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9/16/2013 Imports and exports (% of GDP), 2007 Chapter 5: Open Economy 45% Imports Exports 40% 35% 30% 25% 20% 15% 10% 5% 0% 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 2 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 CHAPTER 5 The Open Economy 3 output 4 CHAPTER 5 The Open Economy 5 1 9/16/2013 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 CHAPTER 5 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 CHAPTER 5 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 CHAPTER 5 The Open Economy 11 2 9/16/2013 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 CHAPTER 5 S, I c implies r* is exogenous The Open Economy 12 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* CHAPTER 5 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 CHAPTER 5 The Open Economy 17 3 9/16/2013 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 CHAPTER 5 2. 0% The Open Economy 18 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 CHAPTER 5 The Open Economy 23 4 9/16/2013 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 25 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 27 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 CHAPTER 5 The Open Economy 28 CHAPTER 5 The Open Economy 29 5 9/16/2013 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 The Open Economy 32 CHAPTER 5 The Open Economy 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 CHAPTER 5 31 The Open Economy NX(ε ) NX 1 NX 35 6 9/16/2013 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 The Open Economy 36 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 The Open Economy 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 7 9/16/2013 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. The Open Economy 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 9/16/2013 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 9 9/16/2013 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