ECON 205 2nd Edition Lecture 14 Outline of Last Lecture I Writing Papers instructions and how to II A Central Bank s Role III The Federal Reserve Continued a How the Federal Reserve Manipulates the Markets b Interest Rates and Federal Reserve Control c In depth treatment of Fed s Goals IV Income Convergence of Malaysia and the United States Outline of Current Lecture I Open vs Closed Economics II The Balance of Trade and Accounting III Determination of Exchange Rates IV The IMF and the World Bank V Marginal Propensity to Import Current Lecture I Open vs Closed Economics When we talk about the macroeconomic model we can classify countries into two categories open economics and closed economics Closed economies mean economies without any international trade or investment In a closed economy GDP is equal to consumption investments and government expenditures only However in the real world there are no closed economies When the Soviet Union disintegrated all the Eastern nations fell behind the Western nations They had lower GDP per capita overall Open economies have GDPs equal to consumption investment government expenditures and net exports exports minus imports In traditional accounting of open economies the GDP would actually go down if there is a trade deficit imports are greater than exports However the reason that the United States has a trade deficit is because we have a higher growth rate than much of the world as we do not save as much II The Balance of Trade and Accounting The balance of trade simply looks at exports and imports When exports are greater than imports we have a favorable trade balance and vice versa This balance of trade is part of the balance of payment account which includes current account merchandise trade services between nations the investment account investments both domestic and abroad and the government which can send money abroad as aid or borrow money A second form of account is the financial account which is largely buying bonds stocks and other financial instruments between countries It balances out with the current account The financial account will balance out any discrepancies in the current account III Determination of exchange rates We determine the various values of currencies through three methods 1 The Gold Method Standard Using the gold standard each country had so much gold and would define their currency based on their gold holdings To make equilibrium gold would transfer from one country s vaults to another in the Federal Reserve Bank in New York City Most countries would back their currency to the US dollar the Bretton Woods System However in 1972 President Nixon unilaterally withdrew the United States from the gold standard the Nixon Shock After World War II over 60 of the world s gold was owned by the United States but due to the gold standard much of the gold reserves were leaving 2 Floating exchange rate the market exchange rate it is when the currency is determined by market prices Currency rates are therefore determined by supply and demand on the foreign currency market rather than any fixed value Trillions of dollars of exchange occurs as people gamble whether the currency value will increase or decrease The floating system is very volatile 3 The Hybrid System It is a managed market system in which countries try to target the exchange rate If it deviates from the central bank s expectations they manipulate the market to bring it back to the target rate The IMF manages the currency rates IV The IMF and the World Bank After World War II two organizations were created to manage the world economy the IMF International Monetary fund and the World Bank Every country participating on the global market is part of the IMF and it is owned by the member nations Likewise the World Bank located in the same building as the IMF in Washington D C is in charge of helping low and middle income economies grow and provides loans to help create infrastructure and other necessities The IMF stabilizes a country s currency by going to the market and buying inflated currencies lowering the exchange rate When the currency rate stabilizes it then sells it slowly Likewise if there is a shortage of currency the IMF pumps money into the economy The World Bank however operates by sending a mission consisting of ten to twenty people to endangered nations to look over the entire country s economy By doing so they determine what issues the economy faces and how to fix the problems i e lowering taxes creating infrastructure etc The difference between the IMF and the World Bank is that the IMF provides short term relief to member nations and is concerned more often with currency stability and international trade while the World Bank is concerned with the rate of economic growth of member nations Therefore the World Bank s loans are for long term purposes Finally in the General Assembly of the United Nations every country has one vote in the World Bank and the IMF however is proportional to their amount of investment in the institutions the United States has the largest in both V Marginal Propensity to Import If you recall the multiplier is equal to one over the marginal propensity to save If you add international trade the multiplier becomes equal to 1 MPS MPI That means the value of the multiplier becomes smaller Marginal propensity to import MPI is the amount of imports added per dollar of income added