2013. In an open economy, Y = C + I + G + NX. Chapter 5: Open Economy

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 Sc...
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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

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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

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output

4

CHAPTER 5

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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

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(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%

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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

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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

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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

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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%

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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

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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

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 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.

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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

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CHAPTER 5

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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

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CHAPTER 5

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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

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The Open Economy

NX(ε ) NX 1

NX

35

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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

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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

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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

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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

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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

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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

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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

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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

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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

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50

CASE STUDY:

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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

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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.

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