Few economics are closed in Chapter 4. Trade allows economics to spend more than it produces temporarily. The economy can import more than it exports, and borrow from abroad to pay the difference: This creates a trade deficit, creating foreign debt which must be paid in the future. The main determinant of the foreign trade of a country is its investment and saving choices.

A. Introduction

1) Expands the national income accounts from chapter two to include international transactions.

2) Credits—Any transaction that involves a flow of money into the domestic economy, exports are the best example.

3)Debits-Any transaction that involves a flow of money out of the domestic economy, imports are the best example

B. The Current Account—Measures countries trade in currently produced goods and services total of: Net Exports of Goods and Services; Net investment income from abroad; and Net unilateral transfers.

1) Net Exports of Goods and Services (NX in expenditure approach)

Two categories Merchandize and Services

2) Net Investment Income from abroad

Interest payments, dividends, royalties, and other returns on assets owned by domestic individuals in a foreign country.

3) Net Unilateral Transfers

Payments from one country to another which do not correspond to the purchase of a good or service. For example, foreign aid.

4) Current Account Balance

Adding all the credit items and subtracting the debit items of the above three categories yields the current account balance. If the balance is positive (negative) then there is a current account surplus (deficit).

C. The Capital an Financial Account

1) Trade between countries in existing assets, either real estate or financial assets are measured in the capital account.

2) Capital inflow-When an individual in the domestic country sells an asset to an individual in a foreign country (a credit item in the capital account).

3) Capital outflow-When an individual(s) in the domestic country purchase an assets from a foreign country ( a debit item in the capital account)

4) Capital account balance-The value of capital inflows minus the value of capital outflows. Will be positive when domestic individuals sell more assets to foreign individuals than domestic individuals buy from foreign interests.

5) Official Reserve transactions are a portion of the capital account-important in determining exchange rates.

D. The relationship between Current Account and the Capital and Financial Account

1) The Current Account and Capital Account will always sum to zero. Each transaction has an offsetting transaction in the other account.

Example:

An American buys a $200 bottle of French wine. And import of goods for the United States. This is recorded by a reduction in the United States current account (and an increase in the current account of France or an export) The French importer now has $200 and will respond in on the following ways.

a) Purchase American goods costing $200 which would increase the US current account balance by $200. Therefore there has been a change in the current account (this would decrease the French current account)

b) Purchase an American Asset worth $200. This would change the capital account. The US capital account would increase by $200 since it is a capital inflow for the US (The French Capital account would decrease since it is a capital outflow for France)

c) The importer might trade the $ for French Francs at her bank. The bank will then either trade the dollars for francs with an individual who is going to purchase a US good or asset and needs dollars (then a or b occurs). If the bank does not do this it will exchange the dollars for French francs from the Federal Reserve. In giving up the French francs the US capital account increases as the amount of Official reserves of francs has decreased, offset by the capital inflow from the French bank. (The capital account of France will decrease.)

In practice there is a measurement error recorded as a statistical discrepancy for between the current and capital account. Usually in practice they will not sum to zero.

E. Net Foreign Assets Foreign assets minus foreign liabilities

1) Can change when there is a change in the price of assets (stock market)

2) The net increases in foreign assets equals a countries current account surplus

Net increase in foreign assets results in a capital outflow or a decrease in the capital account.

3) Summary Current account Surplus=Capital Account deficit=net acquisition of foreign assets=net foreign lending.

F. Is the US the worlds largest debtor?

Foreign liabilities for the US have increased dramatically, however they are still a small part of the GDP (13%) and the holdings of foreign assets is misleading since many are measured at book value, (original price) instead of the market value.

A. Chapter 2 S = I + CA = I + (NX + NFP)

Saving has two uses: Increase in the capital stock by domestic investment

Increase in the stock of net foreign assets by lending to foreigners

B. In equilibrium national saving and investment equal their desired levels.

S^d = I^d + CA = I^d + (NX + NFP)

Closed economy CA = 0 (implying S^d = I^d), now there is trade accounted for by the current account.

Will assume that NFP are equal to zero since NFP are effected by past investment and usually do not relate to current macroeconomic activity then:

S^d = I^d + NX using S^d = Y – C^d – G substitute for S^d

Y – C^d – G = I^d + NX Rearranging Y = C^d + I^d + G + NX

Rearranging NX = Y – (C^d + I^d + G)

Net exports equals current output minus domestic absorption (C^d + I^d + G) which is the total spending by domestic residents.

A. Will use a saving investment diagram similar to the closed economy.

Vertical Axis is now the world rate of interest

Horizontal axis is the level of desired national saving and desired national investment.

Find the equilibrium level of saving and investment in the national economy.

Assume that the individuals in the economy can borrow and lend at the world rate of interest.

The national economy faces a fixed world interest rate r^w.

If the world rate of interest is greater than the national equilibrium interest rate, there will be excess saving in the domestic economy. The difference between the level of domestic investment and saving at the world interest rate will equal Foreign lending.

If the world interest rate is below the national equilibrium real interest rate, there will be an excess of investment demand. The difference between the amount of domestic investment and domestic saving at the world rate of interest will equal foreign borrowing.

B. The Effects of Economic Shocks in a Small Open Economy.

1) A Temporary Adverse Supply Shock that lowers output. (Severe drought)

Starting with the equilibrium level of interest rates below the world rate.

Shifts the saving curve to the left Sd Since there is a decrease in current income people save less. The amount of foreign lending will decrease. (The current account surplus falls.)

2) An increase in the Expected Future Marginal Product of Capital

Starting with a country which has saving > investment at the world rate.

An increase in MPK^f will cause the amount of desired capital held by firms to increase.

Investment will shift to the right. Again the current account surplus falls ( the amount of foreign lending will decrease.)

3) What if the country stars out as with the investment greater than saving, example a developing country?

No countries are large enough that changes in their level of national saving or investment will affect the world interest rate.

A. The world interest rate is in equilibrium when international lending is equal to international borrowing.

1) Simple example two countries in the economy. The world interest rate will move to make desired foreign lending in one country equal to desired foreign borrowing in the other economy. (The current account surplus of one country will equal the current account deficit of the other country)

B. World interest rate changes when national levels of desired saving and investment change, causing a change in the countries desired level of foreign borrowing or lending.

A. What if an increase in the budget deficit reduces national saving? Then it will increase the current account deficit.

Example in small open economy.

The saving curve shifts left as shown above the current account surplus decreases (deficit increase)

B. The gov’t budget deficit and desired national saving revisited.

1) An increase in gov’t purchases, creates a budget deficit.

National Saving will decline

2) A deficit caused by a tax cut:

a) Desired saving will fall only if desired consumption increases

b) Under Ricardian Equivalence consumption does not change

C. The United States. And the Twin Deficits debate.