(BQ) Part 2 book Macroeconomics has contents: Long-Run economic growth - Sources and policies; aggregate demand and aggregate supply analysis; supply analysis; inflation, unemployment, and federal reserve policy; macroeconomics in an open economy; the international financial system,...and other contents.
Find more at www.downloadslide.com Lo n g-Ru n Eco n o m i c G rowth : Sou rces a n d Po l i c i es C h a pte r Outl i n e a n d Lea r n i n g Objectives 1 Economic Growth over nme ond around Ihe World, page 304 Define economic growlh, calculate economic growlh rates, and describe global trends i n economic growlh 0.2 Whal Delermlnes How Fast Economies Grow? page 308 Use the econom i c growlh model to explain why growlh rotes differ across countries 0.3 Economic Growth I n Ihe Unlled Sloles, poge 31 Discuss flucluotions i n produclivity growlh in Ihe United states 0.4 Why Isn'l Ihe Whole World Rich? page Explain economic catch-up ond discuss why mony poor countries hove not experienced rapid economic growlh 0.5 Growth Policies, poge 326 Discuss govemment poli cies that fosler economic growlh Find more at www.downloadslide.com » Goog le's D i lemma i n China Google was founded in 1998 b y Larry Page and Sergey Brin By 2009, Google employed more than 20,000 people and had annual rev enues exceeding $21 billion But Google encountered problems when expanding into China in 2006 The Chinese government has insisted on regulating how people in that country access the Internet In setting up Google.cn, Google had to agree to block searches of sensitive topics, such as the 1989 pro-democracy demonstrations in Tiananmen Square In 2009, Google ran into further problems as the Chinese government insisted that it stop showing some results from foreign Web sites Google's problems highlight one of the paradoxes of China in recent years: very rapid economic growth occurring in the context of government regulations that may ultimately stifle that growth From the time the Communist Party seized control of China in 949 until the late 970s, the government controlled production, and the country expe rienced very little economic growth China moved away from a centrally planned economy in 1978, and real GDP per capita grew at a rate of 6.5 percent per year between 979 and 1995; it grew at the white-hot rate of more than percent per year between 1996 and 2008 These rapid growth rates have trans formed the Chinese economy: Real GDP per capita today is 10 times higher than it was 50 years ago But, as the experience of Google has shown, China is not a democracy, and the Chinese government has failed to fully estab lish the rule of law, particularly with respect to the consistent enforcement of property rights This is a problem for the long-term prospects of the Chinese economy because without the rule of law, entrepreneurs cannot fulfill their role in the market system of bring ing together the factors of production-labor, capital, and natural resources-to produce goods and services For a discussion of the Chinese govern ment's attempts to spur economic growth through higher investment spending, read AN INSIDE LOOK AT POLICY on page 330 Sources: Aaron Back and Jessica E Vasceliaro, ·China Orders Google to Halt links to Some Foreign Sites,' Wall Stleet Journal, June 20, 2009 Econom ics i n YOU R LIFE! Would You Be Better Off without China? Suppose that you cou ld choose to l ive and work in a world with the Chinese economy growi ng very p i d ly or in a world with the Chi nese economy as it was before 978-very poor a nd g rowi ng slowly Which world wo uld you choose to l ive i n ? How does the cu rrent high-growth, hig h-export Chi nese economy affect you as a co nsumer? How does it affect you as someone a bout to start a career? As you read the chapter, see if you can answer these q uestions You can check your answers agai nst those we provide at the end of the cha pter � Continued on page 328 303 304 PA R T I Find more at www.downloadslide.com Macroeconomic Foundations and Long-Run Growth E conomic growth is not inevitable For most of human history, no sustained increases in output per capita occurred, and, in the words of the philosopher Thomas Hobbes, the lives of most people were "poor, nasty, brutish, and short." Sustained economic growth first began with the Industrial Revolution in England in the late eighteenth century From there, economic growth spread to the United States, Canada, and the countries of western Europe, Following World War II, rapid economic growth also began in Japan and, eventually, in several other Asian countries, but the economies of many other countries stag nated, leaving their people mired in poverty Real GDP per capita is the best measure of a country's standard of living because it rep resents the ability of the average person to buy goods and services Economic growth occurs when real GDP per capita increases Why have countries such as the United States and the United Kingdom, which had high standards of living at the beginning of the twentieth cen tury, continued to grow rapidly? Why have countries such as Argentina, which at one time had relatively high standards of living, failed to keep pace? Why was the Soviet Union unable to sustain the rapid growth rates of its early years? Why are some countries that were very poor at the beginning of the twentieth century still very poor today? And why have some countries, such as South Korea and Japan, that once were very poor now become much richer? What explains China's very rapid recent growth rates? In this chapter, we will develop a model of economic growth that helps us answer these important questions, 1 LEARNING OBJ ECTIVE Define economic growth, calculate economic growth rates, and describe global trends In economic growth, Econom ic Growth over Time and a round the World You live i n a world that i s very different fr o m the world when your grandparents were young, You can listen to music on an iPod that fits in your pocket; your grandparents played vinyl records on large stereo systems You can pick up a cell phone or send a text message to someone in another city, state, or country; your grandparents mailed letters that took days or weeks to arrive More importandy, you have access to health care and medicines that have prolonged life and improved its quality, In many poorer countries, however, people endure grinding poverty and have only the bare necessities of life, just as their great-grandparents did, The difference between you and people in poor countries is that you live in a coun try that has experienced substantial economic growth With economic growth, an econ omy produces both increasing quantities of goods and services and better goods and services It is only through economic growth that living standards can increase, but through most of human history, no economic growth took place Even today, billions of people are living in countries where economic growth is extremely slow Economic Growth from , 000 , 000 B.C to the Present In ,000,000 B.C., our ancestors survived by hunting animals and gathering edible plants Farming was many years in the future, and production was limited to food, clothing, shelter, and simple tools Bradford DeLong, an economist at the University of California, Berkeley, estimates that in these primitive circumstances, GDP per capita was about $ 140 per year in 2008 dollars, which was the minimum amount necessary just to sustain life Delong estimates that real GDP per capita worldwide was still $ 140 in the year 300 A.D In other words, no sustained economic growth occurred between ,000,000 B.C and 300 A.D A peasant toiling on a farm in France in the year 300 was no better off than his ancestors thousands of years before In fact, for most of human existence, the typical person had only the bare minimum of food, clothing, and shelter necessary to sustain life Few people survived beyond the age of 40, and most people suffered from debilitating illnesses Find more at www.downloadslide.com C H A P T E R I O I Long-Run Growth: Sources and Policies Significant economic growth did not begin until the Industrial Revolution, which started in England around the year 750 The production of cotton doth in factories using machinery powered by steam engines marked the beginning of the Industrial Revolution Before that time, production of goods had relied almost exclusively on human or animal power The use of mechanical power spread to the production of many other goods, greatly increasing the quantity of goods each worker could produce First England and then other countries, such as the United States, France, and Germany, experienced long-run economic growth, with sustained increases in real GDP per capita that eventually raised living standards in these countries to the high levels of today Maki ng the Connect i on I 305 Industrial Revolution The application of mechanical power to the production of goods beginning in England around 1750 Why Did the Industrial Revolution Beg in in England? The Industrial Revolution was a key turning point i n human history Before the Industrial Revolution, economic growth was slow and halting After the Industrial Revolution, in a number of countries eco nomic growth became rapid and sustained Although historians and economists agree on the importance of the Industrial Revolution, they have not reached a consensus on why it happened where and when it did Why the eighteenth century and not the six teenth century or the twenty-first century? Why England and not China or India or Africa or Japan? There is always a temptation to read history backward We know when and where the Industrial Revolution occurred; therefore, it had to happen where it did and when it did But what was so special about England in the eighteenth century? Nobel Laureate Douglass North, of Washington University in St Louis, has argued that insti tutions in England differed significantly from those in other countries in ways that greatly aided economic growth North believes that the Glorious Revolution of 1688 was a key turning point After that date, the British Parliament, rather than the king, controlled the government The British court system also became independent of the king As a result, the British government was credible when it committed to upholding private property rights, protecting wealth, and eliminating arbitrary increases in taxes These institutional changes gave entrepreneurs the incentive to make the investments necessary to use the important technological developments of the second half of the eighteenth century-particularly the spinning jenny and the water frame, which were used in the production of cotton textiles, and the steam engine, which was used in mining and in the manufacture of textiles and other products Without the institu tional changes, entrepreneurs would have been reluctant to risk their property or their wealth by starting new businesses Although not all economists agree with North's specific argument about the origins of the Industrial Revolution, we will see that most economists accept the idea that eco nomic growth is not likely to occur unless a country's government provides the type of institutional framework North describes Sources: Douglass C North, Understanding the PrQcess ofEconomic Change, Princeton, NJ: Princeton University Press, 2005; and Douglass C North and Barry R Weingast, "'Constitutions and Commitment: The Evolution of Institutions Governing Public Choice in Seventeenth-Century England," Journal of &Qnomic History, VoL 49, No 4, December 1989 YOUR TURN : Test your understanding by doing related problem on page 332 at the end of this chapter Figure 10-1 shows how growth rates of real GDP per capita for the entire world have changed over long periods Prior to 300 A.D., there were no sustained increases in real GDP per capita Over the next 500 years, to 800, there was very slow growth Significant growth began in the nineteenth century, as a result of the Industrial Revolution A fur ther acceleration in growth occurred during the twentieth century, as the average growth rate increased from 1.3 percent per year to 2.3 percent per year The British government's guarantee ofproperty rights set the stage for the Industrial Revolution 306 PA R T I Find more at www.downloadslide.com Macroeconomic Foundations and Long-Run Growth Figure 0- Average Annual Growth Rates for the World Economy World economic growth was essentially zero in the years before 1300 and it was very slow-an average of only 0.2 percent per year-before 1800 The Industrial Revolution made possible the sustained increases in real GDP per capita that have allowed some coun tries to attain high standards ofliving Source: J Bradford DeLong, "Estimating World GOP, One Million B.C.-Prescnt," working papcr, University of California Berkeley Rates of long· run growth In real GOP per capita 2.5% 2.3% 2.0 0.5 0% million 9.C.-1300 300-1800 800-1900 900-2000 Small Differences in Growth Rates Are Important The difference between 1.3 percent and 2.3 percent may seem trivial but, over long periods, small differences in growth rates can have a large impact For example, suppose you have $ 00 in a savings account earning an interest rate of percent, which means you will receive an interest payment of $ 30 this year If the interest rate on the account is 2.3 per cent, you will earn $2.30 The difference of an extra $ 00 interest payment seems insignif icant But if you leave the interest as well as the original $ 00 in your account for another year, the difference becomes greater because now the higher interest rate is applied to a larger amount-$ 102.30-and the lower interest rate is applied to a smaller amount $ 1 30 This process, known as compounding, magnifies even small differences in interest rates over long periods of time Over a period of 50 years, your $100 would grow to $312 at an interest rate of 2.3 percent but to only $ at an interest rate of 1.3 percent The principle of compounding applies to economic growth rates as well as to inter est rates For example, in 1950, real GOP per capita in Argentina was $6,942 (measured in 2000 dollars) , which was larger than France's real GOP per capita of $5,92 Over the next 58 years, the economic growth rate in France averaged 2.7 percent per year, while in Argentina, growth rate was only percent per year Although this difference in growth rates of less than percentage points may seem small, in 2008, real GOP per capita in France had risen to $27,274, while real GOP per capita in Argentina was only $ 2,994 In other words, because of a relatively small difference in the growth rates of the two economies, the standard of living of the typical person in France went from being below that of the typical person in Argentina to being much higher The impor tant point to keep in mind is this: In the long run, small differences in economic growth rates result in big differences in living standards Why Do Growth Rates Matter? Why should anyone care about growth rates? Growth rates matter because an economy that grows too slowly fails to raise living standards In some countries in Africa and Asia, very little economic growth has occurred in the past 50 years, so many people remain in severe poverty In high-income countries, only out of every ,000 babies die before the age of one In the poorest countries, more than 00 out of every ,000 babies die before the age of one, and millions of children die each year from diseases that could be avoided by having access to clean water or cured by using medicines that cost only a few dollars Although their problems are less dramatic, countries that experience slow growth have also missed an opportunity to improve the lives of their citizens For example, the failure of Argentina to grow as rapidly as the other countries that had similar levels of GOP per capita in 1950 has left many of its people in poverty Life expectancy in Find more at www.downloadslide.com CHAPTE I Long-Run Growth: Sources and Policies R I O 307 Don 't Let This Ha ppen to YO U I However, this is not the growth rate between the two years The growth rate between these two years is the rate at which $ ,225 in 1950 would have to grow on average each year to end up as $43,714 in 2008, which is 2.1 percent Don't Confuse the Average An n u a l Percentage Change w i t h t h e Total Percentage Change When economists talk about growth rates over a period of more than one year, the numbers are always average annual percentage changes and not total percentage changes For example, in the United States, real GDP per capita was $ 3,225 in 1950 and $43,714 in 2008 The percentage change in real GDP per capita between these two years is: ( $43,714 - $ ,225) ( $ 3,225) X 100 = YOUR TURN: Test your understanding by doing related problem on page 333 at the end of this chapter 231% Argentina is several years lower than in the United States and other high-income coun tries, and more than twice as many babies in Argentina die before the age of one Maki ng the Connection I The Benefits of an Earlier Start: Standards of Living in China and Japan We noted at the beginning o f this chapter that China has expe rienced very high growth rates in recent years Between 996 and 2008, real GOP per capita in China grew at an average annual rate of 8.8 percent Real GOP per capita in Japan, in contrast, grew at the much slower rate of percent Between 1950 and 978, however, China had grown relatively slowly, while Japan was growing rapidly As a result, in 2008, the standard of living in China was still well below that in Japan For example, GOP per capita measured in U.S dollars was $6, 140 in China in 2008 but $34,092more than five times higher-in Japan The following table shows other measures of the standard of living for China and Japan Lffe expectancy at birth CHINA JAPAN 73.5 years 82 years Infant mortality (per , 000 live birthsl 20.3 2.8 Percentage of the population surviving on less than $2 per day 35% 0% Percentage of the population with access to improved water source 77% 100% Percentage of the population with access to improved sanitation 44% 100% Internet users per , 000 people 85 668 In each of the measures shown in the preceding table, China continues to lag behind Japan as well as the United States and other high-income countries If the Chinese econ omy can sustain the high growth rates of recent years, it will continue to close the gap with Japan in real GOP per capita and other measures of the standard of living The moral of the story is that only by sustaining high rates of economic growth over many years will the currently low-income countries be able to attain the high living standards people in Japan, the United States, and other high-income countries enjoy today Sources: United Nations Development Programme Humnn Development Report, 200712008, New York: Palgrave Macmillan, 2007; Organization for Economic Cooperation and Development; and CIA World Ftlctbook, 2009 online edition YOUR TURN : Test your this chopter understanding by doing related problem on page 333 at the end of Although China has experienced rapid economic growth, its living standards are still well below those o/Japan Find more at www.downloadslide.com Find more at www.downloadslide.com C H A P T E R I O I Long-Run Growth: Sources and Policies How can a country's workers become more productive? Economists believe two key factors determine labor productivity: the quantity of capital per hour worked and the level of technology Therefore, the economic growth model focuses on technological change and changes over time in the quantity of capital available to workers in explain ing changes in real GOP per capita Recall that technological change is a change in the quantity of output firms can produce using a given quantity of inputs There are three main sources of technological change: Better machinery and equipment Beginning with the steam engine during the 309 Technological change A change in the quantity of output a firm can produce using a given quantity of inputs Industrial Revolution, the invention of new machinery has been an important source of rising labor productivity Today, continuing improvements in computers, factory machine tools, electric generators, and many other machines contribute to increases in labor productivity Increases in human capital Capital refers to physical capita� induding computers, factory buildings, machine tools, warehouses, and trucks The more physical capital workers have available, the more output they can produce Human capital is the accumulated knowledge and skills that workers acquire from education and train ing or from their life experiences As workers increase their human capital through education or on-the-job training, their productivity also increases The more edu cated workers are, the greater is their human capital Hwnan capital The accumulated knowledge and skills that workers acquire from education and training or from their life experiences Better means of organizing and managing production Labor productivity increases if managers can a better job of organizing production For example, the just-in-time system, first developed by Toyota Motor Corporation, involves assem bling goods from parts that arrive at the factory at exactly the time they are needed With this system, Toyota needs fewer workers to store and keep track of parts in the factory, so the quantity of goods produced per hour worked increases Note that technological change is not the same thing as more physical capital New capital can embody technological change, as when a faster computer chip is embodied in a new computer But simply adding more capital that is the same as existing capital is not technological change To summarize, we can say that a country's standard of living will be higher the more capital workers have available on their jobs, the better the capi tal, the more human capital workers have, and the better job business managers in organizing production The Per-Worker Production Function The economic growth model explains increases in real GOP per capita over time as resulting from increases in just two factors: the quantity of physical capital available to workers and technological change Often when analyzing economic growth, we look at increases in real GOP per hour worked and increases in capital per hour worked We use measures of GOP per hour and capital per hour rather than per person so we can ana lyze changes in the underlying ability of an economy to produce more goods with a given amount of labor without having to worry about changes in the fraction of the popula tion working or in the length of the workday We can illustrate the economic growth model using the per-worker production function, which is the relationship between real GOP per hour worked and capital per hour worked, holding the level of technology con stant Figure 10-3 shows the per-worker production function as a graph In the figure, we measure capital per hour worked along the horizontal axis and real GOP per hour worked along the vertical axis Letting K stand for capital, L stand for labor, and Y stand for real GOP, real GOP per hour worked is YIL, and capital per hour worked is KIL The curve represents the production function Notice that we not explicitly show techno logical change in the figure We assume that as we move along the production function, the level of technology remains constant As we will see, we can illustrate technological change using this graph by shifting up the curve representing the production function The figure shows that increases in the quantity of capital per hour worked result in movements up the per-worker production function, increasing the quantity of output Per-worker production function The relationship between real GDP per hour worked and capital per hour worked, holding the level of technology constant 310 PA R T Find more at www.downloadslide.com Macroeconomic Foundations and Long-Run Growth Figure 0-3 The Per-Worker Production Function The per-worker production function shows the relationship between capital per hour worked and real GDP per hour worked holding technology constant Increases in capital per hour worked increase output per hour worked but at a diminishing rate For example, an increase in capital per hour worked from $20,000 to $30,000 increases real GDP per hour worked from $200 to $350 An increase in capital per hour worked from $30,000 to $40,000 increases real GDP per hour worked only from $350 to $475 Each additional $10,000 increase in capital per hour worked results in a progressively smaller increase in output per hour worked Real GDP per hour worked, YII Per-worker production function $575 475 350 200 : : I I YI � ! - ! ! - ! $20.000 30.000 40.000 50.000 capital per hour worked, KlL each worker produces When holding technology constant, however, equal increases in the amount of capital per hour worked lead to diminishing increases in output per hour worked For example, increasing capital per hour worked from $20,000 to $30,000 increases real GOP per hour worked from $200 to $350, an increase of $ 50 Another $ 0,000 increase in capital per hour worked, from $30,000 to $40,000, increases real GOP per hour worked from $350 to $475, an increase of only $ 25 Each additional $ 0,000 increase in capital per hour worked results in progressively smaller increases in real GOP per hour worked In fact, at very high levels of capital per hour worked, fur ther increases in capital per hour worked will not result in any increase in real GOP per hour worked This effect results from the law ofdiminishing returns, which states that as we add more of one input-in this case, capital-to a fixed quantity of another input in this case, labor-output increases by smaller additional amounts Why are there diminishing returns to capital? Consider a simple example in which you own a copy store At first you have 10 employees but only I copy machine, so each of your workers is able to produce relatively few copies per day When you buy a second copy machine, your employees will be able to produce more copies Adding additional copy machines will continue to increase your output-but by increasingly smaller amounts For example, adding a twentieth copy machine to the 19 you already have will not increase the copies each worker is able to make by nearly as much as adding a sec ond copy machine did Eventually, adding additional copying machines will not increase your output at all Which Is More Important for Economic Growth: More Ca pita l or Technological Change? Technological change helps economies avoid diminishing returns t o capital Let's con sider two simple examples of the effects of technological change First, suppose you have 10 copy machines in your copy store Each copy machine can produce 10 copies per minute You don't believe that adding an eleventh machine identical to the 10 you already have will significantly increase the number of copies your employees can pro duce in a day Then you find out that a new copy machine has become available that produces 20 copies per minute If you replace your existing machines with the new machines, the productivity of your workers will increase The replacement of existing capital with more productive capital is an example of technological change Or suppose you realize that the layout of your store could be improved Maybe the paper for the machines is on shelves at the back of the store, which requires your work ers to spend time walking back and forth whenever the machines run out of paper By Find more at www.downloadslide.com CHAPTE R I Long-Run Growlh : Sources ond Policles Real GOP per hour wot1(ed, YIL 31 Fig u re 0-4 - � Production function4 l-_ - Production function3 �_ Production function $875 775 675 _�_ Production function1 575 $50,000 Capital per hour worked, KJL placing the paper closer to the copy machines, you can improve the productivity of your workers Reorganizing how production takes place so as to increase output is also an example of technological change Technological Change: The Key to Susta ining Economic Growth Figure 0-4 shows the impact of technological change on the per-worker production function Technological change shifts up the per-worker production function and allows an economy to produce more real GOP per hour worked with the same quantity of cap ital per hour worked For example, if the current level of technology puts the economy on Production function I ' then when capital per hour worked is $50,000, real GOP per hour worked is $575 Technological change that shifts the economy to Production func tion2 makes it possible to produce $675 in goods and services per hour worked with the same level of capital per hour worked Further increases in technology that shift the economy to higher production functions result in further increases in real GOP per hour worked Because of diminishing returns to capital, continuing increases in real GOP per hour worked can be sustained only if there is technological change Remember that a country will experience increases in its standard of living only if it experiences increases in real GOP per hour worked Therefore, we can draw the following important conclusion: In the long run, a country will experience an increasing standard ofliving only if it experiences continuing technological change Maki ng the Connection I What Explains the Economic Failure of the Soviet Union? The economic growth model can help explain one o f the most striking events of the twentieth century: the economic collapse of the Soviet Union The Soviet Union was formed from the old Russian Empire following the Communist revolution of Under Communism, the Soviet Union was a centrally planned economy where the government owned nearly every business and made all pro duction and pricing decisions In 1960, Nikita Khrushchev, the leader of the Soviet Union, addressed the United Nations in New York City He declared to the United States and the other democracies, "We will bury you Your grandchildren will live under Communism." Technological Change Increases Output per Hour Worked Technological change shifts up the production function and allows more output per hour worked with the same amount of capital per hour worked For example, along Production function ! with $50,000 in capital per hour worked, the economy can produce $575 in real GDP per hour worked However, an increase in technology that shifts the economy to Production function2 makes it possible to produce $675 in real GDP per hour worked with the same leve1 of capital per hour worked Find more at www.downloadslide.com C H A P T E R I lhe International Financial System � Continued from page 605 Economics in YOU R LIFE! At the beginning of the chapter, we posed this question: If eco nom ists are correct about the rela tive rates of average productivity growth between Spain and the Un ited States i n the next decade, then, a l l else being equal, wi l l the savi ngs that you accu m u l ate (in euros) be worth more or less in U.S dollars than it wou l d have been worth without the relative gains in Spanish productivity? To a nswer this question, we saw in this chapter that when the average productivity of firms in one cou ntry increases faster than the average productivity of firms i n a nother country, the value of the faster-g rowi ng country's cu rrency should-a l l else being equa l-rise agai nst the slower-growing country's cu rrency Of course, Spain is only of the 16 cou ntries using the eu ro, so the i m pact of productivity i ncreases i n Spa i n on the va lue of the euro may not be large B ut the savings that you accu m u l ate i n euros while you a re in Spa i n a re l i kely to be worth more i n U S dol l a rs than they wou l d have been worth without the gains in Spanish productivity Conclusion Fluctuations i n exchange rates continue t o cause difficulties for firms and governments From the gold standard to the Bretton Woods system to currency pegging, governments have attempted to find a workable system of fixed exchange rates Fixing exchange rates runs into the same problems as fixing any price: As demand and supply shift, surpluses and shortages will occur unless the price adjusts Most of the countries of Western Europe are attempting to avoid this problem by using a single currency Economists are looking closely at the results of that experiment Read An Inside Look at Policy on the next page for a discussion of an attempt by some members of Congress to use tariffs to deal with a dispute over exchange rates 62 Find more at www.downloadslide.com » Ca n Ta riffs Offset the Effect of Overva l uation? FINANCIAL TIMES US Lawmakers to Revive China Tariff Bill e A group of Republican and Democratic lawmakers will on Wednesday revive a bill that threatens to raise tariffs on Chinese goods to punish the country for what they call "currency manipulation" Highlighting the protectionist sentiment within Congress, the bill would let companies apply for tariffs on imports from countries deemed to be deliberately undervaluing their currencies to be more competitive China is its main target e "By illegally subsidising its exports through the undervaluation of its currency by 30 per cent or more, China distorts the gains from trade, creates barriers to free and fair trade, harms US industries and has destroyed millions of us jobs;' those sponsoring the bill said in a statement Their move comes as countries across the world consider protection ist trade rules in the face of recession Measures such as anti-dumping inves tigations rose 18.8 per cent in the first quarter of this year against the same period in 2008, according to research by Chad Bown at the Brookings Insti tution, with China's exporters the tar get in two thirds of those cases 622 In the US there have been several attempts in the past four years to introduce a currency manipulation bill, none of which has gained real traction On the campaign trail, Barack Obama suggested China was a currency manipulator, but his administration has since backed away from confrontation over the issue Nonetheless, a group of lawmakers from manufacturing-dominated states are determined to give it another try and some analysts think the US recession could help build support this time The charge in the Senate will be led by Debbie Stabenow, a Democrat from Michigan, and Jim Bunning, a Republican from Kentucky In the House, it will be pushed by Tim Ryan, a Democrat from Ohio, and Tim Murphy, a Republican from Pennsylvania They will be joined at the bill's launch by a coalition of labour and business leaders who feel they have been hurt by the value of the [yuan] "The rising unemployment rate in the US warns that there might be more support for such a measure than in the past," said Marc Chandler, global head of currency strategy at Brown Brothers Harriman "Even if the measure dies an ignoble death like the other bills, the mere proposal reminds China and others of the protectionism that lurks below the surface in the United States." The US is not alone in facing rising protectionist sentiment Threequarters of the new anti-dumping investigations launched this year were by developing countries-half by India and Argentina alone The Treasury is legally obliged to edetermine every six months whether any country is manipulating its curreney to gain an unfair trade advantage Last month the administration disappointed manufacturers and trade groups by deciding not to pick a fight with China, a crucial US creditor, saying instead it had "shown great commitment to playing a stabilising role in the system" Source: Sarah O'Connor, ·US lawmakers to Revive China Tariff Bill,· Fmancial TllTles, May , 2009 Find more at www.downloadslide.com Key Points in the Article This article discusses a bill introduced in the U.S Congress to raise tariffs on Chinese imports China was the main target because many politicians, including Sarack Obama in his presidential election campaign, claimed that China had manipulated its currency to give Chinese exporters an unfair advantage over U.S companies Politicians, business leaders, and labor leaders supporting this bill argued that the Chinese yuan was at least 30 percent undervalued, leading to job losses in the United States The article also explains that a global recession and rising unemployment had led to increased support for protectionist policies Finally, the article mentions that the U.S government has decided not to charge China because it has become a major U.S creditor Analyzing the News e currency is said to be undervalued if it is pegged at a value below the market equi librium exchange rate Many politicians, e Politicians supporting the tariff bill argued that the Chinese yuan was at least 30 percent undervalued The bill was including Barack Obama in his presidential also supported by labor u n ions and busi election campa i g n , claimed that China ness leaders, who claimed that China's kept its cu rrency undervalued i n order undervalued currency had given Chi nese to keep the prices of its exports low The exporters an unfair advantage in competing figure shows the value of yuan agai nst with U.S firms, lead ing to millions of job the U S dollar After 2005, the apprecia losses The article also pOi nts out that a tion of yuan against the dollar was rela global recession and rising unemployment tively modest i n comparison with the had led many developed countries to con growing U.S trade deficits with China As sider trade protection policies and anti you read in this chapter, the Chinese cen dumping investigations against developing tral bank has managed to keep the yuan countries at relatively low levels by buying large amounts of U.S dollars with yuan An increase in the U S trade deficit with e The U.S Treasury is required by law to investigate every six months whether any country unfairly manipulates its China caused an increase in the supply of currency With a total holding of U.S gov dollars in the currency market Without any ernment securities at about $770 billion in government i ntervention, the exchange 2009, China had become the country's rate between the U.S dollar and the yuan largest creditor I n 2009, the government would have dropped below yuan per dol decided not to charge China with manipu lating its currency In mid-2009 politicians were consid- lar To keep the yuan from appreciating, ering a bill that would allow U.S com China p u rchased dollars in exchange for pan ies to apply for tariffs on imports from yuan By increasing the demand for dollars cou ntries that deliberately undervalued in exchange for yuan, the Chinese govern their currencies in order to become more ment was able to keep the exchange rate competitive As you read in this chapter, a at yuan per dollar Thinking Critically About Policy The sponsors of the tariff bill discussed in this article claimed that their intent was to save jobs in the United States Would anyone in the U n �ed States be hurt by Yuan per U.S dollar 8.5 passage of the bill? Briefly explain Suppose Congress passed the tariff bill and China retaliated by selling all of its holdings of U.S Treasury bonds How would the exchange rate of the U.S dol 8.0 lar be affected? Briefly explain 7.5 7.0 6.5 6.0 O fL � � � � � 2004 2005 2006 2008 2009 2007 Historically, the exchange rate between the yuan and the dollar has been stable 623 PA R T 624 I Find more at www.downloadslide.com The International Economy Key Terms Euro, p 607 Floating currency, p 606 Pegging, p 615 Quota, p 609 Exchange rate system, p 606 Managed float exchange rate system, p 606 Purchasing power parity, p 609 Tariff, p 609 Fixed exchange rate system, p 606 III Exchange Rate Systems, pages 606-607 LEAR NI NG OBJECTIVE: Understand how different exchange rate systems operate Summary When countries agree on how exchange rates should be determined, economists say that there is an exchange rate system A floating currency is the outcome of a country allowing its currency's exchange rate to be determined by demand and supply The current exchange rate system is a managed float exchange rate system, under which the value of most currencies is determined by demand and supply, with occasional government intervention A fixed exchange rate system is a system under which countries agree to keep the exchange rates among their currencies fixed Under the gold standard, the exchange rate between two currencies was automatically determined by the quantity of gold in each currency By the end of the Great Depression of the 1930s, every country had abandoned the gold standard Under the Bretton Woods system, which was in place between 1944 and the early 1970s, the United States agreed to exchange dollars for gold at a price of $35 per ounce The central banks of all other members of the system pledged to buy and sell their currencies at a fixed rate against the dollar � Visit www.myeconklb,com to complete these exercises online and get Instant feedback Review Questions 1.1 What is an exchange rate system? What is the differ 1.2 How were exchange rates determined under the gold standard? How did the Bretton Woods system differ from the gold standard? Problems a nd Applications 1.3 ( Related to the Don 't Let This Happen to You! on page 607) Briefly explain whether you agree with the following statement: "The Federal Reserve is limited in its ability to issue paper currency by the amount of gold the federal government has in Fort Knox To issue more paper currency, the govern ment first has to buy more gold." The United States and most other countries aban doned the gold standard during the 1930s Why would the 1930s have been a particularly difficult time for countries to have remained on the gold stan dard? (Hint: Think about the macroeconomic events of the 1930s and about the possible problems with carrying out an expansionary monetary policy while remaining on the gold standard.) 1.5 If a country is using the gold standard, what is likely to happen to the country's money supply if new gold deposits are discovered in the country, as happened in the United States with the gold discoveries in California in 849? Is this change in the money sup ply desirable? Briefly explain ence between a fixed exchange rate system and a man aged float exchange rate system? IIiiI » End Learning Objective • The Current Exchange Rate System , pages 607-61 LEAR NI NG OBJECTIVE: Discuss the three key features of the current exchange rate system Summary The current exchange rate system has three key aspects: ( I ) The U.S dollar floats against other major currencies, (2) most countries in Western Europe have adopted a common currency, and ( ) some developing countries have fixed their currencies' exchange rates against the dol lar or against another major currency Since 1973, the value of the U.S dollar has fluctuated widely against other major currencies The theory of purchasing power parity states that in the long run, exchange rates move to equal ize the purchasing power of different currencies This the ory helps to explain some of the long-run movements in the value of the U.S dollar relative to other currencies Purchasing power parity does not provide a complete explanation of movements in exchange rates for several reasons, including the existence of tariffs and quotas A tariff is a tax imposed by a government on imports A quota is a government-imposed limit on the quantity of a good that can be imported Currently, 16 European Union Find more at www.downloadslide.com C H A P TE R I The International Financial System member countries use a common currency, known as the euro The experience of the countries using the euro will provide economists with information on the costs and benefits to countries of using the same currency When a country keeps its currency's exchange rate fixed against another country's currency, it is pegging its cur rency Pegging can result in problems similar to the prob lems countries encountered with fixed exchange rates under the Bretton Woods system If investors become convinced that a country pegging its exchange rate will eventually allow the exchange rate to decline to a lower level, the demand curve for the currency will shift to the left This illustrates the difficulty of maintaining a fixed exchange rate in the face of destabilizing speculation � Visit www.myeconlab.com to complete these exercises online and get Instant feedback Review Questions What is the theory of purchasing power parity? 2.2 2.3 2.4 2.5 Does it give a complete explanation for movements in exchange rates in the long run? Briefly explain Briefly describe the four determinants of exchange rates in the long run Which European countries currently use the euro as their currency? Why did these countries agree to replace their previous currencies with the euro? What does it mean when one currency is "pegged" against another currency? Why countries peg their currencies? What problems can result from pegging? Briefly describe the Chinese experience with pegging the yuan Prob l ems a nd Applications 2.6 (Related to the Making the Connection on page 608) The following appeared in an article on the Blue jays baseball team in the Toronto Star news paper: The jays spent slightly less than $ 00 mil lion [in U.S dollars] last season, the high est payroll in their 32 seasons Former president Paul Godfrey indicated at sea son's end that he expected Rogers owner ship to leave just about the same amount available for '09 But will they be able to, now that the loonie [the Canadian dollar] has slipped to just over 80 cents [in exchange for the U.S dollar] Why would a decline in the value of the Canadian dollar versus the U.S dollar make it difficult for the Toronto Blue jays to maintain their current payroll? Source: Richard Griffin, "A Buyer's Market for Free Agents," ( Toronto ) Star, November 15, 2008 625 2.7 The following is from an article in the New York Times: The Xerox Corporation said fourth-quarter profit shrank to nearly nothing Revenue from developing markets fell 14 percent, in contrast to growth of per cent in those markets in the first three quarters of the year Xerox cited soft cur rency exchange rates and the rapid weak ening of Russian and eastern European economies What is a "soft currency"? Why would soft currency overseas hurt Xerox's revenues? Source: "Xerox 4th-Quarter Profit Falls to Nearly Nothing," New York Times January 23, 2009 2.8 Consider this statement: It usually takes more than 100 yen to buy I U.S dollar and more than 1.5 dollars to buy I British pound These values show that the United States must be a much wealthier country than japan and that the United Kingdom must be wealthier than the United States Do you agree with this reasoning? Briefly explain 2.9 The following is from an article in the Wall Street fournak In japan, demand for videogame machines is declining In the past three years, the number of videogame players sold there has declined by more than 8%, while more household members say they are not inter ested in playing, according to an annual survey by the japanese industry group Computer Entertainment Supplier's Asso ciation Sales of both hardware and soft ware have fallen about 20% to 496.5 billion yen ($4.3 billion) in 2005 from 623.2 bil lion yen ($5.7 billion) in 2000, according to the group a According to the information in this article, what was the exchange rate between the yen and the dol lar in 2000? What was the exchange rate between the yen and the dollar in 2oo5? b Was the change in the yen-dollar exchange rate between 2000 and 2005 good news or bad news for japanese firms, such as Sony, that export video game consoles to the United States? Was the change in the yen