Covid-19 and the Global Economy

Globalization and Economic Shocks

The Covid-19 pandemic highlighted the interconnectedness of the global economy. Uncertainty led to forecasting errors by firms, which, due to globalization, had significant worldwide effects.

• 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 Linkages

Countries are linked at the macroeconomic level through:

• Trade in goods and services

• Flows of financial investment

Understanding these linkages is essential for analyzing the effects of fiscal and monetary policy.

Open and Closed Economies

• Open Economy: Engages in international trade or finance.

• Closed Economy: No interactions in trade or finance with other countries (rare in practice; e.g., North Korea).

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.

Main Components of the U.S. Balance of Payments (2020)

Additional info: The BoP must always sum to zero, as every transaction is offset by another.

Current Account Details

• Trade Balance: Difference between exports and imports of goods.

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

• Net Income on Investments: Earnings on foreign investments minus payments to foreign investors.

• Net Transfers: Transfers of money where no good or service is provided in return (e.g., remittances).

• For simplicity, net exports are often used as a proxy for the current account balance in the U.S.

Financial Account

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

• Capital Inflows: Purchases of domestic assets by foreigners.

• Includes foreign portfolio investment (stocks, bonds) and foreign direct investment (factories, real estate).

Net Foreign Investment (NFI)

• Net Foreign Investment: Difference between capital outflows and inflows.

• Also equals net foreign direct investment plus net foreign portfolio investment.

Capital Account

• Since 1999, refers only to minor transactions (e.g., intellectual property, migrants' transfers).

• Balance is small and often ignored in macroeconomic analysis.

Why Is the Balance of Payments Always Zero?

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

• Any deficit in one account is offset by a surplus in another (e.g., a current account deficit is financed by a financial account surplus).

Foreign Exchange Market and Exchange Rates

Exchange Rates

• Nominal Exchange Rate: Value of one currency in terms of another (e.g., $1 = ¥100).

• Real Exchange Rate: Adjusts the nominal rate for price level 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 $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 occurs where quantity supplied equals quantity demanded.

Market and Fixed 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

• Factors shifting demand for foreign exchange (apart from the exchange rate itself):

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

  2. Changes in investment attractiveness

  3. Expectations about future exchange rates

• Supply shifts mirror demand shifts in the opposite direction.

Exchange Rates, Imports, and Exports

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

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

• Example: If $1 = €1, a $200 iPhone costs €200. If $1 appreciates to €1.20, the iPhone costs €240 in Europe, reducing demand.

Case Study: Toyota and Exchange Rates

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

• This reduces profits for Japanese exporters like Toyota because:

  1. Cars sold abroad become more expensive in foreign currencies, reducing sales.

  2. 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 imports cheaper and exports more expensive.

• The effect on a country depends on its economic structure and the balance between imports and exports.

National Saving, Investment, and the International Sector

Key Identities

• When a country's spending exceeds its income, it finances the gap by selling assets or borrowing.

• Identity: Current Account Balance + Financial Account Balance = 0

• Therefore: Net Exports = Net Foreign Investment

Domestic Saving, Investment, and Net Foreign Investment

• National Saving (S):

• Private Saving:

• Public Saving:

• National Saving:

The Saving and Investment Equation

• From the national income identity:

• So:

• Since ,

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

Application

• If net foreign investment (net exports) is negative, national saving is less than domestic investment.

• Example: Saving used to buy a bond can finance domestic investment or foreign investment.

Government Budget Deficits and Investment

• A budget deficit reduces national saving ( negative).

• To finance the deficit, governments sell bonds, raising interest rates and attracting foreign capital.

• This can cause the domestic currency to appreciate, reducing net exports and net foreign investment.

The Twin Deficits

• When budget deficits lead to current account deficits (declines in net exports), this is called the "twin deficits" phenomenon.

• Historically observed in the U.S. in the 1980s, but the relationship is not always strong.

Policy in an Open Economy

Monetary and Fiscal Policy Channels

• Open economies have more policy channels than closed economies.

• Monetary policy (e.g., lowering interest rates) can affect exchange rates and net exports, making it more effective in open economies.

• Fiscal policy (e.g., increased government spending) may raise interest rates, appreciate the currency, and reduce net exports, making it less effective in open economies.

Summary Table: Effects of Policy in Open vs. Closed Economies

Practice Questions (Selected)

• Which transactions are included in the current account? (e.g., exports/imports of goods/services)

• How do changes in the exchange rate affect imports and exports?

• What is the relationship between national saving, investment, and net foreign investment?

• How do budget deficits affect the trade balance and exchange rates?

Additional info: Practice questions reinforce understanding of the balance of payments, exchange rates, and the effects of policy in an open economy.