Chapter Fourteen

Economic
Interdependence
 The International Business Cycle
• Countries are not independent of one another;
downturns in one country may coincide with
others
• The relationship between these countries is the
international business cycle
1. What causes the business cycles of different
countries to be related?
2. Is the whole world in the same phases of the
business cycle simultaneously?
3. How are shocks in one country transmitted to other
countries?

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 Why Is There an International
Business Cycle?
• Shocks may affect several countries
– A shock is an unexpected change in an exogenous variable.
When large enough, shocks can lead to macroeconomic
fluctuations
– Example: uncertainty about the price of oil demanded by OPEC
(negative shock) or a change in technology (positive shock)
• Shocks may spread because of economic
interdependence
– When a shock hits one country, others are affected because of
international trade
– Example: a tax cut in one country to reduce aggregate demand
also decreases demand for imports, affecting the output/income
of another country

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 The International Business Cycle
How correlated are business cycles?
1970-1985 1985-2000
US-Europe 0.7 0.3
US-Japan 0.6 0.0
US-Canada 0.8 0.8
• A correlation of 1 would mean output changed in both places at the
same time and by the same amount.
• Strong correlations existed from the 1970s through the mid-80s.
• Correlation sharply declined in late 80s and 90s because the U.S
entered a recession two years before the other nations.

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 The International
Transmission of Shocks
Three mechanisms whereby shocks are transmitted
• Trade effects
– Exports are a component of aggregate demand, so
demand from other countries bears influence
• Interest-rate effects
– Investment flows across borders, so increased foreign
investment raises output domestically
• Exchange-rate effects
– Exchange rates help determine the prices of exports
and imports, thereby affecting aggregate demand

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 Exchange Rates
• The exchange rate is the amount of one currency
needed to purchase one unit of another currency
• Consumers desire foreign currency so that they can
purchase goods from other countries
• Because currency is traded via the market, the price of
currencies change
– Appreciation: when the value of one currency increases relative
to another
– Depreciation: when the value of one currency decreases
relative to another
– Example: Exchange rate: Y/Z
• if Y/Z falls, Z depreciates & Y appreciates
• if Y/Z rises, Z appreciates & Y depreciates

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 Exchange Rates (cont’d)

The euro depreciated against the dollar from January 1999-January

2001, and the dollar appreciated relative to the euro

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 Exchange Rates (cont’d)
• The appreciation or depreciation of a country’s currency
affects the prices of imports and exports
– For a given cost of production
• when a currency appreciates, export prices rise
• when a currency depreciates, export prices fall

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 Exchange Rates (cont’d)

• Recently, U.S. dollar

depreciates vs. euro
– U.S. goods sold in Europe
now cheaper
– European goods sold in
U.S. now more expensive.
– U.S. exports rise; U.S.
imports fall
– European exports fall;
European imports rise

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 How Supply & Demand Determine
Exchange Rates

• Demand slopes downward because lower euro/$ means $1 costs

fewer euro, so demand for $ will be higher ($ is cheaper)
• Supply slopes upward because lower euro/$ means you get more $
from selling 1 euro, so you supply more $

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 How Supply & Demand Determine
Exchange Rates (cont’d)

Increased demand: currency appreciates

Increased supply: currency depreciates

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 How International Trade
Affects Exchange Rates
• The law of one price: if
only one good exists, it
should sell for the same
price everywhere
• The equilibrium exchange
rate will hold if the law of
one price is true
• But in reality, many goods
are traded between
countries

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 Purchasing Power Parity

• Exchange rates depend on price indexes in

different countries
• Absolute Purchasing Power Parity (PPP)
– The exchange rate should equal the ratio of price
indexes of different countries
– Idea: Generalize the law of one price to all goods

– Problem: does not hold in practice because goods

differ across countries and not all goods are traded

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 Purchasing Power Parity (cont’d)

• Relative PPP is the idea that a currency in one

country should depreciate relative to the
currency in a second country by the amount by
which inflation is higher in the first country
– Idea: Levels of prices may not be reflected in
exchange rate, so absolute PPP doesn’t hold; but
changes in inflation do affect exchange rates
– Evidence: works reasonably well, though other
factors matter more and it takes a long time to adjust

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 Real Exchange Rates

• Real exchange rates are exchange rates

adjusted for inflation in both countries

P
xX F
P
– real exchange rate: x = number of units of foreign
good per unit of domestic good
– nominal exchange rate: X = amount of foreign
currency per unit of domestic currency

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 Real Exchange Rates (cont’d)

In percentage change terms

%ΔX = %Δx + πF – π

– Under relative PPP, the real exchange rate

does not change, so the nominal exchange
rate changes by: %ΔX = πF – π

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 How Financial Investment Affects the
Exchange Rate

• A key concern with investing in another

country is the risk that the exchange rate
might change
• If you invest in a foreign security earning
nominal interest rate iF, your expected
return in dollar terms is: iF – %ΔXe
• Compare to domestic interest rate iD
D F e
i  i  %X
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 How Exchange Rates
Affect the Economy

In nominal terms, the dollar has mostly appreciated since 1973.

In real terms, the dollar has been fairly stable

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 International Payments Accounting
• Savings = Domestic investment + Net exports
+ Government budget deficit

S = I + NX + (G – T)
• This system reflects the balance on current
account system, a measure of the flow of
payments between countries
• Net exports, net income from abroad, and
unilateral current transfers are included

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International Payments Accounting (cont’d)

• The balance on capital and financial

account is the amount foreign citizens,
firms, and governments invest in a
country, minus the amount the country’s
citizens, firms, and governments invest
abroad
S = I + NFI + (G – T)
• The negative balance is net foreign
investment

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The Business Cycle & Exchange Rates
How does the business cycle affect nominal and real
exchange rates?
Figure 14.5 Recessions and the Foreign-Exchange Value of the U.S. Dollar

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 How Independent Should
a Country Be?
• Increased openness to trade and capital
flows enables a country to grow faster

• Being open also allows foreign shocks to

be transmitted domestically

• Open countries must be prepared to face

the consequences of foreign investors’
changing expectations

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 How Independent Should
a Country Be? (cont’d)
The Asian crisis in 1997
– Investors pulled out because their
investments were not paying off well

– Because those countries borrowed from

foreigners and owed debt in foreign
currencies, as exchange rates fell, they owed
more in terms of their own currencies

– Default risk necessarily increased

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 How Independent Should
a Country Be? (cont’d)
• What can a country do if investors flee and
the currency depreciates?
– Buy the currency in foreign-exchange markets
using reserves: but reserves may run out
– Raise real interest rate to attract investors, but
as real rate rises, business capital investment
falls
– Restrict flow of capital: don’t let foreign
investors in, but then growth is slower

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