1. Eco Slide 2
After Midterm Exam 1

2. Drawing Graph
An economic relationship can be represented either mathematically or graphically.
For example, consider the demand relation:
Quantity Demanded = f (price, other factors) where other factors include income, preference, and etc.
This relationship can be represented by the demand curve, a two-dimensional diagram.

3. A Two-Dimensional Diagram
In general, a two-dimensional diagram can represent the relationship of
Y = f (X, Z)
The diagram is upward sloping if Y and X move in the same direction
The diagram is downward sloping if Y and X move in the opposite direction
We move along the diagram when X varies, holding Z constant.

4. What if Z changes? The diagram shifts when Z changes.
For example, let Y = quantity demanded, X = price, Z = income. After income (Z) rises, quantity demanded (Y) rises for each given price (X). So the demand curve shifts up.
Exercise: what happens to demand curve if Z = price of substitute rises?

5. Two Special Cases
The diagram is a horizontal line if Y remains unchanged when X varies
The diagram is a vertical line if X remains unchanged when Y varies
Exercise: draw the demand curve when the demand is perfectly inelastic

6. UIP and Asset Approach
UIP is the fundamental equation of the (short-run) asset approach to exchange rate
We use UIP to solve for current spot exchange rate provided that we know the interest rates and expected future spot rate:

7. FX Market Diagram
The Y variable is dollar rate of returns of dollar deposit and euro deposit
The X variable is current spot rate
We use FX market diagram to solve for

8. DR Curve DR stands for domestic (US) rate of return
Mathematically, DR =
DR curve is horizontal because it is independent of current spot rate (i.e., DR remains unchanged when current spot rate varies)

9. FR Curve FR stands for foreign (EUR) rate of return
Mathematically, FR =
FR curve is downward sloping because FR and current spot rate move in opposite direction (Intuition?)
The Z variable for FR curve is and

10. FX Market Equilibrium
The foreign exchange market is in equilibrium where DR and FR curve intersect
To the left of equilibrium point, FR > DR. Euro deposit is more attractive. People will buy euro and sell dollar. Dollar depreciates.
To the right of equilibrium point, FR < DR. Dollar deposit is more attractive. People will buy dollar and sell euro. Dollar appreciates.

11. What if dollar interest rate rises?
DR curve shifts up
FR curve remains fixed
Dollar appreciates instantaneously
Figure 4-3-(a)
Intuition?

12. What if Euro interest rate falls?
DR curve remains fixed
FR curve shifts down
Dollar appreciates instantaneously
Figure 4-3-(b)
Intuition?

13. What if expected future rate falls?
DR curve remains fixed
FR curve shifts down
Dollar appreciates instantaneously
Figure 4-3-(c)
This example shows that expectation is self-fulfilling: expected future appreciation for dollar will lead to actual instantaneous appreciation for dollar

14. (Current) Euro Crisis http://www.google.com/finance?q=EURUSD#
What causes the recent depreciation of euro against dollar?
Due to the debt crisis in Euro-zone, people expect that euro will depreciate in future (or in long run)
Expectation is self-fulfilling. We see euro has actually been depreciating.

15. Expectation Management
Because expectation is self-fulfilling, it is vital for the government to do something in order to revert people’s unfavorable expectation
1997 Asian crisis revisited: Soros bet against Hong Kong Dollar, and he expected HK dollar would depreciate against US dollar
China central government announced that it would back up HK dollar. This credible announcement changed people’s expectation
In the end Soros suffered a big loss

16. Figure Equilibrium in the Home Money Market Feenstra and Taylor: International Economics, Second Edition Copyright © 2012 by Worth Publishers

19. Figure Temporary Expansion of the Home Money Supply Feenstra and Taylor: International Economics, Second Edition Copyright © 2012 by Worth Publishers

20. Figure U.S.–Eurozone Interest Rates and Exchange Rates, 1999–2004 Feenstra and Taylor: International Economics, Second Edition Copyright © 2012 by Worth Publishers

21. Some Accounting Identities
GNE = C + I + G
GDP = GNE + TB
GNI = GDP + NFIA
GNDI = GNI + NUT

23. Figure Major Transfer Recipients Feenstra and Taylor: International Economics, Second Edition Copyright © 2012 by Worth Publishers

24. Figure The Open Economy Feenstra and Taylor: International Economics, Second Edition Copyright © 2012 by Worth Publishers

25. National Income Identity
A country saves if CA>0
A country borrows (overspends) if CA<0
National Income Identity: Y = C + I + G + CA

26. Table U.S. Economic Aggregates in 2009 Feenstra and Taylor: International Economics, Second Edition Copyright © 2012 by Worth Publishers

27. Figure U.S. Gross National Expenditure and Its Components, 1990–2009 Feenstra and Taylor: International Economics, Second Edition Copyright © 2012 by Worth Publishers

28. Figure U.S. Current Accounts and Its Components, 1990–2009 Feenstra and Taylor: International Economics, Second Edition Copyright © 2012 by Worth Publishers

29. Current Account Identity
Let S = Y – C – G
The national income identity becomes the current account identity:
S = I + CA
CA > 0 if S > I
CA < 0 if S < I

30. Figure Saving, Investment, and Current Account Trends: Industrial Countries Feenstra and Taylor: International Economics, Second Edition Copyright © 2012 by Worth Publishers

31. Discuss: Tariff and US CA Deficit
CA = S – I = (Y – C - G) - I
What are the effects of tariff on Chinese import on C, G and I

32. Why do American people save so little
Cultural of consumption
Demographic reason
Government entitlement program
Housing market boom

33. Why do Chinese people save so much?
Cultural of saving Lack of social benefits Even old people save (for the down payment of new house bought by their child)

34. Private and Public Savings
Private Saving (Sp) = Y – T – C
Public Saving (Sg) = T – G
Total Saving S = Sp + Sg
The current account identity becomes
CA = Sp + Sg – I
Everything else equal, rising government budget deficit leads to rising current account deficit (foreign debt)

35. Greece Crisis Widespread tax evasion
Huge government expenditure (on entitlement program)
Huge government budget deficit
Private saving is low (unlike Japan)
Huge foreign debt (from French banks)
The crisis is caused by the potential default of foreign debt (downgrade of its credit rating)

36. Euro Crisis Crisis is contagious Greece is member of EU
Greece borrows a lot from French and German banks
Germany is increasingly reluctant to support Greece

37. Dilemma for US
In long run, in order to cut the current account deficit, US should cut budget deficit and increase personal saving
In short run, however, double-dip recession is looming.

38. Twin Deficits: Greece and USA
CA = Sp + Sg – I
Assuming Sp = 0, I = 0
Then Sg < 0 (government budget deficit) indicates that CA < 0 (current account deficit)
So there are twin deficits.
Greece and USA have twin deficits now.

39. Discuss: Greece Debt Crisis

40. Japan and China Sg is negative but small (small budget deficit)
Sp is positive and big (big personal saving)
Overall, national saving (S = Sg + Sp) is greater than investment
So Japan and China are running CA surplus (lending money to other countries)
Government budget deficit does not necessarily lead to CA deficit

41. Balance of Payment (BOP) Account
BOP = CA + FA + KA
FA: Financial account
KA: Capital account (close to zero for US)
FA and KA record international transactions in assets. They show how the current account is financed.

42. One Principle
Every transaction is two-way. If A receives from B an item of given value, in return B receives from A an item of equal value.
For example. When you buy an Iphone at ATT store, you get the phone, and the ATT store gets the payment (either cash or check).

43. Double-Entry Bookkeeping
Any transaction resulting in a payment to foreigners is entered in the BOP account as a debit and is given a negative sign(-).
Any transaction resulting in a receipt from foreigners is entered in the BOP account as a credit and is given a positive sign(+).

44. Asset US asset is a claim on US; Foreign asset is a claim on ROW
There is capital inflow (receipt) to US if US exports US asset to ROW (borrow from ROW). So exporting US asset is entered in the BOP account as a credit and is given a plus sign(+).
There is capital outflow (payment) if US imports foreign asset from ROW (lend to ROW). So importing asset abroad is entered in the BOP account as a debit and is given a minus sign(-).

45. Import of foreign good, - $10
Example
An American student uses credit card to buy a Astro Boy book worth $10 in Tokyo
Current Account (CA):
Import of foreign good, - $10
Financial Account (FA):
Export of US asset, + $10
Note: US asset is a claim on US. Credit card is one form of IOU, an asset.
Note CA + FA = 0 for this transaction

46. BOP Identity
From microeconomic view, because of double-entry bookkeeping, the following BOP identity holds:
CA + FA + KA = 0
From macroeconomic view, BOP identity holds because

47. Implications of BOP Identity
For simplicity, let KA = 0
FA < 0 if CA > 0. A country lends money to ROW if it is running current account surplus
FA > 0 if CA < 0. A country borrows money from ROW if it is running current account deficit

48. Statistical Discrepancy
In practice, because of data error, BOP identity holds only when statistical discrepancy (SD), a correction term, is included:
CA + FA + KA + SD = 0
The above identity holds because by definition
SD = -(CA + FA + KA )

50. Remarks
Item 7: US-owned assets abroad = importing foreign assets (lending to ROW). There is capital outflow (payment), so entered in BOP with a minus sign.
Item 8: Foreign-owned assets in US = exporting US assets (borrowing from ROW). There is capital inflow (receipt), so entered in BOP with a plus sign.