trade balance/savings and investment. government budgets g+tr>t g+tr-t> 0 – government...

Trade Balance/Savings and Investment

Government Budgets

• G+TR>T G+TR-T> 0– Government Surplus

• G+TR<(T) G+TR-(T)< 0 – Government Deficit

• More Sophisticated Government Budget:• T-(G+TR) =Sg

• Sg = Government Savings – Sg < 0 (Deficit) or Sg > 0 (Surplus)

EX and IM

• As of 2011Q4 NX = 3.8% of GDP• Total EX + IM = 31% of GDP• EX = Goods produced (income earned) but sold to

foreigners. It is output above what is consumed (C+G+I) in the US

• IM = Goods consumed (C+G+I) in the US but produced (income earned) by foreigners.

• EX-IM = Trade Balance• EX >IM (EX-IM >0) Trade Surplus • EX <IM (EX-IM <0) Trade Deficit

Savings/Investment Identity

• This is an important concept– Savers = People with money sitting around– Investors (really investment spenders) = People who have a

use for that money.• No Gov; No Trade:• Y= Income = C+S – S = Savings

• Y= Purchases/Output= C + I• Y = C + S = C + I• S = I

Savings/Investment Identity (cont)

Adding Government (No Transfers) and Trade• Y = Income = C + S + T

Disposable Income = Y – T• Y = Purchase/Product = C + G + I + (NX)• Y = C + S + T = C + G + I + NX• Do some math:• I = (T-G) + (-NX) + S• I = Sg + SF + Sp

• I = Government Savings + Foreign Savings + Private Savings

The (–NX) term

• The inverse of Net Exports.o -NX = -(Ex-IM) = IM-EX

• How do you pay for imports?– Export something in exchange, kind of like barter– Offer an IOU or an Asset in exchange

• (-NX) is the same as the “capital account” (KA)

The Capital Account

• KA = KI - KO• KI = Capital Inflow– Foreign Purchase of domestic assets.

• KO = Capital Outflow– Domestic Purchase of foreign assets.

• Capital Flows = FDI + Paper Assets + Loans + Reserve Assets

• Punchline: NX + KA = 0– Imports must be paid for by either an offsetting export

or asset transfer.

Exchange rates

So we left last class asking

• Will an increase in the demand for exports cause and appreciation or depreciation of a currency.

• Lets take a step back.

Exchange rates.

• Depreciation: – or – Then number of Euros bought per dollar falls.

• Appreciation– or – The number of Euros bought per dollar increases

One way of talking about exchange rates

• Purchasing Power Parity• Exchange rates are determined such that intl

trade would equalize prices across countries relative to exchange rates.

And changes in exchange rates reflect differences in inflation rates.

In this case, trade changes exchange rates

• If a Europe’s exports to the US increase:• EX↑Y↑PL↑↑• But the increase is indirect. Trade influences a

countries PL and its exchange rate.

Asset demand and exchange rates

• These days we focus on asset demand as determining exchange rates.

• Currency trading of $ is something like 25 times our current account balance.

• So much of what drives exchange rates are differences in asset returns across countries.

Money in the US a brief history

• 1787 – 1963– Notes from different—state chartered banks—were

circulating• 1863-1915– National Banks notes issued by nationally chartered

banks, backed by deposits of treasuries with the Treasury (Comptroller of Currency)

– Not unlike Open Market Operations with the Fed today.• 1915-Today– Federal Reserve prints and issues currency.

The Gold Standard

• 1870(ish) the gold standard comes to prominence– US 1879.

• 1870(ish)-1915: Classical Gold Standard• 1918-1933: Interwar Standard• 1946-1971: Bretton Woods• 1971-Now: No Gold

The Gold Standard is not about price stability.

1870 1875 1880 1885 1890 1895 1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

-0.08

-0.06

-0.04

-0.02

0

0.02

0.04

0.06

Inflation 1870 to 1915

Inflation rate

It gets even worse

1919 1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933

-0.15

-0.1

-0.05

0

0.05

0.1

0.15

0.2

Inflation during the Interwar Gold Standard 1919-1933

Inflation rate

So what is the gold standard?

• It is an international currency standard• If all countries are valued in gold then all

countries have bilateral exchange rates.– This is supposed to make it easier for foreign

investment.

How the it is supposed to work

• Example: US/British Exchange rate– EUS/EUK is determine by two things

1. The Demand for US vs British Assets2. The Price level in the US and the UK

– These are kind of the same thing• Balance of Payments (BoP) imbalances cause gold

outflows• Gold outflows cause Ms ↓ thus PL↓

What is a BoP imbalance?

• Cross country flows.– If the inflow of Capital (KIN) is less than the outflow

of capital (Kout) then you have an imbalance. – The extra $1 you want to spend in another

country (Kout) has to be in gold from the central bank.

• Same with trade if IM>EX then you have to export gold to make up the difference.

So BoP deficit

• KIN<KOUT or EX<IM• Causes gold to flow out of a country.– Monetary Base ↓ → Money Supply ↓ →

Investment↓ → Price Level Falls ↓• When the PL falls Exports increase and this

should right the BoP.

A central bank’s Job

• According to the “rule of the game”– CB should reinforce the decline in the money supply

by increasing the interest rate (i)– i is the rediscount rate. The rate at which a central

bank exchanges cash for securities. – This can also be done with open market operations– When i increases two things should happen

1. Y & PL ↓ → IM ↓ & EX↑2. I attracts more KIN

Central banks didn’t follow the rules

• Central banks often “sterilized” gold inflows– Gold↑ → MB↑ – Paper Assets↓ → MB↓

• However, the US had very large stocks of gold relative to foreign exchange, money supply etc.

• In part because the US banking system was so unstable.

Why did the gold standard work

• Mostly because the British had the credibility needed to maintain the system.

• The British had very little gold relative to its foreign exchange liabilities.

• All foreign currency regimes essentially work or don’t work based on the credibility of it “anchor” country. They type of regime seems somewhat secondary

The interwar gold standard

• During WWI all the major economies go off the gold standard.

• After WWI the world looks totally different politically/economically but the British fight to keep the system the same.

• 1917-1946 is largely about the transition from a British centered world economy to a US centered world economy.

1919-1933

• The British refuse to acknowledge they are no longer the “center of the world”

• The US refuse to acknowledge they are now the “center of the world”

• Monetary stupidity ensues

1925

• Britain goes back on the Gold Standard at pre-war parity $4.86 per pound (£).– But the British economy was different (weaker)

and its price level was higher.– So it created a persistent trade imbalance IM >EX.– What’s more, the Bank of England kept i high to

try to fix the BoP problem.

The other side of the coin

• The US and France (who devalues the Franc after WWI) enjoy gold inflows.

• And they sterilize those inflows.• Free to Choose Episode 3; 18:40• https://www.youtube.com/watch?

v=z12P6PbK4xw

The roaring 20s

• Unemployment in the US still averages 7.6%• While gold inflows are being sterilized, money

supply still increases.– Real estate bubble pops in 1926– Stock market bubble pops in 1929

• Also issues with Germany (Dawes Plan)

It is not exactly clear what started the Great Depression

• Stock market crash?• Agricultural price collapse?• Banking Crises made it the Great Depression– Banking Panics 1930-1933

Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

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