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USC ECON 205 - Open Economies, the IMF, and the World Bank

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ECON 205 2nd Edition Lecture 14 Outline of Last Lecture I. Writing Papers (instructions and how-to)II. A Central Bank’s RoleIII. The Federal Reserve Continueda. How the Federal Reserve Manipulates the Marketsb. Interest Rates and Federal Reserve Controlc. In-depth treatment of Fed’s GoalsIV. Income Convergence of Malaysia and the United StatesOutline of Current LectureI. Open vs. Closed EconomicsII. The Balance of Trade and Accounting III. Determination of Exchange RatesIV. The IMF and the World Bank V. Marginal Propensity to ImportCurrent LectureI. Open vs. Closed EconomicsWhen 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 closedeconomies.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 AccountingThe 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, servicesbetween 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 ratesWe 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 tobring it back to the target rate. The IMF manages the currency rates.IV. The IMF and the World BankAfter 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, toendangered 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 tomember 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 WorldBank 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 ImportIf 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


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