A Frugal Governed OPEN Economy Lecture 24 Dr. Jennifer P. Wissink ©2018 Jennifer P. Wissink, all rights reserved. April 25, 2018 1

Announcements(MACRO)-Spring 2018 About Prelim 2 See Blackboard for message about Prelim 2. Keep working hard! About the final It’s Cumulative Will stress LECTURE material since we drew the line for Prelim 2 more than anything else. Official Final is Monday May 14 at 2pm, in Barton Hall West (side closer to Statler and Uris) Makeup Final (for those who qualify or have permission from Wissink) is Thursday May 17 at 2pm, location tda… But please sign up via Blackboard link if you are taking the makeup. About MEL Quiz#10 due TONIGHT Keep on track Be mindful of due dates

Optional Problem Set Offer This problem is worth 50 MEL points if turned in on time (points will be added in May to our master Excel grade sheet, if you need it). Due: In class on Wednesday May 2 - Absolutely NO extensions or makeups or late submissions! Please do not even ask. An answer key will be posted after class on the 2nd. Here is the problem: Suppose the following equations for a macro model with no money market and no inflation: Consumption C = A + aYd  where Yd = disposable income Desired Investment Id = B + bY Government Expenditures G = D + dY Exports EX = E + eY Imports IM = F + fY Taxes T = H + hY Find the following: The equation for Y*. The multipliers for A, B, D, E, F, and H. The balanced budget multiplier. Why might one argue that the variable "d" is probably a negative number?

The Typical Fiscal Response to the State of the Economy Basic Policy Tools: G = government expenditures T = taxes Typically see expansionary policy (which shifts AD to right) when at low Y* and little inflation, and just the opposite with high Y* and troublesome inflation. Same concerns as with the Fed with stagflation. Note: Some G and T “policy” is built into the system by existing laws. The system has built in automatic stabilizers automatic destabilizers

Economic Stability & Fiscal Policy Automatic stabilizers refer to revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to stabilize Y* or GDP. the tax code the government safety net, social insurance Automatic destabilizers refer to revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to destabilize Y* or GDP. deficit targeting policy

FIGURE 9.6 The Federal Government Surplus (+) or Deficit (−) as a Percentage of GDP, 1993 I–2014 IV MyEconLab Real-time data

Fiscal Policy: Deficit Targeting The Gramm-Rudman-Hollings Balanced Budget Act, passed by the U.S. Congress and signed by President Reagan in 1985, is a law that set out to reduce the federal deficit by $36 billion per year, with a deficit of zero slated for 1991. In practice, these targets never came close to being achieved. The deficits were: -149,730million in 1987 -155,178million in 1988 -152,639million in 1989 -221,036million in 1990

Fiscal Policy: The Effects of G on the Deficit Consider: Government Expenditures (G) and Taxes (T) Recall: when G>T  we run a deficit. Recall: when G<T  we have a surplus. Consider: Changes in Y* and the deficit first... When Y* falls (contracts) the deficit tends to rise. WHY? Taxable income of households and taxable profits of firms fall. Automatic government payments also rise. When Y* rises (expands) the deficit tends to fall. WHY? Reverse the argument above... Now... recall... a decrease in G causes the economy to contract. Two effects on the deficit: tends to reduce the deficit since you’ve reduced G, but… tends to increase the deficit since you will contract the economy Now... recall... an increase in G causes the economy to expand. tends to increase the deficit since you’ve increased G, but… tends to decrease the deficit since you will expand the economy

Fiscal Policy: The Effects of Tax Policy on the Deficit Very similar to what we just said about G, but more complicated and harder to predict! Basically, a decrease in Taxes works “like” an increase in G. An increase in Taxes works “like” a decrease in G. BIG QUESTIONS WITH TAX POLICY: Whose taxes are changing? How do these people behave as a consequence? 4 Questions About Trump's Tax Plan (NPR 4/26/17) http://www.npr.org/2017/04/26/525683530/4-questions-about-trumps-tax-plan

Fiscal Policy: Consequences for Economic Stability & Deficit Reduction Congress often has two options (1) Choose a target deficit and adjust government spending and taxation to achieve this target. (2) Decide how much to spend and tax regardless of the consequences on the deficit. Congress often stuck with the following problem

Deficit Targeting as an Automatic Destabilizer With deficit targeting, the contraction in the economy would be larger. With deficit targeting, taxes could be rising or government spending declining while the economy is experiencing a contraction.

So What Do We Do? Good question. Options Worry about spend less on what? tax more on whom? Worry about Short run? Long run? Both?

The Last Wrinkle: International Trade All economies, regardless of their size, depend to some extent on other economies and are affected by events outside their borders. It’s an OPEN Economy! 1970s: imports roughly 7% of US GDP 2008-2011: imports roughly 18%, 14%, 16%, 18% of US GDP Want to see others? http://data.worldbank.org/indicator/NE.IMP.GNFS.ZS The “internationalization” or “globalization” of the U.S. economy has occurred everywhere: in the private and public sectors, in input and output markets, in business firms and households.

Basics: Trade Surpluses & Deficits Trade Surplus: When a country exports more than it imports. Trade Deficit: When a country imports more than it exports.

TABLE 19.1 U.S. Balance of Trade (Exports Minus Imports), 1929–2012 (Billions of Dollars) +0.4 1991 −27.0 1933 +0.1 1992 −32.8 1945 −0.8 1993 −64.4 1955 +0.5 1994 −92.7 1960 +4.2 1995 −90.7 1965 +5.6 1996 −96.3 1970 +4.0 1997 −101.4 1975 +16.0 1998 −161.8 1976 −1.6 1999 −262.1 1977 −23.1 2000 −382.1 1978 −25.4 2001 −371.0 1979 −22.5 2002 −427.2 1980 −13.1 2003 −504.1 1981 −12.5 2004 −618.7 1982 −20.0 2005 −722.7 1983 −51.7 2006 −769.3 1984 −102.7 2007 −713.1 1985 −115.2 2008 −709.7 1986 −132.5 2009 −388.7 1987 −145.0 2010 2011 −511.6 −568.1 1988 −110.1 1989 −87.9 2012 −566.7 1990 −77.6

http://www.census.gov/briefrm/esbr/www/esbr042.html

The Economic Basis for Trade: Recall Comparative Advantage David Ricardo’s theory of comparative advantage: “specialization and free trade will benefit all trading partners (real wages will rise), even those that may be absolutely more efficient producers.” Recall England and Portugal Wine Cloth i>clicker question: Given the table, suppose Portugal and England are going to trade wine and cloth with each other. Suppose Portugal is making wine and England cloth. What is the lowest price (in terms of cloth) we would expect to see barrels of wine selling for? 1/10 a yard of cloth 1/20 a yard of cloth 10 yards of cloth 20 yards of cloth 10 barrels of wine LABOR (L) HOURS REQUIRED ENGLAND PORTUGAL 1 yd. cloth 2 hours 1 hour 1 barrel wine 40 hours 10 hours

From Terms of Trade to Exchange Rates The ratio at which a country can trade domestic products for imported products is the terms of trade. Was easy with only two goods like guns & butter. We looked at internal MOC versus terms of trade. When we have more than two goods and two countries and lots of trade  money  currencies  currencies need to be exchanged  foreign exchange rates. An exchange rate is the ratio at which two currencies are traded, or the price of one currency in terms of another. For any pair of countries, there is a range of exchange rates that can lead to both countries realizing the gains from specialization and comparative advantage.

Exchange Rates and Comparative Advantage If exchange rates end up in the right ranges, the free market will drive each country to shift resources into those sectors in which it enjoys a comparative advantage. Only those products in which a country has a comparative advantage will be competitive in world markets.

Sources of Comparative Advantage The Heckscher-Ohlin (H-O) Theorem is a theory that explains the existence of a country’s comparative advantage by its factor endowments. Factor endowments: the quantity and quality of labor, land, and natural resources of a country. Eli Heckscher and Bertil Ohlin: economists from Sweden, circa 1933. According to the H-O theorem, a country has a comparative advantage in the production of a product if that country is relatively well endowed with inputs used intensively in the production of that product.

Sources of Comparative Advantage A country with a great deal of good fertile land… California & Iowa in agriculture Brazil and coffee beans A country with a large amount of accumulated capital… New Jersey in oil refining South Korea and passenger cars A country well-endowed with human capital… New York in highly technical financial services US and advanced education Check out this site! Very interesting and oddly fun. http://www.worldsrichestcountries.com/top_us_exports.html

Other Suggested Explanations for Observed Trade Flows Product differentiation and competitive markets Acquired comparative advantage Economies of scale and scope However, because evidence suggests that economies of scale are exhausted at relatively small size in most industries, it seems unlikely that they constitute a valid explanation of world trade patterns. Trading Environments, Openness of Economy Free Trade Policy Protectionist Policy

Keeping Track of Trade: Foreign Exchange & The Balance of Payments Foreign exchange is simply all currencies other than the domestic currency of a given country. The balance of payments: it’s the record of a country’s transactions in goods, services, and assets with the rest of the world. It’s a record of the country’s sources (supply) and uses (demand) of foreign exchange. Note: it’s not a “balance sheet”. But: the overall account always balances. It’s broken into two pieces the Current Account the Capital Account

TABLE 20.1 United States Balance of Payments, 2011 37.7 (11) Net capital account transactions and financial derivatives (13) Balance of payments (5 + 10 + 11 + 12) −89.2 (12) Statistical discrepancy 517.4 (10) Balance on capital account (6 + 7 + 8 + 9) 211.8 (9) Change in foreign government assets in the United States −119.5 (8) Change in U.S. government assets abroad (increase is −) 789.2 (7) Change in foreign private assets in the United States −364.1 (6) Change in private U.S. assets abroad (increase is −) Capital Account −465.9 (5) Balance on current account (1 + 2 + 3 + 4) −133.1 (4) Net transfer payments 227.0 (3) Net investment income −517.6 Income payments on investments 744.6 Income received on investments 178.6 (2) Net export of services −427.4 Imports of services 606.0 Exports of services −738.4 (1) Net export of goods −2,235.8 Goods imports 1,497.4 Goods exports Current Account Billions of dollars TABLE 20.1 United States Balance of Payments, 2011 All transactions that bring foreign exchange into the United States are credited (+) to the current account; all transactions that cause the United States to lose foreign exchange are debited (−) to the current account

In the Current Account… −465.9 (5) Balance on current account (1 + 2 + 3 + 4) −133.1 (4) Net transfer payments 227.0 (3) Net investment income −517.6 Income payments on investments 744.6 Income received on investments 178.6 (2) Net export of services −427.4 Imports of services 606.0 Exports of services −738.4 (1) Net export of goods −2,235.8 Goods imports 1,497.4 Goods exports Current Account Billions of dollars TABLE 20.1 United States Balance of Payments, 2011 All transactions that bring foreign exchange into the United States are credited (+) to the current account; all transactions that cause the United States to lose foreign exchange are debited (−) to the current account In the Current Account… Debit items: any transaction that causes the US to loose foreign exchange. Imports use up foreign exchange and are a debit (–) item. Credit items: any transaction that provides the US with foreign exchange. Exports generate foreign exchange and are a credit (+) item on the current account.

TABLE 20.1 United States Balance of Payments, 2011 37.7 (11) Net capital account transactions and financial derivatives (13) Balance of payments (5 + 10 + 11 + 12) −89.2 (12) Statistical discrepancy 517.4 (10) Balance on capital account (6 + 7 + 8 + 9) 211.8 (9) Change in foreign government assets in the United States −119.5 (8) Change in U.S. government assets abroad (increase is −) 789.2 (7) Change in foreign private assets in the United States −364.1 (6) Change in private U.S. assets abroad (increase is −) Capital Account −465.9 (5) Balance on current account (1 + 2 + 3 + 4) −133.1 (4) Net transfer payments 227.0 (3) Net investment income −517.6 Income payments on investments 744.6 Income received on investments 178.6 (2) Net export of services −427.4 Imports of services 606.0 Exports of services −738.4 (1) Net export of goods −2,235.8 Goods imports 1,497.4 Goods exports Current Account Billions of dollars TABLE 20.1 United States Balance of Payments, 2011 All transactions that bring foreign exchange into the United States are credited (+) to the current account; all transactions that cause the United States to lose foreign exchange are debited (−) to the current account

TABLE 20.1 United States Balance of Payments, 2011 37.7 (11) Net capital account transactions and financial derivatives (13) Balance of payments (5 + 10 + 11 + 12) −89.2 (12) Statistical discrepancy 517.4 (10) Balance on capital account (6 + 7 + 8 + 9) 211.8 (9) Change in foreign government assets in the United States −119.5 (8) Change in U.S. government assets abroad (increase is −) 789.2 (7) Change in foreign private assets in the United States −364.1 (6) Change in private U.S. assets abroad (increase is −) Capital Account −465.9 (5) Balance on current account (1 + 2 + 3 + 4) −133.1 (4) Net transfer payments 227.0 (3) Net investment income −517.6 Income payments on investments 744.6 Income received on investments 178.6 (2) Net export of services −427.4 Imports of services 606.0 Exports of services −738.4 (1) Net export of goods −2,235.8 Goods imports 1,497.4 Goods exports Current Account Billions of dollars TABLE 20.1 United States Balance of Payments, 2011 All transactions that bring foreign exchange into the United States are credited (+) to the current account; all transactions that cause the United States to lose foreign exchange are debited (−) to the current account

TABLE 20.1 United States Balance of Payments, 2011 37.7 (11) Net capital account transactions and financial derivatives (13) Balance of payments (5 + 10 + 11 + 12) −89.2 (12) Statistical discrepancy 517.4 (10) Balance on capital account (6 + 7 + 8 + 9) 211.8 (9) Change in foreign government assets in the United States −119.5 (8) Change in U.S. government assets abroad (increase is −) 789.2 (7) Change in foreign private assets in the United States −364.1 (6) Change in private U.S. assets abroad (increase is −) Capital Account −465.9 (5) Balance on current account (1 + 2 + 3 + 4) −133.1 (4) Net transfer payments 227.0 (3) Net investment income −517.6 Income payments on investments 744.6 Income received on investments 178.6 (2) Net export of services −427.4 Imports of services 606.0 Exports of services −738.4 (1) Net export of goods −2,235.8 Goods imports 1,497.4 Goods exports Current Account Billions of dollars TABLE 20.1 United States Balance of Payments, 2011 All transactions that bring foreign exchange into the United States are credited (+) to the current account; all transactions that cause the United States to lose foreign exchange are debited (−) to the current account

TABLE 20.1 United States Balance of Payments, 2011 37.7 (11) Net capital account transactions and financial derivatives (13) Balance of payments (5 + 10 + 11 + 12) −89.2 (12) Statistical discrepancy 517.4 (10) Balance on capital account (6 + 7 + 8 + 9) 211.8 (9) Change in foreign government assets in the United States −119.5 (8) Change in U.S. government assets abroad (increase is −) 789.2 (7) Change in foreign private assets in the United States −364.1 (6) Change in private U.S. assets abroad (increase is −) Capital Account −465.9 (5) Balance on current account (1 + 2 + 3 + 4) −133.1 (4) Net transfer payments 227.0 (3) Net investment income −517.6 Income payments on investments 744.6 Income received on investments 178.6 (2) Net export of services −427.4 Imports of services 606.0 Exports of services −738.4 (1) Net export of goods −2,235.8 Goods imports 1,497.4 Goods exports Current Account Billions of dollars TABLE 20.1 United States Balance of Payments, 2011 All transactions that bring foreign exchange into the United States are credited (+) to the current account; all transactions that cause the United States to lose foreign exchange are debited (−) to the current account