Unit Four Case Analysis
Read the CASE ANALYSIS: The limits to Macroeconomic Policy (page 261).
Write a 3 to 5 page paper (1000 to 1500 words) in APA format in response to the questions:
a. Provide an overview of this case analysis; summarize the key points.
b. Explain why a currency devaluation, whether intentional or not, would be a
problem.
c. Consider the question: Does this mean that developing countries cannot use
expansionary macroeconomic policies? Provide an answer to this question.
Below is a recommended outline.
2. Cover page (See APA Sample paper)
3. Introduction
a. A thesis statement
b. Purpose of paper
c. Overview of paper
4. Body (Cite sources using in-text citations.)
a. Provide an overview of this case analysis; summarize the key points.
b. Explain why a currency devaluation, whether intentional or not, would be a problem.
c. Consider the question: Does this mean that developing countries cannot use
expansionary macroeconomic policies? Provide an answer to this question.
5. Conclusion – Summary of main points
e. lessons learned and Recommendations
6. References -list the references you cited in the text of your paper according to APA format.
(Note: Do not include references that are not cited in the text of your paper)
groups are considered unemployed. In addition, there are always a number of
people who have voluntarily quit their jobs to look for better ones, and people
who lack the job skills they need to find a job.
In a strong economy, unemployment may temporarily fall to a very low level,
but this tends to resolve itself. Initially, employers may grab whoever is available
to fill their job vacancies, but as the pool of the unemployed dries up, they raise
wages and look for ways to get by with fewer workers. Ultimately, this returns the
unemployment rate to its normal level. Conversely, in a weak economy unemployed workers put downward pressure on wages, which ultimately resolves the
problem of unemployment, since employers hire more workers when wages fall.
The most controversial issue is how long these changes might take. Some
observers believe they happen fast, while others are skeptical, particularly about
the speed at which wages fall. In one sense, the debate over the amount of time it
takes an economy to reach its long-run equilibrium at full employment is a debate
over the meaning of the long run. Is it two years, five years, or ten?
In Chapter 10, we saw that in the long run, purchasing power parity determines exchange rates. Fiscal and monetary policy may cause deviations from
purchasing power parity, but in the long run, a combination of exchange rate
changes and changes in domestic prices will restore balance to the purchasing
power of national currencies.
The current account must also tend toward balance in the long run. No nation
can run deficits forever, nor can it run surpluses forever. Since deficits are equivalent to foreign borrowing and surpluses equivalent to foreign lending, there are
limits in each direction. The limits are not well defined, however, and countries
such as the United States have been able to run enormous deficits for long periods, while countries such as Japan have run surpluses.
The Limits to Macroeconomic Policy
In 1900,Argentina was among the richest countries in the world. Its good fortune
was not to last, however, and by mid-century its per capita income had fallen
behind. Although it still had the highest per capita income in Latin America, the
gap with western Europe and North America was substantial, and it was not getting smaller when it was hit by the Latin American debt crisis and the Lost
Decade of the 1980s (see Chapter 15). The debt crisis was vicious and hard to
shake off. In 1989, seven years after it began, Argentina was still caught in it, and
its GDP fell 7 percent while inflation hit 3,080 percent. Politicians tried a variety
of experiments to get out of the recession and hyperinflation, but none of them
led to sustained growth or brought down the inflation rate. In 1991, a radical
experiment was tried. The country fixed its currency to the dollar at a 1:1 rate
and dramatically restricted the creation of new money. For every new Argentine
peso put into circulation, the central bank was required to have a dollar to back
it up, and a newly created currency board was there to oversee the exchange rate
system and enforce the rules.
The currency board worked extremely well through most of the 1990s.
Argentina was back on a strong growth path with low inflation and was widely
viewed as a successful model for other countries. Problems began to develop in
1998, however, when the global fallout from a crisis in East Asia spread to Latin
America. Argentina’s main trading partner, Brazil, devalued its currency in early
1999, giving Brazilian firms an advantage and putting Argentine firms at a disadvantage since goods valued in pesos were now more expensive. Argentina’s current account balance developed a relatively large deficit of 4-5 percent of its
GDP, and the loss of exports led to a recession in 1999.
At this point, conventional economic theory prescribed a demand-side stimulus
for Argentina. Total expenditures in the economy were down, in part because it was
more difficult to export, so the country should have cut taxes, raised government
spending, increased the money supply, or some combination of those policies. There
were a few obstacles, though. First, anything that might upset the 1:1 exchange rate
was viewed as a potential problem. All else equal, exapnsionary macroeconomic
policies cause prices to rise, and it was feared that deliberately increased government deficits might undermine confidence in the anti-inflation committment of the
government. Argentina was already running a budget deficit that was hard to control, and increased spending and tax cuts were not an option. Monetary expansion
was also out since that would undermine the peg to the dollar by increasing the circulation of pesos beyond the level of dollars available to back them up.
Secondly, a currency devaluation, whether intentional or not, would be a
problem. During the growth years of the 1990s, Argentine firms and Argentina’s
government had borrowed dollars in international capital markets. There was
nothing particularly unusual about Argentina’s borrowing, except that its ability
to raise revenue to service its debts was constrained by domestic political factors. Taking on debt denominated in dollars is common, but it imposes a high
price when there is a currency devaluation, since the dollar value of the debt
does not change, but the domestic currency value rises. Given that the government and most firms earned revenues in pesos, but that their international debts
were in dollars, anything that caused the value of the peso to decline would
increase the burden of debt.
The debate over policy was intense: Should Argentina devalue and increase
the debt burden or maintain the exchange rate and continue to watch the current
account deficit grow and the economy shrink? Cut government spending to create confidence in the fiscal soundness of the government; or, use expansionary
fiscal policy to address the recession while undermining confidence in the government’s committment to the 1:1 exchange rate? In effect, there were two
choices. On the one hand, the government could use expansionary macroeconomic policies to try to combat the recession, but at the cost of a probable
devaluation of the peso since no one would believe that it was still committed to
anti-inflation policy and fiscal prudence. On the other hand, it could maintain the
peso’s link to the dollar at the 1:1 ratio, but at the cost of ignoring the recession.
Argentina’s recession began in 1999. Two year later, in 2001, the country was
still in recession and prospects seemed to be getting worse. As people lost confidence in the government’s ability to maintain the 1:1 exchange rate, they decided
that a devaluation was coming and began to take their money out of banks. After
enormous losses in the banking sector, the government closed all banks in early
December 2001. When they reopened in January 2002, the peso’s link to the dollar had been cut. The peso began a steady decline, dropping from 1 peso per dollar to 0.7 pesos on January 7, to 0.545 pesos on Juanuary 22, and on down in
value. Eventually, around June 2002, it stabilized around 0.27 pesos per dollar. In
the end, it lost about three-fourths of its value.
Some observers argue that Argentina should have sought more flexibility
in its policies by severing the one-to-one relationship between the peso and
the dollar much earlier-in 1997 or 1998. Others argue that it should have
made deeper cuts in its budgets, because that was the only way to maintain
confidence in its currency. At first, the government tried the latter approach,
but political and institutional obstacles prevented the budget cuts from being
large enough.
The Argentine case still poses questions for economists. Recessions caused by
a decline in demand are most effectively fought by increasing demand, either
through government spending, tax policy, or monetary policy. However, if a
country needs to demonstrate to the world that it is fiscally prudent because
doing so will prevent speculation against its own currency and maintain the
inflow of foreign currency, then expansionary macroeconomic policies may be
impossible. Does this mean that developing countries cannot use expansionary
macroeconomic policies?
Fiscal, monetary, and exchange rate policies are essential tools for eliminating a
current account imbalance. While any persistent imbalance can be portrayed as a
problem, in practice the most dangerous imbalances are large current account
deficits. Persistently large surpluses may bother a country’s trading partners, but
they rarely threaten a national economy the way that large deficits sometimes do.
The macro policies for addressing a current account deficit are a combination of
fiscal, monetary, and exchange rate policies, often collectively called expenditure
switching policies and expenditure reducing policies. Both are essential.
We have already seen one type of expenditure switching policy when we
talked about the exchange rate effects of fiscal and monetary policy. In general,
an appropriate expenditure switching policy for eliminating a current account
deficit is one that turns domestic expenditures away from foreign-produced
