Macroeconomics Chapter 171 World Markets in Goods and Credit C h a p t e r 1 7

Macroeconomics Chapter 172 World Markets in Goods and Credit  Assumptions: the goods are physically identical. transport costs and barriers to trade small enough to neglect.

Macroeconomics Chapter 173 World Markets in Goods and Credit  law of one price. Markets work to ensure that the same good sells at the same price for all buyers and sellers in all locations. We also simplify by ignoring inflation, so that the price level, P, is constant over time.

Macroeconomics Chapter 174 World Markets in Goods and Credit  i t = i f t home nominal interest rate = foreign nominal interest rate  r t = r f t home real interest rate = foreign real interest rate

Macroeconomics Chapter 175 The Balance of International Payments  Closed economy: Y t = C t + I t + G t real GDP = real domestic expenditure

Macroeconomics Chapter 176 The Balance of International Payments  Open Economy Exports are the goods and services produced in the home country that are sold to the rest of the world, and imports are the goods and services produced by the rest of the world that are bought by the home country.  The difference between exports and imports, or net exports, is called the trade balance.

Macroeconomics Chapter 177 The Balance of International Payments  Y t + Imp t = C t + I t + G t + Exp t  trade balance = Exp t - Imp t = Y t − (C t + I t + G t )  trade balance = real GDP − real domestic expenditure

Macroeconomics Chapter 178 The Balance of International Payments  B f t : the net nominal holdings of foreign assets by the home country at the end of year t. These assets or debts could be held by the home country ’ s households or government. The addition to the home country ’ s ownership of capital located in the rest of the world is called foreign direct investment.

Macroeconomics Chapter 179 The Balance of International Payments  net real asset income from abroad = r t−1 · B f t−1 /P  The total real income of domestic residents in year t is the sum of real GDP, Y t, and the net real asset income from abroad, r t−1 · B f t−1 /P. This total is called the real gross national product (real GNP).

Macroeconomics Chapter 1710 The Balance of International Payments  real GNP= Y t + r t−1 · B f t−1 / P real GNP = real GDP+ net real asset income from abroad  (B f t − B f t−1 )/P. is called net foreign investment

Macroeconomics Chapter 1711 The Balance of International Payments  C t + I t + G t + (B f t − B f t−1 )/ P = Y t + r t−1 · B f t−1 / P  real domestic expenditure+ net foreign investment = real GNP on goods and services

Macroeconomics Chapter 1712 The Balance of International Payments  (B f t −B f t−1 )/P = Y t + r t−1 · B f t−1 /P − (C t + I t + G t ) net foreign investment = real GNP − real domestic expenditure = real current-account balance

Macroeconomics Chapter 1713 The Balance of International Payments  the real current-account balance. a current-account surplus a current-account deficit a balance on current account

Macroeconomics Chapter 1714 The Balance of International Payments  (B f t − B f t−1 )/ P = Y t − ( C t + I t + G t ) + r t−1 · B f t−1 /P  real current-account balance = trade balance + net real asset income from abroad

Macroeconomics Chapter 1715 History of the U.S. Current-Account Balance

Macroeconomics Chapter 1716 History of the U.S. Current-Account Balance

Macroeconomics Chapter 1717 History of the U.S. Current-Account Balance

Macroeconomics Chapter 1718 History of the U.S. Current-Account Balance

Macroeconomics Chapter 1719 History of the U.S. Current-Account Balance

Macroeconomics Chapter 1720 Chinese Trade Balance

Macroeconomics Chapter 1721 Chinese FDI

Macroeconomics Chapter 1722 Chinese FDI 年 份 黄金储备外汇储备 ( 万盎司 )( 亿美元 ) 年 份 黄金储备外汇储备 ( 万盎司 )( 亿美元 )

Macroeconomics Chapter 1723 Determinants of the Current-Account Balance A small country model:  Production Function: Y t = A · F( K, L t )  Total Expenditures Y t = C t + I t + G t  the real interest rate on bonds, r t, has to equal the real rate of return on capital r t = MPK − δ

Macroeconomics Chapter 1724 Determinants of the Current-Account Balance  Suppose, to begin, that The real interest rate in the rest of the world, r f, is constant The domestic real interest rate is also set at r f  The opening up to the world credit market would not change the real interest rate available to the home country ’ s households.

Macroeconomics Chapter 1725 Determinants of the Current-Account Balance  The home country would end up with the same real GDP, Y t, consumption, C t, gross domestic investment, I t, and so on.  Therefore, the condition Y t = C t + I t + G t would continue to hold.  We see, accordingly, that the trade balance would be zero trade balance= Y t - （ C t + I t + G t ）

Macroeconomics Chapter 1726 Determinants of the Current-Account Balance  The real current-account balance: (B f t − B f t−1 )/P = Y t − ( C t + I t + G t ) + r t−1 · B f t−1 /P  Since the home country had initially been closed, it must have started with a zero net international investment position, B f t−1 = 0.

Macroeconomics Chapter 1727 Determinants of the Current-Account Balance  Effects of an increase in A (B f t − B f t−1 )/P = Y t − ( C t + I t + G t ) + r t−1 · B f t−1 /P the net real asset income, r t−1 · (B f t−1 /P), is given — for example, at zero if the home country starts with a zero net international investment position, B f t−1 /P. Real government purchases, G t, are also given.

Macroeconomics Chapter 1728 Determinants of the Current-Account Balance  The higher A raises the MPK and thereby increases gross domestic investment, I t.  If the change in A is permanent, C t will rise by roughly as much as Y t, so that Y t -C t does not change.  The current-account balance falls overall, i.e., it moves toward deficit because of the increase in I t.

Macroeconomics Chapter 1729 Determinants of the Current-Account Balance

Macroeconomics Chapter 1730 Determinants of the Current-Account Balance  current-account balance, saving, and investment (B f t − B f t−1 )/P = Y t + r t−1 · B f t−1 /P − δ K t−1 − (C t +G t ) − ( I t − δ K t−1 ) real current-account balance = real national saving − net domestic investment

Macroeconomics Chapter 1731 Determinants of the Current-Account Balance  Results concerning the opening up of the home country to the world credit market. Suppose that r t > r f. In this case, the opening up of the home country to the world credit market results in a current- account deficit. The home country borrows from the rest of the world to pay for higher net domestic investment, I t −δK t−1.

Macroeconomics Chapter 1732 Determinants of the Current-Account Balance  Results concerning the opening up of the home country to the world credit market. If r t < r f, the results are the opposite. The home country has a current-account surplus — it lends to the rest of the world and has lower net domestic investment, I t −δK t−1.

Macroeconomics Chapter 1733 Determinants of the Current-Account Balance  Economic Fluctuations A raises net domestic investment, I t − δK t−1. We also have that consumption, C t, rises, but by less than the increase in real GDP, Yt (because the increase in A is less than fully permanent). Therefore, real national saving increases. The overall change in the real current-account balance depends on whether I t − δK t−1 rises by more or less than real national saving. In general, the overall effect on the real current- account balance is ambiguous.

Macroeconomics Chapter 1734 Determinants of the Current-Account Balance  Economic Fluctuations the equilibrium business-cycle model predicts that the real current account balance will be countercyclical — low in booms and high in recessions.

Macroeconomics Chapter 1735 Determinants of the Current-Account Balance

Macroeconomics Chapter 1736 Determinants of the Current-Account Balance  Harvest Failures Consider a harvest failure, which results in a drop in the home country ’ s real GDP, Y t. If the harvest failure is expected to be temporary the income effect is weak, and the response of consumption, C t, is small. Therefore, Y t − C t falls sharply — the home country ’ s real national saving decreases almost one-to-one with the decline in Y t.

Macroeconomics Chapter 1737 Determinants of the Current-Account Balance The harvest failure may be little impact on the MPK. In this case, there would be little response of net domestic investment, I t − δK t−1. A harvest failure leads to a current-account deficit. The home country borrows from abroad to maintain roughly stable consumption, C t, and net domestic investment, I t − δK t−1. In this case, a current-account deficit is a symptom of bad economic times.

Macroeconomics Chapter 1738 Determinants of the Current-Account Balance  Government Purchases wartime government purchases are valid only if we can hold fixed the real interest rate in the rest of the world, r f. In this case, a current-account deficit is a symptom of bad economic times.

Macroeconomics Chapter 1739 Determinants of the Current-Account Balance  Developing Countries Suppose that the home country is a developing country with a low capital stock, K t−1, and a high MPK. A current-account deficit tends to be a sign of a favorable growth environment, whereas a current-account surplus is a sign of an unfavorable environment.

Macroeconomics Chapter 1740 Determinants of the Current-Account Balance  Case studies: Australia (Scoggins 1990) Poland WWI and WWII Mexico and Brazil

Macroeconomics Chapter 1741 Determinants of the Current-Account Balance  The Current-Account Deficit and the Budget Deficit If we allow for an open economy, the important issue is still whether a budget deficit affects real national saving. The real current-account balance is (B f t − B f t−1 )/P = Y t + r t−1 · B f t−1 /P − δ K t−1 − (C t +G t )− ( I t − δ K t−1 )

Macroeconomics Chapter 1742 Determinants of the Current-Account Balance  The Current-Account Deficit and the Budget Deficit In the Ricardian case, a budget deficit does not change real national saving and real current-account balance would not change. in the Ricardian case, a budget deficit does not create a current-account deficit.

Macroeconomics Chapter 1743 Determinants of the Current-Account Balance  The Current-Account Deficit and the Budget Deficit If households do not save the full amount of the tax cut — that is, if a budget deficit reduces real national saving. Consumption, C t, rises, and real national saving declines. A budget deficit leads to a current- account deficit.

Macroeconomics Chapter 1744 Determinants of the Current-Account Balance  The Current-Account Deficit and the Budget Deficit Twin deficits. Economists applied this label to the U.S. economy in the mid- 1980s, when budget deficits were large and the ratio of the current-account deficit to GDP gradually widened.

Macroeconomics Chapter 1745 The Terms of Trade  For heterogeneous goods The ratio P/P f is called the terms of trade. The units for the terms of trade are ($ per home good)/( $ per foreign good) = foreign good per home good

Macroeconomics Chapter 1746 The Terms of Trade  The terms of trade give the number of units of foreign goods that can be imported for each unit of home goods exported. If the terms of trade, P/P f, rise — or improve — the home country is better off because it gets more foreign goods in exchange for each unit of home goods. If P/P f falls — or worsens — the home country is worse off because it gets fewer foreign goods in exchange for each unit of home goods.

Macroeconomics Chapter 1747 The Terms of Trade  In our equilibrium business-cycle model, economic fluctuations result from shocks to the technology level, A.  For a single country, changes in the terms of trade have effects that are similar to changes in A.

Macroeconomics Chapter 1748 The Terms of Trade  The Terms of Trade and the Current-Account Balance current-account balance in nominal terms is B f t − B f t−1 = P Y t + r t−1 · B f t−1 − P · ( C t + I t + G t ) nominal current-account balance = nomimal GNP − nominal domestic expenditure

Macroeconomics Chapter 1749 The Terms of Trade  B f t − B f t−1 = P Y t + r t−1 · B f t−1 − P f · ( C t + I t + G t )  (B f t − B f t−1 )/P f = (P/P f ) · Y t + r t−1 · (B f t−1 /P f ) − P f · ( C t + I t + G t ) a real value in the sense of being measured in units of foreign goods.

Macroeconomics Chapter 1750 The Terms of Trade (B f t − B f t−1 )/P f = (P/P f ) · Y t + r t−1 · B f t−1 /P f −δK t−1 − (C t +G t ) − (I t −δK t−1 ) real current-account balance= real national saving − net domestic investment

Macroeconomics Chapter 1751 The Terms of Trade  The Terms of Trade and the Current- Account Balance An increase in P/Pf raises real GNP, measured in units of foreign goods, for a given Y t. Households respond to the higher real GNP by increasing consumption, C t. The response of C t is larger the more long-lasting the rise in P/P f. As long as the change is less than fully permanent, C t tends to rise by less than real GNP. Therefore, real national saving increases The real current-account balance moves toward surplus.

Macroeconomics Chapter 1752 The Terms of Trade  The Terms of Trade and Investment an increase in the terms of trade, P/Pf, affects net domestic investment, I t −δK t−1. net real rate of return on capital = (P/P f ) · MPK − δ

Macroeconomics Chapter 1753 The Terms of Trade  The Terms of Trade and Investment The effect of higher terms of trade, P/Pf, on net domestic investment, It − δK t−1, is analogous to the effect we considered before from an increase in the technology level, A. When A increased, the rise in the MPK raised the net real rate of return on capital. We noted that the response of It − δK t−1 would be large, typically greater than the increase in real national saving. The same conclusion applies when the terms of trade, P/P f, rise. It − δK t−1 will rise by more than real national saving. Therefore, the real current-account balance moves overall toward deficit.

Macroeconomics Chapter 1754 The Terms of Trade  The Terms of Trade and Investment we predict that an increase in the terms of trade, P/Pf, that is expected to be permanent moves the current- account balance toward deficit. The reason is that the expansion of net domestic investment, It − δKt−1, tends to be greater than the rise of real national saving.

Macroeconomics Chapter 1755 The Terms of Trade  The Terms of Trade and Investment we predict that an increase in P/P f that is expected to be temporary moves the current-account balance toward surplus. In this case, the increase of I t − δK t−1 tends to be smaller than the rise of real national saving.

Macroeconomics Chapter 1756

Macroeconomics Chapter 1757 The Volume of International Trade  The trade balance is given by trade balance= Y t − ( C t + I t + G t ) trade balance= exports− imports trade balance= net exports

Macroeconomics Chapter 1758 The Volume of International Trade  When we studied the impact of the home country ’ s technology level, A, and other variables on the current-account balance, the effects worked through changes in net exports.  However, the model has nothing to say about the volume of international trade — that is, the absolute levels of exports and imports.