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ECO 155 750 LECTURE 38 1 TODAY WHAT WE WANT TO DO IS FINISH UP THE SEMESTER. AFTER TODAY WE'LL HAVE ONE MORE, A SEMESTER REVIEW, BUT THIS IS THE LAST REGULAR LECTURE THIS SEMESTER. WHAT WE WANTED TO DO IS TALK ABOUT THE INTERNATIONAL SECTOR OF THE ECONOMY. NOW, WE'VE ALREADY TALKED ABOUT INTERNATIONAL ECONOMICS EARLIER ON. IF YOU'LL REMEMBER, WE TALKED ABOUT THE PRODUCTION POSSIBILITIES FRONTIER AND HOW OUR NATION COULD SPECIALIZE IN PRODUCING CERTAIN GOODS AND TRADE WITH OTHER NATIONS. THOSE OTHER NATIONS WOULD BE SPECIALIZED IN PRODUCING GOODS AND TRADE WITH US. AND SO WE'VE ALREADY SEEN SOME OF THAT MATERIAL. OF COURSE, THE TERMS I THINK WE'VE TALKED ABOUT FROM TIME TO TIME, IMPORTS AND EXPORTS. IF THE UNITED STATES SELLS SOMETHING TO FOREIGNERS, WE CALL THAT OUR EXPORTS. IF WE BUY SOMETHING FROM FOREIGNERS, THAT WOULD BE OUR IMPORTS. AND SO SOME OF THESE CONCEPTS WE'VE ALREADY TALKED ABOUT BEFORE. WHAT WE WANT TO DO IS GO ON AND EXTEND THAT DISCUSSION OF PRODUCTION AND TRADE. WE WANT TO EXTEND THAT INTO THE FOREIGN EXCHANGE MARKETS. AND CERTAIN CONCEPTS THAT MAYBE YOU'VE HEARD ABOUT ON TELEVISION OR READ IN THE NEWSPAPER ABOUT, SUCH AS THE BALANCE OF TRADE AND THE BALANCE OF PAYMENTS, WE WANT TO DISCUSS SOME OF THOSE IDEAS AS WELL.

ECO 155 750 LECTURE 38 2 SO LET ME GET THE BALL ROLLING HERE WITH JUST A SIMPLE DIAGRAM OF A TWO-PARTY EXCHANGE. YOU'RE ALREADY FAMILIAR WITH THIS. THE WAY TRADE HAPPENS WITHIN THE UNITED STATES IS, MAYBE ONE PERSON SELLS GOODS, SENDS GOODS TO THE OTHER, AND THE PERSON RECEIVING THE GOODS SENDS MONEY BACK IN RETURN. SO THIS IS JUST AN ORDINARY TRADE, WHAT WE WOULD NORMALLY SAY IS SUPPLY AND DEMAND. THIS IS THE SUPPLIER, THE PRODUCER, AND THE DEMANDER IS THE ONE RECEIVING GOODS. HERE'S WHAT'S A LITTLE BIT DIFFERENT. WHEN WE START TALKING ABOUT FOREIGN CURRENCY AND FOREIGN TRADE, HERE'S WHAT'S DIFFERENT. IF THIS IS A PERSON IN THE UNITED STATES AND THE OTHER PERSON'S FROM BRITAIN, OR I'LL SAY UNITED KINGDOM, THEN THESE GOODS THAT THE UNITED STATES IS SELLING TO THE BRITISH PERSON, THOSE ARE OUR EXPORTS. U.S. EXPORTS, I'LL SAY. IT'S IMPORTS FOR BRITAIN. AND THEN RATHER THAN THE BRITISH PERSON PAYING FOR THOSE GOODS DIRECTLY, IT WORKS IN A LITTLE BIT OF A ROUNDABOUT WAY. THE REASON THAT IT HAS TO BE IN A ROUNDABOUT WAY IS THE AMERICAN SUPPLIER OR SELLER DOESN'T WANT BRITISH POUNDS, THE CURRENCY THAT THEY HAVE IN BRITAIN. AND SO THE WAY IT WORKS IS LIKE THIS. THE BRITISH PERSON, THE CONSUMER, THE BUYER, THEY SEND THEIR POUNDS -- AND THAT'S THE SYMBOL FOR THE POUND, IS SORT OF AN L WITH THAT LINE THROUGH IT. THEY SEND THEIR POUNDS TO THE FOREIGN EXCHANGE MARKET AND THAT'S

ECO 155 750 LECTURE 38 3 WHERE THEY TRADE THEIR POUNDS FOR DOLLARS, AND THEN THE DOLLARS ARE SENT TO THE UNITED STATES. OKAY. SO THE REAL KEY HERE FOR UNDERSTANDING WHAT'S GOING ON IS THAT IN THE FOREIGN EXCHANGE MARKET THERE'S AN EXCHANGE OF ONE CURRENCY FOR ANOTHER AND THERE'S -- AND WE'LL GET TO THIS LATER ON IN THE HOUR. THERE'S REALLY SUPPLY AND DEMAND THAT'S TAKING PLACE THAT DETERMINES THE VALUE OF THE POUND RELATIVE TO THE DOLLAR, AND THE VALUE OF THE DOLLAR RELATIVE TO THE POUND. THESE FOREIGN EXCHANGE MARKETS -- AND I DON'T MEAN TO SAY JUST THE FOREIGN EXCHANGE MARKET BETWEEN DOLLARS AND POUNDS. ALL FOREIGN EXCHANGE MARKETS DO ABOUT ONE TRILLION DOLLARS WORTH OF TRADING PER DAY. AND SO THIS IS THE MOST ACTIVE MARKET IN THE WORLD. IT'S FAR MORE ACTIVE THAN STOCK MARKETS AND BOND MARKETS AND THINGS LIKE THAT. SO THIS IS A HUGE MARKET AND WHAT WE WANT TO DO IS WE WANT TO UNDERSTAND THAT AND UNDERSTAND WHAT DETERMINES THE EXCHANGE RATE BETWEEN DOLLARS AND POUNDS, AND DOLLARS AND THE EURO, AND DOLLARS AND YEN -- THAT WOULD BE THE JAPANESE CURRENCY -- AND SO FORTH. SO ANYWAY, WE'RE GONNA START OFF TALKING ABOUT THIS EXPORTS AND OUR IMPORTS AND THINGS LIKE THAT, AND SLOWLY BUILD, DEVELOP MORE AND MORE COMPLICATED CONCEPTS. AND FINALLY WE WILL ARRIVE BACK AT THIS SUPPLY AND DEMAND MODEL FOR THE DIAGRAM. LET ME SORT OF SCOOT OVER HERE AND START DOING THIS. SOME OF

ECO 155 750 LECTURE 38 4 THE TERMS THAT YOU'RE FAMILIAR WITH ALREADY -- I MENTIONED EXPORTS AND IMPORTS. THOSE ARE KEY IDEAS THAT WE NEED TO UNDERSTAND. MOST OF THE TIME WHEN YOU'LL HEAR PEOPLE TALKING ABOUT EXPORTS AND IMPORTS, THEY'RE MAINLY THINKING IN TERMS OF PHYSICAL GOODS. LIKE WE EXPORT CARS OR WE EXPORT AIRPLANES, OR WE IMPORT COMPUTERS AND COMPUTER CHIPS, AND SO FORTH. AND THEN IN TERMS OF TANGIBLE IMPORTS AND EXPORTS, THAT'S IMPORTANT BUT WE DON'T WANT TO FORGET THAT THERE'S ALSO TRADE IN SERVICES. AND THE REASON WE DON'T WANT TO FORGET ABOUT THAT IS THE UNITED STATES IS A SPECIAL -- OR IT SPECIALIZES IN PRODUCING SERVICES AND THE UNITED STATES SELLS A LOT OF SERVICES OVERSEAS. WHAT WE'LL DO IS WE WILL DO A CERTAIN TYPE OF ACCOUNTING AS WE GO THROUGH. WE'LL HAVE CREDITS REPRESENTED BY A POSITIVE SIGN AND DEBITS IN THESE ACCOUNTS WE'LL REPRESENT WITH A NEGATIVE SIGN. REALLY, WHAT THIS REFERS TO IS, ANYTIME YOU SEE A CREDIT -- AND THIS IS IN THE U.S. ACCOUNTS. BUT IF YOU SEE A CREDIT IN THE U.S. ACCOUNTS, THIS MEANS THAT FUNDS ARE FLOWING INTO THE U.S. IF WE SEE A DEBIT, FUNDS FLOW OUT OF THE U.S. AND SO IF WE CAN COME BACK OVER TO THIS EXAMPLE THAT I GAVE EARLIER, WHERE THE UNITED STATES EXPORTED GOODS AND SERVICES OVERSEAS, THE FOREIGNER RECEIVES THAT AND THEN THE FOREIGNER HAS TO SEND DOLLARS TO THE UNITED STATES. THIS IS DOLLARS COMING INTO THE UNITED STATES. IT'S A CREDIT IN OUR ACCOUNTS. AND THEN WE

ECO 155 750 LECTURE 38 5 WOULD SHOW THAT, AS I SAY, WITH A POSITIVE SIGN. IF WE REVERSE THE ARROWS -- WE DON'T ACTUALLY HAVE TO DRAW ANOTHER DIAGRAM TO DO THIS. BUT IF WE REVERSE THE ARROWS WHERE GOODS WERE COMING INTO THE UNITED STATES AND FUNDS WERE FLOWING BACK TO BRITAIN, THEN WHAT WE WOULD HAVE IS -- THIS WOULD BE A DEBIT IN THE U.S. ACCOUNTS AND DOLLARS WOULD BE FLOWING OUT OF THE UNITED STATES AND GOING TO FOREIGN EXCHANGE MARKETS. SO YOU CAN KIND OF KEEP THOSE GENERAL CONCEPTS IN MIND OF THESE DEBITS AND CREDITS. BECAUSE WHAT WE'RE GONNA DO AT THE END IS WE'RE GONNA ADD UP ALL THE CREDITS AND SUBTRACT ALL THE DEBITS, AND THEN WE'LL HAVE A NET FIGURE THAT IS GONNA BE CALLED THE BALANCE OF PAYMENTS. LET ME SAY THAT AGAIN JUST IN CASE IT GOT BY YOU A LITTLE BIT QUICKLY. WE'RE GONNA ADD UP ALL THE CREDITS, WE'RE GONNA SUBTRACT OFF ALL THE DEBITS AND ALL OF THE FLOWS BETWEEN COUNTRIES, AND THEN WHEN WE'VE GOT ALL THE CREDITS AND ALL THE DEBITS TAKEN INTO ACCOUNT, THE FINAL BOTTOM LINE FIGURE IS BALANCE OF PAYMENTS. AND WHAT WE'RE GONNA FIND OUT IS THAT THIS HAS TO EQUAL ZERO. THAT IS TO SAY, THE CREDITS AND THE DEBITS WILL HAVE TO BALANCE. BUT MORE ON THAT LATER. JUST TO KIND OF LET YOU SEE WHERE WE'RE GOING BEFORE WE GET STARTED. NOW, WHEN WE TALK ABOUT THIS BALANCE OF PAYMENTS, WE'VE GOT FOUR THINGS THAT GO INTO IT. AND, BY THE WAY, SOMETIMES I'LL USE THIS BOP AS BALANCE OF PAYMENTS. THIS IS THE MOST BROAD MEASURE OF

ECO 155 750 LECTURE 38 6 INTERNATIONAL FINANCIAL ACTIVITY SO YOU'LL BE HEARING ABOUT THIS FOR THE REST OF YOUR LIFE. AS I SAY, IT INCLUDES FOUR THINGS: THE BALANCE ON CURRENT ACCOUNT, THE BALANCE ON THE CAPITAL ACCOUNT, OFFICIAL RESERVE BALANCE, AND SOMETHING CALLED THE STATISTICAL DISCREPANCY. LET ME JUST MENTION ABOUT THAT STATISTICAL DISCREPANCY AND THEN WE WON'T TALK ABOUT IT ANYMORE. THE STATISTICAL DISCREPANCY IS REALLY THIS. THERE ARE FUNDS THAT FLOW, AND ALSO GOODS, BUT FUNDS THAT FLOW ACROSS BORDERS THAT WE JUST DON'T MEASURE VERY WELL, THAT WE DON'T SEE THEM GO, THE UNITED STATES GOVERNMENT ISN'T ABLE TO MEASURE 'EM. AND SO THEN AT THE END, WHAT WE DO IS WE HAVE SOMETHING THAT'S REALLY JUST AN ERROR TERM. AND THIS IS NOT HUGE, BUT SOMETIMES IT'S A PRETTY SUBSTANTIAL NUMBER. ANOTHER THING I'LL MENTION TO YOU IS THAT THE -- THIS IS --I'LL SAY SMALL -- THE OFFICIAL RESERVE BALANCES WHICH IS THE UNITED STATES GOVERNMENT HOLDINGS OF GOLD AND FOREIGN CURRENCIES AND THINGS LIKE THAT. THIS IS PRETTY SMALL ALSO. AND SO MOST OF THE ACTION TAKES PLACE WITH RESPECT TO THE FIRST TWO ITEMS THERE, THE BALANCE ON CURRENT ACCOUNT AND THE BALANCE ON CAPITAL ACCOUNT. THAT'S WHERE MOST OF THE ACTION IS. SO WE WANT TO SPEND MOST OF OUR TIME TALKING ABOUT THOSE. I'LL SPEND A LITTLE TIME TALKING ABOUT THE OFFICIAL RESERVE ACCOUNTS. AND STATISTICAL DISCREPANCY, WE WON'T BE DOING ANY MORE WITH THAT OTHER THAN NOW WE'VE

ECO 155 750 LECTURE 38 7 RECOGNIZED WHAT THAT IS, JUST SORT OF AN ERROR TERM. SO ANYWAY, LET'S GET STARTED. WHAT DO WE MEAN BY BALANCE ON CURRENT ACCOUNT? IN GENERAL, BUT IT'S NOT VERY SPECIFIC JUST TO GIVE THIS GENERAL DEFINITION. BUT IN GENERAL, WHAT WE MEAN BY THE BALANCE ON CURRENT ACCOUNT, THIS IS THE TRADING GOODS AND SERVICES. THERE'S A LITTLE BIT MORE TO BE ADDED TO THAT, BUT LET ME COME UP HERE AND GIVE A LIST. THIS IS EXPORTS OF GOODS, WHICH IS A CREDIT IN OUR ACCOUNT. WHEN WE IN THE UNITED STATES EXPORT GOODS, WE GET PAID FUNDS FROM OVERSEAS. AND SO THE POSITIVE SIDE MEANS FUNDS ARE FLOWING INTO THE UNITED STATES. EXPORTS OF SERVICES. WHAT KIND OF SERVICES COULD THESE BE? WELL, FOR EXAMPLE, INSURANCE SERVICES. IF A UNITED STATES INSURANCE COMPANY INSURES A FOREIGN SHIP OR A FOREIGN AIRPLANE, THEN AMERICAN INSURANCE COMPANIES CHARGE FOR THAT SERVICE AND THIS WOULD BE AN EXPORT OF SERVICES FROM THE UNITED STATES -- OR BY THE UNITED STATES. AND WHEN WE EXPORT OUR SERVICES, WE GET PAID BY THE FOREIGNERS. INCOME FROM U.S. ASSETS OVERSEAS. WHAT'S HAPPENING IN THIS PARTICULAR CASE OF U.S. ASSETS OVERSEAS: FOR EXAMPLE, SUPPOSE I OWNED A HOME IN MEXICO CITY AND RENTED IT TO PEOPLE, AND THEN THEY PAID ME -- ONCE A MONTH THEY PAID RENT. LET'S SAY A HUNDRED DOLLARS A MONTH RENT. SO THEN OVER THE COURSE OF A YEAR I WOULD'VE RECEIVED TWELVE HUNDRED DOLLARS FOR RENTING MY HOME THAT IS A

ECO 155 750 LECTURE 38 8 U.S. ASSET OVERSEAS. AND, BY THE WAY, WHEN WE SAY "U.S. ASSETS," I DON'T MEAN TO SAY THAT THE UNITED STATES GOVERNMENT OWNS IT, BUT AMERICANS OWN THESE ASSETS. COULD BE THE GOVERNMENT, BUT MORE LIKELY IT'S SOMEBODY IN THE PRIVATE SECTOR. SO THE INCOME THAT WE RECEIVE FROM THAT, THERE'S ANOTHER CREDIT IN OUR ACCOUNTS. MY HOME, MY ASSETS ARE SERVICES BEING PROVIDED TO OTHER PEOPLE. THEY HAVE TO PAY US FOR THOSE. THAT'S THE FIRST PART OF THIS. A SECOND PART, WE'VE GOT IMPORTS OF GOODS INTO THE UNITED STATES. WHEN WE RECEIVE GOODS, WE HAVE TO PAY FOR THOSE GOODS AND PAY THE FOREIGNERS FOR THE GOODS. AND SO FUNDS ARE FLOWING OUT OF THE UNITED STATES, IT'S A DEBIT ON OUR ACCOUNTS. IMPORTS OF SERVICES. AGAIN, WE PAY FOR THOSE. IT'S A DEBIT IN OUR ACCOUNTS. AND THEN PAYMENTS TO FOREIGN ASSETS IN THE UNITED STATES. THAT IS TO SAY, SUPPOSE A PERSON IN MEXICO OWNED A HOUSE IN LOS ANGELES AND RENTED THAT, AND EVERY MONTH THE PERSON IN LOS ANGELES SENT A CHECK TO THAT PERSON IN MEXICO FOR THE USE OF THE HOUSE. THEN DOLLARS WOULD BE LEAVING THE UNITED STATES. AND, THAT BEING THE CASE, WE WOULD RECORD THAT AS A DEBIT. ANYWAY. SO YOU CAN SEE THESE EXPORTS AND IMPORTS. THAT'S MOST OF THE CURRENT ACCOUNT. WE HAVE ONE MORE ITEM TO ADD WHICH IS NET UNILATERAL TRANSFERS ABROAD. THIS CAN BE EITHER A POSITIVE OR A NEGATIVE NUMBER. THAT IS TO SAY, IT CAN EITHER BE A CREDIT OR A DEBIT. IT DEPENDS ON WHICH WAY THE FUNDS ARE GOING MOST RAPIDLY

ECO 155 750 LECTURE 38 9 AND THEN THE GREATEST VOLUME. WHAT A UNILATERAL TRANSFER REFERS TO, IN A DIFFERENT WAY OF SAYING THIS, THIS WOULD BE A GIFT. LET'S SUPPOSE THAT YOU'VE GOT A COUSIN LIVING IN FRANCE AND YOU WROTE A CHECK FOR A HUNDRED DOLLARS AND SENT IT TO THE COUSIN. THEN YOU'D BE ENGAGING IN A UNILATERAL TRANSFER ABROAD. AND THEN DOLLARS WOULD BE LEAVING THE UNITED STATES AND WE WOULD RECORD THAT OUTFLOW OF FUNDS AS A DEBIT. ON THE OTHER HAND, IF YOUR COUSIN IN FRANCE WROTE YOU A CHECK, THEN THERE WOULD BE AN INFLOW OF FUNDS AND WE WOULD RECORD THAT AS A CREDIT FOR THE UNITED STATES. FUNDS WOULD BE COMING INTO THE UNITED STATES. SOME OTHER TYPES OF THINGS THAT WOULD GO IN HERE: GRANTS, FOR EXAMPLE. THE UNITED STATES GOVERNMENT GIVES GRANTS OVERSEAS. HERE'S ONE THAT HAPPENS MORE OFTEN THAN YOU WOULD THINK. AN AMERICAN RETIRES AND MOVES TO ANOTHER COUNTRY, AND THEN WE SEND THEIR SOCIAL SECURITY CHECK TO 'EM AT THE END OF EACH MONTH. I GUESS AT THE START OF EACH MONTH. AND SO THE SOCIAL SECURITY CHECK LEAVES THE UNITED STATES, GOING TO THAT OTHER COUNTRY. THAT WOULD BE AN OUTFLOW OF FUNDS FROM THE UNITED STATES AND WE'D RECORD THAT AS A DEBIT. FOR THE MOST PART, OR EVERY YEAR THAT I'M AWARE OF, THE UNITED STATES HAS TRANSFERRED -- UNITED STATES, THE GOVERNMENT, AS WELL AS CITIZENS HAVE TRANSFERRED MORE FUNDS OVERSEAS THAN WE HAVE RECEIVED. WE DON'T RECEIVE A LOT OF FOREIGN AID BUT WE

ECO 155 750 LECTURE 38 10 GIVE A CERTAIN AMOUNT OF IT. SO FOR THE MOST PART, IF YOU LOOK THROUGH HISTORY, WHAT YOU'LL FIND IS A BUNCH OF DEBITS FOR THIS FINAL ITEM. AND SO THAT'S THE WAY I'M GONNA LEAVE IT IN HERE. BUT IT CERTAINLY COULD BE A POSITIVE NUMBER. I'M JUST SAYING THAT THAT POSITIVE NUMBER, EVEN THOUGH IT'S POSSIBLE IN THEORY, WE DON'T REALLY OBSERVE THAT IN PRACTICE. SO WE'VE GOT THESE THREE DIFFERENT CATEGORIES, IF YOU LIKE TO ADD UP. AND WHEN WE PUT ALL OF THOSE TOGETHER, WHAT WE END UP WITH IS THIS BALANCE ON CURRENT ACCOUNT. LET'S JUST TAKE A SECOND AND I'LL SHOOT A FEW NUMBERS UP HERE FROM A RECENT YEAR SO YOU CAN GET AN IDEA OF THE MAGNITUDE OF THE NUMBERS WE'RE TALKING ABOUT. FOR EXAMPLE, EXPORTS OF GOODS IN A RECENT YEAR, 19 -- I'M LOOKING BACK AT '98, 1998. SOME GOOD NUMBERS ARE AVAILABLE FOR THAT YEAR, HAVE BEEN REVISED AND SO FORTH. SIX HUNDRED AND SEVENTY-ONE BILLION DOLLARS WERE U.S. EXPORTS IN THAT PARTICULAR YEAR. OKAY. AND IN THAT SAME YEAR, OUR IMPORTS WERE NINE HUNDRED AND NINETEEN BILLION DOLLARS. AND SO WHAT YOU CAN SEE IN THIS PARTICULAR INSTANCE, WE'RE SELLING LESS THAN SEVEN HUNDRED BILLION DOLLARS WORTH OF GOODS TO FOREIGNERS AND THEY ARE SELLING MORE THAN NINE HUNDRED BILLION DOLLARS WORTH OF GOODS TO US. AND SO THERE'S ABOUT A TWO HUNDRED AND FORTY BILLION DOLLAR DEFICIT, IS THE TERMINOLOGY THAT WE WOULD USE, IN JUST OUR TRADE BALANCE.

ECO 155 750 LECTURE 38 11 AND, BY THE WAY, I'LL BRING THESE DOWN. EVERY ONCE IN AWHILE YOU'LL HEAR ABOUT A TERM CALLED THE BALANCE OF TRADE. AND ALL IT REALLY REFERS TO IS JUST THESE TWO ITEMS NETTED OUT AGAINST EACH OTHER. IT'S -- MERCHANDISE TRADE WOULD BE A MORE SPECIFIC TERMINOLOGY HERE. THE BALANCE OF MERCHANDISE TRADE -- THE GOODS, NOT SERVICES BUT JUST THE TANGIBLE GOODS. AND IN THIS PARTICULAR CASE THERE'D BE A DEFICIT FOR THE UNITED STATES OF ABOUT -- WHAT'D I SAY -- TWO HUNDRED AND FORTY BILLION DOLLARS. WE'VE PUT A NEGATIVE THERE. THE DEBITS EXCEED THE CREDITS, AND SO THAT'S WHY WE SAY THERE'S A DEFICIT. A LOT OF PEOPLE MAKE A BIG DEAL OF THIS. I DON'T PARTICULARLY THINK IT'S ALL THAT IMPORTANT. SINCE SO MANY PEOPLE DO THINK IT'S IMPORTANT, YOU SHOULD BE AWARE OF IT. THIS BALANCE OF MERCHANDISE TRADE IS SOMETIME THOUGHT TO BE AN INDICATOR OF HOW EFFICIENT UNITED STATES FACTORIES AND WORKERS ARE COMPARED TO OTHERS. AND SO WHAT YOU WOULD HEAR SOMEBODY SAY IS, "WELL, WE'VE GOT A BIG DEFICIT IN OUR BALANCE OF TRADE. AND, THAT BEING THE CASE, U.S. INDUSTRY IS NOT VERY EFFICIENT AND U.S. WORKERS AREN'T VERY EFFICIENT. WE'RE NOT ABLE TO COMPETE SUCCESSFULLY. WE CAN'T SELL AS MANY GOODS TO FOREIGNERS AS THEY'RE SELLING TO US." THAT'S NOT ALTOGETHER CONVINCING. THERE'S SOME GRAIN OF TRUTH IN ALL THAT, BUT THERE'S ALSO SOME FLAWS IN THAT WAY OF THINKING. WHAT IT DOES, NUMBER ONE, IS IT LEAVES OUT SERVICES WHICH

ECO 155 750 LECTURE 38 12 ARE VERY IMPORTANT AS WELL. AND, YOU KNOW, IF YOU -- THERE'S ALWAYS GONNA BE -- IF YOU JUST PICK OUT TWO OF THESE ITEMS AND JUST FOCUS ON THAT, WE'RE EITHER GONNA HAVE A POSITIVE NUMBER OR A NEGATIVE NUMBER. IF YOU PICK ON SOME THAT THE UNITED STATES IS NOT PARTICULARLY GREAT AT, YOU KNOW, IN THAT CERTAIN CATEGORY, THEN IT'S GONNA LOOK LIKE THERE'S A PROBLEM WITH THE UNITED STATES. BUT THERE'S OTHER THINGS GOING ON HERE AS WELL. WE IMPORT OIL, FOR EXAMPLE, BECAUSE WE CONSUME A LOT OF OIL AND WE CAN'T PRODUCE ENOUGH FOR OURSELVES. AND THAT HAS NOTHING TO DO WITH THE EFFICIENCY OF THE WORKERS; IT HAS TO DO WITH WHAT'S UNDERGROUND IN A PARTICULAR COUNTRY. AND SO ANYWAY, WE JUST DON'T WANT TO GET TOO HUNG UP ON THIS. LET ME PUT A COUPLE OF OTHER NUMBERS UP HERE. EXPORTS OF SERVICES IN THAT SAME YEAR, TWO HUNDRED AND SIXTY BILLION DOLLARS. EXPORTS -- OR IMPORTS -- I'M SORRY -- OF SERVICES, A HUNDRED AND EIGHTY-TWO BILLION DOLLARS. AND SO IN THIS PARTICULAR CASE, THERE'S NOBODY THAT TALKS ABOUT THE BALANCE OF SERVICE TRADE. BUT IN THIS PARTICULAR INSTANCE, WHAT WE WOULD HAVE IS A SURPLUS AMOUNTING TO ALMOST EIGHTY BILLION DOLLARS. SO ANYWAY, THERE'S A COUPLE OF NUMBERS FOR YOU AND I'LL COME BACK AND PRESENT A COUPLE MORE OF THESE LATER ON. I DID WANT TO MENTION WHERE YOU CAN SEE THESE NUMBERS IF YOU'RE INTERESTED. EVERY MONTH THE -- WHAT IS IT -- DEPARTMENT OF COMMERCE PUTS OUT

ECO 155 750 LECTURE 38 13 SOMETHING CALLED THE SURVEY OF CURRENT BUSINESS, AND BACK IN THE BACK THEY HAVE TABLES, AND IN THOSE TABLES YOU CAN RUN ACROSS A LARGE NUMBER OF DIFFERENT ECONOMIC DATA -- FOR EXAMPLE, GROSS DOMESTIC PRODUCT WHICH WE TALKED ABOUT EARLIER IN THE SEMESTER AND ALSO THESE INTERNATIONAL ACCOUNTS. SO ANYWAY. BALANCE OF TRADE. LET ME GET THIS OUT OF MY -- OFF OF THE PICTURE SO WE DON'T GET OURSELVES CONFUSED BY THAT ANYMORE. SO, AS I WAS SAYING EARLIER -- AND I WON'T GO THROUGH AND TRY AND FILL IN ALL THESE BECAUSE THERE REALLY IS A PAGE OF SEVENTY OR EIGHTY NUMBERS AS YOU GO DOWN IT. BUT ALL THESE THINGS THAT HAVE TO DO WITH US EXPORTING GOODS AND SERVICES AND RECEIVING INCOME FROM OUR ASSETS THAT ARE WORKING FOR US AND PROVIDING SERVICES TO FOREIGNERS, THOSE ARE CREDITS. WE HAVE DEBITS WHEN WE IMPORT GOODS, IMPORT SERVICES, AND RECEIVE THE SERVICES FROM FOREIGN ASSETS. AND THEN, OF COURSE, AS I SAY, FROM OUR GIFTS TO FOREIGNERS, WE HAVE A NEGATIVE NUMBER IN MOST YEARS FOR OUR UNILATERAL TRANSFERS. THIS BALANCE ON CURRENT ACCOUNT IN THAT SAME YEAR WAS MINUS -- THAT IS TO SAY A DEFICIT OF -- TWO HUNDRED AND THIRTY-THREE BILLION DOLLARS. THAT IS THE ENTIRE CURRENT ACCOUNT DEFICIT. SO LET'S TURN TO THIS CAPITAL ACCOUNT NEXT. WHEN WE TALK ABOUT THE CAPITAL ACCOUNT, AGAIN WE'RE TALKING ABOUT IMPORTS AND EXPORTS BUT OF A DIFFERENT TYPE. NOW WHAT THE IMPORTS AND

ECO 155 750 LECTURE 38 14 EXPORTS ARE OF, WHEN WE TALK ABOUT THE CAPITAL ACCOUNTS, IT'S IMPORTS AND EXPORTS OF FINANCIAL ASSETS AND LOANS, AND THAT TYPE OF THING. SO LET'S DISCUSS THAT JUST A LITTLE BIT. ON THE CAPITAL ACCOUNT WE'VE GOT INFLOW OF CURRENCY INTO THE UNITED STATES TO PAY FOR U.S. FINANCIAL ASSETS, BUSINESSES, ETC., OTHER TYPES OF THINGS OF THAT NATURE, A GOLF COURSE OR SOMETHING LIKE THAT, AND LOANS TO THE UNITED STATES. SO IF CURRENCY IS FLOWING INTO THE UNITED STATES, WE RECORD THAT AS A DEFICIT IN THESE ACCOUNTS. I'M SORRY. A CREDIT. CURRENCY IS FLOWING INTO THE UNITED STATES. AND THEN FLOWING OUT IS -- THERE'S AN OUTFLOW OF CURRENCY TO PAY FOR ONE, FINANCIAL ASSETS, COMPANIES, ETC., AND LOANS TO FOREIGNERS. WE'RE SENDING OUR MONEY OVERSEAS IN THIS PARTICULAR INSTANCE. AND SINCE FUNDS ARE FLOWING OVERSEAS, THEN WE RECORD THIS AS A CREDIT -- OH, I'M SORRY -- AS A DEFICIT -- AS A DEBIT. I BEG YOUR PARDON. CREDIT, DEBIT. FUNDS ARE FLOWING OUT OF THE COUNTRY SO WE RECORD THAT AS A DEBIT IN OUR ACCOUNTS. WE ADD ALL THE CREDITS TOGETHER, WE SUBTRACT ALL OF THE DEBITS, AND THEN WE GET THE NET AMOUNT WHICH IS THE BALANCE ON CAPITAL ACCOUNT. THE BALANCE ON CAPITAL ACCOUNT IN THAT SAME YEAR THAT WE WERE TALKING ABOUT BEFORE IS A POSITIVE -- OR WAS, I SHOULD SAY -- A POSITIVE TWO HUNDRED AND SIXTY-SIX BILLION DOLLARS. LET ME COME BACK OVER AND WRITE THAT DOWN HERE. NOW, LET'S JUST TAKE ONE SECOND AND THINK ABOUT WHAT THIS IS TELLING US. THE UNITED STATES

ECO 155 750 LECTURE 38 15 IS BUYING LOTS OF GOODS FROM FOREIGNERS. WE ALREADY SAW THIS. WE'RE BUYING MORE GOODS FROM FOREIGNERS THAN THEY'RE BUYING FROM US, GOODS AND SERVICES, AND SO WE'RE RUNNING A DEFICIT OF ABOUT TWO HUNDRED AND THIRTY-THREE BILLION DOLLARS. OKAY. ON THE OTHER HAND, FOREIGNERS LIKE TO INVEST IN THE UNITED STATES AND LIKE TO HOLD U.S. STOCKS AND BONDS. THEY LIKE TO MAKE LOANS IN THE UNITED STATES. THEY LIKE TO BUY COMPANIES IN THE UNITED STATES, GOLF COURSES AND THINGS LIKE THIS. AND SO FOREIGNERS LIKE INVESTING THEIR FUNDS IN THE UNITED STATES SO MUCH THAT THEY SEND US TWO HUNDRED AND SIXTY-SIX BILLION DOLLARS IN THAT PARTICULAR YEAR. OKAY. SO THESE ARE THE TWO BIG ACCOUNTS. AND THEN THE OFFICIAL RESERVE ACCOUNT, AS I MENTIONED BEFORE, THIS REFERS TO BASICALLY THE HOLDINGS OF THE UNITED STATES GOVERNMENT AND THE FEDERAL RESERVE AND THE TREASURY, BUT UNITED STATES GOVERNMENT HOLDINGS OF CERTAIN ASSETS. AND THESE ASSETS WOULD INCLUDE GOLD, FOREIGN EXCHANGE, AND SOMETHING CALLED SPECIAL DRAWING RIGHTS WHICH ARE REALLY JUST CREDITS WITH THE INTERNATIONAL MONETARY FUND. YOU DON'T REALLY NEED TO KNOW ABOUT THAT IN ORDER TO GET THROUGH THIS MATERIAL. THE IMPORTANT THING TO KNOW IS THAT THIS IS THE GOVERNMENT'S ACTIVITIES THAT WE'RE TALKING ABOUT HERE. AND THE IDEA IS, IF THE GOVERNMENT OBTAINS MORE GOLD OR MORE FOREIGN EXCHANGE OR MORE SDR'S, THE GOVERNMENT HAS TO PAY FOR THAT. AND

ECO 155 750 LECTURE 38 16 SO IF THESE THINGS GO UP, IF GOVERNMENT'S HOLDINGS INCREASE OF GOLD OR FOREIGN EXCHANGE OR SDR'S, WHEN THAT HAPPENS AND THE GOVERNMENT GETS MORE OF THOSE ASSETS, THE GOVERNMENT HAS TO PAY FOR 'EM. AND HOW DO THEY PAY? AND THE ANSWER IS: THEY PAY BY HANDING OVER DOLLARS. SO WHEN THE GOVERNMENT'S HOLDINGS OF GOLD AND FOREIGN EXCHANGE AND SPECIAL DRAWING RIGHTS GOES UP, WE RECORD THAT AS A DEBIT IN THESE INTERNATIONAL ACCOUNTS BECAUSE, AS I SAY, THE GOVERNMENT HAS TO PAY. IF THE GOVERNMENT WOULD HAND OVER GOLD TO SOMEBODY ELSE OR HAND OVER FOREIGN EXCHANGE OR HAND OVER SDR'S, THEN WHEN THE GOVERNMENT HANDS THOSE OVER AND REDUCES ITS HOLDINGS OF THOSE PARTICULAR ASSETS, OUR GOVERNMENT WOULD BE PAID. WHEN THE GOVERNMENT GETS PAID, THEN THAT WOULD BE A CREDIT IN THESE ACCOUNTS. AS I TOLD YOU EARLIER, THERE'S VERY LITTLE ACTIVITY NOWADAYS IN THESE OFFICIAL RESERVE ACCOUNTS. AND SO EVEN THOUGH I'M TELLING YOU ABOUT IT RIGHT NOW AND YOU SHOULD BE FAMILIAR WITH IT, FOR THE MOST PART THERE'S NOT MUCH ACTIVITY IN THIS ACCOUNT. IT'S A FEW BILLION DOLLARS. LET ME JUST MENTION TO YOU WHY THIS WOULD HAPPEN, WHY DOES THE GOVERNMENT HAVE MORE OR LESS GOLD, YOU KNOW, AND CHANGE THE AMOUNT OF ITS GOLD HOLDINGS OR THE AMOUNT OF ITS FOREIGN EXCHANGE HOLDINGS OR SPECIAL DRAWING RIGHTS. AND THE ANSWER IS THAT WHEN THE GOVERNMENT IS TRYING TO INTERVENE IN

ECO 155 750 LECTURE 38 17 CURRENCY MARKETS -- LET'S SAY THAT THE GOVERNMENT OFFICIALS SAY, "OH, YOU KNOW, THE EXCHANGE RATE BETWEEN DOLLARS AND POUNDS IS WRONG. WE WISH -- NOT WRONG, BUT NOT WHERE WE'D LIKE IT TO BE. WE WANT THAT EXCHANGE RATE TO GO UP" OR "WE WANT IT TO GO DOWN." THAT'S WHEN OUR GOVERNMENT WOULD INTERVENE IN THOSE MARKETS AND START DOING SOMETHING LIKE TAKING -- THEY'VE GOT A HOLDING OF POUNDS, BRITISH POUNDS. TAKING SOME OF THEIR POUNDS AND GOING TO THE FOREIGN EXCHANGE MARKET AND SAYING, "WE WANT TO TRADE THESE POUNDS. GIVE US BACK DOLLARS." AND SO THAT ACTIVITY BY OUR GOVERNMENT WOULD CHANGE EXCHANGE RATES, CAUSE THAT RATE OF EXCHANGE BETWEEN DOLLARS AND POUNDS TO VARY. AND SO ANYWAY, WHAT I'M TELLING YOU IS THAT THESE ACTIVITIES ARE VERY SMALL NOW BECAUSE, FOR THE MOST PART, THE UNITED STATES GOVERNMENT DOES NOT INTERVENE IN THESE CURRENCY MARKETS. FOR THE MOST PART, THE GOVERNMENT JUST SAYS, "WELL, WHATEVER SUPPLY AND DEMAND DETERMINES THE EXCHANGE RATE TO BE, THAT'S FINE WITH US. WE DON'T REALLY HAVE A POINT OF VIEW ON THAT." NOW, THIS IS REALLY QUITE A CHANGE FROM THE PAST. UP UNTIL 1973, OUR GOVERNMENT TRIED TO KEEP FIXED EXCHANGE RATES. AND SO ANY TIME THAT THE FORCES OF SUPPLY AND DEMAND -- THAT IS TO SAY, THE FLOW OF CURRENCY IN AND OUT OF THE COUNTRY ON CAPITAL ACCOUNT AND THE FLOW OF CURRENCY IN AND OUT OF THE COUNTRY ON CURRENT ACCOUNT. ANY TIME THAT WOULD CHANGE IN THE PAST, OR BE LARGE

ECO 155 750 LECTURE 38 18 AMOUNTS IN THE PAST AND CAUSE EXCHANGE RATES TO START MOVING EITHER UP OR DOWN, OUR GOVERNMENT WOULD SAY, "OH, NO. WE CAN'T HAVE THAT. WE WANT A FIXED EXCHANGE RATE." SO THEN THE GOVERNMENT WOULD GET INTO THESE FOREIGN EXCHANGE MARKETS AND THEY WOULD HAVE VERY ACTIVE OFFICIAL RESERVE ACCOUNTS. IN 1973, IT WAS THEN PRESIDENT NIXON AND HE SAID, "WELL, YOU KNOW, WE'RE NOT GONNA DO THAT ANYMORE." AND SO THAT WAS JUST THE END OF THE UNITED STATES INTERVENING IN THESE CURRENCY MARKETS IN A BIG WAY. THEN AFTER PRESIDENT NIXON CAME ALONG FORD AND CARTER. FORD AND CARTER CONTINUED TO INTERVENE IN THESE MARKETS TO A CERTAIN EXTENT, STILL SEVERAL BILLION DOLLARS A YEAR OF ACTIVITY AND TRYING TO MANIPULATE THESE EXCHANGE RATES. IF NOT KEEP THEM IN ONE SPOT, AT LEAST NOT LET EXCHANGE RATES JUST GO UP AND DOWN ACCORDING TO MARKET FORCES. AND SO THROUGH THE 1970S WHAT WE OBSERVED WAS THAT THESE OFFICIAL RESERVE ACCOUNTS WERE NOT SMALL. STILL PRETTY BIG, BUT JUST AS BIG AS THEY HAD BEEN IN EARLIER YEARS. IN 1980 PRESIDENT REAGAN -- NOT THEN PRESIDENT BUT GOVERNOR REAGAN THEN, THEN HE BECAME PRESIDENT REAGAN. HE TOOK OFFICE AND ONE OF HIS FIRST ACTS WAS TO TELL THE TREASURY, "STOP INTERVENING IN THESE CURRENCY MARKETS. WHATEVER SUPPLY AND DEMAND SAYS THAT THE EXCHANGE RATE OUGHT TO BE, THAT'S WHAT IT'S GONNA BE." PRESIDENT REAGAN WAS SHOT EARLY IN HIS FIRST TERM AND I THINK AFTER

ECO 155 750 LECTURE 38 19 HE'S JUST BEEN IN OFFICE FOR A COUPLE OF MONTHS. AND WHEN HE WAS SHOT, THERE WAS A BIG SORT OF PANIC AND THE TREASURY GOT INTO THESE MARKETS AND DID A CERTAIN AMOUNT OF TRADING IN ORDER TO STABILIZE THE DOLLAR'S VALUE. BUT THAT WAS, TO MY KNOWLEDGE, THE BIGGEST INTERVENTION BY THE REAGAN ADMINISTRATION IN THESE FOREIGN CURRENCY MARKETS. AFTER JUST A DAY OR SO OF THAT, THE NEWS CAME OUT PRESIDENT REAGAN WAS GONNA BE ALL RIGHT. AND SO AFTER THAT ONE SHOCK WENT BY -- YOU KNOW, OH THE PANIC OF WHAT'S GONNA HAPPEN -- THEN THE UNITED STATES GOT OUT OF THESE CURRENCY MARKETS AND HAS DONE VERY LITTLE SINCE THEN. EVERY ONCE IN AWHILE YOU'LL HEAR ABOUT SOME ACTIVITY, SOME OPERATION BY THE TREASURY OR THE FEDERAL RESERVE TRYING TO INTERVENE IN CURRENCY MARKETS, BUT NOW THOSE OPPORTUNITIES -- OR THOSE EVENTS ARE FEW AND FAR BETWEEN. SO NOWADAYS, WHAT WE'RE TALKING ABOUT, AS I MENTIONED EARLIER, IS THAT ALMOST ALL THE ACTION TAKES PLACE IN THESE FIRST TWO CATEGORIES: BALANCE ON CURRENT ACCOUNT, BALANCE ON CAPITAL ACCOUNT. THESE OTHER NUMBERS -- AND, BY THE WAY, I TOLD YOU THIS EARLIER HOW THE BALANCE OF PAYMENTS -- THIS FINAL NUMBER HAS TO BE EQUAL TO ZERO. AND SO IF WE TOOK ALL OF THESE DIFFERENT POSITIVES AND NEGATIVES AND PUT THEM ALL TOGETHER, THEY WOULD SUM UP TO ZERO. OKAY. THIS IS THE BALANCE OF PAYMENTS. BOP, BALANCE OF PAYMENTS, EQUALS ZERO. MEANING THE NEGATIVES AND THE POSITIVES

ECO 155 750 LECTURE 38 20 AND WHATEVER THESE OTHER NUMBERS ARE, THEY ALL HAVE TO ADD UP AND OFFSET EACH OTHER. WELL, YOU CAN SEE THAT. THESE ARE WITHIN THIRTY-THREE BILLION DOLLARS OF EACH OTHER, THE CAPITAL ACCOUNT AND THE CURRENT ACCOUNT. AND SO THERE'S ONLY THIRTY-THREE BILLION DOLLARS IN BOTH OF THE OTHER TWO. AND SO WHAT I WANT TO DO AND WHAT FOLLOWS THE REST OF OUR DISCUSSION IS I WANT US TO JUST ASSUME THAT WE CAN IGNORE THESE LAST TWO CATEGORIES, THE OFFICIAL RESERVE ACCOUNT AND THE STATISTICAL DISCREPANCY. WE'LL JUST PUT THOSE ASIDE. I'M NOT TELLING YOU THAT YOU DON'T HAVE TO BE AWARE OF 'EM, THAT YOU DON'T HAVE TO KNOW ABOUT 'EM. BUT FOR THE ANALYSIS THAT COMES -- AND WE'RE GONNA DO SOME SUPPLY AND DEMAND AND THINGS LIKE THAT -- WE'RE GONNA LEAVE THIS OUT, THIS NUMBER THREE AND NUMBER FOUR. WE'RE GONNA LEAVE THESE OUT OF HERE JUST BECAUSE THEY ARE SO SMALL AND BY INCLUDING THEM, WE DON'T HELP OURSELVES UNDERSTAND VERY MUCH ABOUT EXCHANGE RATES. SO WHY DON'T I GET STARTED WITH THAT. THE FIRST THING WE HAVE TO DO IS INTRODUCE AN IDEA THAT'S A LITTLE BIT ALIEN TO US. ALWAYS BEFORE WHEN I'D DRAW SUPPLY AND DEMAND IT'D BE SUPPLY AND DEMAND FOR SOME GOOD OR SUPPLY AND DEMAND FOR SOME SERVICE, BUT NOW WE'RE GONNA BE DRAWING IT SUPPLY AND DEMAND FOR CURRENCY. LET'S PUT HERE QUANTITY OF DOLLARS. AND I DON'T MEAN TO SAY THIS IS THE MONEY SUPPLY IN THE UNITED STATES. I MEAN TO SAY QUANTITY OF

ECO 155 750 LECTURE 38 21 DOLLARS IN FOREIGN EXCHANGE MARKETS. ON THE VERTICAL AXIS WE'LL PUT THE PRICE OF DOLLARS. HMMM, NOW WHAT'S THE PRICE OF A DOLLAR? AND THE ANSWER IS: THE PRICE OF A DOLLAR IS A DOLLAR. THAT'S IF YOU'RE BUYING IT WITH ANOTHER DOLLAR. BUT THAT'S NOT WHAT WE'RE INTERESTED IN HERE, EITHER. WE'RE INTERESTED IN THE VALUE OF THE DOLLAR, THE PRICE OF THE DOLLAR, RELATIVE TO OTHER CURRENCIES. AND THERE'S ONLY REALLY ONE WAY OF DOING THIS AND LET'S JUST PICK OUT ONE OTHER CURRENCY AND TALK ABOUT THE PRICE OF THE DOLLAR RELATIVE TO, LET'S SAY, THE POUND. THE TERMINOLOGY OR THE SYMBOLS THAT WE'LL USE WILL LOOK LIKE THIS: THE POUND SIGN DIVIDED BY DOLLARS. THIS IS NUMBER OF POUNDS PER DOLLAR. FOR EXAMPLE, IF THERE WAS A DOZEN EGGS FOR A DOLLAR, THEN YOU'D WRITE EGGS PER DOLLAR AND THIS IS POUNDS PER DOLLAR. THAT'S THE VALUE OF THE POUND -- I'M SORRY -- THE VALUE OF THE DOLLAR. AND LET'S JUST TAKE AN EXAMPLE. LET'S SAY THAT IT TOOK TWO DOLLARS TO BUY ONE POUND. THEN IF WE WANT TO KNOW HOW VALUABLE IS THE DOLLAR, PUT A PRICE ON THE DOLLAR, WHAT WE'D SAY IS: WE COULD DIVIDE BY TWO, SO ONE DOLLAR IS WORTH ONE-HALF POUND. OKAY. AND THAT'S REALLY WHAT WE'RE GONNA PUT ON THIS VERTICAL AXIS IS A MEASURE LIKE THIS: POUNDS PER DOLLAR. AND SO POUNDS PER DOLLAR -- LET ME GIVE ANOTHER EXAMPLE. SUPPOSE THAT THE PRICE OF A POUND -- I'M A LITTLE BIT JERKY HERE. IT'S HARD FOR ME TO THINK IN TERMS OF POUNDS. BUT THE PRICE OF A POUND IN TERMS OF A DOLLAR. LET'S SAY IT

ECO 155 750 LECTURE 38 22 WAS ONE TO ONE. THAT WOULD BE A MORE VALUABLE DOLLAR BECAUSE -- OR A MORE VALUABLE DOLLAR THAN BEFORE. A MOMENT AGO THAT DOLLAR'S VALUE WAS ONLY A HALF A POUND, AND SO NOW THE VALUE OF THAT DOLLAR IS ONE POUND. AND SO AS THE EXCHANGE RATE CHANGES, WE'RE GONNA HAVE DIFFERENT NUMBERS ALONG THIS VERTICAL AXIS. OKAY. AND THIS MIGHT BE THE ONE-HALF OF A POUND PER DOLLAR, AND THE ONE POUND PER DOLLAR, AND SO FORTH. OKAY. NOW WHAT WE WANT TO DO IS WE WANT TO PUT SUPPLY AND DEMAND IN OUR DIAGRAM. LET ME DRAW A SUPPLY CURVE TO BEGIN WITH. THIS IS THE SUPPLY OF DOLLARS IN FOREIGN EXCHANGE MARKETS. THIS IS WHEN AMERICANS ARE HANDING OVER DOLLARS, TRYING TO GET RID OF DOLLARS BECAUSE THEY WANT SOMETHING ELSE. THIS CORRESPONDS TO DEBITS THAT WE WERE TALKING ABOUT BEFORE IN THOSE BALANCE OF PAYMENTS ACCOUNTS, EACH ONE OF THE CATEGORIES OF BALANCE ON CURRENT ACCOUNT. SO EVERY TIME THAT AN AMERICAN IMPORTS A GOOD OR IMPORTS A SERVICE OR INVESTS OVERSEAS, THEN THE AMERICAN, BY IMPORTING THE GOOD OR IMPORTING THE SERVICE OR BUYING THE FINANCIAL ASSET OVERSEAS AND PAYING FOR IT, THEN THE AMERICAN IS SUPPLYING DOLLARS IN FOREIGN EXCHANGE MARKETS. OKAY. HERE'S A DEMAND FOR DOLLARS. DEMAND FOR DOLLARS IN FOREIGN EXCHANGE MARKETS. WHO'S DEMANDING DOLLARS? WELL, AND THE ANSWER IS: FOREIGNERS ARE. IT'S FOREIGNERS THAT WANT TO BUY AMERICAN CARS OR AIRPLANES OR MOVIES AND THINGS LIKE THIS. AND SO

ECO 155 750 LECTURE 38 23 THE DEMAND FOR DOLLARS IN FOREIGN EXCHANGE MARKETS, THAT'S WHEN SOMEBODY'S TRYING TO BUY A DOLLAR AND THEY'RE BUYING DOLLARS SO THEY CAN SEND 'EM TO THE UNITED STATES, AND THEY DO THAT WHEN THE UNITED STATES HAS THESE CREDITS IN THE BALANCE OF PAYMENTS ACCOUNTS. AND JUST IN GENERAL TERMS, I COULD COME BACK OVER HERE AND SAY, "GEE, WE'RE SUPPLYING A LOT OF DOLLARS ON THIS CURRENT ACCOUNT DUE TO THE FACT THAT WE IMPORT MORE GOODS AND SERVICES THAN WE EXPORT, AND THEN WE ARE SENDING THE FUNDS OVERSEAS AND WE'VE GOT A LOT OF THESE DEBITS REPRESENTED BY THE SUPPLY OF DOLLARS." I'LL PUT A LITTLE DOLLAR SIGN DOWN HERE. AND THEN ON THE OTHER HAND, FOREIGNERS LIKE TO INVEST IN THE UNITED STATES. WE SEE ON THE CAPITAL ACCOUNTS A BIG SURPLUS, A BIG POSITIVE NUMBER, SO THEY'RE TRYING TO BUY DOLLARS SO THEY CAN SEND 'EM TO THE UNITED STATES TO PARTICIPATE IN OUT STOCK AND BOND MARKET AND SO FORTH. AND SO YOU COULD THINK OF THIS AS SORT OF A DEMAND FOR DOLLARS DUE TO ACTIVITY IN OUR CAPITAL ACCOUNTS, SUPPLY OF DOLLARS DUE TO ACTIVITY IN OUR CURRENT ACCOUNTS. THAT'S A SIMPLE WAY OF THINKING ABOUT IT. AND THEN WHAT WE HAVE IS AN EQUILIBRIUM EXCHANGE RATE. AND WHAT IT COMES DOWN TO IS: BASICALLY, THE DESIRABILITY OF BUYING AMERICAN GOODS AND SERVICES AND MAKING INVESTMENTS IN THE UNITED STATES VERSUS AMERICANS BUYING GOODS AND SERVICES OVERSEAS AND INVESTING OVERSEAS. AND THE THING IS, THOUGH --

ECO 155 750 LECTURE 38 24 FOLLOW ME HERE WITH THIS -- SINCE THE BALANCE OF PAYMENTS, ALL OF THESE ITEMS ADDED TOGETHER -- THE CREDITS AND THE DEBITS ALL HAVE TO BALANCE EACH OTHER AND ADD UP TO ZERO. AND IF WE JUST ASSUME THAT THE OFFICIAL RESERVE ACCOUNTS AND STATISTICAL DISCREPANCY EQUALS ZERO, JUST BECAUSE THEY ARE SMALL NUMBERS, THEN WHAT WE CAN SEE IS THAT THE DEBIT IN THE CURRENT ACCOUNT AND THE SURPLUS -- I SHOULD SAY CREDITS IN THE CAPITAL ACCOUNT, THOSE THINGS HAVE TO EQUAL EACH OTHER APPROXIMATELY. THEY HAVE TO EQUAL EACH OTHER. NOW, WHO CARES? AND HERE'S WHO CARES. THAT WAS SOMETHING I DIDN'T REALLY BRING UP EARLIER WHEN I STARTED TALKING ABOUT THIS TOPIC. SOMETIMES PEOPLE WILL -- AGAIN, THEY'LL SAY, "OH, YOU KNOW, THE UNITED STATES IS NOT VERY EFFICIENT AT PRODUCING GOODS AND SERVICES, NOT AS EFFICIENT AS FOREIGNERS, AND HERE'S OUR PROOF: WE'RE BUYING MORE GOODS AND SERVICES FROM THEM THAN THEY BUY FROM US." YOU KNOW, THERE'S SOMETHING TO BE SAID FOR THAT POINT OF VIEW. BUT HERE'S SOMETHING I THINK THAT TRUMPS THAT CLAIM AND IT'S THIS: WHATEVER IS HAPPENING IN OUR CURRENT ACCOUNTS, IF WE -- IF FOREIGNERS LOVE TO INVEST IN THE UNITED STATES -- AND LET ME MAKE THIS CLEAR THAT FOREIGNERS DO LOVE TO INVEST IN THE UNITED STATES. IF FOREIGNERS LOVE TO INVEST IN THE UNITED STATES, WE'RE GONNA RUN A SURPLUS IN OUR CAPITAL ACCOUNTS. WE'RE GONNA HAVE A BIG CREDIT IN THOSE CAPITAL ACCOUNTS. AND THEN SINCE THESE THIRD AND FOURTH ITEMS WE CAN IGNORE, WE MUST HAVE A DEFICIT IN THE CAPITAL -- IN THAT

ECO 155 750 LECTURE 38 25 CURRENT ACCOUNT. I BEG YOUR PARDON. WE MUST HAVE A DEFICIT IN THE CURRENT ACCOUNT TO BALANCE THESE OFF. WE CANNOT HAVE A POSITIVE NUMBER IN BOTH CATEGORIES. THE NEGATIVES AND THE POSITIVES, THEY HAVE TO ADD TO ZERO. AND SO THERE'S TWO DIFFERENT WAYS OF LOOKING AT THIS. NUMBER ONE, WHICH I DON'T REALLY FIND VERY PERSUASIVE, THIS NUMBER IN THE CURRENT ACCOUNT IS NEGATIVE. THIS BALANCE ON OUR CURRENT ACCOUNT IS NEGATIVE BECAUSE WE'RE LOUSY AT PRODUCING GOODS AND SERVICES. WE PRODUCE GOODS AND SERVICES NOBODY WANTS. THAT'S ONE INTERPRETATION. I'M NOT PERSUADED BY THAT. HERE'S THE INTERPRETATION I PLACE ON IT. WE ARE A MARVELOUS PLACE TO INVEST -- AND, BY THE WAY, THAT'S FOR A VARIETY OF REASONS. ONE IS THAT AMERICAN INDUSTRY IS GOING THROUGH A -- REALLY, SORT OF A NEW INDUSTRIAL REVOLUTION. IT'S THIS INFORMATION REVOLUTION THAT WE'RE GOING THROUGH. COMPUTERS, INTERNET, TELECOMMUNICATIONS, ALL THE THINGS THAT HAVE BEEN OCCURRING FOR THE LAST FEW YEARS AND WILL CONTINUE IN THE NEXT FEW YEARS, WE'RE GOING THROUGH THAT. THERE'S A LOT OF COMPANIES MAKING HUGE PROFIT. THIS IS A WONDERFUL, WONDERFUL PLACE TO INVEST. THAT'S PART OF WHAT'S GOING ON. PART OF WHAT'S GOING ON IS U.S. TAXES. EVEN THOUGH WE SOMETIMES CONSIDER 'EM HIGH, U.S. TAXES ARE PRETTY MODERATE COMPARED TO TAXES IN MANY OTHER COUNTRIES. AND SO IF FOREIGNERS

ECO 155 750 LECTURE 38 26 ARE WORRIED ABOUT PAYING TAXES, THEN THERE'S A LIKELIHOOD THAT THEY'RE GONNA SEND THEIR DOLLARS TO THE UNITED STATES OR THEIR FUNDS TO THE UNITED STATES TO INVEST. AND SO THAT'S THE SECOND PART OF THE STORY. SO FOR WHATEVER REASONS, AND THERE ARE OTHERS THAT WE COULD TALK ABOUT, THE UNITED STATES IS A GREAT PLACE TO INVEST. SO WE RUN A BIG SURPLUS IN THIS CAPITAL ACCOUNT AND THEN IT IS NECESSARY BY THE NATURE OF THE ACCOUNTS AND BY THE WAY THAT THE FOREIGN EXCHANGE MARKETS WORK, IT IS JUST ABSOLUTELY NECESSARY THAT WHATEVER SURPLUS WE RUN ON THE CAPITAL ACCOUNT MUST BE BALANCED BY A DEFICIT IN THE CURRENT ACCOUNT. AND THAT'S MORE OR LESS THE WAY I SEE THIS WORKING OUT FOR THE LAST SEVERAL YEARS. AND SO THEREFORE I DON'T FIND ANY SORT OF ALARMING TREND UNDERWAY, THAT WE HAVE A DEFICIT IN OUR CURRENT ACCOUNTS. IT'S -- BASICALLY, WHAT HAPPENS IS ALL THE FUNDS FLOWING INTO THE UNITED STATES TO MAKE INVESTMENTS HERE DRIVE UP EXCHANGE RATES -- WE'LL TALK ABOUT IT IN A MOMENT. AND THEN AT THE HIGHER EXCHANGE RATES, WE'RE NOT ABLE TO SELL SO MANY FOREIGN GOODS AND SERVICES. LET'S PUT IT ANOTHER WAY, THOUGH. LET'S SAY THE UNITED STATES COULD JUST TURN OFF THE SPIGOT AND SAY, "NO MORE INVESTMENT HERE IN THE UNITED STATES BY FOREIGNERS." IF THE MONEY STOPPED FLOWING IN FROM FOREIGNERS, THIS CAPITAL ACCOUNT WOULD TURN INTO A ZERO. THERE'S BE NO DEFICIT AND NO SURPLUS. AND AT THAT POINT THE

ECO 155 750 LECTURE 38 27 CURRENT ACCOUNTS WOULD EQUAL ZERO. THAT IS TO SAY, OUR EXPORTS OF GOODS AND SERVICES WOULD EXACTLY EQUAL OUR IMPORTS OF GOODS AND SERVICES, AND WE'D HAVE NO DEFICIT. SO ANYWAY, I GUESS WHAT I'M TELLING YOU IS THIS: DON'T GET AWFULLY CONCERNED WHEN YOU SEE THESE NEWSPAPER REPORTS OR TELEVISION NEWS REPORTS ABOUT HOW WE'RE RUNNING THIS BIG TRADE DEFICIT. IN MY OPINION, THAT'S JUST NOT SOMETHING TO BE ALARMED ABOUT. OKAY. WHAT I WANT TO DO IS DIVIDE THIS DIAGRAM INTO TWO PARTS AND SORT OF DISCUSS IT A LITTLE BIT MORE IN DEPTH. LET'S PUT ONE DIAGRAM HERE. THIS WOULD BE THE VALUE OF THE DOLLAR IN TERMS OF POUNDS AND THE QUANTITY OF DOLLARS. AND WHAT WE'LL JUST TALK ABOUT HERE IS THE BALANCE ON CURRENT ACCOUNT. OKAY. SO WHAT I'M SAYING TO YOU IS, THERE'S A SUPPLY AND DEMAND FOR DOLLARS BY PEOPLE WHO'RE INVOLVED IN TRADE, GOODS AND SERVICES, AND THEN THIS OTHER ITEM THAT WE TALKED ABOUT WHERE THERE'S INCOME FLOWING BACK AND FORTH FOR THE USE OF CERTAIN ASSETS. OKAY. SO IF THAT'S ALL WE'RE INTERESTED IN, HERE'S WHAT WE WOULD SAY. AS THE DOLLAR GETS MORE AND MORE VALUABLE, AS IT MOVES UP IN VALUE, FOREIGNERS -- LET'S NOT TALK ABOUT FOREIGNERS -- AMERICANS BUY MORE AND MORE FROM OVERSEAS. AND THAT'S WHAT THIS DIAGRAM IS SHOWING US. IT SAYS THIS -- AND DON'T FORGET THIS SUPPLY CURVE IS A SUPPLY OF DOLLARS BY AMERICANS. WE'RE GETTING RID OF

ECO 155 750 LECTURE 38 28 DOLLARS, HANDING THOSE OVER. HERE'S WHAT WE'RE SAYING: IF THE DOLLAR IS WEAK AND NOT VERY VALUABLE, THEN IT TAKES A LOT OF DOLLARS TO BUY GOODS FROM OVERSEAS. A BRITISH CAR, FOR EXAMPLE, THAT COSTS A THOUSAND POUNDS WOULD COST A LOT OF DOLLARS IF THE DOLLAR IS WEAK, IF THE DOLLAR'S VALUE IS NOT VERY HIGH. AND SO SINCE IT COSTS A LOT OF DOLLARS, WE DON'T IMPORT MANY OF THOSE DOLLARS AND THEREFORE WE'RE NOT SENDING MANY -- I'M SORRY. WE DON'T IMPORT MANY CARS AND SO WE WOULD NOT SEND MANY DOLLARS OVERSEAS. AS THE DOLLAR GETS STRONGER AND STRONGER, THAT IS TO SAY AS ITS VALUE GOES HIGHER AND HIGHER, THEN THAT ONE THOUSAND POUND CAR, POUND STERLING, THAT ONE THOUSAND POUND CAR, THAT GETS CHEAPER AND CHEAPER IN TERMS OF UNITED STATES DOLLARS. NOW WHAT WE WANT TO DO IS WE WANT TO BUY MORE AND MORE OF THOSE CARS. SO AT A VERY EXPENSIVE DOLLAR OR A VERY VALUABLE DOLLAR, WHAT WE WOULD SAY IS, "WOW, THOSE BRITISH CARS SURE ARE CHEAP. LET'S BUY A LOT OF 'EM." AND SINCE WE'RE SAYING LET'S BUY A LOT OF 'EM, NOW WE ARE SUPPLYING LOTS OF DOLLARS AND WE'RE BUYING A LOT OF CARS. OKAY. SO ANYWAY, THIS CURVE RIGHT HERE IS SHOWING US THE WILLINGNESS OF AMERICANS TO BUY GOODS AND SERVICES FROM FOREIGNERS. THE STRONGER THE DOLLAR IS, THE MORE WE WANT TO BUY FROM FOREIGNERS, THE MORE WE WANT TO TRAVEL OVERSEAS ON VACATION AND SO FORTH. OKAY. IT WORKS IN EXACTLY THE OPPOSITE

ECO 155 750 LECTURE 38 29 DIRECTION WHEN WE START TALKING ABOUT BRITISH CONSUMERS OR FOREIGN CONSUMERS OF U.S. GOODS. IF THE DOLLAR GETS STRONGER AND STRONGER AND STRONGER, AS WE GO HIGHER AND HIGHER ON THIS DIAGRAM, FOREIGNERS FIND U.S. GOODS MORE AND MORE EXPENSIVE. AND THE MORE EXPENSIVE U.S. GOODS ARE, THE MORE THEY WANT TO BUY. AND SO WITH RESPECT TO THE DEMAND FOR DOLLARS IN THESE CURRENCY MARKETS, THERE'S -- THE SMALLER QUANTITY DEMANDED, THE MORE VALUABLE THE DOLLAR IS BECAUSE THE MORE VALUABLE DOLLAR MAKES OUR GOODS MORE EXPENSIVE AND SOMETHING THAT FOREIGNERS JUST START SAYING, "WELL, AT AN EXPENSIVE DOLLAR, I THINK I WON'T BUY A U.S. CAR. I THINK I'LL BUY A CAR FROM GERMANY OR I'LL BUY A CAR FROM JAPAN." OKAY. SO ANYWAY, WE'VE GOT SUPPLY AND DEMAND -- LET ME KIND OF CLEAN MY DIAGRAM UP HERE JUST A LITTLE BIT. WE'VE GOT SUPPLY AND DEMAND FOR DOLLARS THAT REFLECT ONLY THE CURRENT ACCOUNT, TRADE IN GOODS AND SERVICES. OKAY. NOW WHAT WE'VE GOT IS ANOTHER SUPPLY AND DEMAND DIAGRAM THAT REFERS TO THE CAPITAL ACCOUNTS. LET ME GET EVERYTHING DRAWN UP HERE. I NEED TO STOP ONE SECOND, KENT, AND LOOK THIS OVER SO I DON'T DRAW IT WRONG. SO WHEN WE TALK ONLY ABOUT THE CAPITAL ACCOUNTS, WHAT WE WANT TO DO IS AGAIN DRAW SUPPLY AND DEMAND. WHAT WE'D SAY IS, "OH, AMERICANS WANT TO INVEST OVERSEAS AND SO WE ARE SUPPLYING OUR DOLLARS TO BUY FOREIGN CURRENCIES TO MAKE THOSE FOREIGN

ECO 155 750 LECTURE 38 30 INVESTMENTS." AND THAT'S WHAT THIS CURVE REFLECTS. AND REALLY WHAT WE'RE SAYING IS THE MORE VALUABLE THE DOLLAR IS, THE MORE WE WANT TO BUY OVERSEAS STOCKS AND BONDS AND BUILDINGS, AND SO FORTH, BUSINESSES. AND THE REASON WE WANT TO DO THAT IS BECAUSE THE STRONGER THE DOLLAR, THE CHEAPER THOSE FOREIGN GOODS AND SERVICES ARE. AND THEN FOREIGNERS -- I'M GONNA DRAW THIS WHERE IT'S PRETTY HIGH -- BUT FOREIGNERS HAVE A DEMAND FOR U.S. DOLLARS WHEN THEY WANT TO INVEST HERE ON OUR STOCKS AND BONDS AND THINGS OF THAT NATURE. AND IF THE DOLLAR GETS -- LET'S SAY, IN THIS PARTICULAR CASE, THE DOLLAR GETS CHEAPER AND CHEAPER, LESS AND LESS VALUABLE COMPARED TO THE ENGLISH CURRENCY. THEN BRITISH INVESTORS WANT TO INVEST MORE HERE. AND SO AS THE DOLLAR GETS CHEAPER, AS WE GO DOWN THE DIAGRAM, THERE'S MORE AND MORE INVESTMENT WITHIN THE UNITED STATES. THAT IS TO SAY, MOVING IN THE RIGHTWARD DIRECTION, QUANTITY DEMANDED OF DOLLARS IS INCREASING. WELL, HERE'S WHAT YOU CAN SEE BY JUST KIND OF GLANCING AT THESE TWO DIAGRAMS, SIDE BY SIDE. AND WE SHOULD HAVE THESE DRAWN ON THE SAME HORIZONTAL PLANE. BUT WHAT YOU CAN SEE IS THAT THERE'S A CERTAIN EXCHANGE RATE THAT WOULD BE EQUILIBRIUM IF WE WERE ONLY INTERESTED IN THE CAPITAL ACCOUNT TRADE OR BUSINESS. THERE'S A DIFFERENT EXCHANGE RATE THAT WOULD BE THE EQUILIBRIUM RATE IF WE ONLY LOOK AT THE CURRENT ACCOUNTS. BUT THE EXCHANGE

ECO 155 750 LECTURE 38 31 RATE, THE OVERALL EXCHANGE RATE, TAKES BOTH OF THESE THINGS INTO ACCOUNT. IT INCORPORATES BOTH PIECES OF INFORMATION. THAT IS TO SAY, THE CURRENT ACCOUNT AND THE CAPITAL ACCOUNT. JUST SO THERE'S NO MISTAKE: AGAIN, THIS IS NOT THE CURRENT ACCOUNT AND THIS THE CAPITAL ACCOUNT. THIS IS THE AMOUNT OF CURRENCY COMING INTO THE UNITED STATES AND OUT OF THE UNITED STATES. HERE'S OUT OF THE UNITED STATES, INTO THE UNITED STATES, DUE TO TRADE IN THE CURRENT ACCOUNT. HERE'S THE CURRENCY FLOWING OUT OF THE UNITED STATES AND INTO THE UNITED STATES DUE TO TRADE THAT'S TAKING PLACE IN THESE FINANCIAL SECURITIES IN OUR CAPITAL ACCOUNTS. THE OVERALL EXCHANGE RATE IS HALFWAY, SO TO SPEAK, IN-BETWEEN THESE OTHER TWO EXCHANGE RATES. THAT IS TO SAY, THE EQUILIBRIUM EXCHANGE RATE WHICH CORRESPONDS TO WHAT WE'VE BEEN TALKING ABOUT UP TO NOW, THAT SHOWS US THE EXCHANGE RATE THAT WILL EQUILIBRATE BOTH OF THESE MARKETS SIMULTANEOUSLY, IN A MANNER OF SPEAKING. SO WHAT WE HAVE IS A DEFICIT IN THE CURRENT ACCOUNT AND WE HAVE A SURPLUS IN THE CAPITAL ACCOUNTS, AND THE SIZE OF THIS SURPLUS IS APPROXIMATELY EQUAL TO THE SIZE OF THE DEFICIT, AND THE SIZE OF THE SURPLUS IN THE CAPITAL ACCOUNTS EQUALS THE SIZE OF THE SURPLUS IN THE CURRENT ACCOUNTS. AND THEREFORE, WE THEN FIND AN EXCHANGE RATE THAT EQUILIBRATES THE DEFICIT IN THE ONE ACCOUNT AND THE SURPLUS IN THE OTHER. OR, IF YOU LIKE, THE CREDITS AND THE

ECO 155 750 LECTURE 38 32 DEBITS ARE EQUAL. SO WHAT YOU DON'T WANT TO DO IS LET THIS DISTURB YOU, THESE ACCOUNTS THAT ARE TELLING US ABOUT THE BAD NEWS: OH, WE'RE RUNNING A DEFICIT. YES, WE ARE RUNNING A DEFICIT. TELL ME THE REST OF THE STORY. TELL ME ABOUT THE SURPLUS WE'RE RUNNING IN THE CAPITAL ACCOUNTS. I GUESS FINALLY WHAT WE WANT TO DO -- ALMOST FINALLY -- IS WE WANT TO TALK ABOUT SOME THINGS THAT WILL SHIFT THESE CURVES. LET'S SAY, FOR EXAMPLE, THAT THERE'S A DIFFERENCE IN -- I DON'T EXACTLY KNOW WHERE I'M GONNA WRITE. MAYBE I'LL WRITE RIGHT DOWN HERE. LET'S SAY THAT THERE WAS A DIFFERENCE IN INCOME GROWTH BETWEEN THE U.S. VERSUS U.K., BRITAIN. LET'S SEE HOW THAT WOULD AFFECT THIS. LET'S SAY THE UNITED STATES INCOME IS GROWING AT FIVE PERCENT A YEAR -- AND THESE ARE REAL INCOMES, NOT NOMINAL. LET'S SAY U.S. INCOME IS GROWING FIVE PERCENT A YEAR AND BRITISH INCOME IS GROWING ONE PERCENT A YEAR, AND THAT'S JUST TO PICK A COUPLE OF NUMBERS OUT FOR PURPOSES OF ILLUSTRATION. IF THAT HAPPENS, HERE'S WHAT HAPPENS TO THESE ACCOUNTS. THE UNITED STATES INCOME IS GOING UP RAPIDLY. WE START BUYING MORE AND MORE GOODS FROM FOREIGNERS. WE BUY MORE GOODS FROM OURSELVES AS WELL, BUT WE'RE BUYING MORE AND MORE GOODS FROM FOREIGNERS. WHEREAS, FOREIGNERS ARE BUYING A LITTLE BIT MORE GOODS FROM US BUT NOT VERY MUCH BECAUSE THEIR INCOMES ARE NOT GROWING AS MUCH, NOT

ECO 155 750 LECTURE 38 33 GROWING AS RAPIDLY. SO THIS RAPID GROWTH IN U.S. INCOME, THAT CAUSES US TO IMPORT MORE GOODS AND SERVICES. THAT CAUSES OUR -- WHERE ARE WE HERE -- OUR CURRENT ACCOUNTS TO WORSEN. MAYBE THIS NUMBER GOES DOWN TO TWO HUNDRED AND FORTY BILLION OR TWO HUNDRED AND FIFTY BILLION, OR SOMETHING LIKE THAT. AND SO NOW WHAT HAPPENS IS THE SUPPLY OF DOLLARS INCREASES, S2. AND AS THE SUPPLY OF DOLLARS INCREASES, WHAT YOU CAN SEE IS THAT DEFICIT'S GONNA GET LARGER FOR THE UNITED STATES AND THAT WILL BRING DOWN THE EXCHANGE RATE. HERE'S HOW WE CAN SEE THAT OVER IN OUR MAIN DIAGRAM. THE SUPPLY OF DOLLARS HAS INCREASED TO S2, AND SO NOW THE U.S. DOLLAR WOULD WEAKEN. OKAY. SO IF OUR INCOME GROWTH EXCEEDS THAT IN FOREIGN COUNTRIES, THAT'S GONNA CAUSE THE DOLLAR TO WEAKEN, ALL OTHER THINGS BEING THE SAME. LET'S TRY SOMETHING ELSE. LET'S SAY THAT THERE'S A DIFFERENCE IN INFLATION RATES. AND I WON'T TRY AND DRAW ALL THE DIAGRAMS TO GO ALONG WITH IT. BUT LET'S SAY THE UNITED STATES HAS A HIGHER INFLATION RATE THAN THE FOREIGN COUNTRY. THEN THAT MEANS OUR GOODS AND SERVICES ARE GOING UP MORE RAPIDLY IN PRICE THAN THE FOREIGN GOODS AND SERVICES. AND, THAT BEING THE CASE, FOREIGNERS ARE GONNA FIND OUR GOODS LESS AND LESS DESIRABLE NOW THAT WE HAVE THIS INFLATION THAT EXCEEDS THEIRS. AND SO WE'RE GONNA IMPORT MORE GOODS FROM OVERSEAS, WE'RE GONNA EXPORT FEWER

ECO 155 750 LECTURE 38 34 GOODS, AND WE'LL HAVE EXACTLY THE SAME KIND OF AN EFFECT THAT WE SHOWED EARLIER ON. A THIRD THING THAT COULD HAPPEN IS THAT THERE COULD BE AN INCREASE IN THIS DIFFERENCE BETWEEN REAL INTEREST RATES -- HOW AM I GONNA DESCRIBE THIS -- DIFFERENCE IN REAL INTEREST RATES IN THE U.S. VERSUS U.K. IF OUR INTEREST RATE GOES UP AND FOREIGN INTEREST RATES DO NOT GO UP, WHAT WILL HAPPEN THEN? IF OUR INTEREST RATES GO UP, FOREIGNERS THEN WILL SAY, "OH, THERE'S A GREAT PLACE TO SEND OUR MONEY. INTEREST RATES ARE HIGHER IN THE UNITED STATES." AND SO DOLLARS START FLOWING INTO THE UNITED STATES. AND WHEN THAT HAPPENS, THIS NUMBER WILL INCREASE TO TWO HUNDRED AND EIGHTY BILLION DOLLARS OR SOMETHING OF THAT NATURE. AND SO THAT WILL CAUSE -- WHAT WILL IT DO? IT WILL CAUSE THIS CURVE TO SHIFT TO THE RIGHT, TO D PRIME. AND IF WE CAME BACK OVER AND SHIFTED THE DEMAND CURVE OUTWARD, THAT WOULD MAKE THE DOLLAR GO UP IN VALUE. NOW, WE DON'T NEED TO GO THROUGH EACH AND EVERY ONE OF THESE. I'LL LET YOU READ ABOUT IT IN YOUR TEXTBOOK. BUT THE POINT IS IS THAT WE FOUND AN EQUILIBRIUM EXCHANGE RATE AND NOW WHAT WE WANT TO UNDERSTAND IS THAT THAT EQUILIBRIUM EXCHANGE RATE WILL CHANGE OVER TIME AS ECONOMIC CONDITIONS CHANGE IN THE VARIOUS COUNTRIES. AND SO PEOPLE WHO SPECULATE IN THESE FOREIGN EXCHANGE MARKETS ARE CONSTANTLY WATCHING THINGS LIKE REAL INTEREST RATES AND INFLATION REPORTS COMING OUT OF THE VARIOUS

ECO 155 750 LECTURE 38 35 NATIONS. WE ALSO HAVE POLICIES, OUR GOVERNMENT DOES, THAT WILL AFFECT THESE ACCOUNTS. SUPPOSE THE GOVERNMENT SAYS, "YOU MAY NOT IMPORT ANY MORE CARS PRODUCED IN JAPAN." THAT WOULD BE CALLED A QUOTA. OR SUPPOSE THEY PUT A BIG TAX ON CARS IMPORTED FROM OVERSEAS. THAT WOULD BE A TARIFF. WELL, THAT TARIFF AND QUOTA, THAT WOULD DISCOURAGE OUR PURCHASES OF FOREIGN GOODS, WHICH WOULD THEN SHIFT THE CURRENT ACCOUNT AND CAUSE THESE CURVES TO SHIFT IN A CORRESPONDING WAY AND EXCHANGE RATES WOULD CHANGE. SO WHAT WE WANT TO UNDERSTAND IS THAT THE FOREIGN EXCHANGE MARKET AND THE EXCHANGE RATE IS TAKING INTO ACCOUNT ECONOMIC CONDITIONS AND ECONOMIC POLICY AROUND THE WORLD. LET ME FINALLY SAY THAT BACK IN THE OLD DAYS, EXCHANGE RATES WERE FIXED BY LAW. THE GOVERNMENT INTERVENED IN THESE CURRENCY MARKETS TO KEEP EXCHANGE RATES AT A FIXED LEVEL. ESSENTIALLY, THAT'S WHAT THE GOLD STANDARD REFERRED TO. THAT'S WHAT THE EURO IS IN EUROPE WHERE THEY MAINTAIN FIXED EXCHANGE RATES WITH RESPECT TO EACH OTHER'S NATIONS. EVEN THOUGH THE EURO IS SORT OF A NEW THING AND JUST BEEN GOING NOW FOR A FEW YEARS, EVEN THOUGH WE'VE GOT THE EURO, THAT IS SORT OF BUCKING THE TREND. THE TREND IN THE WORLD ECONOMY IS TO HAVE FLEXIBLE EXCHANGE RATES AND FOR THIS SUPPLY AND DEMAND DIAGRAM TO BE THE ONE THAT WE NEED IF WE WANT TO UNDERSTAND INTERNATIONAL FINANCE.

ECO 155 750 LECTURE 38 36 I GUESS THAT WILL FINISH UP FOR THE DAY AND NEXT TIME WE'LL BE HAVING THE SEMESTER REVIEW, AND THEN THE FINAL EXAM. SO LONG. I'LL SEE YOU NEXT TIME.