INTERNATIONAL ECONOMICS

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Francisco L. Rivera-Batiz

BAU International University

Section 6. The National Income Accounts, Conclusion

March 28, 2018

Assignment #3 will be distributed today.

It is due before class next week.

Hard copy only please!

We also need to make up the class we missed last week.

So we will extend the class for 15 minutes each day, beginning next week, so that we finish at 9:15 PM instead of 9:00 PM.

Readings for this section:

Rivera-Batiz and Rivera-Batiz, International Finance and Open Economy Macroeconomics, chapter 11.

Andrea Pescatori, Damiano Sandri and John Simon, “No Magic Threshold,” Finance & Development, June 2014, 39-42.

Thomas Herndon, Michael Ash and Robert Pollin, “Does High Public Debt Consistently Stifle Economic Growth?: A Critique of Reinhart and Rogoff,” Working Paper, Department of Economics, University of Massachusetts at Amherst, April 2013.

Dennis Tao Yang, “Aggregate Savings and External Imbalances in China,” Journal of Economic Perspectives, Vol. 26, No. 4, Fall 2012, 125-146.

Carmen M. Reinhart and Kenneth S. Rogoff. 2010. "Growth in a Time of Debt" American Economic Review, Vol. 100, No. 2, May 2010, 573-577.

A previous section examined the concept of a current account balance deficit –or trade deficit-- from the point of view of the balance of payments accounts.

In this section, as discussed last time, we adopted a different point of view on the U.S. current account balance deficit.

We focused on the national income and product accounts, which describe the various production and spending outcomes of an economy over a certain period of time (say, a year).

As we have discussed in the last class, current account balance deficits represent an excess of the imports and goods and services over exports and goods and services.

This excess of purchases of imports from foreign residents over sales of exports to foreigners must be paid-for or financed.

So, current account balance deficits, if they accumulate over time, are either financed from the country’s official foreign exchange reserves (cash) or by borrowing, that is, by accumulating debt.

Neither of these is a good choice.

So, as we saw in the last class, the U.S. has a substantial, persistent current account deficit.

Let me refresh your memory.

The U.S. Current Account Balance Deficit, 1991-2016

_______________________________________________________

Year CAB/GNP

________________________________________________________

1991 0.0

1999 -2.5%

-3.7%

-2.0%

2016 -1.7%

________________________________________________________

Source: National Income and Product Accounts of the US, 2017.

Note: The CAB (current account balance) in this table excludes unilateral transfers.

This current account balancer deficits corresponds to a trade balance deficit and it is the basis for the policies President Trump has been engaging lately.

He argues the current account balance and trade deficit of the United States is because unfair trade practices of other countries.

This is not correct.

But this is not the problem just of the United States.

Many other countries also have significant and systematic current account balance (CAB) deficits.

Which country has CAB deficits, a country important for BAU?

TURKEY: CAB/GDP, expressed as a %

In the case of the United States, the current account deficits have been financed by borrowing.

But excess borrowing is generally to be avoided, even in the U.S.

So, what are some possible ways through which the U.S. could reduce its current account balance and trade deficits

According to the national income accounts perspective, a current account balance deficit means that a country is spending too much (consuming too much) and this is what generates the imports that causes the trade deficits.

There are two sources of spending in a country: the private sector and the government.

Form this perspective, what are the solutions for the trade deficit in the U.S.?

(1) Reduce budget deficits. The twin deficits disorder syndrome means that, holding other things constant, a reduction of the U.S. budget deficit will result in a reduction of the current account balance deficit, foreign borrowing, etc.

(2) Provide incentives for private savings. If private savings were to increase, this would also act to reduce the current account balance deficit, with a resulting decline of borrowing from the rest of the world.

In the 1990s, the US economy increased both its savings and investment.

And the increased investments did pay off substantially as they were in a number of areas (information sector, electronics, biotechnology, construction, infrastructure) that increased American productivity and were associated with strong economic growth.

(3) Promote supply-side and market-creating policies that increase U.S. production through technical change, innovation, and worldwide economic expansion. These policies will increase income while at the same time generating export niches for the American economy. Seeking closer economic ties and ventures with East Asia (including China), Africa and other parts of the world may be part of such a strategy.

These constitute more sustainable policies than seeking to switch exports from China or other countries to the U.S. through exchange rate or trade policies.

INTERNATIONAL ECONOMICS

Francisco L. Rivera-Batiz

BAU International University

Section 7

The Effects of Macroeconomic Policies

In an Open Economy

March 28,2018

The basic reference for this discussion is Rivera-Batiz and Rivera-Batiz, chapter 13.

Please check out also the other readings:

Nouriel Roubini, “America’s Bad Border Tax,” Project Syndicate, March 3, 2017.

The Economist, “Big Currency Devaluations are Not Boosting Exports as Much as they Used to,” The Economist Print Edition, January 9, 2016.

International Monetary Fund, “Exchange Rates still Matter for Trade,” IMF Survey, World Economic Outlook Analysis, September 2015.

Jose Antonio Ocampo, “The Federal Reserve and the Currency Wars,” Project Syndicate, October 20, 2012.

Martin Feldstein, “Resolving the Global Imbalance: The Dollar and the U.S. Savings Rate,” Journal of Economic Perspectives, Vol. 22, No. 3, summer 2008,113-125.

Christine Ebrahim-Zadeh, “Dutch Disease: Too Much Wealth Managed Unwisely,” Finance and Development, March 2003.

In order to introduce our next topic today –macroeconomic analysis-- let me first talk to you about a paradox in economics.

What we are going to try to do today –among other things– is to explain this paradox.

It shows very well how macroeconomic analysis can explain what, at first glance, appears unexplainable.

There is a perception that countries without natural resources have a much more difficult growth experience than those with natural resources.

That the best that can happen to the citizens of a country is to have the discovery of oil, minerals or other natural resources.

Indeed, for most people, the discovery of valuable natural resources in an economy is a matter for celebration.

But the reality is very different.

As we will see, the evidence shows that resource-rich countries do not grow faster than other countries and may actually grow at a slower rate.

A simple look at the richest countries in the world does not find many natural-resource rich countries.

Suppose, for example, that we divide the endowment of natural resources (say, barrels of crude oil reserves) by the population in a country.

Which country has the highest value?

Do Rich Countries Have Greater Crude Oil Reserves?

________________________________________________________________

País GDP Crude oil reserves,

per-capita(2012) thousand barrels (2012) per person

_____________________________________________________________

Singapore $51,709 0.0

Kuwait 51,497 101,500.0

United States 49,965 26,800.0

Japan 46,720 0.0

Finland 46,178 0.0

Austria 47,226 0.0

Belgium 43,412 0.0

United Arab Emirates 39,057 136,700.0

Saudi Arabia 25,136 265,400.0

South Korea 22,590 0.0

Russia 14,037 74,200.0

Venezuela 12,728 296,500.0

Angola 5,484 13,500.0

Nigeria 1,555 37,000.0

_________________________________________________________________

Sources: World Bank, US Department of Energy, 2014.

Consider the case of Nigeria, one of the largest oil exporters in the world today.

Oil reserves were discovered in Nigeria in 1965.

The sum of oil revenues over the period of 1965-2000 was equal to about $500 billion (in today’s prices).

Did Nigeria become richer as a result of its natural resources?

Nigeria’s Economic Development Experience

______________________________________________

1970 2000

______________________________________________

GDP Per-Capita $1,113 $1,084

(PPP-inflation-

adjusted)

Poverty rate 36% 70%

People living 19 million 90 million

Under poverty

______________________________________________

But, of course, this is just one case.

Can we draw a similar conclusion from an analysis of other countries, using

statistical analysis, such as linear regression?

In the 1990s,

Jeffrey Sachs,

then at Harvard

now at Columbia UNiversity,

examined the issue

empirically and

found no positive

relationship between

a country’s natural

resources and greater

economic growth.

The reference is:

J. Sachs and A. Warner, “Natural Resource Abundance and Economic Growth,” NBER Working Paper, December 1995.

Growth of GDP Per-Capita and Natural Resource Exports

Source: Jeffrey Frankel, Resource Abundance: Pitfalls and Prescriptions,

Harvard University (2013).

The fact that most natural-resource-rich countries appear to be growing slower than other economies has led some to refer to the presence of a “Natural Resource Curse.”

What explains the negative empirical connection between endowments of natural resources and growth?

One common hypothesis is that the presence of large rents (profits) connected to the natural resources industry leads to corruption and poor public sector governance that destroy the rest of the economy.

This is the point made by the Spanish economist

Xavier Sala-i-Martin, and his co-author, Arvind Subramanian,

In their paper: “Addressing the Natural Resource Curse:

An Illustration from Nigeria.”

“Stunted institutional development –including corruption, weak governance, rent-seeking, plunder, etc.– is a problem intrinsic to most countries that own certain natural resources, such as oil or minerals.”

Sala-i-Martin and Subramanian, IMF Working Paper.

It is a problem that is

not limited to Nigeria

but affects many

countries that have

natural resources.

The human behavior

underlying the discovery

of natural resources

serves as the basis for the

movie The Treasure

of Sierra Madre.

But although this explanation helps in explaining some specific cases, there must be other causes at work in explaining why the exploitation of natural resources has failed to lift standards of living in so many countries.

For example, the Netherlands discovered the presence of rich natural gas deposits a few decades ago.

They have excellent governance in their country, yet they also had difficulties experiencing growth when they started exploiting natural gas.

In fact, their situation was documented in an article by the magazine The Economist entitled: The Dutch Disease.

This is how this paradoxical situation has become known in the economics literature.

We will try to provide an explanation.

The analytical framework I am going to talk about today is inherited from the work of John Maynard Keynes, published in his 1936 masterpiece, The General Theory of Employment, Interest and Money.

It was later extended to better incorporate international issues by two economists Robert Mundell (a Columbia University economist) and Marcus Fleming (a Canadian economist working at the IMF at the time).

It is now known as the Mundell-Fleming model.

The Mundell-Fleming framework focuses on how international forces affect the impact of government policies or other economic changes in an economy.

It argues that the effects of government policies and other economic changes vary enormously when you consider their international implications.

Let us consider monetary policy.

We already talked about the difficulties encountered by countries under fixed exchange rates in managing monetary policy.

So, let us consider the effects of monetary policy under flexible exchange rates.

Suppose the Federal Reserve decides the expand the monetary base, and therefore the money supply in the United States.

How does the increased money supply affect the economy?

What is its most immediate effect?

An increase of the money supply increases the liquidity available in the economy and the financial system and tends to lower interest rates.

Banks tend to have lots of money to lend and because of this they offer lower interest rates to their customers.

The lower interest rates tend to raise private sector investment and this raises, output, income and employment. Remember that, from the national income accounts:

YN = C + I + G + CAB

Where YN is GNP, C is private consumption, I is private investment, G is government spending and CAB is the current account balance.

So, domestically, the expansionary monetary policy lowers interest rates, raises investment and leads to increased employment and output.

But, there is an additional impact of expansionary monetary policy.

This impact occurs through the international effects of monetary policy.

Remember again, that, from the national income accounts:

YN = C + I + G + CAB

The international effects of monetary policy enter through its impact on CAB, the current account balance.

To examine, how monetary policy affects the current account balance, let us ask first: what impact do lower U.S. interest rates have on the value of the dollar?

To think about this problem, first ask what effect would lower interest rates have on the flow of capital to the United States.

Would it increase or decrease?

If interest rates in the rest of the world are constant, then lower U.S. interest rates will lead to capital outflows, as investors will seek higher returns in the rest of the world.

But what would capital outflows do to the value of the dollar?

In order to purchase foreign assets, U.S. residents would need to buy foreign currencies.

So, the demand for foreign currencies rises and the supply of dollars (to buy the foreign currencies) would rise in foreign exchange markets.

But what happens when there is an increase in the supply of dollars for sale in foreign exchange markets?

There is a reduction in the price of a dollar in terms of foreign currencies, or what is the same, there is a depreciation in the value of the dollar.

But what would a depreciation of the dollar do to U.S. exports and imports and, therefore, to the current account balance?

It is not as simple as it seems.

Let me remind you that the current account balance is equal to the balance of exports and imports of goods and services plus net factor income from abroad plus net unilateral transfers.

But in the case of the U.S., the current account balance is determined essentially by the net balance of exports, X, and imports of goods, M, so that ignoring everything else:

CAB = X – M

What factors influence exports and imports?

There are four main sets of factors affecting the current account balance:

1. Domestic income, Y. As domestic income rises, domestic residents spend more. Some of this falls on imported goods and services. So, the domestic demand for imports increases.

2. Foreign income, Y*. As foreign income rises, foreign residents spend more. Some of this falls on the goods and services that we (the domestic economy) exports. As a result, domestic exports increase.

3. The exchange rate (to be discussed next)

4. Other factors, such as politics, the weather, earthquakes, oil discoveries, etc.

Remember that the real exchange rate is defined as:

eP* e ($ per Yuan) P* (Price of Chinese goods in Yuan)

q = ------ = -------------------------------------------------------------------

P P (Price of US goods in dollars)

Price of foreign goods in domestic currency

q = -------------------------------------------------------------------

Price of domestic goods in domestic currency

Since the real exchange rate is:

q = eP*/P

As the real exchange rate increases, foreign goods and services become relatively more expensive.

This causes imports to decrease and exports to increase.

So, holding prices constant (P and P*), an increase in the exchange rate, e (a domestic currency depreciation) causes the real exchange rate to increase and it would tend to increase exports and reduce imports.

But the impact of an increase in the exchange rate on the current account balance is not necessarily positive!

CAB = Value of Exports – Value of Imports

= P EX - e P* IM

P = Price of exports (domestic goods exported)

EX = Quantity of Exports

e = exchange rate (dollars per yuan)

P* = Price of Imports (price of foreign, say, Chinese goods)

IM = quantity of imports (say, imports from China)

So, what happens when the exchange rate increases?

Let us assume that prices, P and P*, are fixed in the short-run (which is what we do observe happens).

Suppose e goes up (the dollar depreciates in value)

CAB = Value of Exports – Value of Imports

↑ ↑ ↓

= P EX - e P* IM

Note that the dollar depreciation, the increase in e, tends to improve the current account balance because it tends to reduce the quantity of imports, IM, and increase the quantity of exports, EX.

But it also tends to worsen the current account balance because it raises the cost of imports, and therefore, the value of those imports.

Whether the current account balance improves or not depends on whether the dollar depreciation leads to a large enough reduction in the quantity of imports and a large enough increase in the quantity of exports to offset the rise in the value of imports.

Economists refer to this condition as the Marshall-Lerner condition, for the economists who established the exact mathematical condition for a currency depreciation to have a positive impact on the trade balance.

The empirical evidence on this issue shows that currency devaluations have very little impact on the current account balance in the short-run.

If anything, the impact can be negative in the short-run, because the quantities exported and imported do not change much over a short period of time (weeks or even months)

The impact is more positive over longer periods of time, as the currency depreciation leads to a reduction in the quantity of imports and to greater exports as well.

CAB

Time

↑

Currency

Depreciation

J-Curve effect of a currency depreciation on

The Current Account Balance (CAB)

But some have questioned recently whether currency depreciations exert any significant influence on exports even in the long-run.

One of your readings, from The Economist, appears to suggest the relationship has weakened.

What is the recent evidence on how currency value changes affect trade in the long-run?

A recent study by Daniel Leigh, Weicheng Lian, Marcos Poplawski-Ribeiro, and Viktor Tsyrennikov published as part of the 2015 World Economic Outlook –published by the IMF-- examined this issue.

You have a summary of this article as part of your readings.

Leigh et. al. define the long-run effects of a real effective currency depreciation, which takes place after one year.

They look at case studies of 60 countries in the period of 1980 to 2014.

What do they conclude?

“The results suggest that a 10 percent real effective depreciation in an economy’s currency is associated with a rise in real net exports of, on average, 1.5 percent of GDP, with substantial cross-country variation around this average.” (p. 111)

“Similarly, the estimates indicate that the Marshall-Lerner condition holds, so that a currency depreciation [in the long-run] improves the trade balance” (page 111)

So, the impact of currency devaluation is positive in the long-run, but not necessarily in the short-run.

American policymakers who think that a revaluation of the yuan (a depreciation of the dollar relative to the yuan) is going to reduce the U.S. trade deficit with China will be disappointed since this may not happen until several years in the future.

Similarly, those who expect that if Greece abandons the euro and re-creates its own currency, the drachma, a depreciation of the drachma will improve Greece’s trade balance may be disappointed in the short-run.

So, let us assume that a dollar depreciation does improve the current account balance by raising exports and reducing imports.

Let us summarize the chain of events regarding expansionary monetary policy:

An increase of the money supply leads to:
Reduction of interest rates, which causes:
Capital outflows, which causes:
A depreciation of the domestic currency, which leads to:
An improvement of the current account balance, by raising exports and reducing imports (assuming the Marshall-Lerner condition is satisfied).

But what does this do to output, and therefore income, employment, etc.?

The impact on output can be determined from the national accounts equation, we derived earlier, for GNP:

YN = C + I + G + CAB

Where YN is GNP, C is private consumption, I is private investment, G is government spending and CAB is the current account balance.

So, if CAB rises, then output, income, employment, etc. increase.

So, monetary policy is highly effective in stimulating economic growth in an economy under flexible exchange rates because of two reasons:

First, domestically, the effect is to lower interest rates, which stimulates private domestic investment spending (I above), which raises production and employment.

Second. There is an indirect effect through international trade: the lower interest rates generate capital outflows that cause a depreciation of the domestic currency, which –over time--stimulates exports and also raises production and employment (raising CAB above).

The U.S. has flexible

Exchange rates.

So, Ben Bernanke, the

Chairman of the Fed

In the U.S., was

right in seeking to

counteract the

Great Recession with

massive, expansionary

monetary policy.

However, although the objective of the Federal Reserve’s expansionary monetary policy was to support the banking system and stimulate the economy by raising credit, consumer spending, etc., the expansionary policy had also other consequences.

As we just explained, an increase in the money supply of a country causes that country’s currency to depreciate in value.

So, the expansionary monetary policy in the U.S. led to a depreciation of the dollar, which was then reflected in an appreciation of other currencies.

But these exchange rate changes then had consequences on the international competitiveness of American versus the products of other countries.

The depreciation of the dollar caused U.S. export products to become relatively more competitive relative to the exports of other countries. Other countries, therefore, lost competitiveness and their exports dropped.

A currency depreciation is therefore what economists call a beggar-thy-neighbor policy.

It helps the domestic economy grow at the expense of other countries.

Of course, other countries will react to such policies.

The reaction, in Brazil, Colombia and many other developing countries, in 2011 and 2012, was to intervene in foreign exchange markets by buying dollar reserves in order to reduce the supply of dollars and cause an appreciation of the dollar and a depreciation of their own currencies.

Other countries also adopted policies to depreciate their currencies, including Japan, to counteract the dollar depreciation.

This currency war has subsided but remains a threat in world economic affairs.

Let us now go back to the issue of how the exploitation of natural resources affects an economy.

So, let us examine the effects of an increase in the export of natural resources, obtained as a result of the discovery and exploitation of those resources, say crude oil.

What would be the impact of such an expansion using the Mundell-Fleming theoretical framework? How does it affect output and employment?

The impact on output can be determined from the national accounts equation, we derived earlier, showing the demand determinants of GNP:

YN = C + I + G + CAB

Where YN is GNP, C is private consumption, I is private investment, G is government spending and CAB is the current account balance.

So, what happens if crude oil exports increase?

The direct effect of the increased oil exports is to increase the current account balance, thus raising output and employment.

But this is not the end of the story. We have to look also at the international repercussions of the increased exports and production.

To understand the repercussions of the oil expansion, you must understand that the expansion of production is based on greater needs for capital in the oil industry.

The increased demand for capital, however, will tend to cause an increase in domestic interest rates.

This has significant repercussions.

If interest rates in the rest of the world are constant, then higher domestic interest rates will lead to capital inflows, as investors will seek the higher returns offered by the booming oil-based economy.

But what would capital inflows do to the value of the domestic currency?

In order to invest in domestic assets, foreign residents would need to buy the domestic currency.

So, the demand for domestic currency would rise in foreign exchange markets.

But what happens when there is an increase in the demand for domestic currency in foreign exchange markets?

There is a increase in the price of the domestic currency in terms of foreign currencies, or what is the same, there is an appreciation in the value of the domestic currency.

But what would an appreciation of the domestic currency do to domestic exports and, therefore, to the current account balance?

A domestic currency appreciation will tend to hurt domestic competitiveness, which will reduce domestic exports of non-oil products.

So, although exports of oil rise, the exports of everything else declines.

And this phenomenon is what economists call “Dutch disease.”

The conclusion is that, although an increase in the exploitation and export of natural resources may have a positive initial impact on the economy, this is reversed by the negative impact on other sectors of the economy.

Overall, then the exploitation of natural resources, may not have such a beneficial effect on a country.