No Such Thing as a Free Lunch: Principles of Economics (Part 179)

Monetary policy is like juggling six balls... it is not 'interest rate up, interest rate down.' There is the exchange rate, there are long term yields, there are short term yields, there is credit growth.

Raghuram Rajan

Open Economy Macroeconomics: The Balance of Payments and Exchange Rates

(Part A)

by

Charles Lamson

The economies of the world have become increasingly interdependent over the last five decades. No economy operates in a vacuum, and economic events in one country can have significant repercussions on the economies of other countries.

International trade is a major part of today's world economy. In the preceding posts, we explored the main reasons why there is international exchange. Countries trade with each other to obtain goods and services they cannot produce themselves or because other nations can produce goods and services at a lower cost than they can. Foreign countries supply goods and services to the United States, and the United States supplies goods and services to the rest of the world.

From a macroeconomic point of view, the main difference between an international transaction and a domestic transaction concerns currency exchange:

When people in different countries buy from and sell to each other, an exchange of currencies must also take place.

Brazilian coffee exporters cannot spend U.S. dollars in Brazil they need Brazilian rials. A U.S. wheat exporter cannot use Brazilian rials to buy a tractor from a U.S. company or to pay the rent on warehouse facilities. Somehow, international exchange must be managed in a way that allows both partners in the transaction to wind up with their own currency.

As you know from preceding posts, the direction of trade between two countries depends on exchange rates---the price of one country's currency in terms of the other country's currency. If the Japanese Yen were very expensive (making the dollar cheap), both Japanese and Americans would buy from U.S. producers. If the Yen were very cheap (making the U.S. dollar expensive), both Japanese and Americans would buy from Japanese producers. Within a certain range of exchange rates, trade flows in both directions, each country specializes in producing the goods in which it enjoys a comparative advantage, and trade is mutually beneficial.

Because exchange rates are a factor in determining the flow of international trade, the way they are determined is very important. Since the turn of the twentieth century, the world monetary system has been changed several times by international agreements and events. Early in the twentieth century nearly all currencies were backed by gold. Their values were fixed in terms of a specific number of ounces of gold, which determined their values in international trading exchange rates.

In 1944, with the international monetary system in chaos as the end of World War II drew near, a large group of experts unofficially representing 44 countries met in Bretton Woods, New Hampshire, and drew up a number of agreements. One of these agreements established a system of essentially fixed exchange rates under which each country agreed to intervene by buying and selling currencies in the foreign exchange market when necessary to maintain the agreed to value of its currency.

In 1971, most countries, including the United States, gave up trying to fix exchange rates formally and began allowing them to be determined essentially by supply and demand. For example, without government intervention in the marketplace, the price of British pounds in dollars is determined by the interaction of those who want to exchange dollars for pounds (those who "demand" pounds) and those who want to exchange pounds for dollars (those who "supply" pounds). If the quantity of pounds demanded exceeds the quantity of pounds supplied, the price of pounds will rise, just as the price of peanuts or paper clips would rise under similar circumstances.

In the next several posts, we explore what has come to be called "open-economy macroeconomics" in more detail. First, we discuss the balance of payments---the record of a nation's transactions with the rest of the world. We then go on to consider how the analysis changes when we allow for the international exchange of goods, services, and capital. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 687-688*

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