Econ 13, Foldvary

Mankiw, Chapter 18 - Open-economy Macroeconomics

Closed economy - without foreign trade and investment.

Open to international trade, global movements of money, and foreign ownership of assets.

In a college dorm, what are the imports and exports?

Current and capital accounts.

Current account: goods (merchandise) and services plus income from investments plus transfers.

Net exports: exports of goods minus imports, in the current account.

Balance of trade refers to the "goods and services" account.

Trade deficit: more imports than exports of goods and services.

Trade surplus: the opposite.

The US has a large trade deficit.

International trade has been growing relative to GDP

Since WWII, trade barriers have been reduced,

largely with international agreements: GATT and WTO.

Also with trade blocks such as NAFTA.

Besides the trade in goods, there are also transactions for investments and financial assets.

The "net capital outflow" equals the purchase of foreign assets of domestic residents

minus the purchase of domestic assets by foreigners.

The US has a negative net capital outflow: foreigners are buying more US assets than are Americans buying foreign assets.

Net exports equal the net capital outflow.

Y = C + G + I + X - M

Y - C - G = I + X - M

In the US, (X-M) is negative, so Y < C + G + I

Savings (S) = Y - C - G

S = I + X - M

since X-M = net capital outflow (O),

S = I + O

In the US, O is negative.

I = S - O.

Since O is a negative number, -O is positive.

The US has had a low savings rate, and so much of US investment come from foreign savings.

Is the U.S. trade deficit good, bad, or neutral?

It depends on the reason for the deficit.

If the deficit comes from voluntary choices, it does no harm.

If the deficit comes from decisions imposed on the economy by government,

then the real problem is the government policy,

such as a budget deficit, or taxes that make exports more expensive than necessary.

Real and nominal exchange rates

Foreign exchange: the trade in different currencies.

Has transactions costs and the cost of uncertainty.

Can gain or lose from the future value of foreign money.

The nominal exchange rate: the ratio of currencies, such as 1 euro for $1.15

Nominal variables are those expressed in current dollars or other money units.

The real exchange rate is the ratio of real goods, such as

the cost in dollars of a pound of American cheese divided by that of a pound of French cheese.

The real exchange rate = (nominal exchange rate) * (domestic price) / (foreign price)

Suppose a pound of cheese costs $2.20 in the US and in Europe, 2 euros.

US$1 exchanges for .87 euros.

The real exchange rate = (.87 euros/$)*$2.20/(2 euros)

= .87*2.2/2 = .957

The real exchange rate for cheese is 1 pound US cheese for .957 pounds French cheese.

The real exchange rate determines the exports and imports.

French would import American cheese if there are no transactions costs, including taxes.

For all goods, the real exchange rate = e*p/f, where

e is the nominal exchange rate, p is the US price index, and f is the foreign price index.

Purchasing power parity

Parity means equality.

Purchasing power parity: the proposition that a dollar should buy roughly the same amount of tradable goods in all countries. This is only very loosely so.

The purchasing power of a unit of a currency is

1/p = e/f (p. 394)

So, e = f/p

The nominal exchange rate = f/p

So it changes when price levels change at different rates.

If the US has higher inflation than Europe, a euro will exchange for more dollars.

PPP is very incomplete because many goods don't trade. Causes:

transaction costs, trade barriers, taxes, restrictions, preferences

But PPP does roughly match the cost of many goods. Example: hamburgers

Big macs, p. 397.

In the long run, the relative values of currencies change with differing rates of inflation. In the short run, interest rates and government policy can affect the exchange rates.