Chapte 5: Open Economy Impots and expots (% of GD), 2007 45% Impots 4 Expots 35% 3 25% 2 15% 1 5% CHATER 1 The cience of Macoeconomics 0 Canada Fance Gemany Italy Japan U.K. U.. In an open economy, spending need not equal output saving need not equal investment eliminaies d f C C C d f I I I d f G G G supescipts: d = spending on domestic goods f = spending on foeign goods EX = expots = foeign spending on domestic goods IM = impots = C f + I f + G f = spending on foeign goods = net expots (a.k.a. the tade balance ) = EX IM 2 3 GD = expenditue on domestically poduced g & s The national income identity in an open economy d d d Y C I G EX Y = C + I + G + ( C C f ) ( I I f ) ( G G f ) EX C I G EX C I G f f f ( ) o, = Y (C + I + G ) C I G EX IM C I G net expots output domestic spending 4 5 1
Tade supluses and deficits = EX IM = Y (C + I + G ) tade suplus: output > spending and expots > impots ize of the tade suplus = tade deficit: spending > output and impots > expots ize of the tade deficit = Intenational capital flows Net capital outflow = I = net outflow of loanable funds = net puchases of foeign assets the county s puchases of foeign assets minus foeign puchases of domestic assets When > I, county is a net lende When < I, county is a net boowe 6 7 The link between tade & cap. flows = Y (C + I + G ) implies = (Y C G ) I = I tade balance = net capital outflow Thus, a county with a tade deficit ( < 0) is a net boowe ( < I ). 8 aving, investment, and the tade balance (pecent of GD) 1960-2007 24% 22% 2 18% 16% 14% saving investment 8% 6% 4% 2% 12% -2% 1 8% tade balance -4% (ight scale) 6% -6% 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 U..: The wold s lagest debto nation Evey yea since 1980s: huge tade deficits and net capital inflows, i.e. net boowing fom aboad As of 12/31/2008: U.. esidents owned $19.9 tillion woth of foeign assets Foeignes owned $23.4 tillion woth of U.. assets U.. net indebtedness to est of the wold: $3.5 tillion--highe than any othe county, hence U.. is the wold s lagest debto nation aving and investment in a small open economy An open-economy vesion of the loanable funds model fom Chapte 3. Includes many of the same elements: poduction function Y Y F ( K, L) consumption function C C( Y T ) investment function I I ( ) exogenous policy vaiables G G, T T 10 11 2
National saving: The supply of loanable funds Y C( Y T ) G As in Chapte 3, national saving does not depend on the inteest ate Assumptions about capital flows a. domestic & foeign bonds ae pefect substitutes (same isk, matuity, etc.) b. pefect capital mobility: no estictions on intenational tade in assets c. economy is small: cannot affect the wold inteest ate, denoted, I a & b imply = c implies is exogenous 12 13 Investment: The demand fo loanable funds Investment is still a downwad-sloping function of the inteest ate, but the exogenous wold inteest t ate detemines the county s level of investment. I ( ) I ( ), I If the economy wee closed the inteest ate would adjust to equate investment and saving: c I ( ) c I ( ), I 14 15 But in a small open economy Next, thee expeiments: the exogenous wold inteest ate detemines investment and the diffeence between saving and investment detemines net capital outflow and net expots c I 1 I ( ), I 1. Fiscal policy at home 2. Fiscal policy aboad 3. An incease in investment demand (execise) 16 17 3
1. Fiscal policy at home and the fedeal budget deficit (% of GD), 1965-2009 An incease in G o decease in T educes saving. Results: I 0 0 1 2 I 1 2 1 1 I ( ), I 8% 6% 4% 2% -2% Net expots (ight scale) Budget deficit (left scale) 2% -2% -4% 18-4% -6% 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2. Fiscal policy aboad Expansionay fiscal policy aboad aises the wold inteest ate. 1 Results: I 0 I 0 2 I ( ) 2 2 1 I ( ) 1 1 I ( ), I NOW YOU TRY: 3. An incease in investment demand Use the model to detemine the impact of an incease in investment demand on,, I, and net capital outflow. I 1 1 I ( ) 1, I 20 ANWER: 3. An incease in investment demand I > 0, 2 = 0, net capital outflow and fall 1 by the I ( ) 2 amount I I ( ) 1 The nominal exchange ate e = nominal exchange ate, the elative pice of domestic cuency in tems of foeign cuency (e.g. Yen pe Dolla) I 1 I 2, I 23 4
A few exchange ates, as of 6/24/2009 The eal exchange ate county Euo aea Indonesia Japan Mexico Russia outh Afica U.K. exchange ate 0.72 Euo/$ 10,337 Rupiahs/$ 95.99 Yen/$ 13.3 esos/$ 31.4 Rubles/$ 8.1 Rand/$ 0.61 ounds/$ = eal exchange ate, the elative pice of the lowecase domestic goods Geek lette in tems of foeign goods epsilon (e.g. Japanese Big Macs pe U.. Big Mac) 25 Undestanding the units of ~ McZample ~ e (Yen pe $) ($ pe unit U.. goods) Yen pe unit Japanese goods Yen pe unit U.. goods Yen pe unit Japanese goods Units of Japanese goods pe unit of U.. goods one good: Big Mac pice in Japan: = 200 Yen pice in UA: = $2.50 nominal exchange ate e = 120 Yen/$ e 120 $ 2. 50 15. 200 Yen To buy a U.. Big Mac, someone fom Japan would have to pay an amount that could buy 1.5 Japanese Big Macs. 26 27 in the eal wold & ou model In the eal wold: We can think of as the elative pice of a basket of domestic goods in tems of a basket of foeign goods In ou maco model: Thee s just one good, output. o is the elative pice of one county s output in tems of the othe county s output How depends on U.. goods become moe expensive elative to foeign goods EX, IM 28 29 5
U.. net expots and the eal exchange ate, 1973-2009 of GD) (% 4% Tade-weighted eal exchange ate index 2% -2% -4% -6% Net expots (left scale) 140 120 100 80 60 40 20 1973 = 100) Index (Mach The net expots function The net expots function eflects this invese elationship between and : = ( ) -8% 0 1970 1975 1980 1985 1990 1995 2000 2005 2010 31 The cuve fo the U.. The cuve fo the U.. When is elatively low, U.. goods ae elatively inexpensive so U.. net expots will be high () 2 At high enough values of, U.. goods become so expensive that we expot less than we impot () 0 ( 1 ) ( 2 ) 0 32 33 How is detemined How is detemined The accounting identity says = I We saw ealie how I is detemined: depends on domestic factos (output, fiscal policy vaiables, etc) ) I is detemined by the wold inteest ate o, must adjust to ensue ( ) I ( ) Neithe no I depend on, so the net capital outflow cuve is vetical. adjusts to equate with net capital outflow, I. 1 I ( ) ( ) 1 34 35 6
Intepetation: supply and demand in the foeign exchange maket demand: Foeignes need dollas to buy U.. net expots. supply: Net capital outflow ( I ) is the supply of dollas to be invested aboad. 1 I ( ) 1 ( ) 36 Next, fou expeiments: 1. Fiscal policy at home 2. Fiscal policy aboad 3. An incease in investment demand (execise) 4. Tade policy to estict impots 37 1. Fiscal policy at home 2. Fiscal policy aboad A fiscal expansion educes national saving, net capital outflow, and the supply of dollas in the foeign exchange maket causing the eal exchange ate to ise and to fall. 2 2 I ( ) 1 I ( ) ( ) 2 1 38 An incease in educes investment, inceasing net capital outflow and the supply of dollas in the foeign exchange maket 2 causing the eal exchange ate to fall and to ise. I ( ) 1 1 1 I ( 2 ) ( ) 1 2 39 NOW YOU TRY: 3. Incease in investment demand Detemine the impact of an incease in investment demand on net expots, net capital outflow, and the eal exchange ate I 1 1 ( ) 1 ANWER: 3. Incease in investment demand An incease in 1 I 2 investment 1 I1 educes net capital outflow 2 and the supply of dollas in the foeign exchange maket ( ) causing the eal exchange ate to ise and to fall. 2 1 7
4. Tade policy to estict impots At any given value of, an impot quota IM demand fo dollas shifts 2 I ight ( ) 2 Tade policy doesn t affect o I, so capital flows and the supply of dollas emain fixed. 1 ( ) 1 42 4. Tade policy to estict impots Results: > 0 (demand incease) = 0 (supply fixed) IM < 0 (policy) EX < 0 (ise in ) I 2 ( ) 2 1 ( ) 1 43 The deteminants of the nominal exchange ate tat with the expession fo the eal exchange ate: e olve fo the nominal exchange ate: e The deteminants of the nominal exchange ate o e depends on the eal exchange ate and the pice levels at home and aboad and we know how each of them is detemined: M L (, Y ) e ( ) I ( ) M L (, Y) 44 45 The deteminants of the nominal exchange ate e Rewite this equation in gowth ates (see aithmetic ticks fo woking with pecentage changes, Chap 2 ): e e Fo a given value of, the gowth ate of e equals the diffeence between foeign and domestic inflation ates. 46 Inflation diffeentials and nominal exchange ates fo a coss section of counties % change in nominal exchange ate 3 25% Mexico 2 Iceland 15% akistan 1 Austalia. Afica 5% Canada ingapoe. Koea U.K. Japan -5% -1-5% 5% 1 15% 2 25% 3 inflation diffeential 8
uchasing owe aity () uchasing owe aity () Two definitions: A doctine that states that goods must sell at the same (cuency-adjusted) pice in all counties. The nominal exchange ate adjusts to equalize the cost of a basket of goods acoss counties. Reasoning: abitage, the law of one pice 48 : e = Cost of a basket of foeign goods, in foeign cuency. Cost of a basket of Cost of a basket of domestic goods, in domestic goods, in foeign cuency. domestic cuency. olve fo e : e = / implies that the nominal exchange ate between two counties equals the atio of the counties pice levels. 49 uchasing owe aity () Does hold in the eal wold? If e = /, then e and the cuve is hoizontal: 1 I Unde, changes in ( I ) have no = 1 impact on o e. 50 No, fo two easons: 1. Intenational abitage not possible. nontaded goods tanspotation costs 2. Diffeent counties goods not pefect substitutes. Yet, is a useful theoy: It s simple & intuitive. In the eal wold, nominal exchange ates tend towad thei values ove the long un. 51 CAE TUDY: The Reagan deficits evisited G T I 1970s 2.2 19.6 1.1 19.9-0.3 115.1 1980s 3.9 17.4 6.3 19.4-2.0 129.4 actual change closed economy no change no change small open economy no change no change Data: decade aveages; all except and ae expessed as a pecent of GD; is a tade-weighted index. The U.. as a lage open economy o fa, we ve leaned long-un models fo two exteme cases: closed economy (chap. 3) small open economy (chap. 5) A lage open economy like the U.. falls between these two extemes. The esults fom lage open economy analysis ae a mixtue of the esults fo the closed & small open economy cases. Fo example 53 9
A fiscal expansion in thee models A fiscal expansion causes national saving to fall. The effects of this depend on openness & size: I closed economy ises falls no change lage open economy ises, but not as much as in closed economy falls, but not as much as in closed economy falls, but not as much as in small open economy small open economy no change no change falls Chapte ummay Net expots--the diffeence between expots and impots a county s output (Y ) and its spending (C + I + G) Net capital outflow equals puchases of foeign assets minus foeign puchases of the county s assets the diffeence between saving and investment 54 Chapte ummay National income accounts identities: Y = C + I + G + tade balance = I net capital outflow Impact of policies i on : inceases if policy causes to ise o I to fall does not change if policy affects neithe no I. Example: tade policy Exchange ates Chapte ummay nominal: the pice of a county s cuency in tems of anothe county s cuency eal: the pice of a county s goods in tems of anothe county s goods The eal exchange ate equals the nominal ate times the atio of pices of the two counties. Chapte ummay How the eal exchange ate is detemined depends negatively on the eal exchange ate, othe things equal The eal exchange ate adjusts to equate with net capital outflow Chapte ummay How the nominal exchange ate is detemined e equals the eal exchange ate times the county s pice level elative to the foeign pice level. Fo a given value of the eal exchange ate, the pecentage change in the nominal exchange ate equals the diffeence between the foeign & domestic inflation ates. 10