Author:  Lori Alden

Audience:  High school, advanced placement and college economics students

Time required:  About 50 minutes of class time.

Summary:  This classroom simulation illustrates some basic principles of international finance.  Students are grouped into four countries, which are endowed with goods (candy), stock, and domestic currencies.  During a brief trading session, students can use their currency to buy domestic goods and assets, or they can convert it into foreign exchange and buy foreign goods and assets.  When the trading session ends, students use tables to record each country’s net exports, net foreign investment, foreign exchange transactions, and balances on current and capital accounts.   The tables demonstrate that net exports and net foreign investment are equal, and show the relationship between a country’s current account and capital account balances.  The four-country simulation described in this article is designed for classes of 17 to 73 students, but the number of countries can be decreased or increased to accommodate smaller or larger classes.

Resources

• Click here to download the materials for the simulation in pdf format.  The materials include masters of a student handout, fake currency notes, and fake stock certificates.
• 25 copies of fake currency notes for each of four countries, denominated so that each country’s note is worth \$1.  Examples of fake currency for the United States , Britain , Japan , and Mexico are provided, and are based on exchange rates of  \$1 = £.6 = ¥120 = MXN 10.  (As exchange rates change over time, you may want to update the denominations of the fake currencies.)
• 25 pieces of each of four different kinds of candy.  Individually wrapped Halloween candy works well.
• 6 stock certificates for each of the four candy firms.  To minimize confusion between currency and stock certificates, it helps to print one or the other on colored paper.
• Copies of the student handout.
• An overhead projector and transparencies of the tables in the student handout.

Procedure:

Begin by giving each student a copy of the student handout.  Appoint a capable student to serve as a foreign exchange broker, and give him or her 10 bills from each of the four countries and a desk at the front of the classroom.   Divide the remaining students into 4 countries, appoint a leader for each country, then give each leader a packet containing 15 bills of currency, 5 stock certificates, and 10 pieces of candy.    Ask each of the leaders to appoint a stockbroker, who will sell stock, and a candy retailer, who will sell candy.   Announce that all the other students in each country will serve as households, and that they will be buying stock and candy.  (Let the leaders also serve as households in small classes, otherwise have them sit out.)  Have the leaders give the stock certificates to the stockbrokers, the candy to the retailers, and then divide the currency as evenly as possible among the households.

Read aloud the rules listed in the handout, and then ask each leader to tell the class about the candy and stock available in his or her country, and the currency used.   Emphasize that just as households in the real world use all of their disposable income to consume or save, households in this simulation must spend all of their currency on either candy (representing consumption) or stocks (representing saving).  Allow the trading to proceed for about 5 to 10 minutes, until all of the currency has been spent and all of the candy and stock has been sold.   You may need to help the last few buyers and sellers find each other.  When the trading ends, ask the leaders to count all of the currency, stock certificates, and candy in their countries.  Have them report these amounts to you and record them on a transparency of Table 2.

Before proceeding, check the accuracy of the numbers.  Each country should end up with 15 domestic currency notes, one for each of the candies and stock certificates it sold.   Each of the rows should also add up to 30, since each country was initially endowed with, and should have ended up with, 30 tradable items in the form of currency, stock certificates, and candy.  I’ve found that discrepancies sometimes occur, and that they’re usually caused by misplaced or miscounted stock certificates or candy, or by illegal “two-for-one” trades.  It’s usually easy to discover and correct these problems.  Indeed, doing so enhances the lesson in that it illustrates how economists can pinpoint statistical discrepancies that show up in international accounts because of reporting errors and illegal flows of money over borders.

If you can’t quickly track down the source of the discrepancy, go to the leader’s desk and adjust that country’s holdings using, if necessary, extra currency, stock, or candy so that each of the rows sums to 30 and the three middle columns sum to 60, 20 and 40 respectively.   Don’t bother figuring out whether the stock or candy you need to add or subtract should be foreign or domestic—it won’t significantly affect the outcome.   After you’ve done that, fix the numbers in the table accordingly.

Once Table 2 is in order, have students fill out the rows in Tables 3 and 4 for their own countries, and then report the results to you.  Record each country’s results using transparencies and an overhead projector, and instruct students to use that information to completely fill out the two tables.  At this point, students will have enough information to complete Tables 5 and 6 on their own.

When the tables are completed, ask your students to search for patterns and relationships in them.   Here are some of the observations they should make:

1. The sum of the current account balances of all of the countries in the world equals zero.   Another way of expressing this is that the sum of net exports in the world equals zero.  To help students understand why this is true, ask them to imagine a world with only two countries.  If one country is exporting more than it’s importing, the other must be importing more than it’s exporting.
2. Net exports and net foreign investment are equal for each country.  Japan ’s net foreign investment, for example, represents the difference between the foreign assets that are acquired by Japanese residents minus the Japanese assets that are acquired by foreign residents.  Japan ’s positive net foreign investment serves as compensation for the sacrifice of having positive net exports—that is, of producing more than it’s consuming.
3. Surpluses and deficits in any country’s current account are offset by corresponding deficits and surpluses in the capital account.   In the simulation, households in a country pay for imports either by exporting goods or by exporting assets.  If a country imports more goods than it’s exporting, then it must compensate by exporting more assets than it’s importing.  In doing so, it runs a current account deficit and an offsetting capital account surplus.  In the real world, it’s possible for a country to run a balance of payment surplus or deficit, in which the sum of its current account and capital account is either positive or negative.  But this can only occur if the country’s central bank is buying or selling international reserves.  If the United States had a balance of payments deficit, for example, it must be true that the Fed is selling international reserves equal to that deficit.
4. The capital account balances of all of the countries in the world should sum to zero.  This follows from observations (1) and (3).
5. The quantity of currency supplied equals the quantity of currency demanded for each country.  In this experiment, each market is forced into equilibrium by requiring that every currency note be spent, and by matching the number of currency notes to the amount of candy and stock certificates sold.  In the real world, however, exchange rates are often allowed to rise or fall in order to equate the quantity of currency supplied to quantity demanded.

Point out that errors occur in the real world and that balance of payments accounts always contain entries for statistical discrepancies, which force the accounts into balance.

After you’ve discussed these findings, allow the leaders to distribute the candy and stock among the students in their countries.  I usually redeem the stock (for two pieces of candy each) at the end of the class period, but you can, if you wish, wait until later in the semester to do so.

Sample Results

To illustrate how this exercise works, the following completed tables show the outcomes of a sample simulation.  Actual simulations in my classes have consistently yielded similar outcomes.

 Currency (Number of bills) Stock (Number of certificates) Candy Row totals USA 15 5 10 30 Japan 15 5 10 30 Mexico 15 5 10 30 Britain 15 5 10 30 Column totals 60 20 40

 Currency (Number of bills) Stock (Number of certificates) Candy Row totals USA 15 4 11 30 Japan 15 6 9 30 Mexico 15 7 8 30 Britain 15 3 12 30 Column totals 60 20 40

Table 3:  Net Exports

 1.  Domestic candy before trade 2.  Domestic candy after trade 3.  Exports = (1) – (2) 4.  Imports = Foreign candy purchased 5.  Net exports = (3) – (4) USA 10 3 7 8 -1 Japan 10 7 3 2 1 Mexico 10 4 6 4 2 Britain 10 5 5 7 -2

Table 4:  Net foreign investment

 1. Domestic stock before trade 2.  Domestic stock after trade 3.  Foreign purchases of domestic stock = (1) – (2) 4.  Domestic purchases of foreign stock 5.  Net foreign investment = (4) – (3) USA 5 2 3 2 -1 Japan 5 1 4 5 1 Mexico 5 3 2 4 2 Britain 5 2 3 1 -2

Table 5:  The Quantity of Currency Supplied and Demanded

 1.  Imports 2.  Domestic purchases of foreign stock 3. Quantity of currency supplied = (1) + (2) 4. Exports 5.  Foreign purchases of domestic stock 6.  Quantity of Currency Demanded = (4) + (5) USA 8 2 10 7 3 10 Japan 2 5 7 3 4 7 Mexico 4 4 8 6 2 8 Britain 7 1 8 5 3 8

Table 6:  Balance of Payments

 1.  Spending flowing into country (excluding purchases of assets) = exports 2.  Spending flowing out of country (excluding purchases of assets) = imports 3. Balance on current account = (1) – (2) 4.  Spending flowing into country for purchases of assets = foreign purchases of domestic stock 5.  Spending flowing out of country for purchases of foreign assets = domestic purchases of foreign stock 6.  Balance on capital account = (4) – (5) USA 7 8 -1 3 2 1 Japan 3 2 1 4 5 -1 Mexico 6 4 2 2 4 -2 Britain 5 7 -2 3 1 2

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