ECON 201 Lecture 23: International Macroeconomics Fall 2024 PDF

Lecture 23: International Macroeconomics Fall 2024 Jonas Jin November 20, 2024 Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 1 / 43 Outl...

Lecture 23: International Macroeconomics Fall 2024 Jonas Jin November 20, 2024 Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 1 / 43 Outline 1 Introduction 2 Gains from Trade 3 International Flows of Goods and Capital 4 Trade Deficit Implications 5 Exchange Rates 6 Government Policies and Trade Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 2 / 43 Introduction Thus far, we have assumed a closed economy which does not interact with other nations However, trade is an (increasingly) important part of the domestic and global economy! Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 3 / 43 Trade Volume International trade volume has increased 45x since 1950 Largely due to improvements in: Transportation Telecommunication Technology Trade policies (GATT, NAFTA, USMCA, etc.) Source: World Trade Organization All have lowered the costs of trade substantially Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 4 / 43 Trade as Share of GDP Likewise, trade has comprised an increasing share of GDP: Source: Our World in Data Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 5 / 43 Trade in the News Trade has also been a hot-button topic recently... Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 6 / 43 Topics in Trade We now introduce the concept of an open economy, or an economy that trades in world markets, covering topics such as: Imports, exports, and trade balance International flow of capital Exchange rates Tariffs and quotas Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 7 / 43 Why Trade? Recall the production possibilities frontier from the beginning of the quarter X and Y axes represent the maximum goods the economy could produce by itself, without trade Assuming a closed economy without trade (“autarky”), the production possibilities frontier is the same as the “consumption possibilities frontier” Non-Avocados Avocados For simplicity, the production possibilities frontier here is linear, meaning the opportunity cost is constant; the general logic does not change Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 8 / 43 Comparative Advantage A country has a comparative advantage if they are able to produce a good with a lower opportunity cost; which country has a comparative advantage in which good? Country Avocados Non-Avocados USA 250 500 Mexico 200 200 USA: 500 Opportunity cost of producing 1 avocado: 250 = 2 non-avocados per avocado 250 Opportunity cost of producing 1 non-avocado: 500 =.5 avocados per non-avocado Mexico: 200 Opportunity cost of producing 1 avocado: 200 = 1 non-avocado per avocado 200 Opportunity cost of producing 1 non-avocado: 200 = 1 avocado per non-avocado Which country has a lower opportunity cost of producing avocados? Mexico (1 < 2) Which country has a lower opportunity cost of producing non-avocados? USA (.5 < 1) Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 9 / 43 Specialization and Gains from Trade Here, we have that the opportunity cost of 1 avocado is: USA: 2 non-avocados Mexico: 1 non-avocado Mexico has the comparative advantage in avocados, so: → Mexico should specialize in avocados → USA should specialize in non-avocados So Mexico sells avocados for non-avocados to USA. Suppose the trade price lies between 1 and 2 non-avocados per avocado. USA agrees to trade because they normally must give up 2 non-avocados for an avocado Mexico agrees to trade because they receive more than 1 non-avocado per avocado You demonstrated in the first problem set that both countries can achieve a point outside their consumption possibilities in autarky. The full numerical example (with new consumption possibilities frontiers) is in the Appendix. Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 10 / 43 International Flow of Goods Terminology: Exports: goods and services produced domestically and sold abroad Imports: goods and services produced abroad and sold domestically Net exports (NX ) (or “trade balance”) = exports - imports ▶ Net exports > 0: trade surplus ▶ Net exports < 0: trade deficit Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 11 / 43 International Flow of Capital/Financial Resources In addition to international markets for goods and services, we also have world markets for financial resources: stocks, bonds, and other interest-bearing assets. Net capital outflow (NCO) = purchase of foreign assets by domestic residents - purchase of domestic assets by foreigners Outflow = Purchase of foreign assets by domestic residents (sending assets out) ▶ American investor buying Japanese bond Inflow = Purchase of domestic assets by foreigners = inflow (bringing assets in) ▶ Japanese investor buying American bond NCO > ( 0: We sell more goods to foreigners than we buy from them We either hold this foreign currency or use it to buy foreign assets If NX < 0: We buy more goods from foreigners than we sell to them They either hold our currency or use it to buy domestic assets → Either way, NCO = NX ! Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 14 / 43 Savings and Investment in an Open Economy Recall in a closed economy, we had Y = C + I + G , so: S = Y − C − G = I (or S = (Y − T − C ) + (T − G ) = I ) | {z } | {z } Private saving Public saving or national saving S = domestic investment I. In an open economy, this is no longer the case! Now, Y = C + I + G + NX , so: S = Y − C − G = I + NX = I + NCO That is, national savings = domestic investment + net capital outflow In words, every dollar saved is either used to purchase domestic capital (investment) or foreign capital (net capital outflow) If domestic investment is less than national saving, remainder used to purchase assets abroad Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 15 / 43 Alternative Interpretation S = Y − C − G = I + NX = I + NCO That is, national savings = domestic investment + net capital outflow If you prefer, you can think about it another way (which I personally prefer). Define Net Capital Inflow (NCI ) as the opposite of NCO: NCI = −NCO. Then: I = S − NCO = S + NCI In words: our total investment is equal to domestic savings plus “net foreign investment” Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 16 / 43 National Saving and Domestic Investment Domestic investment has exceeded national saving for many years now → Driven by reduction in net capital outflow → On net, foreign countries “investing” in us NCO < 0 =⇒ NX < 0, so this also means we are running a trade deficit Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 17 / 43 Trade Deficit Implications S = I + NX = I + NCO or NX = NCO = S − I Is a trade deficit (NX < 0) a bad thing? Not necessarily! Depends on what caused it, as a trade deficit could be caused by: A drop in national saving (S ↓), where S = (Y − T − C ) + (T − G ) An increase in foreign inflow (NCO ↓) An increase in domestic investment (I ↑) Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 18 / 43 Trade Deficit Implications A few episodes: 1991 - 2000: Technological boom drove higher foreign and domestic investment: good! 2000 - 2009: 2001 and 2007 recessions increased budget deficits (decreased T − G ) and decreased investment: bad 2010 - 2019: Reversed course during recovery from 2000s: good! Takeaway: trade deficits are not issues in themselves, but can be symptomatic of issues Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 19 / 43 Exchange Rates The (nominal) exchange rate is the rate at which one can trade currency of one country for currency of another. For example: US(-to-)CAD exchange rate being 1.4 means that we can exchange $1 USD for $1.40 CAD (or $1.40 CAD for $1 USD) A currency appreciates (depreciates) if it becomes more (less) valuable in terms of the foreign currency it can buy ▶ If the US-CAD exchange rate becomes 1.5, USD has appreciated (or becomes “stronger”) and CAD has depreciated (or becomes “weaker”) How do we determine exchange rates? At least in the short run, just like everything else: supply and demand! Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 20 / 43 Currency Exchange Rates Currency markets involve two currencies, so we simultaneously look at two markets. Let e = exchange rate of USD and Japanese yen: each $1 buys e yen (so 1 yen buys 1 e USD). Market for USD Market for Yen P P S S (Yen per USD) (USD per yen) e 1 e D D Q Q The textbook has vertical supply curves, but all of the analysis is the same Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 21 / 43 Supply and Demand of Currency What affects supply and demand on the currency exchange market? Desire to purchase goods and services or assets (e.g. bonds) from a country When we buy goods or services (in the form of exports) or assets from Japan, prices are expressed in yen We don’t buy Japanese products with USD! First exchange USD for yen on currency market Thus, if demand for Japanese exports or assets increases: Demand for Japanese yen increases Supply of USD (to buy the yen) increases Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 22 / 43 Currency Exchange Markets Suppose demand for Japanese products increases; we shift curves in both markets simultaneously: Market for USD Market for Yen P P S1 S (Yen per USD) (USD per yen) S2 1 e2 1 e1 e1 e2 D2 D D1 Q Q In order to buy more yen, Americans must supply more USD: S1 → S2 in USD market, decreasing the value of USD from e1 to e2 yen per dollar 1 This increases demand for yen: D1 → D2 in yen market, increasing value of yen from e1 to 1 e dollars per yen. 2 Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 23 / 43 Real Interest Rates and Currency Demand One of the main factors affecting currency demand is the real interest rate: Higher real interest rate on US bonds increases return to US bonds, which attracts investors Bonds must be bought in USD → increases demand for USD Notice: when real interest rate increases, dollars to euros exchange rate decreases (dollar becomes stronger) Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 24 / 43 “Strong Dollar” A “strong currency” means that the currency is valuable (or expensive). What does a “strong dollar” mean for the US? An increase in the value of a dollar causes: US exports to be more expensive, and imports from other countries to be cheaper Americans to more easily afford foreign travel, while tourism in the US is more expensive As the dominant global currency, the dollar is generally quite strong and stable (relative to other currencies). Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 25 / 43 Currency Pegging A pegged currency is a currency that is kept at a fixed exchange rate, as opposed to a “floating” exchange rate. A government may want to keep its currency pegged for a number of reasons: Facilitation of trade: easier to exchange currencies and thus goods without having to worry about fluctuations in currency value Control over relative import and export prices: exchange rate determines how expensive exports and imports are Promote currency stability (e.g. in response to fluctuations in inflation) Note: countries do not achieve the peg simply by announcing the exchange rate! They must manipulate the currency market (next few slides) Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 26 / 43 Exports and the Currency Peg in China China’s growth was (and still is) very much export-driven: This number hovers around 10-12% in the US Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 27 / 43 Export-Driven Growth and the Currency Peg in China To keep exports cheap, China kept its currency undervalued at 8 RMB:1 USD from 1997 - 2005. Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 28 / 43 How Does a Currency Peg Work? How did China achieve this undervaluation? By manipulating supply of its currency. Market for RMB P S1 (USD per RMB) S2 e1 1 8 D Q Any time the exchange rate increased above 1/8 (e.g. e1 ), China’s government would supply more RMB to purchase USD (often called defending the peg). Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 29 / 43 Currency Peg as a Stabilizing Mechanism The US dollar is widely considered the most stable currency, so it is often the target of a currency peg Often applies to countries with unstable currency (e.g. high inflation), so may require peg to overvalue the currency Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 30 / 43 Difficulties with the Peg and Overvaluation China was easily able to keep its peg because it could simply print RMB (raise supply) to keep domestic currency undervalued Much more difficult to keep domestic currency overvalued: must stimulate demand for the domestic currency, which requires large amounts of the target currency Must be able to manipulate supply of a foreign currency to stimulate demand for the domestic currency Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 31 / 43 Difficulties with the Peg and Overvaluation 1 1 For example, suppose Japan wanted to keep the yen pegged at e2 > e1 : Market for USD Market for Yen P P S1 S (Yen per USD) (USD per yen) S2 1 e2 1 e1 e1 e2 D2 D D1 Q Q Japan can’t print USD! So it can’t generate S1 → S2 without holding reserves of USD (through bonds, assets, etc.) Becomes very hard to continue to defend the peg over time Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 32 / 43 Alternative to a Currency Peg: Switching Currencies Can a country switch currencies entirely (e.g. to the US Dollar)? Yes! Countries can and do switch to the US dollar for many reasons (e.g. instability or hyperinflation) Requires the country to own/buy USD on the currency market May fully adopt USD or keep own currency in addition to it Typically smaller countries, so it doesn’t substantially affect US currency market Issue: lose control of monetary policy Countries using the dollar are at the mercy of US monetary policy Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 33 / 43 A Unique Solution to Hyperinflation... Massive inflation in Venezuela has left their currency borderline worthless, so some came up with creative solutions to earn money... Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 34 / 43 Long-Run Exchange Rate Determination: Purchasing Power Parity (PPP) Supply and demand in currency markets help determine the price in the short run, but they converge to Purchasing Power Parity (PPP) in the long run. Purchasing Power Parity equates prices of the same good in different countries. Suppose an identical bottle of wine costs $12 USD in the US and 10 euros in France → In the long run, $12 USD should buy 10 euros in France → Exchange rate should converge to 1.2 USD/1 euro Particularly holds for goods that can be traded. Assume no trade costs: Suppose exchange rate was 1.3 USD/1 euro while prices remained $12 and 10 euros → You could buy the wine in the US for $12, sell it in France for 10 euros, then exchange 10 euros for $13. Rinse and repeat. This is called an arbitrage (free money!), and economists don’t like them Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 35 / 43 PPP and the Big Mac Index Tongue-in-cheek way of measuring the PPP exchange rate: the Big Mac Index! Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 36 / 43 Sharing Currency: The Euro The euro is the common currency used by many (but not all) European countries Monetary policy for the euro run by the European Central Bank (ECB), similarly to how the Fed controls monetary policy for the US Advantages of shared currency: Easier to trade across countries “Reduce nationalistic feelings and appreciate shared history” Disadvantage of shared currency: Shared monetary policy: cannot use own national monetary policy to respond to individual issues (e.g. Greece) Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 37 / 43 Tariffs and Quotas There are two types of trade policies: Tariff: tax on imported goods Import Quota: limit on quantity of a good produced abroad that can be sold domestically Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 38 / 43 Recall: Lecture 7 on Trade and Tariffs We saw in Lecture 7 how trade and tariffs impact consumer, producer, and total surplus. Main takeaways: Relative to no trade, allowing free trade increases total surplus Relative to the free trade outcome, introducing a tariff reduces total surplus (deadweight loss) The slides are re-posted in the Appendix. Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 39 / 43 Tariffs/Quotas and Effect on Currency Tariffs and quotas have similar effects on currency (and generally). Consider a US tariff on Chinese steel: Implementing a tariff or quota decreases demand for Chinese goods → Decreases demand for RMB → Causes USD to appreciate relative to RMB → US exports now more expensive, so exports decrease In particular, the decrease in exports will hit the non-steel industries harder! US agriculture not protected/benefited by tariffs, but now export less due to more expensive USD Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 40 / 43 Tariffs as a Source of Government Revenue Tariffs raise government revenue as a source of taxes: Tariffs are taxes levied on foreign producers... But (from the beginning of the quarter) we know how those make their way to us! Logic still hasn’t changed: burden of tax shared between buyer and seller Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 41 / 43 A study of the tariffs in 2018 found that: Trump tariffs brought in $39B in tariff revenue Boosted income by $23B due to reduced foreign competition But...US consumers paid $69B in higher prices! And 69 > 39 + 23 Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 42 / 43 Tariffs in the US The Tax Foundation projects the effect of Trump’s tariffs. A 20% tariff in 2025 will: Raise $233B in revenue Incur $2,045 in expenses per household * 127 million households = $259B total increase in household expenses So basically...inflation Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 43 / 43 Gains from Trade: Numerical Example We will use a simple example to show that both countries gain from trade by specializing in their comparative advantage. Suppose the USA and Mexico are looking to trade avocados and non-avocados. The table below shows the amount of units of each that the countries could produce if they were to only produce that good for the year. Country Avocados Non-Avocados USA 250 500 Mexico 200 200 For example, USA could produce either 400 units of avocados or 200 units of non-avocados, or anywhere along the line representing that tradeoff (see next slide). We say that the USA has an absolute advantage in both avocados and non-avocados: it can produce more of both Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 1 / 10 Autarky Country Avocados Non-Avocados USA 250 500 Mexico 200 200 Consider the autarky (no trade) case: each country can produce/consume any point along its line Non-Avocados Non-Avocados 500 500 400 400 300 300 200 200 100 100 Avocados Avocados 100 200 300 400 500 100 200 300 400 500 USA Mexico Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 2 / 10 Comparative Advantage A country has a comparative advantage if they are able to produce a good with a lower opportunity cost; which country has a comparative advantage in which good? Country Avocados Non-Avocados USA 250 500 Mexico 200 200 USA: 500 Opportunity cost of producing 1 avocado: 250 = 2 non-avocados per avocado 250 Opportunity cost of producing 1 non-avocado: 500 =.5 avocados per non-avocado Mexico: 200 Opportunity cost of producing 1 avocado: 200 = 1 non-avocado per avocado 200 Opportunity cost of producing 1 non-avocado: 200 = 1 avocado per non-avocado Which country has a lower opportunity cost of producing avocados? Mexico (1 < 2) Which country has a lower opportunity cost of producing non-avocados? USA (.5 < 1) Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 3 / 10 Specialization Country USA Avocados 250 Non-Avocados 500 Mexico 200 200 Let’s have each country specialize in its comparative advantage: the US produces 500 non-avocados, and Mexico produces 200 avocados 2 Let the trade price be 1.5 non-avocados per avocado (or 3 avocados per non-avocado). Do both countries agree to trade? USA: opportunity cost in autarky is 2 non-avocados per avocado, and 1.5 non-avocados is cheaper → agree to trade 2 Mexico: opportunity cost in autarky is 1 avocado per non-avocado, and 3 avocados is cheaper → agree to trade As long as the trade price falls between the opportunity costs, both countries agree to trade! What happens to consumption possibilities for each country? Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 4 / 10 Consumption Possibilities with Trade (Price = 1.5 Non-Avocados/Avocado) Non-Avocados Non-Avocados 500 Autarky 500 Autarky Free Trade Free Trade 400 400 300 300 At (200,200), Mexico 200 200 runs out of avocados* 100 100 Avocados Avocados 100 200 300 400 500 100 200 300 400 500 USA can trade up to 300 non-avocados for up Mexico can trade up to 200 avocados for up to to 200 avocados from Mexico, then faces the 300 non-avocados same opportunity cost (2:1) as in autarky* Consumption possibilities have expanded for both countries! *Not realistic, but just for this two-country example Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 5 / 10 Isoland: A World Without Trade Consider the textile market in a country without trade called Isoland: Just your standard supply and demand graph Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 6 / 10 World Price and Comparative Advantage To see how trade affects Isoland, compare the current world price for textiles with the price in Isoland: If world price > domestic price, Isoland has a comparative advantage and should export at the world price If world price < domestic price, the world has a comparative advantage, and Isoland should import at the world price Notice in both cases, we now operate at the world price: this is because we consider the domestic country’s market to be small relative to the world market Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 7 / 10 Gains from Trade: Isoland as an Exporter What’s the gain for Isoland if the world price is above the domestic price (exporting)? Domestic producers can sell more at world price =⇒ producer surplus ↑ B + D Domestic consumers demand less at world price =⇒ consumer surplus ↓ D Total surplus increases by (B + D) − D = B Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 8 / 10 Gains from Trade: Importers What’s the gain for Isoland if the world price is below the domestic price (importing)? Domestic producers sell less at world price =⇒ producer surplus ↓ B Domestic consumers demand more at world price =⇒ consumer surplus ↑B +D Total surplus increases by (B + D) − B = D Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 9 / 10 Tariffs A tariff is a tax on imports: increases the price of imports. Relative to free trade, Domestic consumers face higher price =⇒ consumer surplus ↓C +D +E +F Domestic producers have an easier time competing =⇒ producer surplus ↑ C Government collects the per-unit tariff on each unit imported (E ) Total surplus ↓ D + F Jonas Jin (Northwestern University) ECON 201 Lecture 23 November 20, 2024 10 / 10