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 were amplified by globalization.

• Globalization: The increasing integration of economies worldwide through trade, investment, and technology.

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

Balance of Payments: Linking the U.S. to the International Economy

International Linkages

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

• Trade: Exchange of goods and services across borders.

• Financial Investment: Cross-border flows of capital, such as investments in stocks, bonds, and physical assets.

Open and Closed Economies

Definitions and Examples

Most modern economies interact with others through trade and finance.

• Open Economy: Engages in international trade and financial transactions.

• Closed Economy: No international trade or financial interactions (rare; e.g., North Korea).

Balance of Payments (BoP)

Structure and Components

The balance of payments records all economic transactions between residents of a country and the rest of the world.

• 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.

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

U.S. Balance of Payments, 2020 (Billions of Dollars)

Additional info: Values are illustrative; actual tables may include more detailed breakdowns.

Trade Flows and the Current Account

Trade Balance

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

• Trade Surplus: Exports > Imports (positive balance)

• Trade Deficit: Imports > Exports (negative balance)

• 2022 Example: The U.S. had a trade deficit of $1,183 billion.

Other Current Account Components

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

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

• Net Transfers: Transfers such as foreign aid, remittances.

Note: For simplicity, net exports are often treated as equal to the current account balance.

Financial Account and Net Foreign Investment

Capital Flows

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

• Capital Inflows: Purchases of domestic assets by foreigners.

• Types of Investment:

  • Foreign Portfolio Investment: Investment in financial assets (stocks, bonds).

  • Foreign Direct Investment: Investment in physical assets (factories, real estate).

Net Foreign Investment (NFI) is the difference between capital outflows and inflows.

Why Is the Balance of Payments Always Zero?

Accounting Identity

The sum of the current account, financial account, and capital account balances must equal 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).

The Foreign Exchange Market and Exchange Rates

Nominal and Real Exchange Rates

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

• Real Exchange Rate: Adjusts the nominal rate for differences in price levels between countries.

• Foreign Exchange Market: Where currencies are traded; 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 comes from:

  1. Foreigners buying U.S. goods/services

  2. Foreigners investing in U.S. assets

  3. Currency traders/speculators

• Supply of $US is driven by Americans buying foreign goods/services or investing abroad.

Exchange Rate Equilibrium

• If the exchange rate is too high, surplus of $US; rate will depreciate.

• If too low, shortage of $US; rate will appreciate.

Market vs. Fixed Exchange Rates

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

Shifts in Demand and Supply for Foreign Exchange

• Factors shifting demand/supply (other than exchange rate itself):

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

  2. Changes in investment preferences

  3. Expectations about future exchange rates

• Example: Rising U.S. incomes increase demand for imports, raising supply of $US in exchange markets.

• Example: Higher U.S. interest rates increase demand for $US as foreign investors seek higher returns.

Exchange Rates, Imports, and Exports

• When $US appreciates:

  • Imports become cheaper for Americans

  • U.S. exports become more expensive for foreigners

• Example: If $US appreciates against the euro, French consumers buy fewer U.S. goods, while Americans buy more European goods.

Case Study: Toyota and Exchange Rate Fluctuations

Impact of Currency Strength

• A stronger yen means fewer yen per U.S. dollar.

• Reduces profits for Japanese exporters like Toyota by:

  1. Making Japanese goods more expensive abroad

  2. Reducing the value of foreign earnings when converted to yen

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

Is a Strong Currency Good for a Country?

Pros and Cons

• Strong currency: Makes imports cheaper, exports more expensive.

• Impact varies by sector; firms may benefit or lose depending on their reliance on imports/exports.

The International Sector: National Saving and Investment

Key Relationships

• When spending exceeds income, the difference is financed by selling assets or borrowing.

• Accounting Identity:

  • Current Account Balance + Financial Account Balance = 0

  • Current Account Balance = – Financial Account Balance

  • Net Export = Net Foreign Investment

Domestic Saving, Investment, and Net Foreign Investment

Formulas and Equations

• National Saving ():

• Private Saving:

• Public Saving:

• National Saving Simplified:

• GDP Identity:

• Saving and Investment Equation:

  • Since ,

• Interpretation: National saving equals domestic investment plus net foreign investment.

Government Budget Deficits and Investment

Effects on the Economy

• Budget deficits reduce public saving (), lowering national saving.

• To finance deficits, governments sell bonds, often raising interest rates.

• Higher interest rates discourage private investment and attract foreign capital, causing currency appreciation and reducing net exports.

Twin Deficits

• When budget deficits lead to current account deficits, the phenomenon is called twin deficits.

• Historically observed in the U.S. during the 1980s; relationship less clear since 1990.

Policy in an Open Economy

Monetary and Fiscal Policy Channels

• Open economies have more channels for policy effects than closed economies.

• Monetary Policy:

  • Expansionary policy lowers interest rates, depreciates currency, and boosts net exports.

  • More effective in open economies due to additional impact on net exports.

• Fiscal Policy:

  • Expansionary policy may raise interest rates, appreciate currency, and reduce net exports.

  • Multiplier effect is smaller in open economies, as some spending leaks to imports.

  • Overall, fiscal policy is less effective in open economies.

Summary Table: Key Macroeconomic Relationships in an Open Economy