Slides 2 After the First Midterm Exam

Open Economy Build a long run theory to explain trade balance and exchange rate Idea 1: Y = C + I + G + NX (net export) Idea 2: NX is function of real exchange rate Idea 3: use classical dichotomy to determine nominal exchange rate after real exchange rate is determined

Exchange rate

Two Key Equations

Accounting Stuff

What causes US trade deficit? Dr Mankiw’s answer: because US overspends Politician’s answer: because Chinese currency is undervalued Which one makes more sense?

Politicians may be misleading Yes, cheap Chinese currency means cheap Chinese goods But, does cheap Chinese currency affect Services, the biggest part of C? Housing, one big part of I? Military spending, entitlement program, bailout program?

Dr. Mankiw’s Answer US budget deficit is caused by (1) (increasingly) big budget deficit (twin deficits) (2) close to zero private saving (3) big investment (including housing market boom)

Data Talk

A Right Move Give firms tax breaks if they bring jobs back to US. ss/economy/a-lure-to-keep-jobs-made-in- america.html ss/economy/a-lure-to-keep-jobs-made-in- america.html Can you draw a graph to show this is a good idea?

Another Good News currencies of most countries are not reserve currencies. For those country trade deficit must be financed by foreign debt, and persistent trade deficit is a big issue The issue of US trade deficit is exaggerated Because US can print dollar, which is reserve currency, to finance its trade deficit.

Classical Dichotomy

Classical (Long Run) Model Chapter 3: GDP and Real Interest Rate Chapter 4: Price, Inflation Rate and Nominal Interest Rate Chapter 5: Net Export and Exchange Rates Chapter 6: Unemployment Rate

Policy Implication Fiscal Policy has crowding out effects Trade policy is useless Minimum wage law and unemployment insurances have side-effects All policies pick winners and losers. Policy is unnecessary if the loss of losers offsets the gain of winners

Monetary Policy See in class exercises

In Long Run Policy is Not Needed Unemployment is natural Inflation has some good effect Trade deficit is ok “Small government is the best”, says a republican

China can control exchange rate, but only the nominal rate In long run policy is useless because market forces prevail China uses fixed nominal exchange rate But the real exchange rate is very flexible. “What really matters is the real rate” says Dr. Jing Li

A Successful Story

Steady State

Computer Simulation of Steady State Table 7-2 on page 201

In-Class Exercise What if the production function has the property of increasing marginal product? Does steady state exist? If steady state exists, does the economy goes there eventually? What happens to total capital and total income over time?

Conclusion The basic Solow model implies that economy eventually goes to steady state and stays there. Eventually, if there is no population growth, the total income and per-capita income (living standard) both remain constant. Put differently, there is no sustained growth in either total income or living standard.

Solow Model with Population Growth

Solow Model with Technological Progress

In-Class Exercise Show that in steady state, with technological progress there is sustained growth in living standard

Golden Rule