GNP = Expenditure on a Country’s Goods and Services

Y = Cd + Id + Gd + EX

= (C-Cf) + (I-If) + (G-Gf) + EX

= C + I + G + EX – (Cf + If +Gf)

= C + I + G + EX – IM

= C + I + G + CA

Absorption (expenditure by domestic individuals and institutions)

Net expenditure by foreign individuals and institutions

expenditureon domestic production

value of domesticproduction

Components of US GDP

Current Account Identities

CA = Y – (C + I + G )

current account = income - absorption

CA = (Y – C – G ) – I

= S – I

current account = national saving – investment

current account = net foreign investment

• A country that imports more than it exports has low national saving relative to investment.

US Current Account

US: CA/GDP

16-5

Euro Area Current Account (%GDP)

Source: ECB 16-6

Net International Investment Position

• Foreign assets held by the US have grown since 1980, but US liabilities (our debt held by foreigners) have grown more quickly. The US current account deficit in 2006 was $811

billion dollars: US net foreign wealth continued to decrease.

• The US has the most negative net foreign wealth in the world, and so is therefore the world's largest debtor nation. By the end of 2006, the US international

investment position was -$2.54 trillion dollars.

US International Investment Position

Copyright © 2009 Pearson Addison-Wesley. All rights reserved.12-9

Fig. 12-2: U.S. Current Account and Net Foreign Wealth, 1976–2006

Source: U.S. Department of Commerce, Bureau of Economic Analysis, June 2007 release

Copyright © 2009 Pearson Addison-Wesley. All rights reserved.12-10

Fig. 12-3: U.S. Gross Foreign Assets and Liabilities, 1976-2006

Source: U.S. Department of Commerce, Bureau of Economic Analysis, June 2007

Income Account: Payments and Receipts

Investment Income

• In 2006, the US ran a surplus on Investment Income. Income receipts were about $650 billion. Income payments were about $614 billion.

• How can the US NIIP be so negative, yet we have this surplus? Mismeasurement of the NIIP? (But still ... !) Differing rates of return on assets and liabilities.

• Relative return: Higgins (2005) argues that our FDI has a much higher rate of return.

• Portfolio composition: our accumulated net FDI position is very positive.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16-13

Determinants of Consumption

• Determinants of consumption expenditure include:

Disposable income: income from production (Y) minus taxes (T).

More disposable income means more consumption expenditure, but consumption typically increases less than the amount that disposable income increases.

Real interest rates may influence the amount of saving and spending on consumption goods, but we assume that they are relatively unimportant here.

Wealth may also influence consumption expenditure, but we assume that it is relatively unimportant here.

16-14

Rise in Current Output Increases Saving

16-15

Determinants of the Current Account

real depreciation: ↑EP*/P increased relative price of foreign products

expenditure on domestic products rises, and expenditure on foreign products falls.

real appreciation: ↓EP*/P decreased relative price of foreign products

expenditure on foreign products rises, and expenditure on domestic products falls.

• Changes in disposable income: Y-T when disposable income rises we spend more

on foreign commodities (imports)

16-16

Real Depreciation and the Current Account

• CA = EX – IM

the value of exports relative to the value of imports

• Real depreciation: ↑q (i.e., ↑ EP*/P)

prices of foreign products rise relative to the prices of domestic products.

1. The volume of exports that are bought by foreigners rises.

2. The volume of imports that are bought by domestic residents falls.

3. The value of any given amount of imports in terms of domestic products rises (i.e., the relative price of imports rises, foreign products becomes relatively expensive)

Marshall-Lerner Condition

• Real current account: CA = Ex - q Im measured in domestic goods

• Conflicting volume and valuation effects

• Condition for improvement: volume responses large enough

εX + εM > 1

Value Effect, Volume Effect and the J-curve

• Suppose the volume of imports and exports is fixed in the short run. Then a depreciation of the domestic currency

does not affect the volume of imports or exports,

increases the value/price of imports in domestic currency and therefor decrease the current account: CA ≈ EX – IM..

• The current account could immediately decrease after a currency depreciation, then increase gradually as the volume effect begins to dominate the value effect.

• for most countries the volume effect dominates the value effect after one year or less.

Source: KO 2007

J-Curve

J-curve: valueeffect dominatesvolume effect

volume effect dominatesvalue effect

Immediateeffect of real depreciationon the CA

J-curve and Pass Through

• Pass through rate: the percentage by which import prices change when the value of the domestic currency changes by 1%.

• In our basic model, the pass through rate is 100%: import prices in domestic currency exactly match a

depreciation of the domestic currency.

• In reality, pass through may be less than 100% due to price discrimination in different countries. firms that set prices may decide not to match changes in the

exchange rate with changes in prices of foreign products denominated in domestic currency.

J-curve and Pass Through (cont.)

• Suppose a pass through rate less than 100%, then

the value of imports will not rise as much after a domestic currency depreciation, and the current account will not fall as much

volume of imports and exports will not adjust much over time since domestic currency prices do not change much.

• Pass through of less than 100% dampens the effect of depreciation or appreciation on the current account.

Table 16A2-1: Estimated Price Elasticities for International Trade in Manufactured Goods

Exchange Rates andReal Exchange Rates

• Nov 10, 2007 59.92 Icelandic króna per USD

• Nov 10, 2008 128.78 Icelandic króna per USD

• Depreciation over the period: 114.92%

• Inflation over the period: 15.90%

• HUGE real depreciation: 99.02%

Depreciation in Iceland

Determinants of Aggregate Demand

• Determinants of the current account include:

Real exchange rate: an increase in the real exchange rate increases the current account.

Disposable income: an increase in the disposable income decreases the current account.

Determinants of Aggregate Demand

• Aggregate demand is therefore expressed as:D = C(Y – T) + I + G + CA(EP*/P, Y – T)

• Or more simply:

AD = AD(EP*/P, Y – T, I, G)

Investment expenditure andgovernment purchases(exogenous)

Current account depend on the realexchange rate and disposable income.

Consumptionexpenditure respondes todisposableincome

Short Run Equilibrium in the Goods Mkt

• Equilibrium is achieved when the value of production (output) Y equals the value of aggregate demand AD.

Y = AD(EP*/P, Y – T, I, G)

Permanent Fiscal Expansion

• Permanent change in fiscal stance increase in G or decrease in T

Changes aggregate demand• subject to usual qualifications

Permanent Fiscal Expansion

• SR effects does up demand -> up Y?

No: E appreciates -> real E appreciates• Ee appreciates (permanent shock)

How much does E appreciate?• Enough to restore D=Yf

(to see, think LR)

Permanent Fiscal Expansion (LR)

• LR same as SR M=M0, Y = Yf, R=R*

• so P is unchanged!

• But then AD(EP*/P,Y-T,I,G)=Yf up G must "crowd out" private demand

• through CA!

• Twin deficits once again

Bond yields (missing part of our story)

Source: IMF 2009, Global Financial Stability Report16-31

US: Debt and Debt/GDP

Source: Wikipedia 16-32

Eurozone: Debt/GDP

Source: ECB 16-33