Balance of Payments Lecture 24 Dr. Jennifer P. Wissink ©2016 Jennifer P. Wissink, all rights reserved. April 27, 2016

Announcements 1120(mAcro) Spring 2016 u Keep working on the MEL stuff. Get your 500 points ASAP, and then continue working on them for practice. u Important end-of-semester reminders –Register for makeup final on Bb if you plan to sit the final then – see policy there. –Check Bb under Tools: i>clicker registration & points and make sure your device is registered with your name for this class! u Wissink Office Hours This Week: I am around a lot this week so if you want to me to stop by and see me about anything, please contact me with a suggestion or two for when you are available.

Example 1: u Cool currency converter site: u The Wissinks go to France. u Hotel/food/train/gifts costs €5,000 Euros –The Wissinks need to buy Euros –€ 1 Euro = $1.33 USD OR $1 USD = € 0.75 Euro –So... it all costs $6,650 USD u The Wissinks are importing goods and services. u In the Current Account, “Import of goods and services” shows a - $6,650. (Note: a debit item, since we use up foreign exchange!) u I take $6,650 US dollars and purchase € 5,000 Euros from a French private bank to pay the hotel/tour bill. u In the Capital Account, line (7) “Change in foreign private assets in the United States” (in this case, French holdings of US dollars) are increased by +$6,650. (Note: this is a credit item!) u The net wealth position of the US vis-à-vis the rest of the world has decreased by $6,650.

Example 2: u Prof. Wissink decides to buy a British bond from a non- government (private) British issuer. u The bond costs £10,000. –£1 GBP = $1.54 USD OR $1 USD = £0.65 GBP –I take $15,400 USD and purchase the £10,000 GBP bond (which has a US dollar value of $15,400). u “Change in foreign private assets in the US” (in this case, British holdings of US dollars) show a +$15,400 in the Capital Account. –(Reminder: increases in this item get recorded as a “+” item in line (7) of the Capital Account.) u But now I hold this bond so there is a “change in private U.S. assets abroad”, that is an increase in US assets abroad (the U.S.(me!) now holds more British bonds) and so we show this as a -$15,400 in the Capital Account. –(Reminder: increases in this item get recorded as a “–” item in line (6) of the Capital Account.) u So there is still “balance” in the Balance of Payments accounts.

Trade Policy: Free vs. Protection u Free Trade - the practice of leaving the markets alone and letting the invisible hand of the price mechanism do its work. u Protection - the practice of shielding a sector of the economy from foreign competition via various policies. u So… –Should we? (Protectionist Policies) –Should we not? (Free Trade Policies) u Common protectionist policies –A tariff is a tax on imports. »The average tariff on imports into the United States is about 5 percent. –A quota is a limit on the quantity of imports. –Export subsidies are government payments made to domestic firms to encourage exports. –Dumping refers to when a firm or industry sells products on the world market at prices below the cost of production. »The Comprehensive Trade Act of 1988 contains clauses that permit the president to impose trade sanctions when investigations reveal dumping by foreign companies or countries.

The Case For Free Trade u The case for free trade is based on the theory of comparative advantage. u When countries specialize and trade based on comparative advantage, consumers pay less and consume more, and resources are used more efficiently. u When tariffs and quotas are imposed, some of the gains from trade are lost. u Why did The Economist favour free trade? –Sep 6th 2013, 13:55 by C.R. | LONDON – 09/economic-history

Economic history; Why did The Economist favour free trade? Sep 6th 2013, 13:55 by C.R. | LONDON A better understanding of economic history might have helped the world avoid the worst of the recent crisis. Free exchange continues its discussion of milestones in economic history, showing how they contributed to the development of economic thought (you can read earlier entries here and here). This week’s post, which marks the 170th anniversary of the first issue of The Economist on September 2nd 1843 looks at free trade, the economic idea the newspaper was originally founded to campaign for. IN NINETEENTH century Europe and America, debates over whether tariffs or free trade produced the most economic growth dominated the political scene. Up until the early 1840s, protection appeared to be winning the argument. In Britain, high tariffs were imposed on agricultural imports in 1819, by legislation known as the Corn Laws. The ideas of Friedrich List, a German economist who argued that tariffs boosted industrial development through the protection of infant industries, were gaining ground, particularly in the United States. One Pennsylvanian legislator even joked in 1833 that the dictionary definition of man should be changed to “an animal that makes tariff speeches” so frequently were they heard. Against this atmosphere, James Wilson founded The Economist in 1843 to campaign for free trade. His first target was to repeal the Corns Laws in Britain. He argued: They are, in fact, laws passed by the seller to compel the buyer to give him more for his article than it is worth. They are laws enacted by the noble shopkeepers who rule us, to compel the nation to deal at their shop alone. But his ambition was greater than Corn Law repeal. According to Scott Gordon, an economic historian at Indiana University, Wilson and The Economist in the 1840s supported free trade views “with remarkable completeness and consistency” compared to other newspapers of the day. In its prospectus, Wilson announced that The Economist would include “articles in which free-trade principles will be most rigidly applied to all the important issues of the day”. Wilson believed that protectionism caused “war among the material interests of the world”, in other words, war between nations and classes. A high tariff regime was no longer economically “productive”; Britain was stuck in an economic depression in the early 1840s. In contrast, free trade produced “abundance and employment”. It was appropriate for Britain’s economy where “a large proportion of the population and property depended on commerce and industry alone”. On the other hand, List’s ideas about protection were dismissed as unnecessary “swaddling clothes” for a mature economy, such as Britain’s. The Economist’s early views on free trade were strongly influenced by the classical economists Adam Smith and David Ricardo, as Ruth Dudley Edwards, a historian, has pointed out. Wilson, like Smith, realised that trade was a two way exchange. Countries needed to “increase imports to increase exports” to boost economic growth. Consumers, Smith argued in the Wealth of Nations, should buy products from where they were cheapest. All protection did was create monopolies, which were “a great enemy to good management”. Ricardo took Smith’s ideas further, arguing that all countries benefit from free trade by producing what they were best at relative to other countries. However, some more recent economists have identified situations where the benefits of free trade can be inhibited. Charles Bickerdike and Francis Edgeworth argued in the early 1900s that large countries could benefit from imposing “optimal tariffs” by abusing their monopoly power over global markets. Similarly, John Maynard Keynes argued in 1931 that the introduction of tariffs in Britain, a big country, could help its economic recovery from the Great Depression. A 1989 paper by Michael Kitson and Solomos Solomou suggests there might be some credit in Keynes’ line of thought. They argue that the imposition of the General Tariff in Britain in 1932 “benefitted the British economy” by boosting new industries and accelerating the trend rate of growth in the period. But economists are quick to admit that these policies only work in specific or temporary circumstances, if ever. Bickerdike and Edgeworth always maintained that free trade was only policy that could boost growth in the long run on a global basis. “Optimal tariffs” as a policy to them were “contrary to the highest morality”. Keynes himself never deviated from view that the free trade was the best policy for growth in the long run. Even Mssrs Kitson and Solomou admit that the lack of competition the General Tariff produced may have damaged “long-term economic growth” in Britain’s “ boom”. Perhaps the persistence in economic history of the idea that free trade provides the optimal long-run conditions for growth may be a better reason than any other why The Economist still supports free trade today— just as it did 170 years ago. Suggested reading list: Dudley Edwards, R. (1993). The Pursuit of Reason: The Economist, Hamish Hamilton. Gomes, L. (2003). The Economics and Ideology of Free Trade: An Historical Review. Edward Elgar Publishing. Gordon, S. (1955). The London Economist and the High Tide of Laissez Faire. The Journal of Political Economy, 63(6), Ricardo, D. (1951) [1821]. On the Principles of Political Economy and Taxation. Cambridge University Press. Smith, A. (1993) [1776]. Inquiry into the Nature and Causes of the Wealth of Nations. Oxford University Press.

The Case For Protection u Protection saves jobs at home. u Some countries engage in unfair trade practices, so we need to protect against that. u Cheap foreign labor makes competition unfair. u Protection safeguards national security. u Protection discourages dependency. u Protection safeguards infant industries.

U.S. Trade Policies u Long and complicated history. u Affected by: –economic conditions –political conditions –social conditions u High water mark: the Smoot-Hawley tariff was the U.S. tariff law of the 1930s, which set the highest tariffs in U.S. history (average tariff rate reached 60 %). –It set off an international trade war and caused the decline in trade that is often considered a cause of the worldwide depression of the 1930s.

U.S. Trade Policies with the World u The General Agreement on Tariffs and Trade (GATT) is an international agreement originally singed by the United States and 22 other countries in 1947 to promote the liberalization of foreign trade. –GATT was supposed to be temporary but lasted a long time and in 1995 spawned the WTO through the Uruguay Round negotiations. For all intents and purposes, GATT now lives vicariously through the WTO. [Special Thanks to Barrett Lane (S08) for great detective work provided to me on the history between GATT and the WTO.] u The World Trade Organization (WTO) is the only global international organization dealing with the rules of trade between nations. At its heart are the WTO agreements, negotiated and signed by the bulk of the world’s trading nations and ratified in their parliaments. The goal is to help producers of goods and services, exporters, and importers conduct their business. –Location: Geneva, Switzerland –Established: 1 January 1995 –Created by: Uruguay Round negotiations ( ) –Membership & Observers: 160 countries on 26 June 2014 –

Economic Integration u Economic integration occurs when two or more nations join to form a free-trade zone. u Two Examples: –The European Union (EU) – 28 member countries »Initially, the EU consisted of just six countries: Belgium, Germany, France, Italy, Luxembourg and the Netherlands. »In 1991 they signed the Maastricht Treaty  the EURO, which 16 of the EU countries adopted. –The North American Free-Trade Agreement NAFTA »Canada, The U.S. and Mexico »Started in 1994 »An agreement signed by the United States, Mexico, and Canada in which the three countries agreed to establish all North America as a free-trade zone.

The EU Today u The European Union is now composed of 28 independent sovereign countries which are known as member states, they are: u Members: Austria, Belgium, Bulgaria, Croatia, Cyprus, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, and the United Kingdom. u Candidates: Albania, FYROM, Iceland, Montenegro, Serbia, Turkey

Our Model and Simple Policy Prescriptions…? u So... AE d = C + I d + G + EX – IM and to get equilibirum set Y* = AE d (Y*) and solve for Y* u So… it’s good to  EX and  IM to make your Y* as large as possible… u …however, this implies another country’s exports may go  and its imports may go  which might not be good for them. –Get beggar thy neighbor policies –Exporting unemployment –Retaliation via tariffs and quotas, etc –Bad for international trade overall u GOOD QUESTION: What really determines EX and IM?

Determinants of Exports & Imports u The determinants of imports include the same factors that affect consumption and investment. –i.e., Y or Y d, r, wealth and any other stuff you think belongs in the model u Imports also depend on the prices of domestically- produced goods relative to foreign-produced goods. –prices at home relative to abroad –exchange rates matter a lot here u The determinants of exports are the same – just from the position of the rest of the world. –US exports depend on economic activity in the rest of the world. –I.e., If foreign output increases, U.S. exports tend to increase.

Exports and Imports and the so-called “Trade Feedback Effect” u The trade feedback effect is the tendency for an increase in the economic activity of one country to lead to a worldwide increase in economic activity, which then feeds back to that original country. u Suppose the U.S. economy starts to grow  Y*   IM  –Because U.S. imports are somebody else’s exports, the extra import demand from the United States raises the exports of the rest of the world, expanding their economies. –Some of the desire for those countries to import creates exports for the US!  a trade feedback effect back in the U.S. u In good times, this might appear nice, but in bad times, not so much.

Export and Import Prices and the so-called “Price Feedback Effect” u The price feedback effect is the process by which a domestic price increase in one country can “feed back” on itself through export and import prices. u Suppose... –Inflation picks up in Italy  –shoe prices and olive oil prices in Italy go up  –imported shoes and olive oil from Italy are now more expensive in the U.S.  –in the U.S., IM  and its EX   –AD shifts right and SR-AS shifts left in the U.S.  –upward pressure on prices in the U.S.  –a tendency for even higher prices back in Italy. u Inflation might be “exportable” and it might “boomerang” back on you. u Need to address exchange rate determination.

The Open Economy with Flexible Exchange Rates u Recall: The exchange rate is the ratio at which two currencies are traded, or the price of one currency in terms of another. u Floating, or market-determined, exchange rates are exchange rates determined by the unregulated forces of supply and demand. –Haven’t always been flexible in the U.S. –Not all countries have flexible exchange rates now. –See Case, Fair & Oster appendix for history.

The Market for Foreign Exchange u Consider only 2 countries: the U.S. and the U.K. u Consider the market for pounds. u What does a pound cost in dollars? –Suppose 1 pound costs $1.89 u (What does a dollar cost in pounds?) –1 dollar costs £ 0.53 u The demand for pounds is comprised of holders of dollars wishing to acquire pounds. u The supply of pounds is comprised of holders of pounds seeking to acquire dollars.

The Demand for Foreign Exchange: E.g., British Pounds THE DEMAND FOR POUNDS: derived from the need to obtain pounds to buy UK goods and services 1. Firms, households, or governments that import British goods into the United States or wish to buy British-made goods and services 2. U.S. citizens traveling in Great Britain 3. Holders of dollars who want to buy British stocks, bonds, or other financial instruments 4. U.S. companies that want to invest in Great Britain – build factories there 5. Speculators who anticipate a decline in the value of the dollar relative to the pound 6. US wanting to send foreign aid to the UK

The Demand Curve for Pounds u The demand for pounds is downward sloping. u When the $price of pounds falls, British made goods and services appear less expensive to U.S. buyers. u If British prices are constant, U.S. buyers will buy more British goods and services, and the quantity demanded of pounds will rise.