What is ?• Sometimes called “open economy macro”

• Typical topics include– trade deficit– exchange rate policy--flexible, fixed, single

currency (such as Euro)?

Haven’t we covered the trade deficit and exchange rate

determination before?• Yes (so we will do some useful review), and

• No, focus is more on international relationships between countries and on exchange rate policy (fixed versus flexible)

• Recall that international trade (comparative advantage, tariffs, etc) was covered in earlier lectures

Determinants of the overall trade deficit

• Recall spending-GDP identity Y = C + I + G + X

• Y = GDP

• C = consumption

• I = investment

• G = government purchases

• X = net exports

• Or S - I = X• X < 0 (trade deficit), if S < I as in U.S.• X > 0 (trade surplus), if S > I as in Japan

31_01

1200

1000

800

600

400

BILLIONS OFDOLLARS

NET EXPORTS (BILLIONS OF DOLLARS)(=EXPORTS - IMPORTS)

199619941984 1990 1992198819861982

0

25

50

75

100

125

150

175

Trade deficitbecause netexports are less than zero(exports are less than imports)

199619941984 1990 1992198819861982

Investment

Nationalsaving

GAP

Example of relevance for policy:U.S. international relations with Japan

• Policy problem: Japan had (has) a trade surplus and U.S. had (has) a trade deficit

• What to do about it, if anything?

• Trade restrictions are not the answer

• Must change S or I in the U.S. and Japan

• Let’s use SAM to show how it works

Long run effect of a direct investment stimulus (Japan)

22_07

2.5

5.0

7.5

0.0

R

65.062.5 67.5

C

Y

(a) Consumption Share

R

2.5

5.0

7.5

0.0

15.012.5 17.5

I

Y

(b) Investment Share

R

2.5

5.0

7.5

0.0

8075 85

NG

Y

(d)

R

2.5

5.0

7.5

0.0

0.0 2.5

X

Y

(c) Net Exports Share

-2.5

PERCENT PERCENT PERCENT PERCENT

NongovernmentShare

Long run effect of a direct savings stimulus (U.S.)

22_07

2.5

5.0

7.5

0.0

R

65.062.5 67.5

C

Y

(a) Consumption Share

R

2.5

5.0

7.5

0.0

15.012.5 17.5

I

Y

(b) Investment Share

R

2.5

5.0

7.5

0.0

8075 85

NG

Y

(d)

R

2.5

5.0

7.5

0.0

0.0 2.5

X

Y

(c) Net Exports Share

-2.5

PERCENT PERCENT PERCENT PERCENT

NongovernmentShare

Developing a U.S. policy position

• President to meet with Japanese prime minister– Options

• (1) tell PM to use policy to raise I • (2) tell PM to use policy to lower S

• President favors (1)– Decides over lunch with CEA

•Basic economic principles inform decision

The Balance of Payments ($Billions in 1996)

Merchandise trade balance -186+ Services trade balance 87= Overall trade balance (X) -99+ Net factor income from abroad -9+ Net transfers from abroad -39= Current account balance -147

31_02

Currentaccountbalance

BILLIONS OFDOLLARS

50

0

50

100

150

200

Trade balance(net exports)

1982 199619941984 1990 199219881986

Capital Account

• The the amount of funds (new debt or equity) needed to finance the current account deficit in any year

• For example, in 1996 the U.S. increased its net debtor position by $147 billion– note that the current account was $147 billion

31_03

BILLIONS OFDOLLARS

1986 19941988 19951987 199319901989 1991 1992

3,500

4,000

4,500

3,000

2,500

1,500

1,000

2,000

Foreign assets in U.S.

U.S. assets abroad

Net debtor

Net creditor

Deficits were also large at an earlier stage of U.S. history

• In the 19th century the U.S. ran large international trade deficits for many years

• The gap between S and I was large (I>>S)– Railroads across country– Leland StanfordStanford University!

• Funds were lent to the United States by Europeans

• Similar stories in Argentina and Australia

Bilateral deficits

• always a part of world trade

• preventing them by trade restrictions is harmful

• they have little to do with trade barriers

• why discussed so much?

Sector deficits

• Focus on trade within a sector or industry

• Example, U.S. runs a deficit in “baseball” caps and runs a surplus in “higher education”

• Like bilateral deficits,– micro rather than macro– do not reflect trade barriers

• Overall deficits are macro

END OF

LECTURE