### Eco 344---

```Eco 344----Slide 2
After Midterm Exam 1
Drawing Graph
• An economic relationship can be represented
either mathematically or graphically.
• For example, consider the demand relation:
Quantity Demanded = f (price, other factors)
where other factors include income, preference,
and etc.
This relationship can be represented by the
demand curve, a two-dimensional diagram.
A Two-Dimensional Diagram
• In general, a two-dimensional diagram can
represent the relationship of
Y = f (X, Z)
• The diagram is upward sloping if Y and X move
in the same direction
• The diagram is downward sloping if Y and X
move in the opposite direction
• We move along the diagram when X varies,
holding Z constant.
What if Z changes?
• The diagram shifts when Z changes.
• For example, let Y = quantity demanded, X =
price, Z = income. After income (Z) rises,
quantity demanded (Y) rises for each given
price (X). So the demand curve shifts up.
• Exercise: what happens to demand curve if Z =
price of substitute rises?
Two Special Cases
• The diagram is a horizontal line if Y remains
unchanged when X varies
• The diagram is a vertical line if X remains
unchanged when Y varies
• Exercise: draw the demand curve when the
demand is perfectly inelastic
UIP and Asset Approach
• UIP is the fundamental equation of the (shortrun) asset approach to exchange rate
• We use UIP to solve for current spot exchange
rate provided that we know the interest rates
and expected future spot rate:
i\$

Dollar rate of return on
dollar deposits
 i€ 
E
e
\$/€
 E\$/ €
E\$/ €
   
Expected dollar rate of return
on euro deposits
FX Market Diagram
• The Y variable is dollar rate of returns of dollar
deposit and euro deposit
• The X variable is current spot rate E
• We use FX market diagram to solve for E
\$/€
\$/€
DR Curve
• DR stands for domestic (US) rate of return
• Mathematically, DR = i\$
• DR curve is horizontal because it is
independent of current spot rate (i.e., DR
remains unchanged when current spot rate
varies)
FR Curve
• FR stands for foreign (EUR) rate of return
E
E
i

• Mathematically, FR =
E
• FR curve is downward sloping because FR and
current spot rate E move in opposite
direction (Intuition?)
• The Z variable for FR curve is i and E
e
\$/€
\$/€
€
\$/€
\$/€
€
e
\$/€
FX Market Equilibrium
• The foreign exchange market is in equilibrium
where DR and FR curve intersect
• To the left of equilibrium point, FR > DR. Euro
deposit is more attractive. People will buy
euro and sell dollar. Dollar depreciates.
• To the right of equilibrium point, FR < DR.
Dollar deposit is more attractive. People will
buy dollar and sell euro. Dollar appreciates.
What if dollar interest rate rises?
•
•
•
•
•
DR curve shifts up
FR curve remains fixed
Dollar appreciates instantaneously
Figure 4-3-(a)
Intuition?
What if Euro interest rate falls?
•
•
•
•
•
DR curve remains fixed
FR curve shifts down
Dollar appreciates instantaneously
Figure 4-3-(b)
Intuition?
What if expected future rate falls?
•
•
•
•
•
DR curve remains fixed
FR curve shifts down
Dollar appreciates instantaneously
Figure 4-3-(c)
This example shows that expectation is selffulfilling: expected future appreciation for
dollar will lead to actual instantaneous
appreciation for dollar
(Current) Euro Crisis
• What causes the recent depreciation of euro
against dollar?
• Due to the debt crisis in Euro-zone, people
expect that euro will depreciate in future (or
in long run)
• Expectation is self-fulfilling. We see euro has
actually been depreciating.
Expectation Management
• Because expectation is self-fulfilling, it is vital for
the government to do something in order to
revert people’s unfavorable expectation
• 1997 Asian crisis revisited: Soros bet against Hong
Kong Dollar, and he expected HK dollar would
depreciate against US dollar
• China central government announced that it
would back up HK dollar. This credible
announcement changed people’s expectation
• In the end Soros suffered a big loss
Figure 15.4 Equilibrium in the Home Money Market
Feenstra and Taylor: International Economics, Second Edition
Figure 15.8 Temporary Expansion of the Home Money Supply
Feenstra and Taylor: International Economics, Second Edition
Figure 15.10 U.S.–Eurozone Interest Rates and Exchange Rates, 1999–2004
Feenstra and Taylor: International Economics, Second Edition
Some Accounting Identities
•
•
•
•
GNE = C + I + G
GDP = GNE + TB
GNI = GDP + NFIA
GNDI = GNI + NUT
Figure 16.4 Major Transfer Recipients
Feenstra and Taylor: International Economics, Second Edition
Figure 16.2 The Open Economy
Feenstra and Taylor: International Economics, Second Edition
National Income Identity
• A country saves if CA>0
• A country borrows (overspends) if CA<0
• National Income Identity: Y = C + I + G + CA
Y  C
 I 
G  { ( EX  IM )  ( EX FS  IM FS )  (UT   UT  )}



 
       
GNDI
GNE
balance
( TB )
Net factor income
( NFIA )
Net unilateral
transfers
( NUT )
                
Current account
( CA )
Table 16.1 U.S. Economic Aggregates in 2009
Feenstra and Taylor: International Economics, Second Edition
Figure 16.5 U.S. Gross National Expenditure and Its Components, 1990–2009
Feenstra and Taylor: International Economics, Second Edition
Figure 16.6 U.S. Current Accounts and Its Components, 1990–2009
Feenstra and Taylor: International Economics, Second Edition
Current Account Identity
• Let S = Y – C – G
• The national income identity becomes the
current account identity:
S = I + CA
CA > 0 if S > I
CA < 0 if S < I
Figure 16.7 Saving, Investment, and Current Account Trends: Industrial Countries
Feenstra and Taylor: International Economics, Second Edition
Discuss: Tariff and US CA Deficit
• CA = S – I = (Y – C - G) - I
• What are the effects of tariff on Chinese
import on C, G and I
Why do American people save so little
•
•
•
•
Cultural of consumption
Demographic reason
Government entitlement program
Housing market boom
Why do Chinese people save so much?
Cultural of saving
Lack of social benefits
Even old people save (for the down payment of
new house bought by their child)
Private and Public Savings
•
•
•
•
Private Saving (Sp) = Y – T – C
Public Saving (Sg) = T – G
Total Saving S = Sp + Sg
The current account identity becomes
CA = Sp + Sg – I
• Everything else equal, rising government
budget deficit leads to rising current account
deficit (foreign debt)
Greece Crisis
• Huge government expenditure (on
entitlement program)
• Huge government budget deficit
• Private saving is low (unlike Japan)
• Huge foreign debt (from French banks)
• The crisis is caused by the potential default of
foreign debt (downgrade of its credit rating)
Euro Crisis
• Crisis is contagious
• Greece is member of EU
• Greece borrows a lot from French and German
banks
• Germany is increasingly reluctant to support
Greece
Dilemma for US
• In long run, in order to cut the current account
deficit, US should cut budget deficit and
increase personal saving
• In short run, however, double-dip recession is
looming.
Twin Deficits: Greece and USA
• CA = Sp + Sg – I
• Assuming Sp = 0, I = 0
• Then Sg < 0 (government budget deficit)
indicates that CA < 0 (current account deficit)
• So there are twin deficits.
• Greece and USA have twin deficits now.
Discuss: Greece Debt Crisis
Japan and China
• Sg is negative but small (small budget deficit)
• Sp is positive and big (big personal saving)
• Overall, national saving (S = Sg + Sp) is greater
than investment
• So Japan and China are running CA surplus
(lending money to other countries)
• Government budget deficit does not
Balance of Payment (BOP) Account
•
•
•
•
BOP = CA + FA + KA
FA: Financial account
KA: Capital account (close to zero for US)
FA and KA record international transactions in
assets. They show how the current account is
financed.
One Principle
• Every transaction is two-way. If A receives
from B an item of given value, in return B
receives from A an item of equal value.
• For example. When you buy an Iphone at ATT
store, you get the phone, and the ATT store
gets the payment (either cash or check).
Double-Entry Bookkeeping
• Any transaction resulting in a payment to
foreigners is entered in the BOP account as a
debit and is given a negative sign(-).
• Any transaction resulting in a receipt from
foreigners is entered in the BOP account as a
credit and is given a positive sign(+).
Asset
• US asset is a claim on US; Foreign asset is a claim
on ROW
• There is capital inflow (receipt) to US if US
exports US asset to ROW (borrow from ROW). So
exporting US asset is entered in the BOP account
as a credit and is given a plus sign(+).
• There is capital outflow (payment) if US imports
foreign asset from ROW (lend to ROW). So
importing asset abroad is entered in the BOP
account as a debit and is given a minus sign(-).
Example
• An American student uses credit card to buy a
Astro Boy book worth \$10 in Tokyo
• Current Account (CA):
Import of foreign good, - \$10
• Financial Account (FA):
Export of US asset, + \$10
Note: US asset is a claim on US. Credit card is one
form of IOU, an asset.
Note CA + FA = 0 for this transaction
BOP Identity
• From microeconomic view, because of doubleentry bookkeeping, the following BOP identity
holds:
CA + FA + KA = 0
• From macroeconomic view, BOP identity holds
because
GNE
CA


Resources available
to home country due to income

FA

KA



Extra resources available
to the home country

GNE
Implications of BOP Identity
• For simplicity, let KA = 0
• FA < 0 if CA > 0. A country lends money to
ROW if it is running current account surplus
• FA > 0 if CA < 0. A country borrows money
from ROW if it is running current account
deficit
Statistical Discrepancy
• In practice, because of data error, BOP identity
holds only when statistical discrepancy (SD), a
correction term, is included:
CA + FA + KA + SD = 0
• The above identity holds because by definition
SD = -(CA + FA + KA )
Remarks
• Item 7: US-owned assets abroad = importing
foreign assets (lending to ROW). There is
capital outflow (payment), so entered in BOP
with a minus sign.
• Item 8: Foreign-owned assets in US =
exporting US assets (borrowing from ROW).
There is capital inflow (receipt), so entered in
BOP with a plus sign.
```