Balance of Payments

Balance of Payments

• Measures of money inflows and outflows between the United States and the rest of the world
• Inflows are referred to as credits
• Outflows are referred to as debits

Balance of Payment is divided into 3 accounts

1. Current Account
2. Capital/Financial Account
3. Official Reserves Account

Double Entry Book Keeping

• Every transaction in the balance of payments is recorded twice in accordance

Current Account

• Balance of Trade or Net Exports
• Exports of goods/services- Import of Goods/Services
• Exports create a credit to the balance of payments
• Imports create a debit to the balance of payments
• Net Foreign Income
• Income Earned by the U.S owned foreign assets
• Net Transfers
• Foreign Aid- Debit to the current account
• Ex- migrant worker sending money to family

Capital/ Financial Account

• Balance of capital ownership
• Includes the purchase of both real and financial assets
• Direct Investment in the United States is a credit to the capital account
• Ex- Toyota company in San Antonio
• Direct Investment by United States in foreign countries are debits to the capital accounts
• Purchase of foreign financial assets represents a debit to the capital account
• Purchase of domestic financial assets by foreigners represents a credit to the capital account

Relationship between Current and Capital Account

• Current account and the capital account should zero each other out
• If current account has a negative balance (deficit) then capital account should then have a positive balance (surplus)

Official Reserves

• Foreign currency holding of the United States Fed
• When there is a balance of payments surplus the Fed accumulates foreign currency and debits the balance of payments
• When there is a balance of payments deficit, the Fed depletes its reserves of foreign currency and credits the balance of payments 

Active vs. Passive Official Reserves

• United States is passive in its use of official reserves. 
• Does not seek to manipulate the dollar exchange rate
• People's Republic of China is aactive in its use of official reserve. 
• Actively buys and sells dollars in order to maintain a steady exchange rate w/ the United States

Formulas

• Balance of Trade
• Good exports + Goods Imports
• Balance on Goods & Services
• Good Exports + Services Exports + Good Imports + Service Imports
• Current Account
• Balance on Goods and Services + Net Investment + Net Transfers
• Capital Account
• Foreign Purchases + Domestic Purchases 

Unit 7: Foreign Exchange/ Flexible & Fixed Rates

Foreign Exchange

• Ex: In order to purchase souvenirs in France, it is first necessary for Americans to sell (Supply) their dollars and buy Euros. 
• Any transactions that occurs in the balance of payments necessitates foreign exchange.
• Exchange Rate is determined in the foreign currency markets.

Changes in the Exchange Rates

• Exchange Rates are a function of the supply and demand for currency
• An increase in the supply of a currency will decrease the exchange rate of a currency.
• A decrease in supply of a currency will increase the exchange rate of a currency
• An increase in demand for a currency will increase the exchange rate of a currency
• A decrease in demand for a currency will decrease the exchange rate of a currency

Appreciation and Depreciation

• Appreciation of a currency occurs when the exchange rate of the currency increases
• Depreciation of a currency occurs when the exchange rate of that currency decreases 
• The more you supply, the more the value depreciates. The more you demand, the more value appreciates

Exchange Rates Determinants

• Consumer Rates
• Relative Income
• Relative Price Level
• Speculation

Exports and Imports

• Exchange Rate is a determinant of both exports and imports
• Appreciation of the dollar causes American goods to be relatively more expensive and foreign goods to be relatively cheaper, thus reducing exports and increasing imports
• Depreciation of the dollar causes American goods to be relatively cheaper and foreign goods to be relatively more expensive, thus increasing exports and reducing imports

As two currencies trade: 

• One supply line will change while the other demand line will also change
• They will move in the same direction
• One currency will appreciate while the other will depreciate

Flexible Rates

• Based on supply and demand of that currency versus the other currency
• Very sensitive to the business cycle and it provides options for investment

Fixed Rates

• Based on countries willingness to distribute currency and to control the amount

Unit 7: Absolute & Comparative Advantage

Absolute Advantage

• Individual- exists when a person can produce more of a certain good/service than someone else in the same amount of time (Or how they can produce a good using the least amount of resources.)
• National- exists when a country can produce more of a good/service than another country can in the same time period.
  
  

Comparative Advantage: 

• A person or a nation that has a comparative advantage when it can produce the product at a lower domestic opportunity cost than a trading partner can. 

Examples of Output Problems:

• Words/Min
• MPG
• Tons/Acre
• Apples/Tree
• Televisions Produced Per Hour

Examples of Input Problems:

• # of hours to do a job
• # of acres to feed a horse 
• # of gallons of paint to paint a house

Specialization and Trade: 

Gains from trade are based on comparative advantage, not absolute advantage

Unit 5: Laffer Curve

Laffer Curve

• Depicts a theoretical relationship between tax rate and government revenue
• As tax rates increase from zero, government revenues increases from zero to a maximum level, and then decline

Criticsms of the Laffer Curve

• Research suggests that the impact of tax rates on incentives to work, save, and invest are small. 
• Tax cuts also increase demand which can fuel inflation, which causes demand to exceed supply
• Where the economy is actually located on the curve is difficult to determine

Unit 5: Supply Side Economics

Reaganomics

• Makes changes in AS but not AD and it determines the level of inflation, unemployment, and economic growth. 
• Lower marginal tax rate induce more work this AS increases.
• Makes leisure more expensive and make work more attractive. 

Supply Side Economics

• Support policies that promote GDP growth by arguing that high marginal tax rates along with the current system of transferred payment
• Ex. Unemployment compensation, 
• Welfare Programs that provided disincentives to work, invest, innovate and undertake entrepreneur inventions.

Incentive to save and invest

• High Marginal Tax Rate can reduce the rewards for savings and investments
• Consumption might increase, but investment depend upon savings
• Lower Marginal Tax Rates encourage saving and investment

Unit 5: Phillips Curve

The Long-Run Phillips Curve (LRPC)

• Long-Run Phillips curve exists off the natural rate of Unemployment (Un)
• Structural changes in the economy that affect Un will also cause the LRPC to shift.
• Increase in Un will shift LRPC to the right.
• Decrease in Un will shift LRPC to the left.

The Short-Run Philips Curve (SRPC)

• There is a trade off between inflation and unemployment. 
• As one increases, the other decreases and vice versa. 

LRPC

1. There is no trade off between inflation and unemployment. 
2. LRPC is represented by a vertical line.
3. The LRPC occurs at the natural rate of unemployment.
4. The LRPC only shifts if the LRAS shifts

NRU= Frictional + Structural + Seasonal Unemployment 

What changes LRPC?

The major LRPC assumption is that more worker benefits create a higher natural rate of unemployment and fewer worker benefit creates a lower natural rate

The Misery Index-

• It's a combination of inflation and unemployment in a given year. 
• Single digit misery is good
• Inflation: It is the general rise in the price level
• Deflation: A general decline in the price level
• Disinflation: Decrease in the rate of inflation over time
• Stagflation: Unemployment and inflation increasing at the same time 

Unit 5: Extending the Analysis of Aggregate Supply

SRAS

• This is the period in which wages and input prices remain fixed as price level decrease or increases. 

LRAS

• This is the period of time in which wages have become fully responsive to changes in prices level.

Effects Over the Short Run

• In the short run, price level changes to allow for companies to exceed Normal Outputs and hire more workers. 
• Prices are increasing while wages remain constant
• In long run, wages will adjust to the price level and previous output levels will adjust accordingly

Equilibrium in the Extended Model

• The extended model means the inclusion of both the short run and the AS curves. 
• The Long AS curve is represented with a vertical line at full employment level of real GDP.

Demand Pull Inflation in the AS Model

• Demand Pull: Prices increase based on increase in Aggregate Demand.
• In the short urn, demand pull will drive up prices and increase production. 
• In the long run, increase in aggregate demand will eventually return to previous levels.

Cost Push and Extended Models

Cost-push arises from factors that will increase per unit costs such as increase in the price of a key resources.

Dilemma for the Government

• In an effort to fight cost-push, the government can react in two different ways;
• Actions such as spending by the government could begin an inflationary spiral.
• No actions however could lead to recession.

Key Concept and Functions of the FED

Functions of the FED: 

• Presidential appointment
• Issues paper money
• Sets Reserve Requirements and holds reserves of the bank
• Lends money to the banks and charges them interest
• Check clearing service for banks
•  Acts as personal bank for the government
• Supervises member banks
• Controls the Money Supply

·         Reserve Requirement - Only a small % of your bank deposit is in the safe. The rest of your money has been loaned out. 

·         Fractional Reserve Banking- FED sets amount banks must hold -RR is the % of deposits that banks must hold in reserve and NOT loan out –

·         FED increases the MS by increases in the amount of money held in bank deposits

                                   

• Recession- what should FED do to RR?
•  Decrease the RRatio, banks hold less money which means more ER.
• Banks create more money loaning out excess MS increases, interest rate fall, AD increases
• Inflation-
• Banks hold more money which  measn less ER
• Banks create less money MS decreases, interest rate increases, AD decreases 
• Discount Rate - is the interest rate that the FED charges commercial banks
• To increase the MS, the FED should decrease the discount Rate (Ex:Monetary Policy)
• To decrease the MS, the FED should increase the Discount Rate (Ex:Tight Money Policy)

Open Market Operations (OMO)

• FED buys/sells gov't bonds (securities)
• This is money important and widely used monetary policy
• Increase the MS- FED should BUY government securities
• Decrease the MS- FED should SELL government securities

Value of Money

·         Is a dollar today worth more than a dollar tomorrow? - Yes

·         Why? - Opportunity costs & inflation

Let :

• v = future value of $ 
• p = Present value of $
• r = real interest rate (nominal - inflation rate) expressed as decimal
• n = years
• k = # of times interest is credited per year 

Formulas

• Simple Interest Formula - -v = (1 + r)^n x p 
• Compound Interest Formula - - v = (1 + r / k)^nk x p

Money demand has an inverse relationship between nominal interest rates and the quantit of money demanded

·         What happens to the quantity demanded of money when interest rates increases? Quantity demanded falls because individuals would prefer to have interest earning assets instead of borrowed liabilities

·         What happens to quantity demanded when interest rates decrease? Quantity demanded increases, there is no incentive to convert cash into interest earning assets

What happens if price level increases?

• Money demand Shifters that affects investment
• Changes in Price Level
• Changes in Income
• Changes in Taxation

Increasing the Money Supply

- If the FED increases the money supply a temporary surplus of money will occur at 5% interest. The Surplus will cause the interest rate to fall to 2%

 

How this affect AD:

Money supply (increase) -> interest rate(decrease) -> Investment (increases) -> Increases AD

Decreasing the Money Supply:

Money supply (decreases) -> interest rate (increase) -> investment (decrease) -> Decrease AD

Financial Sector:

• Financial Assets (Own) vs Financial Liabilities (Owe)
• Financial Assets:-
• Stocks or bonds that provide expected future benefits
• Benefits the owner only if the issuer of the asset met certain obligations
• Financial Liabilities:
• Incurred by the issuer of a financial asset to stand behind/by the issued asset

Interest Rate - price paid for use of a financial asset

Stocks vs Bonds

• Stocks:
• Financial assets that convey ownership in a corporation
• Bonds:
• Promise to pay a certain amount of money plus interest in the future

What Banks do

·         A bank is a financial intermediary - uses liquid assets (i.e. bank deposits) to finance the investment of borrowers

·         Process kown as Fractional Reserve Banking - system which depository institutions hold liquid assets less than the amount of deposits

·         Can take the form of:

• Currency in bank vaults.
• Bank Reserves- deposits held at the Federal Reserve

 

Basic accounting review

·         T- Account (Balance sheet) - statement of assets and liabilities

·         Assets (Amounts owned) - items to which a bank holds legal claim - the uses of funds by financial intermediaries

·         Liabilities (Amounts owed) - the legal claims against a bank - the sources if funds for financial intermediaries

Banking System

Money Supply

• Affects AD when increased: - r down, Ig up, AD up (Vertical)
• Decreases - MS down, r up, Ig down, AD down

Financial Sector

• Financial. Assets - Stocks and bonds provide expected future benefits
• Benefits owner from issuer of asset meeting certain obligations
• Fin. Liabilities - Incurred by issuer of financial asset to stand behind issued asset
• Interest Rate - $ paid to use financial asset
• Stocks – Financial asset that represent ownership in a company
• Bonds - Promise to pay $ and interest in the future

Banks

Financial Intermediary - use liquid assets to fund investments of borrowers -> Fractional Reserve Banking

Liquid assets include currency in bank vaults and bank reserves

Banks creates money by lending out deposits that are used multiple times

When a customer deposits cash or withdraws cash from their demand deposit account, it has NO EFFECT ON THE MONEY SUPPLY

Only changes

The composition of money

• Excess Reserves
• Required Reserves

Changes in Money Supply for

• Single Bank
•  Loan money from ER
• Banking System
•  ER x Money multiplier (1/RR) -> Total Money Supply
• When the FED buys or sells bonds, ER is created
• Basic accounting
• Assets (Amounts owned) - Items claimed legally by bank; use of funds by fin. intermediary
• Included in assets
• Required Reserves - % of DD in vault
• Excess Reserves - Remaining % of DD used for loans
• Property - Statement of a bank's property values
• Securities or Bonds - Previously purchased bonds held by the banks as investments
• Loans - Previously loaned funds now owed back to the bank
• Liabilities (Amounts owed) - Legal claims against a bank; sources of funds.
• Included in liabilities
• Demand Deposits- Cash deposits from the public to the bank
• Part of MS if from person's cash holdings
• Becomes new $ if from a bond -> MS up
• Owner's equity or stock shares - Values of the bank stocks as held by the public
• DD = RR + ER
• Reserve Requirement- Fed needs banks to always have $ to meet demand
• Amount = Reserve Ratio - % of DD locked to bank

Scenario 1

A private citizen takes cash that they possess and put it into a bank account

• The cash placed into the bank is already part of the money supply
• The deposit is counted as a bank liability
•  A % must be placed into required reserve
• The remainder is placed into excess reserve
• The bank will want to lend all of the ER, if possible
• The amount in ER is multiplied by the monetary multiplier
• This will be assumed to become new loans in the banking system
• This will be counted as the change in money supply
•  

Scenario 2

The Fed buys bonds back from the public

• The public now has new cash
• This new cash is new loans
• Assume that the public puts the cash into demand deposits
• A set percentage is placed into required reserve
• The remainder becomes excess reserve
• Excess reserve is multiplied by the money multiplier (1/RR)
• This amount becomes new loans and is new money supply
• The total change in money supply is the amount of demand deposits plus the new loan amounts

Scenario 3

The Fed buys bonds back from the member bank

• The banks now have new ER
• No money is needed to be placed in RR, since this is not owed to the public
• All of these ER are multiplied by the monetary multiplier
• This amount becomes new loans
• This amount is the change in the money supply

Money

Uses of Money Vocabulary

•  Medium of Exchange - To barter/trade
•  Unit of Account - Establishes economic worth in the exchange process
•  Store of Value - Money holds its value over a period of time, whereas products do not

Types of Money Vocabulary:

• Commodity Money - Gets its value from the type of material from which it is made. EX: Gold/Silver coins
• Representative Money - Paper money backed up by something tangible that gives it value EX: IOU
• Fiat Money - Money because the gov't says so EX: US Money

Characteristics of Money:

• Portable - Money is portable
• Durable - Money is durable
• Scarce - Bills
• Divisible - Dollar - breaks down
•  Acceptable - Everywhere in [US]
• Uniform - Everywhere you go

Money Supply:

• M1 [75% most liquid] <- (easy to convert to cash) - (Currency) [cash/coins] (checking accounts) -> Checkable deposits/Demand deposits + Travelers checks
• M2 [Not as liquid to convert to cash] - Consists of M1 money along w/ saving accounts, common market accounts, and deposits held by banks outside of US.
• M3 [withdraw early = penalty] - Consists of M2 money + Certificates of Deposits (CD's) Held by private institutions

AP Monetary Policy Video

Classical vs. Keynesian

CLASSICAL

• Followers
• Adam Smith
• J.B. Say
• David Ricardo
• Alfred Marshall
• Say's Law
• Supply creates own demand
• Production= Income= Spending
• Under spending unlikely
• Whatever output produced will be demanded
• Savings and Investment

• Savings= Investment Income
• Savings (Leakage)= Investment (Injection)
• Loan able Funds Market
• Wages/ Price Flexibility
• Downward
• Supply Curve
• Vertical
• Output and Employment
• Determined by AS
• Unemployment
• Rarely exists because of wage/price flexibility
• Cause: External (War)
• Aggregate Demand
• Determines PL
• Stable if Money Supply is Stable
• Basic Equation
• MV= PQ
• 1965-1972
• Role of Government
• Monetary Policy maintains steady Money Supply
• Laissez-faire is best
• Self Regulating Economy
• Inflation
• When the economy has too much money flowing around

Short Run last a Short Time

Microeconomics= Emphasis Today

• Other
• Competition is Good
• Invisible Hand
• Long Run- Balance= FE
• Trickle Down Effect- Help Rich 1st, Everyone Else 2nd

KEYNESIAN

• Followers
• J.B. Keynes
• Say's Law
• Depressions refute Say's Law
• Demand creates own Supply
• Under Spending Persists 
• Savings and Investments
• Savings is not equal to Investment
• Different Motivations
• Savings
• Future Needs
• Precaution
• Habit
• Income Level
• Interest Rate
• Investment
• Interest Rate
• Rate of Profit
• Expectations
• Loan able Funds Market 
• Investment from Savings, Cash, and Checking Accounts
• Lending creates Money which leads to the Supply of Money Increases
• Inflation and Unemployment are Unstable
• Wages/ Price Inflexibility
• Ratchet Effect- Prices and Wages inflexible Downward
• Supply Curve
• Horizontal
• Output and Employment
• Determined by AD
• Unemployment
• Usually exists
• Causes:
• External (War)
• Internal (Savings is not equal to Investment)
• Aggregate Demand
• Changes due to Determinants
• Unstable even if Money Supply is stable due to Fluctuations in Investment Spendings
• Basic Equation
• C+Ig+G+Xn
• 1973- Present
• Role of Government
• Fiscal Policy- Tax and Spend
• Active Government
• Economy is not Self Regulating
• Inflation
• Too much Demand

Short Run last a Long Time

Emphasis Today= Macroeconomics

• Other
• Flawed Competition
• AD is key; not AS
• Leaks+Savings=Recession
• Ratchet Effects and Sticky Wages block Say's Law
• We are doomed in the Long Run

Fiscal Policy

Fiscal Policy

• The change in Expenditures or Tax Revenue of the Federal Government
• Can either increase or decrease Taxes or Spending

Type of Budget

• Balanced Budget=Revenue = Expenditures
• Deficit= Revenue < Expenditures
• When in Deficit, Government borrows from:
• Individuals
• Corporations
• Financial Institutions 
• Foreign Entities and Countries
• Surplus= Revenue > Expenditures
• Government Debt= Sum of Deficits- Sum of Surplus
• Discretionary (Action)- 
• Expansionary 
• Combats Recession
• Increase Spending; Decrease Taxes
• Contractionary
• Combats Inflation
• Decrease Spending; Increase Taxes
• Increase/ Decrease Government Spending or Taxes to get back Fiscal Policy 
• Non Discretionary 
• Automatic/ Built-in Stabilizers- Include Unemployment Compensation and Marginal Taxes; They happen without Policy Makers

Tax Systems

• Progressive- Average Tax Rates rises with GDP 
• Proportional- Average Tax Rates remains constant as GDP Changes
• Regressive- Average Tax Rates falls with GDP
• More Progressive- More Stability 

MPC, MPS, and Spending/Tax Multiplier

Disposable Income

·         Income after Taxes or Net Income

·         DI= Gross Income- Taxes

Choices

·         With DI, Households can either

o   Consume (Spend money on Goods and Services)

o   Save (Not Spend money on Goods and Services)

Consumption

·         Household Spending

·         Ability to Consume is Constrained by

o   Amount of DI

o   Propensity to Save

·         Do Households Consume if DI= 0?

o   Autonomous Consumption

o   Dissaving

Saving

·         Household is NOT spending

·         Ability to Save is Constrained by

o   Amount of DI

o   Propensity to Consume

·         Do Households save if DI=0?

o   NO

APC and APS

·         APC= Average Propensity to Consume

·         APS= Average Propensity to Save

o   APC+APS=1

o   1-APC=APS

o   1-APS=APC

o   APC>1= Dissaving

o   –APS= Dissaving

Marginal Propensity to Consume (MPC)- Fraction of any change in DI that is consumed

·         MPC= Change in Consumption/ Change in DI

Marginal Propensity to Save (MPS)- Fraction of any change in DI that is saved

·         MPS= Change in Savings/ Change in DI

Marginal Propensities

·         MPC+MPS=1

·         MPC=1-MPS

·         MPS=1-MPC

Spending Multiplier Effect

·         Initial change in Spending Causes a larger change in AS or AD

o   Multiplier= Change in AD/ Change in Spending

·         Calculating the Spending Multiplier

o   Spending Multiplier can be calculated from MPC or MPS

o   Multplier= 1/(1-MPC) or 1/MPS

o   Spending Multipliers are positive when there is an increase in spending and negative when there is a decrease

Calculating the Tax Multiplier

·         When Government taxes, multiplier works in reverse

·         Why?

o   Because now, money is leaving the Circular Flow

·         Tax Multiplier is Negative

o   Multiplier= -MPC/ (1-MPC) or –MPC/MPS

·         If there is a Tax Cut, then the multiplier is positive, because now there is money going in the Circular Flow