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Open Economy Macro:
Republican shot across the bow of the Fed
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Classical Open Economy Equilibrium
Now study open-economy equilibrium:
1. Classical economy
• Full employment, flex w and p; this implies that domestic
output is at potential (Y = Yp)
2. Small open economy
• Too small to affect goods prices or financial markets
3. Mobile financial capital
• Free flow of funds among countries
• Investors therefore compare domestic and foreign interest
rates (rd, rw )
• In small economy, rd = rw = world interest rate (riskless)
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Savings and Investment in the Open Economy
ACCOUNTING:
Y = output = C + I + G + NX
Y = income = Yd + T + Sb = C + Spers + Sb + T = C + Spriv+ T
→ I + NX = Spriv + Sgov = Sn
This gives us the following identity:
NX = Spriv + Sgov – I = Sn – I
The equilibrium comes where:
NX(R) = [S + T – G] – I(r)
Here, R = real exchange rate (Mankiw’s ε), which we ignore for
moment.
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Open Economy S and I equilibrium
Real interest rate (r)
Sn = Spriv + (T-G)
Net exports > 0
r*=rW
China,
Japan,
OPEC
today
Id (r)
S, I
I*
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Open Economy S and I equilibrium
Real interest rate (r)
Sn = Spriv + (T-G)
US today;
LDCs
classically
rW
Net exports < 0
Id (r)
I*
S, I
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Shock I: Increase in world interest rate
Real interest rate (r)
S = Sp + (T-G)
rW’
NX**
rW
NX*
Id (r)
I**
I*
S, I
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Shock II: Increase in G (or tax cut)
Real interest rate (r)
S*
S**
NX*>0
rW
NX**<0
Id (r)
I*
S, I
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The Transmission Mechanism in Open
Economy Macro
We saw that changes in domestic saving and investment, or
changes in world interest rates, or domestic risk premiums would
affect net exports.
How does that happen?
Through the adjustment of the real exchange rate.
Let see how … here in
Econ 122.
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Financial Globalization
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Exchange rates
Foreign-exchange rates are the relative prices of different
national monies or currencies.
Convention in Econ 122 and Mankiw: Nominal exchange rate
• exchange rates = amount of foreign currency per unit of
domestic currency.
• Think Japanese Yen: 100 yen to $.
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Terminology
For market-determined exchange rates:
• An appreciation of a currency is when the value of the
currency rises
– e or R rises
• A depreciation of a currency is when the value of the
currency falls
– e or R falls
For fixed exchange rates:
• Price set by government is the “parity.”
• A revaluation is an increase in the official parity.
• A devaluation is a decrease in the parity.
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Index of US nominal exchange rate (e)
Appreciation
Depreciation
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Real exchange rates
Real exchange rate, R [Mankiw uses ε)
R = nominal exchange rate corrected for relative prices
R = e × (p d / p f )
= p d / (p f / e)
= domestic prices/foreign prices in a common currency
Note: If you calculate the rate of growth of R, you get
Example of car exchange rate: 100 Yen/$; Toyota = 2,000,000Y;
Ford = $20,000; R = 100 * 20000/2000000 = 1 Toyota/Ford
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Big Mac Real Exchange Rate
R = p d / (p f / e)
Example of Big Mac*
Price in Beijing: 14.7 Yuan
Price in New York: $4.07
Real exchange rate: $4.07/(Y14.7/6.45) = $4.07/( $2.28) = 1.79
People use this to argue that Yuan is “overvalued.”
Anything wrong with this argument?
* http://www.economist.com/node/16646178?story_id=16646178
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Real exchange rate of $ relative to major currencies (R)
Appreciation
Depreciation
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Now to the Macroeconomic Equilibrium
We saw last time that changes in the domestic S-I balance
led to changes in NX (the trade balance).
We need next to understand the macroeconomic mechanism
by which this occurs.
We will see that this operates through changes in the real
exchange rate, which leads to changes in the relative
prices of foreign and domestic goods.
FINANCIAL COUNTERPART of S-I balance
NX = Spriv + Sgov – I = Sn – I
Net domestic saving = net foreign investment
= lending abroad = change in net foreign assets = ΔNFA
= financial account deficit that corresponds to the current
account surplus
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The important condition is:
NX(R) = Spriv + Sg – I(rw)
Note on why S does not depend upon r (but unimportant for our analysis)
The only new relationship is NX(R):
– Real deprecation (R ↓) lowers the price of exports in foreign markets
and raises import P in domestic markets.
– This raises exports and lowers imports; raising NX.
– Hence NX’(R) < 0
Putting this with the S-I curves, we can see how real exchange rate is
determined.
Net exports and the real
exchange rate
Real
exchange
rate (R)
R*
NX(R)
NX*
0
NX
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Have two behavioral
relationships:
(1) NX and (2) net
savings.
R and NX are determined
as the equilibrium of
these two functions.
Savings-investment
and the determination
of the real exchange
rate:
Sn-I(rw)
R
NX(R) = Sn-I(rw)
R*
E*
NX(R)
NX*
S-I, NX
0
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Fiscal tightening
(S-I(rw))*
(S-I(rw))**
R
Fiscal policy:
G↓→
net S ↑ →
R ↓→
NX ↑
E*
E**
NX(R)
NX*
0 NX**
S-I, NX
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Protectionism
(S-I(rw))
R
R**
NX(R)’
R*
NX(R)
NX*=NX**
0
S-I, NX
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A Greek Economic Tragedy
• Assume that there is a political crisis in Greece or Ireland.
• Investors now require a risk premium for investing there
(relative to the rest of the world)
• What happens?
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Risk premiums on European debt
[Interest rate relative to German debt]
Interest rate relevant for investment =
Real interest rate with risk premium =
Nominal risk-free rate
– inflation
+ risk premium
=i – π + δ
Source: IMF, Financial Stability Report, Sept 2011
Political crisis and a domestic risk premium
Question for class:
• Assume that there is a political crisis
• Investors now require a risk premium for
investing there (relative to the rest of the world)
• What happens?
• Domestic interest rate rises above world rate by
risk premium (δ).
• This is similar to rise in world interest rate.
• Investment falls and the trade account heads
toward deficit.
• In a Keynesian world, the investment effect
dominates and the country heads into recession.
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Shock III: A Greek Tragedy
Real interest rate (r)
S = Sp + (T-G)
rd = rW +
risk
premium
rW
NX**
NX*
Id (rd)
I**
I*
S, I
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The world economy before the crisis
The world is a closed economy.
Look at the global S-I balance using Bernanke’s theory.
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Here are the basic US data (pre-crisis)
Bernanke’s surprising theory of
why the US deficit is so high
“I will argue that over the past decade a
combination of diverse forces has created a
significant increase in the global supply of saving--a
global saving glut--which helps to explain both the
increase in the U.S. current account deficit and the
relatively low level of long-term real interest rates in
the world today.” (Bernanke, 2005)
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Global savings glut: Global effect
Real interest rate (r)
Sworld *
Sworld **
r*
r**
Id (r)
I*
I**
S, I
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From Greek tragedy to global tragedy
Suppose that the world is in an equilibrium with low real
interest rates and zero inflation.
Then there is a big shock to investment, and the
equilibrium real interest rate is very negative.
Outcome: liquidity trap and the Great Recession (in the
Keynesian world we will examine next week).
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