ECON 3010 Intermediate Macroeconomics Chapter 6

Transcription

1 ECON 3010 Intermediate Macroeconomics Chapter 6 The Open Economy

2 Imports and exports of selected countries, Exports Imports Percent of GDP Australia China Germany Greece S. Korea Mexico United States

3 In an open economy, spending need not equal output saving need not equal investment

4 Preliminaries d f C = C + C d f I = I + I d f G = G + G superscripts: d = spending on domestic goods f = spending on foreign goods 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

5 GDP = expenditure on domestically produced G & S d d d Y = C + I + G + EX f f f = ( C C ) + ( I I ) + ( G G ) + EX f f f = C + I + G + EX ( C + I + G ) = C + I + G + EX IM = C + I + G + NX

6 The national income identity in an open economy Y = C + I + G + NX or, NX = Y (C + I + G ) net exports domestic spending output

7 Trade surpluses and deficits NX = EX IM = Y (C + I + G ) trade surplus: output > spending & exports > imports trade deficit: spending > output & imports > exports

8 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

9 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 ).

10 Saving, investment, and the trade balance % investment 15% Saving, Investment (% of GDP) 20% 15% 10% 5% saving trade balance (right scale) 0% % 5% 0% -5% -10% Trade Balance (% of GDP)

11 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

12 Saving and investment in a small open economy An open-economy version of the loanable funds model from Chapter 3: production function consumption function Y = Y = F ( K, L) C= CY ( T ) investment function I = I ( r ) exogenous policy variables G = G, T = T

13 National saving: The supply of loanable funds r S = Y CY ( T) G As in Chapter 3, national saving does not depend on the interest rate S S, I

14 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

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

16 If the economy were closed the interest rate would adjust to equate investment and saving: r r c S I (r ) I ( r ) = S c S, I

17 But in a small open economy the exogenous world interest rate determines investment and the difference between saving and investment determines net capital outflow and net exports r* r r c I 1 NX S I (r ) S, I

18 Next, three experiments: 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand (exercise)

19 1. Fiscal policy at home r An increase in G or decrease in T reduces saving. * r1 NX 2 S 2 S 1 Results: NX 1 I = 0 NX = S < 0 I (r ) I 1 S, I

20 10% 8% 6% NX and the federal budget deficit (% of GDP), Budget deficit (left scale) 2% 0% 4% 2% -2% 0% -2% Net exports (right scale) -4% -4% %

21 2. Fiscal policy abroad Expansionary fiscal policy abroad raises the world interest rate. 1 r r * r 2 * NX 2 NX 1 S 1 Results: I < 0 I (r ) NX = I > 0 I ( r ) * 2 I ( r ) * 1 S, I

22 NOW YOU TRY 3. An increase in investment demand Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow. r * r I 1 NX 1 S I (r ) 1 S, I 21

23 ANSWERS 3. An increase in investment demand I > 0, S = 0, net capital outflow and NX fall by the amount I r * r NX 1 NX 2 S I (r ) 1 I (r ) 2 I 1 I 2 S, I 22

24 The nominal exchange rate e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency (e.g. yen per dollar)

25 The real exchange rate ε the lowercase Greek letter epsilon = real exchange rate, the relative price of domestic goods in terms of foreign goods (e.g., Japanese Big Macs per U.S. Big Mac)

26 Understanding the units of ε ε = = = = e P P * (Yen per $) ($ per unit U.S. goods) Yen per unit Japanese goods Yen per unit U.S. goods Yen per unit Japanese goods Units of Japanese goods per unit of U.S. goods

27 ~ McZample ~ one good: Big Mac price in Japan: P* = 200 Yen price in USA: P = $2.50 nominal exchange rate e = 120 Yen/$ ε e P = P * 120 $ = = Yen To buy a U.S. Big Mac, someone from Japan would have to pay an amount that could buy 1.5 Japanese Big Macs.

28 How NX depends on ε ε U.S. goods become more expensive relative to foreign goods EX, IM NX

29 U.S. net exports and the real exchange rate, % 2% Trade-weighted real exchange rate index NX (% of GDP) 0% -2% -4% Index (March 1973 = 100) -6% Net exports (left scale) 20-8%

30 The net exports function The net exports function reflects this inverse relationship between NX and ε : NX = NX(ε )

31 The NX curve for the U.S. ε When ε is relatively low, U.S. goods are relatively inexpensive ε 1 so U.S. net exports will be high NX(ε) 0 NX (ε NX 1 )

32 The NX curve for the U.S. ε ε 2 At high enough values of ε, U.S. goods become so expensive that we export less than we import NX(ε 2 ) NX(ε) 0 NX

33 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 *)

34 How ε is determined Neither S nor I depends on ε, so the net capital outflow curve is vertical. ε S 1 I ( r *) ε adjusts to equate NX with net capital outflow, S I. ε 1 NX 1 NX(ε ) NX

35 Interpretation: supply and demand in the foreign exchange market demand: Foreigners need dollars to buy U.S. net exports. ε S 1 I ( r *) supply: Net capital outflow (S I ) is the supply of dollars to be invested abroad. ε 1 NX 1 NX(ε ) NX

36 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

37 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 ε 2 ε 1 S 2 I ( r *) S 1 I ( r *) NX(ε ) NX 2 NX 1 NX

38 An increase in r* reduces investment, increasing net capital outflow and the supply of dollars in the foreign exchange market 2. Fiscal policy abroad ε ε 1 ε 2 S I ( r *) 1 1 S 1 I ( r 2* ) NX(ε ) causing the real exchange rate to fall and NX to rise. NX 1 NX 2 NX

39 NOW YOU TRY 3. Increase in investment demand Determine the impact of an increase in investment demand on net exports, net capital outflow, and the real exchange rate. ε ε 1 S I 1 1 NX 1 NX(ε ) NX 38

40 ANSWERS 3. Increase in investment demand An increase in investment reduces net capital outflow and the supply of dollars in the foreign exchange market ε ε 2 ε 1 S 1 I 2 S I 1 1 NX(ε ) causing the real exchange rate to rise and NX to fall. NX 2 NX 1 NX 39

41 4. Trade policy to restrict imports At any given value of ε, an import quota IM NX demand for dollars shifts right ε S I ε 2 ε 1 NX (ε ) 2 Trade policy doesn t affect S or I, so capital flows and the supply of dollars remain fixed. NX 1 NX (ε ) 1 NX

42 The determinants of the nominal exchange rate Start with the expression for the real exchange rate: e P ε = * P Solve for the nominal exchange rate: e = ε P P *

43 The determinants of the nominal exchange rate e = ε P P Rewrite this equation in growth rates * ε = + ε * e ε P P * = + π * e ε P P π For a given value of ε, the growth rate of e equals the difference between foreign and domestic inflation rates.

44 Inflation differentials and nominal exchange rates for a cross section of countries % change in nominal exchange rate 8% 6% 4% Mexico Iceland Pakistan 2% U.K. S. Africa 0% Sweden S. Korea -2% Japan Denmark Canada -4% Singapore Australia -6% Switzerland New Zealand -4% -2% 0% 2% 4% 6% 8% inflation differential