Covid-19 and the Global Economy

Impact of Globalization and Uncertainty

The Covid-19 pandemic highlighted the interconnectedness of the global economy and the challenges of economic forecasting in a globalized world.

• Globalization means that economic shocks and forecasting errors in one country can have significant effects worldwide.

• Example: Vehicle computer chip manufacturers underestimated demand, leading to a global chip shortage and higher automobile prices in the United States in 2021.

The Balance of Payments: Linking Economies

International Economic Linkages

Countries are connected through trade in goods and services and through financial investment flows. Understanding these linkages is essential for analyzing the effects of fiscal and monetary policy.

• Open economy: Engages in international trade and finance.

• Closed economy: Has no interactions in trade or finance with other countries (rare in practice).

Balance of Payments (BoP)

The balance of payments is a comprehensive record of a country's economic transactions with the rest of the world, including goods, services, and assets.

• Current account: Records net exports, net income on investments, and net transfers.

• Financial account: Records purchases of assets abroad and foreign purchases of domestic assets (long-term flows).

• Capital account: Records minor transactions such as migrants’ transfers and sales/purchases of nonproduced, nonfinancial assets.

Table: Main Components of the U.S. Balance of Payments (2020, Billions of Dollars)

Additional info: Values are illustrative; see official sources for precise data.

Trade Flows and the Current Account

• Trade balance: Difference between the value of exports and imports of goods.

• Balance of services: Difference between exports and imports of services.

• Net exports: Often used as a proxy for the current account balance in the U.S.

• Positive trade balance = trade surplus; negative = trade deficit.

The Financial Account and Net Foreign Investment

• Capital outflows: Purchases of foreign assets by domestic residents.

• Capital inflows: Purchases of domestic assets by foreigners.

• Net foreign investment (NFI): Difference between capital outflows and inflows; also equals net foreign direct investment plus net foreign portfolio investment.

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 spends more on foreign goods/services than it receives (current account deficit), it must finance this by selling assets or borrowing (financial account surplus).

Foreign Exchange Market and Exchange Rates

Exchange Rates

• Nominal exchange rate: Value of one country’s currency in terms of another’s (e.g., $1 = ¥100).

• 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 ($US):

  1. Foreigners buying U.S. goods/services

  2. Foreigners investing in U.S. assets

  3. Currency traders/speculators

• Supply of $US: Americans buying foreign goods/services or assets (e.g., yen for Japanese goods).

• Equilibrium exchange rate: Where quantity supplied equals quantity demanded.

Market and Non-Market Exchange Rates

• Most exchange rates are market-determined, but some are fixed by governments (e.g., Chinese yuan for over a decade).

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 (e.g., Japanese goods) increases, shifting supply of $US up and potentially raising the exchange rate.

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

Exchange Rates, Imports, and Exports

• When the $US appreciates, imports become cheaper and exports more expensive for foreigners.

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

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:

  1. Cars produced in Japan become more expensive in foreign markets, reducing sales.

  2. When converting foreign earnings back to yen, firms receive fewer yen per dollar.

• Firms with production in the export market (e.g., Toyota in the U.S.) are less exposed to exchange rate risk.

Is a Strong Currency Good?

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

• The effect on a country’s economy is ambiguous; it can help or hurt firms depending on their input and output markets.

National Saving, Investment, and International Flows

National Saving and Investment Identity

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

• Key identity:

  • Current Account Balance + Financial Account Balance = 0

  • Net Exports (NX) = Net Foreign Investment (NFI)

Domestic Saving, Investment, and Net Foreign Investment

• National Saving (S) = Private Saving + Public Saving

• Formulas:

• From the national income identity:

  • Since ,

• Interpretation: National saving finances both domestic investment and net foreign investment.

Government 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 (appreciating the currency).

• Higher interest rates can discourage private investment and reduce net exports (the "twin deficits").

The Twin Deficits

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

• Since 1990, the relationship between budget and current account deficits has been less clear.

Policy and International Capital Flows

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

• 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 in Open vs. Closed Economies

• Open economies have more policy channels than closed economies, affecting the effectiveness of monetary and fiscal policy.

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.

• Contractionary monetary policy is also more effective in an open economy due to its effect on exchange rates and net exports.

Fiscal Policy

• Expansionary fiscal policy (increased government spending or tax cuts) can raise interest rates, attracting foreign capital, appreciating the currency, and reducing net exports.

• The multiplier effect is smaller in an open economy because some spending leaks into imports.

• Overall, fiscal policy is less effective in an open economy than in a closed economy.