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Chapter Introduction

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Topics in International Macroeconomics

This chapter surveys four separate topics that have been, and are currently, important areas of research. They are: (1) long-run deviations from PPP and the Balassa-Samuelson model; (2) deviations from UIP and the efficiency of the FX market; (3) sovereign default; and (4) the recent macroeconomic crisis.

Exchange Rates in the Long Run: Deviations from Purchasing Power Parity
Exchange Rates in the Short Run: Deviations from Uncovered Interest Parity
Debt and Default
The Global Macroeconomy and the 2007–2013 Crisis

Economics is a science of thinking in terms of models joined to the art of choosing models which are relevant to the contemporary world.

John Maynard Keynes, 1938

This chapter consists of four standalone, short chapters on topics that remain at the cutting edge of research in international macroeconomics.

1. Deviations from PPP work in the long run? Develop the Balassa-Samuelson model

2. Does UIP provide a good theory of short-run exchange rate determination? FX traders make massive profits and losses that should be predictable. This is inconsistent with arbitrage. Proposes aversion to extreme riskiness as a limit to arbitrage.

3. Sovereign default: Why do lenders lend, given this risk? When do borrowers default, and at what price? Develops a model in which adverse shocks make a country more likely to default. Larger shocks therefore make lenders less willing to lend, and so demand higher interest rates. This is consistent with the stylized facts that poor countries have more volatile output, face higher interest rates, default more at low rates of output, and lenders make little profit.

4. Reviews the global macroeconomy before, during, and after the recent crisis.

Like other fields of economics, international macroeconomics is evolving continually. New empirical analyses are constantly appearing, deepening our understanding, and bringing attention to new phenomena. New theoretical models are always being developed, to better explain long-standing puzzles or to confront new ones. The fast-changing global economic environment of recent years has pushed forward research faster than ever.

In the four stand-alone sections of this final chapter, we examine several important topics that have occupied researchers for many years and that remain at the cutting edge. In these “mini-chapters” we explore new issues as well as important extensions to the core models presented earlier in the book:

We ask whether purchasing power parity really works as a long-run theory of exchange rates. Evidence shows that a better theory has to explain why price levels are higher in richer countries. We develop such a theory and show how it can be applied to improve exchange rate forecasts.
We ask whether uncovered interest parity really works as a short-run theory of exchange rates. We show that forex traders often make massive profits (and also losses) and that such profits may be somewhat predictable. If arbitrage operates to support uncovered interest parity in an efficient market, such profits ought to be eliminated. One explanation might be that there are limits to arbitrage, such as an aversion to the extreme riskiness of profits in the forex market.
We study the problem of defaults by governments on their debt. Some of the facts to be explained are why any lenders lend given the risk of default, why borrowers choose to default when they do, and what price they pay for defaulting. We develop a model in which adverse economic shocks (low output) make countries more likely to default. The bigger such shocks are, the more the countries default, and the less willing lenders are to lend, unless they receive a higher interest rate. The model fits various facts: poorer countries have more volatile output, are charged higher interest rates, default more often even at lower levels of debt, and lenders don’t make much profit.
We look at the performance of the global macroeconomy before, during, and after the 2007–2009 Global Financial Crisis and subsequent Great Recession. We look to understand some of the causes and consequences of this event using the tools we have developed throughout the book, even as the repercussions of this event continue to unfold.