Part 3 Exchange Rates and Open-Economy Macroeconomics 323

13 National Income Accounting and the Balance of Payments 323

14 Exchange Rates and the Foreign Exchange Market:

350

384

414

451

An Asset Approach

15 Money, Interest Rates, and Exchange Rates

16 Price Levels and the Exchange Rate in the Long Run

17 Output and the Exchange Rate in the Short Run

18 Fixed Exchange Rates and Foreign Exchange Intervention 493

Part 4 International Macroeconomic Policy 534

534

587

616

19 International Monetary Systems: An Historical Overview

20 Optimum Currency Areas and the European Experience

21 Financial Globalization: Opportunity and Crisis

22 Developing Countries: Growth, Crisis, and Reform 649

Mathematical Postscripts

Postscript to Chapter 21: Risk Aversion and International Portfolio
Diversification 691

Credits 698

Index 699

viii

ix

Contents

Preface xvi

Part 3 Exchange Rates and Open-Economy Macroeconomics 323

13 National Income Accounting and the Balance of Payments 323

The National Income Accounts325

National Product and National Income326

Capital Depreciation and International Transfers327

Gross Domestic Product327

National Income Accounting for an Open Economy328

Consumption328

Investment328

Government Purchases329

The National Income Identity for an Open Economy329

An Imaginary Open Economy329

The Current Account and Foreign Indebtedness330

Saving and the Current Account332

Private and Government Saving333

CASE STUDY: Government Deficit Reduction May Not Increase

the Current Account Surplus334

The Balance of Payments Accounts336

Examples of Paired Transactions337

The Fundamental Balance of Payments Identity338

The Current Account, Once Again339

The Capital Account340

The Financial Account340

Net Errors and Omissions341

Official Reserve Transactions342

CASE STUDY: The Assets and Liabilities of the World’s Biggest Debtor343

Summary346

14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 350

Exchange Rates and International Transactions351

Domestic and Foreign Prices351

Exchange Rates and Relative Prices353

The Foreign Exchange Market354

The Actors354

Characteristics of the Market355

Spot Rates and Forward Rates356

Foreign Exchange Swaps358

Futures and Options358

The Demand for Foreign Currency Assets358

Assets and Asset Returns359

BOX: Nondeliverable Forward Exchange Trading in Asia360

Risk and Liquidity362

Interest Rates362

Exchange Rates and Asset Returns364

A Simple Rule364

Return, Risk, and Liquidity in the Foreign Exchange Market366

Equilibrium in the Foreign Exchange Market367

Interest Parity: The Basic Equilibrium Condition367

How Changes in the Current Exchange Rate Affect Expected Returns368

The Equilibrium Exchange Rate369

Interest Rates, Expectations, and Equilibrium371

The Effect of Changing Interest Rates on the Current Exchange Rate372

The Effect of Changing Expectations on the Current Exchange Rate373

x Contents

CASE STUDY: What Explains the Carry Trade?374

Summary376

Appendix: Forward Exchange Rates and Covered

Interest Parity381

384

Money Defined: A Brief Review385

Money as a Medium of Exchange385

Money as a Unit of Account385

Money as a Store of Value386

What Is Money?386

How the Money Supply Is Determined386

The Demand for Money by Individuals387

Expected Return387

Risk388

Liquidity388

Aggregate Money Demand388

The Equilibrium Interest Rate: The Interaction of Money

Supply and Demand390

Equilibrium in the Money Market390

Interest Rates and the Money Supply392

Output and the Interest Rate393

The Money Supply and the Exchange Rate in the Short Run393

Linking Money, the Interest Rate, and the Exchange Rate394

U.S. Money Supply and the Dollar/Euro Exchange Rate395

Europe’s Money Supply and the Dollar/Euro Exchange
Rate396

Money, the Price Level, and the Exchange Rate in the Long Run398

Money and Money Prices399

The Long-Run Effects of Money Supply Changes399

Empirical Evidence on Money Supplies and Price Levels400

Money and the Exchange Rate in the Long Run401

Inflation and Exchange Rate Dynamics402

Short-Run Price Rigidity versus Long-Run Price Flexibility402

BOX: Money Supply Growth and Hyperinflation in Bolivia404

Permanent Money Supply Changes and the Exchange Rate404

Exchange Rate Overshooting407

CASE STUDY: Can Higher Inflation Lead to Currency Appreciation?

The Implications of Inflation Targeting408

Summary411

414

The Law of One Price415

Purchasing Power Parity416

The Relationship Between PPP and the Law of One Price416

Absolute PPP and Relative PPP417

A Long-Run Exchange Rate Model Based on PPP418

The Fundamental Equation of the Monetary Approach418

15 Money, Interest Rates, and Exchange Rates

16 Price Levels and the Exchange Rate in the Long Run

Ongoing Inflation, Interest Parity, and PPP420

The Fisher Effect421

Empirical Evidence on PPP and the Law of One Price424

Explaining the Problems with PPP425

Trade Barriers and Nontradables426

Departures from Free Competition427

Differences in Consumption Patterns and Price Level Measurement427

Contents xi

BOX: Some Meaty Evidence on the Law of One Price428

PPP in the Short Run and in the Long Run430

CASE STUDY: Why Price Levels Are Lower in Poorer Countries431

Beyond Purchasing Power Parity: A General Model of Long-Run

Exchange Rates433

The Real Exchange Rate434

Demand, Supply, and the Long-Run Real Exchange Rate435

BOX: Sticky Prices and the Law of One Price: Evidence

from Scandinavian Duty-Free Shops436

Nominal and Real Exchange Rates in Long-Run Equilibrium438

International Interest Rate Differences and the Real Exchange Rate440

Real Interest Parity442

Summary443

Appendix: The Fisher Effect, the Interest Rate, and the Exchange Rate

Under the Flexible-Price Monetary Approach448

17 Output and the Exchange Rate in the Short Run 451

Determinants of Aggregate Demand in an Open Economy452

Determinants of Consumption Demand452

Determinants of the Current Account453

How Real Exchange Rate Changes Affect the Current Account454

How Disposable Income Changes Affect the Current Account454

The Equation of Aggregate Demand455

The Real Exchange Rate and Aggregate Demand455

Real Income and Aggregate Demand455

How Output Is Determined in the Short Run456

Output Market Equilibrium in the Short Run: The DD Schedule458

Output, the Exchange Rate, and Output Market Equilibrium458

Deriving the DD Schedule459

Factors That Shift the DD Schedule459

Asset Market Equilibrium in the Short Run: The AA Schedule462

Output, the Exchange Rate, and Asset Market Equilibrium462

Deriving the AA Schedule464

Factors That Shift the AA Schedule464

Short-Run Equilibrium for an Open Economy: Putting the DD and AA

Schedules Together465

Temporary Changes in Monetary and Fiscal Policy467

Monetary Policy468

Fiscal Policy468

Policies to Maintain Full Employment469

Inflation Bias and Other Problems of Policy Formulation471

Permanent Shifts in Monetary and Fiscal Policy472

A Permanent Increase in the Money Supply472

Adjustment to a Permanent Increase in the Money Supply472

A Permanent Fiscal Expansion474

xii Contents

Macroeconomic Policies and the Current Account476

Gradual Trade Flow Adjustment and Current Account Dynamics477

The J-Curve477

Exchange Rate Pass-Through and Inflation479

BOX: Exchange Rates and the Current Account480

The Liquidity Trap481

Summary484

Appendix 1: Intertemporal Trade and Consumption Demand488

Appendix 2: The Marshall-Lerner Condition and Empirical

Estimates of Trade Elasticities490

18 Fixed Exchange Rates and Foreign Exchange Intervention 493

Why Study Fixed Exchange Rates?494

Central Bank Intervention and the Money Supply495

The Central Bank Balance Sheet and the Money Supply495

Foreign Exchange Intervention and the Money Supply497

Sterilization497

The Balance of Payments and the Money Supply498

How the Central Bank Fixes the Exchange Rate499

Foreign Exchange Market Equilibrium Under a Fixed Exchange Rate499

Money Market Equilibrium Under a Fixed Exchange Rate500

A Diagrammatic Analysis501

Stabilization Policies with a Fixed Exchange Rate502

Monetary Policy502

Fiscal Policy503

Changes in the Exchange Rate504

Adjustment to Fiscal Policy and Exchange Rate Changes506

Balance of Payments Crises and Capital Flight506

Managed Floating and Sterilized Intervention509

Perfect Asset Substitutability and the Ineffectiveness of Sterilized
Intervention509

BOX: Brazil’s 1998–1999 Balance
of Payments Crisis510

Foreign Exchange Market Equilibrium Under Imperfect Asset Substitutability511

The Effects of Sterilized Intervention with Imperfect Asset Substitutability512

Evidence on the Effects of Sterilized Intervention513

Reserve Currencies in the World Monetary System514

The Mechanics of a Reserve Currency Standard515

The Asymmetric Position of the Reserve Center515

The Gold Standard516

The Mechanics of a Gold Standard516

Symmetric Monetary Adjustment Under a Gold Standard517

Benefits and Drawbacks of the Gold Standard517

The Bimetallic Standard518

The Gold Exchange Standard519

CASE STUDY: The Demand for International Reserves519

Summary523

Appendix 1: Equilibrium in the Foreign Exchange Market

with Imperfect Asset Substitutability528

Demand528

Supply529

Equilibrium529

Appendix 2: The Timing of Balance of Payments Crises531

Part 4 International Macroeconomic Policy 534

19 International Monetary Systems: An Historical Overview 534

Macroeconomic Policy Goals in an Open Economy535

Internal Balance: Full Employment and Price Level Stability536

External Balance: The Optimal Level of the Current Account537

Classifying Monetary Systems: The Open-Economy Trilemma539

Contents xiii

International Macroeconomic Policy Under

the Gold Standard, 1870–1914540

Origins of the Gold Standard541

External Balance Under the Gold Standard541

The Price-Specie-Flow Mechanism541

The Gold Standard “Rules of the Game”: Myth and Reality542

Internal Balance Under the Gold Standard543

BOX: Hume versus the Mercantilists544

CASE STUDY: Gold Smuggling and the Birth of the UAE Dirham544

The Interwar Years, 1918–1939546

The Fleeting Return to Gold546

International Economic Disintegration546

CASE STUDY: The International Gold Standard and the Great Depression547

The Bretton Woods System and the International Monetary Fund548

Goals and Structure of the IMF549

Convertibility and the Expansion of Private Financial Flows550

Speculative Capital Flows and Crises551

Analyzing Policy Options for Reaching Internal and External Balance551

Maintaining Internal Balance552

Maintaining External Balance553

Expenditure-Changing and Expenditure-Switching Policies554

The External Balance Problem of the United States Under Bretton Woods555

CASE STUDY: The End of Bretton Woods, Worldwide Inflation,

and the Transition to Floating Rates556

The Mechanics of Imported Inflation558

Assessment559

The Case for Floating Exchange Rates559

Monetary Policy Autonomy.560

Symmetry.561

Exchange Rates as Automatic Stabilizers561

Exchange Rates and External Balance563

CASE STUDY: Monetary Regimes in Europe Post Bretton Woods563

Macroeconomic Interdependence Under a Floating Rate567

CASE STUDY: Transformation and Crisis in the World Economy568

What Has Been Learned Since 1973?574

Monetary Policy Autonomy.574

Symmetry.575

The Exchange Rate as an Automatic Stabilizer576

External Balance576

The Problem of Policy Coordination577

Are Fixed Exchange Rates Even an Option for Most Countries?577

Summary578

Appendix: International Policy Coordination Failures584

20 Optimum Currency Areas and the European Experience 587

How the European Single Currency Evolved589

What Has Driven European Monetary Cooperation?589

The European Monetary System, 1979–1998590

German Monetary Dominance and the Credibility Theory of the EMS591

Market Integration Initiatives592

European Economic and Monetary Union593

The Euro and Economic Policy in the Euro Zone594

The Maastricht Convergence Criteria and the Stability and Growth Pact594

xiv Contents

The European System of Central Banks595

The Revised Exchange Rate Mechanism596

The Theory of Optimum Currency Areas596

Economic Integration and the Benefits of a Fixed Exchange Rate Area: The GG
Schedule596

Economic Integration and the Costs of a Fixed Exchange Rate Area: The LL
Schedule598

The Decision to Join a Currency Area: Putting the GG and LL Schedules
Together600

What Is an Optimum Currency Area?602

CASE STUDY: Is Europe an Optimum Currency Area?602

The Future of EMU608

BOX: The Euro Zone Debt Crisis of 2010610

Summary612

21 Financial Globalization: Opportunity and Crisis 616

The International Capital Market and the Gains from Trade617

Three Types of Gain from Trade617

Risk Aversion618

Portfolio Diversification as a Motive for International Asset Trade619

The Menu of International Assets: Debt versus Equity620

International Banking and the International Capital Market620

The Structure of the International Capital Market621

Offshore Banking and Offshore Currency Trading622

The Growth of Eurocurrency Trading623

The Importance of Regulatory Asymmetries624

The Shadow Banking System624

Regulating International Banking625

The Problem of Bank Failure625

CASE STUDY: Moral Hazard627

Difficulties in Regulating International Banking628

BOX: The Simple Algebra of Moral Hazard629

International Regulatory Cooperation629

CASE STUDY: Two Episodes of Market Turmoil: LTCM and the Global Financial

Crisis of 2007–2009631

BOX: Foreign Exchange Instability and Central Bank Swap Lines636

How Well Have International Financial Markets Allocated Capital and Risk?638

The Extent of International Portfolio Diversification638

The Extent of Intertemporal Trade640

Onshore-Offshore Interest Differentials641

The Efficiency of the Foreign Exchange Market641

Summary645

22 Developing Countries: Growth, Crisis, and Reform 649

Income, Wealth, and Growth in the World Economy650

The Gap Between Rich and Poor650

Has the World Income Gap Narrowed Over Time?651

Structural Features of Developing Countries653

Developing-Country Borrowing and Debt656

The Economics of Financial Inflows to Developing Countries656

The Problem of Default657

Alternative Forms of Financial Inflow659

The Problem of “Original Sin”661

The Debt Crisis of the 1980s662

Reforms, Capital Inflows, and the Return of Crisis663

East Asia: Success and Crisis666

The East Asian Economic Miracle666

Contents xv

BOX: Why Have Developing Countries Accumulated Such High Levels

of International Reserves?667

Asian Weaknesses669

BOX: What Did East Asia Do Right?670

The Asian Financial Crisis671

Spillover to Russia672

CASE STUDY: Can Currency Boards Make Fixed Exchange Rates Credible?674

Lessons of Developing-Country Crises676

Reforming the World’s Financial “Architecture”677

Capital Mobility and the Trilemma of the Exchange Rate Regime678

“Prophylactic” Measures679

Coping with Crisis680

CASE STUDY: China’s Undervalued Currency681

Understanding Global Capital Flows and the Global Distribution of Income:

Is Geography Destiny?683

Summary686

Postscript to Chapter 21: Risk Aversion and International Portfolio
Diversification691

An Analytical Derivation of the Optimal Portfolio691

A Diagrammatic Derivation of the Optimal Portfolio692

The Effects of Changing Rates of Return695

Credits 698

Index 699