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1. Class next week is one of two places.
A) Saturday 11-2 in C230. Section will follow. We will have only 15 minut= es for lunch, so please bring a brown bag and do not count on visiting a restaurant. or B) Wed. in C230 at the regular time (but a larger room). There will not be class on Thanksgiving. 2. Please read the attachment in Word 6 (or plain text below) before class= =20 next week. 3. Also read "The Open Economy" and "The Open Economy in the Short Run,"=20 Mankiw Chapters 7&11 Homework #5: Prepare Mankiw problem 5, p. 213 for class. i. Explain the claim that "Countries that run persistent trade deficits are also net borrowers." ii. Why is monetary policy less effective with fixed exchange rates tha= n with flexible? iii. Why is fiscal policy less effective with flexible exchange rates than= =20 with fixed? David Levine November 18, 1999 B.A. 201B Macroeconomics Some Open Economy Macroeconomics Accounting: Recall that Net Exports =3D NX =3D Exports - Imports. Also, in an open economy, Y =3D C + I + G + NX. When exports rise, foreigners buy m= ore=20 of our output; thus, aggregate demand for domestically produced goods rises. = =20 When imports rise we are buying from foreigners, so imported purchases do not en= ter domestic aggregate demand. NX =3D trade surplus =3D -trade deficit =3D net borrowing from abro= ad. When NX is negative (imports < exports), we have a trade deficit. This is finan= ced by borrowing from abroad. To a first approximation, when the US spends mor= e=20 on exports than it earns on imports, it needs to borrow to make up the difference. The trade deficit is not exactly equal to borrowing from abroad=20 because of the returns from net foreign assets. When the US was a creditor nation,= it also made money on its investments abroad--this income permitted a modest= =20 trade deficit without borrowing. Now, as a debtor nation, a modest trade surplus= is required to avoid the need for new borrowing. (We are also ignoring=20 government buying and selling of currencies.) The Current Account Surplus =3D Exports= - Imports + interest and profits received from net foreign assets. Exchange rates: An exchange rate is the price of one currency in= =20 terms of another. For example, a French Franc (FF) costs 15.7? yesterday, while = it was 10? when I traveled in France in 1985. The US currently has floating exchange rates, meaning that the valu= e=20 of the dollar fluctuates. The is about 105.8 yen today, but has varied from 103.76 to 124.44 in the last 12 months. Thus, the dollar bought fewer yeni= t weakenedover much of the last year. Under fixed exchange rates there would, in principle, be no day-to-= day changes in the exchange rate. The Federal Reserve would buy and sell dolla= rs and foreign currencies to keep the exchange rate fixed. The float is a lit= tle bit "dirty," since the Fed and other central banks intervene on currency markets (i.e., buy and sell dollars) to affect the value of the dollar. Unlike the U.S., most nations in the world fix their exchange rates with someone. A few dozen use common currencies: the West African Franc is used= by many former French colonies and Panama uses the $U.S. Other countries such= as Argentine or Hong Kong promise to keep as many U.S. dollars (or DM) as they have circulating currency; this "currency board" arrangement makes a fixed exchange rate credible because if folks want to sell the local currency, th= ere are always dollars or DM to redeem them. The value of the dollar: Many factors affect the value of the dollar: US and foreign aggregate demand, U.S. and foreign interest rates, speculative bubbles, and so forth. The dollar becomes stronger (i.e., can buy more of = a foreign currency) when US real interest rates (r) are high. If r is high,= =20 then foreigners want to buy dollars in order to put them into US banks and recei= ve the high interest rate. When the demand for dollars goes up, so does its= =20 price in terms of foreign currencies -- it gets stronger. The net demand for dollars is low and the dollar will depreciate (weaken)= =20 when: * Foreigners don't want to buy U.S. goods (U.S. exports low, foreigne= rs importing little); * US want to buy foreign goods (U.S. imports high, foreigners exporting a lot). US AD high implies leakage to foreign markets, IM high. * Foreigners don't want to buy U.S. assets, often when U.S. interest rates are low. * U.S. wants to buy foreign assets, often when foreign real interest rates are high. * People think $ will get even weaker. This adds a speculative dimension, so speculative bubbles sometimes appear to be important, as are expectation= s=20 of foreign or US changes in policy. David Levine Macroeconomics November 18, 1999 A Morality Play of International Trade Chris and Pat were having a conversation one day upstairs at Kip's. Chris: Pat, I don't see how you can be for free trade. If Taiwan grows fas= ter than us, we will lose. Pat: Chris, you clearly do not understand the great economist Ricardo's ide= a=20 of Comparative Advantage. C: That's for sure, I don't. Wazzat? P: Comparative advantage is what you are least worst, or most best at. For example, this great entrepreneur whose name escapes me was the world's fast= est typist, but hired a secretary nevertheless. He was perhaps 5 times as productive as she was as an entrepreneur, but only 3 times as productive as= a typist--thus, he had absolute advantage in both, but she had comparative advantage in typing. C: So what does that have to do with free trade? P: An example may clarify. Step over to this handy blackboard, and let me write a bit. First, imagine a world with two countries, the US and Taiwan,= =20 and two goods, computers and wine. Further, assume that labor is the only inpu= t into production. Each country has 100 hours of labor. First consider a case with no trade, when each nation's output equals their consumption: USA WITH NO TRADE Product Productivity Output computers 30 hrs / PC 2 wine 2 hrs / bottle 20 total hours =3D 30 * 2 + 2 * 20 =3D 100 TAIWAN WITH NO TRADE Product Productivity Output computers 10 hrs / PC 8 wine 1 hrs / bottle 20 total hours =3D 10 * 8 + 1 * 20 =3D 100 Note that Taiwan makes computers in 1/3 the US time, and wine in 1/2 the US time. Thus, Taiwan has absolute advantage at both wine and computers. Tai= wan has comparative advantage (is most best at) computers. US has comparative advantage (is least worse at) wine. Now let's see what happens if we permit trade. The US will specialize in= =20 wine, what it is best at. The world price will be about 12 bottles of wine per P= C=20 in the world with trade. USA WITH TRADE Product Productivity Output Consumption computers 30 hrs / PC 0 2 wine 2 hrs / bottle 50 26 wine 2 hrs / bottle 50 26 total hours =3D 0 * 30 + 2 * 50 =3D 100 consumption of wine =3D production - 24 sold to Taiwan consumption of computers =3D 2 bought from Taiwan TAIWAN WITH TRADE Product Productivity Output Consumption computers 10 hrs / PC 10 8 wine 1 hrs / bottle 0 24 total hours =3D 10 * 10 + 0 * 1 =3D 100 Both countries receive at least as much of both goods after trade. (The ex= act price with free trade, and therefore the amount of consumption in each=20 country, depends on the demand elasticities in the two countries and other factors.) Thus, in a world of comparative advantage, trade helps both countries! =20 Nations should specialize in what they do best. Complete specialization, as in thi= s example, is an extreme case. As Adam Smith pointed out 200 years ago, specialization permits all to grow wealthier. C: Your argument assumes quite a bit. Implicit in your example is the assumption that when the US quits producing computers, all of those Cory-ha= ll types be magically transformed into Vit & Eno majors from Davis. If we are= in a recession, then the computer workers who lose their jobs won't get new jo= bs; policies to protect our domestic industry can avoid unemployment and increa= se aggregate demand. P: You are recommending "beggar-thy-neighbor" policies, since any gain in o= ur demand is offset by losses to our neighbors'. If we get started on that ta= ck, the whole world loses. Not everyone can increase demand by restricting imports! C: Even without the macroeconomic problem, there is still the unemployment caused by free trade destroying industries. How will all the ex-computer f= olk get the skills to make wine? P: You are correct, and both US computer makers and Taiwanese wine makers= =20 (both companies and employees) prefer not to have trade in the short run. The po= int is that the winners (i.e., US wine makers, Taiwanese computer makers, and consumers in both countries) win more than the losers lose. C: If free trade brings so many benefits, then it should bring enough prosperity to compensate the losers. It is not fair to the computer worker= s that they bear the cost of adjustment. It makes sense to tax some of the winners, and pay some subsidy to help the losers retrain. Full employment is not your only key assumption. You also assume that mark= ets are competitive, so that firms make no monopoly profits. In fact, it appea= rs that some industries make big profits. When we lose market share in these industries, the capital flows to a less profitable industry. P: Again, I must grant your point that there are monopolistic industries an= d most Americans would rather the monopoly profits stay at home. In general, free trade eliminates monopoly profits, and will help consumers enormously. C: Yes, but in addition to there being high-profit industries, there are high-wage industries, so workers care which industry they are in. When we= =20 lose market share in these industries, the workers move to industries with lower= =20 pay and lower productivity. Autoworkers who become hamburger flippers are not making a marginal switch to their next best-paying job. For example, Boeing has traditionally made big profits, and paid its worker= s well. When Europeans subsidized Airbus and we lost airplane manufacturing jobs, we lost both those high profits, and the workers had to move to lower-wage employers. P: I agree that it is theoretically possible for subsidies to increase a nation's welfare, if the subsidies bring oligopoly profits and high-wage jo= bs. Nevertheless, it would be better for everyone if nobody subsidized, and=20 markets were more competitive. In the US today, both imports and exports are mostl= y made in high-wage jobs. Thus, we should favor the expansion of trade, not restrictions. C: Your hypothetical situation is irrelevant, since other nations are subsidizing. Japan is famous for protecting its industries until they beco= me big enough to compete internationally--then, watch out! P: Do you really think that the US steel, auto and computer industries are = too small to compete internationally? C: Well, I have to admit that USX, GM and IBM are not what one usually thin= ks of as part of infant industries. But the Japanese also subsidize industrie= s and dump exports below cost in order to drive competitors out of business. Once they have a monopoly, then they really gouge. P: Have the Japanese really increased prices of color TVs, RAM chips, or ot= her goods? Anti-dumping laws primarily mean that foreigners are not allowed to= =20 cut prices--price cuts that would benefit US consumers. Even with an uneven playing field, I disagree with you. As usual with protectionists, you ignore consumers. When European subsidies created Airb= us, Airbus made the market for passenger aircraft much more competitive. US consumers won in terms of lower airfares--something you forgot to stress in your arguments about Boeing's loss of high profits and high-wage jobs. I am very suspicious of these claims that we need to protect all sorts of industries, since it gives companies enormous incentives to pour money into lobbying. The large firms of the US steel industry have been incredibly successful at lobbying for protection. This protection has mostly protecte= d=20 an inefficient oligopoly, at great cost to US consumers. C: But we sometimes need protection as a stick, to beat foreigners into=20 opening their markets to us. P: While protection can be a stick, it is not easy to wield. It seems most likely to lead to a trade war, where retaliation by foreigners leads them t= o close markets to us if we restrict trade. Usually when we run protectionism, it is in the form of the misnamed "voluntary" export restraint (VER), like the one that we have with the=20 Japanese for automobiles. These basically require the foreigners to form a cartel, lower sales, and increase price. I do not know why the US government helps foreigners run cartels that hurt US consumers! Anti-trust policy is suppos= ed to restrict cartels. The auto VERs cost consumers over $100,000 for each US job that is saved. C: Well, I am not convinced. All of your arguments concerning the advanta= ges of free trade are based on this notion of comparative advantage, which you assume is somehow granted by nature. In today's high-tech industries, comparative advantage is won by experience in producing complicated technologies, not by weather or natural resources. P: If comparative advantage is won by experience, then experience in produc= ing becomes a sort of investment. Why can't US firms undertake investments tha= t are profitable? You cannot seriously believe that IBM is too small to comp= ete with foreigners. C: But there are spillovers from one industry to another. The experience o= f Silicon Valley, for example, shows that when one part of high-tech does wel= l, other parts learn from it and do well also. Even your economists have always agreed that when there are positive externalities that there is a role for public subsidies. For example, an innovating firm rarely captures all the gains of its research and developme= nt. In the example above, when new computer technologies are developed, only th= e Taiwanese will be able to develop the new products based on their expertise= in PC manufacture. P: I agree that companies providing positive spillovers should be encourage= d. I think that support of university research, coupled with an R&D tax credit makes more sense than protectionism. You, on the other hand, seem to be promoting an "industrial policy," in whi= ch the government picks winners to promote. Didn't the billions of dollars th= at France and Britain poured into the Concorde supersonic transport, as well a= s wastage of the US with Synfuels synthetic gasoline teach you that industria= l policy won't work? C: Well aren't you self-righteous. The US has always had a multitude of vigorous and expensive industrial policies, they have just gone under a=20 variety of other names and have never been coordinated to work together. Agricultu= re receives billions in subsidies, steel and textiles have quotas on imports, Lockheed and Chrysler received government-backed loans, and housing gets th= e mortgage interest deduction. Perhaps most importantly, a vast proportion o= f our research is funded by the military, which has always looked to advantag= es for certain industries. All I want is a rational and democratic industrial policy. We should coordinate our goals, and choose our subsidies more democratically and in ways that do= =20 not work to cross-purposes. For example, any bailouts or protection from impor= ts should be short run, and explicitly tied to promises to invest in new=20 machinery and new skills for workers. New technologies to be promoted should be chos= en by democratically-chosen representatives, not by nameless bureaucrats at DA= RPA (the Defense Advanced Projects Research Administration)--an agency almost nobody has heard of. P: I would just as soon cut subsidies to all those industries as adjust wha= t subsidies I give. Nevertheless, I grant you that if subsidies are given th= ey should at least include promises from the industry and its workers to inves= t, not just enjoy high current wages and profits. C: You're starting to talk sense now. We must always keep in mind that=20 America needs high tech to maintain its competitiveness. P: I don't understand this word "competitiveness." I, like you, would like= US productivity to grow quickly so that we are more prosperous, and have more resources to care for the disadvantaged, the environment, and so forth. I= =20 care about the absolute level of US growth, not the relative level. C: But if the US growth more slowly than Japan, we will lose our standing a= s a world power! P: I am not thrilled about any nation being overwhelmingly powerful. It is= ok with me if the US must consult with its allies before invading various smal= l open economies. C: Well, I have won enough points from you that I should probably stop. Yo= u agree that (at least in theory) protectionism can help keep high-profit, high-wage, and high-spillover industries at home, and raise national output= . P: I must agree in theory, and also remind you that the industries have political clout to receive protectionism are often the worst-run. =20 Furthermore, any protectionist policy leads to the risk of trade wars, and they make everyone worse off. C: Hey, that's enough economics talk. Let's go have a beer--Anchor Steam, = not Beck=0F's. - INTLHND99a.doc David I. Levine Associate professor Haas School of Business ph: 510/642-1697 University of California fax: 510/643-1420 Berkeley CA 94720-1900 email: levine@haas.berkeley.edu http://web.haas.berkeley.edu/www/levine/
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