Download Chapter 5: Open Economy In an open economy, Y = C + I + G + NX

9/16/2013
Imports and exports (% of GDP), 2007
Chapter 5: Open Economy
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35%
30%
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CHAPTER 1
0
The Science of Macroeconomics
In an open economy,
Canada France Germany
Italy
Japan
U.K.
U.S.
Preliminaries
superscripts:
d = spending on
domestic goods
f = spending on
foreign goods
C C d C f
 spending need not equal output
 saving need not equal investment
I Id If
G G d G f
EX = exports =
foreign spending on domestic goods
IM = imports = C f + I f + G f
= spending on foreign goods
NX = net exports (a.k.a. the “trade balance”)
= EX – IM
CHAPTER 5
The Open Economy
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CHAPTER 5
The Open Economy
The national income identity
in an open economy
GDP = expenditure on
domestically produced g & s
Y  C d  I d  G d  EX
f
f
Y = C + I + G + NX
f
 (C  C )  (I  I )  (G  G )  EX
or,
 C  I  G  EX  (C f  I f  G f )
NX = Y – (C + I + G )
domestic
spending
 C  I  G  EX  IM
net exports
 C  I  G  NX
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The Open Economy
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output
4
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The Open Economy
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International capital flows
Trade surpluses and deficits
 Net capital outflow
NX = EX – IM = Y – (C + I + G )
=S –I
= net outflow of “loanable funds”
 trade surplus:
output > spending and exports > imports
Si off the
Size
th ttrade
d surplus
l = NX
= net purchases of foreign assets
the country’s purchases of foreign assets
minus foreign purchases of domestic assets
 trade deficit:
spending > output and imports > exports
Size of the trade deficit = –NX
 When S > I, country is a net lender
 When S < I, country is a net borrower
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The Open Economy
6
(percent of GDP) 1960-2007
8%
investment
22%
implies
6%
20%
NX = (Y – C – G ) – I
S
–
4%
18%
I
saving
14%
0%
12%
Thus,
a country with a trade deficit (NX < 0)
is a net borrower (S < I ).
-2%
10%
trade balance
(right scale)
8%
The Open Economy
8
U.S.: “The world’s largest debtor nation”
 Every year since 1980s: huge trade deficits and
6%
1960 1965
1970
1975 1980
1985 1990
-4%
1995
2000 2005
-6%
2010
Saving and investment in a
small open economy
 An open-economy version of the loanable
net capital inflows, i.e. net borrowing from abroad
funds model from Chapter 3.
 As of 12/31/2008:
 Includes many of the same elements:
 U.S. residents owned $19.9 trillion worth of
 production function
f i assets
foreign
t
 Foreigners owned $23.4 trillion worth of
 consumption function
U.S. assets
 U.S. net indebtedness to rest of the world:
$3.5 trillion--higher than any other country,
hence U.S. is the “world’s largest debtor nation”
The Open Economy
2%
16%
trade balance = net capital outflow
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7
24%
NX = Y – (C + I + G )
CHAPTER 5
The Open Economy
Saving, investment, and the trade balance
The link between trade & cap. flows
=
CHAPTER 5
 investment function
Y  Y  F (K , L )
C  C (Y  T )
I  I (r )
 exogenous policy variables G  G , T  T
10
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The Open Economy
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National saving:
The supply of loanable funds
r
Assumptions about capital flows
a. domestic & foreign bonds are perfect substitutes
S  Y  C (Y  T )  G
(same risk, maturity, etc.)
b. perfect capital mobility:
As in Chapter 3,
national saving
g does
not depend on the
interest rate
no restrictions on international trade in assets
c. economy is small:
cannot affect the world interest rate, denoted r*
a & b imply r = r*
S
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S, I
c implies r* is exogenous
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Investment:
The demand for loanable funds
r
I (r* )
CHAPTER 5
r
…the interest
rate would
adjust to
equate
investment
and saving:
I (rc )
S
But in a small open economy…
…and the
difference
between saving
and investment
determines net
capital outflow
and net exports
CHAPTER 5
S
I (r )
14
r
13
rc
S, I
The Open Economy
the exogenous
world interest
rate determines
investment…
The Open Economy
If the economy were closed…
Investment is still a
downward-sloping function
of the interest rate,
but the exogenous
world
ld iinterest
t
t rate…
t
…determines the
country’s level of
investment.
I (r )
r*
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CHAPTER 5
The Open Economy
S, I
15
Next, three experiments:
1. Fiscal policy at home
S
2. Fiscal policy abroad
NX
3. An increase in investment demand
r*
(exercise)
rc
The Open Economy
I (r )
I1
S, I
16
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The Open Economy
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1.
NX and the federal budget deficit
Fiscal policy at home
(% of GDP), 1965-2009
r
An increase in G
or decrease in T
reduces saving.
8%
S 2 S1
NX2
r1*
Budget deficit
(left scale)
6%
2%
4%
0%
NX1
Results:
2%
-2%
I  0
I (r )
NX  S  0
S, I
I1
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2.
0%
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3. An increase in investment demand
r
NX2
r2*
S1
Use the
model to
determine
the impact of
an increase
in investment
demand on
NX, S, I, and
net capital
outflow.
NX1
r1*
Results:
I  0
I (r )
NX  I  0
I (r2* )
CHAPTER 5
S, I
I (r1* )
The Open Economy
r
S
r*
NX1
I (r )1
I1
S, I
20
ANSWERS:
3. An increase in investment demand
r
I > 0,
S = 0,
net capital
outflow and
NX fall
by the
amount I
-4%
-6%
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
NOW YOU TRY:
Fiscal policy abroad
Expansionary
fiscal policy
abroad raises
the world
interest rate.
-4%
Net exports
(right scale)
-2%
The nominal exchange rate
S
NX2
r*
NX1
e = nominal exchange rate,
the relative price of
domestic currency
in terms of foreign currency
I (r )2
(e.g. Yen per Dollar)
I (r )1
I1
I2
S, I
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The Open Economy
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The real exchange rate
A few exchange rates, as of 6/24/2009
country
exchange rate
Euro area
0.72 Euro/$
Indonesia
10,337 Rupiahs/$
Japan
95 9 Yen/$
95.9
Mexico
13.3 Pesos/$
Russia
31.4 Rubles/$
South Africa
8.1 Rand/$
U.K.
0.61 Pounds/$
ε = real exchange rate,
the lowercase
G k lletter
Greek
epsilon
CHAPTER 5
Understanding the units of ε
ε 

CHAPTER 5

Units of Japanese goods
per unit of U.S. goods
The Open Economy
The Open Economy
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 one good: Big Mac
 price in Japan:
P* = 200 Yen
(Yen per $)  ($ per unit U.S. goods)
Yen per unit Japanese goods
Yen per unit U.S. goods
Yen per unit Japanese goods
(e.g. Japanese Big Macs per
U.S. Big Mac)
~ McZample ~
e P
P *

the relative price of
domestic goods
in terms of foreign goods
 price in USA:
P = $2.50
 nominal exchange rate
e = 120 Yen/$
ε


26
ε in the real world & our model
CHAPTER 5
e P
P *
120  $2.50
 1 .5
200 Yen
To buy a U.S. Big Mac,
someone from Japan
would have to pay an
amount that could buy
1.5 Japanese Big Macs.
The Open Economy
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How NX depends on ε
 In the real world:
ε  U.S. goods become more expensive
relative to foreign goods
We can think of ε as the relative price of
a basket of domestic goods in terms of a basket
of foreign goods
 EX, IM
 In our macro model:
 NX
There’s just one good, “output.”
So ε is the relative price of one country’s output
in terms of the other country’s output
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CHAPTER 5
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U.S. net exports and the real exchange rate,
The net exports function
1973-2009
4%
140
Trade-weighted real
exchange rate index
100
0%
80
-2%
60
-4%
40
Net exports
(left scale)
-6%
-8%
1970
1975
1980
1985
1990
Index (March 1973 = 100)
NX (% of GDP)
 The net exports function reflects this inverse
120
2%
relationship between NX and ε :
NX = NX(ε )
20
1995
2000
2005
0
2010
CHAPTER 5
The NX curve for the U.S.
The Open Economy
The NX curve for the U.S.
ε
ε
ε2
When ε is
relatively low,
U.S. goods are
relatively
inexpensive
so U.S. net
exports will
be high
ε1
NX(ε1)
NX (ε)
NX
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33
How ε is determined
 The accounting identity says NX = S – I
 We saw earlier how S – I is determined:
 S depends on domestic factors (output, fiscal
Neither S nor I
depend on ε,
so the net capital
outflow curve is
vertical.
policyy variables, etc))
 I is determined by the world interest
rate r *
ε adjusts to
ε
NX (ε )  S  I (r *)
34
CHAPTER 5
S 1  I (r *)
ε1
equate NX
with net capital
outflow, S  I.
 So, ε must adjust to ensure
The Open Economy
NX
0
NX(ε2)
How ε is determined
CHAPTER 5
At high enough
values of ε,
U.S. goods become
so expensive that
we export
p
less than
we import
NX (ε)
0
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The Open Economy
NX(ε )
NX 1
NX
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Interpretation: supply and demand
in the foreign exchange market
demand:
Foreigners need
dollars to buy
U.S. net exports.
supply:
Net capital
outflow (S  I )
is the supply of
dollars to be
invested abroad.
CHAPTER 5
Next, four experiments:
1. Fiscal policy at home
S 1  I (r *)
ε
2. Fiscal policy abroad
3. An increase in investment demand
(exercise)
ε1
4. Trade policy to restrict imports
NX(ε )
NX
NX 1
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1. Fiscal policy at home
A fiscal expansion
reduces national
saving, net capital
outflow, and the
supply of dollars
in the foreign
exchange
market…
ε
CHAPTER 5
An increase in r*
reduces
investment,
increasing net
capital outflow
and the supply of
dollars in the
foreign exchange
market…
S 2  I (r *)
S 1  I (r *)
ε1
NX(ε )
NX 2
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37
2. Fiscal policy abroad
ε2
…causing the real
exchange rate to
rise and NX to fall.
CHAPTER 5
NX
NX 1
The Open Economy
ε
CHAPTER 5
S 1  I (r 2 * )
ε1
ε2
NX(ε )
…causing the real
exchange rate to fall
and NX to rise.
38
S 1  I (r1 *)
NX 1
NX
NX 2
The Open Economy
39
NOW YOU TRY:
ANSWERS:
3. Increase in investment demand
3. Increase in investment demand
Determine the
impact of an
increase in
investment
demand on
net exports,
net capital
outflow,
and the real
exchange rate
ε
S1  I1
ε1
NX(ε )
NX 1
NX
An increase in
investment
reduces net
capital outflow
and the supply
of dollars in the
foreign
exchange
market…
ε
S1  I 2
S1  I1
ε2
ε1
…causing the real
exchange rate to rise
and NX to fall.
NX(ε )
NX 2
NX 1
NX
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4. Trade policy to restrict imports
At any given value of
ε
ε, an import quota
 IM  NX
 demand for
ε2
dollars shifts
right
ε1
Results:
S I
NX (ε )2
ε1
NX (ε )2
NX (ε )1
EX < 0
(rise in ε )
NX
The Open Economy
ε2
IM < 0
(policy)
NX (ε )1
NX1
S I
ε
ε > 0
(demand
increase)
NX = 0
(supply fixed)
Trade policy doesn’t
affect S or I , so
capital flows and the
supply of dollars
remain fixed.
CHAPTER 5
4. Trade policy to restrict imports
42
The determinants of the
nominal exchange rate
CHAPTER 5
The Open Economy
43
The determinants of the
nominal exchange rate
 Start with the expression for the real exchange
rate:
e P
ε 
P*
 So e depends on the real exchange rate and
the price levels at home and abroad…
…and we know how each
of them is determined:
 Solve
S l ffor th
the nominal
i l exchange
h
rate:
t
P*
e  ε 
P
M*
 L * (r *   *, Y * )
P*
e  ε 
P*
P
M
 L (r *   ,Y )
P
NX (ε )  S  I (r *)
CHAPTER 5
The Open Economy
44
The determinants of the
nominal exchange rate
P*
P
Rewrite this equation in growth rates
e

ε
ε

P *
P*

P
P

ε
ε
Mexico
Iceland
Pakistan
 *  
10%
5%
Australia
Canada
Singapore
0%
the growth rate of e equals the difference
between foreign and domestic inflation rates.
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45
15%
 For a given value of ε,
CHAPTER 5
The Open Economy
% change 30%
in nominal
25%
exchange
rate 20%
(see “arithmetic tricks for working with percentage
changes,” Chap 2 ):
e
CHAPTER 5
Inflation differentials and nominal exchange
rates for a cross section of countries
e  ε 

NX
NX1
-5%
-10% -5%
46
S. Africa
S. Korea
U.K.
Japan
0%
5%
10% 15% 20% 25% 30%
inflation differential
8
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Purchasing Power Parity (PPP)
Purchasing Power Parity (PPP)
 PPP:
Two definitions:
e P = P*
 A doctrine that states that goods must sell at the
same (currency-adjusted) price in all countries.
 The nominal exchange rate adjusts to equalize
Cost of a basket of
domestic goods
goods, in
foreign currency.
the
h cost off a basket
b k off goods
d across countries.
i
Reasoning:
 arbitrage, the law of one price
 Solve for e :
Cost of a basket of
foreign goods, in
foreign currency.
Cost of a basket of
domestic goods, in
domestic currency.
e = P*/ P
 PPP implies that the nominal exchange rate
between two countries equals the ratio of the
countries’ price levels.
The Open Economy
CHAPTER 5
48
 If e = P*/P,
and the NX curve is horizontal:
ε =1
Under PPP,
changes in
(S – I ) have no
impact on ε or e.
NX
49
No, for two reasons:
1. International arbitrage not possible.
 nontraded goods
 transportation costs
2 Different countries’
2.
countries goods not perfect substitutes
substitutes.
P
P* P
then ε  e  * 
 * 1
P
P
P
S I
The Open Economy
Does PPP hold in the real world?
Purchasing Power Parity (PPP)
ε
CHAPTER 5
Yet, PPP is a useful theory:
 It’s simple & intuitive.
 In the real world, nominal exchange rates
tend toward their PPP values over the long run.
NX
CHAPTER 5
The Open Economy
50
CASE STUDY:
The Open Economy
51
The U.S. as a large open economy
The Reagan deficits revisited
1970s 1980s
CHAPTER 5
actual
change
closed
economy
small open
economy
G–T
2.2
3.9



S
19.6
17.4



r
1.1
6.3


no change
I
19.9
19.4


no change
NX
-0.3
-2.0

no change

ε
115.1
129.4

no change

Data: decade averages; all except r and ε are expressed as a percent of GDP;
ε is a trade-weighted index.
 So far, we’ve learned long-run models for
two extreme cases:
 closed economy (chap. 3)
 small open economy (chap. 5)
 A large open economy – like the U
U.S.
S – falls
between these two extremes.
 The results from large open economy analysis
are a mixture of the results for the
closed & small open economy cases.
 For example…
CHAPTER 5
The Open Economy
53
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A fiscal expansion in three models
Chapter Summary
 Net exports--the difference between
A fiscal expansion causes national saving to fall.
The effects of this depend on openness & size:
closed
economy
large open
economy
r
rises
rises, but not as much
as in closed economy
no
change
I
falls
falls, but not as much
as in closed economy
no
change
NX
no
change
falls, but not as much as
in small open economy
falls
CHAPTER 5
 exports and imports
 a country’s output (Y )
small open
economy
The Open Economy
Chapter Summary
 National income accounts identities:
 Y = C + I + G + NX
 trade balance NX = S  I net capital outflow
and its spending (C + I + G)
 Net capital outflow equals
 purchases of foreign assets
minus foreign purchases of the country’s
assets
 the difference between saving and investment
54
Chapter Summary
 Exchange rates
 nominal: the price of a country’s currency in
terms of another country’s currency
 real: the price of a country’s goods in terms
 Impact
I
t off policies
li i on NX :
 NX increases if policy causes S to rise
or I to fall
 NX does not change if policy affects
neither S nor I. Example: trade policy
Chapter Summary
 How the real exchange rate is determined
 NX depends negatively on the real exchange
rate, other things equal
 The real exchange rate adjusts to equate
NX with net capital outflow
of another country’s
country s goods
 The real exchange rate equals the nominal
rate times the ratio of prices of the two
countries.
Chapter Summary
 How the nominal exchange rate is determined
 e equals the real exchange rate times the
country’s price level relative to the foreign
price level.
 For a given value of the real exchange rate,
rate
the percentage change in the nominal
exchange rate equals the difference between
the foreign & domestic inflation rates.
10