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To Accompany
Mannig J. Simidian
Chapter
Five
Y = C + I + G + NX
Total demand
for domestic
output
is composed
of
Investment
spending by
businesses and
households
Net exports
or net foreign
demand
Consumption
Government
spending by purchases of goods
households
and services
Notice weve added net exports, NX, defined as EX - IM. Also, note that
domestic spending on all goods and services is the sum of domestic
spending
on domestics goods and services and on foreign goods and
Chapter
3
Five
services.
Y = C + I + G + NX
After some manipulation, the national income accounts identity can be
re-written as:
NX = Y - (C + I + G)
NetExports
Exports
Net
Output
Output
Domestic
Domestic
Spending
Spending
Chapter
Five
Trade Balance
5
S I = NX
If S - I and NX are positive, we have a trade surplus. We would be net
lenders in world financial markets, and we are exporting more
goods than we are importing. Simply put, if Saving > Investment then
Net Capital Outflow > 0.
If S - I and NX are negative, we have a trade deficit. We would be net
borrowers in world financial markets, and we are importing more
goods than we are exporting. Simply put, if Saving < Investment then
Net Capital Outflow < 0.
If S - I and NX are exactly zero, we have balanced trade since the value
of imports equals the value of exports. Simply put, if Saving = Investment
then Net Capital Outflow = 0.
Chapter
Five
Chapter
Five
Recall that the trade balance equals the net capital outflow, which
in turn equals saving minus investment. Our model focuses on saving
and investment. Well borrow a part of the model from Chapter 3, but
wont assume that the real interest rate equilibrates saving and
investment. Instead, well allow the economy to run a trade deficit
and borrow from other countries, or to run a trade surplus and lend
to other countries.
Consider a small open economy with perfect capital mobility in
which it takes the world interest rate r* as given, denoted r = r*.
NX = (Y-C(Y-T) - G) - I (r*)
NX =
S - I (r*)
This equation suggests that the trade balance is determined by the
difference between saving and investment at the world interest rate.
Chapter
10
Five
Chapter
Five
11
Real
interest
rate, r*
S'
NX = (Y - C(Y - T) - G) - I (r*)
NX = S
- I (r*)
r*
NX
I(r)
Investment, Saving, I, S
Chapter
Five
13
S
The higher world interest rate reduces
investment in this small open
economy, causing a trade surplus
where S > I.
r2*
r1*
NX
I(r)
Investment, Saving, I, S
Chapter
Five
14
r1*
NX
I(r)2
I(r)1
Investment, Saving, I, S
Chapter
Five
15
AAMankiw
Mankiw
Macroeconomics
Macroeconomics
Case
CaseStudy
Study
During the 1980s, 1990s, and 2000s, the U.S. ran large trade deficits, with the exact size
fluctuating over time yet still quite large. In 2007, the trade deficit was $708 billion or 5.1%
of GDP. As accounting identities require, this trade deficit had to be financed by borrowing
from abroad (i.e. selling U.S. assets abroad). During this period the U.S. went from being the
worlds largest creditor to the largest debtor.
What caused the U.S. trade deficit? There is no single explanation. But to understand some
of the forces at work, look at national saving and domestic investment (remember that the
trade deficit is the difference between saving and investment).
The start of the trade deficit coincided with a fall in national saving. This development can
be explained by the expansionary fiscal policy in the 1980s. With the support of President
Reagan, the U.S. Congress passed legislation in 1981 that substantially cut personal income
taxes over the next three years. Because these tax cuts were not met with equal cuts in
government spending, the federal budget went into deficit. These budget deficits were the
largest ever experienced in a period of peace and prosperity, and they continued long after
Reagan left office. According to our model, such a policy would reduce national saving,
causing a trade deficit. Because the government budget and the trade balance went into
deficit at the same time, these shortfalls were called the TWIN DEFICITS. Lets see what
happens as things start to change in the 90s on the next slide
Chapter
Five
16
AAMankiw
Mankiw
Macroeconomics
Macroeconomics
Case
CaseStudy
Study
Things started to change in the 1990s, when the U.S. federal government got its fiscal house in order.
The first President Bush and President Clinton both signed tax increases, while Congress put a lid on
spending. In addition to these policy changes, rapid productivity growth in the late 1990s raising
incomes and thus further increased tax revenue. These developments moved the U.S. federal budget to
surplus, which in turn caused national savings to rise.
In contrast to what our model predicts, the increase in national saving did not coincide with a
shrinking trade deficit, because domestic investment rose at the same time. The likely explanation
is that the boom in information technology caused an expansionary shift in the U.S. investment
function. Even though fiscal policy was pushing the trade deficit toward surplus, the investment boom
was an even stronger force pushing the trade balance toward deficit.
In the early 2000s, fiscal policy once again put downward pressure on national saving. With the
second President Bush, tax cuts were signed into law in 2001 and 2003, while the war on terror led
to substantial increases in government spending. The federal government was again running budget
deficits. National saving fell into historic lows, and the trade deficit reached historic highs.
A few years later, the trade deficit started to shrink, as the economy experienced a substantial decline
in housing prices (see Chapters 11 and 18). Lower house prices reduced housing investment. They
also made households poorer, inducing them to reduce consumption and increase saving. The trade
deficit fell from .1% of GDP as its peak in the fourth quarter of 2005 to 4.9% in the third quarter of
2007.
The history of the U.S. trade deficit shows that this statistic, by itself, does not tell us much about
what is happening in the economy. We have to look deeper at saving, investment, and the policies and
events that cause them (and thus the trade balance) to change over time.
Chapter
Five
17
Chapter
Five
18
Lets think about when the United States and Japan engage in trade. Each
country has different cultures, languages, and currencies, all of which
could hinder trade. But, because of the foreign exchange market, trade
transactions become more efficient. The foreign exchange market is a
global market in which banks are connected through high-tech
telecommunications systems in order to purchase currencies for their
customers.
The next slide is a graphical representation of the flow of the trade
between the United States and Japan, and how the mix of traded things
might be different, but is always balanced. Also, notice how the foreign
exchange market will play the middle-man in these transactions. For
instance, the foreign exchange market converts the supply of dollars
from the United States into the demand for yen, and conversely, the
supply of yen into the demand for dollars.
Chapter
19
Five
SupplyYEN
Goods and
Services
Foreign
Foreign
Exchange
Exchange
Market
Market
Supply$
Demand$
&
ES
I
T
I
R
U
SEC
20
21
Chapter
Five
22
Chapter
Five
23
Suppose that there is an increase in the demand for U.S. goods and
services. How will this affect the nominal exchange rate?
S$
e
e1
e0
D$
$
Dollar Value of Transactions
Chapter
Five
24
The real exchange rate is the relative price of the goods of two
countries. That is, the real exchange rate tells us the rate at which we
can trade the goods of one country for the goods of another.
To see the difference between the real and nominal exchange rates,
consider a single good produced in many countries: cars. Suppose an
American car costs $10,000 and a similar Japanese car costs 2,400,000
yen. To compare the prices of the two cars, we must convert them into
a common currency. If a dollar is worth 120 yen, then the American
car costs 1,200,000 yen. Comparing the price of the American car
(1,200,000 yen) and the price of the Japanese car (2,400,000 yen), we
conclude that the American car costs one-half of what the Japanese
car costs. In other words, at current prices, we can exchange two
American cars for one Japanese car.
Chapter
25
Five
Real Exchange
Rate
Nominal
Exchange
Rate
Ratio of Price
Levels
= e (P/P*)
Note: P is the price level of the domestic country (measured
in the domestic currency) and P* is the price level of the
foreign country (measured in the foreign currency).
Chapter
Five
27
Real Exchange
Rate
Nominal Exchange
Rate
Ratio of Price
Levels
= e (P/P*)
The real exchange rate between two countries is computed from the
nominal exchange rate and the price levels in the two countries. If the
real exchange rate is high, foreign goods are relatively cheap, and
domestic goods are relatively expensive. If the real exchange rate is
low, foreign goods are relatively expensive, and domestic goods
are relatively cheap.
Chapter
Five
28
How does the level of prices effect exchange rates? It doesnt. All
changes in a nations price level will be fully incorporated into the
nominal exchange rate. It is the law of one price applied to the
international marketplace.
Purchasing-Power Parity suggests that nominal exchange rate
movements primarily reflect differences in price levels of nations. It
states that if international arbitrage is possible, then a dollar must
have the same purchasing power in every country. Purchasing power
parity does not always hold because some goods are not easily
traded, and sometimes traded goods are not always perfect
substitutesbut it does give us reason to expect that fluctuations in
the real exchange rate will be small and temporary.
Chapter
Five
29
Real
exchange
rate,
S-I
NX()
Net Exports, NX
Chapter
Five
30
Real
exchange
rate,
0
Chapter
Five
Real
exchange
rate,
2
NX2
Chapter
Five
Real
exchange
rate,
1
2
NX()
NX1
Chapter
Five
33
Real
exchange
rate,
S - I2
2
1
NX2
Chapter
Five
S - I1
34
Net exports
Net capital outflow
Trade balance
Trade surplus and trade deficit
Balanced trade
Small open economy
World interest rate
Nominal exchange rate
Real exchange rate
Purchasing-power parity
Chapter
Five
35