econ 3010 intermediate macroeconomics · u.s.: the world’s largest debtor nation every year since...
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ECON 3010Intermediate Macroeconomics
Chapter 6
The Open Economy
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Imports and exports of selected countries, 2010
0
10
20
30
40
50
60
Australia China Germany Greece S. Korea Mexico UnitedStates
Perc
ent o
f GD
P
ExportsImports
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In an open economy,
spending need not equal output saving need not equal investment
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Preliminaries
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
d fC C C= +d fI I I= +d fG G G= +
superscripts:d = spending on
domestic goodsf = spending on
foreign goods
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GDP = expenditure on domestically produced G & S
d d dY C I G EX= + + +
( ) ( ) ( )f f fC C I I G G EX= − + − + − +
( )f f fC I G EX C I G= + + + − + +
C I G EX IM= + + + −
C I G NX= + + +
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The national income identity in an open economy
Y = C + I + G + NX
or, NX = Y – (C + I + G )
net exportsdomestic spending
output
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Trade surpluses and deficits
trade surplus: output > spending & exports > imports
trade deficit: spending > output & imports > exports
NX = EX – IM = Y – (C + I + G )
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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
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The link between trade & capital 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 ).
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-10%
-5%
0%
5%
10%
15%
0%
5%
10%
15%
20%
25%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Trad
e B
alan
ce (%
of G
DP
)
Sav
ing,
Inve
stm
ent (
% o
f GD
P)
Saving, investment, and the trade balance 1960–2012
trade balance (right scale)
saving
investment
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U.S.: The world’s largest debtor nation
Every year since 1980s: huge trade deficits and net capital inflows, i.e. net borrowing from abroad
As of 12/31/2011:◦ U.S. residents owned $21.1 trillion worth of
foreign assets◦ Foreigners owned $25.1 trillion worth of
U.S. assets◦ U.S. net indebtedness to rest of the world:
$4.0 trillion—higher than any other country, hence U.S. is the “world’s largest debtor nation”
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Saving and investment in a small open economy An open-economy version of the loanable
funds model from Chapter 3:
◦ production function
◦ consumption function
◦ investment function
◦ exogenous policy variables
Y Y F K L= = ( , )
C C Y T= −( )
I I r= ( )
G G T T= =,
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National saving: The supply of loanable funds
r
S, I
As in Chapter 3,national saving does not depend on the
interest rate
( )S Y C Y T G= − − −
S
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Assumptions about 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, r*
a & b imply r = r*c implies r* is exogenous
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Investment: The demand for loanable funds
Investment is still a downward-sloping function
of the interest rate,
r *
but the exogenous world interest rate…
…determines thecountry’s level of
investment.
I (r* )
r
S, I
I (r )
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If the economy were closed…
r
S, I
I (r )
S
rc
cISr
=
( )
…the interest rate would adjust to equate investment and saving:
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But in a small open economy…
r
S, I
I (r )
S
rc
r*
I 1
the exogenous world interest rate determines investment…
…and the difference between saving and investment determines net capital outflow and net exports
NX
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Next, three experiments:
1. Fiscal policy at home
2. Fiscal policy abroad
3. An increase in investment demand(exercise)
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1. Fiscal policy at homer
S, I
I (r )
1S
I 1
An increase in Gor decrease in Treduces saving.
1*r
NX1
2S
NX2
Results: 0I∆ =
0NX S∆ = ∆ <
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-6%
-4%
-2%
0%
2%
-4%
-2%
0%
2%
4%
6%
8%
10%
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
NX and the federal budget deficit (% of GDP), 1965–2012
Budget deficit (left scale)
Net exports (right scale)
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2. Fiscal policy abroadr
S, I
I (r )
1SExpansionary fiscal policy abroad raises the world interest rate. 1
*rNX1
NX2
Results: 0I∆ <
0NX I∆ = −∆ >
2*r
1( )*I r2( )*I r
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NOW YOU TRY
3. An increase in investment demand
21
r
S, I
I (r )1
Use the model to determine the impact of an increase in investment demand on NX, S, I , and net capital outflow.
NX1
*r
I 1
S
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ANSWERS
3. An increase in investment demand
22
r
S, I
I (r )1
∆I > 0,∆S = 0,net capital outflow and NX fall by the amount ∆I
NX2
NX1
*r
I 1 I 2
S
I (r )2
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The nominal exchange rate
e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency (e.g. yen per dollar)
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The real exchange rate
= real exchange rate, the relative price of domestic goods in terms of foreign goods (e.g., Japanese Big Macs per U.S. Big Mac)
the lowercase Greek letter
epsilon
ε
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Understanding the units of ε
(Yen per $) ($ per unit U.S. goods)Yen per unit Japanese goods
×=
Units of Japanese goods
per unit of U.S. goods=
Yen per unit U.S. goodsYen per unit Japanese goods
=
*e PP×
=ε
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one good: Big Mac price in Japan:
P* = 200 Yen price in USA:
P = $2.50 nominal exchange rate
e = 120 Yen/$
~ McZample ~
To buy a U.S. Big Mac, someone from Japan would have to pay an amount that could buy 1.5 Japanese Big Macs.
120 2 50 1 5200 Yen
e PP×
=
×= =
*$ .
.
ε
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How NX depends on ε
↑ε ⇒ U.S. goods become more expensive relative to foreign goods
⇒ ↓EX, ↑IM
⇒ ↓NX
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0
20
40
60
80
100
120
140
-8%
-6%
-4%
-2%
0%
2%
4%
1970 1975 1980 1985 1990 1995 2000 2005 2010
U.S. net exports and the real exchange rate, 1973–2012N
X(%
of G
DP)
Inde
x(M
arch
197
3 =
100)
Trade-weighted real exchange rate index
Net exports(left scale)
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The net exports function
The net exports function reflects this inverse relationship between NX and ε :
NX = NX(ε )
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The NX curve for the U.S.
0 NX
ε
NX (ε)
ε1
When ε is relatively low, U.S. goods are relatively inexpensive
NX (ε1)
so U.S. net exports will be high
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The NX curve for the U.S.
0 NX
ε
NX (ε)
ε2
At high enough values of ε, U.S. goods become so expensive that
NX(ε2)
we export less than we import
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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
policy variables, etc.)◦ I is determined by the world interest
rate r * So, ε must adjust to ensure
( ) ( )*NX ε S I r= −
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How ε is determined
Neither S nor Idepends on ε , so the net capital outflow curve is vertical.
ε
NX
NX(ε )
1 ( *)S I r−
ε adjusts to equate NXwith net capital outflow, S − I .
ε 1
NX 1
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Interpretation: supply and demand in the foreign exchange market
demand:Foreigners need dollars to buy U.S. net exports.
ε
NX
NX(ε )
1 ( *)S I r−
supply: Net capital outflow (S − I ) is the supply of dollars to be invested abroad.
ε 1
NX 1
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Next, four experiments:
1. Fiscal policy at home
2. Fiscal policy abroad
3. An increase in investment demand(exercise)
4. Trade policy to restrict imports
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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…
…causing the real exchange rate to rise and NX to fall.
ε
NX
NX(ε )
1 ( *)S I r−
ε 1
NX 1NX 2
2 ( *)S I r−
ε 2
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2. Fiscal policy abroadAn 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.
ε
NX
NX(ε )
1 1( *)S I r−
NX 1
ε 1
21 ( )*S I r−
ε 2
NX 2
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NOW YOU TRY
3. Increase in investment demand
38
NX(ε )
ε 1
1 1S I−
NX 1
ε
NX
Determine the impact of an increase in investment demand on net exports, net capital outflow, and the real exchange rate.
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ANSWERS
3. Increase in investment demand
39
An increase in investment reduces net capital outflow and the supply of dollars in the foreign exchange market… NX(ε )
ε 1
1 1S I−
NX 1
21S I−
NX 2
ε 2
ε
NX…causing the real exchange rate to rise and NX to fall.
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4. Trade policy to restrict imports
At any given value of ε , an import quota ⇒ ↓IM ⇒ ↑NX⇒ demand for
dollars shifts right
ε
NX
NX (ε )1
S I−
NX1
ε 1
NX (ε )2Trade policy doesn’t affect S or I , so capital flows and the supply of dollars remain fixed.
ε 2
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The determinants of the nominal exchange rate
Start with the expression for the real exchange rate:
*
e PεP×
=
Solve for the nominal exchange rate:*Pe ε
P= ×
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The determinants of the nominal exchange rate
Rewrite this equation in growth rates
*Pe εP
= ×
*
*
e ε P Pe ε P P
= + −∆ ∆ ∆ ∆ *ε
επ π= + −
∆
For a given value of ε, the growth rate of e equals the difference between foreign and domestic inflation rates.
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-6%
-4%
-2%
0%
2%
4%
6%
8%
-4% -2% 0% 2% 4% 6% 8%
Inflation differentials and nominal exchange rates for a cross section of countries
% change in nominal exchange
rate
inflation differential
Pakistan
U.K.
Singapore
Switzerland
Japan
Sweden
Iceland
Mexico
S. KoreaS. Africa
Australia
CanadaDenmark
New Zealand