In the last couple of months the exchange rate of the US dollar against the currencies of many of its trading partners has been rising steadily. The charts below show the value of the dollar in terms of Japanese Yen and Euro in the last month.
The reasons for the rise in the dollar are simple and illustrate some of the determinants of exchange rates that we learn about in our IB Economics classes. Listen to a recent story from APM’s Marketplace radio show about the dollar’s recent rise, then answer the questions that follow.
Discuss with your class how each of the factors mentioned in the podcast help explain the recent rise in the value of the US dollar against other major currencies:
Using your knowledge of macroeconomics, discuss and explain the following claim: “the impact of more expensive exports and cheaper imports may be to stifle inflation just enough to make the Fed slow down any rate increases, which would in turn slow down the dollar’s rise.”
Using diagrams for the market for US dollar in Europe and for the Euro in the United States, and referring to one of the determinants of exchange rates mentioned in the story, illustrate the rise in the dollar’s value against the Euro over the last month and the corresponding fall in the Euro’s value against the dollar. Use values from the chart above on to determine the appropriate exchange rate values for your graphs.
Explain how each of the following interventions could be used to devalue the dollar, assuming the US government or Federal Reserve Bank decided the dollar’s appreciation posed a threat to the US recovery:
Note: This post was originally published in August of 2010. It is being reposted today to support a lesson on fiscal policy in my year 2 IB Economics class.
In the seemingly endless and currently ongoing debate over the role of the government in the macroeconomy, there are two main camps: Those who think the governments of the developed economies have not done enough to get their economies out of recession, and those who think they have already done too much, and therefore need to start rolling back stimulus and reducing deficits.
At the heart of this debate are the two macroeconomic schools of thought, the Keynesian demand-side theories and the classical, supply-side theories. Two intellectuals have emerged in the last several years representing the two sides of the macroeconomic debate. On the demand-side, representing the Keynesian school of thought, is 2008 Nobel Prize winning economist Paul Krugman. Representing the classical, supply-side school of thought is Harvard economic historian Niall Ferguson. These two have squared off in many forums over the last three years, Krugman arguing for more and continued fiscal stimulus to prop up and increase demand in the economy, Ferguson arguing for smaller deficits, lower taxes and less government spending to increase private sector confidence and thereby supply in the economy.
During our long summer break the two squared off once again in the aftermath of a G20 meeting in which the governments of several major economies from Europe and North America announced plans to begin rolling back the stimulus spending they embarked on throughout 2008 and 2009. The reason for increased “austerity measures” (policies that reduce the budget deficit and slow the growth of national debt), argue global leaders, is to reduce the chances of more countries experiencing debt crises like that experienced in Greece this spring.
International investors realized earlier this year that Greece’s budget deficits were a much larger percentage of its GDP than previously thought, and very quickly decided that Greek government bonds were an unsafe investment. Almost overnight the cost of borrowing in Greece shot up above 20%, bringing investment in the economy to a halt and forcing the government to cut its budget, leading to higher unemployment and reduced social benefits for the people of Greece. If investors were to look at the growing budget deficits in other developed countries and then suddenly lose faith in other government’s ability to pay back their debts, then a similar crisis could occur in much larger economies, including the UK, Germany and the United States. Hence these country’s apparent desire to begin reducing deficits and rolling back stimulus spending; measures that may just plunge these economies into an even deeper recession than that which they have experienced over the last two years.
The videos below show the leading intellectuals on both sides of the stimulus/austerity debate presenting their arguments. Below each video are discussion questions to help guide your understanding of their views. Watch the videos and respond to the discussion questions in the comment section below.
Update: Once again I have updated this post with a few minor changes. Notably, I have added to graphs illustrating a separate shift in supply and demand for loanable funds. Based on discussions with readers via email, it appears that my previous graph illustrating in one diagram the shifts of both supply and demand was confusing and could be considered double counting the effect of an increase in deficit spending. Thanks again to Professor Chuck Orvis for his valuable input.
*Click on a graph to see the full-sized version
Two markets for money, right? Yes… so do they show the same thing? NO! You must know the distinction between these two markets. First let’s talk about the Money Market diagram.
This market refers to the Money Supply (M1 and M2). The Money Supply curve is vertical because it is determined by the Fed’s (or central bank’s) particular monetary policy. On the X axis is the Quantity of money supplied and demanded, and on the Y axis is the nominal interest rate. A tight monetary policy (selling of bonds by the Fed) will shift Money Supply in, raising the federal funds rate, and subsequently the interest rates commercial banks charge their best customers (prime interest rate). On the other hand, an easy money policy (buying of bonds by the Fed) shifts Sm out, lowering the Federal Funds rate and thus the prime interest rate.
You should also know why a tight money policy is considered contractionary and why an easy money policy is considered expansionary monetary policy. Higher nominal interest rates resulting from tight money policy will discourage investment and consumption, contracting aggregate demand. On the other hand, an easy money policy will encourage more investment and consumption as nominal rates fall, expanding aggregate demand.
First watch this video lesson, which defines and introduces the money market diagram (skip ahead to 0:43 to hear the definition and explanation of the money market):
Government deficit spending and the money market: Does an increase in government spending without a corresponding increase in taxes affect the money market? You may be inclined to say yes, since the Treasury must issue new bonds to finance deficit spending. After all, when the Fed sells bonds, money is taken out of circulation and held by the Fed, thus it’s no longer part of the money supply.
When the Treasury issues and sells new bonds, however, the money the public uses to buy the bonds is put back into circulation as the government spending is increased. Therefore, any leftward shift of the money supply curve caused by the buying of bonds by the public is offset by the injection of cash in the economy initiated the government’s fiscal stimulus package takes effect (be it a tax rebate or an increase in spending). Therefore, money supply should remain stable when the government deficit spends.
However, since the money demand curve depends on the level of transactions going on in a nation’s economy in a particular period of time, an increase in government spending on infrastructure, defense, corporate subsidies, tax rebates or other fiscal policy initiatives will increase the demand for money, shifting the Dm curve rightward and driving up interest rates. The higher interest rates resulting from the greater demand for money reduces the quantity of private investment; in this way the crowding-out effect can be illustrated in the money market.
Now to the loanable funds market. Loanable funds represents the money in commercial banks and lending institutions that is available to lend out to firms and households to finance expenditures (investment or consumption). The Y-axis represents the real interest rate; the loanable funds market therefore recognizes the relationships between real returns on savings and real price of borrowing with the public’s willingness to save and borrow.
Watch this video for a clear explanation of the loanable funds market and how it can be used to illustrate the crowding-out effect (skip ahead to 3:18 for a definition and explanation of the loanable funds market):
Since an increase in the real interest rate makes households and firms want to place more money in the bank (and more money in the bank means more money to loan out), there is a direct relationship between real interest rate and Supply of Loanable Funds. On the other hand, since at lower real interest rates households and firms will be less inclined to save and more inclined to borrow and spend, the Demand for loanable funds reflects an inverse relationship. At higher interest rates, households prefer to delay their spending and put their money in savings, since the opportunity cost of spending now rises with the real interest rate.
Government deficit spending and the loanable funds market: We learned above that only the Fed can shift the money supply curve, but what factors can affect the Supply and Demand curves for loanable funds? Here’s a few key points to know about the loanable funds market.
When the government deficit spends (G>tax revenue), it must borrow from the public by issuing bonds.
The Treasury issues new bonds, which shifts the supply of bonds out, lowering their prices and raising the interest rates on bonds.
In response to higher interest rates on bonds, investors will transfer their money out of banks and other lending institutions and into the bond market. Banks will also lend out fewer of their excess reserves, and put some of those reserves into the bond market as well, where it is secure and now earns relatively higher interest.
As households, firms and banks buy the newly issued Treasury securities (which represents the public’s lending to the government), the supply of private funds available for lending to households and firms shifts in. With fewer funds for private lending banks must raise their interest rates, leading to a movement along the demand curve for loanable funds.
This causes crowding out of private investment.
Another, simpler way to understand the effect of government deficit spending on real interest rates is to look at it from the demand side.
Deficit spending by the government requires the government to borrow from the public, increasing the demand for loanable funds. In essence, the government becomes a borrower in the country’s financial sector, demanding new funds for investment, driving up real interest rates.
Increased demand from the government pushes interest rates up, causing banks to supply a greater quanity of funds for lending. The private, however, now has fewer funds available to borrow as the government soaks up some of the funds that previously would have gone to private borrowers.
What could shift the supply of loanable funds to the right? Easy, anything that increases savings by households and firms, known as the determinants of consumption and saving. These include increases in wealth, expectations of future income and price levels, and lower taxes. If savings increases, supply of loanable funds shifts outward, increasing the reserves in banks, lowering real interest rates, encouraging firms to undertake new investments. This is why many economists say that “savings is investment”. What they mean is increased increased savings leads to an increase in the supply of loanable funds, which leads to lower interest rates and increased investment.
On the other hand, an increase in demand for investment funds by firms will shift demand for loanable funds out, driving up real interest rates. The determinants of investment include business taxes, technological change, expectations of future business opportunities, and so on (follow link to our wiki page on Investment).
It is important to be able to distinguish between the money market and the market for loanable funds, as both the AP and IB syllabi xpect students to understand and explain the difference between these concepts.
The chart below shows how the value of the Swiss franc has changed against the Indian rupee over the last year and a half.
The Value of the Swiss Franc in terms of India Rupees – last 18 months
As can be seen, the franc, which is the currency in which I get paid here in Switzerland, has risen from only 40 rupees 18 months ago to as high as 63 rupees in August this year, and is currently at 57 rupees per Swiss franc. We’ll explore the underlying causes of this appreciation of the franc in a moment, but first let’s examine its effect on my dream of skiing in the Himalayas.
So just yesterday morning I did, at last, after six years of dreaming of this adventure, book a six day guided ski trip in the Indian Kashmir town of Gulmarg, which sits at an elevation of 2800 meters and has lift-accessed skiing up to 4,000 meters, making Gulmarg the second highest ski resort in the world. Okay, enough facts. The strong franc made this trip a reality for me for the following reason:
18 months ago, the 40,000 rupee price tag of this ski trip would have meant a cost of 1,000 swiss francs.
Today, due to the strong franc, the 40,000 rupee price tag means this trip is only costing me 700 swiss francs.
Due to the strengthening of the franc, and the weakening of the rupee, my Himalayan ski odyssey is now costing me 30% less than it would have 18 months ago… so… I’m doing it! YEAH!
The Swiss currency has appreciated by 42.5% in the last 18 months against the India rupee. WHY?! What could be going on in the world that accounts for this massive swing in exchange rates? There are a few causes worth mentioning here, which have to do with factors within Switzerland and India, but also external factors beyond the control of either country. Here are some of the major ones:
The franc has risen against most world currencies, not just the rupee, due, ironically, to economic uncertainty in the rest of Europe. Since Switzerland has its own currency, and a strong economy, whereas all of its European neighbors have a common currency (the euro), and struggling economies, investments in Swiss assets (primarily savings accounts and government debt) have become increasingly attractive. This has caused demand for francs to rise, causing its value to increase against most currencies.
The debt crisis in the rest of Europe, most notably in Greece and Italy, reduces certainty among investors in these European governments’ ability to repay their debt, creating further demand for investment in Switzerland, causing the franc to rise.
According to the Associated Press, “Slowing growth, a swelling current account deficit and waning investor interest in India are adding to pressure on the rupee…” India runs a large trade deficit, equaling about 3% of the nation’s GDP. This means Indians are dependent on imported goods, while foreigners do not demand as many of its exports. This puts downward pressure on the exchange rate of the rupee.
In addition, the “slowing growth” rate in India sends the signal that the country’s central bank may lower interest rates to try and stimulate GDP. However, the expectations of lower interest rates in the future make international investors look elsewhere for investments with relatively higher returns.
Next, weaker growth prospects make investments in Indian assets (such as corporate stocks or bonds) less attractive to international investors, since they expect demand for Indian output to slow in the future, thus demand for rupees declines now.
Finally, the decline in the rupee’s value itself is fueling a further increase in the value of the franc. Not all currency exchanges are for the purpose of purchasing a nation’s goods or its assets. Much currency trading is among forex brokers who buy and sell currencies to hold as assets themselves. The weakening of the rupee may be fueling speculation about the future value of the rupee, which acts as a self-fulfilling prophecy, as forex investors will continue to swap rupees for other currencies, including the Swiss franc.
All this adds up to one thing for me: A 30% discount on my ski vacation to India! Of course, for the Indian economy, a weaker rupee might be just what is needed to boost future economic growth. As the rupee falls and the Swiss franc and the US dollar gain value, not only will ski vacations to India become more attractive to foreigners, but so will other exports from the South Asian nation. That 3% trade deficit that has contributed to the rupee’s decline may begin to move towards the positive if foreigners like me begin taking more trips to and buying more goods from Indian firms.
The weaker rupee could, in the long-run, increase total demand for India’s output, which would improve employment and growth prospects on the sub-continent. Furthermore, if India’s growth rate picks up due to increased net exports, the Indian central bank may be able to raise interest rates a bit, reducing the incentive for investors to flee the rupee and put their money in countries with higher returns.
Through this process of self-balancing, in time the weaker rupee will probably lead to an improvement in India’s economic situation and eventually the rupee will begin to strengthen against the currencies of India’s trading partners. But for now, I’m going to enjoy my week of guided skiing in the Himalayas, and thank the forex traders and currency speculators for allowing me to take this dream vacation for such a bargain price!
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The most important graph used in Macroeconomics today is almost certainly the Aggregate Demand / Aggregate Supply (AD/AS) model. This graph can be used to illustrate most macroeconomic indicators, including those objectives that policymakers are most interested in achieving:
The AD/AS model, on its surface, is a very simple diagram, showing the total, or aggregate demand for a nation’s output and the total, or aggregate supply of goods and services produces in a nation. It is very similar to the microeconomics supply and demand diagram, except that instead of comparing the quantity of a particular good to the price in the market, the AD/AS model plots the national output (Y) against the average price level (PL). The model shows an inverse relationship between aggregate and price level, and a direct relationship between aggregate supply and price levels.
What makes this seemingly simple model so interesting, however, is that there are two wildly different opinions among economists on one of the its two primary components. Some economists, whom we shall refer to as Keynesians, believe that the AS curve is horizontal whenever aggregate demand decreases, and vertical whenever AD increases beyond the full employment level of output. On the other side of this debate is whom we shall refer to as the Hayekians who believe that AS is vertical, regardless of the level of demand in the nation. The two views of AS can be illustrated as follows.
Underlying the two models above are very different ideas about a nation’s economy. The Keynesian AS curve implies that anything that leads to a fall in a nation’s aggregate demand (either household consumption, investment by firms, government spending or net exports) will cause a relatively mild fall in prices in the economy but a significant decline in the real GDP (or the total output and employment in the nation). The neo-classical AS curve, on the other hand, being vertical (or perfectly inelastic), implies that no matter what happens to AD, the nation’s output and employment will always remain at the full employment level (Yfe).
Behind these two models of AS are two schools of economic thought, one rooted in Keynesian theories and one rooted in the theories of an intellectual rival and contemporary of John Maynard Keynes’, Friedrich Hayek. Keynes and Hayek were the most pre-eminent economists of their era. Both lived in the first half of the 20th century, and rose to prominence in between the two World Wars. Both economists saw the world fall into the Great Depression, but each of them formulated their own distinct theory on the best way to deal with the Depression. The episode of Planet Money below goes into some detail about the lives and the theories of these to most influential economists.
Keynes believed in what we today call demand-management. The idea that through well planned economic policies, governments and central banks could intervene in a nation’s economy during periods of economic downturn to return the economy to its full-employment level, or the level of output the nation would be producing at if everyone who was willing and able to work was actually working. Keynes believed that aggregate demand was the most vital measure of economic activity in a nation, and that through its use of fiscal and monetary policies (changes in the tax rates, the levels of government spending, and the interest rates in the economy), the government and central bank could provide stimulus to a depressed economy and create demand for the nation’s resources that would help move a depressed economy back towards full employment.
Hayek and his disciples, on the other hand (sometimes referred to today as the supply-siders) had a different interpretation of the macroeconomy. Hayek was what many today refer to as a libertarian. He believed that the government’s best strategy for handling an economic downturn was to get out of the way. Any attempt by the government to influence the allocation of resources through “stimulus projects” would only reduce the private sector’s ability to quickly and efficienty correct itself. The free market, argued Hayek, was always superior to the government when it came to allocating resources towards the production of the goods and services consumers demanded, so why allow government to intervene in the economy at all. All a government should do, argued Hayek, was provide a few basic guidelines to allow the economy to function. A legal system of property rights, for instance. The government need not provide anything else. The free market would take care of health care, education, defense, security, infrastructure, and anything else the market demanded.
During depressions, Hayek believed that government could only make things worse by trying to intervene to restore full employment. At any and all times, government’s best action would be to lower taxes, reduce its spending on goods and services, and thereby encourage private entrepreneurs to provide the nation’s households with the output they demand. Any regulation of the private sector, including minimum wages, environmental regulations, workplace safety laws, government pensions, unemployment benefits, welfare payments, or any other measures by government to redistribute wealth or promote equality or social welfare would reduce incentives for individuals in society to achieve their full productivity and strive to maximize their potential output. By minimizing the government’s role in the economy, argued Hayek, a nation would be likely to recover swiftly from a 1930’s style Depression, and output can be maintained at a level that corresponds with full employment of the nation’s resources.
The graphs below show how the two competing ideologies view the effects of a fall in aggregate demand in the economy.
On the left we see the Keynesian model, which shows output (real GDP) falling with a fall in AD. The fall in output corresponds with a fall in employment, and therefore a recession (or Depression). To return to full employment, aggregate demand must move back to the right (or increase). To facilitate this, Keynes and his contemporaries believed that government should increase its spending, decrease taxes (to encourage households and firms to spend) and lower interest rates (to make saving less appealing). All that is needed, say the Keynesians, is a dose of stimulus to get back to full employment (Yfe).
In the Hayekian model, no government intervention is needed at all when aggregate demand falls. In fact, in an economy with very limited government, a fall in AD will have little or no effect on output and employment. Without minimum wages or laws making it difficult or expensive for firms to reduce wages or fire and hire workers, firms faced with falling demand will simply lower their employees’ wages and reduce the prices of their products to maintain their output. If there is no more demand for some products, those firms will shut down and their workers will go to work for firms whose products are still in demand, at whatever wage rate the market is offering. Wages and prices are perfectly flexible in the Hayekian view, because there is no government interfering, demanding workers for big government projects, competing wages up, enforcing a minimum wage, or paying unemployment benefits to those out of work: all policies that make it difficult for wages to adjust downwards during a recession. Without government intervention, wages and prices rise and fall with the level of demand in the economy, but output remains constant at its full employment level.
The two models could not be more different. In one (Keynes’) recessions will occur anytime demand falls below the level needed to maintain full employment. In the other (Hayek’s), recessions are impossible as long as government gets out (and stays out) of the way.
Which models is the right model? For most of the last 100 years, most Western economies have demonstrated more of the characteristics of the Keynesian model. As the last several years show, recessions certainly are possible. Wages and prices have NOT fallen as much as Hayek’s model suggest they should, and economic output has declined in many Western nations and remains below the levels achieved in 2007 in many places. Most economists would argue that this prolonged recession is likely due to a weak level of aggregate demand. And the economic policies of many Western nations have reflected the Keynesian belief that government can “fix the problem” through stimulus plans involving tax cuts, spending increases, and low interest rates.
But two years of Keynesian policies are now being reversed. US President Obama’s latest attempt at a Keynesian-style stimulus (his $447 billion “American Jobs Act”) has been rejected by the US Congress. Across Europe, government spending is being slashed and taxes are being raised, both policies that threaten to further reduce aggregate demand. Deregulation is the battle cry of the Republican Party in the United States one year before the next presidential election. Presidential candidates are promising to “cut taxes, cut spending and cut government”, which sounds like a Hayekian battle cry. Less government will lead to more competition, greater efficiency, more employment and a stronger economy, goes the thinking. Government cannot solve our problems, government is our problem.
This debate is not a new one. It has been going on since the 1930s when two scholars, one an Englishman from Cambridge, the other an Austrian at the London School of Economics, went toe to toe on the role of government in a nation’s economy. The two models of aggregate supply above survive to this day, and 80 years later, in the midst of what may be the second Great Depression, economists and politicians still haven’t figured out which theory is correct. Part of our problem is that in our Western democracies in which economic policies are determined by politicians who are often only in office for two to four years, we have not had the opportunity to truly put either economic theory to the test. Less than three years ago Barack Obama, freshly elected, embarked on the greatest experiment in Keynesianism since Franklin Roosevelt’s “New Deal”, which was widely credited with getting the US out of the Depression. Now, with another election looming, we have politicians promising to bring America back to economic prosperity in a truly Hayekian fashion, by “cutting, cutting and cutting”.