Macroeonomics. 19 this chapter, A Macroeconomic Theory of the Open Economy. look for the answers to these questions: The Market for Loanable Funds

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1 C H A P T E R In 19 this chapte, look fo the answes to these questions: A Macoeconomic Theoy of the Open Economy P R I N C I P L E S O F Macoeonomics N. Gegoy Mankiw Pemium PowePoint Slides by Ron Conovich 2009 South-Westen, a pat of Cengage Leaning, all ights eseved In an open economy, what detemines the eal inteest ate? The eal exchange ate? How ae the makets fo loanable funds and foeign-cuency exchange connected? How do govenment budget deficits affect the exchange ate and tade balance? How do othe policies o events affect the inteest ate, exchange ate, and tade balance? 1 Intoduction The pevious chapte explained the basic concepts and vocabulay of the open economy: net expots (NX), net capital outflow (), and exchange ates. This chapte ties these concepts togethe into a theoy of the open economy. We will use this theoy to see how govt policies and vaious events affect the tade balance, exchange ate, and capital flows. We stat with the loanable funds maket A MACROECONOMIC THEORY OF THE OPEN ECONOMY 2 The Maket fo Loanable Funds An identity fom the peceding chapte: Saving S = I + Domestic investment Supply of loanable funds = saving. Net capital outflow A dolla of saving can be used to finance the puchase of domestic capital the puchase of a foeign asset So, demand fo loanable funds = I + A MACROECONOMIC THEORY OF THE OPEN ECONOMY 3 1

2 The Maket fo Loanable Funds Recall: S depends positively on the eal inteest ate,. I depends negatively on. What about? A MACROECONOMIC THEORY OF THE OPEN ECONOMY 4 How Depends on the Real Inteest Rate The eal inteest ate,, is the eal etun on domestic assets. A fall in makes domestic assets less attactive elative to foeign assets. People in the U.S. puchase moe foeign assets. People aboad puchase fewe U.S. assets. ises. A MACROECONOMIC THEORY OF THE OPEN ECONOMY Net capital outflow The Loanable Funds Maket Diagam adjusts to balance supply and demand in the LF maket. Loanable funds S = saving Both I and depend negatively on, so the D cuve is downwad-sloping. A C T I V E L E A R N I N G 1 Budget deficits and capital flows Suppose the govenment uns a budget deficit (peviously, the budget was balanced). Use the appopiate diagams to detemine the effects on the eal inteest ate and net capital outflow. D = I + LF A MACROECONOMIC THEORY OF THE OPEN ECONOMY 6 7 2

3 A C T I V E L E A R N I N G 1 Answes When woking with this model, keep in mind: The A budget highe deficit makes educes U.S. saving bonds and moe the attactive supply of elative LF, the LF maket detemines (in left gaph), to causing foeign to bonds, ise. educes. then this value of detemines (in ight gaph). 2 1 Loanable funds S 2 S 1 D 1 LF 2 1 Net capital outflow 1 8 The Maket fo Foeign-Cuency Exchange Anothe identity fom the peceding chapte: Net capital outflow = NX Net expots In the maket fo foeign-cuency exchange, NX is the demand fo dollas: Foeignes need dollas to buy U.S. net expots. is the supply of dollas: U.S. esidents sell dollas to obtain the foeign cuency they need to buy foeign assets. A MACROECONOMIC THEORY OF THE OPEN ECONOMY 9 The Maket fo Foeign-Cuency Exchange Recall: The U.S. eal exchange ate (E) measues the quantity of foeign goods & sevices that tade fo one unit of U.S. goods & sevices. E is the eal value of a dolla in the maket fo foeign-cuency exchange. A MACROECONOMIC THEORY OF THE OPEN ECONOMY 10 The Maket fo Foeign-Cuency Exchange EAn adjusts incease to balance in E makes supply U.S. goods and demand moe fo expensive dollas in to the foeignes, maket educes fo foeigncuency fo U.S. goods exchange. and demand U.S. dollas. An incease in E has no effect on saving o investment, so it does not affect o the supply of dollas. E 1 S = A MACROECONOMIC THEORY OF THE OPEN ECONOMY 11 E D = NX Dollas 3

4 FYI: Disentangling Supply and Demand When a U.S. esident buys impoted goods, does the tansaction affect supply o demand in the foeign exchange maket? Two views: 1. The supply of dollas inceases. The peson needs to sell he dollas to obtain the foeign cuency she needs to buy the impots. 2. The demand fo dollas deceases. The incease in impots educes NX, which we think of as the demand fo dollas. (So, NX is eally the net demand fo dollas.) Both views ae equivalent. Fo ou puposes, it s moe convenient to use the second. A MACROECONOMIC THEORY OF THE OPEN ECONOMY 12 FYI: Disentangling Supply and Demand When a foeigne buys a U.S. asset, does the tansaction affect supply o demand in the foeign exchange maket? Two views: 1. The demand fo dollas inceases. The foeigne needs dollas in ode to puchase the U.S. asset. 2. The supply of dollas falls. The tansaction educes, which we think of as the supply of dollas. (So, is eally the net supply of dollas.) Again, both views ae equivalent. We will use the second. A MACROECONOMIC THEORY OF THE OPEN ECONOMY 13 A C T I V E L E A R N I N G 2 The budget deficit, exchange ate, and NX Initially, the govenment budget is balanced and tade is balanced (NX = 0). Suppose the govenment uns a budget deficit. As we saw ealie, ises and falls. How does the budget deficit affect the U.S. eal exchange ate? The balance of tade? A C T I V E L E A R N I N G 2 Answes The budget deficit educes and the supply of dollas. The eal exchange ate appeciates, educing net expots. Since NX = 0 initially, the budget deficit causes a tade deficit (NX < 0). E 2 E 1 E Maket fo foeigncuency exchange S 2 = 2 S 1 = 1 D = NX Dollas

5 The Twin Deficits Pecent of GDP 5% 4% 3% 2% 1% 0% -1% -2% -3% -4% -5% Net expots and the budget deficit often move in opposite diections. U.S. fedeal budget deficit U.S. net expots SUMMARY: The Effects of a Budget Deficit National saving falls The eal inteest ate ises Domestic investment and net capital outflow both fall The eal exchange ate appeciates Net expots fall (o, the tade deficit inceases) A MACROECONOMIC THEORY OF THE OPEN ECONOMY 17 SUMMARY: The Effects of a Budget Deficit One othe effect: As foeignes acquie moe domestic assets, the county s debt to the est of the wold inceases. Due to many yeas of budget and tade deficits, the U.S. is now the wold s lagest debto nation. Intenational investment position of the U.S. 31 Decembe 2007 Value of U.S.-owned foeign assets Value of foeign-owned U.S. assets U.S. net debt to the est of the wold $17.6 tillion $20.1 tillion $2.5 tillion A MACROECONOMIC THEORY OF THE OPEN ECONOMY 18 The Connection Between Inteest Rates and Exchange Rates Anything Keep that in mind: The inceases LF maket (not shown) will educe detemines. and the This supply value of dollas then detemines the foeign exchange (shown in uppe maket. gaph). This value of then Result: detemines supply of The eal exchange dollas in foeign exchange ate appeciates. maket (in lowe gaph). 2 1 E E 2 E 1 2 S S 1 = 1 D = NX dollas

6 A C T I V E L E A R N I N G 3 Investment incentives Suppose the govenment povides new tax incentives to encouage investment. Use the appopiate diagams to detemine how this policy would affect: the eal inteest ate net capital outflow the eal exchange ate net expots 20 A C T I V E L E A R N I N G 3 Answes Investment ises, and the demand fo LF incease at each value causing of. to fall. 2 Loanable funds S D 1 D 2 LF 2 Net capital outflow A C T I V E L E A R N I N G 3 Answes The fall in educes the supply of dollas in the foeign exchange maket. The eal exchange ate appeciates, educing net expots. E 2 E 1 E Maket fo foeigncuency exchange S 2 = 2 S 1 = 1 D = NX Dollas 22 Budget Deficit vs. Investment Incentives A tax incentive fo investment has simila effects as a budget deficit: ises, falls E ises, NX falls But one impotant diffeence: Investment tax incentive inceases investment, which inceases poductivity gowth and living standads in the long un. Budget deficit educes investment, which educes poductivity gowth and living standads. A MACROECONOMIC THEORY OF THE OPEN ECONOMY 23 6

7 Tade Policy Tade policy: a govt policy that diectly influences the quantity of g&s that a county impots o expots Examples: Taiff a tax on impots Impot quota a limit on the quantity of impots Voluntay expot estictions the govt pessues anothe county to estict its expots; essentially the same as an impot quota Tade Policy Common easons fo policies to estict impots: Save jobs in a domestic industy that has difficulty competing with impots Reduce the tade deficit Do such tade policies accomplish these goals? Let s use ou model to analyze the effects of an impot quota on cas fom Japan designed to save jobs in the U.S. auto industy. A MACROECONOMIC THEORY OF THE OPEN ECONOMY 24 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 25 Analysis of a Quota on Cas fom Japan An impot quota does not affect saving o investment, so it does not affect. (Recall: = S I.) Loanable funds 1 1 S D LF A MACROECONOMIC THEORY OF THE OPEN ECONOMY 26 Net capital outflow Analysis of a Quota on Cas fom Japan Since unchanged, S cuve does not shift. The D cuve shifts: At each E, impots of cas fall, so net expots ise, D shifts to the ight. At E 1, thee is excess demand in the foeign exchange maket. E ises to estoe eq m. A MACROECONOMIC THEORY OF THE OPEN ECONOMY 27 E E 2 E 1 Maket fo foeigncuency exchange S = D 1 D 2 Dollas 7

8 Analysis of a Quota on Cas fom Japan What happens to NX? Nothing! If E could emain at E 1, NX would ise, and the quantity of dollas demanded would ise. But the impot quota does not affect, so the quantity of dollas supplied is fixed. Since NX must equal, E must ise enough to keep NX at its oiginal level. Hence, the policy of esticting impots does not educe the tade deficit. A MACROECONOMIC THEORY OF THE OPEN ECONOMY 28 Analysis of a Quota on Cas fom Japan Does the policy save jobs? The quota educes impots of Japanese autos. U.S. consumes buy moe U.S. autos. U.S. automakes hie moe wokes to poduce these exta cas. So the policy saves jobs in the U.S. auto industy. But E ises, educing foeign demand fo U.S. expots. Expot industies contact, expoting fims lay off wokes. The impot quota saves jobs in the auto industy but destoys jobs in U.S. expot industies!! A MACROECONOMIC THEORY OF THE OPEN ECONOMY 29 CASE STUDY: Capital Flows fom China In ecent yeas, China has accumulated U.S. assets to educe its exchange ate and boost its expots. Results in U.S.: Appeciation of $ elative to Chinese enminbi Highe U.S. impots fom China Lage U.S. tade deficit Some U.S. politicians want China to stop, ague fo esticting tade with China to potect some U.S. industies. Yet, U.S. consumes benefit, and the net effect of China s cuency intevention is pobably small. A MACROECONOMIC THEORY OF THE OPEN ECONOMY 30 Political Instability and Capital Flight 1994: Political instability in Mexico made wold financial makets nevous. People woied about the safety of Mexican assets they owned. People sold many of these assets, pulled thei capital out of Mexico. Capital flight: a lage and sudden eduction in the demand fo assets located in a county We analyze this using ou model, but fom the pospective of Mexico, not the U.S. A MACROECONOMIC THEORY OF THE OPEN ECONOMY 31 8

9 Capital Flight fom Mexico The As Demand foeign equilibium fo investos LF = values I + sell. of thei and assets and both pull incease. out thei capital, The incease inceases inceases at each value demand of. fo LF. Loanable funds Net capital outflow S D 1 D 2 LF 2 1 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 32 Capital Flight fom Mexico The incease in causes an incease in the supply of pesos in the foeign exchange maket. The eal exchange ate value of the peso falls. E 1 E 2 Maket fo foeigncuency exchange S 2 = 2 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 33 E S 1 = 1 D 1 Pesos US Dollas pe cuency unit. Examples of Capital Flight: Mexico, /23/ /12/ /2/ /22/1994 1/11/1995 1/31/1995 2/20/1995 3/12/1995 4/1/1995 Examples of Capital Flight: S.E. Asia, 1997 US Dollas pe cuency unit. 1/1/1997 = /1/1996 2/24/1997 5/20/1997 8/13/ /6/1997 1/30/1998 South Koea Won Thai Baht Indonesia Rupiah 4/25/1998 7/19/1998 9

10 Examples of Capital Flight: Russia, 1998 Examples of Capital Flight: Agentina, 2002 US Dollas pe cuency unit /5/1998 6/14/1998 7/24/1998 9/2/ /12/ /21/ /31/1998 U.S. Dollas pe cuency unit /1/2001 9/19/ /8/2001 2/26/2002 5/17/2002 8/5/ /24/2002 1/12/ CASE STUDY: The Falling Dolla U.S. tade-weighted nominal exchange ate index, Mach 1973 = Fom 10/2005 to 6/2008, the dolla depeciated 17.3% 38 CASE STUDY: The Falling Dolla Two likely causes: Subpime motgage cisis Reduced confidence in U.S. motgage-backed secuities Inceased U.S. inteest ate cuts Fom 7/2006 to 4/2009, Fedeal Funds taget ate educed fom 5.25% to 0.25% to stimulate the sluggish U.S. economy. Inceased A MACROECONOMIC THEORY OF THE OPEN ECONOMY 39 10

11 CONCLUSION The U.S. economy is becoming inceasingly open: Tade in g&s is ising elative to GDP. Inceasingly, people hold intenational assets in thei potfolios and fims finance investment with foeign capital. A MACROECONOMIC THEORY OF THE OPEN ECONOMY 40 CONCLUSION Yet, we should be caeful not to blame ou poblems on the intenational economy. Ou tade deficit is not caused by othe counties unfai tade pactices, but by ou own low saving. Stagnant living standads ae not caused by impots, but by low poductivity gowth. When politicians and commentatos discuss intenational tade and finance, the lessons of this and the peceding chapte can help sepaate myth fom eality. A MACROECONOMIC THEORY OF THE OPEN ECONOMY 41 CHAPTER SUMMARY CHAPTER SUMMARY In an open economy, the eal inteest ate adjusts to balance the supply of loanable funds (saving) with the demand fo loanable funds (domestic investment and net capital outflow). In the maket fo foeign-cuency exchange, the eal exchange ate adjusts to balance the supply of dollas (net capital outflow) with the demand fo dollas (net expots). Net capital outflow is the vaiable that connects these makets. 42 A budget deficit educes national saving, dives up inteest ates, educes net capital outflow, educes the supply of dollas in the foeign exchange maket, appeciates the exchange ate, and educes net expots. A policy that esticts impots does not affect net capital outflow, so it cannot affect net expots o impove a county s tade deficit. Instead, it dives up the exchange ate and educes expots as well as impots

12 CHAPTER SUMMARY Political instability may cause capital flight, as nevous investos sell assets and pull thei capital out of the county. As a esult, inteest ates ise and the county s exchange ate falls. This occued in Mexico in 1994 and in othe counties moe ecently