Understanding Trade Balance and Exchange Rates in Open Economy Post Midterm Exam

1. Slides 2 After the First Midterm Exam

2. 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

3. Exchange rate • Nominal exchange rate is denoted by whose format is foreign currency perUS dollar. • US dollar appreciates if rises • Real exchange rate (term of trade) is • US goods become relatively more expensive when rises, so US net export falls. • Exercises: what may cause appreciation of US dollar in real terms?

4. Two Key Equations • We assume the real interest rate is exogenous, • That mean real interest rate cannot adjust to equilibrate spending () and income • Instead, real exchange rate adjusts to clear economy

5. Accounting Stuff • There is trade deficit if a country overspends (borrows), i.e., • There is trade surplus if a country saves (lends ), i.e., • After net export is determined, real exchange rate is determined. This ordering really matters!

6. 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?

7. 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?

8. 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)

9. Data Talk

10. A Right Move • Give firms tax breaks if they bring jobs back to US. • http://www.nytimes.com/2012/02/03/business/economy/a-lure-to-keep-jobs-made-in-america.html • Can you draw a graph to show this is a good idea?

11. 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.

12. Classical Dichotomy • Real Exchange Rate: • Nominal Exchange Rate: • Relative Purchasing Power Parity: Absolute Purchasing Power Parity:

13. 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

14. 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

15. Monetary Policy • See in class exercises

16. 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

17. 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

18. A Successful Story • http://people.bu.edu/timbond/

19. Steady State • In steady state • In steady state both total capitaland total income ) remain constant, because both and are fixed.

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

21. 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?

22. 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.

23. Solow Model with Population Growth • where is growth rate of population • Everything else equal, higher causes lower , see Figure 7-12 • So higher population growth rate causes lower living standard, see Figure 7-13 • Discuss: is China’s one-child policy good or bad?

24. Solow Model with Population Growth • Now we can explain sustained growth in total income because So the growth rate of total income (GDP) is the same as the population growth rate Discuss: what happens to living standard ( in steady state? Do we get sustained growth in living standard?

25. Solow Model with Technological Progress • Let denote the growth rate of technology • Let denote the per-effective-worker capital • Then the key equation now becomes In steady state the per-effective-worker capital remains constant.

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

27. Golden Rule • For the basic Solow model the consumption is maximized when Denote the level of capital that satisfies this condition • Policy can affect the saving rate so that is the steady-state level: Policymakers can solve this equation for • See Example on page 209