Balance of Payments
Econ 116 Problem Set 9
Due November 17, 2015
1. List the following transactions in the current account and capital account of the
United States. Denote under which category they are listed and whether they are a
credit or a debit.
a) A U.S. citizen spends $500 for a hotel room in Paris.
Debit current account (import of services)
b) A Chinese company buys a solar power plant in the United States for one
billion dollars.
Credit capital account (increase in foreign assets in the U.S.)
c) A French woman buys a $1,000 dress on Fifth Avenue in New York.
Credit current account (export of goods)
d) A U.S. investment bank earns $15,000 in interest on German bonds.
Credit current account (foreign interest income)
e) The U.S. government sends $1,000,000 in aid to Egypt.
Debit current account (transfer payment)
2. How is it that the United States can run a current account deficit and still increase
its holding of foreign assets?
The reason that US is able to run current account deficit while increases its
holding of foreign assets is that it is able to increase foreign liabilities at the same
time. For example, countries around the world have accumulated large amounts of
US treasury bonds in recent years, and these foreign purchases are foreign
liabilities on US’s cross-border balance sheet. The availability of such capital
inflows allows US to purchase foreign assets, despite its current account deficit.
Fixed Exchange Rate Analysis
1. Explain carefully the intuition behind the trade feedback effect. Why does this
effect increase the size of the government spending multiplier?
The trade feedback effect is the tendency for an increase in the economic activity
of one country to lead a worldwide increase in economic activity, which than
feeds back to that country. Assume there is an expansionary fiscal policy, so G
increases. This leads to an increase in planned expenditure on Y, C and imports.
This corresponds to an increase in the rest of the world exports, which gives a
boost to income in the foreign countries, which increases the foreign demand and
foreign imports. This translates into an increase in domestic exports and so into an
additional increase in income. Therefore the presence of trading partners makes
the spending multiplier bigger because for a given initial increase in G there is a
bigger increase in Y.
2. Explain carefully the intuition behind the price feedback effect. How does this
help explain the macro events of the 1970’s?
The price feedback effect is the process by which a domestic price increase in one
country feeds back on itself through export and import prices. A rise in the price
level in one country drives up the price of exports and so the price of imports for
its trading partners, shifting up their AS curve, raising prices. Households in these
countries will also tend to substitute domestically produced goods for imports,
and this is equivalent to a rightward shift of the aggregate demand curve. These
shifts in demand and supply will cause prices in this second country to rise,
including prices of exports, which in turn will increase the price of imports in the
first country, as well as the overall price level.
In the 1970s, we saw a large increase in oil prices, which is an increase in the
price of imports for all oil-importing countries. This supply shock drives up the
price level and reduces output. The increase in the price level is reflected in the
price of exports, which then affects all other countries, including oil-producing
ones.
3. Why is it not sensible to say that the U.S. federal government budget deficit
causes the U.S. trade deficit? What would lead them to be positively correlated
and what would lead them to be negatively correlated?
Positively correlated: Assume there is an increase in G. If taxes are fixed, this
leads to an increase in the budget deficit. By increasing demand for imports (by
the usual multiplier effect), this leads in general to an increase in the current
account deficit.
Negatively correlate: a stock market boom raises aggregate demand, increasing
imports and the current account deficit, but because tax income rises and spending
on stabilizers falls, this decreases the government deficit.
Depending on what kind of shocks are more common, there may be either a
positive or negative correlation between the government deficit and the current
account deficit. In any case, it is not appropriate to say that the government
budget deficit causes the trade deficit, because in fact the trade deficit is based on
the market equilibrium of imports and exports, which may be affected by a broad
variety of factors, while the deficit is simply the difference between government
spending and receipts (taxes).
4. Explain carefully why adding the import demand equation to the AS/AD model
lowers the size of the government spending multiplier.
If we solve the Y = AE equation (where C = bY and IM = mY) with a marginal
propensity to import of m, we get:
Y = [1/(1-b+m)][G+I+X]
The multiplier here, 1/(1-b+m), is smaller than the multiplier in a closed
economy, 1/(1-b).
Intuitively, when we introduce the import demand equation in our macro model,
then the consumer is allowed to buy foreign goods in addition to domestic
products. This means that when the income of the consumers rises, a fraction of
this additional income is devoted to buy goods coming from foreign countries,
and thus the positive feed-back effect on total income through consumption (that
is, the multiplier effect) is dampened. Obviously, the higher the marginal
propensity to import, the lower the multiplier.
5. What else explains the demand for imports other than income? Explain the theory.
Imports are another form of consumption, and as such is affected by the same
income (or wealth) and substitution effects. When wealth increases (e.g. an
appreciation of housing, bond, or stock prices), the demand for income will likely
increase, under a life-cycle theory of consumption. When the relative price of
domestic goods increases, or the relative price of imports falls, we would also
expect consumers to substitute away from the relatively higher-priced domestic
goods, increasing demand for imports.
Exchange rates may also affect the demand for imports by affecting the price, but
we will dive deeper into that analysis next week.