CHAPTER B. INTERDEPENDENCE IN THE GLOBAT EGONOMY

ETCHAP

l4 Open-Economy Macroeconomics

Btfitn I bttill u ¡tttll I'rl t:k to k¡toiull'ltul I tuu.s uallirtg' itt rtr iuulltttg rtrtl .

Robt'rt Frosl

Tht' i¡rtcrnational ltrrsincss t\clc crel-ts a pt>rvcrfrrlclli'ct o¡t ertr-r rratir¡ll of tlrt'glolrt'. Slrocks in ()n(':lr(':lcan havt' ri¡l¡tl<' t.fli'tts anrrurtl tlrc r,,rrrlcl. l,oliric;rlrlistrr ¡-b;ut ces ilr Ilrc \'lirkllc East c:ut set ()ff a soir:il inoil ¡rrices tlr:lt triguclr ilrllatiorr and rrnern pk ¡\ltrt'lt t.I)ef:¡rrlts t':rl rrrck st(xL nlurk(.ts lrnrl shitke brrsi¡ressct¡nlidt'n< r' irr (list:ult laltls. Tlle in t('t'c()llnccl ('(lnessr¡l <-<¡rr¡ltrics rvas illLrstratcrl rlr':u rraticallr in thc firralr-ci:¡l crisis of 2(X)7-2lX)l). \\'lrt.lr L.S. finu¡rcial insrirrr-ti¡rns srrfleled lrrrgc losscs. stock ancl b<lnrl nlal-kers¿uorrrrd flrc rrr¡rlrl also tlctline<l. and a banking crisisirr F.rrro¡rt' t'r'rr¡ttt.tl alntost sirrrtrlt:tneoLrslv rvitl¡ that inthc ['niterl 5ta tt.s.

Th<' ¡rrr.r'iotrs clra¡rtcr srrrvt:r'cd the nr:rjor con-c('l)ts ()f irr t ('n):rti()llirl lr¡i.tt t 0cc1¡¡11¡¡1¡i¡5-1[1' bal¿ttct'()f p¿\'rn('nts, tlrt. rlctcrrltination <lf exchan¡¡e ralcs.artcl thc irrtclllatir¡rral nlolletal-\' svslcnr. Th<' l)r('scntclra¡rl<'r' r'onti rrcs tlle st<ln ltr sh<lrving llOrv nlacrr><'cor.rornic slrr¡t ks i¡r ()nc c()untr-\ lr:nt' ri¡rplc elli'<.ts()lr llr(' ()utl)ut an<l i¡lfl:rti0lt of 0tlrt'r r.oruttrit's. \\'ct'x¡rlolt' tlrt. ¡lalatloricitl finding that tr-ark' l¡alalrct'sar-e lalgclr' (lctcr rninc(l ltr, the ltal¿rrtces betrr.ct'rrdonresti< savirr¡.¡ antl investtncllt. The chaptt'r corr-clttrles rvitlr ¿r rcrit'rt of s<¡ntc of'tlle ker ilttt'rnation¿rlissut's ¡ rl tr ¡tl:rr.

A. FOREIGN TRADE ANDECONOMIC ACTIVITY

Net Exports ond Outputin the Open Economy

( )pc n-cco rt orrtv Itt:l( r()('a()nonlits is tltc strrdr' <lf'horv ecorronlies hellar'<' r'lrt'rr tlrt. tr utlt. arr<l fin-.rn-cial linkages anrorrg naliorrs al't. cor¡sirler-etl. Thepreviorrs chaptcr rlcsctil¡ctl tlrc basic concepts of'tlte b¿rlance ()f l)a\,nr(.nt\. \\'c carr l estate tlrosc con-cepts lrcrc in f cl rns ol tltt n:ttiorr:rl irrco¡trc ¿rnd

Drodrrcl ¿l('col¡t.tls.Forcign lradc irrrolvcs irnp()r ts arr(l expor.Ls.

.{lthorrgh the I'nitt.rl St;rtcs prorlrrccs rnost ol'rvh¿rlit consrun<'s, it rronctlrt'lcss lras a lar-ge qrrantitv ofimports, which a¡ c goorls arrrl serlices ploduct'd:rbr-oad :rr.¡rl cr¡lrsrur)crl rlollrcsticalh. Exports ar.eqoods arrd st'r-r'iccs ¡rrorlrrcctl dorlcstic:rllr' :rnrl prrr-ch¿sed br lirrc igrr r.r's.

Nct cxporLs al c clcf itrr^<l as exp()l'ts of goods artrlsenict's rnirrtrs irrrports ol gr>ocls :rnd scnict's. Ilr2007, net c\l)()rts fol tllc L'rrirecl States rr'crt.nrinrrsS70lt billion, as calcrrlart'tl fionr $16(i2 billiorl r'orrh

280

vtr()Rt.t(;N TRADl-.\].-t) E(l()NovI(. A(:'l l\'I fl

of'exports rninus $2370 billio¡-r worth of inrporLs.

\\'hen a countr v Iras positive net exports. it is acctt-

mulating foreign asscts. 'l'hc cottttterpurrt of netcxporls is net foreign investrnent' utich dellotesnct U.S. savings abroir<l and is a¡-rpI oxitnatelv eqttal1o thc value of net expors. Bccattsc tllt- Ll.S. lradncgative net exports, is nct ltlrcigrl ilrvestnlentwas ncgative, implving that thc U.S. lbrcign indebt-edncss was grorvir-rg.

ln otlrcl worrls, ftreignrrs wtn' making u signtJt

cant rr.nlribution to Ii.S. inuc.stntenl. \\trf is it that richfunerica l¡olrowed so much from abroad? As wc willsee later in this chapter, this paradoxical phettotnc-non is explainccl bv a lelativeh'l<'¡w U.S. saving r:rte' a

high foreign saving ratc, arrd an ¿rttractive investmentclimate in the Llnitctl Statt's.

In an open cconorrl\', a tration's expendituresma1'differ from irs prodtrctiotr. Torll dorncsti( expm-

ditzrz.s (sometimcs callccl o¡n¿slit dcnnnd) are equalto consumplion pltts dolltcstic illveslnlent plrts gov-

crnment purchases. This lncastrrc tliffcr-s from totalrhnneslir produrt (or GDP) fbr lrvo lcasous. First, some

part of domestic experttiitttt cs will ltc orr goods pro-dr¡ced abroad, these itc¡rts bcing irnports (denotedb1' In) like lVlexicir¡r oil arrd -lapancse automobiles'ln addition, some part ol Atltcrica's rlontestic pr<>

rh¡ction rvill be sold abroad its exPorts (clcnotecl by

l!x)-itenrs like lowa rvheat irnd Bocing aircrali' Therliffc|ence benveen lr tiollal outPut alrd dolnesticcxpcnditttres is exporc minus itttptlrts, wlriclr eqttals

rrct cxports, or lix - Im -- X.'lb calcrrlate lhe total prudu lion ol Arneric¿rn

goorls arrd sen'ices. rve need to acltl tratlc to (loltlcsticclc¡nand. That is, we tteed to ktrorv thc total plocltrc-tion for Anrerican residenLs as wcll as thc net PrcFdrrctior.l for f<rreigners. This total ilrcll¡dcs domesticexpenditrtres ((,' + / + (i) plrrs salcs to f'orei¡5ners

(/x) minus domestic purchascs liorl lirr-eigners (/rz).

Total outpttt, or (lDP, cqttals cottsttttrption pltlsdomeslic investment plts ¡¡ovcrrlllrcrrt Prlrclrases plus

rret exp()rls:

T()tal ([()lnestic otttJrttt = (il)l)

- (:+ l+ (;+ r

Determinonts of Trode ond Net Exports\4¡har deterrnirrcs thc lcvcls o[ cxports and importsand therefbre of lret cxports? lt is hest to think of

28t

tlrc irnport and export components of net cxportsseparalclv.

Impors into tlle Unitcd States are positivelyrelated to U.S. income and otttput. Whcn LI.S. GDPr-ises, imporf^s into the U.S. increase ( I ) bccause

some of the increased (: + I + C purchises (sttch as

cars arrd shoes) come from foreign production andalso (2) bccar¡sc America rtses foreign-macle inpus(like oil or Iurnbcr) in plodtrcing its orvn goods. Thedemand for imports depends ttpotr the relative priceof foreign and domcstic gt-rods. ll thc price of domes-tic cars rises relative to thc pricc ol'Japatrcsc cars.

say, becarrse the dollar's exchange rutc aPPrcciatcs,Anrclicans will brry more.fapanese cars alld ll'wcrñnericarr t¡ncs. Hence lhc uolutnc and ualue ol imports

uill be aJfectetl lr¡ dotn¿stir oulfut a .d thc relntite priecs ofdornestic and foreign gowls.

Exports are the tnirror imagc of imports: [J.S.

exporls are other coulrtries' irl)Ports. Americanexporls therefore depend prirnarily trpon foreignoutput as rvell as upon the prices of U.S. exports rcla-tivc to the prices of foreign goods. As foreigrt otrtputr-iscs, or as tlre exchange rate of the dollar de preci-atcs, thc volrrme and value of American exPOrLs tclldto grow

Figurc l4l shows the ratio of U.S. net exporlsro GDP. For rnost ol' thc period after l'\¡orldWar II, the U.S. exte¡-Iral accotlr.tts were in sttrplusor balance. Starting in thc carly 1980s, a declinein national saving, fircled bl lalgc lederal budgetcleñcits, led to a sharp appreciatiorr o[ the dollar'l'nreign economies grew less rapidlv than the U.S.

cconorn\', depressing exports. The net cfll'ct rvas

a lalgt' trade deficit ancl growing foreign iudcbt-edncss. Was it a good thing or a bad thing? I'hcfbllorvirrg rliscr¡ssiorr b1' the president's (loutlcil ol'Econornic Advisers puts the U.S. trade cle ficit itl ar.l

ccononllc colltext:

Bt'themsclvcs, ('xl('t-rlal trade and ctlrrent account

deficis arc neit]¡cr inltcrct¡lly goorl nor inherentlybacl. What matters are the reasotrs frrl thr: rlelicis.Thc nrain reas<¡rr for the deficits t()da) al)l)('al s t()

llc tlr<'stlt'ngth ol tht'U.S. economic expallsi()Illelative to lhc slr¡w ot tregative growth in manv othct'counries. . . . TIrcsc <lcficiLs are esscntially a milcroeconomic phenomenon, rt'flt'< titt¡4 a higher nrte ofdo¡nestic investment than of natioltal savirrg Tlrcdeficit's gr orvtlr . . . reflect-s rising investment r¿thcr

than falling saring.

282 CHAPTER I4 ()PEN-F.CON( ) M!' MACROECONOTTTICS

1950 1960 1970 1980

Y6ar

1990 2000 2010

FIGURE l4- L U.S. Net Exporrs Have Been in Deficit for Many Years

Th<: ll.itt:d Stares had a large trade surplus ajier.\4trrltl \!hr ll as it helped rebuild Europe.Nr¡tc how net expors turned sharply negaüvc in tlrt't:arly lg80s as.A,merica's saring declin<:d.Nct exports grew even more negativc in tlrc last <lccade with the global salings gh.rt.

5rnrrcc: t .S. llt¡rc¡ t rl F.( (nr¡nric :\ irl\\is

.9

Y

¡o

oc(!o-(g

oE

eoo.o-

E0Eoo.o62

63

)!E

5ü

.9

f

-qo

E

t(5

lC

3

SHORT.RUN IMPACT OFTRADE ON GDPHow do changes in a nation's trade flows affect itsGDP ancl crrrplo,rment? \4¡e first anallze this qtrcs-tion in the contexr of or¡l' shor-t-t'ulr rnodel of outputdetermination, the multiplier model of Chaptcr 7.

The multiplier model shows how, in the shorr runwhcn there are unemployed resourccs, changesin trade will allcct aggregate demand, orrtput, andcrnplo''nent.

There are two nrajor new macroecorromic ele-lncr)ts in the presence of international trade: First,

we have a for¡rth cotnporrcnt of spending, netexporls, which adds ro aggregate demand. Second,an open economy has diflerent multipliers for pri-vate investment and govcl nmcnt domestic spendingbecause some spending lcaks out to the rest of thersorld.

Table 14-l on thc l)cxt page shows how intro-ducing net cxports aflecs output determina-tion. This tablc begins rvith the same componentsas those for a clt¡sed economv. (Look back toTable 7-2 oll pagr. 138 t<¡ refresh vorlr mentoryabor¡t the rnajor cornponents and the rvav theysum to total spcnding. ) Total domestic denralrd

SHORT-RUN TNIPA(]T O} 'I'RAI)F. ON GI)P 283

Output Determination w¡th Foreign Trade(b¡ll¡ons of dollers)

(l)Initisl

level ofGDP

4,100

3,800

35003,2009 qY)

ExportsE¡

250

250

250

zto250

(4)

LnportsIm

410

380

350

320

290

(2)Domesticdem¡nd

(c+ I+ G)

4,000

3,800

3,600

3,400

3,200

(5)Net

exlrcrlslX= k- Iml

- 160

- 130

-r00_70

-40

(6)Tot¡l

(c+I+c+x)3,840

|3,670 J8,50O

3.330 |I3.160 |

(7)R€sultingtend€úcy

of economy

contractionCont¡action

EqullibriumExpansion

Expansion

(3)

TABLE l4- l. Nel Exporb Add to Aggregate Demand of Economy

To the domestic tlctnat¡<l of (: + I + (;, we must:rdd net expors of X = ¡;r - /rn t() Bct total

aggref¿te demand f<rr a coun Ir\"s output. Higher net expors affect aggrcgatc <lt'tttatttl.jttsL

as do investme¡rt and government prtrt ltast's.

in column (2) is composed of the consumption,investment, and govcl'nmclrt Prtrchases we anah'zed

earlier. Column (3) thcn atltls the exporls of goods

and sen'ices. y'rs describccl abovc, expot'ts dependlrpon foreign incomes and otltPtlts and ttpon pricesand exchange rates, all ol rvhiclr are also nken as

given for this analvsis. Exports alc asstrmed to be aconstant level of $250 billion of lblcign spendingon dornestic goods and servi( es.

The interesting new elcment al iscs fi'otn itnports,shown in coh¡mrt (1) . Like exports, irnpors dcpelrduporr exogenotts variables such as priccs andcxchange rates. But, in addition, intpot'ts clcpcndrr¡rorr domesfic incomes ¿rnd otttPt¡t, which clearl,v

change in the different rows of Tablc ltl'l. Fol sim-

plicity, we assl¡me that the countrv alwavs imPortsI0 percent of its total outpt¡t, so inlPorts iu colrtnrl.l(4) are l0 percent of column ( I ).

Strbtracting column (4) fionr colurtrn (3) gives

¡rct cxports in column (5) . Net expors arc a ncgativentrr¡rbcr whcn imports exceed exports and a positivcnurnbcr rvhcn exports are greater than inlpolts. Nctexports in coh¡mn (11) are the net addition to thcspcndirrg stream contributed b,v foreigrr tradc.-Ibtalspcnding on domestic output in colunrlr (6) cqtrals

donlestic dcmand in colt¡mn (2) plus net exPorts itlcollunn (5). tquilibrirrm otttpttt in an open ecolloltly

trccuLs whcLc total net domestic and fbreign spend-ing in colunrn (6) exactly equals toutl domcstic otlt-put in colurnn ( I ). In rhis case, equilibrium conles

with net cxpolts of - 100, indicating that the co(tlltn'is inrporting molc than it is exporting. At this equi-librirr¡n, llote as wcll that domestic demand is greaterthan output.

Figure l,l'2 shows the open-economv e quilit>rium graphicallv. 'I'hc uprvard-sloping blue linemarked C + I + (j is tltc sarne crl¡-ve used in Fig-

rrre 7- 10. To this line wc nlr.lst add the level of netexports that is forthcolrtitrg at cach lcvel of GDP NetexporLs from colulnn (5) ot 'Ihblc l'L'l are added toget the green li¡re of tt¡tal aggrcgate dernand or totalspending. Whcn the grccn liuc lies belou' the bltlecurve, imports exceed cxpot'ts and net exporLs are

negative. When the grcclr linc is above the blue line,the country has a rtet-cxpol't surPltls and outpr¡t isgreater than donlesl.ic clclnaud.

Equilibrium GDP occurs tvhcre the green line oftotal spending intcrsects thc 45' line. This intersec-tion comes at exactl)' ttte sal¡rc point, at $3500 bil-lion, that is shown iu equilibrir-rnr GDP in Thble l'l.l.Onh' at $3500 billion dots GDP cxactlv equal whatconsumers, businesscs, governlncnts, and foreignersuant to spend on goods atrd scrviccs prodrtced in thedomestic economv.

284 CHAPTER l,l oPl,:,N-E(;ONOlvn' Nf

^CROEcONOnT r(is

C+l+c

C+/+c+X

(ú

oo

.9ñ

(Do-

E

3,000

GDP2,s00 3,000 3,500Gross domestic product (b¡ll¡ons ol dollars)

FIGURE l4-2. Adding Net Exports to Domestic Demand Gives Equilibrium GDP in theOpen Economy

The blue line represenLs domesric (l('rnan(l (l; + / + (;), which are purchases bv domcslicconsumersi businesses, irnd governments. To this must be added nct fi)rrign spending. NetexporLs plus <lorncstic demand give the green line ol total s¡l:rrrlirrg. F.qrrilibrium comesat point 1'--, rvlrere total GDP equals total spe¡rdi¡rg on grxxls arrd scrlices produced in theUrritcd States. Nore rhat rhc slope of the green l()t¿l (l(:r¡ran(l curle is less rhan that ofdomestic demand to rellect the leakage lirrrrr s¡x.nrling into imporr.

4,000

Nefexport

The Morginol Propensity to lmportqnd the Spending Line

Note that the aggregate clclnand cllrve, the greenC + I + C * Xcumc in Figrrre 142, has a slighrlysmaller slope rhan rhe bluc ctrrve of domesricdemand. The explanation of this is tlraf there is nnadd,ilional leakage from sltnuling into i?nport.s. This newleakage arises from our assrunptiol that l0 cenLs ofevery dollar of income is spcnt on inrports. To handlethis requires introdrrclng a ne!r' term, the marginalpropensity to import, I he rnaryinal propensiry toimport, rvhich we will denotc MPm., is rhe increase

in the dollar value ol imporrs fbr each $l increasein ()DP.

The marginal propensiw to import is closely relatedto the rnarginal propensity to save (MPS). Recall thatthe MPS tells trs what f r¿ction of an additional dol-lar of ir.lcomc is not spent but leaks into saüng. Themargirral propcnsity to import tells horv much of adcli-tional orrt¡trrt and illcome leaks into imports. In ourexample, tl'tc MPm is 0.10 because every $300 billionof incrcasccl inco¡ne leads to $30 billion of increasedimporrs. (What is the marginal propensity ro importin an econolny with no foreign trade? Zero.)

TRAI)!. .\NI) FIN,\NCL l()R l l lll L NI l l.ll) s f -\ l us t \D!.R Fl l.xlBl.t-

Norr examine the slopc of thc total spcntliltuline irr Figure 1.1-2-that litre sllorvs total spcrttlirtQ

on (l * / + (; + X Note that the slope of tltc totalspcrrding linc is less thirn lhe slope of thc d<tlrtestictlcrrranrl lirrc of f. * / + (1. As Ol)P a¡rd total itltotttcsrisc b\, $3(X). spending ()lt c()l)srl l)) ptiolt rises bv

thc incornc clr:rnge tiures the ,1f,|'(l (irssttmed to be

[w(¡tllir(ls), or hv $200. At the salne titne, spclltl-ing on imports, or f<rt'eigtr qrxlds. also lises bt Sll0.

He ncc spcrrtlirrg otr donrestic goods rises b1'rllrlv$170(: 5200 - $i3{)), arrd tlte skrpe of tlre totalspcntting linc falls Irrrnr 0.667 ilt ortr closcd ccon-onlv t() $170,/Sll00 : 0.1-r(i7 itr ortr- ope rt ec()ltottl\'.

The Open-Economy MultiPlierSrrrprisingly, opetritrg r.rp arI cc()r)()ltrt' lorvers tht't:xpendinrre mttltiplier.

One rvav of tttrtlcrst¿tlrtlittg tltc cx¡tt'trrlitttrt' r'tlttl-tiplier in ¡rn operr ccoll()IIIY is Lo calcttlatc tlrt'rottndsof spending irncl ICspcudillg gctrclatcrl bl art addi-tionirl dr¡llar ol' govet lttttcttt s¡rcltclittg. ittlestt'ltt'ltl,or expor$. Supp<lse tlt¿rt Gerltratt! trcctls fo btty

Amt:rican cornputcrs tt¡ ¡rlotletrtizc alrtit¡trated lacili-ties in $'h¿rt r,lsed ttl be E:rst (icl tlrrttr'. E¿clt cxtl a doll:lrof U.S. conrputers tvill gerrclatc $l ol itrcotnc itt tlteUnited States, of which S2,23 = 5,,.,t,tt rvill bt'spcntbv Americans ort cottsttnrptiort. Horvcvcr-. bccatrse tlrem:rrginal propcttsity t() irlrpolt is 0. lt), onc-tt'nth ol'

the extr¿t rlollar of iuconrc. or $0. 10. u'ill be spettl ()n

foreign g<.rods anc[ scn'iccs, leavirrg onlt $0.:167 ofspending otr tlolncstic¿rllv ¡rrodrrccd go<lds. Th:rt$().567 of tlonrcstic s¡rctr<lins will qt'rterate 50.567 of'U.S. incorne, lirln rrhich 0.ir{i7 x 50.567 - 50.321

will be spent olr collsulllPtiolr of rlol.nestic g<xrds andsen'ices ilr the Ilcxt toultd. Hcrrcc tlr('lot:rl ilrcl-e¿st'

in outptrt, or the open<cottottrl rrtttlliplict.. rvill be

Opert-e cortotrtt'nrultiplier - | + o.5{;7 + (0.r{i7)r +.

: | 'l ('/. - th') I (!/t - Vo\! +

:--l -- !-2.¡l-%+v,, '/t"

This corrrparcs llitlr a closed-ec()tt olnt' mtrltiplier ofl/(l-'/'\ -3.

Anothcr wav t¡f calculatirtg tlre trrrrlriplier is as fi>l-

lorvs: Rccall tllat lhc ntulti¡tliel itt orrr sintplest modelrvas I ,/,tr{PS, whcrc ilfP.S is tl.re "leakage" itrto sat'ing.

As we notcrl allovc, ilnports:tre:tnotl)er lcakage.

28s

'l'hc tot:rl leak:rge is tlre dollars le:rking intt> saving(thc ,t'fl'.\ ) plrrs the dollars leaking into inrports (theI'lPrz). Hcncr., f lrc open-e(()nornv nrultiplier shotrldlrc l./(t111!'t l\'ll'n\ - l/(0.333 + 0.1) = liO.l33:2.3. Notc that lroth the leakage analvsis alrd thenrrrurls:rnalvsis ¡r rovirlc cxactl)'lhe sa l ¡l (' a tl s\v('r.

'lb sr¡ nt r¡lir ¡'izt':

Bccausc a l¡ actiorr o[ artl' incr¡nre inc¡-e¡se l<:itks

illt() inrpor ts irr an o¡rctr cc()n()tll!', the oPcn-economymultiplier is snrallcr tlrarr tllc rrtrlti¡rlicl fbr a closede(()ll()nl\'.'l'lrc cxact r-clationsh ip is

( ) p e r r -e c o n o u r r n r r r l t i p l i t. r' - I f ¡,\+-\. + n ¡r,n

rr,het't' l1/5 : nrargirtal proptttsitr Lo s:tvc attrl.\fPlr - nrrrciu:rl pr'opertsitv li) inlpor t.

TRADE AND FINANCE FORTHEUNITED STATES UNDER FLEXIBLEEXCHANGE RATES

\\'r' bcgin rvith a lcr,icw o[ nr;rjot' lrerrds itr tr:rde andfinancc fil thc LJnitcd St:ttt's ort't rh<" period of'flex-iblc cxchangc r:rtcs. wlrich beg:rn :rfter thc ab¿rnd<¡tr-

lrcnt ol thc Br-etton \l't¡ods sl,stt'In in l97lt (recall tlretliscr.rssion in thc previotts chirpter).

l'i¡-sl. r'xzrnrine lhe tnot'cllnells in the dol-Izrr cx< hange r'?rte. showlt in Fi¡4trre I {3. This is

arr irrrlcx <tl- the rrul txrhurgt r¿1¿ <¡f'tlrc U.S. tlollal'against otlrer rrr:rjor cttt'reucics. The t cal cxcltattgcr;ltc ( ()rlects for movetnerrts in tlre pr icc lcvcls indifleltrrt c()lrnlries. Note lrorv the cxcltattgc ratcrv:rs lt'l:rtivelv st¡blt'ttnrler fixed rates. Tltcn, as rtithall rnarkt't-dett'r-mincd asset priccs, cxcllttttgc ratcslrcanrc volatik'irr the flexible-ratc era.

ligrrrt' l4-.l shou's the rtal cotltpottcttt ol Ilctcxyrolts. Tltis is tht: tatio of l-eltl nct exP()rls t() rcll (iL)P

\{ie vur'¿rlxne drart:rtr incre:Lsc itr reirl trct cxJ)ol ts lcll(lsl<l b<' expartsionan'. whilc a (le crcasc iIl t carl rrct ('xlx)rts

tencls to lcduce outprtt. \\¡e tlescl ibc luo pct iotls itr llrt'historl of tlrc LIIrired Sutcs to ltclp trntlclstztnrl thcrolc of irrterrrational tñlde in dottlestic prtxlttctiolr.

Ttode Movements Reinforce ligh t Money in the 1980s.

I'hc rlccadt' of t hc l f)80s rtitncssed a dt-atnatic cyt lcol tlollar' :r¡r¡rrt'ci:rtiotr attd clerprec iirti<¡n. Tltc l isc

in thc valuc of the dollar begatr itr l9tl0 afier tiglrt

286 CHAPTER I4 OPEN-ECONOM}' MACROECONONf ICS

701955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Year

FIGURE l4-3. The Foreign Exchange Rate of üe Dollar

During the fixed-exchange-r'ate (Brcllon \lirods) pcriod, rhe dollar's r,alue was stablein exchange markels. r\ficl tht: finitt'rl Statr:s moved to flexible exchange rates in 197:.1,

üe dollar's valuc llccarrrc nrorc volatile . When the United States pursued ifs tight-rnoncvpolicics in tht: t.arlv 1980s, the high interest rates pulled up the dollar. Wiü lar.gc currcnraccor¡nt deficits and the foreign accumulation of dollar<lenomiltatcd assets, the dollarbegan to depreciare afier 2000.

Srxrrce: Ftdeml Resenc Svrrc¡¡r. at r¡zn¡úl¿r¿lre*n'e .put/nhues/h l0/nonna4.

140

oI r3o

(Y)¡,-qr- '120

(!

-q6qrcol

I(Úqno

o5aoLIJ

U.S. rnonctan' polic,v and loose U.S. fiscal polic,vdrovc interest rdtes up sharply. High interesr ratesat home and economic turmoil abroad attractcdfunds into financial inrestmenLs in U.S. dollals. Fig-ure 143 shorvs that during the period from 1979 r<r

carly 1985, the real exchange rate otr thc dollar rr¡seby 80 percent. Many economists believe rhc dollarwas o!'erralued in 1985-an ounttalaed. cunnul is onewhose ralue is high relative to irs long-run or susr¿in-able level.

As the dollar rose, Americar) export pricesincreased and the prices of goods inrported into theUnited States fell. Figrrre | 4-5 shorvs r.l¡e inrportanrrelationship between rtal exchangc rates andthe tr¿de deficir. It illustratcs the drarnatic effectof the appreciating dollar on tlade flows. Fromthe lrough in 1980 to the pcak in 1986, rhe tradedeñcit increased by 3 percent of GDP as the dollarappreciated.

By'itself, this sharp increase in the trade deficirworrld bc contractionary. The decline in net exportsreinfbrced a decline in domesric demarrcl indi¡ccclby tight moneury policy. The resulÍ was the dccpcstrecession in 50 vears.

Countercyclical Net Exports in the 1995-2000 Pe¡iod.The late 1990s were the opposite story. Aftcr 1995,the combination of low real in tercst ratcs and abooming stock market led to thc rapid growth ofdomesüc demand in the U¡ritcd Statcs, particularlvin primte inl€stment. Unenrployrncrrt f'ell sharply. Arapid increase in foreign demaltd fbr U.S. asseLs ledto the sharp appreciation of thc clollar.

ln contrast with thc earlv lg80s, the macroecG.nomic impact of thc dollar appreciation in thisperiod was appropriatc. As the Arnerican economvapproached fr,rllemplovment, import priccs rose, netexports declined, and the foleigrr scctor cxcrcised

THF, ]\{ONET.¡\RY TR\NSMISSION I\,IE(:HANISI\I IN AN OPEN ECONOI\{Y

- 1950 1960 1970 1980 1990 2000 201(Year

FIGURE l4-4. Real Net Exports Have Been an ImPortant ComPonent of Demand

With a stron¡¡ risc in the dollar exchange rate and weak economic growth abroad, [, S.

real ner exports trrrnr.<l shar ¡rly t)egative in the early 1980s. This shift producctl a rrrassiyc

drag on aggregate spending ¡n thc l; + / + (; + X equation and helped prodrtce the deep

recession of 1982. The growing deficit frorrr tltc ¡rcriorl afier 1990 moderated the growth()f outl)ut. Note horr net exporls increased after thc dollar's <l<:prt:ciation in the late 2000s.

li¡u¡tc: L S. Brne:rrr ,f ti ¡'rr,,nri¡ \rr.rlrri..

287

IEc.)

gofLocD -16o

o

Eo)tÍa

c'oooE3

9eoovc

a drag on the econom)'. Had the dollar dcprcciatedrather than appreciated, the fbreign sectol' wotrldhavc been expansionan', the Arnerican econolnyrvor¡ld have experienced rising inflatiorl, and thcFcd uould have found it necessat-r'to tiglttett ntoncvto choke off the boom. ln the late 1990s, thcrefbrc,an appreciation of the dollar ancl a declinc in uetcxports were.iust what the macr<)ecotroltt ic doctorordered.

THE MONETARY TRANSMISSIONMECHANISM INAN OPEN ECONOMY

Our earlier rnr,rltiplicr analysis of brsiness q'cles andeconomic growth fbcused on policies in a closed econ-

omy. We analyzed the wa1' that morretan' and ñscal

policies can help stabilize the business cyclc. Ho$' dothe impacLs of macroeconomic policies changc in an

open economy? How is the monetary u?trstnissionmechanism different in this situation? Surprisinglx thcanswer to these questions depends crucially ou whcüerthe col¡ntry has a fixed or a flexible exclralrgc ratc.

Our sun'ey here will concentr¿te on high-incomecorrntries whose financial markes are closcly linkerltogether-the United States,Japan, and thc cotlntriesof the Errropean Union. \\'hen financial it)vcstmentscan florv easily among countries and the rcgulatotybarriers to financial inr€stments are low, wc say tlratthese countries have high mobilill ofJinantial cal¡ital.

Fixed Exchonge Rote¡. The key feature of countricswith fixed exchange r¿tes and high capiul mobility is

288 CHAPTER I4 OPEN-ECONOMY MACROECONOMICS

Real effect¡ve exchangs rate(right scale)

20

10

05

o-oo

oIoCI

C,

.9ll,

osf-

3.5

3.0

2.5

-0.5

120 66oa110 ioo(l)

1oo 6 rl

oxg| it)t! a--

on -c

@

ETrade def¡c¡üGDP

(left scale)

-1.01 976 1990 1995

Year

FIGURE l4-5. Trade and Exchange Rates

Trade floss respond to exchange-rate chat)gcs, but with a rinrc lag. The real appreciitúonof the dollar during rhe early l'1)ll0s incrc¿st.rl [1.S. cxport prices ancl reduced pricesofgoods inrported in to rhc f-Initt.<l Statcs. As a rcsuh, the rr.rde deficit rose sharpl):Wherr the dollal rlt'Jrr<.< iatcd :rfrer 1985, üe rrade deficit began to shl.ink. Tht. incrcasein thc clrrr('nt-account deficir resulted liom dollar appreciatiorr and slow glru'th orrtsidel lr(: f:rnited Srares.

S('urccl Cooncif (t l:conorn¡( ^(lüi\ers,

lin ouu Rt1úrt Df th¿ Í,n.\i¿¿¡ . 20Ot)

that their intercst r¿tcs rnust be very closely aligned.Anv rli','ergencc in lhe interest rates betlteen twosuch countries will attr¿ct speculators rrho uill sellone currency and buy thc other until the interestrates are equalizcd.

Consider a srnall c<¡untrv rvhich pegs iLs exchanger¿te to tlrc curler¡cy of a larger country. B¿cause tlv.small country's inln¿sl rutes arc d¿lcrmined Íry the monetary

folh of the large rcuntry, tht smnll rounlry can no long?rcon¡luct ind.eFend¿¡t.t m.onetary polir"¡. The small counrry'smonetary policy rnr-rst be devoted to ensuring rhat itsinterest ratcs are aligned with those of irs partner.

Macroccr.¡rrornic policy in such a sitrr:rtion is

therefore cxactly üle case described in orrr mrrlti-plier modcl discussed earlier. From the small coun-try's point ol- vierv, investment is exogenous, becarrseit is deterrnincd bv r,r'orld interest rates. Fiscal policyis highl,v ellective because there is no monetary reac-tion to changes in government spending or taxcs.

Flexible Exchange Rqtes. One important insight inthis area is that lnacroeconomic oolicv with flexible

exchangc ratcs operates in quite a differenr wavfrom the casc of fixed exchange rates. A flexibleexchange ratc has a reinforcing effect on moneurrvpolic)'.

[.et's considcl rhc case of the United States. Themonctarv trarrsnlissi<)n mechanism in the UniteclStatcs has changed significantly in recenr decadesas a lcsrrlt ol irrcreased openness and the change toa flcxiblc cxchange rate. In the modern era, inter-national tladc and finance have come to play anincrcasingly irnportant role in U.S, macroeconomicpolicy.

tigruc 1.1.6 shows the monetary transmissionrnccharrisrn rurder flexible exchange rates. Panel (a)shows thc relationship berween net exporr,s andthc cxcharrge rate, the actual hisrory of which rvesaw in F'igure 1.15. This is an inverse relationshipbecause a depreciation stimr¡lates exports arrd clis-corrrages imports. Suppose rhar the Fed decidcs torcducc interest rates ro stimulate the economy. Thcdcclinc in intercst rates would lead to a deorecia-tion in thc clollar as financial inveslors rn.,u"á f.o-

THE |lf ONETARY TRANSN'ISSION VE(;HANfSV IN AN ()I'¡:N I](:ON0VY

(a) Nel Export and the Exchange Fate (b) Total Expendltures and Output

289

x,0x"Net exporls Total oulput

FIGURE | ¡l-ó. Wiü Flexible Exchange Rates, üe Monetary Transmission MechanismIs Reinforced

Suppose that th(' central barrk krrvt.¡s intcra'st rat(:s. This rvill tt.rrrl to k>rvcl thc cxclrangcratc frrrrrr ¿* lo ?** ilr a flexiblc<'xchanHc-rate system. Such a depreciadon üll sümulate netexports by moving dorrn alnng ahe net-export cun'e. This increase in net exports from X(e*)to X(r**) shifts up the total expenditrrre cune, increasing total output from Q* to q**.

e (exchange rate)

C + l - G + X(e')

dollar to nondollar stocks and bonds. The depre-ciation is shown in Figure l.t6 as a movement frome* to e**. This depreciation changes a net exportdeficit of X* to a net export surplus of X**. Thedecline in interest rates would also rend to increasedomestic investment, but we omit that effect fromour discussion.

\4t sh<.¡w tlle result <.¡f this net cxport expansionin Figure l4-ti(r). (This assumes, as with all ourmulti-plier analyses, a situation where there are unemplovedrcsourccs.) 'I'hc increasc irr nct cxporls shif's the tt¡talcxpcrrditulc curvc up lionr C + I + G t X(a*) toC + I + () -f X(e++). 'I'hc rcsl¡lt is ar¡ incrcasc irr totalexpenditurc and an incrcasc irr output frorn Q+ toQ**. nll the changes shown in Figurc l,l-6 ilhrstratcthc policics and rcactiorrs dtrring thc 1995-2000pcriod discrrssed irr the prcviorrs scction.

Altcrrtativcl,l', urkc the opposite casc. Supposelhat thc F-ed clccides to slow thc ecouonly, as it did

after 1979. The monetary tightening raised U.S.interest rates, rvhich attrac¡ed fi¡nds into dollarsecurities. This increase in the demand for dollarsled to an appreciation of the dollar. The high dollarexchange rate reduced net exports and contributedto the recession of l98l-1983, as we described ear-lier. The impact on net exports in such a situationwould be the opposite of that shown in Figure I tf6.

Forei¡¡n trade pr-oduces u nerv ¿rnd porverftrl linkin tlre nronctar'\, tlarrsnlissi()n rrrechanisr¡r wlrerr ir

c()untrv Ilas a flcxil¡lc exclrarrge r att'. \4:llcn l¡rorretarYpolicv changcs intclcst ratcs, tl¡is afli'cts cxcharrgt'ratcs antl llct cxp()rts as rvt'll :rs tlonrcstic ilrvcstnrcllt.lVlonctan tiglrtt'rrirru lc¿lrls tr¡ arr a¡r¡lrcci;rtion in tlrccxclrange ¡att' :ur<l a cor lcs¡lonrlir rg tlcclirtc irt rtct.

cxl)olts: ln()rtctilr'\ casirrg tlor:s tllc ()pp()sitc. I'llcirrrpact of clrangt's in irrtclest riltcs ()rr nct cxp()r'tsrcirrl¡r¡ttr tlrt iD¡uact t¡rr tk.¡rrrcstic ilr\cstnrcnt.

290

B. INTERDEPENDENCE IN THEGLOBAT EGONOMY

ECONOMIC GROWTH INTHE OPEN ECONOMY

The first section described the short-ntn impact of'inrernational tnde and policy changes in the openeconomy. These issues are crucial for open econo-mies combating unemplo,lrnent and inflation. Butcountries must also keep their eye on the implica-tions of their policies for long-run econt¡mic growth.Particularly for small open economies, effective use

of interna¡ional trade and international financc is

central for promoting economic growth.Economic growth involves a wide variety of

issrres, as we saw in Chapter 11. Perhaps the singlemost important approach for promoting rapid ec<.r.

nomic grorvth is to ensure high levels of saüng and¡nvestment.

Btrt economic gron th involves rnore than justcapital. It requires moring tonard tlre technologicalÍiontier by adopting the best teclrnological practiccs.It reqtrires developing instituúons that nlrñtu'c invcst-

ulcrlt and ürc spirit of cntcrprisc. Othcr issues-tr¿clc

CHAPTER I4 . OPEN-ECONOMI' M,ACROECONOI\f ICS

policies, intellectual propert.v righs, p<.rlicies torrarddirect inlestment, and the orerall macroeconomic cli-mate-are essenüal ingrediens in the growü of openeconomles.

SAVINGAND INYESTMENTINTHE OPEN ECONOMY

In a closcd economy, total invcstment cquals dotnes-tic saving. Operr econonries, however, can draw ttponw<-¡rld financial rnarkets fbr investment funds, andother courrtries can be aIr orrtlet fbr donrcstic saving.(Recall Table I &3, which shows thc nctsaving of itnpor-tant regions.) We first review the irvcstrncnt-savingrelationship, ancl then we exarninc thc rncchanismsfbr allocating saüng among difl'erent courltries.

The Saving-lnvestment Relation in an

Open Economy

Let's pause to recall our saving-investment

ident¡ties from Chapter 5:

l,=l+X=S+(T C)

This states that total national investment (lr) con-

sists of inyestment in domestic capital (l) plus net foreign

III

FIGURE | 4-7. Saving and Investnent in üe Closed!Jconomy

Investment is inversel,v related to the real interest mte,rvhile private saving and public saüng ¿rre relativelvunresponsive to the interest rate. Equilibrium savingand irrvestment comes at r+, Sr.rppose that govern-

nrenr nrilitara spendiug incr-eases. -Ihis

increases thegovcnrrncnt dcficit and therefore rcduccs prtblic sav-

ing. The resr¡lt is a shift in the national saving cune tothe left rc .S + 7'- G', raising the market interest rateto r** ;rnd reducir.rg national saüng and investment

t" t'Investment, sav¡n9

SAVTNC AND INVES'I'NILN'I' IN 1'II[, OPIN ICONOMY

¡nyestment or net exports (X).This must equal toal pri\r¿te savinS (S) by households and businesses plus totalpublic saving, which ¡s g¡ven by the government surplus

(r - c).We can rewrite the identity as follows to emphasize

the components of net expons:

x:s+(r-Gl.-l

Net exports : (private saving * government sav¡ng)

- domestic investment

Th¡s ¡mportant equation shows that ner exports are the

difference between domestic saving and domestic invest-

ment.The comoonents of total U.S. national investment for

recent decades are shown in Table l4-2.

Determinotion of Soving and ,nvelmentot Full Employment

We need to go beyond the idendties to understand thetn¿chnnism bv which saring and investment are equal-iz-ed in the open econom\,. This analvsis concerns pri-marily the long run in which there is full employmentand outprrt equals irs potential. That is, we considerhow saving and investment are allocated in the longnrn in a 'classical" econom1¡.

Closed Economy. \4'c bcgin with a closc<l cconornywlrcrc thc¡-c is no inflatio¡r ancl no rrnccrtairrt\,. ln

291

this situation, investment must equal prirate savingplus the government surplus. The equilibrating priceis the leal interest rate, which adjrrsts to balance thclevels o[ sali r.rg and investment.

Figrrre I ,1.7 shou's how na tional sar,'ing and irrvcst-ment are equilibratcd irr a full-crnploynrcnt closcdecononlv. Thc S .| 7- - G curvc shows national sav-

ing, which is assunrcd to incrcasc slightlv with thcrcal intcrcst ratc. Additionally, as wc lcarncd inCltaptcr 6, thcrc is an invcrsc r-clationship bctwee¡rinvcstnlcrrt and tllc iutercst rate. Higher interest.rates reduce spending on hotrsing and on businessplant and equiprnent. \4'e therefbre rvrite our invest-mcnt schedule as /( r) to indicate that investmentdepends upon the real interest rate, r.

The saving and investment schedules intersect inFigure l,t7 to determine an interest rate at r* rvithhigh levels of saüng and investment.

No*' suppose that lhe go\ernment increases itsprrrchases withorrt increasing taxes, sali becarrse ofan increase in military spending to fight Foreignwars. This nill shift the saving schedr¡le to the left to.S+ 7'- (.1'. As a resr¡lt, the real interest rate increasesto equilibrate saving ancl investment, and the levelof investment falls. A similar olrtcome unr¡ld occr¡r ifthe govcrnnrcnt lorvered taxes or if the private sectorlowercd its dcsired salings.

lrr a frrll-emplr¡vmen t closerl t'conornv (alwavs

holding other Ihings c()nst¿rnt), hight'r gor.ernment

Saving and lnvestment as Fe¡tentate of NNP

Secto¡

Net doneatic eaving

Net private saving

Net government saving

Net donestic invesünent (in capital)Net fo¡eign invcsüent

1959-r9El 1982-1ml

I t.5 6.4I 1.6 8.8

-0.1 -2.5It.t 8.50.4 -2.1

2002-200?

1.7

4.6

-2.8

-6.0

TABLE l{-2. The Declining U.S. Saüng Rate

This tablt-- shows thc changing structure ol U.S. saüng orer the la;t half-century For mostr¡f thc L9l-rf)-l f)U l ¡x'r ir xl, saving arr(l ¡nvcstfirerrt were about equal and at a high level. 'l hen,aftcr 1981 , govcrnnl( n t sar.irrg tlcclirrrrl as tlrt: [r:dt:r'al burl¡4ct ntovcd i¡r to del icit. -fhis

decline was reinforced in üe 2000s as personal and othcr privatc saürrg tln4r¡rctl shar¡rlv. By

the 2002-2007 period, most U.S. capinl investment was financed b;- foreign saring, rvhich is

(he c(nrnterpart to the large cr¡rrent-account deficit.

&'Lrr((: Burcnr (l tl(oDo||ri( An lrsis.

292

spcudillg. lorver taxes. or lowcr clcsilerl pliratc savingrvill r-:,rise the rcal intcrest ratc ar)(l lorrcr cqrrilibritrrIrsavirrg and illvcstnlcnt.

Open-Economy Equilibrium, Nor,r' corrsider thc situa-tion of an open economy in which finalrci¿l r¡rarkcLs

are integrated r+'i th rv<¡rld markets. An t-rpen econolnyhas alternative sources ol in!'cstllre¡)t and altcrna-tive outl€ts fbr saüng. We simplify by assurning thatthe economy is small and cann<¡t afl'ect world intelest rates. We show this situation in Figr-rre I tf8 fora small open economy with a high degree of mobil-iry of financial capital. A small open econorny mustequate its domestic real interest rate with the worl<lreal interest rate, rrr. Because financial markets arc

CHAPTER l4 - OPEN-ECONOMY M.A,CROECONOlvf ICS

opcn, financial capital will movc to cquilibratc intcr.cst l?tcs at homc and abroad.

I igrrrc l.l8 hclps cxplain thc dcterminatio¡r ofsaving, invcsúuer¡1, and net exports in the open econ-orny. At the prevailing world interest rate, domescicirrvestrlrent is stlt¡wn at point A, which is the intersec-tiolr of'tl¡e i¡rvestrne¡rt schedule and üe interest rate.'Ibtal uational savirrg is given at point ,B on the totalsaving sclredtrle, S + 7' - G. The dift'erence betrveenthem-gil'en by the line segment AB-is net exports.(This equality is shown by the saüng-investment iden-tity irr the box on page 290.)

Heuce net exports are determined b;" the dif-Icrence betrveen n¿rtional s:rving and national

s+ G

t,s,xInveslment, savrng, net exporls

FIGURE l4-8. Saüng and Investment in a Small Open Economy

Dourestic investmcnl and rkrnlcstic savirrg arc dctrrrrinrrl by income, interest rates,arrd govtrnrncnt fiscal policv, as in Fig. 1,f7. But the small open economv with mobilefinancial capiral has its real interest rates determined in world financial markets. At üerelatively high real interest rate at rr¡, domestic saving exceeds donrestic iDYestment andthe excess saving flows to more lucrative irrvestment op¡roltrrnitics abroarl. Thr: diffcr.ence betn'een nadonal savirrg and donrestir: irrvcs(r¡rcrrt is n('t ('xJ)orts (also er¡ual to netfbreign investnrent), shown as Xin lhr'figrrrt:. A t rark' srr r¡rl rrs sr¡ch ¿s has been seen inJapan and China is carrscd by the intcraction of high domestic saving and low domesticirrvestment.

Domeslic Domestic

sAVtN(; ANt) IN\/t:S'fMUN',t tN l rIr.: ()t'laN lr(:oNO¡\.1\,

investment, which is deterrnined bv domestic facrr¡rsplus the world interest rate.

This discussion pushes into the backgrorrnd themechanism by which a countn' adjust-s irs trade, sav-

ing, and inr€stment. It is here that the exchangerate plays the crucial equilibrating role. Ohnnge.s irt.

cxchange ralcs ar? lhe mcchanisnt lry whirh sattin.g a¡tdinue.stnuttl adjusl.'fhat is, exchangc ratcs nrovc t()ensrrre that tlre level of net exports balanccs thc rli[-ference betweerr domestic saving and investmenl.

This analysis can help explain thc trcrrds ilr sav-

ing, inveslrnent, and trade pattcnrs in nrajol corrn-trics irr rccclrt ycars. Figrrr c 148 rlcscribcs wcll thcrolc ofJaparr i¡r thc rvorld ccononrv. Japan has tradi-tionallv had a higlr dorrcstic saving ratc. Yct in r-cccnt

¡cars-bccarsc of-high plodrrction costs at hornc alldconrpetitivc conclitions in ncighboring ncwly indus-trialized countries-thc rcturn on Japanese capitalhas bcen depressed. Japanese saring therefore seeks

outlets abroad, with the consequence that.fapan hashad a largc trade surplus and high net exports.

The United Surtes has sccn an interesting nrist inis sal'ing and investment position, as was shown inTable 142. Until 1980, the United Sntes had a mod-estl,v positive netrxport position. But in the early1980s the U.S. government's fiscal position shiftedsharplv toward deficit. You can depicr this by drarv-ing a nerv.S + Z' - G' line in Figure l4-tl that inter-sects the real-interest-rate line at point C. YrIr c¿rn

see that total national saring would decline witha larger government deficit. Domestic investmentwould be unchanged. Net exporLs would turn nega-tive and be given by the line segment CA.

Ir!'e can also use this analysis to explain the mech-anism b1' rvhich net expor'¡s adjust to proride thenecessary investrnent rvhen the governmen¡ nrns a

brrdget deficit. Consider a country with a net-exportsurplus as shown in Figure 148. Suppose that thegovernment suddenly begins to run a large budgetdeficit. This change u.ill lead tr¡ an imbalance in thesaling-investmen t market, which rv<¡uld tend to pushup domestic interest. rates relative to world interestrates. The rise in domestic interest rates will attractfunds from abroad and rvill lead to an appreciationin the foreign exchange rate of the countn, runningthe budget deficit. The appreciation rvill lead to fall-ing exporrs and rising imporrs, or ¿r decrease in netexporls. This trend will continue lrntil net exporls

293

have fallen sufficiently to close the saüng-inl'estmentgap.

Other important examples of thc opcn-cconornysaving-i nvestmen t theory in thc small opcn econ-omy are the followirrg:

. An increase in privatc saving or lower govern-nrent spcnding will incrcase national saüng as

rcplcscntcd by a rightward shifi in the nationalsaving schcdulc in Figure l,l-8. This lr.ill lead toa dcprcciation ol thc exchangc rate until netcxpolts havc i¡tcrcased enough to balance theincr'<'ast' irt dorrrcstic savirrg.

¡ An i¡rcre¿¡,sc in domestic investment, say, becauseol an irnproved busi¡ress climate or a burst ofirrr¡t¡rati<.¡rrs, will lead tt-¡ a shift in the investmentschedule. This will lead to an appreciation of rheexchange r¿te until net exports decline enough tobalance saving irnd investment. In tiis case, domes-tic investment crowds out foreign investment.

. An increase in s,orld interest rates will reduce thelevel of investment. This rvill lead to an increasein the difference between saling and investment,to a depreciation in the foreign exchange rate,and to an increase in net exports anrl foreigninvestment. (This woulrl be a shift along theinvestment scherlule.)

Thble I't3 summarizes the major resr¡lls for thesmall open economr'. Make srrre )'olr can also r.r'ork

through the cases of decreases in the governmcnt'sñscal cleficit, in private savirrg, in in\€stment, and itrworld interest rates. This hancly table and is explana-tiorr desene careful strrdy.¡

Inlc-¡¡ration t¡l a corultn il)to lhc world cco¡ro¡rrt,ad<ls arr irrrporla¡ lt rrcrt tlirnerrsioll to rnacr'oecononlicpcrfbrrrrancc arrtl ¡rolicr,. Kcy fintlings arc:

o The forcign scctor' ¡rrovirles an inrportant sorrrcco[ dornestic investnrcnt atrd a p()tcrrtial outlet fbr'dornestic savirrg.

. Highcr sal'itrg at hornc-whcthcl in thc lbrlrr olhighcr' ¡l'ivatc saving ol highcl public saving-*'ill lead to hight'r'nct cxpolts.

| 'lhis discussion covers "s¡nall" oo.en econo¡rries that cannotaffcct thc world ¡ntcrcst r¿rc. F()r'largc" opcn cconomics likcthe United States, the inrpact would be so¡newhere berr¡eentlrc srrrall<'conomy and th<: closcd+conomy cascs. This morccomplex case is corered in i¡rtelrnediatc lcxtbooks (see theFrrrthcr R<'ading section in (lhaprer 4).

294 C I{APTE R I,I . OPEN-ECONOM}_ M.¡\CROECONOIúICS

{harge in policy or exogenouavari¡ble

Increase in G o¡ decrease in TIncrease in private S

Increase in investment demand

Increase in world interest rates

Chonge inexdrange rate

"f"I+,J

Change ininvertsnent

0

0

]I¡l

(haoge in netexports

XJX1XJXT

TABLE l4-3. Major Conclusions of Sarins-Investment Model in Small Open Economy

Nlake surc vou rrndcrsla¡lrl (hr: nrer:hanism by r4rich each of these occurs.

. A counu\,'s trade balance is prirnarilv a leflec-tion of irs nati()nal saring and investment baliurccrather thiu) of its :rbsolrrte procluctiviry-. t¡r' nealth.

. Ad-itrstments in a c<¡rrntn''s trade accorrrrts r-equilc¡ ch¡ngc irr dornestic saving or irl\esuIent.

o In the li>ng rur.r. actjustments in trlde ¿lcc()u¡¡ts

will be brougl-rt about b1' r.¡rovelnent.s ilr the coun-try"s relative prices. often thlough exchan¡4c-r'att'chanp¡es.

PROMOTING GROWTH INTHEOPEN ECONOMY

Increasin¡¡ the growü of orrtput in open economiesinvolves more than just r.laüng a magic wand thatnill attract investors or savers. A favorable saüng andinvesting climate involves a uide array of policies,inclrrdinp¡ a stable macroeconomic enüronment.secure property righs, and, above all, a predictableand atracdve returns on investment. \4'e reüerv inthis section some of the rlz'ys that open economiescan improve their growth rates by using the globalmarketplace to their best advantage.

Over the long nrn, the single most ¡mpormnt wayof increasing per capita output and lir.ing standardsis to ensure that the country ndoftts bc-sl-lrnctire lech-

niques in irs production processes. It does little goodto have a high investment rate if the investments arein the wrong technology. This point was abundantlyshoun in the last years of Soviet centr¿l planning(discussed in Chapter 12), when the investment ratewas extremely high but much investment rvas poorlydesigned, left unfinished, or put in unproductivesectors. Moreover, individual poor countries do notneed to start from scratch in designing their orvn

turbines, machinery computers, and managementsystems. Often, reaching the technological frontierrvill involve engaging in joint ventures n'i th foreignñrms, which in turn requires that the institutionalframework be hospitable to foreign capital.

Another important set of policies is trade policirs.

Eüdence shows that an open trading rystem premotes competitiveness and adoption of best-practicetechnologies. By keeping tariffs and other barrieruto trade low countries can ensure üat ctonlestic6rms feel the spur of competition and that f<rreignfirms are permitted to enter domestic markets whendomestic producers sell at inefficientlv high prices ormonopolize particular sectors.

\Alhen cottntries consider their saving and invest-ment, they tftt¡st not concentftrte entil'ely on p]rysicalc pit^|. Intangibk capital is .just as important. Stud-ies shorv that countries that invest in htrman capi-tal through education tend to perform well and beresilient in the face of shocks. \{any countries havevahlable stocks of natural resources-forests, miner-als, oil and gas, fisheries, and arable land-that mustbe managed carefullv to ensure that they prol'ide thehighest vield for the country.

One of the most complex factors in a country'sgrorvth invoh€s ímrnigrution aútd rmigation. Historically;the Unitcd States has attracted large flows of immi-granls th:rt not onl,v hare increased the size of its laborforce but ¿rlso have enhanced the quality of its cultureand scientific research. More recentl,l', however, theimmigrants har,e possessed less education and lowerskills than the domestic labor force. As a result, accord-ing to some studies, immigration has depressed the rel-ative wages of loll.wage workers in the United States.

Countries that "export" workers. such as Mexico, often

PROMOTI NG CROWTI I I N -I'I I I.] OPHN I.](:0 N O I\I'I'

have a stead)' stream of earnings that are sent home bycitizens to their reladves, and this can proüde a nicesrrpplement to export eamings.

Onc of thc rnost inrportant yet subtle inflr¡encesconcclns thc inslitulions of lhe mnrket. The most suc-

cessful opcn cconomies-like tl.re Nether'larrds andLuxenrbourg in Europe or Tair,tan and Hong Korr¡;in Asia-l¡avc provided a secure environment forinvestment and entlcprcncu rship. This invohedestablishing a securc sct of propclty rights, guidcd b,v

the rule <¡f law. Increasinglv irrtportant is thc clcvclopment of intellectual prope rty rights so tl)at invcntorsand creative artists are assurcd that thc)' will bc ablcto profit from their activities. Ct¡untries nlust fightcorrupt¡on, which is a kind of prirate taxation si'stcnlthar prevs on the most pro6table entcrpriscs, creates

295

uncertainqv about propcrt,y rights, raises costs, andhas a chilling effect on investment.

A stablz macmercnomic climate means that taxes arereasonable and predictable and that inflation is low,

so lenders need not worry about inflation confiscadngtheir investments. lt is cnrcial that exchange r¿tes be

relatively stable, with a convertibiliw that allows ean'and inexpensive entry into and exit out of the domes-tic currency. Cnuntries that prolide a favorable institu-tional stnrctrrre attract large flows of foreigrr financialcapital, *'hile corrntries that have unstable institrrtionsattract relativelv little foreign ñrnds and suffer "capi-tal llight," in wl-rich local residents mole their fundsabr-oad to avoid taxcs, cxpropriation, or loss o[raluc.

Figurc 149 illustratcs thc impact of thc in\€stmentclirnatc orr national invcstrr)cnt. T'hc lcft-hand panel

(a) Lort -Risk Country (bl High-R¡sk Country

r hlgh risk - rw + risk premium

, hioh flsk

Investment lnveslment

FIGURE | 4-9. Busincss Climatc Affects Interest Rate and Investment lf,r'el

In the lor,r.risk country in (a), a stablt' t't orrorn i< rlirlatc leads to a lorr do¡lestic interestrate at rtt and a high le\€l of investment at 1r* '"r. Irr thc higlr-risk t otttt tt-1', t ackcrl b;.' ¡;oliti-cal ttrrmoil, cornrption, and economic t¡nceraintv, investt>ni require a large risk ¡.rrttrtitttrtolr tlrr.il irrvcstlnenls. so the dornestic ¡nterest rate is far abore the rvorld interest rate. Thert'sr¡lt is a dt ¡rrt'ssc<l lcv(:l (,f inv(:stnrerrt as lbreign investors seek s¿rfcr terrain.

\\

o(!

o(D

:o

oco

(¡)

o

q)

q)

=o96oEoo

\-'ñ't\

't(r)

296

depicts a country that has a fav<¡r¿ble in\€slrnentclimate, so the domestic interest rate is equal to theworld interest rate. The ol'erall level of investmentthere is high, and the country can attrzrct foreignfunds t<¡ finance domestic investment.

Panel (ó) shows a high-risk country Look backat Figure l2-2 on page 244, which shows the pre-mium on emerging-market bonds. In periods of cri-sis, these countries might pay interest rates 8 or l0 or12 percentage poins above the rate paid by investorsin advanced countries. The high risk premium mightarise because of high inflation, unpredictable raxes,nation¿lizations, default, corruption, an unsÍrble for-eign exchange rate, or sometimesjust panic and con-tagion. The real cost of capital woulcl therefore bcextremely high. The risky country will have trorrbleattracting both domestic and foreign investment, andthe resulting level of inl'estment will be lorv. Comparethe equilibrium le!€l of invesrment in lo*.risk panel( a) to that of high-risk panel ( á) .

Prornoting economic gro\r'th in ln open ec()n-omy involves ensuring rhat business is ¿ittractive fbr-

fbreign and domestic investors rvho lrave a rvide arr-av

<.¡f investment opportunities in the rvorld ecol.ron¡\'.Thc ultirnate goals of policy are to have high ratesof savinp; and investment in productive chalrnelsa¡¡d to ensure that businesses trse best-practice teclr-niqtres. Achieving these goals involves settir)g a sublelnacroeconornic climate, guaranteein¡¡ dependableproperty righs for both tangible investtleuLs andintellectual properw. providing exch:rrrge-rare corr-vel'tibiliry* that allows investors to t¿rke honre theirprofits, and maintaining confidellce in the politicalluncl economic stabiliw of the countrr.

C. INTERNATIONALECONOTTIIC ISSUES

In this final section, we apply the tools of interna-tional economics to examine two of the central issuesthat have c<.rncerned nations in recent years. In thefirst part, rve examine the issue of the differencebc-twccn cornpeti tiveness and productir.iry*. In thesccolrcl part, we examine the birth of the EtrropeanMonetary Union.

CHAPTER l4 . OPEN-E(IONO¡,t¡-M^(IROE(IONON{l(:S

COMPETITIVENESSANDPRODUCTIYITY

"The Deindustr¡olizotion of America"Often, when the trade deficit becomes large, peoplebeco¡ne concerned and worry about the nation's prcFductiviw and competitiveness. Just such a situationoccurred in the United States in the 1980s, and laterresrrrfaced in the 2000s. A review of this history is

a helpful reminder abolrt the determinants o[ tradeflows.

The appreciation of the dollar in the 1980s preduced severe economic hardships in many tl.S. sec-

tors exposed to international trade. Industries likcarrtomobiles. steel. and textiles found thc dcmandFor their prodrrcts shrinking as an apprcciation of thcexchange rate led to a rise in their prices rclativc tothose <¡f their foreign competitors. Unernploymcntin America's manufactrrring heartland incrcasedsharply, factories wcre closccl, and the Nfidwestbecame kno*rr as the "nrst belt."

Many noneconomists interyreted U.S. tlaclcproblems as inclicative of "America in decline." Thcyfretted that A¡¡erica's technological leadership rvas

eroding because of rvhat they saü' as r¡nfair tradepractices, excessive regrrlation, declining innovation,and managerial sloth. Some called for a reversal oftracle agreemenls such as the North American FreeTrade Agreement (NAFTA). America was pictured as

ir. land condemned to sening potato chips u'hile oth-ers were manrrfacturing or¡r computer chips.

Economist-s saw a different smdrome at $'ork-this sitrratio¡r is a classic disease of an ovcrualucdexchange rate. To understand the fundamentals,we must distinguish a nation's competitiveness frorllits prodrrctivity. Comlntitirenes.r refers to thc cxtcnttrr which a nation's goods can compete in the rnar.ketplace; this depends primarily upon the rclativcprices of domestic arrcl foreign products. Cornpcti-t¡veness shorrlrl not tre co¡rfused \,'rifh prod ur.ti..r itl,which is measured by the outpr.rt pel urlit o[ input.Productirity is firndamental to thc growth of livingst¿rnd¿rrds in a rration; to a first approxirnatiorr, a

n¿rtion's real inconre grolrs in step with its productiv-itv growth.

It is trrre that [J.S. competitiveness lell shar-pl,v

during the l9fl0s and again in the early 2000s. How.g1'g¡ these changes were not carrsed by a deteriora-tion in productirity growrh. Actuallr', productivitl

TI I I.] I.]LIR0I'I.]AN NIONF,TARY TTNION

growth increasedjust as thc tradc deficit iDcrcascrl.Macroecon<,rr¡risLs l¡elievc that dete¡'iorating cornpct-itileness ar<-rsc because the dcclinc itt natiottal savingin the United States lctl to arr appr-cciation t.¡l'thc <[ol-

lar arrd raised Americ¿rn priccs relative to thosc ol iLs

trading partners.

Trends in ProductivityThe real st()ry about Ll.S. rcal incontcs is n()t al)outcompetitive ncss but aboul productivity. Rccallthat productivitv measures the output per ulrit of'input (such as labor-hours). Our chapter on ec(>

nomic growth shoued that increases in rcirl wagcs

depencl primarily on the grotth ol'domestic laborproductivity.

Competitiveness is important fi>r tr¿de br¡t has

no intrinsic relationship to the level or growth of realincomes. Ohina enioled a massive trade sttrplus inthe 2000s at the same time ¿ns the United Sutes rarr

a l¿rrge trade deficit. But would Arnericans theref()retrade their living standards for those in (lhin¿ with

.jobs paying $l an hour? [,oss of competitiveness ininternational markels resulLs frorn a nation's pric¿s

being out of line with those of is trading partners;it has no necessary connection with how a nation's

Inodurthit¡ compares üth that of other countries.Studies of productirity differcnces among corrn-

tries emph:rsize the impornnce of mnfclil¡on andot¿lutnrd orienlalion. ;\n essential aspect of policydcsigned to increase productiritv is to force domesticindustrics to compete with foreign firms, n'ho oftenhavc srrpclior, frontier technologies. Foreign directinvcstrr)cr)t bv thc nrost productive countries (such

as thc Ja¡-rarrcsc atrtornobilc plants opcrating in tlreUnited Statcs) has contlibutcd to drarrratic prodrrc-tivity inrprovcrrrcnts through botlr thc introdrrctior.lol cutting{(lgc tcchnologies arrd the sfimulation ofc0n)Pctltron.

( i¡nrlu¡it¡¡t rtn lnrnlrtr lit,tll un t on ptt il itrntss: As

lhc fhcorv ol cortt ¡ra t ;tl ivt' arh.antage denronstrltcs,rr:rtions ;uc rrr¡t inh<'¡enllt rrnconrpctitivr'. R:ttlter,l lrcr' lrt'r'onrc rrrrcortt¡l<'l il ir t' rr lren t ltci r prict:s ttt<>t'e

r¡rrt ol lint rvilh tlrost' of their trarlinLI ¡raltnt'r's. The\rrrcsI r()utc to lriglr ¡r-orlrrctivitl arrcl lriglr livirrgstarrrlarrls is to t'x¡lost' rlonrcslrc inclrrstlit's to rvorldrnar lt'ts arrrl tr¡ t ncor¡r:rgc ligororrs rlt¡ltrcsfic c()nlpe-titi¡rrr rvitlr lirlt'igrr corl¡ranics rhat hitte ado¡rterl tltenlost itrhanccrl I t'<-h rrr llr lgit'..

297

THE EUROPEAN MONETARY UNIONAn ideal cxchange-ratc systcrn is one that allows highlevels of prerlictabilit,v of lclativc 1-rliccs wl¡ilc stabiliz-ing thc econonly in tllc lácc t¡l ect¡nr.¡lnic shocks. In a

well-lunctioning svstcnr, pcoplc can tr¿dc and investin other countries without worryirrg that cxchangerates will sr¡ddenlv change and l¡rake their venturesunprofitable.

Fror¡r the early' 1990s, hon'evc¡ fixcd-cxchangc-rate systems wcre often ksk tilizing lather ttlanstabilizing. Tinre and again, fixed-€xchange-rate systems were tlre subicct of intense speculative attacksthat spread to other countries throtrgh contagion.They were seen in Europe in l99l-1992, Mexico in1994-1995, Rrrssia and East Asia in 1997-1998, andl-atin America from 1998 to 2002.

Nowhere were problems rr.ith the exchange-rate system nrore persistent and profi)und thi¡n ittWestern Europe. As a rcsult, thc countries of theErrropean Union took the giant step of linking theireconomic fortr¡nes through the Etrropean MonetaryUnion, which forged a common currencli the Euro.

The FundamenalTrilemma of Fixed

Exchange Rates

"You cant ha\€ it all" is one of the central

tenets ofeconomics. This was driven home in

macroeconomic afrain on sever¿l occasions during the 1990s.

As countries on fixed exchange ntes liberalized their finan-

ciaf markes, they encountered a f-rndomenaol trilemmo of firedexchonge rata: A county can hove only *ro of the fúwing (o) o

fixed brt djusro e exchonge rste, (b) free copitnl ond finorcolmorements.,ond (c) on ind+endent do/r,el(k ñonetary polrl.

Th¡s ¡ncons¡stenq, amonS the three obiectives was

explained by Paul Krugman as follows:

The point is that you cant have it all: A countq,/ must pick

two out of three. lt can fix its exchange rate without emas-

culatint its central bank, but only by mainta¡ning controls on

capital flows (like Chrna roday); it can leave capital movement

free and reta¡n moneurry aulonoml but onl), by letlint the

exchange r-ate fluctuate (like Brita¡n----or Canada); or it can

choose to leave capiol free and stabil¡ze the curreñcy, but

only by abandoning an/ ab¡litt to adiust inrcrest rates to fitht¡nfladon or recess¡on (lik€ Artentina today,or for that marter

most of Europe).'?

2 S( ( (llis ( lraptcr's Furtltct Rcatlittg scctiolr.

298

Toword o Common Currency: Ihe EuroSince rvl¡orld \,!hr II, the democratic countries ofVt'estern F,rrrope have prrrsrred ever-closer econc¡micintegration, primarily to promore political stabilityafter nvo deva-statir.rg wars. Peace and tmdc go handin hancl, according fo nrany political sciclrtists. Begirr-r-ring in l9ir7 with a free-trade agreement. !!'esternErrropeans gradrrally removed all barriers to trade ingoods, senices, and finance. The ñnal step in eccF

nomic integration rvas to adopt a common crlrrcncv.This wor¡ld not only foster clc.rser ccono¡nic tics butalso resolve the ploblem of rrnstablc currcrrcics thatplagrted the earlier fixcd-cxchangc-r'atc systclns.

Elevcn Europcan corrntrics joincd thc L,uropcanMonetary Union (EMLI) in 1999. 'I'hcsc corurtrics,somctimcs callcd L,rrroland, acloptcd thc Eur r-r as theirrunit of accot¡nt and rncclitr¡rr ol cxchangc. The firststcp was to bcgil tr-ansactions in Euros. The trickieststcp canlc on Januarv l, 2002, when thc countriest¡l'Eurola¡rd replaced their national currencies withL,rr rt¡ c<rirrs arrd notes, saying, in etIect, "Au reaoiri

Frcnclr frarrc; bonjour, Etro." 'I'hc L,uro was lau¡rchedsnroothly and has l)ow takcn its placc arnoDg thewolld's majol cun'cncics.

Thc monctart stnrctrrr-c undc¡' thc EuropeanMonetarl LJnion rcscrnblcs that ol' tllc Llnitcd States.Control over L,rrropcan monctaly policv is cxercisedby the Eutopean C¿ntrul Bunk (ECd), which conductsmonctar"y policv lbr ct¡untries in the accord. The ECBr¡ndcrtakcs opcn-rnarket oper¿tions and therebyclctcrmincs intcrcst rates lbr tlre Euro.

Onc oI' thc nrajol qtrcstions lbr rtronetarv policyinvolves thc objcctivcs ol thc ccrrtr¿l barrk. The ECBis directcd r¡ndcr its chartcr to purur.re "price stabil-ity" as is prinrar-v objective, although it can pursueotlrcr corrrrrrurrinwide goals irs long as these do notcomprornist price srability. The ECB defines pricestability as an i¡¡cle¿r,se in Euroland consumer pricesof bclow 2 pcr-ccnt pcr year over the medium term.

Costs ond Beneftts of Monetory Union14¡hat ar c thc costs and benetits of Er¡ropean monetaryr¡rrion? Advocatcs of rnonetary union see imporurntbcnefts. Litdcr a conlrnon currencl exchange-ratevolatility within Etrropc rvill bc rcth¡ced to zero, sotrade and llnancc will rro longer have to contendrvith tlrc r¡nccrtaintics about prices inducecl bt'changing cxchangc ratcs. 'I'he prirrrarl result n'illbe a reductio¡r in transat (ions costs arnong ('oun-tries. To tlre extent that national linaucial lnarkets

CHAPTER I¿I . oPEN-E(]ONOIlfY IúA(:ROF](]ONOM I(:S

are segmented, moving to a comnron currency Inayallow a more efficierrt allocation of capital acrosscountries. Some believe that firm nracrocconornicdiscipline will be presewecl b1' haring an indcpcn-dent European cc¡rtral bank committcd to stric(inflation targets. Per-haps thc nrost iurpoltant bcncfitmay be political integration and stabilin' of !!'cstcrnErrrope-a region that has been at pcacc for half a

centrlry afier being at *'ar with itsclf for ntost of itsrecorded histon'.

Some economists arc skcptical about the wisdornof rnonetar] r¡nion in Europc and point to sigrrili-carrt a¿rs¿J ol such a union. 'l'hc clorniuallt concerrlis that thc inclivicltral cotrntrics will lt¡sc thc use t¡fbotlr monctary policv and cxchange rut"es as tt.¡ols lbrrnacroccon<-r¡¡ric adjustrnent. This questiorr conccrnsthc optirrral currencv area, a concept first prop<-rsed

by' Colurnbia's Robert Mtrndell, who w<-¡n the 1999i.r-t.¡bel Prize fbr his contributions in this field. Anoptimal crrrrency area is one whose regions have highlabor nrobility r.¡r havc common and synchronousaggrcgatc supply or tlernand shocks. l¡r an optimalcurrcncy area, sigrrificarrt changes in exchange ratcsarc not necessan' to ensure rapid macroeconomicadjustrncr)t.

MOst cconolnisLs believe that t]re Unitcd Sutes is anoptirnal currcncv area. V!'llen üe Unitcd Statcs is facedwith a shock that all'ects tlle diÍIerent rcgions iu¡mmet-rically, labor migration tends to restore balance. Forcxanrple, workerc left the hard-hit northern shtes andnrigrated to the oil-rich southwestern states irfter the<.¡il shocks of the 1970s.

ls Europe an optimal currencv arca? Some econ-o¡niss think it is not because of the rigidiw of itswage structures and the low degree of labor mobil-it1' among the different countries. \{rhen a shock hasoccrrrred-for example, after the 1990 reunificarionof Gcrmanr'-inflexible wages and prices led to ris-ing inflation in the regions with a demand increaseand rising unemplorment in depressecl regions.Monetan, union might therefore condemn llnfor-tunate regions to persistent lorv grouth and highunemployment.

\{'hat is the initial verdict on the EuropeanMoneurry Union? The creation of the Euro hasremored one of the major sorrrces of instability inthe European economy-intra-European exchange-rate movemenls. In addition, it has led to a conver-gence of interest rates and inflation rates amongEuropcirn countries. On the other hand, Europe has

s L :\1 I\f ,\ RY

continued to experience high rrnemplolrtent ratessince the Et¡ro's introdrrction. Tlre fin:rnci:rl crisisof 2007-2009 rvas tlre first nr:rior rcst ¡¡l the Eulo-pean Monetary S,vstem. ¿rnd ec<¡nor.nists rvill strrdvlrorv well this nerv nrrrltin¡itional irrstitution rvt,atlr-ers the storm.

'Ihc t.rrro¡r<,un N{()nctar\ trrrion is o¡rt. r¡l llisto-r.\'s glc:rt cc¡¡nonric c\pcrilncnts. )icvt'r l¡tlirrc Ilnsstrtll a llrrgt':rrr<l ¡lor$c|lLrl gr0tr¡-r ()l c()untt¡(:, tunt('(lits ct¡lrornic lirrtrurcs ()\'(r [() ¿ nrL¡ltirrltiorral lrorlvliLc tlrt' llrrro¡lr':rn (lt'rrtlal llarrk. \cvcl l;t'firc lr:s :r

tt'rrtlal brrrrk lx't'n clriugcrl *'ith the rnat rr)cc(,lonl i(li)r'tun('s r¡l ;t lar-gt qtrrrt¡r ol nations lritll l-125 nlillit¡rr

¡rco¡llc ¡lnrrlrrtin¡¡ lillr trilliorr t¡l utxrrls antl scnitcs.!\'lrilt o¡rtirlrists ¡roirrt to tllc urit lr¡cr ononr ic lrncfitsol lt llrtl¡t t nuu kct lul<l l(,1\('r lr':ur:\ir( lirrtts tosls. ptssi-rrrist: rr,or |r tllrt rn()||( tlü ). rl|rion tlU.clrtcrrs stagn¿rtiollarttl rrrtt'rrr¡llovnl('nI lx'(ausc ol tltt' lack ol ¡tricc arr<l

*agc llt'xibilitr. ¿rrrl insrrllicit nt lalxrr rrrolrilitr iurrt.rngtotr¡rt¡ ics. 'l lrc firr:rrrt ial clisis ol 2(X)7-2(X)t) is the firstItr:rior test of tltis ncrl nl()nct:ut'svstcnl.

FINALASSESSMEN'IThis srrn'e1' of inf erlrational ccorlr¡mics n)ust ackn()wl-edge a r.nixed picture. wirh botlr slrcc(,sscs :urrl lail-r¡res. It is n.tre that mal'ket ecollonries occasion:rlll'sr¡ffer fro¡n inflation and recession. ){orer>r'er, irr thenlost rec('nt dorvntrrrn in 2007-2009, llnemplolmonIrose sharplv and nranv fi¡'rancial gi¿rnLs teetered orrthc eclge of bankrrrptcv. Nonetheless, if rve step back,al¡ impartial.it¡r1 of historians u'otrld srrrely rate thel¿rst half'-cenI rrrl'ns one of unparalleled srrccess for lht'corrnrries of Nortlr Arnt:ri<':r :urd \\bsfern Errrope:

299

Rohu.sl eronontir lmJonn.a ne. 'l'ht- pcriocl llas sccnthe most rapid alr(l sust¿tincd ccononlic growthi¡r rccolclccl lristory. lt is thc onlv periotl sincc theIndrrstrial Rcvoll¡tion irl rvllicll thcsc countricslravc avoidcd dccp cleprcssit.ll and the cancer ofhv¡rcrirr flation.'l-h e ernergin g ¡¡ton?lulj splarz.'l'lrc i¡rtcrnational11)oDct2rr! svstcrn continLres to bc a s(-)rrrce of tur-lrr¡¡il, willr lrcqrrerrt criscs as (ountrics encoun-tcl balance<rflpaytncnLs or cLtrrency difficulties.Norr t'tlrt'lt'ss, w(' ( an s('( all ctncrging system inwlriclr tht- n)aior cconolnic rcgiorrs-the LlnitedStatcs, liLrropc, ancl Japan-conduct indepen-dc¡lt rnonctarv policics with flcxible exchangeratcs, rrhih srrrallcl cotr¡ttries eiürcr float or have"lrarrl" lircd cxcharrgc ratcs tied to t¡ne of then)ajor l)locks. A rnajor challenge fbr the füturewill l;c to intcgratc thc ,¡tsian giarrts Chirra andIndi:l into thc intcr national tradc and financialsystclns.'l'hr reemergtnte olJfue narkcls. You c¡fien hear thatirrritation is thc sirrcerest Ícrrrn ol flattery. In eco-nollics, i¡nitaLiorr occtrrs rvlrcn a nation adoptsthc cconornir stnrcturc ol anothcl in tlre hopethar it $'ill ploducc grorvth anrl stability. ln thclast tr4o dccadcs, coul)trv altcl cor¡Dtrt' tlrlcrvoff tlrc shacklcs of colnn)unisnr ancl stilling ccn-tr-al ¡llanning. l'his occult'c<l not onl\, llccarrsct.colronlics tcxtbooks cxplaitrcd thc ltriraclc o[lhe ñ'ee nr?rrket but prinrarily becarrse pcoplccor¡ld see rvith rlreir oll'n eyes how the nrarkcf-oliented cour.rtries of the \l'est prospered wlrilethe centr:rlll planned command economiesc<rlf:rps<:d. Iin lhc fir.sl tirnc, nn emlnre collnpsedlnt a¡tst il t ould nol ltndurc suffrienl blrltfi nlongu,ilh ilt gt ns.

SUMITIARY

A. Foreign Trade and Economic Activ¡ty

l. Arr o¡lcrr ('((rr()rnv i\ r)n( tlr¿rt crrgirgts irr irrtcrlrirtiorr¿lcx< lrattg< of g<lorls. st'rviccs, ¡rrrl irrvt slrtrcrrts. tix¡rot tsurc go<lds artd seniccs sol<l tr> br¡r'crs orrtsidc the <t¡trn-t11, wlrile imporLs:rr-c those purclraserl Irorn lirrt'igrrcrs.'l'ht' dilli'rcrrce betrveen cx¡lor Lr anrl irn¡xr tr ol grxxlsirn<l st rvict's is cirllrrl ¡rr't cxu¡¡r ts.

2. \!'hen foreign tr¿rde is introduced. domestic demandcarr difler [r<>m rratic¡n;rl output. l)()¡Dcsúc demandcorttplist's co¡lsunlpt¡()n, irtr cstrncnt, irrtd government

¡rru-chases ((: + I + (j). lir obtain (l[)l', cxport-s (Ix)rnust lx a(l(lc(l an(l irnp()rts ( /m) sulrtmctctl, so

(;DP = l.+ /+ (;+ X

300

where X = net exports : lix - Im. Impons are deter-nrincd by dor¡estic irrcome and output along wiür üe¡rri<t's rf dornrxüc goorls relatire to those of fin'cigrgoods: cxpor ts art: drt' rni¡rrlr intagt', rk:tr:rnrincd bv lbr-eign income and outptrt along with rclativc ¡.rriccs. Tlrt'dollar increase of imporls for elch dollar increar i¡r()DP is called üe nrargir.ral propensin'to import (,1fl',2).

3. Forcigrr t.mde has an eflect on (iDP similar to th:rt ofinvcstlncnt 0r l{( rvc r'n rlr(.n t prtrchases.,\s tret exporsrise, therc is an ilrt rt'as<' irr a¡¡gn:gatr' <l<:nra¡rrl lbrdomestic output. Nct cx¡rorts ltcnct lravt'a trtttlti¡rlit'reffect on outpr¡t. But the expenclitrrrc multiplier inan open economy will be smaller thur that in a closedeconomy becatrse of leirkages from spending intoimporrs. 'l'he rnultiplier is

O¡rcrr<'r'orrorrrv rrrrrlti¡rlit'r = =-=+....IÍPS + t)IPn¿

Clearly, other things eqrral, the open-€conorny mul-tiplier is smaller than the closed-economv multiplier',where .llf Pr¿ : 0.

4. The opclariorr ol monetarl policv has neu' implicationsirr an olx-'n econonrv. An inrportant exanrple ir.tvolves

tht: o¡rcration of rnont'tary policy irr a srlall o¡lcrt ccon-omy that has a high dcgrct' of ca¡rital rnobility. Sr¡clr

a counry mttsr align its interest r¿tes $ith th()s('irrthe countries to $hom it pegs is exchange rate. Thismeans that countries operrting on a fixed exchangerate essenúallr'lose monetarv polict'as an independentinstrunlcnt of nra( r()('( on()rrrir' ¡xrlicr'. Fist al ¡rolicy-, b1

conúast, becomes a powerfirl i¡rstnrment bccause fis-

cal stimulus is not offset bv changes in interest rates.5. An open economy oper¡dng wiü flexible exchange

ñrtes can use monetary policv for macroeconomic sta-

bilization whiclr o¡rrates irrdcpcrrdentll-' ol other coun-trics. ln this casc, thc intcnrati<¡nal link arl<ls ant¡thcr'powerfrrl chan¡rel tr¡ üe domestic monetan tr¿nsmis-sion mechanism. .{ moneurry tightening leads to higherinterest rates, att-racd¡rg lbreign firrancial capital andleading to a lisc (ol applcciation) of tlre exchange mte-Tht' t'xr:hangt.mtc a¡rprr'< iatiorr tt'rr<ls to rlt'¡rn'ss rrt'lexports, so this impact reinforces the conu-actionary-'

impact of higher interest rates on domestic inrestmenL

B. Interdependence in the Global Economy

6. In the lorrgel rurr, operating in the global nrarketplacc

¡rrovidcs ncw c()rrstntirrt.s anrl op¡xrr-trrrtitics lil rrrrrrr-tries to improve their economic growth. Perhaps themost imporEnt element concerns saring ancl irrvest-

ment, which are highlv mobile a¡rd resporrd to incen.tives and the investment climate in clillerent countries.

7. 'Ihe fbr-eign sector prorides a¡rodrer source of lündslbr inr€stnrent and a¡rother oudet lbr- s:wing. Higher-

cHAPTER l4 . O Pt_ \-U(:()NOIf\' t\{.\(:ROE(:ONO} CS

domestic srring-whether through prirate saving orgovenl¡nent fisc:rl sr.rrpluses-rrill increase the sum o[rlo¡nestic invesune¡rt and net exrxrrts. Recall the idendw

x:.s+ (7'- (;)- /

Net exporrs = private s;rving+ g()vernment saving

- donrcstic irrvestnrent

In the long run, ¿r c()rrnlrJ's u-zrde position primar-ilv n'flrtts its natiolral sirvirr¡5 artd ill!('stnr(:nt r?tes.

Rcducing a ¡r¿dc rlcfirit rcr¡rrirt's clrarr¡¡irrg dorn<'sti<'

saving irnd investnlent. Onc important nrech¿nism forbringing tnrde flons irr li¡rc with domestic saving andinvestment is the exchlnge rarte.

Besicles promoting high sar,ing ;rnd investment, coun-tries i¡rc¡case their gr()wth rhr-orrgh :r l.icle arrav of poli-cics an<l institrrtions. lrnrrollant conside¡ations are astalllc rnacr ocr on¡rrrric clir¡rate. stron¡{ l)r()[x'rt,v ri¡{htsf<rr both tangible investme¡rts and intellectual propert\,. n convertible crrrrencv rrith few restrictions onfinirncial florvs, ¿rnd poliucal and economic snbiliry.

Internat¡onal Economic lssues

PopLrlar analysis looks at largc tra(lc ([('fi( its anrl sct's"deindustrialization. " But this rnalysis overlooks theimportant disdnctio¡r between productirity and com-

Pcl¡tivencss. (ioDrpctitiveness ¡-elers to lrorv rvell anation's g(xxls (an (onrlx't('irr tlrc global rrralkt't¡rlaccand is deterrnined primarily by relative prices. Prt>ductiriw denotes the level of'orrtprrt per rrnit of input.Real incomes and li\ing st¡rnd:rrds depend primaril;-upon productivin, where:rs the trade and current-accorrrrt ¡rositiorrs rl<'¡rt'rtrl l¡l)on c()rr pclit iveness,

Thcrc is no tlosc lirrkagt'lx'twce n corrr¡rt'titiv<'ncss an<l

p rod rr c tivi tvFixed exchange r?tes ¿rre :r source <¡f instability in a

rvolld ol highly mobile firra¡rcial capital. Recall the furr-(lanl('ntal tlilt'rnrra of fixcrl cxclrarrge r?tes: .^ coun-tr] (ann()t silrrrrltancr¡rrslv havc a fixc<l brrt a<ljrrstalrk'

exchange r¿te, fiee capital and financial movenens,and :rn independent domestic monetarv poliry-'.

In l9'99. Er.rropean cor¡ntries chose to mo\'e to a com-nr('n crrrr('n(-\'alrrl a ruril¿lv cclttlal bank. ;\ co¡lt¡llt¡lt('ulr('n(

?v is a¡r¡llo¡rriatt' wlrcrr a rt'¡4iorr firrrrrs an opti-ntal ctrrrclrt,v are a. Advocatcs of Etrro¡-rcarr rn()n('talvtunion point to rhe improved predicurbilitl, lorvertr¿nsactions coss. and potential tbr better capiurlalkrcation. Skeptics rvorry that a conlulorr currenc\,-lik<' any irrcvocably fixtxl ('x.hange-mte svste¡n-willrcr¡rrirt' fk'xiblt' wagcs arrrl ¡rrict's to l)r()rn(¡te a(ljrtst-nl('lrl l(r rra( r(['( 0no||¡it slrrlck".

8.

c.9.

10.

ll.

301

(: - I+ (; r X ( rr\( firr rr¡x rr

c( ()ll() l\

rrct c\l)r)rts : -\: /r l¡¡t

(lolr)('st ¡( <lt'¡larttl r s. :'¡lcrtrlittgorr ( il)l)

rnnrgirral ¡rlo¡rcrtsitr t() irnl¡r)r I

(,\l/'lr)

CONCEPTS FOR REVIEW

c r¡rcr rr litr rrc rrrrrlti¡rlicr:in clt¡scd cc()nl¡n\' : l,/,11/lsl ()l)('lI cc()n()nl\' =

L/ (,1t15 + .u/rr¡)irr¡r.rr I ol trirrk' llr¡rvs lrrrrl cxclr:rrrl¡r'

nrtcs ou (il)l'

sir\ir|!.1-ir|\( \Ilr|( rIt irlt'rrtitr irr o¡rt'rrccorrr>nrics: X=,lt(7 O) I

cr¡rrilibratiorr in sali lrg- irrvcstrncrr t¡u.rr-ket irr t losccl irn<l <rpen( ( ( Il{ )tlur's

gr()rrllr J)()lici('s irr tlrc o¡rctr ((()nonlvt, rrrr ¡lt't it ilcrr< ss r s. pr rrdrrctivitl

FURTHER READING AND INTERNET WEBSITES

Further Reading

lf r( rffr(,t¡ti()r) lron tlrt' Itortotn lltltort ol tltt I'utttltnl,2l.lf.,/,f ((;()\( r'rnr( r)r I)tintinS, ()ffict. \\'irslrinut¡r¡r. l)-(1..

:0{Xl). c:fn rrlso lrt'li¡urrd ú lfurvt: ú louilul.org/ lruhliru liort t/l.lll'. 1t1t. !3 1-!3ir.

Websites

l)nur r¡n ulr<lc lurrl Iirrlrtr<'r' Iirr <lilfi r< rrI ¡¡rr¡tttri¡'s r:ul lxfi¡rr¡rrl in lhc stlcti()rr,rr rr'cbsitts lirr (.lra¡rtt'r' li?

Rolxrt \lrlrrltll rron tlrr' ¡..¡rlxl l)rizt in lfX)l) firr'Iris t r¡rrtril¡t¡tiotr tr¡ irttct nlttir¡n:rl lnir( t(x ( (,n(,nti( \. \¡isiltr'¡nt, nt'l¡4 u'/hrtttlalt: to ¡-c¡<l alrout his c<ln tribr¡ tiorr.

Tlrt rrr'frsilt'rrf tlx l.rrrrr¡x:rrr (i ntral Ra¡¡1, ¿l untn'.c¡l¡.inI/uh/htnl/inltx.nt./rtlrl. exphirrs somc of thc issrrcs inr'olvcdin tlrt rrranagrrrrt'¡r t ¡¡l the l'lurrr. llsr¡ sec th('\rtcs listed li)r( ihaptc r l '.1.

QUESTTONS FOR DISCUSSTON

2.

l. \sr¡¡rtc tlt¡t rttt ct ¡t:r rrsiorr i.trr ur()llttitr-r ¡t<llicr lt'rrds toa rlcclirrt'or rle¡lcriatiort t¡l tlx t .S. rl<¡llar rcl¡tir'<' tollrc r rr¡ rc||r-it s ()l ,\rttt |it a s t|arlittg l)irr lt1('r s ¡n lh( sllorl¡urr r.itlr rrrrt rrr¡r|orcrI r(\(,rt{(\. t.r¡llairr tlrc rrrttlra-¡lis¡n br rrlricll tlris rrill ¡lrrxlrrtt lrr t<orrrrttric ct¡lrn-siorr i¡r tlrt'L'rritc<l Surtts. [xplairr lror, thc ua(l{ inrl)ir( t

¡r'irrlirr', t s llr( inrl)ir( I on tlortt sli¡ in\r'snrr'nll.,rplairr tlrc sllt¡rt-rr¡n irrr¡rnct u¡-lon rtt't t'x¡;olts ;ur<l(il)l' r¡l tlrc li¡llt¡uins irt tlrt' rurrlti¡rlicr r))(xlcl, lrsit)g'klrlc l*'l trltctt' ¡xrssilrlt :

a. \rr irrr r(:r\( irr ¡|l\( stl|r( t|t ( / ) ()f Sl(X] l¡illirrllb, '\ dct r cast' itt gotct tttttt ttl ¡lttt lr:rst s ( li) of'

Si¡l) billi<¡nr.. ,\¡l i¡lcrt:rs< rn loltigrr ()utput rr'l)i(h irtcrt'ltst'<l

cr¡rr rlts lrr Sl0 billiond. ,\ rk ¡rrrr ilrliorr of llrc cxr Ir.rnur' r,ll(' llrilt rius('(l

( \J)r)rts l^ SllO lrilli¡r¡r itttrl lr¡rrcrt rl ilr¡xrrts ll S20lrillir¡rr lrt crt r r lcrr'l ¡¡l ( ll)l)

\\'hlt rrorrlcl thc t'x¡rcnditulr rnrrlti¡rlicr-lrc i¡l ul¡ ccor-¡rnlr rritlror¡t l{(}\('r'nDl('nt s¡rttt<littg ()r tir\c\ \\hcl'e thc

,\l/{l is o.S ¡rrd tlrt ,ll/'¿¡ is (}r \\'lrt'rc tlrc ill/)¿r is 0.1?

\\'hcrc rlrc :\f/'rz is 0.!)? lixplairr rvll rhc rrrultiplierrn¡gllt ('\(.n bc lcss tharr l.( i¡nsirk l lablc l.t-ll.a. l.r¡rl.rirr r'¿t lr ol tlrr'('ntri('s in tht' trblt:.b. .\tl¡l rrrrotlrtr rolr¡rnrr rritlr tlr<' lrcatlirrl.i "(ilrartgc

ir irt('r(\t ri¡t<s- tolirlrlt'll-li Tlrcrr. ()rr tlt( l);rsis

of tlrc gr-a¡rlr irr l-igrrr t' 14.7. fill in tlrt talrlt firr ¿

cl<¡scrl <'< ort<lnlt.,\n c¡llirt<'rrl lllacrotc()ll()nrist reccntl\' \\'rr)tc:'J\f oringt()ward ll llt()n('lAr-\ uni()l) b\ ldoptinf{ it (onlm()¡) ctrr-rt.rrr l is rlol lt'¡llr' ¡b<¡rrt tht crrllencr-. 'l ltc nlost intp()r-lilnt fa( t()r is tlr¿rt cr¡rrrtr icr ir tlrc rrnion rnust agr('(' orl;t sirrgle monctun policl lirr tlr('cr1(ir c lcgion.' Ex¡llaittthis srirrenlcllt. \l hr, nright ir(l()pting a single ntortetan

¡lrlit v carrse tr<¡ttl¡lcsi'(irnsrcler thc cit\ ()l \cu llr'¡nc¡r. rr'hich is:r verl'()lx ¡l (r()n(¡n1\. IIlc cit\ c\p()lts reliqr¡arics .Urd has

n{, i||\('\IIrl( rlI or tirx(.\. Tlrt < ilr's rt'sidc¡lts c(}nsunleirO ¡r< r'< crrt ol-thcir- dis¡rosablc inr.r ¡rr ¡t's, u¡ ttl 1)l) ¡tct t t't t l

5.

6.

:i.

302

of all prrrchases are imports from üe rest of thc cor¡n-try The mavor proposes leq'ing a tax of $100 millionto spend on a public-works progr.rm. -\layor (lains

argues that output and incomes in tlre city will Iisenicclv bccarrsc of sonrething callcd "thc nrrr lt i¡rlit.r:"Estimate the impact of the publíc'rvorks progmm onthe incomes and output of New Heaven. l)o yotr irgreewith the nrayor's :rssessment?

7. Rcvicw thc brrllctcd list of the (hr¡.:r: intcr¿r'tirl¡¡s Of

saürtg, investmen t, and tr¿dc on l)age 293. Makc a

graph like that of Figure 1+8 to illustrare each of rheimpacrs. Make sure that you can explairr the reversecases mentioned in the paragrirph that lbllows the brrl-leted list.

L Politi<:ia¡rs oit<:rr <lccry thc lar¡¡t: tratlc <lclicit of tllcfTnitecl States. Economists reply that to rcduce thctrade deficit worrld require a L¡x increase ¡rr a crrr ingovernment expenditures. Explairr the ec()nomisL,i'riew using the analysis of-the saving-invcst rncr l l)al-attc<'irt Figurc 148. .Also, cxplairr thc qrrotatiou firrrrr¡he licornmit IlrPml 2000 on page 281 .

9. Look back at Figure l2-2 and make srrre you urrder-srand it. \ow, consider an emerging-market cou¡rtn,like Brazil or Argentina.a, Draw a diagram like l'igure l*9(á) fbr the corrntry

in goocl tinres, when üc risk pn'rrrirrrn r¡n it-s lxr¡-r-owing is low. Call tlris Fisr¡rr: A.

b. Ncxt, ct¡nsider a shock that raiscs thc risk pn'-mium by a large amount. Dr¿w a new figtrre withthe high premium and the nerv equilibrirrrn. (Jall

this Figure B.c. Now compare the cqrrilibria in Figult's A arrrl B.

Spccifi<:ally, cxplain thr: <liflirr<'ncc in (i) tlrt't'r¡rri-lil¡riurn domcstic real intcrcst rate. (ii) dr¡lnesticinvestment, (iii) the exchangc rare, and (iv) nerexPorts.

10. Consider the exanrple of small opeD economie s likeBelgiurn and the Netherlands that hav<'hi¡¡lrly rrrolrilc

CHAPTER l4 . ()PEN-ECON O:vf1' ITIACROE(:ONOMI(lS

finrncial capitirl and fixed exchange rates but alsohave high governmenr budget deficis. Suppose thatthese cour.ltries lind thenrselves in a deplessed eco-trotnic cotrditiorr. with low oLrl¡rut and lrigh unr-nr¡llor'-rnt'rrt. Ex¡rlairr why thcy cannot use monetary policvto stimulate their economies. lVhy would fiscal expan-sion be ellective if they corrlcl tolerate higher budgetde licits?

I l. Advanced problem. Af lcr thc rcrrnific¿tion of Ger-rnanv, f)aynrents to rebuild the former East Germanyled to a major expansion of aggregate demancl in Ger-many.'l'l.tc (iernran ccntral bank r-esponded by raising(ienn;ut rcal interest rates. These actions trxrk ¡rlar:t'in tll(' ( ()nl(:xl ol tlrt: Errro¡rcarr Monctarl Systcrn, irrrvlri<ll rrrost cor¡ntries had fixcd exchange rates andwhcr c the Clerman central bank was dom inant in mon-eurn policy.a. Bxplain lvhy liuropean corultr-ies having fixed t-x-

r lrarrgr: rat<'s arrcl followitrg the lcacl of tlre C,cnnanccnrral barrk rvorrld fi¡rd their interest rates risingalong üth (lennan interest rates. Explain why oüerl',rrropean countries rvotrld thereby be plrrnged intodeep reccssions.

b. Explair.r whv countries would prefer the EuropeanI\loncur1 [-'niorr to thc carlier svstcrn.

c. Tta( (' tltrorr¡¡h wh1, this Cierman nronetary tighten-irr¡; worrld be expected to lead to a depleciationof tlrc dollar. Explain wh1- the depreciarion wouldsti¡nr¡late economic :rctiriry in rhe United Sutes.

12. Advanced problem. Reread the definition ol the Iün-(lan)cntal trilt'nrura as rrcll as thc <liscr¡,ssion lrv ParrlKr ugrnarr orr pa¡¡c 297. Explain why the threc element,scannot go together \{'lrv is there not a fundamenLlltrilc¡nma lilr thc. fixcd-exchange-rarc s\srem between'Califi¡rnia doll;rrs" arrd "Texas dollars"? Explirin howthe rile mma would apply to (;lrina today. Explain theargrur('rrt,s f-or-and againsl cach ¡r[ tht: lhrcr: ¡xrssihk'lhoircs irr thc trilcnrma described by Kmgrnan,