Macroeconomics: The USA and the World

Janet OrrCTL Teaching RetreatApril 21-22, 2005

Global Connections for US

Market Systems vs. Command EconomyEconomic FreedomCircular Flow Model of the US EconomyInternational TradeForeign ExchangeNet ExportsEffects of international economy on US Fiscal and Monetary Policy

Market Economy vs. Command Economy

Economic Systems

Market economy (capitalism)

Private ownership of resources

Allocation of resources determined by actions of sellers and buyers (prices and profits)

Laissez-faire capitalism Let-it-be, keep gov’t out

of business

US capitalism has a major role for gov’t.

Command economy (communism, socialism, feudalism)

Public or state ownership of resources

Allocation of resources determined by a central planning authority (shadow prices)

Only Cuba and North Korea currently have largely centrally planned economies

Economic FreedomFreedom of Enterprise and Choice “Economic freedom is defined as the

absence of government coercion or constraint on the production, distribution, or consumption of goods and services beyond the extent necessary for citizens to protect and maintain liberty itself. In other words, people are free to work, produce, consume, and invest in the ways they feel are most productive.” Heritage Foundation

Index of Economic Freedom

Index of Economic Freedom www.heritage.org studies 50 factors arranged in 10 broad

categories Trade policy, Fiscal burden of government, Government intervention in the economy, Monetary policy, Capital flows and foreign investment, Banking and finance, Wages and prices, Property rights, Regulation, and Informal market activity

Published by Heritage Foundation and Wall Street J ournal

Circular Flow Model of the US Economy

International Linkages

Goods and servicesCapital and laborInformation and technologyMoneyLinkages flow both ways

International Trade

USA & World TradeVolume

Increased in absolute size since 1950Increased as a percentage of GDPExports & imports are 12% and 17% of GDP, double their importance from 25 years agoJust after WWII, USA was 1/3 of all tradeCurrently, USA is 1/8 of all trade

USA & World Trade

DependenceUSA imports many food items, raw silk, diamonds, natural rubber, petroleumUSA exports agricultural products, chemicals, aircraft, cars, computers

International Trade

USA & World Trade

Trade PatternsTrade deficit in goodsTrade surplus in servicesNet trade deficitMost trade is with industrialized nationsCanada is our largest trading partner• 24% of exports• 20% of imports

USA & World Trade

Growth of trade facilitated byTransportationCommunicationReduction in trade barriers

International Trade

Specialization

Absolute advantage:You should buy a good from someone else if the other person can produce it more cheaply than you can.

Comparative advantage:

Goods should be produced by the person having the lowest opportunity cost to produce the good.

International Trade

Specialization and Trade

Improves world-wide production.Allows both trading partners to move beyond their domestic production possibilities curve.

Additional Benefits of Free Trade

Promotes competition and deters monopoly power.Specialization may increase the productivity of the resources used to produce certain goods and thereby expand the production possibilities frontier.Linking of national interests may reduce nationalistic animosities.

International Trade

Barriers to Free Trade

Tariffs--excise taxes on importsRevenue tariffProtective tariff

Import quotas--maximum amount of imports allowed in a certain period of time (immigration quotas?)

Barriers to Free Trade

Non-tariff barriers include licensing requirements, standards, bureaucratic red tapeVoluntary Export Restriction (VER)

Pros/Cons of Free Trade

Arguments for Trade Barriers:Are the arguments valid?

Military self-sufficiencyIncreasing (or maintaining) domestic employmentDiversity for stabilizationInfant industry (similar to diversity)Strategic trade policyProtection against “dumping”Protection against cheap foreign labor

Evidence for Free Trade

U.S. constitution forbids individual state from levying tariffsCreation of Common Market in Europe eliminated tariffs among member nationsTariff reduction since mid-1930s directly related to expansion of the world economyResult of Smoot-Hartley Act of 1930 was to worsen the Great DepressionDeveloping countries that have relied on import restrictions to protect industries have showed slower economic growth

Trade Agreements

Movement toward Free Trade• Reciprocal Trade Agreements Act,

1934•Presidential Authority•Generalized Reductions•Most-Favored-Nation Clauses

• General Agreement on Tariffs and Trade (GATT)

• World Trade Organization (WTO)

Movement toward Free Trade•The European Union (EU)

•The Euro•North American Free Trade Agreement (NAFTA)

•CAFTA

Foreign Exchange

Equals

Equals

Equals

Equals

Dollar priceof foreigncurrency

rises

Internationalvalue of dollar

falls (dollardepreciates)

Foreigncurrencyprice of

dollar falls

Internationalvalue of foreigncurrency rises

(foreign currencyappreciates)

Currency Appreciation and Depreciation

THE FOREIGN EXCHANGE MARKETThe Market for Yen

Quantity of Yen

Dol

lar

Pric

e of

1 Y

en

0

.01

P

QQe

Sy

Dy

ExchangeRate: $.01 = ¥1

THE FOREIGN EXCHANGE MARKET

Net Exports

Xn = Net Exports

Equals exports minus imports

Xn = X - M

Can be positive or negative

Positive (exports>imports is a trade surplus

Negative (exports<imports) is a trade deficit

Size of US Economy Is Affected by International Economics

GDP= C + G + Ig +Xn

Determinants of Xn Prosperity abroad

Increased prosperity abroad will increase exports and Xn

Tariffs Imposition of tariffs may temporarily increase

Xn by decreasing imports However, retaliation will decrease exports

Exchange rates Depreciation of the U.S. dollar will increase

our exports relative to our imports

Fiscal and Monetary Policies

International Effects on/of Fiscal PolicyInternational Effects on/of Fiscal Policy Recession Recession leads toleads to Expansionary fiscal policy Expansionary fiscal policy leads toleads to

–– Increase G, Decrease TIncrease G, Decrease T–– Government borrowing raises interest rateGovernment borrowing raises interest rate

Higher interest rate Higher interest rate leads toleads to–– Makes lending to US attractiveMakes lending to US attractive

Increased foreign demand for dollars Increased foreign demand for dollars leads leads toto–– Price of dollar in foreign currency risesPrice of dollar in foreign currency rises

Dollar appreciates Dollar appreciates leads toleads to–– Makes US goods relatively more expensiveMakes US goods relatively more expensive–– Decreases exportsDecreases exports

Net Exports decline Net Exports decline leads toleads to AD decreasesAD decreases——ACTS COUNTER TO FISCAL ACTS COUNTER TO FISCAL

POLICYPOLICY

How Does an Easy Money Policy Increase Aggregate Demand?

Increase M1

Interest rate decreases (more supply, lower prices)

Domestic gross investment increases

AD increases

Increase M1

Interest rate decreases (more supply, lower prices)

Dollar depreciates

Net exports increase

AD increases

2 out of 17 chapters covered this semester deal with international tradeMany comparisons between conditions in the USA and other countries throughout the courseInterdependence stressedMany discussion questions for my online macroeconomics course deal with international issues

Open-ended Questions for Online Macroeconomics Class

According to the Heritage Foundation’s Index of Economic Freedom what is the Number one free economy of the world? Does this ranking surprise you? Why or why not? Why isn’t the United States ranked among the top three free economies? Right after WWII, about 1/3 of the world’s trade was with the US. Currently, about 1/8 of the world’s trade is with the US. Do you think that the reduction in percentage dependence on the U.S. for trade has a positive or negative effect on world stability? Explain your reasoning. Find a current political quote in favor of or opposed to a trade barrier. Why do you suppose this politician holds this opinion? Is there an economic basis underlying this position?

Open-ended Questions for Online Macroeconomics Class

Support for trade barriers or protectionism is in seven areas: military self-sufficiency; increased domestic employment; diversification-for-stability; infant industry; strategic trade policy; protection against dumping; and, protection against cheap foreign labor. Pick one of the seven arguments and state both sides. Try to use a real world example to support your pro and con. Are you in agreement with any trade barriers? Why or why not? (Don’t forget barriers to countries whose policies are in direct opposition to ours.) In some of the discussions, we’ve mentioned job outsourcing; trade barriers are one to deal with this problem. Do you feel that the inefficient use of resources caused by trade barriers are a smaller problem than unemployment caused by outsourcing? Can you suggest another way to handle loss of jobs to more efficient countries?

Open-ended Questions for Online Macroeconomics Class

Discuss the protests against the WTO. You can find additional information at www.wto.org. Alternative views can be found at the website of Public Citizen (http://www.citizen.org ). In their words, “Public Citizen is a national, nonprofit consumer advocacy organization founded in 1971 to represent consumer interests in Congress, the executive branch and the courts.

It almost sounds like a “catch 22”: If a country is doing well with high levels of income so that its citizens can afford to buy imported goods, then net exports may be negative which has the effect of reducing that country’s GDP. Is this a sufficient reason to implement trade barriers? Why or why not?

Open-ended Questions for Online Macroeconomics Class

If a country has a trade deficit, what is the effect of depreciation in that nation’s currency relative to the currency of its trading partner with which the deficit is worst? Does this mean that there can be a positive to having a “weak” dollar?Explain one of the two views on the high rates of unemployment in Europe. How does having an open economy affect our fiscal policy? Discuss either shocks originating from abroad (use an example similar to the textbook’s example) or the Net Export Effect.