Define: The Trade Balance

1
Define The Trade Balance

• The Trade Balance X-M

2
Define The Current Account

• Two types of international financial flows are
  ignored in our model
• interest payments on debt
• direct foreign investment
• Both these types of financial flows are grouped
  with the trade balance into what is called the
  current account.
• Current account trade balance loan payments
  direct foreign investment.
• In our model, current account X-M

3
Define The Capital Account

• The Capital Account S-I
• It is the gap between domestic Savings and
  Investment at world expected real interest rates

4
The Balance of Payments

• AE Aggregate Income (Y) in equilibrium
• This implies that S-I X-M in equilibrium
• Proof

5
The Balance of Payments S-IX-M

• If S gt I (the country is a net saver in intl
  capital markets)
• All S pays for I somewhere
• If Sgt domestic I then we paying for foreign I
• Define this as a capital account deficit
• Deficit because money is leaving the economy
• If SgtI then XgtM
• Outflows of money on the capital account
  (deficit) balanced by a trade balance surplus
• surplus because money is entering from other
  countries

6
The Balance of Payments S-IX-M

• If SltI (the country is a net borrower in intl
  capital markets)
• There is a capital account surplus
• money coming into the country on the capital side
  of the equation
• A capital account surplus implies a trade deficit
  (X-Mlt0)
• Money is leaving the economy on the current
  account side of the equation

7
Intuition behind the Balance of Payments

• Think of foreign exchange markets
• Barter Euros for Dollars
• Exchange rate assures us that Euros they give to
  get Dollars are demanded (used) by suppliers of
  Dollars
• Means that the value of the Euros they use to buy
  our stuff is equal to the Euros we use to buy
  their stuff

8
The foreign exchange market

• British demand dollars to get our goods and
  assets
• U.S. supply dollars to Brits to get UK goods and
  assets
• British demand more dollars the cheaper they are
  (makes our goods, assets cheaper for Brits)
• Americans supply more dollars the more expensive
  they are (the more pounds they get for every
  dollar)

9
Example The twin deficit relationship
Yuan/
DYuan1
e1
D1
Q in this market
10
Foreign Exchange Markets

• This market is by nature bilateral As many U.S.
  e-rates as are foreign currencies.
• Press often refer to the e-rate, by which they
  mean a trade-weighted index of bilateral weights.

11
U.S. Treasury and e-rate policy

• The Treasury has a budget of U.S. currency
  reserves and of foreign currency reserves
• Use them to buy/sell dollars
• Influence dollar or foreign-country currency
  price
• Budget too small to affect anything but temporary
  movements in e-rate

12
Long-run determination of real e-rate

• Result of goods market arbitrage
• Causes P(U.S.) yen/dollar P(Japan)
• Where the price index covers all traded goods
• Leads to purchasing power parity of the dollar
• Dollar buys the same basket of goods in all
  countries if were in long-run equilibrium
• Long-run (real) e-rate determination doesnt tell
  us anything about the nominal rate or about the
  price level

13
Things to note about PPP

• PPP only applies to traded goods
• The imported and domestically-produced goods must
  be identical for parity to hold
• There cant be any tax differences or
  transportation costs if PPP is to hold

14
Relative versus Absolute PPP

• Transportation costs and tax differences exist
  between countries in the real world even if you
  can find identical, traded goods to test if were
  in long-run equilibrium or not
• But, those costs and taxes dont change very
  often (their growth rate is zero)
• If put PPP in growth rates, dont have to worry
  about that criticism

15
Relative PPP

• For example,
• If taxes and transportation costs dont change,
  then relative PPP implies
• This means that the nominal e-rate adjusts to
  make up for any difference between the two
  countries inflation rates (in equilibrium)