Lecture 1b. The open economy. The international flows of capital and goods, balance of payments and exchange rates.

Transcription

1 Lecture 1b. The open economy. The international flows of capital and goods, balance of payments and exchange rates. Carlos Llano (P) & Nuria Gallego (TA) References: these slides have been developed based on the ones provided by Beatriz de Blas and Julián Moral (UAM), as well as the official materials from Mankiw, 2009 and Blanchard, 2007 books. I am grateful for that. 1

2 Learning objectives A model for the small open economy model. What makes it small How the trade balance and exchange rate are determined How policies affect trade balance & exchange rate 2

3 Outline 1. The international flows of goods 2. The international flows of capital 3. Exchange rate determination: 1. Net balance 2. Purchase Power Parity 3

4 0. PRELIMINARIES 4

5 How NX depends on ε ε U.S. goods become more expensive relative to foreign goods EX, IM NX 5

6 Sterling s Real Exchange Rate and Trade Deficit of the UK: Real Effective Exchange Rate (avrg. 2000=100) depreciation appreciation Net Exports (% of GDP) 6

7 The net exports function The net exports function reflects this inverse relationship between NX and ε: NX = NX(ε) 7

8 The NX curve ε When ε is relatively low, home goods are relatively inexpensive ε 1 so net exports will be high NX(ε) 0 NX(ε NX 1 ) 8

9 The NX curve ε ε 2 At high enough values of ε, home goods become so expensive that we export less than we import NX(ε 2 ) NX(ε) 0 NX 9

10 Dynamic analysis: the J curve + Net Exports, NX 0 Depreciation of your local currency Time 0 A C _ B

11 U.S. Net Exports and the Real Exchange Rate: Real Effective Exchange Rate (avrg. 2000=100) depreciation appreciation Net Exports (% of GDP)

12 1. THE INTERNATIONAL FLOWS OF GOODS 12

13 1. The international flows of goods In an open economy (domestic) spending need not equal output (domestic) savings need not equal investment 13

14 Preliminaries d f C C C d f I I I superscripts: d = spending on domestic goods d f G G G 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 14

15 GDP = expenditure on domestically produced g & s d d d Y C I G EX ( C C f ) ( I I f ) ( G G f ) EX f f f C I G EX ( C I G ) C I G EX IM C I G NX 15

16 GDP identity in an open economy New GDP identity for open economy Y C I G NX Examples of why the new accounting entries are necessary to make the equality hold: An imported Toyota truck is counted in C but not in GDP; the negative entry in IM cancels out the positive entry under C Exported Ford truck is counted in GDP but not in C, I or G domestically; the positive entry in EX provides a way to account for it on the right hand side of the equation. 16

17 The national income identity in an open economy Y = C + I + G + NX or, NX = Y (C + I + G ) net exports domestic spending output 17

18 Trade surpluses and deficits NX = X IM = Y (C + I + G ) trade surplus: If output > spending; exports > imports. Size of the trade surplus = NX trade deficit: If spending > output; imports > exports Size of the trade deficit = NX 18

19 Trade surpluses and deficits Y = C + I + G IM/ε + X ; S = Y C T We subtract C + T from both sides of the equation: S = I + G T IM/ε + X Using the expression: NX X IM/ε NX = S + (T G) Trade = National balance Savings I Investments

20 U.S. net exports, U.S. Net Exports, % billions of dollars % -2% -4% -6% percent of GDP % NX ($ billions) NX (% of GDP) 20

21 2. THE INTERNATIONAL FLOWS OF CAPITAL 21

22 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 22

23 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 ). 23

24 Saving and Investment in a Small Open Economy An open economy version of the loanable funds model. Includes many of the same elements: production function: Y Y F ( K, L) consumption function: C C( Y +TR-T) T ) investment function: I I( r) exogenous policy variables: G G, T T 24

25 National Saving: The Supply of Loanable Funds r S Y C( Y +TR-T)-G T ) G National saving does not depend on the interest rate S S, I 25

26 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 26

27 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 27

28 If the economy were closed r S the interest rate would adjust to equate investment and saving: r c I (r ) I ( r c ) S S, I 28

29 But in a small open economy the exogenous world interest rate determines investment and the difference between saving and investment determines net capital outflows and net exports r r* r c I 1 NX S I (r ) S, I 29

30 Three thought experiments 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand 30

31 1. Fiscal policy at home r S 2 S 1 An increase in G,TR or decrease in T reduces saving. * r1 NX 2 NX 1 Results: I 0 I (r ) NX S 0 I 1 S, I 31

32 3 2 Net Exports (% of GDP) NX and Government Budgets in the U.S.: Government Budget Surplus (% of GDP)

33 NX and Government Budgets in the U.S.:

34 2. Fiscal policy abroad Expansionary fiscal policy abroad raises the world interest rate. 1 r r * r2 * NX 2 NX 1 S 1 Results: I 0 I (r ) NX I 0 I ( r ) * 2 I ( r ) * 1 S, I 34

35 3. An increase in investment demand r S * r EXERCISE: Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow. I 1 NX 1 I (r ) 1 S, I 35

36 3. An increase in investment demand ANSWERS: I > 0, S = 0, net capital outflows and net exports fall by the amount I r * r NX 2 NX 1 I 1 I 2 S I (r ) 1 I (r ) 2 S, I 36

37 3. EXCHANGE RATE DETERMINATION: 3.1. NET BALANCE 37

38 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*) 38

39 How ε is determined Neither S nor I depend on ε, so the net capital outflow curve is vertical. ε S1 I ( r *) ε adjusts to equate NX with net capital outflow, S I. ε 1 NX 1 NX(ε ) NX 39

40 Interpretation: Supply and demand in the foreign exchange market demand: NX Foreigners need your local currency in order to buy your products (exports). ε S1 I ( r *) supply: S I Net capital outflow (S I) is the supply of dollars (local currency) to be invested abroad. ε 1 NX 1 NX(ε ) NX 40

41 Next, four experiments: 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand 4. Trade policy to restrict imports 41

42 1. Fiscal policy at home A fiscal expansion reduces national saving, net capital outflow, and the supply of dollars (local currency in the U.S.) 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 *) S1 I ( r *) NX(ε ) NX 2 NX 1 NX 42

43 2. Fiscal policy abroad An increase in r* reduces investment, increasing net capital outflow and the supply of dollars in the foreign exchange market ε ε 1 ε 2 S I ( r *) 1 1 S 1 I ( r2* ) NX(ε ) causing the real exchange rate to fall and NX to rise. NX 1 NX 2 NX 43

44 3. Increase in investment demand An increase in investment reduces net capital outflow and the supply of dollars (local currency in U.S.) in the foreign exchange market ε ε 2 ε 1 S 1 I 2 S I 1 1 causing the real exchange rate to rise and NX to fall. NX 2 NX 1 NX(ε ) NX 44

45 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 45

46 4. Trade policy to restrict imports Results: ε > 0 (demand increase) NX = 0 (supply fixed) IM < 0 (policy) EX < 0 (rise in ε ) ε S I ε 2 ε 1 NX (ε ) 2 NX (ε ) 1 NX NX 1 46

47 The determinants of the nominal exchange rate Start with the expression for the real exchange rate: e P P * Solve for the nominal exchange rate: e P * P 47

48 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*) e P * P M P * * L ( r * *, Y ) * M Lr ( *, Y) P 48

49 The determinants of the nominal exchange rate Rewrite this equation in growth rates e e e P * P * P * P P * For a given value of, the growth rate of e equals the difference between foreign and domestic inflation rates. P 49

50 Inflation differentials and nominal exchange rates Percentage change in nominal exchange rate Germany South Africa Italy Sweden Australia New Zealand Spain Ireland Canada France UK Belgium Netherlands Switzerland Japan Inflation differential Depreciation relative to U.S. dollar Appreciation relative to U.S. dollar 50

51 3.2. PURCHASE POWER PARITY (PPP) 51

52 Purchasing Power Parity (PPP) PPP: e P = P* Cost of a basket of foreign goods, in foreign currency. Cost of a basket of domestic goods, in foreign currency. Solve for e : Cost of a basket of domestic goods, in domestic currency. e = P*/ P PPP implies that the nominal exchange rate between two countries equals the ratio of the countries price levels. 52

53 Purchasing Power Parity (PPP) If e = P*/P, then e P P P * * P P P 1 * and the NX curve is horizontal: ε = 1 ε S I NX Under PPP, changes in (S I ) have no impact on ε or e. NX 53

54 A fiscal expansion in three models A fiscal expansion causes national saving to fall. The effects of this depend on openness & size: closed economy large open economy small open economy r rises rises, but not as much as in closed economy no change I falls falls, but not as much as in closed economy no change NX no change falls, but not as much as in small open economy falls 54 January 2012