Trade Balance/Savings and Investment

Government Budgets G+TR>T G+TR-T> 0 – Government Surplus G+TR<(T) G+TR-(T)< 0 – Government Deficit More Sophisticated Government Budget: T-(G+TR) =S g S g = Government Savings – S g 0 (Surplus)

Fig. 2.1

Fig. 2.2

EX and IM As of 2011Q4 NX = 3.8% of GDP Total EX + IM = 31% of GDP EX = Goods produced (income earned) but sold to foreigners. It is output above what is consumed (C+G+I) in the US IM = Goods consumed (C+G+I) in the US but produced (income earned) by foreigners. EX-IM = Trade Balance EX >IM (EX-IM >0) Trade Surplus EX <IM (EX-IM <0) Trade Deficit

Savings/Investment Identity This is an important concept – Savers = People with money sitting around – Investors (really investment spenders) = People who have a use for that money. No Gov; No Trade: Y= Income = C+S – S = Savings Y= Purchases/Output= C + I Y = C + S = C + I S = I

Savings/Investment Identity (cont) Adding Government (No Transfers) and Trade Y = Income = C + S + T Disposable Income = Y – T Y = Purchase/Product = C + G + I + (NX) Y = C + S + T = C + G + I + NX Do some math: I = (T-G) + (-NX) + S I = S g + S F + S p I = Government Savings + Foreign Savings + Private Savings

The (–NX) term The inverse of Net Exports. o -NX = -(Ex-IM) = IM-EX How do you pay for imports? – Export something in exchange, kind of like barter – Offer an IOU or an Asset in exchange (-NX) is the same as the “capital account” (KA)

The Capital Account KA = KI - KO KI = Capital Inflow – Foreign Purchase of domestic assets. KO = Capital Outflow – Domestic Purchase of foreign assets. Capital Flows = FDI + Paper Assets + Loans + Reserve Assets Punchline: NX + KA = 0 – Imports must be paid for by either an offsetting export or asset transfer.

Fig. 1.1

Exchange rates

So we left last class asking Will an increase in the demand for exports cause and appreciation or depreciation of a currency. Lets take a step back.

Exchange rates.

One way of talking about exchange rates

In this case, trade changes exchange rates

Asset demand and exchange rates These days we focus on asset demand as determining exchange rates. Currency trading of $ is something like 25 times our current account balance. So much of what drives exchange rates are differences in asset returns across countries.

Money in the US a brief history 1787 – 1963 – Notes from different—state chartered banks—were circulating – National Banks notes issued by nationally chartered banks, backed by deposits of treasuries with the Treasury (Comptroller of Currency) – Not unlike Open Market Operations with the Fed today Today – Federal Reserve prints and issues currency.

The Gold Standard 1870(ish) the gold standard comes to prominence – US (ish)-1915: Classical Gold Standard : Interwar Standard : Bretton Woods 1971-Now: No Gold

The Gold Standard is not about price stability.

It gets even worse

So what is the gold standard? It is an international currency standard If all countries are valued in gold then all countries have bilateral exchange rates. – This is supposed to make it easier for foreign investment.

How the it is supposed to work Example: US/British Exchange rate – E US /E UK is determine by two things 1.The Demand for US vs British Assets 2.The Price level in the US and the UK – These are kind of the same thing Balance of Payments (BoP) imbalances cause gold outflows Gold outflows cause M s ↓ thus PL↓

What is a BoP imbalance? Cross country flows. – If the inflow of Capital (K IN ) is less than the outflow of capital (K out ) then you have an imbalance. – The extra $1 you want to spend in another country (K out ) has to be in gold from the central bank. Same with trade if IM>EX then you have to export gold to make up the difference.

So BoP deficit K IN <K OUT or EX<IM Causes gold to flow out of a country. – Monetary Base ↓ → Money Supply ↓ → Investment↓ → Price Level Falls ↓ When the PL falls Exports increase and this should right the BoP.

A central bank’s Job According to the “rule of the game” – CB should reinforce the decline in the money supply by increasing the interest rate (i) – i is the rediscount rate. The rate at which a central bank exchanges cash for securities. – This can also be done with open market operations – When i increases two things should happen 1.Y & PL ↓ → IM ↓ & EX↑ 2.I attracts more K IN

Central banks didn’t follow the rules Central banks often “sterilized” gold inflows – Gold↑ → MB↑ – Paper Assets↓ → MB↓ However, the US had very large stocks of gold relative to foreign exchange, money supply etc. In part because the US banking system was so unstable.

Why did the gold standard work Mostly because the British had the credibility needed to maintain the system. The British had very little gold relative to its foreign exchange liabilities. All foreign currency regimes essentially work or don’t work based on the credibility of it “anchor” country. They type of regime seems somewhat secondary

The interwar gold standard During WWI all the major economies go off the gold standard. After WWI the world looks totally different politically/economically but the British fight to keep the system the same is largely about the transition from a British centered world economy to a US centered world economy.

The British refuse to acknowledge they are no longer the “center of the world” The US refuse to acknowledge they are now the “center of the world” Monetary stupidity ensues

1925 Britain goes back on the Gold Standard at pre- war parity $4.86 per pound (£). – But the British economy was different (weaker) and its price level was higher. – So it created a persistent trade imbalance IM >EX. – What’s more, the Bank of England kept i high to try to fix the BoP problem.

The other side of the coin The US and France (who devalues the Franc after WWI) enjoy gold inflows. And they sterilize those inflows. Free to Choose Episode 3; 18:40 K4xw

The roaring 20s Unemployment in the US still averages 7.6% While gold inflows are being sterilized, money supply still increases. – Real estate bubble pops in 1926 – Stock market bubble pops in 1929 Also issues with Germany (Dawes Plan)

It is not exactly clear what started the Great Depression Stock market crash? Agricultural price collapse? Banking Crises made it the Great Depression – Banking Panics

Copyright © 2007 Pearson Addison-Wesley. All rights reserved