PRINCIPLES OF MACROECONOMICS
Ranjit Dighe
WEEK 14 (LECTURES 36 & 37)
May 1-5, 2000

[Mon., May 1 was our third midterm exam. Problem Set 9 was handed out on that date as well. The lectures on May 3 and May 5 covered new material, on international trade, from Case & Fair's Chapters 20 and 21.]

LECTURE 36
Wed., May 3, 2000

0. IMPEDIMENTA

* Get exams back
-- Click here for the solutions to the third exam, and for news of the "Rule of 73" adjustment

* MON., MAY 8, 8-10 A.M.: FINAL EXAM (cumulative)
-- Special pre-exam office hours:
---- me: Sun. 12-6 P.M.
---- Rem: Sat. 4-6 P.M., Sun. 7-9 P.M.

* Today: International macroeconomics
   I.   International trade: A quick introduction
   II. Free trade and the theory of comparative advantage
 

I.  INTERNATIONAL TRADE: A QUICK INTRODUCTION

The GDP accounting identity in an open economy (one that conducts trade with other countries):

                         exports    imports
                                 |        |
GDP = C + I + G + EX - IM
                                -----------
                                net exports; trade balance; trade surplus

The "trade surplus" and the "trade deficit" are mirror images of each other.  If the trade surplus is, say, $20 billion, then the trade deficit is -$20 billion (a negative deficit is a surplus).  Likewise, if a country is running a trade deficit, then it has a negative trade surplus, or a negative trade balance, or negative net exports.

Trade deficit = IM - EX
                    = - {trade surplus}

-- Note: The "trade deficit" you hear about on TV is typically the "merchandise trade deficit," which includes EX and IM only of goods, not services. (Not quite proper usage.) U.S. is actually running a trade surplus in services (travel, education, financial, etc.), so current account deficit is much smaller than merchandise trade deficit.

Examples:

-- The U.S. now exports about $1 trillion worth of goods and services, and imports about $1.25 trillion worth of goods and services.
----> The U.S. has a trade deficit of $0.25 trillion, or $250 billion.
------ (trade surplus) = EX - IM = $1.00 trillion - $1.25 trillion = -$0.25 trillion = -$250 billion

-- In 1995, Japan exported $443 billion in goods and services, and imported $336 billion in goods and services.
----> Japan had a trade surplus of $107 billion (= EX - IM = $443 billion - $336 billion)

The U.S. has historically been a relatively closed economy, meaning that international trade has been a relatively small part of the U.S. economy, as compared with smaller countries like Switzerland and Belgium, which import a very large portion of the goods they buy and export a very large portion of the goods they produce. Because the U.S. is so large, heavily populated, and diverse geographically, U.S. firms are able to produce a very wide variety of goods and services, and the U.S. population of 270 million furnishes a very large home market.
-- Still, since 1945 (the end of World War II) and especially since 1970, foreign trade, namely exports and imports, has come to occupy an increasingly large share of the U.S. economy.
---- Exports are about 11% of U.S. GDP, and imports are about 13% of U.S. GDP.
 

II. FREE TRADE AND COMPARATIVE ADVANTAGE

Most of you probably already learned the theory of comparative advantage in Eco 101, but a little review won't hurt. It is one of the most important and most universally accepted ideas in economics. And it could use reinforcing because it's also a bit difficult. As the great economist Paul Samuelson once it, the theory of comparative advantage is one of the few things in economics that is true without being obvious.

Most economists favor free trade over protectionism (the practice of shielding industries from foreign competition), and the theory of comparative advantage is generally the basis of their argument. Trade allows countries to specialize in producing the commodities that they're best at, and that kind of specialization raises the GDPs of all trading partners.  Consumer standards of living are much higher when there is open trade than when there are trade restrictions.
-- COMPARATIVE ADVANTAGE is the ability to produce something at lower opportunity cost than another country can.
---- It is a more subtle concept than absolute advantage, which is the ability to produce something a lower cost, period, than someone else can, or the ability to produce something that another country cannot produce at all.  (Brazil, for example, has an absolute advantage over the U.S. in producing coffee and bananas, since it can produce both and the U.S. isn't tropical enough to produce either one.)

Examples of comparative advantage:
-- Suppose that Thelma and Louise are two friends who take a lot of car trips together.  And suppose that Louise is a better driver than Thelma.  But, suppose that Louise is also the better navigator of the two.  It's just about impossible to drive and navigate at the same time, so Louise can't do both.  If Louise is a better driver than Thelma and a much better navigator than Thelma, then, although Louise is absolutely better at both driving and navigating than Thelma is, Thelma has the comparative advantage in driving and Louise has the comparative advantage in navigating.  Their car trips will go most smoothly if Thelma does the driving and Louise does the navigating.
-- Suppose that world-class defense lawyer Johnnie Cochran is also a brilliant typist, who can type well over 100 words a minute, faster than any of the secretaries at Johnnie Cochran & Associates.  Does that mean he should perform both the legal services and the typing services for the law firm?  Of course not.  His time is much too valuable.  Even though he can type faster than anyone else there, the opportunity cost of using his time on typing (which someone else can do, say, 80% as well as he can) is much too high, since nobody else can do half as good a job as he can preparing and arguing legal briefs.

The THEORY OF COMPARATIVE ADVANTAGE states that countries can maximize their combined output and use resources more efficiently if each one specializes in producing the goods at which it has a comparative advantage.
--> Countries should export the goods in which they have a comparative advantage and import the goods in which they have a comparative disadvantage.
----> Specialization and free trade will benefit all trading partners, by enabling all partners, even those that may be less efficient producers, to purchase more goods and services.

***

PRINCIPLES OF MACROECONOMICS
WEEK 14, LECTURE 37
Fri., May 5, 2000

0. IMPEDIMENTA

* Get review sheet for final exam

* MON., MAY 8, 8-10 A.M.: FINAL EXAM (cumulative)

* Today:
   I.    Evaluations
   II.  Trade feedback effects and GDP
   III. Exchange rates and the balance of payments
   IV. Free trade or protectionism?  A pithy parting quote

* Unemployment rate for April = 3.9% (thirty-year low)
 

I. EVALUATIONS

II. TRADE FEEDBACK EFFECTS AND GDP

Flashback: Societies have a marginal propensity to consume that is positive, meaning that as real GDP increases, so does consumption. Richer people consume more, and so do richer nations. In any nation that is open to foreign trade, some fraction of any increase in the level of consumption will be increased consumption of imports from other countries.
-- The most important determinant of how much a country imports (IM) is the level of GDP in that country.
---- No wonder, then, that the U.S. is the world's largest importer by far.

Also recall that an increase in exports (EX) adds directly to a country's GDP, since

Y = C + I + G + EX - IM.
(Moreover, an increase in exports is likely to have a multiplied effect on GDP. If the multiplier is 1.4, then a $100 billion increase in U.S. exports will ultimately raise U.S. GDP by $140 billion.)

Defn.
TRADE FEEDBACK EFFECT -- the tendency for an increase in the economic activity of one country to lead to a worldwide increase in economic activity, which in turn "feeds back to" (raises GDP in) the home country. Notationally,
                     YUS --> (IMUS <=> EXROW) --> YROW --> (IMROW<=> EXUS)--|
                        /|\                                    |                                                                |
                         |                                    Rest Of the World                                      |
                         |___________________________________________________|

As the world economy becomes more and more open to trade and foreign trade comes to account for an ever-increasing portion of countries' GDPs, trade feedback effects take on a heightened importance. For better or for worse, the state of the U.S. economy is very heavily affected by the state of the economies of Canada, Mexico, Japan, Europe, and all the rest of our major trading partners.
 

III. EXCHANGE RATES AND THE BALANCE OF PAYMENTS

Most countries have their own currencies, and when people in different countries buy and sell to each other, an exchange of currencies must take place. For example, suppose you're from Mexico and you're attending college in the U.S. Your tuition is a U.S. export to Mexico, of educational services. But the school isn't going to let you pay your term bill in pesos -- you're going to have to exchange pesos for dollars in order to pay your term bill. The "price" of dollars in terms of pesos is about 10 pesos per dollar, and we call that price the exchange rate of the dollar in terms of the peso.

Defn.:
EXCHANGE RATE:  the price of one country's currency in terms of another country's currency; the rate at which two countries' currencies are traded for another.
-- Ex.: The U.S.-Mexican exchange rate is 9.395 pesos per dollar, or 0.1064 dollars per peso (as of May 3, 2000).

(Exchange rates can be either fixed or flexible. Right now, most countries, including the U.S. have flexible, or "floating," exchange rates, which change daily. It didn't used to be that way--from World War Two to 1971, most of the industrialized world was under a system of fixed exchange rates known as the Bretton Woods system, where exchange rates were adjusted only occasionally. Before that, a more rigid system of fixed exchange rates known as the Gold Standard was what prevailed.)

Defn.:
FOREIGN EXCHANGE:
all currencies other than the domestic currency (in our case, all currencies other than the dollar).
-- If you want to purchase foreign goods directly, you need to get yourself some foreign exchange. (If you use a credit card like VISA or American Express, then VISA or American Express performs the currency exchange for you.)

A currency APPRECIATES when its value increases, in terms of other currencies.
-- We call that increase an APPRECIATION of the currency.

A currency DEPRECIATES when its value decreases, in terms of other currencies.
-- We call that decrease a DEPRECIATION of the currency.

Example:
If the U.S. dollar was worth 1.1 Canadian dollars in 1990 and is worth 1.4 Canadian dollars today, then the U.S. dollar has appreciated since 1990, relative to the Canadian dollar.
-- Likewise, the Canadian dollar has depreciated since 1990, relative to the American dollar.

Q: Is currency depreciation a good thing or a bad thing?
A: Depends on your point of view-- bad for consumers/tourists, good for exporters and producers of products that compete with imports.
-- If you work in, say, an auto plant that sells a lot of its cars to foreign consumers, then you'd probably welcome a depreciation of the dollar.  If you don't happen to work in the tradeable-goods sector, however (and most of us don't), then you'd prefer to see the dollar appreciate, since imported goods would become cheaper and it would also become cheaper to travel abroad.

When a country's currency depreciates, that depreciation affects the economy in two ways (one good, one bad):
(1) It's good for aggregate demand (AD), because the country's goods become cheaper relative to foreign goods.
--> EXports increase, IMports decrease, and thus net exports (EX-IM) increase
----> GDP rises, since net exports are part of AD and of GDP
------ To be precise, GDP usually rises after a depreciation, but it could fall if the aggregate-supply effect (below) dominates.  Usually, however, this first effect (the AD effect) dominates.
(2) It's bad for aggregate supply (AS): imports become more expensive, so the overall price level increases.  Production costs increase, too, since many intermediate inputs are foreign-produced.
--> P increases;
      GDP could fall if the AS effect dominates the AD effect.
(In countries where imports are a much larger and more critical part of the economy, like most countries in Europe, the AS effect often does dominate.  So one often hears economic policymakers in Germany, Britain, and other countries talking about how they need to take action to keep their currencies from depreciating.)

International transactions involve more than just imports and exports of goods and services.  There are numerous purchases that do not get counted in GDP (like purchases of stocks, bonds, real estate, etc.) that often cross international borders.  For example, Americans have huge holdings of international stocks, and foreigners have huge holdings of American stocks.  For a more complete accounting of a country's international economic activities, we look at that country's BALANCE OF PAYMENTS (BOP).
-- The BOP is the record of a country's transactions in goods, services, and assets with the rest of the world; also, it's the record of a country's sources and uses of foreign exchange.

BOP = Current account balance + Capital account balance = 0
             --------------------------      -------------------------
              ~same as trade balance         "international capital flows":  international purchases of stocks, bonds, property, etc.

-- The BOP is identically equal to zero at all times, because current-account transactions exactly offset capital-account transactions.

THE CURRENT ACCOUNT consists of:
(1) Net exports of goods and services (trade balance)
(2) Net investment income -- dividends, interest, rent, and profits paid to U.S. citizens who own foreign assets, minus the investment income of foreigners who own U.S. assets
---- Note: These flows of investment income are quite large (hundreds of billions of dollars) in both directions.
(3) Net transfer payments + government interest payments to foreigners (including gifts from Americans to foreigners, Social Security checks to retirees living abroad, etc.)

The current account is roughly the same as net exports or the trade balance, since item (1) is by far the largest item in it.

The current account is one side of the BOP. The other side is the
CAPITAL ACCOUNT: net inflows of physical and financial capital, including foreign currency. The U.S. capital account consists of:
(1) Change in U.S. assets abroad -- includes our holdings of physical capital--e.g., factories in Mexico and Singapore--as well as paper assets--such as British stocks and bonds. Since we need foreign currency to pay for these assets, increase is -, because purchasing these assets uses up foreign exchange. Includes both private assets and U.S. government assets.
(2) Change in foreign assets in U.S. -- e.g., Japan's purchase of Rockefeller Center in 1980s was a big positive entry in the U.S. capital account. Again, includes both private assets and foreign government assets in U.S.

At present, the U.S. is running a big current account deficit, because of our big merchandise trade deficit; we're running a big surplus on the capital account. What does that mean? Well, we're importing a lot more than we export, so we need to exchange a lot of dollars for foreign currency in order to pay for these imports; foreigners are then stuck with all these dollars we've exchanged, and they invest them in the U.S.-- they buy land, buildings, companies, T-bills, stocks, etc. Even if they just sit on those dollars instead of investing them in the U.S., they've still got them, and their holdings of those dollars are entered into the capital account under "Change in foreign assets in U.S."
 

IV. FREE TRADE OR PROTECTIONISM? A PITHY PARTING QUOTE

"No nation was ever ruined by trade."
-- Benjamin Franklin