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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”
– But 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 produces bubbles and bursts
• 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, …
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World Trade and Growth in the
Recession
IMF, World Economics Outlook, 2010
What are the today’s issues?
• The Great Recession
• Fight off protectionism
– Sinners are everywhere; EU threatens CO2 trade sanctions;
recent Chinese actions.
• Financial spillovers
– Because of increasingly integrated financial markets
• Markets cannot manage themselves.
– Coordinate risk and regulatory standards for banks (Basel
III)
– Contain protectionism through the WTO
– Dal with exchange rate protectionism (China?)
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Measuring international flows
Essential balancing property
of Balance of Payments
Current Account
Financial Account
Net Balance
A
-A
0
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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, 2009
Goods and services
Exports
Imports
Net income of foreign investments
Unilateral transfers, net
-375
1,571
-1,946
121
-125
Balance on Current Account
Net change in assets
Central banks
Other
Statistical discrepancy
Balance on Financial Account
Net exports
* I have omitted "capital account," which is trivial in $ terms.
-378
216
502
-286
162
378
-375
Globalization in trade of goods and services, US
Imports, exports (% of GDP)
20
16
Rising trend
12
8
4
Imports
Exports
0
1950
1960
1970
1980
1990
2000
9
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
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Supply and Demand for Loanable Funds
Mankiw (chap 3) shows an alternative derivation of the classical model
using the loanable funds. This approach examines the sources and
uses of saving and investment. Do for simplest system:
Basics:
(1)
Y=C+I
(expenditure identity)
(2)
S=Y-C
(definition of private saving)
(3)
I = I(r)
(investment equation)
These imply :
(4)
S= I(r)
In this alternative approach, make sure you understand the difference
between the savings-investment identity and the savingsinvestment equilibrium.
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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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Example of disequilibrium for S and I
r
If there is excess demand for I at r*,
then the rate must rise to
equilibrate S and I.
This means that planned I at the
original interest rate (r0) was
excessive.
Note that equilibrating mechanism
will differ in different markets –
Keynesian mechanism is
quantity rather than price.
S(r)
B
r**
C
r*
A
I(r)
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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
or
NX = Spriv + Sgov – I = Sn – I
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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
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
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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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Open Economy Macro:
The transmission mechanism
through the real exchange rate
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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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 and Mankiw: Nominal exchange rate
• exchange rates = amount of foreign currency per unit of
domestic currency.
• Think Japanese Yen: 100 yen to $.
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Terminology
For market-determined exchange rates:
• An appreciation of a currency is when the value of the
currency rises
– e or R rises
• A depreciation of a currency is when the value of the
currency falls
– e or R falls
For fixed exchange rates:
• Price set by government is the “parity.”
• A revaluation is an increase in the official parity.
• A devaluation is a decrease in the parity.
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Index of US nominal exchange rate (e)
Appreciation
140
120
100
80
60
40
20
1975
1980
1985
1990
1995
2000
2005
2010
Depreciation
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Real exchange rates
Real exchange rate, R [Mankiw uses ε)
R = nominal exchange rate corrected for relative prices
R = e × (p d / p f )
= p d / (p f / e)
= domestic prices/foreign prices in a common currency
Note: If you calculate the rate of growth of R, you get
 rate of real   rate of nominal   domestic
  foreign






appreciation
appreciation
inflation
rate
inflation
rate

 
 
 

Example of car exchange rate: 100 Yen/$; Toyota = 2,000,000Y;
Ford = $20,000; R = 100 * 20000/2000000 = 1 Toyota/Ford
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Big Mac Real Exchange Rate
R = p d / (p f / e)
Example of Big Mac*
Price in Beijing: 13 Yuan
Price in New York: $3.73
Real exchange rate: $3.73/(Y13/6.7) = $3.73/($1.97) = 1.89
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
Flight to safety
120
110
100
90
80
1975
1980
1985
Internet bubble
Dollar bubble with
high US interest rates
Real exchange rate against
broad country group
130
1990
1995
2000
2005
2010
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 = 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.
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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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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Macroeconomics and political upheaval
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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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: Federal Reserve, Monetary Policy Report, July 2010.
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.
Real interest rate (r)
Sn = Spriv + (T-G)
r*
Id (r)
I*
S, I
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Here are the basic data (pre-crisis)
.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
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
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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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