Issues in Macroeconomics
6. International economic fluctuations

For a long time the United States cherished the notion that it was isolated from the rest of the world. It's true that large countries like the United States carry on relatively less trade with the rest of the world than small countries do. Currently, only 11 percent of the goods and services consumed in the United States are produced abroad, while in the tiny Netherlands the percentage is nearly 50. So why should the United States worry about what goes on elsewhere?

Events of the last thirty years have reinforced our awareness that the United States is intimately involved in the world economy. To the older generation, dramatic increases in gasoline prices in 1973-74 brought the message home that the U.S. economy is directly dependent on oil-producing countries. Now the message has been brought home again, with the historically high prices in 2006 of oil and gasoline. When Japanese and European manufacturers began to deliver cars that consumers regarded as superior to U.S. cars, domestic car makers took note: U.S. auto profits fell. Fueled by comparative advantage, friendly trade agreements, and a favorable exchange rate, China has in our time become a major producer of small manufactures for the U.S. market, literally putting screws, so to speak, to the screws and nails firms. Now many Americans are worrying that U.S. industries may not be able to compete with foreign imports. So apparently trade with other countries does matter, even to a large economy like that of the United States.

The importance of international trade was driven home in the 1980s when newspapers began to report high deficits in U.S. trade balances with other countries. The United States was buying more foreign goods and services than it was selling to foreigners. When individuals spend more than they earn, they have to dip into their savings or go into debt to make the payments. The same applies to the U.S. economy. The country has had to borrow from foreigners to finance the deficits. How can U.S. trade deficits be reduced? Should the government take action, or will prices in international markets eventually adjust on their own and eliminate the problem? We will return to these questions in Chapter 31, which deals with the international implications of macroeconomics.

The most important prices in international markets are the exchange rates.

An exchange rate indicates how much one currency is worth in terms of another currency.

Take the exchange rate between the Jamaican dollar and the U.S. dollar, using the U.S. dollar as the base. When the exchange rate is 62, Jamaicans must pay 62 Jamaican dollars to buy one U.S. dollar; to say it the other way, Americans are able to buy 62 Jamaican dollars with one U.S. dollar. A cup of Blue Mountain coffee will run you $180 Jamaican-a terrifying price until you take into consideration the exchange rate. Or consider the pound relative to the euro. On August 14, 2006, one euro bought approximately 0.67 British pounds, and one pound bought around 1.48 euros.

Exchange rates change, sometimes very rapidly. And the changes have an immediate effect on international trade. For example, if the exchange rate between the U.S. dollar and the Jamaican dollar moves to 64, one U.S. dollar will buy two more Jamaican dollars. The U.S. dollar has "appreciated" - that is, it has become more valuable vis-a-vis the Jamaican. The consequence is that Jamaican products-rum, bauxite, Blue Mountain coffee-become cheaper for Americans, and American products become more expensive for Jamaicans (at least for those Jamaicans who hold a lot of Jamaican dollars).

When the exchange rate goes down to, let's say, 60 Jamaican dollars to every one U.S. dollar, the U.S. dollar is said to have "depreciated." Now Jamaican products become more expensive for Americans and American products-clothing, SUVs, computers-become less expensive for Jamaicans.

You will become aware of the fluctuating exchange rate if you buy French wine or travel abroad. The amount of French wine you can buy (either in the U.S. or in France) and the quality of the hotel room you can get in France in return for a given number of dollars varies with the value of the dollar with respect to the franc. In the early 1980s the U.S. dollar was relatively strong against the franc (the official French currency prior to the 1999 introduction of the euro), and Americans could enjoy fine French wines and stay in good hotel rooms. When in the late 1980s the value of the dollar went down, wines and hotel rooms became more expensive for Americans. For obvious reasons, businesses that deal in foreign markets or that import from abroad follow exchange rates with keen interest. In the early 2000s the sterling pound appreciated largely against the U.S. dollar. The result is that middle class Brits feel well-to-do when traveling in America while middle class Americans struggle to eat in London hamburger joints.

Figure 20-7. Value Comparison of U.S. Dollar Against Major Currencies, 1973 - 2006

Concept Check 9: Given the changing values of the dollar shown in Figure 20-8, what do you think happened to U.S. exports during the 1970s? The 1980s? (Answer at end of chapter).