2 International TradeA country’s participation is measured by the value of itsexport as a percentage of GDPImport as a percentage of GDPData indicate that while international trade is important in the U.S., it is even more vital for other countries such as Canada and France.
4 National Income Accounting The GDP for an open economy:Y = C + I + G + NXConsumption = CInvestment = IGovernment purchases = GNet Exports = NX (Exports less Imports)
5 National Income Identity Y = C + I + G + NXY – C – G = I + NXS = I + NXWhere S = Y - C - G is National Savings
6 Saving Investment Identity Equilibrium in the product market:S – I(r) = NXNet Foreign Investment = Trade BalanceIf S>I: foreign capital outflow; hence NX>0: trade surplusIf S<I: foreign capital inflow; hence NX<0: trade deficit
7 Twin DeficitsThe federal budget deficit (G>T), reduces national savings (S = Y – C – G)Reduced national savings foreign capital inflow, hence causing a trade deficit (NX<0)So, budget deficit causes trade deficit
9 Saving Investment: Small Open Economy For a small open economy, r = r*, wherer = domestic real interest rater* = world real interest rateSo, S – I(r*) = NX
10 Determination of Real Interest Rate If r<r*, then S>I for capital outflowand a trade surplus.If r>r*, then S<I for capital inflowand a trade deficit.NX>0r*rDomestic real interest rater*I(r*)NX<0I
11 Fiscal Policy at Home S2 S1 r* I(r*) Real interest rate An increase in G or a decrease in Tresults in a lower S. Now S<I inducescapital outflow and a trade deficit.S2S1r*NX<0I(r*)Investment, Saving
12 Fiscal Policy Abroad S I(r*) Real interest rate NX<0 An increase in G or a decrease in T inthe U.S. results in a higher r* causingS>I and a trade surplus.r2*r1*I(r*)Investment, Saving
13 Increase in Investment Demand Real interest rateAn increase in I(r*) results in S<I and atrade deficit.Sr*NX<0I2(r*)I1(r*)Investment, Saving
14 Exchange RateNominal exchange rate = e: the relative price of the currency of two countries; e.g., $1 = 120 yen or 1 yen = $Real exchange rate = ε: nominal exchange rate adjusted for the foreign price differenceε = e (P/P*)whereP = domestic price levelP* = foreign price level
15 Real Exchange Rate and Trade Balance εNX<0The lower the real exchange rate, the lessexpensive are domestic goods relative toforeign goods, thus the greater is the net export.NX>0NX(ε)-+NX
16 Determinants of Real Exchange Rate Equilibrium value of ε is determined by:Net Foreign Investment = Trade BalanceS – I = NXHere, the quantity of dollars supplied for net foreign investment equals the quantity of dollars demanded for the net export of goods and services.
17 Determinants of Real Exchange Rate εS - IεEquilibrium real exchange rateNX(ε)I
18 Fiscal Policy at Home ε2 ε1 Real exchange rate S2 - I S1 - I An increase in G or a decrease in Treduces S, shifting S-I line to the left.This shift causes ε to increase, but NXto decrease.ε2ε1NX(ε)NX2NX1Net export
19 Fiscal Policy Abroad ε1 ε2 Real exchange rate S1 - I S2 - I An increase in G or a decrease in T inthe U.S. results in a higher r* causing Ito decrease. This shift causes ε to decrease,but NX to increaseε2NX(ε)NX1NX2Net export
20 Increase in Investment Demand Real exchange rateS – I2S – I1ε2An increase in I shifts S-I line to the left.This shift causes ε to increase, but NXto decrease.ε1NX(ε)NX2NX1Net export
21 Effect of Trade Protectionism Real exchange rateProtectionism reduces the demandfor imports, increasing net export.A higher NX line causes ε to increase,with no net change in net export.S - Iε2ε1Here the value of foreigntrade is unchanged becausethe rise in the real exchangerate discourages exports, whichoffsets the decline in imports.NX(ε)2NX(ε)1NX1 = NX2Net export
22 Determinants of Real Exchange Rate From ε = e * (P/P*), write e = ε (P*/P)Take percentage rate:%Δe = %Δε + %ΔP* - %ΔP%Δe = %Δε + (* - )Where ( * - ) is the difference in inflation rates of the two countries
23 Inflation and Nominal Exchange Rate Countries with relatively high inflation tend to have depreciating currencies.Countries with relatively low inflation tend to have appreciating currencies.