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Economics 122a
Open-Economy Macroeconomics
Topics:
1. International issues
2. Balance of payments accounting
3. Saving and investment in the open economy
4. Determination of the exchange rate
What are the enduring international issues?
• International trade and investment increase productivity and growth
(standard trade and capital theory)
• International competition heightens the process of “creative
destruction” and is resisted by those why are hurt (non-standard trade
theory)
• International spillovers (standard macro)
– lead to exports and imports and affect output and employment
– lead to capital flows and affect exchange rates, relative prices,
interest rates, asset prices, and wealth
• Markets cannot manage themselves. This is why nations need active
rules, institutions, and policies:
– Foreign economic policies on trade and finance
– To coordinate policy
– International institutions to help prevent destructive “prisoners’
dilemma” outcomes on trade, capital flows, war, …
3
Trade
and
Growth
IMF
What are the today’s issues?
What was on the agenda at the Pittsburgh G-20 Summit?*
• The Great Recession
• Fight off protectionism
– US probably the worst sinner with “buy America” and recent
“tires” case; CO2 trade sanctions.
• International spillovers
– Coordinate stimulus plans and savings-investment balance
– Climate change
• Markets cannot manage themselves.
– IMF, World Bank, G-20
– Coordinate risk and regulatory standards for banks
* See http://www.whitehouse.gov/the_press_office/Leaders-statement-on-thePittsburgh-summit/
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Measuring international flows
Essential balancing property
of Balance of Payments
Current Account
Financial Account
Net Balance
A
-A
0
7
Balance of Payments v. Real Goods and Services
1.
Macro:
NX =
Net Exports = exports goods and services – imports g&s
2. Current account:
Current account = NX
+ locational adjustments (domestic v. national product)
+ unilateral transfers (not current goods/services)
Difference = locational stuff + transfers
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Balance of Payments, 2008
Goods and services
Exports
Imports
Net income of foreign investments
Unilateral transfers, net
-696
1,827
-2,523
118
-128
Balance on Current Account
Net change in assets
Central banks
Other
Statistical discrepancy
-706
506
482
52
Balance on Financial Account
Net exports
* I have omitted "capital account," which is trivial in $ terms.
200
706
-696
Openness/globalization: Trade
Imports, exports (% of GDP)
20
16
Rising trend
12
8
4
Imports
Exports
0
1950
1960
1970
1980
1990
2000
10
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
or
NX = Spriv + Sgov – I = Sn – I
FINANCIAL COUNTERPART:
Net domestic saving = net foreign investment
= lending abroad = ΔNFA
= financial account deficit that corresponds to the current account surplus
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Overview of analysis
1.
2.
3.
4.
Savings-investment accounting
S, I, and NX determination
How S, I, and NX determine real exchange rate
Small and large open economies
12
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
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
13
Recall Closed Economy S and I equilibrium
Real interest rate (r)
Sn = Spriv + (T-G)
r*
Id (r)
I*
S, I
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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)
I*
S, 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)
rW’
rW
S = Sp + (T-G)
NX**
NX*
Id (r)
I**
I*
S, I
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Shock II: Increase in G
Real interest rate (r)
S*
S**
NX*>0
rW
NX**<0
Id (r)
I*
S, I
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“International money”:
Foreign exchange rates
Financial Globalization
140
Assets as % of US GDP
120
US assets abroad (% US GDP)
ROW assets in US (% US GDP)
100
80
60
40
20
0
1975
1980
1985
1990
1995
2000
2005
2010
Exchange rates
Foreign-exchange rates are the relative prices of different
national monies or currencies.
Convention in Econ 122: Nominal exchange rate
• exchange rates = amount of foreign currency per unit of
domestic currency.
• Think Japanese Yen: 100 yen to $.
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Terminology
For market-determined exchange rates:
• An appreciation of a currency is when the value of the
currency rises
– e or R rises
• A depreciation of a currency is when the value of the
currency falls
– e or R falls
For fixed exchange rates:
• Price set by government is the “parity.”
• A revaluation is an increase in the official parity.
• A devaluation is a decrease in the parity.
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Index of US nominal exchange rate (e)
Appreciation
Nominal exchange rate against
30 major countries
140
January 1997 = 100
120
100
80
60
40
1970
1975
1980
1985
1990
1995
2000
2005
2010
Depreciation
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The Transmission Mechanism in Open Economy Macro
We saw that changes in domestic saving and investment, or
changes in world interest rates, or domestic risk premiums would
affect net exports.
How does that happen?
Through the adjustment of the real exchange rate.
Let see how.
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Real exchange rates
Real exchange rate, R [Mankiw uses ε)
R = nominal exchange rate corrected for relative prices
R = e × (p d / p f )
= p d / (p f / e)
= domestic prices/foreign prices in a common currency
Note: If you calculate the rate of growth of R, you get
 rate of real   rate of nominal   domestic
  foreign






appreciation
appreciation
inflation
rate
inflation
rate

 
 
 

Example of car exchange rate: 100 Yen/$; Toyota = 2,000,000Y;
Ford = $20,000; R = 100 * 20000/2000000 = 1 Toyota/Ford
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Real exchange rate, US dollar,
against broad group of currencies
120
110
75
80
85
90
95
Flight to safety in
financial panic
Internet bubble
spills over
Dollar bubble 1980s
from high interest rates
Real exchange rate of $ relative to major currencies (R)
Appreciation
130
100
90
80
00
05
10
Depreciation
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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.
The important condition is:
NX(R) = Spriv + Sg – I(rw)
Net exports and the real
exchange rate
Real
exchange
rate (R)
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 ………………………..
R*
NX(R)
NX*
Using the NX curve and S-I curves, we can see how real
exchange rate is determined.
0
NX
Net exports and the real
exchange rate
Real
exchange
rate (R)
Why is NX so
negative for
US?
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.
Sn-I(rw)
R
Savings-investment
and the determination
of the real exchange
rate:
NX(R) = Sn-I(rw)
R*
E*
NX(R)
NX*
0
S-I, NX
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Political crisis and a domestic risk premium
Question for class:
• Assume that there is a political crisis in Slobovia.
• Investors now require a risk premium for investing
there (relative to the rest of the world
• What happens?
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Shock III: Domestic financial disturbance
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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Why does fiscal tightening lead to a lower trade deficit?
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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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Impact of protectionism
Protectionism
(S-I(rw))
R
R**
NX(R)’
R*
NX(R)
NX*=NX**
0
S-I, NX
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Now analyze large open economy
Large Open Economy:
- Country large enough to affect world financial markets
- Domestic assets imperfect substitutes for foreign assets.
- Because imperfect substitutes, domestic r differs from foreign r (rd ≠ rw)
Analysis
Goods markets:
(1) NX(R) = Sn – I(rd)
Financial market equilibrium:
CF = net financial investment abroad = - financial surplus
(2) CF = CF(rd, rw). In analysis, we suppress rw
Notes that capital flows in if domestic interest rates rise
CF’(rd) < 0.
Equilibrium comes when (1) and (2) equilibrate the balance of payments:
(3) NX(R) = CF(rd) = Sn – I(rd)
In our diagrams below, we reorganize and use:
(4) I(rd) + CF(rd) = Sn = Spriv + Sg
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rd
Domestic
interest
rate (rd)
Sn
rd*
I(rd)+CF(rd)
CF(rd)
CF*
CF
0
S, I,CF
Real exchange
rate, R
R*
NX(R)
NX*
NX
0
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)
Global savings glut: Global effect
Real interest rate (r)
Sworld *
Sworld **
r*
r**
Id (r)
I*
I**
S, I
40
rd
Domestic
interest
rate (rd)
Sn
rd*
CF(rd)
I+CF
CF
0
S, I,CF
Effect on US of
global savings
glut:
are effects of
increased Chinese
saving
R
R*
NX(R)
NX*
NX
0
rd
Domestic
interest
rate (rd)
S
rd*
CF(rd)
I+CF
CF
0
S, I,CF
R
Bernanke’s “world savings glut”
-Current situation is one in which rest
of world has savings glut (particularly
China, Japan, and oil exporting
countries accumulating $ reserves).
- This increases inflows to US.
- This is leading to low world and US
real interest rates and to the large US
trade deficit.
R*
NX(R)
NX*
NX
0
Here are the basic data
.01
16
NX/GDP ( <---- )
.00
14
-.01
12
-.02
10
-.03
8
-.04
6
Net exports/GDP
10-year T-bond rate
-.05
-.06
80
82
84
86
88
90
92
4
T-bond rate (----> )
94
96
98
00
02
04
2