CHAPTER 9 — INTERNATIONAL TRADE

Big Ideas
 Trade raises consumption possibilities through comparative advantage.
 Relative prices, not absolute costs, determine trade patterns.
 Trade benefits the country overall but creates winners/losers within it.
Key Concepts
 Autarky price: Domestic relative price without trade.
 World price ratio determines whether a country exports or imports.
 Consumption possibility frontier (CPF) expands with trade.
Key Equation: Relative Price
 Relative price of good X in terms of good Y: PX/PY

 A country exports the good in which its opportunity cost is lower.

Graph Logic
 PPF shows production trade-offs.
 Under free trade, consumption occurs on the trade line, not the PPF.
Examples
 US–Mexico trade often used: each country specializes where its opportunity cost is
lower.

CHAPTER 16 — TAXES
Big Ideas
 Good tax systems are:
1. Simple & transparent
2. Broad tax base → low rate → low economic distortion
3. Sufficient to finance spending
Key Concepts
 Tax wedge = difference between price buyer pays and price seller receives.
 Deadweight loss (DWL) rises with the square of the tax rate.
 Exemptions shrink the base → raise rates → increase DWL.
Equations
 Social Cost of a Tax (Deadweight Loss):
1
DWL= (tax)(quantity reduction)
2
Examples
 Classic supply/demand triangle analysis.
 India Vodafone tax (complex system example).

CHAPTER 17 — GOVERNMENT DEBT & DEFICITS

Big Ideas
 Spending must be paid for now or later.
 Later payment = running future primary surpluses.
 Sustainability depends on growth, interest rates, and primary deficits.
Key Concepts
  Primary deficit:
Primary Deficit=G−T
 Government Budget Constraint (GBC):
Δ B=iB+(G−T )
Debt increases with interest + primary deficit.
Debt-to-GDP Dynamics (MOST IMPORTANT)
 Change in debt ratio:
Δ (b t )=(i−g)bt −1+ d t
Where:
o b t=Bt /GD Pt
o g=¿GDP growth rate
o i=¿ interest rate
o d t =¿primary deficit/GDP
Interpretation:
 If g > i, debt ratio falls automatically (growth helps).
 If i > g + deficits → debt explodes without consolidation.
Examples
 Greece, Argentina sovereign debt crises.
 US debt sustainability often discussed using this framework.

CHAPTER 18 — INTERNATIONAL CAPITAL FLOWS

Big Ideas
 Current account (CA) = lending (+) or borrowing (–) from rest of world.
 CA surplus → capital outflow
 CA deficit → capital inflow
 Large inflows can be risky if financing unproductive uses.
Key Equations
1. Current Account Identity
CA=NX+ Net Income+Transfers
2. Saving–Investment Identity
CA=S−I
3. Net Foreign Assets (NFA) Dynamics
NF At +1=NF A t +C At
4. GDP Identity
Y =C + I +G+ NX
Interpretation
 CA < 0 → borrowing from abroad → NFA declines.
 CA > 0 → lending to foreigners.
Examples
 US runs persistent CA deficits → accumulates foreign liabilities.
 Asian economies often run surpluses → accumulate reserves/NFA.

CHAPTER 19 — EXCHANGE-RATE FLUCTUATIONS

Big Ideas
  Short-run exchange rate movements are hard to predict.
 Two main theories: PPP and Interest Parity.
 Both work better in long run than short run.

1. Exchange Rate Definitions

 e : spot exchange rate = home currency per 1 unit foreign currency
 Depreciation → e ↑ (takes more home currency to buy foreign).
 Real exchange rate:
¿
P
RER=e
P

2. Purchasing Power Parity (PPP)

PPP Equation
P
e= ¿
P
PPP in Growth Rates
¿
Δ e=π −π
Interpretation:
Exchange rates move with inflation differentials.
Empirical Reality:
 Good long run, bad short run predictor.
Example:
 Venezuela: long-run depreciation ≈ inflation differential.

3. Interest Rate Parity (IRP)

Covered Interest Parity (CIP) — VERY TESTABLE
¿ f
1+i=(1+ i )
e
Uncovered Interest Parity (UIP)
¿ e t +1
1+i=(1+ i ) E( )
et
Empirical note: UIP often fails due to risk premia → carry trades exist.

CHAPTER 20 — EXCHANGE-RATE REGIMES ✔️FOUND & INCLUDED

Big Ideas
 Countries choose among fixed, floating, and managed systems.
 Trilemma: can't have all three simultaneously:
1. Fixed exchange rate
2. Capital mobility
3. Independent monetary policy
Key Concepts
 Convertibility: ability to freely exchange currency.
 Capital controls: limits on capital flow.
 Foreign exchange reserves: used to defend a peg.
1. Mechanics of a Fixed Exchange Rate
A central bank must buy/sell unlimited foreign currency at the pegged price.
Balance Sheet Logic
When the central bank buys foreign currency:
 FX reserves ↑
 Domestic monetary base ↑
Sterilization:
To neutralize money supply increase, the bank sells domestic bonds.

2. The Trilemma
You can choose only two:
Fixed Rate Capital Mobility Monetary Policy Autonomy
Examples:
 US: capital mobility + monetary policy → floating exchange rate
 China: fixed rate + monetary policy → capital controls
 Hong Kong: fixed + capital mobility → gives up monetary policy

3. Exchange-Rate Crises
Peg collapses when:
 Central bank runs out of foreign reserves
 Investors expect future devaluation (time inconsistency problem)
Classic Example: UK 1992 ERM Crisis
 UK needed low rates (recession)
 Germany needed high rates (inflation control)
 Speculators attacked the pound
 UK forced out of ERM → pound collapsed
 George Soros famously profited

4. Strong Fixes
 Currency boards (Argentina 1990s, Hong Kong since 1983)
 Common currency (Eurozone)

CHAPTER 21 — MACROECONOMIC CRISES

Big Ideas
Crises usually triggered by combinations of:
1. Sovereign debt problems
2. Financial fragility
3. Fixed exchange rates
Key Concepts
 Liquidity vs solvency
 Refinancing (rollover) risk
 Bank runs (Diamond–Dybvig logic)
 Contagion
  Conditionality (IMF programs)

1. Crisis Triggers
A. Sovereign Debt
 Investors fear default → stop lending → yields spike → crisis.
 Examples: Argentina 2001, Greece 2010.
B. Financial Fragility
 Highly leveraged banks → vulnerable to runs.
 Bad assets → insolvency risk.
C. Fixed Exchange Rates
 Peg collapses → sudden stops → recession.
 Often the spark for major crises.

2. Crisis Indicators (Checklist)

 Rapid credit growth
 Large CA deficits
 Large short-term foreign debt
 Overvalued real exchange rate
 Low reserves relative to liabilities
 Weak banking system
 High sovereign debt

3. Crisis Responses
 Lender of last resort support
 IMF conditionality (fiscal adjustments)
 Capital controls (Malaysia 1997 example)
 Devaluation or abandonment of peg
 Bank recapitalization

FINAL QUICK FORMULAS RECAP (WRITE THESE FROM MEMORY)

Trade
Opportunity cost → relative price → determine export good.
Taxes
1
DWL= t Δ Q
2
Government Debt
Δ b=(i−g)b +d
International Capital Flows
CA=S−I NF At +1=NF A t +C At
Exchange Rates
PPP:
¿
Δ e=π −π
CIP:
 ¿ f
1+i=(1+ i )
e
RER:
¿
P
RER=e
P
Exchange-Rate Regimes
Trilemma: Cannot have all three:
 Fixed exchange rate
 Capital mobility
 Independent monetary policy

I. INTERNATIONAL CAPITAL FLOWS & EXCHANGE RATES

(Quotes from GE Slides 8 Capital flows FX [Link] and GE Slides 9 FX regimes BOP
[Link])
A. Capital Flows Overview
 Globalization has led not only to rising world trade, but also to a rise in global capital
flows.
 Investment dollars are also being traded internationally.
 Financial inflows: investments by foreigners in the United States.
 Financial outflows: investments by Americans in foreign countries.
 They are opposite sides of the same coin.

Forms of Financial Investment Flows

 Foreign direct investment (investment in physical assets) = invest 10%+ of a company
 Portfolio investment.
 Deposits and loans.

Drivers of Rising Financial Flows

 Removal of capital controls and deregulation of the financial sector.
 Large institutional investors… Seeking to diversify their portfolios.
 Technology has made investors more comfortable sending their money overseas.
 Financial innovation — new ways for investors to diversify and hedge their risks in
foreign markets.
Examples of Exchange Rates
 Floating – USD/Euro: Exch rate fluctuates with market forces
 Fixed – Hong Kong: Exch rate is set by gov and never changes
 Managed – China: Gov buys/sells curr to red volatility or make it cheap

II. NOMINAL EXCHANGE RATES

 If the price of a U.S. dollar is ¥120, then the nominal exchange rate is ¥120 per U.S.
dollar.

 Nominal exchange rate = Number of units of foreign curr / Number of dollars.

  Number of yen = Number of dollars × Nominal exchange rate.

 Don’t get the exchange rates backward. Both are correct. Just different perspectives.

 Arbitrate: Buy curr at low pr and sell at high pr for prof

Appreciation & Depreciation

 Depreciation: when the price of a currency falls.
 Appreciation: when the price of a currency rises.
 Stronger dollar… Higher exchange rate… Imports are cheaper.
 Weaker dollar… Lower exchange rate… Exports are cheaper for foreign buyers.

III. FOREIGN EXCHANGE MARKET BASICS

Demand for Dollars
 Demand for U.S. dollars comes from: 1. Trade flows… 2. Financial inflows.

 Downward-sloping demand: Lower price of U.S. dollars leads to a larger quantity of

dollars demanded.

Supply of Dollars
 Supply for U.S. dollars comes from: 1. Trade flows… 2. Financial outflows.

 Upward-sloping supply: Higher price of U.S. dollars leads to a larger quantity of dollars
supplied.
 Higher pr of dollar (appreciation): other curr depreciate, stronger USD, higher exch rate,
cheaper imports, expensive exports

Equilibrium
 The equilibrium exchange rate — Where demand crosses supply.
 Dutch Disease: One country is so good at exporting one thing that it brings in so much
money to your country, that then it makes the value of their currency too strong.

IV. SHIFTERS OF DEMAND & SUPPLY FOR USD

Demand Shifters
 An increase in exports or financial inflows… causes an increase in demand for dollars…
The price of the U.S. dollar rises. Shift supp to right.

 Inc in exports:
o ↑ world GDP
o ↓ barriers to foreign markets
 o ↑ domestic innovation and marketing
o ↑ foreign prices
o ↓ domestic prices

Financial Inflow Shifters

 ↑ U.S. interest rates relative to foreign interest rates.
 ↑ U.S. business profitability relative to foreign businesses.
 ↑ Foreign political risk relative to U.S. political risk.
 ↑ Expected future value of the dollar.

Supply Shifters
 An increase in imports or financial outflows… causes an increase in supply of U.S.
dollars… The price of the U.S. dollar falls.

 Examples (quoted):
o ↑ U.S. GDP
o ↓ barriers protecting domestic producers
o ↑ foreign innovation and marketing
o ↑ domestic prices
o ↓ foreign prices

Financial Outflow Shifters

 ↓ U.S. interest rates relative to foreign interest rates.
 ↓ U.S. business profitability relative to foreign businesses.
 ↓ Foreign political risk relative to U.S. political risk.
 ↓ Expected future value of the dollar.

V. PURCHASING POWER PARITY & REAL EXCHANGE RATE

Law of One Price
 PUS = SUSD/EURO PGER.

Real Exchange Rate

 Real exchange rate = Domestic price in dollars / Foreign price converted into dollars.

 Stagflationary

 Deflationary
Example
 Domestic price of American apples: US$20 per bushel… Foreign price of apples: ¥3,000…
Nominal exchange rate: ¥120 per dollar.
 Real exchange rate = 20 / (3000/120) = 4/5.
 Interpretation: the price of U.S. apples is four-fifths that of Japanese apples.

PPP
 PUS = SUSD/EURO PGER.
 US inflation = rate of USD depreciation + German inflation.
 Does PPP hold? Not in the short-run… Better in longer intervals.
 Takes about 5 years to close the gap halfway.
 Absolute PPP to Relative PPP = gUS , pr =gSUSD , EUR + gGER , pr = US infl. = US depreciation +
German infl.

VI. FX REGIMES & THE TRILEMMA

FX Regimes
 They range from degrees of ‘Fixed’ to ‘Floating’.
 To fix an FX, a central bank needs to use its reserves (accumulate or decumulate).
 Tradeoffs: FX volatility; Control inflation; Facilitate trade; Outsource credibility.

The Trilemma
 It is not possible to have all three of the following: Free capital mobility… A fixed
exchange rate… Independent monetary policy.
 Two out of three ain’t bad.
 Examples (quoted):
o You can have free capital mobility and a fixed exchange but then your interest
rates must equal those of the area you have fixed exchange rates against.
o You can have free capital mobility and set your own monetary policy but then
your exchange rate cannot simply be fixed.
o You can set your own monetary policy and fix your exchange rate… but then you
must intervene in capital markets.

VII. BALANCE OF PAYMENTS

Definitions
 The balance of payments summarizes a country’s transactions with the rest of the world.
 Current account: how much income crosses national borders each year.
 Financial account: tracks the financial flows across borders.
 Current Account = Financial Account (mirrored opposites)

Current Account
 Current account balance: measures the difference between the income that Americans
receive from abroad, and the income that Americans pay to people abroad.
 In 2021, Americans ran a current account deficit of $0.8 trillion.
 Exports + investment income received + other inflows – imports – investment income
paid – other outflows = current account balance

Financial Account
 Financial account balance: the difference between financial inflows and financial
outflows.
 In 2021, foreigners bought $0.8 trillion more American assets than Americans bought
foreign assets.
 Financial account balance = inflows (foreign direct investment + portfolio investment +
deposits/loans) - outflows (foreign direct investment + portfolio investment +
deposits/loans)

Identity
 Inflow of dollars must equal outflows of dollars.
 Income paid abroad – Income from abroad = Financial inflows – Financial outflows
(Current account deficit).

Savings & Investment

 Current account deficit = I − S.
 This says that the current account deficit arises because investment exceeds total
national savings.
 Financial inflows from abroad help fund investment.

VIII. INTERNATIONAL TRADE

Why Trade?
 Benefits of specialization. Increase in the production possibilities frontier. A bigger pie.
Non-zero sum.

Comparative Advantage
 Comparative advantage: The ability to do a task at a lower opportunity cost.
 Absolute advantage: The ability to do a task using fewer inputs.
Trade Example
 The US has comparative advantage in producing shirts. France has a comparative
advantage producing wines.
 Trade: Simply rearranging who does what allows you to produce more stuff with the
same inputs.
 Sources of comparative advantage: abundant inputs, specialized skills, mass production

Trade Costs
 Import if: Foreign price + trade costs < domestic price.
 Export if: Foreign price - trade costs > domestic price.
 Trade costs: Shipping costs… Taxes… Hassle of language barriers… different time zones…
foreign laws.

Effects of Imports
 Consumers gains, producer lose…
 Overall, economic surplus increases.
 The gain to consumers offset the loss to producers.

Globalization
 Globalization: The increasing economic, political, and cultural integration of different
countries.
 Lower trade barriers… Improved telecommunications… Containerization…

Trade Policy Tools

 Tariffs: reduce international trade, and raise revenue.
 Import quotas: a limit on the quantity of a good that can be imported.
 Exchange rate manipulation: a country can use this tool to increase its exports and
reduce its imports.

Inequality & Trade

  International trade likely explains some of the rising income inequality in the United
States.
 U.S. exports skill-intensive goods (lower trade costs)… increasing demand for highly
educated workers… raising the incomes of highly educated workers.
 U.S. imports low skill-intensive goods (lower trade costs)… decreasing the wages of
these low-skill workers and dec demand for these type of goods
 Bands" - has some flexibility
 • Argentina today has a band in place
 • Bands give central banks a range to keep their currency
 ○ Inside the bands, the currency floats. Outside the bands, it's fixed.

1. What Fiscal Policy Covers

The slides begin by stating:
We now turn to fiscal policy… • Government expenditure. • The financing of that expenditure
(taxes). • Deficits • Debt • How to conduct fiscal policy?

The U.S. context is introduced with:

The U.S. fiscal deficits are large.

and
Debt has been increasing, and the projections are dire.

The slides then pose key questions:

Is debt sustainable? How to think about fiscal with higher interest rates? What does it mean ‘to
fix it on our own’.

2. What Should Governments Do?

One slide is titled:
What should governments do?

The three functions listed are:

 Protect. • Against violence. Hobbes

 Provide. • Public goods. • Insurance against bad outcomes (unemployment, illness,

disability, outliving your savings). Rawls

 Invest. • In human capacity to allow citizens to succeed.

The slides explain public goods with a four-quadrant table, including examples:
Private goods – Food, books, homes, cars, clothing, parking spaces.
Club goods – Private toll roads, subscription broadcasts, internet, movie theaters.
Common goods – Ocean fishing, shared grazing land.
Public goods – Clean air, national defense.

A key quote summarizing federal spending:

‘The federal government is an insurance company with a military’.

and
Spending on social insurance programs plus spending on the military and veterans’ benefits
account for roughly three-quarters of federal spending.

3. Theory of Taxation
The slides begin the taxation section with a set of foundational quotes:
‘Taxes are the price we pay for a civilized society’ – Oliver Wendell Holmes Jr.

‘The hardest thing in the world to understand is the income tax’ – Albert Einstein.

Taxes. (title slide)

Distortionary Taxes
The deck explains:
Most taxes create distortions, because they change behavior.
Taxes create ‘wedges’ that break the link between producer costs and consumer willingness to
pay.
Distortions diminish market efficiency.
Exception: ‘lump-sum’ taxes.
To minimize distortions: • Tax a broad base at a low rate • Tax goods for which the
supply/demand is insensitive (inelastic) to price
Problem: fairness vs. efficiency.

Another slide emphasizes:

Taxes generate welfare losses.
The more inelastic the market, the smaller the loss.
Distortions grow faster than the tax rate.

Efficiency vs. Equity

Slides state:
Taxes have incentive effects. They can weaken incentives to innovate, work, save, and invest.
There is usually a trade-off between efficiency and equity. Hard to resolve.
Modern tax systems rely on consumption taxes, and progressive income taxes.
Principles of a Good Tax System
A summary slide lists:
Enough revenues for spending.
Keep distorsions low.
Try not to weaken incentives.
Broad tax base.
Administratively simple and transparent.

4. Government Budget Constraint, Debt, and Deficits

𝐺𝑡 + 𝑖𝑡−1𝐵𝑡−1 = 𝐵𝑡 − 𝐵𝑡−1 + 𝑇𝑡.

The theory section begins with the fundamental identity:

𝐵𝑡 = 1 + 𝑖𝑡−1 𝐵𝑡−1 − 𝑆𝑡.

Expenses Revenues.

𝑆𝑡 = 𝑇𝑡 − 𝐺𝑡 is the primary surplus.

Debt Dynamics Equation

As income ratios: 𝑏𝑡 ≈ [1 + 𝑖𝑡−1 − (𝑔𝑡+𝑝𝑡)]𝑏𝑡−1 − 𝑠𝑡.

The slides give:

Debt dynamics depend on the nominal interest rate (𝑖𝑡−1), the nominal growth rate (𝑔𝑡+𝑝𝑡)
and the primary surplus (𝑠𝑡).

𝑠 ≈ (𝑖 − 𝑔 − 𝑝) 𝑏.
In steady state:

The bigger stock of debt, the bigger the surplus you need.
The coefficient [i – (g + p)] can be viewed as a risk premium on the debt.

Long-Run Constraint
A key conclusion slide states:
In the end, all spending must be financed with taxes (present or future).
Present Value G = Present Value of T.

5. Is U.S. Fiscal Policy Sustainable?

Slides describing the outlook include:
Under projected paths for G and T, it is not obvious.

Also:
Government debt is currently high, relative to US history.

Government debt is expected to grow rapidly over coming decades.

The fiscal pressure is driven by:
Much of the federal budget (and much of its rise) reflects promises the government has made
about future payments.
Social Security and Medicare are projected to grow rapidly.
Unfunded liability: a commitment to incur expenses in the future without a plan to pay for
them.

Reasons Not to Worry

The slides list:
1. Most of our government debt is money owed by Americans to Americans.
2. Future generations can help repay the debt.
3. It wouldn’t take a big adjustment to repay the debt.
4. The government never really needs to repay the debt.
5. The government has options that you don’t. • Raise taxes • Print money (but beware of
inflation, or worse, hyperinflation).

Reasons to Worry
Another slide states:
1. Slower economic growth.
2. Future fiscal choices are constrained.
3. The risk of a crisis of confidence.
4. A debt crisis becomes more likely.
Higher government debt can lead to a debt crisis in which the government simply can’t repay its
loans.

6. International Fiscal Sustainability

The slide set includes global comparisons:
Japan, the US and Euro countries have big levels of debt.

and:
Sustainability will depend on what happens to interest rates.

7. Macroeconomic Stabilization and the Fiscal–Monetary Mix

A central concept is the domestic policy trilemma, described as:
Price stability (Independent central bank), No Default, Unsustainable fiscal path.
Governments can only pick two out of three.

How to Finance Expenditures

Slides say:
Tax smoothing: try to keep taxation stable to minimize distortions.
Finance permanent spending with taxes.
Finance transitory spending with debt.
Use fiscal policy countercyclically.

8. Automatic Stabilizers
A major applied concept:
Automatic stabilizers are timely, targeted, and temporary.

The slide elaborates:

Automatic stabilizers are timely: Automatically triggered whenever people’s incomes decline.
Automatic stabilizers are targeted: Taxes decline only for those whose income has fallen.
Automatic stabilizers are temporary: They automatically reverse course as the economy reverses
course.
Even economists who are wary of discretionary fiscal policy are often in favor of creating more
automatic stabilizers.
The three Ts of fiscal policy: timely, targeted, temporary.

9. Fiscal vs. Monetary Policy

The final comparison explains:
Monetary policy is more nimble: The Fed’s decision to lower interest rates can be implemented
by the end of an afternoon!
changes in interest rates can take a year or more to stimulate or dampen spending.
Fiscal policy can be more targeted.
Fiscal policy is particularly important at the zero lower bound.
If the Fed can’t cut short-term nominal rates any further, fiscal policy is the only tool remaining!

10. Final Takeaways Slide (Direct Quotes)

The closing slide lists key points exactly as written:
Provide public goods, insurance.
Low tax rates, broad tax base make tax policy efficient.
Deficits must be financed by issuing debt today and running surpluses in the future.
Debt sustainability depends on i, g, p, and the primary surplus.
High debt creates a knife-edge risk: loss of confidence can raise the debt risk premium [i − (g +
p)].
Limits on monetary policy restore role for fiscal policy as cyclical stabilization tool.
Efficiency vs equity:
 Taxes almost cannot be both efficient and equitable

What's an efficient tax?

 One that doesn't distort behavior too much
 Ex (Inefficient): If you disincentivize work at a certain level, then you're changing the
behavior of ppl who didn't want to work hard
 If demand is elastic, then the tax is probably going to be inefficient
o Ex (Inefficient): If you tax apples and not oranges, that would lead to a distortion
effect
o Ex: Tax red cars higher than blue = substitute, but if you tax all cars higher, there's
less elasticity and less substitutes to move to (could move to public transit or
trucks and motorcycles but not as many options)
 Sales tax = efficient (not change behavior) but not equitable (since it might hit people
with less money more than ppl with more money)
 Bonus tax = same for everyone (efficient but not equitable)
 Poll tax/lump sum tax = every house in the town pays the same toward public benefits
(i.e. $200) - which is efficient but not equitable
 Taxes generate welfare losses – the more inelastic the market, the smaller the loss
o Reasons behind sin taxes -> fairly inelastic


 If you eliminate all government debt, then government expenditure would equal taxes
 Completely balanced budgets (G = T) in every period
 Not a better economy because it creates a lot of volatility in gov expenditure and
removes any flexibility
 Recession => gov revenues dec (employment dec, company profits dec, etc.) => you're
forced to dec gov spending => make the recession almost worse
 If you eliminate all government debt, then government expenditure would equal taxes
 Completely balanced budgets (G = T) in every period
 Not a better economy because it creates a lot of volatility in gov expenditure and
removes any flexibility
 Recession => gov revenues dec (employment dec, company profits dec, etc.) => you're
forced to dec gov spending => make the recession almost worse
 S = (I – (G+P))B
o S = primary balance (as % of GDP)
o I = nominal interest rate
o G = real GDP growth rate
o P = inflation rate
o B = Stock of debt (as % of GDP)
o US Example:
o • Debt ratio today = 100%
o • i = 3.75% (round to 4%)
o • g = 2%
o • p = 2%