Tuesday
7 September
1330-1500 (IS)
"An economist is an expert who will know tomorrow why the things he predicted yesterday didn't happen today."
L. Peter
Overview
To continue our discussion of international trade, we now take a look at exchange rates, the purposes they serve, how they are established and the impact they have.
Going back in time once more, the farmer we met swapped his sacks of corn and beans for the hunter's wild hog carcass. Barter trade was simple. When barter was no longer practical, men substituted other items, such as gold, as the medium of exchange. In this way, the farmer and hunter no longer needed to find one another. That problem was now resolved by a marketplace (most often run by intermediary traders) where consumers could find the products they required. Eventually, people decided that using things such as gold as the medium of exchange also was not very practical. Thus it was that money came into being.
When our Floridian sends oranges to Michigan and ultimately wants to buy those Fords, he has no problem in the transaction, since both parties use the same currency, the dollar. However, when Dell Computers wishes to purchase memory chips from Malaysia, there are two different currencies involved. The problem for the Malaysian producer is that he must pay his workers in local currency, and thus must exchange the dollars he receives for the memory chips for Malaysian ringgits.
In theory, exchange rates should produce equal results - purchasing power parity. Thus, a Big Mac (the example used by The Economist magazine - See Topic 2) should cost the same in Paris as it does in Washington - once francs are converted to dollars. That this is not always the case has an important impact on trade and development around the world.
When countries trade, they seek a balance - that is, they seek to achieve equilibrium between the amounts (stated as a cash value) they import and export. A balance of payments deficit, therefore, is the amount by which a country's imports exceed its exports expressed in monetary terms.
For most of the past decade, the United States has operated in a balance of payments deficit position, and yet its economy has flourished. Japan's economy, which continues to accumulate large trade surpluses, has fared less well. Both situations defy conventional wisdom.
As the leading world currency for most of the 20th century, some would say that the dollar has enhanced the economic power of the United States. A number of people are concerned that the advent of the Euro, the new currency of the European Union which will come into circulation early in the next decade, will threaten the primacy of the dollar and thereby weaken the U.S. economy.
While it is commonplace to identify its weaknesses, the U.S. economy has been dominant throughout most of the 20th century. This is evident in the volume of U.S. imports and exports, the preponderant role of the U.S. dollar in the world economy, and the level of foreign and domestic investment in this country. Nevertheless, while U.S. economic power is indisputable in the absolute sense, it has diminished relative to increased strength in Western Europe and parts of Asia since the end of World War II.
Objectives
- Understand how exchange rates are established and the consequences of interference with free market exchange mechanisms.
- Understand the nature and importance of the role of the convertibility of international currencies.
- Understand the concepts of the balances of trade and payments and their relationship to economic strength (perceived and actual)
- Review the importance and role of the U.S. dollar both to international trade and to the strength of the American economy.
Issues for consideration
- What is an overvalued (or undervalued) exchange rate?
- What are the causes of this?
- What are the consequences of such a rate for a) tourists, b) exporters and c) importers?
- What is the link between U.S. competitiveness and dollar exchange rates? Are other factors more important?
- Is the notion of barter still relevant? Explain.
- As a national security strategist, what are the risks of having a chronic U.S. trade deficit?
- Do you believe that the Euro will threaten the role of the dollar as the world's primary medium of exchange? Explain.
Required readings (77 pages)
* Baumol and Blinder: Chapters 35 (22 pgs.) and 36 (18 pgs.)
* Heilbroner and Thurow: Chapter 18 (11 pgs.) and 19 (12 pgs.)
* "Eurocollision," Richard Morais, Forbes, April 19, 1999 (3 pgs.)
* "World Money," James W. Michaels, Forbes, November 16, 1998. (10 pgs.)
* "Financial Indicators," The Economist, October 13, 1998. (1 pg.)
Suggested reading
* "Currencies In Crisis," Fred Barbash, The Washington Post, February 7, 1999 (2 pgs.)
* "Monomoney Mania," Paul Krugman, Slate, April 15, 1999 (6 pgs.)
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