Week 10 – Some International Economic Thoughts

Some Equations Goods flows across countries: NX = X – IM ≈ Current Account Financial flows across countries: ≈ Capital Account Good flows and financial flows across countries sum to zero (up to changes in foreign reserves): Current Account ≈ - Capital Account Assume no change in foreign central bank reserves: o Good flows = NX o Financial flows = -NX Run a trade deficit (NX < 0) – goods flow into the US and financial flows out of the US (which can be reinvested back in US or held as reserves).

Some Equations Sforeign = -NX = Capital Account When we run trade deficits we endow the world with dollars which can be reinvested back into the U.S. (i.e., it results in foreign saving back into the U.S.). Both interest rates and exchange rates can adjust to make the above equation hold.

Net Exports in the U.S. (X – IM) as a Share of GDP

Caballero, Farhi and Gourinchas (2016)

Net Export Overview - + - + - - + - + - NX(.) = NX(Y, Yf, P, Pf, e, trade policy) o Yf = output (income) in foreign countries (exogenous) o Pf = prices in foreign country (exogenous) o trade policy includes tariffs and quotas (exogenous) e = exchange rate (measured as price of home currency) (endogenous) e = FC/$ for U.S. (price of dollar is number of foreign currencies (FC) exchanged to purchase 1 U.S. dollar) Note – we now have an augmented IS curve: Y = C(.) + Io(.) – dIr + G + NX(.)

“Exporting Business Cycles” In an open economy, growth and business cycles can be exported. When foreign country GDP is high (Yf is high), U.S. exports will be high. NX(.) is a shifter of the IS curve and AD curve If U.S. goes into a recession but Y remains high in the rest of the world, effects of recession in U.S. will be muted (as X increases which will increase NX(.). Implication: Business cycles are dampened in an “open” economy relative to a closed economy” Effects are small (but non-zero) in U.S. because U.S. is mostly closed

Exchange Rate Overview e(.) = e (NX(.), r, rf, exchange rate policy) = e(Y, Yf, P, Pf, e, trade policy, r, rf, exchange rate policy) Note 1: Much of the movements in the exchange rate are due to NX moving. o Need foreign currency to purchase exports and imports. o NX(.) increases, e(.) increases. o These exchange rate movements have second order effects on NX. Note 2: Exchange rates also move because of factors that affect the capital account. o These include both domestic and foreign interest rates (r and rf). o When people want to invest in U.S., dollar appreciates (high r relative to rf)

Exchange Rates and Net Exports e(.) increases: o US goods more expensive (from foreign perspective): X (exports) falls o Foreign goods cheaper (from US perspective): IM (imports) increases The exchange rate is a relative price When e(.) increases, FC/$ increases (dollars are expensive relative to other foreign currency) When e(.) increases, $/FC falls (foreign currency is cheap relative to dollars). If the dollar appreciates relative to the Yen (Yen/$ increases), the Yen depreciates relative to the dollar ($/Yen falls). Summary: e(.) increases, NX falls

Some Examples We will do these in class An increase in Yf (holding Y fixed) NX increases (as exports increase) – first order effect e(.) increases (as NX increases – foreigners need dollars to buy U.S. good) NX falls (as e increase) – this effect is second order NX increases on net – just not as much as it would have if e(.) was held fixed. An increase in r (holding rf fixed)

Foreign Reserve Holding in 2018 (Share of Domestic GDP) South Korea: 24.6% Japan 24.3% China: 23.4% India: 15.3% U.K.: 4.9% Canada: 4.3% U.S.: 0.2%

Why Hold Foreign Reserves Running large trade surpluses, and Want to manipulate exchange rates (either government or central bank) Why manipulate currency? o Similar to open market operations setting interest rates in the U.S. o Can buy and sell currency to move the exchange rate to adjust NX(.). o By controlling NX(.), can control AD and IS curves – similar to Fed policy via interest rates in the U.S.

Pegging a Currency and Currency Unions

Benefits and Costs of Pegging Currency - Manage domestic currency such that the exchange with another currency (like the dollar) is stable over time. - Must actively manage the “peg” buy buying and selling currency on the world market. - May run out of foreign currency. No longer able to maintain the peg. Currency Union - Issue the same currency as other countries controlled by a common central bank. - No active management needed because the exchange rate is fixed at 1 by definition (same currency).

Benefits and Costs of Pegging Currency - Promotes exchange rate stability - Facilitates cross country trade - Businesses and households prefer stability for the investment and consumption decisions. Costs - Loss of independent monetary policy. - Monetary policy is targeted at the union level not the individual country level.

Can Europe Last as a Currency Union?

Can Europe Last Large differences in regional performance o Germany/France did relatively well o Greece, Spain, Portugal (Italy?) did relatively worse Rise of extremism – manifesting itself with more frequency Brexit

UK County Variation: Percent Higher Education vs. Brexit Share

The U.S. as a Currency Union How does the US manage stability across regions? o Some regions are “rich” like Germany (Connecticut) o Some regions are “poorer” like Greece (Mississippi) Solution 1: Economic Mobility Solution 2: Cross-region Transfers

U.S. Inter-Region Transfers: 1990-2009 Average State Yearly Net Transfer (% GDP) Delaware 10.3 Hawaii -6.7 Minnesota 10.0 Virginia -7.3 New Jersey 7.5 Alaska -7.5 Illinois 5.6 Maryland/DC Connecticut 5.3 Maine -7.6 New York 4.4 North Dakota -7.7 Ohio 3.3 Montana -9.2 Michigan 2.7 West Virginia -12.2 Nebraska 2.6 Mississippi -12.7 Massachusetts 2.1 New Mexico -13.1 From Economist: 8/1/2011

Odds and Ends

Effectiveness of Policy in an Open Economy Supplemental Notes 15 o Read parts on whether monetary policy is “more effective” in an open economy (relative to a closed economy). o Read parts of whether fiscal policy is “more effective” in an open economy (relative to a closed economy). More effective means “bigger increase in Y for a given change in policy” given its effect on NX(.).

Other Booth Courses I spend less time on international macro than I would otherwise given the extensive Booth courses we have on this topic “Wealth of Nations” – basically a whole course on economic growth (in China, India, Latin America, Africa, etc.) from Chang-Tai Hsieh – one of the world experts in economic growth. “International Financial Policy” – a whole class on exchange rates and managing exchange rate risk. If you like what we did today, you will love this class. “International Commercial Policy” – this is a trade class. If you are trading across borders, this is a class for you. “Managing the Firm in a Global Economy” – This is an international strategy class. More of a micro/strategy perspective. “The Firm and the Non-Market Environment” - Taught by Marianne Bertrand. This is an amazing course taught by an amazing faculty member. Focuses on big picture topics like lobbying, media, institutions, etc. Lots of developing economy discussion.