McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Global Macro Chapter 18

2 International Trade The flow of goods, labor, and money across national borders makes countries economically interdependent. International trade also affects a nation’s macro outcomes. LO1

3 Imports as Leakage Imports are a source of leakage in the circular flow. Imports – Goods and services purchased from foreign sources. Leakage – Income not spent directly on domestic output, but instead diverted from the circular flow, such as saving, imports, taxes. LO1

4 Imports as Leakage Income lost to imports limits domestic spending and the related multiplier effects. Multiplier – The multiple by which an initial change in aggregate spending will alter total expenditure after an infinite number of spending cycles. LO1

5 Imports as Leakage In a closed (no-trade) economy, total income and domestic spending are always equal. C + I + G = Y LO1

6 Imports as Leakage In an open economy, imports and exports have to be taken into account. C + I + G + X = Y + M The combined spending of consumers, investors, and the government may not equal domestic output. LO1

7 Marginal Propensity to Import Part of any increase in spending will be spent on imports. This fraction is called the marginal propensity to import (MPM). The marginal propensity to import (MPM) – the fraction of each additional (marginal) dollar of disposable income spent on imports. LO1

8 Marginal Propensity to Import The marginal propensity to import: Reduces the initial impact on domestic demand of any income change. Reduces the size of the multiplier. LO1

9 Imports as Leakages LO1

10 Imports and the Multiplier Effect The impact of the MPM on domestic demand is the same as its cousin, the marginal propensity to save (MPS). Marginal Propensity to Save (MPS) – The fraction of each additional (marginal) dollar of disposable income not spent on consumption; 1 – MPC. LO1

11 Imports and the Multiplier Effect Imports reduce the value of the multiplier. The value of the multiplier depends on the extent of leakage. LO1

12 Imports and the Multiplier Effect In a closed (no trade) and private (no taxes) economy, the multiplier takes the familiar Keynesian form. LO1

13 Imports and the Multiplier Effect Once the economy is open to trade, the multiplier changes to reflect the additional leakage of the MPM. LO1

14 Imports and the Multiplier Effect The cumulative increase in aggregate demand is: Cumulative change in aggregate demand = Initial change in spending Income multiplier x LO1

15 Imports and the Multiplier Effect Imports, by increasing leakage, reduce the impact of fiscal stimulus. LO1

16 Real Output (Income) (dollars per time period) Price Level (average price) Imports Reduce Multiplier Effects Induced C in closed economy Induced C in open economy AS AD 1 AD 2 AD 3 AD 4 Fiscal injection LO1

17 Global Stabilizer Import leakages act as an automatic stabilizer. Foreign producers absorb a large portion of a U.S. slowdown when a decline in aggregate demand is concentrated in industries that rely heavily on imported inputs. LO2

18 Exports as Injections Export sales inject spending into our circular flow at the same time that imports cause leakages from it. A change in export demand causes a shift of the aggregate demand curve. Exports – Goods and services sold to foreign buyers LO2

19 Trade Imbalances The impact of trade on domestic AD depends on changes in the difference between exports (injections) and imports (leakages). Net exports (X – IM) equals the value of exports minus the value of imports. LO2

20 Trade Imbalances A convenient way to emphasize the offsetting effects of exports and imports is to rearrange the income identity. C + I + G + (X - IM) = Y LO2

21 Trade Imbalances If exports and imports were always equal, the term (X- IM) would disappear and we could focus on domestic spending. Exports and imports are not equal which leads to a trade imbalance. LO2

22 Trade Imbalances A trade surplus is the amount by which the value of exports exceeds the value of imports in a given time period (positive net exports). LO2

23 Trade Imbalances A trade deficit is the amount by which the value of imports exceeds the value of exports in a given time period (negative net exports). LO2

24 Macro Effects A trade deficit permits domestic living standards to exceed domestic output. A trade deficit represents a net leakage that may frustrate government policies. Import leakages require larger fiscal injections to reach any particular spending goal. LO2

25 Crowding Out Net Exports In an open economy, an increase in imports can reduce domestic crowding out. Crowding out – A reduction in private sector borrowing (and spending) caused by increased government borrowing. LO2

26 Crowding Out Net Exports In an open economy fiscal stimulus tends to crowd out net exports by boosting imports. The objective of reducing the trade deficit may conflict with the goal of attaining full employment. LO2

27 Foreign Perspectives If the U.S. has a trade deficit, other countries must have a trade surplus. In real economic terms, a trade surplus subsidizes the standard of living of the nation with the trade deficit.

28 Foreign Perspectives We cannot focus exclusively on domestic macro goals and ignore international repercussions.

29 A Policy Constraint What we know for certain is: Imports and exports alter the level of aggregate demand. Trade flows may help or impede domestic macro policy attain its objectives. Macro policy decisions need to take account of international trade repercussions. LO2

30 International Finance In addition to goods and services, money flows across international borders. These flows alter macro outcomes and complicate macro decision making.

31 Capital Inflows In 2006, over $1 trillion of foreign capital flowed into the United States. A lot of this inflow was used to purchase U.S. Treasury bonds. U.S. multinational firms also brought home profits from foreign operations.

32 Capital Outflows Most of the money outflow is used to pay for American imports. Outflows occur as U.S. investors purchase foreign land, labor and capital. Money flows out of the economy as foreign investors retrieve interest and profits.

33 Capital Outflows U.S. government spending on defense, embassies, economic development, and emergency relief abroad also cause capital outflows.

34 Capital Imbalances Like trade flows, capital flows will not always be balanced. Capital imbalances are directly related to trade imbalances.

35 Capital Imbalances A capital deficit is the amount by which the capital outflow exceeds the capital inflow in a given time period. A capital surplus is the amount by which the capital inflow exceeds the capital outflow in a given time period.

36 Macro Effects Control of the money supply becomes more difficult when money is able to move across international borders at will. LO3

37 Exchange Rates The exchange rate is the price of one country’s currency, expressed in terms of another’s – the domestic price of a foreign currency. If the dollar’s value in world markets is high, imports are cheap. LO3

38 International Constraints on Monetary Policy Reduced I and C Decline in equilibrium GDP Decreased exports Increased imports Increased C, I, G Lower interest rates Higher value of dollar Higher interest rates Increased capital inflow The impact of a cut in the money supply: In a closed economy:In an open economy: LO3

39 Capital Flows: Another Policy Constraint In addition to other macro worries, the economy has to be concerned about: The flow of capital in and out of the country. The effect of capital imbalances on domestic macro performance. How macro policy affects international capital flows, exchange rates, and trade balances. LO3

40 Productivity and Competitiveness It is very much to our advantage to participate in the global economy.

41 Specialization Imported goods and services broaden our consumption possibilities. Specialization among countries increases world productivity and output, making all nations richer.

42 Specialization Comparative advantage is the ability of a country to produce a specific good at a lower opportunity cost than its trading partners.

43 Competitiveness Trade stimulates improvements in productivity. Productivity – output per unit of input, for example, output per labor hour.

44 Competitiveness The presence of foreign producers keeps domestic producers on their toes. Domestic producers must reduce costs and increase efficiency to compete in international markets.

45 Global Coordination The desire for coordination grows as all countries recognize the international dimensions of their economies.

46 IMF The most visible institution for global coordination is the International Monetary Fund (IMF). The IMF uses funds contributed by all nations to assist nations whose currency is in trouble.

47 Group of Eight The eight largest industrial countries – the United States, Japan, Canada, Germany, France, Italy, Great Britain, and Russia – attempt to coordinate macro policy. Any informal agreements they reach can have a substantial effect on global trade and capital flow.

48 A Global Currency? Eleven European nations adopted the Euro as a single currency on January 1, 1999.

49 The New Euro A common currency facilitates trade and capital flows across national borders. It eliminates the uncertainties and added costs of diverse currencies.

50 Macro Coordination To maintain a common currency, nations must maintain common macro policies. Monetary policy for the Euro nations is now controlled by a single central bank, the European Central Bank.

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