Covid-19 and the Global Economy

Impact of Globalization and Economic Shocks

• Globalization means that economic shocks in one part of the world can have significant effects elsewhere.

• The Covid-19 pandemic created uncertainty, leading to forecasting errors by firms. For example, vehicle chip manufacturers underestimated demand, resulting in a global shortage and higher automobile prices in 2021.

• Example: U.S. automakers faced production limits due to chip shortages, illustrating how interconnected supply chains amplify shocks.

International Linkages and the Balance of Payments

Trade and Financial Flows

• Countries are linked through trade in goods and services and flows of financial investment.

• Understanding these linkages is essential for analyzing the effects of fiscal and monetary policy in an open economy.

Open and Closed Economies

• An open economy interacts with other countries through trade or finance.

• A closed economy has no such interactions (rare in practice; North Korea is a near example).

Balance of Payments (BoP)

• The balance of payments is the record of a country’s transactions with the rest of the world in goods, services, and assets.

Components of the U.S. Balance of Payments

• Current Account: Records net exports (exports minus imports), net income on investments, and net transfers.

• Financial Account: Records long-term flows such as capital outflows (U.S. purchases abroad) and capital inflows (foreign purchases in the U.S.).

• Capital Account: Records relatively minor transactions; its balance is typically small and often ignored in analysis.

Trade Balance and Current Account

• The trade balance is the difference between the value of goods a country exports and imports.

• A trade surplus means exports > imports; a trade deficit means imports > exports.

• For the U.S., the current account is often approximated by net exports due to small net income and transfer balances.

Net Foreign Investment and Capital Flows

• Net foreign investment (NFI) is the difference between capital outflows and inflows.

• It is equal to the negative of the financial account balance.

• Formula:

Why Is the Balance of Payments Always Zero?

• The sum of the current account, financial account, and capital account balances must be zero.

• If a country runs a current account deficit, it must be financed by a surplus in the financial account (i.e., borrowing or selling assets).

Foreign Exchange Market and Exchange Rates

Exchange Rates

• The nominal exchange rate is the value of one country’s currency in terms of another’s (e.g., $1 = ¥100).

• The real exchange rate adjusts the nominal rate for price differences between countries.

• Foreign exchange markets are highly active, with trillions traded daily.

Equilibrium in the Foreign Exchange Market

• Exchange rates are determined by supply and demand for currencies.

• Demand for U.S. dollars comes from:

  • Foreigners buying U.S. goods/services

  • Foreigners investing in U.S. assets

  • Currency traders/speculators

• Supply of U.S. dollars comes from Americans buying foreign goods/services or assets.

• The equilibrium exchange rate is where quantity supplied equals quantity demanded.

Market and Fixed Exchange Rates

• Most exchange rates are market-determined, but some (e.g., Chinese yuan) have been fixed by government policy.

Shifts in Demand and Supply for Foreign Exchange

• Factors shifting demand/supply (apart from the exchange rate itself):

  • Changes in demand for domestic vs. foreign goods/services

  • Changes in investment attractiveness (interest rates)

  • Expectations about future exchange rates

• Example: If U.S. incomes rise, demand for imports increases, raising the supply of dollars in the foreign exchange market.

• If U.S. interest rates rise, demand for dollars increases as U.S. assets become more attractive.

Exchange Rates, Imports, and Exports

• If the dollar appreciates, U.S. imports become cheaper and exports more expensive for foreigners.

• Example: If $1 = €1, a $200 iPhone costs €200 in France. If $1 = €1.20, the same iPhone costs €240, reducing French demand for U.S. goods.

Case Study: Toyota and Exchange Rate Fluctuations

• A stronger yen means the yen is worth more relative to the dollar; 1 dollar buys fewer yen.

• This reduces profits for Japanese exporters like Toyota because:

  • Cars produced in Japan become more expensive abroad, reducing sales.

  • Profits earned in dollars convert to fewer yen.

• Locating production in the U.S. reduces exposure to exchange rate risk.

Is a Strong Currency Good?

• A strong currency makes exports more expensive and imports cheaper.

• The effect on a country depends on the balance between exporting and importing sectors.

National Saving, Investment, and the International Sector

Linking Saving, Investment, and Net Foreign Investment

• If a country spends more than its income, it finances the gap by borrowing or selling assets.

• Key identity:

• Thus,

Domestic Saving and Investment

• National saving () is the sum of private and public saving:

• So,

The Saving and Investment Equation

• From the national income identity:

• Therefore,

• Since ,

• This shows that national saving equals domestic investment plus net foreign investment.

Application: Budget Deficits and Investment

• A government budget deficit reduces national saving.

• To finance the deficit, the government sells bonds, raising interest rates and attracting foreign capital.

• This causes the dollar to appreciate, reducing net exports (the "twin deficits" phenomenon).

The Twin Deficits

• When budget deficits lead to current account deficits, both are called "twin deficits." This was notable in the U.S. during the 1980s.

• Since 1990, the relationship between the two has weakened.

Policy and International Capital Flows

• Large capital inflows to the U.S. (e.g., in the 2000s) were driven by global savings and made the U.S. attractive to investors.

• In the long run, it may be more efficient for high-income countries to lend to low-income countries, where returns to capital are higher.

Monetary and Fiscal Policy in an Open Economy

Policy Channels

• Open economies have more channels for policy to affect aggregate demand, including through exchange rates and net exports.

Monetary Policy

• Expansionary monetary policy (lower interest rates) in an open economy can lead to currency depreciation, boosting net exports and aggregate demand more than in a closed economy.

Fiscal Policy

• Expansionary fiscal policy (higher government spending or lower taxes) can raise interest rates, causing currency appreciation and reducing net exports, making fiscal policy less effective in an open economy than in a closed one.

Summary Table: Key Equations and Relationships

Example Applications

• Budget Deficit: If the U.S. government runs a deficit, national saving falls, interest rates rise, the dollar appreciates, and net exports fall.

• Exchange Rate Fluctuations: A stronger dollar makes imports cheaper and exports more expensive, affecting firms like Toyota and Apple.

Additional info:

• These notes synthesize both the provided slides and standard macroeconomic context for clarity and completeness.