Depreciation and Trade Balance What is the impact of depreciation on trade? –Import goods cost more –Exports increases as they are cheaper abroad –Imports decrease as they are expensive at home Overall impact on Net Exports (X-M) is that it increases. Marshall-Lerner Condition: substitution effect dominates income effect

Depreciation and Trade Balance Change in net export increases demand for domestic goods Does reducing the trade deficit increase output? –In the short-run it does –In the long-run not necessarily Fiscal contraction may compensate short- run impact of depreciation (G  ) Shortcomings: a) source of depreciation; b) why we care for GDP equilibrium

Depreciation and Trade Balance The J-Curve: compares impact effect of depreciation and path to new equilibrium –On impact nominal imports increase (due to price effect) –Then Marshall-Lerner condition kicks in There is a lag between real exchange rate movements and trade balance (about 1year)

Saving = Investment In a Closed Economy domestic savings equals investments In an Open Economy Investmet equals “Total Savings”: –Private Savings –Government Savings –Foreign Savings

Saving = Investment Y = C + I + G +X – M –Since C = Y – S – T then Y = Y – S P – T + I + G + X – M –Y cancels out; rearrange the rest and we get (S P ) + (T-G) + (M-X) = I –Private savings (S P ) plus –Government savings (T-G) plus –Foreign Savings (balance of payments)

Saving = Investment Investment increase either with private savings; government savings; or trade deficit Gov deficit affects either investment or private savings or creates a trade deficit High private saving rate results either in high investment ; trade surplus; or gov. surplus S=I also means that gov deficit does not lead to trade deficit

U.S. Trade Deficit US X/GDP is quite constant through the years US M/GDP has been increasing through time Increasing trade deficit ($856bil; 6% of GDP); half of world savings US has been growing more than EU and Japan Trade deficit increase even with appreciation Answer: increasing foreign savings During depreciation investment has stayed constant while domestic saving has fallen. Why?