The Pennsylvania State University

Department of Economics

Economics 434                                                                                        Professor Barry W. Ickes

Fall 2006

International Finance and Open Economy Macroeconomics

         Office:                   618 Kern Graduate Bldg.

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

Introduction

         This is a 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.

         Why this class may be important is suggested by this report:

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.

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

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. 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? Some argue that this is no problem, that there is a “new Bretton Woods” system in operation. Others mention a Global Savings Glut, or even “Dark Matter” to explain our current account deficit. What does this mean? How do we know what is the correct interpretation? How are we to think about these problems? These are important questions.

         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 recent Argentine crisis 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 15% of your final grade.

         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. 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.

         I must also point out that the exams in this course are not multiple choice. In the past some student have complained that they do not like the exams. Past exams are available on the website. Examine them now. If you don’t like such exams I suggest that you take appropriate action now.

         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. 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

         There is no required textbook for this course. I have ordered as an optional text, Paul Krugman and Maurice Obstfeld, International Economics. This is a good book, but no text conforms perfectly to the needs of this course. It is not a substitute for the lectures, but it will be helpful, and the questions at the end of the chapters are very useful for learning the material (and preparing for exams). I also ordered, Paul Blustein’s book: And the Money Kept Rolling In, which covers the Argentine crisis. This book is just very interesting, especially for anyone interested in the subject matter of this course.

         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. You can access it at: http://econ.la.psu.edu/~bickes/434home.htm.  

         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 15% 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 15%. The remaining 5% will be based on attendance.

         The midterms will take place in class. The first midterm will be on Thursday, October 5, 2006. The date of the second midterm will be Thursday, November 9.

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. 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 Krugman-Obstfeld (optional) 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

                        KO, chapter 1

II.         The Theory of International Capital Flows and Globalization

Lecture Note on Current Account in an Intertemporal Framework

                        KO, chapter 21, chapter 12

III.        International Financial Markets

                        Lecture Note on International Financial Markets

                        Lecture Note on the Real Exchange Rate

                        KO, chapter 13, 15

                        Options 

                        Lecture Note on Options

IV.        The International Monetary System in Historical Perspective

                        Lecture Note on the Gold Standard

                        KO, chapter 18

[First Midterm About Here]

V.         The Asset Approach to the Exchange Rate

                        Lecture Note on Exchange Rate Fluctuations and Overshooting

VI.        Income Determination in the Open Economy

                        Lecture Note on Income Determination

                        Lecture Note on Real Depreciation 

                        KO, chapter 16

[Second Midterm About Here]

VII.       Currency, Debt, and Financial Crises

                        Lecture Note on Currency Crises

                        Lecture Note on Argentina

                        Paul Blustein, And the Money Kept Rolling In, New York, PublicAffairs, 2005.

                        KO, chapter 22