Unit 7

The Balance of Payments

Balance of Payments - measure of money inflows and outflows between the United States and the Rest of the World (ROW)

-inflows are referred to as credits

-outflows are referred to as debits

The balance of payments is divided into 3  accounts

-current account

-capital/financial account

-official reserves account

Every transactions in the balance of payments is recorded twice in accordance with stand accounting practice

-Ex. US manufacturer, John Deere, exports $50 million worth of farm equipment to Ireland

A credit of $50 million to the current account (- $50 million worth of farm equipment or physical assets)

A debit of $50 million to the capital/financial account 

Current Account

Balance of trade or Net Exports

-exports of goods/services - import of goods/services

-exports create a credit to the balance of payments

-imports create a debit to the balance of payments

Net Foreign Income

-income earned by US owned foreign assets - income paid to foreign held US assets

- ex. Interest payments on us owned Brazilian bonds - interest payments on German owned US Treasury bonds

Net Transfers (tend to be unilateral)

-foreign aid to a debit to the current account

-ex. Mexican migrant workers send money to family in Mexico

Capital/Financial Account

-the balance of capital ownership

-includes the purchase of both real and financial assets

-direct investment in the US is a credit to the capital account

-ex. The Toyota Factory in San Antonio

-direct investment by US firms/individuals in a foreign country are debits to the capital account

-ex. The Intel Factory in San Jose, Costa Rico

Capital/Financial Account

-purchase of foreign financial assets represents a debit to the capital account

-ex. Warren Buffet buys stock in Pentrochina

-purchase of domestic financial assets by foreigners represents a credit to the capital account

-ex. The United Arab Emirates sovereign wealth fund purchases a large stake in the NASDAQ

Relationship between Current and Capital Account

-the current account and the capital account should zero each other out.

IF THE CURRENT ACCOUNT HAS A NEGATIVE BALANCE (DEFICIT), THEN THE CAPITAL ACCOUNT SHOULD HAVE A POSITIVE BALANCE (SURPLUS)

Official Reserves

-the foreign currency holdings of the United States Federal Reserve System

-when there is a balance of payments surplus the Fed accumulates foreign currency and debits the balance of payments

-when there is a balance of payments deficit the Fed depletes its reserves of foreign currency and credits the balance of payments

-the official reserves zero out the balance of payments 

Active v. Passive Official Reserves

-the United States is passive in its use of official reserves. It does not seek to manipulate the dollar exchange rate.

-the People's Republic of China is active in its use of official reserves. It actively buys and sells dollars in order to maintain a steady exchange rate with the United States.

Balance of Trade: 

1. Goods and Services Export - Goods and Services Import

2. Goods exports + Goods imports

You can get a trade deficit (imports>exports) or trade surplus (exports>imports)

Current Account:

1. Balance of Trade + Net Investment + Net Transfer

Capital Account:

Foreign purchases of US assets + US purchases of assets abroad

Official Reserve:

Current Account + Capital Account

Good Imports + Service Imports

Foreign Exchange Market

Foreign Exchange - the buying and selling of currency.

The exchange rate (e) is fester mined in the foreign currency markets.

The exchange rate is the price of currency.

Do not try to calculate the exact exchange rate.

TIPS

•Always change the Demand line on one currency graph, the Supply line on the other currency's graph

•Move the lines of the two currency graphs in the same direction (right or left) and you will have the correct answer

•If D on one graph increases, S on the other will also increase

•If D moves to the left, S will move to the left on the other graph

Changes in Exchange Rates

•Exchange rates are a function of the supply and demand for currency

• an increase in the supply of a currency will make it cheaper to buy one unit of that currency 

• a decrease in supply of a currency will make it more expensive to buy one unit of that currency

• an increase in the demand of a currency will make it more expensive to buy one unit of that currency 

• a decrease in demand of a currency will make it cheaper to buy one unit of that currency

Appreciation

Appreciation of a currency occurs when the exchange rate of that currency increases

-hypothetical: 100 yen used to buy $1 now two hundred ten buys $1

Depreciation

Depreciation of a currency occurs when the exchange rate of that currency decreases. 

Determinants of Exchange Rate

•consumer tastes

-the increase in demand of the yen leads to the appreciation of the Yen

•relative income

-imports tend to be normal goods

•relative price level

•speculation

Absolute Advantage v. Comparative Advantage

Absolute Advantage:

Individual- exists when a person can produce more of a certain good or service than someone else in the same amount of time

National- exists when a city can produce more of a good or service than another can in the same time period

•Faster, more, more efficient

Comparative advantage

Individual/national - exists when an individual or nation can produce a good or servers of a lower opportunity cost than can another individual or nation

•lower opportunity cost

Input Problems - the country or individual that uses the least amount of resources, land, or time, has the absolute advantage

Output Problems - the country or individual that can produce the most has the absolute advantage. The country that has the lowest opportunity cost has the comparative advantage in that product. It deals with production

Unit 5

Phillips Curve - Represents the relationship between unemployment and inflation. The trade off between inflation and unemployment only occurs in the short run.

Long Run Phillips curve occurs at the natural rate of unemployment. If the natural rate of unemployment changes, then the Long Run Phillip's curve changes. It is represented by a vertical line. There is no trade off between unemployment and inflation in the long run. That means the economy produces at a full employment level. LRPC will only shift if the LRAS curve shifts, otherwise it is assumed to be stable. 

NRU = seasonal, frictional, and structural

The major LRPC assumption is that more worker benefits create high natural rates and fewer worker benefits create lower natural rates. 

Short Run Phillips Curve - there is an inverse relationship between inflation and unemployment. It has a relevance to Okun's law. Since wages are sticky, inflation changes, moves the points on the SRPC. If inflation persists and the expected rate of inflation rise, then the entire SRPC moves upward, which causes stagflation. If inflation expectation drops due to new technology or economic growth, then the SRPC will move downward. Aggregate supply shocks can cause both higher rates of inflation and higher rates of unemployment. Supply shocks are rapid and significant increases in resource cost

The misery index - combination of unemployment and inflation in any given year. Single digit misery is good.

Supply side economics - the belief that the AS curve will determine levels of inflation unemployment and economic growth. To increase the economy, the AS curve should shift to the right, which will always benefit the company first. Supply side economists focus of marginal tax rates.

Marginal tax rates - amount paid on the last dollar earned or on each additional dollar earned. By reducing the marginal tax rate, supply siders believe that you will encourage more people to work longer and forego leisure time for extra income

They support policies that promote GDP growth by arguing that the high marginal tax rate along with the current system of transfer payments. they provide disincentives to work, invest, innovate, and undertake entrepreneurial ventures

Reganomics - lowered the marginal tax rate to get the US out of a recession which lead to a recession.

Ladder curve - a trade off between tax rates and government revenue. It is used to support the supply side argument.

3 criticism of the Laffer Curve

1. Research suggests that the impact of tax rates on incentives to work, save, and invest are small

2. Tax cuts increase demands, which can fuel inflation and causes demand to exceed supply. 

3. Where the economy is actually located on the curve is difficult to determine.