Unit 7 Balance of Payments

Measure of money inflows and outflows between the United States and the res of the world (ROW)
-Inflows are referred to as credit
-Outflows are referred to as debits

The Balance of Payments is divided into 3 accounts

• Current Account
• Capitol Financial Account
• Official Reserves Account

Current Accounts

• Balance of Trade or Net Exports
• Exports of goods and services - Imports of good/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 U.S. owned foreign assets-Income paid to foreign held U.S. assets
• Ex: Interest payments on German and U.S.s Treasury bonds
• Net Transfers (tend to be unilateral)
• Foreign Aid = a debit to the current account
• Ex: Mexican migrant workers send money to family in Mexico

Capitol Financial Account

• The balance of capitol ownership
• Includes the purchase of both real and financial assets
• Direct investment in the United States is credit o the capital account
• Ex: Toyota factory opens in San Antonio, Texas
• Direct investment by U.S. firms / Individuals in a foreign country are debits to the capital accounts
• Ex: Intel factory in San Jose, Costa Rica
• Purchase of foreign financial assets represents a debt to the capital account . Ex: Warren Buffet buys bonds in petro Chan
• Purchase of domestic assets by foreigners represents a credit to the capital account. Ex: United Arab Emirates sovereign wealth fund purchases a large stake in NASDAQ.

Relationships between Current and Capital Account

• Remember double entry bookkeeping?
• The current account and capital account should zero out
• That is... if the current account has a negative balance (DEFICIT), then the capital account should then have a positive blance (Surplus)

Official Reserves

• The foreign currency hodings 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 or Passive Official Reserves

• The U.S. is passive in its use of official reserves. It does not seek to manipulate the dollar exchange rate

Balance of Trade : Goods  + Goosds

                              Exports    Imports

Balance on goods and services

Goods + Services + Goods + Service

Exports   Exports     Imports   Imports

Current Account:

Balance on goods and services

                    +

  Net investment

                     +

   Net Transfers

Capital Accounts:

Foreign Purchase, Domestic Purchases

Balance of Payments

Mechanics of Foreign Exchange

Foreign Exchange

• Buying and selling of currency

 Ex; In order to purchase souvenirs in France, it is first necessary for Americans to sell their dollars and buy Euros

• Any translation that occurs in the Balance of Payments necessities. Foreign exchange
• Exchange rate is determined in the foreign currency markets

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 decrease the exchange rate of currency
• A decrease in supply of a currency will increase the exchange rate of a currency
• An increase in demand for a currency will increase the exchange rate of a currency
• A decrease in demand for a currency will decrease the exchange rate of a currency.

Appreciation and Depreciation

• Appreciation of a currency occurs when the exchange rate of that currency increases
• Depreciation of a currency occurs when the exchange rate of that currency decreases
• ex: If German tourist flock to America to go shopping, the supply of Euros will increase and the demand for dollars will increase. This will cause the Euros to depreciate and the dollar to appreciate.

Appreciation and Depreciation

Exchange Rate Determinate

• Consumer Taste
• Relative Income
• Relative Price Level
• Speculation

Exports and Imports

• The Exchange rate is a determinate of both export and imports
• Appreciation of the dollar causes American gods to be relatively more expensive and foreign goods to be relatively cheaper thus reducing exports and increasing imports
• Depreciation of the dollar causes American foreign goods to be relatively more expensive thus increase exports and reducing imports

Floating Rate/Flexible Rates

• Depends upon supply and demand of that currency vs other currency
• Very sensitive to the business cycle
• Provides options for investments

*FLOATING RATES ARE NEVER THE SAME PER DAY*

Fixed Rates

• Based Upon a country's willingness to distribute currency and the ability to control the amount
• *U.S. controls our money so it doesn't grow out of control

Floating Rate and Fixed Rates

                                                                       

                                                                     Absolute Advantage

Individual- exists when a person can produce more of a certain good/ service that someone else in the same amount of time (or can produce a good using the least amount of resources)

National - exists when a country can produce more of a good/ service than another country can in the same time period.

Absolute Advantage

                                                                  Comparative Advantage

• A person or a nation has a comparative advantage in the production of a product when it can produce the product at a lower domestic opportunity cost than can a trading partner

Output ex: Tons per acre, miles per gallon, words per minute, apples per tree, televisions produced per hour

Input ex: # of hours to do job, # of acres to feed a horse, # of gallons of paint to paint a house

Comparative Advantage

                                                                      Specialization and Trade

• Gains from trade are based on comparative advantage and not absolute advantage.

Unit 5 and 6

Short Run Aggregate Supply

Short Run Aggregate demand

• Period in which wages ( and other input prices) remain fixed as price level increases or decreases

Effects over short run

• Price level changes allow for companies to exceed normal outputs and hire more workers because profits are increasing while wages remain constant
• In long run, wages will adjust to price level and previous output levels will adjust accordingly

Equilibrium in the extended model

• Inclusion of both short run and long run aggregate supply
• long run curve is representative of natural rate of unemployment

Demand Pull Inflation in AS model

• Demand Pull Prices - Prices increase based on increase in aggregate demand
• Short run- demand pull will drive prices up and increase production
• Long run- increases in aggregate demand will eventually return to previous levels
• Demand Pull Inflation

Cost Push and the extended model

• Cost push arises from factors that will increase per unit cost such as increase in the price of a key resource
• Cost Push Inflation
• Cost Push Inflation video

Dilemma for Government

•  In an effort to fight cost push, the government can react in two different ways:
• Action such as spending by the government could begin an inflationary spiral
• No action however could lead to recession by keeping production and eployment levels declining.

The Phillips Curve

• Because Long Run Philips Curve (LRPC) exists at the natural rate of unemployment (Un) structural changes in the economy that affect Un will also cause the LRPC to shift
• Increases in Un will shift LRPC to right
• Decrease in Un will shift LRPC to left

                                                                 Relation to AS/AD

changes in AS/AD model can also be seen on the Philips curve   *MIRROR IMAGES*

• LRPC occurs at natial rate of unemployment
• Always represented by a yellow line
• There is no tradeoff between unemployment and inflation
• LRPC will only shift if LRAS shifts
• If Natural Rate of Unemployement (NRU) changes, so does LRPC
• NRU = frictional + structural + seasonal unemployment (4% to 5%)

Major LRPC assumpltion is that more workers benefits create higher natural rates and a few workers benefits create lower natural rates

Misery Index

• Combinstion of Inflation and Unemployment in any given year

*Single digit money is good*

ex : inflation 2% and unemployment 4% economy is relatively good

Supply Shocks

• Rapid and significant increase in resource cost

              *caused by war, weather, tax, etc*

supply shocks

supply shocks and disinflation

Supply Side Economics

• Changes in AS and AD are the main active force in determining the level of unemployment rates, inflation, and economic growth.
• supply side economics

Supply Side Economist

• Support policies that promote GDP growth by arguing that high marginal tax rates along with the current system of transfer payments such as unemployment compensation or welfare programs provide disincentives to work, invest, innovate, and undertake entrepreneurial ventures

Incentives to Save and Invest

1. High Marginal Tax Rates

         - Reduce the incentive for savings and investments

     2.   Consumption

         - Might increase but investments depend upon saving

     3.    Lower Marginal Tax Rates

         - Encourage saving and investment

Laffer Curve

• Theoretical relationship between tax rates and tax revenues
• As tax rates increase from zero, tax revenue increases from zero to some max levels and then declines
• Laffer Curve Explained

3 conditions of Laffer Curve

1. Evidence suggests that the impact of tax rates on incentives to work, save, and invest are small
2. Tax cuts also increase demand which can fuel inflation and demand may exceed supply
3. Where the economy is actually located on the curve is difficult to determine