Following are some articles I've come across that are of interest to this course. I include a brief summary of the articles, without comment or criticism.
US Federal Budget Deficit.....
January 8. The Economist Magazine on the US Federal Deficit.
The article (Economist magazine articles are never signed) begins by describing the dramatic shift in the Federal deficit, from a surplus of 2.4% of GDP in 2000 to an expected deficit of 4% for 2004. It argues that the increase in the deficit reflects both an increase in spending (homeland security, war, transportation, education and other domestic things) and a decrease in taxes. The article suggests that no one seems to care about this development. According to the article, the Democrats want to repeal the tax cut, but only to finance additional spending, not cut the deficit. The article says that tax cuts and higher spending during the 2000 recession were a good idea (Keynesian cross model reasoning), but worries that the deficit will continue for some time, despite the fact that the economy is now in an expansion. It points out that spending seems likely to grow a lot for various reasons. First, Bush's prescription drug program will cost about $400 billion over the next 10 years. Second, various expenses, such as health care, associated with the fact that the population is ageing will grow over time. The article argues that something has to give.....'...the country is on a financially unsustainable path over the next half-century'. The article concludes that government spending and taxes are headed for the higher permanent levels that are now experienced in European countries.
January 14. The Economist Magazine and deficits in US and Europe. The article mentions the US deficit briefly, mainly by referencing a widely-cited International Monetary Fund report that worries about it. IMF worries that the US budget deficits will lead to lower investment and higher interest rates over the next few decades. The reasoning behind this can be articulated by the AD-AS model, which we will develop later. Most of the article is devoted to what is going on in Europe, which is shaping up to be quite dramatic. According to the Maastricht treaty (see the text book for discussion of this and see this article for more background), governments in the Euro area must keep their budget deficits below 3 percent of GDP (in class, we'll discuss the rationale for this), unless there is a very good reason (such as a severe recession). The treaty says that countries which violate this limit must be fined a large amount. The treaty is 'policed' by the European Commission. France and Germany will violate the limit for the third year in a row in 2004, and they don't seem ready to take the tough action necessary to bring their deficits back into line. So, the European Commission is taking the case to the European Court of Justice. This squabble should be interesting.
US Employment Picture..
The newspapers report on the net gain or loss of jobs in each month. That is number of jobs gained, minus the number of jobs lost. To absorb normal growth in the labor force, it is thought that the economy needs to generate, on net, about 150,000 extra jobs each month, or about 450,000 extra jobs per quarter. While these may seem like big numbers, they are actually quite tiny by comparison with the gross job gains and losses. For example, in the first quarter of 2003, it is estimated that 7.4 million new jobs were created and 7.9 million jobs were destroyed. There is a HUGE amount of action in the US labor market. If you put your ear to the US economy it would sound like a screeching freight train bearing down on you.
November 6, 2003. Ben Bernanke, a governor of the Federal Reserve and a widely respected academic macroeconomist, gave a speech on the supposedly slow recovery of jobs since the trough of the last recession, which occurred in November, 21, 2003 (the official start of the recession occurred in March, 2001). He first looks at the numbers. He then discusses what it is that might be happening in the labor market.
The numbers.....
Bernanke discusses how there are two ways of measuring employment, one based on a survey of 400,000 business establishments (and, with a lag of one year, it is adjusted to reflect virtually all business establishments) and the other based on a survey of 60,000 households. According to the establishment survey, the US economy lost 2.8 million jobs since March, 2001, of which 1.2 million were lost since the trough. The substantial loss of jobs since the trough is what leads people to refer to the current recovery as the 'jobless recovery'. Most of the lost jobs were in manufacturing. The puzzle is that the household survey suggests a much less severe employment decline. It indicates that 1.3 million jobs were lost during the recession, from March 2001 to November 2001, but that almost half of the loss was made up during the subsequent expansion. That is, the household survey indicates that since November 2001, 600,000 jobs have been created. This is not a great performance, but it is substantially better than what is indicated by the survey numbers.
Generally, the establishment survey is the more trusted source. The survey is larger, and it is thought that the answers received by survey takers from surveys of businesses are more reliable than the answers received from households. In addition, a recent study found a special problem with the household survey. Because the household survey is based on a small fraction of the households in the US, the bureau of labor statistics has to 'blow up' the numbers to obtain their estimates for aggregate employment. How much they blow the numbers up depend on how large they think the US population is. A recent study suggests that they may have substantially over estimated the size of the US population, primarily by overestimating the size of legal and illegal US immigration. So, Bernanke places relatively high weight on the sour labor market picture presented by the establishment survey. He takes the position that the relatively stronger household survey results probably indicates the employment picture is somewhat better, though possibly by not very much.
Bernanke concludes that the number of jobs is around 3.5 million below 'sustainable' levels, based on assumptions about the size of the population, what fraction of that population is normally in the labor market (i.e., either having a job or looking for one) and what fraction of the labor market would normally be out of a job and looking for one. It's fun to try and come up with an estimate about this for ourselves. For example, the Bureau of Labor Statistics estimates that the civilian labor force in December 2003 was 146.878 million people (that was 66 percent of the civilian noninstitutional population - for a look at the historical data on this, see). If we say that in a normal, healthy labor market, 5 percent of the of the labor force would be out of a job, but looking for one, then the number of people working should have been 139.534 million. In fact, there were 138.479 million people working, according to the BLS. So, according to this estimate, we were 'only' 1 million jobs below sustainable levels.
But, this surely overstates the amount by which jobs are down. There has been a significant decline in the fraction of the population that participates in the labor force. In 1997-2000, the fraction was 67 percent, or 1 percent higher than where it stands now. According to the Bureau of Labor Statistics the civilian, noninstitutional population in December 2003 was 222.509 million. If 67 percent of these had been in the labor force, the labor force would have been 149,081, or and 2.2 million more than it actually was. If 95 percent of these people had been employed, then there would have been 141.627 million jobs, or more than if 95 percent of these had had jobs, then employment would have been 141.627 million. This is 3.1 million more people than actually were employed.
One could argue that even this estimate understates the magnitude of the employment shortfall relative to 'normal'. If we look at the unemployment experience in recent years, we find that the unemployment rate in 1999 and 2000 was 4 percent (for a historical perspective, see). If we take that to be the 'normal' rate, then the number of people with jobs in December 2003 should have been 143.118 million, or 4.6 million more than were actually working.
If anything, the jobs numbers may understate the weakness in the labor market. While the trend in hours worked per week has been up since the 1960s, it fell with the recent recession, it is still 4 percent below its value in March, 2001. The people who are working are working less time.
Another indicator of the relative weakness in the labor market in the current expansion is provided by data on the median length of unemployment for people who lose their jobs. This went from around 6 weeks at the start of the recession, March 2001, to around 8 weeks at the trough of the recession, and then continued to rise. The most recent data indicate that it now stands at around 10 weeks.
Finally, there is evidence that firms' efforts to actually find workers has fallen substantially. An index of help wanted advertising suggests that the number of adds fell by 42 percent from the start of the previous recession, March 2001, to now.
(Incidentally, before we get too wrapped up on how 'bad' the US economy is at creating jobs, it's useful to know that the US economy is in fact tremendous at this. Since 1970, the number of people working has increased by 75 percent. Since 1980 it has increased by 40 percent. Since 1990, 16 percent. By contrast, in France employment grew 19 percent from 1970 to 2001. The corresponding figure for Britain and Italy are 13 and 11 percent, respectively. It took these economies 30 years what it took the US economy only 10 years to do.)
What does it all mean.....
Bernanke explores several hypotheses about what is going on in the US labor market. His ultimate conclusion is upbeat. He starts by exploring several explanations, which he ends up concluding are not so important. For example, some people have argued that worker benefits have increased 'too' rapidly. The problem with this is that this implies each individual worker should be used more intensively, but as noted above, average hours worked have in fact fallen. In addition, there is evidence that at least some of the increase in benefits is compensated by weakness in other aspects of worker compensation. Another possibility is that the increase in uncertainty (9/11, Enron, wars in Afghanistan and Iraq), has made firms reluctant to hire more workers until the future looks less uncertain. The problem with this idea, again, is the fact that firms are using their existing workers less intensively. Another possibility is an acceleration in changes in the structure of the US economy. The losing industries shed jobs quickly, while the gaining industries take some time to grow and create new jobs.
The explanation that Bernanke favors is that in recent years technological progress has made workers enormously more efficient. Since March 2001, the amount that a typical worker can produce has grown at an annual rate of 4.5 percent, versus the average increase in the late 1990s of 2.5 percent (and more like 1.5 percent over the whole pos-WWII period). This increased productivity growth reflects, to some extent, that the tremendous investments made in information technology and other things in the 1990s are finally paying off. A given worker can now produce a lot more. The growth rate of the US labor force is about 150,000 per month, and with the increase in productivity, this means that demand must now expand at a much faster pace to create this many extra jobs. The required acceleration in the growth of demand has not yet occurred, according to Bernanke. But, he thinks he can see it coming.
January 10 discussion of employment One thing that is particularly notable from this article is just how little we know about the exact state of the US economy. The article discusses the uncertainty there is about how many, if at all, jobs are being created by the US economy.
Louis Uchitelle comments on the supposedly poor employment performance of the US economy. He notes that there are two sources of employment data. One is based on a survey of business establishments. The other is based on a survey of households directly. The former is thought to be fairly reliable because the number of people surveyed is quite large. However, they sent very different signals about the labor market in December. The survey of establishments suggested that there was very little net job creation (1,000 jobs), something that surprised a lot of people, given that the economy is expanding nicely.
The puzzle is, how come output is growing nicely, but employment is not? One possibility is that worker productivity is increasing rapidly. In the last three months of 2003, output grew 9.3 percent faster than employment. Perhaps all the investments in computer technology and other information technology in the 1990s is finally paying off. Another possibility is that the employment data are somehow wrong. The household survey numbers are signaling a very different picture of the economy. According to the household survey, employment has been growing at the average rate of 278,000 per month from October to December. In contrast, according to the establishment survey, the economy generated a total of 278,000 in the five months leading up to December. To some extent, the difference reflects that two surveys measure different things. The household survey does better on self-employed people and people who are not 'on the books'. In addition, perhaps there is more than the usual amount of error in the establishment survey numbers. The truth about the US labor market probably lies somewhere in between what the two surveys say.
Most of the discussion in this article concerns assessing what's going on in the labor market. The author does bring in some Keynesian-Cross model reasoning in the end, when he speculates household consumption spending may weaken in later 2004, and that this may hurt the economy.
January 11 discussion of employment.
Gretchen Morgenson is commenting on the reportedly poor performance of employment in the US economy. Very few jobs, on net, were created in December (the net job creation is the increase of jobs (of which there are tons) minus the jobs destroyed (of which there are tons)). Also, she reports that the unemployment numbers weren't so great either. The reason that unemployment wasn't higher in December, she says, is that a lot of workers simply got discouraged and stopped looking for work (to be 'unemployed' a person has to not have a job, PLUS be looking for a job). She says that all this evidence of weakness in the economy is no surprise to an economic commentator, Stephen Roach.
Roach's reasoning is easily understood using the Keynesian cross model. He says that consumers haven't been saving much. This makes him think that they'll save more soon, and this will help bring on economic weakness (the 'paradox of saving'). He thinks that 2003 was strong because of the Bush tax cuts, but he apparently things the effects of these are done. These considerations make Roach pessimistic about the second half of 2004. The views of Parks about interest rates are not sufficiently well sketched out in the article to understand what he must have in mind. In any case, our Keynesian cross model does not equip is for thinking about the role of interest rates, which Parks evidently stresses.
January 26 Business Week Article by Robert Barro. Argues that the recent behavior of the labor market is 'surprisingly' weak, but emphasizes that the basic economic picture looks quite good. In the long run, according to Barro, employment growth will match population growth, and so the weak employment numbers will turn around in time (we'll discuss the economics of how this happens when we get to the 'medium run' and 'long run'.) Barro credits the strong economy to Bush's tax cuts (the basic idea about how the tax cuts work is explained by our Keynesian Cross and IS-LM models) and the policy in favor of 'international security' in Afghanistan and Iraq (he does not explain how this contributes to the current expansion...perhaps he has in mind that increased security encourages people to invest because they feel less worried). He also gives some of the credit for the expansion to monetary policy (see our IS-LM model).
Barro says he is worried about Bush's fiscal policy. He compares it, unfavorably, to Reagan's. Reagan also cut taxes and increased spending. However, Reagan's increase in spending was for military expenses, oriented towards bringing an end to the cold war. This was temporary. The Reagan tax cut was part of a general strategy to bring down the size of government. The strategy was to try and cut spending directly, and also indirectly by cutting taxes and thus forcing a cut in spending by starving the government of cash. Like Reagan, Bush also cut taxes. However, unlike Reagan, Bush is increasing spending on all sorts of things (not just on the 'war on terror'). So, Barro is worried that Bush's policy will not be effective in bringing down the size of government. Indeed, he may be worried that - as the IMF article above mentions - the US may actually be headed towards a European style system, with lots of taxes and government spending.
In his discussion of the employment numbers, Barro seems to have made a mistake. It's fun to see Prof. Brad De Long of Berkeley take him to task for this.
January 27 Discussion of Outsourcing. There is increased concern about the 'outsourcing' of jobs to other countries. This means that jobs done by workers in the US are now given to workers elsewhere. In the past, it was thought that the jobs involved were mainly unskilled jobs. However, recently there appears to be a trend towards outsourcing more skilled jobs (see the article). The fear is that in a few years, the only jobs left in America will be plumbers and haircutters, jobs that obviously cannot be shipped overseas. This is probably overly pessimistic. The truth is that America probably does not have a complete monopoly on the world's best workers. But, Americans aren't slouches either. So, I'm sure there will always be stuff to do, in addition to plumbing and hair cutting.
It is interesting to ask whether outsourcing has anything to do with the recent weakness in the US labor market. In contemplating this possibility, you have to wonder whether this hypothesis is consistent with the fact that output in the US has been rising since late 2001. Outsourcing per se reduces output. To see this, imagine the US just produces cars and that before outsourcing it produced every part of each car. Recently, however, they started having the wheels produced in Mexico. If the number of cars produced remained unchanged, then US output drops with this outsourcing. However, it is possible that with the wheels being made in Mexico, the volume of car production rose so much that total output in the US actually went up. You also have to take into account that productivity in the US has risen recently. Well, that may be because overall, it's still the lower productivity jobs that are being outsourced.
This February 4 article about the labor market suggests that output in the services sector is booming. It also indicates that, if anything, employment in the services sector is falling. Presumably, some of the job outsourcing is being done by the services sector. But, if the services sector contributes relatively little to job outsourcing, then this evidence is a challenge for the outsourcing hypothesis about the labor market and favors the technological progress hypothesis instead.
Recently, the Chairman of the Council of Economic Advisors, Greg Mankiw, made the observation that job outsourcing may not be 100% bad, because it is part of the expansion of free trade between countries, which ultimately benefits everyone. This created a political firestorm. Is there any truth in what Mankiw said? This article is from 2/11/2004 and this article is from 2/13/2004. Here is a 2/15/2004 article that tries to give a relatively balanced and in-depth assessment of outsourcing.
The Economist Magazine has a useful discussion of the unemployment rate, and its limitations as an indicator of the health of the economy. The Economist thinks the unemployment rate is based on something that is too subjective to be reliable. Recall that the unemployment rate is the fraction of the labor force that cannot find a job. The problem, according to the Economist, lies with the labor force, which is the number of people who are at work plus those who want to be at work. The want here, is psychological, and therefore too hard to measure, according to the Economist. They think that the number of people who are employed is a much better statistic, because it is easier to measure the number of people who are being paid by somebody to do something. But, even here there are problems, according to the Economist. As discussed above, there are two surveys of employment. One is a large survey of 400,000 establishments and the other is a survey of 60,000 households. According to the household survey, the number employed in the US is greater now than it was at the peak, in 2000. According to the establishment survey the number employed is down 2% since then. They suggest that Republicans, who would like to take credit for a strong economy, will typically refer to the household survey numbers and Democrats will refer to the payroll numbers, in the US presidential election. The Economist compares the employment rate between the US and Europe (the employment rate is the number of people employed divided by the working age population). They say that this is 10 percentage points higher in the US than Europe. They say that a good fraction of the people who are of working age, but not employed, would like to be employed. More than the number of people who are defined as unemployed. This is another reason to pay less attention to the unemployment rate and more to the employment rate.
A (2/20/04) New York Times columnist articulates the fear which some people have, that outsourcing will cause all the good jobs to leave America and go abroad. The implicit suggestion is that there should be protection. Another view is that competition and trade are on balance good. Competition provides a discipline that encourages innovation and improvement. Trade ensures that the greatest variety of goods is produced in the most efficient way. The downside of trade and competition, though, is costly economic turmoil as old jobs are constantly being destroyed and new ones are created. In exchange for this turmoil, though, there has been an explosion of wealth and creativity in the world. We have seen it in the economic history of the US, a huge free-trade area, and in the post-war economic miracle that occurred in Europe with the expansion of trade among European countries. With the expansion of trade to other parts of the world, we can expect to see the benefits of free trade (as well as some of the costs) to be enjoyed by more and more of the world's people. Of course, people have for a long time complained about the economic insecurity that goes with free trade and competition. The Soviet experiment was an attempt to devise a system that was free of this turmoil. However, in the end that system collapsed and produced the greatest possible turmoil for the hapless people caught up in it. The history of the 20th century suggests that, although it is costly and unpleasant sometimes, the best bet is to go with free trade and competition. (This is not to say, however, that we can't do anything at all to reduce economic uncertainty. For example, universal health care may well be an excellent idea.)
A (2/22/04) article on the puzzling difference between employment estimates based on the household survey and estimates based on the establishment survey. According to the first, there has been an increase of more than 500,000 jobs since 2001. According to the payroll survey, there has been a decrease of over 2 million jobs over the same period. One interpretation of the difference is that there has been a surge in self-employment, something that is thought to be missed by the establishment survey, which polls business establishments. The Fed recently tested this hypothesis by dropping the self-employed from the household survey. This does not eliminate the gap between the household and establishment surveys. The Fed speculates that the problem may lie with the household survey. They poll 50,000 households, and then have to draw implications for the economy as a whole. The Fed believes that the household survey's overestimate reflects that they overestimate the size of the US population.
Strength in the Economy
This 1/30/2004 article reports that output grew 4 percent (at an annual rate, which means it actually grew about 1 percent) in the fourth quarter of 2003. In assessing the prospects for growth in the coming year, the article focuses on demand. Will household consumption be high? Will foreigners buy a lot? Etc. It's interesting how much the thinking in our Keynesian Cross model and our IS-LM model, which views output as completely demand determined in the short run, permeates newspaper articles on the economy.
Ouch, consumer sentiment dropped in February.
International
Later, we will discuss the current account. It's (roughly, see pages 384-385 in the text) Y-(I+C+G), the excess of production over spending. In the U.S., this is now a negative number, indicating that total purchases of goods by Americans exceeds what is produced in America. It is currently 4 percent of U.S. ($10 trillion) GDP. The flip side of the current account is the borrowing that Americans do from foreigners to finance this spending (later, we'll discuss whether this is a good thing or a bad thing....obviously, it all depends on what you do with the money you borrowed). Here are some data from the Economist magazine showing the current accounts around the world.
An article from 2/14/2004 on the US Trade Deficit for 2003.
There are two arguments in this 3/2/2004 article, which are of interest to us: (1) that the depreciation in the US exchange rate will lead to an improvement in net exports and (2) that foreigners may suddenly sell their US assets, driving their price down and the interest rate up, with the (not explicitly stated) implication that the economy will collapse. I will address the arguments in (1) and (2) using the open economy IS-LM model we developed in class. In each case, reasoning based on the model gives reason to doubt the conclusion reached in the article. Hopefully, you will see the power of using a simple model to lay bare the logical foundations of an economic argument.
Consider (1) first. The dollar has depreciated 12 percent from its peak in early 2002. According to the article, Greenspan argues that the depreciation may cause the trade gap - over 4 percent of GDP last year - to narrow. Indeed, if the only thing happening were a depreciation in the dollar, the theory we developed in class does imply that the trade gap should narrow (if E rises, NX will go from its current big negative number to a smaller negative number). But, the exchange rate is an endogenous variable in our open economy IS-LM model, so that movements in it are a consequence of a movement in some exogenous variable. What happens to the trade gap depends on what exogenous variable is responsible for the depreciation of the exchange rate. For example, if the exogenous variable is a fall in government spending, then the exchange rate depreciates and income falls, and both of these have the unambiguous implication that the trade gap narrows. However, this is clearly not the exogenous shock at work on the exchange rate now, since government spending has in fact been high in recent years. So, there must be another exogenous shock that is responsible in the recent depreciation of the exchange rate. A natural candidate is loose monetary policy. In our model, that produces a depreciation in the exchange rate, a fall in the interest rate and an expansion in output, all things that we've seen in recent years. However, the implications for the trade balance are ambiguous. The rise in output implies a deterioration in the trade balance and the depreciation of the exchange rate implies an improvement. So, when you think carefully about the causes of the recent depreciation in the US exchange rate, it's not so clear that we should expect an improvement in the trade gap, as the article suggests.
Now consider (2). The flip side of the trade deficit is that foreigners are acquiring more and more financial assets (stocks, bonds, titles to land) in the US. (Recall Figure 12-2 discussed in the 3/2/04 lecture.) The article mentions a fear that foreigners will suddenly become spooked and sell all these assets and take their money out of the country. It suggests that this will cause a collapse in asset prices, a rise in interest rates and one gets the impression that the author believes this will lead to a collapse in the US economy. This seems very unlikely, for two reasons: (i) it seems unlikely that foreigners will be 'spooked' in this way and (ii) even if they did become spooked, it's not so obvious the implications would be so disastrous for the US economy. Consider (i). Commentators who fear that foreign investors in the US will be spooked argue (implicitly) by an analogy with what has happened in some developing countries. But, the analogy is a false one. In many developing countries, the legal system is often not very secure, and does not protect the property rights of foreign investors. For example, if a loan goes bad and a foreign investor tries to seize and sell collateral, a cumbersome and sometimes corrupt legal system can stand in the way. Naturally, foreign investors are reluctant to invest in a country like this. If a country like this wants foreign investment (a negative current account), the best thing to do is to reform the legal system. But, this is often an expensive process that in any case will be resisted by powerful groups in the population that benefit from the status quo. Governments that would like to have foreign capital inflows anyway (i.e., a negative current account), have evolved an alternative way to reassure nervous foreign investors. Through a variety of mechanisms, the governments in such countries offer direct guarantees to foreign investors that their investments are safe. This has the consequence that the soundness of each foreign investment in such a country depends on one thing: the soundness of that country's government. If the government runs out of money, all foreigners stand to lose on their investments. Sometimes this happens, for example, when governments extend guarantees that exceed by far their ability to deliver (sometimes this is because a government is corrupt and guarantees are extended to investments involving cronies of high government officials for projects that are unlikely to generate a high return.) In these cases, the news that the government has overextended itself can come out all at once. When it does, all foreign investors find out about it at the same time. They all try to sell their investments and take their money out of the country at the same time. In a situation like this, the behavior foreign investors resemble a herd of gazelles, spooked by a lion.
The situation in the United States and other wealthy countries with solid legal systems is very different from what one finds in some developing countries. In the US the likelihood that a particular investment will pay off depends on the particular company being invested in. Foreigners invest in a very large range of companies: aircraft in Seattle, rug makers in Dalton, Georgia, bicycle manufacturers in Florida, etc. It is very unlikely that all these investments would simultaneously and suddenly look bad to foreigners. It will always be true that some investments go bad and others will make a higher return than expected. But, there is nothing analogous to governments guarantees in some developing countries, which can suddenly make all investments look bad at the same time. (It is true that an important component of the assets held by foreigners is US government debt. But, this debt is completely sound. That is because US government debt is a commitment to supply US dollars in the future, and the US government prints dollars. Thus, there is no reason to think that the US government could ever be in a situation that it could not honor its debt.) So, when commentators, such as in this article, refer to the possibility that foreigners may become spooked and sell their US assets, they are implicitly relying on a false analogy. Here is a more relevant analogy. Consider all the business structures and equipment in the state of New Jersey. These have been financed with assets that are held by people who live all over the United States as well as in other countries. It is quite conceivable (though probably not true!) that most of the financial assets issued by businesses in New Jersey are held by people living outside of New Jersey. Do we ever hear concerns that people living outside of the state of New Jersey may become spooked and sell all their New Jersey financial assets? Of course not. It is simply very unlikely that something could happen in New Jersey that would suddenly make holders of all New Jersey financial assets drastically revise down their valuation of those assets.
Turning to (ii), suppose, for the sake of argument, that foreigners all of a sudden decided to convert their US financial assets into dollars and then convert the dollars into their own currency. The open economy IS-LM model can be used to think about what might be the consequence of this. Recall that that model is composed of three equilibrium conditions: equilibrium in international financial markets (the UIP relation), equilibrium in goods markets and equality of the demand and supply of money. The analysis is short run and holds the price level fixed. The shocks it is used to analyze are temporary, so that the expected future exchange rate remains unchanged. How to model foreigners' concerns about US assets? One way is to suppose that they are no longer satisfied for US assets to generate the same return as foreign assets. Now they require that US assets generate a higher expected return: i = i* + (Ee-E)/E + ρ, where ρ>0. This could be accomplished in a variety of ways. At one extreme, it could be accomplished by a rise in the return, i, on US assets. Another possibility is that it is accomplished by a fall in the return on foreign assets. We are holding i* fixed, so this could be accomplished by a rise in E. This has the effect of reducing the anticipated depreciation of the US dollar, so that a domestic resident acquiring foreign bonds expects to make a lower return, once the round-trip through the foreign exchange market is taken into account. We don't know what actually will happen to E or i, until we bring in the other two relations in the model. The one relation, UIP, is simply not enough to pin down what happens to the two endogenous variables, E and i. Do this by constructing the open economy IS curve that we discussed in class. That is, substitute out for the nominal exchange rate in the net exports component of aggregate planned spending. Now, the whole model can be analyzed just by studying the IS and LM curves. The first question to ask in doing the analysis is, which curve shifts when ρ jumps from its former value of zero to its new, positive value? Obviously it is not the LM curve, since ρ does not enter there. It enters into the IS curve. What the increase in ρ does is to shift the IS curve to the right. The reason is the following. For a fixed level of the interest rate, i, it was noted above that the nominal rate of interest, E, must depreciate to ensure that UIP holds. But if E depreciates (i.e., it goes up), then the real exchange rate has gone up too. Because this implies foreign prices are relatively higher by comparison with domestic prices, this leads to a rise in net exports. The rise in net exports implies that equilibrium output in the goods market (for a given i) is bigger. The amount by which this is bigger, is the amount by which the IS curve shifts right. So, the short run equilibrium occurs at the intersection of the new IS curvce and the unchanged LM curve. This involves a higher interest rate, as well as a higher level of output. In words, what is going on is that the jump in ρ leads international traders to sell US assets and buy foreign assets. This leads to a depreciation of the US currency, which - by making US goods less expensive - stimulates demand for US goods. The rise in demand for US goods leads to an increase in output. The rise in output leads to a rise in the demand for money which is why the interest rate goes up. This happens as people try to increase their cash balances by selling assets and thereby driving down their price, and the interest rate up. These implications of foreigners selling US assets resemble in some respects what is said in the article. For example, it is true that there is pressure to sell US assets, which drives down their price and raises their yield, i. This in turn discourages investment in the US which, other things the same, depresses aggregate planned spending and acts as a drag on the economy. However, other things are not the same. The net effect is that economic activity actually rises, though this is offset somewhat by a fall in investment. The flavor of the article is that the jump in ρ will lead to a high interest rate which will depress economic activity. While this is one dimension of what the open economy IS-LM model implies, it is not the central one, since that model implies that the dominant effect is to increase output.
The article argues, in effect, that China is operating a 'beggar thy neighbor' policy towards the rest of the world. The idea is that they do it by keeping the currency, the yuan, cheap, in terms of foreign currency. The cheap yuan, the article claims implicitly, is the reason the US is running a $124 billion deficit against China.
