1. Class next week is one of two places.

A) Saturday 11-2 in C230.  Section will follow.  We will have only 15 minutes
for lunch, so please bring a brown bag and do not count on visiting a
restaurant.
        or
B) Wed. in C230 at the regular time (but a larger room).
        There will not be class on Thanksgiving.

2. Please read the attachment in Word 6 (or plain text below) before class 
next
week.

3. Also read "The Open Economy" and "The Open Economy in the Short Run," 
Mankiw
Chapters 7&11
Homework #5:
Prepare Mankiw problem 5, p. 213 for class.
i.      Explain the claim that "Countries that run persistent trade
deficits are
also net borrowers."
ii.     Why is monetary policy less effective with fixed exchange rates than
with flexible?
iii. Why is fiscal policy less effective with flexible exchange rates than 
with
fixed?



David Levine    November 18, 1999
B.A. 201B       Macroeconomics

        Some Open Economy Macroeconomics

        Accounting:  Recall that Net Exports = NX = Exports - Imports.
Also, in
an open economy, Y = C + I + G + NX.  When exports rise, foreigners buy more 
of
our output; thus, aggregate demand for domestically produced goods rises.  
When
imports rise we are buying from foreigners, so imported purchases do not enter
domestic aggregate demand.

        NX = trade surplus = -trade deficit = net borrowing from abroad.  When
NX is negative (imports > exports), we have a trade deficit.  This is financed
by borrowing from abroad.  To a first approximation, when the US spends more 
on
exports than it earns on imports, it needs to borrow to make up the
difference.

        The trade deficit is not exactly equal to borrowing from abroad 
because
of the returns from net foreign assets.  When the US was a creditor nation, it
also made money on its investments abroad--this income permitted a modest 
trade
deficit without borrowing.  Now, as a debtor nation, a modest trade surplus is
required to avoid the need for new borrowing.  (We are also ignoring 
government
buying and selling of currencies.)  The Current Account Surplus = Exports -
Imports + interest and profits received from net foreign assets.

        Exchange rates:  An exchange rate is the price of one currency in 
terms
of another.  For example, a French Franc (FF) costs 15.7? yesterday, while it
was 10? when I traveled in France in 1985.

        The US currently has floating exchange rates, meaning that the value 
of
the dollar fluctuates.  The is about 105.8 yen today, but has varied from
103.76 to 124.44 in the last 12 months.  Thus, the dollar bought fewer yenit
weakenedover much of the last year.

        Under fixed exchange rates there would, in principle, be no day-to-day
changes in the exchange rate.  The Federal Reserve would buy and sell dollars
and foreign currencies to keep the exchange rate fixed.  The float is a little
bit "dirty," since the Fed and other central banks intervene on currency
markets (i.e., buy and sell dollars) to affect the value of the dollar.

        Unlike the U.S., most nations in the world fix their exchange rates
with
someone.  A few dozen use common currencies: the West African Franc is used by
many former French colonies and Panama uses the $U.S.  Other countries such as
Argentine or Hong Kong promise to keep as many U.S. dollars (or DM) as they
have circulating currency; this "currency board" arrangement makes a fixed
exchange rate credible because if folks want to sell the local currency, there
are always dollars or DM to redeem them.

        The value of the dollar: Many factors affect the value of the
dollar: US
and foreign aggregate demand, U.S. and foreign interest rates, speculative
bubbles, and so forth.  The dollar becomes stronger (i.e., can buy more of a
foreign currency) when US real interest rates (r) are high.  If r is high, 
then
foreigners want to buy dollars in order to put them into US banks and receive
the high interest rate.  When the demand for dollars goes up, so does its 
price
in terms of foreign currencies -- it gets stronger.

The net demand for dollars is low and the dollar will depreciate (weaken) 
when:


     *  Foreigners don't want to buy U.S. goods (U.S. exports low, foreigners
importing little);

     *   US want to buy foreign goods (U.S. imports high, foreigners
exporting a
lot).  US AD high implies leakage to foreign markets, IM high.

     *  Foreigners don't want to buy U.S. assets, often when U.S. interest
rates
are low.

     *  U.S. wants to buy foreign assets, often when foreign real interest
rates
are high.

     *  People think $ will get even weaker.  This adds a speculative
dimension,
so speculative bubbles sometimes appear to be important, as are expectations 
of
foreign or US changes in policy.
David Levine    Macroeconomics
November 18, 1999

        A Morality Play of International Trade

Chris and Pat were having a conversation one day upstairs at Kip's.

Chris: Pat, I don't see how you can be for free trade.  If Taiwan grows faster
than us, we will lose.

Pat: Chris, you clearly do not understand the great economist Ricardo's idea 
of
Comparative Advantage.

C: That's for sure, I don't.  Wazzat?

P: Comparative advantage is what you are least worst, or most best at.  For
example, this great entrepreneur whose name escapes me was the world's fastest
typist, but hired a secretary nevertheless.  He was perhaps 5 times as
productive as she was as an entrepreneur, but only 3 times as productive as a
typist--thus, he had absolute advantage in both, but she had comparative
advantage in typing.

C: So what does that have to do with free trade?

P: An example may clarify.  Step over to this handy blackboard, and let me
write a bit.  First, imagine a world with two countries, the US and Taiwan, 
and
two goods, computers and wine.  Further, assume that labor is the only input
into production.  Each country has 100 hours of labor.

First consider a case with no trade, when each nation's output equals their
consumption:

                        USA WITH NO TRADE


        Product                 Productivity            Output

        computers               30 hrs / PC              2
        wine                    2 hrs / bottle          20

          total hours = 30 * 2 + 2 * 20 = 100


                  TAIWAN WITH NO TRADE

        Product              Productivity               Output

        computers               10 hrs / PC              8
        wine                    1 hrs / bottle          20

          total hours = 10 * 8 + 1 * 20 = 100


Note that Taiwan makes computers in 1/3 the US time, and wine in 1/2 the US
time.  Thus, Taiwan has absolute advantage at both wine and computers.  Taiwan
has comparative advantage (is most best at) computers.  US has comparative
advantage (is least worse at) wine.

Now let's see what happens if we permit trade.  The US will specialize in 
wine,
what it is best at.  The world price will be about 12 bottles of wine per PC 
in
the world with trade.

                     USA WITH TRADE

        Product         Productivity            Output    Consumption


        computers               30 hrs / PC              0        2
        wine                    2 hrs / bottle          50        26
        wine                    2 hrs / bottle          50        26



          total hours = 0 * 30 + 2 * 50 = 100
          consumption of wine = production - 24 sold to Taiwan
          consumption of computers = 2 bought from Taiwan


                   TAIWAN WITH TRADE

        Product         Productivity            Output    Consumption


        computers       10 hrs / PC             10          8
        wine            1 hrs / bottle           0         24


          total hours = 10 * 10 + 0 * 1 = 100


Both countries receive at least as much of both goods after trade.  (The exact
price with free trade, and therefore the amount of consumption in each 
country,
depends on the demand elasticities in the two countries and other factors.)
Thus, in a world of comparative advantage, trade helps both countries!  
Nations
should specialize in what they do best.  Complete specialization, as in this
example, is an extreme case. As Adam Smith pointed out 200 years ago,
specialization permits all to grow wealthier.

C: Your argument assumes quite a bit.  Implicit in your example is the
assumption that when the US quits producing computers, all of those Cory-hall
types be magically transformed into Vit & Eno majors from Davis.  If we are in
a recession, then the computer workers who lose their jobs won't get new jobs;
policies to protect our domestic industry can avoid unemployment and increase
aggregate demand.

P: You are recommending "beggar-thy-neighbor" policies, since any gain in our
demand is offset by losses to our neighbors'.  If we get started on that tack,
the whole world loses.  Not everyone can increase demand by restricting
imports!

C: Even without the macroeconomic problem, there is still the unemployment
caused by free trade destroying industries.  How will all the ex-computer folk
get the skills to make wine?

P: You are correct, and both US computer makers and Taiwanese wine makers 
(both
companies and employees) prefer not to have trade in the short run.  The point
is that the winners (i.e., US wine makers, Taiwanese computer makers, and
consumers in both countries) win more than the losers lose.

C: If free trade brings so many benefits, then it should bring enough
prosperity to compensate the losers.  It is not fair to the computer workers
that they bear the cost of adjustment.  It makes sense to tax some of the
winners, and pay some subsidy to help the losers retrain.

Full employment is not your only key assumption.  You also assume that markets
are competitive, so that firms make no monopoly profits.  In fact, it appears
that some industries make big profits.  When we lose market share in these
industries, the capital flows to a less profitable industry.

P: Again, I must grant your point that there are monopolistic industries and
most Americans would rather the monopoly profits stay at home.  In general,
free trade eliminates monopoly profits, and will help consumers enormously.

C: Yes, but in addition to there being high-profit industries, there are
high-wage industries, so workers care which industry they are in.  When we 
lose
market share in these industries, the workers move to industries with lower 
pay
and lower productivity.  Autoworkers who become hamburger flippers are not
making a marginal switch to their next best-paying job.

For example, Boeing has traditionally made big profits, and paid its workers
well.  When Europeans subsidized Airbus and we lost airplane manufacturing
jobs, we lost both those high profits, and the workers had to move to
lower-wage employers.

P: I agree that it is theoretically possible for subsidies to increase a
nation's welfare, if the subsidies bring oligopoly profits and high-wage jobs.
Nevertheless, it would be better for everyone if nobody subsidized, and 
markets
were more competitive.  In the US today, both imports and exports are mostly
made in high-wage jobs.  Thus, we should favor the expansion of trade, not
restrictions.

C: Your hypothetical situation is irrelevant, since other nations are
subsidizing.  Japan is famous for protecting its industries until they become
big enough to compete internationally--then, watch out!

P: Do you really think that the US steel, auto and computer industries are too
small to compete internationally?

C: Well, I have to admit that USX, GM and IBM are not what one usually thinks
of as part of infant industries.  But the Japanese also subsidize industries
and dump exports below cost in order to drive competitors out of business.
Once they have a monopoly, then they really gouge.

P: Have the Japanese really increased prices of color TVs, RAM chips, or other
goods?  Anti-dumping laws primarily mean that foreigners are not allowed to 
cut
prices--price cuts that would benefit US consumers.

Even with an uneven playing field, I disagree with you.  As usual with
protectionists, you ignore consumers.  When European subsidies created Airbus,
Airbus made the market for passenger aircraft much more competitive.  US
consumers won in terms of lower airfares--something you forgot to stress in
your arguments about Boeing's loss of high profits and high-wage jobs.

I am very suspicious of these claims that we need to protect all sorts of
industries, since it gives companies enormous incentives to pour money into
lobbying.  The large firms of the US steel industry have been incredibly
successful at lobbying for protection.  This protection has mostly protected 
an
inefficient oligopoly, at great cost to US consumers.

C: But we sometimes need protection as a stick, to beat foreigners into 
opening
their markets to us.

P: While protection can be a stick, it is not easy to wield.  It seems most
likely to lead to a trade war, where retaliation by foreigners leads them to
close markets to us if we restrict trade.

Usually when we run protectionism, it is in the form of the misnamed
"voluntary" export restraint (VER), like the one that we have with the 
Japanese
for automobiles.  These basically require the foreigners to form a cartel,
lower sales, and increase price.  I do not know why the US government helps
foreigners run cartels that hurt US consumers!  Anti-trust policy is supposed
to restrict cartels.  The auto VERs cost consumers over $100,000 for each
US job
that is saved.

C:  Well, I am not convinced.  All of your arguments concerning the advantages
of free trade are based on this notion of comparative advantage, which you
assume is somehow granted by nature.  In today's high-tech industries,
comparative advantage is won by experience in producing complicated
technologies, not by weather or natural resources.

P: If comparative advantage is won by experience, then experience in producing
becomes a sort of investment.  Why can't US firms undertake investments that
are profitable?  You cannot seriously believe that IBM is too small to compete
with foreigners.

C: But there are spillovers from one industry to another.  The experience of
Silicon Valley, for example, shows that when one part of high-tech does well,
other parts learn from it and do well also.

Even your economists have always agreed that when there are positive
externalities that there is a role for public subsidies.  For example, an
innovating firm rarely captures all the gains of its research and development.
In the example above, when new computer technologies are developed, only the
Taiwanese will be able to develop the new products based on their expertise in
PC manufacture.

P: I agree that companies providing positive spillovers should be encouraged.
I think that support of university research, coupled with an R&D tax credit
makes more sense than protectionism.

You, on the other hand, seem to be promoting an "industrial policy," in which
the government picks winners to promote.  Didn't the billions of dollars that
France and Britain poured into the Concorde supersonic transport, as well as
wastage of the US with Synfuels synthetic gasoline teach you that industrial
policy won't work?

C: Well aren't you self-righteous.  The US has always had a multitude of
vigorous and expensive industrial policies, they have just gone under a 
variety
of other names and have never been coordinated to work together.  Agriculture
receives billions in subsidies, steel and textiles have quotas on imports,
Lockheed and Chrysler received government-backed loans, and housing gets the
mortgage interest deduction.  Perhaps most importantly, a vast proportion of
our research is funded by the military, which has always looked to advantages
for certain industries.

All I want is a rational and democratic industrial policy.  We should
coordinate
our goals, and choose our subsidies more democratically and in ways that do 
not
work to cross-purposes.  For example, any bailouts or protection from imports
should be short run, and explicitly tied to promises to invest in new 
machinery
and new skills for workers.  New technologies to be promoted should be chosen
by democratically-chosen representatives, not by nameless bureaucrats at DARPA
(the Defense Advanced Projects Research Administration)--an agency almost
nobody has heard of.

P: I would just as soon cut subsidies to all those industries as adjust what
subsidies I give.  Nevertheless, I grant you that if subsidies are given they
should at least include promises from the industry and its workers to invest,
not just enjoy high current wages and profits.

C: You're starting to talk sense now.  We must always keep in mind that 
America
needs high tech to maintain its competitiveness.

P: I don't understand this word "competitiveness."  I, like you, would like US
productivity to grow quickly so that we are more prosperous, and have more
resources to care for the disadvantaged, the environment, and so forth.  I 
care
about the absolute level of US growth, not the relative level.

C: But if the US growth more slowly than Japan, we will lose our standing as a
world power!

P: I am not thrilled about any nation being overwhelmingly powerful.  It is ok
with me if the US must consult with its allies before invading various small
open economies.

C: Well, I have won enough points from you that I should probably stop.  You
agree that (at least in theory) protectionism can help keep high-profit,
high-wage, and high-spillover industries at home, and raise national output.

P: I must agree in theory, and also remind you that the industries have
political clout to receive protectionism are often the worst-run.  
Furthermore,
any protectionist policy leads to the risk of trade wars, and they make
everyone
worse off.

C: Hey, that's enough economics talk.  Let's go have a beer--Anchor Steam, not
Beck's. - INTLHND99a.doc

David I. Levine                 Associate professor
Haas School of Business    ph: 510/642-1697
University of California    fax: 510/643-1420
Berkeley CA  94720-1900                            email:
levine@haas.berkeley.edu
http://web.haas.berkeley.edu/www/levine/