lecture13 - Economics 202A Lecture Outline October 16-18...

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Economics 202A Lecture Outline, October 16-18, 2007 (version 1.1) Maurice Obstfeld The Current Account Y = GDP C = consumption I = investment G = government purchases NX X ± M = net exports F = net foreign income earnings (+ transfers). The ²ow F is basically the interest, dividend, and pro±t income we earn on our gross foreign assets less the income foreigners earen on their gross assets located in our country. The national income identity states that Y = C + I + G + NX: The determination of NX is complicated in reality. In the Dornbusch model, NX is a function of the real exchange rate, EP =P; where the nominal exchange rate E is the price of foreign currency in terms of home currency, so that a rise in E is a relative depreciation of home currency. (In general NX also depends on domestic spending, with more spending raising imports.) Thus, in Dorn- busch, as in the earlier Mundell-Fleming model, NX is the aggregate demand component that is sensitive to the real exchange rate, with @NX @ ( EP =P ) > 0 : De±ne the current account balance as CA = NX + F: In the paper "Has the Adjustment Process Worked?³in the reader, Paul Krug- man asks if, as one would expect from the Mundell-Fleming-Dornbusch setup, the falling dollar of the late 1980s was associated with a reduction in the large (at the time) U.S. current account de±cit. He argues yes, but with a lag. He also presents supportive evidence for Japan and Germany. For the U.S. we have the following ±gure: 1
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Current account surplus (%GDP), left axis, blue, and US dollar real exchange rate index, right axis, red (2000 = 100) -7 -6 -5 -4 -3 -2 -1 0 1 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 5 25 45 65 85 105 125 145 2
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In the most recent data, the dollar has depreciated fairly sharply (following has started to fall. How can we understand the latter development? It may help to look at the link between the current account , saving, and investment. From the identity Y = C + I + G + NX; we derive national income = Y + F = C + I + G + CA: National saving is de±ned as S = Y + F C G: Then we can see that CA = Y + F ( C + I + G ) = S I: The current account equals saving less investment. Savings in excess of domestic investment needs are invested abroad. Investment needs in excess of the home supply of savings must be borrowed from foreigners. Relation to current events: U.S. saving has been very low. Thanks to the subprime crisis, it is likely that saving will rise and investment will fall. The following picture is useful for thinking about how spending and the exchange rate must adjust so that the U.S. can simultaneously reach internal balance (de±ned as full employment) and internal balance (de±ned as a "sus- tainable" level of the current account). Let
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This note was uploaded on 08/01/2008 for the course ECON 202A taught by Professor Akerlof during the Fall '07 term at Berkeley.

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lecture13 - Economics 202A Lecture Outline October 16-18...

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