dollar, the currency that holds the world monetary system together, suffered a severe sinking spell.” 1979

7. “Japan acts alone to weaken its currency”

8. “Joining Switzerland, Japan acts to ease currency’s strength”

9. “Dollar’s fall tests nerve of Asia’s central banks”

10.“When weakness is strength”

11.“Talk in Japan shakes dollar and Treasuries”

12.“Germany’s export prowess weighs on euro-zone”

13.“Will the euro survive?”

14.“Europe tries to lure Chinese cash to rescue euro”

To trade or not to tradeTo trade or not to trade

We looked at this question before, so we know the answer. There are benefits and costs to trading – and to not trading – but we live in a world where the movement is toward more trade as you can see in the graphs that follow. In the map that follows you can see countries have developed their own language and eventually we needed translators to bridge the language differences. The same is true with trade – countries developed their own currencies so we needed to bridge the individual monetary systems to facilitate trade. In fact we needed two systems – an international accounting system and an international monetary system.

EnglishChinese

Portuguese

Spanish

Japanesedollar

real

yuan yen

peso

In the beginning!!Russian

ruble

Monetary systemscommodity / fiat

Grammar/ translations

Trade has expanded much faster than GDP since the end of WW II

You can see this in the ratio of world exports to world GDP – from about 1/10th of world GDP to 2 times GDP.

The growth in trade was accompanied by a faster rate of economic growth.

In the next two graphs compare how China did under Mao’s policy of closing off China from the West and Deng’s policy of embracing trade with the west.

China sleeps

and wakes begins to shake the world

1. Build an International Accounting System1. Build an International Accounting System

Record of international transactions

Money flowing in (what we sell and to whom we sell it)

Money flowing out (what we buy and from whom we buy)

International accounting system

Positive Effects (credits) $s flow into country   Any receipt from a foreign country   Any earnings on investment in a foreign country   Any sale of goods or services abroad   Any gift or aid from a foreign governments   Any purchase of stocks or bonds by a foreign investor

Negative Effects (debits) - $s flow out$s flow out   Any payment to a foreign country   Any investment in a foreign country   Any purchase of goods or services abroad   Any gift or aid to foreign governments   Any purchase of stocks or bonds in a foreign country

Two components of account

Current Account (consumption = purchase of things)

Goods and services (exports & imports)

Factor income (interest & dividend income)

Transfer income (foreign aid, remittances)

Capital Account (investment – purchase of assets)

Private capital flows (assets = stock, bonds, land…)

Public capital flows (assets = gold, foreign currency)

US Current Account Transactions

+ Exports of goods & services plus income receipts on US owned assets Japanese tourists visit US / French buys California wine American investors receive interest income on German bonds- Imports of goods and services and income payments on foreign-owned assets in the United States American tourists visist China / Americans buy French wine Chinese investors receive interest income on US bondsUnilateral current transfers, net

Imports

Exports

The rise in these numbers mean that when I checked the labels on my “stuff” when I was in college I found many more “Made in America” labels than you find today

ANDThe widening gap means we have a bigger trade deficit today

Check out these graphs to see the pattern of world and US trade

1948

2008

1983

1948 1983

2008

Imports

Exports

Balancing the books: Balance of US International Transactions

Balance on goods

Balance on services

Balance on goods and services

Balance on income

Unilateral current transfers, net

Balance on current account

The flip side of the flow of stuff is the flow of money, so we keep records on the balance. In fact there are many different measures of balance as you can see below. The Balance on Goods measures the difference between imports and exports of “stuff.” A deficit would mean that we import more than we export so money flows OUT.

You can see how big the imbalance is here, but a better measure is the next one where the numbers are divided by GDP.

Can you see the impact of the Great recession? Do you have any idea what is happening to the US $s that are flowing out?

Peculiarities of systemPeculiarities of system

Current Account (Cu) and Capital Account (Ca) must balance out each other

Cu + Ca + SD = 0Or

-Cu = Ca

This means that the US$s flowing out to pay for the foreign made “Stuff” are returned to the US by foreigners buying US assets. If we run a Current Account deficit ( US $s flowing out) then we run a Capital Account surplus ( US $s flowing in)

US Capital Account Transactions

- U.S.-owned assets abroad, net (increase/financial outflow (-)) Direct investment & Foreign securities

US investors buy stock on China’s stock exchange

US government buys Japanese yen.

US firm buys European company

+ Foreign-owned assets in the United States, net (increase/financial inflow (+))

    U.S. Government securities & Direct investment

English investors buy stock on US stock exchange

China’s government buys US Treasury securities.

Japan’s government buys US$.

US sends $ to buy ‘stuff’ CU account

World sells US ‘stuff’

World sends $s to buy US assets CA account

2. Build an International Monetary System2. Build an International Monetary System

Desirable features of international monetary system

1. free flow of capital (money)

2. stable exchange rates

3. control of the domestic money supply

Trilemma - you only get 2 features

Evolution of international monetary system

1. Gold standard (1717-1945)Give up control of MsEnds with Great Depression

and WWII

2. Bretton Woods (1946 -1971)Restrict capital flowsEnds in early 1970s with

Nixon’s closing of gold window

3. Flexible exchange rates (1972- )Give up fixed exchange rates

Case Study: England’s options after wartime inflation made its goods too expensive

England’s Situation after War

Goals 1.Mobility of capital 2.Fixed exchange rate3.Control of Ms

Trilemma (only 2 goals possible)

Three Possibilities1.Give up control of money supply2.Devalue the currency 3.Restrict capital flows

Option 1: Give up control on money supply (gold standard)

1. Price of shirt rises in UK during war

2. UK imports rise and UK exports fall

3. UK runs trade deficit and gold leaves UK

4. Outflow of gold reduces money supply

5. Lower money supply means lower prices and lower wages and higher unemployment and trade imbalance is eliminated BUT

UK loses control of its money supply but problem is solved

Option 2: Devalue currencyDevalue currency

1. Price of shirt rises in UK during war2. Devalue UK currency / increase price of gold

1. lower value of currency means exports look cheaper and imports look more expensive

2. Lower price for exports means rise in exports & higher prices of imports reduces imports

3. Trade deficit eliminated

UK loses control of its currency value, but the deficit is eliminated

Option 3: Restrict capital flows

1. Price of shirt rises in UK during war and UK consumers want to buy shirts outside of UK

2. Government simply refuses to allow currency to leave country to buy imported shirts

UK loses control of its capital mobility, but solves the deficit problem

Case Study: Nixon’s Problem

In the early 1970s president Nixon had two overriding goals - Reelection in 1972 and Maintaining an “image” of strength in Cold War.

He also faced some very real problems.1. High unemployment & stubborn inflation and the

Phillips Curve indicated there was no easy solution2. High foreign military spending (Vietnam War)

needed to “contain” communism = US $s flow out3. US households had a high demand for imports &

for foreign travel = US $s flow out4. Trade surplus disappearing meant US gold supply

was falling – US was running out of gold

Nixon’s Problem: Trade Surplus disappears

Nixon’s 3 BAD 1971 options (trilemma)

1. Devalue $ – bad for image of superpower2. Restrict capital flows – bad for image of

superpower3. Reduce outflow of gold by

1. Reducing military spending abroad & bring home troops - bad for image

2. Increasing exports - raise tariffs – bad for image and against “rules” of post WWII free trade

3. Reducing consumers’ import spending by creating a recession - bad for election

Nixon’s Choice: New Economic Policy

Nixon surprises everyone. First, a conservative Republican orders wage-price freeze meaning the government and not markets would set prices. Second, he abandons the gold standard and blames speculators. By abandoning the gold standard the US $’s value would now be set in the market, so now we will look at that market.

1."NIXON ORDERS 90-DAY WAGE-PRICE FREEZE, ASKS TAX CUTS, NEW JOBS IN BROAD PLAN: SEVERS LINK BETWEEN DOLLAR AND GOLD."  headline of the New York Times on August 16, 1971

Understanding Flexible Exchange RatesUnderstanding Flexible Exchange Rates

“Rules of the game”

1. Specify exchange rate2. Identify participants3. Identify determinants of behavior4. Convert into S&D diagram

Remember the Cookbook approach to S&D. Now you need to follow the rules once again. Below are the “Rules of the foreign exchange game.” It may seem slow, but follow the rules carefully if you are to avoid the common pitfalls of those who have come before you.

Specify the Exchange Rate

There are two ways to specify the price of the US$, what some would refer to as the value of dollar or the exchange rate.

1. the number of units of a foreign currency needed to buy a dollar (ex. 97 ¥ per US $).

2. the number of US $s to buy one unit of a foreign currency (ex. $1.3 per 1 €)

In the next four slides you will see a few examples. When we talk about the value of the US $ we will be using the approach used in the Japan and Swiss examples.

# US $s to buy a euro

What does this rise here mean about the value of the US $?

The US $ is getting weaker = more US $s to buy the foreign currency

# US $s to buy a UK £

What does this decline here mean about the value of the US $?

The US $ is getting stronger= fewer US $s to buy the foreign currency

# US $s to buy a euro

What does the decline here mean about the value of the US $?

The US $ is getting weaker = less foreign currency to buy the US $

# US $s to buy a euro

What does this rise here mean about the value of the US $?

The US $ is getting stronger = more foreign currency to buy the US $

2. Identify the players

There are four major players in the foreign exchange market.

1.US consumers who want to buy foreign “Stuff”

2.Foreign consumers who want to buy US “Stuff”

3.US investors who want to buy foreign “assets.

4.Foreign investors who want to buy US assets

3. Specify determinants of players’ behavior

Everyone wants their own currency.  German workers want euros while the US government wants US dollars when it sells Treasuries to British investors.

1.US consumers purchases of foreign “Stuff” depends upon US income and wealth

2.Foreign consumers purchases of US “Stuff” depends upon foreign income and wealth

3.US investors who buy foreign “assets are looking for good returns = high interest rates abroad.

4.Foreign investors who buy US “assets are looking for good returns = high interest rates in US.

supply of dollars is generated every time someone in the US tries to buy goods, services or assets from abroad. Americans must go to the international money market where they will supply US dollars to the money market to finance their purchases of foreign goods and assets. 

Supply curve has + slope because as $ increases in value, imports look cheaper to Americans so imports to the US increase which means more $s being supplied to the international money market.

4. Convert into graphs

Supply of $s in international money market

Who comes to international money market with US $s?

Americans with US $s who want to buy things (consumers) or assets (investors) in other country.

Supply depends on (US) residents

S (US)

Supply of $s in international money market

Initial situation (S)

Increase in supply of US $s to international money market (because US consumers feel wealthier and travel abroad more OR US investors move more money to investments in Europe where interest rates are higher)

* *P1

S (US)

Q1

Demand for dollars is generated every time someone anywhere in the world wants to buy US goods, services or US assets. Foreigners will need to go to the international money market where they will demand US dollars in the money market in order to finance their purchases of US goods and assets.

As $ increases in value US exports look more expensive so exports decrease which means fewer $s being demanded on the international money market.

Ground Rules

Demand for $s in international money market

Who comes to international MM demanding US $s?

Foreigners with currency who want to buy things (consumers) or assets (investors) in US.

Demand depends on foreign (ROW) residents

D (ROW)

Demand for $s in international money market

Initial situation (D)

Increase in demand for US $s in international money market(because foreign consumers feel wealthier and buy more US stuff OR foreign investors move more money to investments in the US where interest rates are higher)

* *P1

D

Q1

Model of exchange rate

As with all markets, the equilibrium exists when S = D. In this case the exchange rate would be e*, and any “story” about changes in exchange rates is a story about a shift in the S or D curve.

S (US)

D (ROW)

e*

What’s happening with exchange rates

In the following graph you see a time-series graph of the exchange rate for Japanese yen. Every movement in the exchange rate coincides with a shift in either the S or D curves in the foreign exchange market. For example, in the 1975-1978 period the value of the US dollar is falling. This happens IF the supply curve shifts to the right (US consumers or investors buy more from abroad) OR the D curve shifts to the left (foreign consumers and investors buy less from the US)

S

D

US$Explain / forecast this

What would happen to the dollar if…?

a. Japan lowered interest rates that affected Japanese investors. What is impact on US $?

b. OPEC raises price of oil and US imports rise. What is impact on US $?

c. The Fed lowered interest rates and US investors move money abroad?

d. Europe falls into a recession and buys fewer US exports?

Now let’s get some practiceNow let’s get some practice

Try to convert the story into the S&D graphs – so get out those writing utensils and start shifting those curves.

a. Japan lowered interest rates that affected Japanese investors. What is impact on US $?

QuestionsQuestions

S (US)

D (ROW)

b. OPEC raises price of oil and US imports rise. What is impact on US $?

QuestionsQuestions

D (ROW)

S (US)

c. the Fed lowered interest rates and US investors move money abroad. What is impact on US $?

QuestionsQuestions

D (ROW)

S (US)

d. Europe falls into a recession and buys fewer US exports. What is impact on US $?

QuestionsQuestions

D (ROW)

S (US)

a. Japan lowered interest rates that affected Japanese investors. Foreign investors = D curve, lower interest rates in Japan make US more attractive = increase demand = outward shift in D = stronger $

b. OPEC raises price of oil and US imports rise. What is impact on US $? US imports = S curve, imports rise = increase supply as we buy more from abroad = outward shift in S = weaker $

Compare your resultsCompare your results

c. The Fed lowered interest rates and US investors move money abroad? US investors = S curve, lower interest rates in US make US less attractive = increase supply as investors buy foreign assets = outward shift in S = weaker $

d. Europe falls into a recession and buys fewer US exports? Foreign consumers = D curve, recesson in Europe means lower US exports = decrease demand = inward shift in D = weaker$

Compare your resultsCompare your results

What would happen to the dollar if…? a. World recession deepened and foreign investors

became very nervous about $?

b. US investment in China slows down as result of recession?

c. US recession lowers imports from China ?

d. Chinese investors get nervous about $ and sell US treasuries?

e. Foreign investors get worried about financial crisis and begin to buy US government securities?

Try a few moreTry a few more

Try to convert the story into the S&D graphs – so get out those writing utensils and start shifting those curves.

QuestionsQuestions

a. World recession deepened and foreign investors became very nervous. What is impact on US $?

US

ROW

QuestionsQuestions

b. US investment in China slows down as result of recession. What is impact on US $?

US

ROW

QuestionsQuestions

c. US recession lowers imports from China. What is impact on US $?

US

ROW

QuestionsQuestions

d. Chinese investors get nervous about $ and sell US treasuries. What is impact on US $?

US

ROW

a. World recession deepened and foreign investors became very nervous about $? Foreign investors = D; more nervous = lower D = D shifts left

b. US investment in China slows down as result of recession? US investors = S; Less investment = lower S = S shifts left

c. US recession lowers imports from China? US consumers = S; lower imports = lower S = S shifts left

The short answersThe short answers

d. Chinese investors get nervous about $ and sell US treasuries? Foreign investors = D; sell Treasuries = lower D = D shifts left

e. Foreign investors get worried about financial crisis and begin to buy US government securities? Foreign investors = D; buy Treasuries = higher D = D shifts right

The short answersThe short answers

““Special” casesSpecial” cases

Now let’s look at two special cases – Europe and China.

China is special because it has tried to hold its exchange rate constant and override the influences of S&D, which is why it is accused of being a currency manipulator.

Europe has embarked on an experiment in which a number of countries have given up control of their own money supply and currencies and adopted a common currency – the euro (€).

China

What is happening?What is happening?

Why would China try to keep the exchange rate at 8 instead of letting it fall to 4 yuan per US$?

The answer can be seen with the simple example – the US price of a China T-short.

Tshirt costs 16 yuan in China @ exchange rate of 8 costs $2

Tshirt costs 16 yuan in China @16 yuan @ exchange rate of 4 costs $4

Question: How does China manipulate its Question: How does China manipulate its currency?currency?

You can see in the next slide that at the exchange rate of 8 the US has a trade deficit with China so US$s are flowing out of the country as we buy China’s exports. This would put downward pressure on the US $ - increase the value of the yuan. The only thing China can do is to offset the outflow of $s by using them to buy US assets. So we buy Chinese toys and computers and they buy US Treasuries and US land and US companies. So, why would China do this?

Here is the situation

D S

P2

US trade deficitstable yuan

US $

The US runs a trade deficit at the existing exchange rate, which should push the US $ lower. Why does it not fall?

And here is the answer

D S

P2

US trade deficitstable yuan

US $

The Chinese buy US assets and this increase D for US $.

Europe’s euro

Europe’s euroEurope’s euro

Winston Churchill proposed the creation of the United States of Europe right after WW II, and since then a number of countries have joined in the experiment. We have not quite gotten to the US of E, but a number of European countries did adopt a common currency – the euro – that has been in the news a lot since the financial crisis. In the diagrams that follow you can see the growth of the European Union that allows pretty free movement between these countries and the subset of those countries that have adopted the euro. You also see the slide of unrest in Greece, a country that was running a trade deficit that needed to be closed.

European Union: Political and Economic

• 1951 European Coal and Steel Community (Treaty of Paris)

• 1957 European Economic Community (Treaty of Rome)

• 1973 add England, Ireland, and Denmark

• 1986 Greece, Spain, & Portugal

• 1995 Austria, Norway, Finland

• 2004 Poland, Estonia, Latvia, Lithuania, Hungary, Czech Republic, Slovenia, Slovakia, Cyprus, Malta

2015

?

Europe’s 21st century: US of E?

EUEuropean Union

EuroCommon currency

Greece

Greece was running a trade deficit, so what were its options – and why did they choose one that ended up with scenes like the one above?

Greece’s Options

We know from our earlier work that Greece had three options because of the trilemma

1.Simply stop the flow of currency – could not do this while on the euro

2.Devalue its currency – could not do this while on the euro

3.Strangle its economy to reduce imports and increase exports – the only option if it stayed on the euro – and you can see the results.

England’s Suez Moment

Greece’s problem looks very much like England’s Suez moment

America’s Suez Moment?

Will the US suffer its own moment?