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CHAPTER 5 The Open Economy Adapted for EC 204 by Prof. Bob Murphy MACROECONOMICS SIXTH EDITION N. GREGORY MANKIW PowerPoint® Slides by Ron Cronovich © 2007 Worth Publishers, all rights reserved Trade-GDP ratio, selected countries, 2004 (Imports + Exports) as a percentage of GDP Luxembourg 275.5% Germany 71.1% Ireland 150.9 Turkey 63.6 Czech Republic 143.0 Mexico 61.2 Hungary 134.5 Spain 55.6 Austria 97.1 United Kingdom 53.8 Switzerland 85.1 France 51.7 Sweden 83.8 Italy 50.0 Korea, Republic of 83.7 Australia 39.6 Poland 80.0 United States 25.4 Canada 73.1 Japan 24.4 CHAPTER 5 The Open Economy slide 2 In an open economy, spending need not equal output saving need not equal investment See Supplements 5-1, Terminology of Trade, and 5-2, Saving-Investment in Open Economies. CHAPTER 5 The Open Economy slide 3 The national income identity in an open economy Y = C + I + G + NX or, NX = Y – (C + I + G ) domestic spending net exports output CHAPTER 5 The Open Economy slide 6 Trade surpluses and deficits NX = EX – IM = Y – (C + I + G ) trade surplus: output > spending and exports > imports Size of the trade surplus = NX trade deficit: spending > output and imports > exports Size of the trade deficit = –NX CHAPTER 5 The Open Economy slide 7 U.S. net exports, 1950-2006 2% 0 0% -200 -2% -400 -4% -600 -6% -800 1950 -8% 1960 1970 NX ($ billions) 1980 1990 2000 NX (% of GDP) percent of GDP billions of dollars 200 U.S. Net Exports, 1950-2006 International capital flows Net capital outflow =S –I = net outflow of “loanable funds” = net purchases of foreign assets the country’s purchases of foreign assets minus foreign purchases of domestic assets When S > I, country is a net lender When S < I, country is a net borrower CHAPTER 5 The Open Economy slide 9 The link between trade & cap. flows NX = Y – (C + I + G ) implies NX = (Y – C – G ) – I = S – I trade balance = net capital outflow Thus, a country with a trade deficit (NX < 0) is a net borrower (S < I ). CHAPTER 5 The Open Economy slide 10 “The world’s largest debtor nation” U.S. has had large trade deficits, been a net borrower each year since the early 1980s. As of 12/31/2005: U.S. residents owned $10.0 trillion worth of foreign assets Foreigners owned $12.7 trillion worth of U.S. assets U.S. net indebtedness to rest of the world: $2.7 trillion--higher than any other country, hence U.S. is the “world’s largest debtor nation” CHAPTER 5 The Open Economy slide 11 Saving and investment in a small open economy An open-economy version of the loanable funds model from Chapter 3. Includes many of the same elements: production function consumption function investment function Y Y F (K , L ) C C (Y T ) I I (r ) exogenous policy variables G G , T T CHAPTER 5 The Open Economy slide 12 National saving: The supply of loanable funds r S Y C (Y T ) G As in Chapter 3, national saving does not depend on the interest rate S CHAPTER 5 The Open Economy S, I slide 13 Assumptions re: Capital flows a. domestic & foreign bonds are perfect substitutes (same risk, maturity, etc.) b. perfect capital mobility: no restrictions on international trade in assets c. economy is small: cannot affect the world interest rate, denoted r* a & b imply r = r* c implies r* is exogenous CHAPTER 5 The Open Economy slide 14 Investment: The demand for loanable funds r r* Investment is still a downward-sloping function of the interest rate, but the exogenous world interest rate… …determines the country’s level of investment. I (r ) I (r* ) CHAPTER 5 The Open Economy S, I slide 15 If the economy were closed… r …the interest rate would adjust to equate investment and saving: S rc I (r ) I (rc ) S CHAPTER 5 The Open Economy S, I slide 16 But in a small open economy… the exogenous world interest rate determines investment… …and the difference between saving and investment determines net capital outflow and net exports CHAPTER 5 r S NX r* rc The Open Economy I (r ) I1 S, I slide 17 Next, three experiments: 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand See Supplement 5-4, Benefits of a Trade Deficit. CHAPTER 5 The Open Economy slide 18 1. Fiscal policy at home r An increase in G or decrease in T reduces saving. r * 1 S2 S1 NX2 NX1 Results: I 0 I (r ) NX S 0 I1 CHAPTER 5 The Open Economy S, I slide 19 NX and the federal budget deficit (% of GDP), 1960-2006 4% 8% Budget deficit (right scale) 2% 6% 4% 0% 2% -2% 0% -4% Net exports (left scale) -2% -6% -4% 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 slide 20 2. Fiscal policy abroad Expansionary fiscal policy abroad raises the world interest rate. r NX2 r2* S1 NX1 r * 1 Results: I 0 I (r ) NX I 0 I (r ) * 2 CHAPTER 5 The Open Economy I (r1* ) S, I slide 21 3. An increase in investment demand r S r* EXERCISE: Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow. CHAPTER 5 The Open Economy NX1 I (r )1 I1 S, I slide 22 3. An increase in investment demand r ANSWERS: I > 0, S = 0, net capital outflow and NX fall by the amount I S NX2 r* NX1 I (r )1 I1 CHAPTER 5 The Open Economy I (r )2 I2 S, I slide 23 CHAPTER 5 The Open Economy slide 24 The nominal exchange rate e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency (e.g. Yen per Dollar) CHAPTER 5 The Open Economy slide 25 The real exchange rate ε = real exchange rate, the relative price of domestic goods the lowercase Greek letter in terms of foreign goods epsilon CHAPTER 5 (e.g. Japanese Big Macs per U.S. Big Mac) The Open Economy slide 27 Understanding the units of ε e P P * ε (Yen per $) ($ per unit U.S. goods) Yen per unit Japanese goods CHAPTER 5 Yen per unit U.S. goods Yen per unit Japanese goods Units of Japanese goods per unit of U.S. goods The Open Economy slide 28 ε in the real world & our model In the real world: We can think of ε as the relative price of a basket of domestic goods in terms of a basket of foreign goods In our macro model: 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 slide 30 How NX depends on ε ε U.S. goods become more expensive relative to foreign goods EX, IM NX CHAPTER 5 The Open Economy slide 31 U.S. net exports and the real exchange rate, 1973-2006 140 Trade-weighted real exchange rate index 2% 120 NX (% of GDP) 1% 100 0% -1% 80 -2% 60 -3% -4% 40 Net exports (left scale) -5% 20 -6% -7% 1973 Index (March 1973 = 100) 3% 0 1977 CHAPTER 5 1981 1985 1989 The Open Economy 1993 1997 2001 2005 slide 32 The net exports function The net exports function reflects this inverse relationship between NX and ε : NX = NX(ε ) CHAPTER 5 The Open Economy slide 33 The NX curve for the U.S. ε When ε is relatively low, U.S. goods are relatively inexpensive so U.S. net exports will be high ε1 NX (ε) 0 CHAPTER 5 The Open Economy NX(ε1) NX slide 34 The NX curve for the U.S. ε ε2 At high enough values of ε, U.S. goods become so expensive that we export less than we import NX (ε) NX(ε2) CHAPTER 5 0 The Open Economy NX slide 35 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 policy variables, etc) I is determined by the world interest rate r * So, ε must adjust to ensure NX(ε) = S – I(r*) CHAPTER 5 The Open Economy slide 36 How ε is determined Neither S nor I depend on ε, so the net capital outflow curve is vertical. ε adjusts to equate NX with net capital outflow, S I. CHAPTER 5 ε S 1 I (r *) ε1 The Open Economy NX(ε ) NX 1 NX slide 37 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 ε S 1 I (r *) ε1 The Open Economy NX(ε ) NX 1 NX slide 38 Next, four experiments: 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand 4. Trade policy to restrict imports CHAPTER 5 The Open Economy slide 39 1. Fiscal policy at home A fiscal expansion reduces national saving, net capital outflow, and the supply of dollars in the foreign exchange market… S 2 I (r *) ε ε2 ε1 …causing the real exchange rate to rise and NX to fall. CHAPTER 5 S 1 I (r *) The Open Economy NX(ε ) NX 2 NX 1 NX slide 40 2. Fiscal policy abroad An increase in r* reduces investment, increasing net capital outflow and the supply of dollars in the foreign exchange market… …causing the real exchange rate to fall and NX to rise. CHAPTER 5 S 1 I (r1 *) ε S 1 I (r2 *) ε1 ε2 The Open Economy NX(ε ) NX 1 NX 2 NX slide 41 3. Increase in investment demand An increase in investment reduces net capital outflow and the supply of dollars in the foreign exchange market… …causing the real exchange rate to rise and NX to fall. CHAPTER 5 S1 I 2 ε S1 I 1 ε2 ε1 The Open Economy NX(ε ) NX 2 NX 1 NX slide 42 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 Trade policy doesn’t affect S or I , so capital flows and the supply of dollars remain fixed. CHAPTER 5 The Open Economy S I NX (ε )2 NX (ε )1 NX1 NX slide 43 4. Trade policy to restrict imports Results: ε > 0 (demand increase) NX = 0 (supply fixed) IM < 0 (policy) EX < 0 (rise in ε ) CHAPTER 5 ε S I ε2 ε1 The Open Economy NX (ε )2 NX (ε )1 NX1 NX slide 44 The determinants of the nominal exchange rate Start with the expression for the real exchange rate: e P * P Solve for the nominal exchange rate: * P e P CHAPTER 5 The Open Economy slide 45 The determinants of the nominal exchange rate 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: M* * * L ( r * *, Y ) * P P* e P NX() = S - I(r*) CHAPTER 5 The Open Economy M L (r * , Y ) P slide 46 The determinants of the nominal exchange rate * P e P Rewrite this equation in growth rates (see “arithmetic tricks for working with percentage changes,” Chap 2 ): e e P * P * P P * For a given value of , the growth rate of e equals the difference between foreign and domestic inflation rates. CHAPTER 5 The Open Economy slide 47 Inflation differentials and nominal exchange rates 35 Percentage 30 change in nominal 25 exchange 20 rate 15 Mexico Iceland Singapore 10 South Africa Canada 5 South Korea _ 0 U.K. Japan -5 -5 CHAPTER 5 0 5 The Open Economy 10 15 20 25 30 Inflation differential slide 48 CASE STUDY: The Reagan deficits revisited actual 1970s 1980s 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. CHAPTER 5 The Open Economy slide 53 The U.S. as a large open economy 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.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 slide 54 A fiscal expansion in three models A fiscal expansion causes national saving to fall. The effects of this depend on openness & size: closed economy large open economy 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 r CHAPTER 5 The Open Economy small open economy slide 55