Chapter 5: The Open Economy Prof. Chris Foote Harvard University Department of Economics

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Outline

1

International Flows of Capital and Goods

2

Saving and Investment in a Small Open Economy

3

Exchange Rates

4

The Large Open Economy

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International Flows of Capital and Goods

Trade Participation Ratios in 2004: (EX + IM)/GDP Country Luxembourg Ireland Sweden Poland Canada Germany Mexico U.K. France Australia U.S. Japan

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Ratio 275.5% 150.9% 83.8% 80.0% 73.1% 71.1% 61.2% 53.8% 51.7% 39.6% 25.4% 24.4%

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International Flows of Capital and Goods

Rearranging the national accounts identity C d : Consumption of domestically produced goods and services I d : Investment in domestically produced goods and services Gd : Government purchases of domestically produced goods and services C d + I d + Gd : Domestic spending on domestic goods and services EX : Exports of goods and services
Y = C d + I d + Gd + EX

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International Flows of Capital and Goods

Making the identity more useful C f : Consumption of foreign goods and services I f : Investment in foreign goods and services Gf : Government purchases of foreign goods and services C = Cd + Cf I = Id + If G = Gd + Gf
Y = C d + I d + Gd + EX Y = (C − C f ) + (I − I f ) + (G − Gf ) + EX

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International Flows of Capital and Goods

Making the identity more useful (con’t)

Y = (C − C f ) + (I − I f ) + (G − Gf ) + EX = C + I + G + EX − (C f + I f + Gf ) = C + I + G + (EX − IM) = C + I + G + NX

Note that IM = (C f + I f + Gf ) ... ... and EX − IM = NX

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International Flows of Capital and Goods

Intuition behind national accounts identity Y = what is produced within U.S. borders (GDP) C + I + G = what gets “used up” within U.S. borders, regardless of where it comes from NX = net amount of stuff we send abroad Y = C + I + G + NX Y − (C + I + G) = NX

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International Flows of Capital and Goods

Intuition behind national accounts identity (con’t) Y − (C + I + G) = NX If Y > (C + I + G): NX > 0 We send our excess stuff abroad We have a trade surplus

If Y < (C + I + G): NX < 0 We get excess stuff from abroad We have a trade deficit

If Y = (C + I + G): NX = 0 We have balanced trade

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International Flows of Capital and Goods

U.S. Exports and Imports U.S. Exports and Imports 18.0 Exports Imports

16.0

14.0

Percent of GDP

12.0

10.0

8.0

6.0

4.0

2.0

0.0 1947

1951

1955

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1959

1963

1967

1971

1975

1979

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1983

1987

1991

1995

1999

2003

2007

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International Flows of Capital and Goods

U.S. Trade Balance Trade Balance (NX) 2

1

0

Percent of GDP

-1

-2

-3

-4

-5

-6

-7 1960 1964 1968 Foote (Ec 1010b)

1972

1976

1980 1984 Open Economy

1988

1992

1996 2000 2004 February 14, 2008

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International Flows of Capital and Goods

International Capital Flows Y = C + I + G + NX Y C − G} = I + NX | − {z National Saving S = I + NX S − I = NX An economy’s NX must always equal the difference between its saving and investment S − }I = NX |{z} | {z Net Capital Outflow Trade Balance Foote (Ec 1010b)

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International Flows of Capital and Goods

International Capital Flows (con’t) = NX S − }I |{z} | {z Net Capital Outflow Trade Balance Net capital outflow: Amount that domestic residents are lending abroad ... ... less the amount that foreign residents are lending to us.

Note that net capital outflow is sometimes called net foreign investment

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International Flows of Capital and Goods

Is a trade deficit “bad”? The U.S. has a trade deficit By definition, that must mean that S − I is in the U.S. is negative Many people believe that low private saving and low public saving in the U.S. are a problem Others believe that S − I < 0 because foreigners are attracted to investment opportunities here Don’t really know whether S − I = NX < 0 is a “problem” without more information

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International Flows of Capital and Goods

Saving, Investment, and Net Exports: 1960-2006 25

Investment

20

15

Percent of GDI

Saving 10

5

0

Net Exports

-5

-10 1960

1964

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1968

1972

1976

1980

1984

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1988

1992

1996

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2004

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International Flows of Capital and Goods

Gross Saving Rates: 1960-2006 25 Private 20

Percent of GDI

15

10

Government

5

0

-5 1960

1964

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1968

1972

1976

1980

1984

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1988

1992

1996

2000

2004

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International Flows of Capital and Goods

Forms of Foreign Investment into the U.S. 1

Foreigners making loans by buying U.S. debt Lending to U.S. treasury via purchase of a Treasury bond ... or corporations via corporate bond or commercial paper ... or U.S. homeowners via mortgage-backed securities

2

Foreigners purchasing U.S. assets Rockefeller Center Stake in Citibank or other investment banks Shares of stock in U.S. companies

In either case, foreigners obtain claims to future returns of the U.S. capital stock

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International Flows of Capital and Goods

An intuitive example Think of a U.S. resident buying an iPod from China for $100: NX falls A Chinese citizen then receives $100 U.S. dollars What will he do with the money? 1

Stick it in the mattress? This is an investment in the U.S. economy by the Chinese resident U.S. net capital outflow (S − I) declines (because there has been an inflow of capital into the U.S.)

2

Purchase share of U.S. corporation or U.S. Treasury bond?

3

Buy an American good worth $100?

Same as #1 U.S. exports rise, so NX rises Ultimate effect of iPod purchase and offsetting purchase of U.S. good is no change to NX or S − I

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International Flows of Capital and Goods

Irrelevance of Bilateral Trade Balances = NX S − }I |{z} | {z Net Capital Outflow Trade Balance Note that this identity holds for the world as whole, not for individual countries A country with S − I = NX > 0 might run a large trade deficit with a single trading partner ... ... but multilateral trade position must be in surplus if S − I > 0. Bilateral trade balances don’t matter Example: Solow’s barber

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Saving and Investment in a Small Open Economy

The Small Open Economy (SOE) and r ∗ 1

SOE is small – its own S and I have little effect on world real interest rate: r ∗ World r ∗ is set to equilibrate world saving and world investment SOE is too small to affect this balance SOE’s own S need not equal its own I, so NX need not equal zero

2

SOE has perfect capital mobility: Domestic r is equal to world r ∗ Borrowers would never borrow at a higher r than r ∗ Lenders would never lend at a lower r than r ∗ So, r = r ∗

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Saving and Investment in a Small Open Economy

The Model As before, economy’s output is pinned down by F (K , L): Y = F (K , L) = Y As before, consumption depends on disposable income: C = C(Y − T ) = C(Y − T ) As before, investment is negatively related to real interest rates: I = I(r ) But, we are now assuming that r is SOE is equal to world real interest rate: r = r∗

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Saving and Investment in a Small Open Economy

The National Accounts Identity Revisited

Y = C + I + G + NX (Y − C − G) − I = NX [Y − C(Y − T ) − G] −I(r ∗ ) = NX | {z } National Saving S − I(r ∗ ) = NX

NX depends on variables that determine difference between S and I Fiscal policy (G and T ) World real interest rate r ∗ Any “autonomous” movers of C or I (e.g., wealth for consumption) Foote (Ec 1010b)

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Saving and Investment in a Small Open Economy

Saving and Investment in an SOE

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Saving and Investment in a Small Open Economy

Policy Experiment #1: Fiscal Expansion at Home Consider situation if SOE increases G Direct reduction in national saving (S), because S = Y − C − G Savings schedule shifts to the left No change in r ∗ , because SOE assumption says economy is too small to affect world S or I No change in I(r ∗ ) S − I = NX , so fall in S moves NX toward deficit

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Saving and Investment in a Small Open Economy

Pol. Exp. #1: Fiscal Expansion at Home

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Saving and Investment in a Small Open Economy

Policy Experiment #2: Fiscal Expansion Abroad Consider situation if rest of the world (ROW) increases G No change in SOE’s national saving: S = Y − C − G However, higher world G means smaller world G and higher world r∗ Higher world r ∗ reduces I(r ∗ ) at home S − I = NX , so fall in I moves NX toward surplus

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Saving and Investment in a Small Open Economy

Pol. Exp #2: Fiscal Expansion at Abroad

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Saving and Investment in a Small Open Economy

Policy Experiment #3: Shift in Investment Demand Assume that animal spirits (φ) rises: I(r ) = φ − d · r Demand for investment goods at given r increases Investment schedule I(r ∗ ) shifts up and to the right No change in S = Y − C − G S − I = NX , so rise in I moves NX toward deficit

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Saving and Investment in a Small Open Economy

Pol. Exp. #3: Shift in Investment Demand

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Exchange Rates

Nominal Exchange Rate Definition The nominal exchange rate is the relative price of the currencies of two countries. We will define nominal exchange rate as: e=

U $

If e gets bigger, then it takes more U to get one dollar Dollar strengthens relative to the yen

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Exchange Rates

Dollar vs. Yen

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Exchange Rates

Euro – NOT as Mankiw defines e

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Exchange Rates

Pound – NOT as Mankiw defines e

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Exchange Rates

Nominal Trade-Weighted Value of the Dollar 140 e = 4N curr / $ (as in Mankiw's text) 120

Index (Jan 1997 = 100)

100

80

60

40

20

0 1973

1976

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1979

1982

1985

1988

1991

Open Economy

1994

1997

2000

2003

2006

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Exchange Rates

Real Exchange Rate Definition The real exchange rate is the relative price of the goods of two countries. How many Japanese goods does it take to get one U.S. good? How many U.S. goods does it take to get one European good?

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Exchange Rates

Calculating the real exchange rate American basketball costs $12 Japanese basketball costs 1000 yen Nominal exchange rate = 100 yen / dollar How many Japanese basketballs is one U.S. basketball worth?

Real exchange rate =

(100 yen/dollar ) × ($12/U.S. basketball) 1000 yen/Japanese basketball

Real exchange rate = 1.2

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Japanese basketball U.S. basketball

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Exchange Rates

Calculating the RER (con’t) RER =

(Nominal exch rate) × (Price of Domestic Good ) Price of Foreign Good

RER = (Nominal exch rate) × (Ratio of Price Levels)

P P∗ P = Domestic Price Level ǫ=e×

P ∗ = Foreign Price Level

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Exchange Rates

Avoiding confusion in exchange rates Note that we have defined both the nominal and real exchange rate so that higher numbers mean that the U.S. goods or dollars are stronger Nominal exchange rate = U $ Example: e = 100 means that it takes 100 yen to get one dollar If e rises to 120, that means it takes more yen to get one dollar The dollar has therefore strengthened with respect to the yen

Real exchange rate =

Foreign goods American goods

Example: ǫ = 1.0 means that it takes 1.0 Japanese goods get one American good If ǫ rises to 1.2, that means it takes more Japanese goods to get U.S. good The U.S. real exchange rate has therefore strengthened with respect to Japan

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Exchange Rates

Real exchange rate and NX Real exchange rate is a relative price Higher real exchange rate means that it takes more foreign goods to get one U.S. good Foreign goods are therefore cheaper than U.S. goods Net demand for foreign goods would be expected to be stronger (other things equal) ... ... because demand curves slope down We therefore define our NX function as: NX = NX (ǫ) where higher ǫ reduces NX

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Exchange Rates

Net Exports and the Real Exchange Rate

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Exchange Rates

Real Trade-Weighted Value of the Dollar 140

İ = e (P / P*) (as in Mankiw's text)

120

Index (Jan 1997 = 100)

100

80

60

40

20

0 1973

1976

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1979

1982

1985

1988

1991

Open Economy

1994

1997

2000

2003

2006

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Exchange Rates

Real Exchange Rate and Net Exports 2

140 İ = e (P / P*) (as in Mankiw's text) [right scale]

120

1

0

-1 80

-2

-3

60

Percent of GDP

Index (Jan 1997 = 100)

100

-4 40 -5 20 NX (left scale)

-6

-7

0 1973

1976

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1979

1982

1985

1988

1991

Open Economy

1994

1997

2000

2003

2006

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Exchange Rates

Determinants of Real Exchange Rate We know that ǫ is negatively related to NX We know that NX must equal the net capital outflow, which is just S−I Saving: S = Y − C(Y − T ) − G Investment: I = I(r ) = I(r ∗ ) Neither of these items are depend on ǫ

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Exchange Rates

Net Exports and the Real Exchange Rate

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Exchange Rates

Supply and Demand for Foreign Currency We can think of previous graph in supply and demand terms S − I: Net supply of dollars to be exchanged for investment abroad NX : Net demand for dollars from foreigners who want to buy our goods

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Exchange Rates

Policy Experiment #1: Fiscal Expansion at Home Consider an increase in G or a decrease in T Either one of these movements will reduce S Neither of these movements will change I I = I(r ) = I(r ∗ ) Small open economy does not affect r ∗ , so no ∆r ∗ or ∆I

S − I = NX is reduced

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Exchange Rates

Policy Experiment #1: Fiscal Expansion at Home

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Exchange Rates

Pol. Exp. #1: Fiscal Expansion at Home (con’t) Y = C(Y − T ) + I(r ∗ ) + G + NX When fiscal expansion occurs via rise in G: No change in C(Y − T ) No change in r ∗ or I Decline in NX , so NX are “crowded out” by higher G Y = C(Y − T ) + I(r ∗ ) + |{z} G + NX (ǫ ↑) | {z } rises falls

When fiscal expansion occurs via drop in T : Increase in C(Y − T ) No change in r ∗ or I Decline in NX , so NX are “crowded out” by higher C Y = C(Y − T ↓) +I(r ∗ ) + G + NX (ǫ ↑) | {z } | {z } rises falls

In closed economy case, it is I, not NX , that gets crowded out Foote (Ec 1010b)

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Exchange Rates

Policy Experiment #2: Fiscal Expansion Abroad Fiscal expansion abroad raises r ∗ This will have no effect on S Higher r ∗ will reduce I S − I is increased, ǫ declines, and NX rises

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Exchange Rates

Policy Experiment #2: Fiscal Expansion Abroad

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Exchange Rates

Pol. Exp. #2: Fiscal Expansion Abroad (con’t) Y = C(Y − T ) + I(r ∗ ) + G + NX When fiscal expansion occurs abroad, r ∗ increases No change in C(Y − T ) Increase in r ∗ reduces I Lower ǫ increases NX to offset drop in I Y = C(Y − T ) + I(r ∗ ↑) +G + NX (ǫ ↓) | {z } | {z } rises falls

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Exchange Rates

Policy Experiment #3: Shift in Investment Demand Think of an increase in “animal spirits” (φ) in I = φ − d · r Investment rises at each interest rate r ∗ does not change, so overall I increases S − I is decreased, ǫ rises, and NX declines

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Exchange Rates

Policy Experiment #3: Shift in Investment Demand

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Exchange Rates

Pol. Exp. #3: Shift in Investment Demand (con’t) Y = C(Y − T ) + I(r ∗ ) + G + NX With a shift in investment demand and no change in r ∗ , I increases No change in C(Y − T ) Increase in I No change in G Higher ǫ reduces NX to offset increase in I Y = C(Y − T ) + I(r ∗ ) +G + NX (ǫ ↑) | {z } | {z } rises falls

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Exchange Rates

Policy Experiment #4: Import Restrictions Think of a tariff or quota that makes it harder for Americans to import goods Unless policy affects S or I, it cannot affect S − I = NX Trade policies can reduce imports and raise net exports at any given ǫ, however

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Exchange Rates

Policy Experiment #4: Import Restrictions

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Exchange Rates

Pol. Exp. #4: Import Restrictions (con’t) Y = C(Y − T ) + I(r ∗ ) + G + NX Trade restrictions that would tend to increase NX are offset by increase in ǫ that reduces NX No change in C(Y − T ) No change in I No change in G No change in NX Y = C(Y − T ) + I(r ∗ ) + G +

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NX (ǫ ↑) | {z } stays the same

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Exchange Rates

Determinants of Nominal Exchange Rate We can rearrange our equation for the real exchange rate: ǫ = e × PP∗ ... ... to become an equation for the nominal exchange rate: e=ǫ×

P∗ P

Our rules for percentage changes of products and quotients imply %∆e = %∆ǫ + (π ∗ − π) A country with a high rate of inflation relative to the U.S. will see its currency weaken relative to the dollar Makes sense: If the other country is printing lots of money, its currency become relatively less valuable Foote (Ec 1010b)

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Exchange Rates

Inflation Differentials and Nominal Exchange Rates: 1972-2004

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Exchange Rates

Purchasing Power Parity (PPP) Consider a world without trade frictions, transport costs, and perishable goods In this world, the “law of one price” would hold A U.S. good would trade for a Chinese good, as long as the goods were the same P ǫ=e× ∗ =1 P Net exports would be extremely sensitive to real price differentials NX (ǫ) schedule would be very flat

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Exchange Rates

Purchasing Power Parity

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Exchange Rates

Implications of PPP 1

Because NX (ǫ) schedule is flat, S − I does not affect ǫ or e

2

Because ǫ = 1, all changes in e result from changes in price levels P =1 P∗ P∗ e= P

ǫ=e×

We can use this last implication to devise a test of exchange rates, to see if they are “undervalued” or “overvalued” Find a good that is sold in the two countries ∗ Find PP and compare to e ∗ If e < PP , then dollar is undervalued relative to foreign currency ∗ If e > PP , then dollar is overvalued relative to foreign currency Good often used for this test? Big Mac Foote (Ec 1010b)

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Exchange Rates

Figure 1. Foote (Ec 1010b)

c A Big Mac

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Exchange Rates

Big Mac Test: Some examples (from Table 5-2)

Country

Price of Big Mac

Predicted e ∗ ( PP )

Actual e

Dollar is Over or Under Valued?

U.S. Indonesia China U.K.

3.06 14,770 10.5 1.89

— ? ? ?

— 9,654 8.48 .55

— ? ? ?

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Exchange Rates

Big Mac Test: Some examples (from Table 5-2)

Country

Price of Big Mac

Predicted e ∗ ( PP )

Actual e

Dollar is Over or Under Valued?

U.S. Indonesia China U.K.

3.06 14,770 10.5 1.89

— 4,771 3.43 .61

— 9,654 8.48 .55

— Over Over Under

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Exchange Rates

Verdict on PPP Predictions are often in the ballpark ... ... but often far from the mark PPP turns out to hold better in changes than in levels Levels (less support):

P∗ P Changes (more support – see Figure 5-13): e=

%∆e = π ∗ − π

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The Large Open Economy

Large Open Economy U.S. is like an intermediate case between closed economy and SOE A reduction in U.S. saving raises U.S. interest rates (r vs. r ∗ ) But U.S. is not immune to international developments Turns out that we can think of U.S. as an “average” of two polar cases Example: Increase in U.S. G (fiscal expansion) U.S. saving declines U.S. r rises (as in closed economy case) → I ↓ U.S ǫ rises (as in SOE case) → NX ↓

Closed Economy Case: Y = C + I ↓ +G ↑ Small Open Econ Case: Y = C + I + G ↑ +NX ↓ Large Open Econ Case: Y = C + I ↓ +G ↑ +NX ↓ Foote (Ec 1010b)

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