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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
2
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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
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3
output
4
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The Open Economy
5
1
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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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The Open Economy
6
(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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8
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
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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
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The Open Economy
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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
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12
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
CHAPTER 5
The Open Economy
17
3
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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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18
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
The Open Economy
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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
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Understanding the units of ε ε
CHAPTER 5
Units of Japanese goods per unit of U.S. goods
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25
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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27
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
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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.
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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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33
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
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31
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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36
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
The Open Economy
39
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
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43
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
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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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53
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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.
10