Mankiw Principles of Macroeconomics (3rd ed)

362	PART SIX MONEY AND PRICES IN THE LONG RUN

IN THE NEWS

How to Protect Your Savings from Inflation

3 percent, if someone had bought

30-year government bond yielding percent, he would have expected by now his investment would be 180 percent of its original value. However, after years of higher-than- d inflation, the investment is only 85 percent of its original

.

Because inflation has been modin recent years, many people today not worried about how it will affect savings. This complacency is danEven a low rate of inflation can seriously erode savings over long peri-

of time.

Imagine that you retire today with a invested in Treasury bonds pay a fixed $10,000 each year,

the reasons for short-run moneunderstanding of the causes and costs

Summar y

The overall level of prices in an economy adjusts to bring money supply and money demand into balance. When the central bank increases the supply of money, it causes the price level to rise. Persistent growth in the quantity of money supplied leads to continuing inflation.

The principle of monetary neutrality asserts that changes in the quantity of money influence nominal variables but not real variables. Most economists believe that monetary neutrality approximately describes the behavior of the economy in the long run.

CHAPTER 16 MONEY GROWTH AND INFLATION	363

regardless of inflation. If there is no inflation, in 20 years the pension will have the same purchasing power that it does today. But if there is an inflation rate of only 3 percent per year, in 20 years your pension will be worth only $5,540 in today’s dollars. Five percent inflation over 20 years will cut your purchasing power to $3,770, and 10 percent will reduce it to a pitiful $1,390. Which of these scenarios is likely? No one knows. Inflation ultimately depends on the people who are elected and appointed as guardians of our money supply.

At a time when Americans are living longer and planning for several decades of retirement, the insidious effects of inflation should be of serious concern. For this reason alone, the creation of inflation-indexed bonds, with their guarantee of a safe return over long periods of time, is a welcome development.

No other investment offers this kind of safety. Conventional government bonds make payments that are fixed in dollar terms; but investors should be concerned about purchasing

power, not about the number of dollars they receive. Money market funds make dollar payments that increase with inflation to some degree, since short-term interest rates tend to rise with inflation. But many other factors also influence interest rates, so the real income from a money market fund is not secure.

The stock market offers a high rate of return on average, but it can fall as well as rise. Investors should remember the bear market of the 1970s as well as the bull market of the 1980s and 1990s.

Inflation-indexed government bonds have been issued in Britain for 15 years, in Canada for five years, and in many other countries, including Australia, New Zealand, and Sweden. In Britain, which has the world’s largest in- dexed-bond market, the bonds have offered a yield 3 to 4 percent higher than the rate of inflation. In the United States, a safe long-term return of this sort should make indexed bonds an important part of retirement savings.

We expect that financial institutions will take advantage of the new

inflation-indexed bonds and offer innovative new products. Indexed-bond funds will probably appear first, but indexed annuities and even indexed mort- gages—monthly payments would be adjusted for inflation—should also become available. [ Author’s note: Since this article was written, some of these indexed products have been introduced, but their use is not yet widespread.]

Although the Clinton administration may not get much credit for it today, the decision to issue inflation-indexed bonds is an accomplishment that historians decades hence will single out for special recognition.

SOURCE: The New York Times, May 18, 1996, p. 19.

A government can pay for some of its spending simply by printing money. When countries rely heavily on this “inflation tax,” the result is hyperinflation.

One application of the principle of monetary neutrality is the Fisher effect. According to the Fisher effect, when the inflation rate rises, the nominal interest rate rises by the same amount, so that the real interest rate remains the same.

Many people think that inflation makes them poorer because it raises the cost of what they buy. This view is a fallacy, however, because inflation also raises nominal incomes.

Economists have identified six costs of inflation: shoeleather costs associated with reduced money holdings, menu costs associated with more frequent adjustment of prices, increased variability of relative prices, unintended changes in tax liabilities due to nonindexation of the tax code, confusion and inconvenience resulting from a changing unit of account, and arbitrary redistributions of wealth between debtors and creditors. Many of these costs are large during hyperinflation, but the size of these costs for moderate inflation is less clear.

364	PART SIX MONEY AND PRICES IN THE LONG RUN

Key Concepts

quantity theory of money, p. 344 nominal variables, p. 345

real variables, p. 345 classical dichotomy, p. 345

effect, p. 352 shoeleather costs, p. 354 costs, p. 356

Questions for Review

1.Explain how an increase in the value of money.

2.According to the quantity theory effect of an increase in the quantity

3.Explain the difference between variables, and give two examples the principle of monetary neutrality, affected by changes in the quantity

4.In what sense is inflation like a about inflation as a tax help

Fisher effect, how does an increase in affect the real interest rate and the

of inflation? Which of these costs do important for the U.S. economy?

than expected, who benefits—debtors

.

Problems and Applications

1.Suppose that this year’s money supply is $500 billion, nominal GDP is $10 trillion, and real GDP is $5 trillion.

a.What is the price level? What is the velocity of money?

b.Suppose that velocity is constant and the economy’s output of goods and services rises by 5 percent each year. What will happen to nominal GDP and the price level next year if the Fed keeps the money supply constant?

c.What money supply should the Fed set next year if it wants to keep the price level stable?

d.What money supply should the Fed set next year if it wants inflation of 10 percent?

2.Suppose that changes in bank regulations expand the availability of credit cards, so that people need to hold less cash.

a.How does this event affect the demand for money?

b.If the Fed does not respond to this event, what will happen to the price level?

c.If the Fed wants to keep the price level stable, what should it do?

3.It is often suggested that the Federal Reserve try to achieve zero inflation. If we assume that velocity is constant, does this zero-inflation goal require that the rate of money growth equal zero? If yes, explain why. If no, explain what the rate of money growth should equal.

4.The economist John Maynard Keynes wrote: “Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.” Justify Lenin’s assertion.

5.Suppose that a country’s inflation rate increases sharply. What happens to the inflation tax on the holders of money? Why is wealth that is held in savings accounts not subject to a change in the inflation tax? Can you think of any way in which holders of savings accounts are hurt by the increase in the inflation rate?

6.Hyperinflations are extremely rare in countries whose central banks are independent of the rest of the government. Why might this be so?

7.Let’s consider the effects of inflation in an economy composed only of two people: Bob, a bean farmer, and Rita, a rice farmer. Bob and Rita both always consume equal amounts of rice and beans. In 2000, the price of beans was $1, and the price of rice was $3.

a.Suppose that in 2001 the price of beans was $2 and the price of rice was $6. What was inflation? Was Bob better off, worse off, or unaffected by the changes in prices? What about Rita?

b.Now suppose that in 2001 the price of beans was $2 and the price of rice was $4. What was inflation? Was Bob better off, worse off, or unaffected by the changes in prices? What about Rita?

c.Finally, suppose that in 2001 the price of beans was $2 and the price of rice was $1.50. What was inflation? Was Bob better off, worse off, or unaffected by the changes in prices?

What about Rita?

d.What matters more to Bob and Rita—the overall inflation rate or the relative price of rice and beans?

8.If the tax rate is 40 percent, compute the before-tax real interest rate and the after-tax real interest rate in each of the following cases:

a.The nominal interest rate is 10 percent and the inflation rate is 5 percent.

b.The nominal interest rate is 6 percent and the inflation rate is 2 percent.

c.The nominal interest rate is 4 percent and the inflation rate is 1 percent.

9.What are your shoeleather costs of going to the bank? How might you measure these costs in dollars? How do you think the shoeleather costs of your college president differ from your own?

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365

10.Recall that money serves three functions in the economy. What are those functions? How does inflation affect the ability of money to serve each of these functions?

11.Suppose that people expect inflation to equal 3 percent, but in fact prices rise by 5 percent. Describe how this unexpectedly high inflation rate would help or hurt the following:

a.the government

b.a homeowner with a fixed-rate mortgage

c.a union worker in the second year of a labor contract

d.a college that has invested some of its endowment in government bonds

12.Explain one harm associated with unexpected inflation that is not associated with expected inflation. Then explain one harm associated with both expected and unexpected inflation.

13.Explain whether the following statements are true, false, or uncertain.

a.“Inflation hurts borrowers and helps lenders, because borrowers must pay a higher rate of interest.”

b.“If prices change in a way that leaves the overall price level unchanged, then no one is made better or worse off.”

c.“Inflation does not reduce the purchasing power of most workers.”

O P E N - E C O N O M Y

M A C R O E C O N O M I C S :

B A S I C C O N C E P T S

When you decide to buy a car, you may compare the latest models offered by Ford and Toyota. When you take your next vacation, you may consider spending it on a beach in Florida or in Mexico. When you start saving for your retirement, you may choose between a mutual fund that buys stock in U.S. companies and one that buys stock in foreign companies. In all of these cases, you are participating not just in the U.S. economy but in economies around the world.

There are clear benefits to being open to international trade: Trade allows people to produce what they produce best and to consume the great variety of goods and services produced around the world. Indeed, one of the Ten Principles of Economics highlighted in Chapter 1 is that trade can make everyone better off. Chapters 3 and 9 examined the gains from trade more fully. We learned that international trade can raise living standards in all countries by allowing each

IN THIS CHAPTER YOU WILL . . .

Lear n how net expor ts measur e the inter national flow of goods and ser vices

Lear n how net for eign investment measur es the inter national flow of capital

Consider why net expor ts must always equal net for eign investment

See how saving, domestic investment, and net for eign investment ar e

r elated

Learn the meaning of the nominal exchange rate and the r eal exchange rate

Examine pur chasing - power parity as

a theor y of how exchange rates ar e deter mined

369

370	PART SEVEN THE MACROECONOMICS OF OPEN ECONOMIES

closed economy

an economy that does not interact with other economies in the world

open economy

an economy that interacts freely with other economies around the world

country to specialize in producing those goods and services in which it has a comparative advantage.

So far our development of macroeconomics has largely ignored the economy’s interaction with other economies around the world. For most questions in macroeconomics, international issues are peripheral. For instance, when we discussed the natural rate of unemployment in Chapter 14 and the causes of inflation in Chapter 16, the effects of international trade could safely be ignored. Indeed, to keep their analysis simple, macroeconomists often assume a closed economy—an economy that does not interact with other economies.

Yet some new macroeconomic issues arise in an open economy—an economy that interacts freely with other economies around the world. This chapter and the next one, therefore, provide an introduction to open-economy macroeconomics. We begin in this chapter by discussing the key macroeconomic variables that describe an open economy’s interactions in world markets. You may have noticed mention of these variables—exports, imports, the trade balance, and exchange rates—when reading the newspaper or watching the nightly news. Our first job is to understand what these data mean. In the next chapter we develop a model to explain how these variables are determined and how they are affected by various government policies.

THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

expor ts

goods and services that are produced domestically and sold abroad

impor ts

goods and services that are produced abroad and sold domestically

net expor ts

the value of a nation’s exports minus the value of its imports, also called the trade balance

trade balance

the value of a nation’s exports minus the value of its imports, also called net exports

trade surplus

an excess of exports over imports

An open economy interacts with other economies in two ways: It buys and sells goods and services in world product markets, and it buys and sells capital assets in world financial markets. Here we discuss these two activities and the close relationship between them.

THE FLOW OF GOODS: EXPORTS, IMPORTS,

AND NET EXPORTS

As we first noted in Chapter 3, exports are domestically produced goods and services that are sold abroad, and imports are foreign-produced goods and services that are sold domestically. When Boeing, the U.S. aircraft manufacturer, builds a plane and sells it to Air France, the sale is an export for the United States and an import for France. When Volvo, the Swedish car manufacturer, makes a car and sells it to a U.S. resident, the sale is an import for the United States and an export for Sweden.

The net exports of any country are the value of its exports minus the value of its imports. The Boeing sale raises U.S. net exports, and the Volvo sale reduces U.S. net exports. Because net exports tell us whether a country is, in total, a seller or a buyer in world markets for goods and services, net exports are also called the trade balance. If net exports are positive, exports are greater than imports, indicating that the country sells more goods and services abroad than it buys from other countries. In this case, the country is said to run a trade surplus. If net

CHAPTER 17 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS

371

“But we’re not just talking about buying a car—we’re talking about confronting this country’s trade deficit with Japan.”

exports are negative, exports are less than imports, indicating that the country sells fewer goods and services abroad than it buys from other countries. In this case, the country is said to run a trade deficit. If net exports are zero, its exports and imports are exactly equal, and the country is said to have balanced trade.

In the next chapter we develop a theory that explains an economy’s trade balance, but even at this early stage it is easy to think of many factors that might influence a country’s exports, imports, and net exports. Those factors include the following:

The tastes of consumers for domestic and foreign goods

The prices of goods at home and abroad

The exchange rates at which people can use domestic currency to buy foreign currencies

The incomes of consumers at home and abroad

The cost of transporting goods from country to country

The policies of the government toward international trade

As these variables change over time, so does the amount of international trade.

trade deficit

an excess of imports over exports

balanced trade

a situation in which exports equal imports

CASE STUDY THE INCREASING OPENNESS

OF THE U.S. ECONOMY

Perhaps the most dramatic change in the U.S. economy over the past five decades has been the increasing importance of international trade and finance. This change is illustrated in Figure 17-1, which shows the total value of goods and services exported to other countries and imported from other countries expressed as a percentage of gross domestic product. In the 1950s exports of goods and services averaged less than 5 percent of GDP. Today they are more than twice that level and still rising. Imports of goods and services have risen by a similar amount.

372	PART SEVEN THE MACROECONOMICS OF OPEN ECONOMIES

This increase in international trade is partly due to improvements in transportation. In 1950 the average merchant ship carried less than 10,000 tons of cargo; today, many ships carry more than 100,000 tons. The long-distance jet was introduced in 1958, and the wide-body jet in 1967, making air transport far cheaper. Because of these developments, goods that once had to be produced locally can now be traded around the world. Cut flowers, for instance, are now grown in Israel and flown to the United States to be sold. Fresh fruits and vegetables that can grow only in summer can now be consumed in winter as well, because they can be shipped to the United States from countries in the southern hemisphere.

The increase in international trade has also been influenced by advances in telecommunications, which have allowed businesses to reach overseas customers more easily. For example, the first transatlantic telephone cable was not laid until 1956. As recently as 1966, the technology allowed only 138 simultaneous conversations between North America and Europe. Today, communications satellites permit more than 1 million conversations to occur at the same time.

Technological progress has also fostered international trade by changing the kinds of goods that economies produce. When bulky raw materials (such as steel) and perishable goods (such as foodstuffs) were a large part of the world’s output, transporting goods was often costly and sometimes impossible. By contrast, goods produced with modern technology are often light and easy to transport. Consumer electronics, for instance, have low weight for every dollar of value, which makes them easy to produce in one country and sell in another. An even more extreme example is the film industry. Once a studio in Hollywood makes a movie, it can send copies of the film around the world at almost zero cost. And, indeed, movies are a major export of the United States.

The government’s trade policies have also been a factor in increasing international trade. As we discussed in Chapters 3 and 9, economists have long believed that free trade between countries is mutually beneficial. Over time, policymakers around the world have come to accept these conclusions. International agreements, such as the North American Free Trade Agreement (NAFTA) and the General Agreement on Tariffs and Trade (GATT), have gradually lowered trade barriers, such as tariffs and import quotas. The pattern of

INTERNATIONAL TRADE IS

INCREASINGLY IMPORTANT

FOR THE U.S. ECONOMY.

CHAPTER 17 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS

373

Percent
of GDP
15
							Imports
10
								Exports
5
0	1955	1960	1965	1970	1975	1980	1985	1990	1995	2000
1950

Figur e 17-1

THE INTERNATIONALIZATION

OF THE U.S. ECONOMY. This

figure shows exports and imports of the U.S. economy

as a percentage of U.S. gross domestic product since 1950. The substantial increases over time show the increasing importance of international trade and finance.

SOURCE: U.S. Department of Commerce.

increasing trade illustrated in Figure 17-1 is a phenomenon that most economists and policymakers endorse and encourage.

THE FLOW OF CAPITAL: NET FOREIGN INVESTMENT

So far we have been discussing how residents of an open economy participate in world markets for goods and services. In addition, residents of an open economy participate in world financial markets. A U.S. resident with $20,000 could use that money to buy a car from Toyota, but he could instead use that money to buy stock in the Toyota corporation. The first transaction would represent a flow of goods, whereas the second would represent a flow of capital.

The term net foreign investment refers to the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. When a U.S. resident buys stock in Telmex, the Mexican phone company, the purchase raises U.S. net foreign investment. When a Japanese resident buys a bond issued by the U.S. government, the purchase reduces U.S. net foreign investment.

Recall that foreign investment takes two forms. If McDonald’s opens up a fast food outlet in Russia, that is an example of foreign direct investment. Alternatively, if an American buys stock in a Russian corporation, that is an example of foreign portfolio investment. In the first case, the American owner is actively managing the investment, whereas in the second case the American owner has a more passive role. In both cases, U.S. residents are buying assets located in another country, so both purchases increase U.S. net foreign investment.

We develop a theory to explain net foreign investment in the next chapter. Here, let’s consider briefly some of the more important variables that influence net foreign investment:

The real interest rates being paid on foreign assets

The real interest rates being paid on domestic assets

net for eign investment the purchase of foreign assets by domestic residents minus the purchase of domestic

assets by foreigners