Mankiw Principles of Economics (3rd ed)

trade policy

a government policy that directly influences the quantity of goods and services that a country imports or exports

much, so the result was a large budget deficit. Our model of the open economy predicts that such a policy should lead to a trade deficit, and in fact it did, as we saw in a case study in the preceding chapter. The budget deficit and trade deficit during this period were so closely related in both theory and practice that they earned the nickname the twin deficits. We should not, however, view these twins as identical, for many factors beyond fiscal policy can influence the trade deficit.

TRADE POLICY

A trade policy is a government policy that directly influences the quantity of goods and services that a country imports or exports. As we saw in Chapter 9, trade policy takes various forms. One common trade policy is a tariff, a tax on imported goods. Another is an import quota, a limit on the quantity of a good that can be produced abroad and sold domestically. Trade policies are common throughout the world, although sometimes they are disguised. For example, the U.S. government has often pressured Japanese automakers to reduce the number of cars they sell in the United States. These so-called “voluntary export restrictions” are not really voluntary and, in essence, are a form of import quota.

Let’s consider the macroeconomic impact of trade policy. Suppose that the U.S. auto industry, concerned about competition from Japanese automakers, convinces the U.S. government to impose a quota on the number of cars that can be imported from Japan. In making their case, lobbyists for the auto industry assert that the trade restriction would shrink the size of the U.S. trade deficit. Are they right? Our model, as illustrated in Figure 30-6, offers an answer.

The first step in analyzing the trade policy is to determine which curve shifts. The initial impact of the import restriction is, not surprisingly, on imports. Because net exports equal exports minus imports, the policy also affects net exports. And because net exports are the source of demand for dollars in the market for foreigncurrency exchange, the policy affects the demand curve in this market.

The second step is to determine which way this demand curve shifts. Because the quota restricts the number of Japanese cars sold in the United States, it reduces imports at any given real exchange rate. Net exports, which equal exports minus imports, will therefore rise for any given real exchange rate. Because foreigners need dollars to buy U.S. net exports, there is an increased demand for dollars in the market for foreign-currency exchange. This increase in the demand for dollars is shown in panel (c) of Figure 30-6 as the shift from D1 to D2.

The third step is to compare the old and new equilibria. As we can see in panel (c), the increase in the demand for dollars causes the real exchange rate to appreciate from E1 to E2. Because nothing has happened in the market for loanable funds in panel (a), there is no change in the real interest rate. Because there is no change in the real interest rate, there is also no change in net foreign investment, shown in panel (b). And because there is no change in net foreign investment, there can be no change in net exports, even though the import quota has reduced imports.

The reason why net exports can stay the same while imports fall is explained by the change in the real exchange rate: When the dollar appreciates in value in the market for foreign-currency exchange, domestic goods become more expensive relative to foreign goods. This appreciation encourages imports and discourages exports—and both of these changes work to offset the direct increase in net exports

1. An increase in net foreign investment . . .

NFI1 NFI2

Real

Exchange

Rate

E1

5. . . . which causes the E2 peso to depreciate.

Net Foreign

Investment

S1 S2

4. At the same time, the increase in net foreign investment increases the supply of pesos . . .

Demand

Quantity of

Pesos

To analyze the macroeconomics of open economies, two markets are central—the market for loanable funds and the market for foreign-currency exchange. In the market for loanable funds, the interest rate adjusts to balance the supply of loanable funds (from national saving) and the demand for loanable funds (from domestic investment and net foreign investment). In the market for foreign-currency exchange, the real exchange rate adjusts to balance the supply of dollars (for net foreign investment) and the demand for dollars (for net exports). Because net foreign investment is part of the demand for loanable funds and provides the supply of dollars for foreign-currency exchange, it is the variable that connects these two markets.

A policy that reduces national saving, such as a government budget deficit, reduces the supply of loanable funds and drives up the interest rate. The higher interest rate reduces net foreign investment, which reduces the supply of dollars in the market for

foreign-currency exchange. The dollar appreciates, and net exports fall.

Although restrictive trade policies, such as tariffs or quotas on imports, are sometimes advocated as a way to alter the trade balance, they do not necessarily have that effect. A trade restriction increases net exports for a given exchange rate and, therefore, increases the demand for dollars in the market for foreign-currency exchange. As a result, the dollar appreciates in value, making domestic goods more expensive relative to foreign goods. This appreciation offsets the initial impact of the trade restriction on net exports.

When investors change their attitudes about holding assets of a country, the ramifications for the country’s economy can be profound. In particular, political instability can lead to capital flight, which tends to increase interest rates and cause the currency to depreciate.

IN THE NEWS

How the Chinese Help

American Home Buyers

tinue to buy a lot of U.S. debt for years to come.

Thanks to high domestic savings, a continuing inflow of foreign investment and tight controls on domestic spending, China is awash in capital. Last year’s capital surplus . . . reached an estimated $67 billion.

China squirrels more than half of that away into foreign reserves, which

THEIR SAVING HELPS US GET

CHEAP MORTGAGES.

-sucking hole, China has become fountain of capital.

This isn’t the first time a developing has sent abroad funds that could

1.Describe supply and demand in the market for loanable funds and the market for foreign-currency exchange. How are these markets linked?

2.Why are budget deficits and trade deficits sometimes called the twin deficits?

3.Suppose that a textile workers’ union encourages people to buy only American-made clothes. What would this

policy do to the trade balance and the real exchange rate? What is the impact on the textile industry? What is the impact on the auto industry?

4.What is capital flight? When a country experiences capital flight, what is the effect on its interest rate and exchange rate?

be used productively at home. Often, such money was fleeing instability, as it was in Latin America in the 1980s, Russia in the 1990s, and Africa in both decades.

Usually, however, developing countries invest their capital in their own growing economies. And some Chinese officials believe that’s what China should be doing, too. One former Chinese central bank official calls it “scandalous” that a country of poor peasants is financing investment of an industrialized power such as the United States.

Others complain that China isn’t even getting good returns on its investments. It pays an average of 7 to 8 percent on its $130 billion foreign debt but earns only about 5 percent on the $140 billion of its reserves invested abroad. That’s partly because yields on U.S. debt—widely considered the safest securities in the world—are relatively low.

But China has good reasons to send some of its capital overseas. vestment in fixed assets as a percentage

of its gross domestic product was an extraordinarily high 34 percent in 1996, the latest year for which figures are available. It’s doubtful that China could increase that ratio without wasting money or fueling inflation. Thailand’s ratio was 40 percent and Korea’s 37 percent before their overspending undermined those nations’ economies. . . .

“They’re already investing as much as they can absorb,” says Andy Xie, an economist for Morgan Stanley Dean Witter & Co. in Hong Kong.

Yet while investment is constrained, savings keep growing. The percentage of working-age people in the population has climbed to 62 percent from 51 percent in the past 30 years. And those workers, often allowed only one child on which to spend, are hitting their peak saving years. With consumption low, the pileup of money pushes capital offshore.

The result: Chinese capital is spreading everywhere. The country is

concessions in Sudan, Venezuela, Iraq and Kazakstan. Mainland capital also has poured into Hong Kong, where it helped inflate property prices before East Asia’s crisis began letting out some of that air. The capital surplus has even allowed China to help its neighbors when they got into trouble: Beijing pledged $1 billion to the International Monetary Fund bailouts in Thailand and Indonesia. Most of the money, though, goes into U.S. Treasury bonds. China won’t say how much, but estimates run as high as 40 percent.

And China’s central bank, like 50 others around the world, lends money to Fannie Mae and Freddie Mac, which use the funds to buy mortgage loans that banks and others extend to ordinary Americans. The flood of money keeps the market liquid and reduces the rates that U.S. home buyers pay.

SOURCE: The Wall Street Journal, March 30, 1998,

Outlook, p. 1.

1.Japan generally runs a significant trade surplus. Do you think this is most related to high foreign demand for Japanese goods, low Japanese demand for foreign goods, a high Japanese saving rate relative to Japanese investment, or structural barriers against imports into Japan? Explain your answer.

2.An article in The New York Times (Apr. 14, 1995) regarding a decline in the value of the dollar reported that “the president was clearly determined to signal that the United States remains solidly on a course of deficit reduction, which should make the dollar more attractive to investors.” Would deficit reduction in fact raise the value of the dollar? Explain.

3.Suppose that Congress passes an investment tax credit, which subsidizes domestic investment. How does this

policy affect national saving, domestic investment, net foreign investment, the interest rate, the exchange rate, and the trade balance?

4.The chapter notes that the rise in the U.S. trade deficit during the 1980s was due largely to the rise in the U.S. budget deficit. On the other hand, the popular press sometimes claims that the increased trade deficit resulted from a decline in the quality of U.S. products relative to foreign products.

a.Assume that U.S. products did decline in relative quality during the 1980s. How did this affect net exports at any given exchange rate?

b.Use a three-panel diagram to show the effect of this shift in net exports on the U.S. real exchange rate and trade balance.

c.Is the claim in the popular press consistent with the model in this chapter? Does a decline in the quality of U.S. products have any effect on our standard of living? (Hint: When we sell our goods to foreigners, what do we receive in return?)

5.An economist discussing trade policy in The New Republic wrote: “One of the benefits of the United States removing its trade restrictions [is] the gain to U.S. industries that produce goods for export. Export industries would find it easier to sell their goods abroad—even if other countries didn’t follow our example and reduce their trade barriers.” Explain in words why U.S. export industries would benefit from a reduction in restrictions on imports to the United States.

6.Suppose the French suddenly develop a strong taste for California wines. Answer the following questions in words and using a diagram.

a.What happens to the demand for dollars in the market for foreign-currency exchange?

b.What happens to the value of dollars in the market for foreign-currency exchange?

c.What happens to the quantity of net exports?

7.A senator renounces her past support for protectionism: “The U.S. trade deficit must be reduced, but import quotas only annoy our trading partners. If we subsidize U.S. exports instead, we can reduce the deficit by increasing our competitiveness.” Using a three-panel diagram, show the effect of an export subsidy on net exports and the real exchange rate. Do you agree with the senator?

8.Suppose that real interest rates increase across Europe. Explain how this development will affect U.S. net foreign investment. Then explain how it will affect U.S. net exports by using a formula from the chapter and by using a diagram. What will happen to the U.S. real interest rate and real exchange rate?

9.Suppose that Americans decide to increase their saving.

a.If the elasticity of U.S. net foreign investment with respect to the real interest rate is very high, will this increase in private saving have a large or small effect on U.S. domestic investment?

b.If the elasticity of U.S. exports with respect to the real exchange rate is very low, will this increase in private saving have a large or small effect on the U.S. real exchange rate?

10.Over the past decade, some of Japanese saving has been used to finance American investment. That is, American net foreign investment in Japan has been negative.

a.If the Japanese decided they no longer wanted to buy U.S. assets, what would happen in the U.S. market for loanable funds? In particular, what would happen to U.S. interest rates, U.S. saving, and U.S. investment?

b.What would happen in the market for foreigncurrency exchange? In particular, what would happen to the value of the dollar and the U.S. trade balance?

11.In 1998 the Russian government defaulted on its debt payments, leading investors worldwide to raise their preference for U.S. government bonds, which are considered very safe. What effect do you think this “flight to safety” had on the U.S. economy? Be sure to note the impact on national saving, domestic investment, net foreign investment, the interest rate, the exchange rate, and the trade balance.

12.Suppose that U.S. mutual funds suddenly decide to invest more in Canada.

a.What happens to Canadian net foreign investment, Canadian saving, and Canadian domestic investment?

b.What is the long-run effect on the Canadian capital stock?

c.How will this change in the capital stock affect the Canadian labor market? Does this U.S. investment in Canada make Canadian workers better off or worse off?

d.Do you think this will make U.S. workers better off or worse off? Can you think of any reason why the impact on U.S. citizens generally may be different from the impact on U.S. workers?

A G G R E G A T E D E M A N D

A N D A G G R E G A T E S U P P L Y

Economic activity fluctuates from year to year. In most years, the production of goods and services rises. Because of increases in the labor force, increases in the capital stock, and advances in technological knowledge, the economy can produce more and more over time. This growth allows everyone to enjoy a higher standard of living. On average over the past 50 years, the production of the U.S. economy as measured by real GDP has grown by about 3 percent per year.

In some years, however, this normal growth does not occur. Firms find themselves unable to sell all of the goods and services they have to offer, so they cut back on production. Workers are laid off, unemployment rises, and factories are left idle. With the economy producing fewer goods and services, real GDP and other measures of income fall. Such a period of falling incomes and rising

IN THIS CHAPTER YOU WILL . . .

Learn thr ee key facts about shor t - r un economic fluctuations

Consider how the economy in the

shor t r un dif fers fr om the economy in

the long r un

Use the model of aggr egate demand and aggr egate supply to explain economic fluctuations

See how shifts in aggr egate demand or aggr egate supply can cause booms and

r ecessions