Applied Macroeconomics

Import Import : The purchase of goods and services from abroad. Export Export : The sale of home goods and services abroad. Re-Export Re-Export : To export again what has been imported. trade balance trade balance : A country's exports minus its imports,the largest component of a country's balance of payment. also called balance of trade. balance of payments balance of payments : An accounting document that record all the flows of money in and out of a country during one year. Thanks to the balance of payment we can see if more money is flowing into a country or more money is flowing out of a country, and give us an indication of the competiveness of that country.

T T he balance of payment is spilt between two account the Current account and the Capital account. So the flow of money in and out of the country is either recorded in the current account or the capital account. The Balance of Payment ( BOP ) Current Account + Capital and Financial account = 0 Current Account = - Capital and Financial account Current Account surplus ( or deficit ) = Capital and Financial account deficit ( or surplus ) ( X - M ) = K O – K i The Capital Account The Capital Account : an account that record the flow of money as result of public and private international investments flowing in and out of a country, which includes foreign direct investment, plus changes in holdings of stocks, bonds, loans, bank accounts, and currencies.

The current account Visible trade Inflow ( + ) Outflow ( - ) Trade in goods Invisible trade Inflow ( + ) Outflow ( - ) Trade in services Invisible trade Credit ( + ) Debit ( - ) Profits and Income Invisible trade Credit ( + ) Debit ( - ) Current Transfers The Current account The Current account : An account made of four components : it records flows of money as result of : E E ach components could be negative and could be positive, If we combine these elements and have a current account deficit that’s indicate that more money is going out of a country than its going in, and generally this is considered to be BAD NEWS.

B B ecause this implies that we are NOT competitive and implies that we MUST be borrowing money to finance our over spending. We Usually measure the Current account as a percentage of the GDP or GNP. Gross Domestic Product (GDP) : Gross Domestic Product (GDP) : is the total value of final goods and services produced within a country's borders in a year. GDP = C + I + G + (X - M) Gross National Product (GNP) : Gross National Product (GNP) : is the total value of final goods and services produced in a year by domestically owned factors of production. GNP = C + I + G + (X - M) + NR C =Personal consumption expenditures I =Gross private domestic investment G =Government consumption expenditures X =Net exports of goods and services M =Net imports of goods and services NR =Net income from assets abroad

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B alance O f T rade B alance O f T rade : The difference between the value of the total exports and the value of total imports of a nation during a specific period of time.  The nominal value of exports equals the price index of exports times the volume of exports. X=P x.X volume (export in nominal terms)  The nominal value of Imports equals the price index of Imports times the volume of imports. M=P m. m volume (export in nominal terms) This means the balance of trade is: BT = P x.X volume - P m.m volume (balance of trade)

If If we divided through by a price index such as the price of the import we obtain: BT = P M [(P X /P M )X - M] (balance of trade In real terms) The balance of trade depends not only on the physical quantities of exports and imports, X and M, but also on the price of exports divided by the price of imports. This ratio is known as the Terms Of Trade ( TOT ). T erms O f T rade ( TOT ) T erms O f T rade ( TOT ) : is the Relationship between the prices at which a country sells its exports and the prices paid for its imports. TOT = P X /P M

BT = P M [ ( P X /P M )X - M] If the Terms Of Trade fall, for example, exports become cheaper relative to imports this mean that more goods and services have to be exported to pay for a given volume of import, the country is said to have "deterioration in its Terms Of Trade “ and a decline in the trade balance. C Conversely, If a country's export prices rise relative to import prices, its terms of trade are said to have moved in a favorable direction or improving, since it now receives more imports for each unit of goods exported, and will lead to an improvement in the trade balance. BT = P M [ (P X / P M )X - M]

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W hat affects our demand for foreign goods and services and the demand from the rest of the world for our products? The main factor determining the level of exports and imports is the competitiveness of UK producers compared with producers in other countries. N ow, What is the best measure of competitiveness??  Price competitiveness: The most straightforward measures of competitiveness. θ = (p. of foreign goods expressed in home currency)/(p. of home goods) θ = P*.e/P (price competitiveness, real exchange rate) P* is the foreign price level, P is the UK price and e is the nominal exchange rate measured in number of home currency per unit of foreign currency.

e = ₤/€ (nominal exchange rate) D D efining e= ₤/€ as the domestic currency units for a foreign currency unit this is only one convention the other convention is used as well as e= €/₤ is the foreign currency units for a domestic currency unit. e = (no. of units of home currency)/(one unit of foreign currency)

 Relative producer prices (RPP) : RPP = WP*.e/WP It’s the ratio of foreign to UK wholesale prices.  Relative export prices ( REP ) : RPP = P x *.e/P x It’s the ratio of foreign to UK export prices. RPP = P*.e/Px or RPP = P*.e /WP T wo relative measures of competitiveness are T wo relative measures of competitiveness are :

 Relative profitability of exporting (RPE): RPE= P x /WP – This is the ratio of export prices to domestic prices or the wholesale price index. – This is not a measure of international competitiveness, but it is useful because it shows the extent to which changes in export prices reflect changes in the profit margins on exports against home sales. e= ₤/€ Px RPE= Px/WP

 Relative unit labor costs (RULC) :  Unit labor costs in the UK are given by : ULC = WL/Y = W/y where W is the wage rate, L is labor employed, Y is output and y is domistic output per unit of labor input (Y/L).  foreign Unit labor costs in the rest of the world : ULC* = e.W*L*/Y* = eW*/y* W* is the rest of the world’s wage rate, e is nominal exchange rate, L* is foreign labor employed, Y * is foreign output and y* is foreign output per unit of foreign labor input (Y*/L*).

If If we take the ratio of foreign to UK unit labor costs we obtain the relative unit labour costs (RULC): RULC = ULC*/ULC = (e)(W*/W)(y*/y) RULC thus depends on three things:  the exchange rate (e).  relative wage rates (W*/W).  relative productivity levels (y*/y). A raise in the RULC indicate a rise in the foreign costs relative to the UK costs, i.e. an improvement in the UK competiveness or a real depreciation in the RULC and a fall of the RULC is a real appreciation and a fall in the UK competiveness. A second way to measure RULC is what referred to as normalized relative unit labour costs- RULC (N).

(RPP) Relative producer prices. ( REP ) Relative export prices. (RPE) Relative profitability of exporting. (IPC) Import price competiveness (RULC-N) Normalized relative unit labor costs.

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 Exports Function : Exports are the demand by the rest of the world for UK production. a variable that measure world demand : - world GDP ( Y*). - world trade ( total world exports ). a variable that measure Competitiveness : (RULC-N ) normalized relative unit labor costs.  If we estimate a simple export equation we obtain the following: X t = 0.05WX t RULC t where X is exports, WX is the world exports and RULC is relative unit labor costs.

 It implies that the ‘world trade’ elasticity of demand for exports is 0.84, that a 1 per cent increase in world trade is associated with a rise of less than 1 per cent in UK exports. This is consistent with the UK’s share of world exports having fallen progressively over time as world trade has expanded.  It suggests a low ‘price’ elasticity of demand, of around  Imports Function: Imports are the demand by the UK for rest of the world production. a variables that measure domestic demand : - total final expenditure (TFE) = C + I + G + X where C is consumption, I is investment, G is government expenditure and X is exports. - excess capacity  The justification for this is that when the economy is being run at a relatively high level of demand, businesses will turn to imports because the goods they want are unavailable at home.

a variable that measure Competitiveness: - (RULC-N ) normalized relative unit labor costs.  If we estimate a simple import function we obtain the following: M t = 0.34TFE t RULC t XSCt M is imports, XSC is the measure of excess capacity, TFE total final expenditure and RULC is the competitiveness measure.  The income elasticity of demand of about 1.5.  Imports appear to be less responsive to relative unit labour costs than are exports, a change in RULC takes 2 years to affect imports, but only one year to affect exports.  if excess capacity falls by £ 1 billion, imports rise by £ 0.55 billion. This means that if output rises without any rise in capacity the effective marginal propensity to import is much higher than 0.34.

An alternative way of specifying this equation is to have the marginal propensity to import depending on competitiveness. If we estimate such an equation we obtain: Mt = aTFE t XSC t where a = RULC t-2 This is the type of import function used in some macroeconomic models, It is easy to check that it gives income and price elasticity that are very similar to those given by the simpler import function described above.

 UK imports have grown more quickly than UK demand (the high income elasticity).  UK exports have grown more slowly than world trade (the low income elasticity). Britain’s balance of payments problems, has been the high level of imports. the reason for this can be found in the income elasticities contained in the export and import functions we have just considered. if the income elasticity of demand for imports is high and the income elasticity of demand for exports is low, then if the UK grows at the same rate as the rest of the world imports will grow faster than exports. 

 UK exports have grown more quickly than UK output. It is possible that exports rise more quickly than output simply because of increasing specialization. If the trade balance is to remain constant on average a high growth of exports must lead to a high growth of imports. In this case a high level of import to GDP may be nothing to be concerned about.    The evidence also suggests that competitiveness has a significant effect on both exports and imports, with exports responding more quickly and more strongly. Given the importance of exports and imports in the UK economy (in 1988 exports were 28 per cent and imports 32 per cent of GDP) together with significant price elasticities of demand it can be argued that the exchange rate, which affects competitiveness, is a key variable in regulating the level of aggregate demand.

balance of payments GOODS EXPORTS: F.O.B GOODS IMPORTS: F.O.B SERVICES: CREDIT SERVICES: DEBIT TRADE BALANCE INCOME: CREDIT INCOME: DEBIT CURRENT TRANSFERS : CREDIT CURRENT TRANSFERS: DEBIT CURRENT ACCOUNT, N.I.E CAPITAL ACCOUNT: CREDIT CAPITAL ACCOUNT: DEBIT CAPITAL ACCOUNT, N.I.E FINANCIAL ACCOUNT, N.I.E NET ERRORS AND OMISSIONS OVERALL BALANCE Kuwait Balance of Payment ( 1975 – 2007 )

 Exports Function : X t = α + β 1 y* t-1 + β 2 θ t-1 X is exports, y* world GDP and θ is the competitiveness measure. X t = y* t θ t-1 In Log : X t = ,43 y* t θ t-1

SUMMARY OUTPUT Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations28 ANOVA dfSSMSFSignificance F Regression E-06 Residual Total CoefficientsStandard Errort StatP-valueLower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable X Variable E

SUMMARY OUTPUT Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations28 ANOVA dfSSMSFSignificance F Regression Residual Total CoefficientsStandard Errort StatP-valueLower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable X Variable

 Imports Function : M t = α + β 1 y t-1 - β 2 θ t-2 M is imports, y Domestic GDP and θ is the competitiveness measure. Mt = y t-1 – 2.61 θ t-2 With Log : M t = y t-1 – 0.1 θ t-2

SUMMARY OUTPUT Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations26 ANOVA dfSSMSFSignificance F Regression Residual Total CoefficientsStandard Errort StatP-valueLower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable X Variable

SUMMARY OUTPUT Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations26 ANOVA dfSSMSF Significance F Regression Residual Total Coefficients Standard Errort StatP-valueLower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept E X Variable X Variable

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