Wednesday, April 23, 2008

Lecture 4 - Saving, Investment and Trade Balance in an Open Economy

Output in an Open Economy
Recall the national economy equation in an open economy (including net exports):
Y = C+I+G+NX

Y (output) = total expenditure on domestic goods and services
= Cd + Id + G d + Exports
where d denotes domestic consumption, investment or gov't purchases

= C-Cf+ I - If + G - Gf + EX
=C + I + G + EX - (Cf+If+Gf)
that last term is all the imports
= C + I + G + EX - IM
= C + I + G + NX

NX = EX-IM = net exports = trade balance

NX = Y - C - I - G
NX > 0 indicates a trade surplus
NX < 0 indicates a trade deficit
NX = 0 balanced trade

(ii) Y-C-G-I=NX
(Y-T-C) + (T-G) - I = NX
Sp + Sg - I = NX
S - I = NX

We run a trade surplus if NX > 0, which means S > I
We run a trade deficit if NX < 0, which means S < I

Savings, Investment and Trade Balance

S - I = Net foreign lending
= amount of money we lend abroad - amount of money foreigners lend to us
NX = Net exports = Trade balance
Thus, S-I=NX implies that international flow of capital and international flow of goods & services are two sides of the same coin

Trade deficit: NX < 0
Import more than export
Someone needs to pay for the gap
Pay by borrowing form abroad (S-I < 0)

When running a trade deficit, we finance the deficit by borrowing the equivalent amount from abroad, and vice versa.

The borrowing can take many different forms: straight loans, gov't bonds, corporate bonds, etc. There was a brief discussion of foreign investment limits, particularly real estate and the Chicago Skyway leased to Macquarie.

Twin Deficits
(see Mankiw page 129)

Gov't deficit and trade deficit.
Consider the savings-investment (S-I) model in a small open economy, under free capital mobility.

(i) Ybar = AxF(Kbar, Lbar)
(ii) S - I(r) = NX (investment is a fxn of the interest rate)
(iii) r = rworld
since we're assuming it is a small open economy the domestic interest rate (and banana prices) will be dictated by the world interest rate (and worldwide price of bananas).

If the equilibrium interest rate is the same as the world interest rate, there will be a trade balance. If the world interest rate is higher, there will be a trade surplus (NX>0). If the world interest rate is lower, there will be a trade deficit (NX<0).

(see packet page 15)
Assume that initially the economy is at equilibrium and that the govt has a balanced budget. Then assume that the govt pursues fiscal expansion (G up or T down). Then the saving (S) curve will shift to the left. But the interest rate can't go up since it's dictated by the world interest rate!
This will create a gap between domestic savings and investment. We will end up with NX < 0 - a trade deficit!

(see packet page 17)
In the 60s and 70s, we had mostly a trade surplus, and the federal budget deficit was kept to 3% or less. In the mid 80s, the trade deficit jumped up to 2-3%. At the same time, it was matched by an increase in the federal budget deficit of about 2-3%. Decline in budget deficit in the late 80s was matched by a decline in the trade deficit.

But in the late 90s when Clinton cut the federal deficit and actually created a surplus, it was not matched by a similar movement of the trade deficit. Rather, the trade deficit continued to increase.

Explanation of the model break down
Why did the twin deficit mechanism break down in the 1990s? Because the model assumes "other things being equal". Private savings, private investment were factors.
(i) the twin deficit mechanism tells us that if Sg goes up (govt budget deficit reduction), then S overall increases and NX increases. But that didn't happen!
(ii) Instead, Sp went way down, i.e. household savings plummeted. I (investment) increased due to the IT investment boom. As a result, S overall went down, I increased. Therefore, S-I=NX went down and we saw increasing trade deficits.

Why did private savings go down? Because of the stock market boom and low interest rates.

(See Whatever Happened to the "Twin Deficits" - Chapter 2 of Is the US Trade Deficit Sustainable by Catherine L Mann)

Balance of Payments System (BOP)

The balance of payments is a measurement of all transactions between domestic and foreign residents over a specified period of time.

BOP consists of subaccounts:
current account: accounts for flows of goods and services (imports and exports) sometimes called "above the line items"
capital account: accounts for flows of financial assets (financial capital)

(See BEA, Survey of Current Business, March 2008 data for 2007)

Current Account
2007 US trade deficit was -708 billion. Current account deficit was -738 billion.
Current account deficit = Trade balance+Net Foreign Receipts+Unilateral current transfers (international charity)

In the US, current account and trade deficit are used interchangeably. But in some countries like Czech Republic and Ireland (the "Celtic Tiger"), they have a trade surplus, but because of the Net Foreign Receipts they end up with a current account deficit.

Capital Account

Increase in US holdings of foreign assets = 1206 B
Increase in Foreign holdings of US assets = 1863 B
Net = 657 B

There's a 81B$ statistical discrepancy between the current account balance and the capital account balance. This is due to various different measurement errors that go into these enormous calculations which are really estimates, not exact accountings. It may also be explained by the underground economy. The statistical discrepancy is growing from year to year.

Exchange Rates

When the capital account measures the foreign holdings of US assets, the transactions are in dollars. Fine. US holdings in foreign assets, the transactions are in foreign currencies and must be converted to dollars using the exchange rates. Dollar depreciation impacts this accounting. There is a question as to how long the foreign investors will continue to finance our trade deficit with their investments since they often lose money on the transactions due to the falling dollar.

Consumption and the Balance of Trade

Trade deficits could be worrisome, if C is the main cause.

(i) In a closed economy, if C goes up, S goes down. Since S=I, I goes down, leading to K (capital stock) going down, which will cause C to go down in the future.

(ii) In an open economy, if C goes up, S goes down. Since S-I=NX, NX will go down. Then we will pile up foreign liabilities which will need to be paid back eventually.

Australia and Canada have run a big trade deficit for many years and financed it through foreign investment (not loans). In other countries, like Argentina, the investors have panicked and pulled out. 8% of GDP for a trade deficit is the threshold beyond which investors consider it a big risk to continue investing.

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