econ-1120-orlov-lecture-19-pre

Introduction

• Lecture Title: Micro Foundations of Macro: International Trade, Financial Flows & Accounts

• Course: ECON 1120 – Lecture 19A

• Instructor: George Orlov, Cornell University

• Date: November 14, 2024

Real Exchange Rate: Micro

• Definition: Measures the price of domestic goods relative to foreign competitors.

  • Formula: Domestic Price / Foreign Price in Foreign Currency

• Implications of Depreciation in Real Exchange Rate:

  • Higher net exports.

  • Domestic consumers shift to cheaper domestic goods (imports decrease).

  • Foreign consumers opt for cheaper imported goods (domestic exports increase).

Real Exchange Rate: Macro

• Economy-wide metric assessing overall competitiveness of the domestic economy.

  • Formula: Domestic Price Index / Foreign Price Index

  • Nominal Exchange Rate plays a critical role.

The Balance of Payments: Current Account

• Definition: Measures the difference between income from abroad and payments to foreigners.

• Components:

  • Income Inflows: Exports and investment income from foreign assets.

  • Income Outflows: Imports and investment income earned by foreigners on domestic assets.

• Current Account Status:

  • Current Account Deficit: Inflows – Outflows < 0

  • Current Account Surplus: Inflows – Outflows > 0

The Balance of Payments: Current Account (Cont'd)

• Sales of financial assets do not count as income.

  • Example: Selling $1,000 of US financial assets to a foreign entity results in receiving $1,000 cash, which is not recorded as income.

The Balance of Payments: Financial Account

• Definition: Measures financial inflows and outflows.

• Components of Financial Inflows:

  • FDI into domestic markets (Foreign Direct Investment).

  • Portfolio Investment (purchase of domestic stocks and bonds).

  • Deposits at domestic institutions and loans to domestic entities.

• Components of Financial Outflows:

  • FDI into foreign economies.

  • Portfolio Investments in foreign assets.

  • Deposits at foreign institutions and loans to foreign entities.

• Financial Account status:

  • Financial Account Deficit: Inflows – Outflows < 0

  • Financial Account Surplus: Inflows – Outflows > 0

The Balance of Payments Equilibrium

• Principle: Inflows must equal outflows.

  • Relationships:

    • Each current account inflow corresponds with a financial outflow.

    • Each current account outflow corresponds with a financial inflow.

• Equation:

  • Financial Inflows + Income from Abroad = Financial Outflows + Income paid Abroad

• Expressions of imbalance:

  • Current Account Deficit = Financial Account Surplus

Bilateral Trade Deficit: Perspective

• Importance of continuous sustainability of trade with all partners over bilateral balances.

• Key Focus: Overall macroeconomic stability instead of scrutinizing individual trade partners.

Saving, Investment, and Current Account

• GDP formula: Y = C + I + G + NX

  • Current account deficit interpretation: -NX reflects overall spending exceeding earnings.

Saving, Investment, and Current Account (Cont'd)

• National Saving Definition:

  • Private Saving, Government Saving concepts included.

• Equation Integration:

  • Current Account Deficit = I - Y - C - T - G

  • Connects savings to Financial Account Surplus.

Saving, Investment, and Current Account (Conclusion)

• Investment in the economy is financed by national savings and foreign savings directed to domestic needs: I = S + Financial Account Surplus.

Upcoming Content

• Reading Assignment: Chapter 16 (pp. 405 – 433)

  • Next Topic: Building the Fed Model, Part I

Building the Fed Model: Aggregate Expenditure & Multiplier

• Purpose: Understanding policy implications over varying timeframes.

Short-Run vs Long-Run Analysis

• Long Run: Period of significant shifts in resources and potential output.

  • Timeframe: Typically a decade or longer.

  • Focus: Supply-side factors.

• Short Run: Current production levels can vary; influenced by demand-side factors.

The Output Gap

• Definition: The disparity between estimated potential GDP and actual GDP.

• Calculation:

  • Output Gap = (Actual Output - Potential Output) / Potential Output × 100%

Changes in the Output Gap

• Descriptive Language for changes:

  • More negative output gap: Actual output grows slower than potential.

  • More positive output gap: Actual output grows faster than potential.

Aggregate Expenditure Breakdown

• Components of Aggregate Expenditure:

  • Consumption, Planned Investment, Government Purchases, Net Exports.

• Formula: AE = C + I + G + NX

Planned Investment & Inventories

• Investment includes:

  • Planned investments (machinery, buildings, etc.) and

  • Unplanned changes in inventories that are stockpiled but unsold.

  • Unpurchased inventory changes do not affect Aggregate Expenditure.

Aggregate Expenditure: Income Dynamics

• Consumption correlates with income levels.

• Marginal Propensity to Consume (MPC) influences Aggregate Expenditure function:

  • Simplified formula under certain assumptions: AE = I̅ + G̅ + NX + C0 + MPC × Y.

Keynesian Cross: Macroeconomic Equilibrium

• Conditions for equilibrium AE:

  • AE matches total production Y: AE = C + I + G + NX = Y.

• Equilibrium exhibited isn’t necessarily aligned with long-run potential output.

• Factors affecting Aggregate Expenditure can alter macroeconomic equilibrium (shifts in equilibrium).

The Multiplier Effect

• Spending cycle initiates multiple rounds of income creation:

  • Process:

    • Initial spending generates income, MPC dictates subsequent spending.

• Formula:

  • ΔGDP = ΔSpending × Multiplier = ΔSpending × 1 / (1 - MPC).

The Multiplier Effect Practical Implication

• Government spending can amplify economic activity beyond the direct impact of expenditure increases due to the multiplier effect.

Next Class and Readings

• Reading Assignment: Appendix A (pp. A-1 – A-16)

• Next Topic: Building the Fed Model: IS-MP Model.