Economics work due tonight

McEachern, W. A. (2012). ECON Macro 3 (3rd ed.). Mason, OH: South-Western.

 

Your response should be at least 75 words in length. You are required to use at least your textbook as source material for your response. All sources used, including the textbook, must be referenced; paraphrased and quoted material must have accompanying citations.

 

What is foreign aid and what is the goal of foreign aid? Does foreign aid promote economic development? Explain briefly.

How did the Bretton Woods system operate? What caused its collapse? Some think the current system of managed but floating rates is too unstable. What would generate the instability?

 

Describe developing countries and how they differ from industrial market economies. How can international trade aid development? In what ways does the international economy impose problems on developing countries?

 

How can two countries both be better off as a result of trade? How can tariffs protect U.S. jobs? Do tariffs lead to a net increase in jobs? Explain. Who are the winners and losers from trade restrictions? Given that trade restrictions impose losses on an economy, why are trade restrictions so common?

 

Why can’t all the balance of payments accounts be in surplus? What factors determine the demand for British pounds in foreign exchange markets? How are exchange rates determined under a flexible exchange rate system?

 

Case StudiesCase Studies
INTERNATIONAL FINANCE

Case Study 19.1: The Big Mac Index

As you have already learned, the PPP theory predicts that in the long run the exchange rate between two cur-

rencies should move toward equalizing the cost in each country of an identical basket of internationally traded

goods. A light-hearted test of the theory has been developed by The Economist magazine, which compares prices

around the world for a “market basket” consisting simply of one McDonald’s Big Mac—a product that, though not

internationally traded, is essentially the same in more than 100 countries. The Economist begins with the price of a

Big Mac in the local currency and then converts that price into dollars based on the exchange rate prevailing at the

time. A comparison of the dollar price of Big Macs across countries offers a crude test of the PPP theory, which predicts that prices should be

roughly equal in the long run.

This chart lists the

dollar price of a Big Mac in

March 2010, in 22 surveyed

countries plus the euro zone

average. By comparing the

price of a Big Mac in the

United States (shown as

the green bar) with prices

in other countries, we can

derive a crude measure of

whether particular curren-

cies, relative to the dollar,

are overvalued (red bars) or

undervalued (blue bars). For

example, because the price

of a Big Mac in Norway,

at $6.87, was 92 percent

higher than the U.S. price of

$3.58 the Norwegian krone

was the most overvalued

relative to the dollar of the

countries listed. But Big

Macs were cheaper in most

of the countries surveyed.

The cheapest was in China, where $1.83 was 49 percent below the U.S. price. Hence, the Chinese yuan was the most undervalued relative to

the dollar.

Thus, Big Mac prices in March 2010 ranged from 92 percent above to 49 percent below the U.S. price. The euro was 29 percent overval-

ued. The price range lends little support to the PPP theory, but that theory relates only to traded goods. The Big Mac is not traded internation-

ally. Part of the price of a Big Mac must cover rent, which can vary substantially across countries. Taxes and trade barriers, such as tariffs and

quotas on beef, may also distort local prices. And wages differ across countries, with a McDonald’s worker averaging about $8 an hour in the

United States versus more like $1 an hour in China. So there are understandable reasons why Big Mac prices differ across countries.

SOURCES: “The Big Mac Index: Exchanging Blows,” The Economist, 17 March 2010; David Parsley and Shang-Jin Wei, “In Search of a Euro Effect: Big Lessons from a Big Mac
Meal?” Journal of International Money and Finance, 27 (March 2008): 260–276; Ali Kutan et al., “Toward Solving the PPP Puzzle: Evidence from 113 Countries,” Applied Economics,
41 (Issue 24, 2009): 3057–3066; and the McDonald’s Corporation international Web site at http://www.mcdonalds.com.

QUESTION
1. The Big Mac Index computed by The Economist magazine has consistently found the U.S. dollar to be undervalued against some curren-

cies and overvalued against others. This fi nding seems to call for a rejection of the purchasing power parity theory. Explain why this index

may not be a valid test of the theory.

19
Cost of a Big Mac by Country

$0.00 $1.00 $2.00 $3.00 $4.00 $5.00 $6.00

Norway
Switzerland

Euro zone
Canada

Australia
Hungary

Turkey
United States

Japan
Britain

South Korea
United Arabs Emirates

Poland
Saudi Arabia

Mexico
South Africa

Russia
Egypt

Taiwan
Indonesia

Thailand
Malaysia

China

6.16
4.62

4.06
3.98

3.75
3.71

3.58
3.54

3.48
3.00
2.99

2.86
2.67

2.56
2.44
2.39
2.37

2.28
2.36

2.12
2.16

1.83

Big Mac prices converted to U.S. dollars

$7.00

6.87

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Case Study 19.2: What About China?

The U.S. trade defi cit with China of $227 billion in 2009 exceeded America’s combined defi cits with the European Union, OPEC countries, and

Latin America. The defi cit with China grew about 15 percent annually between 2007 and 2010. Americans spend four times more on Chinese

products than the Chinese spend on American products. Between 2007 and 2010, China’s holdings of U.S. Treasury securities more than

doubled from $400 billion to $900 billion.

Many economists, politicians, and union offi cials argue that China manipulates its currency, the yuan, to keep Chinese products cheaper

abroad and foreign products more expensive at home. This stimulates Chinese exports and discourages imports, thereby boosting Chinese

production and jobs. At the same time, the average Chinese consumer is poorer because the yuan buys fewer foreign products.

As we have seen, any country that establishes a fi xed exchange rate that undervalues or overvalues the currency must intervene continu-

ously to maintain that rate. Thus, if the offi cial exchange rate chronically undervalues the Chinese yuan relative to the dollar, as appears to be

the case, then Chinese authorities must continuously exchange yuan for dollars in foreign exchange markets. The increased supply of yuan

keeps the yuan down, and the increased demand for dollars keeps the dollar up.

But the charge that China manipulates its currency goes beyond simply depressing the yuan and boosting the dollar. China’s trading part-

ners increasingly feel they are being squeezed out by Chinese producers without gaining access to Chinese markets. China seeks every trade

advantage, especially for the 125 state-owned enterprises run directly by the central government. For example, China offers some domestic

producers tax rebates and subsidies to promote exports, while imposing quotas and tariffs to discourage imports, such as a 25 percent tariff on

auto-parts imports.

China has tried to soothe concerns about the trade defi cit. Most importantly, Chinese authorities in 2005 began allowing the yuan to rise

modestly against the dollar. As a result, the yuan rose a total of 20 percent against the dollar between July 2005 and July 2010. China also

announced plans to cut tax rebates paid to its exporters and to lower some import duties. But these measures seemed to have had little effect

on America’s monster defi cit with China.

Prior to an international fi nance meeting in June 2010, a key European Central Bank offi cial said “the rigidity of the Chinese monetary

regime had slowed down the recovery in the developed world.” Facing political pressure to do something, China announced that it would allow

the exchange rate to become more fl exible. We’ll see.

SOURCES: Lee Branstetter and Nicholas Lardy, “China’s Embrace of Globalization,” NBER Working Paper 12373 (July 2006); Jason Dean and Shen Hong, “China Central Bank
Tames Yuan Appreciation Hopes,” Wall Street Journal, 22 June 2010; Yujan Zhang, “China Steel Group Accuses U.S. Lawmakers of Protectionism,” Wall Street Journal, 5 July 2010;
and Michael Casey, “Showdown Looms Over China’s Currency at G-20,” Wall Street Journal, 11 June 2010.

QUESTION
1. Why would China want its own currency to be undervalued relative to the U.S. dollar? How does China maintain an undervalued currency?

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