interesting because I was able to get so much Zimbabwean currency for my U.S. dollars that I felt like a rich man in Victoria Falls. While the Zimbabwean currency was weak compared to the U.S. dollar, it was rock solid compared to the currency of Zambia. So motivated were these Zam-bians to get some hard currency that they chased after me for more than a mile-running beside my damaged bicycle in their street clothes and hard-soled shoes.

If one were to visit Victoria Falls today, the situation would be reversed. The Zimbabwean currency is now extremely weak compared to that of Zambia. What happened? The current inflation rate in Zimbabwe is over 640%. By comparison, the Zambian rate of 18.5% looks positively tame.2 Because of the different inflation rates, the Zimbabwean currency is dropping on a daily basis. People who want to store their money in a stable currency are willing to work hard to avoid Zimbabwean currency.

Of the two currencies, the Zambian is now rock solid because of the difference in inflation rates. The lesson from this is that whenever we discuss exchange rates, we need to be sure to consider relative inflation rates. We care about the purchasing power of our money (the real exchange rate), not the number of bills we can get (the nominal exchange rate). The real exchange rate takes into account inflation rates.

With high inflation rates, the difference between nominal and real exchange rates can be enormous. In January 1913, one U.S. dollar converted into 4.2 German marks. In October 1923, the same dollar was worth over 25 billion German marks! Because German prices had risen even faster than the exchange rate, however, the purchasing power of these 25 billion marks was less than the 4.2 marks in 1913.3 The nominal value of a U.S. dollar in marks had gone up astronomically while the real value actually fell.

Wouldnt it be nice if we could just ignore the difference between real and nominal exchange rates? Yes, and we will. Most of our discussion focuses on the three big currencies: the U.S. dollar, the euro, and the Japanese yen. All three regions have similarly low inflation rates these days.

When countries have similar levels of inflation, it is okay to use nominal exchange rates.

Two Roads to Times Square

In The Out of Towners, the protagonists George and Gwen Kellerman (played by Jack Lemmon and Sandy Dennis in the 1970 original; Steve Martin and Goldie Hawn in the 1999 remake) make a hellish trip to New York City.

When their flight intended for New York is diverted to Boston, the Kellermans improvise and push on to Manhattan by train. After a very long night including a mugging, a police chase, and sleeping outdoors, the Kellermans run into one of their fellow passengers from the original flight. Unlike the frazzled Kellermans, their calm compatriot rested overnight in Boston and took a morning flight. Both parties ended up in Manhattan for breakfast, but by very different routes.

Similarly, there are various paths the world can take as we adjust from the United States having the biggest current account deficit in history to a future with U.S. current account surpluses. Two relevant and recent examples exist in North America. In these sagas, Mexico took a painful Kellermanesque path of adjustment, while Canada eased through its transition with many fewer aches and pains.

In the 1960s and 1970s my family used to vacation in Canadas Point Pelee National Park. As an industrious child, I scavenged for discarded bottles with my sister Miranda to make money on the deposits. On good days, we would gather more than 100 bottles, which, depending on the brand, each carried a 2 cent or a 3 cent deposit. We were able to get our hot little hands on 2 or 3 dollars for a few hours of work. But there was one small catch; we earned Canadian dollars (now also known as loonies ), not U.S. dollars.

When we began our bottle collecting, the loonie was worth slightly less than its U.S. counterpart.4 So we had a bit of disdain for the Canadian

currency. Furthermore, because some of the coins were of similar size (particularly the quarters), people who lived in Detroit and the neighboring Canadian town of Windsor would often exchange the coins at an even rate. I was always happy if I could unload my Canadian quarters at full value, whereas I felt cheated when someone slipped me a Canadian quarter.

In the early 1970s something magical happened. The Canadian dollars that we earned from our bottle work became worth more than a U.S. dol-lar.5 Although the adjustment was quite small, the movement to more than a buck was accompanied by tremendous pride. Instead of shyly sliding my Canadian dollar across the counter at Harrys hobby shop and hoping I wouldnt get yelled at, the crisp Canadian bills became something that I could proudly display.

Were I to earn some Canadian dollars today they would be worth far less than a U.S. dollar. In late 2001, the loonie dropped to 63 U.S. cents. What happened to my beloved loonie?

For many years, particularly in the 1980s, Canada ran a large current account deficit.6 In the post-1973 world, without governments controlling exchange rates under Bretton Woods, Canadas current account deficits were among the largest for an industrialized country. In other words, Canada in the 1980s was consuming more than it produced to a degree almost as extreme as the United States in 2004.

In the 1980s, Canada was enjoying its Wimpy burgers with the promise of repayments on Tuesdays to come. The decline of the Canadian dollar indicated that it was Tuesday and time for repayment. The subsequent fall in the value of the Canadian dollar made Canadians less able to import products from abroad. The cheap currency also made Canadian products into excellent values. In short, Canada went through a textbook process. Years of consuming more than it produced were followed by repayment; this repayment, in the form of a current account surplus, was accompanied by a cheap currency.

Canada consistently runs a current account surplus, and the adjustment process was gradual.7 Over a quarter of a century, the Canadian