Slides 2

After the First Midterm Exam

Open Economy

• Build a long run theory to explain trade balance and exchange rate

• Idea 1: Y = C + I + G + NX (net export)• Idea 2: NX is function of real exchange rate• Idea 3: use classical dichotomy to determine

nominal exchange rate after real exchange rate is determined

Exchange rate

• Nominal exchange rate is denoted by whose format is foreign currency per US dollar.

• US dollar appreciates if rises• Real exchange rate (term of trade) is

• US goods become relatively more expensive when rises, so US net export falls.

• Exercises: what may cause appreciation of US dollar in real terms?

Two Key Equations

• We assume the real interest rate is exogenous,

• That mean real interest rate cannot adjust to equilibrate spending () and income

• Instead, real exchange rate adjusts to clear economy

Accounting Stuff

• There is trade deficit if a country overspends (borrows), i.e.,

• There is trade surplus if a country saves (lends ), i.e.,

• After net export is determined, real exchange rate is determined. This ordering really matters!

What causes US trade deficit?

• Dr Mankiw’s answer: because US overspends• Politician’s answer: because Chinese currency

is undervalued• Which one makes more sense?

Politicians may be misleading

• Yes, cheap Chinese currency means cheap Chinese goods

• But, does cheap Chinese currency affect• Services, the biggest part of C?• Housing, one big part of I?• Military spending, entitlement program,

bailout program?

Dr. Mankiw’s Answer

• US budget deficit is caused by• (1) (increasingly) big budget deficit (twin

deficits)• (2) close to zero private saving• (3) big investment (including housing market

boom)

Data Talk

A Right Move

• Give firms tax breaks if they bring jobs back to US.

• http://www.nytimes.com/2012/02/03/business/economy/a-lure-to-keep-jobs-made-in-america.html

• Can you draw a graph to show this is a good idea?

Another Good News

• currencies of most countries are not reserve currencies. For those country trade deficit must be financed by foreign debt, and persistent trade deficit is a big issue

• The issue of US trade deficit is exaggerated• Because US can print dollar, which is reserve

currency, to finance its trade deficit.

Classical Dichotomy

• Real Exchange Rate: • Nominal Exchange Rate: • Relative Purchasing Power Parity:

Absolute Purchasing Power Parity:

Classical (Long Run) Model

• Chapter 3: GDP and Real Interest Rate• Chapter 4: Price, Inflation Rate and Nominal

Interest Rate• Chapter 5: Net Export and Exchange Rates• Chapter 6: Unemployment Rate

Policy Implication

• Fiscal Policy has crowding out effects• Trade policy is useless• Minimum wage law and unemployment

insurances have side-effects• All policies pick winners and losers. • Policy is unnecessary if the loss of losers

offsets the gain of winners

Monetary Policy

• See in class exercises

In Long Run Policy is Not Needed

• Unemployment is natural• Inflation has some good effect• Trade deficit is ok • “Small government is the best”, says a

republican

China can control exchange rate, but only the nominal rate

• In long run policy is useless because market forces prevail

• China uses fixed nominal exchange rate• But the real exchange rate is very flexible.• “What really matters is the real rate” says Dr.

Jing Li

A Successful Story

• http://people.bu.edu/timbond/

Steady State

• In steady state

• In steady state both total capitaland total income ) remain constant, because both and are fixed.

Computer Simulation of Steady State

• Table 7-2 on page 201

In-Class Exercise

• What if the production function has the property of increasing marginal product?

• Does steady state exist?• If steady state exists, does the economy goes

there eventually?• What happens to total capital and total

income over time?

Conclusion

• The basic Solow model implies that economy eventually goes to steady state and stays there.

• Eventually, if there is no population growth, the total income and per-capita income (living standard) both remain constant.

• Put differently, there is no sustained growth in either total income or living standard.

Solow Model with Population Growth

• where is growth rate of population• Everything else equal, higher causes lower ,

see Figure 7-12• So higher population growth rate causes lower

living standard, see Figure 7-13• Discuss: is China’s one-child policy good or

bad?

Solow Model with Population Growth

• Now we can explain sustained growth in total income

because So the growth rate of total income (GDP) is the same as the population growth rate

Discuss: what happens to living standard ( in steady state? Do we get sustained growth in living standard?

Solow Model with Technological Progress

• Let denote the growth rate of technology• Let denote the per-effective-worker capital• Then the key equation now becomes

In steady state the per-effective-worker capital remains constant.

In-Class Exercise

• Show that in steady state, with technological progress there is sustained growth in living standard

Golden Rule

• For the basic Solow model the consumption is maximized when

Denote the level of capital that satisfies this condition

• Policy can affect the saving rate so that is the steady-state level:

Policymakers can solve this equation for

• See Example on page 209