International Economics

International Economics: Theory and
Policy
Twelfth Edition
Chapter 17
Output and the Exchange
Rate in the Short Run
Copyright © 2022, 2018, 2015 Pearson Education, Inc. All Rights Reserved
Learning Objectives (1 of 2)
17.1 Explain the role of the real exchange rate in
determining the aggregate demand for a country’s output.
17.2 See how an open economy’s short-run equilibrium can
be analyzed as the intersection of an asset market
equilibrium schedule (AA) and an output market equilibrium
schedule (DD).
17.3 Understand how monetary and fiscal policies affect the
exchange rate and national output in the short run.
17.4 Describe and interpret the long-run effects of
permanent macroeconomic policy changes.
17.5 Explain the relationship among macroeconomic
policies, the current account balance, and the exchange
rate.
Preview
• Determinants of aggregate demand in the short run
• A short-run model of output markets
• A short-run model of asset markets
• A short-run model for both output markets and asset markets
• Effects of temporary and permanent changes in monetary and
fiscal policies
• Adjustment of the current account over time
• IS-LM model
Introduction
• Long-run models are useful when all prices of inputs and
outputs have time to adjust.
• In the short run, some prices of inputs and outputs may
not have time to adjust, due to labor contracts, costs of
adjustment, or imperfect information about willingness of
customers to pay at different prices.
• This chapter builds on the short-run and long-run models
of exchange rates to explain how output is related to
exchange rates in the short run.
– It shows how macroeconomic policies can affect
production, employment, and the current account.
Determinants of Aggregate Demand (1 of 3)
• Aggregate demand is the aggregate amount of goods
and services that individuals and institutions are willing to
buy:
1. consumption expenditure
2. investment expenditure
3. government purchases
4. net expenditure by foreigners: the current account
• Determinants of consumption expenditure include:
– Disposable income: income from production (Y)
minus taxes (T).
– More disposable income means more consumption
expenditure, but consumption typically increases less
than the amount that disposable income increases.
– Real interest rates may influence the amount of
saving and spending on consumption goods, but we
assume that they are relatively unimportant here.
– Wealth may also influence consumption expenditure,
but we assume that it is relatively unimportant here.
• Determinants of the current account include:
– Real exchange rate: prices of foreign products relative to
the prices of domestic products, both measured in
WP *
domestic currency:
P
▪ As the prices of foreign products rise relative to those

of domestic products, expenditure on domestic
products rises, and expenditure on foreign products
falls.
– Disposable income: more disposable income means
more expenditure on foreign products (imports).
Table 17.1 Factors Determining the
Current Account
Change Effect on Current Account, CA
EP *
Real exchange rate, CA
P
C A upward arrow
start fraction E P asterisk over P end fraction upward arrow
EP * CA ¯
Real exchange rate, ¯ C A downward arrow
P
start fraction E P asterisk over P end fraction downward arrow
Disposable income, Y d Y super d upward arrow
CA ¯
C A downward arrow
Disposable income, Y ¯
d
CA
C A upward arrow
Y super d downward arrow
How Real Exchange Rate Changes Affect
the Current Account (1 of 2)
• The current account measures the value of exports relative to the value
of imports: CA » EX - IM.
EP *
– When the real exchange rate rises, the prices
P
of foreign products rise relative to the prices of domestic products.
1. The volume of exports that are bought by foreigners rises.

2. The volume of imports that are bought by domestic
residents falls.
3. The value of imports in terms of domestic products rises: the
value/price of imports rises, since foreign products are more
valuable/expensive.
How Real Exchange Rate Changes Affect
the Current Account (2 of 2)
• If the volumes of imports and exports do not change much, the
value effect may dominate the volume effect when the real
exchange rate changes.
– For example, contract obligations to buy fixed amounts of
products may cause the volume effect to be small.
• However, evidence indicates that for most countries the
volume effect dominates the value effect after 1 year or less.
• Let’s assume for now that a real depreciation leads to an
increase in the current account: the volume effect dominates
the value effect.
Figure 17.1 Aggregate Demand as a
Function of Output
EP *
Aggregate demand is a function of the real exchange rate , disposable
P
income (Y - T ), investment demand (I), and government spending (G). If all
other factors remain unchanged, a rise in output (real income), Y, increases
aggregate demand. Because the increase in aggregate demand is less than the
increase in output, the slope of the aggregate demand function is less than 1 (as
indicated by its position within the 45-degree angle).
• Determinants of the current account include:
– Real exchange rate: an increase in the real
exchange rate increases the current account.
– Disposable income: an increase in the disposable
income decreases the current account.
• For simplicity, we assume that exogenous political factors
determine government purchases G and the level of
taxes T.
• For simplicity, we currently assume that investment
expenditure I is determined by exogenous business
decisions.
– A more complicated model shows that investment
depends on the cost of spending or borrowing to
finance investment: the interest rate.
• Aggregate demand is therefore expressed as:
æ EP * ö
D = C (Y -T ) + I + G + CA ç ,Y -T ÷
è P ø
– where C (Y - T ) is consumption expenditure as a
function of disposable income,
– I + G is investment expenditure and government purchases
(both exogenous), and
æ EP * ö is the current account as a function of the real
– CA ç ,Y -T ÷
è P ø
exchange rate and disposable income.
æ EP * ö
• Or more simply: D = Dç ,Y - T , I,G ÷
è P ø
• Determinants of aggregate demand include:
– Real exchange rate: an increase in the real exchange rate
increases the current account, and therefore increases
aggregate demand of domestic products.
– Disposable income: an increase in the disposable income
increases consumption expenditure, but decreases the current
account.
▪ Since consumption expenditure is usually greater than
expenditure on foreign products, the first effect dominates
the second effect.
▪ As income increases for a given level of taxes, aggregate
consumption expenditure and aggregate demand increase
by less than income.
Short-Run Equilibrium for Aggregate
Demand and Output
• Equilibrium is achieved when the value of output and
income from production Y equals the value of aggregate
demand D
æ EP * ö
Y = Dç ,Y -T , I,G ÷
è P ø
– where aggregate demand is a function of the real

exchange rate, disposable income, investment
expenditure, and government purchases.
Figure 17.2 The Determination of Output
in the Short Run
In the short run, output settles at Y 1 (point 1), where aggregate

demand, D1, equals aggregate output, Y .
1
Short-Run Equilibrium and the Exchange
Rate: DD Schedule (1 of 2)
• How does the exchange rate affect the short-run equilibrium of
aggregate demand and output?
• With fixed domestic and foreign levels of average prices, a rise
in the nominal exchange rate makes foreign goods and
services more expensive relative to domestic goods and
services.
• A rise in the nominal exchange rate (a domestic currency
depreciation) increases aggregate demand of domestic
products.
• In equilibrium, production will increase to match the higher
aggregate demand.
Figure 17.3 Output Effect of a Currency
Depreciation with Fixed Output Prices
A rise in the exchange rate from E 1 to E 2 (a currency depreciation)

raises aggregate demand to Aggregate demand (E 2 ) and output to
Y 2 , all else equal.
Figure 17.4 Deriving the DD Schedule
The DD schedule (shown in the lower panel) slopes upward because a rise in the
exchange rate from E 1 to E 2 all else equal, causes output to rise from Y 1 to Y 2 .
Short-Run Equilibrium and the Exchange
Rate: DD Schedule (2 of 2)
DD schedule
• shows combinations of output and the exchange rate at
which the output market is in short-run equilibrium (such
that aggregate demand = aggregate output).
• slopes upward because a rise in the exchange rate
causes aggregate demand and aggregate output to rise.
Shifting the DD Curve (1 of 3)
• Changes in the exchange rate cause movements along a
DD curve. Other changes cause it to shift:
1. Changes in G: more government purchases cause

higher aggregate demand and output in equilibrium.
Output increases for every exchange rate: the DD curve
shifts right.
2. Changes in T: lower taxes generally increase
consumption expenditure, increasing aggregate
demand and output in equilibrium for every exchange
rate: the DD curve shifts right.
Figure 17.5 Government Demand and the
Position of the DD Schedule
A rise in government demand from G1 to G 2 raises output at every level of

the exchange rate. The change therefore shifts DD to the right.
3. Changes in I: higher investment expenditure shifts the
DD curve right.
4. Changes in P: higher domestic prices make domestic
output more expensive compared to foreign output and
reduce net export demand, shifting the DD curve left.
5. Changes in P*: higher foreign prices make domestic
output less expensive compared to foreign output and
increase net export demand, shifting the DD curve right.
6. Changes in C: willingness to consume more and save
less shifts the DD curve right.
7. Changes in demand of domestic goods relative to
foreign goods: willingness to consume more domestic
goods relative to foreign goods shifts the DD curve right.
Short-Run Equilibrium in Asset Markets (1 of 2)
• Consider two sets of asset markets:
1. Foreign exchange markets
– interest parity represents equilibrium: R = R *

+
(E e
-E )
E
2. Money market
– Equilibrium occurs when the quantity of real monetary assets

supplied matches the quantity of real monetary
MS
assets demanded: = L ( R,Y )
P
– A rise in income from production causes the demand of real

monetary assets to increase.
Figure 17.6 Output and the Exchange
Rate in Asset Market Equilibrium
For the asset (foreign exchange and money) markets to remain in equilibrium,
a rise in output must be accompanied by an appreciation of the currency, all
else equal.
Short-Run Equilibrium in Asset Markets (2 of 2)
• When income and production increase,

– demand of real monetary assets increases,
– leading to an increase in domestic interest rates,
– leading to an appreciation of the domestic currency.
• Recall that an appreciation of the domestic currency is
represented by a fall in E.
• When income and production decrease, the domestic
currency depreciates and E rises.
Short-Run Equilibrium in Asset Markets:
AA Curve
• The inverse relationship between output and exchange
rates needed to keep the foreign exchange markets
and the money market in equilibrium is summarized as
the AA curve.
Figure 17.7 The AA Schedule
The asset market equilibrium schedule (AA) slopes downward because a

rise in output from Y 1 to Y 2 , all else equal, causes a rise in the home
interest rate and a domestic currency appreciation from E 1 to E 2 .
Shifting the AA Curve (1 of 3)
1. Changes in M s : an increase in the money supply
reduces interest rates in the short run, causing the
domestic currency to depreciate (a rise in E) for every
Y: the AA curve shifts up (right).
2. Changes in P: An increase in the level of average

domestic prices decreases the supply of real monetary
assets, increasing interest rates, causing the domestic
currency to appreciate (a fall in E): the AA curve shifts
down (left).
3. Changes in E e : if market participants expect the
domestic currency to depreciate in the future, foreign
currency deposits become more attractive, causing the
domestic currency to depreciate (a rise in E): the AA
curve shifts up (right).
4. Changes in R * : An increase in the foreign interest

rates makes foreign currency deposits more attractive,
leading to a depreciation of the domestic currency (a
rise in E): the AA curve shifts up (right).
5. Changes in the demand of real monetary assets: if
domestic residents are willing to hold a lower amount of
real money assets and more non-monetary assets,
interest rates on nonmonetary assets would fall, leading
to a depreciation of the domestic currency (a rise in E):
the AA curve shifts
up (right).
Putting the Pieces Together: the DD and
AA Curves (1 of 2)
• A short-run equilibrium means a nominal exchange rate
and level of output such that
1. equilibrium in the output markets holds: aggregate

demand equals aggregate output.
2. equilibrium in the foreign exchange markets holds:
interest parity holds.
3. equilibrium in the money market holds: the quantity of
real monetary assets supplied equals the quantity of
real monetary assets demanded.
Putting the Pieces Together: the DD and
AA Curves (2 of 2)
• A short-run equilibrium occurs at the intersection of the D
D and AA curves:
– output markets are in equilibrium on the DD curve
– asset markets are in equilibrium on the AA curve
Figure 17.8 Short-Run Equilibrium: The
Intersection of DD and AA
The short-run equilibrium of the economy occurs at point 1, where the output
market (whose equilibrium points are summarized by the DD curve) and the
asset market (whose equilibrium points are summarized by the AA curve)
simultaneously clear.
Figure 17.9 How the Economy Reaches
Its Short-Run Equilibrium
Because asset markets adjust very quickly, the exchange rate jumps
immediately from point 2 to point 3 on AA. The economy then moves to point 1
along AA as output rises to meet aggregate demand.
Temporary Changes in Monetary and
Fiscal Policy
• Monetary policy: policy in which the central bank influences
the supply of monetary assets.
– Monetary policy is assumed to affect asset markets first.
• Fiscal policy: policy in which governments
(fiscal authorities) influence the amount of government
purchases and taxes.
– Fiscal policy is assumed to affect aggregate demand and
output first.
• Temporary policy changes are expected to be reversed in the
near future and thus do not affect expectations about
exchange rates in the long run.
Temporary Changes in Monetary Policy
• An increase in the quantity of monetary assets supplied
lowers interest rates in the short run, causing the
domestic currency to depreciate (E rises).
– The AA shifts up (right).
– Domestic products relative to foreign products are
cheaper, so that aggregate demand and output
increase until a new short-run equilibrium is achieved.
Figure 17.10 Effects of a Temporary
Increase in the Money Supply
By shifting AA1 upward, a temporary increase in the money supply

causes a currency depreciation and a rise in output.
Temporary Changes in Fiscal Policy
• An increase in government purchases or a decrease
in taxes increases aggregate demand and output in
the short run.
– The DD curve shifts right.
– Higher output increases the demand for real
monetary assets,
▪ thereby increasing interest rates,
▪ causing the domestic currency to appreciate
(E falls).
Figure 17.11 Effects of a Temporary
Fiscal Expansion
By shifting DD1 to the right, a temporary fiscal expansion causes a

currency appreciation and a rise in output.
Policies to Maintain Full Employment (1 of 3)
• Resources used in the production process can either be over-
employed or underemployed.
• When resources are used effectively and sustainably, economists
say that production is at its potential or natural level.
– When resources are not used effectively, resources are
underemployed: high unemployment, few hours worked, idle
equipment, lower than normal production of goods and services.
– When resources are not used sustainably, labor is over-
employed: low unemployment, many overtime hours, over-
utilized equipment, higher than normal production of goods and
services.
Figure 17.12 Maintaining Full Employment after a
Temporary Fall in World Demand for Domestic Products
A temporary fall in world demand shifts DD1 to DD 2 , reducing output from Y 1 to Y 2

and causing the currency to depreciate from E 1 to E 2 (point 2). Temporary fiscal
expansion can restore full employment (point 1) by shifting the DD schedule back to its
original position. Temporary monetary expansion can restore full employment (point 3)
by shifting AA1 to AA2 . The two policies differ in their exchange rate effects: The
fiscal policy restores the currency to its previous value (E 1 ), whereas the monetary
policy causes the currency to depreciate further, to E3.
Figure 17.13 Policies to Maintain Full
Employment After a Money Demand Increase
After a temporary money demand increase (shown by the shift from AA1 to AA2 ),
either an increase in the money supply or temporary fiscal expansion can be used to
maintain full employment. The two policies have different exchange rate effects: The
monetary policy restores the exchange rate back to E 1, whereas the fiscal policy
leads to greater appreciation (E ).
3
• Policies to maintain full employment may seem easy in theory, but are
hard in practice.
1. We have assumed that prices and expectations do not change, but

people may anticipate the effects of policy changes and modify their
behavior.
– Workers may require higher wages if they expect overtime and
easy employment, and producers may raise prices if they expect
high wages and strong demand due to monetary and fiscal
policies.
– Fiscal and monetary policies may therefore create price changes
and inflation, thereby preventing high output and employment:
inflationary bias.
2. Economic data are difficult to measure and to understand.
– Policy makers cannot interpret data about asset markets and
aggregate demand with certainty, and sometimes they make
mistakes.
3. Changes in policies take time to be implemented and to affect the
economy.
– Because they are slow, policies may affect the economy after
the effects of an economic change have dissipated.
4. Policies are sometimes influenced by political or bureaucratic

interests.
Permanent Changes in Monetary and
Fiscal Policy
• “Permanent” policy changes are those that are assumed
to modify people’s expectations about exchange rates in
the long run.
Permanent Changes in Monetary Policy
• A permanent increase in the quantity of monetary assets
supplied has several effects:
– It lowers interest rates in the short run and makes
people expect future depreciation of the domestic
currency, increasing the expected rate of return on
foreign currency deposits.
– The domestic currency depreciates (E rises) more
than is the case when expectations are constant
(Econ Chapter 14/Finance Chapter 3 results).
– The AA curve shifts up (right) more than is the case
when expectations are held constant.
Figure 17.14 Short-Run Effects of a
Permanent Increase in the Money Supply
A permanent increase in the money supply, which shifts AA1 to AA2

and moves the economy from point 1 to point 2, has stronger effects on the
exchange rate and output than an equal temporary increase, which moves the
economy only to point 3.
Effects of Permanent Changes in
Monetary Policy in the Long Run
• With employment and hours above their normal levels,
there is a tendency for wages to rise over time.
• With strong demand for goods and services and with
increasing wages, producers have an incentive to raise
prices over time.
• Both higher wages and higher output prices are reflected
in a higher level of average prices.
• What are the effects of rising prices?
Figure 17.15 Long-Run Adjustment to a
Permanent Increase in the Money Supply
After a permanent money supply increase, a steadily increasing price level

shifts the DD and AA schedules to the left until a new long-run equilibrium
(point 3) is reached.
Effects of Permanent Changes in Fiscal
Policy (1 of 2)
• A permanent increase in government purchases or reduction
in taxes
– increases aggregate demand
– makes people expect the domestic currency to appreciate
in the short run due to increased aggregate demand,
thereby reducing the expected rate of return on foreign
currency deposits and making the domestic currency
appreciate.
• The first effect increases aggregate demand of domestic
products, the second effect decreases aggregate demand of
domestic products (by making them more expensive).
Effects of Permanent Changes in Fiscal
Policy (2 of 2)
• If the change in fiscal policy is expected to be permanent, the
first and second effects exactly offset each other, so that
output remains at its potential or natural (or long run) level.
• We say that an increase in government purchases completely
crowds out net exports, due to the effect of the appreciated
domestic currency.
Figure 17.16 Effects of a Permanent
Fiscal Expansion
Because a permanent fiscal expansion changes exchange rate expectations,

it shifts AA1 leftward as it shifts DD1 to the right. The effect on output
(point 2) is nil if the economy starts in long-run equilibrium. A comparable
temporary fiscal expansion, in contrast, would leave the economy at point 3.
Macroeconomic Policies and the Current
Account (1 of 4)
• To determine the effect of monetary and fiscal policies on the
current account,
– derive the XX curve to represent the combinations of
output and exchange rates at which the current account is
at its desired level.
• As income from production increases, imports increase and
the current account decreases when other factors remain
constant.
• To keep the current account at its desired level, the domestic
currency must depreciate as income from production
increases: the XX curve should slope upward.
Figure 17.17 How Macroeconomic
Policies Affect the Current Account
Along the curve XX, the current account is constant at the level CA = X.
Monetary expansion moves the economy to point 2 and thus raises the current
account balance. Temporary fiscal expansion moves the economy to point 3,
while permanent fiscal expansion moves it to point 4; in either case, the current
account balance falls.
Account (2 of 4)
• The XX curve slopes upward but is flatter than the DD
curve.
– DD represents equilibrium values of aggregate
demand and domestic output.
– As domestic income and production increase,
domestic saving increases, which means that
aggregate demand (willingness to spend) by
domestic residents does not rise as rapidly as
income and production.
Account (3 of 4)
– As domestic income and production increase, the
domestic currency must depreciate to entice foreigners to
increase their demand of domestic products in order to
keep the current account (only one component of
aggregate demand) at its desired level—on the XX curve.
– As domestic income and production increase, the
domestic currency must depreciate more rapidly to entice
foreigners to increase their demand of domestic products
in order to keep aggregate demand (by domestic
residents and foreigners) equal to production—on the DD
curve.
Account (4 of 4)
• Policies affect the current account through their influence
on the value of the domestic currency.
– An increase in the quantity of monetary assets
supplied depreciates the domestic currency and often
increases the current account in the short run.
– An increase in government purchases or decrease in
taxes appreciates the domestic currency and often
decreases the current account in the short run.
Value Effect, Volume Effect, and the
J-Curve (1 of 3)
• If the volume of imports and exports is fixed in the short run, a
depreciation of the domestic currency
– will not affect the volume of imports or exports,
– but will increase the value/price of imports in domestic currency
and decrease the current account:
CA » EX - IM .
– The value of exports in domestic currency does not change.

• The current account could immediately decrease after a currency
depreciation, then increase gradually as the volume effect begins to
dominate the value effect.
Figure 17.18 The J-Curve
The J-curve describes the time lag with which a real currency depreciation
improves the current account.
J-Curve (2 of 3)
• Pass-through from the exchange rate to import prices
measures the percentage by which import prices change when
the value of the domestic currency changes by 1%.
• In the DD-AA model, the pass-through rate is 100%: import
prices in domestic currency exactly match a depreciation of
the domestic currency.
• In reality, pass-through may be less than 100% due to price
discrimination in different countries.
– Firms that set prices may decide not to match changes in
the exchange rate with changes in prices of foreign
products denominated in domestic currency.
J-Curve (3 of 3)
• If prices of foreign products in domestic currency do not
change much because of a pass-through rate less than 100%,
then
– the value of imports will not rise much after a domestic
currency depreciation, and the current account will not fall
much, making the J-curve effect smaller.
– the volume of imports and exports will not adjust much
over time, since domestic currency prices do not change
much.
• Pass-through of less than 100% dampens the effect of
depreciation or appreciation on the current account.
Global Value Chains and Exchange Rate
Effects of Export and Import Prices
• Some imported intermediate goods become part of goods that

are exported, leading to complex global value chains in which
multiple countries produce portions of the value added of final
products.
• For many countries, imported value accounts for a significant
portion of the gross value of exports (backward linkages).
– A country’s exports may go on to be included in exports
from other countries (forward linkages).
• Backward and forward linkages tend to dampen the effects of
currency depreciations by creating offsetting forces.
Figure 17.19 Import Content of Exports for Selected
Countries in the European Union, 2005–2016
Imported value added can account for a significant fraction of the value of
exports.
Source: OECD.
The Liquidity Trap (1 of 3)
• During the Great Depression of the 1930s, the nominal interest rate
hit zero in the United States, and the country found itself in a
liquidity trap.
• Once an economy’s nominal interest rate falls to zero, a central bank
experiences difficulty lowering it any further.
– At negative nominal interest rates, people find holding money
preferable to bonds.
– Central banks may want to avoid the zero lower bound (ZLB)
on the nominal interest rate to keep monetary expansion as an
option.
– Starting in 2014, some major central banks have pushed
nominal interest rates into slightly negative territory.
• The dilemma facing a central bank when the economy is in a liquidity
trap slowdown can be seen by considering the interest parity
condition when the domestic interest rate R = 0,
(
R = 0 = R * + E e - E / E.)
• Assume for the moment that the expected future exchange rate,
E e , is fixed.
• Suppose the central bank raises the domestic money supply so as

to depreciate the currency temporarily
– that is, to raise E today but return the exchange rate to
the level E e later.
• The interest parity condition shows that E cannot rise once R =
0 because the interest rate would have to become negative.
• Instead, despite the increase in the money supply, currency
cannot depreciate further and the exchange rate remains
steady at
E = E e / (1 - R * ) .
• At an interest rate of R = 0, people are indifferent between

bonds and money as both yield a zero nominal rate of return.
– An increase in the money supply has no effect on the
economy!
Figure 17.20 A Low-Output Liquidity Trap
At point 1, output is below its full employment level. Because exchange rate
expectations E e are fixed, however, a monetary expansion will merely shift
AA to the right, leaving the initial equilibrium point the same. The horizontal
stretch of AA gives rise to the liquidity trap.
Summary (1 of 3)
1. Aggregate demand is influenced by disposable income
and the real exchange rate.
2. The DD curve shows combinations of exchange rates
and output where aggregate demand = aggregate
output.
3. The AA curve shows combinations of exchange rates
and output where the foreign exchange markets and
money market are in equilibrium.
Summary (2 of 3)
4. In the DD-AA model, we assume that a depreciation of
the domestic currency leads to an increase in the current
account and aggregate demand.
5. But reality is more complicated, and the
J-curve shows that the value effect at first dominates the
volume effect.
Summary (3 of 3)
6. A temporary increase in the money supply is predicted to
increase output and depreciate the domestic currency.
7. A permanent increase does both to a larger degree in the
short run, but in the long run output returns to its normal level.
8. A temporary increase in government purchases is predicted
to increase output and appreciate the domestic currency.
9. A permanent increase in government purchases is predicted
to completely crowd out net exports, and therefore to have no
effect on output.
Figure 17A1.1 Change in Output and
Saving
Table 17A2.1 Estimated Price Elasticities for
International Trade in Manufactured Goods
Source: Estimates come from Jacques R. Artus and Malcolm D. Knight, Issues in the
Assessment of the Exchange Rates of Industrial Countries. Occasional Paper 29.
Washington, D.C.: International Monetary Fund, July 1984, table 4. Dashes indicate
unavailable estimates.
Copyright
This work is protected by United States copyright laws and is

provided solely for the use of instructors in teaching their
courses and assessing student learning. Dissemination or sale of
any part of this work (including on the World Wide Web) will
destroy the integrity of the work and is not permitted. The work
and materials from it should never be made available to students
except by instructors using the accompanying text in their
classes. All recipients of this work are expected to abide by these
restrictions and to honor the intended pedagogical purposes and
the needs of other instructors who rely on these materials.
Policy
Twelfth Edition
Chapter 18
Fixed Exchange Rates and
Foreign Exchange
Intervention
Learning Objectives
18.1 Understand how a central bank must manage monetary
policy so as to fix its currency’s value in the foreign exchange
market.
18.2 Describe and analyze the relationship among the central
bank’s foreign exchange reserves, its purchases and sales in
the foreign exchange market, and the money supply.
18.3 Explain how monetary, fiscal, and sterilized intervention
policies affect the economy under a fixed exchange rate.
18.4 Discuss causes and effects of balance of payments crises.
18.5 Describe how alternative multilateral systems for pegging
exchange rates work
Preview
• Balance sheets of central banks
• Intervention in the foreign exchange markets and the
money supply
• How the central bank fixes the exchange rate
• Monetary and fiscal policies under fixed exchange rates
• Financial market crises and capital flight
• Types of fixed exchange rates: reserve currency and
gold standard systems
Introduction
• Many countries try to fix or “peg” their exchange rate to a
currency or group of currencies by intervening in the
foreign exchange markets.
• Many with a flexible or “floating” exchange rate in fact
practice a managed floating exchange rate.
– The central bank “manages” the exchange rate from
time to time by buying and selling currency and
assets, especially in periods of exchange rate
volatility.
• How do central banks intervene in the foreign exchange
markets?
Central Bank Intervention and the Money
Supply
• To study the effects of central bank intervention in the
foreign exchange markets, first construct a simplified
balance sheet for the central bank.
– This records the assets and liabilities of a central
bank.
– Balance sheets use double-entry bookkeeping: each
transaction enters the balance sheet twice.
Central Bank’s Balance Sheet (1 of 2)
• Assets
– Foreign government bonds (official international reserves)
– Gold (official international reserves)
– Domestic government bonds
– Loans to domestic banks (called discount loans in United
States)
• Liabilities
– Deposits of domestic banks
– Currency in circulation (previously central banks had to
give up gold when citizens brought currency to exchange)
Central Bank’s Balance Sheet (2 of 2)
• Assets = Liabilities + Net Worth
– If assume that net worth is constant, then
▪ An increase in assets leads to an equal increase in
liabilities.
▪ A decrease in assets leads to an equal decrease in
liabilities.
• Changes in the central bank’s balance sheet lead to changes
in currency in circulation or changes in deposits of banks,
which lead to changes in the money supply.
– If their deposits at the central bank increase, banks are
usually able to use these additional funds to lend to
customers, so amount of money in circulation increases.
Assets, Liabilities, and the Money
Supply (1 of 2)
• A purchase of any asset by the central bank will be paid

for with currency or a check written from the central bank,
– both of which are denominated in domestic currency,
and
– both of which increase the supply of money in
circulation.
– The transaction leads to equal increases of assets and
liabilities.
• When the central bank buys domestic bonds or foreign
bonds, the domestic money supply increases.
Assets, Liabilities, and the Money
Supply (2 of 2)
• A sale of any asset by the central bank will be paid for

with currency or a check written to the central bank,
– both of which are denominated in domestic currency.
– The central bank puts the currency into its vault or
reduces the amount of deposits of banks,
– causing the supply of money in circulation to shrink.
– The transaction leads to equal decreases of assets
and liabilities.
• When the central bank sells domestic bonds or foreign
bonds, the domestic money supply decreases.
Table 18.1 Effects of a $100 Foreign
Exchange Intervention: Summary
Domestic Central Effect on Domestic Effect on Central Effect on Central
Bank’s Action Money Supply Bank’s Domestic Bank’s Foreign
Assets Assets
Nonsterilized foreign +$100 0 +$100
exchange purchase
-$100
Negative $100
Sterilized foreign 0 +$100

exchange purchase
Nonsterilized foreign -$100
Negative $100
0 -$100
Negative $100
exchange sale
Sterilized foreign 0 +$100 -$100
Negative $100
exchange sale
Foreign Exchange Markets
• Central banks trade foreign government bonds in the
foreign exchange markets.
– Foreign currency deposits and foreign government
bonds are often substitutes: both are fairly liquid
assets denominated in foreign currency.
– Quantities of both foreign currency deposits and
foreign government bonds that are bought and sold
influence the exchange rate.
Sterilization
• Because buying and selling of foreign bonds in the
foreign exchange markets affects the domestic money
supply, a central bank may want to offset this effect.
• This offsetting effect is called sterilization.
• If the central bank sells foreign bonds in the foreign
exchange markets, it can buy domestic government
bonds in bond markets—hoping to leave the amount of
money in circulation unchanged.
Fixed Exchange Rates (1 of 4)
• To fix the exchange rate, a central bank influences the quantities
supplied and demanded of currency by trading domestic and
foreign assets, so that the exchange rate (the price of foreign
currency in terms of domestic currency) stays constant.
• Foreign exchange markets are in equilibrium when
R=R *
+
( E e
-E )
E
• When the exchange rate is fixed at some level E 0 and the

market expects it to stay fixed at that level, then
R =R*
• To fix the exchange rate, the central bank must trade foreign
and domestic assets in the foreign exchange market until
R = R *.
• Alternatively, we can say that it adjusts the quantity of

monetary assets in the money market until the domestic
interest rate equals the foreign interest rate, given the level
of average prices and real output:
MS
= L(R * ,Y )
P
• Suppose that the central bank has fixed the exchange
rate at E 0 but the level of output rises, raising the
demand of real monetary assets.
• This is predicted to put upward pressure on interest rates

and the value of the domestic currency.
• How should the central bank respond if it wants to fix
exchange rates?
• The central bank should buy foreign assets in the foreign
exchange markets,
– thereby increasing the domestic money supply,
– thereby reducing interest rates in the short run.
– Alternatively, by demanding (buying) assets
denominated in foreign currency and by supplying
(selling) domestic currency, the price/value of foreign
currency is increased and the price/value of domestic
currency is decreased.
Figure 18.1 Asset Market Equilibrium
0
With a Fixed Exchange Rate, E E sub 0
To hold the exchange rate fixed at E 0 when output rises from Y 1 to Y 2 , the central
bank must purchase foreign assets and thereby raise the money supply from M 1 to M 2 .
Monetary Policy and Fixed Exchange
Rates
• When the central bank buys and sells foreign assets to
keep the exchange rate fixed and to maintain domestic
interest rates equal to foreign interest rates, it is not able
to adjust domestic interest rates to attain other goals.
– In particular, monetary policy is ineffective in
influencing output and employment.
Figure 18.2 Monetary Expansion Is
Ineffective Under a Fixed Exchange Rate
Initial equilibrium is shown at point 1, where the output and asset markets simultaneously
clear at a fixed exchange rate of E 0 and an output level of Y 1. Hoping to increase output to
Y 2 , the central bank decides to increase the money supply by buying domestic assets and
shifting AA1 to AA2 . Because the central bank must maintain E 0 , however, it has to sell
foreign assets for domestic currency, an action that decreases the money supply
immediately and returns AA2 back to AA1. The economy’s equilibrium therefore remains at
point 1, with output unchanged at Y 1.
Fiscal Policy and Fixed Exchange Rates
in the Short Run
• Temporary changes in fiscal policy are more effective in
influencing output and employment in the short run:
– The rise in aggregate demand and output due to
expansionary fiscal policy raises demand for real
monetary assets, putting upward pressure on interest
rates and on the value of the domestic currency.
– To prevent an appreciation of the domestic currency,
the central bank must buy foreign assets, thereby
increasing the money supply and decreasing interest
rates.
Figure 18.3 Fiscal Expansion Under a
Fixed Exchange Rate
Fiscal expansion (shown by the shift from DD1 to DD 2 ) and the

intervention that accompanies it (the shift from AA1 to AA2 ) move the
economy from point 1 to point 3.
in the Long Run (1 of 2)
• When the exchange rate is fixed, there is no real appreciation of the
value of domestic products in the short run.
• But when output is above its potential level, wages and prices tend
to rise in the long run.
• A rising price level makes domestic products more expensive:
æ EP * ö
a real appreciation ç falls ÷ .
è P ø
– Aggregate demand and output decrease as prices rise: DD
curve shifts left.
– Prices tend to rise until employment, aggregate demand, and
output fall to their normal (potential or natural) levels.
in the Long Run (2 of 2)
• Prices are predicted to change proportionally to the
change in the money supply when the central bank
intervenes in the foreign exchange markets.
– AA curve shifts down (left) as prices rise.
– Nominal exchange rates will be constant (as long as
the fixed exchange rate is maintained), but the real
exchange rate will be lower (a real appreciation).
Devaluation and Revaluation
• Depreciation and appreciation refer to changes in the
value of a currency due to market changes.
• Devaluation and revaluation refer to changes in a fixed
exchange rate caused by the central bank.
– With devaluation, a unit of domestic currency is made
less valuable, so that more units must be exchanged
for 1 unit of foreign currency.
– With revaluation, a unit of domestic currency is made
more valuable, so that fewer units need to be
exchanged for 1 unit of foreign currency.
Devaluation
• For devaluation to occur, the central bank buys foreign
assets, so that domestic monetary assets increase and
domestic interest rates fall, causing a fall in the rate
return on domestic currency deposits.
– Domestic products become less expensive relative to
foreign products, so aggregate demand and output
increase.
– Official international reserve assets (foreign bonds)
increase.
Figure 18.4 Effect of a Currency
Devaluation
When a currency is devalued from E 0 to E 1, the economy’s

equilibrium moves from point 1 to point 2 as both output and the money
supply expand.
Financial Crises and Capital Flight (1 of 6)
• When a central bank does not have enough official
international reserve assets to maintain a fixed exchange
rate, a balance of payments crisis results.
– To sustain a fixed exchange rate, the central bank
must have enough foreign assets to sell in order to
satisfy the demand of them at the fixed exchange
rate.
• Investors may expect that the domestic currency will be
devalued, causing them to want foreign assets instead of
domestic assets, whose value is expected to fall soon.
1. This expectation or fear only makes the balance of
payments crisis worse:
– Investors rush to change their domestic assets into
foreign assets, depleting the stock of official
international reserve assets more quickly.
2. As a result, financial capital is quickly moved from domestic assets
to foreign assets: capital flight.
– The domestic economy has a shortage of financial capital for
investment and has low aggregate demand.
3. To avoid this outcome, domestic assets must offer high interest

rates to entice investors to hold them.
– The central bank can push interest rates higher by reducing the
money supply (by selling foreign and domestic assets).
4. As a result, the domestic economy may face high interest rates, a

reduced money supply, low aggregate demand, low output, and low
employment.
Figure 18.5 Capital Flight, the Money
Supply, and the Interest Rate
To hold the exchange rate fixed at E 0 after the market decides it will be devalued
to E 1, the central bank must use its reserves to finance a private financial
outflow that shrinks the money supply and raises the home interest rate.
• Expectations of a balance of payments crisis only worsen
the crisis and hasten devaluation.
– What causes expectations to change?
▪ Expectations about the central bank’s ability and
willingness to maintain the fixed exchange rate.
▪ Expectations about the economy: shrinking
demand of domestic products relative to foreign
products means that the domestic currency should
become less valuable.
• In fact, expectations of devaluation can cause a
devaluation: a self-fulfilling crisis.
• What happens if the central bank runs out of official
international reserve assets (foreign assets)?
• It must devalue the domestic currency so that it takes more
domestic currency (assets) to exchange for 1 unit of foreign
currency (asset).
– This will allow the central bank to replenish its foreign
assets by buying them back at a devalued rate,
– increasing the money supply,
– reducing interest rates,
– reducing the value of domestic products,
– increasing aggregate demand, output, and employment
over time.
• In a balance of payments crisis,
– the central bank may buy domestic bonds and sell
domestic currency (to increase the money supply) to
prevent high interest rates, but this only depreciates
the domestic currency more.
– the central bank generally cannot satisfy the goals of
low domestic interest rates (relative to foreign interest
rates) and fixed exchange rates simultaneously.
Figure 18.6 The Swiss Franc’s Exchange Rate against
the Euro and Swiss Foreign Exchange Reserves,
2006–2016
The Swiss National Bank intervened heavily to slow the Swiss franc’s appreciation
against the euro, setting a floor under the price of the euro in September 2011 and
abandoning that floor in January 2015.
Source: Swiss National Bank.
Interest Rate Differentials (1 of 3)
• For many countries, the expected rates of return are not
the same: R > R *

+
( E e
-E ). Why?
E
• Default risk:
The risk that the country’s borrowers will default on their loan
repayments. Lenders therefore require a higher interest rate to
compensate for this risk.
• Exchange rate risk:
If there is a risk that a country’s currency will depreciate or be
devalued, then domestic borrowers must pay a higher interest
rate to compensate foreign lenders.
• Because of these risks, domestic assets and foreign assets
are not treated the same.
– Previously, we assumed that foreign and domestic
currency deposits were perfect substitutes: deposits
everywhere were treated as the same type of investment,
because risk and liquidity of the assets were assumed to
be the same.
– In general, foreign and domestic assets may differ in the
amount of risk that they carry: they may be imperfect
substitutes.
– Investors consider these risks, as well as rates of return on
the assets, when deciding whether to invest.
• A difference in the risk of domestic and foreign assets is
one reason why expected rates of return are not equal
across countries:
R =R *
+
( E e
-E )+r
E
where r is called a risk premium, an additional amount

needed to compensate investors for investing in risky
domestic assets.
• The risk could be caused by default risk or exchange rate
risk.
r
The Rescue Package: Reducing rho
• The United States and IMF set up a $50 billion fund to
guarantee the value of loans made to Mexico’s government,
– reducing default risk,
– and reducing exchange rate risk, since foreign loans could
act as official international reserves to stabilize the
exchange rate if necessary.
• After a recession in 1995, the economy began to recover.
– Mexican goods were relatively inexpensive, allowing
production to increase.
– Increased demand of Mexican products relative to demand
of foreign products stabilized the value of the peso and
reduced exchange rate risk.
Figure 18.7 Effect of a Sterilized Central Bank Purchase
of Foreign Assets Under Imperfect Asset Substitutability
A sterilized purchase of foreign assets leaves the money supply unchanged but raises the
risk-adjusted return that domestic currency deposits must offer in equilibrium. As a result,
the return curve in the upper panel shifts up and to the right. Other things equal,
this depreciates the domestic currency from E 1 to E 2 .
Types of Fixed Exchange Rate Systems
1. Reserve currency system: one currency acts as
official international reserves
– The U.S. dollar was the currency that acted as official
international reserves from under the fixed exchange rate
system from 1944 to 1973.
– All countries except the United States held U.S. dollars as
the means to make official international payments.
2. Gold standard: gold acts as official international reserves

that all countries use to make official international payments.
Reserve Currency System
• From 1944 to 1973, central banks throughout the world fixed the value of
their currencies relative to the U.S. dollar by buying or selling domestic
assets in exchange for dollar denominated assets.
• Arbitrage ensured that exchange rates between any two currencies

remained fixed.
– Suppose Bank of Japan fixed the exchange rate at 360 ¥ US$1
and the Bank of France fixed the exchange rate at 5Ffr US$1.
æ 360 ¥ ö
ç US$1 ÷ 72 ¥
è ø= .
– The yen/franc rate was æ 5Ffr ö 1Ffr
ç US$1 ÷
è ø
– If not, then currency traders could make an easy profit by buying

currency where it was cheap and selling it where it was expensive.
Gold and Silver Standard
• Bimetallic standard: the value of currency is based on both silver
and gold.
• The United States used a bimetallic standard from 1837 to 1861.
• Banks coined specified amounts of gold or silver into the national
currency unit.
– 371.25 grains of silver or 23.22 grains of gold could be turned
into a silver or a gold dollar
– So gold was worth 371.25 / 23.22 = 16 times as much as silver.
– See www.micheloud.com for a fun description of the bimetallic

standard, the gold standard after 1873, and the Wizard of Oz!
Figure 18.8 Growth Rates of International
Reserves
Annualized growth rates of international reserves did not decline sharply after
the early 1970s. Recently, developing countries have added large sums to their
reserve holdings, but their pace of accumulation has slowed starting with the
crisis years of 2008–2009. The figure shows averages of annual growth rates.
Source: International Monetary Fund.
Figure 18.9 Currency Composition of
Global Reserve Holdings
While the euro’s role as a reserve currency increased during the first decade of its existence,
it has taken a hit after the euro crisis. The dollar remains the overwhelming favorite.
Source: International Monetary Fund, Currency Composition of Foreign Exchange Reserves
(COFER), at http://www.imf.org/external/np/sta/cofer/eng/index.htm . These data cover
only the countries that report reserve composition to the IMF.
Summary (1 of 4)
1. Changes in a central bank’s balance sheet lead to
changes in the domestic money supply.
– Buying domestic or foreign assets increases the
domestic money supply.
– Selling domestic or foreign assets decreases the
domestic money supply.
2. When markets expect exchange rates to be fixed,

domestic and foreign assets have equal expected
returns if they are treated as perfect substitutes.
Summary (2 of 4)
3. Monetary policy is ineffective in influencing output or
employment under fixed exchange rates.
4. Temporary fiscal policy is more effective in influencing
output and employment under fixed exchange rates,
compared to under flexible exchange rates.
Summary (3 of 4)
5. A balance of payments crisis occurs when a central
bank does not have enough official international
reserves to maintain a fixed exchange rate.
6. Capital flight can occur if investors expect a
devaluation, which may occur if they expect that a
central bank can no longer maintain a fixed exchange
rate: self-fulfilling crises can occur.
7. Domestic and foreign assets may not be perfect
substitutes due to differences in default risk or due to
exchange rate risk.
Summary (4 of 4)
8. Under a reserve currency system, all central banks but
the one that controls the supply of the reserve currency
trade the reserve currency to maintain fixed exchange
rates.
9. Under a gold standard, all central banks trade gold to
maintain fixed exchange rates.
Figure 18A1.1 The Domestic Bond Supply and the Foreign
Exchange Risk Premium Under Imperfect Asset
Substitutability
An increase in the supply of domestic currency bonds that the private sector
must hold raises the risk premium on domestic currency assets.
Figure 18A2.1 How the Timing of a Balance of
Payments Crisis Is Determined
The market stages a speculative attack and buys the remaining foreign reserve
stock FT* at time T, which is when the shadow floating exchange rate
ETS just equals the pre-collapse fixed exchange rate E 0 .
Copyright

Policy
Twelfth Edition
Chapter 20
Financial Globalization:
Opportunity and Crisis
20.1 Understand the economic function of international
portfolio diversification.
20.2 Explain factors leading to the explosive recent growth
of international financial markets.
20.3 Analyze problems in the regulation and supervision of
international banks and non-bank financial institutions.
20.4 Describe some different methods that have been used
to measure the degree of international financial integration.
20.5 Understand the factors leading to the worldwide
financial crisis that started in 2007.
20.6 Evaluate the performance of the international capital
market in linking the economies of the industrial countries.
Preview
• Gains from trade
• Portfolio diversification
• Players in the international capital markets
• Attainable policies with international capital markets
• Offshore banking and offshore currency trading
• Regulation of international banking
• Tests of how well international capital markets allow
portfolio diversification, allow intertemporal trade, and
transmit information
International Capital Markets
• International asset (capital) markets are a group of markets (in
London, Tokyo, New York, Singapore, and other financial
cities) that trade different types of financial and physical assets
(capital), including
– stocks
– bonds (government and private sector)
– deposits denominated in different currencies
– commodities (such as petroleum, wheat, bauxite, gold)
– forward contracts, futures contracts, swaps, options
contracts
– real estate and land
– factories and equipment
Gains from Trade (1 of 4)
• How have international capital markets increased the
gains from trade?
• When a buyer and a seller engage in a voluntary
transaction, both receive something that they want and
both can be made better off.
• A buyer and seller can trade
– goods or services for other goods or services
– goods or services for assets
– assets for assets
Figure 20.1 The Three Types of
International Transaction
Residents of different countries can trade goods and services for other goods and
services, goods and services for assets (that is, for future goods and services), and
assets for other assets. All three types of exchange lead to gains from trade.
• The theory of comparative advantage describes the
gains from trade of goods and services for other goods
and services:
– With a finite amount of resources and time, use those
resources and time to produce what you are most
productive at (compared to alternatives), then trade
those products for goods and services that you want.
– Be a specialist in production, while enjoying many
goods and services as a consumer through trade.
• The theory of intertemporal trade describes the gains from
trade of goods and services for assets, of goods and services
today for claims to goods and services in the future (today’s
assets).
– Savers want to buy assets (claims to future goods and
services) and borrowers want to use assets to consume or
invest in more goods and services than they can buy with
current income.
– Savers earn a rate of return on their assets, while
borrowers are able to use goods and services when they
want to use them: they both can be made better off.
• The theory of portfolio diversification describes the
gains from trade of assets for assets, of assets with one
type of risk for assets with another type of risk.
– Investing in a diverse set, or portfolio, of assets is a
way for investors to avoid or reduce risk.
– Most people most of the time want to avoid risk: they
would rather have a sure gain of wealth than invest in
risky assets when other factors are constant.
▪ People usually display risk aversion: they are
usually averse to risk.
Portfolio Diversification (1 of 3)
• Suppose that two countries have an asset of farmland that
yields a crop, depending on the weather.
• The yield (return) of the asset is uncertain, but with bad
weather the land can produce 20 tons of potatoes, while with
good weather the land can produce 100 tons of potatoes.
1 1
• On average, the land will produce ´ 20 + ´ 100 = 60 tons
2 2
• if bad weather and good weather are equally likely (both with a
probability of 1 / 2).
– The expected value of the yield is 60 tons.
• Suppose that historical records show that when the domestic
country has good weather (high yields), the foreign country has
bad weather (low yields).
– and that we can assume that the future will be like the past.
• What could the two countries do to avoid suffering from a bad
potato crop?
• Sell 50% of one’s assets to the other party and buy 50% of the
other party’s assets:
– diversify the portfolios of assets so that both countries
always achieve the portfolio’s expected (average) values.
• With portfolio diversification, both countries could always enjoy a
moderate potato yield and not experience the vicissitudes of feast
and famine.
– If the domestic country’s yield is 20 and the foreign country’s
yield is 100, then both countries receive
50% ´ 20 + 50% ´ 100 = 60.
– If the domestic country’s yield is 100 and the foreign country’s

yield is 20, then both countries receive
50% ´ 100 + 50% ´ 20 = 60.
– If both countries are risk averse, then both countries could be

made better off through portfolio diversification.
Classification of Assets
Assets can be classified as either
1. Debt instruments
– Examples include bonds and deposits.
– They specify that the issuer must repay a fixed amount
regardless of economic conditions.
or
2. Equity instruments
– Examples include stocks or a title to real estate.
– They specify ownership (equity = ownership) of variable profits
or returns, which vary according to economic conditions.
International Capital Markets (1 of 3)
The participants:
1. Commercial banks and other depository institutions:
– Accept deposits.
– Lend to commercial businesses, other banks,
governments, and/or individuals.
– Buy and sell bonds and other assets.
– Some commercial banks underwrite new stocks and
bonds by agreeing to find buyers for those assets at a
specified price.
2. Non-bank financial institutions such as securities firms,
pension funds, insurance companies, mutual funds:
– Securities firms specialize in underwriting stocks and
bonds (securities) and in making various investments.
– Pension funds accept funds from workers and invest
them until the workers retire.
– Insurance companies accept premiums from policy
holders and invest them until an accident or another
unexpected event occurs.
– Mutual funds accept funds from investors and invest
them in a diversified portfolio of stocks.
3. Private firms:
– Corporations may issue stock, may issue bonds, or may
borrow to acquire funds for investment purposes.
– Other private firms may issue bonds or may borrow from
commercial banks.
4. Central banks and government agencies:
– Central banks sometimes intervene in foreign exchange

markets.
– Government agencies issue bonds to acquire funds, and
may borrow from commercial banks or securities firms.
Offshore Banking (1 of 2)
• Offshore banking refers to banking outside of the
boundaries of a country.
• There are at least three types of offshore banking
institutions, which are regulated differently:
1. An agency office in a foreign country makes loans
and transfers, but does not accept deposits, and is
therefore not subject to depository regulations in
either the domestic or foreign country.
Offshore Banking (2 of 2)
2. A subsidiary bank in a foreign country follows the
regulations of the foreign country, not the domestic
regulations of the domestic parent.
3. A foreign branch of a domestic bank is often subject
to both domestic and foreign regulations, but
sometimes may choose the more lenient regulations
of the two.
Offshore Currency Trading (1 of 3)
• An offshore currency deposit is a bank deposit
denominated in a currency other than the currency that
circulates where the bank resides.
– An offshore currency deposit may be deposited in a
subsidiary bank, a foreign branch, a foreign bank, or
another depository institution located in a foreign
country.
– Offshore currency deposits are sometimes
(confusingly) referred to as eurocurrency deposits,
because these deposits were historically made in
European banks.
Offshore currency trading has grown for three reasons:
1. growth in international trade and international
business
2. avoidance of domestic regulations and taxes
3. political factors (e.g., to avoid confiscation by a
government because of political events)
• Reserve requirements are the primary example of a domestic
regulation that banks have tried to avoid through offshore
currency trading.
– Depository institutions in the United States and other
countries are required to hold a fraction of domestic
currency deposits on reserve at the central bank.
– These reserves cannot be lent to customers and do not
earn interest in many countries, therefore the reserve
requirement reduces income for banks.
– But offshore currency deposits in many countries are not
subject to this requirement, and thus can earn interest on
the full amount of the deposit.
Banking and Financial Fragility
• Banks fail because they do not have enough or the right
kind of assets to pay for their liabilities.
– The principal liability for commercial banks and other
depository institutions is the value of deposits, and
banks fail when they cannot pay their depositors.
– If the value of assets decline, say because many
loans go into default, then liabilities could become
greater than the value of assets and bankruptcy could
result.
• In many countries there are several types of regulations
to avoid bank failure or its effects.
Government Safeguards against
Financial Instability (1 of 5)
1. Deposit insurance
– Insures depositors against losses up to $100,000 in
the United States when banks fail.
– Prevents bank panics due to a lack of information:
because depositors cannot determine the financial
health of a bank, they may quickly withdraw their
funds if they are not sure that a bank is financially
healthy enough to pay for them.
– Creates a moral hazard for banks to take excessive
risk because they are no longer fully responsible for
failure.
▪ Moral hazard: a hazard that a party in a
transaction will engage in activities that would be
considered inappropriate (e.g., too risky) according
to another party who is not fully informed about
those activities
2. Reserve requirements
– Banks required to maintain some deposits on reserve
at the central bank in case they need cash.
3. Capital requirements and asset restrictions
– Higher bank capital (net worth) means banks have more

funds available to cover the cost of failed assets.
– Asset restrictions reduce risky investments by preventing a
bank from holding too many risky assets and encourage
diversification by preventing a bank from holding too much
of one asset.
4. Bank examination
– Regular examination prevents banks from engaging in
risky activities.
5. Lender of last resort
– In the United States, the Federal Reserve System
may lend to banks with inadequate reserves (cash).
– Prevents bank panics.
– Acts as insurance for depositors and banks, in
addition to deposit insurance.
– Creates a moral hazard for banks to take excessive
risk because they are not fully responsible for the risk.
6. Government-organized bailouts
– Failing all else, the central bank or fiscal authorities
may organize the purchase of a failing bank by
healthier institutions, sometimes throwing their own
money into the deal as a sweetener.
– In this case, bankruptcy is avoided thanks to the
government’s intervention as a crisis manager, but
perhaps at public expense.
• Safeguards were not nearly sufficient to prevent the
financial crisis of 2007–2009.
Figure 20.2 Frequency of Systemic Banking
Crises by Country Income Level, 1976–2017
Generalized banking crises have been plentiful around the world since the mid-1970s,
mainly in poorer countries, but starting in 2008, a substantial number of richer
countries were also hit hard.
Source: Reproduced from Laeven and Valencia, op. cit. Thanks to Luc Laeven for
supplying these data
Difficulties in Regulating International
Banking (1 of 4)
1. Deposit insurance in the United States covers losses up
to $100,000, but since the size of deposits in
international banking is often much larger, the amount of
insurance is often minimal.
2. Reserve requirements also act as a form of insurance for
depositors, but countries cannot impose reserve
requirements on foreign currency deposits in agency
offices, foreign branches, or subsidiary banks of
domestic banks.
Banking (2 of 4)
3. Bank examination, capital requirements, and asset
restrictions are more difficult internationally.
– Distance and language barriers make monitoring
difficult.
– Different assets with different characteristics (e.g.,
risk) exist in different countries, making judgment
difficult.
– Jurisdiction is not clear in the case of subsidiary
banks: for example, if a subsidiary of an Italian bank
is located in London but primarily has offshore U.S.
dollar deposits, which regulators have jurisdiction?
Banking (3 of 4)
4. No international lender of last resort for banks exists.
– The IMF sometimes acts a “lender of last resort” for
governments with balance of payments problems.
5. The activities of nonbank financial institutions are

growing in international banking, but they lack the
regulation and supervision that banks have.
Banking (4 of 4)
6. Derivatives and securitized assets make it harder to
assess financial stability and risk because these assets
are not accounted for on the traditional balance
– A securitized asset is a combination of different
illiquid assets like loans that is sold as a security.
The Financial Trilemma (1 of 4)
• Regulations of the type used in the United States and
other countries become even less effective in an
international environment where banks can shift their
business among different regulatory jurisdictions.
• To see why an international banking system is harder to
regulate than a national system, look at how the
effectiveness of the U.S. safeguards described earlier is
reduced as a result of offshore banking activities.
1. Deposit insurance is essentially absent in international
banking.
2. While Eurobanks derived a competitive advantage from
escaping the required reserve tax, there was a social
cost by reducing the stability of the banking system.
3. Bank examination to enforce capital requirements and
asset restrictions is difficult in an international setting.
4. Several governments may have to share operational and
financial responsibility for a rescue or reorganization.
• A financial trilemma constrains what policymakers in an
open economy can achieve. At most two goals from the
following list of three are simultaneously feasible:
1. Financial stability.
2. National control over financial safeguard policy.
3. Freedom of international capital movements
International Regulatory Cooperation (1 of 3)
• Basel accords (in 1988 and 2006) provide standard

regulations and accounting for international financial
institutions.
– 1988 accords tried to make bank capital
measurements standard across countries.
– They developed risk-based capital requirements,
where more risky assets require a higher amount of
bank capital.
• Core principles of effective banking supervision was

developed by the Basel Committee in 1997 for countries
without adequate banking regulations and accounting
standards.
• The financial crisis made obvious the inadequacies of the
Basel II regulatory framework, so in 2010 the Basel
Committee proposed a tougher set of capital standards
and regulatory safeguards for international banks, Basel
III.
• In April 2009, at the height of the global crisis, the

Financial Stability Forum became the Financial Stability
Board (FSB), with a broader membership (including a
number of emerging market economies) and a larger
permanent staff.
• Many countries have embarked on far-reaching national
reforms of their financial systems.
The Macroprudential Perspective
• Ensuring that each individual financial institution is sound
will not ensure that the financial system as a whole is
sound.
• National financial regulators often face fierce lobbying from
their home financial institutions, which argue that stricter
rules would put them at a disadvantage relative to foreign
rivals.
• The Basel multilateral process plays an essential role in
allowing governments to overcome domestic political
pressures against adequate oversight and control of the
financial sector.
The Global Financial Crisis of 2007–2009 (1 of 3)
• The global financial and economic meltdown of 2007–2009 was

the worst since the Great Depression.
• Banks throughout the world failed or required extensive
government support to survive; the global financial system
froze; and the entire world economy was thrown into recession.
• Unlike some recessions, this one originated in a shock to
financial markets, and the shock was transmitted from country
to country by financial markets, at lightning speed.
• The crisis had a seemingly unlikely source: the U.S. mortgage
market.
• In the mid-2000s, U.S. interest rates were very low and

U.S. home prices bubbled upward, with mortgage lenders
extending loans to borrowers with shaky credit.
• Then U.S. interest rates started moving up as the Federal
Reserve gradually tightened monetary policy to ward off
inflation.
– U.S. housing prices started to decline in 2006.
• As subprime borrowers increasingly missed their
payments during 2007, lenders became more aware of the
risks they faced and pulled back from markets.
• Despite central banks providing markets with extensive

liquidity support, stock markets fell everywhere.
• The U.S. economy slipped into recession late in 2007,
pushed by lack of credit and a collapsing housing market.
• American money market mutual funds suffered a run and
had their liabilities guaranteed by the U.S. Treasury.
• The U.S. Congress allocated $700 billion to buy troubled
assets from banks, in hopes that of allowing them to
resume normal lending.
• These problems spread globally. Recovery was quite slow.
Cross-Border Bank Positions in Dollars
and Euros, 1999–2019
Data on international banking transactions illustrate how the U.S. dollar

is the world’s premier funding currency, far outstripping the euro.
Source: Bank for international Settlements, Locational Banking
Statistics data on reporting banks.
Extent of International Portfolio
Diversification (1 of 2)
• In 2008, U.S.-owned assets in foreign countries represented
about 46.6% of U.S. capital, while foreign assets in the United
States represented about 54.7% of U.S. capital.
– These percentages are about 5 times as large as
percentages from 1970, indicating that international capital
markets have allowed investors to diversify.
– In a fully diversified world economy, about 80% of U.S.
capital would be owned by foreigners, while U.S. residents’
claims on foreigners would equal around 80% of U.S.
capital.
• Likewise, foreign assets and liabilities as a percent of GDP
has grown for the United States and other countries.
Extent of International Portfolio
Diversification (2 of 2)
• Still, some economists argue that it would be optimal if
investors diversified more by investing more in foreign
assets, avoiding the “home bias” of investment.
Extent of International Intertemporal
Trade (1 of 2)
• If some countries borrow for investment projects (for future
production and consumption) while others lend to these
countries, then national saving and investment levels should
not be highly correlated.
– Recall that national saving - investment = current account
– Some countries should have large current account
surpluses as they save a lot and lend to foreign countries.
– Some countries should have large current account deficits
as they borrow a lot from foreign countries.
• In reality, national saving and investment levels are highly
correlated.
Figure 20.3 Saving and Investment Rates
for 24 Countries, 1990–2019 Averages
OECD countries’ saving and investment ratios to output tend to be positively

related. The straight regression line in the graph represents a statistician’s best
guess of the level of the investment ratio, conditional on the saving ratio, in this
country sample.
Source: World Bank, World Development Indicators.
Extent of International Intertemporal
Trade (2 of 2)
• Are international capital markets unable to allow
countries to engage in much intertemporal trade?
• Not necessarily: factors that generate a high saving rate,
such as rapid growth in production and income, may also
generate a high investment rate.
• Governments may also enact policies to avoid large
current account deficits or surpluses.
Extent of Information Transmission and
Financial Capital Mobility (1 of 5)
• We should expect that interest rates on offshore currency
deposits and those on domestic currency deposits within
a country should be the same if
– the two types of deposits are treated as perfect
substitutes,
– assets can flow freely across borders, and
– international capital markets are able to quickly and
easily transmit information about any differences in
rates.
• In fact, differences in interest rates have approached zero as
financial capital mobility has grown and information processing
has become faster and cheaper through computers and
telecommunications.
Figure 20.4 Comparing Onshore and
Offshore Interest Rates for the Dollar
The difference between the London and U.S. interest rates on dollar deposits is usually
very close to zero, but it spiked up sharply in the fall of 2008 as the investment bank
Lehman Brothers collapsed and has remained volatile.
Source: Board of Governors of the Federal Reserve System and OECD, monthly data.
• If assets are treated as perfect substitutes, then we expect interest
parity to hold on average:
Rt - R *
=
( E e
t +1 - Et )
t
Et
• Under this condition, the interest rate difference is the market’s

forecast of expected changes in the exchange rate.
– If we replace expected exchange rates with actual future
exchange rates, we can test how well the market predicts
exchange rate changes.
– But interest rate differentials fail to predict large swings in actual
exchange rates and even fail to predict in which direction actual
exchange rates change.
• Given that there are few restrictions on financial capital in most major
countries, does this mean that international capital markets are
unable to process and transmit information about interest rates?
• Not necessarily: if assets are imperfect substitutes, then
(E e t + 1 - Et )
Rt - R *t = + rt
Et
– Interest rate differentials are associated with exchange rate

changes and with risk premiums that change over time.
– Changes in risk premiums may drive changes in exchange
rates rather than interest rate differentials.
Rt - R *
=
( E e
t +1 - Et )+r
t t
Et
• Since both expected changes in exchange rates and risk

premiums are functions of expectations and since
expectations are unobservable,
– it is difficult to test if international capital markets are
able to process and transmit information about
interest rates.
Exchange Rate Predictability
• In fact, it is hard to predict exchange rate changes over

short horizons based on money supply growth,
government spending growth, GDP growth, and other
“fundamental” economic variables.
– The best prediction for tomorrow’s exchange rate
appears to be today’s exchange rate, regardless of
economic variables.
– But over long time horizons (more than 1 year),
economic variables do better at predicting actual
exchange rates.
Summary (1 of 3)
1. Gains from trade of goods and services for other goods

and services are described by the theory of comparative
advantage.
2. Gains from trade of goods and services for assets are
described by the theory of intertemporal trade.
3. Gains from trade of assets for assets are described by
the theory of portfolio diversification.
4. Policy makers can choose only two of the following: a
fixed exchange rate, a monetary policy for domestic
goals, free international flows of assets.
Summary (2 of 3)
5. Several types of offshore banks deal in offshore currency

trading, which developed as international trade grew and
as banks tried to avoid domestic regulations.
6. Domestic banks are regulated by deposit insurance,
reserve requirements, capital requirements, restrictions
on assets, and bank examinations. The central bank also
acts as a lender of last resort.
7. International banking is generally not regulated in the
same manner as domestic banking, and there is no
international lender of last resort.
Summary (3 of 3)
8. As international capital markets have developed,

diversification of assets across countries has grown and
differences between interests rates on offshore currency
deposits and domestic currency deposits within a country
have shrunk.
9. If foreign and domestic assets are perfect substitutes,
then interest rates in international capital markets do not
predict exchange rate changes well.
10.Even economic variables do not predict exchange rate
changes well in the short run.
Copyright

Policy
Twelfth Edition
Chapter 22
Developing Countries:
Growth, Crisis, and Reform
Learning Objectives
22.1 Describe the persistently unequal world distribution of
income and the evidence on its causes.
22.2 Summarize the major economic features of developing
countries.
22.3 Explain the position of developing countries in the world
capital market and the problem of default by developing
borrowers.
22.4 Recount the recent history of developing-country financial
crises.
22.5 Discuss proposed measures to enhance poorer countries’
gains from participation in the world capital market
Preview
• Snapshots of rich and poor countries
• Characteristics of poor countries
• Borrowing and debt in poor and middle-income economies
• The problem of “original sin”
• Types of financial assets
• Latin American, East Asian, and Russian crises
• Currency boards and dollarization
• Lessons from crises and potential reforms
• Geography’s and human capital’s role in poverty
The Gap Between Rich and Poor
• Low income: most sub-Saharan Africa, India, Pakistan
• Lower-middle income: China, Caribbean countries
• Upper-middle income: Brazil, Mexico, Saudi Arabia,
Malaysia, South Africa, Czech Republic
• High income: United States, Singapore, France, Japan,
Kuwait
Table 22.1 Indicators of Economic
Welfare in Four Groups of Countries
GDP per Capita Life Expectancy in
Income Group
(2019 U.S. dollars) 2018 (years)
Low-income 780 63
Lower middle-income 2,177 68
Upper middle-income 9,040 75
High-income 44,584 81
Source: World Bank, World Development Indicators.
Has the World Income Gap Narrowed
Over Time?
• While some previously middle- and low-income
economies have grown faster than high-income countries,
and thus have “caught up” with high-income countries,
others have languished.
– The income levels of high-income countries and some
previously middle-income and low-income countries
have converged.
– But the some of the poorest countries have had the
lowest growth rates.
Table 22.2 Output per Capita in Selected
Countries, 1960–2017 (in 2011 U.S. Dollars) (1 of 4)
Industrialized in 1960
1960–2017
Output per Capita Output per Capita Annual Average
Country
1960 2017 Growth Rate
(percent per year)
Canada 15,573 44,975 1.9
France 11,344 38,170 2.2
Germany 13,337 46,349 2.2
Italy 10,176 35,668 2.2
Japan 6,400 39,381 3.2
Spain 7,301 33,593 2.7
Sweden 14,478 45,844 2.0
United Kingdom 12,719 38,153 1.9
United States 17,319 54,586 2.0
Africa
1960–2017
Country
(percent per year)
Kenya 1,952 3,090 0.8
Nigeria 2.665 5,270 1.2
Senegal 2.917 3,111 0.1
South Africa 7,204 12,004 0.9
Zimbabwe 1,132 1,914 0.9
Latin America
1960–2017
Country
(percent per year)
Argentina 9,283 16,432 1.0
Brazil 3,995 14,066 2.2
Chile 5,734 22,123 2.4
Colombia 4,059 13,585 2.1
Costa Rica 4,329 14,712 2.2
Mexico 6,633 16,792 1.6
Paraguay 2,618 8,948 2.2
Peru 5,135 11,808 1.5
Venezuela 11,935 11,321 -0.1
negative 0.1
Asia
1960–2017
Output per Output per
Country Annual Average Growth Rate
Capita 1960 Capita 2017
(percent per year)
China 815 13,465 5.0
Hong Kong 4,459 50,271 4.3
India 1,048 6,548 3.3
Indonesia 1,635 11,173 3.4
Malaysia 2,639 24,574 4.0
Singapore 4,368 69,150 5.0
South Korea 1,573 36,999 5.7
Taiwan 2,070 43,501 5.5
Thailand 1,162 14,884 4.7
Note: Data are taken from the Penn World Table, Version 9.1, and use PPP exchange rates to compare national incomes
(variables RGDPNA/POP). For a description, see the Penn World Table website at
https://www.rug.nl/ggdc/productivity/pwt/ .
Structural Features of Developing
Countries (1 of 5)
• What causes poverty is a difficult question, but low-income
countries have at least some of following characteristics, which
could contribute to poverty:
1. Government control of the economy
– Restrictions on trade
– Direct control of production in industries and a high level of
government purchases relative to GNP
– Direct control of financial transactions
– Reduced competition reduces innovation; lack of market
prices prevents efficient allocation of resources
Figure 22.1 Richer Countries Have Become
Less Important for Global GDP Growth
As many developing countries have grown more quickly and come to account for larger
shares of world output, their GDP growth rates have become more important in
determining overall world growth. At the same time, growth in the richer economies has
tended to slow over time.
Source: IMF, World Economic Outlook. The group of “advanced economies” in the
chart excludes Japan, Germany, and United States, which are shown separately. World
growth is calculated using GDP weights, with GDP measured at market prices. Partial
data for the 2010s.
Countries (2 of 5)
2. Unsustainable macroeconomic policies that cause high
inflation and unstable output and employment
– If governments cannot pay for debts through taxes, they
can print money to finance debts.
– Seigniorage is paying for real goods and services by
printing money.
– Seigniorage generally leads to high inflation.
– High inflation reduces the real cost of debt that the
government has to repay and reduces the real value of
repayments for lenders.
– High and variable inflation is costly to society; unstable
output and employment is also costly.
Countries (3 of 5)
3. Lack of financial markets that allow transfer of funds from savers to
borrowers
– Banks frequently lend funds to poor or risky projects.
– Loans may be made on the basis of personal connections
rather than prospective returns, and government safeguards
against financial fragility, such as bank supervision, tend to be
ineffective due to incompetence, inexperience, and outright
fraud.
– Usually harder in developing countries for shareholders to find
out how a firm’s money is being spent or to control firm
managers.
– The legal framework for resolving asset ownership in cases of
bankruptcy typically is also weak.
Countries (4 of 5)
4. Where exchange rates are not pegged outright (as in China), they
tend to be managed more heavily by developing-country
governments. Government measures to limit exchange rate flexibility
reflect both a desire to keep inflation under control and the fear that
floating exchange rates would be subject to huge volatility in the
relatively thin markets for developing-country currencies. There is a
history of allocating foreign exchange through government decree
rather than through the market, a practice (called exchange control)
that some developing countries still maintain. Most developing
countries have, in particular, tried to control capital movements by
limiting foreign exchange transactions connected with trade in assets.
More recently, however, many emerging markets have opened their
capital accounts.
Countries (5 of 5)
5. Natural resources or agricultural commodities make up an
important share of exports for many developing countries.
– For example, Russian petroleum, Malaysian timber, South
African gold, and Colombian coffee.
6. Attempts to circumvent government controls, taxes, and

regulations have helped to make corrupt practices such as
bribery and extortion a way of life in many developing countries.
– Due to government control of the economy and weak
enforcement of economic laws and regulations,
underground economies and corruption flourish.
Commodity Price Index
Over the past two decades, aggregate commodity prices have

experienced a boom-bust cycle.
Source: IMF. All Commodity Price Index (2016 = 100). Includes both
fuel and non-fuel indices.
Figure 22.2 Corruption and Per Capita
Output
Corruption tends to rise as real per capita output falls.

Note: The figure plots 2018 values of an (inverse) index of corruption and 2018 values of PPP-adjusted
real per capita output, measured in constant 2010 U.S. dollars (the amount a dollar could buy in the
United States in 2010). The straight line represents a statistician’s best guess of a country’s corruption
level based on its real per capita output.
Source: Transparency International, Corruption Perception Index; World Bank, World Development
Indicators.
Developing-Country Borrowing and Debt
• Another common characteristic for many low- and middle-income
countries is that they have traditionally borrowed from foreign
countries.
– Financial asset flows from foreign countries are able to finance
investment projects, eventually leading to higher production and
consumption.
– But some investment projects fail and other borrowed funds are
used primarily for consumption purposes.
– Some countries have defaulted on their foreign debts when the
domestic economy stagnated or during financial crises.
– But this trend has recently reversed as these countries have
begun to save.
The Economics of Financial Inflows to
Developing Countries
• national saving - investment = the current account
– where the current account is approximately equal to
the value of exports minus the value of imports.
• Countries with national saving less than domestic
investment will have financial asset inflows and a
negative current account (a trade deficit).
Table 22.3 Cumulative Current Account Balances of
Major Oil Exporters, Other Developing Countries, and
Advanced Countries, 1973–2019 (Billions of Dollars)
Other Developing Advanced

Blank
Major Oil Exporters

Countries Countries
1973–1981 253 -246

negative 246
-184
negative 184
1982–1989 -65
negative 65
-143
negative 143
-427
negative 427
1990–1998 -58 -523

-106
negative 58 negative 523 negative 106
1999–2019 5,313 -852

negative 852
-758
negative 758
Source: International Monetary Fund, International Financial Statistics and World

Economic Outlook data. Global current accounts generally do not sum to zero because of
errors, omissions, and the exclusion of some countries in some periods.
The Problem of Default (1 of 6)
A financial crisis may involve
1. a debt crisis: an inability to repay sovereign
(government) or private sector debt.
2. a balance of payments crisis under a fixed exchange
rate system.
3. a banking crisis: bankruptcy and other problems for
private sector banks.
• A debt crisis in which governments default on their debt
can be a self-fulfilling mechanism.
– Fear of default reduces financial asset inflows and
increases financial asset outflows (capital flight),
decreasing investment and increasing interest rates,
leading to low aggregate demand, output, and
income.
– Financial asset outflows must be matched with an
increase in net exports or a decrease in official
international reserves in order to pay individuals and
institutions who desire foreign funds.
– Otherwise, the country cannot afford to pay those
who want to remove their funds from the domestic
economy.
– The domestic government may have no choice but to
default on its sovereign debt (paid for with foreign
funds) when it comes due and when investors are
unwilling to reinvest.
• In general, a debt crisis can quickly magnify itself: it
causes low income and high interest rates, which make
government and private sector debts even harder to
repay.
– High interest rates cause high interest payments for
both the government and the private sector.
– Low income causes low tax revenue for the
government.
– Low income makes loans made by private banks
harder to repay: the default rate increases, which may
cause bankruptcy.
• If the central bank tries to fix the exchange rate, a balance of
payment crisis may result along with a debt crisis.
– Official international reserves may quickly be depleted because
governments and private institutions need to pay for their debts
with foreign funds, forcing the central bank to abandon the fixed
exchange rate.
• A banking crisis may result from a debt crisis.
– High default rates on loans made by banks reduce their income
to pay for liabilities and may increase bankruptcy.
– If depositors fear bankruptcy due to possible devaluation of the
currency or default on government debt (assets for banks), then
they will quickly withdraw funds from banks (and possibly
purchase foreign assets), leading to actual bankruptcy.
• A debt crisis, a balance of payments crisis, and a banking
crisis can occur together, and each can make the other
worse.
– Each can cause aggregate demand, output, and
employment to fall (further).
• If people expect a default on sovereign debt, a currency
devaluation, or bankruptcy of private banks, each can
occur, and each can lead to another.
Alternative Forms of Financial Inflow (1 of 3)
1. Bond finance: government or private sector bonds are
sold to foreign individuals and institutions.
2. Bank finance: commercial banks or securities firms
lend to foreign governments or foreign businesses.
3. Official lending: the World Bank, Inter-American
Development Bank, or other official agencies lend to
governments.
– Sometimes these loans are made on a “concessional”
or favorable basis, in which the interest rate is low.
4. Foreign direct investment: a firm directly acquires or
expands operations in a subsidiary firm in a foreign
country.
– A purchase by Ford of a subsidiary firm in Mexico is
classified as foreign direct investment.
5. Portfolio equity investment: a foreign investor

purchases equity (stock) for his portfolio.
– Privatization of government-owned firms in many
countries has created more equity investment
opportunities for foreign investors.
• Debt finance includes bond finance, bank finance, and
official lending.
• Equity finance includes direct investment and portfolio
equity investment.
• While debt finance requires fixed payments regardless of
the state of the economy, the value of equity finance
fluctuates depending on aggregate demand and output.
The Problem of “Original Sin” (1 of 4)
• Sovereign and private sector debts in the United States,
Japan, and European countries are mostly denominated
in their respective currencies.
• But when poor and middle-income countries borrow in
international financial capital markets, their debts are
almost always denominated in US $, yen, or euros: a
condition called “original sin.”
• When a depreciation of domestic currencies occurs in the
United States, Japan, or European countries, liabilities
(debt) that are denominated in domestic currencies do
not increase, but the value of foreign assets increases.
– A devaluation of the domestic currency causes an
increase in net foreign wealth.
• When a depreciation/devaluation of domestic currencies
occurs in most poor and middle-income economies, the
value of their liabilities (debt) rises because their liabilities
are denominated in foreign currencies.
– A devaluation of the domestic currency causes a
decrease in net foreign wealth.
– In particular, a fall in aggregate demand of domestic
products causes a depreciation/devaluation of the
domestic currency and causes a decrease in net
foreign wealth if assets are denominated in domestic
currencies and liabilities (debt) are denominated in
foreign currencies.
– This is a situation of “negative insurance” against a
fall in aggregate demand.
The Debt Crisis of the 1980s (1 of 2)
• In the 1980s, high interest rates and an appreciation of
the U.S. dollar caused the burden of dollar-denominated
debts in Argentina, Mexico, Brazil, and Chile to increase
drastically.
• A worldwide recession and a fall in many commodity
prices also hurt export sectors in these countries.
• In August 1982, Mexico announced that it could not repay
its debts, mostly to private banks.
The Debt Crisis of the 1980s (2 of 2)
• The U.S. government insisted that the private banks
reschedule the debts, and in 1989 Mexico was able to
achieve
– a reduction in the interest rate
– an extension of the repayment period
– a reduction in the principal by 12%
• Brazil, Argentina, and other countries were also allowed
to reschedule their debts with private banks after they
defaulted.
Reforms, Capital Inflows, and the Return
of Crisis (1 of 9)
• The Mexican government implemented several reforms
due to the crisis. Starting in 1987, it
– reduced government deficits.
– reduced production in the public sector (including
banking) by privatizing industries.
– reduced barriers to trade.
– maintained an adjustable fixed exchange rate
(“crawling peg”) until 1994 to help curb inflation.
of Crisis (2 of 9)
• It extended credit to newly privatized banks with loan
losses.
– Losses were a problem due to weak enforcement or
lack of asset restrictions and capital requirements.
• Political instability and loan defaults at private banks
contributed to another crisis in 1994, after which the
Mexican government allowed the value of the peso to
fluctuate.
of Crisis (3 of 9)
• Starting in 1991, Argentina carried out similar reforms:
– It reduced government deficits.
– It reduced production in the public sector by
privatizing industries.
– It reduced barriers to trade.
– It enacted tax reforms to increase tax revenues.
– It enacted the Convertibility Law, which required that
each peso be backed with 1 U.S. dollar, and it fixed
the exchange rate to 1 peso per U.S. dollar.
of Crisis (4 of 9)
• Because the central bank was not allowed to print more
pesos without having more dollar reserves, inflation
slowed dramatically.
• Yet inflation was about 5% per annum, faster than U.S.
inflation, so that the price/value of Argentinean goods
appreciated relative to U.S. and other foreign goods.
• Due to the relatively rapid peso price increases, markets
began to speculate about a peso devaluation.
• A global recession in 2001 further reduced the demand of
Argentinean goods and currency.
of Crisis (5 of 9)
• Maintaining the fixed exchange rate was costly because
high interest rates were needed to attract investors,
further reducing investment and consumption
expenditure, output, and employment.
• As incomes fell, tax revenues fell and government
spending rose, contributing to further peso inflation.
of Crisis (6 of 9)
• Argentina tried to uphold the fixed exchange rate, but the
government devalued the peso in 2001 and shortly
thereafter allowed its value to fluctuate.
• It also defaulted on its debt in December 2001 because
of the unwillingness of investors to reinvest when the
debt was due.
of Crisis (7 of 9)
• Brazil carried out similar reforms in the 1980s and 1990s:
– It reduced production in the public sector by
privatizing industries.
– It reduced barriers to trade.
– It enacted tax reforms to increase tax revenues.
– It fixed the exchange rate to 1 real per U.S. dollar.
– But government deficits remained high.
of Crisis (8 of 9)
• High government deficits led to inflation and speculation
about a devaluation of the real.
• The government did devalue the real in 1999, but a
widespread banking crisis was avoided because Brazilian
banks and firms did not borrow extensively in dollar-
denominated assets.
of Crisis (9 of 9)
• Chile suffered a recession and financial crisis in the
1980s, but thereafter
– enacted stringent financial regulations for banks.
– removed the guarantee from the central bank that
private banks would be bailed out if their loans failed.
– imposed controls on flows of short-term assets, so
that funds could not be quickly withdrawn during a
financial panic.
– granted the central bank independence from fiscal
authorities, allowing slower money supply growth.
• Chile avoided a financial crisis in the 1990s.
International Reserves Held by
Developing Countries
Since the 1990s, developing countries have sharply increased their

holdings of foreign currency reserves, mostly U.S. dollars.
Source: World Bank, World Development indicators. In this chart,
developing countries include low- and middle-income countries
according to the World Bank’s country income classification.
East Asia: Success and Crisis (1 of 2)
• Before the 1990s, Indonesia, Korea, Malaysia,
Philippines, and Thailand relied mostly on domestic
saving to finance investment.
• But afterward, foreign funds financed much of
investment, and current account balances turned
negative.
East Asia: Success and Crisis (2 of 2)
• Despite the rapid economic growth in East Asia between
1960 and 1997, growth was predicted to slow as
economies “caught up” with Western countries.
– Most of the East Asian growth during this period is
attributed to an increase in physical capital and
education.
– The marginal productivities of physical capital and
education are diminishing: as more physical capital
was built and as more people acquired more
education, further increases added less productive
capability to the economy.
The Asian Financial Crises (1 of 6)
• More directly related to the East Asian crises are issues
related to economic laws and regulations:
1. Weak enforcement of financial regulations and a lack of
monitoring caused commercial firms, banks, and
borrowers to engage in risky or even fraudulent
activities: moral hazard.
– Ties between commercial firms and banks on the one
hand and government regulators on the other hand
allowed risky investments to occur.
2. Nonexistent or weakly enforced bankruptcy laws and
loan contracts worsened problems after the crisis
started.
– Financially troubled firms stopped paying their debts,
and they could not operate without cash, but no one
would lend more until previous debts were paid.
– But creditors lacked the legal means to confiscate
and sell assets to other investors or to restructure the
firms to make them productive again.
• The East Asian crisis started in Thailand in 1997, but quickly
spread to other countries.
– A fall in real estate prices, and then stock prices,
weakened aggregate demand and output in Thailand.
– A fall in aggregate demand in Japan, a major investor
and export market, also contributed to the economic
slowdown.
– Speculation about a devaluation of the baht occurred,
and in July 1997 the government devalued the baht
slightly, but this only invited further speculation.
• Malaysia, Indonesia, Korea, and the Philippines soon faced
speculations about the value of their currencies.
• Most debts of banks and firms were denominated in U.S.
dollars, so that devaluations of domestic currencies
would make the burden of the debts in domestic currency
increase.
– Bankruptcy and a banking crisis would have resulted.
• To maintain fixed exchange rates would have required
high interest rates and a reduction in government deficits,
leading to a reduction in aggregate demand, output, and
employment.
– This would have also led to widespread default on
debts and a banking crisis.
• All of the affected economies except Malaysia turned to
the IMF for loans to address the balance of payments
crises and to maintain the value of the domestic
currencies.
– The loans were conditional on increased interest
rates (reduced money supply growth), reduced
budget deficits, and reforms in banking regulation and
bankruptcy laws.
• Malaysia instead imposed controls on flows of financial
assets so that it could increase its money supply (and
lower interest rates), increase government purchases,
and still try to maintain the value of the ringgit.
• Because consumption and investment expenditure
decreased with output, income, and employment, imports
fell and the current account increased after 1997.
Lessons of Crises (1 of 4)
1. Fixing the exchange rate has risks: governments desire
to fix exchange rates to provide stability in the export
and import sectors, but the price to pay may be high
interest rates or high unemployment.
– High inflation (caused by government deficits or
increases in the money supply) or a drop in demand
of domestic exports leads to an overvalued currency
and pressure for devaluation.
– Given pressure for devaluation, commitment to a
fixed exchange rate usually means high interest
rates (a reduction in the money supply) and a
reduction in domestic prices.
– Prices can be reduced through a reduction in government
deficits, leading to a reduction in aggregate demand,
output, and employment.
– A fixed currency may encourage banks and firms to
borrow in foreign currencies, but a devaluation will cause
an increase in the burden of this debt and may lead to a
banking crisis and bankruptcy.
– Commitment a fixed exchange rate can cause a financial
crisis to worsen: high interest rates make loans for
individuals and institutions harder to repay, and the central
bank cannot freely print money to give to troubled banks
(cannot act as a lender of last resort).
2. Weak enforcement of financial regulations can lead to
risky investments and a banking crisis when a currency
crisis erupts or when a fall in output, income, and
employment occurs.
3. Liberalizing financial asset flows without implementing
sound financial regulations can lead to capital flight
when investments lose value during a recession.
4. The importance of expectations: even healthy
economies are vulnerable to crises when expectations
change.
– Expectations about an economy often change when
other economies suffer from adverse events.
– International crises may result from contagion: an
adverse event in one country leads to a similar event
in other countries.
Reforming the World’s Financial
“Architecture” (1 of 3)
• Countries face tradeoffs when trying to achieve the
following goals:
– exchange rate stability
– financial capital mobility
– autonomous monetary policy devoted to domestic
goals
• Generally, countries can attain only two of the three
goals, and as financial assets have become more mobile,
maintaining a fixed exchange with an autonomous
monetary policy has been difficult.
Preventative (“prophylactic”) measures:
1. Better monitoring and more transparency: more
information allows investors to make sound financial
decisions in good and bad times.
2. Stronger enforcement of financial regulations: reduces
moral hazard.
3. Deposit insurance and reserve requirements.
4. Increased equity finance relative to debt finance.
5. Increased credit for troubled banks through central
banks or the IMF?
Coping with crisis—reforms for after a crisis occurs:
1. Bankruptcy procedures for default on sovereign debt
and improved bankruptcy law for private sector debt.
2. A bigger or smaller role for the IMF as a lender of last
resort for governments, central banks, and even the
private sector? (See 5 above.)
– Moral hazard versus the benefit of insurance before
and after a crisis occurs.
Global Financial Cycles and Movements
in the Developing World’s GDP
The GDP growth rate of poorer countries moves closely in tandem with the global
financial cycle.
Source: GFCy: Miranda-Agrippino and Rey. “U.S. Monetary Policy and the Global
Financial Cycle,” Review of Economic Studies 87 (2020). Yearly observations
on GFCy are averages of monthly observations. GDP growth in emerging and
developing economies: World Economic Outlook database, April 2020.
Geography, Human Capital, and
Institutions (1 of 4)
• What causes poverty?
• A difficult question: economists argue about whether
geography or human capital is more important in
influencing economic and political institutions, and
ultimately poverty.
Geography matters:
1. International trade is important for growth, and ocean
harbors and a lack of geographical barriers foster trade
with foreign markets.
– Landlocked and mountainous regions are predicted to
be poor.
2. Also, geography is said to have determined institutions,
which may play a role in development.
– Geography determined whether Westerners
established property rights and long-term investment
in colonies, which in turn influenced economic growth.
– Geography determined whether Westerners died from
malaria and other diseases. With high mortality rates, they
established practices and institutions based on quick
plunder of colonies’ resources, rather than institutions
favoring long-term economic growth.
– Plunder led to property confiscation and corruption,
even after political independence from Westerners.
– Geography also determined whether local economies were
better for plantation agriculture, which resulted in income
inequalities and political inequalities. Under this system,
equal property rights were not established, hindering long-
term economic growth.
Human capital matters:
1. As a population becomes more literate, numerate, and
educated, economic and political institutions evolve to
foster long-term economic growth.
– Rather than geography, Western colonization, and
plantation agriculture, the amount of education and
other forms of human capital determine the existence
or lack of property rights, financial markets,
international trade, and other institutions that
encourage economic growth.
Summary (1 of 3)
1. Some countries have grown rapidly since 1960, but
others have stagnated and remained poor.
2. Many poor countries have extensive government control
of the economy, unsustainable fiscal and monetary
policies, lack of financial markets, weak enforcement of
economic laws, a large amount of corruption, and low
levels of education.
3. Many developing economies have traditionally borrowed
from international capital markets, and some have
suffered from periodic sovereign debt crises, balance of
payments crises, and banking crises.
Summary (2 of 3)
4. Sovereign debt, balance of payments, and banking
crises can be self-fulfilling, and each crisis can lead to
another within a country or in another country.
5. “Original sin” refers to the fact that poor and middle-
income countries often cannot borrow in their domestic
currencies.
6. Fixing exchange rates may lead to financial crises if the
country is unwilling to restrict monetary and fiscal
policies.
Summary (3 of 3)
7. Fixing exchange rates may lead to financial crises if the
country is unwilling to restrict monetary and fiscal
policies.
8. Weak enforcement of financial regulations causes a
moral hazard and may lead to a banking crisis,
especially with free movement of financial assets.
9. Geography and human capital may influence economic
and political institutions, which in turn may affect long-
term economic growth.
Copyright


International Economics

Uploaded by

Copyright:

Available Formats

You might also like

International Economics

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

International Economics

Uploaded by

Copyright:

Available Formats

International Economics: Theory and

▪ As the prices of foreign products rise relative to those

Change Effect on Current Account, CA

start fraction E P asterisk over P end fraction upward arrow

Disposable income, Y d ­ Y super d upward arrow

Y super d downward arrow

1. The volume of exports that are bought by foreigners rises.

– where aggregate demand is a function of the real

In the short run, output settles at Y 1 (point 1), where aggregate

A rise in the exchange rate from E 1 to E 2 (a currency depreciation)

1. Changes in G: more government purchases cause

A rise in government demand from G1 to G 2 raises output at every level of

– interest parity represents equilibrium: R = R *

– Equilibrium occurs when the quantity of real monetary assets

– A rise in income from production causes the demand of real

• When income and production increase,

The asset market equilibrium schedule (AA) slopes downward because a

2. Changes in P: An increase in the level of average

4. Changes in R * : An increase in the foreign interest

1. equilibrium in the output markets holds: aggregate

By shifting AA1 upward, a temporary increase in the money supply

By shifting DD1 to the right, a temporary fiscal expansion causes a

A temporary fall in world demand shifts DD1 to DD 2 , reducing output from Y 1 to Y 2

1. We have assumed that prices and expectations do not change, but

4. Policies are sometimes influenced by political or bureaucratic

A permanent increase in the money supply, which shifts AA1 to AA2

After a permanent money supply increase, a steadily increasing price level

Because a permanent fiscal expansion changes exchange rate expectations,

– The value of exports in domestic currency does not change.

• Some imported intermediate goods become part of goods that

• Suppose the central bank raises the domestic money supply so as

• At an interest rate of R = 0, people are indifferent between

This work is protected by United States copyright laws and is

• A purchase of any asset by the central bank will be paid

• A sale of any asset by the central bank will be paid for

Sterilized foreign 0 +$100

• When the exchange rate is fixed at some level E 0 and the

• Alternatively, we can say that it adjusts the quantity of

• This is predicted to put upward pressure on interest rates

Fiscal expansion (shown by the shift from DD1 to DD 2 ) and the

When a currency is devalued from E 0 to E 1, the economy’s

3. To avoid this outcome, domestic assets must offer high interest

4. As a result, the domestic economy may face high interest rates, a

the same: R > R *

where r is called a risk premium, an additional amount

2. Gold standard: gold acts as official international reserves

• Arbitrage ensured that exchange rates between any two currencies

– Suppose Bank of Japan fixed the exchange rate at 360 ¥ US$1

– If not, then currency traders could make an easy profit by buying

– So gold was worth 371.25 / 23.22 = 16 times as much as silver.

– See www.micheloud.com for a fun description of the bimetallic

2. When markets expect exchange rates to be fixed,

This work is protected by United States copyright laws and is

– If the domestic country’s yield is 100 and the foreign country’s

– If both countries are risk averse, then both countries could be

4. Central banks and government agencies:

– Central banks sometimes intervene in foreign exchange

– Higher bank capital (net worth) means banks have more

Disposable income, Y d Y super d upward arrow