Business cycles theories predict short run expansions and recessions experienced in an economy.  Caused by imbalances in S & D. 

• Aggregate demand (total demand in the economy) determined by changes in C, I, G, X spending.
  • D > S, economy expanding
  • D < S, recession

Economic growth theories are used to predict functional relationships in the economic model (goods, money, credit, B of P).  Market quantities and prices will adjust until balance is reached (demand = supply: potential production)

• Potential production is determined by what can be produced with the given KLT at full employment (unemployment no higher then natural rate of 4.2 %)

They both help to compare the economy to where it should be.  Aggregate demand helps to predict the direction prices and employment are going.  Potential production helps us to study long term economic growth.

• If AD is high, potential production should be high.
• AD high, firms invest in KLT, which moves toward potential production.

Prices are sticky, firms respond to changes in demand by adjusting production first.  Unwillingness to risk relationships for a temporary gain.

• Expectations for inflation change slowly, so prices must adjust slowly.
• Implicit contracts are voluntary and self-enforcing long term agreements made between two parties (customers, suppliers, and employees) regarding the future exchange of goods or services.  It is risky for business to change prices too dramatically
• Staggered price settings have to do with people wanting prices to remain relatively constant, making them sticky.  It is inefficient to always change prices in reaction to cost of resources.

The multiplier recognizes that a change in behavior sets off a series of circumstances and continues to do so with additional changes in behavior

C  = 0.63Y
I = 0.15y
G = 0 (depends on budget appropriations)
X = 0 (depends on foreign income and capacity)
N = 0.16y (diversion of demand to foreign goods)
Final change in income = d Y
dY = Autonomous & induced change
dA + {dC + dI + dG + dX – dN} = d Y

dA + {0.63 dY + 0.15dY – 0.16dY} = dY

d A = 0.38 d Y à dA [2.63] = dY

For the marginal propensities assumed: long-run multiplier is 2.63

Short run multiplier is 2.08

There are many factors that can’t be controlled.  Autonomous spending may increase money demand and monetary policy rarely accommodates the increased level of demand.  For example, the gov cuts taxes, PDI increases, and spending increases.  In order for there to be an exact correspondence, money supply must be expanded to match the increased demand, and this rarely happens.

Inflation is a rise in the general price of goods and services over a period of time.  It is a erosion of the value of a currency as a medium of exchange.  It can be caused by many things.

·      Demand > supply

·      Actual GDP > potential GDP

·      Money supply growing faster then the rate of economic growth

·      Excessive growth of money supply can cause hyperinflation (now)

Tight monetary policy and tight fiscal policy.

Fed decreasing money base, which decreases money supply and raises interest rates and economic activity may slow.

Cut government spending to reduce AD and get back to potential GDP.

Raise taxes, reduce PDI, reduce spending

If actual > potential, D > S, excess demand, prices increase and inflation occurs

If actual < potential, S > D, excess capacity, spending, production, wages, and prices decrease causing inflation todecrease/stabalize

Banks need deposits to be able to lend out to potential borrowers.  Savers need reward for depositing their money in the bank.  The interest rate earned on the deposit must exceed the inflation rate to even be profitable. 

·      Real interest = nominal – inflation

High interest rates discourage investing because the cost of borrowing is too high.

High interest rates attract foreign currency, driving up the price of the dollar, making exports expensive and imports cheap.

A price shock is a sudden increase in a key commodity (i.e. oil)

·      This raises the price of many other goods (transportation, food)

·      Inflation and interest rates increase

·      Real v. potential GDP gap occurs

·      Stagflation: rising prices, falling GDP

·      Firms have to lay off workers

US = Floating exchange rate

• Money supply influenced by the fed by altering money base
• Money multiplier determined by banking system

Namibia = fixed exchange rate

• Namibian dollar is pegged to the south African Rand 1:1
• Central bank does not control money supply
• Demand determines money supply
• As demand increases, government either has provide supply or people borrow and spend Rand

12 regional reserve banks, each with a president

7 FRB members, 14 year terms, providentially appointed, senate confirmed

FOMC sets monetary policy: 12 voting members, 7 FRB members and 12 presidents (only 5 vote)

• Meets every 6 weeks to determine short term objectives
• Daily conference calls with FOMC, manager at NY reserve bank trade desk, and a group of primary banks and bonds dealers
  • Either buy or sell
  • This is how money circulation is controlled

President proposes budget deficit is made to congress in February and is based on needs requested by all agencies to the office of manpower and budget

Actual budget deficit is passed by congress on October 1 (start of fiscal year), which includes budget resolution and appropriation bills that reflect the spending priorities of congress and authorize and appropriate funds to federal agencies, including emergency appropriations such as for Katrina and the wars in the middle east.  The president has substantial influence through his veto power and congressional party allies when his party has majority in congress.

Structural budget deficits are based on full employment (potential GDP). Affected by levels of government spending.  It is the maximum difference of proposed and actual deficit.

• Actual < potential GDP, actual deficit higher

•  
  • Revenues lower, expenditures higher

Automatic stabilizers are types of government spending and taxes that automatically increase and decrease along with fluctuations in business cycles to cushion recessions and expansions. 

• They change without action by the government to reduce negative effects on national income. 
• Examples are progressive tax rates and income transfers (entitlements)
  • When in a recession, people loose jobs, unemployment insurance spending increases to cushion the loss of income.  When the economy recovers, this spending will decrease as employment increases.
  • Progressive Taxes--taxes proportional to income level to not decrease personal disposable income too far
  • When economy expanding, income increases, and tax revenue progressively increases automatically as people move into higher tax brackets.

A change in government purchases, taxes, or transfer payments will have a direct effect on aggregate demand, and will affect the real GDP, employment, and price level.

• Increase in gov. purchases, increase in demand for domestic products, increase in AD

• Government cuts taxes, people will have more disposable income, and therefore private spending increases, increasing aggregate demand.
• An increase in transfer payments (entitlements) will increase AD.  It is a redistribution of wealth to the poor/needy.

The government (president, congress, treasury) uses fiscal policy to influence desired mix of spending (Gov vs. private, foreign vs. domestic).  This is done through changing government spending and taxes.  Fiscal policy determines who they tax and at what rate, how they spend the money, and how they borrow money (structure of the debt matters; can reduce deficit by shortening maturity dates to get lower interest rates, as Clinton did).

The fed primarily uses monetary policy to influence total spending to get a level that stabilizes production and employment to reach potential GDP. They do this by changing money base, which influences spending, interest rates and the value of the dollar, therefore influencing supply and demand.

As fiscal policy is altered to influence the mix of spending, monetary policy can be adjusted to accommodate the goals of sustainable balance of payments at potential GDP.  The goals of monetary and fiscal policy are essentially the same: price stability, full

Social Science, studies how consumers, business managers, and government officials choose to allocate scarce resources among alternative uses to attain their goals. In economics, one analyzes what happens in markets and why, and how resources are used to turn a profit.

In an economic system, resources need to be organized by the following 5 functions:

1.     Fixing standards

·      Maximizing efficiency by minimizing inputs and maximizing outputs.  Moving resources from where they are abundant to where they are scarce. 

·      Resources consist of land, labor, and capital.

2.     Organizing production

·      The market primarily does this through signals. 

·      Determines what will be produced and how it will be produced.

·      Determine what technology will be used

3.     Distribution

·      Who gets the goods and services?  How do we get goods to the most deserving?

·      Determined primarily by income distribution.  Whoever has the most purchasing power has the most ability to consume.

·      Individuals can choose how to live, within their means, based on their desires.

4.     Maintaining and improving social structure

·      Social structure consists of population, capital, technology, and resources.

·      Optimize these categories to be most efficient and must improve.

·      If not, economy will decline

5.     Adjusting consumption to production

·      Prices determine what is going to be produced how it is going to be produced.

·      Prices signal how much should be produced and ration

   Utilization of natural aptitudes

·      Making the most out of one’s abilities

2.     Development and utilization of knowledge

·       

3.     Task specialization

·      Maximize efficiency by doing one thing well

4.     Natural advantage with respect to natural resources

·      Used more economically

5.     Artificial specialization of material agents

·      Using special machines to perform a task

6.     Minor technical gains

·      Communication improvements

1.     Technical costs – assembly and distribution

·      Costs of special machinery,

2.     Interdependence – cooperation, coordination

·      Reliance on each other, and have to coordinate with others, whih costs money.

These are the 3 things that allow markets to work. 

·      Property rights that can be established, enforced, and transferred serve as the basis for a medium of exchange between parties by providing incentives and security.  The right to own or use marketable resources and to transfer those rights to another party is the basis of fair exchange in markets.  They provide value with which parties can motivate one another to make an exchange.  This is how resource allocation occurs.

·      Prices signal to consumers what will need to be sacrificed to obtain a good or service and to producers the potential profit that can be made by producing a good. Have to be free to adjust in order to ration scarce resources.  Rising prices signal scarcity and opportunity for profit. Relative prices matter; we compare sacrifices to satisfaction.

·      Transaction costs are the value of resources used in the process of exchange.  They influence whether a transaction will be worthwhile.  They could include taxes, shipping costs, fees, etc.  They influence whether a market will develop and whether it will be efficient.  High transaction costs will cause suppressed economic activity.  An example is how Cali is loosing jobs.

They are simplified representations of real life cause and effect relationships that are used to analyze economic situations.  Permit a person to state assumptions and test their theory within the data of the model.

To develop a model, one must go through the scientific analysis process to develop a hypothesis that can be tested within the model to check for validity.

• They state assumptions and then test with data to validate theory
• If it cannot be tested it is not a theory
• One must interpret the information correctly, similar to all scientific models
• The evidence must be viewed an interpreted in an accurate and concise manner.
• Objectivity is important; one shouldn't strive to prove their theory to be correct.

1.     Price

• Primary determinant
• Law of demand sates that as prices fall, quantity demanded will increase

2.     Income & wealth

• The amount of money that people are willing and able to pay

3.     Tastes

• Individual preferences for goods.  Can be heavily influenced by advertising and trends.

4.     Price of substitutes

• Demand for a good increases if price of a related good increases.

5.     Demographics (size of market)

• The larger the demographic, the more consumers there are.  Refers to characteristics with respect to age, race, and gender.

6.     Expectations

• Peoples expectations of future prices. 

1.     Revenue

• The selling price of the good.  How much profit can be made by producing the good.

2.     Costs

• Cost of labor (production) and materials (resources) (inputs) and the technology available to produce them (output per input)
• Opportunity costs
• Price of other products which use the same input

3.     Number of sellers

• Competition
• The more sellers, the more of a good will be produced, driving the price down.

Price elasticity of demand compares the % change in quantity demanded to the percent change in price as we move along the demand curve

PED = % change in quantity demanded / % change in price

The larger the price elasticity of demand, the more responsive the quantity demanded is to the price

PED < 1, inelastic

PED = 1, unit-elastic

PED > 1, elastic

PED = inf., perfectly elastic

PED = 0, perfectly inelastic

Income elasticity of demand is a measure of how much the demand for a good is affected by changes in consumer incomes.

IED = % change in quantity demanded / % change in income

IED positive; normal good

IED negative; inferior good

IED > 1, necessity; IED < 1, luxury

GNP, NNP, NI, PI, DPI.  They are computed in addition to GDP to track total production and total income in the economy.

• Attempt to fill gaps and adjust differences between tax data and financial accounting data
• Can provide a measure of wellbeing through per capita income and its growth over time
• They measure:
  • Output – the total value of the output of goods and services produced
  • Spending – total amount of expenditure taking place in the economy
  • Income – total income generated through production of goods & services

GDP: market value of all final goods and services produced in a country during a period of time.

·      Prices matter:

GNP: value of all final goods and services produced by residents of US, even if done so outside of the US.  Does not include US production by foreign firms.

NNP: GNP – depreciation

·      Have to take out depreciation of worn out machinery, equipment, and buildings

NI: NNP – value of sales tax.

·      Have to subtract the value of indirect business taxes

PDI: personal income – personal tax payments.

·      Best measure of income households actually have available to spend

Consumer Price Index - Inflation indicator that measures changes in the price level of consumer goods and services purchased by households.

• Each category is weighted by order of importance and assigned a % expenditures
• Calculated by measuring price changes weighted by importance to get average
• Fixed weight, fixed base;

CPI = expenditures in current year        x 100%

Expenditures in base year

GDP deflator = nominal GDP/real GDP  x 100%

Where real GDP is GDP adjusted for inflation: individual prices are compared, quality adjustments are made, and weights are assigned.

NIA’s utility is limited by omission of data of home production, underground activity, and illegal production.

• There is more activity going on that is not being measured
• can account for a huge portion of GDP

People who are willing and able to work, both employed and unemployed but actively seeking work.

• Each individual over 16 is either employed, unemployed, or not in labor force
• Working = employed, looking for work = unemployed, eligible but not looking = not part of labor force.
• Reasons for a non-child to not be in labor force are retired, student, or institutionalized.

Frictional – temporary time period between jobs when a worker with marketable skills is searching for or transitioning form one job to another.

·      Market friction = inefficiencies in labor market

·      Risky for employer to take first person, risky for employee to take first job

·      Expensive to find and train new employees

·      New entrants (graduating students) and reentrants (former house makers) may suffer from this

Structural – unemployment due to obsolete or deficient skills or mismatched location.

·      Usually much more long term than frictional because workers need time to learn new skills, gain additional education, or relocate.

·      Unemployed can become discouraged, causing their skills to become rusty.

The quantity of goods and services that can be produced by one worker or one hour of work.  Total output divided by time spent or number employed.  Measures the amount of real GDP produced by an hour of labor.

Labor productivity    =       real GDP

                                          Hours work

4 determinants:

1.     Technological progress

2.     Quantity of capital goods available to workers

3.     Quality of labors

4.     Efficiency with which inputs are allocated, combined, and managed

Even when economy is fully employed, the natural rate of unemployment is a positive %, typically 4.5%.

·      Job rationing makes jobs scarce; more people applying than there are jobs available

o      Insiders vs. outsiders – limits potential good prospects, insiders not always best

§       Unions, legislation, etc. keep insider wages high when outsiders will work for less, causing unemployment

o      Efficiency wage – pay higher wages than the competition to retain skilled workers who want to keep their job. Causes employer to hire less workers, causing unemployment.

§       In and out - ranks first among fast food chains in food quality, value and customer service.

o      Minimum wage – raises equilibrium wage for low paid, unskilled workers.

§       Mainly effects teenagers and elderly

§       Causes unemployment but also helps others to make more money

·      Job Search – contributes to unemployment from frictional and structural unemployment.

o      Unemployment benefits help to provide a long search period

o      Mobility is a good thing, people moving to better jobs

If it is 0 then no one is being fired and will become lazy, which decreases productivity.  It also means that no one is seeking out better jobs.  It gives the employee too much control.

·      High unemployment puts employers in control, low puts employees in control.

o      We want a balance between 2-4.5%

Job loss/total x 100% = fraction

Total – 4,236,000

Job loss – 1,080,000 / 4,236,000 = 25%

Job quits – 825,000 / 4,236,000 = 20%

New entrants – 2,331,000 / 4,236,000 = 55%

When GDP ^, PDI ^, C^

·      Overall standard of living increases, PDI increases and each household has more money to spend, so consumption increases

·      Consumption generally 90% of PDI

1.     Residential real estate

2.     Commercial and industrial real estate

3.     Fixed plant and equipment, and inventories

Aggregated demand – total demand for final goods and services at a given time and price level.  As demand goes up, investment goes up.

·      Represented by the aggregate demand curve, which describes the relationship between price levels and the quantity of real GDP demanded by households, firms, and Govt.

·      Downward sloping because a fall in price level increases the quantity of real GDP demanded

·      A decline in investment spending at each price level will shift the aggregate demand curve to the left, an increase will shift it to the right

CU refers to the extent to which an enterprise or a nation uses its installed productive capacity.

·      Refers to the relationship between actual output and potential output

·      If high have to renew equipment due to depreciation (more investment)

·      If high, demand is high, investment is high.

Depreciation: net investment = gross investment – depreciation

·      Depreciation is the consumption of fixed capital

·      If GI>D: NI is positive and nations stock of capital rises by amount of net investment

·      If GI = D: NI is zero and there is no change in capital stock

·      If GI<D: disinvesting happens, use up more capital than producing, nations stock of capital shrinks

real interest rate = nominal interest rate – inflation premium.  It corrects the nominal interest rate for the effect of inflation on purchasing power.

·      It shows the true cost from borrowing, and return on lending better than nominal rate.

·      An increase in real interest rates will lower investment and reduce aggregate demand because cost of borrowing is high

·      Change in real interest rate is related to a change in money supply.  Increase in money lowers interest rate and increases investment and aggregate demand.

High rates attract foreign capital and raise the value of the dollar but make exports seem expensive and imports seem cheap and import more than export

·      China devaluing their currency to prop up export market

Economic growth is the process by which the standard of living of a country increases.  The best yardstick by which to gauge this improvement is real per capita output, which measures what the average person can produce in a given amount of time. Depends on K & T.

Direct causes:

Improvements in:

• Human capital – knowledge and skills attained from education, work experience and training, and life experience.
• Physical capital – factories, machinery, and other non human resources used to produce goods and services
• Labor productivity – quantity of goods and services that can be produced by one worker or one hour of work.
• Technological advancements – improvement through application of knowledge, and better organization to increase output using a given quantity of inputs.

Pre-conditions:

• Patents, property rights, protection of wealth, and limited and fair taxes – protect the physical and intellectual property of people, and provides security of keeping what one has rightfully earned.  This provides an incentive to invest, invent, and prosper from one’s work, and protects it from the theft of another. 
• Rule of law – the fair and equal enforcement of the laws of the land provide stability and security, giving individuals the confidence to engage in commerce.

Significant economic growth that truly raised the real per capita GDP of people began with the industrial revolution in England.  Before that, people survived on the bare minimum, living very hard and short lives.

• Began with the production of cotton cloth powered by steam machines
• Mechanical power greatly increased labor productivity and spread to many other applications and countries
• Septic systems and modernized medicine.
• From that point, increased capital per worker and productivity, longer life expectancy, and huge improvements in technology have greatly improved the standards of living in many parts of the world.
• Scientific Revolution
• New way of thinking = innovations thru experiments & testing

Technology is improved through applying gained knowledge and organization to improve existing processes and to invent and innovate new processes, tools, and equipment.

·      R&D is expensive and uncertain.  There are two sources:

o      1. Invention factories such as intel, and Edison/bell labs.

o      2. Lone scientists/inventors and clubs, such as jobs, wozniak, gates etc.

• Intellectual property rights, such as copyrights, trademarks, and patents provide incentives for entrepreneurs, inventers, and innovators to produce new technology.

ln(gdp) = ln(T) + 1/3 ln(k) + 2/3 ln(L).  capital takes 1/3 labor takes 2/3 of GDP.  Shows how capital and labor influence (relationship) GDP.  How much weight each use.  To predict how society works?

ln(gdp) = ln(T) + 1/3 ln(k) + 2/3 ln(L).

GDP depends on capital labor and technology.  The growth accounting formula mathematically expresses the relationship of capital and labor’s influence on GDP. 

·      Capitals share is 33%, labors share is 67%.

·      The rate of technological progress is indirectly computed & measured as a residual: it cant be accounted for in factor utilization

·      For example, if the growth rate of capital is 3%, gdp will grow by 1%, or 1/3 of capital.

·      The real growth rate of GDP per capita equals 1/3 of the growth rate of capital per worker, plus the growth rate of technology

Used to Measure growth rate of an economy's total output into that which is due to increases in the amount of capital and labor

• The rate of technological progress is indirectly computed & measured
  as a residual: it cant be accounted for in factor utilization

Any time that real GDP increases significantly over 2%, it is caused
by the growth of tangible capital or labor productivity

The economic growth model predicts that poor countries grow faster than rich countries because they have low levels of per capita GDP.  In countries with low per capita GDP, if there is technological diffusion, they will raise their per capita gdp much more quickly than countries that already have a high per capita GDP.  For example if a us firm replaces an old computer with a new one the effects would be minimal compared to if an African firm converted a hand written filing system with a computer.  Therefore, the international differences in per capita income can be largely attributed to the lack of technological diffusion in some countries.  In addition to technology, there needs to be good political and economic structure to provide stability, attract outside investors, and educated people to support the technology.

There are many obstacles that cause a lack of convergence of incomes in the poorer nations.  The lack of technological diffusion and organization is the biggest contributing factor.

Obstacles to technology

·      Lack of private property rights and freedom does not motivate entreprenuers, inventors and innovators to create jobs or new technology.

·      Unfair and unpredictable regulations and taxation also make technological diffusion very hard.

·      Corruption also creates an unfavorable environment to do business in.

·      Institutional weaknesses such as poor infrastructure, central planning, and no rule of law, fail to create incentives

Insufficient national savings limit what can be invested in KLT

If a country can attract foreign investors policy is sound but when they start leaving it is a sign of trouble (country risk)

Foreign investment should be used last, but it can bring technology with it.  Growth must start within.

strategies-encourage to export. Policy-set high tariffs.  Rational-what will happen if you apply a certain strategy/policy

Import substitution strategies are only a temporary fix and do not work in the long run. 

·      Tariffs, export taxes, and restrictions on currency convertibility and investment creates huge inefficiencies and monopolies that are protected by the government.

·      Impoverishes the countryside, slows growth, and causes inflation.  Why 40% of Argentina lives in Buenos Aries.

Export led strategy is much more efficient to grow a country

·      Balancing the budget, creating price stability, and promoting exports leads to competition, innovation, choices, and low prices and costs.

·      Exposes the country to large markets, which improves efficiency.

·      Brings technology into the country, benefits from exchanging in the world economy.

A country’s chances of catching up are greatly increased is they can build their country from the inside out.

·      By producing goods within the country you support infrastructure and create jobs.

·      When you export, you bring in foreign investors and new technology.

·      Goals of reform: free prices, property rights and incentives, competitive markets, freedom to trade, redefining government—rule of law, monetary and fiscal policy restraint.

Typically this transition is done most effectively all at once as Poland did after the collapse of the soviet union.  However, china has been able to gradually give economic freedoms to their people and build their economy since the 1970’s

Money is useful and scarce, and considered to be anything that serves the following three functions:

• medium of exchange – replacing barter as a means of payment and avoids double coincidence of needs, or having what each other want at the same time.
• Store of value – it holds its value over time, and separates production from consumption which encourages savings and investment
• Unit of account – facilitates comparison of value, providing a common measure of the value of goods and services being exchanged

The demand for money is influenced by many different factors, including: institutions and habits, payment methods, availability of short term credit, economic stability & instability, and price and interest rate risks.

·      Demand for money is proportional to economic activity, GDP, and change gradually over time.

·      Money market interest rates will influence the opportunity costs of holding money balances and therefore will alter “velocity”

3 types of demand:

·      Transaction demand – for day-to-day uses. Money that is held to manage cash flows; making and receiving payments of irregular sizes.

·      Precautionary demand – for emergencies.  Contingency fund held for unexpected expenses.

·      Speculative demand – to take advantage of unexpected opportunities like falling asset prices.

It is important to influence the quantity of money supply because it influences spending and interest rates.

·      Value of money is determined by money supply, which is controlled by the Fed, and money demand, which is created by consumers

·      Money supply influences spending (spending = 2x $ supply)

The Fed controls money with 3 policy instruments

·      Reserve requirements – influence money supply because they limit how much money banks can lend out to create new money

·      Discount loans – loans by fed to other banks at interest called discount rate.  This can be adjusted to encourage banks to take additional loans and increase their reserves, which trickle down to increase loans to households and firms, increasing money supply.  This is also how the fed is the lender of last resort.

·      Open market operations – the fed goes directly into the market and buys or sells treasury securities to expand or reduce the money supply.

The quantity equation:

• demand for $ depends on prices and quantities
• the supply of $ depends on the banking system

Price x Quantity = Money Supply x Velocity

when using this equation, economist theorize that velocity is constant (0), so:

dP/P + dQ/Q = dM/M

So a price change and a change in GDP alter money demand proportionately. Therefore, because the percent change in prices and money demand are equal, the percent change in GDP and money demand are equal, the price and income elasticities of demand for money are 1.

1, bank systems – affects supply and demand for currencies

2, reserve requirements - if reserve requirement going up money supply is going down

3, money base – how much money is actually in circulation

4, money multiplier - bigger money multiplier bigger influence on money supply.  (448-452)

Current account records current flows of funds into and out of a country. It measures all international exchange of currently produced goods and services, and international payments for factor services, employed in current production.

The balance of payments (summary of all intnl transactions) must balance:

• current surplus = capital deficit
• current deficit = capital surplus

Capital account records relatively minor transactions and sales and purchases of nonproduced, nonfinancal assets, such as patents and copyrights.

The international balance of payments is a summary of all international transactions made by a country.  The current account and capital account are two parts of the balance of payments.  The current account measures imports (uses of money) and exports (sources of payment) of goods, services, incomes, and unilateral transfers. The capital account measures financial flows in and out of a country, which vary depending on the yields they are expected to generate.  They are financial transactions, such as the purchase or sale of assets, or lending and borrowing, that affect the buying and selling of currencies.  They both contribute to demand and supply of currency.  The balance of payments must be equal; a current account surplus must equal a capital account deficit and vice versa. For example, in China, because they run a trade surplus, they must invest abroad to stabilize the value of their money.

MTB = exports – imports of goods.

·   A category of the current account balance, it is the net difference between exports and imports of merchandise (cars, clothes, machinery, etc.), in a certain economy.

BGS = MTB + export of services - import of services (net export). 

·   Another category of the current account balance that expresses the net difference between exports and imports of services (transportation, legal, insurance services, etc.), added to the MTB.  Together, these two comprise the balance of trade.

CAB = MTB + BGS + net investment income + net transfer of payments. 

·   CAB is the whole, which is the sum of the balance of trade, net investment income (interest, dividends, etc.), and net transfer of payments (foreign aid, etc.).  It is one of the two major measures of a countries foreign trade.  A surplus equals the difference between national income and national spending. 

The US trade deficit is a function of the gap between national savings and investment.  Because our savings are insufficient to fund our investment needs, foreign capital is needed.  Because we import (invest) more than we export (save), the investment-savings gap increases.  Therefore, as our trade deficit increases, so does our investment-savings gap.  This causes a capital account surplus and a current account deficit.

because of the monetary policy affects interest rate, it has consequences on global economy.

As globalization has rapidly increased, the economies of the world have become very interdependent.  Consequently, the monetary and fiscal policies of one country have global ramifications.  In the US, we have an open economy.  Therefore, when the Federal Reserve engages in an expansionary monetary policy, increasing money supply to lower interest rates, as it is currently doing, it affects the exchange rate between the dollar and foreign currencies.  The same is true of fiscal policy.  As the government changes its taxing and spending policies, interest rates are also affected.