# lecture6 - Economics 202A Lecture Outline #6 (version 1.1)...

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Unformatted text preview: Economics 202A Lecture Outline #6 (version 1.1) Maurice Obstfeld The Open Economy and the Current Account Let&s dene (all in real terms) Y = GDP C = consumption I = investment G = government purchases NX & X M = net exports F = net foreign income earnings (+ transfers). The ow F is basically the interest, dividend, and prot income we earn on our gross foreign assets less the income foreigners earn 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 simple models, NX is a function of (among other variables) 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.) In many models NX is the aggregate demand component that is sensitive to the real exchange rate, with @NX @ ( EP & =P ) > : Dene the current account balance as CA = NX + F: 1 Real Exchange Rate of the U.S. Dollar 85 90 95 100 105 110 115 120 M1 1995 M9 1995 M5 1996 M1 1997 M9 1997 M5 1998 M1 1999 M9 1999 M5 2000 M1 2001 M9 2001 M5 2002 M1 2003 M9 2003 M5 2004 M1 2005 M9 2005 M5 2006 M1 2007 M9 2007 M5 2008 M1 2009 M9 2009 Sources: IMF and FRB Index (January 2004 = 100) 2 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 do- mestic 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. Thus, the U.S. ran historically high external de&cits in the 2000s. Thanks to the sub- prime crisis, private saving has been rising and investment falling, cutting the current account de&cit of the U.S. in half. Real Interest Rates So far we have not talked about interest rates. But the United States is part of a global capital market its current account de&cit, which repre- sents its net demand for foreign savings, must be matched, in equilibrium, by the supply of savings by non-U.S. countries. That means that if the U.S. is runing a big external de&cit, the rest of the world must be running cor- responding external surpluses. Real interest rates serve to bring about the global equilibrium. The &rst point to make is that even under the nominal interest parity condition that would hold with risk-neutral investors (it follows from perfect risk-neutral arbitrage in international &nancial markets), national real inter- est rates need not be equal. Let a hat over a variable denote an expected percentage change. Then (nominal) interest parity states that i = i & + b E: The domestic and foreign real rates of interest are r = i & b P; r & = i & & b P & : 3 U.S. Current AccountU....
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## This note was uploaded on 02/28/2012 for the course ECON 202A taught by Professor Akerlof during the Fall '07 term at University of California, Berkeley.

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lecture6 - Economics 202A Lecture Outline #6 (version 1.1)...

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