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

2. 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

3. 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?

4. 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

5. 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

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

7. 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

8. 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

9. 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)

10. 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

11. 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.

12. 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?

13. 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
: imports roughly 18%, 14%, 16%, 18% of US GDP
Want to see others?
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.

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

15. 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

17. 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

18. 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.

19. 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.

20. 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.

21. 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.

24. 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

25. 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

26. TABLE 20.1 United States Balance of Payments, 2011
37.7
(11) Net capital account transactions and financial derivatives
(13) Balance of payments ( )
−89.2
(12) Statistical discrepancy
517.4
(10) Balance on capital account ( )
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 ( )
−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 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

27. In the Current Account…
−465.9
(5) Balance on current account ( )
−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 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.

28. TABLE 20.1 United States Balance of Payments, 2011
37.7
(11) Net capital account transactions and financial derivatives
(13) Balance of payments ( )
−89.2
(12) Statistical discrepancy
517.4
(10) Balance on capital account ( )
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 ( )
−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 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

29. TABLE 20.1 United States Balance of Payments, 2011
37.7
(11) Net capital account transactions and financial derivatives
(13) Balance of payments ( )
−89.2
(12) Statistical discrepancy
517.4
(10) Balance on capital account ( )
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 ( )
−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 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

30. TABLE 20.1 United States Balance of Payments, 2011
37.7
(11) Net capital account transactions and financial derivatives
(13) Balance of payments ( )
−89.2
(12) Statistical discrepancy
517.4
(10) Balance on capital account ( )
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 ( )
−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 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

31. TABLE 20.1 United States Balance of Payments, 2011
37.7
(11) Net capital account transactions and financial derivatives
(13) Balance of payments ( )
−89.2
(12) Statistical discrepancy
517.4
(10) Balance on capital account ( )
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 ( )
−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 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