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Eco 460: International Finance Lecture 1: Introduction to International Economics and Finance Spring 2007 Lecture 1 2/40 Administrivia • Course: Eco 460: International Finance • Lectures: M/W/F 9:10 a.m.–10:10 a.m. (Crounse 301) • Office hours: M/F 10:30 a.m.–12:30 p.m. (Crounse 421) • Contact: [email protected] • Course webpage: http://web.centre.edu/jamus.lim/teaching/eco460.html • Course requirements: – 4 problem sets (20%), 1 midterm (30%), 1 final (30%) – Participation (20%): Experiments (5%), case study (5%), IMF mission simulation (5%), discussion (5%) • Elements of (lecture) style Spring 2007 Lecture 1 3/40 Readings • Required – K&O Ch. 1, 12 – Chinn & Steil (2006) • Recommended – Fieleke (1996) – Higgins & Klitgaard (1998) – Mann (2002) 1 Spring 2007 Lecture 1 4/40 Why International Economics? Consider the humble T-shirt Spring 2007 Lecture 1 5/40 Why International Economics? • International trade is an increasingly important part of the U.S. economy – Net exports have increased fivefold between 1960 and 2005 – The U.S. moved from a net exporter to importer in the mid-1970s – The share of trade in the U.S. economy has increased threefold in the past 40 years – Trade deficit with China: $232.5 bio (2006)/$83.8 bio (2000) Spring 2007 Lecture 1 6/40 Why International Economics? 2 Spring 2007 Lecture 1 7/40 Why International Economics? • International trade is an increasingly important part of the U.S. economy – Net exports have increased fivefold between 1960 and 2005 – The U.S. moved from a net exporter to importer in the mid-1970s – The share of trade in the U.S. economy has increased threefold in the past 40 years – Trade deficit with China: $232.5 bio (2006)/$83.8 bio (2000) Spring 2007 Lecture 1 8/40 Why International Economics? Spring 2007 Lecture 1 9/40 Why International Economics? Consider the humble dollar 3 Spring 2007 Lecture 1 10/40 What is International Economics? • Definition: The study of interactions between nations via international trade (real) and international finance (monetary) • Core themes: – – – – – – – Gains from Trade Pattern of Trade How Much Trade? Balance of Payments Exchange Rate Determination International Policy Coordination International Capital Market Spring 2007 Lecture 1 11/40 Themes in International Finance 1. Balance of payments – Is it good or bad to run a trade deficit? • • Counterpart to a current account deficit is a capital account surplus Or, a current account surplus implies a capital account deficit – How do we calculate the balance of payments? Spring 2007 Lecture 1 12/40 Themes in International Finance 2. Exchange rate determination – Countries have independent currencies, for which their relative values can change – What determines exchange rates? • • • • • Interest rates Money supply Prices Macroeconomic variables Exchange rate regimes 4 Spring 2007 Lecture 1 13/40 Themes in International Finance 3. International policy coordination – International macroeconomic policy coordination • • International financial arrangements: Multilateral and plurilateral Examples: IMF/BIS, G7, G3 – Globalization and Bretton Woods regime • Spring 2007 Anti-globalization protests Lecture 1 14/40 Themes in International Finance Spring 2007 Lecture 1 15/40 Themes in International Finance 4. International capital market – – Absent financial policy, determined mainly by returns Regulations on international investment • – Capital controls, foreign exchange regimes Financial policy questions: If a government must restrict finance… • Which regime should it use? • By how much should it engage in foreign exchange intervention? • What are the costs and benefits of a given regime? 5 Spring 2007 Lecture 1 16/40 Linkages Between Trade, Finance, and Politics • Linkages between trade and finance – International trade focuses on transactions of real goods and services (tangible commitments of resources) through across nations – International finance focuses on financial or monetary transactions across nations • Linkages between international economics and politics – Trade and financial policies often driven by domestic interests – Politics may lead to deviations from optimal macroeconomic outcome Spring 2007 Lecture 1 17/40 National Income Accounting • Definition: National income – Income earned by a country by its factors of production over a given time period – Equivalent to national product, after adjustments Spring 2007 Lecture 1 18/40 National Income Accounting • National income ≡ National product adjustments 1. Depreciation 2. Foreign transfers 3. Indirect taxes • Components of GNP 1. 2. 3. 4. Consumption Investment Government purchases Current account balance 6 Spring 2007 Lecture 1 19/40 National Income Accounting National income ≡ National product adjustments • 1. Depreciation 2. Foreign transfers 3. Indirect taxes • Components of GNP 1. 2. 3. 4. Consumption Investment Government purchases Current account balance Spring 2007 Lecture 1 20/40 National Income Accounting Spring 2007 Lecture 1 21/40 National Income Accounting 2% 1% 0% -1% 1960 1965 1970 1975 1980 1985 1990 1995 2000 -2% -3% -4% -5% -6% Year Source: Bureau of Economic Analysis, US Department of Commerce 7 Spring 2007 Lecture 1 22/40 National Income Accounting • National income identity Y =C +I +G Y =C +I +G+X −M closed economy open economy Domestic absorption Current account balance • Importance of current account 1. ∆CA correlated ∆Y 2. ∆CA = ∆Net foreign wealth Spring 2007 Lecture 1 23/40 National Income Accounting Spring 2007 Lecture 1 24/40 National Income Accounting • National saving S =Y −C −G ⇒ S = I + CA ⇒ S p = I + CA + (G − T ) Government budget deficit • Twin deficits hypothesis 8 Spring 2007 Lecture 1 25/40 National Income Accounting US current account and public saving relative to GDP, 1960-2004 Percent of GDP 4% 2% 0% -2% -4% -6% -8% 1960 1965 1970 1975 1980 current account Spring 2007 1985 1990 1995 2000 public saving Lecture 1 26/40 Balance of Payments • Components of BOP 1. Current account 2. Financial account 3. Capital account Spring 2007 Lecture 1 27/40 Balance of Payments • Double-entry bookkeeping requires paired credit/debit for international transactions • Fundamental balance of payments identity CA + F A + KA = 0 9 Spring 2007 Lecture 1 28/40 Balance of Payments • Subcomponents of BOP 1. Current account • Exports • Imports • Net current transfers 2. Capital account • Net capital transfers 3. Financial account • Outflow • Inflow 4. Statistical discrepancy Spring 2007 Lecture 1 29/40 Balance of Payments Spring 2007 Lecture 1 30/40 Balance of Payments • Subcomponents of BOP 1. Current account • Exports • Imports • Net current transfers 2. Capital account • Net capital transfers 3. Financial account • Outflow • Inflow 4. Statistical discrepancy 10 Spring 2007 Lecture 1 31/40 Balance of Payments Spring 2007 Lecture 1 32/40 Balance of Payments • Subcomponents of BOP 1. Current account • Exports • Imports • Net current transfers 2. Capital account • Net capital transfers 3. Financial account • Outflow • Inflow 4. Statistical discrepancy Spring 2007 Lecture 1 33/40 Balance of Payments 11 Spring 2007 Lecture 1 34/40 Application: Current Account Imbalances “The United States has never run such large current account deficits and no single nation’s deficit has ever bulked nearly as large relative to the global economy.” Former Treasury Secretary Larry Summers, Oct 3, 2004 “The imbalances between the United States and the rest of the world are not sustainable over the long term. The risk is that if nothing is done to reduce them gradually, they will instead be reduced suddenly, and in a disruptive way.” IMF Managing Director Rodrigo de Rato, Feb 26, 2007 Spring 2007 Lecture 1 35/40 Application: Current Account Imbalances • U.S. current account balance (2005): –$791,508 mio – 6.2% GDP – Exports: $1,749,892 mio – Imports: –$2,455,328 mio • U.S. international investment position (2005): –$2,546 bio • The $790 billion dollar question: Is this sustainable? – Does the deficit matter? What to do? Spring 2007 Lecture 1 36/40 Application: Current Account Imbalances 12 Spring 2007 Lecture 1 37/40 Application: Current Account Imbalances Spring 2007 Lecture 1 38/40 Application: Current Account Imbalances • U.S. current account balance (2005): –$791,508 mio – 6.2% GDP – Exports: $1,749,892 mio – Imports: –$2,455,328 mio • U.S. international investment position (2005): –$2,546 bio • The $790 billion dollar question: Is this sustainable? – Does the deficit matter? What to do? Spring 2007 Lecture 1 39/40 Application: Current Account Imbalances 13 Spring 2007 Lecture 1 40/40 Application: Current Account Imbalances • U.S. current account balance (2005): –$791,508 mio – 6.2% GDP – Exports: $1,749,892 mio – Imports: –$2,455,328 mio • U.S. international investment position (2005): –$2,546 bio • The $790 billion dollar question: Is this sustainable? – Does the deficit matter? What to do? 14