8.0 1111OPEN ECONOMY MACROECONOMICS.pptx

Macroeconomy handbook

1. 8.0 OPEN ECONOMY MACROECONOMICS

2. INTRODUCTION The  balance of trade  (or trade balance) is any gap between a nation’s dollar value of its exports, and it’s dollar worth of imports. Recall that if exports exceed imports, the economy is said to have a  trade surplus . If imports exceed exports, the economy is said to have a  trade deficit . If exports and imports are equal, then trade is balanced. But what happens when trade is out of balance and large trade surpluses or deficits exist? Germany, for example, has had substantial trade surpluses in recent decades. In contrast, the U.S. economy in recent decades has experienced large trade deficits. Between 2012 -2020, Kenya has only had deficits. Nearest surplus was in 1994. 1961-1969 (1967) surplus.

3. INTRODUCTION CONT…… A series of financial crises triggered by unbalanced trade can lead economies into deep recessions. Crises begin with large trade deficits. At some point, foreign investors become pessimistic about the economy and move their money to other countries. The economy then drops into deep recession, with  real GDP  often falling up to 10% or more in a single year. What are the connections between imbalances of trade in goods and services and the flows of international financial capital that set off these economic avalanches?

4. Measuring Trade Balances A few decades ago, it was common to track the solid or physical items that were transported by planes, trains, and trucks between countries as a way of measuring the balance of trade. This measurement is called the  merchandise trade balance . In most high-income economies, goods make up less than half of a country’s total production, while services compose more than half. The last two decades have seen a surge in international trade in services, powered by technological advances in telecommunications and computers. Most global trade still takes the form of goods rather than services, and the merchandise trade balance is still reported. Economists, however, rely on broader measures such as the balance of trade or the  current account balance  which includes other international flows of income and foreign aid.

5. Table 1: Components of Current Account Balance Value of Exports (money flowing in) Value of Imports (money flowing out) Balance Goods $410.0 $595.5 –$185.3 Services $180.4 $122.3 $58.1 Income receipts and payments $203.0 $152.4 $50.6 Unilateral transfers $27.3 $64.4 –$37.1 Current account balance $820.7 $934.4 –$113.7 Table 1. Components of the Current Account Balance

6. Components of the Current Account Balance Table 1  breaks down the four main components of the current account balance. The first line shows the merchandise trade balance; that is, exports and imports of goods. Because imports exceed exports, the trade balance in the final column is negative, showing a merchandise trade deficit. The second row of  Table 1  provides data on trade in services. Here, the economy is running a  surplus . The third component of the current account balance, is “ income payments ,” . It refers to money received by domestic financial investors on their foreign investments (money flowing into Kenya) and payments to foreign investors who had invested their funds here (money flowing out of Kenya). Money on foreign investment is included in the overall measure of trade, since, from an economic perspective, income is just as much an economic transaction as shipments of cars or wheat or oil: it is just trade that is happening in the financial capital market.

7. Components of the Current Account Balance Cont …. The final category of the current account balance is  unilateral transfers , which are payments made by government, private charities, or individuals in which money is sent abroad without any direct good or service being received. Economic or military assistance from Kenya government to other countries, spending abroad by charities, money sent overseas by individuals, all fall in this category. The current account balance treats these unilateral payments like imports, because they also involve a stream of payments leaving the country. In many DCs, its always negative. In 1991, however, when the US led an international coalition against Iraq in the Gulf War, many other nations made payments to the US to offset its war expenses. These payments were large enough that, in 1991, the overall U.S. balance on unilateral transfers was a positive $10 billion.

8. Example Known information: Unilateral transfers: $130 Exports in goods: $1,046 Exports in services: $509 Imports in goods: $1,562 Imports in services: $371 Income received by Kenyan investors on foreign stocks and bonds: $561 Income received by foreign investors on Kenyan assets: $472

9. Table 2: Work It Out feature Exports (in $ billions) Imports (in $ billions) Balance Goods  $1,046  $1,562  –$516 Services  $509  $371  $138 Income payments  $561  $472  $89 Unilateral transfers  – $130  –$130 Current account balance  $2,116  $2,535  –$419 Table 2: Calculating the Merchandise Balance and the Current Account Balance

10. Steps to Calculate Merchandise and Current Account Balance Step 1. Focus on goods and services first. Enter the dollar amount of exports of both goods and services under the Export column. Step 2. Enter imports of goods and services under the Import column. Step 3. Under the Export column and in the row for Income payments, enter the financial flows of money coming back to Kenya. Investors are earning this income from abroad. Step 4. Under the Import column and in the row for Income payments, enter the financial flows of money going out to foreign investors. Foreign investors are earning this money on Kenyan. assets, like stocks. Step 5. Unilateral transfers are money flowing out in the form of military aid, foreign aid, global charities, etc. Because the money leaves the country, it is entered under Imports and in the final column as well, as a negative. Step 6. Calculate the trade balance by subtracting imports from exports in both goods and services. Enter this in the final Balance column. This can be positive or negative. Step 7. Subtract the income payments flowing out of the country (under Imports) from the money coming back to Kenya (under Exports) and enter this amount under the Balance column. Step 8. Enter unilateral transfers as a negative amount under the Balance column. Step 9. The merchandise trade balance is the difference between exports of goods and imports of goods—the first number under Balance. Step 10. Now sum up your columns for Exports, Imports, and Balance. The final balance number is the current account balance.

11. Table 3: Completed Merchandise Balance and Current Account Balance Exports Imports Balance Goods $1,046 $1,562 –$516 Services $509 $371 $138 Income payments $561 $472 $89 Unilateral transfers – $130 –$130 Current account balance $2,116 $2,535 –$419

12. Trade Balances and Flows of Financial Capital Trade surpluses and deficits can be either good or bad, depending on circumstances. The challenge is to understand how the international flows of goods and services are connected with international flows of  financial capital . The intimate connection between trade balances and flows of financial capital can be illustrated in two ways: a parable of trade between Robinson Crusoe and Friday, and a circular flow diagram representing flows of trade and payments. A Two-Person Economy: Robinson Crusoe and Friday To understand how economists view trade deficits and surpluses, consider a parable based on the story of Robinson Crusoe. Crusoe, was shipwrecked on a desert island. After living alone for some time, he is joined by a second person, whom he names Friday. Think about the balance of trade in a two-person economy like that of Robinson and Friday. Robinson and Friday trade goods and services. Perhaps Robinson catches fish and trades them to Friday for coconuts. Or Friday weaves a hat and trades it to Robinson for help in carrying water. For a period of time, each individual trade is self-contained and complete. Because each trade is voluntary, both Robinson and Friday must feel that they are receiving fair value for what they are giving. As a result, each person’s exports are always equal to his imports, and trade is always in balance between the two. Neither person experiences either a trade deficit or a trade surplus.

13. Trade Balances and Flows of Financial Capital CONT… However, one day Robinson approaches Friday with a proposition. Robinson wants to dig ditches for an irrigation system for his garden, but he knows that if he starts this project, he will not have much time left to fish and gather coconuts to feed himself each day. He proposes that Friday supply him with a certain number of fish and coconuts for several months, and then after that time, he promises to repay Friday out of the extra produce that he will be able to grow in his irrigated garden. If Friday accepts this offer, then a trade imbalance comes into being. For several months, Friday will have a trade surplus: that is, he is exporting to Robinson more than he is importing. More precisely, he is giving Robinson fish and coconuts, and at least for the moment, he is receiving nothing in return. Conversely, Robinson will have a trade deficit, because he is importing more from Friday than he is exporting. This parable raises several useful issues in thinking about what a trade deficit and a trade surplus really mean in economic terms. The first issue raised by this story of Robinson and Friday is this: Is it better to have a trade surplus or a trade deficit? The answer, as in any voluntary market interaction, is that if both parties agree to the transaction, then they may both be better off. Over time, if Robinson’s irrigated garden is a success, it is certainly possible that both Robinson and Friday can benefit from this agreement. A second issue raised by the parable: What can go wrong? Robinson’s proposal to Friday introduces an element of uncertainty. Friday is, in effect, making a loan of fish and coconuts to Robinson, and Friday’s happiness with this arrangement will depend on whether that loan is repaid as planned, in full and on time. Perhaps Robinson spends several months loafing and never builds the irrigation system. Or perhaps Robinson has been too optimistic about how much he will be able to grow with the new irrigation system, which turns out not to be very productive. Perhaps, after building the irrigation system, Robinson decides that he does not want to repay Friday as much as previously agreed. Any of these developments will prompt a new round of negotiations between Friday and Robinson. Friday’s attitude toward these renegotiations is likely to be shaped by why the repayment failed. If Robinson worked very hard and the irrigation system just did not increase production as intended, Friday may have some sympathy. If Robinson loafed or if he just refuses to pay, Friday may become irritated.

14. Trade Balances and Flows of Financial Capital CONT… A third issue raised is that an intimate relationship exists between a trade deficit and international borrowing, and between a trade surplus and international lending . The size of Friday’s trade surplus is exactly how much he is lending to Robinson. The size of Robinson’s trade deficit is exactly how much he is borrowing from Friday. Indeed, to economists, a trade surplus literally means the same thing as an outflow of financial capital, and a trade deficit literally means the same thing as an inflow of financial capital. The story provides a good opportunity to consider the law of  comparative advantage . The following Work It Out feature steps you through calculating comparative advantage for the wheat and cloth traded between the United States and Great Britain in the 1800s.

15. TABLE 4: Calculating Comparative Advantage Wheat (In bushels) Cloth (in yards) Relative labor cost of wheat (Pw/Pc) Relative labor cost of cloth (Pc/Pw) United States 8 9 8/9 9/8 Britian 4 3 4/3 3/4 . US AND BRITAIN TRADING WHEAT AND CLOTH - VARYNG HOURS PER UNIT OF OUTPUT

16. Calculating Comparative Advantage Cont.. Step 1. Observe from  Table 4 that, in the US, it takes eight hours to supply a bushel of wheat and nine hours to supply a yard of cloth. In contrast, it takes four hours to supply a bushel of wheat and three hours to supply a yard of cloth in Britain. Step 2. Recognize the difference between absolute advantage and comparative advantage. Britain has an absolute advantage (lowest cost) in each good, since it takes a lower amount of labor to make each good in Britain. Britain also has a comparative advantage in the production of cloth (lower opportunity cost in cloth (3/4 versus 9/8)). US has a comparative advantage in wheat production (lower opportunity cost of 8/9 versus 4/3). Step 3. Determine the relative price of one good in terms of the other good. The price of wheat, in this example, is the amount of cloth you have to give up. To find this price, convert the hours per unit of wheat and cloth into units per hour. To do so, observe that in the US it takes eight hours to make a bushel of wheat, so 1/8 of a bushel of wheat can be made in an hour. It takes nine hours to make a yard of cloth in the US, so 1/9 of a yard of cloth can be made in an hour. If you divide the amount of cloth (1/9 of a yard) by the amount of wheat you give up (1/8 of a bushel) in an hour, you find the price (8/9) of one good (wheat) in terms of the other (cloth).

17. The Balance of Trade as the Balance of Payments The connection between trade balances and international flows of financial capital is so close that the balance of trade is sometimes described as the  balance of payments . Each category of the current account balance involves a corresponding flow of payments between a given country and the rest of the world economy. Figure 1  shows the flow of goods and services and payments between one country—the US in this example—and the rest of the world. The top line shows U.S. exports of goods and services, while the second line shows financial payments from purchasers in other countries back to the U.S. economy. The third line then shows U.S. imports of goods, services, and investment, and the fourth line shows payments from the home economy to the rest of the world. Flow of goods and services (lines one and three) show up in the current account, while flow of funds (lines two and four) are found in the financial account. The bottom four lines of Figure 1  show the flow of investment income. In the first of the bottom lines, we see investments made abroad with funds flowing from the home country to rest of the world. Investment income stemming from an investment abroad then runs in the other direction from the rest of the world to the home country. Similarly, we see on the bottom third line, an investment from rest of the world into the home country and  investment income (bottom fourth line) flowing from the home country to the rest of the world. The investment income (bottom lines two and four) are found in the current account, while investment to the rest of the world or into the home country (lines one and three) are found in the financial account. Unilateral transfers, the fourth item in the current account, are not shown in this figure.

18. Figure 1.  Flow of Investment Goods and Capital.

19. Flow of Investment Goods and Capital Each element of the current account balance involves a flow of financial payments between countries. The top line shows exports of goods and services leaving the home country; the second line shows the money received by the home country for those exports. The third line shows imports received by the home country; the fourth line shows the payments sent abroad by the home country in exchange for these imports. A current account deficit means that, the country is a net borrower from abroad. Conversely, a positive current account balance means a country is a net lender to the rest of the world. Just like the parable of Robinson and Friday, the lesson is that a trade surplus means an overall outflow of financial investment capital, as domestic investors put their funds abroad, while the deficit in the current account balance is exactly equal to the overall or net inflow of foreign investment capital from abroad. It is important to recognize that an inflow and outflow of foreign capital does not necessarily refer to a debt that governments owe to other governments, although government debt may be part of the picture. Instead, these international flows of financial capital refer to all of the ways in which private investors in one country may invest in another country—by buying real estate, companies, and financial investments like stocks and bonds.