The Open Economy Adapted for EC 204 by Prof. Bob Murphy

1. 5 The Open EconomyAdapted for EC 204 byProf. Bob Murphy

2. Trade-GDP ratio, selected countries, 2004(Imports + Exports) as a percentage of GDP CHAPTER 5 The Open Economy

3. In an open economy, • spending need not equal output • saving need not equal investment See Supplements 5-1, Terminology of Trade, and 5-2, Saving-Investment in Open Economies. CHAPTER 5 The Open Economy

4. Y = C + I + G + NX net exports domestic spending output The national income identity in an open economy or, NX= Y– (C+ I + G) CHAPTER 5 The Open Economy

5. Trade surpluses and deficits NX = EX – IM = Y– (C+ I + G ) • trade surplus:output > spending and exports > imports Size of the trade surplus = NX • trade deficit:spending > output and imports > exports Size of the trade deficit = –NX CHAPTER 5 The Open Economy

6. U.S. net exports, 1950-2006

7. 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 CHAPTER 5 The Open Economy

8. The link between trade & cap. 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 ). CHAPTER 5 The Open Economy

9. “The world’s largest debtor nation” • U.S. has had large trade deficits, been a net borrower each year since the early 1980s. • As of 12/31/2005: • U.S. residents owned $10.0 trillion worth of foreign assets • Foreigners owned $12.7 trillion worth of U.S. assets • U.S. net indebtedness to rest of the world:$2.7 trillion--higher than any other country, hence U.S. is the “world’s largest debtor nation” CHAPTER 5 The Open Economy

10. An open-economy version of the loanable funds model from Chapter 3. Includes many of the same elements: production function consumption function investment function exogenous policy variables Saving and investment in a small open economy CHAPTER 5 The Open Economy

11. r S, I National saving: The supply of loanable funds As in Chapter 3,national saving does not depend on the interest rate CHAPTER 5 The Open Economy

12. Assumptions re: 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, denoted r* a & b imply r = r* c implies r*is exogenous CHAPTER 5 The Open Economy

13. r I(r) S, I Investment: The demand for loanable funds Investment is still a downward-sloping function of the interest rate, but the exogenous world interest rate… …determines the country’s level of investment. r* I(r*) CHAPTER 5 The Open Economy

14. r rc I(r) S, I If the economy were closed… …the interest rate would adjust to equate investment and saving: CHAPTER 5 The Open Economy

15. r r* rc I(r) S, I I1 But in a small open economy… the exogenous world interest rate determines investment… NX …and the difference between saving and investment determines net capital outflow and net exports CHAPTER 5 The Open Economy

16. Next, three experiments: 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand See Supplement 5-4, Benefits of a Trade Deficit. CHAPTER 5 The Open Economy

17. r NX2 NX1 Results: I(r) S, I I1 1. Fiscal policy at home An increase in G or decrease in T reduces saving. CHAPTER 5 The Open Economy

18. Budget deficit (right scale) Net exports (left scale) NX and the federal budget deficit (% of GDP), 1960-2006 4% 8% 6% 2% 4% 0% 2% -2% 0% -4% -2% -6% -4% 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 slide 20

19. r NX2 NX1 I(r) S, I 2. Fiscal policy abroad Expansionary fiscal policy abroad raises the world interest rate. Results: CHAPTER 5 The Open Economy

20. r S NX1 I(r)1 S, I I1 3.An increase in investment demand EXERCISE: Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow. CHAPTER 5 The Open Economy

21. r S NX2 NX1 I(r)2 I(r)1 S, I I2 I1 3.An increase in investment demand ANSWERS: I > 0, S = 0, net capital outflow and NXfall by the amount I CHAPTER 5 The Open Economy

22. CHAPTER 5 The Open Economy

23. e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency (e.g. Yen per Dollar) The nominal exchange rate CHAPTER 5 The Open Economy

24. the lowercase Greek letter epsilon 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) ε CHAPTER 5 The Open Economy

25. Understanding the units of ε ε CHAPTER 5 The Open Economy

26. ε in the real world & our model • In the real world:We can think of ε as the relative price of a basket of domestic goods in terms of a basket of foreign goods • In our macro model:There’s just one good, “output.”So εis the relative price of one country’s output in terms of the other country’s output CHAPTER 5 The Open Economy

27. εU.S. goods become more expensive relative to foreign goods  EX, IM  NX How NXdepends on ε CHAPTER 5 The Open Economy

28. Trade-weighted real exchange rate index Net exports(left scale) U.S. net exports and the real exchange rate, 1973-2006 3% 140 2% 120 1% 100 0% -1% (March 1973 = 100) 80 (% of GDP) -2% 60 -3% NX -4% 40 Index -5% 20 -6% -7% 0 1973 1977 1981 1985 1989 1993 1997 2001 2005 CHAPTER 5 The Open Economy

29. The net exports function • The net exports function reflects this inverse relationship between NX and ε: NX = NX(ε) CHAPTER 5 The Open Economy

30. ε so U.S. net exports will be high When ε is relatively low, U.S. goods are relatively inexpensive ε1 NX(ε) 0 NX NX(ε1) The NX curve for the U.S. CHAPTER 5 The Open Economy

31. ε At high enough values ofε, U.S. goods become so expensive that ε2 we export less than we import NX(ε) 0 NX NX(ε2) The NX curve for the U.S. CHAPTER 5 The Open Economy

32. 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*) CHAPTER 5 The Open Economy

33. ε NX(ε) NX How ε is determined Neither Snor I depend on ε, so the net capital outflow curve is vertical. ε1 ε adjusts to equate NXwith net capital outflow, S-I. NX1 CHAPTER 5 The Open Economy

34. ε NX(ε) NX 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. ε1 NX1 CHAPTER 5 The Open Economy

35. Next, four experiments: 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand 4. Trade policy to restrict imports CHAPTER 5 The Open Economy

36. ε ε2 ε1 NX(ε) NX NX1 NX2 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. CHAPTER 5 The Open Economy

37. ε ε1 ε2 NX(ε) NX NX2 NX1 2. Fiscal policy abroad An 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. CHAPTER 5 The Open Economy

38. ε ε2 ε1 NX(ε) NX NX1 NX2 3. Increase in investment demand An increase in investment reduces net capital outflow and the supply of dollars in the foreign exchange market… …causing the real exchange rate to rise and NX to fall. CHAPTER 5 The Open Economy

39. ε ε2 ε1 NX(ε)2 NX(ε)1 NX NX1 4.Trade policy to restrict imports At any given value of ε, an import quota  IM NX  demand for dollars shifts right Trade policy doesn’t affect S or I, so capital flows and the supply of dollars remain fixed. CHAPTER 5 The Open Economy

40. ε ε2 ε1 NX(ε)2 NX(ε)1 NX NX1 4.Trade policy to restrict imports Results: ε > 0 (demand increase) NX = 0(supply fixed) IM < 0 (policy) EX < 0(rise in ε) CHAPTER 5 The Open Economy

41. The determinants of the nominal exchange rate • Start with the expression for the real exchange rate: • Solve for the nominal exchange rate: CHAPTER 5 The Open Economy

42. The determinants of the nominal exchange rate • 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: NX() = S - I(r*) CHAPTER 5 The Open Economy

43. The determinants of the nominal exchange rate • Rewrite this equation in growth rates (see “arithmetic tricks for working with percentage changes,” Chap 2 ): • For a given value of ε, the growth rate of e equals the difference between foreign and domestic inflation rates. CHAPTER 5 The Open Economy

44. Inflation differentials and nominal exchange rates Mexico Iceland Singapore South Africa Canada South Korea U.K. Japan CHAPTER 5 The Open Economy

45. 1970s 1980s 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  CASE STUDY: The Reagan deficits revisited Data: decade averages; all except r and ε are expressed as a percent of GDP; ε is a trade-weighted index. CHAPTER 5 The Open Economy

46. The U.S. as a large open economy • 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.S. – fallsbetween 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 The Open Economy

47. closed economy large open economy small open economy r I NX A fiscal expansion in three models A fiscal expansion causes national saving to fall.The effects of this depend on openness & size: rises rises, but not as much as in closed economy nochange falls falls, but not as much as in closed economy nochange no change falls, but not as much as in small open economy falls CHAPTER 5 The Open Economy