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Figure 7, the two effects of the exchange rate appreciation
appear in the brick-colored lines S2S2 and D2D2: aggregate
Real GDP
supply shifts outward and aggregate demand shifts
inward. This time, as you can see in the figure,
International capital flows increase the power of monetary policy.
In a closed economy, higher interest rates reduce investment spending, I. In an open
economy, these same higher interest rates also appreciate the currency and reduce net
exports, X 2 IM. Thus, the effect of monetary policy is enhanced.
It may seem puzzling that capital flows strengthen monetary policy but weaken fiscal
policy. The explanation of these contrasting results lies in their effects on interest rates.
The main international repercussion of either a fiscal expansion or a monetary contraction
is to raise interest rates and the exchange rate, thereby crowding out net exports. But that
means that the initial effects of a fiscal expansion on aggregate demand are weakened,
whereas the initial effects of a monetary contraction are strengthened.

We have now completed our theoretical analysis of the macroeconomics of open
economies. Let us put the theory to work by applying it to the events of the 1990s, when
fiscal policy was tightened and monetary policy was eased. Should reducing the budget
deficit (or raising the surplus) strengthen or weaken the dollar?
As discussed in Chapter 15, the U.S. government transformed its mammoth budget
deficit into a notable surplus during the 1990s by raising taxes and cutting expenditures.
Column (1) of Table 3 reviews the predicted effects of a fiscal contraction: It should lower
real interest rates, make the dollar depreciate, reduce real GDP, and be less disinflationary
than normal because of the falling dollar. This information is recorded by entering 1 signs
for increases and 2 signs for decreases.
Eliminating the budget deficit reduced aggregate demand. But the Federal Reserve
restored the missing demand by lowering interest rates so that the economy would not

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Chapter 19 387
Exchange Rates and the Macroeconomy

suffer a slump. According to the analysis in this chapter, such TA BL E 3
a monetary expansion should lower real interest rates, make Expected Effects of Policy
the dollar depreciate, raise real GDP, and be a bit more infla-
(1) (2) (3)
tionary than usual because of the falling dollar. These effects
Fiscal Monetary Combination
are recorded in column (2) of Table 3.
Variable Contraction Expansion
Column (3) puts the two pieces together. We conclude that
Real interest rate
a policy mix of fiscal contraction and monetary expansion 2 2 2
Exchange rate 2 2 2
should reduce interest rates strongly, push down the value of
Net exports 1 1 1
the dollar, and strongly stimulate our foreign trade. The net Real GDP ?
2 1
effects on output and inflation are uncertain, however: The Inflation ?
2 1
balance depends on whether the fiscal contraction over-
whelms the monetary expansion, or vice versa.
What actually happened? First, interest rates did fall, just as predicted. The rate on
10-year U.S. government bonds dropped from almost 7 percent in late 1992 to just over
4.5 percent in December 1998, and by 1998 American households were enjoying the low-
est home mortgage rates since the 1960s. Second, the U.S. economy expanded rapidly
between 1992 and 1998; apparently, the monetary stimulus overwhelmed the fiscal con-
traction. Third, inflation fell despite such rapid growth. As we explained in Chapter 10,
one major reason was a series of favorable supply shocks that pushed inflation down.
But what about the exchange rate and international trade? Here the theory did less
well. The dollar generally declined from 1993 to 1995, just as the theory predicts. But then
it turned around and rose sharply from 1995 to 1998, just when the budget deficit was
turning into a surplus. America™s trade performance was even more puzzling. According
to the theory, a lower budget deficit should have led to a lower exchange rate, and there-
fore to a smaller trade deficit. But, in fact, America™s real net exports sagged from just A country™s trade deficit is
the excess of its imports
2$16 billion in 1992 to 2$204 billion in 1998. What went wrong?
over its exports. If, instead,
exports exceed imports, the
The Loose Link between the Budget Deficit and the Trade Deficit country has a trade
To answer this question, let™s explore the connection between the budget deficit and the
trade deficit in more detail. To do so, we need one simple piece of arithmetic.
Begin with the familiar equilibrium condition for GDP in an open economy:
Y 5 C 1 I 1 G 1 (X 2 IM)
Because GDP can either be spent, saved, or taxed away,3
Equating these two expressions for Y gives
C 1 I 1 G 1 (X 2 IM) 5 C 1 S 1 T
Finally, subtracting C from both sides and bringing the I and G terms over to the right-
hand side leads to an accounting relationship between the trade deficit and the budget
X 2 IM 5 (S 2 I) 2 (G 2 T)
Notice that this equation is a matter of accounting, not economics. It must hold in all
countries at all times, and it has nothing to do with any particular economic theory. In
words, it says that a trade deficit”a negative value of (X 2 IM)”can arise from one of two
sources: a government budget deficit (G larger than T) or an excess of investment over
saving (I larger than S).
Now let™s apply this accounting relationship to actual U.S. events in the 1990s. As we
know, the government deficit, G 2 T, fell precipitously. Other things equal, that should

If you do not see why, recall that GDP equals disposable income (DI) plus taxes (T), Y 5 DI 1 T, and that dispos-

able income can either be consumed or saved, DI 5 C 1 S. These two definitions together imply that Y 5 C 1 S 1 T.

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Part 4
388 The United States in the World Economy

have reduced the trade deficit. But other things were not equal. The equation reminds us
that the balance between saving and investment matters, too. As shares of GDP, business
investment boomed while household saving declined from 1992 to 1998. So S 2 I moved
sharply in the negative direction. And that change, as our equation shows, should raise
the trade deficit (reduce net exports).
In brief, taken by itself, deficit reduction would have increased net exports. But in
reality, sharp changes in private economic behavior”specifically, less saving and more
investment”overwhelmed the government™s actions and made net exports fall instead.
The link from the budget deficit to the trade deficit can be a loose one.

The preceding explanation suggests that the large U.S. trade deficits over the past decade
are a symptom of a deeper trouble: The nation as a whole”including both the govern-
ment and the private sector”has been consuming more than it has been producing for
years. The United States has therefore been forced to borrow the difference from foreign-
ers. The trade deficit is just the mirror image of the required capital inflows.
Those who worry about trade deficits point out that these capital inflows create debts
on which interest and principal payments must be made in the future. In this view, we
Americans have been mortgaging our futures to finance higher consumer spending.
But another, quite different, interpretation of the trade deficit is possible. Suppose for-
eign investors come to see the United States as an especially attractive place to invest their
funds. Then capital will flow here, not because Americans need to borrow it, but because
foreigners are eager to lend it. The desire of foreigners to acquire American assets should
push the value of the dollar up, which should in turn push America™s net exports down.
In that case, the trade deficit would still be the mirror image of the capital inflows. But it
would signify America™s economic strength, not its weakness.
Each view has elements of truth, but the second raises a critical question: How long can
it go on? As long as the United States continues to run large trade deficits, foreigners will
have to continue to accumulate large amounts of U.S. assets”one way or another. As we
noted in the previous chapter, starting in 2002 private investors abroad began concluding
that they had acquired about all the American assets they wanted. That would have
marked the day of reckoning for the United States but for one important fact: The govern-
ments of Japan and China decided to buy hundreds of billions of dollars (selling equiva-
lent amounts of their own currencies) rather than let the yen and the yuan appreciate.
These large government capital inflows allowed the U.S. to continue to run mammoth trade
deficits for a few more years. Then in 2007, with the U.S. economy looking weaker than in
the past, foreigners decided to buy fewer U.S. assets, and the dollar declined again.

How can we ameliorate our foreign trade problem and reduce our addiction to foreign
borrowing? There are four basic ways.

Change the Mix of Fiscal and Monetary Policy
The fundamental equation
X 2 IM 5 (S 2 I) 2 (G 2 T)
suggests that a decrease in the budget deficit (that is, shrinking G 2 T) would be one good
way to reduce the trade deficit. According to the analysis in this chapter, a reduction in G
or an increase in T would lead to lower real interest rates in the United States, a depreciat-
ing dollar, and, eventually, a smaller trade deficit.

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Chapter 19 389
Exchange Rates and the Macroeconomy

When the government curtails its spending or raises taxes, aggregate demand falls. If
we do not want the shrinking budget deficit to slow economic growth, we must therefore
compensate for it by providing monetary stimulus. Like contractionary fiscal policy, ex-
pansionary monetary policy lowers interest rates, depreciates the dollar, and should there-
fore help reduce the trade deficit. So the policy recommendation actually amounts to
tightening fiscal policy and loosening monetary policy.
As we have just noted, the U.S. government”after years of vacillation”changed the
policy mix decisively in this direction in the 1990s. But our trade deficit rose anyway be-
cause private investment spending soared while private saving stagnated. Then, starting
in 2001, the federal budget turned rapidly from a substantial surplus to a record-high
deficit, which pushed the trade deficit up further. What else might work?

More Rapid Economic Growth Abroad
One factor behind the growing U.S. trade deficit is that the economies of many foreign
nations”the customers for our exports”grew more slowly than the U.S. economy for
years. If foreign economies would grow faster, the U.S. government frequently argued,
they would buy more American goods, thereby raising U.S. exports and reducing our
trade deficit. So we have regularly urged our major trading partners to stimulate their
economies and to open their markets more to American goods”but with only modest
success. When the U.S. economy slowed down in 2000“2001, our trade deficit did recede a
bit”albeit temporarily. And the same thing happened again in 2007“2008. But no one
thought slower U.S. growth was a very good remedy.

Raise Domestic Saving or Reduce Domestic Investment
Our fundamental equation calls attention to two other routes to a smaller trade deficit:
more saving or less investment.
The U.S. personal saving rate (saving as a share of disposable income) has hit postwar
lows in recent years. The approximately 1„2 percent saving rates recorded in both 2005 and
2006 were the lowest since the Great Depression of the 1930s! If Americans would simply
save more, we would need to borrow less from abroad. This solution, too, would lead to a
cheaper dollar and a smaller trade deficit.
The trouble is that no one has yet found a reliable way to induce Americans to save more.
The government has implemented a variety of tax incentives for saving, and more are sug-
gested every year. But little evidence suggests that any of them has worked. Instead, large in-
creases in stock market wealth in the second half of the 1990s, and then in housing wealth in
the early 2000s, convinced Americans that it was prudent to save even less than they used to.
If the other cures for our trade deficit fail to work, the deficit may cure itself in a particu-
larly unpleasant way: by reducing U.S. domestic investment. The 2001 recession accom-
plished this to some extent, reducing the share of investment in real GDP from 17.7 percent
in 2000 to 15.1 percent in 2003. (It also curbed our appetite for imports.) And with fear of
recession rampant in 2008, those effects were expected again. But these side-effects of re-
cession are only temporary, and the longer-run problem mentioned above remains: If our
trade deficit persists, we will have to borrow more and more from foreigners who, at some
point, will start demanding higher interest rates. At best, higher interest rates will lead to
lower investment in the United States. At worst, interest rates will skyrocket, and we will
experience a severe recession.

We have saved the worst remedy for last. One seemingly obvious way to cure our trade
deficit is to limit imports by imposing stiff tariffs, quotas, and other protectionist devices.
We discussed protectionism, and the reasons why almost all economists oppose it, in
Chapter 17. Despite the economic arguments against it, protectionism has an undeniable
political allure. It seems, superficially, to “save American jobs,” and it conveniently shifts
the blame for our trade problems onto foreigners.

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Part 4
390 The United States in the World Economy

In addition to depriving us and other countries

SOURCE: © The New Yorker Collection 1992, Mort Gerberg
of the benefits of comparative advantage, protec-
tionism might not even succeed in reducing our

from Cartoonbank.com. All Rights Reserved.
trade deficit, however. One reason is that other
nations may retaliate. If we erect trade barriers to
reduce our imports, IM will fall. But if foreign
countries erect corresponding barriers to our ex-
ports, X will fall, too. On balance, our net exports,
X 2 IM, may or may not improve. But world trade
will surely suffer. This game may have no winners,
only losers.
Even if other nations do not retaliate, tariffs and
quotas may not improve the U.S. trade deficit
“But we™re not just talking about buying a car”we™re talking about
confronting this country™s trade deficit with Japan.” much. Why? If they succeed in reducing American


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