The Pennsylvania State University

Department of Economics

Fall 2009

Economics 434

Professor Barry W. Ickes

International Finance and Open Economy Macroeconomics

Office: 618 Kern Graduate Bldg.

Course: Tuesday and Thursday, 4:15 to 5:30, 121 Sparks

Office Hours: Monday 10-11, Thursday 10-11

Course Website: http://econ.la.psu.edu/~bickes/434home.htm

Introduction

This is a one-semester course in international finance and open economy macroeconomics. In this course we study how monetary economies interact. International finance is the macroeconomic counterpart to international trade. The latter studies the determination and impact of flows of goods and services across national economies. In international finance we study trade in financial assets and national monies across national economies and their impact. These are fields that are linked together but there is an important difference in focus. In trade theory the primary focus is the welfare consequences of international transactions. In international finance the primary focus is on the stability of the international monetary system. Of course we are now in the midst of the Great Panic, a worldwide financial crisis. We will try to understand some of the origins of this crisis, especially those that emanated from world imbalances. And we will examine what reforms are necessary to make it harder for such crises to spread in the future.

Why this class may be important is suggested by some reports that the dollar is losing its status as the world’s reserve currency:

China’s central bank renewed its call for a new global currency in June and said the International Monetary Fund should manage more of members’ foreign-exchange reserves. Russian President Dmitry Medvedev last month illustrated his call for a supranational currency by producing a sample coin after a summit of the Group of Eight nations.[1]

Why might the dollar lose its status? Why does it matter to us? These are questions we will try to answer. Sometimes this material gets downright exciting:

A former Thai central bank governor has been fined 186bn baht ($4.6bn; £2.5bn) for his leading role in the country's 1997 financial crash. Rerngchai Marakanond spent that figure trying - and failing - to prop up the country's currency during the crisis. The Bangkok Civil Court has now ordered that Mr Marakanond must reimburse the Bank of Thailand within a month. Otherwise he will face the seizure of his personal assets. The case was brought by the Thai government.[2]

There is a lot of action in this subject. Recall the words of Miss Prism:[3]

Cecily, you will read your Political Economy in my absence. The chapter on the Fall of the Rupee you may omit. It is somewhat too sensational. Even these metallic problems have their melodramatic side.”

I will try to limit the melodrama, but events in this area are often sensational. Some interesting policy issues will frame our discussion. One of the most important for the US is the size and sustainability of the current account deficit. The US borrows nearly $800 billion from the rest of the world each year, almost 7% of US GDP. What are the implications for the US and the rest of the world of such large current account deficits? If the deficits are not cut what will happen to the dollar? If they are cut what will happen to the world economy?

Another set of important issues are related to currency crises. Many of the recent currency crises – Argentina, Brazil, Russia and Turkey come to mind – have occurred in emerging market economies. These sometimes lead to contagion – recall the “Asian Flu” of 1997-98 and the threats to the international monetary system. The Argentine crisis of 2001 led to dramatic political and social turmoil. Why do economies, especially emerging market economies, suffer so much from such crises? The causes and consequences of these crises, and what can be done to prevent them, is an important issue. It is especially important to understand whether these crises are in fact contagious.

The discussion of currency crises and what to do about them merges with the issue of “globalization,” that is now in the air. Many now question the recent moves to liberalize capital markets (and open markets in general). The argument in favor of capital market liberalization is that it improves the allocation of resources, and thus enhances global income. In the past, international flows of capital have helped economies industrialize. But there seems to be a side effect from such flows: currency and debt crises. This leads some to debate the wisdom and timing of such liberalizations. This debate is important so we shall discuss it. It also leads into a discussion of international financial architecture and reform of the international monetary system.

We will also examine the relative merits of alternative exchange rate regimes. Should countries fix their exchange rates, or should they allow them to float? Currently the US would like China to revalue its currency, the yuan, or at least to end its fixed value with respect to the dollar (in the hope that the yuan would appreciate). Is this a good idea? Should the nominal value of currencies be determined by market forces, or should they be fixed by central bankers? Your gut reaction may be that all prices should be determined by market forces so flexible exchange rates are necessarily superior (a view apparently shared by former Treasury Secretary John Snow). Understanding the error in this analogy is only a first step to analyzing the more appropriate exchange rate policies. We will want to examine which types of exchange rate regimes are most popular? If market-determined rates are so good, why has Europe moved to a common currency? What about currency boards? Are they a panacea for international financial problems? These are some of the questions we will look at.

In order to answer these and other questions we will need to develop a basic understanding of international macroeconomics. The determination of exchange rates, the fundamentals of capital flows, and the macroeconomics of an open economy are critical elements. We will need to develop these fundamentals in order to make sense of the grand policy issues.

Course Issues and Philosophy

It is useful to make clear at the start some issues of teaching philosophy. As you will learn, I find this material very interesting. My goal is to make you find it interesting. I enjoy the material and am very enthusiastic about it. I will try hard to convey why this is interesting and important. There are costs to this approach, however. This is not material that has been taught so many times that it practically runs by itself. There is no autopilot in this course. This means that you will have to work. You won’t do well if you are not prepared to work hard and think. In the past my attitude has always been the following: “I am not a monitor. I will not enforce you to supply effort.” I had always thought students have enough incentive to do homework problems on their own. Student evaluations (and test performance) seem to indicate otherwise. So this year we will have (at least four) homework assignments. These assignments will count for up to 10% of your final grade.

Economics is a quantitative subject. It is about stuff that we count. So we will use lots of numbers. It is also an analytic subject: economists have a hard time understanding arguments that do not involve models. Models make the subject matter easier, not harder, but they enforce discipline on thought. So we will make use of some elementary algebra. This is not really above high school levels, but sometimes the sight of mathematical symbols causes psychological paranoia. So be warned. You can see examples of what we do in some of the lecture notes online.

This course is clearly not just theory (but there is a lot of that) and the connection with real world events will be evident. This means that the material is dynamic. Events will upset the order of the topics. A lot of material on current events will get added to the website.[4] And, as new developments occur I will restructure the plan (I will update this syllabus on the web whenever necessary, keep checking). The syllabus is only a rough guide to what we will do each week. If you desire lots of structure you are in the wrong course. I cannot emphasize this enough.

Past exams are available on the website along with answer keys. This semester the exams will look a bit different due to the size of the class. Nonetheless, past exams provide a plentiful supply of problems to practice and learn from. You should use this free resource.[5]

Attendance in this course accounts for 5%. This is a somewhat small (though not insignificant) direct contribution to your grade. The indirect contribution, however, is much larger. One reason is that the lectures do not repeat what is in the book. They are complements, not substitutes (what point would there be to the lectures, otherwise). Past experience suggests that students who do not attend class typically fail exams and drop out.[6] Perhaps you can be the exception. In any event, there will be a seating chart, and I will record attendance.

While attendance is a choice that is left to you, tardiness is not. Showing up late to class not only demonstrates a lack of respect to the instructor, it is also shows a lack of respect to other students. It is disruptive to lectures. It is a negative externality that is dumped on your fellow students. It is not fair to other students to show up late. Better not to show up at all than to show up late (unless you have a good excuse). Of course, it is best to show up on time. You are all too civilized to dump your garbage on your neighbor’s lawn or car. Extend this courtesy to fellow students.

Administration

The textbook for this course is Feenstra and Taylor, International Economics. Worth Publishing, 2008. In the outline below the book is listed as FT. In addition I have lecture notes posted on the website. I tend to follow my lecture notes, but the book provides plenty of additional material and is a very productive way to learn the material.

All administrative announcements will be made on the course website. Please check the website frequently for various items of information. I will update it as frequently as I can.

Whenever possible I will put readings on the web site for this course. There are more readings there than you can probably digest in a whole year. Much of the readings are for further interest. I will also put materials that are discussed in class there whenever possible. Before exams I will also put review questions on the website.

There will be two midterm exams in this course, plus the final exam. The first midterm will count for 20% of the total points, the second midterm will count for 25%, and the final will account for 35%. Recall that homework accounts for 10% of the grade. Of course, this is the direct effect of homework. There is an indirect effect as well. If you do well on homework you should also do well on exams, so the return to doing well on homeworks (as opposed to obtaining the correct answer via copying) should be much higher than 10%. The remaining 5% will be based on attendance.

The midterms will take place in class. The first midterm will be on Tuesday, September 29, 2009. The date of the second midterm will be Tuesday, November 3.

Class Outline

The list of topics will resemble the following outline. This is a plan not a blueprint. It will probably change from time to time. I will put amended versions on the website from time to time. Please take note of this warning. If you need a week-by-week detailed plan of readings this is not the course for you. Some students do not like the flexibility that I retain in this course structure.[7] If you like more organization you really should switch to a different course.

Note that for the most part I only list here lecture notes (in the version of this syllabus on the website the underlined portions are hyperlinks) and chapters in the FT book. In addition, however, there are plenty of readings on the website that relate to the material of given lectures. I put it there for your benefit. I hope you take advantage of it.

I. Introduction

Lecture Note

FT, chapter 12

II. The Theory of International Capital Flows and Globalization

Lecture Note on Current Account in an Intertemporal Framework

FT, chapter 17

III. The Great Panic and the International Financial Crisis

Lecture Note on the Financial Crisis

IV. International Financial Markets

Lecture Note on International Financial Markets

Lecture Note on the Real Exchange Rate

FT, chapter 13, 22

[First Midterm about Here]

IV. The International Monetary System in Historical Perspective

Lecture Note on the Gold Standard

FT, chapter 19, section four

V. The Asset Approach to the Exchange Rate

Lecture Note on Exchange Rate Fluctuations and Overshootinghttp://econ.la.psu.edu/~bickes/forex.pdf

FT, chapter 14-15.

VI. Income Determination in the Open Economy

Lecture Note on Income Determination

Lecture Note on Real Depreciation

FT, chapter 18

[Second Midterm about Here]

VII. Currency, Debt, and Financial Crises

Lecture Note on Currency Crises

Lecture Note on Argentina

FT, chapter 20

VIII. Fixed versus Flexible Exchange Rate, Monetary Unions, and New Bretton Woods

Lecture Note on Optimum Currency Areas

FT, chapter 19, 21

Web Readings

IX. The International Monetary System and Reform of Financial Architecture

Web readings

FT, chapter

Disability Access Statement

The Pennsylvania State University encourages qualified people with disabilities to participate in its programs and activities and is committed to the policy that all people shall have equal access to programs, facilities, and admissions without regard to personal characteristics not related to ability, performance, or qualifications as determined by University policy or by state or federal authorities. If you anticipate needing any type of accommodation in this course or have questions about physical access let me know as soon as possible.

Academic Integrity

Penn State defines academic integrity as the pursuit of scholarly activity in an open, honest and responsible manner. All students should act with personal integrity, respect for other students’ dignity, rights and property, and help create and maintain an environment in which all can succeed through the fruits of their efforts (Faculty Senate Policy 49-20).

Dishonesty of any kind will not be tolerated in this course. Dishonesty includes, but is not limited to, cheating, plagiarizing, fabricating information or citations, facilitating acts of academic dishonesty by others, having unauthorized possession of examinations, submitting work of another person or work previously used without informing the instructor, or tampering with the academic work of other students. Students who are found to be dishonest will receive academic sanctions and will be reported to the University’s Judicial Affairs.

Department Statement on Valid Excuses

During the course many possible situations may arise that would result in your inability to attend class, attend exams, or perform at a minimally acceptable level during an examination. Illness or injury, family emergencies, certain University-approved curricular and extra-curricular activities, and religious holidays can be legitimate reasons to miss class or to be excused from a scheduled examination.

In the case of your own illness or injury, confirmation from a physician, physician’s assistant, a nurse-practitioner, or a nurse is required. Be advised that University Health Services cannot provide such verification unless they have provided treatment and the student authorizes release of information to the instructor. Further, barring extraordinary circumstances, the confirmation must be available to the instructor prior to the missed course event.

With regard to family emergencies, you must provide verifiable documentation of the emergency. Given the vast array of family emergencies the instructor will provide precise guidance as to what constitutes adequate documentation. Unless the emergency is critical you should notify the instructor in advance of your absence from the scheduled course event. In cases of critical emergencies, you must notify the instructor within one week of your absence.

For University-approved curricular and extra-curricular activities, verifiable documentation is also required. The student should obtain from the unit or department sponsoring the activity a letter (or class absence form) indicating the anticipated absence(s). The letter must be presented to the instructor at least one week prior to the first absence.

In the case of religious holidays, the student should notify the instructor by the third week of the course of any potential conflicts.

Please see me if you have concerns or comments about the course. If you would like to provide feedback about this course you may also contact the Director of Undergraduate Studies in Economics or leave a comment in the box that the Department maintains in 303 Kern.

[1] http://www.bloomberg.com/apps/news?pid=20601083&sid=aCM5WaqsP.98.

[3] Oscar Wilde, The Importance of Being Earnest, 1895.

[4] I have also created a blog, http://ickmansblog.blogspot.com/ where I will make posts on items of interest. Hopefully you will find some interesting enough to comment on.

[5] People often ask whether the final will be cumulative. This is a question that one should never ask. Why? The essential meaning of this question is “can I forget everything you taught before the last exam?” It is bound to be insulting to any instructor to hear such a question. Everything we do in the early part of the course builds a foundation for the latter part of the course. How can the discipline be anything but cumulative?

[6] This does not really explain why I give points for attendance. After all, aren’t the costs of absenteeism internalized (i.e., via a low grade)? The problem is not that students who fail to attend lectures do poorly on exams (they do, but that is their problem, not mine). It is that students who fail to attend lectures and then do poorly on exams then pose an extra burden (on me) later in the course (pleading for extra credit, trying to learn in 3 weeks what they should have learned over 12 weeks, etc.). This makes paternalism a potentially optimal social policy.

[7] Some students will ask me from time to time where we are on the syllabus. I am always perplexed by this question. If you listen to the lecture you know the subject. The reading list is divided by subject headings. Hence, you ought to be able to look at the outline and see what you should be reading. What could be more obvious?