Intermediate Macroeconomics, EC2201. L4: National income in the open economy
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1 Intermediate Macroeconomics, EC2201 L4: National income in the open economy Anna Seim Department of Economics, Stockholm University Spring / 50
2 Contents and literature The balance of payments. National income in the open economy. Determinants of the current account. Global imbalances. Literature: Jones (2014), Ch. 19. Klein (2016b). 2 / 50
3 Dimensions of openness Openness in goods markets. Choice between domestic and foreign goods. Openness in financial markets. Choice between domestic and foreign financial assets. Financial markets typically more open than goods markets. Openness in factor markets. Workers may choose where to work. Firms may choose where to locate plants. 3 / 50
4 Extracted from: Jones (2014). 4 / 50
5 Extracted from: Jones (2014). 5 / 50
6 Agenda 1. The relation between trade flows and financial flows. 2. The determinants of trade flows and financial flows. 6 / 50
7 Goods markets and financial markets closely connected to each other. All transactions with the rest of the world (ROW) are documented in a country s balance of payments. 7 / 50
8 The balance of payments (BoP) Detailed record of a country s transactions with ROW at a given point in time. Documents trade flows and financial flows. Comprises the current account and the capital account. Double-entry bookkeeping: all transactions enter twice, i.e. both as debits and credits. 8 / 50
9 Notation and abbreviations GDP t : gross domestic product. GNP t : gross national product. C t : private consumption. I t : investment. G t : government purchases. EX t : exports. IM t : imports. NX t : net exports (the trade balance). NIA t : net income from abroad. NTA t : net transfers from abroad. CA t : the current account. CAP t : the capital account. 9 / 50
10 GDP t : generated using factors of production employed on the territory of a given country. GNP t : generated using factors of production owned by domestic residents. GNP t = GDP t + NIA t + NTA t, where NTA t are net transfers from abroad (mainly foreign aid) and NIA t includes: Compensation for work abroad. Income from the ownership of foreign financial claims. Non-financial property income (patents copyrights). 10 / 50
11 The current account Documents all payments to and from ROW. CA t = EX t IM t + NIA t + NTA t = NX t + NIA t + NTA t. 11 / 50
12 The capital account Documents net sales of assets to foreign residents. Comprises: Foreign direct investment (FDI). Financial investment. Cash transactions. CA t + CAP t = / 50
13 GDP and GNP GDP t = C t + I t + G t + NX t. GNP t = C t + I t + G t + CA t. GNP t GDP t = CA t NX t = NIA t + NTA t. 13 / 50
14 A fictional balance of payments (Klein, 2016b) Debit Credit Imports of goods and services 120 Exports of goods and services 100 Net income from abroad 10 Net transfers from abroad 5 The capital account 5 14 / 50
15 A fictional balance of payments cont d. The trade balance: 20. The current account: 5. Note that the debit side and the credit side both sum to 120. Note that CA t + CAP t = / 50
16 The national income identity where Y t is GDP at time t. Y t = C t + I t + G t + EX t IM t }{{} NX t, (1) Adding and subtracting taxes, T t, from (1) and re-arranging: ) ) (Y t T t C t + (T t G t = I t + NX t, (2) } {{ } } {{ } S P S G where S P and S G denote private and government saving, respectively. 16 / 50
17 Aggregate saving in an open economy Letting S S P + S G we obtain S t = NX t + I t. (3) Re-arranging (3) we obtain: NX t = S t I t. (4) The international flow of goods, NX t, must be equal to the international flow of capital, S t I t. 17 / 50
18 Saving and investment in a closed economy Consider a closed economy where NX t = 0. This implies: S t = I t. In a closed economy, saving must equal investment. In an open economy, countries may run trade deficits by borrowing from abroad according to (4). 18 / 50
19 Extracted from: Jones (2014). 19 / 50
20 Extracted from: Jones (2014). 20 / 50
21 Extracted from: Jones (2014). 21 / 50
22 What determines the current account? Recall (3): S t = I t + NX t. Two types of saving: accumulation of real capital, I t, and accumulation of financial claims on the rest of the world resulting from NX t > 0. If S t > I t NX t > 0. If S t < I t NX t < / 50
23 What determines saving? Given a desire to smooth consumption, sensible to borrow from abroad today and pay back tomorrow if Productivity is expected to increase, so that you are likely to produce more in the future than today. You want to finance an investment that will improve production possibilities in the future. Public saving largely governed by the fiscal policy framework. More on this in the Swedish context below. 23 / 50
24 The Norwegian example Large oil and gas findings in the late 1960s. Substantial increase in oil production (exports) from the mid-1970s onwards. Norway went from a 12 percent current account deficit in 1977 to a 16 percent current account surplus in / 50
25 A model of the current account (Klein, 2016b) Consider a country that exists for two periods, t = 1,2. Production possibilities are described by y 1 0, y 2 0 and where y t is output in period t. y y 2 2 2, (5) The country can borrow and lend in international capital markets where the rate of return is r. Letting c t denote consumption, preferences are represented by u(c 1,c 2 ) = c 1 c 2. (6) 25 / 50
26 Letting s denote saving in period 1 it must be true that c 1 = y 1 s, (7) and c 2 = y 2 + (1 + r)s. (8) Combining (7) and (8) and re-arranging we obtain the intertemporal budget constraint: c 1 + c r = y 1 + y r. (9) 26 / 50
27 Extracted from: Klein (2016b). 27 / 50
28 Optimal consumption choice We note that along any indifference curve u(c 1,c 2 ) = c 1 c 2 = k, (10) where k is a constant. Differentiating (10) with respect to c 1 we obtain: c 2 + c 1 dc 2 dc 1 = 0. (11) Re-arranging, we find the slope of an indifference curve: dc 2 dc 1 = c 2 c 1. (12) 28 / 50
29 To find the slope of the budget line, differentiate (9) with respect to c 1 : dc 2 = 0. (13) (1 + r) dc 1 Re-arranging (13) we obtain: dc 2 dc 1 = (1 + r). (14) Combining (12) and (14), we find that optimal consumption satisfies: 1 c 2 c 1 = (1 + r). (15) 1 Note that we could also solve this problem of constrained optimisation by using the Lagrangian, see Klein (2016b). 29 / 50
30 Optimal production choice To find the optimal production choice, find the slope of the production possibility frontier (PPF). Differentiating (5) with respect to y 1 : 2y 1 + 2y 2 dy 2 dy 1 = 0. (16) Re-arranging (16) we find that the slope is given by: dy 2 dy 1 = y 1 y 2. (17) Combining (17) and (14) we find that optimal production satisfies: y 1 y 2 = (1 + r). (18) 30 / 50
31 The trade balance Equation (7) implies that the trade balance in period 1 is given by: CA = s = y 1 c 1. (19) 31 / 50
32 Example 1: r = 0 Equation (18) implies y 1 = y 2. Equation (5) implies 2y 2 1 = 2 so that y 1 = y 2 = 1. Equation (15) implies c 2 = c 1. Equation (9) suggests 2c 1 = 2 so that c 1 = c 2 = 1. Equation (19) suggests CA = y 1 c 1 = / 50
33 Example 2: r = 6 Equation (18) implies y 1 = 7y 2. Equation (5) implies (7y 2 ) 2 + y 2 2 = 2 50y 2 2 = 2. We obtain: y 2 = 1/5 and y 1 = 7/5. Equation (15) implies c 2 = 7c 1. Equation (9) suggests c 1 + 7c 1 7 = c 1 = We obtain: c 1 = 5/7 and c 2 = 5. Equation (19) suggests CA = y 1 c 1 = 24/ / 50
34 Conclusions A higher interest rate makes the country produce more, and consume less, in period 1. A higher interest rate thus results in a CA-surplus. 34 / 50
35 The real exchange rate The choice between domestic and foreign goods affected by their relative price: the real exchange rate. The real exchange rate, q, is defined: q = EP P (20) where E is the nominal exchange rate (in domestic currency per unit of foreign currency), P the domestic price level and P the foreign price level. 35 / 50
36 The current account and the real exchange rate A real depreciation, q > 0 makes domestic goods relatively cheaper. A real appreciation, q < 0 makes foreign goods relatively cheaper. Next: the effect of a real depreciation on the current account. 36 / 50
37 Notation CA: the current account in terms of domestic goods. EX : exports in terms of domestic goods. IM : imports in terms of foreign goods. Y : disposable domestic income. Y : disposable foreign income. q: the real exchange rate as defined above. 37 / 50
38 For simplicity, assume that CA = NX. Exports increasing in q and Y : EX = EX (q,y ), (21) where EX / q EX q > 0 and EX / Y > 0. Imports decreasing in q and increasing in Y : IM = IM (q,y ), (22) where IM / q IM q < 0 and IM / Y > / 50
39 The current account: CA(q,Y,Y ) = EX (q,y ) q IM (q,y ). (23) q IM (q,y ) measures imports in terms of domestic goods so that all terms in (23) are expressed in terms of the same numeraire. The volume effects of a depreciation, EX q > 0 and IM q < 0, improve the CA. The value effect of a depreciation, increasing the value of imports measured in domestic goods through the direct effect on q in (23), worsen the CA. 39 / 50
40 The Marshall-Lerner condition Wanted: a condition for when CA q > 0. Recall: This implies: d (f (x)g(x)) dx = f x (x)g(x) + g x (x)f (x). (q IM (q,y )) q = IM (q,y ) + q IM q(q,y ). 40 / 50
41 Differentiating (12) Pre-multiplying (24) by q/ex : CA q = EX q IM q IM q. (24) q CA EX q = q EX q EX q IM EX q2 IMq EX. Assume that CA = 0 initially so that EX = q IM. This implies: q CA EX q = q EX q EX q IM q IM q2 IMq q IM = q EX q EX 1 q IM q IM. 41 / 50
42 We conclude: CA q > 0 q EX q q IM q } EX {{} IM > 1, }{{} η η where the price elasticity of exports, η, and the price elasticity of imports, η, are defined so that they will be positive. The Marshall-Lerner condition: dca dq > 0 η + η > 1 42 / 50
43 The J-curve Extracted from: Krugman, P.R., Obstfeld. M. and Melitz, M.J., (2015), International Economics: Theory and Policy, Pearson Education Ltd. 43 / 50
44 Price elasticities of exports and imports Extracted from: Krugman, P.R., Obstfeld. M. and Melitz, M.J., (2015), International Economics: Theory and Policy, Pearson Education Ltd. 44 / 50
45 Global imbalances Over the last 15 years, some countries have been running large current account deficits (US, UK, Greece, Portugal, Spain) while others have been running large current account surpluses (China, Germany, Japan, the oil exporters). Saving glut in China, partly due to inadequate welfare and pension systems, creating incentives for private saving. Capital flows from China to the US. Concern: global economy sensitive to sudden disruptions to financial flows. Cause of the financial crisis of (?) 45 / 50
46 Global imbalances Extracted from: EEAG (2011), The EEAG Report on the European Economy 2011, CESifo, Munich. 46 / 50
47 Extracted from: Jones (2014). 47 / 50
48 Extracted from: Vredin, A., Flodén, M. Larsson, A. and Ravn, M.O. (2012), Simple Rules, Difficult Times, Economic Policy Group Report 2012, SNS Förlag. 48 / 50
49 The Swedish current account Large current account deficits prior to the crisis in the 1990s. Eliminated by large nominal (and real) depreciation when the fixed exchange rate was abandoned in Large current account surpluses from the mid 1990s onwards, largely due to fiscal consolidation. Note: more on exchange rates in Lecture 5. Details on the Swedish fiscal framework in Lecture / 50
50 What we did The balance of payments. National income in the open economy. Determinants of the current account. Global imbalances. Literature: Jones (2014), Ch. 19. Klein (2016b). 50 / 50
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