Transcript Slides 2
Slides 2 After the First Midterm Exam 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 Exchange rate • Nominal exchange rate is denoted by 𝑒, whose format is foreign currency per US dollar. • US dollar appreciates if 𝑒 rises • Real exchange rate (term of trade) is 𝐷𝑜𝑙𝑙𝑎𝑟 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑈𝑆 𝑔𝑜𝑜𝑑 𝜀= 𝐷𝑜𝑙𝑙𝑎𝑟 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑔𝑜𝑜𝑑 𝑃 𝑒𝑃 = ∗ = ∗ (𝑃 /𝑒) 𝑃 • US goods become relatively more expensive when 𝜀 rises, so US net export falls. • Exercises: what may cause appreciation of US dollar in real terms? Two Key Equations • We assume the real interest rate is exogenous, 𝑟 = 𝑟 ∗ • That mean real interest rate cannot adjust to equilibrate spending (𝐶 + 𝐺 + 𝐼 + 𝑁𝑋) and income 𝑌 • Instead, real exchange rate 𝜀 adjusts to clear economy 𝑁𝑋 𝜀 = 𝑆 − 𝐼(𝑟 ∗ ) 𝑆 =𝑌−𝐶−𝐺 Accounting Stuff • There is trade deficit 𝑁𝑋 < 0 if a country overspends (borrows), i.e., Y < 𝐶 + 𝐺 + 𝐼 • There is trade surplus 𝑁𝑋 > 0 if a country saves (lends ), i.e., Y > 𝐶 + 𝐺 + 𝐼 • After net export is determined, real exchange rate is determined. This ordering really matters! 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? 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? 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) Data Talk A Right Move • Give firms tax breaks if they bring jobs back to US. • http://www.nytimes.com/2012/02/03/busine ss/economy/a-lure-to-keep-jobs-made-inamerica.html • Can you draw a graph to show this is a good idea? 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. Classical Dichotomy • Real Exchange Rate: 𝜀 = 𝑃 𝑒 ∗ 𝑃 • Nominal Exchange Rate: 𝑒 = 𝜀𝑃∗ 𝑃 • Relative Purchasing Power Parity: 𝑒% = 𝜀% + 𝜋 ∗ − 𝜋 Absolute Purchasing Power Parity: 𝜀=1 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 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 Monetary Policy • See in class exercises 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 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 A Successful Story • http://people.bu.edu/timbond/ Steady State • • • • ∆𝑘 = 𝑠𝑓 𝑘 − 𝛿𝑘 ∆𝑘 > 0 𝑖𝑓 𝑠𝑓 𝑘 > 𝛿𝑘 ∆𝑘 < 0 𝑖𝑓 𝑠𝑓 𝑘 < 𝛿𝑘 In steady state ∆𝑘 ≡ 0. 𝑖. 𝑒. , 𝑠𝑓 𝑘 ∗ = 𝛿𝑘 ∗ • In steady state both total capital 𝐾 ∗ = 𝐿𝑘 ∗ and total income 𝑌 ∗ = 𝐿𝑓(𝑘 ∗ ) remain constant, because both 𝐿 and 𝑘 ∗ are fixed. Computer Simulation of Steady State • Table 7-2 on page 201 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? 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. Solow Model with Population Growth • ∆𝑘 = 𝑠𝑓 𝑘 − (𝛿 + 𝑛)𝑘 where 𝑛 is growth rate of population • Everything else equal, higher 𝑛 causes lower 𝑘 ∗ , 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? Solow Model with Population Growth • Now we can explain sustained growth in total income 𝐾 ∗ = 𝐿𝑘 ∗ → 𝐾 ∗ % = 𝐿% + 𝑘 ∗ % = 𝑛 𝑌 ∗ = 𝐿𝑓(𝑘 ∗ ) → 𝑌 ∗ % = 𝐿% + 𝑓(𝑘 ∗ )% = 𝑛 because 𝐿% = 𝑛, 𝑘 ∗ % = 0. So the growth rate of total income (GDP) is the same as the population growth rate Discuss: what happens to living standard (𝑌 ∗ /𝐿) in steady state? Do we get sustained growth in living standard? Solow Model with Technological Progress • Let 𝑔 denote the growth rate of technology 𝐾 𝐸𝐿 • Let 𝑘 ≡ denote the per-effective-worker capital • Then the key equation now becomes ∆𝑘 = 𝑠𝑓 𝑘 − (𝛿 + 𝑛 + 𝑔)𝑘 In steady state the per-effective-worker capital 𝑘 ∗ remains constant. In-Class Exercise • Show that in steady state, with technological progress there is sustained growth in living standard Golden Rule • For the basic Solow model the consumption is maximized when 𝑀𝑃𝐾 = 𝛿 Denote the level of capital that satisfies this condition 𝑘𝑔𝑜𝑙𝑑 • Policy can affect the saving rate so that 𝑘𝑔𝑜𝑙𝑑 is the steady-state level: 𝑠𝑓 𝑘𝑔𝑜𝑙𝑑 = 𝛿 𝑘𝑔𝑜𝑙𝑑 Policymakers can solve this equation for 𝑠 𝛿 𝑘𝑔𝑜𝑙𝑑 𝑠= 𝑓 𝑘𝑔𝑜𝑙𝑑 • See Example on page 209