Global Econ

Prof. Laurence Ales

Access Weekend

Macroeconomics

Microeconomics studies a single part of the economy in isolation; Macroeconomics studies the entire economy as a whole.

Normative and Positive Questions

Positive questions: questions independent of any ethical or moral consideration. Focused on “what was/is/will be”. These question rely on an objective investigation of data

Normative questions: questions that deal with the notion of “what should be”. These questions rely on a fully specified set of ethical and social goals

Methodology

How do we get the answers? Build Models

Models should not be evaluated on the basis of realism but on their predictive power

Can Machine Learning (ML) help? No

1. ML tools are good for forecasts in Stationary environments
2. ML need vast amounts of data
3. ML is geared towards determining what will be, not what ought to be

Framework

Actors/Quantities::

• Households: Consumption; Savings; Labor Supply
• Firms: Output; Labor Demand
• Government: Expenditures; Taxes; Debt

The Circular Model

The Super-Immutable Model (Fallacy)

1. Parts in the economy are analyzed in isolation
2. All parts not directly affected by the event do not change
3. The parts of the economy directly affected, change very little

(Ubiquitous usage in media, political commentary, thanksgiving dinners...)

GDP (Gross Domestic Product)

Gross domestic product–GDP: The market value of final goods and services produced within a country in a given period (usually a year)

Gross national product–GNP: The market value of final goods and services produced by resident workers and capital in a given period (usually a year)

Three Definitions of GDP

1. Expenditure Approach: Total spending on newly produced final goods and services produced in a nation during a year (expenditures)
2. Income Approach (National Income): Total income generated by newly produced goods and services, profits and taxes paid by firms and depreciation in a nation during a year (income)
3. Product Approach (Value Added): Market value of final goods and services newly produced in a nation during a year (goods & services,)

The Expenditure Approach:

• Consumption expenditures (C): consumer goods and services
• Investment (I): goods produced but not consumed
• Government expenditures (G)
• Net exports (NX): goods and services exported minus goods and services imported

\[Y(GDP)=C+I+G+NX\]

The Digital Economy

1. The hardware needed for a computer network to exist and operate
2. The digital transactions that take place using that system (e-commerce)
3. The content that digital economy users create and access (digital media)

Difficulty studying digital economy is the speed of change in the industry. Changes occurring faster than data design and collection can take place.

Missing from the estimates:

1. Structures needed for the creation of digital economy goods
2. Digital intermediary services, priced
3. Free goods & services
4. Value of Big Data

Limits of GDP

What is GDP not counting:

1. Non-market production: Home production, In developing countries: subsistence farmers
2. Free services
3. Underground economy

Types of Non-Observed Economy:

• Producers deliberately not registering - underground (N1)
• Producers deliberately not registering - illegal (N2)
• Producers not required to register (N3)
• Legal persons not surveyed (N4)
• Registered entrepreneurs not surveyed (N5)
• Producers deliberately misreporting (N6)
• Other statistical deficiencies (N7)

Corrections:

• Different countries include in GDP different categories (N1–N7) of the non observed economy
• The corrections vary significantly
• Countries that include different categories of the non-observed economy may not be comparable
• Comparability with same categories might also be problematic

Measuring the Underground Economy:

• Direct Approaches: Surveys / Tax audits
• Indirect Approaches: National accounting statistics / Labor force statistics / Transactions / Currency demand / Electricity consumption and other inputs

Indirect Methids

"Using National Income" The gap between the expenditures and income can be used as an indicator of the extent of the hidden economy.

Pitfalls:

1. Expenditure-side components are measured with errors and omissions
2. Some services are priced at zero

"Space & GDP Measurement"

economic activity generates emission of light / Data from United States Air Force Defense Meteorological Satellite Program / an increase in light emission by 1% corresponds to an increase in GDP by 0.3%

Interpreting GDP

In assigning a value judgment to GDP we should also consider:

• The impact on pollution, climate change
• Depletion of natural resources

GDP & Welfare

Prices and Inflation

Real and Nominal Quantities

A nominal quantity: Market value of a quantity with prices defined at the time of production

A real quantity: Market value of a quantity with prices defined in a given year

A price level: Weighted-average of prices at a given time.

CPI and GDP Deflator

CPI (Computed by the BLS - Bureau of Labor Statistics):

• Key feature 1: keep quantities fixed at base year
• Key feature 2: only quantities purchased by consumers

The % change in the CPI price level between two consecutive years:

GDP Deflator (Computed by the BEA - Bureau of Economic Analysis):

• Key feature 1: keep quantities fixed at the current year
• Key feature 2: every good enters in the price index

The PCE(Personal Consumption Expenditure) Index:

• The preferred index used by the FED to study inflation trends
• It’s computed by the BEA
• Some differences with respect to the CPI:
  • Formula averages CPI and GDP deflator
  • Weights from Business Survey (not Household survey as CPI)
  • Includes purchases of Non-profits
  • Lower weight on housing

From Nominal to Real GDP

To define a price index we need to determine a base year. A year for which the price index is normalized to 1.

\[Price\,index(t)=\frac{Price\,level(t)}{Price\,level(base year)}\]

\[Real\,GDP=\frac{Nominal\,GDP}{Price\,index}\]

Key Takeaways

1. We study the economy including all moving parts and relationships (as opposed to super-immutable model)
2. Definition of GDP relies on the circular nature of the economy
3. Statistical framework shows limits in the presence of disruptive changes.
4. Defining inflation requires taking a stand on when to fix weights

Data

US:

1. St. Louis Fed: research.stlouisfed.org/fred2/
2. Bureau of Economic Analysis (BEA): www.bea.gov

International: 1. World Development Indicators: datatopics.worldbank.org/world-development-indicators/ 2. Penn World Tables: www.rug.nl/ggdc/productivity/pwt/

Week 1: Measures

GDP and Consumer Durables/Services/Retail Sales

1. The plot for consumer durables clearly features a trend over time as well as higher frequency fluctuations
2. Hard to quantify/visualize these smaller fluctuations, it’s also hard to relate them precisely to GDP. It is clear that durables fluctuate more than services
3. We still don’t have a sense of what could anticipate these fluctuations

Recession

(log) GDP

• (log) GDP for the US has an unmistakable feature: a linear trend, a 2% to 3% average growth over the last century
• TREND + CYCLES: The study of these fluctuations (business cycles) is as important as the study of the trend (long run growth)

"Co-movements"

Trend and Cycle

• Trend -> long-term growth rate of the variable
• Cycle -> short-lived deviations from the trend

The Hodrick-Prescott filter

Let yt be log GDP in year t. Suppose you have data for T years. Decompose GDP as:

The HP filter finds the trend (xt ) solving the following problem:

• The target term ensures that the trend is close to the original
• The rigidity term provides a certain rigidity to the trend
• λ controls the tradeoff between the two terms

λ is called the smoothing parameter

• Set λ = 100 if GDP is yearly data
• Set λ = 1600 if GDP is quarterly data

• The target term ensures that the trend is close to the original
• The rigidity term provides a certain rigidity to the trend
• λ controls the tradeoff between the two terms

In R:

• Install library: library(mFilter)
• Command: hp filtered variable<-hpfilter(log of variable)

deviations from trend:

BUSINESS CYCLES: STUDY OF FLUCTUATIONS

The Cyclical Component

• frequency of the fluctuations
• amplitude 振幅 of the fluctuations
• the cyclical component of GDP can serve as a benchmark for other macroeconomic quantities

durable vs. non-durable vs. services

consumption vs. investment (more volatile)

CO-MOVEMENTS: RELATIONSHIP TO GDP

Two Time Variables: Correlation

Variable A (Variable B) is positively (negativelly) correlated

Industries and the Cycle:

Two Time Variables: Lead and Lag

Variable A is a leading variable; Variable B is lagging; coincident

Two Time Variables: Amplitude

With two economic variables you should remember:

1. How are they correlated -> pro-cyclical, countercyclical
2. How they are synchronized -> lead-lag
3. How do the fluctuations compare -> amplitude

A REGRESSION APPROACH

A Different Representation - Deviation

Output Elasticity

Regression coefficient results: * For durables: 2.14 (0.11) * For non-durables: .42 (0.07)

How do ecnomic conditions impact...

• Consumer Price Index
• Wages (Multiple forces affect wages, these forces change over time)

BUSINESS CYCLES: THEORY AND DETERMINANTS

Real Business Cycle (RBC) Models: short run fluctuations are driven by productivity

TAKING STOCK

1. The study of fluctuations is important for a variety of economic decision:
   • Equity markets
   • Firm investment
   • Firm hiring
   • Life in general
2. It is important to design a good filter to not generate non-existing deviations from trends
3. A cyclical aggregate variable can be described efficiently using GDP as a benchmark

Recession and Depression

• Recession 经济衰退: Two consecutive quarters of decline in real GDP. / A significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.
• Depression 经济萧条: Large output drop > 10% lasting several years

Week 2: Growth

GDP Over Time: Observations

1. It grows
2. It fluctuates
3. There are some big fluctuations, some are exogenous
4. And....It’s a line!

Historical Growth

Slow growth! World GDP growth:

1. Between 1700-1820: 0.07%
2. Between 1500-1700: 0.04%

GDP Across Countries

Growth In the Last 70 Years:

• Existence of large and sustained growth
• Existence of growth miracles: South Korea, Japan, China, Rwanda
• Existence of growth disasters: Venezuela, North Korea, Sub-Saharan Africa

WHAT DETERMINES GROWTH?

1. Population growth is negatively correlated with GDP levels.
2. Investment is positively correlated with growth rates.
3. Levels of GDP are not correlated with growth rates

CREATING OUTPUT

The Malthusian Model

\[Y = A*land\]

• If Y grows, population (N) grows
• If a discovery occurs -> A grows -> Y grows!
• If Y grows -> N grows -> Y/N roughly constant
• Land plays a key role in depressing growth

The (Modern) Production Function

• Capital: K
• Labor: L
• Output: Y

Capital (Fixed Assets)

1. Structures
2. Equipment

Intangible Capital -> depends

Capital and Growth

Industrial revolution is not only a story of technological development but also one where capital becomes a factor of production

UNDERSTANDING & USING THE PRODUCTION FUNCTION: Y=A*F(K;L)

output per worker or labor productivity or output per hour:

\[Labor\,Productivity=\frac{Y}{L}=\frac{A*F(K,L)}{L}\]

\[Total\,Factor\,Productivity (TFP)=A=\frac{Y)}{F(K,L}\]

USING THE PRODUCTION FUNCTION: COUNTRY ANALYSIS

The amount of cement used by China in 3 years, equals the usage of the US in the 20th century!

THE COBB-DOUGLAS PRODUCTION FUNCTION

1-a=Fraction of GDP payed to workers as compensation

1-a is also referred to as the Labor Share; a as the Capital Share.

• 1-a betweeen 2/3 to 3/4

THE SOLOW GROWTH MODEL

• Where capital comes from
• Where capital goes

"The Bathtub Model"

The Capital Accumulation Equation:

Depreciation Rate in the US

• Physical asset depreciated due to wear and tear
• R&D also depreciates due to lower contribution to firm profit
• US a common benchmark is to set: Depreciation Rate = d = 0.05
• Different assets have depreciation rate

Origin of Investment

1. Investment is financed by savings

\[I=S\]

1. Countries save a constant fraction (s) of GDP

\[S=s*Y\]

"saving rate": * China is much higher than US * High saving rate during a recession

Capital In Equilibrium

In equilibrium when:

\[K'=K=K^*\]

the amount of capital depreciating is equal to the amount of capital invested.

K^*and output only depend on d, s and A.

Sustaining Growth

To sustain growth over time we need growth of A!

Increasing A1 -> A2 generates long term growth!

The Solow Residual

We have identified A as a key source for growth. A is sometimes called either TFP or the Solow Residual

Need information on: GDP (Y) easy, workers (L) easy, a less easy, K harder

\[TFP: US vs the World\]

• For the US we see consistent growth in TFP; a slowdown of US TFP in the 70s and in recent years
• China has little or no growth in A up to 2000 slowing down in 2005

\[CROSS-COUNTRY GROWTH\]

Cross-Country Convergence:

• Question: Suppose the world is described by a Solow model. Suppose there are two countries: rich and poor. What would happen over time?
• Answer: They should converge to the same level of GDP per capita

Cross-country convergence not as strong as implied by model, what is wrong with the model?

1. Maybe all the countries are not the same
2. Barriers to technology adoption
3. Barriers to investment
4. Non optimizing firms

\[THE FUTURE OF GROWTH\]

Recent TFP Growth in the US:

Techno Optimism - Technological Revolution:

• The cross-fertilization of ideas at a global scale
• The real benefit from IT revolution: learning, Data and AI
• A “Cambrian Explosion” coming for robotics

Techno Pessimism

• Demographics (Claim: baby boomers and female labor force participation was a one off event)
• Declining (relative) educational standards
• Energy and the environment (Claim: past growth was too fast, did not internalize externality)
• Debt (Claim: depressed incentive due to higher future taxes)
• Technology (Claim: we exploited “low-hanging” tech discoveries)

The Relative Value of Discoveries - Toilet vs. iPhone

TAKING STOCK

1. Understanding historical growth can help us understand growth today
2. Total Factor Productivity (A) is an important (and sophisticated) measure of productivity
3. Capital AND technological progress are both required for growth, policy hindering them will hinder growth
4. Large frictions exists that hinder growth across countries

GDP, GROWTH & WELFARE

Welfare -> the expected lifetime utility for all individuals in a country

\[W=H*E[u(y)]\]

• H: life expectancy 平均寿命
• y: income
• W: average welfare

• E[]: expectation

• Life Expectancy

• Hours Worked
• Inequality: Gini index, or Gini coefficient, is a measure of the distribution of income across a population
  • Inequality between countries is increasing
  • Inequality within countries is decreasing

GDP & Welfare - a welfare measure combining consumption, leisure, mortality, and inequality

Growth and Welfare

• Growth increases average income
• Growth increases life expectancy
• Growth reduces inequality (maybe)

Week 3: Labor Market

Outline

1. Current Snapshot of US Labor Market
2. Basic definitions
3. Facts on unemployment and participation rate
4. The Supply & Demand Model (Minimum wages / Employment protection laws)
5. The Future of US labor markets

LABOR MARKET: BASIC DEFINITIONS

Working Age Population): The population 16 years and over residing in the 50 States and DC who are not inmates of institutions (for example, penal and mental facilities, homes for the aged), and who are not on active duty in the Armed Forces.

1. Employed: E
2. Unemployed: U
3. Non participating in the labor market: N

Employed: 1. Those who did any work for pay or profit during the survey reference week. 2. All those who did at least 15 hours of unpaid work in a business or farm operated by a family member with whom they live. 3. All those who were temporarily absent from their regular jobs because of illness, vacation, bad weather, labor dispute, or various personal reasons, whether or not they were paid for the time off.

Unemployed: 1. They do not have a job. 2. Have actively looked for work in the prior 4 weeks. 3. Are currently available for work.

Labor Force: The population 16 years old and over who contribute to the production of goods and services in the country. (Includes individuals who are either employed or unemployed)

Unemployment Rates

\[\frac{Unemployed}{Labor\,Force}=\frac{U}{E+U}\]

Participation Rates

\[\frac{Labor\,Force}{Working\,Age\,Population}=\frac{E+U}{E+U+N}\]

Historical Unemployment Rate:

• No long term trend: around 5%/6% during the post-war period
• Large spikes during early 1980s and 2007 recessions
• Men vs women: no systematic differences in unemployment
• Men unemployment rate more sensitive to downturns

THE PARTICIPATION RATE

Historical Participation Rate:

• Participation rate:
  • Around 59% until mid-1960s
  • Rise during three decades to 67%
  • General decline over the last decade and a half

Accounting for the Participation Rate:

• Upward forces:
  • Female labor force participation
  • Gig economy
  • Increase to education (manual occupations have shorter work life)
• Downward forces:
  • Retirement of baby boomers
  • Non-participation of teenagers and young adults.

OUR CONTINUING SERIES ON: TECH VS MEASUREMENT

The Gig Economy:

• In 2017 independent contractors are 6.9% of total employment down from 7.4% in 2005 Also 3.3% of total employment (about 5 million workers) is app-mediated* work

Week 4 & 5: International Economics

First Half: Trade

1. Trade Facts
2. The force behind trade: Comparative Advantage
3. The China Shock
4. Tariffs: History of tariffs / The 2018 trade wars
5. Free trade agreements: NAFTA vs USMCA

Second Half: International Finance

1. Financing Investment
2. International Flows (Current Account / Balance of Payments)
3. Exchange Rates (PPP / Interest rate parity conditions)

TRADE FACTS

1. The amount of trade flows has grown by an incredible amount in the last century -> much faster than World GDP
2. Countries export (and import) a variety of goods and services to multiple trade partners
3. Some countries exhibit a high degree of specialization

THE FORCE BEHIND TRADE: COMPARATIVE ADVANTAGE

The Production Possibility Frontier:

• The distance of the PPF to the origin denotes the overall level of production for the two goods (with fixed resources)
• The slope of the PPF provides information on the opportunity cost of producing B: The cost is expressed in terms of units of A : Slope = - Max_A/Max_B
• We can interpret the slope of PPF as the (minus) relative price of good B in units of good A.
• Two countries can be compared in terms of absolute and comparative advantage
• A country has an absolute advantage in the production of a good if it can produce more of it
• A country has a comparative advantage in the production of a good if it features a lower opportunity cost
• The opportunity cost of production is equal to minus the Slope
• If countries specialize in their comparative advantage and trade freely, total output is increased
• If countries specialize in their comparative advantage and trade freely there exist a trading price that makes both better off

For example: The US has a lower opportunity cost (2/3) of producing B -> US should produce good B, China good A

Comparative Advantage Implications:

• Allocation of workers within a firm
• Allocation of own time within a group (manager)

THE CHINA SHOCK

1. KEY: Trade burden with China is geographically concentrated
2. Local commuting zones face an overall labor market shock beyond the affected industry
3. Chinese manufacturing hurts employment in manufacturing: 0.56 million direct jobs lost in competing manufacturing (1999-2011)
4. Considering Input-Output linkages: 2.0 – 2.5 million jobs lost to import competition (1999-2011)

Some Optimism:

• For the period 1991-2011, job gains from export almost offset losses (.2 million job lost overall)
• 4 million jobs gained in services due to US global exports

Results Thus Far:

1. Trade is highly redistributive across consumers, workers, firms and countries
2. Countries that specialize and trade freely CAN be better off than being in autarky 封闭经济
3. Evidence that trade adjustment with China has been too fast. Workers have struggled to adjust. Unclear if labor markets or trade (or both) are to blame

TARIFFS

A tariff is a tax imposed on a good imported into a country. A tariff may be:

• Specific: when it is levied as a fixed sum per unit of the imported good.
• Ad valorem 从价税: when it is applied at a percentage rate with reference to the value of the import.
• Non Tariff Measures: quotas, import licensing systems, sanitary regulations, prohibitions, etc.

The Three “R” of Trade Policy:

• Revenue: unique source of revenue for Federal Government
• Restriction: protect local industry (infant and established industries)
• Reciprocity 相互性: large global agreements to lower tariffs

Tariffs Over Time:

• From interwar period overall reduction in average world tariffs.
• The latest global major round of multilateral trade negotiations is the Uruguay round (1986-1994 乌拉圭回合):
  • 40% cut in tariffs on industrial products: from an average of 6.3% to 3.8%. Increase in fraction of duty free goods.
• In the last ten years we see increase negotiations towards regional trade agreements:
  • Trans-Pacific Partnership (TPP)
  • Transatlantic Trade and Investment Partnership (TTIP)
  • Comprehensive and Progressive Agreement for Trans-Pacific Partnership
  • Regional Comprehensive Economic Partnership (RCEP)

Tariffs and Welfare:

• Impact:
  1. The government: gains revenue from the tariff;
  2. Producers: gain as they are protected from foreign competitors and raise prices;
  3. Consumers: lose due to higher prices.

World Trade organization (WTO): tariffs redistribute between consumers and producers. Overall, from a societal point of view, tariffs reduce welfare

FROM NAFTA TO USMCA

The revealed comparative advantage (RCA) is an indicator somewhat related to a country’s export potential.

The RCA index of country i for product j is:

Where xij (xwj) are the values of country i’s (world) exports of product j. Xi (Xw) and i’s (world) total exports.

If the index is > 1, the country has a revealed comparative advantage in the product.

NAFTA (North American Free Trade Agreement) - between U.S, Canada and Mexico

1. REDUCE distortions to trade; ESTABLISH clear and mutually advantageous trade rules;
2. CREATE new employment opportunities and improve working conditions and living standards in their respective territories;
3. UNDERTAKE each of the preceding in a manner consistent with environmental protection; PROTECT, enhance and enforce basic workers’ rights;

In practice:

1. Automobiles: tariff going to 0 in 10 years
2. Agriculture: half of US agricultural exports are immediately tariff exempt
3. Financial Services: over six years removes Mexico’s restrictions on Canadian and US ownership of commercial banking

NAFTA 2.0: U.S.M.C.A. (Ratified March 2020)

Some notable changes:

1. 75% content of automobile/trucks from N. America (up from 62.5%)
2. 70% steel + aluminum from N. America
3. 40%-45% from workers making 16$/hour
4. 16 year sunset clause

Potential Impact/Concerns:

1. Gains for US dairy industry
2. Potential uncertainty on agreement could reduce domestic investment
3. Concern of moving supply chains outside N. America (currently 2.5% tariff)

Impact:

1. Manufacturing: increase in revealed comparative advantage for Mexico does not appear to reduce the one for the US.
2. Agriculture: NAFTA has benefited US agriculture.
3. Disappointing job growth in Mexico: Manufacturing goes up but Agriculture goes down
4. High environmental costs
5. Overall Welfare: Mexico’s welfare increases by 1.31%, U.S.’s welfare increases by 0.08%, and Canada’s welfare declines by 0.06%.

TRADE DEFICITS

The Current Account is measure of transactions (payments) between the US and the rest of the world

Is comprised by (net) transactions in:

1. Goods
2. Services
3. Primary income (investment income and compensation)
4. Secondary income (transfers across individuals)

Drawing Connections:

• Start from formula for GDP, denote GDP with Y \(\(Y = C + G + I + NX\)\)
• Add net income from abroad (NI) \(\(Y + NI - C - G - I = NX + NI\)\)
• Substitute the Current Account (CA) \(\(Y + NI - C - T + T - G - I = CA\)\)
• Separate government and private sector saving

\[CA=S-I\]

Trade deficits are related to capital inflows

CA Surpluses: * China - Residents save a lot, invest a lot domestically and abroad * Japan - Residents save a lot but invest a lot abroad

CA Deficits: * US - Additional borrowing used for investments * Greece - Additional borrowing used for consumption

FDI

Quinquennial五年的 Plans In China

great international circulation / dual circulation 国际国内双循环

Foreign Direct Investment A category of cross-border investment made by a resident in one economy (the direct investor) with the objective of establishing a lasting interest in an enterprise (the direct investment enterprise) that is resident in an economy other than that of the direct investor.

Capital and Financial Account: The capital and financial account (KA) shows credit and debit entries for capital and financial assets transfers between residents and nonresident

Balance of Payments: The balance of payments (BoP) is a statistical statement that summarizes all transactions between residents and nonresidents during a period. (The current account (CA)+The capital and financial account (KA))

Capital and Financial Account: The capital and financial account (KA) shows credit and debit entries for capital and financial assets transfers between residents and nonresident

Balance of Payments: The balance of payments (BoP) is a statistical statement that summarizes all transactions between residents and nonresidents during a period. It consists of:

• The current account (CA)
• The capital and financial account (KA)

Each transaction in the balance of payments is recorded as consisting of two equal and opposite entries, reflecting the inflow and outflow element to each exchange.

\[BoP = CA + KA = 0\]

Positive: exports of goods and services, income receivable, increase in foreign assets held domestically.

Negative: imports of goods and services, income payable, increase in domestic assets held abroad.

EXCHANGE RATES

Two currencies: dollar and yuan; dollars be the domestic currency

• Direct: domestic currency per unit of foreign currency (1 yuan = 0.16 dollar)
• Indirect: foreign currency units per domestic unit (1 dollar = 6.44 yuan)

• The domestic currency is depreciating (appreciating) with respect to another if the indirect exchange rate is decreasing (increasing)

• Spot transaction: Exchange of two currencies at rate agreed on the date of the contract for delivery within two business days.

• Outright forward: Exchange of two currencies at a rate agreed on the date of the contract for delivery after two business days. (in some counties: restriction or non-accessible)
• Foreign exchange swap: Exchange of two currencies on a specific date at a rate agreed at the time of the end of the contract (the short leg), and a reverse exchange of the same two currencies at a date further in the future at a rate agreed at the time of the contract (the long leg).
• Currency option: Contract that gives the right to buy or sell a currency with another at a specified rate during a specified period.
• Non-Deliverable Forwards: Contracts settled not in the restricted currency but in the domestic currency. At a future date, the contract will pay in the domestic currency the difference between the spot and the agreed rate today.

DETERMINING EXCHANGE RATES

Lufthansa Case

What Determines Exchange Rates?

• TRIANGULAR ARBITRAGE: given USD/GBP and USD/CAD, the laws of arbitrage tell us GBP/CAD
• PRODUCTIVITY DIFFERENTIALS: Countries with high productivity in their traded goods sectors tend to have strong currencies
• PPP: Inflation and price differentials across countries determine the long-term value of their currencies
• Interest rate differentials: Tricky - international interest rates (and other asset prices) are determined in financial markets simultaneously with exchange rates

PURCHASING POWER PARITY (PPP)

Real Exchange Rates (RER)

The real exchange rate is unit-less and represents the price of the domestic goods in units of foreign goods.

"The Big Mac Index"

Absolute PPP

• If P_US and P_CHN are the prices of individual goods, then refer to RER(RMB/Dollar) = 1 as the Law of One Price
• If PUS and PCHN refer to the prices of broad baskets of goods and services, then we refer to RER(RMB/Dollar) = 1 as (absolute) Purchasing Power Parity (PPP)

Can PPP serve as a model of exchange rate determination? Over-simplication but not too far off

INTEREST RATE DIFFERENTIALS & FX RATES

Uncovered Interest Rate Parity (UIP)

MANAGING EXCHANGE RATES

Exchange rate control and manipulate

Fixed Exchange Rates:

Trilemma 三元悖论：

The following three statements cannot all be true: 1. There is perfect capital mobility 2. There is independent monetary policy -> can you use the central bank to stablize the economy 3. There is a fixed exchange rate

Week 6: International Economics

• American Rescue Plan Act of 2021 (ARPA) (March 2021)
• The CARES Act (March 2020)
• American Recovery and Reinvestment Act of 2009 (ARRA)

Government Spending: Effects

Taxonomy of Spending Bill

delta_G be change in government spending; delta_T change in overall taxes

Labor Multiplier

about 30K per job (much higher during pandemics?)

Fiscal Multiplier

Ramey (2011):

• Significant dispersion on estimates
• Deficit financed spending implies multiplier somewhere between 0.8 to 1.2

Jaimovich, Rebelo (2017):

• Little evidence of effect of tax rates on growth

Consumption Multiplier

Marginal Propensity to Consume – MPC: the rate of consumption increase when income is increased by a small amount.

• Suppose that income for a worker grows by \(1, his consumption expenditures grow by MPC*\)1 (MPC < 1)
• Hence, someone else’s income grows by MPC
  \(1; his expenditures grow by MPC^2*\)1, and on and on
• Total consumption will increase by:

Dampening the MPC: Ricardian Equivalence: a dollar received today might be taken back tomorrow

Negative Effects: Crowding-Out

Fiscal Multiplier:

1. Crowding out effects (-)
2. Higher future taxes (-)
3. Consumption multipliers effects (+)
4. Externalities (+)

HOW BIG IS THE U.S. GOVERNMENT?

Government Consumption Expenditures (G): Goods and services that are produced by general government, less sales to other sectors. The value of government production is measured by the cost of inputs: compensation of employees, onsumption of fixed capital, and intermediate goods and services purchased.

The size of the Government: federal stable; local and state growth

What Do Governments do?

1. Management of taxes and other receipts (T)
2. Management of spending including defense (G)
3. Management of social programs (Tr)
4. Management of debt (B)

Federal Government Outlays): The disbursement of funds made to liquidate federal obligations. Outlays also occur when interest on Treasury debt held by the public is paid

1. National Defense
2. Human resources & Physical resources
3. Net Interest
4. Other: (i) International Affairs; (ii) General Science, Space & Technology; (iii) General Government; (iv) Administration of Justice; (v) Agriculture

Outlays > G; and Outlays grow faster especially during the recession

THE GOVERNMENT BUDGET

1940-2019: outlays on national defense decreases; outlays on human resources increases

GOVERNMENT DEBT

Outlays usually is greater than receipts.

Budget Deficit: The Budget Deficit is the amount by which the government’s budget-outlays exceed budget-receipts in a given period.

Budget Deficit tends to be positive and growing.

Gross federal debt is the sum of two large components:

• 1/3: debt held by government accounts
• 2/3: debt held by the public

Debt Yields (both treasury and corporate) are decresing.

Long-term interest rates have declined (US and elsewhere)

Reasons:

1. Low productivity growth1
2. Low population growth rates
3. Safe asset storage
4. Current fiscal and monetary policies

DEBT ACCOUNTING

Higher the interest rate, higher the budget; higher the growth rate, lower the budget. Growth rate must be higher than the interest rate.

What can we use the formula for?

1. Where is US debt/GDP headed?
2. Debt Accounting
3. Sustainability

Strategies to Contain Debt

• What can help containing debt/GDP?
  • Low debt, low deficits, high growth
  • Lower borrowing costs
• Countries usually encode fiscal rules to contain the “temptation” of borrowing, they include:
  • Controls on expenditures (total and program specific)
  • Control on deficits (EU,...)
  • Debt ceilings (US,...)

TAXATION

Receipts are collections from the public based on the government exercise of its powers. The Federal Government classifies receipts into five categories:

1. Individual income taxes
2. Corporate income taxes
3. Social insurance and retirement receipts
4. Excise taxes
5. Other: Estate and gift taxes / Custom duties and fees / Federal reserve deposits

Trend: corperate tax rate decreases globally

Tax liability: Tax liability, denoted by a function T(
), is the total amount of income owed to the fiscal authority.

Progressive/Regressive Tax System: A Tax system is progressive (regressive) if the marginal tax rate is increasing (decreasing) in income.

A Progressive tax system reduces after-tax level of income inequality

When average tax rate = marginal tax rate, we say that the tax system is flat.

ARE TAXES IN THE US TOO HIGH? TOO LOW?

General Principles:

1. Equity Considerations: Excessive income/wealth/consumption/health inequality
2. Efficiency Considerations: For labor income: behavioral responses

In US nowadays, top 1% income earner would earn 20%+ of total income.

Behavioral Responses

Elasticity of income with respect to the net-of-tax rate: The elasticity of income with respect to the net-of-tax rate 1 􀀀 t denoted by e, is roughly is the answer to the following: If tax rates go up by 1%. By how much would your pre-tax income go down by?

70% - optimal top rate rate